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.”

Foreign Exchange Costs Associated With USD Investments in an RRSP

I have been looking at adding an emerging markets component to my portfolio. I look at my choice as either being Vanguard’s VMO ($USD), iShares’ EEM ($USD), or a Canadian mutual fund offering (such as the TD Emerging Markets Fund or the Altamira Global Discovery Fund. Unfortunately there are no Canadian ETFs investing in emerging markets.

The Vanguard Emerging Markets Fund has an MER of 0.30%. The iShares MSCI Emerging Markets Index Fund has an MER of 0.70%. Once again Vanguard seems to have the lowest-cost ETFs around. The TD Emerging Markets Fund has an MER of 2.88%, and the only thing the Altamira Global Discovery Fund is discovering is how to take MERs to astronomical levels, with an MER of 3.42%. Looks like the Altamira fund is beating the MSCI Emerging Markets Index (CAD$) but those gains are paying for the MER and it ends up just matching the index.

I decided that between the Vanguard VWO and the iShares EEM I would rather go with VMO as the MER is smaller. They hold virtually the same indexes underneath. The VMO one is a “Select” MCSI Emerging Makrts index that was designed especially for Vanguard a long time ago for one of their mutual funds. VMO also has more stocks. It’s daily volume is less than EEM but still high at 400k on average which is what EEM was at a few years ago.

The next thing I was worrying about was the foreign exchange. I have CAD dollars sitting in my E*Trade RRSP. If I buy VMO, E*Trade will convert the CAD to USD and purchase VMO. When I sell VMO (eventually) E*Trade will sell the VMO and covert the USD to CAD. So my CAD dollars gets converted into USD once at a rate of say 1.18 dollars CAD for every dollar USD. Then when I sell VMO they will only give me something like 1.14 dollars CAD for every dollar USD. I don’t know what E*Trade’s spread usually is (if anyone knows, please tell me) but I assume it will be 4-5%.

So I did some calculations to see how bad this hit works out to be on an annualized basis. In other words, what would the effective MER of owning VMO as opposed to a Canadian mutual fund be? I’ll assume that VMO always goes up by 10% every year, has an MER of 0.30%, the nominal foreign exchange rate is 1.16% and the spread is 4%. So obviously if you buy VMO and sell it quickly (say, within a year), it will have increased by 10% but the foreign exchange spread has stolen away 4%. A bit worse than the mutual funds then. But what if you hold it for a long time? It’s going to get better over time. If you hold it for two years, it will increase to 1.1*1.1 = 1.21 of it’s original value but it’s multiplied by (1-0.04) due to the foreign exchange, now what’s the effective annualized return there? It’s about (1.12*0.96)^(1/2)=7.78%, so that’s an effective MER of 2.22%. Already we are better than the mutual funds. (I’ve made an approximation above…it’s not exactly 0.04 that I should be using, it’s 1-(1.14/1.18)… but nevermind, if you want to know more, ask me). If you keep going with the years you’ll get the following graph:

Effective MER for USD Investment

So it looks like it falls off pretty rapidly. Gets down close to 0.5% MER which is not bad. Essentially you can just think of the the foreign exchange hit as multiplying the PV by some number, so it lowers your PV. Over time the effect of lower PV is lessened as the investment grows due to compounding. Note also that I neglected commissions in the above analysis.

Keep in mind that with EEM this graph would be shifted upwards a bit. Since I have beaten the two mutual funds above by a long shot as far as cost goes, I think I might by some shares of VMO. I’ll make it about 5% of our portfolio and then I’ll make an effort to hold it for at least 10 years, where that curve really starts to flatten out.

The Problem With Owning Lots of Mutual Funds

A long time ago I wrote about why having lots of mutual funds is a bad idea. Namely, lots of overlapping mutual funds of the same type, like Canadian equities, for example. In my case, I owned 4 TD large-cap Canadian equity funds. The punchline is that with so many funds and so many underlying stocks, I was starting to get so diversified that I was about as diversified or more so in the Canadian large-cap market than an index. But I was paying exorbitant MERs on the mutual funds, at least 1-3% whereas I could have just bought 1 index ETF and paid 0.17% MER. A 1-3% difference in performance is huge over the long term.

