Tuesday, 29 March 2011

Investing Lessons from a Golf Game

The very first myth in Dan Bortolotti's excellent article on the MoneySense website Busting the Couch Potato Myths is that it is easy to stay the course in following an investing strategy. As Dan says, it is not at all easy! It never gets easy, though it can possibly get easier with the right actions. In fact, it actually never gets foolproof guaranteed that you will not deviate from your plan. Let's explore how this works using a golf game example.

The golf story: One day, a certain blog writer goes golfing with a buddy. The first hole is longish par 3 but with no great hazards or rough, just a nice grass slope gently uphill up to an open green that has a bunker on one side only. To get into real trouble, the tee shot has to go almost 45 degrees askew. [Translation in investing terms, the market looks quite stable and the economy is performing reasonably well, a great time to begin investing one would think]

Looks like an easy start! Except that there is a fallible human golfer [investor] involved. Now this golfer is a high-handicapper (i.e. not very good - an average investor) but he has played enough to know his own penchant for getting upset unlike the rank beginner [i.e. is not a total newbie investor and thus knows that markets can move down] who expects to play like the world number one [who expects markets to always rise], so he mentally prepares himself by thinking as follows "I've not warmed up and hit any practice shots, so if things go bad here, it's no big surprise or disaster and the best thing to do is stay calm and keep at it" [the market might go down some but we won't worry too much, we'll stick with the investing strategy].

That's good preparation [both #1 creating a plan, and #2 learning market history, are excellent first steps, as Dan has noted], but then reality begins to operate. The golf partner's tee shot is very nice and straight at the hole [a peer investor you know starts with a good gain], though just short of the green. The pressure rises to do as well. Unfortunately, our hero's tee shot isn't nearly as good, scuffed out left and only two-thirds of the way to the green. Oh well, that's disappointing but the possibility had been anticipated. No big deal. The next shot is an attempted chip from short rough onto the green, not that hard at all, no bunkers, mounds or other obstacles in the way. A complete duff! The ball moves only a foot. Geez, now that is annoying, the chipping had been so good lately [this latest investment seemed a sure thing but it is going down while the market is going up]. Meanwhile, golf partner makes a chip pretty close to the hole [own investment just sits there, while the friend's continues to move up very nicely].

The next shot is well hit but much too hard and rolls right off the far side of the green. Grr, when is there going to be a good shot [upward move]? The pros [e.g. Warren Buffett in the investing world] seem to stop it within inches every time. The blood pressure is definitely rising. Next shot - needs to be a delicate little chip to the edge of the green since the hole is close to the edge. Another complete duff, the ball moves a few inches! [the investment takes another appreciable drop] At this point, the emotional system suddenly takes over and we will spare readers from an account of the careless, furious series of shots [sell the darn stock!] that followed before a horrible score of 10 finally ended the pain. The partner missed the first put but sunk the next one to record a very respectable, for a high handicapper, single bogey 4 on the hole. It seems that the chance of a good score [profitable investment] has been destroyed on the very first hole [investment month or year]. Were it not for the golfing partner, whose presence made it easier to maintain a certain decorum, the putter might have flown further than the tee shot [#3 it's a good idea to have a neutral investment buddy to talk things over with to avoid the too-rash action we may regret later, like selling everything out at a loss; simply talking about an investment to someone else will assist in restoring calm so that rational thought can supplant emotional reactions; it helps externalize and objectify the problem to move on to sensible decisions].

It is not just the average person who is susceptible to such moments. Those who watch pro golf on TV can observe the occasional similar blow-up, both in shot-making and in self-control, even by the very best golfers. The difference is only that it happens less often and is usually much less severe for the pros. The world number one golfer Martin Kaymer, though already recognized for his calm demeanour, actively works on controlling his emotions. But no one is ever totally immune from bad things happening or from getting unduly emotional, even when the possibility is anticipated. Our own reaction can worsen the results and it is as hard to control our reactions as to make good shots. So it is also with investing.

There are longer term actions, outside the stress moment of a golf or an investment crisis, that bring about improvement: #4 build a feedback loop - go over the incidents afterwards while they are still fresh and ask yourself what you did wrong, what you will change. Part of the revised improved action likely will be: #5 technical practice on shots [collecting more data or doing more analysis]. Another part can be: #6 mental preparation - our golfer partly did that right by anticipating a possible bad outcome and deciding in advance what to do about it, but maybe not enough - only one or two bad shots seemed to be mentally forgivable. We also need to remind ourselves that just as technical practice brings about improvement in fits and starts and it takes time, so does it on the mental side.

