Benefits of Investment Diversification for Retirees

A few weeks ago I noted in my review of Moshe Milevsky's excellent book Are You a Stock or a Bond? that further diversification beyond the US stock, bond and T-bill portfolio he used could provide more benefit. I've done a bit of research and number crunching and take a look at these benefits!

Diversification can:

1. Raise the possible safe withdrawal rate from the investment portfolio by 1.5% a year, perhaps considerably more. Safe withdrawal rate is the percentage amount that can be taken out and spent every year while minimizing the chance of running out of money before dying - a 4% rate on a $100,000 portfolio means taking out $4,000 per year and raising that 1.5% means being able to spend $5,500 per year.
   
2. Reduce the chances of running out of money by anywhere from 3 to 10%.

Most of the benefit of diversification comes from the potential large reduction in volatility, or swings in the portfolio. Diversification helps enormously to reduce the sequence of returns risk (the chance of having bad markets at the start of retirement) which can send a portfolio on a downward spiral from which it never recovers. Retirees face this damaging risk, which is quite different from investors in the accumulation phase, because they are taking money out.

The table below uses Milevsky's formulas, which incorporate the risk of dying along the way, for calculating the risk of running out of money before death. It shows a few hypothetical (but based on realistic numbers) calculations and a couple of results using historical data.

Hypothetical Calculations:

• Weak vs Strong Diversification, keeping the same 4% withdrawal rate - the slight increase in return combined with the large reduction in portfolio volatility (standard deviation from year to year) means that there is a 10% better chance that the money will last till death - which would you rather have an 87% chance of not running out or a 98% chance?
• Weak vs Strong Diversification but boosting the withdrawal rate - for the same risk of 87% chance of successfully having the money last, an extra 2.7% could be withdrawn. That's $2,700 extra for every $100,000 in the portfolio.
• both these scenarios assume a 50% chance of living 19 or more years e.g. a 65 year old getting to 84, which is about the current number according to Milevsky

Historical Data

• TSX from 1958 to 2008 (i.e. including the highly "volatile" 2008!) produced a 2% higher return than the hypothetical scenarios but the volatility is about the same. The comparison portfolio is from the conservative 50 portfolio (50% fixed income) from IFA Canada, which is quite broadly diversified with Canadian, US and international equity holdings, fixed income and real estate, though it does not include other potential asset classes such as commodities and real return bonds. There is still a huge reduction in volatility in the IFA portfolio to 8% from the 15% of the TSX alone. This would have allowed the withdrawal rate to be 1.8% higher with the exact same 97% assurance of not running out.

By playing with the numbers in the spreadsheet, it becomes evident that the longer the expected time in retirement, the stronger the effects.

Bob Clyatt's interesting book on how to semi-retire, Work Less, Live More, shows similar results using the approach of reconstructing actual data for a US investor from 1927 to 2004. He estimates that an internationally-diversified, value- and small-tilted portfolio would allow investors to increase their safe withdrawal rate by 1.5% or more per year. His analysis addresses the needs of much younger people (the semi-retirees) who essentially need their portfolio to last indefinitely, 40 years or more.

PS: Those who want to try Milevsky's formula with their own numbers should read a A Gentle Introduction to the Calculus of Sustainable Income. If you use OpenOffice instead of Excel, be aware that the GAMMADIST function parameters are in the same order as for Excel, not as the OpenOffice help documentation says (that caused me some head scratching till I "reverse-engineered" the correct way to do it).

The moral of the story - in retirement, diversification is a huge opportunity to both boost income and/or reduce the risk of running out.

Vanguard Enters UK Market. Canada Next?

Vanguard will begin selling eight equity index funds and three fixed income funds in the UK as of tomorrow June 23rd (announcement here). This will bring the lowest cost fund competitor to the British public. Vanguard's annual Total Expense Ratios of the various funds vary from 0.15 to 0.55%, less even than the range of iShares ETFs - list on Stock Encyclopedia - (e.g. the Japan Vanguard fund will have a TER of 0.3% while the iShares ETF has a TER of 0.59%) or OEIC tracker funds like the M&G UK All-Share Equity Index Tracker (TER of 0.49% compared to Vanguard's 0.15%) which also serve the passive index investor. It will be interesting to see how much sales commission, if any, gets charged against a purchase of the new Vanguard funds in the fund supermarkets such as Hargreaves & Lansdown, Fidelity UK and FundsDirect where the DIY investor will be able to buy the funds. The M&G Tracker funds have no sales charge.

