UK Portfolio Revamp - Part 1 - Diagnosis

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

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

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

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

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

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

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

The Investment Angle of Children

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

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

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

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

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

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

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

First Uranium's Convertible Debentures

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

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

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

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

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

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

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

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

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

Book Review: Money Logic by Moshe Milevsky

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

The list of topics includes:

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

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

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

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

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

Buy this book at
chapters.indigo.ca

Investing in Canadian vs International Equities

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

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

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

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

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

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

Review: #4 QuickTaxWeb Web Tax Software

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

Have a look at the inserted screen image for QuickTaxWeb.

What I Liked About QuickTaxWeb

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

What I Disliked

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

Review: #3 WebTax4U Web Tax Software

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

I've included a screenshot of this program too.

What I Liked About WebTax4U

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

What I Disliked

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