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.

The 2008 Crash - Case Study in Diversification

Diversification is meant to help protect a portfolio by combining asset classes that do not move in tandem, that move in different directions in a particular time period, for example by moving sideways or up while another is going down (though over the longer term, all investments would be expected to move up, otherwise why would anyone invest in them?). The year 2008 witnessed huge drops of about 35% in the TSX in Canada and the S&P 500 in the USA. How well did various asset classes perform as a diversification tool? Did any go in a different direction, making a lie of the feeling that everything plummeted?

A few charts from Google Finance give us a pretty good idea:

Chart 1 - Real Estate, International Equities and Gold vs the TSX Composite

No diversification help at all - paralleled the TSX very closely and fell just as much

• real estate, as represented by the iShares Canada Real Estate Investment Trust ETF, symbol XRE
• international equities, represented by the iShares MSCI Europe Australasia Far East Index ETF, symbol EFA

Fair diversification effect - dropped some but not nearly as much as the TSX

• gold, as represented by the iShares Canada Gold Sector Index ETF of gold miners, symbol XGD

Chart 2 - Corporate, Government and Real Return Bonds

Superb diversification effect - did not fall and even rose a bit, which is a bit hard to see since the huge drop in the TSX compresses the scale so much

• government bonds, iShares Government Bond Index ETF, symbol XGB, maintained solid steady-as-she-goes value as investors flocked to safety during the worst of the crisis
  

Fair diversification effect - dropped some but not nearly as much as the TSX

• real return bonds, iShares Canada Real Return Bond ETF, symbol XRB
• corporate bonds, iShares Canada Corporate Bond ETF, symbol XCB, which fell as much as 6% at one point but slowly recovered and surpassed government bonds by early April

Observations

1. Diversification works - having a hefty bond holding, as most well-constructed portfolios do, would have limited the damage of the equity crash
2. Diversification may not work the same way in the next downturn and different asset classes may be the ones to hold their value e.g. if inflation begins to ramp up, one would expect real return bonds and perhaps commodities to rise while bonds and equities would fall, at least in the short term. Or, conflict in an oil-producing area may boost commodities due to the petroleum component, while equities fall. Each crisis is different and it is hard to know which asset class will do best. That's why a range of asset classes in a portfolio is beneficial.
   

Commodities: Diversifier and Inflation Hedge or Empty Promise?

Commodities are raw materials and basic products such as wheat, corn, cattle, orange juice, cocoa, coffee, crude oil, natural gas, gasoline, gold, silver, aluminium, copper, zinc and lead. By virtue of being uniform, produced in large quantities, transportable and storable, there exist markets to trade commodities, both at today's (spot) prices and for future delivery (futures). Securities offer an opportunity for an individual to invest in commodities without having to store a pile of coffee beans in the garage and to buy and sell without ever having to take delivery of a shipload of wheat. Commodities are obviously part of the global economy, so what unique qualities do they have that could make them attractive and useful to an investor instead of investing in the companies that produce commodities?
Why invest in commodities?
Two reasons are advanced, which if true, are of significant benefit:

1. Diversification - commodities are negatively correlated to both stocks and bonds, which means that when all are combined in a portfolio, the portfolio will have less volatility and thus less risk. The further away from positive correlation an investment is, the better, and negative correlation is best of all.
2. Inflation protection - in the long run commodity prices track inflation so an investment should help protect an investor's purchasing power.

Risks, Cautions and the Debate

• commodities on their own have enormous and rapid price swings, a very high degree of volatility, which makes them good only for speculation or as part of a portfolio
• the after inflation historical return on individual commodities is more or less zero though return is positive when commodities are combined in a fund
• the inflation protection comes only with a long term investment (more than 10 years) since large short term price swings driven by supply and demand for the commodities mask the effect in a shorter timeframe
  
• some researchers dispute the inflation and diversification benefits - see the Great Commodities Debate on HardAssetsInvestor.com between respected financial authors Rick Ferri and Larry Swedroe. Interestingly, the diversification benefit (negative correlation, i.e. going in the opposite direction) did not always work last autumn during the market crash; in fact, two of the most popular commodities funds (iPath Dow-Jones-UBS Commodity Index Total Return ETN -NYSE: DJP, and iShares Commodity Indexed Trust ETF - NYSE: GSG ) fell harder than the TSX and accentuated rather than reduced the volatility. A third fund, the Elements S&P Commodity Trends Indicator (NYSE: LSC), which employs an active trading strategy, did rise while almost everything else fell. Negative correlation doesn't work all the time.

The place of commodities in a portfolio

• a minor percentage, perhaps 5 to 10% of a portfolio could be devoted to commodities
• replacing a portion of the allocation to each of stocks and bonds
• as a combination in an index fund, though many consider gold an exception worth holding on its own (see previous post on Gold)

How to invest
Though it is possible to buy physical gold, or to buy futures contracts on individual commodities, the easiest and most practical method for a retail investor to get into commodities is to buy index funds - ETFs or their close cousins Exchange Traded Notes (ETNs). Making Sense of Commodity Products on HardAssetsInvestor.com describes the various indexes and their differences, and names common funds based on each index. Stock Encyclopedia list all the currently available Commodity ETF/ETNs in the USA and the handful in Canada. In the list there are many leveraged and even more volatile funds suitable only for speculation so some care should be taken before choosing and investing in anything.
Further Info
HardAssetsInvestor.com has a wealth of primers, background papers and topical information that an investor would be wise to read before making any investment at all.

