Archive | Ask the Spud

Ask the Spud: Switching From e-Series Funds to ETFs

Q: “I currently have $30,000 invested in the TD e-Series funds. When the time comes to move to ETFs, what is the best way to do this while still making automatic contributions? Should I put my biweekly contributions into a money market fund and then make ETF purchases four times per year?” –  C.D.

Too many investors think of the TD e-Series funds as little more than a stepping stone, and they can’t wait to “graduate” to ETFs. The appeal is understandable, since a portfolio of ETFs will typically carry a management fee of about 0.15%, compared with about 0.45% for the e-Series funds. But when I get this common question, I encourage the investor to think carefully before making the leap to ETFs, especially if their portfolio is small and they’re making automatic contributions.

For starters, management fees don’t tell the whole story. Index mutual funds are more investor-friendly than ETFs, and while the cost difference can be dramatic on large portfolios, the gap is narrower on smaller accounts. A fee difference of 0.30% shaves off just $30 annually per $10,000 invested, and that will be reduced—perhaps eliminated—by $9.95 trading commissions,

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Ask the Spud: Is It Time to Hedge Currency?

Q: “I use non-hedged ETFs for US and international equities, which worked out well as the Canadian dollar tanked. But the loonie is now so low that I wonder if it makes sense to move to the hedged versions. My thinking that there is limited risk from the loonie falling much further, and a bigger risk from its recovery.” – B.G.

It’s hard to believe it was just three years ago that the loonie was at par with the US dollar. Since 2013 our currency has trended steadily downward, reaching a low of $0.68 USD in late January, a level not seen since 2003.

My model portfolios recommend US and international equity index funds that do not hedge their currency exposure. That means when the loonie falls in value relative to the US dollar and other foreign currencies, these funds get a boost in returns. That was particularly dramatic in 2015, when US and international equities posted only modest returns in their native currencies but netted close to 20% for Canadians on the strength of the currency appreciation.

Expecting a repeat of that performance is foolishly optimistic.

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Ask the Spud: My ETF Is Shutting Down

Q: I received a notice that an ETF I own will be closed within the next few months. Is it better to sell it now or wait until the termination date? – S.H.

ETFs are now available for just about every niche sector and exotic asset class, so it shouldn’t be surprising when some of these fail to attract investor dollars. If an ETF cannot attract enough assets to be sustainable within a couple of years, the provider may decide to shut down the fund.

ETF closures have been relatively uncommon in Canada, but this year has seen several death sentences. In June, BlackRock announced it will be shuttering six products, including the iShares Broad Commodity (CBR), the iShares China All-Cap (CHI), iShares Oil Sands (CLO) and the iShares S&P/TSX Venture (XVX). Earlier in the year Horizons also terminated its broad commodity ETF as well as couple of its leveraged ETFs.

What should you do if you learn that an ETF you own will soon be shut down? To help answer this question, I reached out to Mark Noble,

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Ask the Spud: GICs vs. Bond Funds

Q: I would appreciate it if you could write an article contrasting the advantages and disadvantages of holding bond funds versus GICs. – A.R.

All of my model Couch Potato portfolios include bond funds, and I’m frequently asked whether a ladder of GICs would be a good substitute. In many circumstances the answer is yes. Indeed, our clients at PWL Capital often hold a combination of bond funds and GICs in their portfolios, because these two investments each have strengths and weaknesses. Let’s look at the relative advantages of each.

When GICs are preferable to bond funds

Higher yields. As of March 25, the yield on five-year federal bonds was 0.75%, while you can easily find five-year GICs paying over 2%. Normally higher yield means higher risk, but both federal bonds and GICs are backed by the Government of Canada: GICs up to $100,000 are insured against default by the Canadian Deposit Insurance Corporation.

Tax efficiency. These days just about all bond funds are filled with premium bonds, which are notoriously tax inefficient. Premium bonds pay a lot of taxable interest and then suffer capital losses when they mature.

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Ask the Spud: Should I Use Global Bonds?

Q: I was surprised to see a Vanguard infographic pointing out that international [non-US] bonds are the largest asset class in the world. Do you have any thoughts on why Canadians have not embraced international bonds in their portfolios? – A.M.

