Comments on: Put Your Assets in Their Place http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/?utm_source=rss&utm_medium=rss&utm_campaign=put-your-assets-in-their-place Your guide to the investment strategy that will help you earn more and sleep better. Thu, 17 May 2012 00:11:49 +0000 hourly 1 http://wordpress.org/?v=3.3.2 By: Nathan http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-41451 Nathan Sun, 25 Mar 2012 03:03:08 +0000 http://canadiancouchpotato.com/?p=663#comment-41451 After doing a bunch more research I've answered my own questions with the help of Fama and French. :) Basically small and value are different risk factors from market/equity risk. Since they are not perfectly correlated, they aren't simply additive. That's why it might make sense to add some risk and expected return with a small or value tilt, while still having some fixed income. In fact, one can theoretically increase return while holding volatility constant or reduce volatility while holding expected return constant (or some combination) by increasing exposure to small and value stocks while decreasing the total percentage of the portfolio in equities. Seems like you could think about over-weighting Canada in the same way. For Canadian taxable investors, Canadian dividend paying stocks (or the Canadian market in aggregate) effectively carry a premium. They also carry increased risk due to lack of diversification, compared to a worldwide market-cap weighted portfolio. The premium is a fair bit smaller than the value premium, and somewhat smaller than the size, historically, but it's also a whole lot more guaranteed going forward, and the risk should be lower. I suppose you could plug a bunch of assumptions into an efficient frontier calculator to get an ideal over-weighting of Canadian stocks, but my guess is you'd probably end up with something like the 25-40%ish range usually recommended! After doing a bunch more research I’ve answered my own questions with the help of Fama and French. :) Basically small and value are different risk factors from market/equity risk. Since they are not perfectly correlated, they aren’t simply additive. That’s why it might make sense to add some risk and expected return with a small or value tilt, while still having some fixed income. In fact, one can theoretically increase return while holding volatility constant or reduce volatility while holding expected return constant (or some combination) by increasing exposure to small and value stocks while decreasing the total percentage of the portfolio in equities.

Seems like you could think about over-weighting Canada in the same way. For Canadian taxable investors, Canadian dividend paying stocks (or the Canadian market in aggregate) effectively carry a premium. They also carry increased risk due to lack of diversification, compared to a worldwide market-cap weighted portfolio. The premium is a fair bit smaller than the value premium, and somewhat smaller than the size, historically, but it’s also a whole lot more guaranteed going forward, and the risk should be lower. I suppose you could plug a bunch of assumptions into an efficient frontier calculator to get an ideal over-weighting of Canadian stocks, but my guess is you’d probably end up with something like the 25-40%ish range usually recommended!

]]> By: Fred http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-41038 Fred Mon, 19 Mar 2012 01:02:02 +0000 http://canadiancouchpotato.com/?p=663#comment-41038 ACMZ, No matter how you look at it you will be doing some form of market timing unless you just buy the bond portion as needed right now. That being said, personally I would invest say 1/4 today in bonds, 3/4 in high interest savings account (at least you'll get some return while you wait). Then dollar cost average the next portions say 1/4 each month. That'll cost you about 0.1% in commissions based on $10 comm. fees. If that comm % bothers you then do 1/3 or 1/2 now and then equal portions later on. Just my thoughts. ACMZ,
No matter how you look at it you will be doing some form of market timing unless you just buy the bond portion as needed right now. That being said, personally I would invest say 1/4 today in bonds, 3/4 in high interest savings account (at least you’ll get some return while you wait). Then dollar cost average the next portions say 1/4 each month. That’ll cost you about 0.1% in commissions based on $10 comm. fees.

If that comm % bothers you then do 1/3 or 1/2 now and then equal portions later on.

Just my thoughts.

