Archive | Ask the Spud

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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Ask the Spud: Combining e-Series Funds and ETFs

I use the Global Couch Potato with e-Series funds in my TD Waterhouse account, but I eventually want to use the Complete Couch Potato. Once my portfolio gets to $50,000 and I qualify for $9.95 trading commissions, should I move everything to ETFs? — Mark V.

If you’re a client of any other brokerage, it makes sense to use ETFs to build the Complete Couch Potato portfolio. But with TD Waterhouse you have the unique opportunity to combine the e-Series mutual funds and ETFs in the same account. For five-figure portfolios (and perhaps even much larger accounts) a hybrid approach is likely to make more sense than using all ETFs.

The Complete Couch Potato has three asset classes that are absent in the Global Couch Potato: real estate, real-return bonds, and emerging markets. There are no e-Series funds for these asset classes, nor are there low-cost index funds from other providers. But that doesn’t mean you can’t create a hybrid portfolio of e-Series funds and ETFs. It would look something like this:

Asset class
 %

Fund name (ticker)
MER

Canadian equity
20%

TD Canadian Index – e (TDB900)
0.33%

US equity
15%

TD US Index – e (TDB902)
0.35%

International equity
10%

TD International Index – e (TDB911)
0.50%

Emerging markets equity
5%

Vanguard MSCI Emerging Markets  (VEE)
0.55%

Real estate
10%

BMO Equal Weight REITs (ZRE)
0.62%

Real return bonds
10%

iShares DEX Real Return Bond (XRB)
0.39%

Canadian bonds
30%

TD Canadian Bond Index – e (TDB909)
0.51%

100%

0.45%

A few words of explanation.

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Ask the Spud: Should I Unbundle My ETF?

Q: What do you think of investing directly in Canadian REITs instead of buying an ETF? It may be possible to achieve similar results without paying the ETF’s management fee. – Philippe V.

ETFs promise broad diversification at rock-bottom costs, but not necessarily in every asset class. Sector ETFs, in particular, still have relatively high fees in Canada. The BMO Equal Weight REITs (ZRE), for example, holds just 18 real estate investment trusts yet carries an MER of 0.62%, including the Ontario HST. The iShares S&P/TSX Capped REIT (XRE) charges about the same for an even smaller portfolio. (Vanguard has announced it will bring out its own REIT fund later this year with a management fee of just 0.35%.)

Since indexing is all about capturing an asset class’s returns at the lowest possible cost, does it make sense to simply buy all (or most) of the REITs in these funds directly and avoid management fees altogether? If your portfolio is very large, it might. But whenever you make a decision like this, you need to do the math carefully. Then you need to consider the convenience factor.

At the most basic level,

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Ask the Spud: Does Home Bias Ever Make Sense?

Q: The Global Couch Potato has one-third of the equity allocation in Canadian stocks, but Canada makes up only about 4% of the world markets. Aren’t you guilty of home country bias? – Jeremy D.

I’m actually pleased that I’ve received this question several times in the last few months. Not long ago, it wasn’t unusual for investors to ask why anyone would invest in any country but Canada. Our domestic market was one of the world’s top performers during the first decade of the new millennium, but that’s changed: Canada has now lagged the MSCI All Country World Index by 3.4% annually over the last three years, and we’ve trailed the US over the last five.

That’s a reminder that the long-term expected returns in any developed country are more or less the same. (Since 1970, the average return on Canadian, US and international stocks are almost identical.) However, since each country’s stock market moves along a different path, a globally diversified portfolio should have lower volatility than any single country, and it should boost returns by providing opportunities for rebalancing.

It makes theoretical sense to build an equity portfolio that assigns weight to every country based on the size of its stock market.

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Ask the Spud: Investing With Multiple Accounts

Q: How do I use the Couch Potato strategy across multiple accounts?  We have a taxable investment account, my RRSP, a spousal RRSP and two TFSAs (one for me, and one for my spouse). Should we hold all of the ETFs in each account—which seems cumbersome—or treat them all as one large portfolio? — B.H.

In most cases, you should think of your assets as one large portfolio. If you’re using the Complete Couch Potato, for example, it doesn’t make sense to hold all six ETFs in each of your individual accounts. This just increases trading costs and complexity. However, it is often impossible to avoid at least some overlap when you’re investing across multiple accounts. Here are the important factors you need to consider as you figure out the right plan for your household assets.

The purpose of the accounts. This is the most important consideration: you should only treat your accounts as a single portfolio if they are intended for the same purpose. If you have a group RRSP through your employer and a self-directed RRSP with a discount brokerage, these are both clearly designed to fund your retirement.

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Ask the Spud: Should I Hold US Bonds?

Q: One of my coworkers and I recently started our own Couch Potato portfolios and we’re wondering if it would be better to have some American bonds in the mix. Wouldn’t that be another way to diversify? – Jason L.

The answer depends on whether you’re talking about government bonds or corporate bonds.

It’s usually not a good idea for Canadians to hold US or other foreign government bonds in their portfolio. In theory, because interest rates are not the same in every country, it can makes sense to diversify your bond holdings globally. However, investing in US or international bonds exposes Canadians to currency risk.

Currency risk is welcome on the equity side of your portfolio, because it can lower volatility without decreasing expected returns. That’s why I recommend using unhedged index funds and ETFs for US and international stocks. But the situation is different for fixed income. The yield differential between Canadian and US bonds is likely to be quite small, and it will be completely overwhelmed by significant changes in the exchange rate. That means adding currency risk to your bond holdings will tend to increase volatility without increasing expected returns.

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Ask the Spud: Am I Vulnerable to US Estate Taxes?

Q: I am ready to follow the Couch Potato and would like to use the US-listed Vanguard ETFs that you recommend in your model portfolios. But when I checked with my accountant, he warned me that I could face US estate taxes when I die. Is this true? — Karl W.

It’s possible, yes. Canadians with a high net worth and significant holdings in US assets (including ETFs listed on an American exchange) may be subject to estate taxes levied by the Internal Revenue Service. This tax can be up to 35%.

Before we go any further, let me remind you that I am not a tax expert, and it is essential that you consult an accountant or other qualified advisor if you think you may be in this situation. It’s also crucial to understand that US estate tax laws have changed several times in recent years (most recently in December 2010) and will likely change again after the presidential election next year: the current law is only valid until the end of 2012. It’s your responsibility to stay on top of these changes.

With that out of the way,

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