Why Not All Equities? Why Hold Bonds at All in a Portfolio?

Fact: Over a suitably long period, like twenty years, equities have always outperformed bonds/fixed income investments. This is well documented in such books as the Equity Risk Premium by Bradford Cornell, which I will be reviewing soon (e.g. see this Google book extract from page 71). If you are a long term investor such as a person in your twenties starting to save for retirement, why not just forget about bonds, grit your teeth through market downturns and go for a 100% equity portfolio?

Here are some reasons:

1. Danger of selling out at the wrong time - if you went through the 40% decline in equities from 2001 to 2003 and did not sell, then you will be ok but believe me it ain't easy. Could you stick out a ten year period like the 1970s when equities went nowhere? As the famous economist John Maynard Keynes once said, "The market can stay irrational longer than you can stay solvent." (reference in the Wikipedia entry here; go look, there are so many other juicy quotes). This quote raises the other way of bailing out too early - you cannot absolutely know what your holding period will be, despite your initial intentions. Your personal circumstances may cause this to happen; suppose you decide you want to use the money to buy a house or to give it away to an important cause. Suppose you die and your family needs to use the money for living expenses. It would be better to avoid the most severe dips if you can without sacrificing returns, which is exactly what bonds can do in a portfolio with equities, as I explain below.
   
2. A portfolio with bonds and equities will have higher performance and lower volatility than an equity-only portfolio! Yes, Michael, you can have your cake and eat it to. This surprising counter-intuitive result I have previously written about last May in Portfolio Magic ... 3+1=5. The beneficial effect is not confined to bonds - international equities, real estate and commodities have also been shown to do the magic. That's why my portfolio, the structure of which is shown at the bottom of this blog, is built as it is. The effect comes about through the combination of assets with positive returns whose returns are not correlated (i.e. don't move in sync, the best situation being when they are negatively correlated so that one goes up when the other goes down). Two great books which explain and demonstrate this effect with real data are Roger Gibson's Asset Allocation (reviewed here; see Chapter 8 The Rewards of Multiple-Asset Class Investing) and Richard Ferri's All About Asset Allocation (reviewed here; see Ch4. Multi Asset Class Investing). Have a look at my portfolio: I find it interesting and reassuring that the only holding that has actually gone up is DJP the iPath DJ-AIP Commodity Index while all my equities are down. The bond holding AGG is down slightly on the chart because it doesn't include the cash interest payments I have received.

So, I'm suffering through this downturn with everyone else but I have confidence that I will be further ahead in the long run. As Keynes also said, "The long run is a misleading guide to current affairs." Fool that I am, I expect to be here for a long run yet.

Bloggers tell institutional investors to stay calm and stick with plan as market weakens

In light of the recent article on the CBC website, titled "Advisers tell investors to stay calm and stick with plan as market weakens", a reply from the blogosphere is called for.

The CBC says:
"After a nearly five-year run, investment advisers say it's time to stay calm, review your investment plan and look to defensive plays such as utilities, health care and consumer stocks to wait out the slowdown."

... Bloggers say it's time time to stay calm, stick with your investment plan, look for stock bargains among long-term high-quality companies and wait out the slowdown.
"Me? I’m sticking to my plan and giving this all some time to settle out." Canadian Dream: Free at 45
"During Monday’s panic, I actually went out and bought more banks." CanajunFinances
"Often the best thing to do is nothing, especially when our emotions are getting the better of us." Michael James on Money
"At times like these, amidst breathless front-page coverage of every gyration in the stock market, you can dust off your copy of The Intelligent Investor and find solace in the counsel of Benjamin Graham." and goes on to quote words saying to stay calm. Canadian Capitalist

Let us also note the results of a small informal poll conducted on this very website regarding the severe market slide of January 15-17. In answer to the question about what they did in response, 39% of readers said they bought stocks they considered a bargain, 71% said they did nothing and were going to wait things out, 0% said they sold to pay for Christmas expenses or for other expenses and 0% (yes, that's a big fat ZERO) said they sold equities! Yes, sir, the average person on the street sure was panic selling!

In contrast, the CBC article quotes mutual fund managers saying, "I think you have to continually look at your portfolio and make sure you're focused on quality and to the extent that you have more speculative or lower quality investments, you may have to have make a decision to exit some of those securities," Pym said." ... and ... "Watson said defensive stocks like utilities, health care and the consumer sector will be areas investors will want to look to." Ah yes, sector rotation, tactical asset allocation, market timing, those discredited and disproved strategies. Now we know who was doing all that panic selling in the last little while.

Off Topic: Ban Carts on Golf Courses

One of the privileges of blogging is being able to write about whatever the heck you want. So I'm going to digress a little, though one could say that this has something to do with retirement planning since the idea came to me while reading Sherry Cooper's recent book The New Retirement (which I will review soon). In it, she talks about leading a good lifestyle as being one of the secrets of successful retirement ... and that includes exercise.

Apart from allowing truly disabled people from playing the game (if my parents in their 80s can walk around the course, I'd submit that 99% of everyone else could too), the golf cart is more bad than good:

• Carts chew up and damage courses, especially as people chronically ignore the no-go areas.
• Carts waste the time gained from faster movement a) by the necessity to zigzag all over the course (when do you ever hit the ball straight down the fairway just like your cart partner or do you each find opposite sides?) and b) due to the longer search for each ball and more lost balls since you cannot follow the line of your shot all the way along from where you hit it - you must approach the ball from either the cart path or from your partner's ball and often it's impossible to know exactly how far you hit
• Carts mean you get almost no exercise, which doesn't help your health
• When you hit a bad shot, you can drive too fast in a cart; or you can have an accident, even when you are a professional race driver.
  
