Wednesday 30 May 2007

Clarification of Foreign Exchange Risk on International ETFs

There is a common misconception, under which I unfortunately found myself for a while, about the foreign exchange risk that one is accepting in purchasing international ETFs like Vanguard's European Equity Fund (ticker VGK). VGK trades on a US stock exchange and is paid for in US dollars. Its holdings are all in 603 different companies traded on European markets and are bought and sold in the currencies of local markets in Europe - Euros and Sterling mainly. As we all know, the Canadian dollar moves up and down against the US$, the Euro and the UK pound. The question is what exposure one has as a Canadian, or for that matter, as a foreigner from any country. Is it the US$ the trading currency only, the local company currencies only, or a mixture of both.

To explain this, I've created a simple example on the spreadsheet. The example uses real foreign exchange (FX) rates from today, taken from Yahoo. The second spreadsheet shows the table I used, though at a different time of day, so the rates won't be exactly the same as they change throughout any trading day.

Yahoo's FX table show the rates for major currencies. The thing to note, and as an illustration I did the arithmetic that proves this on my example spreadsheet, is that the rates all mesh. If one goes from US$ to Canadian$ and then on to UK£, it works out exactly the same as going direct from US$ to UK£. Rounding errors sometimes make the last digit different, as in my spreadsheet example, but in the real world any time there is a tiny discrepancy where it is possible to buy one currency and sell it through another to make a profit, that happens very quickly and the discrepancy disappears. The rates end up constantly aligned.

In my hypothetical, ultra-simplified portfolio of £100, the value at today's rate is CDN$212.28. In example 1, the C$ rate vs the US$ remains the same and rises vs the UK£. The portfolio value in C$ drops! In example 2, the C$ rate vs the US$ rises but is constant vs the UK£ and the portfolio value remains exactly the same! Add in the price changes of the investment and the simultaneous movement of all the currencies involved, the principle is still the same - a Canadian investor only is affected by changes between his/her own currency and the foreign currencies.

In short, the exchange risk I and others who have bought VGK are incurring is the foreign currency of those companies and markets not the US$ despite the fact that VGK is bought and sold in the US. There are international ETFs like XIN, the iShares Canada ETF that trades on the Toronto market, whose currency risk is being removed by the fund managers through trading in foreign exchange. XIN actually owns only one holding, shares of EFA, the ETF bought and sold in the US that tracks the Europe, Australasia, and Fare East MSCI index. XIN removes the currency effects of the EAFE countries not the US$.

VGK and other international ETFs like VPL (Vanguard's Pacific countries fund), VWO (Vanguard Emerging markets, including Russia, China, Korea, Brazil) expose investors to the combined proportional risks of those countries' currencies but not the US$.

Whether that currency exposure is good, indifferent or bad is still unclear to me. In my search for the answer, I've read variously that currency hedged portfolios give the same return as unhedged portfolios, that a certain proportion of the portfolio should be hedged (like 50 or 75% of the value of foreign holdings), or that the currency exposure provides another source of diversification benefit. That uncertainty is nevertheless not keeping from buying those foreign ETFs due to the powerful diversification benefits that international investing offers.

Sunday 27 May 2007

Frustrated with BMO Investorline "Disclosure" on Foreign Exchange Rates

It is my objective to write positive things in this blog and to ignore the negative as much as possible but a significant hidden trap I encountered at my broker BMO Investorline bears writing about.

When placing a trade in an RRSP or a LIRA for a security traded on a US exchange, the BMO Investorline online web page first gives an Equity Order Review screen before the final purchase is submitted on entry of the password. My graphic shows a screen capture of such a real screen in which I set up a potentially real order in one of my accounts. Note the use of the word "estimated" in reference to the US order value and the final Total order value in Canadian funds. What does "estimated" mean in this context? Part of the meaning is that, as it says right on the screen below, the current market price is only indicative and may change on such orders placed at market price, between the time of order entry and the moment when the order hits the market. That's ok, stated and understood. Then there is the estimated Canadian dollar price, which depends on the exchange rate and one could presume as well that the rate could change in the time it takes to commit the order. However, there is nothing on the website, and I checked by phoning a BMOIL representative, that gives an accurate explanation of what "estimated" really means. It turns out that the meaning of "estimated" is significantly different, and negatively so, for the investor.

The reality of "estimated" is as follows:
  • the C$ to US$ exchange rate is not a buy rate for a US equity purchase nor a sell rate for a US equity sale, it is a mid-market rate;
  • the actual exchange rate applied to any purchase or sale is the buy or sell rate at the close of markets each day.
To repeat, nowhere are these critical details available to the investor.

