UK Portfolio Revamp - Part 1 - Diagnosis

Recently I have spent considerable time helping a UK friend restructure an investment portfolio and thought it might be of interest to talk about how I've gone about it. Maybe someone out there would have good ideas on what else can be done.

The spreadsheet image displays the portfolio as it was about a month and a half ago, the "before" shot. This was a portfolio that had evolved by happenstance - an advisor or someone from the bank would recommend an investment, money would be put in and then forgotten, the statements being merely filed away as they arrived in the mail. The person has had, and continues to have little interest in managing the investments ... a factor that will play into the re-design as a strict KISS principle. Anyhow, my observations of the portfolio were as follows:

Equity vs Fixed Income vs Cash - the 56% in equities overall is not unreasonable, well within the range of 25 to 75% equity allocation that I think, along with many financial luminaries, is reasonable, The person is very cautious and a lower equity allocation makes sense for now. Maybe down the road that could change but there are more pressing things to fix. The life insurance components, which I have called "savings", guarantee a certain return when they mature and function more or less like fixed income. The percentage in "cash" is too much above foreseeable needs and more than a six month cushion even. The person's employment benefits and salary provide a lot of protection for unforeseeables and things like health emergencies. In the larger scheme, later the person will also benefit from an inflation-indexed pension, providing a constant guaranteed cash flow through all of eventual retirement. That means equity volatility can be endured without actual reduction in lifestyle.

Taxes - Taxes are a considerable problem area. Way too much is being paid. The bank cash deposits are generating something like 2.5-3.0% interest before tax and the 20% tax means the net return is below inflation, meaning there is a net on-going loss in purchasing power. There has been no investment in tax-exempt accounts like ISAs (similar to Canadian RRSPs, except that the withdrawals are never taxed and the annual limits are lost if not used each year). The same un-necessary tax burden applies on almost all the equity investments - nothing has been put into equity ISAs except the PEP accounts, a precursor to ISAs that haven't been available for years.

Fees - The equity investments are all in the UK version of mutual funds, called OEICs, and the annual management fess of 1.5% are a drain on the returns. UK fund managers are no less immune to the oft-observed under-performance of the majority of actively managed funds than those in Canada or the USA. It is amusing to note that the retailer Marks and Spencer offers funds, which would be like The Bay doing so in Canada! Hey, why not Mcdonalds too!

Diversification - Despite their very different sounding names, all these funds hold UK equities and if one looks at their holdings, the same large company names appear over and over - HSBC, Royal Dutch Shell, Royal Bank of Scotland etc. Only the proportions seem to differ from fund to fund. In other words, there isn't any real diversification, they might as well be one holding. There is nothing international, there are no small company holdings, there is no real estate.

So the table is set for the next phase. asset allocation within the broad groupings. Stay tuned.

The Investment Angle of Children

A comment by Steve on my previous post Key Decisions that Affect Future Wealth to the effect that I had missed the major one of children set me thinking and investigating. Now, I have not worked out the Net Present Value of a child but here are some thoughts for everyone's fun.

There is no doubt that it costs a lot in dollars - about $167,000 in 2004 - to raise a child as this seemingly serious attempt to quantify presents. One could quibble about whether a child has truly been raised at 18 years old ;-) - e.g. what about post-secondary education, which I know from experience costs the proverbial arm and leg. Macleans magazine gives a rough estimate of $18,800 per year. The biggest cost of all is the time, worry and effort that the average parent devotes to raising children. Connected to that is the opportunity cost of not doing other things - maybe so many people wouldn't get sucked into poor mutual fund investing (though a poor investment is better than no investment at all) if they had the time and energy to devote to minimal financial management.

The revenue / income side is a bit thinner and less tangible. It used to be the case that children, until they left home, would bring their pay to their parents, but that stopped before my time in Canada (apparently it stopped only more recently in Scotland as my wife for a short while handed her pay packet to her mom after she started her full time job!).

Perhaps one could consider children as a kind of insurance policy for old age. The kids come and help physically when we get too infirm or sick, avoiding having to pay someone to do jobs like household tasks, or even financial management.

