After Canadian equities fell a lot on Monday (followed by some big losses the week before) I was curious to see how far out of balance my portfolio was. So I plugged my portfolio’s numbers into a spreadsheet I use to balance my portfolio (I would share that spreadsheet but it’s a bit hard to use). It turned out that Canadian equities were the furthest out of whack in percentage terms. The portion of Canadian equities in my portfolio was 20% less than what it started out as (and what I intend it to always be at). I checked out how much cash I had in my RRSP and it was about $1,700. I normally wait until I have $2,000 and just buy something as soon as I notice that my cash balance has exceeded that target. Anyways, I bought $1,700 worth of XIC when the TSX was down about 600 points and got lucky because the next day it was up again and now it’s up over 2.5%. It’s hard to say if this is market timing or not (when I was going to buy some XIC anyways as soon as I had over $2,000 in cash, which would be by February 1, 2008). The one thing I am disappointed about is the fact that I bought and ETF with less than $1,700 and paid a $19.99 commission. I had set a threshold for myself of $2,000 to help minimize transaction costs. In hindsight one could argue that the gains I made offset those costs, however, hindsight is 20/20, and on Monday no on could have predicted what was going to happen on Tuesday. How do I know this? Well everyone would be buying on Monday but they weren’t.
Rob Carrick recently “gathered 10 of our favourite bits of investing advice, on topics ranging from stock-market risk to which mutual funds to buy” and called it the 10 Commandments. A commandment is “a command or order,” so something like “thou shalt not use the word commandment incorrectly” is a commandment. “Commandment” #10 is “Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and almost invariably, abandon it at precisely the wrong time.” C’mon that’s not even a commandment! So what is the order here, that we should not jump ship on a good strategy that goes bad? or should we not use strategies? or should we abandon them at precisely the right time instead of the wrong time? The longer explanation does not leave things any more clearer, offering such advice as “ignore the slumps or use them as a buy-low opportunity,” or ” judge whether your fund manager has what Dreman calls a good strategy.” For what’s it’s worth, the only words of advice in there I thought were useful were Buffett’s (use low-cost indexes) and Malkiel’s (less fees are better).
A while ago a guy named Alan Haft (he wrote a book called “You can never be too rich”) made up his own 10 Commandments of Investing and it’s been in my drafts folder ever since I saw it. I think he sums up the most important things that people should do with regards to investing, they are well written, and they make sense. Here they are:
- Stick with the indexes
- Watch those fees
- Create a bond ladder
- Watch your money
- Don’t rush in
- Don’t take the risk if you don’t need the return
- Get out if something isn’t working
- Understand tax consequences
- Keep it simple
Here are some highlights:
1. Stick with the indexes
Leave the individual stock picking to gamblers and speculators. Very few people really understand how to successfully pick individual stocks, and if they do, the news that drives markets today is totally unpredictable, making individual stock picking a highly risky venture. Reams and reams of statistics prove index investing almost always outperforms the financial advisors, money managers, and stockbrokers. Stick with the indicies and you’ll likely wind up far ahead of the game. Care to speculate a bit on some individual stocks? Do it with a small portion of your money, but certainly not the bulk of it.
2. Watch those fees
Wall Street loves investors that don’t watch their fees. For those investing in funds, check out www.personalfund.com. You might be shocked to find out the total cost your funds are charging you to own them year after year. Especially over the long haul, fees can destroy your returns. Minimize fees as much as possible by investing in low-fee, highly diversified investments such as one of my personal favorites, Exchange-traded funds such as those offered by www.ishares.com
7. Don’t take the risk if you don’t need the return
Many people would do perfectly fine getting 7-10% returns on their money, yet their portfolios are invested in things that strive for well beyond that. Especially if you’re a retiree, if you doubled or tripled your money overnight, would you go out and buy a fancy new sports car? A mansion on the hill? Few of us would. And for that reason, always ebb towards the safer side of investing as much as you possibly can
Check out the original article for the rest!
