Possible Effects of Global Imbalances on Investors

McKinsey & Company's Globalization's critical imbalances in the McKinsey Quarterly report provides a readable summary of those issues along with some implications that, though they are directed at a corporate audience, provide food for thought for individual investors.

Here are a few parts I think to be pertinent:

• "it would be wise to be prepared for the high probability of future financial shocks. To do so, most companies need to become more adept at risk management and to err on the side of being overcapitalized, overliquid, and overprepared." By shocks they mean what is described in the next quote below. To me the implication is to hold a higher amount of fixed income with special regard to credit-worthiness. Canadian government debt seems to me to be a good bet, even better than US Treasury debt.

• "... companies should engage in serious scenario planning around “unthinkables.” These might include the potential for significant, rapid shifts in currency values (for example, a 30 percent decline of the dollar versus emerging-market currencies); an exit from the euro by some nations; dramatic, rapid changes in commodity prices (for example, oil prices spiking to $200 a barrel); or defaults on debt by major nations." Hello major volatility in different parts of a portfolio. Currency exposure may well account for most of the variation in an internationally-diversified portfolio in future. If CAD remains strong because of Canada's production of commodities and because our government's fiscal situation is strong too (thanks again to Paul Martin and Jean Chretien who did the dirty work back in the 1990s that we benefit from today), there is a good possibility we Canadian investors won't gain much overall from such shifts, maybe even lose due to US and European holdings even though emerging markets holdings might rise even more strongly. Since emerging markets are typically a small (only 5% in my portfolio) portion, does that mean one should depart from the traditional backward-looking passive allocation according to current market value and increase the allocation looking forward. Or, an investor has two other choices - 1) try to avoid currency volatility by buying hedged funds but the question is whether such funds are effective given their typical high overhead cost and the tracking error; 2) stay exposed to currency, monitor the portfolio closely and be ready to do major rebalancing. Hmmm, what to do .... cannot say I've decided but just ignoring this stuff isn't smart.
  

The Mighty CAD, Computer Comparison Shopping II: Canada vs UK vs USA and the Olympics

Yes, those things in the blog title post are linked. Let me explain.

A few years ago I compared the price of the same Dell computer and found that a Canadian consumer would need to pay 20-30% more than someone in the UK or the USA.

Goodness, how things have changed. A similar comparison today of a Dell Vostro 220 Mini Tower with the same components delivered within the country tells us that this item in Canada costs 10% more than in the UK and 16% less than in the USA! As noted in the original post, the identical computer should cost the same effective amount in different countries according to the theory of purchasing power parity. The divergence since 2007 has narrowed since 2007 but it is nowhere near purchasing power parity. From being a lot more expensive than in the USA, the Canadian-bought computer is now significantly cheaper. Here are the costs and exchange rates (using mid-market quotes from Google Finance) for this no-monitor system.

• Canada: $598
• UK: £349 at CAD to GBP 1.5475 = approx. CAD $540
• USA: $685 at CAD to USD 1.0357 = approx. CAD $709

Is this only for computers I wonder? Will US shoppers now start reversing the cross-border flow of bargain seekers?

On a shorter time scale of the past year, since the abatement of the flight-to-safety panic of the 2008 crisis, the Canadian dollar has been on a tear against virtually all world currencies, as this chart from RatesFX shows. The blue areas show CAD appreciation and the size of the boxes for each currency on the chart indicate the importance of the currency. Note how the chart is mostly blue. In Olympic terms, the CAD is currently the Gold medal currency ... well maybe silver, since the South Korean won chart is 100% blue (yes, it is tough to own the currency podium ... or does the USD count for more than the won like hockey or curling count for more than short track speed skating? [I've often thought they should count one medal for each player on a team where it is impossible to win more than one medal - like hockey and curling - to compensate for the sports where an athlete can win a half dozen medals]).


