Archive | January, 2015

The Wrong Way to Think About Withholding Taxes

If you live in a big city, you can save a few cents per litre on gas by travelling to the boonies. But you also understand that it doesn’t make sense to burn $10 of fuel driving out of town so you can save $8 on a fill-up. Yet many investors seem to be making a similar error by trying to avoid foreign withholding taxes in their registered portfolios.

About a year ago, Justin Bender and I co-wrote a white paper that estimated the cost of foreign withholding taxes. There are far too many details to review here, but among the most important is that withholding taxes on dividends are lost if you hold a Canadian mutual fund or ETF of foreign stocks inside an RRSP or TFSA. If you hold the same fund in a non-registered account, however, you can recover the withholding taxes by claiming a credit on your tax return.

Sometimes I feel like we created a monster with this paper, because I have received many e-mails from readers who have misunderstood this information and made poor decisions as a result.

Here’s an example: Cyril wants to build a balanced portfolio that includes US and international equities,

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Tracking Error on International Funds

I recently received an email from a reader, J.W., who wanted to know why the tracking error on some popular Vanguard international equity ETFs were so high in 2014. He noted, for example, that the Vanguard FTSE Developed ex North America (VDU) lagged its benchmark index by 1.62% last year, far more than one would expect.

An index fund’s tracking error is the difference between the performance of the fund itself and that of its benchmark. If the index returns 10% on the year and the fund delivers 9.8%, the tracking error is 0.20%, or 20 basis points. But what could possibly cause a fund to show a tracking error of 162 basis points?

Any time you see a surprising number like this, it’s important to determine the reason: otherwise you risk making a bad decision because you’re working with inaccurate or misleading information. If an index were to lag its benchmark by more than 1.6% because it was badly managed, then you should look for a better alternative. But Vanguard has a long record of tight tracking error, so something else has to be going on here—and indeed it is.

Back on track

To understand VDU’s large tracking error—and why it’s not as bad as it looks—let’s look at the reasons its performance deviated so far from the index.

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Taking ETF Trades to the Next Level

Experienced investors know the theory: ETFs are supposed to trade very close to their net asset value (NAV). And most of the time they do. But this week my PWL Capital colleague Justin Bender and I encountered a glaring exception that could have had expensive consequences.

On Monday, Justin and I wanted to sell the iShares US Dividend Growers Index ETF (CUD) in a client’s account. It was a large trade: more than 5,000 shares, which worked out to over $160,000. As we always do before making such a trade, we got a Level 2 quote, which reveals the entire order book. In other words, it tells you how many shares are being offered on the exchange for purchase or sale at various prices. By contrast, a Level 1 quote—the type normally available through discount brokerages—only tells you how many shares are available at the best bid and ask prices.

If an ETF’s market maker is doing its job, there should be thousands of shares available at the best price. But we were surprised to find the Level 2 quote looked like this:

Source: Thomson ONE

Let’s unpack this.

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Couch Potato Model Portfolios for 2015

Call off the hounds: I have finally updated my model Couch Potato portfolios for 2015. Full details appear on the permanent Model Portfolios page, but here are the new versions in downloadable PDF format:

Option 1 — Tangerine Investment Funds

Option 2 — TD e-Series Funds

Option 3 — Vanguard ETFs

You’ll notice some significant changes this year:

I have dropped the Complete Couch Potato and Über-Tuber from the lineup. All of the model portfolios now include only traditional index funds tracking the major asset classes: no REITs, real-return bonds, value stocks or small-cap stocks.

The new lineup presents three options, with the key difference being the type of product. Option 1, from Tangerine, is a one-fund solution that’s ideal for investors who value simplicity. Option 2, the TD e-Series funds, offers more flexibility and lower cost. Option 3, built from Vanguard ETFs, is the cheapest option, but also the most difficult to manage for new investors.

None of the options include ETFs traded on US exchanges.

Each option now includes several different asset allocations, ranging from conservative (70% bonds and 30% stocks) to aggressive (10% bonds and 90% stocks).

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Couch Potato Portfolio Returns for 2014

Here are the 2014 returns for my Model Portfolios.

The data below are from the funds’ websites whenever available: otherwise I used Morningstar. All ETF returns are based on net asset value rather than market price. Performance of US-listed funds is expressed in Canadian dollars using noon exchange rates from the Bank of Canada.

 Global Couch Potato: Option 1
%
Return

Tangerine Balanced Portfolio (INI220)
100%
10.4%

.

 Global Couch Potato: Option 2

%
Return

TD Canadian Index – e (TDB900)
20%
10.2%

TD US Index – e (TDB902)
20%
23.1%

TD International Index – e (TDB911)
20%
2.5%

TD Canadian Bond Index – e (TDB909)
40%
8.3%

10.5%

.

 Global Couch Potato: Option 3

%
Return

RBC Canadian Index (RBF556)
20%
9.8%

TD US Index – I (TDB661)
20%
22.9%

National Bank International Index (NBC839)
20%
1.7%

TD Canadian Bond Index – I (TDB966)
40%
7.9%

10.0%

.

 Global Couch Potato: Option 4

%
Return

Vanguard FTSE Canada All Cap (VCN)
20%
9.8%

Vanguard US Total Market (VUN)
20%
22.6%

iShares MSCI EAFE IMI (XEF)
20%
2.4%

Vanguard Canadian Aggregate Bond (VAB)
40%
8.8%

10.5%

.

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The Folly of Forecasts

The new year has arrived, which means hangovers, doomed resolutions to lose weight, and a host of forecasts from the gurus in the financial media. I’m not sure which will cause more suffering.

The attention investors give to market forecasts remains one of the great mysteries of human psychology. The evidence is overwhelming that no one possesses the ability to consistently call the direction of the stock market, bond yields, or currency rates. Yet every year the media invites experts to do what we know they can’t do. And every year investors listen to them, act on their recommendations and suffer the consequences.

One reason this is allowed to go on is that forecasters are celebrated when they’re right but rarely held accountable for their bad calls. So last year I clipped several articles that included forecasts for 2014 so we could evaluate how accurate they turned out to be.

Let’s start with Outlook 2014 by CIBC World Markets, which included the following forecasts for equities, bonds and currencies:

“US equities are hardly cheap given their run-up in 2013, but the Canadian market would appear to have more room to run … Within the equity market,

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