- UK Housing Hurting – The British Housing bubble, “spurred by a borrowing spree, thanks to interest rates at 40-year lows from 2001 to 2006” may be in its last days after the “average home almost tripled in value in the past decade.” It looks like properties bought as investments are going to be the hardest hit (just as they will in Vancouver): “Gabay says so-called buy-to-let properties, which investors acquire for rental income, are more vulnerable to a fall in prices . . . As interest rates rise, buy-to-let investors are making less profit on rental property, which may drive down housing demand and prices.” There are already many properties in Vancouver where the owners are not making up their mortgage payments with the rent (a few searches on MLS and Craigslist are all it takes to verify this, in addition to my own research while looking for a new place for rent in July ’07.
- Buyers get real returns” – Apparently “if you’re purely interested in accumulating wealth, it’s hard to beat homeownership over the long term, according to a discussion paper (Are Renters Being Left Behind? Homeownership and Wealth Accumulation in Canadian Cities“) completed earlier this year by UBC real-estate professor Tsur Somerville and student research assistants Li Qiang and Paulina Teller.” The results vary by city, but even in “in those cities where it is even possible to accumulate more wealth than owners, renters must be extremely disciplined. They must invest on average nearly 80 percent of the difference between the annual cost to owners and the cost to renters . . . this is approximately equivalent to 9% of a person’s gross income.” 9% of gross income does not seem that bad. If one looks at Table 4 of the study it is not that bad for renters especially if they invest the difference between rent and a mortgage (100% in this case) in lower cost investments. They would have achieved 77% of “owner wealth” if invested only in GICs and 124% of owner wealth if invested in the only the TSX index with 0.75% annual expenses (ie. MERs). I noticed some possible bias in this study and that is that they used the years between 1979 and 1996 as starting years and 25 years OR 2006 as the ending year, then averaged all these scenarios. The later years are thus weighted more heavily in their average. The year 2004 is used in each scenario but 1979 is only used in 1.
- Mishs Global Economic Trend Analysis: What Factors are Affecting the U.S. Dollar? – Just one paragraph here of note: “The housing bubble in the US is well known, but the bubble in Canada, the UK, China, and Spain is just as big (if not bigger) than the bubble in the U.S. In particular, the bubble in Vancouver is as massive as the bubble in Florida or California ever was. Vancouver housing prices are destined to crash. Don’t ask me when, but only fools are buying at these prices. The housing bubble in Australia was the first to start deflating.”
- Buy the fund, or buy the company? – Rob Carrick discusses buying stock of mutual fund companies. I found this comment amusing: “Investors can even take their cues from CI chief executive officer Bill Holland, Paul Desmarais, founder of Power Corp., which controls IGM Financial, and AGF CEO Blake Goldring who all have “the majority of their wealth” tied up in their stock as opposed to the funds, Mr. Almeida added.” These guys are smart, they know that it doesn’t make sense to buy mutual funds when 2% or more (on average) of the return is eaten up by MERs every year. Carrick also comes right out and mentions that “with mutual funds, investors typically get market-type returns minus the fees collected by their managers . . . The allure of fund companies is that their business model allows them to collect fees on assets under management during the good and bad times.”
- Who, in the real world, can afford to live here now? – Another housing story about Vancouver. I knew that the percentage of their income people are now spending on their home has gone up, but I was surprised to learn that “here in Metro Vancouver . . . In the second quarter of 2007, the average owner of a two-storey home spends 73 per cent of the family’s pre-tax income on financing and maintaining that home.” 73% of pre-tax income? How does this average Joe get approved for such a mortgage (or is it a variable-rate?). Or an ever better question, how does average Joe buy food after paying taxes?
With no more foreign holding limits inside RRSPs, a lot of people are looking into holding foreign currency investments inside the RRSP. In fact my first ever “Ask Dave” post was about this very topic (see “Ask Dave: USD Holdings In an RRSP“).