• The fact that you don't walk means that you don't get your body properly warmed up; from the third hole on when I'm walking I'm playing better
  

Over here in Scotland, carts are the exception rather than the norm. At first I thought this was strange but now I'm sold. I daresay Scottish retiree golfers are the fittest anywhere ... not the least because the season is pretty well year-round. It was 10 celsius on the weekend, the snowdrops are in bloom and there were folks on the courses, though some courses are still too wet.

The Impossible: Buying US Mutual Funds in Canada

A reader asks this question:
"I am currently setting up an RRSP for my daughter who plans on providing small monthly contributions. ETF's seem out of the question because of the monthly transaction costs associated. Vanguard index mutual fund for american and international exposure seemed like a good idea since their MER's are so much lower than comparable Cdn products. However my broker (TD ) tells me that they don't offer this. Are you aware of anyone in Canada that does? Any suggestions?"

Maybe your broker should have said instead that it is illegal for US funds to be sold in Canada. All funds must be licensed / registered with the provincial securities commission, e.g. the Ontario Securities Commission, and file a prospectus with it. So I believe Vanguard could theoretically be sold in Canada if it went through all the legal rigmarole of registration and licensing but it hasn't so far. I tried quickly without success to find a link to the actual regulation on the OSC website, though I came across this snippet from another document that confirms the situation:
"Policies that prevent US mutual fund companies from soliciting business in Canada, forbid advisors to recommend US funds to Canadian clients, and prevent the distribution of US mutual funds without filing a prospectus in Canada, all serve to protect the Canadian mutual fund industry. Severe tax consequences also deter Canadian investors from investing in US mutual funds." Source: letter to OSC, Re: An Alternative Trading System, Oct.13, 1999 (I believe the last sentence may refer to the fact that income received from US funds would lose their tax-advantaged character as dividends, or capital gains)

The other alternative of opening an account with a US broker used to be possible years ago but has been shut down by the US authorities - see this (justified) rant by ByloSehi. Sadly, you must forget those great Vanguard mutual funds.

You are aware of the Vanguard ETF option and its limitations for your situation. Perhaps you could accumulate the cash in the TD RRSP in a money market mutual fund to gain a little interest and get the RRSP deduction as well as the regular savings in operation. Once or twice a year you could buy the ETF to minimize the trading fees. I'd also check out brokers like Questrade that offer lower trading fees even for small accounts.

Another option would be to buy TD e-Series (Internet only) mutual funds for a few years. Their fees aren't great but at around 0.48% are not nearly as high as most Canadian mutual funds. After accumulating $20-25k, you could then switch to ETFs. Who knows, by then Vanguard may have expanded to Canada or the Canadian funds may have substantially lowered their fees (both of which are likely to occur at the same time ... call it the Walmart effect)?

I leave you with this statement from the same letter (see p.3) linked to above:
"The result of Canadians being denied access to the US mutual fund industry is the existence of a healthy and productive mutual fund industry in Canada that benefits the Canadian economy." ... but not the Canadian consumer / investor!

DRIPing ETFs in Canada

One of the unfortunate characteristics of ETFs is that one does not have the option of having the cash distributions automatically reinvested by the ETF provider (iShares Canada explains why in this FAQ), unlike the case with mutual funds. That means an investor must receive cash and decide how long to accumulate before making a trade to buy extra ETF shares. It is an extra cost and extra effort. As Canadian Capitalist recently pointed out, the reinvestment cost, when calculated as a percentage of the total portfolio, may not be very large. However, for passive index investors especially, who just want to let the funds accumulate in the ETF, it is an irritant. Instead of making small purchases oneself, there is another possibility - the broker may offer the free and automatic service of purchasing extra units of the ETF, what is often called a synthetic DRIP (because it is not a genuine, original DRIP as offered by Canadian companies and funds - see the Canadian Dividend Reinvestment Plans blog for much detailed info and listings).

It seems that there is no comprehensive source of info on ETF DRIPing capabilities on the Web, so I offer the results of my researches into the services of Canadian discount brokers. It isn't a complete or comprehensive list - maybe folks could add their knowledge and everyone could convince the DRIP guy to add this info to his blog and maintain it?

Much of the story is pretty sad, and the info hard to extract from brokers, with one outstanding exception and one ok alternative.

#1 - Questrade - leader by the length of a traffic jam on the 401, no one is even close
If you want to DRIP a variety of ETFs, this is your broker. There is no list of ETFs they will DRIP because they will do them all, including all US ETFs. Oh, sorry there are a very few exclusions. Here is a quote from an email Lynn Suderman, Communications manager at Questrade:
"Questrade offers a free DRiP service to its clients. All details are on our site here: http://www.questrade.com/trading/stocks_dividend_plan.aspx. We don’t have a list of ETFs available for DRiPs because almost all Canadian and U.S. ETFs qualify.(note that foreign ETFs – non-U.S., non-Canadian – are not eligible). Here is our rule of thumb for exclusion:

· ETFs that hold stocks and bonds;

· ETF listed as an ADR

· It’s a short ETF.

At the moment, 16 ETFs are excluded due to the above criteria:

ABERDEEN ASIA-PACIFIC

ACS MEDIA INCOME FUNDS

ANGLO AMER PLC ADR

ATLANTIC POWER

ASSOCIATED BRANDS

CUSTOM DIRECT INCM

FMF CAP GRP LTD

FORT CHICAGO ENGY

HARDWOODS DIST INC

KEYSTONE NORTH AMER

MEDICAL FACILITIES

PRIMARY ENGY RECYCLNG-EIG

STUDENT TRANS OF AMER

TELESYSTEM INLT WIRLS-NEW

UNITS-TIMBERWEST FOREST

UNITS-TAIGA BLDGS PRODS

Add this to the recent announcement that Questrade now offers the ability to hold USD cash within a registered account, unique among Canadian brokers, the company begins to look pretty darn good. Now maybe it's because I am big shot blogger (har, har) but I liked the complete within-the-day responses to my email enquiry to Lynn. It's still not perfect though, because they will only buy whole shares with the distribution, so the remainder of the cash will still accumulate in your account. The higher the price of the ETF, the more cash will be left over; in a worst case, there may not even be enough to buy one share - e.g. AGG, a US bond index fund, has a market price of about US$100 per share; it pays out monthly distributions, which means you must have a holding of about $27,000 to buy one share each month.

