Why Management Expense Ratio is So Important

One tenth of one percent (0.1%) seems like a trivial number not worth bothering about when it comes to the expenses charged by fund companies to manage our money in mutual funds or Exchange Traded Funds (ETFs), doesn't it? The expense ratio (ER or MER) is the amount levied by the management company as a percentage of net assets in the fund. It is not in any way dependent on the investing success or performance of the managers (see the Wikipedia post on mutual funds for details).

Another way to look at the ER is that it is a reduction in the net return available to fundholders. Managers must make up their percentage fee and better in order to make money for you and me. For example, if the fund is $100, the ER is 1% or $1 per year, in order to gain 6% net, the fund must go up by 7%/$7. Alternatively, the same net gain can be achieved with a lower investment gain and a lower fee. Or, to put it yet another way, with same investment gain, as I am illustrating in this post, and a lower fee, the net gain is higher. In the case especially of passive index funds whose aim is to replicate the gains (and the losses when they occur) of an index such as the S&P 500 or the TSX, there shouldn't be a lot to pick from between various ETFs or funds. Therefore, the lower the expense ratio, the more of the index gain is left for the investor. Since the MER is a known, predictable expense, the opportunity to lower it is pretty well a guaranteed, risk-free return. In short, the lower MER, the better, other things being equal (and they aren't always but interestingly those funds with lower MERs tend to be better in those other things too).

So how much does it matter? I've created a simple table in the accompanying graphic to show the numbers and the results are dramatic. The table shows percentages which are to be understood as the difference in rates of return - i.e. the effect of extra or less MER. Thus the table shows what an ETF/fund that charged 0.1%, 0.2%, 0.5%, 1.0% or 2.0% more would have produced. For example, the Vanguard FTSE All World ex US (VEU) has an MER of 0.25% while the iSharesMSCI EAFE (EFA) has an MER of 0.35%. They are not exactly the same index but the effect of difference of 0.1% in MER will amount to $201.91 after 20 years for every $10,000 invested, as shown in light blue cells of the graph. Multiply by the size of your portfolio to see the total amount.

$201.91 is a relatively small difference but the other columns show how significant the compounding effect can be for long periods and bigger MERs. The 2.0% column is of special interest to Canadians who pay the highest fund expense fees, which are high by something approaching 2% in my view. The moral of the story is to pay close attention to MER - the lower the better.

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.

A Starter Diversified Index Portfolio for Canadians

One of my relatives recently asked what an example "starter" portfolio would look like based on the same principles of diversified passive index investing that I tried to use for my own. Here's my answer. First, my definition of "starter" is:

• any investment amount up to $25k or thereabouts;
• investor with lesser knowledge of investing and taxes and perhaps less interest too.

Such a definition does not indicate any particular risk-aversion stance, i.e. how conservative or aggressive it should be. In other words, the degree of risk would and should be decided independently based on different factors. Just for the sake of comparison with my own decision on the amount of riskiness and volatility, I'll use the 30% fixed income, 70% equity ratio. The idea of once-yearly rebalancing the portfolio back to the target percentage amounts also applies the same to this as any much larger portfolio. For other levels of risk acceptance, simply use different percentages of the same funds.