But more than that by far is the real investment return of children - the satisfaction and pleasure of seeing them grow and succeed is worth huge sums and far exceeds all the costs! I think of it this way - when I invest in stocks and bonds, the payoff is down the road when I get to consume the profits later, like going on holidays (Rome was great in February), drinking nice wines (looking forward to my first taste of Cloudy Bay sauvignon blanc) and so on. It's the same with children, they are a pleasure in themselves. There's a kind of compounding interest phenomenon when the grandchildren come along to increase the fun.

(Oh, and referring back to the other post, marriage for me brings similar rewards!)

Update June 3 ...
Just finished reading and reviewing Peter Bernstein's Capital Ideas book and discovered therein a pertinent reference from no less an authority than Aristotle himself. The Greek word for earnings from interest is apparently "tokos", which literally means offspring. Bernstein cites Aristotle, ",,, interest, which means the birth of money from money, is applied to the breeding of money because the offspring resembles the parent." I'm glad to learn that I'm on the same page as Aristotle :-)

First Uranium's Convertible Debentures

A friend sent along some questions regarding the recent announcement by First Uranium Corp (TSX:FIU) of its debentures. Thought I would post my comments ....

The Press Release
"First Uranium" or "the Company") today announced the pricing of its private placement of 4.25% senior unsecured convertible debentures (the "Debentures") due June 30, 2012 and an increase in the aggregate principal amount of Debentures to be sold to CDN$150 million. The sale of the Debentures is expected to close on May 3, 2007. The Debentures will bear interest at a rate of 4.25% per annum payable semi-annually and will be convertible into common shares of the Company at CDN$16.42 per share representing a conversion premium of approximately 37.5% to the closing price of the shares on the Toronto Stock Exchange (the "TSX") on April 18, 2007."

My Friend's Questions
I am not familiar at all with Debentures and have no intention of buying any - I wouldn't know how to even if I wanted to - but wonder if I understand correctly that those who buy these debentures will be entitled to buy FIU stocks at $16.42 per share on June 30, 2012 and thus make an investment with a guaranteed return of 4.25% per annum plus the possibility of capital gain of the FIU share price in June 2012 less $16.42? Or are the debentures convertible any time? Or have I misunderstood completely?

My Comments
First, I'm glad that my friend doesn't intend to buy any, even if he could. This is all highly risky and speculative. A quick look at the company's website shows that it is a brand new company founded in 2006 whose shares first began to trade in the last six months. FIU is a company that is developing gold and uranium mines in South Africa. It has no production yet and won't till 2008, if it succeeds in its plans. The stock chart shows how volatile the stock has been in its short history; though it has been all upwards, that could change in a flash if bad news comes out of the company.

Now for the debentures themselves. Debentures are a form of debt issued by the company, with no collateral protection against assets of the company in case there would be bankruptcy or insolvency. We ordinary mortals can buy them and other forms of bonds in the fixed income area of our online brokerage accounts. Given that FIU is a new venture, if it spends all the money it has raised from the start-up equity sale in December and from the debentures on development of the mines but is unsuccessful, how likely is it that there will be any left to reimburse the holders of the debentures their capital, let alone pay the promised interest?

FIU is so new that Dominion Bond Rating Service and Standard and Poors, which rate the riskiness of company debt, do not even have FIU listed. Given the start-up nature of FIU, the riskiness of its debentures would likely be off the end of the scale. Yet, the 4.25% rate
of interest offered is comparable to that of high-grade companies, i.e. it is less than generous.

The date June 30, 2012 is when the debenture face value of $1000 of each debenture bond will be repaid to the debenture holders, if they have not converted into common stock of FIU in the meantime.

Convertible means that at the request/option of the debenture holder, FIU will take back the debt and issue new common stock in its place. The $1000 face value of each bond will be divided by the $16.42 conversion price to determine how many shares will be issued (1000/16.42 = 60.9013) The press release doesn't specify but we assume that the simplest conversion privilege is in effect - that the debenture holders can convert their debt into common stock of FIU anytime they please between now and June 30, 2012. With the stock price of FIU currently trading around $12 per share, a debenture holder will not want to convert. The market price of the stock will have to go above $16.42 to make it worthwhile. In effect a convertible debenture is a combination of a debt/bond and a call option on the stock. The more the market stock price is below the conversion price, the more the value of the debenture is based on its bond value, which is the discounted cash flow of the interest payments and the $1000 face value returned at maturity. When the stock price approaches or exceeds the conversion price of $16.42, the price of the debenture will move with the market stock price.

