How Panama Functions With No Central Bank

I just read an interesting article about Panama’s monetary system called “Panama Has No Central Bank. Here’s a summary of how Panama’s monetary system works and the effect it has had on inflation and the economy:

The absence of a central bank in Panama has created a completely market-driven money supply. Panama’s market has also chosen the US dollar as its de facto currency. The country must buy or obtain their dollars by producing or exporting real goods or services; it cannot create money out of thin air. In this way, at least, the system is similar to the old gold standard. Annual inflation in the past 20 years has averaged 1% and there have been years with price deflation, as well: 1986, 1989, and 2003.

Panamanian inflation is usually between 1 and 3 points lower than US inflation; it is caused mostly by the Federal Reserve’s effect on world prices. This market-driven system has created an extremely stable macroeconomic environment. Panama is the only country in Latin America that has not experienced a financial collapse or a currency crisis since its independence.

Read the article for more if you are interested.

Take That Spam

For some reason I am getting way less spam than I used to. I used to get at least 10 comment spams per day, maybe more. It was too much to count. Now I get 1 comment spam every 2-3 days. I wonder if the spam bots have started to realize that they just can’t get through my Akismet spam filter. I do have to wade through the spams as sometimes comments do get caught in the filter and the posters do not notify me that their post did not get through. It sure is nice to be getting less spam.

Favourite Financial Magazines, Books, or Websites

I got tagged by Canadian Money Advisor in hist article, “What are your favourite financial magazines, books, or websites?!!” Here are mine:

The Wealthy Barber by David Chilton: One of the first financial books I ever read. I read some of it when I was really young and first learned about compounding and RRSPs and other simple stuff. I’ve read some of the chapters again over the last few years and it has some great financial advice in it.

The Intelligent Investor (revised edition) by Benjamin Graham: Read this a couple years ago and it really changed the way I think of investing. Mainly it made me realize that being a successful stock picker is really hard and unless you have all day to spend doing it, don’t do it. Great historical recounts of the tech boom (and bust) of not only the 90s but the 60s as well, and other famous bubbles (and bursts). It also taught me to not worry about the daily goings-on in the market.

Efficient Market Canada website by Marting Gale: The writings on this site greatly influenced my decision to go with an all-passive portfolio and to use ETFs to achive that. It has lots of great articles and recommendations.

A Random Walk Down Wall Street (ninth edition) by Burton Malkiel: Since I have an all-passive portfolio, I figure I better learn more about the theory behind this in detail. This famous book is a good start. I am not almost half-way through it and I definitely recommend it for all investors.

Unfortuntely I cannot recomend any magazine, newspaper, or other media publication. Some have decent articles once in a while but not usually. If anyone has any recommendations, please let me know.

Ignore Past Performance

Rob Carrick wrote an article in this weekend’s Globe & Mail titled “Seeking the hottest of the hot-charging funds.” The title alone makes me never want to read through the business section of the Globe & Mail again. If headlines like this don’t sound like nails on a blackboard to you, then you need to ask yourself why it doesn’t.

The first paragraph reads: “Today’s goal will be to find funds that have jumped ahead of their peers and stayed there for longest. The hottest of the hot funds, if you will.” To what end? There must be some purpose or else why do it? If there is one, it is never mentioned in the short article. In the print article, there is some fine-print on the right-hand side that says “Remember, past results guarantee absolutely nothing about the future.” In the online article that text is a bit more prominent and appears before the list of hot funds rather than after. So because past results guarantee absolutely nothing about the future (not just nothing, but absolutely nothing), there doesn’t seem to be any purpose to this article other than as a historical account of the performance of some random funds. However, I can’t help wondering how many people read that article, joted down some of the funds, and on Monday will buy those funds, with some expectation of similar return. After all, Rob Carrick didn’t just choose the funds that have performed the best in some period, he’s “looking for consistent top returns, so let’s zero in on the funds that nailed a top five-star rating for the most months consecutively.” I think people are even more willing to fall into the trap of going for funds that have performed “consistently well”, even more so than funds that have just “performed well in the past.” The way the article is written (besides the disclaimer), to the lay reader, I don’t see how it is anything other than a recommendation of these funds.