#2 Canadian ShareOwner Investments Inc - a fair second place
This smaller broker has a fair selection of ETFs that it will DRIP, including all the Canadian iShares ETFs. The list is actually published here - quite an non-obvious place for it to be in the website but a rep guided me quickly and without hesitation to the right place when I phoned. It enables the reinvestment of every penny of distributions by buying fractional shares, something even Questrade doesn't do. Nevertheless, the list is constrained to more popular ETFs and only a few US ETFs (including the AGG example I used above) and none of those from Vanguard, for example. If they have the ETFs you want, this is your best DRIP broker.

#3-5 blank, as none of the other brokers I looked at deserve to be anywhere near the top for the pathetic coverage, the terrible lack of information on websites, the ignorance of front-line telephone customer service staff in knowing what an ETF is, let alone a DRIP, the slow and time-consuming method of looking it up (most seemed to need to look up from some sort of internal computerized list where it took minutes for each named ETF, some wanted CUSIP numbers not just the trading symbol and one even said I would have to buy the ETF first before they could tell whether it could be DRIPed). Below is a partial list I got of which can be done and which not.

#6 - TD Waterhouse - no on-line list, Yes = XIU, XIC, XSB, XBB, XTR, VTI; No = CPD, XSP, VEU

#7 - RBC Direct Investing - no list, Yes = XIU, XSP, XIN; No = CPD, VEU, VTI, EFA

#8 - E*Trade Canada - no list, Yes = XIU, XIC, XSP; email response a day after telephone contact included no further info as to which ETFs in general could be DRIPed

No Ranking (how can they deserve a ranking if they don't do any ETF DRIPing?)
BMOInvestorline - list at http://www.bmoinvestorline.com/FAQs/FAQ_DRIP.html# but it includes no ETFs; called them to check since the list is dated March 2007 but they said they don't do any US ETFs

CIBC Investor's Edge - no list; still waiting for an email answer four days later since rep could not find answer while I was waiting; a post of Jan.29, 2007 (is this still accurate?) on this Canadian Business.com forum by bindexit says CIBC will DRIP Canadian iShares but no US ETFs.

For others like ScotiaMcLeod, National Bank, QTrade etc listed on Rob Carrick's Globe review and ranking of discount brokers, I have no information.

Those interested can also read the informed discussion on this Financial Webring Forum thread "DRIP through RBC".

Update Jan.27 - I posted a note on the Financial Webring about the lack of info about ETF DRIPing and a certain Operabob has created a thread on the DRIP Investing Resource Center to collect any info people might have on what various brokers will do. So I invite you to contribute to that discussion with your info.

Investing an Inheritance: How to do a "File and Forget for Forty Years"

Most of us save for retirement in tax-deferred accounts like RRSPs and LIRAs. But what happens when you suddenly receive a large lump sum and you do not have RRSP contribution room, in other words you must invest in a taxable account?

Here's a situation I've come across recently that got me thinking and researching. (Initially, I thought it was simple but it has taken me some time to figure it out to get the practical details right.)

Situation:

• $50,000 inheritance, specified in the will to be "for retirement"; a very wise thing the person who died has done, creating a very strong moral, if not legal impediment to spending the money since half the battle of saving is actually doing it; I would note in passing that the person receiving the inheritance does not have to include the amount in income and pay tax since that would already have been done in the process of settling the estate; I would also note that it is not a testamentary trust, which could absolutely ensure that the money not be touched till retirement.
  
• 40 years till retirement; the person is in his twenties so the planning horizon is at least that long; due to the above-noted restriction on the lump sum, it is highly likely that the actual time horizon will correspond to the planned horizon - in other words, people frequently suddenly decide that their "retirement nest egg" needs to be cracked open for an omelette craving today, thus blowing the value of a long term approach to smittereens.
  
• No RRSP room: the inheritance must go into a taxable account, which means that income taxes for various types of investment returns (interest, dividends and capital gains) can play a crucial role in net returns, especially over the long term; though the person could or should intend to move the investments progressively into an RRSP as his career advanced and contribution room became available, in this case, his apparent career orientation into government or educational jobs suggests that one of those golden defined benefit plans will use up most or all of tax-deferred pension room, so it is better to plan as if it will not happen
• Maximize net after-tax wealth: obviously ... but he is not interested in high-risk investments that may suffer absolute final losses, as opposed to waiting through market ups and downs, and subject to the following constraint,
  
• Zero maintenance and attention portfolio: the person would ideally like to have to do nothing at all for forty years! No buying and selling, no rebalancing, nothing, if at all possible; unfortunately, it is still required to file a tax return every year, so tax reporting simplicity is a consideration. As a consequence, things should be as simple as possible - few holdings at one broker.

General Principles: these should always apply to investing

• low costs - paying higher fees for others to manage your investments is a sure way to end up with less; 0.1% less per year can add up to many thousands difference after 40 years - 4.1% return compounded will see $50k reach $240k while 4.2% yields $249k; high MERs = low net returns; this eliminates from consideration all equity mutual funds except index trackers
  
• diversification - the "not all eggs in one basket" and "some go up while others go down" factors entail being invested in many assets with as low as possible correlation with each other; this ensures that there is a net gain, not a loss, over the long term
• tax-effectiveness - deferring and reducing taxes means a greater net in the future; tax rates in Canada are lowest on dividends, higher on capital gains and highest on interest as this previous post on tax rates shows. There is a significant advantage to dividends for all taxable income up to the mid-$70k range, which is where our person is most likely to end up based on his career path. However, the portfolio diversification principle must be respected - meaning that it is not acceptable to ignore the fixed income component of a well-structured portfolio merely to avoid taxes. Fortunately, there is a way - substitute preferred shares returning dividends for bonds returning interest income.
  