What are the negative effects?
  • an investor can never know exactly how much a purchase will cost or a sale will bring, making it impossible to quickly make a series of investments that will leave an account with a target cash balance. Isn't it a fundamental consumer right to know what something will cost before making a transaction? There's the double problem of the mid-market rate and the delayed rate. In this case BMOIL does even disclose the basis on which the ultimate price will be based.
  • all purchases will be systematically under-estimated, that is, will cost more in Canadian dollars, and all sales will be over-estimated, i.e. bring less in after conversion. This happens because the mid-market exchange rate is an average of the buy and the sell rate so it will always be high for one (sales) and low for the other. The effect is significant since the spread between buy and sell rates is over 1.8% for me at BMOIL, thus over 0.9% on each trade.
  • as a result of these two factors, a couple of my accounts ended up in minus balance, a rather nasty surprise. The ironic twist to the story is that registered accounts are not, according to the BMOIL rep I spoke to, allowed to go into negative balance. During the live real-time trading that didn't show up, as evidently the automated "you are not allowed to do that trade because your account will be over-drawn" piece of software, also relies on the estimated order value. The rep also assured me I wouldn't have to pay interest on the negative balance..... good thing they record those voice conversations with clients, huh? Hmmm, think I will leave that negative balance there till next year when I do my next re-balancing.
Consider a few other points:
  1. the estimated mid-market rates on my purchases or sales varied with each trade; obviously therefore, that number is being updated constantly as markets change. The mid-market is an artificial computed rate between the buy and the sell, which are the only real rates. If BMOIL can supply in real time with each trade the mid-market rate, it must also have available the buy and the sell rates in real time. Why cannot it therefore apply this rate to the trade? I believe BMOIL is acting as principal in these foreign exchange transactions with clients, which leaves even less excuse for it not giving an instantaneous, committed exchange rate.
  2. the main source of this whole problem is BMOIL's decision to allow only Canadian dollar cash within any registered account and to force all US transactions to go through the buy and sell of foreign exchange (on which it makes money!). There is no requirement for this at all, certainly no legal restriction since the lifting of foreign content limits a few years ago. One wonders what the practical restrictions are too. My regular open BMOIL account has a Canadian and a US dollar side and I can settle trades within an account, or make online, real time transfers between the two sides, which of course again confirms that the buy and sell rates are readily available.
How to deal with this? First, it's worth asking the brokerage exactly how the foreign exchange rate is calculated. Second, at BMOIL on a buy it is necessary to add about 1% to the Canadian $ cost of US purchases or subtract 1% from US sales and then to leave margin for currency changes by the end of the business day. If trading at market prices, maybe it's worth waiting till near the end of the trading day to lessen the time the currency has to change.

I suppose I should have noticed before since I have bought and sold US equities previously in RRSP and LIRA accounts and I suppose one should always on principle be wary and questioning of the way things work to avoid nasty surprises. However, the almost total lack of disclosure and the appreciable negative consequences resulting from a poorly designed trading tool leave me frustrated and annoyed to say the least. We'll see how BMOIL responds after I send them a letter of complaint.

Saturday 26 May 2007

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?

Wednesday 23 May 2007

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!

Monday 21 May 2007

Book Review: Wealth Logic by Moshe Milevsky

This is another of York University Finance professor Moshe Milevsky's "Logic" books (previously reviewed Money Logic and soon to be reviewed Insurance Logic) about everyday financial, investing, purchasing and spending choices facing ordinary people. Unless you happen to be a finance prof, it's likely there is something of interest for you in this book. It comprises 40 chapters, of 2 to 7 pages each, on a wide, eclectic range of topics, all somehow connected with personal finances, such as insurance, taxes, mortgages, mutual funds, RRSPs, retirement, car loans vs leasing, investing, diversification, risk, pensions, annuities and more. Each chapter addresses a narrow issue or a choice and gives either a definitive answer when there is one, or guidance on how to make the correct choice, when personal circumstances can change the answer. Conveniently, each chapter gives a one or two sentence summary conclusion - e.g. chapter 10 on What is Financial Risk? concludes: "The lesson in all of this is that only a large and well diversified portfolio of stocks can truly grow in the long run. Otherwise, you are simply gambling." Most chapters have one or two simple tables or graphs that present the result of calculations to back up the conclusions. Milevsky presents the rationale, the "logic" and the conclusions, not any complicated math. He does provide some references and a two-page bibliography for further reading. There is no index, something I would normally consider to be a major deficiency but the nature of the book makes an index un-necessary.

The book is accessible to anyone who has basic knowledge of practical money affairs. Milevsky is good at defining terms for the uninitiated. For example, in "Mortgages: Fixed or Floating Rate?", there is an assumption that a reader generally knows that a mortgage is a loan to buy a house, but Milevsky takes the trouble to write, "With a fixed-rate mortgage, your monthly payments are pre-determined and known in advance ...". The test of accessibility for me is that those topics with which I was not familiar did not cause me to scratch my head wondering how his argument / discussion had got to where it led. Maybe it's his teaching background but it is a valuable writing quality for an author addressing a general audience. The writing style is casual and conversational but not cloying or condescending. It's a good book to read in short chunks of 10-20 minutes, on the bus commuting, waiting at the pool during kids' lessons, during commercial breaks while the Ottawa Senators are winning the Stanley Cup for the first time etc. The whole book is 237 pages.

A very small amount of the content suffers from being out of date, for instance, the rant against the foreign content cap in RRSPs that is no longer relevant since the federal government finally removed the restriction a few years ago. Another is the negotiating spreads on mortgages by Canadian banks - is it still one percent reduction one should demand/expect or have the years since 2001 widened or narrowed the spread?

There is some overlap between Money Logic and this book - topics like diversification, risk, borrowing to lend, dollar cost averaging appear in both. Money Logic treats fewer topics in much more length and depth, doing a better job demonstrating the fallacy of dollar-cost averaging, for instance, though of course the conclusion is the same. So, if you decide you can trust Milevsky and don't need all the proof and only want to buy one book, I'd suggest Wealth Logic. I don't regret buying both, since there is real non-repeated value in Money Logic too.

In short, buy this book ($15 to $20 at the on-line retailers) and keep it around till you need to have a quick look at what to do whenever a financial decision comes up. Milevsky may have your answer in his 40 topics and you can be sure it is well thought out and neutral. Five stars out of five is my rating.

