Master Element 6 of the RSE exam covering portfolio construction. Learn asset allocation strategies, risk metrics (Standard Deviation, Beta, Sharpe Ratio), and taxation of RRSP, TFSA, RESP, and RRIF accounts.
RSE Exam Element 6: Portfolio Construction (~11%, 13 Questions)
This section combines math concepts (risk metrics) with rules (account types and tax). Understand the difference between Standard Deviation (Total Risk) and Beta (Market Risk).
Asset Allocation - The Most Important Decision
Asset allocation is the most important determinant of portfolio performance (more important than security selection).
Strategic vs. Tactical Allocation
- Strategic: Long-term "Policy Mix" based on KYC (e.g., 60% Equity / 40% Bond)
- Tactical: Short-term deviations to capitalize on market opportunities
Risk Metrics
Correlation
Measures how two assets move together. Scale: -1.0 to +1.0
- +1.0 (Perfect Positive): Move exactly together - Zero diversification benefit
- 0 (Uncorrelated): No relationship - Good diversification
- -1.0 (Perfect Negative): Move opposite - Maximum diversification (Hedging)
Goal: Combine assets with low or negative correlation to lower portfolio risk without lowering return.
Standard Deviation
Measures Total Risk (Systematic + Unsystematic)
- Measures volatility (variability) of returns around the average
- Higher SD = Higher Risk = Wider range of outcomes
Beta
Measures Systematic (Market) Risk relative to a benchmark
- Beta = 1.0: Moves with the market
- Beta > 1.0: More volatile than market (Aggressive)
- Beta < 1.0: Less volatile than market (Defensive)
Alpha
Measures the manager's value-add (skill)
Calculation: Actual Return - Expected Return (based on Beta)
Positive Alpha = manager beat the risk-adjusted benchmark
Sharpe Ratio
Measures risk-adjusted return: "How much return for every unit of total risk?"
Formula: (Portfolio Return - Risk Free Rate) ÷ Standard Deviation
Higher is Better
Types of Risk
- Systematic Risk (Market Risk): Affects everyone (Inflation, Interest Rates, War) - Cannot be diversified away
- Unsystematic Risk (Specific Risk): Specific to one company/sector (CEO quits, lawsuit) - Can be diversified away
Management Strategies
Rebalancing
Purpose: Return portfolio to original Strategic Asset Allocation
Forces you to "Sell High, Buy Low"
- Calendar Method: Rebalance every year on Dec 31
- Threshold Method: Rebalance if asset class drifts by +/- 5%
Active vs. Passive Management
| Approach | Belief | Goal | Cost |
|---|---|---|---|
| Active | Markets are inefficient | Beat the index (Alpha) | Higher MER |
| Passive | Markets are efficient | Match the index | Low cost |
Core-Satellite Approach
- Core (70-80%): Low-cost Passive ETFs (Beta)
- Satellite (20-30%): Active funds or specific stocks (Alpha)
Registered Accounts
Asset Location (Tax Efficiency)
- Registered (RRSP/TFSA): Hold highly taxed assets (Interest/Bonds) to shelter them
- Non-Registered (Cash): Hold tax-efficient assets (Cdn Stocks for Dividend Tax Credit, Growth Stocks for Cap Gains)
RRSP (Registered Retirement Savings Plan)
- In: Tax Deductible (Reduces taxable income)
- Growth: Tax-Deferred (No tax while inside)
- Out: 100% Taxable as Income
- Limit: 18% of previous year's earned income minus Pension Adjustment (PA)
TFSA (Tax-Free Savings Account)
- In: Not Deductible (After-tax dollars)
- Growth: Tax-Free
- Out: 100% Tax-Free
- Flexibility: Withdrawals create new contribution room following year
RESP (Registered Education Savings Plan)
- CESG (Grant): Government matches 20% of first $2,500/year (Max $500/year)
- Lifetime Grant Max: $7,200 per child
- Withdrawal: Contributions tax-free; Grants/Growth (EAP) taxed in student's hands
RRIF (Registered Retirement Income Fund)
- RRSP must convert to RRIF by end of year client turns 71
- Minimum Withdrawal: Mandatory annual withdrawal starting year after opening
- No Maximum withdrawal
FHSA (First Home Savings Account)
The Hybrid: Contributions are Tax Deductible (like RRSP), Withdrawals are Tax-Free if used for qualifying home (like TFSA)
Limit: $8,000/year, $40,000 lifetime
Taxation of Investments
- Capital Gains: 50% Inclusion Rate - most tax-efficient
- Canadian Dividends: Gross-up and Credit = very low effective tax rate
- Interest Income: 100% Taxable at marginal rate - least tax-efficient
RSE Exam Tips for Portfolio Construction
- Standard Deviation = Total Risk; Beta = Market Risk
- Sharpe Ratio: Higher is better (return per unit of risk)
- RRSP: Tax-deductible in, taxable out
- TFSA: Not deductible in, tax-free out
- RESP: 20% CESG up to $500/year, $7,200 lifetime per child
- RRSP converts to RRIF by age 71