Canadian Capitalist » Investing

Sector Breakdown of Diversified Portfolios

Canadian Capitalist — Wed, 16 May 2012 03:25:07 +0000

In a recent column, The Globe & Mail’s Rob Carrick (see Beware the limitations of buying the index, May 11, 2012) pointed out that investing in just the TSX Composite index might leave an investor with an unbalanced portfolio because of the index’s concentration in just three sectors: financials, energy and materials. The criticism is a valid one because, as you can see from the chart below, resource companies make up more than half the index and financials make up another one-third of the index. (As an aside, the sector breakdown of the S&P/TSX 60 index, which is tracked by the iShares S&P/TSX 60 ETF – TSX: XIU is pretty much the same as the broader Composite index).

This limitation of the TSX Composite Index is one reason why passive investors diversify their portfolios globally. The US Total Stock Market, for instance, offers much better diversification. The three dominant sectors in the Canadian market make up less than a third of the US stock market. The US stock market also offers exposure to sectors such as Information Technology, Healthcare and Consumer goods that have a much smaller representation in the Canadian index.

The MSCI EAFE Index which provides exposure to developed stock markets in Europe and the Pacific region is also well diversified across sectors. Financials and resources make up just 40 percent and the index has significant allocation to stocks representing Consumer goods, Utilities and Telecommunication services.

A globally diversified index portfolio such as the Sleepy Portfolio, which is split between Canadian, US, EAFE and Emerging Markets has a much better balance between sectors when compared to the Canadian stock market. The allocation to financials and resources drops to less than half the portfolio compared to three-quarters for the Canadian-market only index investor. And the allocation to sectors such as Consumer goods, Information Technology and Healthcare is also boosted substantially.

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What is iShares Planning After Acquiring Claymore

Canadian Capitalist — Thu, 03 May 2012 01:16:35 +0000

Recently, I had a chance to chat with Mary Anne Wiley, head of BlackRock Canada on what the 800 pound Gorilla in the ETF marketplace plans to do after the blockbuster acquisition of the #2 player Claymore Investments was recently finalized. After the acquisition closed, iShares rebranded all Claymore products (ticker symbols remained the same) but apart from that the only changes have been some minor adjustments. Here’s what I learnt:

I started off by asking why the Claymore Inverse 10 Year Government Bond ETF (CIB) was terminated and whether it presages any more fund closures. Ms. Wiley said that the decision was made because CIB was not consistent with the iShares brand since it was most effective for short-term holding periods and also had no strong market appeal.
iShares plans on maintaining the lineup of Research Affiliates Fundamental Index (RAFI) ETFs and laddered fixed-income ETFs both of which are very popular among individual investors. It appears that laddered ETFs make it easier to introduce the concept of low-cost fixed-income investing to retail investors compared to capitalization-weighted products, which are more popular among institutional investors.
Dividend Reinvestment Plans (DRIPs), Share Purchase Plans (SPPs) and Pre-Authorized Contribution Plans (PACCs) will be maintained for the Claymore ETFs.
DRIPs will be rolled out to all iShares products later this year. Since, many discount brokers already offer synthetic DRIPs on most ETFs, many investors already have the ability to reinvest dividends.
The advisor class ETFs which are sold through advisors and have an extra fee tacked on top to compensate for financial advice will be maintained for existing products.
iShares plans to roll out advisor class ETFs to the other products in its lineup.

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RBC Direct Investing Simplifies Administration Fees

Canadian Capitalist — Wed, 02 May 2012 02:44:03 +0000

If you are a DIY investor who holds a brokerage account, the reality is that your portfolio is split between many accounts – his and hers RRSPs, his and hers TFSAs, joint or his and hers CAD and USD investment accounts and if you have kids, perhaps a few more RESP accounts. Typically, discount brokers will charge an annual administration fee if the market value of any of these accounts is below a certain value. TD Waterhouse, for example, charges an administration fee of $100 if the market value of a self-directed RRSP account is less than $25,000. In other words, even if you have a large balance in one of the accounts, you may be dinged (note that you should try and get any admin fees waived whenever possible) with a fee for the smaller accounts.

