Friday, 21 November 2014

How Effective is Using Dispersion of Analyst EPS Estimates to Assess Stocks?

Two years ago our post applied the "wisdom of the crowds" principle, made famous by James Surowiecki, to analyst future Earnings Per Share (EPS) estimates to try to differentiate attractive safe Canadian stocks from the not-so-attractive companies. The academic research we uncovered at the time suggested it should be effective but it's always important to check actual results against the theory, so now let's do an update and see what has happened.

As before, we took our 2012 list of the best - the stocks with the lowest dispersion between high and low analyst next year (2013 in the 2012 post) EPS estimates - and the worst - those with the widest spread - and plugged the numbers into a GlobeInvestor WatchList to get the trailing one- and five-year total returns (the sum of capital appreciation plus dividends). Our benchmark for success is the mainstream large company ETF the iShares S&P / TSX 60 Index Fund (TSX symbol: XIU) whose holdings along with the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) and the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) we had used to assemble 110 candidate stocks.

Low EPS dispersion stocks performed impressively well
In our comparison table below of the lowest dispersion stocks in 2012, green is good, indicating substantially better performance than the benchmark XIU. The one- and five-year total returns of the stocks with the lowest dispersion of EPS estimates in 2012 is very consistently green.
(click on image to enlarge)

In the five-year column, not a single stock under-performed XIU or had negative returns. Only three did only as well as XIU, everything else was miles ahead.

In the one-year column, only two stocks, IGM Financial (TSX: IGM) and North West Company (TSX: NWC), had a negative (red) return. Eight stocks (highlighted in orange) had positive returns, though less than XIU's +15.2%.

High EPS dispersion stocks performed remarkably poorly
Our second table below showing the 2012 highest EPS dispersion stocks is filled with ugly red. There is very little good green or minimally acceptable orange. Only one stock - Franco Nevada Corp (TSX: FNV) - had benchmark beating returns over both one- and five-year periods.
(click to enlarge)

... and the middle EPS dispersion stocks are in between
The returns for the middle group are generally positive, more like the top group than the bottom, but display a larger amount of red and orange in the table below.
(click to enlarge)

BMO's Low Volatility Canadian Equity ETF (TSX: ZLB) in 2012 held a lot more of the low EPS dispersion stocks than either XIU or PXC as the left-most column shows. It is thus little surprise that its 26.9% one-year total return (neither ZLB nor PXC has been around five years so five-year return is not yet available) handily beat that of both its rivals.

Why picking low EPS dispersion stocks might not work as well in the future? The low EPS spread stocks are mostly in the financials, real estate and consumer sectors. Those sectors have done well. On the other hand, the high EPS spread stocks tend to be in energy and materials, both of which sectors have taken a beating in recent years. If those sectors rebound (the price of oil, gold and other commodities being such crucial uncertain variables), their returns could easily leap well ahead of the safe and steady stocks. That wouldn't necessarily mean the safe stocks would have negative returns; more likely they would under-perform.

Bottom Line: The method is not foolproof but looks darn good. Taking note of the dispersion of analyst EPS estimates appears to be an extremely useful factor to consider in stock selection. Low dispersion = good, high dispersion = risky.

This being the case, next week we'll review the current list of attractive and un-attractive stocks. We'll also compare the ETFs and their holdings.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

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.

Monday, 17 November 2014

Women on Boards: Pleasing Progress

A few years ago, we explored whether the presence of women on boards of directors was something investors should pay attention to. The indications we found in research and our cursory look at performance was that, yes indeed, companies with women fared better. We were curious to see how things have progressed since then. What we found looks pretty good.

Plenty more women on boards!
In 2012, the slow progression of women into the boardroom caused some controversy, e.g. the "Glacial Progress" Globe and Mail article by Janet McFarland. Corporate Canada seems to be changing fairly quickly, based on our analysis of the 100 largest companies by market cap that are publicly traded on the TSX (extracted using the TMX Money stock screener).

In November 2012, the top 100 companies had 167 women directors. Today the number is 200,a 20% increase. (We assembled this data ourselves by looking at the bios of directors under the Insiders tab of company listings on - e.g. for Royal Bank of Canada, which surprisingly is one of only three companies which have fewer women - one each - on the board than in 2012 ... but we shouldn't be too harsh on the Royal since it still has four women on its board and is thereby still in the upper echelon of the women director count as our comparison table below shows).

Though we don't show it in the table, the 15 companies that already have women are adding more than those with none at all in 2012. Seven of them added women. In contrast, only five companies went from zero to one, Catamaran jumped from zero to two, while eleven stayed at zero.

