Two Ways of Generating Cash from a Portfolio

There comes a time when a portfolio's role is to generate cash to be spent. That may be for a major one-time expenditure such as a vehicle, house, vacation, education. Or it may be to provide a regular income to live off during retirement, supplementing government and private pensions. Assuming that the planning to figure out the amounts and timing of required cash, as described in Setting Investment Objectives, has been done, it is only a question of matching up the sources to the needs. What are the options for generating the required cash? (Note: Other financial cash-generating products such as annuities are available. The following addresses options for a DIY online investor.)

1) Buy Securities that Return Cash
There is a wide choice of individual securities and funds that distribute cash on a regular basis, whether monthly, quarterly, semi-annually, annually or once at maturity. The gamut includes: Treasury Bills, Commercial Paper, Provincial and Canada Savings Bonds, Guaranteed Investment Certificates, Real Return Bonds, Government and Corporate Bonds, Common Stocks and Preferred Stocks (see previous post on Investment Building Blocks for more description).

The chart below shows the usual frequency of payment for each type of security. Mutual and exchange traded funds often provide more frequent payment than the underlying security since their collection of securities will typically have staggered and constant incoming cash.


2) Sell Securities as Needed per the Target Asset Allocation
This method entails selling securities that are in excess of the asset allocation (how to create an asset allocation was previously discussed in Asset Allocation: the Most Important Investment Decision You Will Make) set for the portfolio. If bonds are intended to be 40% of the total portfolio value and due to market changes they have gone up to 50%, then there is 10% extra than there should be in bonds and that would be the place to start to generate cash. Such sales dovetail with the re-balancing that should form part of portfolio management.

Which Method to Adopt
There isn't a cut and dried best answer. A number of factors can influence which one, or which mix of the two, an investor should choose:

• time and effort to set up and maintain - figuring out all the incoming cash flows for various cash-generating securities (they will all be unique) may take considerable time initially but once done properly will be more or less automatic and require little attention with occasional reinvestment of matured fixed income securities; the asset allocation method can also be time consuming to set up, depending on how many asset classes are chosen and though the sell becomes fairly mechanical according to the Investment Policy, the sell must be done each time by the investor (though even that is not strictly speaking true since Claymore, amongst ETF providers, and most mutual fund companies will set up a Systematic Withdrawal Plan for their funds, which includes portfolio-type funds)
• taxes - income from a registered plan, such as a RRSP, RRIF, LRIF is always taxed at the highest marginal rate so it doesn't matter whether the cash comes from dividends, interest or capital gains. From a taxable non-registered account, there is a big difference in tax rates - dividends are taxed lowest, then capital gains, then interest. The above chart shows what tax type of revenue each type of security gives off.
• constancy, reliability of cash flows and return vs risk - securities that return cash on a steady guaranteed basis tend to offer lower returns - it's the old story of less risk equals less return. The big question is whether the lower returns will be sufficient to meet needs. For a long retirement, lower returns increases the possibility of running out of funds. To meet a short-term goal, safe and stable securities such as T-bills, GICs and Money Market funds are much wiser than volatile stocks or long-maturity fixed income.
  
• inflation - most of the fixed income categories, an exception being real return bonds, also offer little protection for unexpected inflation - see force #3 in Investing Principles - Minding the Immutable Forces. Over a long period, such as 20 years in retirement, inflation can drastically reduce buying power
  
• psychology - while withdrawing the cash arising from interest may be easy, it may be difficult to bring oneself to sell a holding to create cash; there can be more of a feeling that the portfolio is going down, despite the fact that in both cases the same amount of cash is coming out. This can be especially tough to do in current circumstances when many investments have gone down. The oft-noted reluctance of investors to sell losers (e.g. Terrence Odean's classic research paper Are Investors Reluctant to Realize their Losses?) can get in the way.

Everyone's total portfolio size and spending intentions vary so neither approach can always be best but hopefully these notes provide readers a way to plan.

Investing in Environmental Sustainability

Want to improve the environment and make money in the process? Then investing in environmental sustainability may be for you.