Another reader recently wrote me with similar questions. Rob writes:
I’m confused. I want to own US $ investments in my RRSP. RBC Direct advises that all RRSP investments must be in CDN $. They didn’t know what a “wash trade” was. With the Cdn $ at $1.08+ is this a good time to own US $ denominated equities or a USD ETF? If so, can I do this in an RRSP or does it have to be held outside?
Rob, you can certainly own US $ investments inside an RRSP (ie. any US stock (this includes ETFs)). As for US$ mutual funds I’m not really sure (as I’ve never done it) although you probably could. If RBC Direct truly does not allow you do hold USD investments in your RRSP (I would be REALLY surprised if they didn’t), find another broker. The one restriction that the Canadian banks and brokers place on customers (although there is nothing in Canadian laws/regulations that forces them to do so, see “Foreign Currency Investments and Exchange Spreads Inside Your RRSP” and this class action lawsuit against BMO for more information) is that you may not hold any foreign currency inside an RRSP. All cash inside an RRSP must be in Canadian dollars. As a consequence of this ridiculous restriction, if a USD investment is sold, the proceeds must be converted into CAD, then to buy another USD investment, the CAD cash is converted into USD again. Hence huge foreign exchange rate spread-related costs, and hence, wash trades’ raison d’être…
I am not surprised that RBC Direct did not know what a “wash trade” was as I think TD Waterhouse is the only one that offers it (and even then, they will only do it for a phone trade, not an online trade). Refer to the Canadian Capitalist’s site on how to make a wash trade. At the time (August 2006) the Canadian Capitalist said that “as far as I know, RBC Action Direct, which is our primary brokerage account does not offer this feature.”
It is impossible to predict what the US or Canadian dollar will do at this point. Much like with the Vancouver housing market 2 years ago in Vancouver, would it defy all odds and go up even further? Or would it come crashing down as it seemed destined to? The pundits and economists will say whatever they want but they have no clue what will actually happen (although there have been some rumblings about possible Bank of Canada currency intervention measures). I say don’t worry about timing your purchases of USD investments and don’t ask the question “is this a good time to own US $ denominated equities.” Instead you should think long term and ask “should I have US $ denominated equities in my portfolio (for the next 10+ years).” You especially should not be trying to “time” investments in USD investments (or any other currency) because the costs of buying and selling USD investments inside an RRSP are huge unless you use wash trades. Your best bet to minimize costs is to buy them once and hold. For more on the costs associated with USD investments inside an RRSP, see “Foreign Exchange Costs Associated With USD Investments in an RRSP.” If you really want to speculate, use a non-RRSP US$ trading account.
It’s good to be diversified and not have all your investments in Canadian dollars, although if you plan to retire in Canada you definitely want to have most of your retirement assets in Canadian investments as you approach retirement and not expose yourself to unnecessary currency risk (see “US vs. Canadian dollar investments made inside an RRSP” for more detail, especially bullet point 2). You will also incur lower costs (assuming you don’t incur too many foreign exchange-related costs). Observe the difference in MERs between the Canadian iShare XSP (0.24%) vs. the American iShares’ IVV (0.09%) or the Vanguard’s VTI (0.07%), for example. Adding foreign currency investments also decreases the correlation between the different components of your portfolio even further, thus providing more diversification, and in the end, a higher risk-adjusted return.
Send your questions for my “Ask Dave” posts using my contact form. I look forward to hearing from you. My queue of questions is not long, but it’s not short either, so I may take anywhere from a few days or a few weeks to respond. Thanks for your patience.