The Proposed Solution: this is necessarily a combined solution of portfolio and broker/financial service provider due to the practical constraints outlined below; theory may tell us to do things a certain way but it is not quite possible in practice.

There are three good alternative solutions, the best ranked first.

1. Portfolio of Four ETFs at Questrade

Portfolio Composition:

• 35% / $17,500 XIC - iShares Canadian Composite Capped Index Fund, MER 0.25% (the alternative is XIU, the TSX 60 fund, which has a lower MER of 0.17% and distributes much less income as interest, but it only includes the 60 largest companies as opposed to the 270+ companies in the Canadian market, which means less diversification as the 60 only account for three-quarters of total market value of the TSX and presents less opportunity to benefit from small company growth, from income funds and from real estate); negatives of XIC are the MER and the fact that some of the annual distributions are higher-taxed interest; XIC exemplifies the simplicity and advantage of a fund that enables one to own a piece of a large number of assets/companies through one purchase; in the proposed portfolio XIC is the Canadian equity asset class
• 15% / $7,500 VTI - Vanguard Total Stock Market ETF, MER 0.07%; this is a broad market index, representing some 95% of the total US market according to Vanguard; it is exposed to USD vs CAD currency swings, which can be good or bad, depending on the direction; to some degree, there is also a diversification advantage (see discussion in a Burgundy Asset Management paper and research by Mark Kritzman - when the Canadian market falls, often the Canadian dollar follows, meaning that a VTI owner will end up with more Canadian dollars (as long as the US market doesn't fall by the same percentage); alternatives might be IYY and IWV, two index ETFs that track the broad US market but they have higher MER of 0.20%
  
• 20% / $10,000 VEU - Vanguard FTSE All-World ex-US ETF, MER 0.25%; provides very broad exposure to some 1300 companies in 47 countries around the world outside the USA
• 30% / $15,000 CPD - Claymore S&P TSX CDN Preferred Shares ETF, MER 0.45%; this is the fixed income portion of the portfolio, in which preferred shares are substituted for the bond funds typically held in registered tax-deferred portfolios; preferrred shares produce dividends so the person in a middle tax bracket will lose only about 8% to tax vs 30% - preferred shares pay less than bonds (James Hymas says about 0.89% for corporate bonds) in an article Corporate Bonds - or Preferred Shares? in the May 2006 Canadian MoneySaver) but compound the tax difference over 40 years and the difference is enormous e.g. 6% gross on $15,000 bonds would net reinvested and compounded after annual tax at above example rates $77,767 in bonds and 5.1% on dividends would net $93,892; note that bond funds always include lower yielding government bonds so this comparison understates the after tax advantage of preferred share dividends; the alternatives to CPD are three closed end funds DPS.UN - Diversified Preferred Shares Trust, PFR.UN - Advantaged Preferred Share Trust and PFD.PR.A - Charterhouse Preferred Share Index Corporation according to Portfolio Construction in the July/August 2007 Canadian MoneySaver issue but a cursory look suggests they suffer from making large distributions of return of capital, which is just giving his own money back to an investor, as well as trading often at well-below NAV.

Why the portfolio allocation proportions and holdings?

This is perhaps the most uncertain area. While the whole world is represented, Canada has a much larger proportion of total equity - equal to the sum of the USA and the rest-of-the-world - than in my own portfolio. The logic is simply that the person is likely to live and retire in Canada and use Canadian dollars. The foreign holdings introduce a significant enough exposure to diversification benefits from the equities themselves and from currency swings, but not too much. I've wrestled with this in the past e.g. this post on IFA Canada's model portfolio and this post on my own portfolio but cannot find the "perfect answer".

What does the above portfolio achieve?

• diversification through diffuse ownership of a large number of companies
• diversification through investment in most areas of the world
• diversification through equity and fixed income asset classes that move in different ways at different times (but which all move upwards over the long term)
• higher net returns through low fees of the ETFs
• higher net returns through use of a discount broker, which will charge nothing for account administration or management and only charges for trading
  
• higher net returns through lower taxes
• zero maintenance through index tracking - the fund managers regularly restructure the holdings to reflect market evolution requiring nothing of the investor
  
• zero market knowledge and investigation required - you get the market average automatically year after year, sometimes that is down but mostly it is up and certainly over the long term it is up
• zero maintenance through automatic dividend/distribution reinvestment by Questrade
  
• minimal administration through the small number of funds requires less work to do annual tax returns for distributions and down the road when they are eventually sold
  

What does it not achieve and what are the risks?

• rebalancing to keep the portfolio proportions the same will not happen without selling and buying by the investor; rebalancing every four years or so, or when one holding gets more than 5% (e.g. XIC goes up to 41% or down to 29%)out of whack, is the optimal strategy (see this post for discussion); over many years, the equity investment growth should far outstrip the fixed income CPD, which will increase the overall riskiness of the portfolio; normally, that's a cause for concern and the reason for rebalancing; in this case it is quite possibly a good thing, a worthwhile natural evolution. Why? As this person gets older and if, as expected, he begins to build up a defined benefit pension plan paying a fixed inflation-adjusted income at retirement, that in effect has increased the fixed income portion of his total personal wealth.
  
