A Risk Free Rate for Retail Investors

The risk free rate is one of the key inputs to measuring your portfolio performance. It is a fundamental element of two key measures, those being the CAPM (Capital Asset Pricing Model), and the Sharpe Ratio. The CAPM is a basic measurement which is central to many aspects of present day portfolio theory, and states that the expected return on a portfolio (or equity) is equal to the risk free rate, plus some variance against the excess return of the market over the risk free rate:

\bar{r_e} = r_f + \beta_e(\bar{r_m} - r_f)

Where \bar{r_e} is the expected return on our equity (or portfolio), r_f is the risk free rate, \bar{r_m} is the return of the market, and \beta_e is the beta of our equity (or portfolio). A deep dive of CAPM is beyond the scope of this blog post, but for more information you can check out Investopedia.

Another measure is the Sharpe Ratio:

s_e = \frac{\bar{r_e} - r_f}{\sigma_e}

Where s_e is the Sharpe Ratio of the equity (or portfolio), \bar{r_e} is the expected return of the equity (or portfolio), \sigma_e is the standard deviation of the equity (or portfolio) returns, and r_f is the risk free rate of return, as with our CAPM above.

Both the CAPM and the Sharpe Ratio are great indicators of how well you, as an investor, are performing. Of the variables above, the expected return and standard deviation of returns on your own portfolio (\bar{r_e} and \sigma_e respectively) are easy enough to calculate, since you should have the historical returns of your portfolio already. The expected return on the market in the CAPM is easy enough to proxy—you can easily use the expected return of an ETF such as the iShares XIC—but the risk free rate takes a little more effort.

Conventionally, theory dictates that we use a truly risk-free asset such as a treasury bill yield (Canadian T-Bills or US T-Bills for North America), since one would hope that treasury bills issued by Canadian or American governments are relatively safe. However, as a retail investor, this presents some challenges:

  • T-bills are not necessarily readily available to us in the conventional sense. It is pretty difficult for us to go out to our investment brokerage and ask to buy a t-bill. The reasons for this are varied, but for the most part it boils down to availability, and minimum purchase required. E.g. the minimum t-bill purchase may be $5,000 or $100,000!
  • T-bills, by definition, mature in less than one year. To position this in practical terms for the retail investor, we would have to buy a new t-bill every year for the duration of our investment, which means we would have to build a yield-curve based on the expected future prices of those future t-bills. This simply isn’t practical for our needs.

Ignoring the theoretical risk-free instrument, there are a number of practical options which are available to retail investors, including real bonds, bond funds, GICs, and high interest savings accounts.

Real Bonds

Real bonds are just as they sound: bonds that you would purchase from your brokerage, backed by governments or companies. Theoretically, since real bonds are backed for corporations or smaller governments (e.g. municipal governments, provincial governments), there is still a degree of risk involved in the backing body defaulting on the bond. The inherent default risk aside, the key reasons I do not consider real bonds a suitable substitute are:

  • Availability. Depending on your brokerage, there may or may not be sufficient inventory to fill your needs.
  • Minimum purchase. Depending on the bond, the minimum purchase could range anywhere from $1,000 to $10,000.

Bond Funds

Bond funds would include ETFs such as iShares’ XBB or Vanguard’s VAB, which hold bonds as their underlying securities, usually in the proportion of some known bond index. ETFs such as these would fall in the fixed income category, which I wrote of previously. However, the key reason I would not consider a bond ETF as a risk-free investment, is that with a bond ETF you are still exposed to loss of capital, and the actual distributions are not necessarily fixed. For loss of capital, a quick look at the 10 year share price of XBB should suffice:

XBB 10 Year Price History as of October 10, 2016

XBB 10 Year Price History as of October 10, 2016

Inspecting the 10 year history, depending on when you had invested, you may have lost your initial investment. This is evidence of a bond ETF not being truly risk-free, even though it is composed of “risk-free” assets.