Admittedly Canada is not as large a market as the UK, but with the expense ratios of Canadian mutual funds being even higher, is it not time for Vanguard to enter the Canadian market? Vanguard's comment today when I asked: "At this time, Vanguard does not have plans to launch funds in Canada."

Acknowledgements to the Telegraph where I found this item.

Gail Bebee asks: Has the death knell sounded for mutual funds?

Author Gail Bebee sent me the following message with the above dramatic title:

"New exchange-traded funds from a Big Five Canadian bank will compete with mutual funds

Toronto, June 17 – The Bank of Montreal (BMO) is getting into the exchange-traded funds (ETFs) business with an offering of seven funds which largely mimic existing products from ETF industry leader, iShares. Says independent investor and personal finance author Gail P. Bebee “ETFs, the low cost alternative to Canada’s high fee mutual funds, are making major inroads into the mutual fund business and BMO wants to profit from this trend. The good news is that a major bank is offering ETFs to clients, so more Canadians will learn about the benefits of investing using ETFs instead of mutual funds. Hopefully, BMO’s decision will motivate other Canadian banks to launch their own ETFs. Canadian consumers will be the winners.”

According to Bebee, ETFs offer several advantages over mutual funds:

1. Better returns than most equivalent funds

2. Lower management fees

3. Greater tax efficiency

4. Ability to buy and sell throughout the trading day.

For more information or to arrange an interview, please contact:

Gail Bebee

Personal finance speaker and author of No Hype - The Straight Goods on Investing Your Money

All the investing basics for Canadians from a savvy financial industry outsider

Tel: 416-733-0221

gbebee@nohypeinvesting.com

www.nohypeinvesting.com"

To which I would comment, I hope not a death knell since there is nothing inherently wrong with the concept and structure of mutual funds. It's just that the current fees are so darn high, they do not provide good value to investors. However, the ability of mutual funds to take small amounts of new money efficiently and to automatically reinvest distributions and keep track of tax info such as Adjusted Cost Base are worthwhile attributes. Some fund company in Canada needs to go the route of Vanguard in the USA by providing ultra-low cost index funds.

The flight from mutual funds that Bebee refers to may just be a good thing. It reminds me of the situation many years ago when Canada's wine industry (which was more aptly described as the whine industry) contentedly produced horrible stuff in high volume until free trade opened up competition and the industry successfully shifted to high-value, high-quality niche wines. I hope the surge of ETFs is a wake-up call to mutual fund providers.

A Good Thing: Assuris Guarantee of Annuities and Insurance Payouts

The failure last year of major financial players like Lehman reminds us that a promise to pay is only as good as the ability of that organization to actually pay. In the case of a life annuity or some form of insurance, one must naturally ask what guarantee there is that a financial company will be around for the twenty or thirty years that an annuity may last, or who will step in if it is not.

The answer in Canada is Assuris, a not-for-profit organization to which all insurance companies are obliged by law to belong. On the failure of any company, it promises to either pay up, or more often, simply have another company take over and continue the coverage or payments. It has its own small "Liquidity" fund of $100 million and can levy up to $900 million more from its members, which it says would more than cover any failure that has occurred in the past.

Whether that would be enough to handle a failure the size of a Great-West which has obligations over $100 billion per its Q1-2009 financial report is debatable. A series of failures in a systemic and cascading crisis could happen, as very nearly happened with banks last autumn. However, as was observed then, some companies and industries are too big and critical to the economy to allow them to fail. The government steps in to provide guarantees and that is the ultimate level of protection for annuities and insurance though it is not formalized as a promise to backstop Assuris.

Assuris does only guarantee 100% of payments up to $2000 per month per insurance company, or 85% of the payment, whichever is higher (example shown here), so it is wise to split up annuities amongst different companies.

