Archive for October, 2012

Sleepy Portfolio 3Q-2012 Update

October 31, 2012

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Background

I started the Sleepy Portfolio in 2005 to benchmark my personal portfolio, which at that time was mostly invested in individual stocks. The portfolio started off with an initial outlay of $100,000 but no new money has been added since. This is not simply a model portfolio; it reflects investment returns that can be obtained in the real world by accounting for costs such as spreads, trading commissions, MERs, foreign exchange conversion charges etc. The portfolio is assumed to be held in a registered account, so it does not take taxes into account. The portfolio has a target allocation of 5% cash, 15% short bonds, 5% real return bonds, 20% Canadian stocks, 22.5% US stocks, 22.5% Europe and Pacific, 5% Emerging markets and 5% REITs. The entire portfolio (apart from the cash portion) is invested in broad-market, exchange-traded funds (ETFs) trading in the Canadian and US stock exchanges. The cash portion is invested in a high-interest savings account that is available through many discount brokers.

3Q-2012 Update

The Sleepy Portfolio has gained a modest 1.8 percent since my previous update. The bulk of the gains were provided by dividend payments. Pretty much every single asset class stayed flat since my previous update. The only exception was REITs, which dropped 4.2 percent during the past quarter. REITs did gain about 10 percent in my 2Q-2012 update and the portfolio benefited slightly from selling some REITs in the previous update. Year-to-date the portfolio is up 7.3 percent.

Here’s how the portfolio looked as of October 31, 2012:

Sleepy Portfolio Balance as of Oct. 31, 2012

Since the cash position is significantly above target and emerging markets are significantly below target, we’ll perform just one rebalancing transaction this quarter.

Transaction

Buy 34 shares of VWO at $41.49. Proceeds = $1,441.82. (includes trading commission of $10 and currency conversion charge of 1.5 percent).

Impact of Benchmark Change on Vanguard MSCI EAFE ETF (VEA)

October 16, 2012

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Recently, Vanguard announced that it will be switching the benchmark index for many of its Exchange-Traded Funds (ETF). In an earlier post, we took a closer look at what the benchmark change means for the Vanguard Emerging Markets ETF (VWO) and found a significant difference in past performance. In this post, we’ll take a closer look at the impact of the benchmark change on the Vanguard MSCI EAFE ETF (VEA).

The Vanguard MSCI EAFE ETF (VEA) currently tracks the MSCI EAFE Index, a benchmark that tracks stock markets in developed markets in Europe, Australasia and Far East (EAFE). VEA will shortly start tracking the FTSE Developed ex North America Index. The FTSE index includes a lot more stocks than the MSCI index as you can see from the following table.

FTSE Developed MSCI EAFE Index
No. of stocks 1384 920
Total Market Cap $11.69T $10.26T
Average Market Cap $8.4B $11.15B
Median Market Cap $3.05B $4.9B

The top countries represented in each index look similar but there are two significant differences: Korea, which FTSE classifies as a developed country gets a 5.8% allocation and Hong Kong has a higher weighting of 4.7% in the FTSE Index compared to 3% in the MSCI EAFE Index.

Country FTSE Developed MSCI EAFE Index
United Kingdom 23% 23%
Japan 20% 19%
Switzerland 9% 9%
France 9% 9%
Australia 9% 9%

Perhaps due to the differences in composition and country weightings of the two indexes, there are significant differences in annual returns over the past 10 years as you can see in the table below:

Year FTSE Developed Markets MSCI EAFE Index Delta
2002 -15.1% -15.9% 0.8%
2003 39.4% 38.6% 0.8%
2004 20.8% 20.3% 0.5%
2005 13.9% 13.5% 0.4%
2006 27.6% 26.3% 1.3%
2007 12.8% 11.2% 1.6%
2008 -43.2% -43.4% 0.2%
2009 34.0% 31.8% 2.2%
2010 9.1% 7.8% 1.4%
2011 -12.1% -12.1% 0.0%
Total 171.1% 157.8% 13.3%

Though the FTSE Developed Markets ex North America Index has outperformed the MSCI EAFE Index over the past 10 years, the key point for investors is that the risk-return profile of these two indexes looks pretty similar. Investors holding VEA in their portfolios can expect it to perform the same role it did before: capture the performance of developed markets outside Canada and the United States.

Comparing Annual Returns of Developed Market ex North America Indexes

Double Dipping on Currency Conversions in US Dollar RRSP DRiPs

October 10, 2012

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Many investors sign up for synthetic Dividend Reinvestment Plans (DRiPs) at discount brokers to save on trading commissions. With a synthetic DRiP, an investor can reinvest dividend payments in whole shares and have the leftover amount deposited as cash in their account. Let’s take an example. Investor John owns 1000 shares of ABC Corp. (ABC), which pays a quarterly dividend of $1.25. ABC Corp. is currently trading at $100. Since John had signed up for a synthetic DRiP on ABC Corp., his broker purchased 12 shares of ABC Corp. with a recent quarterly dividend payment of $1,250 and deposited another $50 into John’s account. This arrangement is beneficial from John’s point of view because he was able to increase his investment in ABC Corp. without paying a trading commission.

While DRiPs are usually a good thing, investors need to pay attention to the hidden costs they are incurring when they sign up for synthetic DRiPs on US Dollar stocks or Exchange-Traded Funds (ETFs) held in registered accounts such as RRSPs and TFSAs at discount brokers that do not segregate US Dollar and Canadian Dollar holdings (TD Waterhouse would be an example). Investors are probably aware that US Dollar dividends are converted to Canadian dollars at a rate that is typically 1.5 percent higher than the spot rate. But if you had signed up for a synthetic DRiP, the Canadian dollar dividends are again converted to US Dollars at a rate that is 1.5 percent higher than the spot rate and used to purchase whole shares of a stock or ETF. In effect, investors who are DRiPping US Dollar stocks or ETFs in registered accounts could be paying as much as 3 percent in foreign currency conversion charges.

A recent post on Canadian Money Forum provides an estimate of the hit from DRiPing US Dollar stocks in a RRSP account. Client received US$325 worth of US Dollar dividends out of which US$219 was DRiPped into shares and C$96.50 was deposited as cash. An exchange rate of 0.9645 for the converting US dollars to Canadian dollars. If no currency conversion charges were applied on the DRiPs, client would expect to receive $102 as a cash deposit. Instead he received $6 less. In other words, it cost C$6 to DRiP US$219 worth of shares or 2.8 percent.

What you can do about it

Fortunately, discount brokerage clients who are hit with double currency conversions on US Dollar DRiPs in registered accounts have a few options. If your broker allows segregation of US and Canadian dollar holdings, make sure your US Dollar denominated holdings are held in the US side of the account. If your broker does not offer segregated accounts, take a long hard look at whether synthetic DRiPping is worth the additional currency conversion charge. The break-even point for converting currency with the Norbert Gambit and then purchasing shares yourself is $2,000 (assuming 1.5 percent currency conversion charge, 2 trading commissions for the Norbert Gambit and 1 trading commission for the buy order). Therefore, a rough thumb rule would be that it’s better to reinvest on your own if you receive more than $2,000 worth of dividends. If you would really really like to implement synthetic DRiPs but the costs bother you, consider moving your accounts to a broker that does segregate holdings in registered accounts.

It is likely that clients at all discount brokers, even those that currently offer segregated USD registered accounts, charged double currency conversion fees on US stock DRiPs in the past. I hope that clients would raise this issue with their brokers and demand why currency was converted twice in synthetic DRiPs and what the brokers are going to do about it.