Tom Bradley at SteadyHand just wrote an article about the exact same thing, however, the example in his case is far more extreme: “The featured couple had registered retirement savings plans totaling $170,000 that were spread across 29 mutual funds.”

I’ll summarize his analysis:

Holding 29 funds is ridiculous whether you’re investing $170,000 or a million dollars . . . But more than anything, owning 29 mutual funds means you’re seriously over-diversified . . . If we assume that there were 45 unique stocks per fund, that’s 900 stocks plus the ones that showed up in multiple funds. Let’s say you own 1000 stocks. What you really own is a very expensive index fund.

and the conclusion/recommendation:

Through exchange-traded funds (ETFs) you could get the same market exposure for an average fee of 0.25 to 0.30 per cent a year on their management expense ratios. I hazard a guess that the couple in the article were paying in the neighbourhood of 2.5 per cent. It is no wonder they were disappointed with their mutual fund returns.

I suspect that there are many Canadians in a situation similar to the one that I was in, or similar to the one the couple above was in. My guess it that there is a subset of those people who DO look at the MERs on funds (so they are thinking about cost a little) and given two funds, will choose the lower MER one over the high MER one. But most probably fail to think about their cost relative to an index ETF and their risk-adjusted return relative to an index ETF.

MERs in the Globe & Mail

I sometimes wonder what it takes to be a reporter for the Globe & Mail these days. This article on MERs by Dale Jackson had an interesting final paragraph:

However, there is a tradeoff when it comes to ETFs versus mutual funds. Investors are exposed to the whim of the broader markets, without the benefit of an experienced portfolio manager to steer clear of danger.

That will be the day, when a portfolio manager of a Canadian equity fund “steers clear of danger.” And how are investors NOT exposed to the “broader markets” when they have the “benefit” of an “experienced portfolio manager.” I have yet to see any convincing evidence that mutual fund managers are capable of beating the passive indexes, after they have taken their expenses. In case you need any examples

In one of the earlier paragraphs he said:

It’s important to keep in mind that the cheapest funds aren’t necessarily the best funds. The DMP Canadian Value Class fund returned more than 28 per cent last year even after the 4.11 per cent MER was subtracted – nearly doubling the average Canadian equity fund and the TSX. The United-Canadian Equity Value Pool fund, on the other hand, returned less than 10 per cent in 2006.

Way to pick out a return from a single year and talk about it as if it means anything. It also seems to be the only data point he uses to back up his sub-heading “Fund fees can add up. But sometimes, you get what you pay for.” That return is spectacular though and I like value investing. But that is only one year’s return. It will be interesting to see how it does in the coming years. Investing in the best performing funds of the previous year is definitely not a winning strategy.

E*Trade Might Eventually Allow Exchange-Free Trades in RRSP

I emailed E*Trade Canada about buying and selling USD investments inside an RRSP. This was before I knew anything about at all. Eventually I received this reply:

You can only keep Canadian dollar in rrsp account. You can buy US stocks but the money will be converted to CDN dollars. It is not possible to sell US stock and then buy more US stocks without converting to USD to CDN. Etrade is working towards a option so that you do not have to convert funds back and forth in rsp account.

Sounds promising. At least they are looking into it. Although the more I think about it, this forced exchange between USD and CAD currencies is not such a bad thing. As I’ve said before, my biggest problem before was that I would trade too much. Buying and selling things, reacting to the market. With the 4% exchange hit, it is much less likely that I am going to want to go back to my old active trading ways.

Foreign Currency Investments and Exchange Spreads Inside Your RRSP

Well finally my E*Trade account has been set up and my XIC ETF has been transferred over and now I am just waiting for the mutual funds.