RBC Direct Investing (read review) deserves a pat in the back for taking the initiative to simplify the account maintenance fee structure. Starting this month, RBC Direct will waive all account administration or maintenance fees as long as clients have a balance of $15,000 across all accounts. If the client’s combined assets across all accounts are less than $15,000, a total fee of $25 per quarter split across all accounts with apply.

RBC Direct is also offering ways for clients to avoid administration fees altogether even if their account balances do not add up to $15,000 such as: signing up for pre-authorized contributions that total $100 per month or making three or more trades across all accounts.

The simplified administration fee structure instituted by RBC Direct Investing will help small investors avoid some annoying fees. One hopes that TD Waterhouse and BMO InvestorLine among others will follow RBC Direct Investing’s lead and simplify their respective fee structures as well.

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Estimating the Tax Hit on Dividends in Taxable Accounts

Canadian Capitalist — Wed, 25 Apr 2012 02:42:15 +0000

There is much enthusiasm among investors for dividend stocks these days. Some of the enthusiasm may even be warranted based on studies that have shown that dividend paying stocks have higher returns than non-dividend payers even though dividend payers have a lower standard deviation.

But there are also a lot of misconceptions about dividend payers. One widespread and persistent belief holds that Canadian dividend paying stocks should be held in taxable accounts to take “advantage” of the dividend tax credit. This belief is based on the fact that dividends receive the most favourable tax treatment for many tax brackets. For example, an Ontario resident with a taxable income of $50,000 will face a tax rate of 31% on interest income, 15.5% on capital gains and 13.4% on eligible dividends (Source: Ernst & Young 2012 Tax Calculator).

However, simply looking at marginal tax rates is a mistake. One also has to consider that dividend payments are made regularly and hence taxed at the hands of the investor each and every year whereas capital gains can be realized when the funds are needed, often after very long holding periods. To model the tax hit an investor incurs due to dividend payments, I constructed the spreadsheet available here. The spreadsheet has the following variables: the total return from stocks, the dividend yield, the tax rate on dividends and the tax rate on capital gains. The model assumes that capital gains are completely under the control of the investor. In reality, even the index fund with the lowest turnover will incur some capital gains distributions. Also, the rate of return and the dividend yield is assumed to be the same each year but as you well know, both these rates will fluctuate tremendously with changes in the level of stock prices. It is also assumed that the costs of assembling a portfolio of dividend payers is the same as that of tracking an index. As this is unlikely to be true in a real life portfolio, the model likely underestimates the effect of taxes on dividends.

If we assume that stocks return a total of 8% over a 25 year period, a $10,000 investment will grow into $68,484. Such an investment held in a taxable account will net an investor $59,420 (capital gains rate of 15.5%). As a base case, if we assume that the investment pays a dividend of 2.5%, it will grow into $57,431 (or about 2% less). Observe that even though the investor paid tax on dividends at a lower rate, they ended up with a smaller after-tax return on their original investment. If the dividend yield were 4%, the investment would have grown to $56,282. At 6%, it would grow to $54,798 and if all the stock returns were through dividends, the investment would grow to just $53,368.

It is an even worse decision for an Ontario resident with a taxable income of $100,000 to prefer dividend payers in her taxable accounts. In this case, the marginal tax rate on capital gains is 21.70% and 25.40% on eligible dividends. A $10,000 investment at 8% will grow to $55,793. If the dividend yield were 2.5%, the investment will only grow to $51,141. At a 5% dividend yield, the final amount drops to $46,990. Or look at it this way: a portfolio of stocks with a dividend yield of 5% must post total returns that is 0.40% higher than a portfolio of stocks with a dividend yield of 2.5% for an Ontario resident with a taxable income of $100,000 just to have the same after-tax returns.

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Performance of the Horizons Enhanced Income Equity ETF (HEX)

Canadian Capitalist — Tue, 10 Apr 2012 02:43:03 +0000

Horizons launched a whole slew of covered call ETFs last year of which the Horizons Enhanced Income Equity ETF (HEX) turned out to be the most popular. Enticed by the initial yield of about 20%, investors purchased as much as $247 million worth of HEX last year. The ETF invests in an equally-weighted portfolio of the largest 30 Canadian stocks and aims to generate monthly income by writing out-of-the-money covered calls on its stock holdings.

