Canadian Capitalist

Another day. Another tumble. The TSX Composite closed at 13,771 on August 31st and in the next 6 trading days has fallen 3.4%, 1.2%, 2.5%, 0%, 1.4% and another 3.9% today, for a total of 12%. Hard to believe but the index closed about 15,000 as recently as June and is now flirting with bear market territory.

The rout is global in nature: US, EAFE and emerging markets are all at or near 52-week lows. The right thing to do in the face of market turmoil is to hang tough and maybe look for bargains. Personally, I’m fully invested with all the asset classes at or near my target allocation. Do you have a shopping list ready? If so, which stocks or ETFs are you watching?

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Ellen Roseman’s recent column and blog post on group scholarship plans generated a lot of comments, including the following from a group RESP seller on how the fees of group RESPs stack up against bank mutual funds:

Banks promote their family of mutual funds as the investment vehicle for just about anyone who wants to save for their child’s education with average MER’s of 2.65%. Go to a bank and ask to see for yourself, like I have. By the time junior is off to college or university, the total fees paid by the family to the bank is about 300% higher than with scholarship plans and that’s before we even calculate the erosion of compounding interest by this annual fee that is charged.

While I’ve never been a fan of high-cost mutual funds, the claim that the MER on group scholarship plans works out to 0.9% can only be justified with a lot of fuzzy math. At first glance, it doesn’t sound unreasonable: the Canadian Scholarship Trust, for instance, charges an administration fee of 0.5% and a portfolio management fee of 0.10% to 0.30% on plan assets. There are some miscellaneous fees such as depository fees and trustee fees that we’ll ignore for the purposes of this post. The total administration and portfolio fees, roughly, totals 0.90%.

The typical sales pitch is that though there is a steep enrolment fee charged initially, it is refunded partly or in full. But attention must be paid to the details — the enrolment fee refund is in nominal dollars, without any adjustment for growth and inflation. A promise to repay $200 eighteen years in the future is only worth $83 in today’s dollars at a 5% discount rate. This is a real cost that must be accounted for in calculating the MER of group scholarship plans.

I constructed a spreadsheet with the following assumptions: (1) A rate of return of 5%. (2) Annual contributions of $105. (3) An enrolment fee refund over 4 years. A self-directed RESP earning 5% would total $3,101 after 18 years. The group scholarship plan would deduct an enrolment fee of $100 from the first year’s contribution and $50 from the second and third years. At the end of 18 years, the plan should add back the present value of four future enrolment fee refund payments. The difference between the rate of return of the self-directed RESP (5%) and group scholarship plan is a fair estimation of the impact of enrolment fees:

At full refund, the group plan earned a return of 4.05%.
At a 50% refund, the group plan earned a return of 3.75%.
At no refund, the group plan earned a return of 3.4%.

So, the total impact of all the fees on a group scholarship plan is of the order of 2.15% (1.25% for the impact of the enrolment fees and 0.9% for other fees). While that compares favourably with high-MER mutual funds, it is certainly not 3 times cheaper. And parents have a much better option than having to choose between Tweedledee and Tweedledum: they can walk down the street to a TD Canada Trust branch and open a RESP account and invest in TD e-Series mutual funds for a total cost of less than 0.5%. Now, that is more than three times cheaper.

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There is a larger question that must be asked in discussing the recent introduction of new Claymore funds tracking global real estate and infrastructure: just how many asset classes does a portfolio need? How much more diversification benefits can real estate, infrastructure, commodities, or even more exotic asset classes provide? In Unconventional Success, David Swensen discusses asset allocation is great detail and provides some guidelines:

• A strong equity orientation.
• Sufficient diversification through many asset classes.
• At least 5 to 10 percent should be allocated to any individual asset class — enough to have an impact on the overall portfolio.
• An asset class should not dominate a portfolio — allocate no more than 25 to 30 percent to a single asset class.
• The asset allocation decision should be infrequently revisited.

Mr. Swensen’s reasonable guidelines suggest a portfolio composed of no less than 4 and no more than 20 asset classes. A strong equity bias means that the maximum number of asset classes should be far less than 20. The Sleepy Portfolio, for instance, has only eight asset classes — cash, short-term bonds, real-return bonds, REITs, Canadian equities, US equities, EAFE equities and emerging market equities — but the bulk of it (70%) is in equities. The other 30% is already divided between four asset classes; there is simply no room for new ones.

It seems to me (I don’t know of any studies to back up my claim) that once a certain level of diversification is achieved, adding more asset classes is likely to fall prey to the law of diminishing returns. So, as far as the Sleepy Portfolio is concerned, eight asset classes should be plenty enough.