That's good for Canadians wanting to travel on the cheap, or Canadian expats who bring Canadian funds into the USA, Mexico, Europe etc to live on. It isn't quite so good from an investment point of view since foreign stock returns have been reduced by the CAD appreciation. Still, as this Google chart showing CAD vs USD and EUR, as well as returns from foreign stock ETFs for the USA (Vanguard's VTI) and the rest of the world excl-USA (Vanguard's VEU) demonstrates, the stock market rebound has far outstripped the CAD currency jump, so a Canadian is still well ahead of the game on a net total basis.

Finding Cheap Travel Destinations by Exchange Rate Shifts

In the past few years, I've several times thought of visiting Iceland for its scenic outdoor beauty but found it impossibly expensive so did not not go. Today a GlobeAdvisor article notes that tourists are flocking to Iceland because it has become very affordable as a result of the plummeting Icelandic kronur.

Though the Canadian dollar (CAD) has dropped significantly in the past year against the US dollar, other countries like Iceland have done so much worse that they have become much cheaper travel destinations. Iceland is not at all alone. Other countries whose currency have dropped significantly vs the CAD in the last year: Sweden (-17%), Poland (-25%), Ukraine (-33%) Hungary (-17%), the UK (-10%), Thailand (-9%) and South Korea (-9%). To quickly look at changes over any period from the last 3 months to 3 years check out the RatesFX CAD Visualization chart - the brighter the red the more the CAD has appreciated. Yahoo Finance has historical rates for more countries but it requires doing one at a time searches against individual currencies.

Of course, a drastically falling currency is often associated with inflation so it's necessary to check out actual prices before booking.

Even in places like Europe where the exchange rate has not changed much, the recession is causing good hotel, airline and restuarant deals to appear.

Out of the financial crisis comes opportunity. Instead of not travelling at all, this may be a fine time to get a bargain holiday.

Exchange Rates at a Glance

If you have taken the plunge and put some of your investment portfolio into other countries through international ETFs like VPL, VWO, VGK, EFA and so on, you may already have noticed that the movement of the currency of the foreign countries has as much or more of an effect, either positive or negative, on your net home currency portfolio value as the actual market returns in that foreign country.

For Canadian investors looking abroad, the situation lately has been decidedly negative as the Canadian dollar has appreciated against every major currency around the globe. That's one major reason why my portfolio, whose structure is shown at the bottom of this blog, is down from its initial investment value of May 2007.

There is a great website called RatesFX where you can obtain a visualization of your own currency against all others. I've copied a screenshot for the Canadian dollar for the past year.

Note how the chart is almost completely blue - in other words, just about everything has gone down against the mighty CAD. Among economies of any size, only the Brazilian real has gone up. A neat feature of the live website is that when you hover your mouse cursor over the currency symbol, it shows the country and the actual percentage change so you can find out immediately that KRW stands for South Korean won and it has declined 17.54% in the last year. The other tabs show what has happened over the last day, 3 months or 3 years. In the case of the CAD, the 3 month chart shows a break in the pattern of CAD strength. The USD has still been going down but the euro and the Japanese yen have been going up, a good thing for my portfolio (e.g. a constant value of JPY buys more CAD, which is what I spend).

It is more normal that other currencies do not all move together going up or down against the CAD. Check out table 4 Comovements from the UBC Sauder School of Business (my Alma Mater of long ago!) Pacific Exchange Rate Service website, where it shows that the USD only seems to move with the GBP and the JPY about a third or less of the time. That gives me some reassurance that my portfolio will not continue to go down from currency effects but instead will gain the benefit of volatility reduction from currency diversification.

For the US investor with international holdings, the picture is quite the opposite to Canada. Everywhere the USD has been weakening (see the red chart) and portfolio gains from the currency shift will have been quite juicy.


For the UK investor the story has been mixed - strength against the USD, weakness against the euro, so the effects on a portfolio would depend on its exact makeup and proportions.



The RateFX website features a ton of other useful information, such as statistical indicators of whether a currency's volatility is increasing or decreasing - the CAD seems to be increasing and thus risk is going up - along with predictions for near future ranges of a currency's value against others.
There is an extensive list of resources and links relating to foreign exchange, including some money transfer services. The only thing it seems not to have is links to foreign currency trading sites but there are plenty of those in the Google ads on the website's sidebars.

