Selecting the Bond ETF(s) and Why Bonds instead of Cash

A reader sent in a couple of excellent questions on the practical aspects of setting up the bond portion of a portfolio:

1. which Canadian bond ETF to buy for a portfolio - the iShares Short-Term Fund (Ticker: XSB), or the iShares Canadian Universe Fund (all issuers and maturities; under ticker: XBB), or possibly other funds
   
2. why buy any bond fund if cash in ETrade is paying a healthy 4.15%?

To start a portfolio, I would favour XBB since it covers the whole Canadian bond market. Buying and holding the market is one of the fundamental principles of passive index investing. If one were to buy only XSB, that cuts out a substantial portion of the bond market.

The attached chart, using data from the iShares Canada website on December 6, illustrates more key differences between XBB and XSB:

• long term, the performance of XBB will be superior - note the five year return of 5.89% vs 4.37% (these figures are for the reference index that the fund attempts to track; the tracking error shows how much the ETF deviates from the index); Since XBB holds some long term bonds, it has a longer duration (see here for an explanation of bond duration as opposed to the term to maturity), which means more sensitivity to interest rate changes and more volatility, but which also provides greater yields in the long term.
• XBB's tracking error is a little more than XSB's, partly a reflection of the 0.05% higher MER on XBB
• currently, the yield difference is much slimmer than the long term averages for different maturity funds
• XBB has some of its distributions in the form of capital gains (cf 2005 and 2004), which benefits from a lower tax rate if held outside an RRSP or other registered account
• XLB has a much higher longer term performance, as shown by the results of the index it tracks
  

Note also that TD CanadaTrust also offers a mutual fund - the TD e-Series Cdn Bond Index - that tracks the same whole of market Scotia Capital Universe Bond Index as XBB. The TD fund has a higher MER of 0.48%, which almost certainly results in lower net returns than XBB. However, being a mutual fund, it charges no commissions, so if regular purchases of small amounts in a building up phase of a portfolio are taking place, it may be a better choice (e.g. the 0.15% extra MER is about the same as a $10 trading commission on a $6666 purchase of an ETF) . The other caveat is that one must have an account with TD to buy that fund.

I would note in passing that other commentators like Efficient Markets Canada and Investor Solutions, seem to be saying that short bonds / XSB are a permanently better choice because of the return to risk/volatility relationship - i.e. that long term bonds are too volatile for the small extra return. Perhaps at a moment in time, or for a specific time period, the relationship may be out of whack, but finance theory and research say that they will get realigned. There are bubbles and anomalies in the markets but they get eliminated.

Another point to consider is that just as the equity portion of a portfolio is better off with holdings beyond the Canadian market, so too is it for bonds. The next stop is likely the addition of a US fund. Major ETFs available to Canadians through US markets include BND, the Vanguard whole of US market bond fund and AGG, the iShares Lehman Aggregate Fund. There don't yet appear to be any international bond index ETFs, which would be good for even wider diversification. The Google spreadsheet at the bottom of my blog shows how I have structured my portfolio - instead of my bond ladder, just substitute XBB.

As of today, the minimal difference between the yields on cash and short, medium or long term bonds suggests that it may be just as well temporarily to hold the cash. Sooner or later larger rising differences for longer maturities will re-establish itself. ETrade's fine print does state that the interest rate can change anytime, which means having to monitor it and the funds to decide when to make the shift into the bonds. Incidentally, the ETrade folks said to me in a phone call that cash balances are protected for up to $1 million by the Canadian Investor Protection Fund.

Bonds and cash can provide a highly beneficial diversification effect in a portfolio with equities; through being un- or sometimes negatively-correlated with equities, they can increase returns and lower volatility at the same time. This surprising result has been documented and explained in such fine books as Roger Gibson's Asset Allocation and Richard Ferri's All About Asset Allocation, which I have reviewed previously.

Book Review: The New Investment Frontier III by Howard Atkinson

This is the 3rd edition of Howard Atkinson's book on Exchange Traded Funds. The fact that a 3rd edition was published in 2005, following so quickly on the first edition of 2001 and the second in 2003, reflects the enormous growth and success of ETFs as a new investment vehicle. There's a good reason for that success and Atkinson, with writing assistance from financial journalist Donna Green, explains the what, who, why and how of ETFs with much practical detail, balance and thoroughness. This book is a detailed compendium of ETFs, tailored for Canadians through the inclusion of a great deal of pertinent and useful Canadian tax information, probably everything an individual investor could need or want to know.