• shifting the portfolio into an RRSP for tax deferment and tax-protected growth as and when that becomes possible can only happen with monitoring and action by the investor; contributing the funds in-kind is possible but that will trigger a deemed disposition and the necessity to calculate and declare capital gains along the way, more work for the investor; the first thing that should go into the RRSP is fixed income, but the CPD should then be sold and replaced by a purchase of a bond fund like XBB the iShares Canadian Bond Index Fund since bonds will produce a higher gross and net (once protected from taxes) yield
• keeping a record of the Adjusted Cost Base of ETFs is a manual procedure as I explained in this post and it is a pain in the you-know-where; it doesn't really need to be done till the ETF is sold and the gain is to be reported on a tax return so maybe it can be put off and done in one massive catch-up session after 40 years but I'd want to not be further than five years behind simply because corporate fortunes rise and fall, companies come and go and records disappear or become hard to find (I had a lot of trouble some years back trying to figure out mutual fund ACBs to do final returns going back a mere 20 years)
• potential instability of the solution is an inescapable risk, especially over forty years, since the practical evolves greatly e.g. forty years ago, index funds did not exist and there was no capital gains tax in Canada; change will happen, it's just not possible today to know where, when and to what degree; one thing to remember is that big does not equal absolutely safe, stable or permanent - the current financial turmoil is affecting most the world's biggest banks, some will fall and over the long term, most will fall (just check the stock listings of the TSX, oops it used to be the TSE, 40 years ago and see how many names you recognize); Questrade is a relatively new, smaller player and going with them entails a degree of risk that it will be necessary to shift the portfolio to another institution if they run into business problems ... or maybe their superior product will see them grow into the dominant broker of tomorrow; is CIBC a good place to be, they seem to keep stumbling? Regardless, it will always be necessary for the investor to keep a general eye on developments for this maximum passivity portfolio.
  

Broker: All ETFs produce cash distributions, either monthly, quarterly, semi-annually or yearly, and there is no option, like there is with mutual funds, to have the ETF manager reinvest the cash automatically. So the investor can do it at his own time and expense or a broker can offer the service. But the objective is to have everything run on autopilot. The choice of Questrade boils down to one thing - Questrade is the ONLY Canadian discount broker I found that could reinvest the cash distributions for all the above ETFs so that the cash would not sit around in the account earning little or nothing. CPD was a particular no-can-do for everyone but Questrade and we see above above, it is a key element of the plan.

2. Portfolio of DFA Mutual Funds described on IFA Canada from Advisor De Thomas Financial.

This approach consists of handing over the $50k to De Thomas Financial for them to invest in the DFA mutual funds described in detail on the IFA Canada website. They follow passive indexing principles to the nth degree, they say convincingly enough (i.e. they back up their assertions with believable data) even more than the various index ETFs. The breakdown of asset classes is more numerous, enabling reductions in volatility and higher returns. Though De Thomas charges a 1% annual fee on top of the 0.25-0.70% embedded in DFA funds, their approach makes up for that 1.25 to 1.7% vs 0.07 to 0.45% ETF fee spread by lower tracking costs, by stock lending revenue and by tax deductibility of the fees (on taxable accounts only). Michael Hill of IFA Canada & De Thomas explained all this in my Q&A blog post of Oct.23. The end result is that the investor should attain a higher net return. The fact that the holdings are mutual funds eliminates the special ACB record-keeping hassle of ETFs, as well as the reinvestment of distributions problem. The rebalancing issue goes away too since De Thomas does it. Finally, part of the De Thomas service is general financial advice (I notice that Mr. Hill is a Certified Financial Planner, one of the better designations) and that may come in handy.

My biggest concern is that all of the portfolios have only bond funds and none with preferred shares and so taxes will be considerably higher. Another is that the "Easy Chair" portfolio for accounts smaller than $100,000 (the minimum required to do the full asset allocation using all the funds) has some limitations but those are not described.

3. Portfolio of TD Canada Trust e-Series Mutual Funds

This portfolio mimics the ETFs in the first portfolio with the difference that they are mutual funds available only through having an account at TD Canada Trust. The funds are:

• TDB900 - TD Canadian Index Fund, MER 0.31%, tracks the TSX Composite Index (it doesn't appear to be a capped fund like XIC, which limits any stock to no more than 10% of the fund; this shoudn't cause any difference or problem as long as there is no tech bubble II where Nortel gets up to 30% of the total value of the TSX!)
• TDB902 - TD US Index Fund, MER 0.33%, tracks the S&P 500, which is only three quarters or so of the total US market and really only tracks large companies, a disadvantage since small company stock returns historically have outperformed large company returns
• TDB911 - TD International Index Fund, MER 0.48%, tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index("MSCI EAFE Index"), which is probably quite a bit less diversified ( we cannot tell because TD's fund information on the above website is too incomplete) than VEU
• TDB909 - TD Canadian Bond Index, MER 0.48%, tracks the Scotia Capital Universe Bond Index ("Universe Bond Index"); because it's a bond fund in a taxable account this is much less desirable than CPD
  

The TD funds do offer the advantages of mutual funds over ETFs already noted above but the higher MERs and a bit less ideal diversification characteristics promise lower long run returns. The biggest negative is the absence of a preferred shares fund. Of course, it would be possible to take the $15,000 for fixed income, go to Questrade and have an account only for that holding there. But why start to complicate life with accounts here and there if there is a better overall solution with Questrade?

Stock Markets and Multi-Vehicle Pile-Ups

Today's CBC web headline included a report about a monster multi-vehicle pile-up on highway 400. Thankfully, no one seems to have died. Having been in the middle of one such pile-up on the 401 a few years ago, I extend my sympathies to those involved. I remember the feeling of helpless foreboding in the brief moments after I had stopped safely - watching in the rear-view mirror while vehicles approached, hoping none was a semi-trailer going too fast, trying to guess whether I should move into the gap between vehicles ahead or stay where we were, or jump out and head to the ditch, though that would mean we were even more exposed. There was no long time to think, only seconds. As it was, we stayed put and sure enough, someone in an SUV couldn't quite stop and banged into our rear, smashing our plastic bumper, but we were ok and so were they. Not so lucky was the guy in a large pick-up a few hundred meters back, killed in the sandwich between two semis.