Click on the image to see the portfolio. It has these characteristics for these reasons:
1) only five holdings in total - this is to have large enough amounts in each holding to make it likely there will be something worth rebalancing in a year and to make it simpler and easier to do the rebalancing.
2) the five holdings give the maximum amount of diversification / low- or non-correlation base on what I've seen and read. Especially significant is the XRE for real estate, the asset class that seems to offer the most extreme negative correlation with other equities and thus the most diversification effect, the highly desirable quality passive portfolio investors seek.
3) use of TD e-Series mutual funds instead of Exchange Traded Funds (ETFs) because the benefit of slightly higher MERs (e.g. the TD MER of 0.31 vs iShare Canada's XIU's 0.17%) will be more than offset by trading fees in a year when rebalancing takes place (I assume that at a discount broker it will cost $25 per trade so a two-trade rebalancing of one sell and one buy at $50 would compare to 0.14% of $7500=$10.50 in extra MER for the Canadian holding). On top of that, as I've noted before, tax tracking is easier with mutual funds. And adding new money to the portfolio is much cheaper with mutual funds as no trade is required. TD's funds take as little as $100 for additonal contributions. Hopefully a small portfolio will be on the growth path with new money being added.
4) the US holding is the currency-hedged version while the international holding is not, because it seems to me that the multi-decade currency shifts of the US$ vs Canada$ have been large and can drastically negatively affect portfolio returns despite what the US stock market may actually do ... who is ready to predict and stake their financial future on the Canadian dollar either staying the same or depreciating vs the US$ from now on? To me, that's a too-severe and too-concentrated risk. On the other hand, the international holding is not currency-hedged, despite the availability of a hedged version, because the large number of countries and currencies spreads the effect much more and therefore lessens the chance of negative consequences. In addition, I have read material that says Canadian equity investors can benefit from foreign currency exposure so it seems to have positive support for that position as well. If any can point to serious number crunching studies that address the issue of currency risk please tell me as it is an area of doubt for sure. Yet one cannot sit on the fence till the perfect answer is available, huh? So I'm giving it my best guess.

What would come next as an addition to the portfolio? Probably a small cap equity holding, as a diversification and higher expected return asset, which would involve something like US small cap ETFs iShares Canada's currency hedged XSU or Vanguard's VBR, a small cap value ETF, or perhaps the new iShares Canadian small cap ETF XCS.

One negative of the TD e-Series funds is that they are a tied product and can only be purchased through TD Asset Management or TD Waterhouse and only on-line. That may not be convenient for everyone.

Other simple portfolios I have come across include those of Efficient Market Canada and Shakespeare, so take your pick.

That's it. What do folks out there think?

Major Portfolio Renovation, Canadian Style

It's done at last. I've completely changed my investment portfolio to an asset allocation methodology. For the first time, my investments are now an integrated whole, with the holdings selected to complement each other, as opposed to the disparate, hodge-podge of holdings I have had up to now. There is no longer any single company equity holding in any of my accounts - goodbye Cisco, Oracle, JDS Uniphase, SAP, Microsoft. Most difficult was selling my large holdings of Royal Bank and Scotiabank, which have been such stellar long term performers and have made me so much money. The decision to completely adopt the principles of portfolio theory drove all the changes.

For anyone else contemplating such a move, here is how I did it and where I encountered tricky bits.

The basic idea was to build a portfolio with the highest return and the least volatility/risk through selecting assets that are as a non-correlated as possible, i.e. they do not move and down together - one zigs while the other zags. In addition, the assets themselves are not single companies, they are many companies held together as a mutual fund or Exchange Traded Fund (ETF), in order to remove the effect of single company events.

The end results of my many hours spent on the planning of the renovation are shown in the extract from the spreadsheet I used that is included with this post.

Here are the key features:

• no individual companies eligible for the portfolio, only ETFs and mutual funds to ensure diversification; however, for my 27% Canadian bond allocation I decided to keep the bond ladder I have built; the range of maturities from 2007 to 2026 probably suffices to be diversified and I don't sacrifice yield from management fees e.g. XBB has an MER of 0.30%
  
• the range of asset classes is both geographical, covering more or less all the main economic areas of the world - Canada, the US, Europe, Japan, Pacific nations, emerging countries such as Russia, China, India, Korea, and sectoral, with large cap and small cap companies, value companies (low price/book and other measures), real estate, commodities; these asset classes have been chosen based on multiple sources that demonstrate their un-correlated returns over time - books such as those of Richard Ferri and of Roger Gibson, online resources such as Bylo Selhi and Index Fund Advisors
  
• the diversifying sectoral asset classes each only have a small percentage of the total and where possible this is spread amongst the various geographical areas, in order not to be too concentrated in any one asset class;
  
• no asset class has less than 2% of my total asset allocation and the total number of holdings is 16; this is to ensure that any holding is sufficiently large that when rebalancing comes along in a year, the dollar amount to be rebalanced will be large enough that trading costs will not chew up the amount; as a rough rule of thumb I'll want the rebalancing amount to be at least $1000 since my trading cost is $10/trade (1%); Ferri recommends no more than 15 holdings to keep the rebalancing exercise from being too complicated and I fully agree based on my own experience of doing rebalancing amongst only six ETFs the last few years (XIU, XGD, XIT, XRE, XFN, XMD); given that I have four accounts (open, RRSP, LIRA1 and LIRA2), none of which can transfer money to another, the limit on number of holdings is a practical necessity. It was at this point that a number of candidate asset classes, seen in the bottom chart with the ETF ticker symbols, disappeared from the final allocation.
  