What is included in environmental sustainability?
These are companies whose products and services contribute in a positive way to the environment. Definitions can vary but they generally include the following sectors:

• Alternative and renewable energy - hydro, wind, solar, geothermal, biofuel / ethanol, energy from waste
  
• Clean technology - technologies that improve efficiency and lower energy consumption in buildings and transportation, to reduce global warming and CO2 emissions - things like advanced materials, batteries, green buildings
• Water efficiency, filtration, recycling
• Pollution control, cleanup and waste management

How to invest?
Mutual Funds - the available range includes only one Canadian equity fund focussed on the environment, the Acuity Clean Environment Equity Fund, and a dozen or so funds with global investments (download Jantzi's Canadian SRI Investment Review 2008 and go to page 15)

ETFs - one must buy funds traded on US exchanges to find environmentally-oriented ETFs. Most of the ETFs invest globally and most of the holdings are companies of medium to large size. Go to Stock Encylopedia's Ethical Funds, amongst which the good dozen of environmental funds can be found.

Companies - to find individual companies that may suit your investment criteria, save some time by clicking through to the holdings on the websites of the various funds. You will see companies that have passed the vetting of index researchers like Jantzi and KLD. Many of those companies are from around the world and not all can be bought on US exchanges. As a result they may not be easily accessible through a Canadian online discount broker.

An interesting option for buying Canadian is the series of power utility income trusts listed on Investcom, which coincidentally offer double-digit yields on distributions at the moment (though it is good to remember those high levels could/probably will go down once the tax change to income trusts goes into effect in 2011 as discussed in this previous post).

There is a challenge in that many if not most companies and sectors are involved to a greater or lesser degree in developing or using such technologies so it may be difficult to draw a line as to whether a company qualifies. For instance, one fund (Invesco Progressive Transportation ETF, symbol: PTRP on NASDAQ) includes CN Rail amongst its holdings.

Risks
As with any investment, there are risks to consider. Smaller, less established companies tend to be more prevalent, with attendant less stability of income and greater volatility (see the dramatic rise, then fall, in the chart below from Invesco Powershares of the Global Clean Energy index underlying one of these funds). Depending on the company, the technology may be unproven commercially. Concentrating in a sector increases risk. The funds themselves are often small with less active trading, which means the difference between buying and selling prices, a cost to the investor, is often much higher than broad market funds.


Are returns lower?
Does one sacrifice investment return to be environmentally progressive? There seems not to be a definitive answer on this score. The limited time many funds have been in existence makes it unreasonable to draw a conclusion. In 2007 and 2008, the environmental investor looking at the above chart would have been very pleased in outperforming two major broad market indices but 2009 sees them right back down.

Gold: the Why, What and How of Investing in It

The Chinese government is apparently now buying gold in a big way. Is it time for the individual investor to do so? You decide.

Why Invest in Gold?
A couple of reasons are often suggested:

• safe store of value - gold is a substance that has been sought after for thousands of years and will probably continue to be so for a long time yet; it is very durable, in limited supply and does not decompose or disappear when made into jewelry or put into industrial products. Unlike paper money, governments cannot arbitrarily print more of it out of thin air and thus gold may serve as protection against currency crashes and inflation.
• portfolio diversification as another asset class - gold's price has varied considerably over the years and is observed to be uncorrelated, or even negatively correlated with other investments (i.e.when stocks or bonds go up or down, gold is doing something very different), which reduces the variability and risk of a portfolio. See the chart and article Asset Class Correlations on Seeking Alpha and Gold: a Different Asset Class on Gold News.

How to Invest in Gold
There is a myriad of ways of varying degrees of risk, volatility and convenience. Most of these are available to a self-directed investor at discount brokerages. A good introductory description of the options is the Moneyweek Beginner's guide to investing in gold. All types of gold investments are eligible to be held in an RRSP or other registered account.