The TSX and How Blue Chip Stocks Have Done: Food for Thought

For those shaken up by the market turmoil of last fall and looking to big companies, the supposed steady blue chip stocks for safety, it is worth a look at the evolution of the TSX to get an idea of how safe or risky such stocks might be.

The TSX from 1995 to July 2009
The TSX has changed tremendously since 1995, as the following table shows.


It reveals some Sobering Facts:

• Many companies have disappeared - Of the top 25 companies in the 1995 list (on the left), about half no longer exist (12, indicated by white lines). Most have merged with others, perhaps minimizing losses for an investor, or maybe even making a profit, but several are spectacular business failures, such as the current headline star, Nortel.
  
• Many companies have slipped - The largest company by market value in 1995, BCE Inc. has slipped badly - to 17th spot overall. It is not alone. Another eight companies that still exist like BCE have gone down in the rankings and lost market cap share (they are the ones with red negative percentages in the column comparing 1995 with 2009 market cap share / % of Index).
• A small minority have risen - Only four companies, three of them banks, have stayed in the top 25 and increased their position.
• The index itself has shrunk considerably - not shown on the table is the fact that the TSX composite in 1995 had 300 companies while today there are only 208, a reduction of almost a third. For investors practising index investing and seeking safety in diversification, that is a noticeable difference and all the more reason, in the opinion of this writer, to look to beyond Canada to invest.
  

Some Encouraging Facts:

• All the big banks have survived and mostly thrived - The Royal Bank has strengthened its lead. For investors in blue chips and dividend payers, the banks have shown great consistency when all about there has been great turmoil and change. The big question all investors must ask themselves today is whether the future will be like the past for the banks.
• A few new companies have rocketed from nowhere to the top - RIM, CNR and Goldcorp were not even in the TSX in 1995, let alone in the top of the table. The search for and identification of new winners is a worthwhile task, but not easy.
  

As the cliche goes, those who ignore history are condemned to repeat it. Depending which companies you choose, that could be good or bad.

Portfolio Rebalancing - What, Why and How

What is Portfolio Rebalancing?
Portfolio rebalancing is the purchase and/or sale of investments in order to bring the various types of holdings (e.g. Canadian equities, Canadian bonds, REITs, foreign equities, commodities funds etc), known as asset classes, back to the intended target allocation (see Asset Allocation post for how to create a target allocation).

Why Rebalance?
Different classes of investments go in different directions over periods of weeks, months or years. Some go up while others go down or sideways for a time. As a result, the original target percentages allocated to each class can get far out of whack. For instance, if equities were initially set at 60% of a portfolio and bonds at 40% but equities grow a lot while bonds remain stable, equities could rise to 70% of the portfolio. Suddenly the investor has a riskier portfolio with more allocation in the volatile equity class. Rebalancing is thus a method of risk control.

Rebalancing can also be thought of as selling high and buying low. Renowned financial author William Bernstein has written about a rebalancing bonus, whereby a disciplined strategy of rebalancing in most cases will provide higher returns than a simple buy and hold portfolio with the same asset classes. Rebalancing is most worthwhile and effective when the portfolio includes volatile asset classes that behave very differently from each other (have low correlation).

What are the choices for a Disciplined Rebalancing Strategy?
Portfolio allocations are changing every second that markets are open, so some leeway for movement is necessary. There are two primary methods for rebalancing, both of which are quite mechanical and remove the need for an investor to make arbitrary decisions about how much and when to rebalance.
Various researchers have compared the two methods and tested the numerical trigger points, out of which the rules below summarize a more or less middle position. There is no definitive best method and both methods below will be effective since data sets used to test have varied considerably and most importantly, the future will not be exactly like the past - returns, volatility and co-movements of asset classes will differ.

1) Rebalance at fixed regular intervals, such as once per year - other intervals like per month, per quarter or bi-annually are possible. Or,
2) Rebalance when an asset class deviates from target by more than 5% - this works best in a portfolio with four or five asset classes with individual allocations of 20% or more.

When a portfolio grows and an investor subdivides it into fine-grained asset classes, such as allocations of 10% or less per class, the 5% rule might be too high, such that rebalancing never occurs, which would mean never taking advantage of the rebalancing bonus. Unfortunately no research seems to exist to suggest what works best with many small asset classes, so I've come up with what makes sense based on the trade-off factors below. Rebalance when a class is more than half its weight above or below target - e.g. a class with a 5% target allocation only gets rebalanced when it reaches 7.5% or 2.5% of the total portfolio.

Trade-off Factors to Consider in Choosing a Method:

• Costs - trading commissions, fund redemption or switching fees and capital gains taxes (in taxable accounts) rise with more frequent rebalancing and reduce portfolio return
  
• Effort - the percent deviation rule requires constant monitoring of the portfolio. The yearly interval may be combined with an annual financial review.
  
