How to Minimize Portfolio Volatility and Sleep (a lot) Better

That an investor is able to sleep well at night matters. It matters first for peace of mind, since the sickening feeling of a threatened retirement resulting from plunging markets is not what life is all about. It matters also to prevent the rash reaction of selling out at precisely the wrong time, after a plunge and before recovery has come about.

Many portfolio structures that are described as conservative or balanced are actually quite volatile. Let's explore how to adjust a portfolio to reduce volatility. We'll use two free online tools - the Stingy Investor Asset Mixer, which provides long term return data of the main asset classes, and the recently launched InvestSpy Calculator, which provides market price volatility data. Both allow the user to enter various combinations and percentage allocations over different time periods, a very useful feature for "what if" testing.

Test Portfolio - The Simple Recipe Portfolio
We'll examine a classic simple portfolio, one of a bunch of such portfolios we compared here. The Simple Recipe has only four ETF holdings, three equity (Canadian TSX Composite ETF: trading symbol XIC, USA S&P 500: symbol SPY and international developed country MSCI EAFE: symbol EFA) and the Canadian bond universe (both government and corporate): symbol XBB. Assuming a 50 year old investor, the Simple Recipe allocates 50% to XBB, 25% to XIC, 8% to SPY and 17% to EFA. Those are the numbers we entered into the two tools to get the results of the Pre-Adjustment version of the portfolio.

Reduce volatility by equalizing the Risk Contribution of each holding
Beginning with the InvestSpy tool we enter the initial Pre-Adj allocations and find that almost all the volatility in the portfolio, as seen in the Risk Contribution result column, comes from XIC and EFA. XBB provides a powerful offsetting negative volatility reduction (see screen shot of results below).

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The source of this effect is revealed in XBB's negative numbers in the correlation matrix.

Next we reduce the overall portfolio volatility by changing the allocation to each ETF to try equalizing the Risk Contribution. That means boosting XBB's percentage and reducing both XIC and EFA. Remember that playing with the numbers is not a matter of trying to find the exact perfect minimum volatility. There really isn't such a thing as an optimal solution, since what works best for the past one year goes out of kilter for the past two years, five years or the entire price history. Volatility and correlation has changed over time and will continue to do so in future. In addition, SPY and EFA are traded in US dollars so that currency shifts with the Canadian dollar will alter the results. We are merely looking for something more stable than the initial portfolio, knowing that it also won't be perfectly adapted to the future. The before and after-adjustment results are summarized in the table below.

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Our Volatility-adjusted allocation reduced volatility by about half compared to the initial portfolio allocation! That includes the period of the financial crisis in 2008-2009. One big takeaway is therefore - increasing the bond allocation brings much stability to the portfolio.

What happens to the returns, do we lose half the returns too?
To find out we entered both pre- and volatility-adjusted allocations in Stingy Investor for various time periods. The Stingy tool has the merit of taking account of currency shifts by converting returns to Canadian dollars, i.e. we assume that the investor does not hold a CAD-hedged ETF. The negative numbers in the Alpha input column approximate ETF expense ratios (we entered current MERs for our ETFs), which reduce returns. This is necessary to get a reasonable estimate of what would have happened since Stingy does not use actual ETF data. ETFs did not even exist in 1970. Looking at the longer historic time data helps us see how our portfolio allocation would have fared through more economic and market environments like the high inflation 1970s oil crisis and the 2000 Tech bubble. Unfortunately, all the data is only year-end annual so we cannot see what happened day-to-day during any year. However, it's better than nothing. We online investors must make do with what we can get, knowing in any case that we are always approximating, since the future is never exactly like the past.

The results vary slightly amongst sub-periods and the total time period for which data is available, 1970 to 2012, but a pattern is clear.

The screenshot below shows detailed results for the volatility-adjusted portfolio:

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We've taken the results and created the following summary table comparing the pre- and volatility-adjusted portfolio allocation results for the total time period 1970-2012 and the high inflation years of the 1970s, when bonds might have been thought to severely drag down the portfolio performance:

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• Returns for the volatility-adjusted portfolio are still highly positive but reduced by about a half-percent a year BUT
• Downside risk is hugely reduced - fewer downside years, a lot less volatility and especially, worst drop years have very small decreases

Bottom line: It is quite possible to drastically reduce sleep-depriving portfolio volatility without much loss in returns. Is that a worthwhile trade-off? It's up to you the investor to decide.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Comparing the Canadian High-Yielding Mortgage Companies

A few weeks back, we introduced the various alternatives for investors to obtain steady dependable income from mortgages. Today let's go a little deeper and compare the seven mortgage-focused companies available through online brokers and traded on the TSX. In particular, we want to see what the chances are that these companies will be able to maintain their current attractive distribution yield rates of 6 to 7%. Many of these companies state outright that they aim to provide a return of 4 to 4.5% over the federal Treasury Bill rate while safely preserving capital. We'll use the excellent guidelines PIC-A-MIC from Fisgard as our checklist of factors to consider.