Fortunately in golf, as in investing, the first hole is not the end of the round, the final result. At least in golf, it is quite difficult to walk off the course and refuse to play the rest of the round after the first hole, or worse, stop playing the sport entirely [quit investing and retreat into the low return safety of Canada Savings Bonds or GICs].

Following the disastrous first hole, the golfer, more by accident than by design, ignored the score, letting the playing partner keep track, and merely played each hole as it came. [#7 check returns and performance infrequently only when you need to and at a moment you have planned in advance - if you don't know how well or poorly you are doing in the interim, you will be unable to react and deviate from the plan! This presumes you have built a proper plan beforehand - see our post on creating an Investment Policy, part of which specifies how often you will review and make changes to investments] The result was that the shotmaking settled down to what eventually overall compensated for bad first hole and the total score turned out even a bit lower than average [investment returns tend to even out over the long term too, but we must be patient]. A successful day!

May our readers' golf games, or other sporting endeavours, enjoy success ... and may their investing be so too.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 22 March 2011

Tax Champion ETFs of 2010

The main Canadian ETF providers have now published the tax breakdown of 2010 distributions for their ETFs:
The other provider Horizons has not yet published the final 2010 tax breakdown for its ETFs.

With the tax breakdown we can compare results and see which ETFs produce the most after-tax bang for each buck distributed. For those investors who hold ETFs in taxable accounts there is a crucial distinction between whether the ETF throws off the most highly taxed ordinary income and foreign income, or much less taxed dividends and capital gains or not-at-all taxed return of capital (ROC). The exact tax rates vary by province and by the investor's taxable income level (see the excellent tables of personal tax rates on TaxTips.ca).

Our comparison uses a middle of the income scale Ontario taxpayer with a taxable income between $65k and $74k. At that income level, dividends are, apart from ROC of course, a more tax-efficient type of distribution than capital gains. At the highest income levels, the relationship reverses and capital gains get taxed less than dividends. Our results change a bit but the tax champion ETFs remain quite consistently the same. So, with further ado,

The Results: 2010 ETF Tax Champions
(click on table below to expand)

Gold Medallist: The champion Canadian ETF of 2010 in after-tax net cash distribution in the pocket of the investor is the Claymore Canadian Financial Monthly Income ETF (TSX symbol: FIE). FIE will have managed to deliver an amazing 99 cents after-tax out of every dollar in distributions to the investor - only 1 cent going in taxes to the government! The secret of that success is that almost all of the distribution consisted of ROC (dare we say that FIE ROCks!?). We have previously discussed ROC and the crucial difference between good and and bad ROC. FIE is a brand-new fund, having started up in April 2010, so it is no surprise that a big chunk of its distributions could come in the form of good ROC as growth of the fund and the unit creation process transformed dividends into ROC. We should anticipate that given the portfolio holdings of FIE, in future years there will be a lot more distribution income in the form of dividends and even ordinary interest income.

The other reason we rate FIE tops is that it provided a substantial level of income (4.9% yield), expressed roughly as a yield - total distributions as a percent of the year-end ETF price.

Silver Medallists, with 90+% of distributions staying in the hands of the investor after tax added to a healthy distribution yield:
Bronze Medallists, which netted 80% or more after-tax to the investor - see the ten other bronze medal tax-efficient ETFs in the table.

Before we get too excited and go merrily off buying these funds wily-nilly, we should keep in mind other factors that influence whether these ETFs might be good investments:
  • Sustainability and repeatability of the tax breakdown - Consider, as we discussed regarding FIE, that special factors may change the future breakdown. For funds with a longer track record, such as XDV, check prior years' distributions (in XDV's case, they look quite stable). Consider the type of holdings and the fund objectives - are the holdings primarily dividend payers that will consistently generate mainly dividend income?
  • Return from capital gain (or possible loss) in the fund price - Distributions are not everything. Preferred share-based ETFs may be vulnerable to fall with interest rate rises. Common equity-based ETFs may be vulnerable too in the short term but able to respond over time. Some of the ETFs in our table will most likely generate only capital gains, both for distributions and ETF unit value, e.g. gold and base metals ETFs but that return can vary a lot year to year with market conditions.
  • Portfolio fit - Each ETF fits somewhere in the asset mix and we should consider how much of each asset class to hold in our portfolios - see our discussions on investment policy, asset allocation, diversification and here. There are also other ways than distributions to generate income from a portfolio, such as simply selling assets - see our post on generating cash by rebalancing.
Tax Reporting - Though brokers will send out to its investor clients T5s and T3s with the actual amounts of the various distributions for preparing the individual 2010 income tax return, the tax breakdown info from the providers also allows us to do another necessary task, the updating of Adjusted Cost Base as we explained in ETFs and Mutual Funds - Calculating Capital Gains.

