Archive | January, 2014

A Periodic Review of Diversification

After the financial crisis of 2008–09, financial commentators loved to take shots at “old school” investment strategies. First came the declarations that diversification no longer works, because during a crisis everything goes down together—though this wasn’t true in 2008 unless you ignored bonds, which make up a significant part of most portfolios. Then the investment industry sounded the death knell for the traditional balanced portfolio. Apparently we were in a new era where active investing, tactical asset allocation and alternative asset classes would rule the day.

One of the most effective ways to expose this nonsense is to build a “periodic table” of investment returns. (Norm Rothery has maintained one on his Stingy Investor site for several years.) The resemblance to the poster that hung in your high-school chemistry class is only superficial: this table simply presents the returns of various asset classes ordered from highest to lowest over a period of several years. By adding a colour for each asset class, the results jump off the screen.

I thought it would be interesting to build a periodic table with the returns of the seven individual asset classes in the Complete Couch Potato,

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A Reality Check for Couch Potatoes

The investment industry never misses an opportunity to take credit for outstanding performance. In fact, many mutual fund providers crow about their returns even when they’re mediocre or downright bad compared to appropriate benchmarks. One of my recent favorites was an ad that read: “Over the 1-year period, 91% of Trimark global equity funds returned 10% or more.” This is touted as an impressive accomplishment, but during this one-year period (ending September 30, 2013), the MSCI World Index was up over 21%. An actively managed global equity fund that returned even 15% would have been an absolute dog.

The recent performance of my model portfolios has been excellent: in 2013, the humble Global Couch Potato returned more than 15%, and over the last five years, a balanced index portfolio could easily have achieved 10% annualized returns. But if you’re a passive investor, it’s important to understand this performance simply reflects that we’ve enjoyed a five-year bull market in stocks—not to mention five years of bond returns that were higher than most people expected. Unlike the proud fund managers at Trimark, indexers shouldn’t take credit personally—except to pat themselves on the back for building a diversified portfolio and staying invested.

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Calculate Your Personal Rate of Return

On January 9, I published the 2013 returns of my model portfolios. The equity markets performed spectacularly last year, but most investors are likely to be far more interested in the performance of their own portfolios. Problem is, calculating your personal rate of return is more difficult than most investors realize.

If you’ve made no contributions or withdrawals during the year, the math is simple enough. But what if you made a big lump sum contribution during RRSP season? Or took $7,000 out of your TFSA to buy a used car? If you make monthly automatic monthly contributions, you may have seen your account balance grow every month, but most of that increase is from new money, not investment returns. Any time you introduce cash flows to the portfolio, calculating your rate of return suddenly becomes much harder.

If you work with an advisor, he or she should provide you with your personal rate of return at least once a year. But hard as it is to believe, many aren’t doing this. The Canadian Securities Administrators issued a policy in July making it mandatory, but firms have three years to comply.

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Currency Exposure in International Equity ETFs

My last post explained that Canadian investors are exposed to currency risk any time they hold US equities, even if their holding is an ETF or mutual fund that trades in Canadian dollars.

In my example, Gerry owned the Vanguard S&P 500 (VOO), which is listed on the New York Stock Exchange and trades in US dollars, while his wife Sharon owned the Vanguard S&P 500 (VFV), which trades on the TSX in Canadian dollars. Since the underlying holdings of both ETFs are the same—500 large-cap US stocks—both Gerry and Sharon have the same exposure to the US dollar, even though they’re trading in different currencies. (The exception would be if one chose an ETF with currency hedging, such as the Vanguard S&P 500 CAD-hedged (VSP), which is designed to eliminate currency risk.)

If that idea is confusing, it gets even more fun when you add international equities to the mix. Let’s say Gerry owns the Vanguard FTSE Developed Markets (VEA), an ETF that trades in US dollars and holds stocks from western Europe, Japan, Korea, Australia and many other overseas countries.

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How a Falling Loonie Affects US Equity ETFs

Over the last year the loonie has declined significantly relative to the US dollar: the currencies were at par early last February, but the Canadian dollar closed under $0.92 US on January 10. That has been a benefit for Canadians who hold US equities: not only did the stocks deliver huge returns in their local currency in 2013, but we got a further boost thanks to the appreciation of the US dollar.

Unfortunately, the drop in our dollar has encouraged some ETF investors to attempt to exploit a buying opportunity. Trying to make currency plays is foolish at the best of times, but it’s especially unwise if you don’t fully understand how currency exposure works.

Meet Gerry, who uses the Vanguard S&P 500 (VOO) to get exposure to US stocks. This ETF is listed on the New York Stock Exchange and trades in US dollars. With the greenback riding high, Gerry plans to sell VOO and use the proceeds to buy an equivalent fund listed on the TSX: the Vanguard S&P 500 (VFV). Gerry tells his friends he’s selling US dollars high and buying Canadian dollars low while keeping his equity exposure the same.

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Couch Potato Portfolio Returns for 2013

Here are the 2013 performance figures for my Model Portfolios. Last year was one of stark contrasts: huge returns in stocks combined with dismal bond performance. But for anyone who had a balanced index portfolio, the returns would likely have been in the double digits.

As it turns out, the Global Couch Potato and the Über-Tuber performed almost identically in 2013, which can only be attributed to coincidence, since their asset mix is very different. The Complete Couch Potato, on the other hand, dramatically underperformed. That’s easy to explain: the Complete includes three asset classes absent in the Global Couch Potato—real-return bonds, real estate and emerging markets—and they were all duds in 2013.

There were a few other remarkable events in the markets in 2013:

The long-predicted rise in interest rates finally came in the spring, leading to the first negative year for the DEX Universe Bond Index since 1999. It’s easy to say this wasn’t a surprise, but let’s remember commentators have been forecasting rising rates since early 2010 and were wrong for three-and-a-half years.

Real-return bonds had their second-worst year since they were created by the Government of Canada 22 years ago.

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Remodelled Portfolios for 2014

Another new year is upon us, and it’s time review my model Couch Potato portfolios. I’ve been at pains to discourage investors from tinkering with their portfolios every time a new fund comes along, but 2013 did see the launch of some significant ETFs. In a couple of other cases, it was just time to replace the incumbents with less expensive choices. You can visit the Model Portfolios page for full details, but here’s a summary of the changes:

Global Couch Potato

I’ve added the ING Direct Streetwise Balanced Portfolio as a simple option for the Global Couch Potato. While using individual index mutual funds allows for lower costs (especially if you use the TD e-Series option) and more flexibility, the Streetwise Portfolios are ideal for investors who have small portfolios in registered accounts.

The ETF version of this portfolio (now Option 4) has been overhauled completely. I’ve replaced the Canadian  equity and bond funds with cheaper alternatives from Vanguard. And in place of the iShares MSCI World (XWD), I’ve suggested the Vanguard US Total Market (VUN) and the iShares MSCI EAFE IMI (XEF).

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