Death is bad enough for the person involved without the potential for taxes on investments to add pain for the inheritors of whatever legacy is left behind. Fortunately there are a few choices that an investor can make in a Will or that an Executor can make after death to minimize the damage of the grim tax reaper. We'll say in advance that the following is meant to give readers an awareness of some worthwhile options. Due to the complexities of tax law inter-acting with the details of individual situations, this is one area of investing where consulting professionals like lawyers and accountants is advisable especially where large sums are at stake. You only die once and there is no second chance to do it right.
The Law: No inheritance tax, capital gains on deemed disposition instead
Canada has no inheritance tax on assets. Instead, tax law dictates that all assets are deemed to have been sold on the day of death at fair market value. As a result, capital gains calculations must be done for the deceased taxpayer and the income reported on the return for the year of death. It's the day of reckoning - no more deferral of capital gains.
In addition, tax-deferred (RRSP, RRIF, LIRA, LRIF etc) and tax-exempt TFSAs of the taxpayer are forced to end and everything is considered to have been withdrawn in the year of death. For example, someone with a $250,000 RRIF balance will have that much income on their year of death final return, putting them into the highest tax bracket. RRSP contributions that years before may have received a refund based on much lower marginal tax rate suddenly are reclaimed at the top marginal rate. Ouch! Considering that a taxpayer may have other assets like a family cottage that has accumulated a large capital gain but which the children do not want to sell to pay the tax, the sudden large tax hit may cause cash flow problems. Big financial worries are not welcome at a time that is already emotionally stressful. What can be done?
Transfer RRSP / registered plan or TFSA to spouse
If there is a surviving spouse (or common law partner or financially dependent children and grandchildren), the deemed disposition of such plans can be avoided by naming the spouse as beneficiary to the plan issuer / administrator (e.g. the online brokerage like BMO InvestorLine etc). The Income Tax Act allows this. The surviving spouse in effect steps into the deceased's shoes and continues on. There is no effect or dependence on the survivor's contribution limits or room. See TaxTips.ca's Death of a TFSA holder and Canada Revenue Agency's TFSA Guide and Death of an RRSP Annuitant for details. Estate Planning for RRSPs at the CGA website explains some of the mechanics how all this is accomplished and gives an informative example.
An added benefit is that such direct transfers avoid the registered plan assets being taken into the Estate of the deceased and being subject to another tax, the provincial probate fees. In some provinces probate fees/taxes are minimal, while in others like Ontario and Nova Scotia, they can be substantial for larger estates (see TaxTips.ca tables for each province).
Implement a Spousal Rollover
The law allows the Executor to decide, after death and presuming it is also in accord with provisions of the Will about who inherits pieces of the estate, to rollover assets to the spouse (or the same qualified beneficiaries as above) in order to avoid deemed disposition. The spouse takes over the assets at the same Adjusted Cost Base the deceased had.
The rollover is a more general case of the RRSP rules i.e. it also can apply to non-registered accounts and assets. That can be very beneficial in avoiding a large immediate tax hit if there is a large accumulated unrealized capital gain in an unregistered portfolio. Lawyer John Mill in his Succession [Tax Counsel] blog article Spousal Rollover - the most valuable tax plan? provides more detail on how rollovers work and when there are or are not useful.
One situation where they might not help is if the deceased taxpayer has accumulated capital losses of previous years to offset potential gains from deemed disposition.
The Executor is allowed to decide to rollover, which is the default, or opt out of it. Deciding exactly what to do can get quite involved as the rollover is allowed on a property by property basis (see Tax Specialist Group's Electing Out of a Spousal Rollover on Death) e.g. one stock with no unrealized gain might not be rolled over while another with a large gain might be to avoid triggering immediate tax in the final return. When a Will divides an Estate amongst a spouse and children for example, the spouse could receive assets with gains to rollover while children get assets with no unrealized gains. If the deceased taxpayer pays less, everyone gets more. However, if the Will gets too specific about who gets what assets, that may not be possible - a Will drafted with good professional tax advice and properly written with good legal advice becomes ever more important the more investments there are and the more complicated the situation.
Consider a post-death contribution to a spousal RRSP
To obtain a RRSP deduction and reduce taxable income in the year of death on the final return of the deceased taxpayer, the Executor can make a contribution to a spousal RRSP within 60 days of the date of death. Death and Taxes in the CGA magazine discusses this option amongst others.