The final point is that this is immaterial to my friend, to me and to other members of the investment public since it was a private placement, meaning that the debentures were sold on FIU's behalf by RBC and other members of the sellers group, called the underwriters, directly to institutional investors like pension funds (though I doubt they would be buying such speculative securities). Some of the debt may be re-sold by these initial buyers and show up in the secondary market and be available through our brokers at which point we could buy them. Not by me, though!!

Book Review: Money Logic by Moshe Milevsky

York University finance professor Moshe Milevsky (with co-author Michael Posner) takes us through a series of investment issues in this very worthwhile book, valuable both for its impeccable logic debunking certain common misconceptions and for its informal, readable, common sense approach to providing the explanations. The focus is on principles not on assessment of specific products from individual companies. That is not to say the analysis he presents to the reader is general and not actionable. On the contrary, Milevsky gives us the tools to make our own decision about the topics he covers.

The list of topics includes:

• assessing mutual fund performance
• dollar cost averaging as an investment approach
• the value of segregated mutual funds
• the whys of international diversification
• index-linked GICs
• how to do-it-yourself to get the same benefit as offered by index-linked GICs
• the mortgage paydown vs RRSP invest decision
• asset allocation in retirement - how much equity vs fixed income and why
• after the RRSP years - RRIFs vs annuities
• general discussion of risk or uncertainty in making future decisions and how to factor it in

For each of these topics, Milevsky first explains the nature of the product or issue, with analogies and simple examples, then he brings to bear the logic and the results of research (sparing us the details of the math or the computer models used) to draw out the conclusions or principles. His constant reference to probabilities makes us understand how many of the decisions depend on certain circumstances. For instance, in the annuities vs RRIF chapter, he uses life expectancy statistics to show how the benefit rises progressively (and differently for men and for women due to the longer life expectancy of women) the later the purchase of the annuity is made. His conclusion does not waffle however: "... it therefore makes very little sense in my judgment to convert an RRSP to a life annuity at age 69. The odds say that it makes more sense to wait." Hint: it's age 75 for men and 80 for women. There is also a handy short summary at the end of each chapter.

Though not revised since its publication in 1999, there is little feeling of it being dated. In some cases, like the admonition to us to diversify internationally, it has become more relevant, since the federal government has since removed the RRSP foreign content limit, advocated by Milevsky in the book.

Many people could benefit from reading this book and understanding and accepting some basic conclusions that still rage on as debates in the blogosphere. For instance, dollar cost averaging as an investment approach is stupid because it lowers investment returns, though regular automatic savings that are invested make a lot of sense because most people don't save. In other words, if you have a lump sum available from a lottery win, don't wait to invest it for reasons of dollar cost averaging. If you want to see why, buy Milevsky's book or borrow it from the library. Another topic of this sort is the RRSP vs mortgage payment debate (see here at MillionDollarJourney for example). Hint: There is only one factor to consider - anyone want to guess what it is? ;-)

In short, get the book and read it, it's only 200 big print pages and won't put you to sleep. Five out of five stars.

Buy this book at
chapters.indigo.ca

Investing in Canadian vs International Equities

Just came across a fascinating article on the CTV website titled "The identity crisis that will change the TSX" that was published in Saturday's Globe and Mail. Midway through it is a key phrase - "the Toronto Stock Exchange is becoming a market of smaller companies clustered in a narrow range of industries". The narrow range works out to financial, energy and mining.

The article is another good reminder about the need for Canadian investors, me included, to reduce equity holdings in the TSX to a minor portion - 10% or less - of the equity portfolio.

One of the benefits of moving to Scotland is that the distance adds perspective. It is easier to see how foreigners view Canada and to see Canada in its true place in the world. With respect to investment, Canada is a minor player, valuable primarily as an additional diversification element through resources.