RESP: Maximizing Withdrawal Benefits

You've had an RESP for long time, you've made lots of contributions, got Canada Education Savings Grants (CESG) and perhaps an Alberta Centennial Education Savings Plan Grant if you live in Alberta. You have a family plan with two or three kids as beneficiaries. The kids are young adults and it is now time to take the money out. Here are some thoughts on getting the maximum benefit from the RESP.

Note the best source of information - the Human Resources and Skills Development Canada Promoter Tools. HRSDC is the horse's mouth and the information is detailed and precise with helpful tables and examples. Skip their consumer info pages if you really want to know how things work. The Canada Revenue Agency has a good FAQ on RESPs. Other government sources like CanLearn, Financial Consumer Agency of Canada and Service Canada serve up really basic baby pablum type info which in some cases is misleadingly general. I would also warn people off CRA's IC93-3R, as the copy I found on the CRA website is dated 2004 and is out of date. CRA's RC4092 is better.

1) Wait till the child/beneficiary is in a qualifying educational program before removing any funds. You (the subscriber) are allowed to take out your contributions (actually, anyone's contributions since, as far as HRSDC and plan promoters are concerned, the subscriber becomes the owner of the contributions, not the beneficiaries, nor the aunt, uncle or grandparents who may have deposited money). But taking money out early means you will have HRDSC asking for the corresponding CESG back.

The list of qualifying institutions is vast, not just university or college, so there is no excuse. The minimum length for a program is three weeks. Send them to the Kanine Klipping All Breed Grooming School in Saskatoon (check the list under K). The travel expenses can count as education expenses since there isn't anything more detailed about the requirements for expenses than to further post-secondary education.

2) Remove the CESG (and Alberta grant, if applicable) once the student is enrolled in a program by requesting the Promoter (discount broker if an self-directed RESP; complete list is here at HRSDC) to make an Education Assistance Payment (EAP). Once the student is enrolled, i.e. eligible for the EAP, you can also ask for contributions back, even if you have not requested an EAP. Your contributions always come back tax-free no matter who they go to, you, the student or anyone else (makes sense since you paid tax on that money before contributing and did not get a tax deduction or credit when making the RESP contribution). When the RESP has made money, some of the EAP will consist of CESG and some from interest, dividends or capital gains but the source of the return is lost and all the EAP is considered other income and taxed in the hands of the student at the student's marginal rate .... which should be minimal or zero due to low income and lots of deductions. It's probably best in most cases to remove only what is needed each year of a study program to even out the student's taxable income flow and allow the remainder to continue growing tax-protected.

You do not get to choose the proportions of CESG and profit removed in an EAP. You state a total desired withdrawal and there is a mandated formula that pro-rates the amounts. There is no withholding tax on withdrawal, unlike on RRSPs.

An EAP with earnings passed to a no-tax child achieves income splitting, a big tax benefit as the profits that you could have made in a taxable plan would have been taxed at your much higher marginal rates.

After the first 13 weeks of study, during which time only $5000 in EAP can be paid to a full-time student, the only limit to EAP without hassle is the informal $20,000 (2008 dollars that will be inflation-indexed) limit that CRA has told RESP providers it will not question in paragraph 6(i) of its RESP FAQ. Part-time studies are a bit more complicated in restricting an EAP to $2500 in each 13 week period preceding the EAP (see example worked through on this HRSDC page). There is an option to obtain more as an exception by having your RESP provider write to the folks at HRSDC. All the EAPs are only supposed to be paid for legitimate education expenses but receipts and strict lists of acceptable vs unacceptable expenses are not provided so I would guess most RESP providers will be quite cooperative when you ask for an EAP amount.

3) If the child doesn't go on to any sort of post-secondary studies, transfer the earnings of the plan to your RRSP. Up to $50,000 of earnings can be transferred if there is RRSP contribution room and as long as your are under 71, when one can no longer make any contribution to an RRSP. A transfer to an RRSP is better than taking earnings as an Accumulated Income Payment (AIP) into your own income since you will pay tax at your normal rate plus a 20% surcharge. AIP does not include your contributions, which you can withdraw without tax. It is also better than another possibility, which is to give the AIP money to an educational institution, since such a gift does not even qualify for a charitable donation receipt.