Buy this book at

Friday 18 May 2007

Detective Work Uncovers Excess Fund Fees in Canada

Today I came across another example of the ridiculous excess of fees charged to Canadian investors by fund companies, this time by Barclays Global Investors and its ETF arm, iShares Canada.

If you look up iShares Canada in the website, you will find therein a mutual fund called iShares CDN S&P 500 Index C$, which tracks the S&P 500 US stock index and is hedged in Canadian dollars. It's code is BGII500R. This is the self-same thing as the Exchange Traded Fund (ETF) called iShares CDN S&P 500 Index under the ticker XSP trading on the TSX. You will note in Morningstar that the Objective text for BGII500R says "XSP is ..." and the MER is only 0.15%. Morningstar also says that BGII500R is offered by Barclays Global Investors Canada. Funny, I thought, I've never heard of a mutual fund version by Barclays, maybe they are getting smart and beginning to offer ETF and mutual fund versions of the same thing as Vanguard has started to do in the US. It looked even better when I remembered that the MER for XSP is 0.24%.

Just to be sure I tried calling iShares Canada to confirm BGII500R's existence but the rep there said he didn't know anything about it since it isn't an ETF and they don't deal with mutual funds, then he gave me a number for BGI USA that turned out to be a wrong number (great customer service iShares!). I tried looking up BGII500R on my BMO Investorline mutual fund lookup and sure enough it is there. There's got to be a catch I thought, this "looks too good to be true". We've all heard the warnings about that expression, right? Well, so it is. Here is the explanation I got from BMO Investorline (kudos to the rep who took the trouble to make an enquiry). BGII500R is indeed available but it is only offered to US investors! (Just for fun, I tried to put in an order on the BMOIL system but it told me the mutual fund code BGII500R is invalid). That's right, a US stock index hedged in Canadian dollars sold only to US folks. Is that 'cause they're planning to retire here? Do they know something we don't about the US$?

And why should we Canadians pay more MER for the identical thing? And it's our hedged dollar too!

Thursday 17 May 2007

ETF Screeners, Tools and Primers

Since I have been spending huge amounts of time researching Exchange Traded Funds (ETFs) in preparation for a complete re-structuring of my investments based almost completely on ETFs, it might be of interest for me to relate what I have found of use on the Internet.

ETF Primers, FAQs and Portfolio Principles:
  • Wikipedia's ETF Entry - summary explanation of ETFs; lists of providers and exchanges around the world where ETFs are available; lots of links
  • Efficient Market Canada's Example ETF Portfolio - Martin Gale explains how a Canadian can build a simple global portfolio using ETFs
  • ETFs vs Index Mutual Funds and ETF vs Open-End Fund Shootout (Wm Bernstein) - pros and cons of each
  • IFA Canada - lots of high-quality educational material as well as sample portfolios for this company that sells low cost funds, but the principles are the same.
  • Altruist Financial Advisors - links to more complicated and technical references on ETFs (and many other investing topics) under the Reading Room tab
  • Bogleheads Forum - fans of John Bogle, Vanguard Fund founder; lots of links to ETF and other investing material in the Reference Library, plus opportunity to ask questions of investing junkies who generally believe in low cost passive investing
  • Seeking Alpha - extensive information on all aspects of ETFs, from basics, investment strategy, asset allocation resources and tools, indexes with many links, all of it annotated
  • Financial Webring - Canadian investors, including those who write the most and have published some excellent resources; permanent section on funds and ETFs; good place for discussion and to ask questions
ETF Screeners and Comparison Data:
  • - Canadian, US and UK-traded ETFs in one place; useful categories / asset classes for portfolio building; ETF names are written out, not abbreviated; ticker symbols always visible to avoid confusion; ETF investment objective and reference index but little else - links to provider / sponsor websites for details; links to multiple quote websites like Yahoo, Bloomberg, Google, MSN Money; doesn't include all ETFs e.g. missing REITs like ICF, IYR; no side-by-side comparisons, portfolios or other fancy stuff but I found it to be very useful for preliminary identification of candidate ETFs because the site is so simple and quick and includes US and Canadian ETFs together
  • (engine for Wall Street Journal and - US ETFs only; Quickscreener tool has useful asset classes; includes Management Expense Ratio (MER), Net Assets, Performance, Turnover, Top Ten holdings, Sector breakdown in one compact, easy-to-read page but is missing Geographical breakdown for international funds and Number of Holdings; no links to Providers; fund names are abbreviated making some difficult to understand; no portfolio tool
  • engine for Investors Business Daily) and - US, UK and Canadian sites for each of those countries' ETFs and mutual funds; very sophisticated and complete but consequently complex and slow to use; important things are buried several clicks down, like ticker symbols, holdings, sector and geographical details; enables creation of a portfolio, which can then be characterized using the X-Ray tool to show sector and geographical dispersion, expected returns and other very useful stats to judge whether a proposed portfolio will be well diversified. Very cool! But it only works for the funds within that country so Canadian investors like me who want/need to use US funds to diversify properly cannot see the whole portfolio analyzed. It's still very handy and unique.
  • - US ETFs only; you need to register (it's free) to get access to the database and screener; same complete coverage of 498 US ETFs plus articles and commentary, discussion forum; the screener has a lot of variables one can choose but there are a lot of pre-set ones ticked having to do with performance so it is necessary to do a lot of un-clicking then re-clicking to select the factors one needs; the MER is one screen and it has a good increment of 0.25%; US investors have it easy since mutual funds and ETFs can be screened at the same time or separately; names of funds are somewhat abbreviated but not too badly and the ticker can always be made to appear; there are no market quotes, no links to provider websites and no sectoral of geographical breakdown of fund holdings, no total number of holdings within a fund, no portfolio capability.
  • - Canadian ETFs along with mutual funds and it is hard to tell them apart from the way the data is presented and certainly the entry link doesn't mention ETFs. Nowhere, for instance, is the ticker symbol XSP shown for the ETF iShares S&P 500 C$ on this data page; it is possible to filter using MER, though the increment is only 0.50%; it is difficult to tell apart actively managed from passive funds, a matter of interest to me; the website is generally slow to respond; there are performance figures, sector and geographic weighting charts, though the latter doesn't work properly for the iShares EAFE ETF that is based on the US-traded ticker: EFA and so is marked as 100% US though it is everywhere but there underneath.
  • Financial Post / National Post - Canadian mutual funds with the few domestic ETFs, though the website label doesn't say anything about ETFs ... oops, the Claymore Investments range isn't included; a lot less data than the other sites; with so little ETF choice in Canada it would be imperative to include them.
  • - the most popular Canadian-traded ETFs with lots of useful data and explanations
  • Vanguard and - US websites of low cost US-traded ETFs that will likely attract most Canadian and UK (those who can trade on US exchanges) investors with a bent for passive index investing; good places to get the details on funds to round out the diversification objectives with other asset classes; Vanguard has a neat tool that lets you compare side-by-side any of its ETFs with another of any other company, e.g. for a European holding should it be VGK or IEV or EZU - Vanguard's tool provides more data than some of the big specialized websites above.
Happy research everyone. If anyone has other suggestions for sources, let me know.

