The Real 10 Commandments of Investing

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:

  1. Stick with the indexes
  2. Watch those fees
  3. Create a bond ladder
  4. Diversify
  5. Watch your money
  6. Don’t rush in
  7. Don’t take the risk if you don’t need the return
  8. Get out if something isn’t working
  9. Understand tax consequences
  10. 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!

Indexes Have the Advantage in Bear and Bull Markets

There was yet another Rob Carrick disaster in the Globe & Mail this week, a newspaper that I am losing respect for all the time. After reading the headline,
ETF advantage fades in down market, I knew it was going to be a beauty. He starts off by explaining that index funds and ETFs “clean up” in a bull market.

One of the top no-brainer investing moves is to put money in an exchange-traded fund or index fund if you want to clean up in a bull market.

But why just in a bull market? It is unfortunate that he doesn’t give any reason why indexes might perform better in a bull market (or bear market). The most obvious reason is that index funds or exchange-traded funds represent “the average” but have lower MERs. This same logic should apply to bear markets right? His whole argument that ETFs and index funds “beat” actively managed mutual funds in bull markets but perform poorly in bear market is weak. It rests completely on being selective about what past periods to look at and a belief that mutual fund managers are “market pros [that] are using their training and experience to pick the best stocks.” Couple that with reporters’ tendencies to write about both sides of the story, in this case searching for advantages and disadvantages to both index ETFs and mutual funds even if it means leaving readers with an unfair and inaccurate picture.

In the second paragraph, he mentions that ETFs did not perform that well between Sep. 1, 2000 and Oct. 31, 2007 but from 2002 onward they performed much better than actively managed mutual funds. He thinks he has it all figured out; index ETFs perform poorly in a period that includes a bear market.

. . . the advantage of ETFs isn’t so clear over a longer period that includes a down market. The past seven years are a good example. If you bought ETFs at the peak of the last bull market on Sept. 1, 2000, and held until this past Oct. 31, your returns would look puny compared with many popular Canadian equity mutual funds.

He even suggests that investors consider “investing in the Canadian market, but through mutual funds rather than ETFs” because “the S&P/TSX composite is looking shaky right now after a five-year bull run.”

He describes accurately how the S&P TSX Large Cap index did poorly after Sep. 2000 and explains one of the reasons for this: the fact that Nortel made up close to one third of the index whereas mutual funds were limited to about 10% exposure for each stock. So when Nortel lost almost all of its value after 2000, the index, with more Nortel exposure, would have faired much worse than actively managed mutual funds (in fact, the index performed so badly that the “capped” S&P/TSX 60 index was created after the Nortel debacle). The index would have also faired much better than the actively managed funds between 1997 and 2000 because of Nortel’s gains thus compensating for the loss from 2000-2002; however, he conveniently leaves out the 10-year figures (1997-2997) and only uses a “seven-year comparison prepared especially for this Portfolio Strategy column.” His reason for not using 10-year data is that “a 10-year slice is of little use because many funds and ETFs haven’t been around that long.” I find that rather odd because the TSE/S&P TSX Composite has been around since 1977 and the TD Canadian Index mutual fund have been around for 10 years! Of course I agree that “many funds and ETFs haven’t been around that long,” but since we’re only looking at Canadian equities here, isn’t one Canadian index enough? After all, he only looked at one index for the 7-year period.

I decided to get my own figures from Morningstar’s Fund Selector:

  Number of funds that beat the TD Canadian Index Fund Total number of Canadian Equity funds % of funds that performed worse than the TD Canadian Index Fund
3 yr. 90 279 68%
5 yr. 25 218 89%
10 yr. 23 68 66%

My Method: Using Morningstar’s Fund Selector I searched for funds in the “Canadian Equity” category that have a 10-year return greater than -50%. This allowed to me to find out how many funds have been around for the past 10 years. Then I searched for funds that had performed better than the TD Canadian Index fund over that same 10 year period to determine how many funds beat this index fund. I then repeated the same procedure for 5 yr. and 3 yr. periods. The TD Canadian Index fund’s performance over the 3, 5, and 10 years periods was 19.8%, 20%, and 9.2% annualized, respectively.

As you can see from the table, the indexes beat a large percentage of actively managed mutual funds over the past 3, 5, and 10 year periods. Note also that there is some survivorship bias in these figures. Presumably, in 1997 there were more than 68 mutual funds in the “Canadian Equity” category but only 68 “survived” until 2007. One can assume that the ones that did not survive were more likely to have performed worse than the index, hence their reason for being discontinued, retired, or merged with other funds. So the percentage of funds that performed worse than the TD Canadian Index Fund is likely to be higher than 66% if we could somehow include funds that existed in 1997 but no longer exist in 2007.

