Cap-Weight vs Fundamental Portfolio after 3 Years (July 2013) - Tight Race Continues

Three years after launching in June 2010 a realistic portfolio simulation (which includes trading commissions, actual prices, distributions, foreign exchange fees for converting CAD vs USD) of traditional cap-weighted ETFs pitted against fundamental factor-weighted ETFs, the race continues to be very close.

Neck and neck contest - tiny differences in total portfolio value
2010 Year-end - dead heat: 0.1% difference
2011 August - cap-weight slight lead by 0.6%
2012 March - dead heat, 0.07% difference
2013 August 7 - fundamental slight lead by 0.6%

There isn't a huge divergence in any asset class either, the largest gap being the 10% ($500) advantage of PDN over EFV in the small- to mid-cap developed markets holding.

First ever portfolio rebalancing
For the first time in three years, some of the asset classes finally exceeded the policy limit set at portfolio creation that rebalancing should occur when any asset class strays more than a quarter from its allocation. The strong performance of the US equity market and the weakness of emerging markets and bond market caused a big enough imbalance to exceed the threshold in both portfolios. It was a good time in any case to invest the accumulating cash balances.

Perhaps counter-intuitively to some, the portfolio rebalance policy is obliging sale of recent winners US equities (PRF & PRFZ and VV & VBR) and purchase of losers bonds (XBB and ZRR), emerging markets (PDN and EFV) and commodities (UCI).

Solid performance by both - up about 26% in total over the three years, or 8% per year compounded. That may be the biggest lesson of this exercise - a diversified portfolio works well.

The current market value of holdings in the two portfolios is shown in the spreadsheet at the bottom of this blog page. Between updates like this one, which I do every six months or so, the monthly distributions are not reflected in the portfolio cash holdings so the total portfolio value may be slightly under-stated for both. The spreadsheet is still a pretty good reflection of the current status of the contest since the distributions of the two portfolios are quite similar i.e. the current market price of the ETFs creates most of the difference.

The Benefits and Imperfections of Asset Class Investing

What's Wrong with Judging Investment Performance with an Index
One of my pet peeves is articles about investment performance based on the price variation of indexes such as the TSX, the Dow or the S&P 500. Unfortunately they do not reflect real world individual investor experience. Though it is possible to buy ETFs or mutual funds whose objective is to track an index, such things as trading costs / commissions, tracking error, bid-ask spreads and distributions can cause actual results to vary from the index.

Another thing I find annoying is that people often limit themselves to indexes for only two asset classes - stocks and bonds. We've all seen the classic 40% bonds, 60% stocks. There are a lot more asset classes out there with which to diversify, like real estate (REITs), real return bonds, foreign developed or emerging market equities (which introduce the issue of currency hedging), small and value cap tilts, commodities. Current theory says we should take advantage to maximize diversification and the ETFs are there to allow the average investor to do that, so why not model it?

Another issue of note is whether and when to rebalance a portfolio. Would a policy of reviewing the portfolio every December, and rebalancing if too much out of sync with target allocations, have done better than simply buying and holding?

Finally, the recent (on-going?) financial crisis and market crash provides a real high stress period in which to see how various realistic portfolios fared.

Assumptions: So, I've done some calculations in as realistic a way as possible. I started with $100,000 in May 2007 before the troubles really began and took it to the close last Friday, September 11, 2009. The portfolio is split 70% equity, 30% fixed income, with finer sub-divisions of both for the 4- and 16-asset portfolios. I used passive index ETFs available on US exchanges and the TSX.

The USD-CAD exchange rate I've used is based on the mid-market closing rate, which I've adjusted for the initial purchases by adding 1% to approximate the foreign exchange fee embedded in Canadian broker rates. At the Dec.17, 2008 rebalancing date, I have not adjusted for FX since almost all of the FX fee could be avoided by doing wash trades offered by most brokers and/or keeping the USD distributions in a USD account when received, as all brokers allow for non-registered accounts and some do for registered accounts. Also I have not deducted any US withholding tax from the US ETF distributions, which is ok for ETFs held in registered accounts but not in a TFSA or a non-reg account. So that assumption might slightly overstate returns depending on the account in which a portfolio is held.