Set up a Testamentary Trust(s) in the Will
Testamentary Trusts, most commonly created by a Will, begin when a person dies. They hold assets on behalf of one or more beneficiaries. The key benefit is that they are treated as a separate taxpayer under tax law. That means that income splitting between spouses can continue. The trust is taxed at graduated rates just like an individual. Two income streams, one from the trust containing the deceased taxpayer's assets and one from the surviving spouse can each pay at a lower rate than the combined larger income would. Properly written, the Trustee (often set up to be the surviving spouse) can decide whether and how much of the income to have taxed in the Trust or to be distributed to the beneficiary for taxation in his/her hands year by year. RRSP money can go into a Testamentary Trust.
The biggest limitation is that the Trust is not allowed to distribute capital losses to the beneficiary. Losses can only be used to offset capital gains within the Trust. Capital gains on the other hand, may be distributed to the beneficiary.
There's another benefit. Rollover rules apply, so assets can be rolled over into a Spousal Testamentary Trust, avoiding deemed disposition and deferring the realization and taxation of capital gains.
Though a non-Spousal Testamentary Trust, e.g. a Testamentary Trust for non-financially dependent children, cannot benefit from rollover, it can still provide income-splitting tax advantages for them. A high-earning top tax bracket adult child might benefit from receiving an inheritance from a parent not directly but indirectly in a Trust, which they could control if named as trustee with full discretion, since the income could be taxed in the Trust at a lower rate. See McEwan & Co Law Corp's Estate Planning page for more detail on ins and outs of Testamentary Trusts in amongst other topics.
A separate account to manage a Testamentary Trust can be set up at most online brokers. It should also not add much to lawyer's fees for writing a Will.
Check out the possible tax benefit of carryback of Capital Losses
Special unique tax rules apply upon and just after death, when the deceased's investments pass temporarily into the Estate, pending distribution to the people named in the Will. The Estate is a separate taxpayer from the deceased person and from the subsequent inheritors or Trusts such as those discussed above. In fact, the Estate itself is a Trust.
After death, the financial world doesn't stop. Interest on bonds is received, dividends too. When the Executor takes control after the Will has been approved by a court through probate (cautious financial institutions won't let Executors trade until probate is done) there may be buying and selling of securities within the Estate. Normally, as a separate taxpayer the Estate would have to compute and report its own taxes. The special rules of Subsection 164(6) allow the Executor to carryback capital losses in the Estate, incurred up to a year after death, to the final return of the deceased taxpayer.
Another special rule allows capital losses, normally deductible only against capital gains, incurred during the year up to the date of death to be deducted against any type of income in the final return and in the return of the year preceding death (which if already filed would be done with an adjustment form - see CRA's T-4011 Preparing Returns for Deceased Persons 2012 and the T-4013 T3 Trust Guide). However, the Estate carryback can only be applied to the final return, not also to the preceding year.
As we said at the outset, if you are not already convinced of the usefulness of professional advice when it comes to carrying out these strategies, please consider it. The words of Albert Einstein, one of history's most brilliant thinkers, merit reflection: "The hardest thing in the world to understand is the income tax." That he said this talking to his accountant shows he was also smart enough to know the limits of his own skills.
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, 21 June 2013
Friday, 14 June 2013
Building Your Own Index ETF
Ever thought of building and managing your own equity portfolio using ETF-like index methods? Let's explore how much time, trouble and cost it takes.
The Basic TSX Composite
The TMX Money website lists all the 237 constituents of the TSX Composite Index but not the proportion of each stock, which is needed to know how much of each to buy, so we must turn to BMO, which offers an ETF that tracks the index. Well, almost. The BMO offering traded under symbol ZCN tracks a version of the Composite Index which caps the maximum holding of each stock at 10% of the total fund. BMO does post the percentage weight allocation of each holding, but not the industry Sector each stock belongs in. iShares Canada has an ETF (symbol: XIC) that tracks the same index and it does post the Sector for each stock.
Our comparison table shows the end result ETF-like portfolio, as well as the workings described below.
Challenge #1 - Too many stocks to buy, picking a representative subset
An attempt to buy and hold all 237 stocks is would overwhelm even the most enthusiastic individual investor. We winnow the list down drastically and yet maintain something representative of the index by taking about 10%, or 24, of the stocks, spreading them across the various Sectors.
The principle upon which the Composite Index / ZCN is based is that each stock should be weighted and held in proportion to its total market value of shares, or market cap. We sorted the downloaded ZCN holdings by Sector and market cap and then took 10% of the stocks within each Sector, ensuring that each Sector was represented by at least one holding. For example, there are only four Health Care stocks in ZCN, so we selected one, Valeant Pharmaceutical, which has the largest market cap. As a result of picking more than 10% in small Sectors our final list of stocks expanded a bit to number 26 in total.
