Archive | 2017

Bond Basics 3: Should You Wait for Higher Yields?

In my last podcast, I set out to answer a series of common questions about bonds. Here’s one I’ve been hearing on and off since 2009: “With yields so low now, is it even worth it to invest in bonds? Wouldn’t I be better off waiting until interest rates go up?”

It’s true that interest rates are near historical lows: as of early May, 10-year Government of Canada bonds are yielding just over 1.5%, and a broad-based bond index fund like the ones I recommend in my model portfolios yield a little less than 2%. It’s hard to get excited about that, especially when equity returns have been so strong in recent years.

It’s also hard to tune out the financial media, which is still populated by gurus who warn interest rates have “nowhere to go but up.” Since rising rates will cause the value of bonds to fall, why not just stay out of bonds until yields are higher?

The first thing to discuss is this idea that interest rates are highly likely to go up in the near future. I don’t think we can take people seriously anymore if they continue to beat this drum.

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Bond Basics 2: Why Your ETF Isn’t Losing Money

In my latest podcast, I answer a series of frequently asked questions about bonds. The second of these came from a reader named Andrew: “I have been investing using your Couch Potato strategy for just over three years now,” he wrote. “However, does it still make sense to invest in bonds when they are continually losing money?”

As it happens, bond ETFs have not been “continually losing money” at all. Indeed, over the three years ending March 31, broad-based funds such as the BMO Aggregate Bond Index ETF (ZAG) and the Vanguard Canadian Aggregate Bond Index ETF (VAB) returned close to 4% annually, with positive returns in each calendar year. A $1,000 investment in either ETF would have grown to about $1,120 over that period. So why would an investor think he had lost money?

I don’t blame Andrew for being confused, as this one trips up a lot of investors. The problem lies in the way brokerages display the holdings in your account. Rather than calculating the total return on your investments—which would include both price changes and all interest payments and dividends—your list of holdings reflects only the change in market price.

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Podcast 7: Making Sense of Bonds

I’ve always felt that being a defenseman is the toughest job on a hockey team. Forwards score most of the goals, and goalies can steal the show with a few timely saves, but fans rarely notice a defenseman until he makes a mistake. Bonds get that same lack of respect from investors: everyone seems to forget the times they provided a safety net when stocks plummeted, but if they lose a few percentage points they get kicked to the curb.

Part of the problem is that bonds can be difficult to understand. So in my latest podcast, I devote the full episode to answering common questions about the asset class investors love to hate.

I previewed this episode in my last post about why bond prices fall when rates rise, and I’ll continue with a series of blog posts that expand on some of the other issues discussed in the podcast:

If you started investing in bond ETFs about three years ago, chances are good that your holding is showing a loss on your brokerage statement. So you might be surprised to learn that broad-based bond index funds returned close to 4% annually over the three years ending March 31.

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Bond Basics 1: Why Bond Prices Fall When Rates Rise

Bonds have a reputation for being conservative, even boring. But no one ever accused them of being easy to understand. I get a steady stream of emails and blog comments about bonds, and they reveal that many investors are very confused by how bond ETFs work, how they’re affected by changes in interest rates, whether investors can use alternatives to bonds, and even whether it’s OK to abandon them altogether. So my next podcast (which goes live on April 19) is devoted to answering common questions about bonds, with the hope of clearing up some of this confusion. As a companion to the podcast, I’ve also created a short series of blog posts addressing the same questions.

In this first installment, let’s dig into one of the most fundamental concepts for bond investors to understand: the inverse relationship between bond prices and interest rates: when one goes up, the other goes down. This is confusing for many people—after all, investors regularly complain that bond yields are low, so shouldn’t higher interest rates be a good thing? And why are we told to stay away from bonds because yields might rise? You never hear people say you should avoid stocks because their dividends might get higher.

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Can ETFs Make the Market Go Up in Smoke?

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

Does the growing popularity of indexing and ETFs pose a real danger to the markets? As I discussed on a recent podcast, some market experts are concerned that the swelling ranks of index investors is creating a bubble. I used to brush off these concerns as the paranoid ramblings of money managers who are losing billions in assets as investors discover they add no value. But I’m starting to wonder if it might be true. After all, there are lots of articles on the Internet that say so.