4) Include all your children in a family plan - and you can add them later if they are under 21 - so that the CESG can be shared amongst the siblings. CESG paid into a family plan RESP may be used by any beneficiary of the RESP to a maximum of $7,200 per beneficiary. It doesn't have to be the same child under whose name the CESG was obtained. Nor does the CESG or the EAP have to be shared equally amongst the beneficiaries, which can be a boon if only one child goes on to further studies. How you maintain fairness in the family is your personal matter unaffected by this flexibility in the rules.

Plan providers are supposed to keep accounts of contributions and track how much CESG is paid out to each beneficiary. My provider insists that it will prevent an EAP that would try to take too much CESG out for a particular beneficiary in a family plan - e.g. if two beneficiaries had $10,000 in CESG between them, only $7200 could be taken in EAPs by either one. But I would double check and track the CESG for each child just to be sure because if an over-wthdrawal happens, HRSDC will ask for the extra CESG back from the beneficiary.

An interesting aside is that only blood relatives can share a family plan. Blood relatives includes parents, brothers and sisters, children, grandchildren and great grand-children and onwards, but not nieces, nephews, aunts, uncles, cousins. A grandparent can start a plan too, so your parents could start a plan where CESG is shared amongst your children and their cousins. The sharing only applies to the basic CESG, not the extra supplement of $50 or $100 per child given to lower income earners (see this HRSDC page). If it is not a sibling-only plan, the additional CESG is not given.

5) If the RESP has a loss then don't close it even if the children have finished their education and all the CESG has been used up with EAP. There is no hurry to close the RESP since a plan now may stay open for 35 years. That gives time to recoup any investing losses tax-free! Here's how this works. First, a loss exists when "the fair market value is less than the total of assisted contributions, unassisted contributions, the CLB, the CESG, and the Alberta Grant accounts in the RESP." (on this HRSDC page) There is no need for messy accounting on interest or dividends received from investments being considered as earnings, it is simply whether the market value is less than "book value". When one also notes that contributions can be made for a beneficiary up to his/her age 30 and up to 31 years after plan opening, that can even allow further contributions to be made. Such contributions can gain profit tax-free up to the point all the losses have been recouped, at which point everything can be withdrawn tax-free as a return of contribution. The rules allows you to make up your investing misfortune (or stupidity) tax-free.

On top of that, when a withdrawal is made and the RESP is in a net loss position, the rules consider that the contributions are what suffered the loss and any EAP comes purely out of the CESG, so that liability goes away faster. But the book value of contributions doesn't disappear, it just doesn't figure in the calculations of the CESG and EAP. Below is a simple spreadsheet to illustrate the calculation.

In the example, the $15,000 loss is such a large deficit to make up with only $35,000 remaining in the RESP account following the withdrawal (which conveniently consumed all the CESG, unlike the profit example), that a new contribution of $10,000 is made to make it more feasible to recover the loss. Of course, new contributions must remain within the $50,000 lifetime maximum permitted for each beneficiary.

A tricky point that caused me needless extra phone calls is the fact that HRSDC only tracks CESG and the contributions related thereto. This means their records only go back to 1998 when CESG started. RESPs existed long before that. The RESP provider is obliged to record all contributions and pass this along with other essential data (like when your plan was opened) to another provider if there is a transfer. HRSDC will provide the subscriber with a written table of all their CESG plus contribution per beneficiary records upon request - phone 1-888-276-3624. If you make contributions after the kids get beyond 17, the maximum age to receive CESG, then HRSDC isn't interested and only your plan provider will keep that data (nor does Canada Revenue Agency keep any data on contributions or CESG).

Book Review: The Clean Tech Revolution by Ron Pernick and Clint Wilder

A compilation of facts on the technologies and companies in solar energy, wind power, biofuels, biomaterials, green buildings, efficient personal transportation, smart electrical grid, mobile technology, water filtration. Useful to an investor as a starting point to know what to research but the book provides little analytical insight. Dull reading. Two out of five stars.

