Why It’s Nice to Own Bonds

I have been checking my portfolio quite a bit lately (although it is getting a bit boring and the performance of my holdings has been predictably bad). The only part of my portfolio that has showed an increase in market value vs. book value were my two bond ETFs (Short-Term Bond Index ETF (XSB) and Real Return Bond Index ETF (XRB)). Makes me glad that 25% of my portfolio is made up of bonds. It helps me get through the night, so to speak. Even better is that it helps preserve capital during these bear markets and provides some holdings that are not so correlated with stocks for increased risk-adjusted return.

Increased My XIC Position

After Canadian equities fell a lot on Monday (followed by some big losses the week before) I was curious to see how far out of balance my portfolio was. So I plugged my portfolio’s numbers into a spreadsheet I use to balance my portfolio (I would share that spreadsheet but it’s a bit hard to use). It turned out that Canadian equities were the furthest out of whack in percentage terms. The portion of Canadian equities in my portfolio was 20% less than what it started out as (and what I intend it to always be at). I checked out how much cash I had in my RRSP and it was about $1,700. I normally wait until I have $2,000 and just buy something as soon as I notice that my cash balance has exceeded that target. Anyways, I bought $1,700 worth of XIC when the TSX was down about 600 points and got lucky because the next day it was up again and now it’s up over 2.5%. It’s hard to say if this is market timing or not (when I was going to buy some XIC anyways as soon as I had over $2,000 in cash, which would be by February 1, 2008). The one thing I am disappointed about is the fact that I bought and ETF with less than $1,700 and paid a $19.99 commission. I had set a threshold for myself of $2,000 to help minimize transaction costs. In hindsight one could argue that the gains I made offset those costs, however, hindsight is 20/20, and on Monday no on could have predicted what was going to happen on Tuesday. How do I know this? Well everyone would be buying on Monday but they weren’t.

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.

Some Minor Rebalancing: Bought XRB

There was some cash piling up in one our RRSPs again so it was time to buy something with it. I entered in my current portfolio into a spreadsheet that I have been using for probably over five years now. Once I enter in the current values of every part of the portfolio it tells me how much of each investment I would need to buy (or sell) in order to make things balance out. This assumes I sell my investments and buy others (which I don’t, I just buy more of the investments I have with available cash). So the spreadsheets numbers don’t exactly mean much. Basically it gives me some idea of how far off my portfolio’s asset allocations are from my desired asset allocations. I was wrestling last night with the decision of which investment to buy. I had about $2400 in spare cash. My holding in iShares MCSI EAFE International Index ETF (XIN) where a bit lower than the desired. $1000 or more into it and it would be balanced (bare in my mind that I won’t be splitting up this $2400 at all; I just want one transaction here). So if I put $2400 into XIN it would be more than balanced. Which is fine. Some of the other investments that I had small holdings in, such as Vanguard’s Emerging Markets Index ETF (VWO) and iShares Real Return Bond Index ETF (XRB) had much larger deviations from their desired/original allocation relative to their original allocation. So maybe I should be buying some more of those? So I modified my spreadsheet by adding a column that showed the percent change between the desired/original and actual allocations. I decided that since XRB had declined the most recently, and it’s actual allocation was the most below the desired, in relative terms, that I should buy some of it. I only needed to put in about $500 more into XRB to rebalance it. Buying $2400 more of XRB would put the actual allocation well above the desired. Like driving a boat, I’ve overcompensated a bit but that’s ok.

The most important thing I am trying to do is to minimize cost by only incurring one buy transaction every time I have enough money to reduce my commission to 1% of the trade’s value. E*Trade trades are $20, so I make a purchase every time I have over $2000 in cash. I never plan on selling in the near term, and finally, I try to add to an existing holding whose actual allocation is less than the desired/original allocation.

Some Minor Rebalancing: Bought VTI

I had $2150 cash built up in my E*Trade account from monthly contributions. It was not hard to decide what to invest it in. I simply entered all the market values of my investments into a spreadsheet and looked at how far off the current asset allocations were from the original “desired” allocations. Looks like the US equity component (furnished by VTI) was way down (thanks to the strong CAD dollar). Other components like International equities (provided by XIN) and Canadian equities (provided by XIC) were way up. Bonds were almost flat. So it was pretty obvious, rebalancing necessitated a purchase of VTI. This also made sense since everything else was up and VTI (in CAD dollars) was down (relatively speaking). So I bought $2150 of Vanguard Total Stock Market Index ETF (VTI) a few days ago.

Long Break Almost Over

I might start blogging again soon. I got back from my vacation but since then I have been very busy with personal things, including getting a new computer to replace the one that was broken. Haven’t done any trading though. My portfolio is very boring. But in around the middle of June I will probably make a purchase as there will be $2500 in my RRSP by that time. Most likely I will buy some more US Index (VTI) as it is down and everything else is up.

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

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

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

My New Passive Index ETF Portfolio

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Canadian Tour of Personal Finance Blogs

Quicken 2007 XG

I bought Quicken 2007 XG the other day. I wanted it for the detailed investment performance reporting using IRR (internal rate of return). It seems to deliver on that for the most part although I have only loaded in some investment transactions. I actually loaded in my first transactions ever! I still had my transactions from 1996-1999 when I was purchasing the AIC Advantage Fund. I’ll talk more about that investment and what I found out from Quicken’s reports. I looked at the options in the investment performance report and it looks very flexible in terms of showing results for only certain accounts or investments, and for all dates (not just 1,3,5 years). The part that sucks about Quicken is that it’s still a Mickey Mouse program because it doesn’t to double-entry accounting. When I was entering “Bought” transactions there seemed to be an associated cash account that was going negative, but I couldn’t choose the account. Nor do I remember creating this account. I used the BoughtX transaction type instead, and then I could choose an account to fund the purchase. I have been using Gnucash up until now and was very satisfied with it but wanted better investment reporting. I love Gnucash’s double-entry accounting, and it is too bad that Quicken doesn’t have that capability. I thought about getting QuickBooks but it didn’t seem like QuickBooks had any investment support, although I could be wrong. The other annoyance is that Quicken has such a cluttered interface. Gnucash was so simple, just a list of accounts and a ledger. I’ll have to see if I can customize the interface in Quicken at all, but I doubt it. I have made a tentative decision to stop tracking individual transactions in my chequing accounts and just track investments instead. Not sure if I’ll go ahead with it, I’ll have to see how easy it is to import transactions from statements downloaded from online banking sites into Quicken. Only 1 of our 3 institutions allows us to connect right from Quicken. For the other 2 I have to go to the website myself, and click on “download statement.”

New Portfolio Preview

I haven’t blogged in a while and might not for some time as I’m really busy right now with work and personal things. I am waiting for one more transfer from Clearsight to E*Trade in my wife’s RRSP (yes, my wife is coming over to E*Trade as well) then I will provide an update on our portfolio allocations. Suffice to say that our combined portfolio is an all-ETF, all-index portfolio and is very low-cost. It is also very simple, with so far just 6 ETFs in total. It will remain that way for the foreseable future. I dumped all the old mutual funds after looking closely at their past performance vs. the indexes and not being overwhelmingly convinced that any of them were beating indexes.