The Seven Contenders

• MCAN Mortgage Corp (TSX symbol: MKP)
• First National Financial Corp (FN)
• First National Mortgage Investment Fund (FNM.UN)
• Firm Capital MIC (FC) 
• Timbercreek MIC (TMC)
• Timbercreek Senior MIC (MTG)
• Atrium MIC (AI)

As our first comparison table details, the seven use various combinations of two legal structures - corporation or closed end fund - and two tax structures - ordinary taxable entity and tax-exempt Mortgage Investment Corporation (MIC).

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Tax treatment matters and it differs a lot
A MIC's tax-exemption only means the income is passed along to the investor to be taxed in his/her hands, which in turn could be in a tax-exempt TFSA or a tax-deferred RRSP, LIF, LRIF, LIRA or a tax-advantaged RESP. Since the five MICs in our list all distribute interest income which is subject to the highest tax rate, these stocks should preferably go into a TFSA, RRSP (or the like) or a RESP, or simply in a taxable account.

The other two funds, FN and FNM.UN, are taxable. FN distributes primarily eligible dividends and sporadic small capital gains so it can go well in an investor's taxable account. FNM.UN uses a forward agreement to transform interest income into primarily return of capital distributions. Unfortunately, as mentioned in our previous post, the recent federal budget said it would prevent these arrangements but the company believes the existing FNM.UN will be able to continue till the forward agreement expires in December 2017. Since return of capital is effectively deferred capital gains, investors can continue to benefit for up to almost five years of tax advantaged income. As such, FNM.UN fits nicely into a taxable account.

Trading below or above Net Asset Value (NAV)
Perhaps the uncertainty about FNM.UN explains the fact it is trading at 1.8% below the net asset value of its holdings. In contrast, TMC is trading a fairly significant 7% over NAV and MTG is at 1.6% above NAV. Some investors may be chasing the yield without noticing what each fund is really worth.

Cash yield is often supplemented at year end
The MICs all must distribute all their income to retain their tax-exempt status so they typically set a conservative monthly amount to distribute. Then at year end there is an extra top-up amount to parcel out the remainder, which means the indicated cash yield in our table most probably under-estimates what the investor will eventually get by year end.

Distributions have trended in different directions
Disappointing - TMC and AI have seen their distributions fall appreciably over the past several years.
Pleasing - MKP, FN  and FC have been increasing their regular monthly distributions.
The other two don't have a long enough track record to detect any trend.

Dividend reinvestment plans at discounted price
Five funds offer the opportunity to reinvest distributions at no brokerage cost and at a 2% - MKP, FC and AI - or a 5% discount - TMC and MTG - to current market price of the shares.

Risks - Things that could go wrong
Look at any prospectus for these companies on Sedar and there is a long list of factors that can knock down the distributions and the capital value of the shares:

• credit risk assessment poorly organized or controlled resulting in higher defaults on loans and losses
• liquidity risk or cash flow control that does not match up incoming with outgoing cash or put adequate just-in-case sources of funds in place
• changes in real estate values
• concentration and composition of the portfolio
• economic conditions and cyclicality of residential and commercial real estate causing slowdowns in loan growth and rises in bad loans
• actions by higher-ranking debt holders
• leverage magnifies the downward as well as upward returns
• mortgage holdings may not be very liquid / easily saleable
• increasing price competition from other lenders that reduces profitability
• interest rate decreases reduce possible returns and increases can hurt the value of existing holdings, especially as term to maturity of holdings increase
• availability of investments
• mortgage extensions that go bad
• foreclosure costs
• litigation costs
• reliance on key personnel
• failure of internal computer systems
• changes in legislation or taxation
• environmental liabilities on repossessed properties
• natural disasters, wars, terrorism

It is impossible to precisely assess the exposure, probability and potential impact of any or all these factors. The PIC-A-MIC list and our table below gives an idea of the current state of affairs for the most likely and most influential factors.

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Mortgage portfolio holdings average yield mostly above payout rates
FC, TMC, MTG and AI all sport portfolios whose yields exceed the rate they pay out, which leaves a better chance that after costs are deducted there will be enough to sustain payouts.

In MKP's case, the portfolio yield at end of 2012 was only 5.81%, a lot less than the 7.74% paid out to shareowners. The difference can only come from leverage. But in MKP's case that doesn't necessarily mean huge extra risk. As a deposit taking financial institution, it can, unlike the others in our list, get cheap funding by issuing plenty of low interest term deposits just like the mainstream banks to lend out for higher rate mortgages. The interest rate spread of many such transactions can create a big sum for the many fewer shareholders of MKP shares. The fact that it has been in existence since 1991 and is regulated by the OSFI adds to the comfort that it knows what it is doing and can sustain the business model and the distribution.

Mortgage assets and concentration of loans
A bigger asset base gives more scope for spreading things out and being less exposed to any one borrower or geographic area. Another row in the comparison table shows how concentrated are the portfolios of the various companies. FN and MKP come out looking safest on this dimension.