Indexes can do even better than this if only the MER was lower. The TD Canadian Index fund has an MER of 0.85% but the iShares CDN S&P/TSX Cap Composite Index (XIC) has an MER of 0.25%. XIC does go back 5 years; however, it wasn’t always tracking the TSX Composite; it used to track the TSX/S&P LargeCap 60 index so I will not look at its performance values. Let’s assume that if XIC (in it’s present form) had existed 10 years ago, it would have performed 0.6% better than the TD Canadian Index Fund over that same period due to its lower MER, or 20.4%, 20.6%, and 9.8% annualized over the past 3, 5, and 10 year periods, respectively. This approximation is consistent with the fact that in 2006 the TD index returned 16.4% but XIC returned 17.0%, a difference of exactly 0.6%. I re-ran my fund searches on Morningstar and here is what the performance would be if XIC existed 10 years ago in its present form with an MER of 0.25%:

  Number of funds that beat the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC) Total number of Canadian Equity funds % of funds that performed worse than the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC)
3 yr. 63 279 77%
5 yr. 14 218 94%
10 yr. 20 68 71%

As we see once again, the S&P/TSX Composite Index with a 0.25% MER has outperformed over 71% of all actively managed mutual funds in the “Canadian Equity” category in the last 10 year, 5 year, and 3 year periods ending in Oct. 31, 2007. I have not cherry-picked any period and I have shown three different periods, not just one. I have not thrown out any periods based on whether or not they include or don’t include either bull markets or bear markets. The original article only looks at one bear market and concludes that indexes perform worse than active management in bear markets. I am not at all convinced that this is a consistent truth or “rule.” There is lots of data from the US for example that shows that over long periods of time (which include more than just one bear market) indexes handily beat actively managed mutual funds. In A Random Walk Down Wall Street, Burton Malkiel quotes a Lipper study (2007 edition, pages 267-268) that found that from Dec. 31, 1985 to Dec. 31, 2005, the S&P 500 index beat 82% of mutual funds and on average performed 1.5% better than the average fund per year. I would find it very hard to believe that one could increase performance even more by switching from indexes to mutual funds at certain times, or even holding some balance of mutual funds and indexes. Even if we looked at more than one bear market and it turned out that indexes did perform worse in every bear market, without being able to predict when future bear markets start and end, would this information be helpful? How would you know when to switch to mutual funds and then back into index ETFs for the next bull market? You would be guessing and in the end you would lose out due to commissions spent on buying and selling the ETFs and the higher MERs on mutual funds.

Ask Dave: Index ETFs and Rebalancing (or lack therof)

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.

Fidelity Says You Need 80% Pre-Retirement Income in Retirement (just don’t use them to get you there)

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.

See also:
Should Retirement Replacement Ratio be 50%, 80% or in between?

The Average Actively Managed Fund Must Underperform the Index

In last Saturday’s Globe & Mail (finally got around to reading the paper today), Rob Carrick compared the performance of Canadian equity funds to a low-cost index ETF that covers the entire Canadian market, iShares CDN Composite Index Fund ETF (XIC). It is the one I own to capture the Canadian market and it makes up the entire Candian equity portion of my portfolio. He went five years back because the ETF has not been around for 10-years yet. He compared this ETF to the “100 or so funds in the Canadian equity category that have been around for the five years to Sept. 30.” Surprise, surprise, only 5 mutual funds beat the index over that period. Here are some of those funds, sorted by 5-yr % return:

