Archive | Asset classes

Cost Versus Convenience in “ex Canada” ETFs

I used to own one of those one-piece cutlery tools designed for hiking and camping—the kind with a knife, fork and spoon that all fold into a single unit. It was hardly ideal for eating, especially if you needed the fork and knife at the same time. But it was more convenient than trekking around with three individual pieces of flatware that might tear your pack or get left behind on the trail.

As investors we often make similar trade-offs. Consider the Vanguard FTSE Global All Cap ex Canada (VXC) or the iShares Core MSCI All Country World ex Canada (XAW), which both offer one-stop global diversification by holding thousands of US, international and emerging market stocks. But as with folding cutlery, you give up something to get that convenience. These two “ex Canada” funds get at least some of their exposure by holding underlying US-listed ETFs rather than holding their stocks directly. This structure can result in additional foreign withholding taxes on dividends.

In a recent blog post, Justin Bender estimated the impact of foreign withholding taxes on RRSP investors who hold VXC.

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The Real Problem With Inflation-Protected Bonds

When I announced my stripped-down model portfolios at the beginning of last year, one of the asset classes I dropped was real-return bonds (RRBs). Part of the reason was simplicity: it’s easier to manage a portfolio of three or four funds compared with five or six, and you’re not giving up much diversification. But there was a more important reason for booting real-return bonds from my recommended portfolios.

First, a quick refresher. RRBs are a type of government bond designed to protect investors from the effects of inflation. Both their face value and interest payments are pegged to the Consumer Price Index and adjusted twice a year, which means you’re guaranteed to maintain your purchasing power over the life of the bond. That feature overcomes one of the biggest shortcomings of traditional bonds.

There’s little question that RRBs are useful in theory. Consider a retiree who needs $50,000 annually to meet her expenses today. She could build a 10-year ladder of traditional bonds with a face value of $50,000 each, but by the time that last bond matures $50,000 won’t buy as much as it used to.

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It’s Better With Beta

The title of Larry Swedroe’s latest book, The Incredible Shrinking Alpha, raises a question: what happened to the idea that skilled managers can consistently beat the market? In a recent interview with Swedroe, we discussed the idea that this ability hasn’t really disappeared: it’s just that “alpha has become beta.”

What exactly does that mean? In investing jargon, alpha is the name given to the excess return a fund manager achieves through skill. Beta, on the other hand, refers to the returns available to anyone who is willing to accept a known risk. When Swedroe says “alpha has become beta,” he simply means that anyone who understands how to structure a portfolio can increase their expected returns by simply changing their exposure to specific types of risk, known as “factors.”

A factor is a characteristic of a stock that affects its expected return and risk. Factor investing (sometimes marketed as “smart beta”) means identifying which of these characteristics might predict higher returns in the future—even if it also brings more risk—and then building a diversified portfolio that captures those returns in a systematic way,

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Raining on the All Seasons Portfolio

Investors are hungry for success stories, especially tales that include high returns with low risk. And the investment industry is always happy to stoke that appetite.

One of the most popular stories today is the so-called All Seasons portfolio, whose virtues are trumpeted in the massive bestseller Money: Master the Game, by motivational speaker Tony Robbins. The book has been out since last November and I thought the hype would blow over quickly, but I’m still getting inquiries about it, so I thought I’d take a closer look.

The All Seasons portfolio was created by Ray Dalio of Bridgewater Associates, one of the largest hedge fund managers in the world. It’s based on Dalio’s similarly named All Weather fund, which reportedly has more than $80 billion USD in assets. The portfolio has the following asset mix:

30%      Stocks
40%      Long-term bonds
15%      Intermediate bonds
7.5%     Gold
7.5%     Commodities

In a backtest covering the 30 years from 1984 through 2013, the All Seasons portfolio had an annualized return of 9.7% (net of fees) and only four years with a loss.

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Should You Replace Bonds With Cash?

Not many investors are enthusiastic about bonds these days, and it’s hard to blame them. While rates have ticked up in the last few weeks, they’re still so low that even some sophisticated investors have abandoned them altogether. I’ve spoken to some investors who are ready to follow that advice, though they are not prepared to ride the roller coaster of a 100%-equity portfolio. So they’re asking whether they should just swap their bonds for cash.

At first blush, this looks like a good strategy. As of May 6, the yield to maturity on short-term bond ETFs is barely 1% after fees. Even broad-based bond ETFs (which have average maturities of about 10 years) have a yield to maturity well below 2% after accounting for management fees. Meanwhile, most investment savings accounts (ISAs) are paying at least 1%, and if you hunt around you can find high-interest savings products with much better yields: Equitable Bank offers one at 1.45%, while People’s Choice has a savings account at 1.60% and a TFSA savings account at 2.25%. Why take risk with a bond ETF when you can get a higher yield from cash,

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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 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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