Buying Scottish Cash - Caveat Emptor

Travellers to this lovely part of the world should take heed when buying some cash before departure that Scottish money (cash) costs more than English money despite the fact that both are the same currency - pound sterling!

RampantScotland describes this anomaly and provides other useful money travel advice for Scotland. Is this anomaly due to the fact that Bank of England paper currency notes are accepted everywhere in Scotland but notes issued in Scotland by the three Scottish banks are not commonly accepted in England (even though they are legal tender anywhere in the UK)? The other pages of RampantScotland contain a miscellany of useful and amusing facts about the place, well worth a wee browse.

For trivia buffs, BBC article "Scottish Money Needs Protection" explains how the anomaly came about:
"In 1826, the British parliament passed legislation preventing banks from issuing their own pound notes, a practice which was threatening to get out of hand.

But a vigorous campaign in Scotland, which enlisted figures such as the writer Sir Walter Scott, ensured that it was exempted from the new law."

Although RampantScotland says overseas banks issue only Bank of England notes, that is apparently not so in Canada as the the Royal Bank of Canada has two sets of buy/sell rates for cash and indeed you must pay more for Scottish pounds than English pounds. In addition, when you want to sell them back to the bank at the end of your trip, you get less for Scottish pounds. Today, for instance the buy/sell spread for Scots pounds is 7.165% but only 6.893% for the English kind.

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.

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.

Comparison Shopping on Computers: Canada vs USA vs UK

There has been a lot of complaining lately on the slow downward movement of prices in Canada compared to the USA. Since I probably will soon be in the market for a new computer and I have the luxury of buying it in the UK or in Canada as I travel back and forth between the two countries a lot, I decided to do a simple comparison. Computers have the convenient property of being pretty well standardized worldwide so it is easy to make apples to apples comparisons, especially when there are are worldwide vendors like Dell Computer, whose online ordering and configuration website make it possible to build the identical machine for different countries. Purchasing power parity would lead us to believe that identical items in different countries should have the same price after currency conversion.

Below are the results of my little experiment on the delivered price, including taxes and shipping, for a Dell Inspiron 530s. The only substantial difference is that the Canadian version has Windows Vista Home Premium while the US and UK versions have XP Professional. There might be a price difference on that account but since Dell offers some systems with a choice of Vista or XP at the same price, surely there cannot be a big difference in the total cost of the system.

The currency conversion rates are those on Yahoo as of today UK£ = 1.9528 C$ and USS$ = 0.9344 C$.

Total Delivered Price

• UK £597 = C$1165
• USA $1158 = C$1082
• Canada $1435, or 23% more than the UK and 33% more than the USA!!

Looks like I will be buying my next computer in the UK, not Canada. I used to think that the UK's cost of living was shockingly high compared to Canada's but the substantial rise of the Canadian dollar against the pound sterling is changing that situation. My cost of living (in C$ terms) here has declined by about 10% in the last year as a result (which is a great consolation, since my portfolio investment losses in the Vanguard Europe ETF (VGK) have thereby been offset to a large degree).

A final insult is that only Dell Canada does not offer any systems with Ubuntu Linux, an operating system I have been happily using on a 2000 vintage Dell laptop. In fact, the only reason I will replace the laptop is an intermittent and growing hardware malfunction (my cursor seems to wander uncontrollably around the screen at times). Linux will enable me to use the hardware till it breaks, as opposed to having it become obsolete in half the time due to software bloat in the Microsoft environment.

Dell Computer in particular has no excuse for the above pricing differences since it doesn't manufacture any systems in Canada and since it manufactures PCs as and when they are ordered and so has no inventory pipeline with embedded costs to cycle through that might somewhat justify a delay in adjusting prices downward.

Q&A on IFA, DFA with Michael Hill

Readers of this blog may be aware that I consider the website of IFA Canada to be one of the best for the quality and quantity of investment information, a mix of financial theory and practical application of significant usefulness to the DIY investor.