As to rebalancing, I modeled none in Decmeber 2007 because the ETFs had not strayed far from their May target percentage allocations. Ths cash distributions were merely accumulated in the account. I ignored interest on the cash since it would have been too little to matter. ... all this stuff about my assumptions shows why so many people don't like taking the trouble to do realistic calculations - it's painstaking!

Results:

• big surprise, the simplest portfolio, consisting of only the iShares S&P/TSX 60 Index (XIU) and the iShares ScotiaCapital DEX Bond Index (XBB) fared best in every way!! It dropped the least to the review point of Dec.17, 2008 and has recovered almost fully (less than 1% below) to the starting value. That's why I've named it the "KISS Me Quick" portfolio - It has treated you well - who doesn't like a kiss!? It's KISS = Keep It Simple Stupid and it sure is quick to implement.
• big surprise again, the more diversified the portfolio, the worse the results! Huh, I though diversification was supposed to help, but whether or not the strategy was buy-and-hold or rebalancing, the fancy 16 asset portfolio did worst: it dropped the most and has receovered the least. That's why it's called the "Diversification Guru" - we all know what gurus are really worth.
• wow, rebalancing really worked well. In the short time since last December, all three rebalanced portfolios have outdone the buy-and-hold approach by anywhere from 7% to 9%.
• no surprise, diversification by holding fixed income is a lot better than just equities; if only XIU had been in the portfolio, there would have been a 31% drop in value, even including distributions. That's much worse than the 22% fall of even the worst portfolio, the 16-asset version. And XIU as of Sept.11th was still 14% below its initial value of May, 2007. The strong recovery of XIU has not made up the ground lost up to December. The reason is that no rebalancing occurred, as it could not with a single asset.

Why More Diversification Didn't Work

• real estate and foreign markets - some of the extra asset classes fell harder than Canada's; the UK's banks made up a bigger chunk of the FTSE index and they had just as much trouble as US banks
  
• currency shifts - up to last December, the CAD's big drop relative to USD as the flight to safety occurred cushioned some of the blow of drastically falling stock markets but since then the strength of CAD (check all the blue appreciation of the last 3 months at RatesFX) has limited the upside.

Further Thoughts:

• the future may not be like the past - this time and in this relatively short period, it was bonds, particularly government bonds, that provided the critical diversification benefit. Safety of principal was the issue. That may not be the case if inflation for instance, is the next big threat. In an uncertain world, different assets for different threats is still my best guess at what will allow me to survive if not thrive quite as much as the strategy which has worked best in retrospect.
  

Portfolio Heavyweights Square Off on Commodities

The battle is joined. Should commodities figure in a portfolio? It is to be expected that there be a big division and difference of opinion between investors with an active strategy trying to beat the market and those with a passive, market index allocation strategy. But commodities seem to be controversial even amongst the passive index asset allocation crowd, in which I count myself.

Pro Commodity
Main proponent: Larry Swedroe, best-selling author and principal of Buckingham Asset Management
Arguments: collateralized commodity future funds provide positive return, that is negatively correlated with both stocks and bonds (i.e. a strong diversification benefit), as well as protection for unexpected inflation, which together are excellent portfolio insurance

Anti Commodity
Main proponents: Rick Ferri, author of several "All About ..." books, and head of Portfolio Solutions LLC investment advisors and managers; William Bernstein, author of The Intelligent Asset Allocator and The Four Pillars of Investing amongst others; Kenneth French, renowned finance prof and researcher.
Arguments: commodities have no real expected return net of inflation and the backtested returns on various commodities indexes are essentially trading strategies, not passive market investments in an index, whose future success in uncertain

