Split Shares: What are They?

My parents’ investment advisor has got them investing in something called “split shares.” When I first heard about them I had no idea what they were. That worried me. What worried me was the fact that my parents were invested in some sort of investment vehicle that I had never heard about before, and that maybe the reason I hadn’t heard about them before, is because they are a bad/risky/costly investment. Either that, or they are an extremely conservative investment (like GICs) that just aren’t relevant to me right now. I think they are invested in the Mulvihill Capital Management Top 10 Split Trust and the Oil Sands Split Trust (see here and here; not to be confused with the Oil Sands Trust). There are several split shares trading on the TSX.

There is some decent information on the TSX Group’s website on split shares:

The “split share” structure is another unique type of financial structured product. The split share structure allows the risk-reward component of common shares to be broken down into two components and then allocated differently for investors who are more or less risk averse. A split share corporation will hold common shares of one company or more, typically a portfolio of common shares (based on a sector or industry). The split share corporation then issues two classes of shares – capital shares and preferred shares . . . Using this structure, a portfolio of regular common shares can be divided into capital shares that have a higher level of risk than the underlying common shares and preferred shares that exhibit less risk than the underlying common shares.

By the way, phrases like “unique type of financial structured product” scare me. So basically the way it works is some corporation (called “split share corporation” in quote above) buys common stock in some company or companies. They were able to buy those common shares by raising capital through the sell of two forms of shares in the “split share corporation”: capital shares and preferred shares. The capital shares pay no dividend and only experience capital appreciation or depreciation in value. The preferred shares do not go up or down in value and only pay a dividend. Note that the split share/trust does not purchase any preferred shares in the companies in the underlying portfolio, they issue preferred shares. They purchase common shares. Whenever I talk about preferred shares in this article, I am referring to the preferred shares that the split trust/share/corporation issues.

So why/how would I use them in my investment portfolio??

. . . Where the split comes in is the investor chooses to either receive all the dividends from the portfolio shares, or the capital gains, but not both. That’s what makes split shares different from direct common share ownership, where the investor gets both. Those who opt for the dividends buy what are called preferred shares in the trust, and those who opt for the capital gains buy what are called capital shares. Both types of shares then get listed on the stock exchange, so you can trade them, unlike regular mutual fund units. . .

Here’s a great example of how split shares actually work:

The common shares of ABC Corp. trade on the TSX at $35 and pay a $1.50 dividend to yield 4.3%. A sponsor sets up a company though a public offering to buy the shares and then split them into preferred shares priced at $25 and capital shares at $10. The ABC Preferred Split share gets the dividend, while the ABC Capital Split share gets the capital gains (or losses). Now assume the underlying ABC common shares rise over three years from $35 to $50 for a 43% capital gain. The ABC Preferred shares get an annual dividend yield of 6% ($1.50/$25), while holders of the ABC Capital shares earn a capital gain of 150% because their $10 shares are now worth $25 ($10+$15).

In case you still don’t get it and need another example, here it is:

. . . Let’s use the Split Sixty shares you cite as an example. This mutual fund trust was created by Scotia Capital Inc. and the portfolio shares consist of some $300 million invested in the common shares of the companies which make up the S&P/TSX 60 Index. The portfolio shares currently have a NAV of $44.32, and the MER is 0.36%.
To get dividend income, you could by the preferred shares in this split corporation (ticker SXT.PR.A), currently at $25.82 per share, and earn a yield currently of 5.52%. Compare that with the yield on the iUnits on the S&P/TSX 60, ticker XIU, which is only 1.60%.

To get any capital gains earned by the portfolio shares, you could buy the capital shares today at $9.30 (ticker SXT) . . . If the value of the portfolio shares rises between now and the final redemption date, the capital shares should rise at a greater rate than the portfolio shares (2:1 in the simple example). You could then sell for a gain through the stock exchange.

Note that, as mentioned here, “the returns are leveraged on split shares, somewhat like buying stocks, bonds or futures on margin.” Margin is defined as: “Borrowed money that is used to purchase securities.” This is the basic concept at work here. The capital share holders are essentially lending their shares to the preferred share holders who take all the dividends from it and the preferred share holders are lending their shares to the capital share holders, who take all the capital gains from it. Buying with borrowed money increases yours risk because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price – the potential for greater losses.