Fund name MER 5-yr % return 5-yr beta
Acuity All Cap 30 Canadian Equity 2.85 27.96 1.385346
imaxx Canadian Equity Growth 2.76 24.54 0.986167
Altafund Investment Corp. 2.72 22.02 1.042311
TD Canadian Equity 2.09 21.39 1.145336
iShares CDN LargeCap 60 Index 0.15 21.39 0.980728
TD Canadian Equity-A 2.09 21.09 1.130500
iShares CDN Composite Index 0.25 20.94 1.002607
Desjardins Environment 2.35 20.71 0.985526
OTG Diversified 1.30 20.51 0.981718
Altamira Precision Cdn Index 0.53 20.45 0.983078
iShares CDN MidCap Index 0.55 20.45 0.983592
Hartford Canadian Stock D 1.88 20.43 0.949451
Integra Canadian Value Growth 2.24 20.04 0.906116
TD Canadian Index – e 0.31 19.93 0.987276
National Bank Canadian Index 1.14 19.84 0.983619
Leith Wheeler Canadian Equity B 1.50 19.72 0.720842
Ferique Equity 0.66 19.58 0.964336
Manulife Sector Rotation Fund 2.69 19.55 1.012749
RBC Canadian Index 0.71 19.55 0.996493
GGOF Canadian Lrg Cap Equ Mutual 2.39 19.54 0.878637
Hartford Canadian Stock B 2.60 19.53 0.952128
Acuity Social Values Canadian Equ 2.85 19.52 1.178193
Sceptre Canadian Equity – A 1.69 19.42 0.939199
TD Canadian Index 0.85 19.41 0.997669
FMOQ Canadian Equity 0.95 19.34 0.933744
CIBC Canadian Index 0.97 19.30 0.995622
Scotia Canadian Stock Index 1.03 19.20 0.997593
BMO Equity Index 1.01 19.12 0.994472
PH&N Canadian Equity-A 1.13 19.09 0.870502
Fidelity Cdn Disciplined Equity-B 2.24 18.98 1.019771
Fidelity Cdn Disciplined Equity-A 2.45 18.85 1.021164
Meritas Jantzi Social Index 1.94 18.81 0.872850
PH&N Community Values Cdn Equ-A 1.39 18.65 0.815829
Fidelity Cdn Disciplined Equ Cl-B 2.30 18.65 1.019219
Fidelity Cdn Disciplined Equ Class 2.50 18.52 1.020240
Manulife Canadian Equity Fund – A 2.23 18.38 1.046150
OTG Growth 1.30 18.37 0.933543
Supposedly
60+ more funds to go on this list…

Note that some funds that started 5 years ago probably got canned due to poor results (or other reasons) and are thus excluded from the “100 or so equity funds” that Carrick mentions. See Survivorship Bias.

These results should come as no shock to anyone. If it does surprise/shock you, I recommend reading A Random Walk Down Wall Street as Burton Malkiel explains the reasons why index funds do much better far better than I can. You don’t even have to believe in efficient-market theory. According to Malkiel (and others of course):

But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. The index fund achieves the market return with minimal expenses. The average actively managed fund incurs an expense ratio of about 1.5 percent per year [ed: in Canada I think this is higher]. Thus the average actively managed fund must underperform the market as a whole by the amount of the expenses that are deducted from the gross return achieved.

The only way mutual funds will do you any good is if you can predict beforehand which mutual funds will be one of the handful that do outperform the indexes (good luck). He goes on mention that this claim is actually borne out in the data from the US market in the past 20 or so years,

Between 1974 and 2006, for example, the S&P 500 outperformed more than three-quarters of the public equity mutual funds–the average annual total return for the S&P 500 was more than 1.5 percentage points better than that of the media fund

Again survivorship bias plays a role here. If we included some of the funds that existed in 1974 but did not make it to 2006, the S&P 500 would most likely have outperformed an even larger fraction of the public equity mutual funds from 1974 to 2006.

Portfolio Update: Switched from iShares’ XIN to Vanguard’s VEA

On Friday it was time for another ETF purchase as about $2500 had built up in one of our RRSPs. According to the actual allocations and the expected/desired/original allocations, the area we were most deficient in was International equities. I decided it was time to put the new cash into Vanguard Europe Pacific ETF (VEA), and at the same time, transfer my current holdings in iShares CDN MSCI EAFE Index Fund (XIN) into VEA. At the time that I chose XIN, I did not have time to do any detailed investigations so I chose it over EFA because of some advice I read on Martin Gale’s blog (note: VEA did not exist at that time). In an article called “Exchange Traded Funds: Recommendations” he said “Something is missing in the above: There’s no EAFE listed. That’s because the EAFE funds available on the US exchanges such as EFA, IEF, and EZU, or the country-specific funds, all have the same or higher cost than a fund that is available to you right here in Canada, so there is no point to buy them.” Unfortunately there is no date on that article so I am not exactly sure when he wrote it, but he wrote a later article called “Changes To Barclays Canadian iShares: XSP and XIN“:

Barclays’ new idea for these Canadian iShares exchange traded funds is to concentrate on eliminating “currency risk”. The idea is to give you a way of investing in American and overseas securities without having to worry about fluctuations in the Canadian dollar. Given the massive appreciation of the Canadian dollar over the past few years this certainly seems like a good idea–but it is not necessarily. It requires careful thought
. . .
Thus, a very strong argument can be made that if foreign securities made sense for you before, that they still make sense to you today, and that you should prefer to hold them in a foreign currency. The new XSP and XIN Canadian iShares are thus bad news for you, and you should avoid them–instead you should look at the alternatives you can now freely buy on the U.S. market.