The Debate:
Rick Ferri and Larry Swedroe go head to head in a discussion hosted by Hard Assets - The Great Commodities Debate part 1 and part 2
Kenneth French video interview on Yahoo Finance Why Investors Shouldn't Own Commodities
William Bernstein writes on his Efficient Frontier website "On Stuff"
Dimensional Fund Advisors quotes paper by Truman Clark on their website

The Research
Hard Assets Investor lists a half dozen seminal papers on the Hard Assets University page - see the Grad School section which links to free downloads from SSRN. Must read: The Tactical and Strategic Value of Commodity Futures by Claude Erb and Campbell, 2006, which everyone seems to quote. It's almost a book at 61 pages but a very worthwhile couple of hours of slow reading. Around pages 39-40 there is a great general explanation of the beneficial effects of negative correlation, variance and number of securities interacting with regular rebalancing in a portfolio. HAI also has useful primers, interviews, current news.

My Take
Despite his being outnumbered, my reading of Erb and Campbell tells me that I believe more Swedroe's conclusion. Commodity ETFs/ETNs do depart from the purist passive asset allocator model, being essentially active portfolio strategies based on futures (i.e. derivatives) but there is good reason to believe that the diversification return of around 3% will continue and the powerful portfolio risk reduction effect from (most of the time) negative correlation makes them worthwhile. I don't believe in the inflation protection benefit. An allocation of about 5% of my portfolio seems reasonable. So I'm sticking with my holding of DJP, the iPath Dow Jones-UBS Commodity Index Total Return ETN (recently renamed, replacing the AIG reference in the name with UBS).

The Truman Clark paper cited by Dimensional, which seems to have no visibility (or credibility?) amongst the other researchers on commodities, being cited by none of them, seems too impossible to believe - how could there be no reduction in portfolio standard deviation, as it concludes, when negatively correlated commodity assets are added? It seems to be a mathematical impossibility the way covariance works.

Another Advocate of Infrequent Portfolio Rebalancing

For those who believe in an asset allocation investment approach with periodic rebalancing back to target percentages, here's more evidence that less often, specifically only every four years or so, is better. I've discovered that financial planner and author Jim Otar had independently reached the same conclusion as academic researchers David Smith and William Desormeau, whose findings I had written about in December in My Rebalancing Policy Refined. Otar used US data and found that rebalancing every four years produced better results in a retirement portfolio - see his paper Optimizing Rebalancing in Retirement Portfolios. Otar found that rebalancing only every four years, as opposed to once a year, was especially important in secular bull or bear markets, in either maximizing the upward benefit of multiple years of good returns, or in minimizing the downward losses in the other directions. The latter effect was critical in helping to avoid what retirees fear most - running out of money before death.

Otar based his four-year cycle on the US Presidential cycle, doing the rebalancing at the completion of each cycle. The Smith and Desormeau article did not study the US Presidential cycle but it did look at the Federal Reserve Monetary Policy as reflective of expansion and contraction of the business cycle and found that coordinating rebalancing with changes in Fed policy (i.e. whether it goes from rate hikes to cuts or vice versa) produced the best results. Do Fed policy changes correspond to the US Presidential cycle and therefore the two sets of research are just expressing the same forces at work? Whatever that answer, both researchers say four-year long waits between rebalancing is better and it appears the reason is that one is therefore able to take advantage of multi-year bull markets or minimize the damage of bear markets.

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?

My Rebalancing Policy Refined

Readers of this blog may remember (well, you can be forgiven if you don't, I had to look it up myself) that in May I described a wholesale reworking of my portfolio including how and when to rebalance holdings back to a target asset allocation within the total portfolio. My best available information at the time was Richard Ferri's book All About Asset Allocation, so my rebalancing method was based on his recommendations. Then I came across a great article by David M. Smith and William Desormeau on the topic through a posting on Larry MacDonald's blog and wrote about the surprising findings. As a result I've decided to refine my policy on rebalancing.

