Archive | November, 2013

Pulling Off the Bandage Quickly

Deferred sales charges (DSCs) may have been the mutual fund industry’s greatest marketing innovation. Back in the 1980s, it wasn’t unusual for funds to be sold with front-end loads of 5% or more. Then fund companies realized it’s a mistake to charge an entry fee that discourages people from buying your product. Better to draw them in for free and charge them dearly to leave: DSCs typically start at about 6% and continue on a sliding scale for six or seven years, with no time off for good behaviour.

For investors who have six-figure mutual fund portfolios, the cost of selling funds with DSCs is downright painful: in our DIY Investor Service we have worked with clients who have had to swallow more than $5,000. There are no doubt countless others who want to break free of a bad relationship and start fresh with a low-cost portfolio of index funds, but who just can’t bring themselves to fork over those DSCs. They’d prefer to sell their funds gradually over two or three years in order to reduce the upfront cost.

That’s understandable, but in most cases it’s probably the wrong decision. While there may be ways to make a gradual exit,

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The Hidden Cost of Bid-Ask Spreads

Trading commissions get a lot of attention from ETF investors, and rightly so. But depending which ETFs you use and the size of your trades, the impact of bid-ask spreads may be larger than you thought.

The bid price is what you expect to receive when you sell shares, while the ask price (or offer price) is what you would expect to pay to buy them. The difference between the two is called the bid-ask spread, and it represents the profit taken by the market makers.

Unlike with individual stocks, trading volume doesn’t have a major effect on the bid-ask spread of an ETF. The liquidity of an ETF is largely determined by the liquidity of its underlying holdings: if the fund holds frequently traded large-cap stocks, its bid-ask spread should be very tight even if the ETF itself doesn’t trade very often. If the ETF holds micro-cap stocks or illiquid bonds the spread will be wider even if units trade frequently.

The underlying story

But that’s not the whole story. If the liquidity of the underlying holdings was the only factor, ETFs in the same asset class would have more or less identical bid-ask spreads,

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A Touch of (Corporate) Class

ETFs are generally more tax-efficient than mutual funds, but there is one area where they’re at a disadvantage. Investors who use non-registered accounts can take advantage of corporate class mutual funds, which can reduce or defer taxes. Well, now the country’s newest ETF provider, Purpose Investments, has launched the first corporate class ETFs in Canada.

It’s little surprise the innovation comes from Purpose. The company’s CEO is Som Seif, who founded Claymore Investments back in 2005. Claymore was an ETF pioneer: they were the first to offer pre-authorized cash contributions (PACCs), dividend reinvestment plans (DRIPs) and systematic withdrawal plans (SWPs). Then they teamed up with Scotia iTRADE to offer the first commission-free ETF program. Seif exited Claymore after they were bought by BlackRock in 2012, and it was only a matter of time before he got behind a new project that shook up the ETF business.

Before looking at the new ETFs, let’s review how corporate class funds work. Most mutual funds are structured as trusts. Income flows through to investors and retains its character: in other words,

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Worst Mutual Fund Ad of the Year?

The mutual fund industry loves to sell past performance, and it’s not above massaging the data to make that performance look even better. But every now and then an advertisement appears that sets the bar even lower. Michael Callahan, a financial planner in Ottawa, recently sent me an ad for IA Clarington Investments that might be the worst one I’ve seen yet. “I figured you might welcome an opportunity to rip this one to shreds,” he wrote. Challenge accepted.

First there’s the time frame. The ad says the company believes active managers “can and do persistently outperform over the long-term.” But as explained in the fine print (microscope not provided), the year-to-date returns in the first column of the table are for the period ending March 31, so we’re talking about three months. We get 12-month returns in the second column, and the third column gives the funds’ returns since their inception. Problem is, the three funds spotlighted here were launched in the late summer of 2011, so they had been around for all of 18 to 19 months when these returns were calculated. That might be long-term if you’re an insect,

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Looking for Value in Canadian Equity ETFs

Monday’s post about factor analysis was, I admit, too technical for most readers’ tastes. At least that’s the conclusion I drew when the two most enthusiastic comments came from a professor of statistics and an astrophysicist. But the brave few who managed to read to the end saw my promise to put all this in context. What can factor analysis teach us about where an ETF’s returns are really coming from?

Two decades of research has shown that the returns of a diversified equity portfolio can largely be explained by its exposure to three factors: the market premium, the value premium, and the size premium. A broad-market index fund like the iShares S&P/TSX Capped Composite (XIC), by definition, should be neutral in its exposure to the value and size premiums. And as we saw in my previous post, it is: the value and size coefficients for XIC are negligible. So, on to the next step.

Let’s now take a look at the iShares Dow Jones Canadian Value (XCV) and the iShares S&P/TSX Small Cap (XCS).

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Going on a Factor-Finding Mission

Pick up almost any financial magazine or newspaper and you’ll find full-page ads touting the recent performance of mutual funds and ETFs. What’s the reason for their outperformance? The fund companies will give the credit to the genius of the manager, but there’s a way you can tease out a more complete explanation: it’s called factor analysis.

Don’t worry, I’m not going to get all mathy on you—well, maybe a little bit. Performing this kind of analysis is complicated, but understanding the basic ideas doesn’t require a a Ph.D. in statistics. We know  investment returns come from exposure to known risk factors (or premiums), and every equity portfolio is exposed to these in varying degrees. What we want to learn is how much each factor contributed to the fund’s returns. If the fund outperformed or underperformed its benchmark, factor analysis can tell you why.

Just the factors, ma’am

What are the risk factors? The first is the market premium (or equity premium), which is simply the expected excess return from stocks compared with risk-free investments like T-bills. The second is the value premium: stocks with high book-to-market ratios have historically delivered higher returns than growth stocks.

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