I was confused by something I read in E*Trade’s help:

E*TRADE Canada offers a U.S. dollar trading account and a Canadian dollar trading account for customers who wish to trade (and pay for their trades) in the currency of the market in which they trade, thereby insulating themselves from exposure resulting from fluctuations in Canadian/US dollar foreign exchange rates. This enables you to trade U.S. securities in your U.S. dollar account, and Canadian securities in your Canadian dollar account (except for registered accounts, which are available in Canadian currency only)

For a second, I thought this might mean that I could only trade Canadian-dollar based investments inside my RRSP. I realized that was probably not the case as I am sure that it was possible to hold USD based investments inside your RRSP. What they MUST mean is that the cash portion of the RRSP must be in CAD, therefore, every time you buy or sell a USD investment inside your RRSP you will be hit with the exchange spread. Apparently TD Waterhouse can do “wash trades” where you can buy a USD money market fund (and get hit with the exchange) but then you can sell part of that and buy a US stock, for example, without having to go back to Canadian dollars in between. Or vice versa, you can sell part of the stock and go back to cash (the money market fund is like cash) without incurring any expense from the exchange. You have to call TD for these trades and cannot do them online.

It turns out that Canadians are allowed to hold foreign currencies inside an RRSP, it’s just that no one has implemented it yet. A guy from Ontario is suing BMO over this issue. The spreads are about 4-5%. So if you take $20,000 CAD and change it to USD and then change it back to CAD, you will have about 4-5% less than what you had when you started. That is almost $1000 CAD. I am looking forward to hearing what happens in this case. I hope that once one company decides to (or is forced to) allow clients to hold USD or to trade between two USD investments without incurring exchange spread costs, that all the other online brokers will follow suit.

Update (2007/03/01): Larry McDonald talks about this in his article “Beware of the details of foreign diversification.”

Should I Go It Alone?

Over the past year I have been an advocate for using an advisor as a source of some good advice and as a way to keep a small barrier between you and your money, to prevent over-active trading. Frustrated by the fact that Clearsight Wellington West, after getting rid of my former investment advisor, has not bothered to call me, and unimpressed by what I see on the web pages of investment management companies, I have been contemplating going it alone. The main reason I got a financial advisor was to stop me from doing stupid things and that worked. It was also done to save myself time. But if I don’t do stupid things and stop trying to be too active with my money, then it should not take too much time. Having an advisor for the past year was a great experience. Over the year we never sold a single investment. I don’t think I ever went a year before without at selling a mutual fund at some point. Am I ready to go it alone? I don’t know, anyways, it is just an idea at this point.

After my unsuccessful search for an investment management company, I briefly looked at options for self-directed RRSP accounts. I first looked at TD Waterhouse (I used to be at TD Waterhouse and TD EasyWeb) because I really like their web services. I also looked at E-Trade. Their trades are a bit cheaper at $20. My portfolio as it stands right now mostly consists of a bond mutual fund, a Canadian ETF, a Canadian small-cap mutual fund, a US mutual fund, and an international mutual fund. I might switch the US component to an ETF and leave the CDN small-cap and international where they are for the time being. If after the transfer is all done from Clearsight to E-Trade and I buy 1 ETF, if all I have to pay is $20 then that is pretty good. It looks like their have some conceirge account transfer thing so the transfer fee is waived if you have more than $25,000. I have that much but my wife doesn’t so I’ll have to think about what to do there.

Split Shares: Why Not Buy Both?

This is the last article concerning split shares. Why did I write 3 articles? Well it started out as one but it was just too long. The other reason is because I found there wasn’t much information on the web. There were the few articles I found, but it took me a long time to find those, and some of them were not even available from the source, I had to use Google’s cache to view them.

This last article asks the question, “Why not buy both?” Well, the answer is simple. If you bought both that would be no different than buying the common stock in the trust’s underlying portfolio. But you would be paying annual fees for the management of the split shares/split trust (see Split Shares: the Downside for more information about fees).

