Archive | February, 2013

Ask the Spud: The Role of Real Return Bonds

Why has the iShares DEX Real Return Bond (XRB) dropped so dramatically this year? I thought this asset class was protective in times of rising interest rates (which are correlated with inflation), but perhaps I misunderstood. I also see the yield to maturity is almost zero. Please set me straight about the role of real return bonds in a portfolio. – K.T.

Let’s begin with a refresher on real return bonds, or RRBs. They have a lower coupon than traditional bonds, but their principal gets adjusted every six months according to the current rate of inflation, as measured by the Consumer Price Index.

For example, let’s say an RRB has a face value of $1,000 and a coupon of 3% annually (1.5% semi-annually). This bond would initially pay you $15 in interest every six months. However, if inflation rises by 1% before the next interest payment is due, the RRB’s principal will be adjusted upwards to $1,010. Now the 1.5% semi-annual coupon applies to this larger amount, and your next interest payment would be $15.15.

The coupons on federal RRBs today range from 1.5% to 4.25%,

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Estimating Future Stock Returns

What are the long-term expected returns for stocks? That’s a fundamental question every investor needs to consider when deciding on an appropriate asset allocation. Unfortunately, it’s not a question anyone can answer with certainty—though there’s no shortage of gurus with opinions.

In a paper published last October, researchers at Vanguard examined 15 commonly used methods for forecasting stock returns to see how much predictive power they would have had in the past. These included price-to-earnings (P/E) ratios, dividend yield, earnings growth, economic fundamentals, and recent stock returns. And just for fun, they threw in a red herring: the trailing 10-year average rainfall in the US.

For each variable, the researchers set out to find whether it would have helped predict US stock returns during the 10 years that followed. Suppose, for example, you measured the trailing one-year dividend yield on stocks in 1950. How useful would that variable have been in explaining inflation-adjusted returns from 1951 through 1960? They repeated this for all the factors, in all rolling 10-year periods starting in 1926.

Turns out about half the variables were entirely useless: “Many popular signals have had a lower correlation with the future real return than rainfall,” the researchers wrote.

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Why Index Mutual Funds Still Have a Place

Responding to a recent article on mutual funds by Rob Carrick, a Globe and Mail reader rehashed a common refrain: “Perhaps mutual funds were once a great way for ‘average Canadians’ to invest, but they have been totally subverted by the greed and mediocrity of the financial institutions who dominate the field … Canadians are generally far better served by ETFs.”

The problem with remarks like this is they present the debate as “mutual funds versus ETFs,” and that’s the wrong way to think about it. The mutual fund industry in this country has enormous problems, to be sure: some of the highest fees in the world, deferred sales charges, and bad advice from salespeople with vested interests. These are all disgraceful practices, but they have little or nothing to with the mutual fund structure.

Index investors have broken free of the worst industry practices, but they still seem reluctant to embrace mutual funds. For example, when Scotia iTrade began offering Claymore (now iShares) ETFs without commissions, I heard from many folks who couldn’t wait to get on board.

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What’s On Your ETF Wish List?

It seems like ETFs are appearing in Canada every month, but it’s been a while since I got genuinely excited about a new product. It was great to see both Vanguard and BMO create S&P 500 funds with no currency hedging: they certainly filled a gap in the marketplace. A few other recent launches have been interesting (bond barbells, preferred share ladders, low volatility), if a bit esoteric. Some just induce yawning—do we really need another dividend ETF? It makes you wonder: if you could have one ETF wish, what would you ask for?

Turns out a Canadian ETF provider is granting wishes. First Asset has just announced a contest that invites advisors to submit ideas about what’s missing in the ETF marketplace. They’ll reward the best suggestion with $10,000, which will be donated to the advisor’s favourite charity. Two runners-up will also snag $5,000 for their chosen cause.

“Launching this competition seemed like a natural thing to do as part of our search to find what’s missing in the Canadian ETF landscape,” First Asset’s president and CEO,

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Under the Hood: Vanguard FTSE Canadian Capped REIT (VRE)

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: Vanguard FTSE Canadian Capped REIT (VRE)

The index: The fund tracks the FTSE Canada All Cap Real Estate Capped 25% Index, which includes large, mid and small-cap companies in the Canadian real estate industry as defined by FTSE. The index is weighted by market cap with a limit of 25% on any single company. It currently has 19 holdings.

The cost: The management fee is 0.35%. Because the fund is less than a year old it has not published its full MER, but expect it to be about 0.40% after adding taxes and incidentals.

The details: Vanguard launched VRE last November and continued its tradition of being a cost leader: its management fee is about 20 basis points lower than its competitors.

VRE is not limited to REITs: some of its holdings are developers and real estate services companies that are not set up as income trusts. But even with this expanded definition,

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Scary When They’re Down, Scary When They’re Up

It’s been barely a month since Alexander Green remarked that we’re currently enjoying “the most disrespected bull market in history.” Green described how investors who were shell-shocked by 2008 were still pulling money out of equities and taking shelter in fixed income and cash. And until very recently, the financial media were fanning the flames of pessimism: a Wall Street Journal reporter called 2012 “another very difficult year for investors” even though the MSCI World Index was up over 16%.

I’m ready to declare this trend is reversing. I have no hard data, but in the last couple of weeks I’ve noticed a dramatic shift in the tone of reader emails. For almost three years, the common refrain was “I’m nervous about getting into stocks because the markets have been terrible lately.” But since the New Year, that’s changed to, “I’m nervous about getting into stocks because the markets have been so good lately.”

In case you missed the irony, let me hit you over the head with it: instead of being afraid because stocks fell sharply in 2008, investors are now afraid because they’ve risen sharply since 2009.

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A Monte Carlo Case Study: Can I Retire Early?

Last week’s post about Monte Carlo simulations in financial planning sparked some interesting comments, so I thought a case study would help readers see how they work. Our real-life example comes from a past client of PWL Capital’s DIY Investor Service: the details were supplied by Justin Bender with the client’s permission.

Laura is 57 years old, single, and earning about $68,000 a year with expenses of $37,500. She socks away about $14,000 annually and has accumulated $330,000 in her RRSP and TFSA, as well as a rental property worth about $250,000. She has a defined benefit pension through her employer, though it is not indexed to inflation, and she’s eligible to receive full Canada Pension Plan and Old Age Security benefits in retirement.

Her investment portfolio was not very efficient: about a quarter of it was sitting in cash, and much of the rest was in narrow sector ETFs, individual stocks and corporate bonds. Some of the ETFs were in the wrong account types, resulting in unnecessary taxes.

Before Justin could rebuild her portfolio, however, he needed to make sure it was aligned with her financial goals. Laura’s primary objective was to determine whether she could retire before age 65—perhaps as early as 60—so she needed to know whether her investments would be able to generate enough cash flow after she quit work.

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