Archive for April, 2009

Portfolio Size for Choosing ETFs over Index Funds

April 26, 2009


A popular question from investors convinced of the merits of passive investing is: at what portfolio size does it make sense to use Exchange-Traded Funds (ETFs) instead of index mutual funds? While ETFs typically have a lower MER and hence are cheaper to own, it costs trading commissions (and foreign exchange fees for some ETFs) to buy and sell, which could simply overwhelm any MER savings. For instance, it wouldn’t make much sense to pay $30 to buy $200 worth of iShares CDN LargeCap 60 Index Fund (TSX: XIU) but you can buy index mutual funds such as the TD e-Series funds for as little as $100 (or even $25 for pre-authorized purchase plans).

Unfortunately, it is not possible to give a clear cut answer to the question about portfolio size because it depends on a number of variables such as the commissions charged, the frequency of buying and selling, the growth rate of investments etc. One simple thumb rule that I use is that the MER savings from owning ETFs should cover the initial trading commissions in one year.

Size of portfolio for choosing ETFs = Trading commissions / (Higher MER – Lower MER)

Take the Sleepy Mini Portfolio, which is invested in four TD e-Series mutual funds and has a blended MER of 0.401%. The equivalent ETF portfolio would comprise of XBB, XIC, VTI and VEA and would have a blended MER of 0.167%. If your brokerage charges $30 per trade and you invest a lump-sum once every year and you ignore any foreign currency conversion charges and no fees are charged for selling, the thumb rule indicates that when the portfolio is over $51,000, it makes sense to switch the Sleepy Mini holdings to ETFs.

Of course, ignoring foreign currency conversion charges, which typically costs about 1%, does not result in a very accurate estimate. If you want to account for foreign conversion fees, you’ll need to solve for the following equation (assume size of portfolio for choosing ETFs is x and foreign exchange fees are amortized over y years):

(MER difference) * x = trading commissions + (portion in foreign stocks * x * foreign exchange conversion fee) / y

For the Sleepy Mini Portfolio, which has 60% in foreign stocks, assuming foreign exchange fees cost 1% and are amortized over 5 years and trading commissions cost $120 per year, x works out to $143,000.

If this math makes your head hurt, rest assured that it is only a very rough estimate as savings from holding ETFs accrue over the entire holding period, not just the first year. Then, you need to make assumptions about the growth rate of the investments and even then all you have is a more refined estimate. The Sleepy Portfolio, which is valued around $100,000 holds ETFs and the Sleepy Mini portfolio, which is a modest portfolio to which $1,000 is added every quarter holds TD e-Series mutual funds. In our personal portfolios, I follow the same rough guideline. Portfolios that are larger than $50,000 are implemented using ETFs. Modest portfolios, such as our kids’ RESPs are implemented using index mutual funds.

This and That: Bank of Canada Cuts Rates Again

April 24, 2009


Don’t forget that the deadline for filing your personal taxes for 2008 is Thursday, April 30, 2009. If you’ve been procrastinating, you have just one weekend to do your taxes.

Canadian Money Forum Highlight: Alexandra and her husband have earned money “on the side” by owning rental properties. She has bought and sold properties over the years and shares some tips for aspiring landlords in this highlight post. If you haven’t done so already, you can register for the forum here and add your two cents to the lively discussions.

  1. The Bank of Canada cut interest rates by 25 basis points and conditional on inflation outlook, committed to hold interest rates at that level until the end of second quarter of 2010. The big banks followed suit by decreasing the prime rate by a similar amount to 2.25%. This is a great opportunity for homeowners with prime-minus mortgages to pay it down rapidly.
  2. Jon Chevreau reported that CARP, a lobby group representing Canadians aged 45 or more, is calling for a Universal Pension Plan to cover Canadians without employer-sponsored pensions.
  3. Larry Swedroe points out that the supposed outperformance of actively-managed funds in bear markets is a myth.
  4. Frugal Trader shares some of the lessons learned so far on his Million Dollar Journey.
  5. The practice of post-claims underwriting in mortgage insurance came in for well-deserved criticism on Four Pillars.
  6. Michael James points out that market timers risk missing out on a sharp rebound such as the one we’ve been having.
  7. Thicken My Wallet conducted a two-part, three-way conversation with Preet of Where Does All My Money Go? and Brad of Triaging My Way To Financial Success on the value of stock market research.
  8. Rob Carrick opines that the great recession mortgage sale isn’t even close to being over and the lowest rates anyone can remember will be around for months to come.
  9. Ellen Roseman has some tips for haggling for extra perks and better prices.
  10. The Wealthy Baker is a new blog by a Toronto-based financial planner, writer and baking enthusiast. The blog features fresh-baked financial advice, never store-bought.

Have a great weekend!

Book Review: The Great Depression Ahead

April 22, 2009

[Front Cover of The Great Depression Ahead]

The author, Harry Dent, initially made his name by forecasting a severe downturn in Japan and a great boom in the United States in the 1990s. He was right on both counts and he has been milking his success ever since, churning out an endless stream of books filled with predictions. In his previous book, The Next Great Bubble Boom, published in 2006, Mr. Dent called for a peak in the last bull market between late 2009 and early 2010. And what a bull market it would be! The Dow would hit a peak between 35,000 to 40,000 and the Nasdaq “advancing to around 13,000 and potentially as high as 20,000”. That book, in turn was preceded by the unfortunately titled and unfortunately timed The Roaring 2000s Investor (published in 1999 as the great bull market was peaking).

Perhaps tired of being constantly bullish, Mr. Dent tries a different tack in this book. He foresees the crash of 2008 to be an appetizer to the main course, which will be ushered in by an equally brutal crash in late-2009 taking the Dow down to 3,800 and stocks would continue to deflate even more between 2010 and 2012 and repeating the process into the early 2020s. (And you thought the past ten years were tough!).

Mr. Dent claims he can make these forecasts based on cause-and-effect cycles that can be projected years or even decades into the future. For instance, one of the cycles he looks at is the demographic cycle, in which birth rates rise and fall over a 40-year period. As one generation ages, it enters its peak earning and spending years around age 50, resulting in a boom in the economy and in turn the stock market. A cycle in the stock market can hence be projected 50 years in advance based on the demographic cycle.

The theory of cycles, while interesting, has resulted in predictions that turned out to be wildly inaccurate. You could then reasonably conclude that cycles are, at best, unreliable and at worst, have no predictive power at all. But, Mr. Dent remains undaunted when a forecast he so confidently made did not pan out. He simply explains it away by claiming that not taking into account other important cycles resulted in an “overforecast”. In other words, if these hitherto unsuspected cycles had been taken into account, the past was indeed predictable! For example, he explains that he cut his Dow 35,000 forecast down to 16,000 to 20,000 based on the discovery of two new cycles: “a clocklike 29- to 30-year Commodity Cycle and a 32- to 36-year Geopolitical Cycle, which alternates between favourable and unfavourable environments pretty reliably every 16 to 18 years”.

As I find his arguments to be specious, I’m happily ignoring Mr. Dent’s latest prognostications (which I only read because the publisher sent me a free copy) without a second thought. You can be sure of a couple of things though: if this forecast turned out to be wrong, Mr. Dent would be writing another book offering yet more predictions, discovering more cycles (a 75-year Halley’s Comet Cycle, perhaps?) and offering reasons for his “overforecast” (or is it “underforecast”?). If he is right, he’ll still be out with a new book of predictions, in which he will crow about his latest success.

The book is published by Free Press and has a cover price of $32.