Monday 24 December 2007

My Rebalancing Policy Refined

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

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

Why the Changes?
  • the move to doing the review in December is to do it at the same time as tax loss selling, to kill two birds with one stone and to minimize trading;
  • the 5% or more deviation test is the major change, coming directly from the findings of the article; though I could have simply eliminated the yearly review and applied the 5% test at any time throughout the year, I still want to do an annual review of my portfolio, my net worth, the tax situation, decisions about RRSP conversions or withdrawals, perhaps a fundamental alteration of the portfolio targets (which is not the same as rebalancing). In the practical world, rebalancing has to contend with, and fit with, lots of other ofttimes more powerful financial forces;
  • tax loss selling on its own may justify a trade, so the opportunity to rebalance fits naturally.
Incidentally, one thing I have seen mentioned as a problem to do rebalancing based on percentages is one no longer. Formerly, it would have been a lot of work to constantly track a portfolio and actual vs target percentages but that is no longer an issue. Google's wonderful online spreadsheet with constantly updated market values for the holdings, including a good-enough kludge to calculate the foreign exchange component, does it for you. I have placed a Google spreadsheet at the bottom of this blog that replicates my portfolio structure and tells me at any given minute-hour-day the portfolio value and target vs actual percentages so I can see where I have gains or losses and how much they are (I have to apply a multiplication factor to convert the model into my own total but that's not too difficult).

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

Saturday 22 December 2007

A Blog about Finance and Investing Blogs, Books and Resources

The Value Blog Review is a blog whose purpose and content is "Devoted To Helping New Investors Determine What Blogs, Websites, And Other Resources Are Essential To Stock Market Success". Check it out - there appear to be a lot of links to high quality sites.

Friday 21 December 2007

What is Retirement, anyway?

Came across a neat, thought-provoking post about how to define retirement titled the Five Minute Retirement Plan on the The Financial Philosopher blog. His definition - doing what he wants, when he wants, within reason - has a lot of merit. It isn't age-dependent, it doesn't rely on a specific level of wealth or income. And his admonition not to blindly accept his, or anyone else's definition, to make up your own, has even more merit.

Indeed, these days, I wonder what to answer on the immigration arrival cards when flying back and forth between Canada and the UK because I have not been working in a job but don't rule that out. And what would happen if thousands upon thousands of people defined retirement as our friend above does because they do what they want when they want? Would travel statistical systems go haywire (what do they use that information for, anyway?)? At some point, would authorities get concerned and charge people with providing false information - immigration officer: "retired, huh? let's see, you also checked that the purpose of your visit was business, how could that be? please step aside, we'd like to ask you a few more questions, if you don't mind." ... tasers ready! shunt to suspicious person queue.

So what is my definition of retirement? "The time when I rely on various passive sources of income (government payments and private investments), as opposed to active work (though that may still occur, but by choice), to pay my living expenses with the confidence that I will not run out of money till I am at least 120 years old doing my current activities and pastimes." Unlike The Financial Philosopher I prefer to define retirement directly rather than indirectly in financial
terms. His definition is a little too general, too much of a philosophy of life, albeit a good one, that can apply at any age and under any circumstances. If the definition doesn't provide a distinction between retired and not-retired, then it isn't too useful.

What's your definition of retirement?

Thursday 20 December 2007

Survey Results: Number of Times Laid Off

The results are in for the survey question "how many times have you been laid off in your career?". Thirty-five brave people answered as follows:
  • 17 (48%) Never
  • 6 (17%) Once
  • 5 (14%) Twice
  • 7 (20%) More than twice
On to the next fascinating topic to survey.

Tuesday 18 December 2007

Book Review: Learn to Bounce by Anita Caputo & Lee Wallace

Bounce is a sneaky book. Read it straight through quickly and it will seem a bit mundane, dry and repetitious. That's a mistake. Read it slowly, one short case at a time, and you will find yourself drifting off into reflection on your own life and career. That's quite therapeutic.

Three quarters of the book consists of two to four page stories of twenty-eight real individuals or couples (most often with their real names and given some of the details they reveal, it was a brave act to do so ... but then I always found tech work culture and people to be more direct and open) going through a layoff and ultimately successful job search after the high-tech bubble burst. One of the authors, Anita Caputo, tells her own story. From high-tech job she has now made the career transition from IT business manager to career coach, motivational speaker and management trainer. Disclosure: I am proud to say that Anita is a former colleague at the big N and a good friend. Fellow author Lee Wallace brings his 30 years experience as a career counselor and coach to the book.

