Nokia (NOK: 54)
Nortel Networks (NT: $770)
Enron (ENE: $73)
Oracle (ORCL: $37)
Broadcom (BRCM: $118.50)
Viacom (VIA: $69)
Univision (UVN: $56.50)
Charles Schwab (SCH: 36)
Morgan Stanley (MWD: $89)
Genentech (DNA: $37.50)

A reader who followed this advice would have experienced a grievous loss of capital. Some of the stories are well-known: Nortel and Enron went poof! The technology names in the list have all declined substantially. Nokia is today trading at $5, Oracle is trading at $29; Broadcom at $38 and Charles Schwab at $12. Morgan Stanley survived the financial crisis but today trades at just $20. A little bit of financial archeology revealed what happened to the other names:

- The original Viacom split into Viacom Inc. (VIA) and CBS Corp. (CBS). Each share of the old VIA was split into 0.5 shares of VIA and 0.5 shares of CBS. The market value of the original shares today is $43.

- Univision, a Spanish-language broadcaster, went private in an all-stock deal in 2006 for $36.

- Genentech, the only winning stock in the list, was acquired by Roche for $95.

A $10,000 investment in each of these stocks in 2000 when the column was published, for a total of $100,000, would today only be worth $55,600 — a loss of 44% over a 11-year period. In the interest of fairness, it should be pointed out that the S&P 500 is down 10% in price level over the same time period. Granted, I did not bother to include the dividends that some of these stocks paid over the decade because it most likely won’t change the final conclusion: stock picks in magazines may be fun to read but the investment advice may not be worth the paper it is printed on.

Related Reading:

• Why You Shouldn’t Listen to Media Gurus
• Do you still own Nortel?
• An Enron Myth
• This and That: Who killed Nortel and more …
• IQ Trends Newsletter

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It is true that an investor can obtain spectacular returns by picking the right penny stock. If you had picked up Aber or Aurelian Resources back when they were penny stocks, your investment would have become a ten bagger many times over. But that’s a bit like saying if you pick the right combination in the LottoMax draw, you can turn a $5 “investment” into $50 million. The key question is how likely is it that an investor will pick a winner out of the thousands of penny mining stocks that trade on the Venture exchange?

Research into penny mining stocks is hard to come by but I did find one study that looked at returns on stocks trading in the over-the-counter (OTC) markets in the US. The study covered a 9-year period and examined the returns from more than 7,000 stocks that traded in the OTC. The findings in the paper, titled Do investors overpay for stocks with lottery-like payoffs? An examination of the returns on OTC stocks, will be sobering for investors interested in penny stocks. It found that more than half the stocks in the sample lose more than 95% of their value (and in the interest of fairness, it must be mentioned that slightly less than 1 percent of the stocks in the sample returned 1,000 percent or more) and average annual returns were -30 (minus thirty) percent. A $1,000 investment in OTC stocks would, on average, turn into $30 over a 10 year period.

If penny mining stocks were to have similar return characteristics as US OTC stocks, an investor can, on average, expect a total loss of the capital allocated to the risk portion over time. One would hope that this particular risk barbell strategy does not require an investor to regularly rebalance her portfolio!

Related Reading:

• Bogle’s Estimate of the Behavioral Gap
• The Dogs (of the Dow) Don’t Bark
• Mensa’s Poor Investment Record
• Emotions affects fixed income investors too
• Morningstar study on investor returns

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According to the Canadian ETF Association, iShares is already the dominant player in the ETF sector with a market share of 67%. Claymore currently occupies the #2 slot with a market share of 15.5%. When the deal is consummated (unfortunately, it is likely a question of “when”, not “if” the deal will be approved, because BlackRock can probably successfully argue that its market share of the overall fund business is fairly small), BlackRock’s market share will become even more dominant at 82.5%. Or look at it this way: iShares currently has 13 out of the 20 largest ETFs by assets under management. After acquiring Claymore, BlackRock will have 18 out of the top 20 ETFs.

It is true that other ETF vendors are competing strongly. In 2011, BMO was virtually tied with iShares in net ETF creations at 33%. Claymore occupied the #3 spot with 20%. Combining iShares with Claymore (Jon Chevreau cleverly dubbed the combination “ClayShares”) would mean BlackRock would have more than 50% of the 2011 ETF sales to go along with its dominant position in the ETF landscape. It is hard to see how the creation of a virtual monopoly will deliver innovation and choice for ETF investors.

