Stock Market Outlook - The Insider View

Insiders - company executives and board members - know better than anyone else what the prospects are for their own company. Investors are wise to take account of their views, as we have previously written about in relation to individual companies in Insider Trading: Using It to Get an Edge. There is no better indication of what insiders really think than when they put their own cash on the line by buying shares when good prospects loom, or selling when things look dicey.

The same idea can be extended to overall market prospects by totalling up insider buying and selling and comparing the two. Fortunately, we don't have to dig the data out ourselves as the Canadian Insider publishes on its home page what it calls Insider Sentiment versus TSX. The screenshot below of that chart is how things look today.

Insiders appear to be mildly but not wildly optimistic right now, based on the sentiment ratio somewhere around 125% (i.e. a bit more buying than selling). That's nothing like the huge insider buying that occurred in late 2008 after the crash, shown on this CI page, when the sentiment indicator reached about 550%.

This cautious view seems to be in rough accord with mainstream media reports on professional forecaster outlooks such as this one in the Financial Post on a BMO presentation, or this collection of 2012 outlook articles at the Globe and Mail.

Naturally, the situation varies by individual company as insiders at some are big net buyers and while others are big net sellers, as also shown at CI for the past seven days total on the homepage. For those readers interested in individual company insider trading, we note in passing that the CEO of Canadian Insider Ted Dixon publishes a regular commentary on individual companies in the Globe and Mail's Who is Buying and Selling.

Among what might be called the pessimists are three of the big banks - Bank of Nova Scotia (TSX: BNS), National Bank (NA) and CIBC (CM). Could the insiders be worried about their bank stock being sideswiped by the "tough outlook" ahead as reported in the Financial Post? Also amongst the nabobs of negativity is TransCanada Corp (TRP) - is the selling a reaction to the Keystone XL fiasco?

On the optimistic side, insider buyers seem to be most prevalent amongst very small companies. One bigger company with an upsurge in buying is Canfor (CFP). Lumber companies have had a hard time for years but might the insiders be thinking that prospects are as good as this Financial Post article says 2012 will be? Another company with keen insiders is CCL Industries (CCL.B). In this case, the company's own outlook paints a modest growth story, so could it just be that it is under-valued, as the current P/E of 12.6 suggests. The sole stock analyst rating the company at TMX Money likes it too, recommending the stock as a "Strong Buy".

There's nothing like putting your money where your mouth is and the insiders are speaking. Of course insiders do not have infallible foresight but their opinion matters.

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.

Investing Book Gift Ideas

Still need a few gifts and don't know what to get for that investor on your list, or are you an investor looking for something good to read during the holidays? Here are some suggestions.

The Intelligent Investor - by Benjamin Graham, updated by Jason Zweig

This classic should be on every investor's reading list. It teaches us how not to lose money in the market, both from the technical standpoint of assessing accounting and business factors to the psychological discipline required. If we can absorb and adhere to the lessons within, we can aspire to doing as well as Graham's most famous disciple, the multi-billionaire Warren Buffett.

Stock Market Superstars by Bob Thompson

A dozen of Canada's most successful stock-picking fund managers say how they do it in a series of rollicking free-form interviews which entertain and educate about how to succeed by being different from the herd. Not many investment books can make you laugh but this one does with the irreverent, no-punches pulled comments by the superstars.

Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez

For the more advanced investor, once you want to get into the ins and outs of financial statements and the tricks of the accounting trade in order to assess companies and stocks yourself, this book will help enormously. It assumes you know the basics of income statements and balance sheets but you don't have to be a chartered accountant to follow along. Highly readable for the layman despite the subject matter, it tells us how to protect ourselves and spot trouble by taking account of the motivations of company managers.

Understanding Wall Street (5th ed) by Jeffrey Little and Lucien Rhodes

If you need something simpler to get started, whether it is to understand accounting statements or how markets and investments work in general, this is the book to buy. Very practical and intuitive with many simple examples, it can be read through or used merely as reference.