Tuesday 15 May 2007

Internationally Diversified Portfolios from IFA - US vs Canada

Now that Index Fund Advisors has opened up shop in Canada, there is the chance to see how some real experts approach the issue of building an internationally diversified portfolio based on principles of modern finance in two different countries - Canada and the USA. The websites of IFA Canada and IFA USA each present a series of twenty model portfolios with varying amounts allocated to various fixed income and equity asset classes.

For comparison, I've chosen a portfolio allocation that interests me - 70% equities and 30% fixed income - but you could pick any range from 0 to 100% for either asset class. It is extremely interesting that the Canadian version includes a hefty 16% Canadian equity allocation while there is zero separate Canadian allocation in the US version. This is apparently in keeping with the home company bias every country has. It isn't justified by finance theory that says a country's weight should approximate its value portion of the whole world, which is 3-4% in Canada's case. However, this makes no effective difference to the risk/volatility profile or the diversification effect since Canada's long term correlation with the US market is in the mid 90% area. It's a good illustration of the principle that in order to be an asset class, a grouping of equities needs to move up and down differently than, aka be uncorrelated with the other.

Another big difference is that Emerging markets is completely absent from the Canadian portfolio while it takes up 8% of the US portfolio. This time the problem is apparently that it is impossible at the moment to create the Emerging markets component in Canada ... it is apparently to be resolved by next year. Similar difficulties must explain the lack of breakdown in the fixed income portion into Global and Government components seen in the US version. The total number of holdings in the Canadian list is 12,924, much less than the 16,540 in the US list but it is still an awesome number.

IFA has just barely launched in Canada so it is a player worth watching and considering, given the high quality of its products in the USA.

Jonathan Chevreau Report: Index Fund Advisors come to Canada

Just came across the news on reporter Jonathan Chevreau's blog here that says the US firm Index Fund Advisors has expanded into Canada at this site. Anyone interested in passive portfolio index investing based on strategic asset allocation offered by real experts should take note and visit them, for ideas and background information if nothing else. IFA offers only funds created by Dimensional Fund Advisors, the Board of which includes a veritable who's who of modern investment research - such as Eugene Fama, Kenneth French, Roger Ibbotson, Myron Scholes, Robert Merton!!! IFA Canada will work with De Thomas Financial Corp. IFA will provide the website, educational material and portfolio construction while De Thomas will deal with customers.

To start off the minimum account size (to enable proper diversification) will be CDN$150,000 (vs $100,000 in the US - hey, our dollar has gone up lately!) though later there is an intention/hope to accept clients with $25,000. As in the US it will be mandatory to use the advisor (De Thomas in Canada) with the associated 1% advisor fee on top of the MERs of the DFA funds themselves, which range from 0.25 to 0.45%. For that, clients get guidance for their risk/volatility tolerance and corresponding optimal portfolio.

UK Tracker Indices not Wholly Representative of UK Economy

Came across this fascinating article titled "Buying British not what it seems" by Sylvia Morris that discusses how the presence of many foreign companies on the London Stock Exchange and the foreign operations of many UK based companies (even the big food retailer Tesco!) means that buying the FTSE 100 or the All Share Index entails a very significant foreign exposure. The All-Share is apparently not quite as foreign as the 100 Index but in either case one is more or less buying an internationally diversified holding. Hmmm, not sure what to do about this so that the UK holding better represents the UK economy as the more purely domestic funds in the UK are high-fee actively managed funds.

The progress of globalisation is no doubt having this growing effect in all markets and on all market indices. Might it be that the diversification benefits of international investing are becoming less and less so? Perhaps diversification on the basis of non-correlation of asset classes/holdings would be better pursued through asset classes based on something like industry sectors?