The article also mentions the small cap nature of most of the TSX, so it can also play a small cap role in a portfolio (as we all know, small caps over long holding periods like twenty years, have been shown to give higher returns and to have weak correlation with the overall market, which in turn offers diversification benefit). Martin Gale over at Efficient Market Canada has an excellent article showing how the actual world equity market proportions work out - Canada is just over 3% of the total - and he uses this to show how a truly global portfolio would be structured, even to the names of the funds to buy. The reassurance of investing in what one knows about - domestic companies - is a great hazard as a result of the extra risk through inadequate diversification. (It's the same here in the UK. I'm in the midst of helping a friend do a portfolio makeover and that portfolio was 100% in UK equities yikes! ... through a raft of different mutual funds yikes! ... more on that in a future post).

Since I was due to do my semi-annual portfolio re-balancing in May, I will be doing some fairly drastic re-allocations along these lines, about which I will be posting down the road.

In my poking around thegoodwebguide.co.uk review of UK online brokerages, I came across TD Waterhouse, the UK version. It offers what seems to be a wonderful account for those interested in international investing and diversification. Through one account, it is possible to trade directly on 15 different exchanges around the world, including Canada, the USA, the UK, various other European exchanges, Australia, Hong Kong and Singapore. In addition, the holdings can be in four different currencies - Canadian and US dollars, sterling and euros. The trade costs are not the lowest at £12.50 for online trades (around CDN$ 30) but that's a lot better than the $100-200 BMO Investorline had told me a few years ago that it would cost to buy UK securities. Unfortunately the account is only available to UK residents and it doesn't look like TD Waterhouse Canada offers a similar one but it sure looks to me like it would be a smart thing to offer.

Review: #4 QuickTaxWeb Web Tax Software

Here is my review of the QuickTaxWeb package that I ranked fourth amongst the Canadian web-based tax preparation packages with a score of 7.5 out of 10.

Have a look at the inserted screen image for QuickTaxWeb.

What I Liked About QuickTaxWeb

• the screen is very clean and attractive; it's easy to navigate, the tab and other links are clear and the whole screen is uncluttered
• the program is very polished and complete, with details such as separate forms for the T2202A Tuition and Education Amounts - no spelling mistakes on this package
• complete and well presented context-sensitive help throughout
  

What I Disliked

• SLOW!! the screens seem to refresh at a crawl; this is a major annoyance and a real customer experience quality issue in my view
• no on-site convenient password recovery mechanism; I forgot my password after over a month of non-use; the only way I managed to sign in again was to phone the customer support line, which did give me the info right away but why can Intuit not create a serve yourself procedure?
• pricing is outrageous at $24.99 and no free returns at all. Actually, there was a free return policy till early April for income under $20k but that has been suspended ... could that have anything to do with trying to alleviate the horrible response time?
  

Review: #3 WebTax4U Web Tax Software

Here is a review of the third-ranked WebTax4U web-base tax preparation software package for Canadian taxes. I gave it a score of 8.0 out of 10.

I've included a screenshot of this program too.

What I Liked About WebTax4U

• it has a clean, uncluttered, well-organized interface with tabs and links that take one directly to all forms and parts of the program; the colours are pleasing and easy on the eyes
• data entry boxes are grouped within the top screen area; I found this program required the least amount of scrolling down
• Help is reasonable though not nearly as extensive as UFile's; links go to CRA pages
• it clearly explained that the $25 student residence Ontario tax credit was only applicable if the school is in Ontario, not the student's home
• price is reasonable at $11.99 for one return and $5.99 for extras; free filing for returns with under $25k of income
  

What I Disliked

• upon entering one T3 slip, it did not offer the opportunity to add another; it was necessary to return to the main menu
• for the tuition amount to transfer, it does not calculate on the spot/screen the maximum amount that can be transferred; instead it says this will be calculated automatically and shows only on the final pdf
  
• some superficial quality control problems like spelling mistakes e.g. on T3 screen "Instituttion" or on ON479 "Residense"
• speed of screen refresh is slow enough that it is starting to be noticeable
  

Review: #2 CuteTax Web Tax Software

Here is my review of the CuteTax package that came out number two in my testing of web-based Canadian tax preparation packages with a score of 8.5.

I've included a screen capture of the program to give an idea of its look.