Maintaining the proper Sector weight, which is shown on the BMO holdings page for ZCN, required us to ramp up the allocation to each stock, done in proportion to the share each stock occupies in the Sector. That meant, for example, that Magna and Thompson Reuters went from 1.12% and 0.86% weighting respectively in ZCN, to 3.04% and 2.33% in our home-made ETF to keep the Consumer Discretionary Sector weight total at 5.37%. One of the good and encouraging figures we notice is that the end result 26 stocks make up fully half of the total market value weight out of the 237 original list. It doesn't take many stocks to represent a big chunk of the index.
Challenge #2 - Smaller weight stocks suggest a large amount of capital is required
The next part of our experiment was to estimate how much to buy of each stock. It quickly became apparent that the smaller weight holdings would require low dollar amounts and very few shares. Our example table uses a total portfolio size of $100,000 and even then the smallest holdings are quite puny, like First Quantum Minerals which gets $1269 allocated to it. There would be only 16 shares to buy of Canadian Pacific Railway.
Challenge 3# - Maintenance requires monitoring and trading
The world, and markets, don't stop the day shares are bought. Though the market cap basis of this pseudo-ETF means that values of Sectors will generally stay reasonably in line with the overall index, when non-included companies go up more than the overall Sector, our ETF will go out of whack. In addition, acquisitions and divestitures, mean companies enter or disappear from the index (index creator and maintainer S&P Dow Jones publishes changes as required here). Some trading will be required and expenses incurred.
Testing the feasibility of a novel ETF-like strategy - fundamental weighting of low volatility stocks
Despite the plethora of ETFs, some slants are not yet covered. Inspired by previous blog posts where we wrote about promising alternative index methods like fundamental weighting and low volatility stock selection plus this article - An Investor's Low Volatility Strategy - from Research Affiliates that advocates a combination of the two investment strategies, we decided to put our own home-grown version together.
The idea is to select the least volatile stocks from the fundamental index and to correct the small cap and Sector bias of a typical low volatility index. This is done by ensuring a) the stocks selected are the largest, as measured obviously by the fundamental factors sales, dividends, cash flow and book value (instead of market cap as the TSX Composite does), and b) that the Sector weights of the fundamental index are maintained. There is no such ETF on the market so we have built our own for Canadian stocks and the result is shown below.
The PowerShares FTSE RAFI Canadian Fundamental Index ETF (PXC) already selects the largest Canadian companies by fundamental factors. From amongst those we have taken the third (c.29 of 88 stocks) with the lowest volatility,as measured by Beta (figures obtained from the Globe's My WatchList tool where we entered all of PXC's stock stock symbols).
In this portfolio we ended up with 30 stocks after applying the rule to select at least one stock from each industry Sector. Those 30 stocks only represent 35% of the value of the original PXC portfolio, much less than the ZCN-imitator. On the other hand, two companies alone, TD Bank and TransCanada Corp each make up an uncomfortably large 13% of the total portfolio. A mere five of the financial and energy stocks make up half the portfolio, quite a concentrated portfolio. There is a lot more difference in weight than in our first portfolio effort above between between the largest and the smallest holdings. The smallest holdings are really small, much more so than the ZCN-clone.
As both volatility and fundamental weights evolve, there would be a requirement for more monitoring and probably more rebalancing trading. In short, though the paper reveals some very attractive backtested performance results for such a strategy, it does not look very practical for the individual investor to do him or herself.
Conclusion: For tracking a broad index, building your own ETF-like portfolio isn't worth the time and effort. BMO's ZCN charges 0.15% annually, which would be $150 on a $100,000 holding, ZCN holds the entire portfolio to boot, providing even greater diversification and, BMO does all tracking and rebalancing trading for the investor.
For constructing a portfolio to implement a trading strategy that has index features, it also looks to be impractical. Better to wait for an ETF provider to implement the strategy on a scale that avoids introducing concentration and holding size problems, providing of course that the fees are reasonable.
When it might make sense to build your own ETF-like portfolio - if the index has very few constituents - Specialized ETFs, such as those for individual Sectors, can sometimes be effectively copied with a handful of holdings. For example, the Canadian REIT Sector has only a handful of companies. iShares' REIT offering has 14 holdings, while BMO's has 19. Taking a handful of the main companies may replicate the Sector very effectively. Several years ago, Stingy Investor looked at various Sectors and whether unbundling them, as he termed it, made sense.
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.
