Archive | March, 2011

Are You Ready For a Venture?

As I discussed in Monday’s post, an American ETF provider launched the Global X S&P/TSX Venture 30 Canada ETF (NYSE Arca: TSXV) on March 17, the first index fund pegged to Canada’s junior stock exchange. iShares has announced that it will launch its own the S&P/TSX Venture Index Fund (XVX) in the coming months.

These new ETFs give Canadian index investors an opportunity to access a whole new market that was previously off-limits to anyone who wasn’t willing to trade individual stocks. But before you decide to add one of these funds to your portfolio, understand what you’re getting into.

A risky Venture

The Venture exchange is a play on commodities. If you think the broad Canadian market is poorly diversified, it has nothing on the Venture market. All 30 of the companies in TSXV are involved in either mining or energy (oil and gas). So don’t make the mistake of thinking that this fund gives you broad exposure to small companies in all sectors of the economy.

These are really small companies. It’s a stretch to call these companies small caps — all but the largest Venture-listed companies are micro caps (worth less than $300 million),

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A Bold New Venture

When most of us consider the Canadian equity market, we think of the companies listed on the Toronto Stock Exchange. Anyone can get exposure to this market with a plain vanilla index fund that tracks the S&P/TSX Composite Index. Although this benchmark includes only about 240 of the 1,500-odd stocks traded on the TSX, those companies represent about 95% of the Canadian market.

Fewer investors are familiar the TSX’s little brother, the TSX Venture Exchange, which is headquartered in Calgary. There are close to 2,400 companies traded on this exchange: the vast majority are involved in energy or mining, although there is a growing number of tech start-ups among the listings.

The standard benchmark for the junior exchange is the S&P/TSX Venture Composite Index, which you’ll often see flashing across the screen on BNN. This index includes about 450 stocks and is a good proxy for the Venture market, but it’s not investable. Many of the stocks are extremely small and illiquid, so any fund or ETF that tried to replicate the index would suffer from huge tracking error.

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Where Do Returns Come From?

You don’t need a lot of mathematical horsepower to be a Couch Potato investor. Indeed, simplicity is one of the strategy’s virtues: just keep your costs low, diversify widely, and stick to the plan. But if you’re a finance geek, it can be fun to delve into the more arcane theories behind index investing.

One of the most interesting chapters in Rick Ferri’s The Power of Passive Investing (Wiley, 2010) looks at how academics have learned where investment returns come from. Twenty years ago, if a money manager beat the market, it was pretty much impossible to explain why. Was the outperformance due to skill (or alpha)? Did the manager simply take more risk? Or did he just get lucky? Until recently, we didn’t have the tools to answer those questions.

Now we can get very close. The work of professors Eugene Fama and Kenneth French in the 1990s showed that a portfolio’s returns can be largely explained by three risk factors: its overall allocation to stocks (called the market factor, or beta), its exposure to small-cap stocks (the size factor), and its exposure to stocks with high book-to-market ratios (the value factor).

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The Making of a Couch Potato

I know very few people who began their investing lives as Couch Potatoes. Most started out in mutual funds or as stock pickers and, somewhere along the line, realized they were overpaying and underperforming.

These days, it’s easy to learn about the indexing alternative, but that wasn’t true even a decade ago. And when Rick Ferri began his career in the financial industry, it was heresy.

I recently had the pleasure of interviewing Ferri about his newest book, The Power of Passive Investing (Wiley, 2010), and I asked him about his own journey.

After earning a degree in finance, Ferri was an officer and fighter pilot in the US Marine Corps. He left active service in 1988 at 30 years old, earned his CFA designation, and started a new career in the financial industry. At that time, passive investing was almost unheard of, at least among retail investors. (Vanguard had been around since 1975, but by the late 1980s it still held only $30 billion in assets, compared with $1.4 trillion today.) Certainly Ferri knew nothing about indexing when he joined Kidder,

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Can Your Funds Outperform Over a Lifetime?

Advocates of active management admit that only a minority of mutual funds will outperform their benchmarks, but they argue there is still a significant probability of success. According to the data Rick Ferri provides in his new book, The Power of Passive Investing (Wiley, 2010), the odds of an actively managed fund beating an index fund are as high as 42% in any given year, and about 30% over five years. Surely by zeroing in on funds with good track records and low costs you can give yourself a decent chance of building an index-beating portfolio. Right?