As an interesting aside, the financial sector which dominates the top of our table seems also (our impression from reading bios- we didn't count) to be the source, in the form of retired executives, of many women board members for other industries.
(click to enlarge image)

Companies with women directors score better on governance
We again took the scoring from the independent Clarkson Centre for Business Ethics and Board Effectiveness of the Rotman School at the University of Toronto (2013 scores since the 2014 update is not yet available). The results in the CCBE columns on our table for the 15 companies with four or five women directors are better than the 15 companies with no women.

... and their stock performance is generally better too
As we found in 2012, the one- and five-year total returns of companies (performance data is from the GlobeInvestor WatchList tool) with the most women directors at the top of the table look much more impressive on average, with positive returns that more often exceed our benchmarks, the TSX Composite (embodied in the iShares ETF that tracks that index with stock symbol XIC) and the large cap TSX 60 index (tracked by the iShares ETF with XIU symbol). Dividends are higher on average and five-year dividend growth is almost always positive and more often in excess of the benchmarks.

Board diversity is greater in other ways too - with the inclusion of academics.
We were a bit surprised to come across Professors in the Boardroom and Their Impact on Corporate Governance and Firm Performance by Bill Francis, Iftekhar Hasan and Qiang Wu (acknowledgement to Alpha Architect blog for the reference) that found a positive relationship between company performance and the presence of academics on boards. The paper sums up that profs are often "valuable advisors and effective monitors".

We scanned the director bios for the profs too and lo and behold, though few companies seem to consider academics at all (only 16 out of the 100 largest have even one), several of the companies that do are at the top of our table, while there are none in the bottom. Mere coincidence of no significance? Probably not, board diversity helps sound decision-making by bringing together different perspectives and ways of thinking about issues.

Bottom line: The conclusion is the same as two years ago - women directors do not absolutely ensure a profitable investment but it is a positive factor to include in the analysis of a company and its stock.

Disclosure: This blogger directly owns shares of stocks mentioned with symbols BMO, BNS, CU, EMA, IFC, NA, POT and RY at the top of the list and HR.UN at the bottom, along with ETFs that contain more or less all the stocks. In addition, he has a stake in the futures of four daughters who might well one day be considered for board membership somewhere somehow.

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.

Friday, 7 November 2014

Currency and Inflation Effects on Model Portfolio Performance

Almost five years ago we reviewed how a broadly diversified international portfolio would have fared in the period from 1992 to late 2009. There's been more water under the bridge so let's update and expand the original analysis. We can add nine more years of data - the five from 2009 to 2013 and those back to 1988 - because Norbert Schlenker at Libra Investment Management has performed the excellent favour to investors by continuing to update the annual investment returns for a range of asset classes and making it available for free as a downloadable spreadsheet. In the intervening years we have also written about various model portfolios so we'll test those that we can to see how they might have performed (the main gap is those portfolios that invest in real estate since the spreadsheet unfortunately does not include that asset class).

The International Portfolio still performs very well
The diversification benefit of additional equity holdings in the USA, developed market countries (abbreviated as EAFE - Europe, Australasia, Far East) and Emerging markets (such as India, China, Russia and Brazil), continues to be felt, primarily by boosting returns, while the T-Bill and bond holdings dampen portfolio swings, as our chart below shows.
(click on image to enlarge chart)

Inflation continues to steadily reduce returns ...
On the chart below inflation continues to take a chunk out of returns, though at a lesser rate in recent years than the long term average. Inflation is highly unlikely to go away since it is Bank of Canada policy to target an inflation rate in a range of 1 to 3%.
(click on image to enlarge)

... and currency swings often have quite substantial effects, sometimes boosting, sometimes hindering, returns of foreign equities, which also confirms what we noted in the first post five years ago. As the Canadian dollar (CAD) declines vis-a-vis foreign currencies, the same amount of foreign currency buys more Canadian dollars. That boosts returns. When CAD appreciates, the reverse happens. Thus, in our chart, CAD gains/appreciation are shown as a negative effect on returns (of the foreign holdings) and CAD losses/depreciation have a positive effect. In the early 2000s, for example, the Canadian dollar was gaining in value and that undermined returns of foreign holdings for six years in a row as the chart shows.

Note that the currency exposure for holdings such as developed countries and emerging markets is to the currency of those countries and not the US dollar when, for example, holding ETFs that are traded in USD on US exchanges. CanadianFinancialDIY explained how and why this works in this post.

In the 26 years covered by 1988 to 2013 almost exactly half - 12 years - currency movement helped returns for a Canadian investor. The mean of the yearly gains and losses over the period is slightly negative, just under 1%. That seems to add further evidence to the conclusion we presented in a 2012 post that hedging foreign currency holdings is not really necessary in the long term.

