Archive | April, 2013

The Power of Simple Portfolios

Carl Richards, author of The Behavior Gap, wrote an insightful article in February called Why We Fear Simple Money Solutions. “People say they want things to be simpler—investing, life insurance, retirement planning, etc.,” he observed. “But when a simpler (and effective) option is proposed, they reject it as too simple.”

I recently came face to face with this idea when working with a client of PWL Capital’s DIY Investor Service. Barbara had a portfolio of dozens of stocks and ETFs that followed no rhyme or reason. She admitted she enjoyed making trades and was inclined to buy simply buy stocks she had read about in the media. There were some blue-chip dividend payers, a couple of precious metal ETFs, plus a few random penny stocks thrown in for good measure. In other words, the portfolio was a complicated mess.

To Barbara’s credit, she realized this sort of seat-of-the-pants strategy wasn’t working: with about half a million in her RRSP and retirement approaching quickly, she knew she needed a more disciplined plan. That’s why she came to us.

After we reviewed Barbara’s spending patterns, pension income and other factors,

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When You Can Ignore Tracking Error

In Monday’s post, I reviewed the major factors that contribute to an index fund’s tracking error. Here are some other things to consider when you’re comparing your fund’s performance to that of its benchmark. These can cause tracking errors to seem unusually large or small, but they need to be understood in context.

Changes to the index. A number of ETFs changed their benchmark index during 2012, including some core equity funds from BMO and Vanguard. When there is an index change in the middle of the year, measuring tracking error becomes difficult and the numbers can be misleading. Until late September, the BMO S&P 500 Hedged to CAD (ZUE) held just 100 large-cap stocks selected using a different methodology. ZUE ended up lagging the S&P 500 by less than its management fee, which is normally an excellent result, but in this case it was a fluke.

A small number of ETFs in Canada are not tied to any third-party benchmark. The BMO Canadian Dividend (ZDV), for example, includes 30 stocks selected using an in-house methodology. In cases like this,

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What Causes an ETF’s Tracking Error?

Last week I explained the importance of monitoring an ETF’s tracking error, which is the difference between a fund’s actual performance and the returns of its index.

The most significant reason index funds lag their benchmarks is the impact of management fees and GST/HST. If your index fund has an MER of 0.25%, you should expect its tracking error to be within a basis point or two of that figure. But it’s often more than that—and sometimes it’s much less. In a series of two posts this week, I’ll look at some real examples from 2012 to illustrate the other factors that can cause an ETF’s returns to vary.

Currency hedging. US and international equity ETFs hedge currency risk using futures contracts. These are renewed every month, and if there’s a dramatic currency movement between contracts—or if the fund experiences a large cash inflow or outflow—that can show up as tracking error. The iShares S&P 500 (XSP) and Vanguard MSCI U.S. Broad Market (VUS) both had tracking errors over 70 basis points in 2012, despite MERs of just 0.24% and 0.17%, respectively.

Currency hedging can also work in the fund’s favour,

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How Well Does Your ETF Track Its Index?

The ideal index fund would deliver the precise return of its benchmark, but we all know that’s not realistic. ETFs and index funds may be cheap but they’re not free, and fees almost always cause them to lag slightly. Index investors accept this because they know the alternatives are usually much worse, but they can’t be too complacent. It’s important to periodically check your ETF’s tracking error: that is, the difference between the index return and the fund’s actual performance.

Where do you find this information? Over at iShares, you simply visit the ETF’s web page and click the “Performance” tab. You’ll see the returns of both the fund and its index over various periods from one month to 10 years, as well as calendar-year returns. iShares currently lists fund returns according to net asset value (NAV) only: the market price field is blank. For example, over the 12 months ending March 31 the iShares S&P/TSX Capped Composite (XIC) lagged its index by 29 basis points:

The process is almost identical at Vanguard: again, simply visit the ETF’s web page and click the “Performance” tab.

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New iShares ETFs Give Canadians the World

In an era when ETFs are becoming increasingly narrow and specialized, the new iShares funds launched this week were a pleasant surprise.

Granted, they were late to the game with the iShares S&P 500 (XUS), which is now the fourth ETF that tracks the S&P 500 with no currency hedging. (Vanguard, BMO and Horizons all beat them to market.) But the two international equity ETFs are a lot more interesting. In fact, the iShares MSCI EAFE IMI (XEF) and the iShares MSCI Emerging Markets IMI (XEC) are the most significant index funds to be launched in Canada in at least six months.