To top it off, the longest return period that is given is the 5-year return. This takes us back to 2002 when the current bull market started. I dunno, I sort of feel a sense of deja-vu here. It feels like 1999-2000, when a list of the “hottest of the hot-charging funds” would include a bunch of technology funds (now replaced with precious metals funds apparently). A couple years later they would appear on lists of the worst performing funds.

Pitfalls of Do-It-Yourself (DIY) Investing: Checking Your Account Daily

Since switching to E*Trade I am noticing an all-to-familiar behaviour creeping back into my daily life. It is something that I have not done since I had my TD Mutual Fund account in 2005. Last year I had an advisor and I pretty much never knew how my portfolio was doing except for those monthly statements I would get in the mail. I loved those days. Now I find myself checking my E*Trade account online about once a day, depending on the week. This week and last week were bad but the week before that wasn’t so bad. Checking your portfolio daily is bad for so many reasons. Reasons that are so obvious that I am not going to waste time mentioning them.

I am thinking of changing my password to something really complicated and giving it to my wife. Then once every 3 months or so (about the time it will take for enough cash to build up to buy some more ETFs) I will ask her for it. That might actually work.

My New Passive Index ETF Portfolio

Unfortunately this is the second time my portfolio has changed in the past two years. The first change was when I moved from a TD Mutual Funds account to Clearsight last year. My advisor had great plans for my portfolio. He wanted to eventually have me primarily invested in low-cost ETFs and we were going to have a 25-25-25-25 split between Canadian bonds, Canadian equities, international equities, and US equities. Due to the high commissions ($75) charged by Clearsight we bought one ETF and the rest was in mutual funds. Anyways, before we got very far Clearsight was acquired by Wellington West and my advisor was let go, so I began the transition to E*Trade where I could manage my portfolio on my own. I learned a lot from my advisor at Clearsight, like what an ETF is, and importance of lowering cost. I have come a long way since just owning just TD mutual funds and eFunds through a TD Mutual Funds account back in 2005. So before I introduce you to my new portfolio at E*Trade, here’s what my portfolio looked like when I was with Clearsight:

RRSP holding Symbol Type %
CI Value Trust US Equity 11%
Templeton International Stock Fund Global Equity 26%
Canadian TSX60 index ETF XIU Canadian Large Cap 34%
E&P Growth Opportunities Canadian Small Cap 4%
TD Canadian Bond Fund Canadian Bond 25%

Some of the things I did not like about my old portfolio are:

  • High cost – Too many mutual funds with high MERs. I checked all of these funds’ performance again and for the most part they didn’t seem to be capable of beating their benchmarks in the past. The Growth Opportunities has not beaten the S&P/TSX Venture Composite Index in the range I looked at. CI Value Trust (clone of Legg Mason Value Trust) has not been impressive of late, but even worse, it has assumed far more risk than an index, with its investments in Google and other high-tech stocks. The Templeton International Index fund (last time I checked) had not beaten the MSCI EAFE index over the long term. Also, the TD Canadian Bond fund is not all that spectacular compared to ETFs like XSB.
  • No emerging markets – I wanted some emerging markets to provide increased diversification and greater risk-adjusted return due to their low correlation with other markets. The fact that emerging markets have done very well of late is of no concern to me, I realize if I buy emerging markets equities now I might suffer a bit in the near future.
  • No real return bonds, or inflation-sensitive assets – I looked at the Ontario Teacher’s Pension Plan and the CPP Investment Board and both have significant real return bond holdings. The former has 11.1% and the latter has 3.5% in real return bonds.
  • Huge domestic bias – Although I had originally wanted 25% in Canadian equities my advisor had me at 40% because he had concerns about the US dollar, so we weighted Canadian equities more. This is way too much allocated to a handful of Canadian companies that make up a large part of the TSX/S&P 60 Index.
  • No foreign currency exposure – Foreign currency exposure can be a good thing. If inflation is high in Canada, our dollar will decrease in value relative to other currencies. More importantly, some of my investments, such as the CI Value Trust were hedged versions of USD mutual funds so I was paying extra management expense when I could have just owned the USD version and possibly reduced my total risk at lower cost.
  • Lack of US exposure – I only had something like 11% of my assets in US equities. This is extremely underweight for such a large market like the US. My advisor was planning to “ease in” to US equities (he had some issue with the falling US dollar) but I would prefer to just go with some desired allocation and re-balance when necessary rather than thinking one can be smarter than the market.
  • Lack of broad US exposure – Bill Miller’s Value Trust is invested in relatively few investments compared to the size of the US market. He also invested a lot in high tech companies like Google, Yahoo, Amazon, eBay, etc… I wanted to own more blue chips/boring companies, mid-caps, small-caps, etc…