It appears that many investors had (just like they did with the BMO Covered Call Canadian Banks ETF) hoped that the juicy distributions will translate into higher total returns compared to a plain vanilla product like the iShares S&P/TSX 60 Index ETF (XIU). Now that HEX has a 1 year track record, let’s compare its performance with that of XIU:

Total Returns for the 1-year period ending March 31, 2012
Horizons Enhanced Income Equity ETF (HEX): -11.50%
iShares S&P/TSX 60 Index ETF (XIU): -10.32%

Now, let’s compare the income generated by the two ETFs as a percentage of starting NAV:

Income generated for the 1-year period ending March 31, 2012
Horizons Enhanced Income Equity ETF (HEX): 13.34%
iShares S&P/TSX 60 Index ETF (XIU): 2.25%

and the change in price level (assuming distributions are not reinvested):

Horizons Enhanced Income Equity ETF (HEX): -24.55%
iShares S&P/TSX 60 Index ETF (XIU): -12.62%

It is too early to draw definitive conclusions but it is interesting to note that HEX has slightly underperformed XIU on a pre-tax basis over the past year. However we can draw one conclusion: it is important to look beyond just the current distributions in evaluating an investment. A product with higher current income may not necessarily be the one that turns out to have higher total returns.

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Sleepy Portfolio 1Q-2012 Report Card

Canadian Capitalist — Thu, 05 Apr 2012 02:34:54 +0000

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 and no new money has been added since. This is not a model portfolio; it reflects investment returns that can be obtained in the real world because it accounts 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.

The Sleepy Portfolio gained 4.35% during the first quarter of 2012. The big gains were provided by international stocks: US stocks gained 9.5%, Emerging markets were up 10.2% and European stocks were up 5.9% (all returns in Canadian dollar terms). The portfolio also generated an income of $673 during the quarter.

Here’s how the portfolio looked as of April 4, 2012:

It has been a while since even a single transaction was made in the portfolio and as a result the cash position has now ballooned to 2.4% over target. With European markets stuck more or less in neutral, the allocation to EAFE markets now has a shortfall of 3.55%. Over the next few days, $3,268 worth of cash equivalents will be redeemed and the proceeds will be used to purchase roughly 100 shares of the Vanguard MSCI EAFE ETF.

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TD Waterhouse Launches Mobile Trading

Canadian Capitalist — Wed, 21 Mar 2012 03:28:10 +0000

TD Canada Trust has recently released an update to its mobile app that now allows clients to place trade orders from their smartphone. The TD Canada Mobile App previously provided features such as viewing bank and brokerage account balances, bill payment, Interac e-Transfer, fund transfer between TD accounts, stock quotes etc. TD Waterhouse has now added mobile trading to the feature list. The trading feature allows clients to place orders to buy or sell Canadian and US stocks and change or cancel orders. However, the TD Mobile app, which is available on the iPhone, Android and BlackBerry devices does not allow trading in mutual funds.

It appears that adequate security measures are in place to prevent unauthorized access if the mobile phone gets stolen or is lost. First, the app offers to store the access card number or connect id but the password is not stored. Second, the app does not allow adding a new payee for bill payment or adding a new recipient for email transfer. Third, TD Canada Trust extends its security guarantee that reimburses losses due to unauthorized or fraudulent transactions to mobile banking.

Though I tested out the TD Mobile App, I don’t think I will be using a smartphone to execute my stock trades. However, the app includes a couple of features that will come in quite handy in certain situations. For example, if you are visiting an unfamiliar place and would like to access the nearest bank machine, the app automatically detects your current location and displays the nearest TD Bank branches. Another example is an accident toolkit that will allow motorists to document the details of a collision they are involved in.

I’m told that RBC will also be bringing mobile trading to smartphones in the near future.