Congratulations again to the Claymore Canadian Financial Monthly Income ETF on its gold medal. Long may it continue to be so beneficial to taxable investors.

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.

Tuesday, 15 March 2011

How to Calculate Interest and Capital Gains for Tax on Bonds, T-Bills, GICs, CSBs

The April 30 deadline for filing a personal income tax return is not that far off (see list of this and other tax deadlines from the Canada Revenue Agency) so it is a good time to talk tax. Today, we discuss common types of fixed income.

Not everyone holds fixed income investments in tax-free or tax deferred accounts such as a TFSA, RRSP, RRIF, LRIF, LIRA, RESP etc, though one should do so if at all possible. When fixed income is held in a taxable account, the income must be reported every year. Some calculation and reporting is easy and some is fairly intricate.

Misconceptions - First, let's clarify a few points about fixed income that might lead people astray.
  1. Income subject to tax is not the same as cash received - You may not receive any cash, yet still have income to report, especially income such as capital gains within a mutual fund or ETF (e.g. see previous post The Mystery of Capital Gains in 2008 Explained). No cash is received till maturity from strip bonds or compound GICs. Fixed income funds regularly generate taxable income that differs from the cash distribution, as a quick look at the distribution detail of the iShares DEX Universe Bond Index Fund (symbol: XBB) shows.
  2. Taxable income often includes more than just interest - Witness the XBB tax breakdown, which shows everything but dividends - interest, aka other income in tax parlance, capital gains, return of capital. The return of capital component is unique to funds (arising because of the way that money flows in and out of the fund - see our post on ROC for an explanation) but individual bonds can throw off capital gains if they are sold or mature for more than their purchase price.
Guaranteed Investment Certificates (GICs) and Canada Savings Bonds (CSBs)
Tax reporting is easy. The financial institution where such investments are held sends you a T5 with the correct amounts to transfer onto your tax return. In the case of compound GICs or CSBs, where the interest cumulates and is only paid at maturity, you still must, since you are legally entitled to receive it, report the income year by year as if you had received it, and the T5 includes it.

In the case of cashable or escalating GICs where you may receive a lower rate of interest if cashed in early, the interest is reported year by year as if you were holding to maturity. If this maximum rate is not achieved, then the loss difference is reported as negative income in the year it happens.

CSBs and GICs never have a capital gain or loss since you always receive back the exact principal amount invested.

Coupon Bonds
The most common type of corporate and government bond bears interest coupons that are structured to be paid twice a year six months apart. Since current required rates of return or yields fluctuate constantly and never exactly match the coupon interest rate, coupon bonds will produce both interest income and a capital gain (or loss) whether held to maturity or sold before maturity.

Two situations are possible when buying a bond. In one case the bond asking price from the broker is above the standard $100 par value, which is when the coupon interest rate is above the current yield. That is the case today for almost every bond on the market as current record low interest rates have increased the value of bonds issued in past years far above their initial price. These are called premium bonds. The other case is the opposite - bond price below par and bond coupon interest below current yield - and such bonds are called discount bonds.

The best way to explain how the taxes work is to use examples.

Premium Bonds
Click on the image below to enlarge the spreadsheet.
Our example bond is the Government of Canada bond with a 5% coupon paid twice a year on June 1st and December 1st as 2.5% (half of 5%), or $250 of interest on our supposed purchase of $10,000 worth (called face value) of bonds. Since the coupon rate is far above current interest rates on offer, manifested as the 1.999% yield, the price of the bond per $100 of par face value is, not surprisingly, much higher at $109.313. If we place our order on March 11, 2011, the cash and ownership trades hands three business days later on March 16th, the settlement day.