Monday 14 May 2007

UK Portfolio - Part 4 - Fund Selection

This step of the creation of the new diversified UK portfolio required translating the asset class selection into an actual fund to purchase. The process turned out to be somewhat iterative as I discovered that my initial intention to obtain diversification by buying US small cap and value funds could not be done since there are no such low-cost funds (there are probably high-cost actively managed OEICs or unit trusts but those have been excluded from the potential purchase list due to the harmful effect of those fees) available on the UK markets. Instead I picked European ETFs from the iShares stable. Since the low correlation behaviour of small cap (e.g. this research paper) and value funds (see this reference at Dimensional Fund Advisors and this research paper titled Global Portfolios with Market, Size and Value Considerations) has been found to hold internationally as well as in the US, this switch seemed reasonable to do.

The result of the search and selection process is shown on the spreadsheet summary with the fund names in the boxes of each asset class. I conducted the fund search through a combination of the iShares UK website, since they are the only company currently offering ETFs on the UK market, the TrustNet website and the SelfTrade broker website (another reason that it won out as my next post explains). It is interesting (to me at least!) that there are a few index-tracking low cost OEIC (i,e, not ETF) funds available to represent the UK FTSE index and a pan-European index. The reason I chose them instead of the comparable iShares ETF, is that the ISF only holds the 100 largest UK FTSE-listed companies, whereas the M&G UK Index Tracker holds the whole market and has a lower expense ratio (0.30% vs 0.40%). Similarly, the M&G European fund is far more representative than the largest 50-company iShares DJ Stoxx 50.

So that's it, with eight holdings, there are around 2000 companies from around the world that will form part of the total portfolio.

UK Portfolio - Part 5 - Broker Selection

The final step in the UK portfolio revamp required selection of an appropriate broker through which mutual funds or ETFs could be purchased.

Since I was not very familiar with the UK scene, initially my search for a broker involved Google searches. It would have been far quicker had I known about the GoodWebGuide of Share Dealing brokerages, which contains a brief synopsis and rating of most if not all the online brokerages available in the UK, though be sure to follow the links to each company website as I discovered several instances of inaccurate or incomplete information in the synopsis. The main criteria I used included:
  • low cost - per trade costs, monthly/quarterly/annual account administration costs, account closure or transfer costs. Since the investment strategy will involve few trades (once annually amongst a maximum of eight holdings) slightly higher trading fees may be offset by account inactivity fees or other costs.
  • PEP, ISA and regular accounts - being able to have all types of accounts at one brokerage simplifies life in many ways, such as doing summaries/portfolio views, transferring money from a regular account into an ISA, as is planned to be done for the next number of years
  • customer service - ability to phone and readily get explanations or assistance from a human being, a capability that was tested informally as I collected information from websites; for instance, eTrade quoted the cheapest prices but I got into voice mail wilderness trying to contact them while SelfTrade posts their phone number everywhere on their website and polite knowledgeable staff answered the phone quickly, a very handy thing whenever a less than expert investor is involved, as in this case. Some low trading fee brokerages, such as iDealing don't even offer phone support, only email support.
  • direct foreign market access - ability to trade directly on foreign markets, especially the US' NYSE and Amex for ETFs due to the paucity of ETFs in the UK. This was a secondary objective in this case since adequate diversification could be achieved within what is available on the London Stock Exchange (LSE).
Some criteria that had no real importance but might for others with different investment strategies include:
  • research tools - availability, breadth and quality of such tools as stock or fund screeners and research reports, charting tools, market news and market activity streamers
  • discounts for frequent trading
Here are comments on some of the main players and the reason that they got disqualified:
  • HSBC - no ISA account admin charge, nor any account closure or transfer fees but requires the opening of an HSBC bank account
  • Abbey Sharedealing - the GoodWebGuide has more information than the Abbey website itself - pathetic!
  • Barclays - charges account inactivity fees
  • iDealing - low trading costs but offers only email support and website has very skimpy info
  • Royal Bank of Scotland - higher trading, account admin and transfer/closure costs
  • Lloyds TSB - higher trading fees and higher account admin costs
  • eTrade - low trading fees but trying to talk to them is voice support hell
  • Halifax Sharedealing - reasonable trading fees but higher admin costs
  • TDWaterhouse - offers direct access to US NYSE, Amex markets, which means access to the wider range of ETFs available there, but I wasn't initially aware of TDWaterhouse and had already begun the process of opening accounts and transferring funds into SelfTrade so decided not to back track; maybe next year it will be worth switching.
In the end, it was SelfTrade that came out on top. The company's fees are in the middle for trading and low for account administration. By happy coincidence, SelfTrade has been offering no trading fees on purchase of LSE-quoted ETFs till May 31st, which is exactly suited to the ETF orientation of this portfolio. Best of all, SelfTrade wins on customer service: the phone gets answered quickly by knowledgeable, polite people both before and after one becomes a customer.

Thursday 10 May 2007

Book Review: Asset Allocation by Roger Gibson

The mere fact that this book is now in its 3rd edition indicates that to some degree it has stood the test of time. It is indeed a very good book, much of it brilliant, but it has some serious flaws and a 4th edition could/should correct those short-comings.

Gibson's primary target audience is financial planners and US investors. There is nevertheless a great deal of value for individual investors everywhere and as a do-it-yourself investor, I found much of personal benefit. Though not for the absolute beginner, this book is at an intermediate level and is understandable to anyone who has been dabbling in mutual funds and knows generally about bonds. He explains terms and builds knowledge carefully from a fairly low level, utilizing the results of finance research without delving into the heavy duty maths that characterize modern finance.