Book Review: Are You a Stock or a Bond? by Moshe Milevsky

The top financial concern about retirement is not to run out of money. How can that be achieved? That's the question addressed in this book.

Author Moshe Milevsky, a finance prof at York University and one of the world's leading experts on pensions, insurance, and personal financial planning, has distilled the latest research and principles into a readable, non-technical guide for the proper way to select and balance financial products to achieve financial security.

His starting point is the demonstration that the person him/herself is the most important financial asset (You Inc) by far at the start of a working career due to the many years of salary ahead, which he terms human capital. I had a laugh at the You Inc analogy as he spun it out: "You Inc. will eventually consider merger opportunities, otherwise known as marriage. Marriage is the largest merger and acquisitions activity undertaken by You Inc. and may occur more than once." This light-hearted depiction leads to the quite serious demonstration that life insurance may be a highly worthwhile risk mitigation financial product when a lot rides on You Inc's human capital. He discusses the odds of living or dying at various ages and rules of thumb to decide whether life insurance is advisable or not and if so, how much is needed.

He covers in turn the importance of diversification, both across asset classes and internationally as a risk reduction method, He explains how non- or negative correlation are the mechanism that makes diversification work and extends that idea to You Inc by saying that people should think how their own human capital/job is linked to investment asset classes. Had I considered this ten years ago I would not have invested in shares of Nortel when I worked there - when the tech bubble burst my job loss was highly correlated with investment losses!

Milevsky's advice gets further from popular concepts when he looks at debt and concludes that debt in retirement is NOT necessarily bad. It may be good if it is used for investment where the return is greater than the cost of borrowing and where the borrower can withstand financial shocks and still pay the interest i.e. if you have the stable characteristics of a bond. He says a tenured professor such as himself at age 45 should have a 280% allocation to equity (i.e. have borrowed the amount over 100%) because he is a triple A bond. Along the way he trashes a common rule of thumb: "the age-old general rule that you should allocate your numerical value to bonds - or 100 minus your age value to stocks - is somewhat meaningless at best, and wrong at worst."

Three chapters are devoted to each of what he says are the key risks to financial security in retirement: inflation, longevity and sequence of investment returns (which is having a series of bad years near or at the beginning of retirement). Here again he debunks with a detailed example a common idea - the notion that one can best counter sequence of return risk by setting aside several years of cash to live off (what he calls the buckets approach) instead of maintaining a constant portfolio asset allocation. The failing of the buckets approach is that it does not withstand a prolonged bear market. One is reminded of the famous quote of John Maynard Keynes "The market can stay irrational longer than you can stay solvent." Irrationality can work both ways, optimistic or pessimistic.

When it comes to the latter chapters where he develops integrative solutions that consider all the risks and factors together, he proposes a unique and innovative way of calculating whether one is likely to run out of money given a spending rate (e.g. 5% of portfolio withdrawn each year) and investment assumptions (rate of return and volatility). Instead of the usual Monte Carlo simulation he has developed two equations, alpha and beta, that use the aforementioned inputs, along with median remaining lifespan (how long half the people your age will live according to mortaility statistics) to create a cross-table with varying probabilities of success.

Using a simple bond and stock portfolio, Milevsky performs other calculations that show that the optimal asset allocation whether a person is 55, 65 or even 75 is about 60 to 70% equity. He explains this as the result of the higher long term rate of return on equities more than counter-acting their high short-term volatility.

The concluding chapters present the essential characteristics of annuities and show how to combine them with an investment portfolio to control the three retirement risks. He differentiates standard (not inflation-indexed) lifetime payout income annuities (LIPA) from those which provide riders for a guaranteed withdrawal benefit (GMWB) or a guaranteed income benefit (GMIB). The final bits of integration include retirement goals: liquidity for unforeseen expenses, estate bequests and prevention of behavioural mistakes (i.e. if you have an annuity you are locked in and cannot mess things up but if you have a portfolio it is easy to make all those investing errors of judgement).