The Basic TSX Composite
The TMX Money website lists all the 237 constituents of the TSX Composite Index but not the proportion of each stock, which is needed to know how much of each to buy, so we must turn to BMO, which offers an ETF that tracks the index. Well, almost. The BMO offering traded under symbol ZCN tracks a version of the Composite Index which caps the maximum holding of each stock at 10% of the total fund. BMO does post the percentage weight allocation of each holding, but not the industry Sector each stock belongs in. iShares Canada has an ETF (symbol: XIC) that tracks the same index and it does post the Sector for each stock.
Our comparison table shows the end result ETF-like portfolio, as well as the workings described below.
(click on image to enlarge)
An attempt to buy and hold all 237 stocks is would overwhelm even the most enthusiastic individual investor. We winnow the list down drastically and yet maintain something representative of the index by taking about 10%, or 24, of the stocks, spreading them across the various Sectors.
The principle upon which the Composite Index / ZCN is based is that each stock should be weighted and held in proportion to its total market value of shares, or market cap. We sorted the downloaded ZCN holdings by Sector and market cap and then took 10% of the stocks within each Sector, ensuring that each Sector was represented by at least one holding. For example, there are only four Health Care stocks in ZCN, so we selected one, Valeant Pharmaceutical, which has the largest market cap. As a result of picking more than 10% in small Sectors our final list of stocks expanded a bit to number 26 in total.
Maintaining the proper Sector weight, which is shown on the BMO holdings page for ZCN, required us to ramp up the allocation to each stock, done in proportion to the share each stock occupies in the Sector. That meant, for example, that Magna and Thompson Reuters went from 1.12% and 0.86% weighting respectively in ZCN, to 3.04% and 2.33% in our home-made ETF to keep the Consumer Discretionary Sector weight total at 5.37%. One of the good and encouraging figures we notice is that the end result 26 stocks make up fully half of the total market value weight out of the 237 original list. It doesn't take many stocks to represent a big chunk of the index.
Challenge #2 - Smaller weight stocks suggest a large amount of capital is required
The next part of our experiment was to estimate how much to buy of each stock. It quickly became apparent that the smaller weight holdings would require low dollar amounts and very few shares. Our example table uses a total portfolio size of $100,000 and even then the smallest holdings are quite puny, like First Quantum Minerals which gets $1269 allocated to it. There would be only 16 shares to buy of Canadian Pacific Railway.
Challenge 3# - Maintenance requires monitoring and trading
The world, and markets, don't stop the day shares are bought. Though the market cap basis of this pseudo-ETF means that values of Sectors will generally stay reasonably in line with the overall index, when non-included companies go up more than the overall Sector, our ETF will go out of whack. In addition, acquisitions and divestitures, mean companies enter or disappear from the index (index creator and maintainer S&P Dow Jones publishes changes as required here). Some trading will be required and expenses incurred.
Testing the feasibility of a novel ETF-like strategy - fundamental weighting of low volatility stocks
Despite the plethora of ETFs, some slants are not yet covered. Inspired by previous blog posts where we wrote about promising alternative index methods like fundamental weighting and low volatility stock selection plus this article - An Investor's Low Volatility Strategy - from Research Affiliates that advocates a combination of the two investment strategies, we decided to put our own home-grown version together.
The idea is to select the least volatile stocks from the fundamental index and to correct the small cap and Sector bias of a typical low volatility index. This is done by ensuring a) the stocks selected are the largest, as measured obviously by the fundamental factors sales, dividends, cash flow and book value (instead of market cap as the TSX Composite does), and b) that the Sector weights of the fundamental index are maintained. There is no such ETF on the market so we have built our own for Canadian stocks and the result is shown below.
(click on image to enlarge)
The PowerShares FTSE RAFI Canadian Fundamental Index ETF (PXC) already selects the largest Canadian companies by fundamental factors. From amongst those we have taken the third (c.29 of 88 stocks) with the lowest volatility,as measured by Beta (figures obtained from the Globe's My WatchList tool where we entered all of PXC's stock stock symbols).
In this portfolio we ended up with 30 stocks after applying the rule to select at least one stock from each industry Sector. Those 30 stocks only represent 35% of the value of the original PXC portfolio, much less than the ZCN-imitator. On the other hand, two companies alone, TD Bank and TransCanada Corp each make up an uncomfortably large 13% of the total portfolio. A mere five of the financial and energy stocks make up half the portfolio, quite a concentrated portfolio. There is a lot more difference in weight than in our first portfolio effort above between between the largest and the smallest holdings. The smallest holdings are really small, much more so than the ZCN-clone.