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Sleepy Mini Portfolio Q1-2012 Update

Canadian Capitalist — Wed, 14 Mar 2012 02:40:09 +0000

Since my previous update, the Sleepy Mini Portfolio has gained 5.4 percent. About half of the gains can be attributed to the S&P 500, which is up 9 percent in Canadian dollar terms in the past quarter alone. Long time readers will recall that the Sleepy Mini Portfolio started out with an initial investment of $1,000 in August 2007 and $1,000 was added to the portfolio every quarter ever since. A total of $18,000 has been invested in the portfolio so far and as of March 13, 2012, here’s how it looks:

TDB909 – Canadian Bonds – $3,880 (19.3%)
TDB900 – Canadian Equities – $3,950 (19.6%)
TDB902 – US Equities – $6,238 (31.0%)
TDB911 – International Equities – $6,049 (30.1%)
Total – $20,117
Total Invested – $18,000

We’ll now add another $1,000 to the portfolio and rebalance it according to our original asset allocation — 20% bonds, 20% Canadian stocks, 30% US stocks and 30% international stocks — using this rebalancing spreadsheet. Here are the results:

Transactions

TDB909 – TD Canadian Bond Index (e-Series) – Buy units for $343.49.
TDB900 – TD Canadian Index (e-Series) – Buy units for $272.97.
TDB902 – TD US Index (e-Series) – Buy units for $100.00.
TDB911 – TD International Index (e-Series) – Buy units for $283.54.

The TD e-Series Funds have a minimum purchase of $100 and the amount allocated to TD US Index Fund (TDB902) was slightly less than the minimum. Therefore, $100 was allocated to the TD US Index Fund and the amount allocated to the TD International Index (TDB911) reduced by the same amount.

It is interesting to see how the increase in the value of stocks has affected the portfolio’s annualized rate of return. In my previous update, I noted how the portfolio has returned an anemic 2.8% since inception. A mere quarter later, the annualized rate of return of the portfolio is a much healthier 5.3 percent. It goes to show how important it is to be patient when it comes to investing.

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Warren Buffett on Stocks, Bonds and Gold

Canadian Capitalist — Thu, 23 Feb 2012 04:02:03 +0000

In a column in Fortune magazine (see Warren Buffett: Why stocks beat gold and bonds), Warren Buffett explained why he prefers stocks over cash, bonds and gold. It is true that cash does not fluctuate in nominal value but its returns are close to zero after one accounts for inflation and taxes. At today’s low yields, he quips that bonds are “priced to deliver return-free risk”. Buffett also pointed out that despite its stellar recent returns, gold has limited uses and does not produce an income stream. Therefore, he says, he prefers stocks to bonds and gold:

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM), and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

It is interesting to contract Buffett’s enthusiasm for stocks in 2012 with another Fortune column he co-authored in 1999 (see Mr. Buffett on the Stock Market) in which he took a decidedly downbeat tone on stocks. He explained that stocks were so richly priced at that time that investors would be lucky to earn 4% in real terms, which would leave them disappointed with stocks. With so many investors fleeing the stock market these days, those words are now sounding very prophetic.

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A look at the Performance of the BMO Covered Call Canadian Banks ETF (ZWB)

Canadian Capitalist — Tue, 21 Feb 2012 03:17:32 +0000

BMO launched its Covered Call Canadian Banks ETF (TSX: ZWB) in January 2011. The ETF immediately started attracting investor attraction. Investors were mesmerized by the initial annualized yield of 10% and piled money into the fund: among ETFs launched in 2011, ZWB ranked first by Assets under Management by a wide margin. Interestingly, the second most popular among ETFs launched in 2011 is another covered call product: the Horizons Enhanced Income Equity ETF (TSX: HEX). Investors have clearly developed a preference for income products.

It appears that many investors thought (or at least hoped) the higher yield from ZWB compared to a plain vanilla product like the BMO S&P/TSX Equal Weight Banks Index ETF (TSX: ZEB) would translate into higher total returns. Now that ZWB has a 1 year track record under its belt, we can analyze how ZWB’s returns stacks up against ZEB’s.

Performance for the 1-year period ending Jan. 31, 2012
BMO Covered Call Canadian Banks ETF (ZWB): 2.84%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.59%

If we look at the income generated by these two ETFs as a percentage of starting NAV, we get:

Income generated for the 1-year period ending Jan. 31, 2012
BMO Covered Call Canadian Banks ETF (ZWB): 9.2%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.5%

In other words, though an investor earned a significantly higher current income with ZWB, she would have earned lower total returns compared to an investment in ZEB over the past year. Also, the income an investor receives from ZWB has also been dropping: the current annualized yield is 7.25%. Granted, a one year time frame is too short to make a fair comparison of ZWB and ZEB but the early results are not promising.

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