At my invitation, Michael Hill of DeThomas Financial, who also represents IFA Canada, has written responses to my questions on IFA and DFA. Note that I do not own any DFA funds, nor do I have any business relationship with DeThomas or IFA. I just borrow their ideas, which they willingly offer to everyone - even their competitors(!) - as you will read below.

1) What is IFA Canada and what is the difference or relationship between IFA, Dimensional Fund Advisors (DFA) and De Thomas Financial? What about other financial advisors such as Milestone Financial who also say they offer DFA funds?

IFA Canada is an educational company which provides information, data and portfolio allocations and design as well as a proprietary Risk capacity survey which allows Canadian investors to fully understand the power of index investing. IFA Canada's mandate is to "Change the Way Canadians Invest." This is accomplished by providing peer reviewed, empirical evidence showing the results of index based portfolios. The Risk Capacity Survey further refines the investor’s knowledge in directing them to the proper portfolio allocations. Although Index Funds Advisors Canada may provide data, information, and content relating to investment approaches and index mutual funds, you should not construe any such information or other content available through the Site as legal, tax or investment advice. You should not consider any information on www.ifacanada.com as an offer to sell or solicit for sale any securities listed or mentioned on the website. Securities may only be sold by qualified licensed broker/dealers in Canada.

There is a distinct difference between IFA Canada, De Thomas Financial and Dimensional Fund Advisors (DFA). IFA Canada as described above is an independent company separate from De Thomas Financial and DFA.

De Thomas Financial Corp. is a licensed mutual fund dealer in BC, Alberta, Ontario and soon Quebec. De Thomas Financial acts as a Certified Broker/Dealer given authority to use IFA Canada's portfolios for their clients. IFA Canada has criteria for Certified Broker/Dealers and all dealerships in Canada are eligible to use the IFA portfolios should they agree to fulfill the obligations of a Certified Broker/Dealer. http://www.ifacanada.com/brokerdealers/index.asp IFA Canada does not charge investors a fee or commission for use of its data or Index folios. Certified Broker/Dealers agree to pay a monthly fee to IFA Canada for use of their portfolio allocations and data. These costs are fixed and NOT passed on to clients or investors.

DFA is a provider of index mutual funds for most IFA Index folios. Dimensional Funds Advisors Canada is the manager, trustee, principal portfolio advisor, and promoter of the funds, while Dimensional Fund Advisors (US)acts as sub-advisor for each of the funds.

Other dealerships in Canada many offer DFA funds, but only Certified Broker/Dealers may use the IFA portfolios legally for their own investor clients. The advantages of using the IFA Portfolios are many:

· No minimum limits (as imposed) by DFA on investments per fund. (DFA and others have a $10,000 minimum investment per fund)

· 80 years of back tested data showing the advantages of proper asset allocation using index funds

· Lower MER costs per fund as per exclusive IFA Canada portfolio allocations then other retail Brokers (see web)

· None, absolutely no trading costs for purchases, sales, rebalancing or withdrawals.

· Constant maintenance and auto rebalancing to original IFA portfolio allocation.

· Reduced fees and tax considerations.

· All fees for non-registered accounts completely tax deductible.

· Lower minimum to invest $100,000.00 at a cost of $1,000.00 per year not $5,000.00 annually.

There are other dealers in Canada who sell DFA funds but nobody in Canada has compiled an 80 year data base of 20 index portfolios specifically matched to an investor's Risk Capacity.

2) Are the funds offered by IFA mutual funds or ETFs?

Again, IFA Canada does not "offer" any investments; the investments used to build the portfolios are index mutual funds not ETFs. We chose DFA's index funds for a number a reasons, value, small cap, reduced tracking error and low cost, but also because we would be able to compile and execute the portfolios with no trading costs. ETFs have trading cost each time one buys, sells or attempts to rebalance, the IFA Index folios are designed with no trading fees- over time this saves clients money and keeps them in line.

3) Why do you think IFA's offering is superior to other investment possibilities, whether mutual funds or ETFs? Your website says IFA focuses on passive investing using index funds - how is this different or better than ETFs?