I while ago I bought Vanguard Europe Pacific ETF (VEA) for the international portion of my portfolio and one reader had the following comment:
Just a quick question. With regards to balancing one’s portfolio, would ETFs like VEA (and I see there is now one that encompasses the whole world excluding the US), not pose a problem? If for example the European markets did well one year but the Pacific markets performed poorly, then one would be unable to rebalance by selling a European based ETF’s (like VGK for example) and buying more Pacific based ETF’s (VPL for example). With everything in one basket one could not take advantage of the gains to be made by selling high and buying low. Is this assumption correct? Or is it true that because VEA comprises 75% VGK and 25% VPL, that it would reflect any net changes made by owning a combination of both VGK and VPL?
Your assumption is correct, one could not take advantage of the gains to be made by selling high and buying low the stocks in one region vs. another. These rebalancing “bonuses” are small, but more importantly, they may completely disappear after trading costs are taken into account. VEA does not contain a fixed percentage of VGK and VPL underneath. It contains the market cap weighting of all its components. Market cap-weighted indexes have several advantages as investments:
Market value-weighted indexes have lower trading costs. If you made your own index, and the index never added or removed stocks the stocks would be bought once and never sold. As one stock goes up in value, it maintains the desired allocation in the index. This keeps trading costs low as one essentially rarely needs to make trades, except for when stocks are dropped or added from the index. Market value-weighted indexes have the lowest MERs, and other indexes like fundamental-weighted indexes, or fixed-weight indexes have higher MERs due to increased trading within the index.
With market value-weighted indexes, one never ends up holding on to dogs. Imagine it is the early 1900s and you own shares in a fixed sector-weighted index (did such a thing exist back then?). The index contains 25% financials, 25% railways, 25% consumer goods, and 25% manufacturing (or a fixed percentage of each individual stock, it’s the same thing). Every year the index is rebalanced. Pretty soon railways start to go out of style as air travel is invented and highways are built. The 1960s arrive and “tech” stocks are all the rage. The index rebalances religiously, which leads it to purchase a lot of railway stock which continues to do badly, meanwhile it has missed out on the rise in tech stocks. The worse railways do, the more you have to buy in order to keep your portfolio balanced (in addition to paying more commissions). You now wish the index had altered their weightings to contain less railways. One way to do it might have been to not fix the amount allocated to each sector and just use market cap-weighting instead. Or use market cap-weighting while taking into account large changes in what is going on in the market. For example, one could have envisioned a “smarter” version of the S&P 500 index that underweighted tech/IT stocks in around 2000 (selling high) and went back to their appropriate market cap-weight in 2002. Of course we only wish we had a crystal ball back in 2000 that could have warned us that tech stocks were about to fall. It seemed inevitable, just as it did in 1997. Unfortunately there is no foresight in the market and there was no telling if tech stocks would not have kept climbing after 2000. Furthermore, if you believe that markets are largely efficient, there is no such thing as “buying low” or “buying high” and it is not possible to “take advantage of the gains to be made by selling high and buying low” as there are essentially no “gains” to be made. There are only “losses” to be incurred through increased costs of trading and higher turnover.
In the scenario you described you said “If for example the European markets did well one year but the Pacific markets performed poorly, then one would be unable to rebalance by selling a European based ETF’s (like VGK for example) and buying more Pacific based ETF’s (VPL for example).” Personally I would get a bit nervous in buying more VPL. How do you know it is at a “low”. What if it actually at a “high” of even greater future “lows.” I was in an investment club from around 1999-2005 (the club ended in 2005). We consistently thought we were buying stocks at “lows.” We bought stocks like Nortel, Nokia, 360 Networks, Global Crossing, Lucent, etc… after sharp declines only to watch them decline even further (often with another purchase on the way down for good measure). So this is the problem I have with fixed allocations and rebalancing. If you bought 75% VPL and 25% VGK and held them in your portfolio. How do you know if 25% VGK is “just right”, “over-valued”, or “under-valued.” If it falls to 15% now how would you classify it? If it was over-valued before, now it might be just right. If it was just right before it might be considered under-valued now. But if it were truly under-valued (in the sense that the equities in VGK are worth far more than what the market is valuing them at) most likely other smart investors would have already taken advantage of it (as if you’d be the first to realize it!) and so it’s most likely that those equities are “just right.”