As both volatility and fundamental weights evolve, there would be a requirement for more monitoring and probably more rebalancing trading. In short, though the paper reveals some very attractive backtested performance results for such a strategy, it does not look very practical for the individual investor to do him or herself.
Conclusion: For tracking a broad index, building your own ETF-like portfolio isn't worth the time and effort. BMO's ZCN charges 0.15% annually, which would be $150 on a $100,000 holding, ZCN holds the entire portfolio to boot, providing even greater diversification and, BMO does all tracking and rebalancing trading for the investor.
For constructing a portfolio to implement a trading strategy that has index features, it also looks to be impractical. Better to wait for an ETF provider to implement the strategy on a scale that avoids introducing concentration and holding size problems, providing of course that the fees are reasonable.
When it might make sense to build your own ETF-like portfolio - if the index has very few constituents - Specialized ETFs, such as those for individual Sectors, can sometimes be effectively copied with a handful of holdings. For example, the Canadian REIT Sector has only a handful of companies. iShares' REIT offering has 14 holdings, while BMO's has 19. Taking a handful of the main companies may replicate the Sector very effectively. Several years ago, Stingy Investor looked at various Sectors and whether unbundling them, as he termed it, made sense.
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, 10 June 2013
Corporate Sustainability (aka SRI/ESG) in Canadian Consumer Stocks
Last November when we first explored the idea of investing according to principles of social responsibility (abbreviated to SRI), often also called Environmental, Social and Governance (ESG) investing, or simply Corporate Sustainability, we focussed on the available SRI/ESG mutual funds and ETFs and used them to look at recent performance of the stocks held in these funds.
Today, we'll return to the topic. A first motive is that those funds are the not final word on which companies merit inclusion. They do not necessarily include all stocks that meet Sustainability principles since the funds attempt to have a mix of holdings across many sectors and thus may neglect worthy companies. Second, there is growing evidence that investors can make money by paying attention to Sustainability. The paper The Added Value of ESG/SRI on Company and Portfolio Levels – What Can We Learn From Research? reviews the literature and finds a positive relationship between company financial performance and the adoption of Sustainable practises. In another paper, The Impact of Corporate Sustainability on Organizational Processes and Performance, Harvard Business School researchers Robert Eccles, Ioannis Ioannou and George Serafeim found that SRI/ESG adopters outperformed both in stock market and accounting terms. Moreover, "The outperformance is stronger in sectors where the customers are individual consumers instead of companies, companies compete on the basis of brands and reputations ...".
Therefore, we will focus on consumer facing companies.
Finding the consumer stocks
Using the free TMX Money stock screener, we selected the Consumer Defensive sector to extract an inital list, cutting it off at companies with $1 billion or more in market cap, to which we added hardware retailer Rona Inc and fast-food vendor Tim Hortons and from which we removed three companies (Saputo, Maple Leaf Foods and Canada Bread) that don't deal directly with consumers.
Getting the "green" info
Unfortunately, and hopefully this will change soon since the data is useful and important to a growing number of individual stock investors, it is not easy to get the data on how much or well companies have implemented Sustainable policies. Bloomberg and Thompson do compile such data and it is available to institutional investors paying the hefty fees but the individual investor is left to troll through corporate documents like the annual report, the management information circular (aka the proxy circular) or presentations freely available on the company Investor Relations website area or on Sedar (under the Search Database tab). So that's what we did and compiled the comparison table below, which we note may not be 100% accurate since some factors are often not very clearly explained - especially the degree to which to which executive compensation is tied to ESG results.
Three key Sustainability factors
The Harvard paper says three indicators explain best the combination of Sustainability adoption and financial success of consumer-facing companies:
The results - who is green who is not
There are twelve companies in our list:
Have the more Sustainably-oriented companies attained higher profitability and stock returns?
Alas, the answer at the moment seems to be No. The company with the best trailing profitability, as seen in Return on Equity and Return on Assets, is the non-SRI/ESG Jean Coutu Group. The company with best five-year compound stock total return is Alimentation Couche Tard, also non-SRI/ESG.
It is encouraging, though we should remember that it may simply reflect the general market trend of what has been a popular sector lately, that all but two of the stocks have given off returns vastly ahead of the overall TSX index, as shown in the table by the iShares S&P/TSX Composite ETF (symbol: XIC).
All in all, the short term results are a reminder of what the researchers found. Adopting Sustainability practices is a long term strategic choice that pays off in the long term and on average. Not every high Sustainability company will do gangbusters, or even necessarily avoid major troubles. Nor will companies that ignore such practises go down the tubes or be financial laggards. The investor needs to undertake normal stock investment assessment as well.