The thorough treatment is accorded not just to the tax implications. The same completeness characterizes the rest of the book. The book begins with a brief explanation of what ETFs are and why index investing makes sense, why passive index ETFs offer better returns than actively managed mutual funds and even index mutual funds. It does a lot of comparison to mutual funds, especially useful since that is the alternative for most investors, and shows how ETFs are more tax efficient and lower cost than mutual funds. He demonstrates the tremendous negative effects that higher costs have on an investor's net return returns over the long run. The balance I mentioned above is evident in this section since Atkinson lists such advantages as mutual funds do have over ETFs - namely ability to invest small amounts on a regular basis, automatic dividend reinvestment, no trading commissions on purchases or sales (the term commissions excludes the onerous and pernicious deferred sales charges on many mutual funds) and the availability to obtain certificates to be able to use the fund holding as collateral. There is lots of explanation and discussion of the merits of different indexes that many ETFs track, very handy for making informed decisions about one's asset allocation choices.

Atkinson throughout the book names products, ticker symbols and companies, giving references and copious weblinks; it's a very practical book. Probably, it would be possible to amass through the Internet all the same information that's in this book. However, it would take a huge amount of time and effort. Some of the more arcane detail in the book - things like the effect of trading by institutional investors - comes from Atkinson's position as an industry insider. He works for, or did at the time of publication at least, Barclays Global Investors Canada, which offers many of the leading ETF products. However, it is worth saying that the book does not read like an infomercial for Barclays - all the competing ETFs and companies with their various flavours are reviewed in a factual manner.

One area in which I find Atkinson goes a bit over the top is the discussion of how ETFs are perfect for doing tilts, style weightings, sector rotations in a portfolio termed the Core and Satellite (pages 93 to 122) and then how ETFs can support those who like to do technical analysis (page 123). I think Atkinson knows better since he includes a note of caution that says those tactics really amount to market timing and he has put forth the evidence right at the beginning of the book of the book that market timing doesn't work. Just because ETFs can be (mis)used that way doesn't mean he should tell everyone how to misuse them. He even quotes John Bogle, founder of Vanguard Group, saying that ETFs are like giving investors a loaded shotgun. Yes, indeed! This part of the book is the explanation of how the shotgun can be used, instead of for hunting geese, ducks, or partridge, as it was designed to do, for blowing off your own financial foot. Effectiveness isn't always the test of whether you should be doing something. Atkinson isn't completely wrong - there are two tilts, justified by proper peer-reviewed financial research, that produce greater risk-adjusted returns. These are small capitalization and value (as defined by price/book value only) companies/equities, known as the Fama and French Three Factor Model (see this Wikipedia entry for a brief explanation and link to the scholarly research article). There may other tilts and it is possible that they are beneficial but they remain to be proven so the average investor is best to stay away.

The chapter on using ETFs with a financial advisor provides an excellent introduction to the alternative types of fee arrangements that are possible. It shows how ETFs enable a convergence of interests of the advisor who charges fees (instead of collecting commissions and trailer fees from fund companies) and of the investor. The fee-based relationship with ETF investments can save the investor money compared to mutual funds and provide more comprehensive advice to boot. This happy result is illustrated and explained with real examples of advisers citing hard numbers. Atkinson, however, says forthrightly that for total holdings of under $100,000 the investor is better off with a DIY approach or simply the famous Couch Potato Portfolio.

Quotes

• ''... some active managers do beat the market, sometimes even after costs, but the trick is to find them before they do it.'' before, not after, is indeed the key; manager out-performance does not typically last so you cannot reliably use the past good performance to pick the future winners
• ''The more you pay in management fees and expenses, the less you get in returns. Period. Always scrutinize MERs.''
• ''The capital gains distribution and consolidation confuses many investors and advisors.'' investors, ok, but advisers too? ... a good example arguing for mandatory formal training for advisers, n'est-ce pas?
  