The subject matter of the book is not individual stocks and how to pick winners. It is instead about how to make money investing using a kind of tortoise strategy - moving ahead steadily but not spectacularly, in any given year always being behind the current winner but never worst, with the least chance of actually losing money and over the long term being ahead of every individual investment asset alternative. That approach is termed asset class investing in a portfolio built on observed diversification benefits of asset classes. Asset classes are groupings of investment securities that go up or down out of sync with one another, for example, the US stock market, international stock markets and real estate investments.

Gibson does a great job explaining how this works, with numerous graphs and tables using historical data. Chapter 8, titled the Rewards of Multiple-Asset-Class Investing is superb and worth the price of the book alone. Using a didactic method, he unveils the subject matter progressively to surprise the reader with the wonderful diversification benefit that I described in my previous post 3+1=5. This powerful result tells us to diversify using various asset classes such as international stock markets and real estate securities. It was very interesting and comforting for me to read the next chapter on portfolio optimization in which he shows how small changes in any of the inputs (estimates of future returns, volatility and correlation) among asset classes can have enormous effects on the computed optimal percentage allocation asset classes. This is comforting because a key decision is how much to put in Canadian equities vs US equities vs international vs fixed income/bonds. It doesn't matter enormously. Gibson's result is that there isn't a known correct answer - the most important benefits come from the different asset classes being represented, not the exact proportions, so one should spread out the investments relatively evenly (his answer is no less than 5% nor more than 20% in each).

This book does a very good job presenting the principles of asset class investing but does not get as detailed as Richard Ferri for example, whose book I previously reviewed, in identifying other useful asset classes for a portfolio, such as small cap stocks, value stocks and commodities. These asset classes do show up later in Figure 12-2, the Investment Portfolio Design Format but without any supporting explanation of why they are there. The book also does not get down to the actual securities that one can buy to build the portfolio, such as mutual funds and ETFs.

Some of the principles of asset class investing may surprise, e.g. tax minimization and income stream generation must be secondary to the proper asset allocation in a portfolio, which means among other things, do NOT design your portfolio with too much fixed income just to have interest income to live off in retirement. If you need money to spend, sell some of whatever asset class is currently above its allocation.

Where the book falls down in a significant way is the last quarter of the book from chapter 12 on, in which Gibson gives financial planners advice on how to deal with clients. In this section he seems to abandon substantiation and give arbitrary advice, or even worse, present as viable, options that are contradicted by material in the first part of the book. For example, on page 251 and elsewhere he seems to accept that "frame-of-reference" risk (the feeling by his client investors that they want to not be different than their peers), is puzzling to say to say the least. Isn't is desirable to do better and thus perhaps inevitably different, than one's peers? And isn't it the financial planner's professional duty to guide the investor to better and probably different approaches to investing? The advocacy of dollar cost averaging as an investment approach on page 265 is simply wrong, as Moshe Milevsky shows in his book Money Logic (maybe Gibson succumbed to frame-of-reference risk too as no less a luminary than Sir John Templeton, founder of the Templeton Funds, repeats the same mistake in the forward on page xii). The worst sin of all is Gibson's acceptance of an active management approach by trying to pick asset class winners and timing the market on pages 260-261. The rest of the book says that is not necessary or desirable but Gibson blesses it here because some financial advisors do it. He should be stomping all over the idea. Similarly, on page 272-273, Gibson discusses mutual fund fees and manager's compensation as justified - "Similarly, at the level of individual security selection, the money management specialist should be paid for work well done." I ask, what work, what security selection? Doesn't one just buy the index/market of the asset class? Let's see, for the Canadian stock market amongst low cost alternatives of funds or ETFs, there are maybe half a dozen and a good advisor should know them by heart, have one already determined by previous research (mine is XIU). How much is that worth - 1% fee on assets per annum? There's no on-going work. Perhaps a flat one-time fee?

There is one great quote cited in the book. Asset class investing, despite being superior, cannot ensure that one makes money investing. Paul Volcker, former US Federal Reserve Chairman: "You cannot hedge the world." (p.304) At times of world crises, all asset classes become one and move together. There is no escape. And if the crisis were something like nuclear Armageddon or global environmental collapse, it wouldn't matter anyways.

Despite the flaws, this is a book worth buying. It gives one the knowledge and the confidence to go ahead to select the actual investment securities for a diversified portfolio. My rating, 3.5 out of 5.

Buy this book at

Monday 7 May 2007

Portfolio Magic ... 3+1 = 5!

If someone told you that you should buy for your investment portfolio a holding with low annual returns and high volatility of returns (wide swings from year to year, i.e. the "sleep at night" factor) would you not think that this is against common sense, that this would lower your overall returns and make the swings even worse? For example, why add an investment that increased on average 10.3% annually and with volatility of 24.3% (this is the standard deviation, the usual measure of volatility) to a portfolio that has a higher return of 13.7% annually with lower volatility of only 14.7%? Well, contrary to common sense, the marvels of diversification can make this worthwhile. Certain precise, though quite simple and understandable, circumstances that go to the heart of diversification, make this seemingly odd result come about. How does it work you ask?

The key is to combine investment assets that move, in the best case, in contrary directions – when one is going up the other is going down and vice versa. Beneficial, but less so, is the case where the assets move randomly or independently – sometimes together, sometimes in opposite directions. There is still benefit when the assets tend to move together, but not all the time, in a weak positive relationship. Most of the investment assets that can easily be bought by the average investor tend to fall into the last category so it isn't possible to build a high return portfolio with zero volatility but the improvement can be considerable.