A recent piece in the Globe and Mail, for example, featured billionaire hedge fund manager Seth Klarman, who worries that the growth of indexing is making markets less efficient: “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

I appreciate that index investors want to get broad diversification at the lowest possible cost, and that they’re attracted to a strategy that has the weight of academic evidence behind it.

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How TD Put the “Managed” in ETF Portfolios

What Canadian bank was first to launch a line of ETFs? You might think it was BMO, which is by far the biggest bank in the industry today, with more than 70 ETFs and some $37 billion in assets. But in fact it was TD, who were ahead of the curve when they created a small family of ETFs way back in 2001. Five years later, with truly terrible timing, they shuttered those ETFs because of lack of interest. Of course, the industry exploded in popularity almost immediately afterwards.

TD re-entered the ETF marketplace in 2016 with six funds covering the core asset classes: Canadian, US and international stocks (the latter two available with or without currency hedging) and Canadian bonds. The ETFs were copycats of what’s long been available from iShares, BMO and Vanguard, and the launch had almost no fanfare: one suspects TD just wanted to provide another option for their advisors who had been fielding questions about ETFs from clients.

But this week TD launched something innovative: a lineup of five mutual funds that use the bank’s ETFs as their underlying holdings. Each has a different target asset allocation:

Fund name
Bonds
Stocks

TD Managed Income ETF Portfolio
70%
30%

TD Managed Income &

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Podcast 6: Wishing Upon a Morningstar

Are truly active managers more likely to beat the market than those who stay closer to their benchmark index? In my latest podcast, I discuss this idea with Christopher Davis, a strategist and researcher at Morningstar Canada.

The idea of active share was introduced in a 2009 paper called How Active is Your Fund Manager? A New Measure That Predicts Performance, by Martijn Cremers and Antti Petajisto. For example, a large-cap US equity fund that holds only half the stocks in the S&P 500 would have an active share of 50%. An index fund, by definition, has an active share of zero.

The researchers presented evidence that the most active funds “significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.” A year later, Petajisto published a follow-up paper called Active Share and Mutual Fund Performance, which included more support for the idea that the most active stock pickers can be expected to add value.

Both papers take aim at so-called closet index funds, which charge the higher fees one expects for active management yet differ little from their benchmark.

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A New ETF Structure for Accumulators

ETF launches are generally unexciting these days: most new products focus on increasingly narrow niches or exotic strategies. But last week BMO unveiled an innovative ETF structure that may just have some lasting appeal. They launched a new share class of four existing short-term bond ETFs: called “Accumulating Units,” these new funds do not pay their distributions in cash like traditional ETFs. Instead, they reinvest all the interest payments immediately and increase the net asset value (and market price) accordingly.

An example will help. Consider a bond ETF with a unit price of $15 at the beginning of the year. Over the next 12 months it pays out 3% in interest and falls in price by 1%. The fund’s one-year total return would therefore be 2% (the 3% interest minus the 1% capital loss). If this ETF were available in both the traditional and Accumulating Units structure, both would report the same performance. But they would arrive there in different ways:

Traditional ETF
Accumulating Units

Unit price at beginning of year
$15.00
$15.00

Cash distributions (3%)
$0.45
$0

Reinvested distributions (3%)
$0
$0.45

Capital loss (1%)
-$0.15
-$0.15

Unit price at end of year
$14.85
$15.30

Value of ETF unit + cash
$15.30
$15.30

One-year total return
2%
2%

What they’re not

The idea of reinvested distributions is not new,

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Podcast 5: Master Class with the Millionaire Teacher

My newest podcast features an interview with Andrew Hallam, author of Millionaire Teacher, a compelling introduction to building wealth through smart saving and disciplined investing.

Andrew grew up in Canada, but he’s a citizen of the world. He spent several years as a teacher at the Singapore American School and has lived and travelled all over the globe. As this podcast goes live, Andrew is touring the Middle East to speak to expatriate investors about how to avoid getting fleeced by the financial industry. And he’s not being paid for his appearances: “I’m not a saint,” he writes on his blog. “But when I’m teaching people about money, I’ll do almost anything so others can learn.”

Andrew has an interesting backstory, which I featured in my MoneySense Guide to the Perfect Portfolio. He was both comically frugal and a tremendously successful stock-picker for many years. This combination of talents allowed him to amass a tidy nest egg in his 40s. “So what did I do after a decade of stock-picking success?” he told me. “Apply for a job as a Wall Street analyst?

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