No Hype - The Straight Goods on Investing Your Money, 2nd edition by Gail Bebee

Here's another book that covers basics, but this one is aimed specifically at Canadians. It includes a brief rundown on everything from the types of investments out there (stocks, bonds, GICs, mutual funds, ETFs etc), the various accounts (RRSP, TFSA, RESP, taxable and so on), taxes on investments, annuities, advisors, the list goes on. There is little missing the average investor could want to know about. The book even includes sample portfolios, ranging from the ultra-simple starter to complex with individual stocks and with differing levels of conservatism.

Behavioural Technical Analysis by Paul Azzopardi

We've all heard that our own worst enemy in investing is not the market or some outside agency but our very own selves. We buy when we should sell and sell when it it time to buy. Lots of research has been done into the errors we make and there are some quite well-known books about how and why our behavioural errors happen. But no book does as good a job at explaining them and fitting them together coherently as does this one. The value for the investor is obvious - understanding can lead to fewer costly errors.

What Kind of an Investor Are You? by Richard Deaves

Those who take pleasure in their investing and are good at it may find it hard to believe that many people don't have the interest, time or skills to do respectably at it. If you are among those "many", here is a book that will guide you to figure out whether to simply rely on an advisor (and if so, how to pick a good one, since a bad one could wreck your financial future) or to do-it-yourself. If you are a DIYer there is guidance on how to build a sensible strategy based on Canadian ETFs or mutual funds. The book's advice is brief, simple and practical.

Unconventional Success by David Swensen

David Swensen's long and successful experience managing the gigantic Yale University endowment fund gives him deep knowledge of how the investment industry works and how various types of assets perform, knowledge that he passes along to the reader in this book. He recommends using only certain asset classes and passive index funds for most investors, and explains why in a cogent, persuasive fashion backed by logic and data. Who knows, in a few years the investment strategy he advocates could become the mainstream conventional approach.

All About Asset Allocation by Richard Ferri

This blog has emphasized the importance of asset allocation as a means to lower investment risk and achieve steadier returns. Ferri's book walks us through in more detail from the ground up why asset allocation works and how to do it properly using ETFs or mutual funds.

The New Investment Frontier III by Howard Atkinson

It's still the best book about ETFs in Canada, despite getting out of date due to the multiplication of new ETFs on the market. The explanation of how ETFs function in comparison to mutual funds, the discussion of indices, the run-through on income tax implications, all are as true today as when the book was last revised.

Uncontrolled Risk by Mark T. Williams

Interested to know who to blame for the 2008 credit crisis? Read this book to find out who else there is besides the obvious culprits in investment banking. Through the story of the collapse of central player Lehman Brothers, Williams shows how 2008 was the culmination of decades of build-up among many players. Along the way we learn what acronyms like CDS and MBS mean ... without our brain hurting too much. The scary thing is the author's conclusion that the risk of systemic financial collapse still remains.

Happy holidays to all and good reading!

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.

Gulp! Asset Allocation & Rebalancing Theory Meet a Scary Real World

Have you set up your portfolio structure according to a defined asset allocation with explicit rebalancing rules, as many experts suggest and as we advocate in this blog? Are you coming up to an annual review date to rebalance holdings in the new year after the 2011 results are in? Or perhaps the percentages allocated to each asset class have gone beyond the limits set to trigger rebalancing.

If you have noticed the large performance divergence of various asset classes this year, then the difficult reality of current economic and market conditions will surely test your resolve to go ahead with rebalancing.

Example portfolio - Complete Couch Potato
Let's take one of the model portfolios composed of common ETFs - the Complete Couch Potato - from the popular Canadian Couch Potato blog to illustrate the kind of anxiety-laden situations facing the investor trying to practise disciplined portfolio management. CCP also publishes up-to-date performance figures for the various portfolios and its ETF components, which is very handy since the value of distributions and the effect of currency swings on the US-denominated ETFs is taken into account. Below is a table of the portfolio and how it has performed since the start of the year.


