Book Giveaway and What is the Next Big Investment Threat?

As a reward to readers, this blog is offering a free copy of The Cost of Capitalism by Robert J. Barbera, an engaging and thought-provoking account of the causes and signs of the bubbles and financial crises that have repeatedly plagued our economy, including the 2008 crash. His argument is that such crises are part of the capitalist system and are bound to re-occur. The book got very positive reviews on Amazon and I really like it too.

The book helps the individual investor to detect the indicators like rising debt levels and over-confidence that show a crisis is building. Perhaps this can allow preventative action ... though timing when to get out and back in has been shown to be extremely difficult. (Such is not Barbera's goal anyway. His thrust is to explain and suggest policy to prevent future crisis rather than to tell the investor how to protect him/herself.) Building a diversified portfolio that can weather market storms, or perhaps we should say, hurricanes is probably a more realistic objective. At the least, we can learn to bear such crises with slightly better equanimity.

To be in the random draw for the book, leave a comment with some unique name (i.e. don't comment as "anonymous"). The draw closes a week today, on Thursday, November 19th at midnight EST. The winner will be announced on the blog with a request to email a mailing address and the book will then be shipped out to any Canadian address.

In the comment, if you are so inclined, share your opinion and say what is currently your single greatest investment worry - be it another crisis, inflation, government deficits and likely rising taxes, very low growth and future returns etc.

A thank you to McGraw-Hill Canada for the complimentary copy.

Adjusting RRIFs and RRSPs to the New Reality

Let's say a few years ago you figured your savings could support your retirement and you decided to opt for early retirement. A new reality unexpectedly descended last autumn when markets crashed, decimating all portfolios, even prudently balanced ones. As a result, you and many others, according to BMO Retirement Institute's Boomers Revise Their Retire-By Date as Financial Landscape Changes, have opted either to delay retirement or reverse course, to begin working again to generate savings to rebuild the portfolio and allow the portfolio time to recover. BMO's Retirement Transition Illustrator can help you figure out how much longer you might need to work.

Let's say you had converted your RRSP into a RRIF. This presents two problems.

1. With a RRIF you are obliged to withdraw a legislated minimum percentage each year based on your age (details are in Canada Revenue Agency's IC78-18R6 and TaxTips.ca's RRSP/RRIF calculator will work out the exact amount using the formula 1/(90-age) for the years prior to age 71 - e.g. if you are 60, the percentage is 3.33% so you must withdraw $3330 for every $100,000 balance in your RRIF as of Dec.31st of the year before).
2. You are not allowed to make any additional contributions to a RRIF to build up your portfolio.

The simple solution for those under age 71, which is the age when it is mandatory to convert an RRSP to a RRIF: transfer all, or part, of the RRIF back into an RRSP. There is no cost and no tax consequence of doing so, as long as the transfer is done directly, from registered account to registered account. DO NOT withdraw the whole amount from the RRIF as it would all be taxable income that year and you could only recontribute back into an RRSP to the extent of having contribution room. If you have a sizeable RRIF such an action would be very costly in taxes.

To do the transfer properly, you should contact the customer service folks of the broker - in fact, a phone call may suffice to do the transfer. If your RRSP and RRIF accounts are with the same broker they do not need to fill in the transfer forms. It is a definite convenience to have multiple accounts with the same firm.

For those aged 65 to 71, it may be worthwhile to have both a RRSP and a RRIF open (it is entirely acceptable to have both RRSPs and RRIFs open at the same time) since a withdrawal from a RRIF from age 65 onwards qualifies for the pension income tax credit, which offsets the tax and allows one to receive tax-free up to $2000 of such RRIF income. A withdrawal from an RRSP is not eligible for the pension tax credit. TaxTips explains this on How to create pension income. If you don't need this income to spend it could be put into a TFSA account, where it will remain tax-free.

Though the income tax rate is identical on RRSP and RRIF withdrawals, RRIFs have another small advantage in that there is no tax withheld at the time of withdrawal for the minimum required RRIF payment. Tax may still be payable but the moment of reckoning is deferred to the annual April 30th deadline for income tax returns. In the meantime, you get to keep all the money.

The key to rebuilding a retirement portfolio for those just at the point of retirement is working longer, saving money and giving the market time to recover. But it is useful to know some ins and outs of RRSPs and RRIFs that can help. Every little bit helps.

If you are not sure how to carry out these tips, consult a competent financial planner or an accountant.