Let's continue with the example, which comes from Roger Gibson's fine book, Asset Allocation. The mystery low return/high volatility asset is the Goldman Sachs Commodity Index and the portfolio is a combination of the S&P 500, the MSCI Europe, Australia and Far East Index and the (US) National Association of Real Estate Investment Trusts Equity Index. Gibson shows in chapter 8 that over the period 1972 to 1998, the combination of the four holdings would have increased returns a little, from 13.7% to 13.8%, and reduced volatility a lot, from 14.7% to 10.6%. The reason again for this remarkable result is again, that when commodities go up the others go down and vice versa, even though over the long term, all of them go up. To cap it all, each asset on its own, underperformed the combination of all four. That's the power of diversification.

An investment category that moves differently from others is termed an asset class. So what are the asset classes that can/should be combined in a portfolio that maximizes returns while minimizing volatility? The main ones identified by finance researchers are:

  • cash / Treasury bills

  • bonds, with further useful (i.e. with diversification benefits) subdivisions into corporate, government and international

  • equities, with useful subdivisions into large cap, small cap, value, international Europe, EAFE and emerging markets

  • real estate, purchasable primarily in the form of REITs, though one's home can be considered an investment to a degree

  • commodities - energy, minerals, foodstuffs, gold, basic materials (steel, aluminium)

For examples of how these can be turned into actual portfolios with the purchase of specific ETFs or low-cost mutual funds (the latter being primarily available in the US alas), check out the Index Fund Advisors portfolios. The excellent book All About Asset Allocation by Richard Ferri that I previously reviewed also has example portfolios. The Efficient Frontier shows basic international equity portfolios with ETFs. Bylo Selhi has a handy list of the various low-cost funds available in Canada, some of which represent the above asset classes. For Canadians, since US mutual funds cannot be purchased, US-traded ETFs are the only route. Most (if not all) can be listed and searched for at Index Universe or Morningstar. In the UK, the iShares ETFs are the only low cost option for anything other than UK stocks or bond indices, or European stock indices, which are available from any number of fund companies.

A word of caution is that, as Ferri shows with numerous graphs on every asset class, the advantageous correlation relationships can be absent or reversed from year to year or for periods of many years at a time. The relationships work over long periods when the variations smooth out. While 3+1 is no longer always equal to 4, patience is still a virtue in investing.

Friday 4 May 2007

UK Portfolio – Part 3 – Equity Asset Allocation

This part of the process in revamping my UK friend's investment portfolio consisted of deciding which asset classes to include in the equity portion of the portfolio and which percentage each asset class should have. I must admit upfront that the assignment of target percentages in this step required some kludging and a bit of hocus-pocus. I feel it's the least defensible and any comments or suggestions on how to improve would be most welcome. Rather than search for a perfect answer, I think/hope that what I've done is good enough. After all, as Scotland's immortal poet Robert Burns (or Rabbie but definitely never Robbie!!, if you don't want to be considered an eejit by any Scot you may encounter) wrote in Tam O Shanter, “nae man can tether time or tide” and one must get on with it.

The table extract from my spreadsheet shows what I ended up with in terms of asset classes. One axis has the geographical breakdown and the other various types of holdings within them. All these are based on the wealth of accumulated finance research that shows these various groupings tend to move differently and so provide the benefit of diversification, namely increasing returns and lowering volatility. In the end there are only eight separate holdings, adhering to the objective of keeping to ten or less. I had wanted to include some international and US small cap and value holdings but they are not available to a UK investor and so ended up with European only. On the property (real estate) column I debated whether to include UK and/or US and ended up with only the global holding, partly to keep the number of holdings low and partly not to duplicate assets because the friend owns a house here and thus already has a large UK property investment.

My biggest uncertainty lies with the appropriateness of the percentages allocated to each asset class. Finance theory indicates that one should hold assets in the proportions that they occupy within the total global market. That would lead one to the proportions shown in Efficient Market Canada's article on Building a Globally Efficient ETF Portfolio or in see this presentation by Alejandro Echegorri citing Brinson Partners data. However, when I looked at sources of top professionals like the Index Fund Advisors, no one seems to keep to the market percentages in constructing portfolios. The IFA portfolio most comparable to the one of this UK friend (that's one with a 55% equity allocation) has a 39% US equity allocation compared to the 22% that US equity occupies in the total investable world capital market. In his book All About Asset Allocation, Richard Ferri recommends anywhere from 25 to 40% US equity allocation. There always seems to be a home market over-weighting. Most people seem to do that, including me in my own Canadian equity over-weight portfolio, but is that actually logical?

In the end, I just took round numbers, no less than 5% in each category, keeping the core total market asset classes large and the others small on the general pattern of the portfolios I have seen, like those mentioned above (imitation is the sincerest form of flattery, no?). Part of the reason for rounding up to 5% is also to make a reasonable size investment so that future re-balancing doesn't end up dealing with tiny amounts that would get chewed up by trading costs.

Wednesday 2 May 2007

Canadian Tour of Personal Finance Blogs

A quick note to say that I will be taking part in the next round of the Canadian Tour of Personal Finance Blogs started by Monty Loree at Canadian Money Advisor. This time the host reviewer is The Money Diva. The reason I'm participating is the same reason I read other blogs and post links to them on my website - no one has all the answers or can do all the research and the different perspectives and interests add to everyone's knowledge. Look for the reviews at The Money Diva on Monday, May 7th.