Investment focus, term duration, loan-to-value ratio and 1st vs 2nd proportions exhibit trade-offs of one factor vs another
What they may lack in strength from concentration or smaller size, the other companies make up for with more protection in the form of shorter lending term, lower loan-to-property value and greater proportions of higher ranking first mortgages.

Portfolio impairment and loan losses across the board look to be acceptably low
The proof of lending quality, or deficiencies therein, ultimately comes out as repossessions, foreclosures and losses on loans. None of the companies seems to be facing any serious losses at the moment.

Expense ratios high for two companies
TMC, at 2.6%, and FNM.UN, at 2.5%, appear to be on the too-high end of expenses compared to the others.

Management skin in the game varies from none to dominance
When there is significant share ownership by the executives and directors who run the company, outside investors get more reassurance that attention will be paid to keeping the company profitable and the cash flowing. MKP, FN and AI look especially good on manager ownership stakes. It is interesting also that the three companies with the higher expense ratios - FNM.UN, TMC and MTG - seem to have no shares owned by the managers/executives.

Amount of leverage employed varies from zero to several multiples
TMC is the one company that so far refuses to use any leverage to boost returns. Its only borrowing is strictly to facilitate timing differences in cash flows. The others run the gamut from modest 5.8% liabilities vs assets at AI to 83% at MKP. However, as noted above, the borrowing base of term deposits is very cheap and stable at MKP so it isn't clear the risk is much more, if any.

Bottom Line
It's hard to say that any company stands out as especially weak-looking overall. MKP noses ahead to grab best choice in our opinion for its combination of pluses - starting with a high base cash yield, that has grown steadily over the years, a long track record of profitability, a dividend reinvestment program, low loan losses, a very diversified loan portfolio and a significant management stake.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Time to Fill 'er Up on Oil & Gas Stocks?

Many investors will have noticed that the shares of oil and gas companies have been taking a beating in the last few years. It's one of the main reasons the TSX Composite has been lagging the S&P 500 in the USA. From a peak in mid-2008, oil & gas shares first suffered a big decline and then have got stuck in a doldrum. The chart below (using BMO InvestorLine's internal ETF comparison tool) shows this pattern using the benchmark ETF of the TSX, iShares' S&P/TSX 60 Index Fund (TSX: XIU) and the iShares S&P/TSX Capped Energy Index Fund (XEG), which tracks the oil & gas sector.

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We note that the oil & gas stocks, despite the woes of the past five years, have returned slightly better than the overall TSX over the ten year period. A 150% total return for XEG versus 139% for XIU isn't shabby for either. Maybe we shouldn't be too despondent. Nevertheless, where there is a downtrodden industry, perhaps there is an opportunity to pick up good stocks that have been dragged down with the negative sector trend, so we decided to have a look.
Finding the oil & gas stocks
Using the TMX Money stock screener, we extracted a list of candidate stocks by setting the Sector to Energy and imposing a minimum $2 billion market cap to eliminate the multitude of smaller companies and to thereby focus on established successful companies that have a longer track record. With the 34 companies thus located, we eliminated pipelines like Enbridge, TransCanada, Pembina and Inter Pipeline and utilities like AltaGas. The remainder is a mix of integrated companies that do everything from exploration to production, refining, marketing and distribution, to others that exist in one part of the energy chain or who provide services to the industry. Our first table shows the companies and their type. The table also shows which companies are in the ETFs XIU and XEG. All but two are in XEG, shown by the orange cells, and 11 are part of XIU, the light purple cells. Many of these stocks pay a very attractive dividend, much above that of XIU and XEG's average, as we can also see from the first table. A key question is thus whether the payouts are sustainable.

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Past market performance and profitability
It is no surprise that most of the stocks have had significantly negative returns over the past 1 and 5 years and many have suffered declining profits and have cut dividends, as we can see in our second table below. But, encouragingly, there are some notable exceptions that have increased profits and boosted dividends. Most companies are still making profits, as shown by the positive Return on Equity. Using the profitability factors, we have rated each company with an A (best), B (indifferent) or C (poor) grade. Ten companies out of the 26 get an A.

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Riskiness and volatility
Most investors want to avoid future nasty surprises, so we want to assess how stable and reliable are these companies. Are they paying out too much in dividends as a proportion of earnings, as tested by the dividend payout ratio?  One - Keyera Corp - actually paid out more in dividends than it earned in 2012, which may be sustainable in the short term with enough incoming cash flow but cannot be in the long term. Too low a payout ratio can also be bad if management uses profits for empire building on unproductive investments (which we noted in our recent post on Canadian dividend ETFs). Other risk indicators include the actual daily volatility of the stock relative to the market average (measured by beta, with 1.0 being the market average, i.e. the same as XIU, under 1.0 being less volatile and over 1.0 more so); the dispersion of future earnings per share estimates by analysts (the less the better as we noted in this post); insider trading, i.e. what executives and directors of these companies are actually doing with their own money (buying is obviously a good sign, while selling may be bad as we discussed previously here; and several debt burden indicators since too much debt with the fixed interest obligations makes the company more susceptible to downturns. Only seven companies got A on these factors.