So based on some of the things I did not like about my old portfolio, and some information that I gleaned from various blogs and internet sources, here is my new portfolio that I have putting together for the past couple months:

RRSP holding Symbol Type %
iShares CDN MSCI EAFE Index Fund ETF XIN-T International Equity 35%
Vanguard Emerging Markets ETF VWO Emerging Markets 5%
Vanguard Total Stock Market ETF VTI US Equity 32%
iShares Canadian Short Bond Index Fund ETF XSB-T Canadian Short-Term Bond 15%
iShares Canadian Real Return Bond Index Fund ETF XRB-T Canadian Real Return Bond 5%
iShares Canadian Composite Index Fund ETF XIC-T Canadian Equity 8%

Now I’ll expand on some of the reasons why I chose the above asset allocation as well as the reasons why I chose each investment in my new portfolio. This portfolio is inspired primarily by Martin Gale, Canadian Capitalist, Dan Solin (author of The Smartest Investment Book You’ll Ever Read), and Burton Malkiel (only part way through his book right now).

NOTE: I am under 30, I am looking for long term growth only, I am not planning to take out any of this money until I retire at age 55-65, and I can handle some short-term swings in the market.

ETFs vs. mutual funds
Using ETFs instead of mutual funds was a no-brainer for me. I have come to the realization that beating the market is virtually impossible for all but a few very talented people, and that passive investing can yield greater returns with less risk due to its lower costs. For more information, read my recent blog post “Malkiel, Bogle Argue Against Non-Market Capitalization Weighted ETFs” or read “A Random Walk Down Wall Street.” I can also give credit to the Canadian Capitalist and his blog for convincing me of this fact. He has been tracking a “sleepy portfolio” for a while now, consisting of a few ETFs and it seems to do pretty well.

It was clear to me that I was not going to have a 100% bonds portfolio, nor was I going to have a 100% equities (as my advisor wanted me to have last year). Benjamin Graham is very clear in The Intelligently Investor page 56-57 about his opinion on this issue when he says “just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket–neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation . . .” There is much more discussion about this in the book. Martin Gale also has an excellent article about stocks vs. bonds. He says,

Many investors make the mistake of thinking that the least risky portfolio is one containing just cash and short-term bonds; or that the most aggressive portfolio is one containing only equities. Somewhat surprisingly, that is false. The safest portfolio contains a mix of stocks and bonds, as does the most aggressive. For any portfolio containing all bonds there is a less risky portfolio with a better return that contains some stocks. This is counter-intuitive because in and of themselves bonds are safer than stocks.

I saw some similar arguments in a Powerpoint presentation from an investment advisor recently, that basically said, no matter how risky you want to be, at least hold some bonds (like at least 10%). It is pretty widely accepted that you should have some bonds and some equities. How much of each is up to you. I followed Martin Gale’s advice on short vs long term bonds, and decided to stick to buying short-term bonds, because “whatever risk/return ratio you achieved by buying longer duration bonds, you could achieve by holding fewer bonds and more equities. In general I think the equities have the better risk/return ratio. That could always change–but at least historically, it’s been the case that equities have been a better investment than long-term bonds.” This backs up what I was told by my ex-advisor at Clearsight; stick with short duration bonds and avoid long duration bonds.

So, to minimize cost I see only two options. Buying iShares Short-term Bond Index Fund (XSB), or buying individual bonds and making my own bond ladder. I decided to buy XSB since the commission costs of making my own bond ladder would be prohibitive at this point, although when my nest egg is larger this might be more cost-effective because it would eliminate the MER.

Real-Return Bonds
As I said above, one of the disadvantages of my old portfolio was that I had no real-return bond component. Real return bonds are resistant to inflation because the interest is set to be x number of points above the inflation rate. I looked at the Ontario Teacher’s Pension Plan and the CPP Investment Board and both have significant real return bond holdings. The former has 11.1% and the latter has 3.5% in real return bonds. I decided to have 1/4 of my bond portfolio invested in real-return bonds which amounts to 5%. I might re-evalute this allocation later (in about 5 years).