• Coins, bullion and bars - generally obtained through a gold dealer (e.g. Bank of Nova Scotia is well-known one) not through a brokerage though some like Questrade do offer them (however note that taking delivery from a registered account means de-registration / withdrawal of the gold's value)
• Certificates - are claims backed by physical gold stored in a bank or other secure location. You cannot take delivery of the gold but it solves the challenge of secure storage and facilitates buying and selling, which is usually done by phoning the brokerage's trading desk e.g. BMO Investorline sells certificates in USD (the usual currency conversion from CAD to USD if buying with Canadian dollars), the transaction fee is USD$35 flat plus $1 per ounce with a 5 oz. minimum purchase and no on-going storage fees, though other brokers may charge for storage.
• Stocks of companies that produce gold - highest risk since there is the effect of company competition, uncertainties of mining added to the varying price of the metal - see the huge fluctuations of the TSX company index vs the price of gold bullion on this TMX Money chart. Canada is one of the world leaders in gold production and there are a number of major companies to choose from - Kitco.com has a table with quotes and stock symbols of the twenty gold companies in the TSX Gold Index.
• Specialised ETFs and Mutual Funds - collective investment securities in either physical bullion or gold company stocks, or a combination of the two; GlobeInvestor has a filter to list Precious Metals mutual funds. TMX Money includes the nine currently available gold ETFs traded on the TSX within the comprehensive list of Canadian ETFs.

What Proportion of a Portfolio to Invest in Gold?
Most commentators suggest that gold should form a small percentage - 5 to 10% - of a diversified portfolio. Those who buy a Canadian equity market index fund should keep in mind that gold companies form a significant portion of that index, e.g. they represent 10% of the TSX 60 index.

Further Info and Gold Investing Websites:

• Kitco.com
• Gold Investments
• World Gold Council
• Shakespeare's Gold and Precious Metals page
• Gold and Silver Investments
• The Power of Gold, book by Peter Bernstein

Investing for Children: Building a Portfolio from Scratch with Regular Small Savings

Most portfolios for children start out small and are built up with savings, gifts and government grants or payments that come in month by month or year by year. In that circumstance, there are a couple of important practical challenges to building a portfolio which also conforms to the principles set out in early posts of this blog - controlling costs and diversifying for risk reduction through asset allocation.

Challenge #1 - Initial Purchase vs On-going Costs
Investing a small amount poses the practical problem of gaining effective diversification at reasonable cost. Even with low fees at discount brokerages, a $10 trade on a $100 purchase is a 10% cost - much too great. And buying only one stock or bond provides no diversification.

Option A - Buy Mutual Funds
There are many, many choices of stock and bond funds which allow purchase at no fee but the annual on-going fees may be too high. There are Index funds with low on-going fees of around 1% as well as actively managed (which try to outperform the market) equity funds whose fees are typically around 2.5%.

Option B - Accumulate Savings and Buy ETFs
Save up $1000 in cash and the $10 commission now only costs 1%. ETFs compensate for this cost by typically having much lower on-going annual fees as low as 0.1% (for whole of market equity index funds). In addition to the original passive index funds, ETF choices have expanded to many varieties of stock and bond groupings: industry sectors, countries/regions, size of market cap, strategies (dividend, growth, bearish, leveraged etc) (see Stock Encyclopedia listing)

Challenge #2 - Diversification and Portfolio Size
Within a small portfolio, having a multitude of tiny holdings will probably be costly, difficult, time-consuming and not worth the effort to keep the asset classes in the proportions of the intended asset allocation.

Option A - Individual Holdings of Fewer Asset Classes
Keep it simple. Start with fewer asset classes, adding as the portfolio grows.

Account / portfolio of < $10,000
Four asset classes provide effective diversification:

• Fixed Income - such as a total market bond fund
• Canadian Equity
  
• US Equity
• International Equity - e.g. a fund based on the MSCI Europe, Australasia, Far East (EAFE) index

Portfolios of $10,000 - 25,000
Consider adding:

• Real Estate - typically done with a REIT fund
• Emerging Market Equity - the MSCI EAFE excludes dramatically growing but risky markets such as India, China and Russia

Portfolios of $25,000+
Individual stock and bond holdings become feasible as a large enough number can be bought to achieve reasonable diversification. Additional asset classes to consider:

• Real Return bonds
• US Fixed Income
• Commodity - again through various funds
  
• US Small Cap Equity
• US Value Equity

Option B - Buy Portfolio Fund of Funds
In this case you buy only one holding. The fund company does all the work of buying the different asset classes and keeping them in balance. The issues to examine: is the extra fee charged, anywhere from 0.25 to 1%, worth it (on a $10,000 portfolio that's $100 in extra fees per year) and is the asset allocation what you want. Both mutual funds and ETFs are available. See Bylo Selhi's list of ETFs here and no-load indexed portfolio mutual funds here. CanadianFinancialDIY compares two ETF growth portfolio funds from iShares and Claymore and finds both are reasonably good.