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Price Attractiveness
The final set of measures aims to see whether the stock price reflects a good buy relative to earnings, cash flow, sales and book value. In several cases, the ratios don't all tell the same story. Along with that, we have included (and taken the grain of salt we suggested in this post) the average recommendation of stock analysts on each stock, as well as the often differing results of the value assessment tool provided by BMO InvestorLine to its clients. We are looking for patterns and consistency of results. But there seems to be even less consistency in this set of factors, as only six stocks garnered an A.

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The "A List" of overall best looking stocks to buy
Consolidating the ratings across all the above categories leads us to the following five stocks which we think merit an overall A rating:

• Ensign Energy Services (ESI)
• ShawCor Ltd. (SCL)
• Cenovus Energy (CVE)
• Imperial Oil (IMO)
• Suncor Energy (SU)

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Of course, if you aren't sure which are good and which bad, it is always possible to buy XEG (or other energy sector ETFs listed at TMX Money), which holds almost all of these stocks. If you aren't sure whether the sector is worth buying as against any other sector, XIU holds some of everything.

Disclosure: This blogger owns shares in Imperial Oil.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Foreign Income & Assets - Avoid Nasty T1135 Trouble

Hard-pressed governments everywhere are redoubling their efforts to find tax evaders, one of the prime targets being people who hide investments in distant tax havens. Splashy news like the recent CBC post Massive data leak exposes offshore financial secrets heighten the profile of the issue. Everyone should pay their fair share of taxes but innocent people who actually do pay all they owe can get caught in the crossfire through the strict rules put in place to catch cheats. The consequences can be nasty with penalties easily running into thousands of dollars.

Many situations can cause an investor to get exposed to and possibly caught in the tax penalty net:

• diversified portfolios that include foreign holdings
• inheritances from abroad
• immigrants to Canada who have retained foreign assets
• Canadians abroad who acquire foreign assets

There's one key form that investors need to check whether they need to complete and file, the innocuously titled Foreign Income Verification Statement Form T1135. As can be seen below, the form asks mostly about assets though there is a question about total foreign income.

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Here are some of the basics of the T1135, bearing in mind that we have summarized and the official source of the government pages, mainly the tax collector, the Canada Revenue Agency, contains more complete information. A tax accountant can be extremely useful to interpret and give guidance on "what ifs" and other scenarios not covered. In case of doubt, it is best to get professional advice since the bad consequences of being wrong are so severe.

Who is subject to the T1135?

• individuals corporations, trusts and certain partnerships,
• who is resident of Canada (which is not the same as being a citizen) and thus liable to file a tax return in Canada, keeping in mind that a resident has to declare all world wide income. Potential Gotcha #1 - even if you have no income or foreign income to declare, or your income is too low and you know there will be no income taxes to pay, you might need to file the T1135 by the tax deadline anyway since the criteria is based on assets (see Q1 of this CRA page).

What are the criteria for the T1135 filing requirement?
If the "who" above owned during the past tax year:

• specific foreign assets; "foreign" means either where the assets are held, or who issued securities, like stocks and bonds issued by non-Canadian / non-resident companies or governments. Potential Gotcha #2 - what's in and what's out can get tricky - any securities, including Canadian securities, on deposit with a non-Canadian broker are "foreign", as are any non-Canadian securities in a non-registered taxable account, including any that might happen to be traded on the TSX (see this list on TMX Money) but not a share of a Canadian company bought on a foreign stock exchange (there are many traded in the USA per this list on TMX Money)
• total value over $100,000 i.e. the sum of all assets together, not the value of any individual asset, but not counting any excluded property like what is in RRSPs and the like
• value at any time during the past tax year, not as of the filing date, so that an asset that was sold during the year counts towards the calculation
• cost, not the current market value so that investments bought for $80,000 and now worth $120,000 would be exempt
• dollars in Canadian currency, the conversion rate being that in effect on the purchase date or deemed acquisition date, such as when an immigrant becomes resident
• see more situations in the CRA Questions and answers about Form T1135 page

What must be reported?

• amounts in foreign bank accounts;
• shares in foreign companies;
• interests in non-resident trusts;
• bonds or debentures issued by foreign governments or foreign companies;
• interests or units in offshore mutual funds;
• real estate situated outside Canada; ... but this is only when it's primary purpose is not for personal use (see exclusion below)
• other income-earning foreign property.
• US Roth IRA (probably, unless the proposed change mentioned here came about to exclude Roth IRAs)

What foreign investment property is excluded?