]]> By: ACMZ http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-40889 ACMZ Fri, 16 Mar 2012 02:24:20 +0000 http://canadiancouchpotato.com/?p=663#comment-40889 Hi Dan, Wondering if you have come across an approach to portfolio building that would addrress the following scenario? Assuming one was in the process of building a portfolio and it was heavily weighted in equities at this time. If it needed 40k of bonds ETF to balance the portfolio and the funds were available, would it be wise to commit all of it to bonds at this time? If equities are low and bonds are high because of the economic times, would it not be wise to buy the underperformer (ie. equities) and rebalance at a later date? This has a strong smells of market timing and speculation. Maybe an alternative would be to buy bonds at a slow rate in order to consider dollar cost averaging, but then this alternative would have to consider the lose on the returns from the bonds not purchased. Are you aware of this situationor something similar having been discussed somewhere? This is very interesting. Hi Dan,
Wondering if you have come across an approach to portfolio building that would addrress the following scenario? Assuming one was in the process of building a portfolio and it was heavily weighted in equities at this time. If it needed 40k of bonds ETF to balance the portfolio and the funds were available, would it be wise to commit all of it to bonds at this time? If equities are low and bonds are high because of the economic times, would it not be wise to buy the underperformer (ie. equities) and rebalance at a later date? This has a strong smells of market timing and speculation. Maybe an alternative would be to buy bonds at a slow rate in order to consider dollar cost averaging, but then this alternative would have to consider the lose on the returns from the bonds not purchased. Are you aware of this situationor something similar having been discussed somewhere? This is very interesting.

]]> By: Canadian Couch Potato http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-40597 Canadian Couch Potato Sun, 11 Mar 2012 14:04:04 +0000 http://canadiancouchpotato.com/?p=663#comment-40597 @ACMZ: I'm no tax expert, but your strategy seems sound to me. You're right to shelter the least tax-efficient asset classes first (in this case, the bonds). Have a US-denominated cash account will allow you to trade the US-listed ETFs more cheaply, assuming you have US dollars to begin with, or you're prepared to use Norbert's gambit to convert them. This post might be interesting to you: http://canadiancouchpotato.com/2012/02/27/a-new-way-to-sidestep-currency-conversion-costs/ @ACMZ: I’m no tax expert, but your strategy seems sound to me. You’re right to shelter the least tax-efficient asset classes first (in this case, the bonds). Have a US-denominated cash account will allow you to trade the US-listed ETFs more cheaply, assuming you have US dollars to begin with, or you’re prepared to use Norbert’s gambit to convert them. This post might be interesting to you:
http://canadiancouchpotato.com/2012/02/27/a-new-way-to-sidestep-currency-conversion-costs/

]]> By: ACMZ http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-40504 ACMZ Sat, 10 Mar 2012 04:09:33 +0000 http://canadiancouchpotato.com/?p=663#comment-40504 @CPP Hi Dan, this site really rocks. I understand your hesitance to give specific financial advice and respect that, so let's consider this hypothetical situation. If one was to structure a Uber-Tuber scenario with over 500k, and consider the recommended priority of ETF's placed in registered accounts. Assuming one was to start with XSB, then XIG to max out TFSA's and RRSP accounts, would placing the US ETF's (PDN, PXF, PRF, VWO, VXF) in an US account be the only remaining tax efficient move? As one would get more room in the registered accounts, he or she would move some over (in a US registered account). Is there something wrong with this approach and in general would there be a better strategy taxe wise? Assume that none of these funds are needed for at least 10 years. If one was moving from mutual funds managed by others to taking charge with DIY ETF's, this could be a lot of fun. Thanks for sharing your knowledge and enthusiasm of personnel finance, you are helping lots. @CPP
Hi Dan, this site really rocks. I understand your hesitance to give specific financial advice and respect that, so let’s consider this hypothetical situation. If one was to structure a Uber-Tuber scenario with over 500k, and consider the recommended priority of ETF’s placed in registered accounts. Assuming one was to start with XSB, then XIG to max out TFSA’s and RRSP accounts, would placing the US ETF’s (PDN, PXF, PRF, VWO, VXF) in an US account be the only remaining tax efficient move? As one would get more room in the registered accounts, he or she would move some over (in a US registered account). Is there something wrong with this approach and in general would there be a better strategy taxe wise? Assume that none of these funds are needed for at least 10 years.
If one was moving from mutual funds managed by others to taking charge with DIY ETF’s, this could be a lot of fun.
Thanks for sharing your knowledge and enthusiasm of personnel finance, you are helping lots.