Part of the total price to pay for the bond is the interest owing from the previous regular payment date, in this case December 1, 2010. This $143.84 of accrued interest is important for taxes. The amount of accrued interest is pro-rated as the number of days times the per-day coupon rate, in our case 5% x 105 days/365. From an investment return point of view accrued interest matters only as a question of timing of cash flow since the $143.84 that we pay out to the previous bondholder is recouped on June 1st when we receive the full $250 in interest, not just the portion earned while we have owned the bond. Discount brokers will normally show the accrued interest on the online quote and the trade confirmation sent to the investor. In counting days of interest, a buyer excludes the settlement day, while a seller includes it (see section 3.3 in Canadian Conventions in Fixed Income Markets).

Tax Calculations:

Interest Income
  • Accrued interest paid on purchase is both included in, and deducted from, income (i.e. net zero income) in the tax return for the year - Since we must report the full $250 in interest received June 1, 2011, we get to deduct the $143.84, i.e. only the $106.16 we actually earned is net added to our year's income.
  • T-slips show only the coupon interest on purchase; the accrued interest appears separately as an "amount paid by you "in the year-end summary statement sent by the broker for inclusion as an expense on Schedule 4 of a tax return.
  • Accrued interest on sale before maturity for inclusion in reported income occurs also up to and including the settlement day of the sale
  • T5-slips show the accrued interest on sale.
  • Coupon interest payments (cash received) are all included in reported income
Capital Gains
  • Accrued interest is excluded from the Adjusted Cost Base (ACB) of the bond - ACB is not the total purchase price of the bond.
  • Capital loss will occur if the premium bond is held to maturity, no matter what happens later to interest rates. The capital loss occurs in the year of maturity and may be reported then to offset other capital gains, or carried forward or back.
  • Sale before maturity will change the capital gain or loss depending on the movement of interest rates. When interest rates rise the capital loss will increase - scenario B in our example - and when they fall the loss may turn into a gain - scenario C.
  • All capital gain or loss calculations must be done by the investor him/herself; the broker does not do it or put it on T-slips for you. The T5008 information slips issued by brokers to investors show only the proceeds of disposition and not the ACB.
Discount Bonds
Click on image to enlarge spreadsheet.
Our discount example was hard to find - the Government of Canada 2% coupon maturing 01 June 2016. The coupon is slightly below the 2.45% yield so the price is $97.88 per $100 par value.

Tax Calculations:
The rules are, of course, exactly the same as for premium bonds regarding calculation of interest income and capital gains. The spreadsheet works through the numbers.

What is important is the fact that the discount bond produces a lot less of its return in the form of interest than a premium bond. Some of it is capital gains and that is deferred until maturity or sale. (Note that a capital gain is not guaranteed if interest rates rise in the interim before sale, as our Discount bond scenario B shows.) The fact that a premium bond naturally produces a capital loss for taxes in effect means that it generates too much interest income. The investor ends up paying more in taxes. A discount bond is thus inherently better than a premium bond from a tax point of view. TaxTips.ca constructs a hypothetical example that shows how much tax advantage a discount bond can have over a premium bond with the same yield. TaxTips' recommendation makes sense: in a taxable account, to minimize taxes, choose the bond with the biggest discount.

Possible Future Opportunity - Interest rates / yields are still at long time lows. When they inevitably sooner or later rise, bond prices will fall. There will be many more discount bonds. If interest rates rise strongly, the discount will be even higher and longer maturities will experience the greatest price fall. A greater and greater part of the return on bonds will consist of capital gains, deferred till maturity or sale. That will reduce taxes for the investor. For investors who do not need the income flow, discount bonds could become a very tax-effective holding, especially highly secure Government of Canada bonds, which also tend to have the lowest coupon rates.

Treasury Bills
T-Bills do not pay any interest. Their return comes from being purchased at a discount to the standard par maturity value of $100 per T-Bill (though the minimum purchase amount at discount brokers is usually $5000). The return when held to maturity is considered to be interest by the CRA. Since by definition T-Bills always mature within a year, the easiest way to account and report the interest is for the tax year the T-Bill matures, though the taxpayer / investor could choose to accrue part of the interest, following the method explained below for Strip bonds, in each tax year for T-Bills that straddle two tax years. The broker does not report on T-slips the interest. The broker reports the proceeds of disposition on a T5008 slip. It is up to the investor to do the step of subtracting the ACB to net out the interest.