The International portfolio grew more, with less volatility, than a similar domestic-only balanced alternative
The following comparison chart was compiled from results of the Stingy Investor Asset Mixer tool that uses the data from the Libra spreadsheet.
(click on image to enlarge)

As the table shows, the international portfolio performed better than a domestic-only portfolio with the same basic structure (35% cash & fixed income and 65% equities). This was true both during a savings accumulation phase of life or during a retirement withdrawal phase. In each life phase the international portfolio also experienced fewer down years and a higher reward (return) to risk (volatility) ratio . International diversification showed its value.

The international portfolio also gained more than either the Lifelong portfolio and the Permanent portfolio. However, both these portfolios experienced considerably lower volatility, no doubt due to the 50% allocation of both to T-Bills and bonds.

The Permanent portfolio in particular looked much less attractive during a retirement phase of 4% annual withdrawals as it had a lot more down years and minuscule total growth. The stats reinforce the idea of the Lifelong portfolio as a "good-enough" compromise, never the best but never the worst.

Finally, by way of interest only since few would advocate such an unbalanced portfolio, we include stats for the 100% domestic equity (TSX Composite) portfolio and the 100% Canadian bond portfolio. Neither grew as much as either the Canadian balanced or the Lifelong portfolio, a surprise especially with respect to equities which have the image of higher eventual growth despite higher volatility. Regular annual rebalancing (which is what the tool models) provided the returns boost (see our post Portfolio Rebalancing - What, Why and How). On the bond side, the surprise is the higher number of down years during retirement. The lower returns from bonds are more susceptible to turning negative, closer to the line between positive and negative, when withdrawals are also happening.

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.

Monday, 3 November 2014

Testing the Ultra-Safe ARVA Retirement Portfolio Withdrawal Method

The 4% constant inflation-adjusted rule we posted about in 2009 is the standard advice for setting a retirement portfolio withdrawal rate that is not expected to run out of money, simply because the strategy always worked in the past. But future success depends on the future being like the past. As we recently wrote, there are strong indications that future investment returns will be lower with the consequence that a safe withdrawal rate is closer to 3.5%.

Suppose we don't want to mess around and want an iron-clad guarantee, or as close as is practically achievable, that our portfolio will never run out of money before death while withdrawing the highest amount possible. Step up Barton Waring and Laurence Siegel, whose paper The Only Spending Rule You Will Ever Need, proposes such an approach. The principle under-pinning their proposal makes sense - match assets (portfolio cashflows) with liabilities (spending / withdrawals). Level, guaranteed, lifetime spending with inflation-protected purchasing power most closely matches up with an inflation-indexed annuity, or with a ladder of real return bonds extending out to your expected lifespan.

However, such annuities are difficult if not impossible to find in Canada at the moment (there are annuities which have a set ratcheting increase of 1 / 2 / 3% but none that explicitly adjust to CPI so you have to correctly guess the inflation rate). They also lock in money irreversibly - there's no liquidity or capability to cash out for unexpected needs.

An RRB ladder of Canadian government bonds provides the best possible AAA credit security and direct CPI protection but they are extremely tax inefficient in a non-registered account, As well, the current limited range of issues maturing 2021, 2026, 2031, 2036, 2041, 2044 and 2047 make cash flows lumpy and hard to match with regular even spending. Plus, the furthest maturity is only 33 years away while maximum possible life expectancy is about 40 years, or 105 at age 65, according to the authors. RRB yields are extremely low, at their historic minimums these days, so many investors might still be tempted to keep their portfolio of volatile but higher potential return assets.

Spending must adjust to portfolio fluctuations
For those investors who want to keep their volatile investment portfolio but protect it from exhaustion by respecting the annuity asset-liability matching princple, Waring and Siegel propose doing a simple annual recalculation of how much can be safely withdrawn, which they call annually recalculated virtual annuity or ARVA. Every year after portfolio returns are in, they calculate what income would come from the purchase by the retired investor of a perfectly structured annuity to figure out the maximum withdrawal. The withdrawal fluctuates according to three varying parameters: current average yields on a ladder of RRBs, remaining lifespan aka time in retirement and latest portfolio net balance.

Our Historical Simulation Test - What were amounts and fluctuation of maximum spending?
The authors don't show what would have happened in the past by following their rule. Would the withdrawal fluctuate too widely, especially on the downside? How would the amount compare to the standard 4.0% rate, or 3.5% per today's outlook? For any portfolio size, which factor matters most - interest rate, remaining years? We decided to have a look using available Canadian data.