We are the 99%

The “IMI” in the name of the international funds stands for Investable Market Index. These MSCI benchmarks are designed to capture 99% of the equity market in a given region, including large, mid, and small cap companies. This is the same strategy used by the Vanguard Total International Stock (VXUS), a core holding in my Complete Couch Potato portfolio.

All three of the new funds simply hold an existing US-listed ETF in the iShares Core Series,

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Why You Should Avoid DRIPs in Taxable Accounts

Last week’s post about calculating your adjusted cost base with ETFs drew some interesting comments. It’s clear that many DIY investors who use non-registered accounts were unaware of how much work is involved in accurately reporting capital gains.

Careful record-keeping is an unavoidable burden for taxable investors, but you don’t need to make it any more difficult that necessary. Yet as one reader pointed out (hat tip to Jas), some investors complicate their lives by using dividend reinvestment plans in non-registered accounts.

DRIPs allow you to receive ETF distributions—whether stock dividends, bond interest, or return of capital—in the form of new shares rather than cash. You can only receive whole shares, so if the ETF is trading at $20 and you’re eligible for $87 in distributions, you’ll receive four new shares plus $7 in cash. These plans are extremely popular with do-it-yourself investors, and they can be beneficial, since you pay no trading commissions on the new shares and your money starts compounding immediately rather than sitting idly in your account.

But although they are convenient in RRSPs and TFSAs, dividend reinvestment plans are usually not a good idea in taxable accounts.

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Calculating Your Adjusted Cost Base With ETFs

Being a DIY investor is easy when all your accounts are tax-deferred. As the April 30 tax deadline approaches, pretty much all you need to do is gather your RRSP contribution slips. But if you have nonregistered accounts, things are more complicated, even if you’re a Couch Potato who uses ETFs and index funds.

To begin with, you need to report any income you received during the year. This part is relatively easy: in February or March you should receive a T3 slip that includes a breakdown of the type of income you’ve received from your mutual funds or ETFs: dividends, reinvested distributions, and interest income. Just enter these amounts in the appropriate boxes on your tax return and your software—or your accountant—does the rest.

If you hold US-listed ETFs, you’ll receive a T5 slip from your brokerage: Box 15 contains the amount of foreign dividends you receive, and Box 16 will indicate the amount of foreign tax paid. Dividends from US and international companies are fully taxable as income, but you can recover the withholding tax by claiming the foreign tax credit on your return.

But there’s more to the story than simply reporting income.

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How the 2013 Budget Will Affect ETFs

The federal budget on March 21 included a proposal to put an end to investment funds that “seek to reduce tax by converting, through the use of derivative contracts, the returns on an investment that would have the character of ordinary income to capital gains.” (For the complete text visit the Budget 2013 website and scroll down to the heading “Character Conversion Transactions.”)

These proposed changes affect a number of ETFs, as I explain below. I stress that none of what follows should be considered tax advice: it’s still not clear what changes will be made to the Income Tax Act, nor how these changes will be interpreted. If you own any of the affected ETFs, you should consult with a tax specialist before taking any action.

Advantaged ETFs. The iShares Advantaged ETFs (originally launched by Claymore) will all be affected by the proposed changes, as BlackRock Canada confirmed in a press release on March 25. These ETFs use a type of derivative called a forward agreement that re-characterizes bond interest or foreign dividends (both of which are fully taxable) as return of capital and capital gains. I explained this complicated structure back in 2011,

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Canadian Couch Potato Threatened By Legal Action

[Note: This post was an April Fool's joke!]

I regret to announce that this blog is in jeopardy of being shut down due to pending legal action.

On the afternoon of Friday, March 29, I received a letter from the law firm of Zuckercorn & Loblaw, LLP. The attorneys informed me that the name “Canadian Couch Potato” is owned by an Ontario corporation that is threatening to sue for trademark infringement. According to the letter: “You can avoid legal action by immediately ceasing and desisting from any and all infringing activity including use of the canadiancouchpotato.com domain.”

The letter gives me seven (7) days to decide on a course of action, and I am currently seeking counsel from my own attorney before determining how to proceed. Rest assured I will not give in unless I have no other choice.

You can read the full text of the cease-and-desist letter by clicking the image below.

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