Canadian Equity Component
Now that the foreign content limits are removed we are starting to see more and more people suggesting that Canadians hold somewhere around 3-10% Canadian equities in their equity portfolio, rather than the insane 25-70% allocations we used to see. At the Canadian Capitalist, Dan Solin comments on why investors should have no more than 10% Canadian equities in the equity portion of their portfolio. There is also a good article by Martin Gale here about domestic bias and foreign asset allocation. Finally, according to Carl Spiess at Scotia Macleod, “over the last 20 years, international markets have outperformed Canadian markets by almost 2% a year.” We have had some excellent years in the Canadian equities markets recently as well as in the late 1990s thanks to Nortel so people often forget that Canadian equities have historically underperformed against international markets. If you looked at the risk-adjusted return, the picture would probably be even worse. He continues, “it makes sense to invest globally not only based on historical returns, but also because many economic sectors (eg. Healthcare) are not significantly represented in Canadian markets. In addition, despite several good years recently, Canada only represents 3% of world stock markets.” He’s right; The Vanguard Total Stock Market Index has 12% in healthcare, for example, while the TSX Composite contains less than 1% in healthcare as it is dominated by financials and energy.

Another article here gives “10 key reasons for going global in your RRSP.”

US Equity Component
I relied heavily on Martin Gale’s advice on his Efficient Market Canada website. Specifically, his “Building A Globally Efficient Index ETF Portfolio (updated)” article (and it’s predecessor) and also “Foreign Asset Allocation in your RRSP.” I ended up making US Equities 40% of the equity portion of my portfolio, which corresponds to 32% of my total portfolio. The obvious choice here was some sort of S&P 500 Index, like XSP or SPY, but instead I went with the lowest-cost option out there, which is probably the Vanguard Total Stock Market Fund (VTI). It is even more diverse than the S&P 500 in that it currently holds 3692 different stocks. The US market is huge and this is a great way to own it all without having to purchase both the S&P 500 Index ETF (SPY) and the S&P Mid-Cap Index ETF (MDY) for example.

International Component
Again, as above, I looked at the global market capitalization and decided to put 50% of the equity portion of my portfolio into international stocks. This corresponds to 40% of my overall portfolio. Since Vanguard does not really have much for international index ETFs, and the iShares $USD MSCI EAFE Index ETF (EFA) has the same cost as the iShares $CAD MSCI EAFE Index ETF (XIN), the best option was to go with XIN (see “Exchange Traded Funds: Recommendations“).

I was worried that with my much lower Canadian equity component that I would end up having a lot of US dollar investments in my RRSP. As I mentioned above, since Vanguard does not really have much for international index ETFs, and the iShares $USD MSCI EAFE Index ETF (EFA) has the same cost as the iShares $CAD MSCI EAFE Index ETF (XIN), the best option was to go with XIN, which is traded in Canadian dollars. So now my only USD holdings are the Vanguard Emerging Markets Fund (VWO) and the Vanguard Total Stock Market (VTI) which take up about 37% of my total portfolio. Having less than 50% of my RRSP assets in USD seems alright to me. When I get older and closer to retirement I could move more of my money into CAD investments if I feel the need.

Emerging Markets
There are two emerging markets funds to choose from, the iShares one (EEM) and the Vanguard one (VWO). After much searching on Google for “EEM vs. VMO” and reading many articles I could not discern much difference between the two. The Vanguard one uses a slightly difference underlying index as I discussed in my previous blog post entitled “Foreign Exchange Costs Associated With USD Investments in an RRSP” and, like most Vanguard funds, has a much lower cost than its competitors. So I went with the Vanguard fund. Because of the high risk associated with emerging markets and because of their recent stellar performance, I put only 5% of my total portfolio in emerging markets, even though emerging markets make up about 9% of the world market capitalization. I may increase my desired allocation of emerging markets later, relative to my other international holdings.

REITs are a good addition to the fixed-income portion of a portfolio and they provide good negative correlation with other asset classes. Most of the large pensions funds hold a significant amount of REITs. XRE is the iShares offering and I will probably be adding this in eventually. I don’t want to do too many things at once. I need to decide if I should reduce my bond allocation from 20% and add in the REITs or if I should reduce my equities from 80% and add in REITs. Or lower both? My original thought had been to have 20% bonds, 5% REITs, which is why I went with 20% bonds rather than 25% bonds as I had before.