I blogged a lot about Equal Weight Indexes in the past:
- In Non-Market Cap Weighted Indexes: The Next Big Thing I ballyhooed equal-weighted indexes and lamented the lack of equal-weighted indexes in Canada. My opinion of equal-weighted indexes would soon change.
- In Equal-Weight S&P 500 Index I came to the full realization that RSP, the S&P 500 Equal Weighted index only performed better because of its higher concentration of mid-cap stocks.
- In Too Many Choices (or why I am ready to give up) I mentioned that “I have now come to the realization that RSP is very similar to the S&P 400 Midcap Index which is also available as an ETF (MDY). It is very highly correlated . . .”
Regrettably, I don’t think equal weight indexes are all that I initially hyped them to be. I did some searching on the web for more information on the advantages of market cap-based indexes over fixed weight indexes but had trouble finding any information at all, however, I think my reasoning above makes sense. As in many arguments over financial instruments and investing strategies, cost is again a huge factor.
According to Fidelity, we need 80% of our current income to retire (see Canadian Capitalist’s “Fidelity’s ‘Scary’ Retirement Findings“, where I found this story). Canadians on average have 50% of their pre-retirement income in retirement, but this is no different from other countries; United States: 58%, Britain: 50%, Germany; 56%, Japan: 47% (see “Want to play in retirement? Test your future income“). If those numbers are not adequate, it implies that the average senior in the United States, Britain, Germany, and Japan are all in dire need. I doubt that is the case. (My opinion is that people should save as much as they want. You might need only 50% but if you want to spend a lot in retirement and travel instead of just tinkering in your garden then maybe you need 80% of your pre-retirement income, or maybe 150%, just in case.)
The funny part is that even if you wanted to get to 80%, the hardest way to get there would be to use Fidelity’s products. All their MERs are above 2% (click on Facts & codes). It’s too bad their retirement calculator doesn’t have a slider bar for the MER or rate of return, then you would be able to see just how badly these management expense fees can affect the final value of your portfolio, and in turn, your annual income in retirement.
I just did a calculation and if you invest $8,500 annually starting from the age of 30 you end up with $2 million at the age of 65 if the contributions are indexed to inflation and the rate of return is 8% (the return you might get if you buy a low-MER (0.25%) investment, like an index ETF). Decrease that return to 5.75% (the return you’ll get if you pay a 2.5% MER on Fidelity mutual funds or their managed portfolios) and you’ll have only $1.32 million at age 65. Assuming $2.64 million is what one would need to keep the same income one enjoyed pre-retirement:
In the 2.5% MER case: $1.32 million is 50% of $2.64 million
In the 0.25% MER case: $2 million is 76% of $2.64 million.
So by simply not using a company like Fidelity and going with a competitor like Vanguard or iShares and buying index ETFs (with far lower MERs) instead, you can easily get closer to that 80% figure and increase your nest egg from to $2 million from $1.32 million without even having to save any more money. By the same token, it could probably be argued that one of the main reasons that Canadians do not have 70-80% of their pre-retirement income in retirement (and only have 50% instead) is because of the amount of MERs, fees, and commissions they pay every year to the financial industry.
Another reader had some questions about how to switch from a mutual fund and/or equity-based portfolio to a passive ETF-based portfolio.
My wife and I have 3 accounts which have about 20 equities in each. As a whole, the accounts are not well balanced, and they are overweighted with Canadian securities from the days that there were restrictions to RRSPs in their foreign content.
I have taken over management of the accounts myself. They have been moved to a discount brokerage that was imposed on us because of some quirks in the accounts that forced us to use a particular broker who was agreeable to accept our holdings. Their trading fee is $29.95/transaction.
After doing extensive reading and research, I have decided to restructure the accounts to resemble a structure similar to your Passive EFT portfolio. I was very impressed with your rationale in formulating your post of April 15, 2007.