• Volatility - portfolios containing more volatile investments like real estate, commodities and precious metals can exceed allocation boundaries much more quickly. When markets go haywire, a set interval may miss an opportunity to "sell high and buy low".
  
• Trends - markets and asset classes often have streaks of winning or losing years, which means that frequent rebalancing will either sell out too soon and miss part of the upside, or buy in too early on the downside. Some researchers have concluded that rebalancing only every four years produced the best long-term return.
  

How to Rebalance
Few portfolios remain static nor do they magically appear wholly formed. Almost all portfolios are either being built up with savings or drawn down by withdrawals. Such changes are a sensible moment to rebalance. A previous post Generating Cash: Asset Allocation with the Global Couch Potato Portfolio worked through an example for a net withdrawal scenario. CanadianFinancialDIY's Thoughts on How to Start a Portfolio from Scratch shows in detail a build-up scenario.

Preferred Shares: an Opportunity for Taxable Accounts

What are Preferred Shares?
Preferred shares are a form of equity but their role in a portfolio is more like fixed income in two ways:

1. They provide a regular and reliable stream of income. Preferreds are especially attractive to investors with taxable investment accounts since the income is paid out as a dividend, which is subject to a much lower tax rate in Canada (see the excellent article, including historical before- and after-tax returns, by James Hymas in Corporate Bonds ... or Preferred Shares? at prefInfo.com. The exact tax rate difference varies by province and income level as the Ernst and Young tax calculator reveals. The common rule of thumb is that preferred shares should NOT be held in a registered accounts such as RRSP, LIRA, RRIF, LRIF etc. since the tax advantage will be lost.
2. Like bonds they generally react inversely to interest rate changes - when rates go up, prices of preferred shares go down, and vice versa
   

Preferred shares rank behind bonds but ahead of common equity in case of default. Preferred dividends must also be paid before common dividends can be paid. That increases their relative security but the nature of the issuer counts for far more - think of Nortel's now worthless preferreds versus common shares of a regulated utility like Enbridge.

There are many variations of preferred shares that can bemuse, as well as trip up, someone looking at investing in them for the first time:

• temporarily missed dividends might be accrued and paid in full when dividends recommence - cumulative shares - or they might not - non-cumulative shares
  
• some preferreds pay a fixed amount of dividend, others have an adjustable / floating rate
• shares may be paid off in cash at the option of the issuer (redeemable) or the investor (retractable), or may mature on a certain date or never (perpetual), or may be converted to common shares (convertible) or exchanged for another preferred share (exchangeable)

Shakespeare has a good primer on preferreds, including his trading tips and the PrefInfo site has a number of very useful analytical articles by preferred share expert James Hymas.

What are the Risks?
The two main risks are:

• credit risk, the chance that the issuer will be unable to pay the dividends or go into default and not be able to pay even the principal; virtually all preferred shares are rated by the DBRS and/or Standard & Poor's in the same way as bonds.
  
• interest rate risk, the danger that rising interest rates will cause the price of the preferred shares to fall, again in the same way as happens to bonds

Other lesser but nevertheless important risks to consider include:

• tax risk, the possibility that government could change tax rates to reduce the tax advantage of preferreds
• call risk, the choice of the issuer to redeem the shares, which usually happens just at the time when the issuer stands to gain and the investor to lose, i.e. when interest are declining and the issuer can replace high dividend shares with a new issue of low dividend shares
• liquidity risk, the fact that the market for preferreds is less active, which may mean it is harder to sell a preferred than a bond for a good price - the spread between the bid and the ask price is greater.
  

How to invest:

1. Individual Issues - scores of individual share issues from single companies are available. ScotiaMcLeod's Guide to Preferred Shares Winter 2009 lists them all (as of January 2009) grouped by category, with credit ratings, dates for redemption, amount of dividends, yields calculated in several ways, ticker symbols (preferred shares are traded on the TSX) and other data. PrefInfo keeps an up-to-date list of all issues with links to commentary and news items.
   
2. Funds - there is one Canadian ETF, the Claymore S&P/TSX CDN Preferred Share ETF (symbol: CPD, MER: 0.45%), a passive index fund; a few mutual funds such as Hymas' own Malachite Aggressive Preferred Fund (an actively-traded fund available only to investors with portfolios of $1 million or more), the actively managed Jov Leon Frazer Preferred Equity Fund (MER 1.4%), the Omega Preferred Equity Fund (MER: 1.42%) and the AIC Preferred Income Fund; a handful of Closed End Funds, including the actively managed Preferred Share Investment Trust (symbol: PSF.UN), the passively-managed Diversified Preferred Share Trust (symbol: DPS.UN) and the Advantaged Preferred Share Trust (symbol: PFR.UN)

Though it is by no means the only factor to consider, the current c 5.5% pre-tax dividend yield on the S&P/TSX Preferred Share Index substantially exceeds the 3.8% or so yield that is available on Canadian corporate bonds (see iShares' Canadian Corporate Bond Index Fund ETF which tracks the S&P/TSX Corporate Bond Index). This is a reversal of the normal relationship between the two. Maybe preferred shares are worth a look now?