A Sustainable Portfolio Withdrawal Rate: the 4% Solution

From 1900 to 2008, the compounded before-inflation return on Canadian equities came to an impressive 9.1%, with bonds at 5.2% according to the Credit Suisse Global Investment Returns Yearbook 2009. Assuming that the past is a reasonable guide to the future over the long term, does that mean a mixed portfolio could sustain on-going yearly retirement withdrawals in the range of 7 or 8%?

The answer unfortunately is NO. Someone looking to take money out for 30 or 40 years, say 7% or $35,000 of an initial nest egg of $500,000 and adjusting upwards for inflation every year, will most likely have no portfolio left long before then. One big problem is inflation: the real after-inflation return on equities was 5.9% and on bonds only 2.1%. The other significant reason is that several bad years of returns in row, such as happened in the 1970s and in 2001-2003, especially when they occur at the beginning of the drawdown period, so diminish the portfolio that it never recovers, even if strong returns follow.

Sustainable (Safe) Withdrawal Rate
A sustainable rate is around 4%. Many researchers and planners have taken different approaches and assumptions to estimating this rate, often also called the safe withdrawal rate. The range of estimates varies from as low as 3% up to about 6%. Such a big range is obviously of interest since it can mean double the income. Thankfully some of the factors involved are under the control of the investor, unlike future market returns. What are the factors affecting the sustainable withdrawal rate?

• Flexibility in the annual withdrawal amount - instead of rigidly taking out the same inflation-adjusted amount year after year, which means annual increases, freezing the withdrawal (no inflation increase) after a year of negative returns (e.g. 2008) can allow 0.8% more, or when combined with a rule that inflation increases would never exceed 6% up to 1.4% more - i.e. a total of 5.4% annually - per Jonathan Guyton's Withdrawal Rules: Squeezing More from Your Retirement Portfolio at the American Association of Individual Investors. Paul Merriman's popular book Live It Up Without Outliving Your Money proposes rules that boost withdrawals down or up depending on portfolio success which would have supported eventual on-going rates of 6% using historical data from 1970 to 2007. To carry out such a strategy it helps for retirees to have a budget which differentiates between essential living spending and nice-to-have extras to see how much wiggle room there is.
  
• Diversification of a portfolio using different asset classes such as foreign equities and bonds, real return bonds, REITs, value and small cap stocks reduce portfolio volatility. Reducing the downward jolts is crucial. Diversification then allows a higher withdrawal rate. Guyton's article shows about a 0.4% increase in a successful withdrawal rate in the more effective portfolio.
• Lessening the duration of withdrawals by delaying the start of drawdowns, one obvious way being to work longer and retire later. Funding a 20 year retirement obviously costs less than a 25 year retirement. Table 3 in the famous Trinity study by Phillip Cooley, Daniel Hubbard and Daniel Walz shows how the probability of success rises with shorter payout periods. For example, a 10 year reduction in payout period (25 to 15 years) allows an increase in withdrawal rates from 4% to 5% for a portfolio split 50-50 between stocks and bonds.
  

There is of course a tradeoff - a low withdrawal rate that is sure to last forever means restricted income. We only live once and regret over not doing the things we desire from being too cautious may be a sad way to live in retirement. On the other hand, there may a strong desire to pass along funds to the next generation. Knowledge and confidence of the likely results of a particular withdrawal rate forms the basis for informed decisions.

Resources:
Bogleheads' Safe Withdrawal Rate summarizes and links to US research
ByloSelhi's annotated links on Sustainable Withdrawal including Canadian content, fund companies, media, government, calculators

Ins and Outs of International Bonds

Bonds don't exist only in Canada. The world bond market is vast - at least as large as the equity market.

Why buy foreign bonds

• Diversification - just as foreign equities move up and down in different patterns than Canadian markets, so do foreign bonds. This non-correlation will dampen volatility when incorporated in a portfolio. Roger Gibson describes the effect in his classic book Asset Allocation. The Google Finance chart below shows how differently an international bond fund (NYSE symbol: BWX) behaved during the 2008 market meltdown compared to both the TSX composite equity index and a Canadian index bond fund (TSX symbol: XBB). If one were to factor in the big drop in the Canadian dollar vs the US dollar that occurred (since BWX is sold on a US exchange and denominated in USD) during late 2008, then the beneficial effect for a Canadian holding BWX would be even more pronounced.