As an investor, I now feel much like that moment. The world financial pile-up has started, courtesy of financial institutions guilty of driving too fast with credit in conditions they should have seen were dicey. It started with the sub-prime mortgages in the US and the damage to many banks, hedge funds and investment houses has been in the news for months. The chain reaction continues, the latest crash of a semi being the downgrading of bond insurer Ambac and its follow-on effect on US municipal bonds. Ambac may be a blameless motorist on the financial highway yet it inflicts much destruction when it loses control. (btw, Credit to financial editor Robert Peston of the BBC for consistently exposing the consequences of the sub-prime induced meltdown in the UK and farther afield as his post on Ambac and MBIA attests). It just goes to show that one can follow all the safety procedures with a good vehicle (i.e. diversified portfolio) and behave cautiously yet still suffer collateral damage and be caught in a big mess that will take a while to clean up once the collisions have stopped, which obviously is still not the case. There's more market crashing going on today in Asia and throughout Europe. The market has shifted from greed to fear with good reason.

Unlike for my mini-van, I don't have portfolio insurance. Hmm, maybe I should get some, though it's a little late for this episode of financial highway mayhem.

Of course, we could all just stay home and invest in GICs, never taking the risks of travel, but then we wouldn't get anywhere interesting, would we?

New Survey: Your Reaction to Market Drop

Well, the TSX is down 900 points in three days and if you are internationally diversified and watching other stock markets, you are seeing that in times of crisis, positive correlation reigns, with the S&P 500 down, the FTSE down, the DAX down, the Hang Seng down and so on. The only positive note is that the Canadian dollar has been sliding too so the foreign holdings are not dropping quite as much in C$ terms as they would have with a constant exchange rate. That's a diversification value.

Along with the slide there is the predictable article that accompanies all bear markets - a piece on the CBC website that tells small retail investors like you and me not to panic and sell out. Hmm, most of my friends and family are too busy going to work, watching hockey games, helping kids with homework etc to do more than watch in puzzlement and helplessness as the indexes plummet. Could it possibly be someone else who is doing all the selling, possibly the big boys of the investment houses, the hedge funds, the pension plans who have the vast majority of the money in the market? In order to test this hypothesis I am launching another mini survey for my blog readers to see how many of us small investors are bailing out and how many are hanging tough. If you are reading this and have $100 million or more under your control, please don't answer as the survey results will get skewed and unscientific.

Book Review: Canadians Resident Abroad (4th ed) by Garry R. Duncan and Elizabeth Peck

About half of this book is pure gold and half is more or less junk. Fortunately, it is easy to distinguish the two.

The good stuff is:

• chapters 1 to 6 and 10 to 12 cover the Canadian tax implications for Canadian residents, emigrants, non-residents, immigrants and other permutations from many angles - income, property, investments, pensions, tax plans (RRSP, RRIF, LIRA etc); there is much detailed explanation and numerous mini examples of how things work, which is tremendously helpful because this is very complex and arcane stuff; adding to the value is the commentary of the expert tax practitioner Garry Duncan telling how the Canada Revenue Agency interprets and applies its own too-often ambiguous rules. For instance, on page six, there is a lengthy list of secondary factors that CRA uses to determine whether you are a Canadian resident for tax purposes or not, which tautologically includes whether or not you have filed a Canadian tax return. There is a certain black humour value from explanations of how twisted and bizarre the effects of tax laws can be. I especially enjoyed on page 56 where he explains how "Under certain circumstances, you may be required to pay tax to Canada even though are a non-resident earning income in another country." Yikes! Any one of these many situations, if they apply to you, would justify the price of the book many times over by avoiding huge amounts of aggravation and perhaps unanticipated large tax consequences, or on the other side of the ledger, finding ways to intelligently and legally reduce your taxes. The book should really be titled Taxes and Canadians Resident Abroad.
  

The junk is:

• chapter 7 - purportedly about health coverage, but consisting mostly of pages of contact information for provincial health ministries, private health care providers and clinics; it isn't to me worth writing on page 121 "... since residency regulations vary widely across Canada (and, by the way, are totally unrelated to the residency rates for income tax purposes), you should never assume that your coverage is continuing ..." Well, thanks a lot, but I bought the book to find out the details not to be told to phone the bureaucracy. This is especially annoying since,
• pages 157 to 335 consist of appendices, most of which are complete copies of tax forms and circulars, though there is one bizarre table of foreign currency exchange rates as of 2001 and another with world time zones. In this Internet age (and it had started by the 2002 publishing date of this edition) web addresses and links to find current versions of these documents would save a lot of pages that no one will read.
  
• chapter 8 on Canadian drivers' licenses includes a similar vague mention of varying provincial rules and pages of contact addresses
  
• chapter 9 on the no-longer-in-existence GST rebate program (cancelled as of April 1, 2007 and replaced by a somewhat similar Foreign Convention and Tour Incentive Program) shows the age of the 2002 edition - it's time for an update and revamp.

In short, half this book deserves five stars out of five but the other half only deserves one star, which comes out to an average of three stars out of five.

Still, if you are coming to, or going from, Canada, permanently or temporarily, buy this book. It is available from the publisher Carswell , where you can see the table of contents, or possibly from Chapters or Amazon., where it is currently unavailable.

RRSP Loans: and Another Thing - Timing is Crucial

My last post concluded that it is worthwhile to borrow to make a lump sum RRSP contribution just before the deadline at the end of February if the tax refund is used either to reduce the loan principal or to contribute back into the RRSP.

What happens if you have barely missed the deadline and are sitting there on March 1st wondering if it still makes sense? The answer is most likely NO. You are probably better off to start making monthly contributions (I'd suggest you use automatic deductions from your bank account so you actually do it), for instance by putting in the same monthly amount as you would have done to pay off the loan.