• personal-use property, that is, any property used mainly for personal use and enjoyment, such as a vehicle, vacation property, jewellery, artwork, or any other such property; Potential Gotcha #3 - the vacation property exclusion gets tricky itself as it isn't cut and dried when a property is rented out part of the time to make a profit but is also mainly for personal use (see this answer in the CRA Q&A)
• assets used only in an active business, such as a business inventory or the equipment and building used in a business
• RRSP and other registered account - LIRA, LRIF, LIF, RESP, TFSA, RPP - holdings; though the CRA Q&A specifically mentions only RRSPs, the other types of accounts also presumably qualify for exclusion (which makes us wonder why the CRA would not want to be more completely explicit to avoid a lot of uncertainty amongst taxpayers); this provision lets out many if not most taxpayers from having to file the T1135
• Canadian mutual funds or ETFs that hold foreign stocks and bonds - a US resident ETF like ISHARES CORE S&P 500 ETF (NYSE symbol: IVV) is a foreign asset in a non-registered account but the iShares S&P 500 Index Fund (CAD-Hedged) (TSX: XSP) or the new non-hedged version XUS, both of which actually hold only IVV, would not be considered foreign since they are established in Canada. For more, read MyOwnAdvisor's excellent article on the T1135 with many examples of possible included or excluded assets.
• US Individual Retirement Accounts (IRA) and 401k

What are the penalties?
For not filing, or filing late, the penalties are severe per this CRA webpage, whether or not any foreign tax is owing or undeclared: $25 per day, up to $2500 per year, repeated for each year filing is missed, even when it is an innocent mistake (e.g. when all foreign income has been declared and tax paid!) is very harsh, as accountant The Blunt Bean Counter noted.

The CRA is unforgiving, as shown by the comments and laments on the T1135 Financial Webring thread, on this BritishExpats.com discussion, by this Advisor.ca post by Jamie Golombek on T1135-sparked court cases and another on a specific case where an honest first-time mistake did not escape the penalty. One lucky taxpayer did successfully fight the penalty but this more the exception than the rule. Potential Gotcha #4 - the fact that all foreign income has been declared and taxes paid does not excuse the necessity of declaring foreign assets and filing the T1135.

What to do?

• when in doubt, file the T1135; it seems that there are no penalties for sending it in even if it turns out not to be required; at worst the CRA may ask for more details on assets that aren't an issue. The CRA fillable and savable T1135 pdf is here ; incorporated instructions include the mailing address. Potential Gotcha #5 - right now the only way to file this form is by printing it out and mailing it in. The CRA's nifty electronic NetFile service does not include the T1135, though the CRA says it is working on making the T1135 electronically filable. Most of the NetFile certified software packages to prepare taxes aren't clear enough about the mailing requirement.
• buy Canadian-based mutual funds and ETFs in a non-registered account. This won't avoid the necessity of reporting for the past but it can avoid future hassles. As we noted above, such investments are not considered foreign property by the T1135 and there are plenty of fund alternatives for the main foreign asset classes. Though expense ratios are almost always higher than for US-based funds, owning a Canadian-dollar sold fund also avoids the cost and trouble of currency exchange and possible exposure to US estate tax.

With the April 30th deadline only a few days away, there's still time to comply and avoid unnecessary problems, even if your tax return has already been submitted. Figure out where you stand and take action.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. This topic in particular can be complicated and it can have severe unwelcome consequences. The commentary rests on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Stock Market: Is it Sky Falling Again, Business as Usual or Spring Sale?

In the last few days we witnessed the Toronto Stock Exchange Composite Index fall sharply several days in a row, prompting some to worry e.g. this somewhat frantic news article. So, we asked ourselves, where are things, is this a major reversal, or just par for the course, part of the normal ups and downs of the market? The drop also triggered the thought to go look for stocks on sale at attractive bargain prices, such as we did in August 2011 during another significant drop.

Sky not falling, more like business as usual
A brief look at the Yahoo Finance chart below of the TSX shows us that the current decline is only one of many that have occurred over the past several years alone. It is not nearly the most severe or prolonged.

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The fact is, the market does go up and down. The ride is never smooth. Our previous post on investing risk about volatility and business cycles gives us more context on what extremes we should expect. Being aware of such constant volatility helps us investors avoid panic reaction and allows us to sleep better.

Mining and Oil & Gas in a two-year funk
These two sectors have caused the sustained fall from the TSX high in April 2011. They comprise a significant portion of the TSX Composite. The charts from TMX Money of the Mining and Oil and Gas indices show the market price decline and the tables from Globe Investor's MyWatchlist show the falling profits at the majority of companies that have spurred the declines.

Mining

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Oil & Gas

Opportunity lurking?
As we also see in the tables, most of the companies are still profitable. A good number, like First Quantum Minerals (TSX symbol: FM), Agrium (AGU), IAMGold (IMG) and Katanga Mining (KAT) amongst miners, and Canadian Oil Sands (COS) and Imperial Oil (IMO) amongst energy companies sport very appealing low Price to Earnings ratios. Such indications of possible bargains need to be assessed further using the various accounting figures and ratios such as the Watchlist provides automatically.