The other quarter of the book consists of the authors' tips and strategies for success in finding new work. The book focuses on the impact of emotions and state of mind since the authors believe through their experience and that of the interview subjects that those are the critical elements of a successful bounce back, not just into any old job, but something that is fulfilling. Curiously, the presentation and writing style is not emotional, it is very matter of fact, but maybe that's a reflection of the philosophy of successfully bouncing back - "_ _ _ _ happens", the sooner you accept it and move on, the better off you are.

The large number of stories allows the authors to present a very wide variety of types of people, obstacles and eventual outcomes. Many are more difficult situations - people highly specialized, mid-forties or fifties, lengthy time with one employer (and thus not used to the job search process), children to support, medical problems to deal with, spending years out of work (technical skills getting rusty etc).

All are success stories, there are no tales of permanent failure and woe, though hardships along the route to success are not glossed over. No doubt, the tech meltdown caused some to fail (I know some tech families ended up staying in the City of Ottawa's homeless shelter, though I don't know what happened ultimately). There are many ways to fail. The authors have decided to focus on the positive.

Despite all its subjects coming from high-tech, this is not a book about high-tech. Company names are completely absent from the text, evidently a deliberate attempt to distance the message from the specific industry. The significance of high-tech is that the meltdown provoked a quite unique set of extreme and highly instructive circumstances - educated, skilled and experienced people suddenly faced a situation where their industry and technical knowledge were more or less useless because there were almost no jobs in the sector. They were thus forced to be imaginative and resourceful. But the gratifying result is that they succeeded anyway.

The importance of networking appears consistently in many stories, how making connections through others produced far more results than browsing the Internet. The interviewees and authors say over and over that the time to do networking is always - never to stop. When I was out of work, I found networking to be the most awkward and difficult of things to do. But it did get me at least one job and played a role in the other job I found after my layoffs. Networking is a two-way street - being able to help others find a job is deeply satisfying. In financial terms, it could be termed social capital. Just as you have financial capital, which store financial assets to be spent when you need them, and human capital of training, education, knowledge, experience and skills, which store value of use to employers, you have social capital of connections with people, favours and services rendered, which you can lever/"spend" to find a job (and can be extremely useful in doing a job as well). The authors note that quickest to find work were those with the best networks in place.

In terms of personal finances, the book mentions in passing a number of principles that seem self-evident but they sure help or hurt if you do them or not so the reminder is salutary: having savings to fall back on relieves some of the pressure; having to take on debt during unemployment "rots the gut"; investing in high-tech while working in the sector is a stupid thing to do (mea culpa, I did it), i.e. diversification is more important than "investing in what you know"; household expenses can be cut drastically if necessary (one family cut down to a third of what it spent before the layoff), ideally when the warning signs appear; the time to pay attention to family finances is during good times, i.e. start saving, mind diversification now and if you are too busy working to do it yourself, hire a good advisor.

If you ever get caught in a layoff, you need this book. It will remind you that, no matter what your circumstances, you can bounce back and it will guide you how to do it. Others did it, you can do it.

If you are working in a job you don't like or you feel in a rut, there's a fair chance you will get laid off sometime to relieve you of this problem (e.g. in my mini survey on this blog half the respondents had been laid off at least once). This book will give you ideas what to do next to find something better and make you feel thankful for the layoff.

If you are happily working in a great job (as I was in high tech before laid off), this book will help you understand that being laid off is not the end of the world. It is not even necessarily a net negative. Happiness does not come in only one job. In short, the people in this book exemplify the philosophy in the Tom Hanks line of the movie Forest Gump, "Life is like a box of chocolates. You never know what you're gonna get."

My rating on this book: 4.5 out of 5.

To order a copy on-line, go to the LearntoBounce website. On Chapters it seems to be "temporarily unavailable". Update Jan.12 - Chapters has finally fixed the problem and it can now be ordered there as well.

Monday 17 December 2007

Preferred Shares in a Portfolio?

A reader asks what I think of blue chip preferred shares. A good question since I have to admit not having any in my portfolio right now and I have not thought about them a great deal. Maybe I'm missing an opportunity!