Basically what split shares allow one to do is trade off capital gains for dividends and vice versa, allowing you to receive either capital gains or dividends, and more of them. Are they worth thinking about? Not really in my opinion. The Top 10 Split Trust that I mentioned above invests in the top 10 Canadian banks and insurance companies in Canada. Personally I would rather invest in iUnits XFN ETF. It tracks the S&P/TSX Capped Financials Index. It has a lower MER and carries less risk, due to the fact that you are not restricting yourself to only dividends or only capital gains. Not only that but XFN is a larger basket of stocks thus reducing risk even further.

Tomorrow I’ll talk about some more of the downsides of split shares.

Mutual Fund Loads

When is a Front-End Load NOT a Front-End Load? Answer: when the front-end load is zero.

On a previous blog post of mine about my new portfolio allocation as proposed by my advisor, I received a comment from Average Joe in regards to the MERs and the loads on these funds (CI Value Trust fund, Templeton International Stock fund, and E&P Growth Opportunities fund):

These are all loaded funds as well (ie. they are not no-load funds). You will more than likely be locked in or have to pay a penalty to get out.

I had not looked into the loads of these funds before. In my reply to the comment above, I looked up the load options for 3 three mutual funds in question in their respective prospectuses:

I had assumed these funds were all no-load but they are not, as you have pointed out. I went and looked at the prospectuses (sp?) and here’s what I found:

-CI Value Trust can be purchased and sold after 3 years for free with the low-load option. If you sell before the 3 years are up, the sales charge is 3%.
-Templeton International Stock fund can be sold after 2 years for free with the low-load option. If you sell before the 2 years are up, the sales charge is 2%.
-E&P Growth Opportunities fund can be sold after 2 years for free with the low-load option. If you sell before the 2 years are up, the sales charge is 3%.

This does not concern me too much. I would much rather be locked in to something as it will force me to stay invested, at least on the 2-3 year time scale.

In the above, I am only quoting the “low-load deferred sales charge” option. There are actually three options for these 3 funds:

  • Front-end load (or initial sales charge) option: you pay a sales commission when you buy your shares. The commission is a percentage of the amount you invest and is paid to your financial advisor.
  • Deferred sales charge:
    • Standard deferred sales charge: varies depending on the fund, but usually higher initial penalty percentage than the low-load deferred sales charge option and a longer waiting period until the load disappears, and for some funds you may switch or sell some of your units every year. The penalty charge decreases every year you stay invested in the fund.
    • Low-load deferred sales charge: lower loads compared to the standard deferred sales charge option and shorter time until the load wears off. Usually the penalty is constant rather than decreasing, then after a short period of time, becomes 0%.

I had incorrectly assumed that the low-load deferred sales charge was the cheapest option for the investor. When I asked my advisor about this, he told me how Clearsight handles mutual funds. He said that all funds are available from Clearsight on a no-load basis. They do this by doing front-end loaded funds but with a load of zero. They do have a penalty of 2% if you want to switch or sell within the first 90 days to discourage silly trading. So essentially they have access to all funds on a no-load basis. Also, he told me they get paid a 1% trailer fee from the mutual fund company.

Anyways, that’s just a long-winded way of saying front-end load does not always mean front-end load. If your advisor or his company chooses not to charge the front-end sales charge then it is essentially no-load. After years of investing by myself in TD Mutual Funds through TD’s website, I have a lot to learn about mutual fees!

How is Your Spouse’s Portfolio Managed?

I had assumed my financial advisor was going to manage my RRSP portfolio and my spouse’s separately. ie. I thought he was going to have an asset allocation model for her and an asset allocation model for me and each was going to be totally independent. I was going to suggest to him a long time ago that we use a spousal RRSP for one of us and put all our monthly contributions into one account. One of us would contribute to our RRSP directly, the other would contribute to the spousal RRSP of their spouse. It would be as if we had one portfolio. Except our RRSPs would get really lop-sided after doing that for a while and we would have to switch to the other RRSP and start contributing into it as well. That doesn’t seem like the optimal way to do things.