At some point down the road, when exactly it is impossible to tell, these industries will revive with more vigorous economic growth in other countries who need the resources produced by these companies. Picking individual company stocks or buying a basket of companies in a sector ETF (find them using one of the ETF screeners we compared here). Or failing that, continuing to hold the broad TSX through a composite ETF that includes these sectors will eventually gain the benefit of a rebound too.

Spring sale on other stocks
Using the same filter as in the August 2011 post, we picked out the medium (above $500 million in market cap) to large cap stocks with more attractive P/Es of under 15 and appealing dividend yields of over 3% on the TMX Money stock screener. Then we copied various the stocks along with their data to a spreadsheet and found the potential bargains by calculating and ranking which stocks were most below their highest price of the past year. Along with that we calculated which were closest to their 52 week lowest price.

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The result:

• There are still plenty of low P/E stocks paying attractive dividends - our table above shows the 30 largest companies only, which includes all the banks and several mining and and energy companies. Many have solid profitability (higher Return on Equity), though not as consistently growing sales or earnings. Most of the list is less volatile than the overall TSX, as shown by trailing 60 month betas below 1.0 (above 1.0 is more volatile than the market average).
• Price cuts are less today than 2011 - Price reductions off the highs are not as large as in 2011 when we compare the two lists
• There are fewer bargain stocks overall - our initial screen in 2011 gave more than 100 stocks while this time it was only 98

August 2011 bargain stocks generally fared well
When we looked at the results for the previous effort, they showed generally quite good outcomes:

• TSX Composite as a benchmark lost 1.9% in total return from August 2011 to 19 April 2013 (see GlobeFund chart)
• Eight of the twelve stocks at the top of the list had overall significantly positive returns (symbols BLS, BPO, SLF, MIC, POW, GWO, RY, HSE), three were around zero like the TSX (COS, PWF, IGM) and only one a big negative, Larbrador Iron Ore Royalty Corp (LIF.UN) which had its dividend haved and a 7.5% price drop. Interestingly, seven of these are on our new bargain list - COS, SLF, MIC, POW, GWO, RY and HSE)

Bottom line: Using such filters to seek out good buys amongst stocks generally points in the right direction, though not infallibly so.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Ways to Get Steady Dependable Income from Mortgages

Every adult Canadian knows what a mortgage is and understands that it is a loan against property on which interest must be paid regularly without fail or else there is risk of having the property taken over by the lender. Many of us are mortgage borrowers to buy a home at some point in life. If we put the shoe on the other foot as investors, mortgages can have a definite appeal as a steady income-producing investment that should be quite secure (how many people would easily or willingly default and lose their home?).

Let's look at the alternative ways a Canadian investor can buy into mortgages. Here is a comparison table of the key features of the alternatives we review below.

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Mortgage Investment Corporations
MICs are specialty funds to pool investor capital for lending out as mortgages, primarily for residential buildings but with a portion allowed for commercial properties. MICs have a long history going back to the 1970s when the federal government modified the Income Tax Act (in section 130.1) to allow income from mortgage interest to be passed through tax-exempt in the MIC to individual investors for taxation in their hands. Average Joe, instead of paying interest on a mortgage on his home, can turn the tables, invest in a MIC, and collect interest instead.

More detail:
1) CanadianFinancialDIY's Ins and Outs of Mortgage Investment Corporations,
2) Interview about the origins and workings of MICs with Wayne Strandlund, CEO of one of the biggest private MICs Fisgard Capital Corporation on the Canadian Mortgage Trends.com blog,
3) Regulatory restrictions on who can invest in private MICs, which varies by province, also on Canadian Mortgage Trends.com
4) PIC-a-MIC, Fisgard's more-than-thorough 27 point due diligence checklist for investors. This checklist serves very well for any of the types of mortgage investments we discuss now.

Four MIC flavours - The tax-exempt MIC status can be, and is, available in four different types of corporate structures and investor vehicles.

• Private MICs - The investor deals directly with the MIC and are thus not available to the online investor. They are subject to the provincial regulatory restrictions. Private MICs tend to be smaller and more narrowly focussed on a province, or even a city. With private MICs you basically expect to get your original contribution back, unless there are bigger losses on the mortgage portfolio than the reserves the the MIC management (should) put in place. Your status is that of providing equity to the MIC, not a loan, so it's not like a GIC. The expectation is interest income/return only. There are dozens of private MICs across Canada, some of which CanadianFinancialDIY lists.
• Closed End Funds - There are only a few of these around - we found only two, the Timbercreek MIC (TSX symbol: TMC) and the Timbercreek Senior MIC (MTG) which holds an even safer bag of mortgages albeit at a lower return. CEFs are very convenient to the online investor since they can be bought on the TSX just like any other stock. They are subject to fluctuations in market price and so can create capital gains or losses in addition to the interest income.
• Investment Fund - Almost a CEF except it isn't redeemable, the First National Mortgage Investment Fund's (FNM.UN) days appear to be numbered after the recent federal budget which announced an intention to prevent the transformation of interest income into lower-taxed capital gains by funds such as this one. First National issued a press release denying FNM.UN will be affected so we will have to wait and see the final outcome.
• Public Corporations - There aren't many of these either. We found only three - Firm Capital MIC (FC), MCAN Mortgage Corp (MKP) and Atrium MIC (AI). They also trade like any other stock with capital gains/losses results too.