Preferred shares are stock of a company. They pay a usually fixed, but sometimes variable, dividend to shareholders. This article titled Why I Don't Use Preferred Stocks from the Motley Fool by David Braze provides more detail, explaining features like participating, callable, cumulative and convertible that can alter their character, sometimes quite significantly. Shakespeare's Primer, linked on the sidebar of this blog, has another excellent explanation of preferreds.

There are two key elements of preferreds to focus on:
  1. The fact that they pay dividends not income for tax purposes in Canada (and the UK at least, since in the USA, the tax rules are that they constitute income). The tax status makes a big difference due to the much lower tax rates on dividends as compared to income - e.g. 8% in a middle tax bracket vs 31% (see the table in this post on Canada vs UK tax rates for the rates in the various brackets).
  2. Their price moves up and down with interest rates primarily, though a company's default risk does enter into pricing, mostly negatively. In other words, they behave like long-term bonds, moving down in price when interest rates rise, or up when rates fall. How closely they do so is an open matter. I looked in vain on the web for correlation matrices that include preferreds as a potential asset class, so I stand to be corrected. On the basis of their characteristics, for the time being I consider their role in a portfolio to be a tax-advantaged substitute in fixed income for bonds.
I took a quick look today at the current yields on Royal Bank of Canada's W series preferreds (ticker RY.PR.W) - 5.182%, and on a range of investment grade straight bonds of 10 years or more to maturity - 5.0 to 5.6%. Since yields are comparable and since bonds rank before preferreds (a company must pay its bond interest before paying preferred dividends), I see no reason to hold preferreds in a non-taxable account. All my fixed income is within tax-deferred RRSP or LIRA accounts so I don't hold any preferreds at all.

Some people are big fans of preferreds. There is a really good blog by J Hymas called PrefBlog. The fellow is also a regular poster on the Financial Webring thread devoted to Preferreds, a really excellent source of discussion and an opportunity to ask questions of very opinionated and (most often ;-) knowledgeable people. The article Putting Income-splitting to Work by Rob Carrick in the December 14, 2007 Report on Business contains description of how some people are using preferreds to their advantage on taxes.

A critical word goes to investment god Benjamin Graham - a quote from his classic book The Intelligent Investor: "Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one." Mind you, he was writing in the US context, where their tax status is no better than bonds, so perhaps that is too harsh. I cannot complain about anything that can save on tax.

Saturday 15 December 2007

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

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

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

Their conclusions are these:
"Rebalancing frequency and threshold level are associated with significant differences in portfolio scaled returns. We show that this is true across a wide range of policy weights. From the perspective of both frequency and threshold levels, patient rebalancing policies tend to dominate quick-trigger policies, even before trading costs and taxes are considered. If such costs were taken into account, the advantage in favor of patient policies would be even more dramatic."
Scaled returns means returns that take account of returns relative to risk. Policy weights means the bond vs stock mixes. The threshold means that if bonds are meant to be 40% of the portfolio and the threshold is 10%, then rebalancing was only done if bonds went down below 30% (or above 50%) not when bonds went below 36% (10% of 40%).

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

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

Friday 14 December 2007

Tax-Loss Selling Index ETFs: How to Do It Right

When December rolls around it is time to look over the portfolio and see where certain holdings are in a significant net loss position to decide whether it is time to lock in the loss to offset against current year or past year capital gains (past year because losses can be carried back or appllied against gains up to three years in the past to reduce taxes and get a refund). The objective is to reduce net capital gains to reduce taxes.

In looking over my own holdings, as shown in the model portfolio at the bottom of this blog, just about everything is showing a loss since I remodelled the portfolio in May and booked a pile of capital gains. Lesson number one is therefore to keep a running total of capital gains to be able to tell at any moment whether it is necessary or advisable to do any tax loss selling at all for this year's return. That's why I have my Cost Base tab in the model portfolio spreadsheet, which I update with every trade. Note that capital losses can be carried forward indefinitely into future years so if you think you may have higher income down the road, it may be beneficial to take a loss now to offset future higher gains. For the passive index investor, present market difficulties and losses presents an opportunity to lock in those losses with the confidence and expectation that sectors / asset classes (e.g. REITs have taken a hammering) will eventually recover. The indefinite carry forward feature of CRA rules means that one doesn't have to try predicting when markets will recover, only that they eventually will recover (if they never do, we are all in deep trouble or if you die before they do, will you care?). Patience is a virtue.