Related Reading:

• State of the Canadian ETF Industry Q3-2011
• iShares ETFs becoming more expensive
• Wrap ETFs from Claymore
• More New ETFs
• Scotia iTrade’s Commission-Free ETFs: A good deal for some investors

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Reader Cal wondered how the lag would affect an investor who wants to invest $10,000 in US stocks and has the option of simply picking XSP versus converting to US dollars, buying IVV and after 25 years converting back to Canadian dollars. Since there are a number of variables, I constructed a spreadsheet to play around with the following variables:

- the term of investment (in years)
- annual returns
- Currency-hedged fund tracking error
- Currency conversion cost
- size of currency appreciation / depreciation over the investment term

For a 25 year term, annual returns of 7%, currency-hedging lag of 1.5%, one-way currency conversion cost of 1.5%, we find that (no surprises here) not hedging is advantageous if the foreign currency appreciates or remains the same against the Canadian dollar.

Under these assumptions, due to the large annual performance lag of currency-hedged funds, currency hedging turns out to be unprofitable even when the foreign currency depreciates by 25%. It is only when the foreign currency depreciates by 30% or more that the currency hedged fund comes out ahead. If the depreciation is 50%, the currency hedged fund has an advantage of 31% over its unhedged counterpart.

The spreadsheet will allow you to play around with the variables. For instance, if you use Norbert Gambit to convert currency, your costs might be as low as 0.2%. And if the performance lag of the currency hedged fund is 2% then not hedging is advantageous even at a depreciation of 35%.

The spreadsheet is available here.

Related Reading:

• The Costs of Currency Hedging
• Currency-Hedged Funds Underperformed in 2010
• Performance of Currency-Neutral S&P 500 Index Funds
• Currency-neutral S&P 500 Fund Versus S&P 500 Returns in CAD
• Currency Effect on Foreign Equity Holdings

Comparing Currency-Hedged and Unhedged Holdings is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

I’ve looked at the tracking error of S&P 500 currency-neutral funds in past years but the tracking errors in the iShares CDN MSCI EAFE 100% Hedged to CAD Dollars Index (TSX: XIN) remained a mystery because I didn’t have the annual return data for the MSCI EAFE Index* in local currency. XIN holds the iShares MSCI EAFE Index fund (NYSE Arca: EFA) and hedges the foreign currency exposure that EFA’s holdings are denominated in, so that the returns of stocks will not be impacted by changes in the exchange rates between Canadian Dollars and Yen, Pound, Euros and other currencies. (As an aside note that even though EFA trades in the US, Canadian investors holding EFA are not affected by fluctuations in the exchange rate between the CAD and USD but are exposed to the fluctuations between the CAD and a basket of currencies such as Yen, Pound, Euros etc.).

Fortunately, MSCI Barra reports the returns of MSCI EAFE and other MSCI indices in local currencies on their website. Armed with that data, we can look at how well XIN tracks the MSCI EAFE in local currency terms. The following table shows the annual total returns of MSCI EAFE Index in its local currencies (column 2) with XIN (column 3). The results are consistent with our earlier analysis of the tracking error of XSP. XIN shows an annualized tracking error of 1.30%, which is lower than the tracking error shown by XSP but still wide enough to suggest that currency hedging is highly likely to be unprofitable.

 
When a Canadian investor holds a foreign investment directly, they take on the risk that currency fluctuations will affect their returns. Sometimes, the fluctuations will be in the investor’s favour. Other times, as Canadian investors directly holding US securities can readily attest to, fluctuations will hurt returns. Canadian investors in the iShares MSCI EAFE Index Fund (EFA) would have experienced a significant boost from the currency effect. In local currency terms, the MSCI EAFE Index lost 17.3% over the 2006 to 2011 period. Since investors in XIN trailed the index by an annualized 1.30%, XIN’s loss over the same six year period is 23.73%. However, a Canadian investor holding EFA directly would have a loss of 13.91% over the same time period.

The verdict on currency-hedging then (based on an admittedly short history of just 6 years) is clear: Long-term investors are highly unlikely to profit from hedging their currency exposure because currency effects have to overcome significantly large tracking errors simply to break even. When currency effects are negative (as it was the case of the CAD/USD and US markets over 2006 to 2011), currency-hedging still did not show a profit due to tracking error. With positive currency effects (as was the case with CAD/basket and EAFE index over 2006 to 2011), currency-hedged investors are trailing even more because investors did not get the currency boost and paid for their hedging efforts through tracking error.

* – MSCI EAFE Index tracks stock markets in Europe, Australasia and Far East and holds securities that trade in countries such as Japan, the UK and Germany.