Not so much a final answer as a way of thinking about things, this book broadens one's perspective to a holistic view of assets with financial value. It provides invaluable insight and tools for an individual to understand how to cope with various financial risks throughout life.

The final table in the book, table 11.2 is a chilling assessment of the amount of financial wealth required to sustain an income level when guaranteed government pensions and/or private defined benefit plans will only provide a small portion of the needs. Planning to withdraw from a portfolio at a 5% annual rate or even a 4% rate, which is that most commonly cited as providing indefinite sustainability, still means in his opinion that one should buy a substantial amount of annuities to protect against longevity and sequence of returns risk.

Quibbles:

• the USA is used as the context throughout, with references to US inflation and mortality statistics, US market returns, US retirement plans like 401k and IRA; Milevsky is a Canadian teaching at York University and he uses a lot of the research he and others have conducted at the IFID center in Toronto (where if you wish to do so you can obtain most if not all this book's content for free download, though it is not organized and structured with the convenience of the book); admittedly such references are not material to the principles he expounds in the box since,
• tax optimization is not considered (he deliberately and explicitly sets it aside) - after-tax returns, which is what a retiree investor cares about, may differ greatly with the same investment portfolio size; whether income comes from a tax-deferred account like RRSPs and LIRAs or is tax-advantaged like dividend income, matters a lot. $5000 of interest pulled from an RRSP taxed at a marginal 30% rate is only $3500 in spending, while $5000 in dividends in a taxable account to a taxpayer in the same 30% bracket in Ontario pays about 7% tax, resulting in $4650 available to spend. That's why this book's contribution is not a final answer but a useful set of principles.
• asset classes are ultra-simplified to "cash (US T-bills), stocks (US S&P 500) and bonds (US aggregate)" from which is taken the investment portfolio assumption used throughout - stocks give off 7% average (arithmetic mean) annual return with 20% volatility; the beneficial effects of further diversification with real estate, international equities and bonds, commodities, real return bonds are not examined.
• high spending rate assumptions; everywhere the book uses high spending rates in retirement from 5 to 9%; it would be helpful to have shown the 4% rate in the sustainability tables on pages 135-6. As it turns out there is such analysis in Milevsky's 2007 paper A Gentle Guide to the Calculus of Sustainable Income on the QWeMA website. QWeMA is the company set up and headed by Milevsky to market his research ideas and turn them into tools for insurance and investment companies. This led me to the Manulife Retirement Solutions Center where the Milevsky's ideas are being put into practice to inform advisors with a variety of video clips and short background information (it is telling that this simplified information is prepared for financial advisors!). It features a free to use online product allocation tool where you can plug in your own numbers, fill-in budgeting worksheets and a retirement savings calculator whose results you can print. They even use Canadian facts and figures.
• sensitivity analysis is not performed; since one cannot know if the future will repeat the past in financial markets, the section on the effect of asset allocation on sustainability of spending rates would be more convincing if various return and volatility scenarios showed the same result. The Gentle Guide paper provides such data in tables 3 and 4 showing how dramatically a reduction of volatility can reduce chances of ruin - with 23 years of retirement ahead at a 7% expected portfolio return, the chances of ruin fall from 15.1% to 3.0% which seems to suggest that one's problem can be solved by diversification ... but the same table shows that if returns disappoint for the whole period at only 5%, the likelihood of ruin only falls from 27.5% to 8.8%, which is only on the edge of safety as far as I am concerned. The numerical assumptions are critical! One cannot merely trust the past averages to repeat themselves.
  
• the product allocation algorithm is not revealed and is proprietary (to QWeMA) - what is the magic and art being concealed one wonders
• preservation of human capital aka working part-time in retirement should form an active part of retirement financial planning. One doesn't suddenly go brain dead and become physically incapable the day after pulling the plug on full-time employment. It was instructive to learn from my daughter the new doctor that some recently retired physicians decided to mitigate the recent bad sequence of returns of the financial crisis by going back back to work temporarily doing locums. The book mentions the possibility of prolonging work but doesn't analyze the effects. Every dollar earned saves a dollar coming out of a retirement portfolio, in effect reducing the withdrawal rate, which much prolongs a portfolio's sustainability.
• cutting back on spending is a very effective wealth preservation method and when it comes down to the crunch, a lot of spending that is deemed necessary becomes discretionary. That's why few people actually ever run out of money, they just keep downsizing their lives.
• yearly iterations and repeated re-consideration of plans is not discussed, yet circumstances will change. Retirement finances shouldn't be done as a one-time forever decision. Optimal product allocations may shift back and forth.
  