Strip Bonds
Strip bonds are created when investment dealers or other financial institutions take normal bonds and separate (i.e. strip) each interest coupon and the principal into individual securities that can then be bought by individual investors. For detail on how strip bonds work including tax treatment, see the excellent Strip Bonds Information Center by financial industry insider Keith Campbell.

The essence of taxation is the same as for Treasury Bills. There is no on-going cash flow but the CRA forces tax to be paid each year based on the implicit return an investor receives, which is the yield to maturity at purchase. The return is considered to be interest income for tax purposes, which attracts the highest marginal tax rate. The fact that taxes have to be paid every year at the rate for interest income, while the investor only receives the cash return up to decades later, is the reason strip bonds make most sense in a tax-deferred / tax-free account.

Our example spreadsheet below works through the tax calculation for a strip Government of Quebec maturing 01 June 2014 with a quoted yield of 2.306%.

Tax Calculations:
  • When held to maturity only interest income results. The on-going cumulation of interest to the ACB means that no capital gain or loss occurs at maturity.
  • Capital gains or losses can result if the strip is sold prior to maturity after interest rates / yields go up (resulting in a loss) or down (resulting in a gain). The calculation must still add the year's accrued interest accrued up to the date of sale to the ACB before netting out the gain or loss, as our scenarios B (loss) and C (gain) show.
  • As with T-bills, the broker will send the investor T5008 slips or capital transactions summaries with proceeds of disposition but the investor must do the interest calculation him/herself.
Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment or tax 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.

Tuesday, 8 March 2011

Real Estate ETFs on a Roll - Canada, USA, World

All the continuing bad news about the US housing market may be obscuring the fact that other parts of real estate have been in recovery mode for the past year in Canada, in the USA and to a lesser extent in the rest of the world. These other areas of real estate include Real Estate Investment Trusts (REITs) and ordinary real estate companies that own and manage office buildings, shopping malls, commercial property, apartment buildings, hotels, hospital buildings etc. In the past year ETFs focused on such real estate in Canada and internationally have returned 20 to 30%, and in the US around 40%.

Commentary suggests more good results may yet be in the offing - for example, the GlobeInvestor story REIT recovery inches ahead, Seeking Alpha's ING: Global REIT Returns Estimated at 8%-12% for 2011 and NASDAQ's REIT ETFs Can Do No Wrong.

The chart below from Google Finance shows the price movements (ie excluding the effect of distributions / dividends on returns) since mid 2008 for four representative ETFs - Canada's iShares S&P TSX Capped REIT Index Fund (TSX symbol: XRE), the USA's Vanguard REIT ETF (NYSE: VNQ), the Global SPDR Dow Jones Global Real Estate ETF (RWO) and the International (world excluding USA) SPDR Dow Jones International Real Estate ETF (RWX). The substantial rise in 2010 has only brought XRE back to just above the pre-2008 crisis level, while all of the rest are still significantly below recovery.

Though there are many other ETFs traded in the USA - see our recent post on ETF Resources for the databases to get the lists - we focus on the largest by asset size. Bigger asset size is better since that will reduce investor costs through smaller bid-ask price spreads, greater liquidity and tighter gaps between the funds' Net Asset Value and their market price. There are only three real estate ETFs trading in Canada so we review them all.

The ETFs

Canadian Holdings - these funds hold REITs with operations exclusively in Canada
USA Real Estate Holdings
Global Real Estate - holdings in many countries, including Canada and the USA
International Real Estate - holdings in many countries, excluding the USA. We list only this single fund, though again there a number of other similar funds, since their appeal is mainly to US investors.
Comparisons - details in the table below

Lowest Cost - The winner here is clearly VNQ - compared to its closest competitor, its asset size is more double and its Management Expense Ratio (MER) of 0.13% is half. The Claymore CGR offering has the highest MER. CGR does have the cost advantage that it is bought and sold in Canadian dollars on the TSX, which means an investor can avoid currency conversion costs to/from US dollars that are entailed when the US-traded ETFs are bought or sold. CGR's free optional dividend reinvestment, pre-authorized automatic purchase and systematic withdrawal programs save investors trading fees. Despite CGR being traded in CAD it is still subject to currency risk of the holdings since the fund does not hedge.