• Inflation hedge - the study Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test from Simon Fraser University modeled international bonds within a portfolio during 1996-2006 and found that they provided inflation protection to Canadian investors
• Income - like any other bond, international bonds generate interest income at rates that are likely to be comparable to Canadian bonds of similar quality - XBB's average coupon is currently 5.29% and yields 3.25%, while BWX's coupon average is 4.32% and yields 3.85%

Risk factors and other considerations

• Credit/default risk - the chance the issuer won't pay back the principal as promised; may not be a big factor as some funds hold only developed country government bonds - will the UK, Japan or France likely default? Check the fund holdings and its investment policy. Individual bond risks are always minimized by buying a fund rather than an individual government or company bond.
• Interest rate risk - if rates suddenly move up in a country, bond values will go down. Movements tend to average out over many countries.
  
• Liquidity risk - an individual bond may be hard to sell and if so, a seller will get a lower price
• Currency risk - a key factor, as exchange rate shifts usually far outweigh any other factor. Some funds eliminate this factor by hedging, which adds cost of course. In the long term and over many countries, many but not all, researchers say the currency swings cancel out. In the short term, the swings can provide the basis for the portfolio-rebalancing strategy of buying low and selling high (see renowned Yale University Chief Investment Officer David Swensen's explanation here)
• Costs and Expense Ratios - transaction commissions for discount brokerage customers appear in the form of the buy-sell spread, the difference between the price the broker will buy from you or sell to you; the greater the spread, the costlier this is, though if you hold a bond to maturity, the cost as averaged over many years can be small i.e. constant buying and selling of individual bonds will cost a lot and eat up much of your returns. Expense ratios (MERs) are published for funds and the basic principle is, the lower the better.

What is available to buy

• Individual Bonds - there is excellent choice of bonds of US issuers, sold in USD through the same web online self-serve menus as individual Canadian bonds.
• Global / International Bond Mutual Funds - sold by Canadian mutual fund companies, there is a choice of about 80 funds listed on GlobeFund with MERs ranging from 0.16% up to 3.04%. Most are actively managed and many of the lowest MER funds (1% or less) have a very high minimum initial investment like $100,000 or they are sold only through financial advisers, not directly to DIY investors.
  
• ETFs - unfortunately, there are no international bond ETFs available from Canadian providers. Thankfully, there is a big choice of ETFs sold on US markets (Stock Encyclopedia lists most of them here)- 1) US-bond only funds e.g. the biggest whole-of-market funds are AGG and BND, 2) Emerging Market (higher yield and higher risk) like EMB and PCY; 3) Developed Country funds that exclude the USA like IGOV and ISHG and: 4) Whole of World funds that include Canada, the USA and emerging countries like BWX and BWZ (see IndexUniverse's International Bond ETFs Compared). As is typical of most ETFs, most of these funds have low MERs (0.50% or lower) due to passive tracking of an index. Most are also not hedged and most of the bonds within are government bonds. Note that despite being denominated in USD, the unhedged international funds' currency risk is NOT the USD vs CAD shift but that of the origin country currencies combined as CanadianFinancialDIY explains in Clarification of Foreign Exchange Risk on International ETFs.
  

In today's global village, a savvy investor should not shy away from foreign bonds merely because they come from elsewhere. There's a whole wide world out there.

Disclaimer: This is presented as an investing idea, not as advice. Whether you take up the opportunity is always up to you the DIY investor.

Losing Sleep over Stocks? Figure Out Why Before Bailing Out

"If you cannot sleep at night for worry about your investments, then you need to reduce your allocation to stocks and increase fixed income or GICs." This common measure of risk aversion and advice needs examination. Not being able to sleep is a fear reaction and surely a bad thing that should be dealt with, but the under-lying reason can suggest completely different fixes.

In his book Live It Up Without Outliving Your Money, Paul Merriman provides useful ideas to examine the issue: "Risk is a possibility that you invite into your life in which you could lose something important." He also says: "There are two categories of risk: objective risk, which can be measured, and emotional risk, which depends on each person's perceptions."

With that in mind, here are a few ways in which perceptions might be incorrect and some suggestions for anti-dotes:

• What is the objective risk of stock volatility and returns? - if you were surprised that the 2008 market crash could ever happen, then learning about the short term variability and the long term returns of stocks and those of other asset types will greatly reduce the anxiety - read books such as Richard Deaves' What Kind of Investor Are You? and Keith Matthews' The Empowered Investor.
  