Psychological barriers to rebalancing
The arithmetic about how to rebalance by buying some ETFs and selling others, as shown in the performance table above, is not the issue. The challenge is actually convincing yourself that it makes sense. Consider the situation:

• Canadian Equity - The TSX has been in a downward trend for months now. It doesn't look as though things are likely to get much better anytime soon. The temptation is to wait.
• US Equity - Thanks to the fall of the Canadian dollar against that of the USA along with the receipt of dividends, VTI has managed a slight gain. One might be tempted to put more money into VTI since it looks as though the economic situation in the USA may be stabilizing but our rebalancing calculation tells us to do nothing.
• International Equity - Here is the scariest situation. Our policy says to buy more VXUS when all it has done during the year is slide downwards to a 10% loss. Not only that, the underlying problems in Europe could well get a lot worse, Japan still struggles and now China is said to be slowing down. Poor decisions by authorities might lead to disaster, or perhaps we are already inevitably heading that way. The urge to hold off buying, if not to sell and run for safety, is understandably strong.
• Real Estate, Real Return Bonds and Canadian Bonds - These have been the bright spots, providing the biggest positive returns that have enabled the overall portfolio to eke out a small gain for the year. Rebalancing tells us to sell some of each yet it is hard not to consider that the underlying conditions that produced such returns seem still to be in place. Why not stick with the winners which, after all, are the safest of the holdings in these dangerous times?

Such is the dilemma facing the investor trying to follow the standard advice about diversification, asset allocation and rebalancing. It is much easier to rebalance when everything is going up and it is only a reallocation from a big winner to a small winner. Taking from winners to give to the losers is much tougher. Who knows it might not even be the correct choice.

Long term faith in outcomes is required
The dilemma today highlights that the main challenge we face as investors is ourselves in following our plans despite doubts and uncertainties. Should we adopt the same blind faith as one of the most successful investors ever, Warren Buffett, who said this?

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497" (source BrainyQuote)

Was the original portfolio allocation appropriate?

A reluctance to rebalance also raises the question of whether the original allocation percentages were appropriate for our individual circumstances. Is the 50% allocation to stocks necessary or reasonable if our savings goals have been reached? Is our time horizon for staying invested and not spending the money allocated to equity at least ten years, since that amount of time could easily be required before stocks again begin to pull ahead of bonds? The credit crisis and debt deleveraging troubles are very severe so it should not be a surprise that recovery takes a long time.

Diversification has worked again
The other thing to remind ourselves is that the diversified portfolio has produced a small but positive gain overall (2.2% in this case). That should help encourage us to continue following the basic strategy predicated on the idea that different asset classes will perform differently from year to year but will usually produce positive returns.

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.

High Income Foreign Bond ETFs

With interest rates being so low these days, many investors are casting their eyes further afield in the search for better returns. The benchmark Canadian bond ETF iShares DEX Universe Bond Index Fund (TSX symbol: XBB) offers a paltry 2.3% yield to maturity. Even its current cash distribution yield is only 3.5% (per the TMX Money XBB quote). Let's therefore have a look at some foreign bond ETFs available from Canadian fund providers Claymore, BMO Financial and BlackRock / iShares (new entrant Vanguard doesn't seem to offer any) to see the pros and cons of what they offer.

The ETFs fall into two groups: US corporate bonds and government bonds from Emerging Market countries. Interestingly, no fund seems to offer developed country bonds (so there aren't any opportunities to take a flier on Greek or Italian debt!).

Emerging Markets

• BMO Emerging Markets Hedged to CAD Bond Index ETF (ZEF)
• iShares J.P. Morgan USD Emerging Markets Bond Index Fund (CAD-Hedged) (XEB)

US Corporate

• BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY)
• iShares U.S. High Yield Bond CAD-Hedged Index Fund (XHY)
• iShares U.S. IG Corporate Bond CAD-Hedged Index Fund (XIG)
• Claymore Advantaged High-Yield Bond ETF (Hedged) (CHB)
  