What I Liked About CuteTax

• it has a clean, simple look which makes it easy to find one's way around a page; data entry boxes are a different colour so it's easy to know where data can be entered
• the left-hand menu shows all parts of the return so it is possible to easily and quickly go back and forth between different forms and sections, which I always find myself needing to do
• the Direct Message link on the top right allows one to send a message to the support team; I tried it because I found something the program did different from several other packages I tried and I thought it was an error. To my delight and surprise, the folks at CuteTax, a) responded within a day (3 hours to be precise), a major customer service plus in itself; b) provided a detailed answer with a reference to a CRA publication supporting its position. If one keeps in mind that right now is the extreme busy point of the year, I'm doubly impressed by this experience. (Can anyone with a tax accounting background confirm that if you do not need the foreign non-business income tax credit on Schedule 1 line 431 to reduce your taxes because, for example, your personal exemption is sufficient to eliminate any tax liability, that same T3 box 34 amount can be entered on line 232 to reduce Net Income?)
• the program responds very quickly and there is little noticeable delay refreshing screens
• Help is reasonable with links to CRA website documents
• free filing for income under $25k
• modest pricing at $8.98 for one return
  

What I Disliked

• one cannot use accented characters, e.g. in a French name
• typing in lowercase in the identification section produced lowercase in the final pdf but on the screen this info looked ok as it was displayed all uppercase - I prefer WYSIWYG
  
• pages spill off the bottom of the screen a little more than I would have hoped, requiring extra time to keep scrolling down when that happens
  
• Help not as extensive and embedded everywhere as UFile
  

Review: #1 UFile.ca Web Tax Software

To follow up yesterday's summary rating of various web-based tax preparation software packages for Canadian taxes, here is what I liked and disliked about the best of the lot - UFile.ca, which scored 9.5 out of 10.

I've included a screen capture of the program.


What I Liked:

• before creating an account, it does an automated check of browser compatibility for such things as SSL 128-bit encryption, Javascript, cookies, pop-ups and acrobat to ensure problem-free operation
• the left-side menu shows everything that has been entered so far and provides easy navigational access back and forth
• the font choices, sizes, colours, use of white space, box reference numbers are clear and easy to read
• the ubiqitous ? mini-button beside virtually every conceivable spot where one might have a question is better by far than what any other package has and the help it leads to is complete; often there are direct links to the CRA website so one can read the original source for oneself.
• the program is so well organized I did not need to refer to the Tutorial at all, though it's there for re-assurance
• the explanations and guidance are well written - no awkward phrases, no grammar and spelling mistakes as seen in some of the other programs
• the program response is extremely fast, almost as good as working on a home PC with an installed package; those 10-15 second waits for the server to refresh the screen can add up and make the tax entry exercise slow and frustrating; to me, this is a major element, fast response is table stakes
• there's even a free-form notes and reminders-to-self section - good for doing the return over a number of days to mark where one got to or to note missing receipts for later follow up; little touches like this are a sign of a mature program where all the basics work fine and they have time for extras
  
• if your line 150 Total Income is under $25k, it's free; same goes for students as the Canadian Federation of Students has a deal with UFile.

What I Disliked (not much!)

• pricing is a bit strange with $15.95 for an individual return or $24.95 for a whole family; I have university students dependants who have income and this means I will have to pay the $24.95 (instead of $14.95 for my return alone), though individually each student would be under the $25k free limit and so would be free.
• it's the second priciest after QuickTaxWeb
• maybe they could add a "this is your Payable/Refund" monitor to amuse us as we go along entering data?
  

Review: Web Tax Software Packages - Update 2008

I've just spent some time updating my look at the various Canadian tax preparation packages available through the Web, focussing on those packages which have attained NetFile electronic filing certification from the Canada Revenue Agency. This year, a major new player has appeared - H&R Block.

The advantage of these Web-based programs is that the return is available through any computer connected to the web. Presumably the data is better protected than it would be on the average home computer - i.e. it is backed up and sits behind some sort of firewall in a secure data center. However, none of the companies explain exactly how well they do this job, whether they meet ISO specs or have been IT-security audited. At the end of the preparation process, all the companies allow the download to one's own computer of a pdf containing the paper form image as well as the .tax file to upload to the CRA.