I just found out today that he is planning on manage my RRSP and my wife’s together, treating the two RRSP accounts as one massive portfolio. So I could have the international and US stuff, for example, and my wife could have the Canadian and the fixed income. This would be much more efficient from a cost perspective. If we bought all ETFs all at once for example (one ETF for each market: US, Cdn, Int., Bonds) our commissions would be cut in half. Instead of buying 8 ETFs (4 each) we would just buy 4 ETFs (2 each). I didn’t think advisors ever did this because it would be harder to manage because underneath they are separate accounts. But I’m glad that mine does! What about your spouse? Is his or her portfolio managed together with yours as one large portofolio?

Bad Timing

Here’s an article I found a long time ago, entitled “When Index Funds Go Bad [registration required: may I suggest Bugmenot.com?].” It has been sitting in a draft post for a long time and just today my last post inspired me to publish it. The title doesn’t accurately describe what the article is about. What she talks about applies to all investments, not just stocks. Here’s the main thesis:

Indeed, investors of all stripes are notorious for their poor timing: They often purchase investments after periods of strong performance and sell them belatedly after periods of weak performance. Those timing decisions thus have a major–and negative–impact on the returns shareholders actually pocket.

She then looks at “dollar-weighted returns to gain a better understanding of how investors have really fared, because dollar-weighted returns account for cash flows in and out of a fund.” The results, in my opinion, are quite staggering:

The results indicated that, as with most active funds, investors’ timing decisions were costly when it came to index funds. The dollar-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of the third quarter 2005. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. That’s not chump change.

There is a chart given which gives the dollar-weighted returns and the official returns for many index funds. Over a 10-year period the gap between the two returns ranges from -0.8% to -6.18%. The whole article is excellent and I highly recommend reading it. I will just provide the last paragraph as I think it sums things up pretty well:

Clearly, index investors aren’t immune from the behavioral biases that can produce bad results from good funds. Although many of indexing’s most vocal proponents (Burton Malkiel and Jack Bogle, for example) also preach the importance of disciplined, long-term investing, it appears that many investors didn’t heed that advice. True, investors were challenged by one of the most precipitous bubbles in stock market history, and I take some comfort from the fact that asset flows into index funds have smoothed out over the past few years. But many still have a propensity to pile into the hottest funds at just the wrong time. Witness the recent strong inflows many energy funds have experienced this year. I mistakenly assumed that index funds were less likely to invite such behavior, but this study proved me wrong. I still think index funds provide investors a great way to get low-cost, no-fuss exposure to the stock market, but they are good investments only if shareholders use them wisely and maintain the long-term orientation that’s necessary to benefit from all they have to offer.

Investors are always being told to pay attention to MERs. To look at low-cost ETFs as an alternative to index mutual funds or actively-managed mutual funds. Some people take this to the extreme, recommending ETFs (with MERs of around 0.25-0.5%) instead of index mutual funds (with MERs of around 0.5-1%). To save a few percent on your annual return? As this study shows, a much more important factor affecting your portfolio’s performance has to do with keeping your head. This is something that is easier said than done. As Benjamin Graham said on page 8 of The Intelligent Investor,

We shall say quite a bit about the psychology of investors. For indeed, the investor’s chief problem–and even his worst enemy–is likely to be himself.

This is what investing intelligently is all about. This kind of intelligence, explains Graham, “is a trait more of the character than of the brain.”

Teaching kids about investing

Interesting story here about someone who has set up a stock account for his 9-year old daughter. The account is actually in her name but controlled by the parent. The original post is here, “My 9 Year Old’s First Investing Lesson” and the update is here, “Update on Sharebuilder Account.” It’s too bad that so many parents don’t teach their kids about investing and many parents don’t even teach their children about personal finance, often controlling their chequing accounts well into their 20s (I can give first-hand accounts of this). I think it’s great that this kid has an account opened up where she can buy stock in her own name. I actually hope that her stocks do very, very badly! Losing money in the stock market is a very important lesson that ever person should learn as as young an age as possible! I didn’t learn this lesson until my early 20s; however, I wish I had learned even earlier.

She owns $28 in Apple stock and $21 in Chesapeake Oil stock (as of last weekend). The only thing I found surprising was that they purchased such low amounts. The commission was $4 per trade. So Apple’s stock has to go up 14% just to break even, and 19% for Chesapeake Oil. Apparently “if she does all the chores we have on the list she stands to make $30 a month.” I would have advised her to be patient, wait a few months until she has enough money to invest such that the commissions become a very insignificant percentage of the stock purchase.