Let’s see an example. Say a split share was set up and it owned common shares in ABC Corp. The split trust sold 50% of their assets as preferred shares and 50% of their assets as capital shares. If ABC Corp paid a dividend of 3% annually, the preferred split share will pay 6% (3%/0.5 = 6%). You get the dividend from the equivalent amount of common stock your preferred share is invested in, plus the forfeited dividend from the capital shares. If the common stock rises 3%, the capital share will go up 6% (3%/0.5 = 6%). So if I bought either the preferred share or the capital share I will get a 6% total return (capital gain + dividend). If I buy both the capital shares and the preferred shares I still get a 6% total return, the exact same return I would get if I had bought shares in ABC Corp. directly (see above, I mentioned that ABC Corp. paid a dividend of 3% and it’s stock went up by 3%); however, I will be paying about 1% in managment fees (as an example), so that will reduce my return to 5%.

Some articles online provide further proof that buying both the capital shares and the preferred shares makes no sense. From an article previously available here but now no longer availablel anywhere online:

Now, as to how you would use either of these in a portfolio, the answer may be obvious by now. First, you would buy either the preferred shares or the capital shares, but not both – if you wanted both you could just buy the XIUs. Second, you would hold either outside an RRSP to reap the tax benefits, unless you were using the capital shares to speculate within an RRSP.
But most of all, you’d buy the preferred shares if you needed to supplement your income, and your tax situation made dividend income attractive relative to interest income. Alternatively, you’d buy the capital shares if you didn’t need income and needed enhanced tax-deferred capital gains. So it really comes down to your investment objectives: do you need income, or gains, or both? [emphais mine]

More from Money Digest:

Stripped common investments take dividend-paying stocks and split them into two parts: capital and dividend. Those who buy the capital part benefit from capital gains, while those who buy the dividend part benefit from dividends and any increases in dividends over time. . . To reduce the risk, many split share corporations buy a basket of dividend-paying stocks. An example of a stripped common is Can-Banc, traded on the Toronto Stock Exchange. Can-Banc represents shares in the five largest Canadian banks. You can buy either the dividend part (check the dividend yields with your broker before investing) or the capital gains part (which entitles you to participate in capital gains should these bank stocks appreciate).

The reason I investigated this is because my parents are invested in both the capital and preferred shares of the Top 10 Split Trust, a split trust that invests in common shares of the 6 largest banks and 4 largest insurance companies in Canada. Buying both is equivalent to buying the common stocks themselves in the underlying portfolio. Except when you buy the common shares themselves instead, you don’t have to pay the extra fees imposed by the company managing the trust. If you really want income buy the preferred shares only, not the capital shares as well. Especially with a potential bear market looming, the capital part of the split shares could tumble a lot.

Or just buy the the S&P/TSX Capped Financials Index through the iUnits XFN index. The 6 big banks make up over 70% of that index (so you’ll get a similar return to banks stocks in the Top 10 Split Shares, but with less risk). You’ll also pay less in MER (0.55% for the ETF vs. at least 1% for the split shares). Or just get the iUnits S&P/TSX 60 index through the XIU ETF which has a large financial component.

Their financial advisor is seriously out to lunch. At first I could not believe that he had invested them in both the capital and preferred shares of the split trusts, but he has. He is either: a) afraid to buy banks’ common stock, b) has never heard of XFN, XIU, or has a fear of indexes, c) doesn’t understand how split shares work, d) doesn’t care about cost and MERs (like the 1% MER on the split shares). I really hope they get burned in the next bear market just like they did with Nortel so they can finally leave this guy and his crappy advice for good.

Split Shares: The Downside

A few days ago I introduced split shares/trusts and how they work. Now I will go into the downsides in more detail.

According to Larry MacDonald in this Moneysense article on split shares: “Split shares seem to be regaining popularity. One sign is an upsurge in public offerings. Demand is out there and dealers are rushing to fill it.”