We are locked in to some mutual funds and other fixed income vehicles which will restrict our immediate restructuring abilities. I believe it may be best to leave the best of our Canadian equities that are already in place, rather than selling them and purchasing XIC. We will also need to keep the other restricted holdings, as mentioned above. As a result, we will need to take substantial new positions in VTI, VWO and XIN. In essence, we will be paring 50 or more holdings to less than 10. We will basically sell Canadian equities, mostly banks, to purchase diversified content, US and foreign (VTI, VWO, XIN).
First, I want to make a general point. Do not forget that stocks have no MERs. If you have a portfolio of 60 stocks it has no ongoing expense fee. Hold on to them for many years and you may do better than index ETFs which have a small non-negligible MER. So is worth it to sell those 60 equities you have spread out between 3 accounts? Maybe not. 60 equities is plenty of diversification in one market. If a portfolio of 60 Canadian equities was handed down to me I would think twice about selling them and switching to an ETF. The commission to sell those 60 equities is going to be $1200 at least, plus I am going to have to pay around 0.25% commission on the ETF annually. If some of the 60 Canadian equities were going to be sold in order to diversify into international and US investments then some added cost might be worth it. I just wanted remind people that stocks on their own have no commissions but ETFs do and in some cases it might be best to hang on to those stocks if they have already been purchased. In most cases, however, index ETFs are probably a better solution as they provide lots of diversification at a low-cost with little hassle. Another thing to consider is that the commissions to sell the stocks will one day have to be paid anyways; however the commission as a percentage of the investment will decrease because the stocks will surely grow over the long term.
I am guessing you were also thinking about costs when you said you “believe it may be best to leave the best of our Canadian equities that are already in place, rather than selling them and purchasing XIC.” I agree with you that selling all of them and buying XIC seems a bit unnecessary. Assuming you have a good number of stocks (>=30) that would be just as good as XIC, if not better, due to the lowered on-going cost.
For your international investment please consider Vanguard Europe Pacific ETF (VEA) as an alternative to iShares CDN MSCI EAFE Index Fund (XIN) if you can handle the extra foreign currency holdings, as it has a lower MER. Remember that VEA is equivalent to owning the underlying investments in their respective foreign currencies, not US dollars. So you should not be concerned with the US dollar but with Canada’s currency against world currencies. The MER is a lot less in VEA vs. XIN and it is basically the same thing as EFA (which XIN holds underneath but hedged to CAD dollars).
My questions are:
Should I be concerned about the costs of buying and selling the 30 or more holdings?
Well one thing I would be concerned about is if the cost of selling 30 or more holdings was more than, say, 1% of your portfolio (1% figure chosen arbitrarily). If your portfolio is only worth $1000 and you are paying $100 in commissions it doesn’t really make sense. It would take a year at 10% interest to make up the loss and leave you will no gain. That’s like taking one whole year off the investment period. Or another way of thinking about it is that the commission as a percentage of your portfolio is going to affect the final portfolio by that percentage as well, if you consider the commission as affecting the future value of your investments. Here’s the longer explanation. The future value without any commissions is:
The final value after paying some one-time commission CC is:
where PV is the present value (on the date you pay commissions), FV_0 and FV_C are final values (of the amount PV, not including any future contributions), i is the interest rate, and n is number of years until retirement (for example). If you find the percentage difference between FV_c and FV_0, or the percentage the final value will be reduced by, you get,
So if you you pay $1000 commissions selling 30 securities and your portfolio is currently worth $100,000 your final value will be reduced by of whatever it ends up being in the future. If it would have grown to $1 million dollars eventually it will be reduced by 1% or $100,000. That was just a long winded way of explaining why I think one should always look at their commissions as a percentage of their portfolio’s present value, and remember that it will affect the final value of their portfolio by the same percentage.