I suggest reading the whole article, that is just a snippet. The idea is that if you can tolerate some foreign currency exposure (which I think I can and I do have some Canadian dollar holdings as well, namely, Canadian equities and bonds) foreign currency ETFs like iShares MSCI EAFE Index Fund (EFA) offer lower cost and so they are preferred (unless of course you really want to have all your holdings in Canadian dollars and are convinced that the Canadian dollar will grow to be more and more valuable than other currencies over the long haul). So in his future articles he would recommend EFA (like this one) and in even later articles recommended a combination of VPL and VGK because “there a few new ETF’s [VPL and VGK] on the market that we can use to track foreign equities, that are cheaper than the ETF’s we had available to us last year”.

Now VEA is out (as reported by the Canadian Capitalist) and is the perfect replacement for the higher cost EFA. VEA has an MER of 0.15% and EFA has an MER of 0.35%. Unfortunately I had to pay more commission ($20 CAD) as I had to sell my XIN, however, XIN had an even higher MER of 0.50% so I think it is worth it to switch over to VEA completely.

Ask Dave: Costs of Switching From Stocks to ETFs

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:

FV_0=PV \times (1+i)^n

The final value after paying some one-time commission CC is:

FV_c=(PV-C) \times (1+i)^n

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,

100 \times \frac{FV_c-FV_0}{FV_0} = 100 \times \frac{-C}{PV}

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 100 \times \$1000/\$100,000 = -1\% 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).

Ask Dave: Switching to an Index-Based Portfolio

Dear Dave,

Firstly, I wish to compliment you on your excellent blog. Your posts are simple and they have certainly helped me navigate towards a passive portfolio. Please keep up the excellent work.

Why thank you! Keep reading, tell your friends. And sorry for taking so long to respond to this, I’ve been quite busy.

I know that you are not in the business of giving financial advise, but I was wondering whether you could provide some guidance, or post on subjects related to my current situation. I am a relatively young investor, like you, (25) who now has a steady job and am looking to invest for the long term. I have been investing for a while now and have built up savings of, let us say a fictional $100,000, primarily of mutual funds, including some index funds. I currently use TD Waterhouse’s self-directed brokerage.

My portfolio is as follows:

TD Canadian Index-e
TD Monthly Income
TD Balanced Growth
TD Dividend Growth
Canadian – 12%

TD International Index currency neutral
Cundill International Value
Trimark Fund SC
International – 26%

Vanguard Total Market E.T.F. – VTI
RBC O’Shaughnessy US Value
US – 13%

TD Latin American Growth
Emerging Markets – 2%

GIC (one year, 3.75% matures in Dec. definitely can cash this earlier)
Corporate Bond ($160 a month)
Fixed Income, Bonds – 43%

Cash – 4%

Reminds me of my old portfolio at TD Mutual Funds (not Waterhouse, I had a mutual fund-only account at TD, used to be called TD Greenline Mutual Funds). Lots of funds with a lot of the same holdings; I had TD Canadian Index-e, TD Balanced Growth, TD Dividend Growth on the Canadian side. 3 International funds, 2 US Funds, etc… As my former advisor said to me “with so many mutual funds, what you’ve got is basically an index but with a high MER.”

Most of my portfolio is outside of an RRSP (20% is in RRSPs – I cannot really contribute much more to my RRSP). So if I wanted to switch my actively managed funds into ETFs, how should I do it? I am aware of the early redemption fees, but aside from that, do I just sell them and take that big chunk of cash and buy my proper allocations of ETFs? Are there tax consequences that need to be thought about? I know your thoughts on timing the market, so should I just buy everything I need on one day (the VTI I bought at $150 a couple weeks ago, and I know I shouldn’t even think about it)?

First of all you can do the switch to ETFs outside or inside, and you won’t incur any more costs either way. If you do it outside, you can transfer them into your RRSP later “in-kind” without having to sell them. As far as the tax consequences go, outside an RRSP you will have capital gains (losses) to pay taxes on if you sell anything, or when you transfer them into an RRSP. I think when I did it a long time ago, I sold them outside the RRSP and incurred a capital gain, and when they were sold they went into my linked bank account. I then moved that money into an RRSP cash account and then bought investments from there. I was selling and buying no-fee mutual funds outside and inside respectively so I didn’t incur any costs. I think the only tax consequence you should really worry about is to maximize your RRSP contributions every year and that’s about all you can control. Of course, since you are probably planning to keep VTI inside your RRSP, just transfer the VTI in-kind and you will incur a capital gain (loss) on any gains (losses) since you bought it.

Next, don’t switch all those things into ETFs if your commissions are going to be huge relative to the size of your portfolio. If you are going into 4-5 ETFs and the total commission is going to be about $100, I would say that if your portfolio is $10,000 or more, go ahead.