In Canada, XRE and ZRE have the same MER of 0.55%. XRE will have lower trading costs due to its much heftier asset base, while ZRE offers trading commission savings for those who wish to reinvest distributions through its free DRIP program.
Best Diversification - For Canadian holdings, ZRE comes out ahead of XRE since it has more holdings - 17 vs 13 (out of the 33 REITs in the country according to Investcom.com's current list) - and it weights its holdings equally, whereas XRE has a hefty concentration in one company - RioCan, at 25% of the fund.

For US real estate, VNQ is again tops with appreciably more holdings than any other fund.

Amongst global funds, FFR's 285 different holdings puts it ahead of the others

Room for Further Price Recovery - We suggested above that Canadian real estate has recovered the most towards pre-crisis levels. Canadian REITs are back to 2008 prices but the decline began before that and they are nowhere near the peak of 2007. The same applies for both US (VNQ) and international (RWX) real estate as the Google Finance graph below shows. International real estate has furthest to go. By the simple measure of Price/Earnings ratio, the global / international ETFs are still modestly priced compared to US ETFs - P/E in the mid teens for Global funds and only 10.4 for RWX. Distribution yields are also higher than for the US funds.

Rising Canadian Dollar has Reduced Returns for the Canadian Investor - The above chart includes the plot for the ETF with symbol FXC, an ETF that tracks the Canadian dollar against the US dollar. Since 2007, FXC (Canadian dollar) has risen 18%. This has reduced the returns of all the US-traded / US-dollar denominated ETFs accordingly. In the past year, the situation hasn't been quite as bad. At least net returns are positive instead of losses. We don't show the graph but the gains of RWX (+18%) and VNQ (+31%) have outstripped the 8% rise in FXC.

Canadian REITs Win for Taxable Accounts - Distributions received from all foreign holdings are taxed as ordinary income and do not benefit from reduced tax rates for dividends and capital gains or no tax at all for return of capital. In a registered account (RRSPs etc) tax rates don't matter but in a taxable account it can mean much better after-tax net returns. XRE has in the past given off half or more of its distributions as return of capital. ZRE is too new for the information to be available yet but it will also generate something similar.

Returns and Distributions - The comparison table shows that current cash distributions from US ETFs in the 3.1 to 3.4% range fall below those of Canadian (5.1 to 5.7%) and Global ETFs (3.5 to 7.0%).

Which ETF? - Based on the comparisons above, our preference for a Canadian holding is ZRE due to its lack of concentration and the DRIP, though XRE is pretty close. For the USA, the best choice looks to us to be VNQ and for the Global funds, RWO is first choice with the lowest MER, the largest asset base and second highest number of holdings. Across all the ETFs, the net returns will be far more influenced by the evolution of the real estate sector in various countries than by differences between the ETFs. All but ZRE use a very similar selection and weighting process for companies/REITs to hold. If one looks at the top ten holdings, the same companies show up across all the ETFs in each geographical group.

Real Estate in a Portfolio - Our previous posts on the subject, here and here, discussed the features and risks of real estate and mentioned the rule of thumb that such holdings should be limited to about 10% of a diversified portfolio. A Canadian investor might thus consider an allocation of 5% in a Canadian ETF and 5% in a Global ETF.

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.