• the reduction of the impact of adverse currency shifts, especially against the US dollar, is the concern that led me to buy more than half of my US large cap holding and US small cap as the currency hedged XSP and new iShares Canada XSU; in the international holdings there is some currency risk but it spread over many countries' currencies so it is more acceptable - whether this is truly an acceptable risk I don't know as I have not been able to find clear answers in the finance research I have read so I will keep looking. In the meantime, however, there really isn't much choice to find ETFs that will fill the asset classes in my chart except to buy unhedged ETFs on US markets, so I've decided that diversification is most important. The only exception might be XIN, the hedged counter-part of EFA, the iShares EAFE fund, but since the global whole market class did not make it into my portfolio it isn't relevant. Of course, it is true that despite the funds selected being traded on US exchanges in US dollars, the currency risk is not the US dollar but those of the under-lying holdings; the US$ is only a pass-through currency.
  
• Vanguard funds appear often in my final selections - VGK, VPL, VNQ, VBR, VV, VWO. As my chart shows, there are other good funds (I didn't put any in the chart that weren't low cost, passive index funds) but Vanguard comes out on top pretty well every time they are available in a class. Why? Vanguard ETFs have the lowest tracking errors; a lower Price/Book in the value category; lower turnover than the avg fund in a category = lower transaction costs, less cap gains distributions; more holdings than the avg fund in a category =more diversification, less risk; the lowest management fees. It may interest some to note that I compared a few TD e-Series funds (TDB900, 904 and 911) but their higher management fees offset their plus of not having trading costs. My fund selections are highlighted in the greeny/yellow colour on the chart.
• The case of the US dollar denominated holdings caused me something of a conundrum. All foreign dividends are taxed as ordinary income, which suggests US$ holdings should go into registered accounts while Canadian holdings that can benefit from lower dividend tax rates should go into the open account. However, it is an unfortunate fact that my broker BMO Investorline won't hold US dollars within a registered account. BMOIL still requires US dollar sales to be converted into Canadian dollars and then back again into US$ for a purchase. There is a spread of about 1.8% between the buy and sell rates on the US$ at BMOIL so when I came to do my rebalancing next year I'd get dinged plenty, probably more than the tax differential. So I will keep as much as possible of my US$ holdings in my open account where I can keep a US$ cash balance. BMOIL could fix this deficiency since there isn't any legal impediment to having US$ in a registered account; I'm sure as soon as another of the major bank brokers does it they will too but it rankles in the meantime to pay extra FX costs for no necessary reason.
  
• my portfolio is treated as one across all the four accounts I have - open/taxable, RRSP, LIRA1 and LIRA2; where I put individual holdings is influenced by other considerations such as taxes but taxes are subservient to doing proper asset allocation. All the fixed income/ bond holdings are in the registered accounts for instance. Dividing up the holdings amongst these accounts proved to be a significant challenge just to make things balance. In addition, I tried to anticipate the rebalancing by placing investments within the same account that might end up needing to be rebalanced up or down e.g. I put a big chunk of the DJP commodities holding into the RRSP along with VGK Europe equity and VPL Pacfic equity as they are historically negatively correlated and the former should go down when the others go up. Similarly, in the open account I put VNQ REITs and VV US large cap, which are also negatively correlated. Hopefully, that will enable easy rebalancing within an account next year but we shall see.
• my asset allocation is NOT driven at all by any income needs, though I am starting into that period of life when withdrawal is beginning (for why this is the correct way to approach things, I rely on experts such as Moshe Milevsky). If I will need to withdraw funds from any account, It will be based on the asset allocation - whichever is above its target will have a portion sold.

So that's it. Any comments or observations welcome!

Book Review: Wealth Logic by Moshe Milevsky

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

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

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

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

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

Buy this book at
chapters.indigo.ca

Detective Work Uncovers Excess Fund Fees in Canada

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

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

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

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