Archive | October, 2010

To Hedge or Not to Hedge

 

Last week I wrote about whether US-listed ETFs are really cheaper once you account for currency exchange fees, and then I looked at ways to reduce forex fees. The spreadsheet I created to compare US and Canadian ETFs allows investors to compare the costs using several assumptions.

One of those assumptions was to ignore currency hedging. Unfortunately, the reality is that the decision about whether or not to use hedging is likely to be the single most important factor affecting the return of your foreign investments. If the Canadian dollar moves up or down 15% over the period you’re invested, that will clearly have far more impact than a lower MER or a currency exchange fee. Too bad all we can do when it comes to currency fluctuations is guess.

Most Canadian ETFs with foreign holdings — notably XSP, XIN, CLU and CWO — use currency hedging. Not all of them do, however: unhedged international ETFs include the Claymore International Fundamental (CIE) and the iShares MSCI Emerging Markets Index Fund (XEM).

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The MoneySense Guide to Retiring Wealthy

A few weeks ago, I had the privilege of working on the MoneySense Guide to Retiring Wealthy, which has just been published. The guide is now available at retailers such as Chapters, Indigo, Shopper’s Drug Mart, Walmart and Loblaws, or online for $9.95 plus $3 shipping.

This 132-page book — co-edited by MoneySense editor Duncan Hood, long-time contributor David Aston, and me — collects the best retirement and financial planning articles from the pages of MoneySense and organizes them by decade of life. We start with young investors in their 20s, who are just learning to form good financial habits, and we go all the way to managing retirement in your 70s. Everything has been fully updated to include the latest statistics and most current information about government programs and regulations.

As Duncan Hood explains in the introduction:

Unlike dull retirement books stuffed with dense calculations, or chatty volumes bubbling with lightweight tips, MoneySense’s complete retirement guide has just what you’re looking for: proven retirement advice delivered in a straightforward manner—all of it backed up by the editors of Canada’s most-read personal finance magazine.

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Reducing the Cost of Currency Exchange

Yesterday’s post looked at whether US-listed ETFs are really a good deal for RRSP investors. Although ETFs from Vanguard and other American providers have dramatically lower annual fees, Canadians may face hefty currency exchange fees when trading them.

Most discount brokerages in Canada do not allow you to hold US dollars in a registered account, which means that using US-listed ETFs can involve paying a currency exchange fee when you buy, again when you sell, and every time you receive a dividend.

I’ve created a spreadsheet that helps investors compare the cost of Canadian and US-listed ETFs. With the headwind caused by a 1.5% currency exchange cost (in line with what many brokerages charge), it turns out it would take many years for US-listed funds to pay off: in my test run, a Canadian investing $5,000 annually in an RRSP would need more than 11 years to see the benefit.

If you plan to use US-listed ETFs in your Couch Potato portfolio, consider these strategies to dramatically lower your costs:

Use a brokerage that allows you to hold US dollars inside an RRSP. The only three online brokerages that do this are Questrade,

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Are US-listed ETFs Really Cheaper?

Last week reader W.B. asked why I recommend US-listed ETFs from Vanguard for the US and international equity components. His brokerage charges a 1.5% currency conversion fee, and W.B. argued that this hefty cost would outweigh the savings he’d get buy using US-listed funds with lower annual MERs.

I knew that the US-listed ETFs would be the better deal over the long run, but I couldn’t be specific about the break-even point, because I had never actually done the math. The calculations aren’t straightforward: in addition to the currency fees and MERs, you also have to consider the different ways each ETF is taxed.

Well, now I have done the math. I created an Excel spreadsheet that readers are welcome to download. I had to make several assumptions, but I have designed the spreadsheet to be flexible: you can easily change the amount invested, the currency conversion fee, the projected returns, and the MER of the funds you’re comparing. (Just be careful not to bugger up the formulas!)

Here’s the thought process that went into building the spreadsheet:

I have included two worksheets: the first assumes a single lump-sum contribution of $100,000 CAD,

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Introducing the Cheapskate’s Portfolio

We all know that Canadians pay much higher investing costs than our neighbours to the south, and the gap is widening. Just last week, TD Ameritrade became the fourth online brokerage in the US to offer its clients ETF trades for free. Meanwhile, the big-bank brokerages here at home continue to charge $29 per trade, lowering that to $9.95 only for accounts over $100,000.

But even if we can’t trade ETFs for free, Canadians can certainly build a well diversified portfolio at extremely low cost. In my most recent article for Canadian MoneySaver, published earlier this month, I set out to learn just how much of skinflint I could be.