Tuesday 1 May 2007

UK Portfolio - Part 2 - Principles & Constraints

Before taking any actions and making any decisions regarding the revamping of the portfolio of my UK friend, it is important to spell out the principles and constraints that will drive the portfolio and its management for the indefinite future. So here they are:

KISS (Keep It Simple Stupid) - The over-riding organizing principle is that the portfolio and its on-going management should be as simple as possible. In the immortal words of Albert Einstein who seemed to have mastered KISS with his famous formula, "Everything should be made as simple as possible, but not simpler." Simplicity is in keeping with the desire of the person owning the portfolio to not spend large amounts of time on managing it. The principle will also enable the owner to understand and to track the portfolio and to make the changes without intervention by anyone else.

Consistent with Financial Theory - The portfolio should accept and adhere to the results of the massive amount of financial research, i.e. that is scientific and generally accepted, conducted in the last 80 years. Perhaps this is too obvious to state but it dictates that market timing be avoided and that diversification be pursued. A standard finance textbook like Bodie et al, Investments, is a good source for seeing what is generally-accepted.

Passive Investing with Index ETFs or Funds - The portfolio will therefore take a passive investing approach, rather than active management, and this includes avoiding ETFs or funds that have active managers. Financial theory says that one cannot and should not try to beat the market so buying the market in the form of funds that track the market is the way to go.

Low Number of Holdings - Too many different holdings will add to confusion and will make it more cumbersome and difficult to do the required re-balancing, especially across the four account types that will need to be used for tax reasons. On the equity side, that arbitrarily will mean no more than ten holdings. This factor is less important than the diversification requirement, which is at the heart of the portfolio approach. Thus, if effective diversification had required more than ten holdings, the number would have to be bumped up. Fortunately, this is not the case. There was a certain iterative process I found in doing this whole exercise where the initial objectives and principles needed to be reviewed and somewhat revised when later steps showed something didn't work quite right and slightly revising an earlier decision made it all fit better.

Implementable / Investable - A good example of this iterative revision happened when I tried to later on find the actual ETFs/funds to purchase for the portfolio and discovered that the UK doesn't have anywhere near the depth and breadth of choices in ETFs or low-cost funds that a Canadian can buy in the US market. UK discount brokers generally don't offer the ability to buy such US-traded funds, with the result that some particular holdings like international value and small cap ETFs are simply not readily available to UK investors. I eventually did come across TD Waterhouse UK, which does offer an account that enables full, direct access to US exchanges (NYSE, Amex, NASDAQ) but by then implementation had already started with another brokerage and it would have been a lot of bother to back and start over. It has been said many times that an imperfect plan properly executed now is better than a perfect plan next month.

Long Time Horizon - The investment assumption for the most part is an investment horizon of many years, twenty or more. That's because the person has a salary more than adequate for today's needs, and a pension that will be sufficient to live off without this portfolio's profits. It will be possible to be patient to ride out the inevitable downs of multi-year equity market dips. As Moshe Milevsky notes in his books and articles, time in retirement can easily reach 25-35 years so that's a good investment planning horizon for this person. The reference to the "for the most part" is the possibility that there will be a desire to help out a child financially, for example, to assist making a housing purchase in the very pricey UK market. That explains why in the preceding Diagnosis post, a fairly high allocation in liquid cash was deemed ok.

Tax Minimization - This is a goes-without-saying objective. A guaranteed tax saving is like an extra risk-free return. Not paying 20% tax on interest-bearing investments increases the after-tax net return by that amount. Putting money into tax-exempt accounts/plans like an Individual Savings Account (see here for how they work) or holdings, like tax-exempt bonds (see National Savings and Investments) within the overall portfolio plan, will be pursued in the revamping.

Cost Minimization - Perhaps not as obvious as minimizing taxes, but paying high annual fees on the 1.5% on the existing funds is to be avoided if possible. A target would be 0.5% as desirable and under 1% the maximum. It has been shown that, on average, higher cost funds produce lower returns for the investor (though I cannot find the link as a reference at the moment). The same goes for brokerage account management and trading fees, though the impact is less (unless one would go to a full service broker who charge a percentage of the assets held). A simple portfolio that can be self-managed on-line lends itself well to lower cost discount brokerages.

Annual Re-balancing - The portfolio will be re-balanced once a year in mid-April. The asset allocations will be re-stored by selling and/or buying the same ETFs or funds already in the portfolio. If there is only a small deviation of the order of less than 1% from the total portfolio target a holding will be left alone. The annual re-balancing frequency has been chosen because research such as here at the Journal of Financial Planning and here at William Bernstein's website indicates it gives close to the best investment results vs risks. Once a year, after tax year-end of April 5th here in the UK, is a convenient time to move investments or put new money into the tax-exempt ISAs. Finally, it becomes a file-and-forget item that makes it easy for this well-organized person to schedule into the agenda.

Diversification - The single most critical element is that the portfolio will seek diversification benefits of higher returns and lower volatility. This is accomplished by selecting holdings that are either uncorrelated or negatively correlated with each other (see explanations such as, and William Bernstein, linked above plus books like that of Richard Ferri which I previously reviewed). This apparently is not an exact or perfect science since such correlations vary considerably from year to year and for many years diverge from long-term averages but the benefit is very considerable over long time periods when such variations even out (thus the importance above of adopting a long planning horizon). That means acquiring holdings among equities in real estate, in small cap companies, in value (i.e. measures of "cheap stock price" according to accounting stats) companies and in international markets.

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