There is a distinctive difference between Index funds and ETFs, and it is for these reasons the IFA portfolios are built with index funds.

· ETF's track a particular index as closely as possible if not almost exactly, but of course there are costs involved. MER's range from .17 to .25 or more plus it costs each time to trade.

Aside from these costs, perhaps more important is a concept called tracking error. You may look here for a detailed description, but suffice to say tracking error costs investors between 0.75 and 1.5% per year.

Another reason for Index Funds over EFTs is securities lending. Index funds such as DFA lend securities out of their holdings and earn income for the unit holders from these transactions . This can amount to 0.25 to 0.50% per year.

The largest reasons though we use DFA funds are that they are tilted towards value and small cap, when all other index funds or ETFs are not. (This is all based upon the Fama/French Work). The chart below provided by DFA will help in understanding why we use their investment products to build the Index folios.

Dimensional Management Compared to Traditional Portfolio Management
Dimensional Management		Active Management		Index Management and ETFs
Assumes markets work.		Assumes markets don't work.		Assumes markets work with no liquidity cost.
Captures specific dimensions of risk identified by financial science.		Attempts to beat the market through security selection and market timing.		Allows commercial benchmarks to dictate strategy.
Minimizes transaction costs and enhances returns through portfolio design and trading.		Generates higher turnover, transaction costs, and taxes due to speculative trading.		Accepts high transaction costs and turnover in favour of tracking.

4) What are the fees charged individually and in total by DFA, IFA and De Thomas?

First, all returns posted on IFA Canada are net of fees, meaning all MERs, management fees, auxiliary fees and advisor fees are subtracted before returns posted. The fees breakdown this way:

· IFA fees to investors. 0.0%. IFA charges no fees to investors as it is not a dealership or advisor. IFA receives fees from Certified Broker Dealers for use of the data.

· Index Fund fees (DFA etc) range from 0.25 to 0.70% - See http://www.ifacanada.com/indexfolios/indexes/#CC

· The De Thomas Fee 1.0%

5) What does the client investor get for each set of fees?

What do they get?

· IFA: superior and vast investor education

· DFA (etc):, Custodial services, fund access and research, record keeping, legal and tax filings, audit and valuation.

· De Thomas: access, support, brokerage, portfolio development, trading and research and distribution reporting, planning and more.

6) Is it true the minimum account size you will take is $500,000? Why so much?

No, $500,000.00 is not our minimum investment level. To complete an IFA Canada Index folio, the minimum is $100,000.00, yet we realize and understand that not all investors have $100,000.00; therefore, we have developed the Easy Chair Portfolio using the same concepts as IFA Canada, but with less administration for accounts beginning at $25,000.00. The Easy Chair website is not yet completed but when ready we will send you a link. The portfolios are complete, and we are accepting investment, but the website and brochures are not ready.

7) Any suggestions for investors with smaller portfolios?

See #6 above.

8) Does IFA / De Thomas handle all types of accounts, taxable, RRSP, LIRA etc and if so does this change the asset allocation?

De Thomas Financial is a full service broker dealer. We have a great deal of experience with all types of accounts including but not limited to RRSP, RRIF, LIRA, LIF, Open Cash, RCA and IPPs. In fact, De Thomas Financial has just reached an agreement with Canadian Western Trust and West Coast Actuaries to provide the IFA Canada portfolios for IPP (Individual Pension Plans). The purpose for this is to create in Canada the most efficient, low cost and transparent IPP. In fact, IPP investors can now save over $20,000.00 or more per year on their IPP plans. Yes it does make a difference in the allocations as each plan type has a different goal, income, savings, tax deferrals, pension building and income splitting.

To add to the answer- Yes it makes a difference in the type of account, in particular whether the account is an open cash account or a registered account. We like to treat the entire portfolio as one entity, meaning that all accounts would be looked at as a whole and allocated across all investments as if they were one portfolio, but sometimes this is not possible as in withdrawal accounts (RRIFs) or open accounts since taxes will play a large role. For open accounts we like to have a higher equity portion and in registered accounts more of the fixed income, since they are non-taxable. We also attempt to rebalance open cash accounts with new capital rather than sell then buy as new capital allocations do not create taxable events and sells and buys do. Thus if an account had too high a weighting in Emerging Markets for the risk capacity they need, we may deposit into all other funds except EM to rebalance the account and thus avoid a taxable event.