First, I note that one holding - AGG, the US Intermediate Term Bond Fund - has gone up in price in US funds from $99.37 to $100.38 yet it shows a loss in Canadian dollar terms, which is what counts for Canadian tax purposes. The reason for that is, of course, the tremendous appreciation of the Canadian dollar vs the US dollar; in this case, the C$ has appreciated from about CAD1.0920 per USD on May 23 to about 1.0167 today (yup, that's right appreciation means it takes less CAD to buy USD). It is thus very worthwhile to track a portfolio taking into account the shifting exchange rate. Volatile exchange rates can easily and quickly change a net Canadian dollar gain into a loss (or vice versa).

However, most of my portfolio is held within my RRSP or my LIRAs so there is no chance to claim capital gains or losses. Two holdings are in my non-registered taxable portfolio - VV, Vanguard's US Equity Large Cap ETF and VNQ, Vanguard's US REIT ETF. In the case of these two holdings, the USD price loss has been accentuated by the falling USD, creating a significant enough opportunity to spend the commission costs to lock it in.

Note that the Canada Revenue Agency does not require, nor does it accept, the reporting of foreign exchange gains or losses of $200 or less (see page 18 of the CRA's Capital Gains guide T4037).

Note also that the date on which to do the foreign exchange calculation is the settlement date, when you receive the money from a sale, or pay the money for a purchase, NOT the trade date, which is three business days earlier. It is thus a fact of life that the exchange rate will shift, perhaps a lot, between the trade date and the settlement date, so you can never know exactly how much your gain or loss on foreign property will be. Well, perhaps if you had millions at stake it might be worth locking in the exchange rate with a foreign exchange futures transaction but for us hoi polloi, it won't be practical.

The settlement date rule is especially important to note when one is selling right at year end - if the trade date is in 2007 but the settlement date is in 2008, you cannot report the loss on your 2007 return, you must report that in your 2008 tax return, probably not what you want if you are trying to minimize taxes now. Due to normal holidays when exchanges are closed, this year the last trading day for counting transactions in 2007 is Dec.24th. Incidentally, I phoned CRA and asked for a reference to a written guide where this rule on the settlement date is stated but they had none to point me to except general statements like subsection 40.1 of the Income Tax Act which mentions gains or losses are counted when actual value is received.

Incidentally, there are of other things than ETFs to which tax loss selling applies and a good summary of tax loss selling by Kevin and Keith Greenard appeared in the Dec. 8, 2007, Victoria Times Colonist. As the Greenards point out, it is worthwhile to review capital agins reported in the last three years since present year losses can be carried back to offset past tax and obtain a refund.

One tip that can reduce your foreign capital gain or increase your capital loss by about 2% depends on the exchange rate that you use to convert to/from Canadian to US dollars (or other currencies if you are able to trade in such). The CRA accepts as standard the published Bank of Canada rates account and the funds had not passed into or out of actual CAD. Though they could not quote me a written source to confirm this and therefore there may be some doubt they misunderstood what I was asking, which might mean it is incorrect, such a position conforms to the logic of what a real trade would follow. but these are nominal mid-market (half-way between buy and sell) rates not the rate you or I pay to our broker to buy or sell. The commission charged by the brokerage means you get fewer USD when you buy them / buy the US equity, and less CAD when you sell. In the case of BMO Investorline, it's about 1% commission each way, or 2% for a round trip. The CRA told me when I called their public tax info line at 1-800-959-8281 that I could use the actual broker buy-sell rate, even though the purchase and/or sale may have occurred entirely within a USDCRA is not that unfair to force people to use FX rates that understate their costs or over-state their proceeds of sale. In other words, you and I are better off using the broker foreign exchange rate instead of the Bank of Canada rate . The only requirement is that you must document and be able to show the CRA, if they should ever ask, the actual broker rate. I simply took a screen shot image of the BMOInvestorline FX quote for the CAD-USD exchange on my settlement date. You must also use the same method of FX, Bank of Canada or broker rate, on reporting both original purchase and eventual sale. You don't have to follow the same method for all holdings, however - it can vary holding by holding.