High Interest Savings Accounts

Just as they are named, high interest savings accounts (“HISA” for short) are savings accounts you can open at your local financial institution, which offer higher than average interest rates. Typically, a HISA is a very safe option. Being offered by major financial institutions, your deposit should be insured by the CDIC up to $100,000. Moreover, because it is a regular savings account, you have virtually instant access to the capital when you need it.

The biggest risk with a HISA is that the “high interest” may not be guaranteed. Here is a snippit of historical interest rates for Tangerine Bank:

Effective Date New Rate
July 24, 2015 0.80%
February 3, 2015 1.05%
March 6, 2014 1.30%
March 29, 2012 1.35%
August 5, 2010 1.50%
June 30, 2010 1.30%
December 15, 2009 1.20%
September 9, 2009 1.05%

Since 2009, Tangerine (formerly ING Direct) has changed their rate 8 times! Hardly risk-free!

Guaranteed Investment Certificates

I consider a Guaranteed Investment Certificate (“GIC” for short) the closest approximation to a truly risk-free asset.

  • You can select the term you wish to invest for, and the interest rate will be locked in for this term. Terms may range from 30 days to 6 years at most institutions.
  • The rate is guaranteed, with some exceptions as listed in the terms and conditions of the GIC (e.g. there may be an early redemption penalty).
  • Your investment is most likely insured, up to $100,000, by the CDIC, provided the institution is a member of the CDIC.
  • Depending on the GIC you chose, you can select one with an early redemption clause, giving you access to your capital if you need it in an emergency.

Selecting the Appropriate Vehicle

There are undoubtedly other options available to retail investors for risk-free investments. I know that some brokerages offer money market funds and other term-deposit vehicles. Moreover one could argue that, given the paltry returns available on some of the options above, you may be better off putting your money in a REIT or other high yield “low risk” vehicle. However, investing in conventional equities often entails risks, illustrated by the use of a bond fund: ironically, the fund is made up of riskless investments, yet the capital itself is subject to depreciating market values depending on overall market conditions (e.g. change in interest rates). This risk exposure is counter to the entire notion of selecting a risk-free rate: a risk-free rate is meant to minimize risk, not maximize returns.

Moreover, you have to select the best vehicle to use as the risk-free rate. If you are deciding on an investment with a one year time horizon, the 5-year GIC may not make the best sense to use for the risk-free rate. For example, as of October 10, 2016, the best 5-year GIC rate on rate hub is 2.50%, and the best 1-year GIC rate is 2.00%. Lets crunch some numbers:

  • You have an opportunity for a 1-year investment with a guaranteed return of 4.00%; you invest $1,000 today and receive $1,040 exactly 1 year from now.
  • The 5-year GIC rate is 2.50%.
  • The 1-year GIC rate is 2.00%.

Using the 5-year GIC rate as your risk-free rate, the investment has an NPV of $14.63; meaning you would make $14.63 with the investment, vs. investing in the 5-year GIC. Using the 1-year GIC rate as your risk-free rate, the investment has an NPV of $19.61. All things being equal you may pass up on the investment if you use the 5-year GIC rate as your risk-free rate, even though your absolute return would be better when compared with the 1-year GIC rate.  Realistically, you would select the 1-year GIC rate as your risk-free rate, since the duration of the GIC matches the duration of the investment opportunity.

When I look to purchase an investment, I typically look at the 5 or 10 year horizon. For that reason, I typically use the 5-year GIC rate or 10-year bond rate of a bond currently available at my brokerage as the risk-free rate. By doing this, I have a full understanding of the opportunity cost of my investment decision: I can either invest in the 5-year GIC or 10-year bond, or in the investment at hand.

In summary:

  • HISAs and GICs present two of the more effective vehicles available to retail investors for approximating a risk-free rate of return, when determining the performance of your portfolio.
  • You should pick the risk-free rate that best suits the time duration of your calculations.

Onward and upwards!