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!


Anonymous said...

Wow, what a post. I'm in the process of doing something similar with my portfolio. It's great to hear that you have adapted a strategy and have implemented it completely.

I'm planning to write about my portfolio as well but not all in one post since there are many interesting topics in a portfolio construction.

This could be several more posts but I'd be interested to hear about your reasonings behind some of the asset allocation choices with respect to your situation.

For example, why did you choose 70/30 as your equity/bond split?

Why are almost all your bonds Canadian?

Your US equity holding is much smaller than the world US equity weighting - what were the thoughts behind that?

In the second part of the spreadsheet in Cdn Financial you have RY, BNS listed - is this from the old portfolio? How did you get the commodity exposure?

CanadianInvestor said...

The 70/30 equity/ bond split is one I've had for a couple of years and it is comfortable. I went through the high-tech meltdown and saw my portfolio drop 40% so the possible drop with this new, well-diversified portfolio is likely to be a lot less. The other reason is that several books with drawings of the desirable efficient frontier show that a portfolio with 20-50% bonds is almost always there.

As for the bonds being mostly Canadian, my fear of being caught in US dollar currency shifts is part of the reason. There isn't a lot of choice for non-US or Canadian bond ETFs though DBC or GLD could fit the bill. One of my bonds is maturing in August so it is likely part of that will end up in one of DBC or GLD.

Re the US equity holding, I consider that the Canadian holding is almost the same asset class - correlations I've seen for the TSX300 and the S&P500 range from 0.6 to 0.9.

Yes, BNS, RY were in the old portfolio. At one point I was considering forming my own version of XFN by adding TD and MFC but then the anticipated difficulties of rebalancing with even more holdings made me decide against it.

Formerly, I had (partial) commodity exposure through XEG (energy) and XGD (gold) so the DJP accomplishes that with one holding and is broader to boot with agriculture and minerals.

One other thing I didn't mention is that the 1% not allocated in the table is a placeholder for a mutual fund (Saxon World Growth) that I have yet to cash in and consolidate with the portfolio. It illustrates that there are always exceptions and delays in implementing changes but I thought it better to move ahead now and invest the funds later.

Good luck with your effort. I'll look forward to seeing yours. There are always thiungs to learn from others facing the practical task of carrying out an investment plan.

dj said...

Makes me feel better that there is at least one other nut out there doing this to themselves and their portfolios.

I have been doing mine in steps as my confidence increases and currently am almost entirely in CIBC Index funds (MER .32% with rebate) spread over 2 registered and 2 non-registered accounts.

My next step will be moving towards some ETFs and possibly diversification of fixed income.

I find the foreign exchange issues in the RSP annoying and difficult to quantify, so am leaning toward the CIBC funds and Canadian ETFs only in these accounts and Vanguard funds in the open accounts.

At the moment I am debating/thinking about inflation-protected (RRBs) and junk bonds (PH&N High Yield). Have you posted on these before? If not, what are your thoughts on them.

CanadianInvestor said...

I haven't posted before regarding RRBs or high-yield bonds. Ferri (love that book!) does recommend both as part of the diversified fixed income portfolio for the same reason - it lowers risk. Though he says to buy passive index funds, the argument for it seems less compelling to me in the case of the RRBs as there seems to be little issuer / default risk. On the high-yield side, it's the opposite - I'd never want to buy individual company high-yield bonds.
(though I did once do a chancy thing and buy Telus bonds after they had a bad quarter and downgrade). A fund is the only way. Isn't PH&N's fund one that is actively managed? Maybe the diversification benefit is still worth it if there are no other alternatives - have you found any high-yield index funds in Canada?

Re the foreign exchange in RRSP isn't it only a question of the enforced US$ buy-sell spread (1.095 vs 1.075 the day I called)? If an ETF/fund is quoted in C$ but is European for instance, isn't there still the foreign exchange risk of the movement of European currencies vs the C$? If the fund is quoted in US$ with the same European holdings, the fund value will change with the US$ vs European currencies but the US$ is also changing relative to the C$ and the US$ is washed out. Hmmm, reading this over it isn't too clear how that works. Probably should do a simple numerical example to illustrate and do a post.

Anonymous said...

This is an excellent post. Thanks a lot of sharing.

Out of curiousity, are there data for all the underlying indices? Do we have any information on the return and std-dev of this portfolio for the last 1/3/5/10 years?

Another question: your choice of US Value ETF is VBR, which is a small index. Any reason why you did not chose a large CAP value index?

Thanks, and much appreciated

CanadianInvestor said...

Good questions...

The data for indices comes from various sources, depending on the index used. For those using MSCI indices like most of the ETFs of iShares and Vanguard, the website shows how they are created. is a good website is for comparisons of the meaning of "value" and small cap by different ETFs.

My exact portfolio does not have past performance numbers but I am expecting it will give me 5-8% compounded in real terms with standard deviation of 9-12%. This is based on reading tables of historical results from Ferri and Gibson books.The IFA Canada wesbite shows a roughly similar portfolio as mine with backtested data. For the 70% equity portfolio the before-inflation return is anywhere from 8.6 to 12% p.a. for any period of 10 years or more while the sd varies from 9.3 to 10.6.

As to the choice of small vs large cap for the value holding, there are several reasons:
1 - a desire to limit the number made me eliminate several extra holdings I had selected in draft form, large cap value among them;
2 - small caps have a higher expected return - 3% according to Ferri (and volatility / std. dev.) - so I'm hoping this will increase portolfio returns;
3 - Ferri relates on page 99 how the value benefit is stronger for small caps than large caps;
4 - Ferri also discusses on p.102-107 how small cap value diversifies a total market fund (i.e. reduces volatility) ... though I recognize that I have transgressed and not bought the total market fund VTI, only the large cap fund VV, I am hoping the diversification effect will still work.

Anonymous said...

Thanks a lot for the response.
Haven't read Ferri's book but I sure will soon.

Anonymous said...

One more thing,

I am definitely moving to a very similar portfolio in the very near future. I am just concerned that all equity indices are at record high after a ~4 year strong rally. I know most academics and researchers argue against market timing, but weren't you concerned?

this might not be directly related to the post, but couldn't help ask :).

All the best

CanadianInvestor said...

Ah yes, when is the market peak?, the $64 million dollar question. Maybe it was May 23 when I made all my buys - now my overall portfolio is down. The problem is we just don't know, cannot know, according according to all the research on markets. The upward cycle could continue for years or it could stop today. If you wait to invest, what will you do with the money in the meantime and how will you know when is the time to buy in?

I remember selling all of my Nortel at around $90, (my single largest trade ever!). thinking that it was over-priced. When it dropped back to $65, I thought it had gone down enough and bought some back, then more at $50, then more at $20 (a fine example of downward dollar-cost averaging, huh?). Finally I gave up and sold it all again at $8-9. Then it kept going down to ... what was the lowest low? $1.77 or something? At $1.77 who could tell it wouldn't go under? One friend actually bought quite a bit at that level and made excellent profits he says.

All we know is one thing: the price/market level at any given time is an unbiased estimate of future expectations. It could be exactly right, high or low but that no one can tell reliably enough to make money consistently.

All that to say, you could be right but I don't know. My expectation is that by being diversified, some areas of the portfolio will do well and offset areas that do poorly. If equities go down then bonds or real estate or commodities should (if that negative correlation kicks in) go up.

Good luck with your investments.

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