Why is this so? The reason is that the tax refund won't be coming back to you till the following year instead of within three months or so if you manage to meet the deadline. The absence of that immediate extra boost to your savings destroys the value of the loan in most reasonable scenarios. The only scenario in which the loan still comes out ahead of the regular monthly contributions is when the investment return rate exceeds the loan borrowing rate by 2% or more. Think of the probabilities. On the one hand the loan rate is a sure thing, it won't be lower by chance; on the other hand, the investment return is very uncertain if it is in equities, which is the type of investment that could most likely provide returns in excess of the loan rate. Or, if you invest in something that gives a known return, like a GIC, you will only get a much lower rate that will almost surely be less than the loan rate? Is the loan worth it, then? In my view, no.

As the months pass from March to the following February, the balance gradually shifts in favour of the loan option. At some point, the loan will be the better option. I have not tried to calculate the exact month when it looks better - perhaps half way, after six months, is a guess. But don't put off the contributions just for that reason. The February contribution scenarios all come out ahead of the March contribution scenarios. Putting the power of compounding to work as soon as possible by contributing sooner is the most important principle of all.

RRSP Loans: What to Do and Not to Do

Suppose you have unused RRSP contribution room but it's the end of February and you don't have the cash on hand to make a contribution before the deadline. Should you take out a loan or should you just start contributing monthly to the RRSP? There doesn't seem to be much substantiated / well analyzed advice out there on whether taking out a loan to contribute a lump sum to an RRSP makes sense so here goes. (This one is for you Nicole since you brought up the question.)

Being a non-believer in loans generally (the only loan I've ever had in my life is a mortgage), I have been greatly surprised to find that taking a loan to contribute to an RRSP is a smart move if it is done right. And it is useless if done wrong. The do's and the don'ts are very simple, easy to follow principles.

Do This (in order of priority):

1. by all means take out a loan BUT use all of your tax refund for your RRSP as soon as you receive it by either reducing the loan balance or by reinvesting it in the RRSP (it doesn't matter much which you choose as I explain below).
   
2. repay the loan as soon as possible - the shorter the repayment period the better as you will increase your net savings faster; make sure you can handle the monthly payments, including some leeway in your budget for the inevitable major car repair/vet bills/dental work at the worst possible moment;
   
3. a multi- year loan to catch up a backlog of past accumulated contribution room is beneficial as long as you follow rule #1 above every year
   
4. reduce the loan payment amount, using the reduction to continue to contribute to your RRSP if you still have contribution room and if you have no contribution room left, start investing the payment difference in a non-registered account, or
   
5. keep paying the same amount so that your loan is paid off as soon as possible
   

Do NOT Do This:

1. spend the tax refund; if you do, you would much better off taking the equivalent amount of the monthly loan payment, contributing it to the RRSP each month, then spending the refund you get a year later; spending the refund blows the whole loan scenario out of the water - you are wasting your money.
   

The Scenarios I Looked At:

1. Take Out a Loan, Make a Lump Sum Contribution to the RRSP, Reinvest the Refund in the RRSP and Do Not Reduce the Loan Principal
2. Take Out a Loan, Make a Lump Sum Contribution to the RRSP, Reduce the Loan Principal and the Payments with the Refund, Add the Monthly Difference in the Payment to the RRSP
   
3. Instead of a Loan and Lump Sum, Invest in the RRSP the Same Monthly Contribution as the Loan Payment Would be and Reinvest Tax Refunds in the RRSP as Received

With all the scenarios, I used a spreadsheet to calculate. I plugged in different loan rates and investment return rates, loan repayment durations from one to five years and yes/no refund reinvestment decisions. In all cases, the loan was considered to be taken out just before the February deadline so that the contribution could be counted for the previous tax year and so that the tax refund would be received 3 months later. My criteria for success was net savings wealth, as measured by cumulative RRSP value at the end of each loan repayment.

Caveats, Assumptions and Things That Don't Matter

• if you do happen to have the cash on hand but wonder whether it is better to take out a loan anyway, that will only pay off if the rate of return on the RRSP exceeds the loan interest rate; Moshe Milevsky explained this in Chapter 7 "Borrowing to Invest" of his book Money Logic
• the tax bracket you are in (as long as you pay some taxes ... but then you wouldn't have contribution room if you didn't, would you?) does not affect whether you should take a loan, it only increases the benefit if you are in a higher bracket because you get a bigger tax refund
• surprisingly, the "which is better" answer is quite insensitive to the rate of return on the RRSP investments and the loan interest rate - for differences of 1 or 2% between loan rate and investment return rate, the end result of the two loan scenarios was quite close; in cases where the loan rate exceeded the investment return, scenario 2 was better, and where the return was higher than the loan rate, it was the other way round. It takes a difference of 4-5% to make scenario 1 or 2 significantly better than the other. The reason for this is a key concept for all situations - the tax refund is the critical benefit and main differentiator - the sooner you receive it and invest it, the better off you are. In addition, the loan principal amount on which you pay interest begins to decline from month 1 onwards while the RRSP goes up constantly with any positive return and is boosted significantly by the refund, so that the net interest gained is higher from the RRSP than that paid on the loan - e.g. for a $1000 twelve month loan at 8% the balance in month 6 is $509.97, the interest is $3.95 while the RRSP with annual return of only 4% has gone up to a balance $1333.28 (assuming reinvestment of the $310 refund for an Ontario taxpayer with taxable income in the $37-62k band and a marginal tax rate of 31%) gains $4.43 in return
  
• that also the main reason that scenario 3, where you simply invest on a monthly basis and take no loan, comes out behind the loan options except in extreme cases where the loan rate is very high and the investment return is more or less zero; when you invest as you go, you are always playing catch up, effectively one year behind in receiving those tax refunds and always getting a lower return on a lower RRSP balance
  
• in my calculations, I assumed the refunds from the reinvested refunds would also be reinvested; they get smaller and smaller but they do make a difference; the more you have invested and the sooner it is invested, the greater the effect of compounding
• if you have taken out a multi-year loan and still haven't paid it off but have generated more RRSP room in the past year but still don't have the cash, does it make sense to take out a new loan for a new lump sum contribution? my answer is yes, as long as you can handle, with some safety margin, the combined payments; the same logic applies and it still makes sense for the same reasons.