  • Balanced portfolio - containing passive index tracking ETFs, made up of 50% Canadian broad bond, 50% equity (30% TSX Composite, 10% US S&P 500 equity, 10% developed market MSCI EAFE) rebalanced annually; translated to Canadian dollars with real returns, from Libra Investment Management's free download excel spreadsheet. We applied a 0.3% annual MER cost to the portfolio as if it was composed of low cost ETFs, which doesn't really represent what was possible historically, but we are trying to guesstimate what might have happened if investment opportunities were similar to today. We generously gave ourselves a portfolio worth $1 million at the start of retirement.
  • Life expectancy / retirement duration - 35 years (i.e. to age 100 for a retirement start at age 65) in the base case charts below.
  • Retirement start year - 1992, which is the first year Canadian government real return bonds were issued
  • Real return bond yield rates - the Bank of Canada benchmark rate for a long term RRB at the end of each year; this doesn't really match the average for a ladder of RRBs since shorter maturity issues would most often have had a lower yield and thus reduce the overall average ... but we have to take what we can get and it took quite a bit of Googling to dig up even the benchmark Long-maturity RRB yields from the 1990s. 
  • Excel's function PMT = (RRB rate, Years remaining, Portfolio value, ,1) straight from Waring and Siegel's paper. The 1 means take the withdrawal at the start of the year. PMT = the maximum withdrawal amount for the current year.
  • Example PMT (4.5%, 35, $1,000,000, , 1) = $54,804 in 1992, year 1, of the chart below.
(click on image to enlarge)

  • Maximum ARVA withdrawal beat the historical 4% rule or $40,000 real constant dollars by a big margin - the lowest withdrawal under ARVA was the $54,800 in 1992, the average was $68,000 and the highest was an impressive $83,873 in 2000. Wow, that's wonderful, time to jump on board?
  • Huge variation in the annual ARVA withdrawal - 1992 min to 2000 max was a 53% range and there was more than a $10,000 drop from one year to the next twice over the whole period, from 2002 to 2003 and 2008 to 2009. This might present quite a severe psychological challenge to the retiree - you get used to nicely rising income during the 1990s, perhaps upsizing your spending "needs" then bang suddenly the markets drop for a year or two or three and you need to scale back in a major way. Looking at the chart after the fact tells us that all would have turned out fine but during we could not have been so confident. Hard basic spending needs have to be well below the maximum to be sure the strategy won't catch us out.
What matters most - Retirement duration, then portfolio value, then RRB yield
To see how the parameters inter-act, we plugged various plausible numbers into the formula. Right now, the yield on a benchmark long term RRB (which currently is the 2041 maturity bond) per the above-linked Bank of Canada webpage is around 0.6%.

The table below shows the sensitivity of the withdrawal amount to changes.
(click to enlarge)
The length of retirement has by far the biggest impact on maximum ARVA withdrawal. Longevity is the most significant risk. Next is the portfolio size, as year to year changes translate directly into proportional changes - up 10% or down 10% means the same increase or reduction in withdrawal, other things being equal. Reducing portfolio volatility greatly helps anyone wanting to use the ARVA method.

Finally, and surprisingly, the change in RRB yield has a relatively minor effect! Note how under today's conditions, the base case million dollar portfolio for a 30 year retirement, which is near life expectancy for a 65-year old, gives a far less generous withdrawal amount than in 1992 - only $36,500 per year i.e. less than the 4% rule and a bit more than the our lower 3.5% market valuation adjusted figure.

We took the same formula to create the chart below showing how various combinations of RRB yield and retirement duration inter-act with the $1 million dollar portfolio.
(click to enlarge)

The necessity to make funds last a long time has a huge impact on sustainable withdrawal rates. The difference between 40 and 20 years is much greater than even a several-fold increase in yields, as the contrast between the top and bottom lines vs the left and right edges of the graph show.

Bottom Line: Cautious spending, or the willingness to make fairly substantial spending adjustments year to year are required for the investor looking to use the ARVA method to ensure that his/her portfolio will not expire before he/she does! Building a diversified portfolio that minimizes volatility will directly and proportionally minimize the withdrawal variations.

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.

Monday, 27 October 2014

Ins and Outs of Managing Your Own Portfolio of REITs

As we mentioned a couple of posts ago when we started looking at Canadian REITs again, it is quite feasible for an investor to build a reasonably diversified portfolio of individual holdings instead of buying an ETF. There are several possible reasons to do this: 1) to save the ETF's fees known as the Management Expense Ratio, which get charged year after year, while the investor pays nothing for direct holdings; 2) to be able to customize the companies and/or weights of the portfolio holdings. There are various factors to consider, pro and con. The factors inter-act and the matter becomes a balancing act. Disclosure: this blogger has been wrestling directly with many of the issues, having taken the step of selling his REIT ETFs in 2013 and buying individual REITs instead at that time.

A minimum allocation to REITs of about $25,000
We don't believe it is worthwhile to start buying individual REITs unless there is a fairly substantial sum available. It's really something to consider for larger portfolios of around $125,000 or more, i.e. 10% to 20% of a total balanced portfolio like the Smart Beta or Swensen Seven). Why so?