As for your timing try not to even worry about what the market is doing. Pick an asset allocation that you are comfortable with and then go with it. Switch all at once to a new allocation if you want.

With RRSP space that I do gain each year, which investments should be prioritized to be bought within an RRSP?

I guess if you don’t have the RRSP space for everything yet, it would make sense to put non-Canadian stuff into the RRSP first. The Canadian stuff doesn’t suffer from as much double-taxation as the non-Canadian stuff. I cannot remember what the difference in taxation is between dividends and capital gains (I don’t have any non-RRSP investments at the moment, just some debt :-)) but it’s probably not enough to worry about.

(Aside: when I say double-taxation, I mean that money outside an RRSP is taxed once (as income on your paycheque) and then again when it earns interest or realized capital gains, whereas inside an RRSP it is only ever taxed once (as income).)

It seems that my allocation for bonds/fixed income is too great, but that is only because I did not know exactly how to allocate it, in the end, I only want about 20% bonds.

How did you feel about the recent market downturn? Were you glad to have so much in bonds/cash? If so, keep your current allocation. If you didn’t care too much and think that you could have suffered more and not cared, go with less. Just don’t worry about timing. If you switched to more stocks now, the equities market could continue its fall over the coming year. If you keep your current allocation, the equities market could just as easily bounce back over the coming year as well and you might miss it. You cannot even hope to predict the future.

I recently thought about my emotions during the recent slide, and in retrospect I kind of wished I had a little bit more bonds/cash than the 20% I have (maybe 30%?). I am going to add 5% REITs to my portfolio eventually, so I will eventually have 25%.

I was doing a systematic investment plan where money was taken out and a number of the mutual funds were purchased on a biweekly basis. Now I have stopped the plan and will accumulate money until there is enough to purchase the right ETF (VTI, VEA, VWO, XIC).

I used to do what you did with mutual funds as well. Biweekly, and I would purchase several different funds. Now I also save up cash in my RRSP until I have enough to buy an ETF. I usually wait until. I have $2000. Since I pay commissions of about $20 that means the commission will be 1% of the purchase amount.

I know this is a long rambling post, but any guidance you might be able to share, even if not directly but through future postings, would be much appreciated.

Vanguard Europe Pacific ETF

The Canadian Capitalist mentioned today how he substituted EFA for VEA, a new ETF from Vanguard. The Vanguard Europe Pacific ETF (VEA) is almost identical to iShares’ EFA, which follows the MSCI EAFE index. This is so cool, and its MER is 0.20% less. Not a huge deal, but hey, why not go for VEA over EFA. Looks like Vanguard has the complete offering of ETFs now.

I’m currently in XIN, the Canadian-dollar traded version of EFA. I was thinking of switching to EFA the next time I plan on making a purchase of XIN/EFA (which will probably in 3-6 months time), so I’ll probably go with VEA instead. The bulk of my portfolio will be made up of VEA and VTI, along with XIC, VWO, XRB, and XSB. (Probably phasing in some XRE later too).

Ask Dave: Which Broker to Choose and Couch Potato Technique

A reader recently asked me:

I hope it’s not too much trouble to ask, but what broker or bank would you suggest that I use for my self-directed RRSP? I have Scotia bank for my mortgage, but TD looks like they have an interesting setup for the investor. Low fees and no fees are important to me of course, other vise it defeats the purpose. I plan on doing the “Couch Potato” approach so I should only be buying and readjusting once a year (no monthly purchases necessary).

Do you have any comments on the “Couch Potato” technique?

My answer:

I use E*Trade and their commissions are super cheap. I think TD will allow you to do “wash trades” where you sell a USD ETF and buy another one without having to convert to CAD. They will only do this over the phone, but I have heard that they will do it.

Re: Couch potato technique. I don’t know exactly what it is. It sounds like it involves putting your money into 2-3 index funds in some simple allocation like 33-33-33 or 50-50 and rebalancing only once per year. The most cost effective way to do that would be to save up cash throughout the year and then buy some investments (and sell if necessary) once per year to rebalance. Eventually your portfolio will become much larger than the cash you will put in annually so the “cash drag” is not that significant relative to the size of your portfolio. I agree that investing in low-cost passive investments like indexes are a great way to invest and also believe that everyone should stick to some initial asset allocation and rebalance when necessary. The couch-potato technique is not really much different from mine. I wait until I have over $2000 in cash in my RRSP rather than waiting until some anniversary date, so I end up buying more than once per year. I also try to rebalance my investments and I invest in index ETFs which are passive low-cost investments.