Ferri takes this argument apart with simple math. The key point here is that almost no one builds a portfolio with a single mutual fund. It’s far more common to select several funds in various asset classes. But here’s the rub: to determine the odds that the entire portfolio will beat its benchmark, you need to combine the probabilities that each individual fund will outperform.

Here’s a simplified example. Since the probability of flipping heads is one in two, you’ll flip two heads in a row one time in four (2 × 2),

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Beating the Market Is a New Idea

Today we take it for granted that virtually all mutual funds and stock pickers are trying to earn higher returns than the overall market — or at least earn the same returns with lower risk. But Rick Ferri’s outstanding new book, The Power of Passive Investing (Wiley, 2010), reveals that beating the market hasn’t always been the goal of long-term investors.

When mutual funds first appeared in the 1920s, Ferri explains, there wasn’t even a generally accepted benchmark for the market as a whole: the Dow Jones Industrial Average had been around since 1896, but it contained just 12 companies (increased to 30 in 1928), was weighted by price, and has never been a good measure of the stock market as a whole.

The original goal of mutual funds, then, was to simply give small investors an opportunity to own a portfolio of stocks—something that was difficult and prohibitively expensive to do at that time. “Their mission,” Ferri writes, “was to select superior securities that paid reasonable dividends, to secure profits without undue speculation, and to conserve principal.”

Ben Graham: The first indexer?

Although Ferri doesn’t write about this specifically,

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A DRIP in the Bucket

One of the downsides of using ETFs—as opposed to index mutual funds—is that dividends and interest are not automatically reinvested. Instead, they are paid in cash, where they often sit idly in your brokerage account for months. This happens even more frequently now that many ETFs have started paying distributions monthly, rather than quarterly as in the past.

To address this issue, both Claymore and BMO offer dividend reinvestment plans (DRIPs) for their ETFs. For those who are unfamiliar with DRIPs, they allow investors to receive distributions—whether dividends from stocks, interest from bonds, or return of capital—in new shares rather than in cash. Only whole shares are possible: so if the ETF is trading at $20 and you’re eligible for $67 in dividends, you’ll receive three new shares plus $7 in cash.

If the amount of email I am receiving is any indication, these programs are extremely appealing to investors. Indeed, I have heard from people who are specifically choosing ETFs from Claymore and BMO rather than those from iShares because of the DRIP feature. (iShares does not currently offer such a program.) I believe this is an error in judgment.

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Does Rebalancing Boost Returns?

Rebalancing your portfolio has two potential benefits. The first is that it helps control risk by keeping your asset allocation more or less consistent. The other advantage—assuming you have the discipline to pull the trigger—is that it encourages you to sell high and buy low. In theory, that should lead to higher returns over the long run. But does it work in practice?

In a recent article for Canadian MoneySaver, I set out to learn how things would have worked out for investors who religiously rebalanced a traditional Couch Potato portfolio over the last 20 years. I would have preferred to use real performance data, but that was impossible, since no Canadian index funds or ETFs have a track record going back that far. So I ran the numbers using two decades of historical index data.

I assumed that two investors—let’s call them Norman and Reba—started on January 1, 1991, with $10,000 in a portfolio of 20% Canadian equities, 20% US equities, 20% international equities and 40% Canadian bonds. Norman never touched his portfolio for 20 years, while Reba rebalanced back to these target allocations annually on January 1.

Who came out ahead?

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How to Lower Your Rebalancing Costs

Last week I looked at why you should rebalance your portfolio, and considered the question of how often to do it. The frequency with which you rebalance often comes down to cost. If you’re using index mutual funds in a registered account, the cost may be zero. But if you’re paying ETF trading commissions or incurring capital gains taxes when you rebalance, then you should consider strategies to keep your costs as low as possible.

Here are three ideas for lowering your rebalancing costs. And at the bottom of this post, I’ve also included a rebalancing spreadsheet that you can download and adapt for your own portfolio.

Do it less often

I recently heard from an investor who put $10,000 in the Global Couch Potato four years ago, using iShares ETFs. He said he religiously rebalanced the portfolio once a year—at $29 per trade. That means trading commissions eroded about 1% of his portfolio’s value annually. Any advantage that rebalancing might have given this investor would likely have been wiped out by that excessive cost.

If you have a small ETF portfolio, keep rebalancing to a minimum,

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