The New Policy:

• review portfolio actual market value vs target allocation ( target = the percentage each holding is to have within the total portfolio) once a year in December
• purchase or sell holdings required to rebalance to target percentage of total portfolio if total bonds (funds and ladder combined) vs equities has moved more than 5% away from target; currently my bond target is 30%, so if bonds go up to 35% or down to 25% (the corresponding numbers for equities - all of them, domestic, foreign, real estate, commodities - is 70% up to 75% or down to 65%)
• rebalance only those holdings where the transaction cost is less than 1%, currently that would be a trade of $1000 since my transaction cost is $9.95 or where a tax loss selling opportunity in the taxable account makes a trade worthwhile

The new elements are highlighted in italic.

Why the Changes?

• the move to doing the review in December is to do it at the same time as tax loss selling, to kill two birds with one stone and to minimize trading;
  
• the 5% or more deviation test is the major change, coming directly from the findings of the article; though I could have simply eliminated the yearly review and applied the 5% test at any time throughout the year, I still want to do an annual review of my portfolio, my net worth, the tax situation, decisions about RRSP conversions or withdrawals, perhaps a fundamental alteration of the portfolio targets (which is not the same as rebalancing). In the practical world, rebalancing has to contend with, and fit with, lots of other ofttimes more powerful financial forces;
• tax loss selling on its own may justify a trade, so the opportunity to rebalance fits naturally.
  

Incidentally, one thing I have seen mentioned as a problem to do rebalancing based on percentages is one no longer. Formerly, it would have been a lot of work to constantly track a portfolio and actual vs target percentages but that is no longer an issue. Google's wonderful online spreadsheet with constantly updated market values for the holdings, including a good-enough kludge to calculate the foreign exchange component, does it for you. I have placed a Google spreadsheet at the bottom of this blog that replicates my portfolio structure and tells me at any given minute-hour-day the portfolio value and target vs actual percentages so I can see where I have gains or losses and how much they are (I have to apply a multiplication factor to convert the model into my own total but that's not too difficult).

What I Still Wonder About
Unlike the researchers' model portfolio of two holdings - stocks and bonds - my real portfolio contains 16 different holdings (more, if my bond ladder is broken down). Most are quite small - 5% or less; only three are 10% or more (see the Asset Allocation tab in the Google spreadsheet). Several, especially REITs and commodities, are supposed to be volatility reducing with very low or negative correlation to the mainstream equity holdings. It means they are likely to go up while the mainstream equities go down. So, the question is when or if to rebalance in the case that the overall equity total is within the 5% limit (i.e. it says don't do rebalancing at all) but one of the minor holdings has doubled for instance. I don't want to be arbitrary to go back to the days of doing things by "feel" so I need a rule and a good reason for that rule. Perhaps I need not worry, though. Seven months after my portfolio revamp, the most any individual holding has strayed from its target is Vanguard's European Equity (VGK), down only 1.2% despite being hammered by the rising Canadian dollar, which has been almost as strong against Sterling as against the US dollar.

Rethinking Rebalancing Policy: Is the Rip Van Winkle Model the Best?

Rip Van Winkle is the fictional character who goes to sleep one day and wakes up twenty years later to discover that his principal problem in life - his wife - has died and he can now live an indolent life in peace. Is a similar approach the best for investors who use a portfolio approach?

Larry Macdonald has noted in his blog posting titled "No need for annual rebalancing" on Dec.3, 2007 a fascinating and shocking study "Optimal Rebalancing Frequency for Bond/Stock Portfolios" by David M. Smith and William Desormeau in the November 2006 Financial Planning Journal that seems to suggest an "almost never" approach is best. They studied the two popular approaches to rebalancing: at regular intervals (monthly, quarterly, yearly etc), or based on percentage deviation of asset values from the target (1%, 5%, 10% etc). They did this for a wide range of bond vs stock portfolio proportions using US data for the long period of 1926 to 2003.

Their conclusions are these:

"Rebalancing frequency and threshold level are associated with significant differences in portfolio scaled returns. We show that this is true across a wide range of policy weights. From the perspective of both frequency and threshold levels, patient rebalancing policies tend to dominate quick-trigger policies, even before trading costs and taxes are considered. If such costs were taken into account, the advantage in favor of patient policies would be even more dramatic."