Currency hedging is a worthwhile common feature - All of the funds use futures contracts to hedge the swings of the Canadian dollar against the US dollar. Since currency swings can easily overwhelm the basic bond returns from interest and capital appreciation, we consider currency hedging to be a desirable feature in general. However, the hedging operation is not free or perfect and that usually causes a reduction in the net return and under-performance compared to each ETF's index. Not all the ETF managers do an equally successful job. In our comparison table below, we see that ZHY has done worst with a -1.3% performance drag against its index. In contrast, the best result over the past year has come from XIG which has achieved the unusual result of a performance boost over the index of 0.9%! Most probably XIG's boost comes from unintended profits from the futures hedging contracts, as suggested by the fact that XIG is one of the iShares ETFs with capital gains to distribute in 2011. For more on how tracking error comes about, see Rob Carrick's MoneyShow article Watch Out for Tracking Error When Buying ETFs.

There are a number of US-traded bond ETFs (see list here), both for US bonds and international bonds, but none are Canadian dollar-hedged. A Canadian investor would face both bond and currency risk. In our view currency exposure is best achieved, and sufficiently so, through foreign equity holdings. That's a big reason why we've left them out of this review.


XIG comes out best on MER - Its 0.3% MER is about half that of the other ETFs.

Return vs default risk profile is the key differentiator - Whether we compare by cash distribution yield or more properly by the yield to maturity figures, we first note that all the ETFs offer superior returns varying from 1% to 6% over XBB. However, there's a catch - risk. There is a marked difference amongst the ETFs with respect to default risk, as measured by credit ratings from Standard & Poors (see Wikipedia's table that explains the ratings). Our comparison table shows with a big red line the key cut-off between ratings of investment grade and those riskier ratings underneath. XIG is clearly the safest and it correspondingly has the lowest returns to offer. ZEF and XEB on the S&P ratings measure rank next safest but the high concentration of assets in the top ten countries (such as Mexico, Russia, Korea, Brazil, Venezuela and the Philippines) makes us raise that risk estimate somewhat. ZHY, XHY and CHB are all quite diversified in the sense of having many holdings and low concentration but if a recession hits, it is likely many of these weaker companies will hit the skids at the same time. Peaks of default also happen with governments as we are seeing in the European contagion scenario and as we discussed a few months back in this post on Default Risk. All this is reflected in the year to date evolution of market price of the various ETFs , shown in the Google Finance chart below. XIG is up nicely, XEB and ZEF up a bit and the other three are down. XIG has also been more stable through the year.



Bottom line
XIG works best for investors who want stability with steady cash income.

The others work best when an investor wants cash income, is able to accept higher risk and wants to have another asset type that will help diversify the portfolio since the ETFs will not move in tandem with other equity or Canadian bond holdings.

All but one of these ETFs are best held in registered retirement accounts rather than a taxable account (since the cash distributions are foreign income). The exception is CHB which can be held in taxable account since it doles out Return of Capital and Capital Gains through its clever (and legitimate) use of forward agreements.

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.

Avoiding an Unpleasant Year End Tax Surprise on ETFs

A few years back we delved into the Mystery of Fund Capital Gains in 2008, explaining how it came to pass that investors holding ETFs or mutual funds in taxable accounts (i.e NOT in registered accounts such as RRSP, TFSA, RESP etc) could be liable for tax on capital gains when 2008 was such a horrible down year in markets. Investors received no cash yet there was income tax payable!

Estimated 2011 ETF Capital Gains Distributions
It's time to pay attention again this year, though the problem is not so widespread or severe as 2008. The main Canadian ETF providers have recently published their estimates in the links below of capital gains distributions for 2011 in their funds (final figures are to be published between December 15 and 19):

• Claymore Canada
• BlackRock (iShares)
• BMO Financial Group

ETFs with a Potential Tax Surprise
We have culled the lists and picked out the half dozen ETFs that will occasion significant capital gains tax to pay in taxable accounts despite what has been in most cases a year of declining market price of the ETF. Here are the ETFs to watch out for and their estimated capital gains distribution per share:

• Claymore S&P TSX Canadian Dividend ETF (TSX: CDZ) - $0.8446 capital gains per share
  
