Archive | Indexing basics

A Mutual Fund Refugee

I hear from a lot of investors who are mutual fund refugees: they’ve abandoned their overpriced, inappropriate funds and the advisor who sold them, and they’re trying to move ahead on their own. Darren, a reader in British Columbia, recently wrote to me with his story and gave me permission to share it.

Darren and his wife, Sarah, are in their 60s and have been retired for seven years. Until last year, most of their RRSP savings were in mutual funds handled by a adviser they thought was trustworthy. Only after the markets plunged in 2008–09 did they fully understand their situation: the adviser had all of their savings in equities. Not only did they lose a huge chunk of their nest egg, but when they went to sell their funds in disgust they faced the added insult of deferred sales charges. “After that episode we have become rather jaded with financial advisors,” Darren says.

A year later, he and Sarah are still sitting on $283,000 in cash, plus $57,000 in stocks from Darren’s former employer, a telecom, which he does not want to sell. They’re ready to get back into the market and want to build an ETF portfolio they can manage themselves.

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The Next Hot Fund Manager

Still not convinced that the big returns you occasionally see from stock pickers and fund managers are the result of luck rather than skill? A Russian financial magazine reported this month that it has identified a money manager whose extraordinary stock picking beat more than 94% of professional fund managers last year.

Her name is Lusha, and she’s a circus chimpanzee.

At the beginning 2009, the magazine’s editors presented Lusha with 30 cubes on which were written the names of stocks. They asked her to choose eight of them, and her picks tripled in value during the year. According to a report in the UK’s Daily Mail, Lusha focused her picks on banks, a shrewd forecast. Her play on mining resulted in a return of more than 150%, though she missed out on the telecommunications sector, which rose 250% during the year.

Apparently Russian fund managers are not amused: “’If the experiment had taken place a year earlier, the monkey would not have had enough money to pay for her bananas,” one fumed. We beg to differ: if Lusha was charging her clients a management fee of 2.5%, we think she’d have done just fine.

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Couch Potato Basics, Part 5: Tax Efficiency

This post is the fifth in a five-part series outlining the primary benefits of the Couch Potato strategy.

All investors have to deal with the erosion of their returns by fees and taxes. The first post in this series explained how using ETFs and index funds can cut your costs by 90% or more. Now let’s look at how index investing can also cut your tax bill.

Fair warning: this subject is rather technical and it may leave beginners baffled. The good news is that if all your investments are in registered accounts—RRSPs, RRIFs, RESPs or Tax-Free Savings Accounts—you don’t need to worry about it. But if you’re investing in a taxable account with actively managed mutual funds, you may want to settle in. It just might save you some money.

Most mutual funds are structured as open-end trusts, which enables them to avoid paying taxes. Instead, funds pass along any interest, dividends and capital gains to their unitholders. (Mutual funds incur a capital gain any time they sell stocks, bonds or other securities at a profit.) Usually all of these distributions are reinvested rather than paid in cash, but unitholders are still responsible for paying tax on them: that’s why you get that T3 slip in the mail every year.

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Couch Potato Basics, Part 4: Flexibility

This post is the fourth in a five-part series outlining the primary benefits of the Couch Potato strategy.

Anyone who has invested in both mutual funds and individual stocks knows there’s a world of difference in how they are traded.

You can determine a stock’s current price almost instantaneously. If you place a market order to buy a popular stock, chances are your trade will be executed in seconds, extremely close to the quoted price. And if you’re adamant about receiving a particular price, you can place a limit order, which specifies the maximum you’ll pay when buying, or the minimum you’ll accept when selling. You can do this any time the markets are open.

Mutual funds are far less flexible. Funds calculate their net asset value (NAV) just once daily, after the market closes, and then carry out trade orders made during that day. So even if you place an order to buy or sell at 10 in the morning, the trade will be executed based on the price set at end of that trading day. If you’re moving a large sum, a market drop of even 1% or 2% can cost you a significant chunk of money.

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Couch Potato Basics, Part 3: Transparency

This post is the third in a five-part series outlining the primary benefits of the Couch Potato strategy.