Related Reading:

• The Costs of Currency Hedging
• A Tour of ETFs: iShares MSCI EAFE Index Fund
• Comparing Currency-Hedged and Unhedged Holdings
• Flavours of an Index Fund
• Performance of Currency-Neutral S&P 500 Index Funds

Performance of the Currency-Neutral MSCI EAFE Index Fund is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Many investors would like to have exposure to US stocks in their portfolio even if they believe that the US dollar is in a secular decline against other major currencies. In theory, currency-neutral funds seem to offer the best of both worlds: exposure to one of the world’s most dynamic stock markets without the baggage of the risk of a depreciating currency. However, if you look at the (short) performance history of currency-neutral funds, a different reality emerges.

First, let’s compare the returns of the iShares CDN S&P 500 Hedged to Canadian Dollars Index Fund (TSX: XSP) with the iShares S&P 500 Index Fund (NYSE Arca: IVV) in US dollars. In the following table, the annual total returns of XSP are listed in Column 2 and the total returns of IVV in US dollars are listed in Column 3. The performance between the two funds is compared from 2006 because in 2005 and earlier years, XSP was a clone fund that used derivatives to skirt RRSP foreign content rules that were in place at that time. While XSP’s MER of 0.25% is just 16 basis points (0.16%) higher than IVV, the difference in performance (shown in Column 4) is much wider.

A Canadian investor who put $100 (Canadian) in XSP in 2006 would be left with just $99.27 at the end of 2011. A US investor who put $100 (US) in IVV, on the other hand, would be left with $114.03. In other words, the returns in XSP trailed that of IVV by an annualized rate of 2.33%. A Canadian investor betting that the C$ would appreciate against the USD and opting XSP over holding IVV directly would have been right on the first count but made no money on the bet. The C$ appreciated at an annualized 2.20% against the USD but the tracking error of XSP wiped out all the gains and then some.

This pattern of the currency-neutral fund exhibiting significant tracking error can also be observed in the TD e-Series index funds. As you can see in the following table, the TD e-Series US Index Currency Neutral fund underperforms the TD e-Series US Index (US$) fund by an annualized 1.82%.

It is often asked why currency-hedged funds have exhibited such horrendous tracking errors. It turns out that the bulk of the blame can be attributed to the tendency of stocks and currencies to move in opposite directions (See post Why Currency-Hedged Funds have Large Tracking Errors).

So, what should investors do? If past performance is any indication and if investment performance is the only consideration, it appears that investors will likely be better off obtaining direct exposure to foreign equities without hedging away currency exposure. Owning foreign stocks directly has provided better returns in the past and it has done so with lower risk.

Related Reading:

• Currency Neutral Funds Performed Poorly (Again) in 2008
• The Costs of Currency Hedging
• Performance of the Currency-Neutral MSCI EAFE Index Fund
• Comparing Currency-Hedged and Unhedged Holdings
• Currency-Hedged Funds Underperformed in 2010

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Despite the tremendous volatility in the stock markets, the Sleepy Portfolio was little changed in 2011. The portfolio gained 4.32% during the 4th quarter of 2011 (see the report card for 3Q-2011 here) but lost 1.16% in value during the whole year (see the report card for 2010 here). As I mentioned in my previous post, most stock markets were negative for the year but REITs, bonds and US stocks contributed positively to the portfolio. The depreciating Canadian dollar boosted foreign stock returns somewhat.

In keeping with its name, the only transactions in the portfolio were dividends, interest and distributions received from the component securities. No trading was done and zero trading commissions were incurred. The weighted average of the MERs charged by the component ETFs works out to about 21 basis points per year, which means the Sleepy Portfolio costs about $275 every year or about 75 cents a day — less than half the cost of a large double-double these days. If an investor were to assemble a portfolio such as this out of typical Canadian mutual funds, it will cost at least 10 times more or about $2,750 per year or $7.50 every single day.

Here’s how the portfolio looked as of December 31, 2011:

Portfolio income during the quarter totalled $1,639.54. For the year 2011, the portfolio generated a total of $3,551 and the portfolio trailing cash yield works out to 2.7%. Since inception, the portfolio has returned an annualized 3.96%.