The biggest negative of this book results from the passage of time and the inevitable hazard that information has become dated. The explosion of ETFs and similar new products such as Exchange Traded Notes (ETNs) has continued unabated. Of particular note to Canadian investors are:

• the exit of TD Asset Management from ETFs in March 2006 and replacement by the e-Series index mutual funds (which make a reasonable alternative to ETFs for investors with smaller portfolios)
• the entry of Claymore Investments Inc in September 2006 with a variety of rules-based such as fundamental weighted indices

My thanks to Mike at the publisher Insomniac Press for providing a free copy of the book to review.

I look forward to version four of this very useful book. Four and a half out of five stars.

You can buy it at Chapters.ca.

A Starter Diversified Index Portfolio for Canadians

One of my relatives recently asked what an example "starter" portfolio would look like based on the same principles of diversified passive index investing that I tried to use for my own. Here's my answer. First, my definition of "starter" is:

• any investment amount up to $25k or thereabouts;
• investor with lesser knowledge of investing and taxes and perhaps less interest too.

Such a definition does not indicate any particular risk-aversion stance, i.e. how conservative or aggressive it should be. In other words, the degree of risk would and should be decided independently based on different factors. Just for the sake of comparison with my own decision on the amount of riskiness and volatility, I'll use the 30% fixed income, 70% equity ratio. The idea of once-yearly rebalancing the portfolio back to the target percentage amounts also applies the same to this as any much larger portfolio. For other levels of risk acceptance, simply use different percentages of the same funds.

Click on the image to see the portfolio. It has these characteristics for these reasons:
1) only five holdings in total - this is to have large enough amounts in each holding to make it likely there will be something worth rebalancing in a year and to make it simpler and easier to do the rebalancing.
2) the five holdings give the maximum amount of diversification / low- or non-correlation base on what I've seen and read. Especially significant is the XRE for real estate, the asset class that seems to offer the most extreme negative correlation with other equities and thus the most diversification effect, the highly desirable quality passive portfolio investors seek.
3) use of TD e-Series mutual funds instead of Exchange Traded Funds (ETFs) because the benefit of slightly higher MERs (e.g. the TD MER of 0.31 vs iShare Canada's XIU's 0.17%) will be more than offset by trading fees in a year when rebalancing takes place (I assume that at a discount broker it will cost $25 per trade so a two-trade rebalancing of one sell and one buy at $50 would compare to 0.14% of $7500=$10.50 in extra MER for the Canadian holding). On top of that, as I've noted before, tax tracking is easier with mutual funds. And adding new money to the portfolio is much cheaper with mutual funds as no trade is required. TD's funds take as little as $100 for additonal contributions. Hopefully a small portfolio will be on the growth path with new money being added.
4) the US holding is the currency-hedged version while the international holding is not, because it seems to me that the multi-decade currency shifts of the US$ vs Canada$ have been large and can drastically negatively affect portfolio returns despite what the US stock market may actually do ... who is ready to predict and stake their financial future on the Canadian dollar either staying the same or depreciating vs the US$ from now on? To me, that's a too-severe and too-concentrated risk. On the other hand, the international holding is not currency-hedged, despite the availability of a hedged version, because the large number of countries and currencies spreads the effect much more and therefore lessens the chance of negative consequences. In addition, I have read material that says Canadian equity investors can benefit from foreign currency exposure so it seems to have positive support for that position as well. If any can point to serious number crunching studies that address the issue of currency risk please tell me as it is an area of doubt for sure. Yet one cannot sit on the fence till the perfect answer is available, huh? So I'm giving it my best guess.

What would come next as an addition to the portfolio? Probably a small cap equity holding, as a diversification and higher expected return asset, which would involve something like US small cap ETFs iShares Canada's currency hedged XSU or Vanguard's VBR, a small cap value ETF, or perhaps the new iShares Canadian small cap ETF XCS.

One negative of the TD e-Series funds is that they are a tied product and can only be purchased through TD Asset Management or TD Waterhouse and only on-line. That may not be convenient for everyone.

Other simple portfolios I have come across include those of Efficient Market Canada and Shakespeare, so take your pick.

That's it. What do folks out there think?