Public Corporation but not a MIC
This publicly-traded company concentrates on mortgages but does not have the tax status of the MIC.

• First National Financial (FN) - This is the same company that created FNM.UN. FN, however, isn't about to disappear anytime soon judging by its claimed status as Canada's largest non-bank mortgage originator and lender. Its business model is quite different from the MICs above. It doesn't just lend and collect interest, it sells on many mortgages while continuing to collect fees for administering them. Consequently its capital structure has lots of leverage but isn't necessarily more risky. Unlike MICs FN distributes dividends and possible capital gains to investors.

Mortgage Mutual Funds
There are several dozen (37 were found in GlobeInvestor Fund Lookup by typing in "mortgage" as a fund name search term). Such funds typically buy mortgages created by other companies and have a lot of lower yield guaranteed mortgages along with some short term bonds so their yield is less overall.

Mortgage REITs in the USA
The attraction of such funds within registered retirement accounts (RRSPs and the like but not TFSAs or RESPs) is that no tax is payable, not even US Witholding tax). These funds sport very high 12-18% cash payout yields at the moment which looks great but is a strong clue of much higher risk. That risk comes from a business model (see description in the Wall Street Journal) much different to any of the Canadian options above. The mortgage REITs rely on the return boosting effect of borrowing at very low short-term rates to buy mortgage backed securities (basically bundles of mortgages originated and sold on by other firms). Are these yields sustainable? One Seeking Alpha article thinks yes, for some. In addition to the many individual mortgage REITs, ETFdb lists US ETFs that hold mortgage backed securities.

Portfolio Considerations
Mortgage interest-producing investments fall into fixed income and their current relatively high yield compared to GICs or short term bonds can make them an attractive alternative.

All but one - the exception being First National - of the securities produce income that is taxed as interest despite the misleading name of dividends attached to the distributions. Therefore the best place to hold such mortgage securities is in a RRSP, TFSA, RRIF, LRIF, LIRA or other tax-favoured account.

Payout Stability and Yield
As our table below shows, the cash payouts of the MICs with a longer track record have declined along with interest rates. That's not necessarily a bad thing since they still compare favourably with other short term fixed income as we have already noted. 

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The key to the future is the skill and judgement of the mortgage management team in properly adjusting the risk of the mortgage lending to the interest rate charged while controlling costs and the risk of leverage. To assess that and other factors that can affect the success of a mortgage, it is a wise idea to use the checklist we mentioned above. As usual, the return to be expected, whether it is interest or dividends and capital gains, will be related to the riskiness of the investment. 

Is now a bad time to invest in mortgages?
That's a natural question given the slowdown in sales in a number of markets and some reports of impending doom in the Canadian market akin to what happened in the USA and other countries. Of course, the companies say they are still expanding profitably within acceptable risk parameters due in part nowadays to some pullback in lending by the big banks. In our opinion it's too hard to tell if mortgages are a better or worse investment than anything else right now. The best protection lies in the due diligence to pick the solid companies who can survive in bad times as Canada's banks did through the 2008-09 financial crisis.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Canadian Dividend ETFs Update: How does newcomer Vanguard's fund compare?

After we wrote our original comparison last July about Canadian ETFs that focus on dividend paying stocks, fund giant Vanguard entered the fray in December 2012. Let's see how its fund compares to the existing bunch of ETFs in this category while providing some additional perspectives and updates to the previous analysis.

The ETFs

• iShares Dow Jones Canada Select Dividend Index Fund (XDV) - this dominant fund reinforced its lead in the category and total assets now stand at $1.2 billion
• iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (TSX symbol: CDZ) - still second most popular fund with $867 million in assets
• iShares S&P/TSX Equity Income Index Fund (XEI) - yet another dividend ETF from iShares, assets up $50 million to $156 million
• Horizons Dividend ETF (HAL) - more than 2 years on the market yet still tiny with only $11 million in assets
• BMO Canadian Dividend ETF (ZDV) - BMO's version has made good headway garnering over $100 million from investors to reach $160 million in total assets
• First Asset Morningstar Canada Dividend Target 30 Index ETF (DXM) - still gaining no traction at $6 million in assets
• PowerShares Canadian Dividend Index ETF (PDC) - another laggard since its launch in June 2011 with only $11 million in assets
• *New* Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX symbol: VDY) already up to $19 million in assets after only 4 months, probably because, true to form for Vanguard as a low cost leader, VDY's MER set a new low for dividend ETFs of 0.35%

 
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Cash Distribution Yield - payouts are not necessarily stable or always growing
As in July, XEI still offers the highest cash payout yield of 4.6% (based on the trailing twelve months) but the gap with ZDV and XDV has narrowed. HAL still does worst, offering only a bit more at 3.0% than the TSX market average, seen in the broad market ETF from iShares (XIC), of about 2.5%. VDY's poor 2.2% yield we interpret as being being a temporary effect of the recent startup.