In general each account does not change the allocation of the overall plan, but may change to allocation to each type of account. Some clients find it easier to just have a similar account allocation in all plans suited to their risk capacity.

9) Why has DFA/IFA structured all its portfolios on the basis of geography and not, for instance, sectors such as financial, industrial, mining etc?

We are asked frequently about geographical allocation verses sector allocation. Our view and the view of IFA Canada, DFA as well as the empirical data suggest that global indexing and sector investing are very similar. Consider for a moment the TSX. If, and it does, our Core Index covers the entire universe of the TSX then we will have:

· Financial

· Mining and Minerals

· Industrial Products

· Consumer Products

· Agriculture

· Other (Energy, gold, real estate, income trust, health care etc.)

US and International investments have the same outline and thus by allocating on a Geographical basis we do cover each sector. What we will not do is overweight or underweight a sector in hopes our guess is correct.

10) Why do Canadian Index Folios contain a significant Canadian equity component while those of the US site for US investors don't have that? Wouldn't financial theory suggest that the optimal proportions of any portfolio be the same world portfolio according to market value?

The Canadian content has been zeroed in on because of its higher than world capitalization content and a lack of disclosure in the IFA (US) portfolios but this apparent disparity has been accounted for. I say apparent because Canada is represented in the IFA (US) portfolios via (International, Small Cap and Value). In the USA, DFA included Canada as foreign whereas here (Canada) we have segregated Canada out as a separate "Core" holding. We (DFA, IFA and others) have noticed that each world area of portfolio development has a "home bias", that is a bias towards having assets based in local currency and in local surroundings. Canada is no different. We looked at the relationship between the TSX and the S&P 500 and found a correlation of 89%. Given this and the home bias which exists, we allocate only up to 20% to Canada in lieu of a greater US content to which IFA (US) has. If one accepts the premise of "North America", then the world and our portfolios are in line with world capitalization.

11) Does IFA/DFA do any hedging of its foreign equity funds? What is the logic for the policy followed?

No, DFA does not hedge currency except for the fixed income investments. Exchange rates are notoriously difficult to forecast. Efficient-market research conducted on exchange rates has found the same random walk phenomenon also occurs in interest rates, stock prices, and many other capital market instruments that are priced by competitive forces in a free market. Furthermore, there is no reliable evidence to suggest that the expected currency return is anything other than zero. Currencies don't produce anything; and although they fluctuate relative to each other, the fluctuation is unpredictable.

All currencies, by definition, can't go up and down at the same time, so the concentrated portfolio of currencies in this example is effectively fully hedged; to do otherwise defies the concept of diversification, especially when you consider the impact foreign exchange rate fluctuations have on the client's overall wealth management goals and corresponding financial needs. In other words, clients consume imports, they travel, and their financial needs are affected in several other ways by foreign exchange rates.

Here are the following key points as to why:

	1.	By definition, foreign exchange rates are a zero-sum game, so currencies have a zero expected return.
	2.	There is no evidence that foreign exchange rates can be reliably predicted.
	3.	Diversification works whether we like it or not.
	4.	Maintaining discipline, as always, is a key ingredient of a long-term, successful investment experience.

12) The general investing background information on IFA's website is incredibly detailed and useful. Probably most people who become your clients don't even read a fraction of it, while those who do are probably do-it-yourselfers like me. I really love the website, but aren't you worried you are giving away the shop?

Are we worried we are giving away the shop? Sometimes, but in reality no, we are not giving away the shop. The data, studies and theories exist independent of IFA Canada and thus the shop was never ours to give away. To more fully address the question, investors will fall into three categories in no particular order:

A. DIYs such as yourself.

B. Those who need help, but know the industry is in conflict with them.

C. Those that need help, but don't know about what.

By setting up IFA Canada in the manner in which we have, we are "giving away the shop" but we are resolved that investor education is the most important goal. If any of the above groups learn from IFA Canada then we have accomplished our first priority. If they need or want help our Certified/Broker Dealers are there to provide low cost, high level help in developing their risk adjusted Index folio.