Have you ever tried to learn exactly what stocks or bonds are held in a mutual fund? Don’t bother: it’s impossible.

Mutual funds are required to disclose their holdings only once each quarter, and by the time those reports are released the makeup will have already changed: the most you’ll learn is what the top holdings were weeks or months ago. That makes buying a mutual fund an act of faith as much as anything else.

ETFs, on the other hand, are refreshingly transparent. Their holdings are published every day on the fund company’s website. That makes comparing funds a breeze.

Say you’re trying to decide whether to buy the iShares Canadian Dividend Index Fund (XDV) or its competitor, the Claymore S&P/TSX Canadian Dividend ETF (CDZ). By visiting their websites and clicking the “Holdings” link, you’ll learn that XDV holds 30 stocks, while CDZ holds 56. You’ll know exactly what proportion each stocks represents in each fund. You can compare their weightings in the various sectors, and see their current yields.

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Couch Potato Basics, Part 2: Pure Asset Allocation

This post is the second in a five-part series outlining the primary benefits of the Couch Potato strategy.

Most investors understand the importance of diversifying. By spreading your money across different asset classes—cash, bonds, stocks, real estate, commodities—you can lower your portfolio’s overall risk and boost your returns over the long term. In fact, your asset allocation is probably your single most important investment decision.

Unfortunately for investors buying actively managed mutual funds, getting that target asset mix is often extremely difficult.

Say you decide to split the equity portion of your portfolio equally among Canadian, US and international developed countries. For your domestic and US stocks, you choose the Trimark Canadian Series A and Trimark US Companies, respectively. You round things out with the Dynamic EAFE Value Class fund, because it trounced its benchmark in 2009. (That benchmark, the MSCI EAFE index, includes 16 developed countries in Europe, plus Australia, New Zealand, Japan, Hong Kong and Singapore.)

You might reasonably expect this would put about 33% of your money in each of the three regions. But you’d be wrong.

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Couch Potato Basics, Part 1: Low Costs

This post is the first in a five-part series outlining the primary benefits of the Couch Potato strategy.

Mutual funds are a great investment tool—in theory. They allow small investors to pool their money and buy stocks and bonds that would be far too expensive to purchase individually. They’re managed by professionals who—presumably—use strategies that are more sophisticated than those the average investor could employ. No wonder so many Canadians own them.

Unfortunately, mutual funds have a fatal flaw: they’re too expensive. Especially in Canada.

Equity mutual funds offered by the big banks typically charge 2% to 2.5% in management fees, often considerably more. Fund companies that sell their products directly to investors—such as Phillips Hager & North, Beutel Goodman and Mawer—charge lower fees, but 1.2% to 1.5% is still typical.

Canadians, in fact, pay the highest fund fees in the world: a recent report by Morningstar graded fund expenses in 16 countries and gave Canada the only F. “Canadian investors are comfortable with the fees,” the report says, “because they don’t know how low these fees should actually be.” Now doesn’t that make you feel like a chump?

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Welcome to Canadian Couch Potato

Welcome to Canadian Couch Potato, a brand new blog intended to help investors looking for a low-cost, proven strategy that anyone can implement.

The Couch Potato strategy (also called index investing, or passive investing) involves buying and holding low-cost index funds designed to deliver the same returns as the overall stock and bond markets. After all, no one needs to beat the market to be a successful investor. From 1980 through 2009, Canadian stocks and bonds both averaged 10% annually, including dividends and interest. A 40-year-old investor who started saving $250 a month 25 years ago would be ready to retire with a $300,000 nest egg today if she had simply earned what the market offered.

Unfortunately, most investors earn nowhere near market returns. They chase hot funds, or make bets on individual stocks or sectors of the economy. Or they invest in high-cost mutual funds that pay 1.5% to the fund company and another 1% to the advisor before handing over what’s left.  And how do these investors fare? According to research from Dalbar, during the 20 years ending in 2008, the average mutual fund investor in the US earned well under 2% annually! There are no comparable data for Canada,

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