While stocks grab all the headlines and dominate the conversation among investors, the bond market is vastly larger. Yet while a diversified index portfolio can include 10,000 stocks from over 40 countries, chances are your bond holdings are entirely Canadian.

There are some good reasons for a strong home bias in bonds. The main one is currency risk. Exposure to foreign currencies benefits an equity portfolio by lowering volatility (at least for Canadian investors), but taking currency risk on the bond side is usually a bad idea. Because currencies are generally more volatile than bond prices, you’d be increasing your risk without raising your expected return. That’s a bad combination.

It also gets to the heart of why few Canadians have international bonds in their portfolios: there just aren’t many good products offering global bond exposure without currency risk. iShares and BMO have a number of ETFs covering US corporate and emerging markets bonds.

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Ask the Spud: How Are Investors Protected?

Q: My father lost a large sum of money when the company holding his investments in his home country defrauded its clients. As a result, I worry whether it is safe to keep all our investments in one institution. What would happen to investors if these companies became insolvent? Should we diversify across fund providers and financial institutions the way we diversify our investments? — M.T.

Canadians have many legitimate gripes about their financial institutions, but compared with most other countries we’re pretty fortunate. Fund companies and brokerages may charge too much or provide lousy service, but they aren’t likely to defraud their clients. And in the extremely rare cases when they become insolvent, there are safeguards that should prevent investors from significant losses.

It may not be necessary to diversify your holdings across multiple fund providers or financial institutions. But every Canadian should understand how investor protection programs work and be aware of their limits.

Your online brokerage

Every major online brokerage is a member of the Canadian Investment Protection Fund (CIPF), which was established by agreement with the Investment Industry Regulatory Association of Canada. (IIROC is the self-regulatory organization that oversees investment dealers in Canada.)

The CIPF maintains a pool of money that can be used to compensate investors in the event of a member’s insolvency.

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Ask the Spud: Why Do ETF Yields Differ?

Q: The Vanguard S&P 500 (VFV) currently has a dividend yield of 1.44%, but the US-listed version of the same ETF has a yield of 2.01%. How can these two funds have such different yields when their underlying holdings are exactly the same? – Lindsay

The US and international equity ETFs from Vanguard Canada do not hold their stocks directly: they get their exposure by holding a US-listed ETF. The Vanguard S&P 500 (VFV), for example, simply holds the Vanguard S&P 500 (VOO), which trades on the New York Stock Exchange.

Since the underlying holdings of VFV and VOO are identical, you might expect the two funds to have the same dividend yield. Yet if you visit their respective websites you’ll find the published yields actually vary by 57 basis points. What gives?

More than one way to do the math

Turns out there are several ways to calculate a fund’s yield. Vanguard Canada uses the trailing 12-month yield, which it defines as “the fund’s cash distributions over the past 12 months divided by the end of period net asset value.” The last four quarterly distributions from VFV totaled $0.52905 per share,

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Ask the Spud: Is My Pension Like a Bond?

Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? – Brian

This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets?

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Ask the Spud: Is There an Optimal Portfolio?

Q: I’m new to passive investing and am deciding how to allocate between the asset classes. The best split between Canadian equity, international equity, etc. should be determinable based on studies of their past returns, volatility and correlations. Obviously this would vary over time, but approximate weightings should be achievable. Based on this research, how would you weight the individual asset classes? – R.T.

It would look impressive if I designed my model portfolios based on an analysis of historical volatility, correlation matrices and expected returns based on Shiller CAPE or some other data. But instead I generally recommend a roughly equal allocation to Canadian, US and international stocks. Nice and simple, with no advanced math required. This is isn’t because building a “portfolio optimizer” is difficult: it’s because it’s a useless exercise.

Investors have a tendency to resist simple solutions, and this bias is exploited by fund managers and advisors who use algorithms and models designed to determine the “optimal” asset mix that will maximize returns and minimize volatility, sometimes down to two decimal places. That sounds more sophisticated than simply splitting your equity holdings in three, but there’s no evidence it produces better results.

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