A convenient list of these and the regular on-PC packages is on Wikipedia under Canadian Tax Preparation Software for Personal Use. For all the packages I tested using real data though the intent was not to test tax situations but ease of use, understandability, help features, navigation and speed to figure out value for money - Wikipedia gives all the prices.

Here are my ratings out of 10 on the packages:

1. uFile.ca - 9.0 Slick, polished, fast, the winner but by less than last year; good value, free for students or under $20k family income
   
2. CuteTax - 8.5 Clean and clear interface, fast, solid product; free for under $25k income
   
3. AceTax - 8.0 Works fine; good value for money, tied with WebTax4U - 8.0 Some quality control issues and slightly clunky but works fine and with H&R Block - 8.0 Slick and quick but pricey and the user agreement allows them to market their other products and services to you.
4. QuickTaxWeb - 7.5 Polished but very slow response, overpriced and doesn't support Firefox version 1.5 (used on Ubuntu Linux)
   
5. EachTax - 7.0 Looks like paper forms, sacrifices some ease of use
6. MBOTax - 7.0 Serviceable but not very user friendly
   
7. eTaxCanada - 5.0 Program didn't seem to work properly in 2007 - barely better in 2008; still awkward, frustrating and slow
   
8. FileTaxOnline - 5.0 Good for a laugh: home page has button for "Techincal Support" Why bother with it for $9.89 if there are better cheaper alternatives?
   

Tomorrow I'll post some observations on AceTax and then on H&R Block that led me to the above ratings.

I Hate It When the Government Owes Me an Income Tax Refund

Am nearing completion of preparing my 2006 tax return and have discovered to my horror that the government owes me money! That's the intellectual reaction at least, based on the logic that when the government owes me a refund, it means I have, in effect, made an interest-free loan to the government for most of 2006 (since the government does not pay any interest on refunds to a taxpayer). It's strange that despite knowing this and thinking it for years, there's a residual emotional reaction of pleasure that I am getting money back. The reaction reminds of buying fries from a chip stand - when the vendor puts in too little initially and then adds some, it's more satisfying then when the vendor puts in too much then removes the excess even though you may end up with less in total in the former case.

The way to prevent the government owing a refund is to request that less tax be withheld at source from your pay cheque by one's employer using the TD1 form that is distributed and filled-in annually at work. It is even possible to contact the CRA district office to request that the employer be permitted to reduce tax withheld for items like RRSP contributions that one is planning, which are not normally on the TD1 form.

TIP: Reductions on Commissions for Sales of Leftover Stocks

Here's a tip that that a friend brought up recently which may benefit some out there. Ever been in the situation of having sold all your shares in a company only to discover some days later that a few shares have been credited to your account as a result of a Dividend Reinvestment purchase (DRIP) that you had forgotten about? Those shares may hardly be worth the sales commission. What to do? Phone up your broker, explain the situation and ask if they can give you a break on the sales commission. Sometimes they might give you a part or a complete reduction on the sale of such small odd lots that got there inadvertently.

Book Review: The Art of Asset Allocation

Here's the one word review: yucchh!

This book is to asset allocation and finance as metaphysics is to philosophy. Much complicated ado that ultimately is of little use.

I was really looking forward to reading this book by David Darst, which I had bought at the same time as Richard Ferri's All About Asset Allocation. The contrast between the two could not be greater. Ferri is excellent, as I have written in another review. Darst displays the worst of financial writing - dense, boring sentences, superfluous numbers and tables, chart junk illustrations, endless checklists, non-actionable general recommendations and worst of all, radical departures from financial theory that will get an investor into trouble - I refer to tactical asset allocation, which is nothing more than market timing in disguise. A little less "art" and a little more "science" in asset allocation is what we need.

Consider that the book has no footnotes, no references or reading lists - as if Darst's exposition is self-sufficient. Even Newton found it beneficial to stand on the shoulders of others. On the other hand, Darst does take time to say, "Of particular value have been the advice and counsel provided by: ...", followed by four and half pages of names, which I guesstimate is over 600 people. Really?! 600 people?