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1. The Bank of Canada decided to stand pat and gave no signals on the direction of rates in its interest rate decision this week. The prime rate to which personal loans and variable-rate mortgages are tied remains at 4.75%.
2. With markets resuming their downward trend once again (it took the TSX just 3 trading days to drop more than 1,000 points), William Bernstein’s column in Money is a timely reminder to stay sane in a wild market.
3. It is entirely predictable — investors are reacting to the market turmoil by flocking to the safety of money market funds. Rob Carrick makes a persuasive argument to start investing the mountains of cash accumulating in money market funds.
4. What happens to mutual funds that sport truly disastrous performance numbers? Why, they get merged with a better performing fund and get a “past performance” makeover! Jon Chevreau writes about a recent example of this practise.
5. Squawkfox is offering an e-book filled with fabulous food and fitness ideas for new and existing subscribers.
6. Investing Intelligently debunks the reasons indexing may not be for you.
7. Million Dollar Journey reviews the book - Work the System.
8. It ain’t easy but Michael James suggests cheering a bear market.
9. Canadian Mortgage Trends thinks that the days of the cash back mortgage may be numbered and points out that it is a bad deal for homeowners.
10. Picking stock market bottoms is a tricky business but Larry MacDonald wrote about a Legg Mason report that suggests a bottom is in place.

Have a great weekend everyone!

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As regular readers know, we have our brokerage accounts with TD Waterhouse. I transferred our accounts over from RBC Direct Investing to take advantage of TD Waterhouse’s wash trade capability in adopting a passive investing strategy. Now, RBC is making a tempting offer: earn 1% cash back when you transfer $25,000 or more from a competing broker into a new or existing RBC Direct account. In addition, RBC is refunding the transfer fees (upto $125) paid for transferring accounts that hold more than $15,000. The only catch: the accounts should be held with RBC Direct until May 29, 2009 and the bonus will be paid on June 22, 2009.

I don’t see any downsides to the offer — RBC Direct now has the same $9.99 commissions as TD Waterhouse — and since wash trading isn’t very important for me any more, I am seriously considering going back to RBC Direct. The way I see it, it is a risk-free way to earn an extra 1% within the next year for an hour’s effort.

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Million Dollar Journey made an interesting post last week in which he listed some points that in his opinion, are the disadvantages of indexing. While I made a detailed comment on that post, I couldn’t resist biting the juicy bait dangled in front of me. So, let’s examine his claims closely:

1. No downside protection: Investors wanting a smoother ride should allocate a portion of their portfolio to assets that are less volatile than equities such as bonds and cash. There is little evidence that money managers are able to provide downside protection either. Their returns in bear markets is, at best, mixed compared to their benchmarks. Neither are they able to add value through market timing and if anything, the evidence points the other way — mutual funds have low cash levels in bull market peaks and high cash levels in bear market bottoms.
2. No control over your holdings: It is true indexing doesn’t allow you to overweight Royal Bank and underweight BMO. But, we all know how well control is working out for mutual fund managers, eh?
3. An indexed portfolio will always be average: It depends on what is meant by “average”. John Bogle estimates that the odds of an index fund outperforming any mutual fund is 95% over 20 years. If that’s average, I’ll take it.
4. It’s boring: I used to own AIG (NYSE: AIG) (as an aside, luckily, I sold it last year when indexing most of our portfolio) and every year, I try to read the annual reports. It is usually 250 pages long filled with financial arcana — not exactly what most people would consider interesting.

The bottomline for an investor is to earn enough returns to achieve their financial goals — not some arbitrary score of how many indices they beat over their investing career. Jason Zweig recounts an encounter with a group of retirees in Your Money & Your Brain. Mr. Zweig asked the retirees how much returns they earned to retire to Florida and their answer: “Who cares? We earned enough to retire here”. Passive investing gives most people the best odds of doing just that — achieving their financial goals.

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The Sleepy Mini Portfolio lost ground, falling 4.3% since our last update in May. The current portfolio holdings are:

TDB909 - Canadian Bonds - $819 (21.2%)
TDB900 - Canadian Equities - $760 (19.7%)
TDB902 - US Equities - $1,187 (30.8%)
TDB911 - International Equities - $1,094(28.3%)
Total - $3,859

It is exactly one year since the Sleepy Mini Portfolio was launched and despite the market turmoil of the past year, the portfolio is down just 3.5% showing the value of both a diversified portfolio and regular additions to it. As per plan, we’ll add another $1,000 to the Sleepy Mini portfolio and rebalance it back to the initial target allocation - Bonds 20%, Canadian Equities 20%, US Equities 30% and International Equities 30%. Using the simple rebalancing spreadsheet, we can easily figure out the transactions we need to make:

Transactions:

TDB909 - TD Canadian Bond Index (e-Series) - Buy units for $153.01.
TDB900 - TD Canadian Index (e-Series) - Buy units for $212.07.
TDB902 - TD US Index (e-Series) - Buy units for $270.88.
TDB911 - TD International Index (e-Series) - Buy units for $364.03.

Investing so easy, you don’t really have to be a pro like Avner Mandelman!