Othe Factors to Consider:

• a loan can be much more forceful in ensuring that you actually make the savings because it's not just your decision to reimburse or not, you are compelled to do it; a big problem in saving is actually getting round to do it and sticking to it
• a loan is riskier in case of unforeseen urgent expenses; it is easy to interrupt RRSP contributions; you need to have confidence in being able to pay the loan
• with scenario 2 and a small loan, the monthly reinvestment amounts may be hard to reinvest at a high rate within the RRSP; having the contribution sitting in cash will ensure that your rate of return is below that of the loan rate; maybe using a mutual fund is the way to invest that monthly amount in the RRSP
• many/most RRSP loan lenders will allow you to defer the first payment for a few months to allow your refund to come in; that may allow you to reduce the loan principal and payment to an affordable level and thus allow you to make a larger catch-up contribution
  

Book Review: No Hype - Straight Goods on Investing by Gail Bebee

This is a brand new book from an unusual source - a person from outside the financial industry who is largely self-educated on investing. That brings about a few of the major advantages of this book: unbiased opinions and advice; a practical, direct, simple approach to a vast subject matter. Bebee does not shy away from saying when she feels a financial product is not worth it ( e.g. principal protected notes) or is worth the money.

With a length of less than 200 pages, there is not a lot of detail or explanation - the chapter on taxes and inflation is all of seven pages - but there is enough to get started and most often links and references on where to obtain further information. This book is ideal for a (Canadian) person new to investing, or someone like the author, a person who wakes up one day after years of inattention buying mutual funds by rote and decides to take control of his/her own investing destiny. After reading this book, such a person will also know whether he/she really wants to manage the DIY way or find a good advisor (and the procedure to do the latter is covered as well).

The writing style is accessible and understandable, the explanations straightforward and simple. It will appeal to those like my wife whose eyes glaze over at long-winded explanations, who say "never mind all the background, just tell me what to do".

The content covers the gamut of personal investing topics: education, financial advisors, brokers, complaints, DRIPs, wrap accounts, asset classes and allocation, stocks, bonds, mutual funds, ETFs, IPOs, fees and commissions, segregated funds, real estate, foreign currency, hedge funds, RRSPs, RESPs, annuities, retirement, RRIFs, LIRAs, a series of model portfolios, reviews and record-keeping etc.

I found myself agreeing with about 95% of Bebee's opinions and recommendations (either we are both stupid or both smart!) so I can confidently say no one will go far wrong just investing blindly the way she recommends. The major areas in which I disagree are that I don't believe in either market timing (e.g. I'm quite convinced there is a pretty nasty recession coming but I'm not about to sell all my equity holdings and put everything in t-bills - who says I'm smarter than the market, whose prices implicitly incorporate the average of everybody's expectations in that regard) or in technical analysis. There are also some non-critical quibbles about certain statements in the text but they can be the subject of some good blog postings. One I will mention immediately, however, is that she doesn't identify blogs as a worthwhile source of investing information and views - harrumph! ... Update ... apologies to the author, as she pointed out to me in an email after this post was originally published, there is a mention of blogs as a source of investing information on page 23, though she doesn't say and it would be interesting to know which ones she recommends or likes.

My rating is four out of five stars. Buy it at the author's website at www.nohypeinvesting.com, or at Chapters/Amazon.

Have a look at Jonathan Chevreau's interview with Gail Bebee, part 1 and part 2.

Rent vs Buy: a Couple of Good Calculators

Many people automatically assume that buying your home is a better investment than renting, probably because your principal residence in Canada enjoys freedom from capital gains taxes. Well, it ain't necessarily so.

Check out the Rent vs Buy calculator at Industry Canada to plug in your own assumptions and see how the balance can easily change between renting and buying as the best option from a purely investment point of view. The calculator was constructed by a top notch expert who is a familiar name in this blog - Moshe Milevsky, a Finance prof at York University, along with researchers at the Individual Finance and Insurance Decisions (IFID) Centre in Toronto. Critically its takes account of the tax difference amongst other variables. As usual the numbers entered in the assumptions are all-important - the Garbage-In Garbage-Out principle still applies. Milevsky himself has elsewhere noted other investment disadvantages of home ownership (not incorporated into the calculator) such as the lack of diversification since a huge proportion of your wealth ends up being tied up in only one asset, i.e. a house suffers from the "too-many-eggs-in-one-basket" risk and possible market slumps.

Another worthwhile Rent vs Buy calculator resides at the website of the Citizens Bank of Canada. It has the merit of showing results graphically, which shows you the cross-over point between renting and buying, as well as how closely the lines follow each other. Much of the trade-off seems to be influenced by house and mortgage one-time costs.

When I tried entering the same assumptions on both calculators, both showed the home purchase to be superior but the Citizens Bank gave an estimate almost double that of Industry Canada after ten years. One difference is that the Citizens Bank calculator includes mortgage insurance and transaction costs but the IC one does not. Without the formulas to examine, it's impossible to figure out why they differ so much. Caveat emptor applies to calculators too, it seems.

Most assumptions that I tried out seemed to show home ownership coming out ahead. But not always. Hopefully this will provide some comfort to those, including at least one of my relatives, who missed the property ownership boat and feel their retirement will suffer as a result.