Cost, for starters. The 0.39% annual MER of the lowest cost ETF from Vanguard (TSX symbol: VRE) on $25,000 is about $98 per year, which is the same cost as 9 trades at $10 each once a year to keep the portfolio in balance if 9 REITs are individually owned. MER is an unavoidable annual cost in an ETF. On the other hand, the DIY investor holding REITs directly pays a one time initial trading commission and then has the opportunity to control further costs for rebalancing, reinvestment and other purchases or sales.

There is a trade-off between the single trade for an ETF to rebalance with the total portfolio once a year versus the multiple trades for a collection of REITs. Stingy Investor provides a free calculator to compare the cost of owning ETFs versus individual stocks for a whole range of sectors, including the iShares REIT (Symbol: XRE). The tool demonstrates, using the higher 0.6% MER of XRE, that longer holding periods, less frequent trading and larger portfolios favour holding individual REITs over the ETF. Note that the tool's selection box titled Dividend Reinvestment really represents the cost of trading commissions of any kind, whether for reinvestment, rebalancing or purchases/sales of units. Most of the REITs offer a free dividend reinvestment program (DRIP), as our comparison table below shows. For that reason, we suggest entering "1" in the "Dividend Reinvestment" box to represent a single annual rebalancing trade, which is the base case frequency advice for managing a portfolio (see our rebalancing post).

An investor (such as retired person) who intends to simply buy and hold REITs, receiving the cash distributions to spend and not to reinvest, nor to do any rebalancing, in other words to do no trading and therefore not incur any commissions, will save the MER every year. The savings on avoided MER really add up over time as Stingy's tool shows.

Reducing individual company risk to achieve diversification
The more companies held, the less the investor's fortunes, good or bad, are determined by any single REIT. Our table below shows that anywhere from five to eight REITs are required to replicate about 50% of the weight of the three main REIT ETFs. BMO's ETF with symbol ZRE requires more due to its scheme of equally weighting all holdings. 75% replication requires eight (for XRE) to thirteen holdings (for ZRE). For the investor who is only trying to mimic the ETF and isn't trying to assess and select the best REITs (as we took a stab at doing last week with considerable time and effort) we believe the 75% replication level is preferable.

Broader coverage of the various REIT sectors results from more companies and higher replication e.g. with 50% replication the cap-weighted XRE and VRE do not include any apartment REITs like Canadian Apartment Properties (CAR.UN) and Boardwalk (BEI.UN), but at 75% replication they are included.
(click to enlarge image)

The diversification vs cost and complexity trade-off
There is a trade-off - as the number of REITs and diversification rises, which is good, the trading costs and complexity of rebalancing rise too. With more holdings each individual holding is smaller, and rebalancing trades can involve quite small amounts - e.g. a 13-holding equally weighted $25k portfolio mimicking ZRE would hold 100%/13 = 7.7% in each, or $1900 for each one.

On top of that, a $1900 holding yielding 6% annually, or 0.5% on the monthly basis that all the REITs use for payout frequency, gives only $9.50 per month, which is insufficient to buy a single share unit of all but one of the REITs. Thus, too many REITs with too small a monthly distribution means being unable to take advantage of the commission-free DRIP. At prevailing yields and unit share prices, it takes a holding of around $6000 to receive enough to buy at least one share on the monthly DRIP. That's another reason we think the minimum overall REIT allocation needs to be at least $25,000. Of course, investors who merely want to receive and spend the distributions need not worry about missing out on the free DRIP.

Strategy for company selection and weighting - cap-weighted or equal weight, or maybe one's own?
It is important to have a strategy, otherwise you will not manage the portfolio, it will manage you.

Cap-weighting is the traditional standard method and requires the least effort to manage. It is only necessary to swap in or out the lowest weight REIT holding every year, or on whatever rebalancing schedule is chosen. For instance, cap-weighted XRE is reviewed quarterly by iShares but a less frequent semi-annual or annual trade would likely suffice. We do have a concern about cap-weighting - too much concentration. The largest holding RioCan is already a hefty 19% in XRE and adjusting its weight in proportion for only eight holdings boosts that to 26% (see table above for weights and dollar amounts of each REIT for 75% replication of XRE).

Equal weighting spreads company risk evenly but more stocks are needed to reproduce the same proportion of the ZRE ETF that has adopted that strategy. The biggest challenge with equal weighting is deciding how often to do rebalancing trades. As soon as they are purchased the REITs' market prices start heading in opposite directions. Quarterly rebalancing is too often. Even ZRE only rebalances twice a year. We feel that annual rebalancing is sufficient for the individual investor, a trade-off between accuracy, cost and effort.