Milevsky also mentions a few other topics he feels should be included in a complete financial plan:

• consideration of life insurance for maximizing a estate value
  
• use of home equity loans or reverse mortgages as another "product"
• long term care insurance to control risk from health
  

The bottom line is that this book helps you figure out whether you are in the "no hope", the "no worries" or the "no guarantees" zone of retirement sustainability. If it is the latter, I am convinced by the book that annuities should form part of a financial arrangement for retirement.

Read this book if you want, as you should in my opinion, to take any hand in planning and constructing your financial future as you enter retirement. Its short 200 pages are rich in high-value, well-explained, well-illustrated content.

Despite my extensive quibbles, some of which (taxes, sensitivity analysis on assumptions) I think are quite important to constructing an actual plan, this book sets out such important and powerful principles that I have to give it my highest rating, five out of five stars.

Is Claymore Being Sneaky about Showing Fees on Its ETFs?

In looking through Claymore Canada's website, one comes across the curious fact that there seem to be two sets of numbers for the management expenses of the various ETFs.

The first number is the one visible on the website's description for each fund, e.g. the Canadian Fundamental Value Index Fund (TSX: CRQ) says the fund's "Management Fees" are 0.65%. (The other fundamental equity index funds - International, US and Japan have the same annual fee.)

The second number appears on page 19 in the Prospectus. CRQ in 2008 had a "Management Expense Ratio" (MER) of 0.70% in 2008 and 0.69% in 2007.

The difference between the Management Fee and the MER is not directly explained but it seems to be that the MER also includes other costs (i.e. MER = Management Fee + Other Expenses). Page 18 of the Prospectus says such expenses come directly out of the fund and they include: "... expenses related to the implementation and on-going operation of an independent review committee under NI 81-107, brokerage expenses and commissions, income taxes and withholding taxes, transaction costs incurred by the Custodian and extraordinary expenses."

Maybe there is a cap on fees to limit what comes out of the fund, which is what it actually costs a Claymore investor, but I could not find this stated anywhere in the Prospectus. It is the MER that counts to the investor and Claymore should post the MER front and center on the ETF's webpage. Better yet, they should do as iShares does (see the iShares Prospectus e.g. page 23 last paragraph) and simply cap the fees.

The danger of Claymore's approach is the confusion evident over at Morningstar, where the CRQ Management Fee has been relabelled the MER).

The same problem applies to the other Fundamental Equity Funds:

• Japan - 2008 MER 0.80% vs Management Fee 0.65%
  
• US (Hedged) - 2008 MER 0.82% vs Management Fee 0.65%

Then there is a strange one

• International (TSX: CIE) - 2008 MER 0.56% ... but Claymore charges 0.65%? Huh? How can it be that the investor pays less than the Management Fee charged, which doesn't even include all expenses?

It doesn't seem to be a typo since the 2007 MER was 0.53%. Maybe it is due to the use of derivatives to substitute for directly investing in the 1000 companies of the target index. The fund is tiny at about $51 million in assets so could not hope to buy 1000 different stocks. Maybe it has to do with the fact that the two main holdings of CIE are the Claymore Japan and Canada ETFs. Dunno, any theories would be welcome.

Update ... on page 36 of the Prospectus, Claymore says that when funds like CIE hold other Claymore ETFs within them, it is bound by securities regulations not charge management fees twice. If they excluded the fees charged within the Japan and Canada funds - about a quarter of the holdings - from the calculation of CIE's expenses, that would lower CIE's fees by about a quarter. Adding back that missing quarter (0.56%/0.75 = 0.74%) would bring CIE's MER up to around the same level as the other funds.