Investing for Children: RESP or In-Trust For Account?

Suppose parents or grandparents want to set aside money for a child. Or suppose a minor child (under age 18 or 19 depending on the province) receives a significant inheritance, or has part-time or summer job earnings that you think should be put away to grow, perhaps for higher education or an eventual house purchase.

The money will be safe in a bank account but not earning much. GICs are also safe but grow slowly. If the intended spending is many years away, investing is an attractive option but there is a problem - legal restrictions prevent minors from opening an investment account in their own name.

Two options may provide a solution. Both are typically available at discount brokerages. The new TFSA is not an option since only those 18 and over can have one in their name.

Registered Education Savings Plan (RESP)
This is a special plan created by the Government of Canada to assist savings for post-secondary education by allowing tax-free growth inside the plan and by providing extra grants, the Canada Education Savings Grant (CESG) for everyone and the Canada Learning Bond for lower income families (details at CanLearn.ca).

Informal Trust aka In-Trust For - (ITF) Account
In such an account, a parent or other adult acts as trustee to manage investments on behalf of the child, who becomes legally entitled to take over at the age of majority. In this type of account, there is no restriction for how or when the funds may be withdrawn and spent (Invesco Trimark describes the basics here).

There are many important differences between RESPs and ITFs in terms of control, ownership, flexibility, grant availability and especially taxation, some of the key ones of which are summarized in the chart below. RESPs and ITFs are essentially equal when it comes to investing itself as all types of stocks and bonds are allowed in both and in allowing virtually anyone to contribute.

Assuming that the possibility of further education is a goal and other things being equal, my take on how RESPs and ITFs shake out are this:

• it is worth contributing enough to the RESP to get the full government grant money, which means making contributions over a period of years, instead of all at once
• if there is enough money, put the max CESG amount in the RESP and the rest in an ITF
  
• to keep things simple, parent or grand-parent money should go into the RESP before it goes into the ITF
  
• put the child's own money into an ITF; in this case, the tax attribution complexity doesn't arise; there will be no taxes for the child to pay unless the sum to invest is very large and produces more than the basic personal tax-free allowance in income every year (e.g. in 2009 the personal allowance is $10,320, which is equivalent to 6% on $172,000)

Of course, things are never exactly equal or the same for every person, so it behooves readers to think carefully about the various factors before deciding what to do. Form-filling and trustee arrangements (separate persons to be trustee and contributor) in compliance with laws and regulations, especially with regard to the ITF option, is critical if the tax benefits are not to be denied by the Canada Revenue Agency. This blog post is not advice. It may well be worth getting proper accounting or legal advice.

More Background:

• Formalizing Informal Trusts by Teresa Gombita on CA Magazine
• Don't let trust accounts be a taxing issue by Arthur Drache at the Financial Post
• Comparing education savings options at Investored.ca
  

How Long Till the Stock Market Recovers?

From time immemorial astrologers have been foretelling the future. They are still at it. Back in January, Vedic Astrologer said the stock market will be good in March (correct), bad in April (wrong), good in May (correct) and June but "A New Moon Solar Eclipse in July 2009 will not be good for Stock Market; there may be some crisis in Stock Market."

Those with a more rationalist bent may discount such prognostications but the question of how long it will take before the stock market regains former highs or even begins rising is an important and valid issue. Various methods propose an answer.

The History of Past Downturns and Recoveries
There have been dramatic stock market downturns associated with severe economic slumps similar to the current episode in the past. The most extreme example is the the 1929 crash and depression that followed. Crestmont Research's Stock Matrix Options chart shows that a taxable US investor who had invested at the peak in 1929 would have had to wait 22 years to break even after inflation with an investment in the S&P 500. Will it be as bad this time?