As DIY investors we can of course do whatever we want. We can select the best looking stocks with methods such as we used in our post last week on the individual REITs. We decided that Artis REIT fell into the less attractive group because it had net losses in two of the last five years, yet mechanically taking the top holdings of ZRE would see it included in a 75% replication portfolio. Deciding to drop it or include it or any other becomes a challenge of stock selection. As investors we would therefore be obliged to become analysts, with the extra time and effort initially and on-going, as well as the uncertain success such an approach entails.

Flexibility to take advantage of DRIPs, discounts, SPPs, tax loss selling
The DIY investor in the process of building up investments can also focus his/her portfolio on REITs with worthwhile additional features. The majority of the big REITs offer plans to reinvest distributions in additional units for no cost (called a DRIP - Dividend ReInvestment Plan). One that does not is Boardwalk.

Some offer attractive cash discounts on the purchase of DRIP units, such as RioCan, H&R, Canadian Real Estate REIT and Calloway. Yet others offer plans that give bonus units when the investor DRIPs, though the size of holding required to get even one share at a discount can be very substantial, as our table below shows. ETFs do not participate in the REITs' DRIP discount or bonus plans - the ETFs' DRIPs merely buy shares on the market. An ETF REIT investor therefore loses that benefit.

Many of the big REITs also offer Stock Purchase Plans (SPP), which allow the investor to periodically buy more units for no commission. Canadian DRIP maintains handy lists of all the DRIP and SPP details, like SPP minimum purchase amounts and allowed frequency of extra purchases. The following table summarizes the DRIP and SPP offerings of the top REITs.
(click to enlarge)

Investors holding REITs in taxable accounts can also more easily take advantage of tax loss selling (see our post on this topic) when holding a number of individual REITs. Chances are, some REIT will have a price decline even when the sector is swinging up. A downside is that there is a multiplication of book-keeping required for multiple individual REITs versus an ETF in a taxable account. All the REITs distribute a lot of Return of Capital (ROC), which is not taxable in the year of receipt, being in effect deferred capital gains. On-going yearly ROC means careful time and effort to properly track Adjusted Cost Base (ACB; see also our ever-popular post on ROC). It may be worthwhile to use a pay service such as ACB Tracking Inc to help do it correctly.

Psychological challenge of on-going portfolio management
Managing a portfolio is not just mechanical effort. There is considerable effort of discipline, both to not do anything or to actually go ahead and do whatever one's intended strategy requires. The stock market is good at inducing mind tricks - "Yes, I know my strategy is to rebalance to equal weights per the ETF now but this REIT has had several bad quarters, its price is way down and the analyst commentary and recommendations are negative. Should I not sell out and buy another REIT instead of buying more? Besides, it's only a few hundred dollars rebalancing amount, it isn't worth the commission." Before we know it, our own strategy rules are not fixed but arbitrary.

Bottom line: Buying and holding a portfolio of individual REITs instead of an ETF offers the potential for appreciable cost savings and flexibility for those with at least $25k to invest in REITs. However, it requires extra time, effort and discipline.

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.

Friday, 17 October 2014

Canadian REITs - Which look good, which don't

Last week's post concluded by noting that the continued success of Canadian REIT ETFs from iShares and Vanguard depend a lot on two of their heavyweight holdings - RioCan and Boardwalk. This week, we'll drill down into these and other REITs, or similar real estate corporations, to see if they look attractive. We take the point of view of an investor looking for steady, high sustainable income and not, for instance, seeking under-valued turn-around candidates.

Safety first - Financial stability
The ability to keep paying distributions, especially higher rates, arises from a very solid financial foundation, notably:
  • Strong, consistent profitability - We looked at the net income performance of the last five years, favouring those REITs who always made money and downgrading the others. One REIT, Northwest Healthcare Properties REIT (TSX symbol: NWH.UN), did fine for four years up to 2013 but has faltered in recent months.
  • Track record aka proven management and size - A longer successful history means management and the internal processes of a REIT are more probably solid. One slightly worrying sign at RioCan is the resignation on October 2nd of the President and CEO Fredric Waks for the reason often given when it is not a happy departure - "... to pursue other interests". A larger portfolio of properties provides more internal diversification. We have thus eliminated REITs whose market cap is below $350 million (which excludes none of the REITs held by any of the three big ETFs). Also eliminated were a couple of REITs tied to one retailer - Canadian Tire for CT REIT (TSX:CRT.UN) and Loblaws for Choice Properties (TSX: CHP.UN).
  • Limited debt - The classic 2004 guide to REITs from Deloitte (still available as a free download from Investor Village) notes that 40 to 60% debt on the balance sheet is a desirable conservative range. We put aside those REITs above that range, shown as a Debt/Equity ratio above 1.5 in our table below (40% debt = D/E 0.67)
  • Business sector - REITs operate in various sectors, from hotels to office buildings. Some sectors are more vulnerable to economic swings, most particularly hotels. The most stable are apartments and seniors homes. In between are retail, office and industrial.
Sustainability of distributions
REITs should not pay out more cash than what is needed to maintain the assets and the business, as a minimum, or to undertake expansion that will grow distributions, as a more ambitious goal. The commonly used metric to gauge how much is Adjusted Funds From Operations (AFFO), which CREIT (TSX: REF.UN) describes as "... a measure of operating cash flow generated from the business, after providing for all operating capital requirements". Taking the actual distribution as a percentage of AFFO the maximum advisable rule of thumb (per the Deloitte Guide) is a 95% payout ratio. A couple of REITs, Pure Industrial (TSX: AAR.UN) at 101.1% and Crombie (CRR.UN) at 98.3%, exceed the target. RioCan is right on the line at 95.3%.