]]> By: Nathan http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-38455 Nathan Fri, 03 Feb 2012 23:22:13 +0000 http://canadiancouchpotato.com/?p=663#comment-38455 Gah, another mistake in my first comment - greater Canadian allocation reduces currency exchange risk; it doesn't increase it. (That's what I get for adding points while skimming through before posting!) Gah, another mistake in my first comment – greater Canadian allocation reduces currency exchange risk; it doesn’t increase it. (That’s what I get for adding points while skimming through before posting!)

]]> By: Nathan http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-38454 Nathan Fri, 03 Feb 2012 22:57:06 +0000 http://canadiancouchpotato.com/?p=663#comment-38454 Actually, that last point about small caps doesn't make sense. The gains there would be capital gains, so at least as good as Canadian dividends assuming a high tax bracket. So theoretically more focus on small caps would do better than more focus in Canada, as far as exchanging diversification for expected return. Actually, that last point about small caps doesn’t make sense. The gains there would be capital gains, so at least as good as Canadian dividends assuming a high tax bracket. So theoretically more focus on small caps would do better than more focus in Canada, as far as exchanging diversification for expected return.

]]> By: Nathan http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-38453 Nathan Fri, 03 Feb 2012 22:44:13 +0000 http://canadiancouchpotato.com/?p=663#comment-38453 @CCP: Great, thanks. Actually, I've been thinking about these sorts of asset allocation issues a bunch lately and am curious what your thoughts are. As I am self-employed and paid in dividends rather than salary, the majority of my investments are in non-registered accounts. I've been struggling with the general question of expected returns vs. diversification on a couple of fronts. First, it is generally accepted and understandable that Canadian equities should be expected to outperform foreign equities on an after-tax basis due to the dividend tax credit. Therefore, it makes sense to have *some* over-weighting of Canadian equities. By doing so, you are adding geographical and sector concentration aka reducing diversification, so can expect higher volatility. Currency exchange risk also adds to that volatility even though it shouldn't affect very long term expectation. In many cases, currency exchange costs would also have to be factored in, although in my personal situation they are not significant given the nature of my business. So for me, the question boils down to how much added volatility I am willing to accept in return for the added expected return of the Canadian dividends. (A tricky question to answer without being able to exactly quantify the volatility involved!) Thinking about this though, I realized it basically mirrors the general equity/fixed income split issue. I currently have a 75/25 equity/income split, where the fixed income is split between preferreds and short term bonds (again trading off between safety/diversification and expected after-tax return). But if I'm contemplating over-weighting Canada in order to increase my expected return at the cost of higher volatility, what am I doing holding fixed income at all? Couldn't I just as easily move to 100% equity, essentially making the same tradeoff, except with a larger boost in expected return? Put another way, in a non-registered account, does it make any sense to start over-weighting Canada at all, while still holding fixed income investments? Even if the fixed income is preferred shares, you could expect to gain more on average by switching that into diversified equities than by over-weighting your equities in Canada. (On the other hand, perhaps the increase in volatility is greater with this change as well.. I don't even know how to begin to quantify that.) Finally, on the far end of the spectrum is the approach of over-weighting small caps. As above, small caps have theoretically higher expected returns but greater volatility. I don't have exact numbers here, but I expect that the increase in volatility is greater, and the expected increase in return is lesser, than either of the options above. So then if this line of thinking makes sense, even if all you care about is expected return, it isn't logical to start adding focus on small-cap stocks until you already have a 100% equity, largely Canadian portfolio. (And likely not even then, since then you would be sacrificing Canadian dividends to do so.) What do you think? Again, all this only applies to non-registered accounts, and basically consists of my musings and assumptions. I haven't thought about this over a long period of time or done any definitive research. And I'm certainly not suggesting just going 100% Canadian equities in registered accounts; just that if a person wants to trade added volatility for added expectation, the various methods for doing so (more equities vs fixed income, more Canadian equities, more small-cap) should be prioritized based on which method increases expectation the most and volatility the least. Hopefully someone can definitively tell me which that is! :) @CCP: Great, thanks.
Actually, I’ve been thinking about these sorts of asset allocation issues a bunch lately and am curious what your thoughts are.