Tuesday, 1 March 2011

Test Your Portfolio with Historical Investing Returns

Have you ever wondered what results different portfolio combinations might have realistically produced using, for instance, the asset categories in the All-in-One portfolio funds we recently reviewed and adjusting for inflation, currency fluctuations, time periods and fund expenses? The Stingy Investor website (a permanent link is in our blog sidebar) has generously posted two unique tools:
  • Periodic Table - annual index returns in Canadian dollars (i.e. adjusted for foreign exchange rates) from 1970 to 2010 in real inflation-adjusted or nominal terms for twelve asset classes ranging from fixed income through equity to gold
  • Asset Mixer - a modelling tool to build hypothetical portfolios using the same data; one can select time periods, asset classes and weights, real vs nominal returns, historical or randomized historic return sequence and a percentage annual withdrawal if desired e.g. to test if the portfolio would have survived during retirement. There is the ability to adjust for fund expenses, either with typical rates for ETFs or various high/medium/low cost mutual funds, or with one's own arbitrary expense rates (note that this is done by setting a negative number in the Alpha cell). The main limitations: no taxes on capital gains/dividend or other income are included (thus this model is most realistic within RRSPs or other registered accounts); rebalancing is inflexibly once per year; initial investment only, no regular monthly or yearly purchases can be modelled.
Lessons from the Periodic Table (using the real returns, since that is what matters most)
  • Asset class returns jump about enormously and unpredictably - They go from top to bottom year to year and decade to decade, or vice versa. They have winning or losing streaks. There is no asset class that is always near the top or the bottom. Investors trying to predict such moves are likely to have a very difficult job.
  • Almost every year several asset classes lose money - It is rare for every asset class to make money - in the 41 years since 1970 it has happened only once, in 1993. It has not happened yet for every asset class to lose money in a year, though 1973 and 1974 in the wake of the 1973 oil crisis came close, when only Gold came through, with 50+% returns. Gold also did very well in the huge equity down years of 2002 and 2008. As for 2008, the year doesn't look so bad across all asset classes with every fixed income category but real return bonds having positive returns. Those who believe that fixed income always makes money, whether it is bonds (cf 1994 and 1999) or cash-like T-bills (cf 2009 and 2010), need to revise their thinking.
  • Real return bonds can also lose money after inflation - Though they compensate for inflation, sometimes the change in real interest rates causes the principal/capital value of these bonds to fall, witness 2006-2008.
Lessons from the Asset Mixer
  • Costs matter - Take any portfolio and try out the Alpha options for ETFs, compared to average mutual fund with much higher costs. Higher costs means lower returns and the resulting end value can differ considerably. We tried the Simply Canadian model portfolio of 50% Canadian All-Bond and 50% Canadian TSX Equity for 1970 to 2010. Results: ETF expenses 0.3% on bonds, 0.25% on equity gave 5.049% compounded (geometric) return and $7535 end value, versus Average Fund expenses 1.4% on bonds, 1.7% on equity gave 3.8% return and only $4558 end value.
  • Diversification smooths the returns ride - Portfolios need to be the focus, not individual asset classes. While the Periodic Table shows that one or another asset class is down every year, what really matters is the overall total portfolio return. The extensive statistics shown for each run of the Asset Mixer confirm the stabilizing benefit of having a portfolio. The same Simple Canadian 50/50 portfolio had a yearly standard deviation (the standard measure of returns volatility) of only 9.4% and nine down years from 1970 to 2010 while a 100% TSX equity holding had a standard deviation of 16.8% and 13 down years. Equally telling, the worst down year of the 50/50 portfolio was the 17% drop in 1974 compared to minus 40% for the TSX equity in 1973 - more than double. For those concerned about sleeping or being spooked into selling out at the worst time, the portfolio wins decisively.
  • Diversification sometimes also brings returns benefits - If one then compares the Aggressive ETF portfolio (28% Canadian bonds and the rest split equally amongst Canadian, US and EAFE/Developed country equity) for the same time period, the TSX equity-only holding fares poorly. The portfolio compound return is 5.3%. That might not seem like much more than the 5.0% of the TSX but the end value of $8407 versus $7299 looks a lot more impressive. Meanwhile the portfolio risk is still less than the TSX - only 10 down years vs 13, 12.1% standard deviation vs 16.8% and a worst down year of 34% loss vs 40%.
  • Portfolios are nevertheless highly variable and regularly experience severe drops too - 2008 was not an exception in being a bad year, as the following chart we have created using data from Asset Mixer shows. The long term investor must expect some big drops and be willing to stick it out for the recovery. The good news our chart brings is that big up years happen regularly as well. It is also worth noting that there is seldom a year that is anything close to the long term average growth of 5%. It's a roller coaster, not a train.
We must be careful not to take precise figures too literally, for example the long run rates of return to be expected. Mark Twain's quip that "the past does not repeat itself, but it rhymes", reminds us of the limitations of any jump from past to future. Another key missing ingredient from the model is the lack of ability to account for regular payments instead of one lump sum invested at the beginning. The choice of start year and end year can also alter the comparative returns of different portfolios.

Nevertheless, these tools are worthwhile for experimentation and education. Stingy Investor Norm Rothery acknowledges the invaluable contribution of Norbert Schlenker of Libra Investment Management in compiling and making publicly available much of the data underlying the tools. To which we add a loud hear, hear to both men.

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.