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.
Today, we'll return to the topic. A first motive is that those funds are the not final word on which companies merit inclusion. They do not necessarily include all stocks that meet Sustainability principles since the funds attempt to have a mix of holdings across many sectors and thus may neglect worthy companies. Second, there is growing evidence that investors can make money by paying attention to Sustainability. The paper The Added Value of ESG/SRI on Company and Portfolio Levels – What Can We Learn From Research? reviews the literature and finds a positive relationship between company financial performance and the adoption of Sustainable practises. In another paper, The Impact of Corporate Sustainability on Organizational Processes and Performance, Harvard Business School researchers Robert Eccles, Ioannis Ioannou and George Serafeim found that SRI/ESG adopters outperformed both in stock market and accounting terms. Moreover, "The outperformance is stronger in sectors where the customers are individual consumers instead of companies, companies compete on the basis of brands and reputations ...".
Therefore, we will focus on consumer facing companies.
Finding the consumer stocks
Using the free TMX Money stock screener, we selected the Consumer Defensive sector to extract an inital list, cutting it off at companies with $1 billion or more in market cap, to which we added hardware retailer Rona Inc and fast-food vendor Tim Hortons and from which we removed three companies (Saputo, Maple Leaf Foods and Canada Bread) that don't deal directly with consumers.
Getting the "green" info
Unfortunately, and hopefully this will change soon since the data is useful and important to a growing number of individual stock investors, it is not easy to get the data on how much or well companies have implemented Sustainable policies. Bloomberg and Thompson do compile such data and it is available to institutional investors paying the hefty fees but the individual investor is left to troll through corporate documents like the annual report, the management information circular (aka the proxy circular) or presentations freely available on the company Investor Relations website area or on Sedar (under the Search Database tab). So that's what we did and compiled the comparison table below, which we note may not be 100% accurate since some factors are often not very clearly explained - especially the degree to which to which executive compensation is tied to ESG results.
Three key Sustainability factors
The Harvard paper says three indicators explain best the combination of Sustainability adoption and financial success of consumer-facing companies:
- Separate Board of Directors committee devoted to Sustainability - If it important enough to the company that the top level policy people are paying attention, it apparently gets done.
- Executive compensation tied to Sustainability - If the top managers' pay depends on doing it, then they tend to do it.
- Formal stakeholder engagement processes are in place - The existence of mechanisms like surveys, focus groups and audits, to engage with customers, with employees, with the communities where they operate and with suppliers reduces risk and improves adaptability of the companies.
The results - who is green who is not
There are twelve companies in our list:
- Only three seem to have adopted none of the three key actions - Rona, Alimentation Couche-Tard and Jean Coutu.
- None has adopted every single measure either.
- All four companies that are held by the iShares Jantzi Social Index Fund (symbol: XEN) - Tim Hortons, Loblaw, Canadian Tire and Shoppers Drug Mart - have adopted at least one of the key measures. It would have been a surprise otherwise.
- Some companies do appear to be further down the path of making Sustainability an integral part of their business at every level from strategy to daily operations, notably Metro, Tim Hortons, Loblaw, Canadian Tire and Shoppers Drug Mart. Metro, Canadian Tire and Tim Hortons all regularly publish a separate report with multiple metrics on Sustainable activity and performance.
(click on image to enlarge)
Have the more Sustainably-oriented companies attained higher profitability and stock returns?
Alas, the answer at the moment seems to be No. The company with the best trailing profitability, as seen in Return on Equity and Return on Assets, is the non-SRI/ESG Jean Coutu Group. The company with best five-year compound stock total return is Alimentation Couche Tard, also non-SRI/ESG.
It is encouraging, though we should remember that it may simply reflect the general market trend of what has been a popular sector lately, that all but two of the stocks have given off returns vastly ahead of the overall TSX index, as shown in the table by the iShares S&P/TSX Composite ETF (symbol: XIC).
All in all, the short term results are a reminder of what the researchers found. Adopting Sustainability practices is a long term strategic choice that pays off in the long term and on average. Not every high Sustainability company will do gangbusters, or even necessarily avoid major troubles. Nor will companies that ignore such practises go down the tubes or be financial laggards. The investor needs to undertake normal stock investment assessment as well.
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, 31 May 2013
Investing Big Stuff vs Small Stuff
We've all heard the expression "don't sweat the small stuff", a wise admonition to focus on what is important. But what is the big important stuff when it comes to investing? In today's information age, there is a deluge of data and advice that can easily confuse and mask what really makes a difference to our long term lifetime (say 30 or 40 years) investing prosperity. Therefore, today we will take a shot at identifying the key issues and quantifying their impact.