As I am self-employed and paid in dividends rather than salary, the majority of my investments are in non-registered accounts. I’ve been struggling with the general question of expected returns vs. diversification on a couple of fronts. First, it is generally accepted and understandable that Canadian equities should be expected to outperform foreign equities on an after-tax basis due to the dividend tax credit. Therefore, it makes sense to have *some* over-weighting of Canadian equities. By doing so, you are adding geographical and sector concentration aka reducing diversification, so can expect higher volatility. Currency exchange risk also adds to that volatility even though it shouldn’t affect very long term expectation. In many cases, currency exchange costs would also have to be factored in, although in my personal situation they are not significant given the nature of my business. So for me, the question boils down to how much added volatility I am willing to accept in return for the added expected return of the Canadian dividends. (A tricky question to answer without being able to exactly quantify the volatility involved!)

Thinking about this though, I realized it basically mirrors the general equity/fixed income split issue. I currently have a 75/25 equity/income split, where the fixed income is split between preferreds and short term bonds (again trading off between safety/diversification and expected after-tax return). But if I’m contemplating over-weighting Canada in order to increase my expected return at the cost of higher volatility, what am I doing holding fixed income at all? Couldn’t I just as easily move to 100% equity, essentially making the same tradeoff, except with a larger boost in expected return?

Put another way, in a non-registered account, does it make any sense to start over-weighting Canada at all, while still holding fixed income investments? Even if the fixed income is preferred shares, you could expect to gain more on average by switching that into diversified equities than by over-weighting your equities in Canada. (On the other hand, perhaps the increase in volatility is greater with this change as well.. I don’t even know how to begin to quantify that.)

Finally, on the far end of the spectrum is the approach of over-weighting small caps. As above, small caps have theoretically higher expected returns but greater volatility. I don’t have exact numbers here, but I expect that the increase in volatility is greater, and the expected increase in return is lesser, than either of the options above. So then if this line of thinking makes sense, even if all you care about is expected return, it isn’t logical to start adding focus on small-cap stocks until you already have a 100% equity, largely Canadian portfolio. (And likely not even then, since then you would be sacrificing Canadian dividends to do so.)

What do you think? Again, all this only applies to non-registered accounts, and basically consists of my musings and assumptions. I haven’t thought about this over a long period of time or done any definitive research. And I’m certainly not suggesting just going 100% Canadian equities in registered accounts; just that if a person wants to trade added volatility for added expectation, the various methods for doing so (more equities vs fixed income, more Canadian equities, more small-cap) should be prioritized based on which method increases expectation the most and volatility the least. Hopefully someone can definitively tell me which that is! :)

]]> By: Canadian Couch Potato http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-38452 Canadian Couch Potato Fri, 03 Feb 2012 21:49:15 +0000 http://canadiancouchpotato.com/?p=663#comment-38452 @Nathan: You're correct about this. There is a link in the post to the CRA's page about the foreign tax credit. @Nathan: You’re correct about this. There is a link in the post to the CRA’s page about the foreign tax credit.

]]> By: Nathan http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/comment-page-1/#comment-38451 Nathan Fri, 03 Feb 2012 21:38:30 +0000 http://canadiancouchpotato.com/?p=663#comment-38451 Just a quick note on the withholding tax on foreign dividends. My understanding is, if these dividends are earned in a non-registered account, you can claim the withholding tax paid on your Canadian tax return as a 'foreign tax credit'. So effectively it is removed from your Canadian taxes owing, without the need to actually 'recover' the money paid from the IRS or other foreign tax agencies. (I'm no accountant though, so you may want to confirm that.) Of course, the foreign dividends would still be taxed as income, and would therefore not be as efficient as Canadian dividends in a non-registered account, even without the effect of withholding taxes. Just a quick note on the withholding tax on foreign dividends. My understanding is, if these dividends are earned in a non-registered account, you can claim the withholding tax paid on your Canadian tax return as a ‘foreign tax credit’. So effectively it is removed from your Canadian taxes owing, without the need to actually ‘recover’ the money paid from the IRS or other foreign tax agencies. (I’m no accountant though, so you may want to confirm that.) Of course, the foreign dividends would still be taxed as income, and would therefore not be as efficient as Canadian dividends in a non-registered account, even without the effect of withholding taxes.

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