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Many investors, noting the effect on their wallets while shopping at the grocery store or filling up at the gas station, are worried about an increase in inflation — total CPI, which includes volatile items like food and energy is running at 3.4% and the “core” rate at 1.5%. But, you wouldn’t know it by looking at the bond market: 10-year Canada bonds are yielding 3.51% and are trading close to their 52-week highs. The difference between the yields on real-return bonds (1.55%) and long-term bonds (4.0%) suggests that the markets are guessing that inflation in the future will be a rather modest 2.5%. Nevertheless, here’s how various asset classes have behaved in an inflationary environment:

• Bonds: Estimating the effect of rising inflation on bonds is easy — it’s bad. And history bears this out. In the 1960s, inflation in Canada averaged 2.6% but spiked in the 1970s to 7.6%. Real returns on bonds fell an average of 1.6% during that decade. It is the direction of inflation that matters, not its absolute level. In the 1980s, inflation averaged 6.2% (lower than the previous decade) and the real return on bonds averaged 6.4%.
• Real-Return Bonds: Inflation-protection is the raison d’etre of real-return bonds as both the coupon and principal are adjusted for inflation. As already noted, befitting their low-risk nature, the current yield on these bonds is quite low.
• Real Estate: In Unconventional Success, David Swensen points out that real estate has a high correlation with inflation due to the ability of landlords to increase rents and increase in asset values to reflect higher replacement costs. However, this is only true when valuations are not extreme. Assuming that valuations are “normal” most of the time, REITs perform well as an inflation hedge.
• Gold: Any discussion of inflation will invariably turn to gold. There are two views on investing in gold. Some, like Benjamin Graham, opine that the US Government did investors a favour when it disallowed its citizens to own gold. Others, like William Bernstein, point out that a small allocation to precious metal equities and diligent rebalancing will help in periods where inflation is soaring.
• Stocks: Increasing inflation has a negative effect on stocks in the short run as future earnings are discounted at a higher rate and reflected in lower prices. But, in the longer term, at least in theory, businesses will find a way to pass along increasing costs to customers, which will find its way to the bottom line as an increase in earnings. In his commentary in The Intelligent Investor, Jason Zweig notes that out of 64 five-year periods since 1926, stocks have outpaced inflation 78% of the time. During the 1970s, the real return on Canadian equities was 2.4% (-0.7% in the US). Stocks do live up to their reputation of inflation hedges over the long-term but over the short term, all bets are off.

Bottomline: Rising inflation is bad for bonds but stocks, precious metals and real estate are reasonable but not perfect hedges. The only perfect inflation hedge is a real-return bond but their yields are very low.

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1. The big banks announced earnings this week but TD Bank was the only one to raise its dividend. Canadian Banks and Insurance blog has extensive coverage of earnings from our banks and insurance companies.
2. The Dividend Guy discovers the joys of not checking how his portfolio is doing.
3. Million Dollar Journey on the “pitfalls” of index investing. Ha!
4. Four Pillars is holding a giant book giveaway (ends tomorrow).
5. Being an engineer (we really take Dilbert’s maxim that “a well-dressed engineer has no credibility to heart”), I’ve never heard the expression “dark suit, grey suit and blue suit”. Thicken my Wallet applies it to personal finance.
6. Preet continues his DFA series with an explanation of the CAPM theory and a slight problem with it.
7. Money Grubbing Lawyer on five places not to scrimp and five places not to spend.
8. Congratulations to Gail Vaz-Oxlade, whose Til Debt Do Us Part show has been nominated for a Gemini award.
9. Ellen Roseman reveals a sleazy tactic employed by Direct Energy agents.
10. Steadyhand’s Tom Bradley is the Dos Equis man of mutual funds.

Have a great weekend everyone! Regular programming will resume on Tuesday.

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Claymore Canada has introduced a couple of ETFs that track interesting asset classes: Claymore Global Real Estate ETF (CGR) and Claymore Global Infrastructure ETF (CIF). CGR tracks the Cohen & Steers Global Realty Majors index, which is composed of 75 securities representing the US (40%), UK (10%), Japan (13%), Hong Kong (10.5%), Australia (11%) and minor weighting to other countries. The MER for the ETF is 0.65% and yields 4.4%. The major alternatives, all of which trade on the US exchanges, are: Cohen & Steers Global Realty Majors ETF (GRI, tracks the same index as CGR and has a MER of 0.55%, First Trust FTSE EPRA/NAREIT Global Real Estate Index Fund (FFR, MER of 0.60%) and SPDR DJ Wilshire International Real Estate ETF (RWX, MER 0.60%).

While CGR is much more diversified than the iShares CDN REIT ETF (XRE) and has a decent yield, I wonder if it is appropriate to add foreign real estate to a portfolio, considering that most investors’ allocation to REITs is already small, say 5% to 10%. In any case, there is reason to adopt a wait-and-watch stance because according to the prospectus, the ETF will track the underlying index’s returns through derivatives and incur expenses in addition to the MER. Moreover it is not clear if a market for CGR can be sustained because global real estate is cooling (down 20% over one year) after extremely good returns over a five year period.

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