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The reason we think it is temporary is an additional metric we found on Morningstar.ca where the Portfolio details page shows the projected dividend yield of the combined holdings of an ETF. VDY's is here and it shows as 4.27%. The number is not a forecast since MER, trading costs, index changes, imperfect tracking or dividend changes will cause actuals to fall short but it is a suggestive indicator. ZDY comes out ahead on the forward-looking dividend yield. DXM and PDC's numbers suggest continued more modest payouts though still ahead of our market benchmark XIC's projected 3.04%.

Surprisingly, some of these ETFs hold a good proportion of stocks that have cut their dividends. About 20% of the stocks in both XEI and VDY have lower dividends today than five years ago, which we discovered when we entered the stock symbols for all these ETFs in the free GlobeInvestor My WatchList and displayed the Dividend view. To be sure we didn't exclude stocks that had cuts during the credit crisis but have since got back on track, we did not count those which have increased dividends in the past year even though they had a negative five-year record. The selection method itself for XEI and VDY - based mainly on high dividend yield - may expose them to more volatile dividends and payouts. Whether the offsetting diversification benefit of the ETFs' many holdings is enough to overcome this factor, only time will tell but it cannot be helpful. Funds like CDZ and PDC both are built on selecting only stocks with rising dividends, which eliminates the problem.

Even that is not the end of the story, however. CDZ has a longer track record back to 2006 and we can see in the graph below that CDZ's distributions fell considerably through 2010 and 2011 before going back up somewhat in 2012. The reason is its particular selection criteria which requires that its stocks have rising dividends. As Canadian Couch Potato explains in this post, after the financial crisis the big banks stopped raising their dividends and these stalwarts of CDZ were cast out causing the ETF to shrink in number of holdings and in cash distributions. Meanwhile the investor in XDV, with its looser criteria requiring only avoidance of stocks cutting dividends, fared much better. Distributions fell much less and are up strongly since 2007.

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Payout Ratios Point to Stronger Future Dividend Growth?
In the 2003 paper Surprise! Higher Dividends = Higher Earnings Growth published in the Financial Analysts Journal, Robert Arnott and Clifford Asness found that in the USA, stocks with higher dividend payout ratios (i.e. higher dividends as a proportion of earnings) had higher future profits. It was not yield - dividends as a proportion of stock price - that mattered but the ratio to earnings. For stocks that experience strong earnings growth, higher dividends are likely to follow too.

On the assumption the pattern will hold in Canada too we have calculated the weighted average payout ratios for these ETFs also using figures from the Globe WatchList view and find that ZDV and XEI sport the desirable higher payout ratios. DXM's is quite low at 31% while VDY's is next lowest at 35%.

Stock and Sector Concentration
As before XDV and PDC remain too heavily concentrated in a few stocks and in the financial services sector. Surprisingly for a fund that holds the most stocks of any of these ETFs, VDY joins them with 61% of its holdings in the top ten stocks and a 59% overall concentration on financials.

The other ETFs' sector restrictions bring them much closer into line with the overall TSX embodied again by XIC, which has only 34% in the top ten and 33% in financials.

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Volatility Riskiness and Performance
Only a few of the ETFs have a long enough track record to get an inkling of their market volatility and performance but they seem to tell the same story. Volatility of market price over the past three years (again obtained from Morningstar) is markedly lower at 8.3 - 8.7% than XIC's 10.7%.

Total returns (dividends plus price appreciation) over both the past three and five years are well ahead of the XIC average, respectively, of 3.2% and 0.7%. What CDZ lost in cash payouts it more than made up in capital gains with total return of 9.4% over 3 years and 6.3% over 5 years. The story of dividend ETFs is not just dividends.

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Though much too short to be in any way definitive, these are encouraging signs supporting the basic idea mentioned in our first post of dividend stocks as providing superior stability and better returns.

Bottom line
We still think that ZDV wins our vote with its much lower MER, high payout ratio and good diversification through low concentration across companies and sectors. HAL is still worst with its high MER, low dividend payout and un-dividend investing strategy. CDZ is well diversified but its MER is quite high and its yield is still not far above the TSX. XEI pays the highest yield and it is reasonably well diversified but it has a fairly high MER and includes a high proportion of dividend-cutting companies. DXM is well diversified but its MER is on the high end and the payout ratio of its holdings is quite low. With their poor growth in assets we wonder whether HAL, DXM and PDC will be able to survive long. XDV and PDC are still too concentrated in the financial sector and in a few companies. Newcomer VDY has joined them in that regard and it also includes too many companies that have cut dividends, offsetting its attractively low MER.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.