The Portfolio Doctor

By David Cruise and Alison Griffiths
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Into the mailbag we leap with a host of interesting queries.

Q: A question popped into my mind when reviewing my portfolio on Morningstar www.morningstar.ca. Does the graph of performance versus index factor in the management expense ratio (MER) for the fund? Gordon V.

A: Good for you attending to such detail. Yes, indeed, when you look at the performance of your funds charted against the performance of the benchmark index the MER has been factored in. In fact, all performance figures for all mutual funds should be reported as net of the MER.

Q: In the past, you made a wonderful case for (investing in) iG5 and iG10 bonds. I can find XBB but not iG5 or iG10 on the TSX. Where am I supposed to look for them? Doug C.

A: As usual, the financial services industry doesn't like to make things easy for us. Just when you get the hang of an investment, a change is made. The old iG5's and iG10's were exchange traded funds (ETF), which held a single government of Canada bond each, the five-year and ten-year respectively.

You now have a choice of six exchange traded bond funds. For more information on these ETFs go to www.ishares.ca, click on Products then selected Fixed Income.

Q: My wife & I set up an Easy Chair Portfolio using your book almost one year ago. At that time, there was no government iG5 bond ETF so we put it into XSB (short term bond ETF.) However, now there appears to be a government bond ETF, namely XGB. We are thinking to transfer from XSB to XGB. It appears that the XGB might be better. M.A

A: The main issue here is duration. The Easy Chair portfolio referred to, by the way, is a passive portfolio with just four investments which we have been following, on and off, since 1997.

XSB is a short term bond fund, while the new XGB is an all-government, longer term fund, a little under 11 years is the average duration. It holds only government bonds while the XSB tracks the Scotia Capital Short Term Bond Index with an average duration of 3 years. There is very little difference right now in the yield between the two, 4.03 per cent for the XSB and 4.06 for the XGB, but diversifying protects you if interest rates rise or fall since you will have money in short and longer term durations.

On the other hand, if you are making regular purchases you are better off with a single ETF bond holding as any advantage will be wiped out by trading fees each time you buy.

Q: My daughter who turns 19 this year will have earned about $4200 in 2006. She would like to start saving for her retirement, hard to believe but true! Is it worth it for her to open an RRSP? Would she be better off saving or investing the money outside an RRSP? She is going to attend a three year college program to become a vet technician and will live at home. We have enough saved for her tuition. Marion D.

A: We sure wish we had started saving for retirement at 19! It sounds like your daughter has all her ducks lined up in terms of paying for college. The debate about investing inside or outside RRSPs will rage unabated for as long as RRSPs exist and contributions continue to be tax deductible.

Non-registered accounts are more flexible than registered accounts. You can deposit or withdraw at will and the only constraint is the tax on interest income or dividends which must be paid on whatever the investments earn or on the gain realized when an investment is sold.

Additionally, if your daughter ends up in a high income bracket or has the good fortune to be in a career with a splendid pension plan, she might find herself paying back a very high percentage of her eventual RRSP withdrawals in tax.

However, an RRSP is valuable even if you don't need the tax deduction, which your daughter won't in the short term. They are more flexible than they used to be. Withdrawals can be made for house down payments and for further education. (For more information: www.cra-arc.gc.ca. Click on the RRSP tab.)

We also like them because the withholding tax on withdrawals acts as a caution. Lots of people cash in their RRSPs if they need them and pay the tax. Encourage your daughter to think of her RRSP as a one way heart valve; money can flow in but the valve shuts behind the deposit and unless you pry it open, the funds sit until the gentle years of retirement arrive.

The trick, especially for young adults, is not to contribute more than they can comfortably live without. If all savings are devoted to an RRSP, when an emergency crops up, as one always does, there is no pool to draw on.

Young people tend to buy cars and go on vacations. If she wants to buy a car, for example, she would be far better off saving up to purchase it outright than devoting the money to an RRSP. She could get lucky and hit a bull market, in which case her RRSP investments will more than compensate for the interest she has paid on a car loan. But we feel that one should have a more defensive strategy by always trying to save up at least a portion of the cost of major purchases, rather then take out loans or put them on credit cards.

Here's a good rule of thumb which will give her the best of both worlds. Split whatever amount is devoted to savings into two piles -- one for emergencies, upcoming purchases and so on and one for a don't-touch-it RRSP. How much in each pile depends on her goals and what purchases she intends to make in the short term.

And don't forget, RRSP deductions can be carried forward to be used in years when her income is higher. On your 2006 return, for instance, you can deduct contributions made between January 1, 1991 and March 1, 2007, provided you haven't used them for any other year and they are less than your RRSP deduction limit for 2006.