Scaled returns means returns that take account of returns relative to risk. Policy weights means the bond vs stock mixes. The threshold means that if bonds are meant to be 40% of the portfolio and the threshold is 10%, then rebalancing was only done if bonds went down below 30% (or above 50%) not when bonds went below 36% (10% of 40%).

They found that the optimal frequency using a time trigger was 44 months, or 3 years 8 months! For percentage deviation triggers, 5% or more was best; 10% was best or second best for about half the portfolio mixes (see table 2). And that is before transaction costs! I am bit puzzled by Figure 4, which if I read it right says that if one had adopted a 10% trigger for rebalancing, then no matter what the portfolio composition, during the whole period of 1926 to 2003, one would NEVER have had to rebalance. Or maybe, the graph is hard to read and it is less than 25 trades in 78 years. Either way that's astounding. Hello Rip, I see you've been a successful investor during your wee nap. Given that equities produce superior returns when calculated over long periods, I wonder how the portfolio could never have deviated that much from the targets.

Maybe the best rebalancing policy is above 10% deviation from target and only if new money added to the portfolio, or withdrawals from it, don't take care of bringing the portfolio allocation within the range. Isn't it good to know that being lazy can be a virtue?

Major Portfolio Renovation, Canadian Style

It's done at last. I've completely changed my investment portfolio to an asset allocation methodology. For the first time, my investments are now an integrated whole, with the holdings selected to complement each other, as opposed to the disparate, hodge-podge of holdings I have had up to now. There is no longer any single company equity holding in any of my accounts - goodbye Cisco, Oracle, JDS Uniphase, SAP, Microsoft. Most difficult was selling my large holdings of Royal Bank and Scotiabank, which have been such stellar long term performers and have made me so much money. The decision to completely adopt the principles of portfolio theory drove all the changes.

For anyone else contemplating such a move, here is how I did it and where I encountered tricky bits.

The basic idea was to build a portfolio with the highest return and the least volatility/risk through selecting assets that are as a non-correlated as possible, i.e. they do not move and down together - one zigs while the other zags. In addition, the assets themselves are not single companies, they are many companies held together as a mutual fund or Exchange Traded Fund (ETF), in order to remove the effect of single company events.

The end results of my many hours spent on the planning of the renovation are shown in the extract from the spreadsheet I used that is included with this post.

Here are the key features:

• no individual companies eligible for the portfolio, only ETFs and mutual funds to ensure diversification; however, for my 27% Canadian bond allocation I decided to keep the bond ladder I have built; the range of maturities from 2007 to 2026 probably suffices to be diversified and I don't sacrifice yield from management fees e.g. XBB has an MER of 0.30%
  
• the range of asset classes is both geographical, covering more or less all the main economic areas of the world - Canada, the US, Europe, Japan, Pacific nations, emerging countries such as Russia, China, India, Korea, and sectoral, with large cap and small cap companies, value companies (low price/book and other measures), real estate, commodities; these asset classes have been chosen based on multiple sources that demonstrate their un-correlated returns over time - books such as those of Richard Ferri and of Roger Gibson, online resources such as Bylo Selhi and Index Fund Advisors
  
• the diversifying sectoral asset classes each only have a small percentage of the total and where possible this is spread amongst the various geographical areas, in order not to be too concentrated in any one asset class;
  
• no asset class has less than 2% of my total asset allocation and the total number of holdings is 16; this is to ensure that any holding is sufficiently large that when rebalancing comes along in a year, the dollar amount to be rebalanced will be large enough that trading costs will not chew up the amount; as a rough rule of thumb I'll want the rebalancing amount to be at least $1000 since my trading cost is $10/trade (1%); Ferri recommends no more than 15 holdings to keep the rebalancing exercise from being too complicated and I fully agree based on my own experience of doing rebalancing amongst only six ETFs the last few years (XIU, XGD, XIT, XRE, XFN, XMD); given that I have four accounts (open, RRSP, LIRA1 and LIRA2), none of which can transfer money to another, the limit on number of holdings is a practical necessity. It was at this point that a number of candidate asset classes, seen in the bottom chart with the ETF ticker symbols, disappeared from the final allocation.
  