Another key rule has to do with passive index ETFs (or mutual funds), identical properties and a superficial loss. If you want to sell for a tax loss but stay invested in the market in the same asset class, you must not buy an ETF that tracks the same index as the one you just sold for the loss. Otherwise, CRA will deny you the loss, i.e. deem it a superficial loss, and treat your transactions as if you had never sold the losing ETF (your adjusted cost base of the new ETF will be considered the same as the old one). That the practical interpretation of identical properties regarding ETFs is such is stated on pages 164-165 in Howard Atkinson's book on ETFs, the New Investment Frontier III (see my review of this book here). Jamie Golombek, with AIM Fund Management at the time, in a Canadian Tax Highlights March 2002 article referred to a Dec. 5, 2001 CRA bulletin (TI 2001-008038) that used the example of two funds which track the TSX 300 from different companies as being identical in CRA's view. I am still awaiting a response two weeks later to my enquiry to CRA's public info line on the matter to confirm this interpretation.

Update January 11, 2008 - a representative of CRA phoned and said that the 2001 bulletin mentioned above is the only and latest information on the subject. He also emailed me a copy. Some key excerpts: "... the determination of whether investment instruments are identical properties requires a review of all the facts of each particular situation which would include a review of the legal structure of the investment entity, the composition of its assets, risk factors, rights of investors and any relevant restrictions. ... a TSE 300 Index Fund, for example, would generally not be considered identical to a TSE 60 Index Fund. ... Accordingly, an investment in a TSE 300 index-based mutual fund of a financial institution would, in our view, generally be considered indentical to an investment in a TSE 300 index-based mutual fund of another financial institution."

In my case, VV tracks the MSCI US Prime Market 750 Index and I bought IVV, the iShares ETF that tracks the S&P 500 Index. By the CRA rule if I now try to sell the IVV and buy SPY, the SPDR S&P500 to lock in further losses (a hefty drop this week), that loss would be disallowed. The VNQ that I also sold tracks the Morgan Stanley REIT Index while my replacement fund, the RWR from SPDR tracks the DJ Wilshire REIT Index. That should not violate CRA's test while keeping me fully invested.

It is thus very handy to keep a list of alternative acceptable ETFs within each asset class, such as the one in the Asset Allocation tab at the bottom of this page. You should also note what index they track to comply with the identical properties rules when selling for tax losses. In my original off-line spreadsheet, I've added that info in the cell Notes, though unfortunately the Notes cannot be displayed in the Google on-line spreadsheet.

Tuesday 11 December 2007

A Canadian Investor's Christmas Wish List

It's the time of year that Santa comes around and this year I'd like him to bring me these small gifts:
  • the capability to hold foreign cash in registered accounts like RRSPs and LIRAs, starting with US dollars but why not other currencies like GBP, EUR and JPY, to avoid having to settle trades back into Canadian dollars and then to repurchase USD again to re-invest, which incurs foreign exchange commissions on each end and 2% extra trading costs. I had suggestions from one discount brokerage (not one of the big five banks) that it was finally about to launch such accounts this month - fingers still crossed.
  • discount brokerage accounts, both registered and non-registered, that enable low cost trading ($10 per trade sounds reasonable) directly on other major world exchanges like London, Tokyo, Paris, Frankfurt; TD Waterhouse, this should be especially easy for you since it already exists in your UK service offering
  • passive index tracking mutual funds with low MERs (0.3% or less is a good target) like those of Vanguard in the US as a competitive alternative to ETFs; this will enable small purchases, re-balancing and will simplify reinvesting and tax returns. Note to TD Canada Trust - start offering your e-Series index funds through other brokerages and not force people to open an account with you ... oh, and lower those fees a wee 0.10% please; at Christmas you will find that if you give something, you will receive too.
  • combined account portfolio reports from my discount brokerage for all types of accounts, into one integrated portfolio, to save me the trouble of copying all the data from my regular trading account, my RRSP and my LIRAs into a spreadsheet; a very useful extra capability would be to enable me to add labels of my choosing for asset classes and to summarize that as well across all accounts; plus, capital gains tracking on the regular accounts, to make it easier to do my income tax return plus plan year-end tax-loss selling or gains lock-in.
  • real tax-exempt savings accounts (wonder if Jim Flaherty reads this blog) from our federal government like the ISAs in the UK, in addition to the tax-deferred RRSPs; it's so much simpler and more flexible - no tax deduction since the funds come from after-tax income but growth is completely tax-sheltered and no tax is due on withdrawal, no matter what the type of investment, one's income or age.
  • again from the federal government, an annual tax-exempt capital gains amount, say $10,000, like that of the UK
That's not a lot to ask is it, only six things? And I've been a good boy all year.