This reminds me of when I first invested in mutual funds in around 1996-1997. I invested my own money that I made through my own jobs, but my dad matched my contributions, much like an employer might. This is another great way to encourage kids to save and teach them about investing. themillionaireblog.com has some other tips for helping children learn about finances.

Another interesting aspect of these articles is this sharebuilder.com site. The millionaireblog.com explains:

The great thing about ShareBuilder.com is you can purchase partial stocks or ETF (Electronic Transfer Fund) of any company they carry. This means that I can fund my account with $30 and buy $26 worth of Apple stock. ($30 minus $4 transaction fee per trade) even though I may not have the funds to buy a full share.

You also have the option of setting up monthly automatic investments. For example I can set up my account so that every 2nd Tuesday I purchase $30 worth of Apple, or I can set it up to purchase $10 worth of Apple, $10 worth of Home Depot, $15 worth of Sirius etc. Keep in mind there is a $4 fee for each stock you buy. That is the fee under the plan we have which is the Basic Account, some account have lower fees.

This is certainly an excellent way to invest in stocks using smaller amounts of money. It makes building a diversified group of stocks (20-30) much easier for the small investor. I haven’t yet looked into whether or not Canadians can open an account at sharebuilder.com. I know that a long time ago when I set up an account at a US based discount online trader I had to send in some extra IRS forms, but other than that anyone could set up an account (in US dollars of course).

S&P 500 equal-weighted index

Found an old article from 2004 about the S&P Equal Weighted Index, “Buy the S&P 500 with better returns,” which can be bought under the Rydex S&P Equal Weight EFT (RSP). The S&P Equal Weight index holds all the stocks in the S&P 500 index equally (0.2% each). Rebalancing works like this:

If the share price of one of the companies in the index climbs sharply, the Rydex fund pares it down to a 0.2% weighting when the portfolio is rebalanced every quarter. If a stock tumbles, more is added. Thus the fund is continuously funneling profits from stronger to weaker issues; in effect, selling high and buying low.

I wouldn’t even really call this value investing. This is just common sense. If you created a portfolio yourself of 60 stocks, like the S&P TSX 60 index, would you weight them according to their market capitalization? Probably not. If one of the stocks in your portfolio went up by 50% and another went down by 50%, would you sell the one that went up and buy more of the one that went down? Yes, you probably should, if your transaction costs aren’t too high. If you want to think of it as value investing, that’s fine. I guess compared to the run-of-the-mill S&P500 it is certainly more value-oriented:

“This is a poor man’s value tilt,” says Robert Deere, head of domestic equities for Dimensional Fund Advisors, the foremost operator of customized index funds for institutions.

DFA heavily favors small and downtrodden stocks, citing academic research that shows they outperform big-cap growth stocks over long periods. Since this fund does that implicitly, “I would expect it to give you a higher return — no doubt about it,” he says.

The article pooh-poohs the Rydex Equal Weighted Index’s MERs, “The ETF’s expense ratio is 0.4%. That’s more than three times that of the Spider, eroding indexing’s greatest advantage.” But that hasn’t hurt its returns. According to the article the equal-weighted index has beaten the market-weighted index by 2% over the past 10 years,

Rydex says that the equal-weighted index has greatly outperformed the market-weighted index over the last 10 years, delivering annualized returns of 14%, compared with 12% for the index.

However, this document on S&P’s website puts the 10-year annualized returns at 12% and 9.3% respectively. I will definitely be buying RSP over SPY and not because I am chasing after good past returns but because the methodology makes sense.

Screwed on Bank Charges

We just got our first bank statement since attempting to stop using our credit cards completely. My plan to reduce our total spending by not using a credit card may have back-fired slightly, as there was a whopping $17 in extra charges charged to our bank account, in addition to the $11 we are already charged for our monthly plan “Everyday Banking Plan.” We were pushed over our transaction limit because we are such heavy Interac/Debit users, and we have many automatic deposits and withdrawals coming in and out of our account every month. To combat the problem, we will carry around more hard cash in our wallets in December and I hope this will help us stay under the transaction limit.

I am seriously considering using our BMO bank account for all our bill payments and direct-deposits, and using a separate ING Direct account (they allow you to create 4) for Interac charges, since as far as I know there is no limit to the number of Interac transactions you can make with ING Direct accounts, just as there is no limits or charges associated with transferring money from an ING Direct account and a big-bank account (except charges incurred from the big-bank). It will be nice when ING Direct one day provides bill payment and direct deposit service.