• the reduction of the impact of adverse currency shifts, especially against the US dollar, is the concern that led me to buy more than half of my US large cap holding and US small cap as the currency hedged XSP and new iShares Canada XSU; in the international holdings there is some currency risk but it spread over many countries' currencies so it is more acceptable - whether this is truly an acceptable risk I don't know as I have not been able to find clear answers in the finance research I have read so I will keep looking. In the meantime, however, there really isn't much choice to find ETFs that will fill the asset classes in my chart except to buy unhedged ETFs on US markets, so I've decided that diversification is most important. The only exception might be XIN, the hedged counter-part of EFA, the iShares EAFE fund, but since the global whole market class did not make it into my portfolio it isn't relevant. Of course, it is true that despite the funds selected being traded on US exchanges in US dollars, the currency risk is not the US dollar but those of the under-lying holdings; the US$ is only a pass-through currency.
  
• Vanguard funds appear often in my final selections - VGK, VPL, VNQ, VBR, VV, VWO. As my chart shows, there are other good funds (I didn't put any in the chart that weren't low cost, passive index funds) but Vanguard comes out on top pretty well every time they are available in a class. Why? Vanguard ETFs have the lowest tracking errors; a lower Price/Book in the value category; lower turnover than the avg fund in a category = lower transaction costs, less cap gains distributions; more holdings than the avg fund in a category =more diversification, less risk; the lowest management fees. It may interest some to note that I compared a few TD e-Series funds (TDB900, 904 and 911) but their higher management fees offset their plus of not having trading costs. My fund selections are highlighted in the greeny/yellow colour on the chart.
• The case of the US dollar denominated holdings caused me something of a conundrum. All foreign dividends are taxed as ordinary income, which suggests US$ holdings should go into registered accounts while Canadian holdings that can benefit from lower dividend tax rates should go into the open account. However, it is an unfortunate fact that my broker BMO Investorline won't hold US dollars within a registered account. BMOIL still requires US dollar sales to be converted into Canadian dollars and then back again into US$ for a purchase. There is a spread of about 1.8% between the buy and sell rates on the US$ at BMOIL so when I came to do my rebalancing next year I'd get dinged plenty, probably more than the tax differential. So I will keep as much as possible of my US$ holdings in my open account where I can keep a US$ cash balance. BMOIL could fix this deficiency since there isn't any legal impediment to having US$ in a registered account; I'm sure as soon as another of the major bank brokers does it they will too but it rankles in the meantime to pay extra FX costs for no necessary reason.
  
• my portfolio is treated as one across all the four accounts I have - open/taxable, RRSP, LIRA1 and LIRA2; where I put individual holdings is influenced by other considerations such as taxes but taxes are subservient to doing proper asset allocation. All the fixed income/ bond holdings are in the registered accounts for instance. Dividing up the holdings amongst these accounts proved to be a significant challenge just to make things balance. In addition, I tried to anticipate the rebalancing by placing investments within the same account that might end up needing to be rebalanced up or down e.g. I put a big chunk of the DJP commodities holding into the RRSP along with VGK Europe equity and VPL Pacfic equity as they are historically negatively correlated and the former should go down when the others go up. Similarly, in the open account I put VNQ REITs and VV US large cap, which are also negatively correlated. Hopefully, that will enable easy rebalancing within an account next year but we shall see.
• my asset allocation is NOT driven at all by any income needs, though I am starting into that period of life when withdrawal is beginning (for why this is the correct way to approach things, I rely on experts such as Moshe Milevsky). If I will need to withdraw funds from any account, It will be based on the asset allocation - whichever is above its target will have a portion sold.

So that's it. Any comments or observations welcome!