Archive | Ask the Spud

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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Ask the Spud: When Should I Use US-Listed ETFs?

Q: Under what specific circumstances would it be better to hold a US-listed ETF if there is a Canadian equivalent? For example, when it is preferable to use the Vanguard Total Stock Market (VTI) rather than the Vanguard U.S. Total Market (VUN)? — R. F.

Until late 2012, there really were no great options for Canadian ETFs that held US and international equities. If you wanted a low-cost, cap-weighted index fund that did not use currency hedging, you were out of luck. That’s why my Complete Couch Potato model portfolio currently uses a pair of US-listed ETFs for its foreign equity components.

But the case for using US-listed ETFs is not nearly as compelling as it used to be. Since April, iShares and Vanguard have launched inexpensive Canadian ETFs covering the broad US and international markets without currency hedging. For example, the Vanguard U.S. Total Market (VUN), launched in August, is virtually identical to the Vanguard Total Stock Market (VTI)—indeed, VUN simply holds units of VTI.

There are three important differences between these ETFs,

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Ask the Spud: Should I Fear Rising Interest Rates?

Q: Recently the bond market—and 40% of my Global Couch Potato portfolio—has dipped significantly. I understand swings like this occur from time to time, but with interest rates moving higher would it be wise to decrease the percentage in bonds to say, 20%? Or maybe temporarily stop my monthly contribution to bonds and instead put it in equities? — C.P.

I’ve received some variation of this question almost every day since interest rates began to spike in May. The unit price of the iShares DEX Universe Bond (XBB), which tracks the most widely followed bond index in Canada, is down about 5.5% on the year, and it could fall further if rates continue to tick upward.

It’s easy to understand the discomfort investors are feeling. After all, Canada has not had a year with negative bond returns since 1999. We’re accustomed to bonds delivering steady returns year after year, and we don’t know how to respond to a sharp decline in price. Our instincts seem to be to stop buying them, and maybe even to sell the ones we already own. But if you’re a long-term investor, that’s getting things exactly backwards.

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Ask the Spud: Should I Buy In Now?

I’ve just inherited a six-figure sum and am interested in investing using the Couch Potato approach. What is your opinion on entering the market now, given it’s at a record high? — C.T.

This is the most common question I hear these days. It took almost four years for investors to finally admit we’re in a charging bull market—US markets are up more than 150% since March 2009—but most of the chatter now seems to be about a looming  correction. This week, one noisemaker even came up with 21 stock market warning signs giving global investors cold sweats. Hard to believe he could only come up with 21.

Even if the media weren’t shouting like this, investing a six-figure lump sum would still be difficult. That’s especially true with an inheritance, since it often takes a while for beneficiaries to feel like that money really belongs to them. But in general—assuming you’ve done a careful risk assessment and have a target asset allocation in mind—it’s usually best to invest the money immediately. Here’s why:

Not everything is at an all-time high. While US markets have been on fire recently,

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Ask the Spud: The US-Dollar Couch Potato

We just sold our condo in Florida and now have some money to invest in non-registered accounts. The problem is, the money is all in American dollars. Is there a way to use the Couch Potato strategy using only USD? – John D.

It’s certainly possible to build a fully diversified ETF portfolio using only US dollars, but there are a number of important issues to consider.

The first is whether you really need to keep the money in USD. If you don’t plan to make another major purchase in the United States (or if you earn a lot of USD income but all your expenses are in Canadian dollars) it might make sense to exchange most or all the money into your home currency before investing it. Of course, you will need to find a low-cost method for doing this, such as Norbert’s gambit.

You also need to consider your overall asset location. Holding fixed income, Canadian equities, and foreign equities in a non-registered USD account probably isn’t the most tax-efficient strategy. Even if your registered accounts are maxed out, you can still make changes so your fixed income stays in Canadian dollars in RRSPs and TFSAs,

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Ask the Spud: The Role of Real Return Bonds

Why has the iShares DEX Real Return Bond (XRB) dropped so dramatically this year? I thought this asset class was protective in times of rising interest rates (which are correlated with inflation), but perhaps I misunderstood. I also see the yield to maturity is almost zero. Please set me straight about the role of real return bonds in a portfolio. – K.T.

Let’s begin with a refresher on real return bonds, or RRBs. They have a lower coupon than traditional bonds, but their principal gets adjusted every six months according to the current rate of inflation, as measured by the Consumer Price Index.

For example, let’s say an RRB has a face value of $1,000 and a coupon of 3% annually (1.5% semi-annually). This bond would initially pay you $15 in interest every six months. However, if inflation rises by 1% before the next interest payment is due, the RRB’s principal will be adjusted upwards to $1,010. Now the 1.5% semi-annual coupon applies to this larger amount, and your next interest payment would be $15.15.

The coupons on federal RRBs today range from 1.5% to 4.25%,

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