The hilarious epitome of useless complication is the chart on page xiii, a series of circles within circles with overlapping wheels, which shows an alternative sequence of reading the chapters. I would suggest an author's task is to simplify for the reader and present the material in one logical sequence of chapters, not complicate matters as he has.

I almost get the impression Darst wrote this book to show how smart and knowledgeable he is, a career move to impress his boss and others in the industry. But it doesn't help Mr. Average Investor. The net effect of trying to read this book for an average investor would be to feel that asset allocation is such an esoteric and arcane subject that only someone like Darst or Morgan Stanley (Darst's employer) could possibly do it.

Is Currency Hedging on Foreign Equity Too Expensive?

Someone named George$ wrote a very pertinent post on the Financial Webring asking what people think of the Globe and Mail article by Allan Robinson in which several major fund managers like Franklin Templeton and Fidelity Investments say they do not do currency hedging on their international equity funds to eliminate the effects of foreign exchange shifts because it is not worth it. I've replied to George$ on the site, where hopefully others will comment too, but here is my reply. This is an important question for anyone who wants to use international investments, whether equities or fixed income, to diversify and reduce risk.

I'd sure like to see those studies done by Templeton because there can be very long term trends between currencies, for example the Canadian vs the US dollar. In the ten years from January 1997 to April 2007, the CDN$ went from 0.73 to 0.87 a 20% increase and from 0.62 to 0.88 in the five years between November 2001 and November 2006, a 42% increase. That would be enough to wipe out a substantial chunk of the US market gains for a Canadian investor. How long does the investor have to wait for currency fluctuations to even out and what is to be done in the meantime if the investor needs to cash in? Is Templeton referring to the situation of a large number of currencies with a very broad portfolio such as the MSCI EAFE index? But then, iShares Canada sells the XIN fund that mirrors the MSCI EAFE index and is 100% hedged to CDN$. Its MER is 0.15% - quite reasonable. The similarly hedged XSP mirroring the S&P 500 also has a 0.15% MER. In the end I ask myself, why do I want to bet on the currency as well as the foreign stock/index if I can avoid doing so at a reasonable cost.

One possibility I cannot admit to having modeled or seen done by someone else is the effect of re-balancing under an asset allocation policy. That would have one pushing more funds into markets when the exchange rate changes, a kind of dollar cost averaging. Not sure if that would reduce or completely eliminate the currency effect over time. Anyone have a view?

I've previously posted other comments on this question on my blog.

I wish Allan Robinson had gone to see the iShares folks but it was good to read anyway.

Book Review: All About Asset Allocation by Richard Ferri

Author Richard Ferri delivers what the subtitle of this compact (300 pages fairly large typeface) book promises: "the easy way to get started". It's a fine introduction that explains what asset allocation is and why it is so important to investment success for the average individual investor. It then shows in straightforward, practical terms exactly what to do, right down to listing the funds that one can choose to form a portfolio according to the asset allocation principles. The words I use to describe this book - "simple, practical and introductory" do not mean this is a dumbed down version or lacking in the theoretical grounding of modern finance.

Asset allocation is a very sure method for an average investor to ensure unspectacular but steady investment results with risk that is well managed through effective diversification. And it requires a minimum of time to maintain once the initial set up is done. As Ferri says: "Asset allocation eliminates the need to predict the future direction of the markets and eliminates the risk of being in the wrong market at the wrong time." (think technology stocks in 2001/2002) The fundamental concept of asset allocation is that different sorts of investment assets do not go up or down in sync. That property, and that property alone, allows one to combine those unconnected types of investments into a portfolio that both raises investment returns and reduces risk. That is true diversification, as opposed to the common misconception that merely having many stocks accomplishes diversification. The holdings required for real diversification and asset allocation, as it turns out according to Ferri, should include European stocks, Far East and Asian stocks, Canadian stocks (for natural resources), Emerging market stocks, US small company stocks, US total stock market, US value stocks, real estate and fixed income. Within the fixed income part of the portfolio, he recommends diversification as well, noting that this is often overlooked by financial advisers. Accordingly, he advises holding a combination of a total US bond market fund, US Treasury inflation-protected, US high-yield corporate bonds, Emerging market bonds and US municipal bonds. All of these stock and bond holdings he says are best obtained through low-cost index funds or ETFs, because of their market representativeness of the asset class, their savings on fees and their ease of re-balancing. What is reassuring is that in each case, he establishes through a review of the correlation of returns that there is indeed worthwhile non-correlation with other classes which creates a diversification benefit.