ETFs vs. Index Mutual Funds

I found an informative Comparison of ETFs and Index Mutual Funds. It has some great information about the internals of ETFs and how they compare to index mutual funds. Notably, that “overall, there are few pros and many cons to using ETFs.” This came as a bit of a surprise to me. Much of what the article says is true, although told in a way that is biased towards index mutual funds. Some of the information is out of date such as: “ETFs have poor coverage of foreign style/size indexes. If you wanted to buy a foreign value ETF, for example, you would not be able to do so at present” and “there are few bond ETF options available at present.” I think these two points are no longer true.

One big difference between ETFs and mutual funds is that “they [ETFs] pay out distributions as cash. If you want to then reinvest that cash, you need to take some action to do so (and incur whatever transaction costs apply).” Although I initially found this annoying, it is really no big deal because the distributions can easily be re-invested into no-load mutual funds on a monthly basis along with other cash. Since you SHOULD be dollar-cost averaging on at least a monthly basis this should not be a problem for most people.

With many low-MER index mutual funds out there (and I expect to see even more, with possibly even lower MERs), the low-MER advantage of ETF is not a huge deal. I still think that the best option is to buy index mutual funds (with as low an MER as possible) on a monthly basis and switch them into index ETFs when the cost of making the ETF purchase (from commissions) becomes a small percentage of the total amount to be invested.

Owning Too Many Mutual Funds a Bad Idea

I used to own many mutual funds in my account at TD Canada Trust. A glance at an old statement shows that at one time, I owned the following funds in the Canadian portion of my portfolio:

TD Canadian Equity Fund
TD Canadian Index Fund
TD Dividend Growth Fund
TD Blue Chip Equity Fund
TD Canadian Small Cap Equity

What is wrong with being invested in so many funds at once? The problem is that with 4 funds, primarily large-cap funds, I was over-diversifying and basically forming an index for myself. I was owning the entire market, which is what indexes do anyways, and diluting the active management within each of the funds. But I was not paying what I should have been paying for an index (MER <= 0.25%). These funds have MERs of at least 2%, except for the index fund. So basically I was buying the equivalent of an index, but paying through the nose for it. The effect of a high MER eating into your returns every year can be huge. Don't make the same mistake I made. Get an index for the large-caps, and no more than one other large cap fund. Perhaps owning an actively-managed small-cap fund as well. If I had to do it again at TD, I would have bought TD Canadian Index Fund and TD Canadian Small Cap Equity. The other large-cap funds (TD Canadian Equity, TD Canadian Dividend, and TD Blue Chip Equity) are not significantly better than the indexes themselves, so I would rather take the low-cost index fund. The small-cap fund gives me some exposure to smaller companies which are not owned by the index.

Selling ETFs to buy index funds a bad idea

A friend recently asked me:

I’m just about to switch my ETF‘s to mutual index funds so I can contribute monthly without the transaction fees associated with ETF’s. I found a few funds from Altamira that have MER fees of 0.54. That seems pretty good to me…not quite as good as the 0.17% that you get for the iShares S&P TSX 60 ETF’s, but I think the ability to automatically contribute monthly makes up for the additional 0.36% in MER fees.

They wanted my opinion on this before they went ahead and did it. My reply was:

I wouldn’t switch if I were you because you’ll pay commission on the sale. If you are already invested in an ETF I would just hold it and let it grow. . . Definitely if you want to contribute monthly you should put your money into a mutual fund. Obviously no one would recommend buying ETFs monthly with the kind of monthly amounts you’re probably putting in, so really you have no choice. Just don’t sell the ETFs you already own.

The only reason I could see for you wanting to sell your ETF is if the mutual funds you are interested in required some sort of initial minimum. That would have surprised me though, because all of TD‘s funds for example, only require a minimum RSP investment of $100, and minimum subsequent investment of $100.

Basically if you are putting in small amounts per month, use mutual funds, that’s what they are for, if you have large amounts, get stocks or ETF indexes. When the amounts in mutual funds are large enough, it might make sense to transfer them into an ETF. But it’s up to the individual, especially if the difference in MER is so small, you might as well just leave it in mutual funds.

The MER on those mutual funds are really low which is great, so I would say buy them every month, but just don’t sell the ETFs you already own.