• iShares S&P TSX Small Cap Index Fund (TSX: XCS) - $0.7841
  
• iShares S&P 500 Index Fund (CAD-hedged) (TSX: XSP) - $0.4748
• BMO Junior Gold Index ETF (TSX:ZJG) - $1.2510
  
• BMO Junior Gas Index ETF (TSX: ZJN) - $ 0.9936
• BMO Equal Weight Global Base Metals Hedged to CAD Index ETF (TSX: ZMT) - $1.5467
  

Why Pay Attention
These ETFs all have, relative to the ETF price, a high amount of capital gains to allocate to investors but that are not actually paid out as cash since the gains stay within the fund. For example, if you own 1000 shares of XCS at the end of 2011 when the tally of shareholders to whom the gains will be attributed is taken, there would be 1000 x $0.7841 = $784.10 of capital gains to report on a 2011 tax return. A top bracket Ontario taxpayer paying about a 23% marginal rate on capital gains would owe $180 extra for gains that he/she would not see in cash.

The only consolation is that the capital gain gets added to Adjusted Cost Base of the investor's ETF holding, which means less tax to pay down the road if the shares are later sold for a gain, or if sold for an eventual loss, it would create a larger capital loss to offset other gains. But that goes against the basic principle of tax minimization, which is to defer payment of taxes.

The investor can well feel aggrieved paying taxes up front on gains that he/she has not seen. The situation feels worse when we look at the price performance in the Google Finance chart image below of these ETFs over the past year.

Only two of our list - ZJN and CDZ - are in positive territory and the others are all down significantly during 2011 up to December 2.

What Can be Done?
For an existing shareholder of these ETFs it is possible to avoid receiving the unwanted capital gains distribution by selling the ETFs on or before December 22nd (from December 23rd onwards, the shares trade ex-dividend, which means that if you sold the shares on December 23rd, you would still receive the year end distributions as the trade settlement would not occur till after the new year and you would still be on the books as the shareowner till then).

The value of doing this depends on the price you bought the shares. In a taxable account, you would need to do the usual capital gain/loss calculation (here is our post explaining how that works). If you bought ZJG at its inception in January 2010 you would be sitting on a sizeable capital gain. Triggering the big gain's realization to avoid the much smaller 2011 distribution does not make sense. However, if you had bought ZJG in January 2011 there would be a big paper loss so the sale before year end makes a lot of tax sense. This would be tax loss selling at its best. For the ins and outs of tax loss selling see this post.

For those investors who do not yet own but want to buy any of these ETFs, they are better off waiting till December 23rd.

Possible Short-Term Substitute ETFs
One tricky issue when an existing investor wants to continue owning the ETF for the long term is to properly comply with the superficial loss rule, by which the Canada Revenue Agency will deny the loss if the ETF is repurchased within 30 days e.g. by selling ZJG December 22 and buying it back on the 23rd.

One option is to wait for a month before buying back the ETF but that takes the chance that the price might rise significantly in the interim.

Another option is to substitute/buy similar, but not identical, ETFs while the 30 day period elapses. ETFs that use the identical index are a no-no but many ETFs using dissimilar indices within a sector follow a similar price price pattern, especially for a short period. That is all one really needs. Here are some matchups for our ETFs that we found using Google Finance charts to give us an eyeball validation.

• CDZ > substitute in BMO Canadian Dividend ETF (TSX: ZDV)
  
• XCS > iShares S&P TSX Capped Composite Index ETF (TSX: XIC)
  
• XSP > BMO Dow Jones Industrial Average Hedged to CAD Index (TSX: ZDJ)
  
• ZJG > Claymore Gold Bullion ETF (TSX: CGL), a so-so fit but it's our best shot
  
• ZJN > iShares S& P TSX Capped Energy Index Fund (TSX: XEG), also a so-so fit
  
• ZMT > iShares S&P TSX Global Base Metals Index Fund (TSX: XBM)
  

In mid-March, the fund companies publish the complete final tax breakdown of all types of fund income (dividends, interest, return of capital, capital gains) to help investors prepare their taxes and track their cost base. Meantime, this advance information helps investors make decisions and take action to defer capital gains.

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.