There is one other group using the IFA Canada.com site and this helps to achieve our goal, but in a more round about way. 10-15% of investors are other investment advisors, managers or sales people attempting to figure out what we are doing. If they take our data and use it with their clients so be it. They are helping to educate investors and that is our goal. If the really believe and understand then they may wish to join us rather then try to copy us.

13) Your risk capacity survey on the website includes questions on investment knowledge and reactions to market swings/drops. I presume the implication is that if the investor is ignorant and nervous, he/she gets shunted into a low risk portfolio, which may not be able to meet the investor's long term goals. Shouldn't financial advisers be more like doctors, telling people to take their medicine as their health demands, not as the they feel?

Wow, another great question to which a new thesis could be written. The full answer is here http://www.ifa.com/book/book_pdf/10_risk_capacity.pdf but for purposes of the Q and A, I will outline the theory for our Risk Capacity Survey. There are 10 dimensions of risk which have been identified by theorists and academics. Five have to do with portfolio risk and five with the particular investor attempting to choose a portfolio in which to invest. (Investor Capacity) The five IFA Canada are most concerned with are Investor Capacities. These capacities are time, knowledge, attitude, income and net worth. Your question deals with attitude. You ask if some are ignorant or nervous if they are shunted to a low risk portfolio and that is just not so. The attitude dimension attempts to assess the aversion to risk an investor has, their ability to stomach inevitable declines with the knowledge that risk is the currency returns are purchased with. While a low attitude towards risk will move one down the scale from 100, it only amounts to a small % move and not a full out drop to a lower level. To use your analogy of a doctor, consider a person who has an aversion to needles or cannot swallow large pills. Does the doctor tell them to "do as the feel"? No, they will work out solutions based upon knowledge and the other information gathered to diagnose and create an environment which allows the long term goal to be met, while still allowing the patient to "feel good". Perhaps the pill is broken down, or the needle given in smaller doses over time. It may not be perfect, but two greatly needed goals are met.

1. The patient gets what they need and

2. They do feel good about what they needed and the way it was delivered and become open to new concepts and ideas that they were afraid of before.

Michael's titles and contact details:

Michael J. Hill, CIM, CFP mjh@dethomaswindsor.com
President IFA Canada

De Thomas Financial Corp. (Windsor)

Visit us at www.dethomaswindsor.com
Ph 519-973-5719
Fax 519-973-1845

BMO Investorline Modifies Foreign Currency Notice

Back on May 27th I posted this complaint about BMO Investorline's lack of disclosure with regard to the foreign exchange rates used when one trades in foreign securities, like those on US markets, on top of the fact that BMOIL does not allow foreign currency to be held within registered accounts, so making unjustified profits for BMOIL in the obligatory two-way currency exchange. Curiously, upon login to my account this morning, I discover that a new notice has suddenly appeared on BMOIL's webpage (see graphic).

Probably this is a coincidence since it is highly unusual for a big organization to make any change in response to an individual's complaint (large organizations by their nature only respond to an appropriately large stimulus, like losing a major lawsuit, getting into major financial problems etc). This notice doesn't provide any better disclosure, it merely says BMOIL can set whatever foreign exchange rates it likes on transactions. That neatly covers their liability, of course, which is BMOIL's primary objective. But it doesn't help investors trade accurately by having exact rates at the time of transactions. Nor does it seem fair for BMOIL to set whatever rates it likes, particularly since BMOIL only sets the rates at the end of the day, long after the trade has been committed. That BMOIL is trading the foreign currency for its own profit makes this unfairness even worse.

Another curiousity is that the link to the full agreement takes one to a pdf document dated March 2007. If there is something "new" in the agreement, wouldn't a more accurate date be June 2007, or is it allowed to retroactively change agreements? Just asking....

