Archive | January, 2012

Market Forecasts Prove Worthless—Again

I’m confused by a lot of things in investing, but the enduring influence of market forecasts is the one that stumps me the most. Year after year, expert predictions, estimates, forecasts and projections prove to be profoundly wrong. And yet next year we seek them out again. It’s like repeatedly pounding your thumb with a hammer and expecting that at some point it will stop hurting.

One of the reasons we still listen to forecasts is that the media love to celebrate the few that turn out to be right. Those that are wrong—which are the vast majority—are rarely held accountable.

With that in mind, I thought it would be interesting to look at the 2011 Fearless Forecast, the latest edition of a report published for 20 years by Mercer. The Fearless Forecast compiles the  consensus opinions of Canadian and global investment managers regarding the capital markets and the economy. The 2011 edition included input from 56 investment management firms, including some of the most prestigious asset managers in the world.

The last shall be first, and the first shall be last

The managers were asked to identify which asset classes they believed would be among the top and bottom performers in 2011.

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Tax-Efficient Investing With ETFs

If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks,

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Dividends: Not As Tax-Friendly As You May Think

If your investments include RRSPs, TFSAs and taxable accounts, asset location is an important consideration. The returns of various asset classes—such as bonds, Canadian stocks, and foreign stocks—are treated differently under tax law. So by selecting the most tax-advantaged assets for your non-registered accounts, you should be able to keep more of the returns for yourself.

As most investors know, eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. In fact, for Canadians who make less than $40,000 or so, the tax rate on dividends is actually negative, which means you can use them to lower the amount of tax you pay on other income. That’s why the conventional wisdom is that Canadian dividend-paying stocks are the most tax-efficient asset class.

That is true in many cases, but the dividend tax advantage is often overstated. For taxable investors who have above-average incomes, it may not make sense to focus on dividends at all.

Dividends v. capital gains

Recall that stock returns come in two flavours: dividends and price appreciation, or capital gains. While dividend investors unleash the hounds whenever I make this argument,

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Are ETFs Growing for the Wrong Reasons?

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.”

What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in Canada now manage about $43.1 billion in assets. By comparison, Canadians have $778.5 billion invested in mutual funds—about 18 times more.

That’s a big gap, but it’s been closing for a few years now. According to a recent report, ETFs in this country saw more than $7.6 billion in new sales in 2011, increasing their total assets by nearly 13%. Compare that with another report from the Investment Funds Institute of Canada. Canadian mutual funds, it says, now manage $8.8 billion less than they did at the beginning of 2011. Of course, part of that decline is a result of negative equity returns and not investor withdrawals. But the stats do make it clear that the mutual fund industry is moving in the opposite direction of ETFs:

Balanced mutual funds saw inflows of $27.7 billion in 2011—a hefty sum,

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Why We Love the One We’re With

Larry Swedroe’s new book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, includes 77 common behavioural blunders. I don’t think there’s anyone alive who hasn’t made at least a dozen of them. In fact, I know two investors who recently fell prey to Mistake 11—and one of them was me.

Mistake 11 in Swedroe’s catalogue goes like this: “Do You Let the Price Paid Affect Your Decision to Continue to Hold an Asset?” This error is what behavioural economists call the endowment effect. It’s what makes us place a greater value on something just because we happen to own it.

Imagine that you want to attend a hockey game. You don’t yet have a ticket, and you decide that you’re willing to pay no more than $100 for one. The next day, you win a ticket to the game in a radio contest. If a friend offers to buy that ticket from you, for what price would you be willing to sell?

If you were purely rational, you would accept any price over $100, since that’s the maximum value you placed on the ticket before you had one.

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BlackRock and Claymore Make Good Partners

Announcements in the ETF world are mostly tedious these days—usually they involve the launch of another exotic and increasingly narrow new product. That’s why yesterday’s announcement that BlackRock is buying Claymore Investments was a shocker. I’m not the only one who didn’t see that coming.

BlackRock, of course, is the parent company of iShares, the largest ETF provider in Canada, with about $29 billion in assets—about 75% of the market. Claymore’s family of ETFs and closed-end funds currently have about $7 billion under management. Together, the two families will be a powerhouse in the ETF space in this country.

It’s way too early to tell what this will mean for Canadian investors, but overall I expect it will be a positive development. I’ve always liked Claymore’s entrepreneurial spirit and its desire to innovate. For example, the company was the first to create preauthorized contribution plans that allow investors to add money to their holdings each month without incurring trading commissions. Their recent partnership with Scotia iTrade—which makes all Claymore ETFs available with no brokerage commissions—was also a game changer that prompted Qtrade to follow suit.

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Couch Potato Portfolio 2011 Returns

The 2011 performance results are now in for my model Couch Potato portfolios. Many thanks to Justin Bender at PWL Capital in Toronto for providing these data. Complete performance results are available here, and an updated PDF is posted monthly on my Model Portfolios page.

It was a challenging year: the MSCI World Index, which measures the equity markets in all developed countries, was down 3.2% in 2011, and emerging markets plummeted over 16%. But broad diversification once again proved its mettle in 2011, as a multi-asset-class portfolio did much better:

The Global Couch Potato (ETF version)
0.54%

The Complete Couch Potato
2.36%

The Yield-Hungry Couch Potato
5.11%

The Cheapskate’s Couch Potato
-2.24%

The Über-Tuber
-2.07%

Breaking it down

While equities were down overall, there was a lot of variation. Europe, Japan and emerging markets got clobbered, and Canada was down about 9%. However, US stocks finished in the black for the year. Currency diversification helped too, as the loonie declined against the US dollar, Japanese yen, and British pound.

iShares S&P/TSX Capped Composite
XIC
-8.93%

Vanguard Total Stock Market
VTI
3.22%

Vanguard MSCI EAFE
VEA
-10.69%

Vanguard MSCI Emerging Markets
VWO
-16.93%

Real estate went a long way toward offsetting the negative returns in the overall Canadian equity market:

BMO Equal Weight REITs
ZRE
13.85%

iShares S&P/TSX Capped REIT
XRE
20.95%

Fixed income once again defied all expectations and delivered outstanding returns,

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Does the Couch Potato Work After Age 50?

Readers often ask me whether the Couch Potato strategy is suitable for investors  approaching retirement, or even those who have stopped working. In his recent book, Retirement’s Harsh New Realities, Gordon Pape addresses the same question—and I strongly disagree with his advice.

Pape acknowledges that the Couch Potato strategy is simple and low-cost, but “the real questions are how safe the investment is and how much you will end up earning on your money by adopting a passive strategy,” he writes. “I think the couch potato approach fails on both counts, for two reasons: time horizon and human nature.”

Fatal flaws?

“Passive investing requires taking a long-term view, ten years or more,” Pape argues, but “many people, especially those over fifty, aren’t comfortable with the idea of waiting many years for a decent return. They need to see profits sooner.”

Second, he argues, it’s not realistic to expect people to adhere to a passive strategy because markets are too volatile. He offers the massive losses of 2008 as an example: “How many couch potato investors would have had the fortitude to stick with the plan through that debacle?”

Pape goes on to explain how he set up a model Couch Potato portfolio in January 2008 and tracked it to the end of April 2011.

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