Archive | Asset classes

An Interview With Wealthsimple: Part 2

Earlier this week I published an excerpt from my interview with David Nugent, portfolio manager of the online investment service Wealthsimple. In this second part of our interview, Nugent goes into more detail about the firm’s investment strategies, including the individual funds they use in their portfolios.

Let’s say you’ve determined an investor’s appropriate asset mix is 60% equities and 40% fixed income. Can you describe how you would divide that across various asset classes?

DN: Our asset classes are Canadian equities, US equities, foreign developed market equities, emerging markets, dividend stocks and real estate, and then there is a component of tactical stocks. The fixed income piece is Canadian investment-grade corporate bonds, Canadian government bonds, US high-yield bonds and cash.

When it comes to choosing ETFs, we try to get the broadest exposure in each asset class. We’re looking to try to capture large caps, mid caps and small caps because we believe that over the long term there is value in having some exposure to that small cap space: they tend to outperform large caps over extended periods. So for Canadian, US, foreign developed and emerging market equities we use total-market cap-weighted ETFs.

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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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Managing Multiple Family Accounts

Model portfolios like those I recommend are ideal for investors who have a single RRSP account. But life isn’t so simple once you’ve accumulated a significant portfolio: chances are you’ll be managing two or three accounts, and if you have a spouse there may well be a few more.

In most cases, it’s most efficient to consider both partners’ retirement accounts as a single large portfolio. In other words, there’s no my money and my spouse’s money: there’s only our money. This strategy has a couple of advantages: first, it allows the family to make the most tax-efficient asset location decisions. Second, it keeps the overall number of holdings to a minimum, which reduces transaction costs and complexity.

Meet Henry and Anne, who have a combined portfolio of $480,000. Let’s assume they are the same age and plan to retire at about the same time. Their financial plan revealed that a mix of 50% bonds and 50% stocks is suitable for their risk tolerance and goals. Anne has a generous defined benefit pension plan and therefore has little RRSP room: most of her personal savings go to a non-registered account.

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Rebalancing With Cash Flows

With stocks continuing to enjoy a roaring bull market, rebalancing is on the minds of many investors—or at least it should be. Disciplined investing starts with choosing long-term targets for the asset classes in your portfolio and making regular adjustments to stay on course. Rebalancing discourages you from chasing performance, timing the markets and taking inappropriate risk.

There are three main rebalancing strategies. The first is based on the calendar: you might rebalance annually, or even several times per year. (Many balanced funds, for example, rebalance every quarter.) The second is based on thresholds: a rebalance might be triggered any time an asset class is five percentage points off its target. Finally, you can rebalance with cash flows, buying underweight asset classes with new contributions or cash from distributions (or, if you’re drawing down your portfolio, selling overweight positions when you make withdrawals).

In the real world, most investors probably do some combination of all three, and that’s fine. But there’s a good argument to be made for emphasizing the cash-flow method.

Go with the flow

Rebalancing with cash flows is particularly useful for those making regular contributions. The idea is that you deposit cash in your account every month or so,

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Do Bonds Still Belong in an RRSP?

It has long been conventional wisdom that bonds should be held in RRSPs wherever possible, since interest income is fully taxable. Once you run out of contribution room, equities can go in a non-registered account, because Canadian dividends and capital gains are taxed more favorably. But is this idea still valid? That’s the question Justin Bender and I explore in our new white paper, Asset Location for Taxable Investors.

Here’s an example we used to illustrate the problem. Assume you’re an Ontario investor with a marginal tax rate of 46.41%. Your non-registered account holds $1,000 in Canadian equities that return 8%, of which 3% is from eligible dividends and 5% is a realized capital gain. You would pay $8.86 in tax on the dividend income ($30 x 29.52%) and $11.60 on the realized capital gain ($50 x 23.20%), for a total of $20.46. Meanwhile, a $1,000 bond yielding 5% (or $50 annually) would be taxed at your full marginal rate, resulting in a tax bill of $23.21.

In this example, even though the total return on the stocks was higher (8% versus 5%) the amount of tax payable on the bond holding was significantly greater.

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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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A Periodic Review of Diversification

After the financial crisis of 2008–09, financial commentators loved to take shots at “old school” investment strategies. First came the declarations that diversification no longer works, because during a crisis everything goes down together—though this wasn’t true in 2008 unless you ignored bonds, which make up a significant part of most portfolios. Then the investment industry sounded the death knell for the traditional balanced portfolio. Apparently we were in a new era where active investing, tactical asset allocation and alternative asset classes would rule the day.

One of the most effective ways to expose this nonsense is to build a “periodic table” of investment returns. (Norm Rothery has maintained one on his Stingy Investor site for several years.) The resemblance to the poster that hung in your high-school chemistry class is only superficial: this table simply presents the returns of various asset classes ordered from highest to lowest over a period of several years. By adding a colour for each asset class, the results jump off the screen.

I thought it would be interesting to build a periodic table with the returns of the seven individual asset classes in the Complete Couch Potato,

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Calculate Your Personal Rate of Return

On January 9, I published the 2013 returns of my model portfolios. The equity markets performed spectacularly last year, but most investors are likely to be far more interested in the performance of their own portfolios. Problem is, calculating your personal rate of return is more difficult than most investors realize.

If you’ve made no contributions or withdrawals during the year, the math is simple enough. But what if you made a big lump sum contribution during RRSP season? Or took $7,000 out of your TFSA to buy a used car? If you make monthly automatic monthly contributions, you may have seen your account balance grow every month, but most of that increase is from new money, not investment returns. Any time you introduce cash flows to the portfolio, calculating your rate of return suddenly becomes much harder.

If you work with an advisor, he or she should provide you with your personal rate of return at least once a year. But hard as it is to believe, many aren’t doing this. The Canadian Securities Administrators issued a policy in July making it mandatory, but firms have three years to comply.

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The Failed Promise of Market Timing

I’ve long believed the most difficult part of being a Couch Potato investor is resisting temptation. Index investors are asked to be content with market returns, but they are bombarded daily by fund companies, advisors and market gurus who promise more.

Back in May 2012, I wrote about one of these enticing strategies, described in The Ivy Portfolio by Mebane Faber and Eric Richardson. The so-called Global Tactical Asset Allocation (GTAA) strategy grew out of Faber’s widely read research paper, A Quantitative Approach to Tactical Asset Allocation, first published in 2007. It begins with a diversified portfolio inspired by the Yale and Harvard endowment funds, combining traditional and alternative asset classes. The “tactical” part involves using market timing to move in and out of these asset classes based on 10-month moving averages.

Faber updated the paper in early 2013 and it now includes four full decades of data. From 1973 through 2012, the GTAA strategy shows exactly one negative year: a modest loss of –0.59% in 2008. And over those 40 years, the GTAA delivered an annualized return of 10.48% with a standard deviation of 6.99%,

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