Sunday 9 December 2007

Thoughts on How to Start a Portfolio from Scratch

A reader has asked:
"This question is about what to do with your money if you have a lot of it to invest every month. Lets say I had $5k per month to invest, how much would you recommend I save up before I purchase more ETFs and as such, re balance my portfolio? You see, if you read what I have been reading, many people promote the passive strategy (i.e: minimal trades per year, spending less time watching each individual holding etc), I have been reading blog posts, and people have been saying that they wait until they have about 2-3k saved up, and then they "buy more ETF's". But if I did that, I would be buying ETF's every month or 12 times/year, and if I have 6-7 holdings (even at e*trades low cost of 9.99) I'm still spending over $700+ in the year just on trades. So that seems bad right? On the one hand I hear I should wait and just "do the couch potato" and re balance once per year - but I also feel like sitting on $60,000 (saving $5k/month for a year) and just plopping in such a large sum every December would be ridiculous. So the answer must
lie between purchases every month (too often) and purchases once per year (not often enough). What is recommended and why? How often should I purchase more?"

My comments:
  • first, all what follows supposes that the intent is to establish a diversified portfolio with specific proportions of the total portfolio value to be invested in various asset classes; my own portfolio structure is shown at the bottom of my blog - you can see the percentages for each asset class on the Asset Allocation tab and the ETFs I have chosen, as well as alternatives. You can adjust the percentage allocations as you wish, the point is to set a target allocation.
  • for someone who will quickly accumulate a portfolio in excess of $100k, using only ETFs and a broad range of them - I have 16 of them in mine - makes it possible to invest in minor asset classes which can provide greater diversification and higher returns.
  • in practical terms there is a trade-off between trading costs and portfolio balance; since any cost is a certain negative return, I believe that's the most important consideration, especially in the short term (a couple of years) while the portfolio is building. At $10 per trade, the commission on a $5,000 purchase is 0.2% but for $1,000 it is 1.0%, which starts to hurt. Do that twice in a year to re-balance and it takes away an appreciable chunk of returns. For that reason, until two or three years had passed (at your rate, you would have $120k invested after two years) I would be very surprised if any asset class had changed so much that it was necessary to do a trade only for re-balancing, so I would only use new funds to progressively establish the portfolio, asset class by asset class and not bother doing trades specifically for re-balancing
  • I would therefore do one monthly trade - a purchase of one ETF with all of the $5k - to get the funds invested immediately. There is no reason to sit on the cash and wait; the method I outline below is simple enough I believe.
  • I would also start with core asset class ETFs to get the basics in place (sooner rather than later since one never knows when it might be necessary to interrupt the build-up; it will be better to leave an in-progress portfolio that is at all times reasonably balanced ).
    For example to build my portfolio:
month 1 - buy $5k of XIU,
month 2 - buy $5k of VGK,
month 3 - buy $5k of XBB,
month 4 - $5k of VV,
month 5 - $5k of VPL,
month 6 - $5k of VWO,
month 7 - $5k of VGK again,
month 8 - $5k of XBB again,
month 9 - $5k of XIU again,
month 10 - $5k of XSP,
month 11 - $5k of DJP,
month 12 - $5k of VGK again.

Total trading costs $10 x 12 = $120. The first table shows the investments at end of year 1 in terms of dollars, actual percentage of portfolio and the eventual target portfolio percentages for reference. The smaller asset classes are over-invested but that quickly begins to change in year 2. The row and column totals for the assets are already taking shape.
  • Continuing this pattern in year 2 buying $5k per month, month 13 - buy $5k of XBB, month 14 - XMD, month 15 - AGG, month 16 - XRE, month 17 - XSU, month 18 - RWX, month 19 - XBB, month 20 - EFV, month 21 - XBB, month 22 - VGK, month 23 - XIU, month 24 - XBB. Only one non-core asset class remains to enter the portfolio - VNQ, US Real Estate. The row and column totals are getting close to the target allocations.
  • The principle is simply to put each new month's purchase into the asset class that is furthest away from its target percentage. Since the evolution of the markets will move the actual percentages away from their initial purchase value, putting each new purchase into the asset class that is furthest away in actual terms as of the day of purchase will perform re-balancing. As long as you continue to put new money in, I would not see a need to do any annual re-balancing at all. For my model $100k portfolio, in the six months since I set it up in May the furthest any asset class has moved away from the target as of today is VGK, down $930; multiply that by 5 to get a hefty $500k portfolio and that could be re-balanced with one purchase. As time goes on, each $5k purchase represents a smaller and smaller percentage of the total portfolio, and each previous purchase goes down in percentage terms, bringing ever greater accuracy to the portfolio balance, especially among the minor asset classes.
  • With fewer ETFs in the portfolio, it would be even easier to attain the target percentages - instead of VGK, VPL and VWO, you could simply buy VEU, the Vanguard Rest-0f-World (non-US), for XIU and XMD, take XIC, the S&P TSX Composite, for XSP, VV, XSU, buy VTI, Vanguard's US total market fund (though that would mean all your US holdings would be subject to the effects of the US$ fluctuations, something I think is too extreme, preferring to have half of my US large cap equity in the hedged XSP). The only minor one I would always wish to own is real estate due to its proven negative correlation with other asset classes, which thus provides very valuable volatility reductions for the portfolio.