Growth in distributions, actual historical and potential future
A track record of growing distributions by a REIT is a good thing, the converse of no growth or reduced distributions being bad of course. The one-year and five-year growth records show what the REITs have delivered to investors. The better-performing REITs levitate towards the preferred upper part of the table.

Growing AFFO, low payout and low debt/equity show a greater capacity and potential for future distribution increases. The REITs in the top of the table show favourable combinations of these elements.

Interest rate effects - The benchmark against which REIT payouts are compared is the Government of Canada 10 year maturity bond. Currently, the GOC10 yields 1.95% (see Y Charts), though it can only be purchased by an individual investor for around 1.77% yield (the broker takes a cut). Is it enough compared to the yields in our table below, or other fixed income investments (see our post a few weeks back comparing best fixed income rates)? It's up to us individually to decide.

One other factor we investors need to keep in mind is that REIT prices will decline should interest rates rise. Last year, CIBC's REIT review estimated that REIT prices would fall about 12% for every 1% rise in GOC10 rates. Another review from Dundee Capital Markets in the Globe and Mail pegged the sensitivity at 13:1. In reality, after the approximate 1% rise in interest rates in 2013, REITs fell 16% on average.

Bottom line: 15 REITs we like - top half of the table - and 13 we don't like - in the bottom half.
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There is a wide range of yields on offer from:
-  a low of 2.9% from Boardwalk (TSX: BEI.UN), which displays a high degree of safety plus past and potential growth, to
- a high of 8.5% from Dream Global (DRG.UN), a smaller, more levered, less established, portfolio in a more economically sensitive sector i.e. riskier player.

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, 14 October 2014

Canadian Real Estate ETFs - Which is best?

REITs are a basic component of most diversified portfolios. We first looked at the basic characteristics of investing in real estate trusts and funds in 2010, with updates in March 2011 and in December 2013 after Vanguard Canada launched its REIT ETF in November 2012. A bare month ago in September, First Asset entered the market with its ETF, joining well-established competitor funds from iShares and BMO. Let's do another update to see which is the best ETF and to see how the sector has been doing.

We've compiled the comparison table below to compare the ETFs and their characteristics. Data was obtained from GlobeInvestor's My WatchList, TMX Money and Morningstar Canada, as well as from the provider websites.
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What are the key points arising from the table?

First Asset's Active Canadian REIT ETF (TSX symbol: FRF) is an unknown - There is very little hard data about FRF. There is no track record, of course. But there is also little visibility into the portfolio. The entire portfolio is not revealed, only the top ten of 32 holdings. The fact that it is actively managed fund means that the fortunes of investors in FRF will depend largely on the skill of manager Lee Goldman in attaining the objective of "... regular income and long-term capital appreciation". One thing that is quite likely are higher trading expenses, as a result of the active management. This in turn is likely to push the management expense ratio (MER) a greater degree above the management fee than FRF's passively managed competitors.

Similar portfolios - There is a high degree of similarity between the other three ETFs, especially between that of iShares (stock symbol: XRE) and Vanguard (VRE). The number of holdings is almost the same, as is the average size of companies, their P/E and P/B ratios, the largest stock and its weight (inevitable given that they both weight holdings by market cap). Our other table below shows in detail the high degree of overlap between the holdings of XRE and VRE.
(click to enlarge) 

BMO's ZRE is also fairly similar with a high degree of holdings overlap. But ZRE weights holdings equally, resulting in much less concentration in one stock - Riocan is only around 6% of ZRE versus the 18/19% it represents in XRE and VRE. We consider the lower concentration risk to be a plus for ZRE.

Similar distribution safety - In consequence, XRE, ZRE and VRE all exhibit similarity in several data points that inform us about the likelihood of continued high distribution yields by the under-lying holdings and thus of the funds themselves:
1) the number of holdings with either no dividend increase or a cut in the past five years - about a third of holdings in each ETF;
2) the number of holdings with a very high dividend yield of over 7% - again all in the 20's percentages;
3) the number of holdings whose ratio of dividend payout to earnings is in excess of a 90% danger zone - between 11 and 20% for the three.

