Archive | December, 2010

Finding Your Personal Rate of Return

One of my favourite tales of investment stupidity is the story of the Beardstown Ladies. This group of grannies from a tiny Illinois town became famous in the 1990s when their investment club reported annualized returns of more than 23% for a decade. These Buffetts in bonnets wrote five books about their stock-picking acumen, which sold hundreds of thousands of copies, and they toured the US, celebrated as folksy, common-sense geniuses. Then someone checked their numbers.

It turned out that when the ladies calculated their returns, they included new money they had added during the year. Their actual investment returns over the decade were 9.1% annually, compared with almost 15% for the S&P 500. If you happen to find a Beardstown Ladies guide in a used bookstore one day, grab it: they’re collectors’ items now.

As the year-end approaches, you’ll likely want to know how well your own portfolio has done during the last 12 months. If you didn’t add or withdraw any money during the year, calculating your return is easy. Let’s say your portfolio’s value was $50,000 last December 31, and at the end of this year it has grown to $60,000.

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Couch Potato on Ice

This week both Canadian Capitalist and I were dismissive about the Dynamic Funds that swept this year’s Canadian Investment Awards. We argued that it’s easy to celebrate past performance, but impossible to identify managers whose success will continue in the future. One commenter on CC’s blog, a financial advisor, disagreed and suggested that choosing a manager who will outperform is no different from identifying a skilled hockey player.

This comparison just doesn’t hold up. If a hockey player scores twice as many points as the average player for several years in a row, it is highly likely his superior performance will continue, because skill determines virtually 100% of a player’s results. Sidney Crosby can be fully expected to outscore the average NHL player for a very long time.

Investing is nothing like playing in the NHL. The bulk of an investor’s return comes from simply accepting market risk, which requires no skill whatsoever. Anyone who buys an index fund can instantly obtain near-market returns, and indeed, he or she will beat most professional managers after costs. I accept that it’s possible to identify skilled managers, but the best they can hope for is returns that are incrementally better.

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Why Dynamic’s Success Proves Nothing

In last weekend’s Financial Post, Jonathan Chevreau wrote an admiring piece about Dynamic Funds, one of the oldest fund families in Canada. The article profiled seven funds with 10-year track records of outperformance that “leave index-hugging rivals behind.”

“Many financial columnists, including yours truly, have imbibed the Kool-Aid of passive indexing and exchange-traded funds (ETFs),” Chevreau writes. “Many popular books refute the idea actively managed mutual funds can beat the indexes and recoup their fees.” He then goes on to say he was “shocked” that these seven funds managed to do just that, even though two of them have MERs over 4%.

First of all, acknowledging the power of index investing is not “imbibing the Kool-Aid,” which implies blind acceptance of an unproven claim. The futility of active management as a whole is not an opinion, it’s simple math. As this classic paper by Nobel laureate William Sharpe explained 20 years ago, “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

They key phrase here is “average actively managed dollar.” No sensible person would ever “refute the idea actively managed mutual funds can beat the indexes,” as Chevreau argues.

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How to Avoid Paying Other People’s Taxes

Before you go shopping for the Couch Potatoes on your holiday wish list, be aware that December can be a terrible time to buy ETFs.

No, it’s not because of all the last-minute shoppers pushing and shoving at the discount brokerage. The reason is that any capital gains that the funds have incurred over the last 12 months are distributed at the end of the year. Although they’re called “distributions,” capital gains are not handed out in cash like dividends or interest. You don’t receive any new shares, and the market price of the ETF won’t change. All you get is a T3 slip showing the amount of the gain, which you’ll need to report on your tax return.

Their gain, your pain

In general, ETFs are extremely tax-efficient, especially if they track broad, cap-weighted indexes. Funds incur capital gains when they sell securities at a profit, and passively managed funds don’t do a lot of selling. (The ETF structure may allow fund managers to avoid taxable gains even when they do sell stocks.) However, a fund may have no choice but to realize capital gains when its benchmark index is changed,

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Potatoes Helping Potatoes

It’s now been almost a year since I launched Canadian Couch Potato. When I first mentioned that I was writing a blog about index investing, many people were surprised that such a thing was needed. “What is there to say?” they would ask. “You build a portfolio of index funds or ETFs and rebalance it once a year. How many times can you write that?”

More than a hundred blog posts later, I know that being a Couch Potato isn’t always that simple. I’ve heard from many readers who have struggled with this investing strategy. Some rushed into indexing expecting instant results, while others understood the strategy but had problems implementing it.

I’m currently working on a feature for MoneySense magazine that’s aimed at preparing new index investors for what they should expect when they take a seat on the couch. I’ll debunk some of the myths surrounding the strategy, and help inexperienced investors avoid common mistakes. And I’d like to ask for your help. I want to include stories from current index investors who are willing to share some of their early mistakes and misunderstandings, and to offer words of wisdom and encouragement.

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Tax-Loss Selling with Index Funds: Part 2

In my previous post, I looked at the Canada Revenue Agency’s position on tax-loss selling with ETFs. According to the only CRA bulletin on the subject, if you sell an index fund or ETF and claim a capital loss, you must wait 30 days before repurchasing another fund that tracks the same index, even if the funds are from two different financial institutions. Otherwise, the sale will be considered a superficial loss, and you won’t be able to use it to reduce your taxable capital gains.

There are many reasons why this might be called unfair: two funds that track the same benchmark may have different fees and slightly different holdings, and they certainly can’t be expected to perform exactly the same. But whether we like it or not, the CRA considers them identical property, and investors who ignore that interpretation risk having their capital loss claim denied.

If you’re a Couch Potato who’s looking to harvest some losses in a non-registered account, your goal is to stay within the CRA’s rules while also keeping your market exposure as consistent as possible.

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Tax-Loss Selling with Index Funds: Part 1

Now that we’re into December, many investors are turning their thoughts to skiing, holiday celebrations — and year-end taxes. If you’re investing in an RRSP, Tax-Free Savings Account, Registered Education Savings Plan (RESP), or other tax-sheltered account, you can ignore what follows. But if you’re a Couch Potato with a taxable account, you may be able to reduce the Canada Revenue Agency’s share of your investment returns with a strategy called tax-loss selling.

First, a primer on how capital gains are taxed. Any time you sell a security (a stock, bond or fund) at a profit in a taxable account, you trigger a capital gain. When you file your return, you need to report half of your capital gains as income, and you’ll pay tax on that amount. For example, suppose you put $10,000 into an ETF that is now valued at $17,000. Selling it would incur a $7,000 capital gain, and you’d have to report $3,500 in income on your return. If your marginal rate is 30%, that will cost you $1,225 in taxes.

The good news is that you can use capital losses to offset your gains. Let’s say in addition to your $7,000 capital gain you also sold a different ETF that had declined by $5,000.

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