Fund provider IFA's Probability of Portfolio Recovery page graphs in figure 9-B the chances that portfolios with various mixes of stocks and bonds will recover within a certain number of years. The graph says two significant things:

• full recovery will probably take a long time - e.g. a portfolio of 50% stocks and 50% bonds is 90% sure to fully recover in 14 years, though there is a 50% chance it could be only 7 years
  
• portfolios with a lower proportion of stocks will likely recover more quickly than one with just stocks since they will not have fallen so much in the first place
  

Secular Market Cycles
This approach maintains that stocks markets go through long term cycles in which stock prices rise unduly compared to earnings and thus the Price to Earnings Ratio (P/E) goes above the normal long term average of about 15x. John Mauldin in While Rome Burns graphs the excessive rise in P/E in recent years and shows that in past cycles, the inevitable correction drove prices and the P/E down below the average. The suggestion is that the correct market downturn may not be over yet and a new bull market probably won't start till the middle of the next decade, after which returns climb strongly again.

Robert Schiller, the author of investing book Irrational Exuberance, expounds a similar view in this Yahoo Finance article and video clip, saying that the S&P 500 P/E is likely to go down to 10x from its current 14x before climbing again.

Credit Crises, Real Estate Slumps and Market Crashes
A third method of trying to figure out when bad times might end and good times return comes from economic studies. International Monetary Fund researchers posted Global Financial Crisis: How Long? How Deep? over at Vox EU in which they summarized past episodes of such crises - yes, they have happened before, though not on a global scale - and found that recessions could last up to four years with stock market declines of up to 50%.

Lessons for an Investor:

• stock / equity investing is for the long term, at least ten years, better 15 years;
• reasonable expectations will increase patience in the downturn, avoiding the error of selling after the downturn; cautious expectations will also improve investment planning
  
• a portfolio approach is the way to go: mixed portfolios of stocks and bonds cope better with market cycles
• portfolio composition needs to be aligned with investment objective time frames
• markets do recover, even extreme downturns are eventually followed by upward cycles
  

Investing for Children: Getting the Goal and Timing Right for Education

A successful plan to invest for a child's post-secondary education must address:

• the cost of the education
  
• the timing of the studies to determine when funds will be required
  
• the variability of various types of investments and their respective returns in the short and long term - stocks do best over long periods but may suffer severe ups and downs in the short term

Total Cost of Education
Develop an estimate of how much you will need to save using the excellent Investored.ca Calculator, where you can enter many variables such as: number of children, current age, duration of post-secondary program, age to start post-secondary studies, live at home or in residence with or without meal plan with actual recent costs for tuition for both college and university and room and board by province. You can select to add in or not the Canada Education Savings Grant.

Timing of Spending
18 years is the usual youngest age when post-secondary education starts, but it can be delayed which may warrant keeping more of the investment assets in more volatile stocks longer. This is a difficult call since young people can change their minds quickly and decide suddenly that they do want to go back to school after all. Such delightful news to a parent should not be marred by discovering that the stock market is in a downturn and the required funds are less than a year previous. There does come a time when the education goal, having not yet been pursued, becomes unlikely and it is best to shift investment goals.

Higher education lasts two to four years, perhaps longer if higher, higher education is pursued. The cash needs to be made available over that span, so investments that mature in time with each new school year make sense.

The Time-to-Spending Asset Mix
The longer there is before the funds will be needed, the greater the proportion of the investment asset mix should be in stocks, which provide higher long term returns than bonds, GICs, money market funds or plain old cash earning interest. One critical caveat - if a large lump sum (like an inheritance) sufficient to fully fund any higher education comes along, then merely protecting that capital against loss and inflation may well be the wisest approach. Most people do need to take advantage of higher stock returns (e.g. 4.5-7% for stocks vs 2-4% for bonds vs 0-2% for T-bills; see these summaries of past and future expected returns at CanadianFinancialDIY and the Bogleheads forum)

Example Asset Mix Over a Childhood
Birth: 80% Equity & Other, 20% Bond
Age 13-14: Child still headed for higher education?

• Yes - shift to 40% Equity, 40% Bond, 20% Cash (incl GIC, Money Market Funds, T-bills)
• No - maintain asset mix to serve different long term goals (e.g. house purchase)

Ages 15-18, assuming still headed for higher ed

• Shift another 10% a year into Cash till it is 100% Cash

Variations of the percentages and ages of shifting are possible but the idea is that as the time for spending approaches less and less should be in riskier, more variable investments and more in the stable, safe, liquid investments.