Archive | 2013

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). We should obviously expect XCV to have extra exposure to the value factor,

Continue Reading 64

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.

Continue Reading 34

Finding the Perfect Pair for Tax Loss Selling

If you’re using ETFs in a non-registered account, there’s plenty of opportunity to harvest capital losses and reduce your tax bill. Justin Bender and I tell you exactly how to do this in our new white paper, Tax Loss Selling: Using Canadian-listed ETFs to defer taxes on capital gains.

As I explained in my previous post, tax loss selling involves dumping an ETF that has declined in value to crystallize the loss, and then buying a similar (but not identical) ETF to maintain the exposure in your portfolio. The Canada Revenue Agency considers any two index funds tracking the same benchmark to be identical property. So you cannot, for example, claim a loss after selling the iShares S&P 500 (XUS) and replacing it with the Vanguard S&P 500 (VFV): if you do, it will be denied as a superficial loss.

Fortunately this year has seen a number of new ETF launches, including international equity ETFs from iShares and Canadian and US equity ETFs from Vanguard. These give Canadians much better options when tax loss selling,

Continue Reading 82

Tax Loss Selling with Canadian ETFs

Traditional equity index funds are often touted for the tax-efficiency of their structure, and rightly so. But there’s another potential tax advantage that few ETF investors employ. Justin Bender and I explain the details in our brand new white paper, Tax Loss Selling: Using Canadian-listed ETFs to defer taxes on capital gains.

Tax loss selling is a technique for harvesting capital losses in non-registered accounts so they can be used to offset capital gains incurred elsewhere. Suppose you hold $50,000 worth of a Canadian equity ETF and its value declines to $45,000. By selling your shares, you can crystallize a capital loss of $5,000. And by claiming that loss, you may be able to offset a $5,000 capital gain elsewhere in your portfolio, potentially deferring hundreds of dollars in taxes.

When you file your tax return, any capital losses must first be used to offset gains you’ve incurred in the current tax year. Any remaining losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains. (To carry back current capital losses to prior years, you need to file form T1A – Request For Loss Carryback with your return.)

The problem with realizing a capital loss is that it can mean selling a security that plays an important role in your portfolio.

Continue Reading 29

More Swap-Based ETFs on the Horizon

I have to admit I was skeptical when the Horizons S&P/TSX 60 (HXT) appeared back in September 2010. In an interview with a Horizons executive a few months later, I asked why the company would go head-to-head against the iShares S&P/TSX 60 (XIU), the largest ETF in the country.

It turns out HXT has become an extremely successful fund. Not only for Horizons’ bottom line (the fund now has close to $1 billion in assets and is the largest non-iShares ETF in the country), but for investors as well. As of September 30, its three-year annualized return was 3.75%, compared with 3.81% for the S&P/TSX 60 Index. As tracking errors go, 0.06% is about as good as it gets. Over the same period, the venerable XIU returned 3.59% for an annual tracking error of 0.22%.

Swapping returns

HXT tracks its benchmark so tightly because it uses a total return swap: rather than holding the underlying stocks in the index, the fund has an agreement with a counterparty—in this case, National Bank of Canada—who agrees to deliver the full return of the S&P/TSX 60,

Continue Reading 41

More DIY Investing Challenges

In my last post, I looked at some of the biggest challenges faced by DIY investors. I came up with the list after working with clients of PWL Capital’s DIY Investor Service. The theory behind indexing is relatively straightforward, and it’s quite easy to set up a simple portfolio. But do-it-yourselfers often face obstacles when trying to implement their plan. Here are a few more that need to be overcome if you want to be a successful DIYer.

Unrealistic expectations. Anyone who works with an advisor completes a risk tolerance questionnaire, and the process is revealing. Investors often say they want an expected return of 6% to 7% (occasionally we get people who expect 8% or more) while also indicating they’ll accept no more than a 10% loss in any given year. Those goals are incompatible.

With bond yields under 3% today, a balanced portfolio of 60% equities and 40% fixed income probably has an expected return of about 5% before fees, and in a scenario like 2008–09 it could suffer a drawdown close to 20%. Unless investors understand these trade-offs they can’t hope to carry out a long-term plan.

Ignoring asset location.

Continue Reading 30

The Biggest DIY Investing Challenges

At the recent Canadian Personal Finance Conference in Toronto, I participated in a panel discussion that touched on a wide range of investing topics. My co-panelists were Michael James and financial planner Jason Heath, and we were moderated by the esteemed Big Cajun Man. The first question we were asked to address is whether it makes sense to use an advisor or to invest on your own.

That was a tough question to tackle in a room full of committed do-it-yourselfers. It’s also one I’ve struggled to answer honestly in the last couple of years. I’ve been an advocate of DIY investing for some time, and I still believe many investors with uncomplicated situations are capable of managing a simple index fund portfolio on their own. Indeed, I think anyone with less than $100,000 or so should seriously consider doing so, because it’s awfully difficult to find an unbiased, fee-based advisor unless your portfolio is larger. And unfortunately, it’s all too easy to find a commission-based mutual fund salesperson who will turn your wealth into his own.

But over the years, as I’ve corresponded with readers—and more recently started working with clients—I’ve learned that DIY investing is much harder than it sounds.

Continue Reading 34

Your Guide to the (Even More) Perfect Portfolio

I’m pleased to announce that the 2013 edition of The MoneySense Guide to the Perfect Portfolio is now on sale. The book is available wherever you would buy MoneySense magazine, including newsstands at Chapters, Shoppers Drug Mart, Walmart and Loblaws. You can also order it online at the Rogers Publishing e-Store. The book retails for just $9.95, or about the cost of a single ETF trade at your discount brokerage. We’re hard at work on e-book versions for Kindle, Kobo and Apple devices and I’ll let readers know as soon as these are available.

This is the third edition of my guide for do-it-yourself index investors, which was first published in 2011. Most of the content is the same—the fundamentals of smart investing don’t change—but this edition has been thoroughly updated. The most significant change is the final chapter, which now includes a version of the ETF All-Stars article I wrote for the February/March issue of MoneySense. (The full article is available in PDF format from the Rogers Publishing e-Store for $2.99.) This includes a list of 21 ETFs that can form the building blocks of virtually any Couch Potato portfolio.

Continue Reading 40

How Not to Prepare for a Bear Market in Bonds

The risk of rising interest rates has become an obsession in the financial media. Those risks are undeniably real: it’s quite possible that broad-based bond funds will see multiple years with negative returns. (As I illustrated in a previous post, that would likely occur if rates across the yield curve rose 1% annually for three years. This article by Dan Hallett also includes some possible scenarios.) But these risks need to be kept in perspective: if you hold a bond fund with a duration shorter than your time horizon, your capital is not at risk. And if you’re a decade or two from tapping your portfolio, rising rates should even be welcomed.

And yet the bond bears just keep on roaring. The latest example is an advisor featured in a Globe and Mail article this weekend. “For the first time in my entire career,” he says, “bonds are in my opinion riskier than stocks.” He’s recommending his clients abandon the asset class altogether. Whenever articles like this are widely read, I get contacted by worried readers who are ready to follow suit. So here’s my preemptive response to what I believe is dreadful,

Continue Reading 55