My starting point was The World’s Cheapest ETF Model Portfolio, created by Matt Hougan of Index Universe. Hougan tracked down the US-listed ETFs with the lowest management fees in six asset classes and assembled a portfolio with a total cost of 0.125%. That’s $12.50 for every $10,000 invested.

Canadians can’t invest that cheaply if we want to include domestic stocks and bonds in our portfolios, but we can get surprisingly close.

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Parking Cash in Your Portfolio

Many RRSP investors like to keep at least a small part of their portfolio in cash. They may want to save their ETF distributions for several months before reinvesting them, or they may want to “keep some powder dry” as they wait for opportunities to buy into an asset class that looks underpriced. Either way, it helps to have a safe place where you can stash some cash and earn a wee bit of interest.

GICs and money market funds have long been the usual places to park cash in a registered account. The problem is that GICs are are not liquid: they’re not cashable without forfeiting the interest, and you can’t add to them each month. Money market funds are more flexible, but these days their yields can be neatly rounded off to 0% after fees. Fortunately, there are alternatives, though many investors don’t even know they exist.

An alternative to money market funds

Several Canadian financial institutions offer high-interest invest savings accounts that can be held inside a registered account at a discount brokerage. These products have a FundServ code, which means they can be bought and sold just like mutual funds. These little-known products combine the best features of GICs and money market funds.

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Index Funds from PC Financial? No, Thanks

President’s Choice Financial has long been a favourite of frugal Canadians looking for no-fee banking. But until a reader pointed it out to me recently (hat tip to Greg S), I wasn’t aware that the online bank also offers low-cost index funds through its partnership with CIBC. True to its nature as a discount bank, PC Financial even offers investors a rebate of 10 basis points off the funds’ annual management fees.

Here’s how it works: banking customers can open an RRSP or non-registered account and invest in any of CIBC’s family of index funds. CIBC has the second-largest selection of index funds of any bank, behind only TD. Investors have a lot of choice here, including some index funds that are unique in Canada: the CIBC US Broad Market Index Fund — which tracks the Wilshire 5000 rather than the S&P 500, like most of its competitors — the CIBC Emerging Markets Index Fund, and the CIBC Canadian Short-Term Bond Index Fund. This means you can build a very well diversified index portfolio with asset classes that would otherwise be available only through ETFs.

Another attractive feature of the program is the Index Portfolio Rebalancing Service,

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High-Yield Bonds and Your Portfolio: Part 2

In Monday’s post, I discussed the growing popularity of high-yield bonds: four Canadian ETFs covering this asset class have appeared in the last 12 months. I explained how investment gurus Larry Swedroe and David Swensen both advise investors to avoid high-yield bonds and instead stick to safer fixed-income investments such as government bonds.

Not all portfolio managers agree with that assessment, however. Today we’ll look at two well-known index investors who believe that high-yield corporate bonds can play role in a diversified portfolio.

Richard Ferri’s All About Asset Allocation, now in its second edition, is one of my favourite books on this important subject. Ferri argues that high-yield bonds aren’t as highly correlated with equities as others believe. “Some market researchers suggest that default risk is nothing more than a type of equity risk,” Ferri writes, “and therefore adding high-yield corporate bonds to a portfolio is the equivalent of adding more equity. That argument is not entirely correct.”

Ferri explains that since the early 1980s, there have been periods where the default risk of high-yield bonds was highly correlated with equities, but also periods where the correlation was zero,

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High-Yield Bonds and Your Portfolio: Part 1

With income trusts facing new rules in 2011, investors are looking for other income-producing securities to fill the gap. Many are looking for a one-two punch of dividend-paying stocks and high-yield bonds.

Four new ETFs holding high-yield bonds have appeared in the past 12 months: the BMO High Yield US Corporate Bond ETF (ZHY) was first on the scene, launching last October. In January, the Claymore Advantaged High-Yield Bond ETF (CHB) and iShares U.S. High Yield Bond Index Fund (XHY) appeared within weeks of each other. More recently, on September 22, BlackRock added the iShares DEX HYBrid Bond Index Fund (XHB), the first ETF to invest in high-yield bonds issued by Canadian companies.

The growing appeal of high-yield bonds shouldn’t be surprising in an era when five-year Government of Canada bonds are paying just 2.5%. Investors are hungry for yield, and they appear to be willing to take more risk to get it. But are these bonds a good addition to a portfolio, or do their big payouts come with too much volatility?

What are high-yield bonds?

Before considering that question, let’s clarify what high-yield bonds are.

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