It sounds like split shares are somewhat like other bad investments such as IPOs in the way that they gain in popularity immensely during bull markets (more so than plain vanilla common stocks become popular) as people are willing to take more risk, before the market takes its inevitable downturn. But more importantly in order to regain popularity it must have lost popularity at some point and you have to ask yourself why. Probably some investors got burned at some point, buying a split share and taking on more risk than they thought they were. Take this example from March 2004:

The Oil Sands Split Trust, linked to the Canadian Oil Sands Trust, recently demonstrated the downside risks. When cost overruns and project delays at its 35%-owned Syncrude oil sands plant were announced on March 5, the income trust units plunged 15% while the split capital trust shares plunged an even greater 23%.

Note that the Oil Sands Split Trust (unfortunately their trustee’s website is down right now) is a split trust whose underlying security is the Oil Sands Income Trust.

There are of course, a lot of little things/potential risks to think about when it comes to split shares:

Although the basic idea behind splits shouldn’t provoke any splitting headaches, looking into all the different wrinkles may. The investor needs to read up carefully, or have good advice, when it comes to purchasing individual split shares. As Brian McChesney, head of Scotia Capital’s structured products division, said, “In a lot of these products, the devil is in the details.”

And there are many little details involved with split shares. There are of course fees associated with split shares, “Apart from brokerage commissions, these products have annual management fees. For the most part, the fees are comparable to index funds or exchange-traded funds (i.e., less than 1% of assets). A few are actively managed and have management fees greater than 1%.” The Top 10 Split Trust, for example, has several fees. According to their prospectus:

  • Fees payable to the agents for selling capital units and preferred shares: 6.00% per Capital Unit and 3.00% per Preferred Security.
  • Annual fee payable to Mulvihill Capital Management (MCM) for acting as investment manager of the Trust (1.0% of the trust’s total assets).
  • Annual fee payable to Mulvihill Capital Management (MCM) for acting as manager of the Trust (0.1% of the trust’s total assets).
  • Trailer fee paid to each dealer whose clients hold capital units of 0.4% of the value of the capital units held by clients of the dealer.

Now that’s a lot of fees! Not to mention the commission for each purchase and sale, as these are traded on the stock market just like stocks and ETFs.

One huge concern concerning split shares is the distinct lack in interest in split shares from the institutional investment community:

Split shares are bought by retail investors. There is almost no institutional interest. “These products are sold with an up-front commission that the institutions just don’t like to pay,” explained one issuer. Another suggests that they don’t like the low trading volumes. Still, the absence of professionals — supposedly the smart money — might raise a yellow flag to some. [emphasis mine]

A few more downsides:

Retraction privileges allow holders to tender their capital shares, a feature reportedly aimed at protecting them from trading at a discount or becoming the target of arbitragers. It might be advisable to check if there are any restrictions on retractability, however. Another thing to consider is that many issuers can force early redemptions of the preferreds. This likelihood increases if the capital shares have risen sharply.

Not to mention their use of covered call options:

Some preferred split shares have their dividends boosted through covered call writing (selling calls on their portfolio of stocks and including the proceeds in the dividend payout). This strategy got a bad reputation a few years ago when it led to some miserable performances. Yet several new issues have recently been floated with the covered call feature. One risk is that the common shares could be called away if their prices rise past the exercise price of the call options sold. Said one money manger, “What investors … do not understand is that by selling covered calls against your portfolio, you are selling away all of your winners (when they are called away), and you are left with your losers.”

I discussed covered call options previously. The split trust my parents are invested in (the Top 10 Split Trust) which, according to the prospectus, will “from time to time, write covered call options in respect to some or all of the securities in the Financial Portfolio [which consist of 6 banks and 4 insurance companies].” This, they say, is done in order to “generate additional returns above the dividend income earned on the Financial Portfolio.”

In my opinion the downsides, risks, and increased costs of owning split shares far outweigh the benefits.