Canadian Capitalist

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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Owning too much real estate may not be prudent

Canadian Capitalist — Wed, 18 Apr 2012 03:40:00 +0000

In a recent story that appeared in The Financial Post (See Big debt the downside of loading up on real estate), a tax accountant noted that a much larger proportion of his clientele own rental properties these days compared to a decade ago. It is a trend that I’m noticing in my circle of friends and acquaintances as well (with the caveat that my sample set is likely too small, unrepresentative or both). In the past, young families first purchased a starter home, lived in it for a few years and then sold it and upgraded to a bigger home to accommodate a growing family. These days, many families appear to opt to rent out their starter home when upgrading to a larger property.

There are a couple of factors driving the trend of more homeowners turning into landlords. First, homeowners have built up significant equity in their starter homes due to the decade-long bull market in housing. Second, financial institutions have made it much easier to tap into home equity. For instance, the big banks used to allow lines of credit up to 60 percent of a home’s value less the mortgage balance. Today, the figure is 80 percent.

Consider the following example: Sue purchased a home in 2003 for $200K, which is today valued at $350K. She currently has a $100K balance on her mortgage. Sue is planning on buying a new home for $500K and she has $300K in other financial assets such as stocks and mutual funds. Option 1 for Sue would be to simply sell the current home when purchasing the new one. She would have $500K in housing assets, $300K in financial assets and a mortgage balance of $250K. Option 2 for Sue would be to keep her current home and rent it out. The bank is willing to allow her to tap into her current home equity to the tune of $180K. In this case, she would have $850K in housing assets, $300K in financial assets and a mortgage balance of $600K ($280 on her first house and $320 on her new house).

By dramatically increasing her exposure to the local housing market, Sue has taken on significantly more risk by keeping her starter home. Any downturn in housing prices will result in a much bigger hit to her net worth. Also, any vacancy in her rental property will put a serious crimp in her cash flow (at an interest rate of 4 percent and interest-only payments, Sue needs to net $933 every month just to break even). It may be tempting to chase real estate riches after extrapolating recent housing market returns but putting too many eggs in one basket is hardly ever a good idea.

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Hear Carl Richards Speak in Toronto, Ottawa or Montreal

Canadian Capitalist — Mon, 16 Apr 2012 13:41:06 +0000

Carl Richards, author of The Behavior Gap: Simple Ways To Stop Doing Dumb Things With Money, will be delivering a speech in Toronto (May 22, 2012 at 6 pm), Ottawa (May 23, 2012 at 11:45 am) and Montreal (May 23, 2012 at 6 pm). Behavior gap refers to the difference between the returns of an investment and the returns of an investor. Many studies have established that a behavior gap exists due to the prevalent tendency to chase “hot” investments and sell out at times of panic in the markets. Mr. Richards, who also writes for the NY Times Bucks Blog, uses a sharpie pen and napkin to capture the behavior gap and other complex ideas for the investing public. For example, here’s how he describes the concept of behavior gap:

Source: New York Times Bucks Blog

The talk in organized by PWL Capital, a financial planning firm that builds passively-managed portfolios for its clients. Cameron Passmore, Portfolio Manager at PWL Capital, has once again kindly offered to invite ten readers to Mr. Richards’ talk in each of the three cities – Toronto, Ottawa and Montreal. If you are a resident of these cities and are free at the times mentioned earlier and would like to attend this event, just leave a comment in this post mentioning which city you would like to attend and do not forget to include your email address. If you are reading this post via e-mail or your favourite RSS Reader, you have to click through to the website and scroll to the bottom of the page and type in your comment. Some quick rules:

(1) Deadline for entries is 11:59 p.m. EDT on Friday, April 20, 2010. (2) One entry per person.
(3) Canadian residents only.
(4) I treat your privacy very seriously. Your e-mail will be used for the sole purpose of sending you an invite for the event.
(5) If I receive more than ten entries, I’ll pick ten entries at random for each of the three cities.
(6) You will be responsible for any expenses incurred in attending the event.

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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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The Penny, Not the Cent will be Gone

Canadian Capitalist — Tue, 03 Apr 2012 03:08:23 +0000

There appears to be quite a bit of confusion surrounding the announcement made in Budget 2012 that the penny would be eliminated from our coinage system. Some Canadians believe that by eliminating the penny, businesses would always round up the cost of individual items and hence drive up prices. That is not quite true.

The Federal Government is simply going to stop producing and distributing pennies as of Fall 2012. Existing pennies will remain in circulation but over time, as the supply of pennies diminishes, businesses will resort to rounding off on cash transactions. Here’s an example: You walk into a dollar store and purchase an item selling for $1.25. Add 13% HST and the final tally is $1.4125. If you are paying cash, the store will round down the price to $1.40. Another customer buying 11 items and paying cash will be charged $15.55 ($15.5375 rounded up), not $15.95 ($1.4125 rounded up to $1.45 * 11). There is already many good examples of this principle at work such as gas prices, which often have a lowest unit of a tenth of a cent.

The eventual elimination of the penny will have no effect on credit, debit, cheque and electronic payments, where the cent will remain the smallest pricing unit. And even if every single retailer refuses to play ball and opts to round up the total final cost to the nearest nickel, it is a cost well worth paying for the hassle of dealing with those pesky pennies.

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Budget 2012: Changes to Old Age Security

Canadian Capitalist — Thu, 29 Mar 2012 21:31:59 +0000

The increase in the age of eligibility of the Old Age Security program in Budget 2012 was widely telegraphed in advance but there were still a few surprises. Here are the other major initiatives introduced by Finance Minister Jim Flaherty in Budget 2012:

Travellers’ Exemptions Increased

The travellers’ exemption is a dollar limit that Canadian residents can bring back after a trip abroad without having to pay customs duties or sales taxes. Budget 2012 proposes that the Travellers’ Exemption limits will increase to $200 for an absence of more than 24 hours (current limit: $50), $800 for an absence of more than 48 hours (current limit: $400) and $800 for an absence of more than 7 days (current limit: $750).

Increase in Old Age Security Age of Eligibility

Starting in April 2023, the age of eligibility for OAS and GIS will be gradually increased from 65 to 67. In other words, Canadians who were born on or after Feb. 1, 1962 can expect to receive OAS benefits at age 67. The age of eligibility will gradually rise for Canadians who were born between April 1, 1958 and January 31, 1962. The OAS age of eligibility remains unchanged for Canadians born before March 31, 1958.

New Option to defer Old Age Security

Budget 2012 proposes that starting on July 1, 2013, Canadians can opt for a voluntary deferral of OAS for up to 5 years and receive an actuarially adjusted higher pension. Here’s an example provided in the Budget document:

Rita will be turning 65 in December 2013. She plans to continue working as long as she can. She prefers to forgo her OAS pension for the maximum deferral period of five years so that she can have a substantially higher annual pension amount, starting at age 70. When she takes up her OAS pension at age 70, her annual pension will be $8,814 instead of $6,481 (in 2012 dollars).

Eliminating the penny

As of Fall 2012, the Government will no longer distribute pennies. Good riddance!

Workforce adjustments

The Federal Government is planning to reduce its headcount by 19,200 over a three-year period, a number that includes attrition. Most of the job reductions will occur in the National Capital Region.

Adjustments to Public Sector Pension Plans

The Government is proposing that public sector employees contribute 50 percent to their pension plans over time (IIRC, the current employee contribution target is 40 percent). Starting in 2013, employees joining the public service will see the age of retirement raised from 60 to 65.

Other changes that maybe of interest in the Budget include protection of long-term disability plans and improvements in the registered disability savings plan.

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