• Will you lose? - your time horizon is critical. For a person investing for the long haul 25 or 30 years down the road to retirement, even a big drop in a year can and will be regained by sticking to it. Fixed income has its own risks such as inflation, interest rate, downgrade/default and reinvestment risk, which the investor also needs to consider.
  
• Do you know the importance of the potential loss? - do you really know what the negative impact of the loss will be? If you do not, then it is likely you do not have a plan in place and the solution is to make an investment plan for life goals, as previously discussed in Setting Investment Objectives. Perhaps taking the risk is necessary. As Merriman says, "Take too much, and you can compromise your future by incurring big losses that you can't afford. Take too little, and and you can compromise your future by depriving yourself of the return you need." You need to know where you stand first. Then you may decide to sacrifice a possibly wealthier future for a more certain but less prosperous one, or vice versa. Of course, the golden rule is always that if you don't need to take the risk, then don't take it.
  

There is a big difference in emotional reaction between consciously facing known risks or adversity and having them appear as a nasty surprise. People constantly face tough situations with equanimity and sleep very well when they know what is going on and when they feel they have made the best decision possible, even when they cannot control the situation, such as stock market ups and downs. Loss of sleep over investments may be a sign of true danger or a reflection of a correctable phobia. Knowing the difference enables one to take the right corrective action. A shift into fixed income may or may not be worthwhile. Maybe it is not sleeplessness but falling asleep at the wheel that one should really worry about.

Investing in China: Four ETFs Compared

Have you become interested in investing in the People's Republic of China after reading that it is now the world's third largest economy on a path to grow larger than Japan's economy within five years, and that it is recovering fastest from the 2008 crash and recession?

While there are a number of emerging markets funds that have China represented within, we'll look at the four main ETFs devoted only to China. All are broad equity market passive index ETFs, i.e. they simply buy what the index contains and do not try time to time or outperform the market. All trade in the USA - and thus in US dollars (USD) - on the New York Stock Exchange.

Four China Equity ETFs:
iShares:FTSE/Xinhua China 25 Index Fund (Symbol: FXI)
iShares MSCI Hong Kong Index Fund (EWH)
PowerShares Golden Dragon Halter USX China Portfolio (PGJ)
SPDR S&P China ETF (GXC)

Comparing the Four in Detail

FXI is the giant, with by far the most net assets, which makes it highly liquid with the lowest buy-sell spreads (i.e. if you buy or sell at market you are going to get the best price). It is the mega cap fund (the average market cap of its constituent companies is $78 billion - by contrast that of the TSX 60 largest companies in XIU is only $9 billion). FXI is not very diversified, with only 25 companies and is it quite concentrated in the financials, which occupy about half its portfolio. Technology is totally absent from the holdings and consumer companies are an inconsequential amount, which is a great surprise given the country's huge consumer export sector. Nevertheless, FXI has had the best performance since 2007, along with GXC (see chart below). FXI also has the highest MER fees at 0.74%

EWH has more holdings than FXI but is even more concentrated in one sector, with almost two-thirds of its investments in financials. It represents Hong Kong and not the mainland. There is no significant overlap with the other ETFs - none of the top ten holdings are the same. EWH holds the smallest size companies of the four ETFs. Its performance price track has also been notably different and weaker than the other three ETFs but it has been much less volatile. It has the lowest MER at 0.52%.

PGJ is unusual in that it only holds companies whose securities are listed in the USA (whose stricter reporting regulations may therefore entail better quality and more reliable published results), though they must derive the majority of their revenue from China. It is well diversified with holdings in 120 companies, its largest sector holding being in technology, which is weak or absent from both FXI and EWH.

GXC would appear to be a well-designed fund, with the broadest diversification of 125 companies and a good balance between many sectors, though the top ten holdings still make up half the market value of the ETF. It has a reasonably low MER of 0.59% too. But GXC trading volume is the lowest of the lot, just barely reaching the 100,000 shares per day that many consider the minimum to achieve acceptable buy-sell pricing spreads and liquidity.

The GXC index objective to buy into the companies "foreigners are allowed to purchase" reveals an important fact - most Chinese companies are not available for various reasons. The Shanghai Stock Exchange includes about 860 companies according to Wikipedia. Any of the four ETFs suffers from this limitation on how extensively a Canadian investor can buy into the Chinese growth story.

The gyrations of the ETFs since 2007 have been considerable, as the chart image from Google Finance shows. All the China ETFs have been much more volatile than the TSX.

The chart also demonstrates that despite their different weightings, FXI and GXC seem to track each other very closely. The similarity and dominance of their respective top ten holdings probably accounts for this fact.