Similar multi-year returns for XRE and ZRE - Despite the different weighting schemes, XRE and ZRE, the funds with the longest history, have amazingly similar returns and volatility. Both have also lagged the TSX benchmark stock fund (iShares' S&P / TSX 60 Index ETF, symbol: XIU) over the past three years.

Encouragingly, after a big dip in 2013 when interest rates took a blip upwards, returns have been positive again recently as interest rates again moderated. Every single holding in all of the ETFs has had a positive total return over the past year.

VRE's management expense ratio advantage - One significant difference between the ETFs is VRE's expense ratio, which is 0.2% or more lower than the others'. All else being equal, which does seem to be quite the case per the above, a lower MER leaves more money for the investor, year-in, year-out. Vanguard's cost simulator shows that the MER difference constitutes a significant long term advantage if the funds achieve the same long term return from holdings.

Distribution smoothing and yield: differences more of optics than of substance - ZRE pays out the same smooth amount of cash every month (currently $0.083 per unit). Meanwhile, XRE typically has paid the same amount for several months at a time, then it changes up or down, and VRE pays an erratically varying amount every month.

That smoothness of ZRE's distribution is not because the underlying holdings produce such steady income. As we've seen above, the holdings are pretty much the same as XRE's and VRE's. The difference arises only because BMO managers have decided to pay out a steady amount to suit investors who look at REIT funds as income generators.

All the ETFs, in order to maintain their internal non-taxable status and allow all income to be taxed in investors' hands, must distribute all their income in any calendar year. Within the year, whether it is paid out evenly each month, or in gyrating amounts, doesn't matter. The choice to smooth the income can result in some return of capital (ROC) to the investor if BMO mis-estimates the yearly income and pays out too much (that might be a bit of bad ROC but we have to remember also that good ROC can consist of unrealized capital gains or index-mimicing distributions - see our post on Good and Bad ROC, and this post in 2013 which discussed XRE and ZRE's ROC performance). The key point is that both XRE and ZRE have had returns, a sum of income received from holdings and their capital gains, that have consistently exceeded what they have distributed annually. So, though both have given out ROC, they are OK.

The other non-issue is Vanguard's consistently lower distribution yield. Read some excellent, simple explanations of how this comes about by Canadian Capitalist or Canadian Couch Potato or in one of Vanguard's FAQs. Vanguard's VRE portfolio is generating the income - see the blue bordered cells in the table that show the low trailing distribution yield of 1.8% along with the 5.4% yield of the portfolio holdings. The income is being distributed by the ETF, it's just that as the ETF grows, the investor benefits from capital gains instead of cash income.

For investors who are not withdrawing but building up assets and reinvesting distributions, the building up of capital gains in VRE's Net Asset Value can even be a convenience, though all the ETFs offer a free automated dividend/distribution reinvestment program (DRIP) which can accomplish more or less the same thing.

Real estate a good diversifier in a portfolio - Some investors look at the high distribution yield for income as the main benefit of REIT ETFs. But long term investors, who follow the strategy of rebalancing to a fixed asset allocation (see our Rebalancing what, why and how and model portfolios we have suggested - Simple, Swensen Seven, Smart Beta), look to the diversification benefits of REIT ETFs. The data is accumulating with time and it reinforces the notion that REITs provide diversification benefit by virtue of providing positive returns that are uncorrelated with other asset classes.

We can see this by using's calculator to find that XRE (enter the symbol XRE.TO) over the past twelve years has a 0.53 correlation with XIU (enter XIU.TO) and a -0.05 correlation with XBB (enter XBB.TO), the iShares broad Canadian bond ETF. The numbers vary somewhat for different time periods but XRE has had consistently low correlation with XIU and XBB i.e. away from the 1.0 mark which indicates the complete perfect correlation that we do not want. By contrast, XIU's correlation with US equities, as represented by the S&P 500 (SPY) in InvestSpy, has been 0.7 or higher all along.

Bottom line: It's a trade-off between the lower concentration risk of BMO's ZRE and the appreciably lower MER of Vanguard's VRE. We tend to favour the certain benefit of the lower MER, but all depends on the continuation of at least reasonable performance of big holdings Riocan and H&R.

Next week, we'll therefore look at the health of the individual REITs. Readers will also have noticed that the ETFs don't have many holdings and even a fairly small individual investor could buy all or most of the REITs in the ETFs themselves and save any MER entirely. In two weeks, we'll examine the considerations involved in managing a portfolio of REITs.

Disclosure: This blogger owns REITs, but only shares of individual REITs, and none of the ETFs mentioned above.

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.