Archive | Ask the Spud

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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Ask the Spud: Do I Have Enough for a DRIP?

Q: I’m planning to use my 2013 TFSA room to purchase a bond ETF. How can I make sure I’m investing enough to benefit from a dividend reinvestment plan? – Phil B.

Dividend reinvestment plans (DRIPs) are a convenient way to make sure your money is compounding every month rather than sitting idly in your account. When you sign up for a DRIP, your distributions (whether dividends, interest or return of capital) are paid in new shares rather than in cash. Discount brokerages typically offer DRIPs for just about all Canadian ETFs, and you can arrange them with a simple phone call or email to the customer service desk.

The potential problem with DRIPs, however, is you can’t receive fractional shares: each distribution must be large enough to purchase one full ETF share, or it will just be paid in cash. Now that more ETFs are paying distributions monthly (as opposed to quarterly, which used to be the norm), each payout is small and you need a fairly significant holding before you’ll receive even a single new share with every distribution. But exactly how much do you need?

It’s not possible to calculate this amount precisely,

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Ask the Spud: Adding a New REIT to the Index

Loblaw recently announced it will be creating a new real estate investment trust (REIT). Once it goes public, how would it be added to existing real estate ETFs? And considering how large the proposed REIT will be, what effect might it have on ETF shareholders? – Joel H.

On December 6, Loblaw Companies announced it would be turning its vast property holdings into a REIT in the new year. Units in this new trust will be listed on the Toronto Stock Exchange and sold during an initial public offering (IPO) in mid-2013.

Any time a new company is listed on the TSX, it may be considered for inclusion in any number of indexes. For example, stocks in the S&P/TSX Composite Index must meet certain criteria (mainly size and liquidity). The index is reviewed every quarter, and if a company no longer meets these criteria it can be removed. By the same token, any newly listed company that does fit the criteria can be added to the index.

The new Loblaw REIT will be one of the largest in Canada, so it will likely qualify for inclusion in the Composite index.

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