The book is structured into thirds. The first part lays the foundations and the principles that serve throughout - how risk works, how asset classes are determined, how diversification results from non- or negative-correlation, the importance of re-balancing. The second part examines each asset class mentioned above in turn, analyzes the correlation characteristics of each, including the possibility of alternative investments such as fine art, wine, collectibles. I very much like the fact that he addresses home ownership and finds it to be a worthwhile investment though he concludes that it cannot practically be part of an asset allocation investment strategy since one cannot re-balance when necessary by selling a part of one's house. The final third is devoted to discussing historical rates of return and variability/risk, building a portfolio adapted to one's real risk tolerance (as opposed to the over-estimate of risk tolerance most people apparently display when encountering a market downturn), dealing effectively with taxes, investment fees and financial advisers.

This is quite a complete book ... for US investors, for that is his audience. Canadian and UK or other non-US investors have to take the principles in hand and assume that the same kind of asset class relationships exist elsewhere. If I were to adopt his actual recommendations and invest mostly in US holdings, I would be incurring significant exchange rate risk of the Canadian dollar versus the US dollar. Mr Ferri only briefly notes the existence of such risk but does not recommend doing anything about it. Will re-balancing fix that problem? It would be better to see an explicit discussion and recommendation within the book.

Another recommendation that Mr Ferri does justify in a bit more detail but it could still do with more in my opinion is that re-balancing of the portfolio be done annually, as opposed to more or less often, or according to thresholds of departure from the target allocation percentages.

The presentation of the book is excellent. There are lots of helpful tables and charts, there are chapter summaries and key points, there are references and extra readings and a glossary of terms. The writing is clear, grammatical and engaging. Most useful of all and a great time saver, is a list of potential funds (from among the thousands available), at the end of each chapter.

Overall, this book could do the job perfectly well for a US investor. For Canadians and others, we need a "foreign" version, Mr Ferri but I still recommend it to everyone.

You can find another review of this book at the Chartered Financial Analysts Institute.

Buy this book at
chapters.indigo.ca

For Once I Agree with Jack Layton of the NDP

I didn't think it would happen but if what Jonathan Chevreau says is true in his April 3 blogpost about comments made by Jack Layton leader of the federal NDP party then I have to say I agree wholeheartedly. The comments in question are that the Canada Revenue Agency should provide tax calculation software for download or as a web application for free to every citizen / taxpayer. After all, the CRA provides the paper forms for free. All we taxpayers are doing by using the commercial tax packages is data entry for the CRA and paying for the privilege!

The CRA is partly along that path that would be necessary to develop free software for taxpayers since it has developed comprehensive test suites for certifying the commercial packages. Since the CRA seems to be stuck on saying no to going the rest of the way, perhaps the next best alternative is for people to develop their own. There is one free package out there that is Netfile certified called StudioTax but it has a few situations it won't handle (see this CRA webpage for details). Is it time for a true public, permanently free version under open source licensing to be created? Any views out there? Are there software developers and accountants willing to work on creating such software?

Insider Trading and Securities Regulation in Canada

The posts by Larry MacDonald on a number of studies which found highly suspicious statistical evidence that insider trading is rampant in Canada are sickening (the insider trading, not the posts!) to say the least. A big thank you to Larry for bringing this up. A few years ago I sent a complaint to the Ontario Securities Commission about what seemed to me to be very suspicious price changes shortly before surprising and important news on a small company called CSI Wireless. I only ever got an acknowledgement back, months later, from the OSC that they would "look into it" and never saw or heard anything more. Maybe there was or there was not information leakage and insider trading but without confidence in the fairness of trading in that stock, it's one reason I eventually sold out and will not consider buying again.

The lack of control over insider trading is another confirmation that a properly funded national securities regulator is badly needed in Canada; I'm with Canadian Money Blogs Reviewer on this one.