By paring down the portfolios we will end up with a very substantial proportion of our assets in only 2 stocks VTI and XIN. Although I understand that these ETFs are made up of multiple equities, the diversification we presently have with 50-60 holdings will be lost. I am, therefore, concerned that the accounts will largely be influenced by movement in only 2 entities? Doesn’t this increase our risk?
Good question, I had not really though of this before as I have never owned that many individual equities before. Owning two ETFs should be equivalent to owning positions in all the underlying securities. Assuming there were no MER and assuming that tracking error was non-existant, the return would be the same and the risk would be the same, as far as I know.
I am impressed with the incredible power of the internet to stimulate discussion and to disseminate valuable information so easily. I would appreciate your answers to my questions as well as any other thoughts you might have about my portfolios.
I hope my answers made some sense. It looks like you are on the right track and I think you have spotted the main problem with your portfolio (lack of global diversification) and are looking to diversify while minimizing your costs (both one-time commissions and ongoing MERs).
For those who don’t know what a wash trade is, a wash trade allows you to convert a holding in USD into another holding in USD without having to switch to CAD first.
After reading Canadian Capitalist’s post about TD Waterhouse Lowering Their Commissions, I posted this comment on his blog:
I just sent an email to E*Trade asking them when they are going to start offering wash trades or the ability to hold US cash in an RRSP. Everyone who has an E*Trade or questrade account, please bug them about this. I hope hoping this move by TD will cause the others to become more competitive. I do not want to move from E*Trade as it is a pain but I will have to in a few years if they don’t react at all.
By the end of the day, E*Trade had gotten back to me (as they have before when inquiring about this). Here was their reply:
Thank you for choosing E*TRADE Canada.
We are always looking for ways to increase customer satisfaction and attract new business and we realize that Wash Trades are something that clients want. With that being said, there is no specific time frame of when this will be offered through E*TRADE.
We are aware of TD Waterhouse’s new commission rates and we strive to be competitive. I will however mention some of the other benefits that are exclusive to E*TRADE, such as our high interest Cash Optimizer Investment Account, free Research from 5 independent resources, and our no fee, no minimum RRSP accounts.
So they aren’t totally clueless and they aren’t totally ignoring me. But that fact that there is no timeframe is a bit annoying. If they have a half-decent team of developers you would think they would have some idea of when this could be implemented. Maybe it’s that management has not okayed any resources for it or something. Well maybe now they will.
Update: Today I got another email from E*Trade, this time from a different person. So maybe my email got forwarded up the chain of command. Here it is:
Thank you for choosing E*TRADE Canada.
We have a plan to set up a system so that you do not have pay FX for buying and selling US stocks in rrsp account. But
we do not have any expected time frame yet. Please feel free to call us anytime from 8am to 12pm 7days a week, if you need further assistance.
I hope they can do this. This will be even better than wash trades.
So my new company offers a group RRSP. It’s free cash so I can’t turn that down. But I am not too impressed with the investment selections available. Basically they are just a bunch of mutual funds and a few “managed portfolios” classified by risk profile. Nothing here that isn’t giving at least 2% in MERs to some company. I might just go for the managed portfolio option, somewhere between balanced and aggressive, so that I don’t have to worry about anything. I will definitely be calling HR and talking about what alternatives they could be doing instead. Like offering some low-fee index mutual funds instead. I definitely will not be putting any of my own money into the group RRSP. Instead I will put the rest of my allotment into my E*Trade account where I will continue to purchase low-cost passive index ETFs.
Update (June 28, 2007): I might have jumped the gun on that post a bit. Assuming that the mutual funds are all high MER funds. It turns out if I don’t choose anything on the initial form, they will just put it in a high interest savings account. Then, when I get online access you can supposedly play around from there all you want. Since I don’t have time to call HR and find out more about the investments options I might just do that for now.
Update (July 10, 2007) : Looks like there are some somewhat low-cost options available. Nothing as low-cost as index ETFs though.
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:
|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:
|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.
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.
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“).
CAD vs. USD
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.
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.