Archive | Asset classes

How Budget 2015 Will Affect Investors

Yesterday’s federal budget included several changes that will affect investors—in the future if not immediately. Let’s look at the three most important announcements, with a focus on how they may apply to those who use an index strategy with ETFs:

The biggest headline was the increase in annual TFSA contribution room from $5,500 to $10,000, beginning immediately.

Minimum withdrawals from RRIFs were reduced significantly.

Investors who hold foreign property (including US-listed ETFs in non-registered accounts) will be able to report this to the Canada Revenue Agency in a more efficient way.

Asset location just got more interesting

If you’re juggling TFSAs, RRSPs and non-registered accounts, asset location is a challenge. To manage your portfolio in the most tax-efficient way, you should consider which asset classes (equities, bonds, REITs and so on) are best held in which type of account. This isn’t straightforward. You can make a strong argument for holding bond ETFs in a registered account because they are so tax-inefficient. But if a TFSA can shelter you from taxes over an entire lifetime, shouldn’t it be reserved for assets with the highest growth potential—in other words, stocks?

There is no single right answer: an awful lot depends on awful lot on individual circumstances such as your current tax rate,

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Ask the Spud: Do Aggressive Portfolios Pay Off?

Q: I noticed that over the long term (10 to 20 years) the average returns of your model portfolios are quite similar regardless of the asset allocation, but the maximum losses vary dramatically. Would you say that people saving for retirement may as well be less aggressive, since their goal can still be reached with less risk? – L.V.

One of the first principles of investing is that more risk should lead to higher returns, while playing it safe comes at the cost of slower growth. That’s why I was surprised when we compiled the historical returns of my model ETF portfolios. Over the 10- and 20-year periods ending in 2014, you were barely rewarded for taking more risk:

As you can see, a portfolio of 30% equities and 70% bonds enjoyed an annualized return of 7.48% over 20 years, while portfolios with 60% and 90% equities returned only slightly more. Yet equity-heavy portfolios would have endured a much rockier ride: the investor with 30% stocks never suffered a loss of even 8%, while the poor sap with 90% equities lost almost a third of his portfolio during the worst 12 months (which was February 2008 through March 2009).

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Are Preferred Share Indexers Dumb Money?

It’s hard to keep a straight face while arguing for active strategies in asset classes like large-cap stocks or government bonds. Those markets are so liquid and so well covered by analysts that it’s almost impossible to find and exploit inefficiencies. But many would argue that active managers at least have a fighting chance in asset classes that like, say, emerging markets or small-cap stocks.

On the heels of my previous posts on Canadian preferred shares, let’s consider whether this is another asset class where active managers can be expected to add value compared with a simple indexed approach using ETFs. I recently explored this idea in a conversation with Nicolas Normandeau of Fiera Capital, who manages the Horizons Active Preferred Share ETF (HPR). I think it’s important to have these debates occasionally, because if you believe in indexing, it’s important to be able to defend the strategy with rational arguments and not ideology.

Here are the main arguments in favour of using an active strategy with preferred shares:

The market is complex and inefficient. The entire preferred share market in Canada is about $60 to $65 billion—about the same as the market cap of Canadian National Railway.

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Does Your Portfolio Need Preferred Shares?

Last week’s blog introduced a new white paper, The Role of Preferred Shares in Your Portfolio, coauthored with my colleague Raymond Kerzérho, director of research at PWL Capital. That article looked at the reasons investors might consider adding Canadian preferred shares to a diversified portfolio: namely high yields relative to corporate bonds, tax-favoured dividend income, and low correlation with other asset classes.

Those are three tempting reasons to use preferred shares. But as Raymond and I explain in our paper, the overall risk-reward trade-off in this asset class is not particularly compelling. In my opinion, most balanced portfolios would likely be better off without preferred shares. For those who want to add them to the mix, we make the following recommendations:

Only use preferreds in non-registered accounts. While preferred shares may be a diversifier in any portfolio, their largest benefit is their tax-advantaged dividend income. If you need current income from a non-registered account, preferreds can be a good alternative to corporate bonds, which are often very tax-inefficient. While preferreds carry more risk than bonds issued by the same corporation, this tax advantage should provide adequate compensation.

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The Role of Preferred Shares

Preferred shares are often considered a hybrid security, since they share characteristics of both common stocks and corporate bonds. Like bonds, preferreds typically have a predictable income stream. But unlike bonds, most preferreds do not have a maturity date. And most important, the income from preferred shares is considered dividends rather than interest.

I’ve received many questions about preferred shares over the years: this asset is class is clearly popular with Canadian investors. But the honest truth is that I didn’t have much insight to share: I don’t include preferreds in my model portfolios for DIY investors, and our Toronto team at PWL Capital does not include them in client accounts. But other PWL advisors use them regularly, so I teamed up with my colleague Raymond Kerzérho, director of research at PWL Capital, to write a new white paper on the subject. In The Role of Preferred Shares in Your Portfolio, we describe the different types of preferreds in the Canadian marketplace, consider their risks and potential rewards, and help investors decide whether it’s worth adding them to a diversified portfolio.

In the first of a series of blog posts on this subject,

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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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