Archive | Research

How Contributions Affect Your Rate of Return

Whenever I update the returns of my model portfolios, readers ask how the performance would have been different had they added money to the portfolios money each month. This question gets to the heart of the difference between time-weighted and money-weighted returns, which I introduced in my previous post.

In our new white paper, Understanding Your Portfolio’s Rate of Return, Justin Bender and I explain the differences between these two methods using two hypothetical investors with a $250,000 portfolio: the first makes a single $25,000 contribution while the other makes a $25,000 withdrawal. Now let’s look at a different example that includes monthly cash flows.

A tale of two accounts

Meet Buster, an investor with an RRSP and a TFSA that both hold an index fund of Canadian stocks (I’ve used the MSCI Canada Investable Market Index for the calculations). At the beginning of 2014, Buster’s RRSP had a balance of $200,000 and he made $500 monthly contributions throughout the year. Buster’s TFSA has valued at $30,000 at the beginning of the year and he made a single lump-sum contribution of $10,000 in September.

At the end of the year,

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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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How Bad Data Leads to Poor Investment Decisions

Making smart investment decisions is difficult enough when you have reliable information. If you’re working with inaccurate or misleading data, good decisions become almost impossible.

The most popular source of confusion and misinformation has to be Google Finance. I don’t want to be too hard on Google: the company offers a suite of extraordinarily useful tools for free. But for Canadian investors, Google Finance provides information about ETFs and mutual funds that is highly misleading, and often flat-out wrong. Let’s look at some examples.

The price is right—but it’s only half the story

Google Finance (and other services offering online stock quotes) is useful for charting the changes in an ETF’s price over time. But it does not measure the effect of reinvested dividends and interest. That means you’re only getting half the story: the total return of an investment fund should always be measured assuming all distributions are reinvested.

This can make a dramatic difference when you’re looking at the performance of a fund that pays large distributions. For example, type ZRE into Google Finance and you’ll see the price change in the BMO Equal Weight REITs Index ETF during the 12 months ending April 30 was just over 5%:

The chart above shows the monthly distributions of $0.08 each,

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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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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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After-Tax Returns on Canadian ETFs

When you invest in a non-registered account, you need to be concerned about more than just your funds’ performance: you also need to know how much of your return will be eaten up by taxes. Unfortunately, while regulators are strict about the way ETFs and mutual funds report performance, fund companies in Canada have no obligation to estimate after-tax returns—something that’s been required in the US since 2001.

To help address this problem, Justin Bender spent the last several months creating a calculator for estimating the after-tax returns on Canadian ETFs. He was inspired by Morningstar’s US methodology, but he made many significant changes to adapt it for Canada. The new methodology is fully explained in our latest white paper, After-Tax Returns: How to estimate the impact of taxes on ETF performance. We have also made our spreadsheet available for free download so DIY investors can experiment on their own. (The spreadsheet is protected so the formulas cannot be altered. However, we have included detailed descriptions of these formulas in the appendix to the white paper.)

The methodology is quite complex, but here’s an overview in plain English:

We begin by recording the ex-dividend dates for all the cash distributions an ETF made during the period being considered.

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How to Estimate Stock and Bond Returns

Even the simplest financial plan requires assumptions about how your investments will perform. We know these assumptions can never be perfectly accurate, but they need to be thoughtful and reasonable. If you’re just assuming a balanced portfolio will return 7% every year, then your projections aren’t likely to be useful.

So what exactly are reasonable assumptions for stocks and bonds? In Great Expectations—a new white paper I’ve co-authored with Raymond Kerzérho, PWL Capital’s director of research—we explain the methodology we use when creating financial plans.

There are two main approaches one can use when estimating future returns. The first is to rely on history: for example, if the average return of global stocks over the last century was 8%, one could simply assume the same going forward. The second approach uses valuation metrics to estimate future stock returns based on current market conditions. You can also apply these two methods to expected bond returns, using either the long-term historical average or the current yield on a benchmark index.

As you’ve probably figured out, both methods are flawed. But as we argue in the white paper,

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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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Why Currency Hedging Doesn’t Work in Canada

In the last two years, Canadian ETF providers have finally launched US and international equity ETFs that do away with currency hedging. Yet the strategy remains hugely popular: the hedged versions of Vanguard’s international and US total market ETFs remain much larger than their unhedged counterparts, while investors have more than $2 billion in the iShares S&P 500 Hedged to CAD (XSP), making it the third largest ETF in Canada.

None of my model portfolios include currency-hedged funds: I’ve long argued the strategy is expensive and imprecise. Even when the Canadian dollar appreciates strongly, the high tracking error of currency-hedged funds often reduces any potential benefit. In one dramatic example, Justin Bender looked at the period from 2006 through 2011, when the US dollar depreciated by almost 13% and hedging should have produced a huge boost: in reality, XSP lagged its US-listed counterpart.

This leads to an interesting question. If currency hedging were free and precise—with an expected tracking error of zero—would it be worth considering?

Does hedging lower volatility?

The most common argument in favour of currency hedging is that it lowers volatility.

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