#1 Not Saving Money - Impact = 100%
It's almost embarrassingly obvious but if there is no money set aside out of income for investment, there can be no growth. The more savings, the greater the eventual total. Moreover, the earlier in life that money can be set aside, even small amounts, the more time that the benefits of compound growth can accumulate (earnings reinvested generate more earnings - see the difference compounding makes in Fidelity's growth calculator).
#2 Chasing Performance or Headlines - Impact = 3 to 5% per year
This is another story familiar to, and sadly applicable to, many investors. Buying into funds or stocks that have done really well recently, only to see subsequent stagnation or worse, losses, as performance cools off. The evidence comes from numerous sources, one well-known example being the annual reports by Dalbar Inc, which document (e.g. the 2013 press release which showed 3.96% under-performance of US equity investors) that investors have chronically under-performed the funds in which they have invested through poor timing.
Another way to see the issue is the panel insert "Dangers of Market Timing" within the superb Big Picture inter-active chart of the TSX going back to 1935 at the Get Smarter About Money website of the Investor Education Fund. There was about a two and a half times difference in total growth between being continually invested in the stock market and missing the best year in a ten-year period (which would be akin to waiting till after the good year to decide to invest).
#3 High or Low Fund Fees - Impact = 1.5 to 2% per year
Funds on average under-perform more or less by the amount of their fees and costs (management expense ratios and trading costs) as shown in many sources, for example, David Swensen's book Unconventional Success. A handful of funds do outperform, justifying their high fees, but they are very hard if not impossible to identify beforehand. The easier, effective solution is to search out funds with low fees, which most often are index funds passively tracking broad markets. Since fees are based on assets, not returns, they take a chunk away from the investor every year. It is a very predictable return reduction, year after year. Our estimation of the return difference is based on the spread in fees between high-fee and low-fee funds.
#4 Utilizing RRSP, TFSA Tax-Advantaged Accounts - Impact = 1 to 4% per year
Every Canadian investor should take advantage of RRSPs (in any of their various forms like LIRAs, LIFs, RRIFs etc) and TFSAs. (We previously explained in this post why taxable accounts do not produce as much after-taxes as RRSPs and TFSAs.) Withing such accounts, the capital gains, interest and dividend returns are tax-free so the investor benefits by the amount of his or her tax income tax rate times the return. An Ontario taxpayer in a 35% bracket on a 6% pre-tax annual investment return would gain about 0.35 x 6% = 2% per year. The higher the tax bracket and the greater the investment return inside the RRSP/TFSA the bigger the benefit.
That a TFSA produces tax-free returns is very obvious but for a RRSP how this works can be confusing. For a fine explanation that separates the mechanics from the financial reality, see RetailInvestor.org's Nitty-Gritty of the RRSP Model).
#5 Creating Diversified, Rebalanced Portfolios with Efficient Funds - Impact = 1 to 2% per year
The last 60 years of financial research, beginning with Markowitz's 1952 seminal paper Portfolio Selection, have shown that combining different types of assets, especially stocks and bonds, with proportions that are set according to the investor's risk requirements and then rebalanced regularly to maintain the risk level, perform better. Beyond the basic level, further benefits can be obtained by adding other assets like real estate and commodities or subdividing stock holdings into geographies, such as domestic market, developed country and emerging market, and into types like small cap, value and momentum.
Finally, and still not mainstream, but supported by a growing body of research that this blogger believes, alternative selection and weighting schemes like low volatility, equal weight and fundamental factor offer opportunity for further portfolio performance enhancement. The alternative scheme effects only reliably happen over decades long periods so the investor must be very patient and determined when the odd decade of under-performance relative to traditional standard cap-weighted indices goes by.
Wealthfront's Investment Methodology outlines the case for diversified rebalanced portfolios up to but not including the alternative weighting schemes, which can be found analyzed in Jacques Lussier's recent book Successful Investing and on the EDHEC Risk-Institute.
Translating the Impact into dollars
The graph below shows how much difference each percent makes to the total compound growth of investments over the long term, such as thirty or forty years. Adding up the lower end values for items 2 to 5 gives us a 6.5% difference, the gap between 0.5% and 7% annual growth, which ends up being in excess of a 12x difference after 40 years - $149,700 vs $12,200.
The longer the time period and the more Big Stuff items the investor takes advantage of, the greater the ultimate difference. Readers can test other combinations of contributions, time period and return differences in Fidelity's online calculator linked 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.