Related Reading:

• Sleepy Portfolio 2Q-2011 Report Card
• Sleepy Portfolio 1Q-2011 Report Card
• Sleepy Portfolio 3Q-2011 Report Card
• The 2010 Sleepy Portfolio Report Card
• 3Q-2006 Report Card

The 2011 Sleepy Portfolio Report Card is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

US stocks provided a welcome surprise in 2011. The S&P 500 returned a total of 2.11% in US dollar terms. Since the Canadian dollar depreciated by 2.2% against the US dollar, US stock markets provided meaningfully better relative returns for Canadian investors. Other major stock markets for Canadians were negative: the TSX Composite was down 8.9%, developed markets excluding the US were down 10.16% and emerging markets were down 16.58%.

CAD/USD -2.2%
DEX Universe Bond Index 9.67%
DEX Short Term Bond Index 4.65%
DEX Real Return Bond Index 18.35%
Canadian REITs 24.17%

TSX 60 -8.93%
TSX Composite -8.89%

S&P 500 (in CAD) 4.41%
MSCI EAFE (in CAD) -10.16%
MSCI Emerging Markets Index (in CAD) -16.58%

If you are interested in asset class returns for previous years, Norbert Schlenker of Libra Investments maintains a spreadsheet of total returns for various asset classes going back to 1970.

Sources: Bank of Canada, PC Bond Analytics, MSCI Barra and Standard & Poors.

PS: Note that percentage returns are inclusive of dividend or interest or distributions.

Related Reading:

• Asset Class Returns for 2010
• Asset Class Returns for 2009
• Asset Class Returns for 2008
• Vanguard to Introduce Six New ETFs
• Investing in Emerging Markets

Asset Class Returns for 2011 is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

iShares recently introduced a Floating Rate Note ETF (Factsheet, Prospectus) that mostly holds federal and provincial bonds that pay a variable coupon that is referenced to a specified market interest rate and adjusted regularly. iShares says that the rationale for owning floating-rate securities is to minimize losses in the bond portion of the portfolio in a rising interest rate environment. The ETF’s management fee is 0.20% and iShares will be waiving the management fees for an introductory period.

Traditional fixed income securities typically decrease in value when interest rates rise and increase in value when interest rates decrease. Floating-rate bonds, on the other hand, are less sensitive to interest rate fluctuations but the income stream from floating-rate securities will fluctuate based on prevailing interest rates. Currently, XFR sports an yield-to-maturity of 1.46% and the duration is just 0.13 years (duration is a measure of the sensitivity of a fixed-income security to interest rate changes). In other words, XFR offers cash like exposure.

Given XFR’s cash-like risk/return profile, it seems to me that investors have better options. High Interest savings accounts offered through discount brokers currently offer an yield of 1.25%, which is pretty much exactly the same as XFR’s yield of 1.46% less the management fee of 0.20%. However, unlike an ETF, the high interest savings accounts can be bought and sold without incurring a trading commission.

Related Reading:

• A Tour of ETFs: iShares Bond ETFs (XSB, XBB)
• Mortgage Rates: Fixed or Floating
• Short-Term versus Long-Term Bonds
• Claymore 1-10 Year Laddered Government & Corporate Bond ETFs
• Natural Gas: Fixed or Floating

iShares DEX Floating Rate Note ETF (TSX: XFR) is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

While it is important to point out that mutual fund fees are egregious, it is also important for Canadians to take the initiative and do the math on how much fees are costing them. Let’s say John invests $10,000 in the Investors Dividend Fund. Jane, on the other hand, invests $10,000 in XDV through an advisor. One can reasonably expect the two funds to post the same returns given that the holdings are very similar. Assuming XDV returns 6%, Jane will have $32,000 after 20 years. John’s investment, on the other hand, will only grow to $26,500 since Investors Dividend Fund will return about 1% less.

There is no reason to just wring out hands in despair over high mutual fund fees. We have plenty of choice when it comes to low-fee investments. Investors can assemble sophisticated portfolios with Exchange-Traded Funds (ETFs) or mutual funds either on their own or through an advisor. Plenty of low-cost active management options also exist. Mutual fund companies like Phillips, Hager & North and Steadyhand have fund in their line up that charge less than half the fees charged by a typical mutual fund and also offer some handholding. And companies like Jarislowsky Fraser offer active management at a fraction of the cost of typical mutual funds.

Mutual Fund companies like Investors Group are for-profit enterprises and there will never be much incentive for them to cut their fees (and take a hit to profits) as long as Canadians are content to hold their fee-laden products. If more Canadians become fee conscious and opt to move their investments to low-fee products, companies like Investors Group will likely be forced to reduce their fees to stay competitive.

Related Reading:

• Active Share: Not an infallible metric
• Top 5 Investment Deals
• Steadyhand Mutual Funds
• A Mutual Fund Investor
• Low-Fee Mutual Funds

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