Currency Effects - Beneficial up to now, but ...
None of the ETFs hedges against shifts of the Chinese currency, the renminbi (symbol RNY). Exposure to foreign currency is one of the diversifying benefits of international investing. The already strong performance of FXI from November 2004 to July 2009 was boosted even more for the Canadian investor when the USD to CAD conversion factor is applied. Of course, there is no guarantee that will continue in future. There are periods when currency will move against the investor and reduce or eliminate foreign market gains.


Which ETF is best? My favorites are the more broadly diversified GXC and PGJ but none stands out as ideal in every way. This is not an investment recommendation and you have to make your own choice.

Real Estate - Down, but Never Out

Observers of the recent housing bubble and the ensuing severe market downturn of 2008 may question the sanity of real estate as an investment possibility. Indeed, real estate has suffered a lot in the past year and the past five years, as seen in the bigger drop in the iShares REIT (Real Estate Investment Trust) ETF (TSX symbol: XRE) compared to the TSX Composite in these Google Finance chart.
One Year

Five Years

Real Estate Investing - what it isn't and what it is
Real estate for the online investor excludes the private individual residential housing which has fallen so mightily in the USA and to a lesser degree in some Canadian cities. Your own house may be an investment in part, though it is mainly a place to live, but there is no market or tradable securities for investing in people's private houses.

Similarly, the direct ownership and renting out of property as a business and an investment, while feasible and sometimes attractive for individuals, is beyond the scope of this blog's focus on online investing in securities.

Real estate investing for the online investor includes companies or funds that own and manage office buildings, shopping malls, industrial and commercial buildings, apartment buildings, hotels and nursing or retirement homes.

Why consider Real Estate in a portfolio?

• regular, high income - most companies in the sector give off monthly or quarterly cash distributions and sustainable yields from 5% to 12%
• tax-advantaged income - half or more of the distribution cash flow to the investor is made as a Return of Capital, which gives the investor two benefits: 1) it effectively defers tax until the investment is sold and; 2) the income is taxed as a capital gain
• possible capital gains - apart from the tax benefit, another form of capital gain may occur if the properties managed by the real estate company rise in value and that gets reflected in the price of the security
• diversification - real estate returns have a low correlation with stocks and fixed income / bonds, which means a portfolio kept in balance that includes all three types of assets will experience lower volatility without suffering lower returns (see Richard Ferri's book All About Assets Allocation for detailed explanations of past correlations and volatility reductions). The usual suggested allocation to REITs is about 5-10%.
  

Risks and Current Conditions

• risks - despite their objective to provide steady income, real estate companies have business risks too and it is necessary to be aware of them. Deloitte's fine The Canadian REIT Guide includes much useful info, especially the How to Evaluate a REIT on page 52.
  
• real estate values are depressed but Canada is faring better than the USA, according to an industry sentiment survey released by the Real Property Association of Canada in August 2009. Some companies have suspended distributions, such as Holloway did on July 21.
  

How to invest

• Individual Canadian Company REITs (Real Estate Investment Trust) - all companies are structured as income trusts to enable the tax benefits. Happily, REITs were specifically exempted from the federal government's decision to begin taxing income trusts as corporations in 2011, which means those benefits will continue. There are 24 such publicly traded REITs listed on the TSX, led by the dominant giant RioCan (TSX symbol: REI.UN) - see list with annual yields at Investcom.com)
• Closed-End Funds - there are a few CEFs containing a collection of REITs e.g. First Asset REIT Income Fund (symbol: RIT.UN) and Split REIT Opportunity Trust (symbol: SOT.UN)
• Exchange Traded Funds - the iShares Canada REIT Sector Index Fund (symbol: XRE) contains the 11 largest REITs in Canada); there is a much larger collection of US-traded funds covering US REITs and international real estate funds, providing further diversification opportunities - summary articles and groupings at Seeking Alpha's Real Estate ETFs.
  
• US REITs - There are over 100 REITs in the S&P US REIT index. Yields on US REITS are generally several percentage points lower than those of Canadian REITs. The National Association of REITs lists publicly traded US REITs. Canadians holding US REITs do not benefit from favorable tax rates on Canadian dividends and non-registered accounts will have US witholding tax levied by US authorities (see page 27 of KPMG's Taxation of REITs).
  

It is always difficult to know when a market bottom has been reached and market excesses have been wrung out but it is certain that REITs are a valuable and enduring element of the investing universe.