Archive | Asset classes

Seeing Diversification in Action

Why should you add multiple asset classes to your portfolio? That seems like a simple question, but it’s one many investors would answer with only a vague comment about “more diversification.” It’s more precise to say you do so to increase expected returns or to decrease volatility. Sometimes these are mutually exclusive, but Harry Markowitz won a Nobel Prize for explaining that you can sometimes accomplish both at the same time. That insight is the basis for Modern Portfolio Theory.

One of the clearest illustrations of this idea can be found in Larry Swedroe’s book Think, Act, and Invest Like Warren Buffett, which I reviewed late last year. Swedroe shows how the return and risk characteristics of a 60/40 portfolio change as you slice and dice the equity allocations.

A portfolio made up of just the S&P 500 and five-year Treasuries returned 10.6% annually from 1975 through 2011, with a standard deviation of 10.8%. By gradually splitting that equity allocation into multiple asset classes (international stocks, value stocks, small caps, and commodities) the portfolio’s annual return increased 150 basis points to 12.1%,

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Why Diversification is a Piece of Cake

After almost four years of false alarms, the bond bears are finally able to act smug. Broad-based Canadian bond index funds have fallen in price about 4% or so in since the beginning of May. Meanwhile, real-return bonds have taken it on the chin: they’ve plummeted about 13% and are headed for their worst calendar year since first being issued by the federal government in 1992.

In times like these investors question the whole idea of including these asset classes in a balanced portfolio. So it’s time for a reminder about how diversification is supposed to work.

It’s helpful to think about a portfolio like a cake recipe. You probably wouldn’t eat flour, baking powder or raw eggs on their own, but when you mix them with sugar, butter, vanilla and other ingredients the results are delicious. A baker doesn’t view ingredients in isolation: she considers how each interacts with the others to produce the final result.

In the same way, it’s important not to view individual asset classes in isolation. Real-return bonds are a perfect example. It would be hard to make a compelling argument for holding nothing but RRBs: their yields are low,

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Understanding Floating-Rate Notes

By now every serious investor understands the consequences rising interest rates will have on bond portfolios. For more than four years we’ve been reminded that when rates go up, bond prices fall—and the longer a bond fund’s duration, the greater the losses will be.

The conventional wisdom is to keep your bond duration short if you expect rates to rise. The problem is, the iShares DEX Short Term Bond (XSB) has a yield to maturity of just 1.38% these days—once you deduct fees, that’s less than a savings account at an online bank. And unlike a savings account (which effectively has a duration of zero), short-term bonds will still lose value if rates move higher.

It should come as no surprise that the financial industry has come up with a product that tries to address this issue: it’s called the floating-rate note. A “floater” has a maturity date like a conventional bond, but its coupon is tied to a benchmark such as the Canadian Dealer Offered Rate (or CDOR, which is this country’s version of LIBOR). The coupon is adjusted every month or every quarter.

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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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What’s On Your ETF Wish List?

It seems like ETFs are appearing in Canada every month, but it’s been a while since I got genuinely excited about a new product. It was great to see both Vanguard and BMO create S&P 500 funds with no currency hedging: they certainly filled a gap in the marketplace. A few other recent launches have been interesting (bond barbells, preferred share ladders, low volatility), if a bit esoteric. Some just induce yawning—do we really need another dividend ETF? It makes you wonder: if you could have one ETF wish, what would you ask for?

Turns out a Canadian ETF provider is granting wishes. First Asset has just announced a contest that invites advisors to submit ideas about what’s missing in the ETF marketplace. They’ll reward the best suggestion with $10,000, which will be donated to the advisor’s favourite charity. Two runners-up will also snag $5,000 for their chosen cause.

“Launching this competition seemed like a natural thing to do as part of our search to find what’s missing in the Canadian ETF landscape,” First Asset’s president and CEO,

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Under the Hood: Vanguard FTSE Canadian Capped REIT (VRE)

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: Vanguard FTSE Canadian Capped REIT (VRE)

The index: The fund tracks the FTSE Canada All Cap Real Estate Capped 25% Index, which includes large, mid and small-cap companies in the Canadian real estate industry as defined by FTSE. The index is weighted by market cap with a limit of 25% on any single company. It currently has 19 holdings.

The cost: The management fee is 0.35%. Because the fund is less than a year old it has not published its full MER, but expect it to be about 0.40% after adding taxes and incidentals.

The details: Vanguard launched VRE last November and continued its tradition of being a cost leader: its management fee is about 20 basis points lower than its competitors.

VRE is not limited to REITs: some of its holdings are developers and real estate services companies that are not set up as income trusts. But even with this expanded definition,

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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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Tim Pickering on Managed Futures, Part 2

Here’s part two of my interview with Tim Pickering, president of Auspice Capital Advisors, who manages both the Horizons Auspice Managed Futures Index ETF (HMF) and the iShares Broad Commodity Index Fund (CBR). You can read part one here.

Managed futures has traditionally been a hedge fund strategy, used mostly by institutions. Can it really be adapted for the retail ETF investor?

TP: All we’ve done at Auspice is said, this is what we do in our alpha program. It’s been around, it’s got a great history. So what are we are willing to make transparent by putting it in an index? How far are we willing to lift the kimono? Can we do that with an ETF-like price? We started talking about that years ago and people thought we were out of our minds. Nobody has done this before, and we are definitely getting a lot of eyebrow raising—that’s a polite way of putting it.

When it became known that we were publishing these broad commodities and managed futures indexes, I got a call from the CEO of a major company in Canada that has a managed futures program.

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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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