That's it.

Thursday 6 December 2007

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

A reader sent in a couple of excellent questions on the practical aspects of setting up the bond portion of a portfolio:
  1. which Canadian bond ETF to buy for a portfolio - the iShares Short-Term Fund (Ticker: XSB), or the iShares Canadian Universe Fund (all issuers and maturities; under ticker: XBB), or possibly other funds
  2. why buy any bond fund if cash in ETrade is paying a healthy 4.15%?
To start a portfolio, I would favour XBB since it covers the whole Canadian bond market. Buying and holding the market is one of the fundamental principles of passive index investing. If one were to buy only XSB, that cuts out a substantial portion of the bond market.

The attached chart, using data from the iShares Canada website on December 6, illustrates more key differences between XBB and XSB:
  • long term, the performance of XBB will be superior - note the five year return of 5.89% vs 4.37% (these figures are for the reference index that the fund attempts to track; the tracking error shows how much the ETF deviates from the index); Since XBB holds some long term bonds, it has a longer duration (see here for an explanation of bond duration as opposed to the term to maturity), which means more sensitivity to interest rate changes and more volatility, but which also provides greater yields in the long term.
  • XBB's tracking error is a little more than XSB's, partly a reflection of the 0.05% higher MER on XBB
  • currently, the yield difference is much slimmer than the long term averages for different maturity funds
  • XBB has some of its distributions in the form of capital gains (cf 2005 and 2004), which benefits from a lower tax rate if held outside an RRSP or other registered account
  • XLB has a much higher longer term performance, as shown by the results of the index it tracks
Note also that TD CanadaTrust also offers a mutual fund - the TD e-Series Cdn Bond Index - that tracks the same whole of market Scotia Capital Universe Bond Index as XBB. The TD fund has a higher MER of 0.48%, which almost certainly results in lower net returns than XBB. However, being a mutual fund, it charges no commissions, so if regular purchases of small amounts in a building up phase of a portfolio are taking place, it may be a better choice (e.g. the 0.15% extra MER is about the same as a $10 trading commission on a $6666 purchase of an ETF) . The other caveat is that one must have an account with TD to buy that fund.

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

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

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

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

International Book Shopping - Where is the Best Place to Buy?

Books are wonderful in their own right and they are also one of the most convenient items to ship anywhere in the world as a Christmas gift to far-flung family members and friends, especially when ordering on the Internet.

I have conducted a small shopping comparison using Amazon to see where is the cheapest and fastest place to buy and ship books, in this case to southeast Asia. Amazon has nine different websites listed here but I have compared only those of the UK, the USA and Canada.

The attached table shows the results of my survey with the green highlighted cells indicating the lowest cost or fastest delivery. When a non-Amazon seller offered a much cheaper book, that's what I picked, which means the Marketplace shipping rate would apply.

My observations:
  • none of the Amazon sites is best across the board
  • many prices are fairly close after the exchange rate is taken into account - a surprise given the huge swings in currencies these days - but there are significant differences for some books; it may be worth shopping around for a book.
  • the UK is far and away the best place for the fastest low cost shipping, and the only place from which one can still order to ensure delivery before Christmas, while Canada is just horrible - is that our pathetic postal system in operation?
Of course, your friendly credit card company will charge you a few percentage points to convert your purchase from a foreign currency back into your home billing currency, unless of course you are a citizen of the world and have credit/debit cards in multiple currencies. However, it may still be worth it. In the past, I have ordered a number of books through the UK website, paid in GBP for delivery to the UK, which were actually shipped from the USA and it all worked just fine.

So now we have international book arbitrage. Happy reading everyone.

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