The Best US Large-Cap Index ETFs Compared

Back in May in my post on the complete overhaul of my portfolio, I showed a chart of my selected ETFs along with some credible contenders in several asset class categories. In one of these, US large-cap companies, my choice was Vanguard's offering, the Vanguard Large-Cap Index Fund (ticker VV), over some very good other choices, the iShares S&P 500 Index Fund (ticker IVV) and the grand-daddy of ETFs, the SPDR aka Spiders (SPY). Along with those, I've included the iShares Canada S&P 500 currency hedged version (XSP) and the TD e-Series S&P 500 currency hedged fund (fund symbol TDB904) for the benefit of Canadian investors like me who don't want to face the negative consequences of a Canadian dollar continuing to rise vs the US$.

The chart illustrates the factors that I believe justifies the conclusion that Vanguard is the best, though not by a great deal. I've coloured the cells light blue where the particular factor favours that ETF. The visual impression is a bit misleading since a number of cells at the bottom all have to do with tax efficiency.

Vanguard's VV is better on:

• MER, or Management Expense Ratio, which is the overhead paid to Vanguard to manage the fund - the lower the number, the better it is for the investor
• on the premium/discount, in this case the discount, which is the average amount the market price of the ETF deviates from the Net Asset Value (NAV), the value of the under-lying stock holdings; the smaller this number the better, the investor neither gains nor loses as the fund is fairly priced; in this case VV is tied with SPY for the best
• 3-year performance, which is higher in VV's case; now some will note that VV uses a different index than all the others, which use the S&P 500 and thus the result should not therefore be comparable. I'm going to stick my neck out a bit by saying that the others suffer from using the S&P 500, a flawed index (as noted by Peter Bernstein in his book, which I reviewed a few days ago). Check out the text below on the S&P 500's flaws and see if you agree with me. The fact that everyone uses it, as they do the far worse Dow, doesn't make it good!
• all the various tax efficiency measures; especially note that the ratios at the bottom of the table, higher in VV's case, mean that the investor loses less to the government through taxes on VV than the other funds. Canadians should note that the source of this is US websites like Vanguard and the absolute numbers reflect US taxpayers but I believe the relative advantage of VV is still there. The size of the 2006 distribution by VV, which would be a highest-rate income item for a Canadian, compared the that of IVV, confirms this conclusion.
  

There are a bunch of blank cells in the table, where I could not find the numbers despite hours of searching. Canadians will note more blanks for XSP and TDB904, where the available data on comparative websites like Morningstar, GlobeFund and those of the providers iShares Canada and TD Asset Management don't seem to be very forthcoming with data. I had to email iShares Canada to learn why their 3-year performance figure on their website differed so markedly from the S&P's results - turns out they only started hedging XSP in November 2005. Therefore, all note, the numbers may not be 100% accurate!

One disappointment for me in all this is how much one loses in buying XSP or TDB904 for currency protection. There's a big performance loss. It's curious that XSP managed in 2006 to distribute some of its distribution as capital gains instead of income, better because of the lower tax paid on capital gains over income. The tracking error of TDB904 at 6+% is abysmal. I had to calculate that one myself so it may be wrong but the high cash holding of 4% of assets, which came from Morningstar Canada, is consistent with such poor tracking.

The suggested weaknesses of the S&P 500 as a market index include:

• it is really only a large cap index with about 75% of the total market value of US shares
• it weights the companies within the index based on the value of the public float in the judgement of the Standard and Poors selection committee, so this biases the index away from a true market cap weighting that follows from financial theory
• some non-US companies are still in the index, having been grand-fathered upon moving away from the US
• some US companies that are illiquid are excluded like Warren Buffett's Berkshire Hathaway, a gigantic omission as it is a huge company
• delays in adding new companies in new sectors distort the true market weighting – it took a while before Google entered the S&P 500

see http://en.wikipedia.org/wiki/S%26P_500 and a letter by Darren Bramen on this page http://www.aicpa.org/pubs/jofa/apr2000/letters.htm

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.

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.