Please let me know if you have any comments and I will add any details to this article that I may have left out.

Canadian Tour of Personal Finance Blogs

Malkiel, Bogle Argue Against Non-Market Capitalization Weighted ETFs

I found this little nugget from June 2006 from a link I saw (not a very interesting read) on Canadian Capitalist’s blog. It’s an article called “Turn on a Paradigm?” (very interesting read) and it was written by Burton Malkiel (author of a Random Walk Down Wall Street) and John C. Bogle (Founder of The Vanguard Group). It attacks the idea that fundamental-weighted indexes can beat the market capitalization weighted indexes. Or, at least, challenges the idea that the former can beat the latter with the same risk. (I thought that’s what they were getting at near the end when they mentioned that fundamental-weighted indexes often hold more small caps which have performed well lately, albeit at higher risk. Although they seem to argue more along the lines that due to the reversion to the mean principle, those equities that recently did well since 2000 will not be doing necessarily so well in the future.)

It’s a great little introduction to the concepts in A Random Walk Down Wall Street (a book that I am reading right now). In case some of you are not interested enough to read it (the article, not the book), I will quote my favourite two paragraphs for you here:

First let us put to rest the canard that the remarkable success of traditional market weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be — must be — an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index. We can not live in Garrison Keillor’s
Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the
market, in principle, must be a zero-sum game.

But only before the deduction of investment management costs. In practice, investors as a group will fail to earn the market return after these costs, and as a group, they will fall far short of the low-expense index funds. For the typical actively managed equity mutual fund, annual operating expense ratios are well over 100 basis points (one percentage point). Add in the hidden costs of portfolio turnover and sales loads, where applicable, and effective annual costs are undoubtedly considerably higher, perhaps as much as 200 to 250 basis points. In total, simply because the average actively managed fund must underperform the capitalization-weighted market as a whole by the amount of financial intermediation costs that are deducted from the gross return achieved, active investing must be, and is, a loser’s game.

Wow! I can’t wait to get into the meat of Malkiel’s book. I’ll give them the last word — “Intelligent investors should approach with extreme caution any claim that a ‘new paradigm’ is here to stay.”

Steadyhand Opens for Business

Mutual fund company Steadyhand recently opened up their Vancouver office. It’s founder is Tom Bradley, formerly of Phillips, Hagar, & North, better known recently for his blog that he started in June 2006. I read his blog once in a while and in general I like what he has to say. I can’t see myself buying any of their funds though. There is zero past performance so you have to take their word for it that they know what they are doing. Their website says “We have a straightforward lineup of no-load, high-conviction funds that we offer directly to investors. Our fees are low, our portfolios are concentrated and our managers focus on making you money, rather than tracking an index.” Again, my faith in mutual fund managers’ ability to beat indexes (after MERs are taken into account) is almost non-existant. According to Jason Zweig in Investing Intelligently 4th Revised Edition page 248, only 37 of 248 U.S. Stock funds outperformed the Vanguard 500 Index Fund from December 1982 to December 2002. I could go on with more references. The fact that Steadyhand’s MERs are fairly low should make their job of beating their competition (indexes) a bit easier. All of SteadyHand’s funds have MERs of 1.7% or less. That might be a lot less than the average mutual fund, but it’s still a lot higher than the 0.5% I can get for iShares MCSI Index ETF (XIN). One thing they have done that I like is that they offer a small discount in the MER, the longer you hold the mutual fund.

So if you’re thinking about giving your money to Steadyhand, first listen to what Tom Bradley has to say about passive index ETFs: “Exchange-traded funds (ETFs) are a great product. They provide exposure to the equity market for a reasonable price. If you buy the iShares XICs, you can be assured of getting the return of the S&P/TSX 60 for only 0.17%. That’s a good deal.” He emphasized it again later: “As I pointed out a couple of weeks ago, I still think the low-cost, broad market ETFs are excellent products, in particular, the iShares XICs, which track the S&P/TSX 60 Index and have an MER of 17 basis points.” (Some of you might have noticed that he was referring to XIC when he should have been referring to XIU).