#1 Not Saving Money - Impact = 100%
It's almost embarrassingly obvious but if there is no money set aside out of income for investment, there can be no growth. The more savings, the greater the eventual total. Moreover, the earlier in life that money can be set aside, even small amounts, the more time that the benefits of compound growth can accumulate (earnings reinvested generate more earnings - see the difference compounding makes in Fidelity's growth calculator).
#2 Chasing Performance or Headlines - Impact = 3 to 5% per year
This is another story familiar to, and sadly applicable to, many investors. Buying into funds or stocks that have done really well recently, only to see subsequent stagnation or worse, losses, as performance cools off. The evidence comes from numerous sources, one well-known example being the annual reports by Dalbar Inc, which document (e.g. the 2013 press release which showed 3.96% under-performance of US equity investors) that investors have chronically under-performed the funds in which they have invested through poor timing.
Another way to see the issue is the panel insert "Dangers of Market Timing" within the superb Big Picture inter-active chart of the TSX going back to 1935 at the Get Smarter About Money website of the Investor Education Fund. There was about a two and a half times difference in total growth between being continually invested in the stock market and missing the best year in a ten-year period (which would be akin to waiting till after the good year to decide to invest).
#3 High or Low Fund Fees - Impact = 1.5 to 2% per year
Funds on average under-perform more or less by the amount of their fees and costs (management expense ratios and trading costs) as shown in many sources, for example, David Swensen's book Unconventional Success. A handful of funds do outperform, justifying their high fees, but they are very hard if not impossible to identify beforehand. The easier, effective solution is to search out funds with low fees, which most often are index funds passively tracking broad markets. Since fees are based on assets, not returns, they take a chunk away from the investor every year. It is a very predictable return reduction, year after year. Our estimation of the return difference is based on the spread in fees between high-fee and low-fee funds.
#4 Utilizing RRSP, TFSA Tax-Advantaged Accounts - Impact = 1 to 4% per year
Every Canadian investor should take advantage of RRSPs (in any of their various forms like LIRAs, LIFs, RRIFs etc) and TFSAs. (We previously explained in this post why taxable accounts do not produce as much after-taxes as RRSPs and TFSAs.) Withing such accounts, the capital gains, interest and dividend returns are tax-free so the investor benefits by the amount of his or her tax income tax rate times the return. An Ontario taxpayer in a 35% bracket on a 6% pre-tax annual investment return would gain about 0.35 x 6% = 2% per year. The higher the tax bracket and the greater the investment return inside the RRSP/TFSA the bigger the benefit.
That a TFSA produces tax-free returns is very obvious but for a RRSP how this works can be confusing. For a fine explanation that separates the mechanics from the financial reality, see RetailInvestor.org's Nitty-Gritty of the RRSP Model).
#5 Creating Diversified, Rebalanced Portfolios with Efficient Funds - Impact = 1 to 2% per year
The last 60 years of financial research, beginning with Markowitz's 1952 seminal paper Portfolio Selection, have shown that combining different types of assets, especially stocks and bonds, with proportions that are set according to the investor's risk requirements and then rebalanced regularly to maintain the risk level, perform better. Beyond the basic level, further benefits can be obtained by adding other assets like real estate and commodities or subdividing stock holdings into geographies, such as domestic market, developed country and emerging market, and into types like small cap, value and momentum.
Finally, and still not mainstream, but supported by a growing body of research that this blogger believes, alternative selection and weighting schemes like low volatility, equal weight and fundamental factor offer opportunity for further portfolio performance enhancement. The alternative scheme effects only reliably happen over decades long periods so the investor must be very patient and determined when the odd decade of under-performance relative to traditional standard cap-weighted indices goes by.
Wealthfront's Investment Methodology outlines the case for diversified rebalanced portfolios up to but not including the alternative weighting schemes, which can be found analyzed in Jacques Lussier's recent book Successful Investing and on the EDHEC Risk-Institute.
Translating the Impact into dollars
The graph below shows how much difference each percent makes to the total compound growth of investments over the long term, such as thirty or forty years. Adding up the lower end values for items 2 to 5 gives us a 6.5% difference, the gap between 0.5% and 7% annual growth, which ends up being in excess of a 12x difference after 40 years - $149,700 vs $12,200.
The longer the time period and the more Big Stuff items the investor takes advantage of, the greater the ultimate difference. Readers can test other combinations of contributions, time period and return differences in Fidelity's online calculator linked above.
(click to enlarge image)
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, 24 May 2013
Portfolio Volatility of Swensen Seven, Smart Beta vs Simple Recipe - Which is best?
Last week when we examined how to reduce portfolio volatility, we found that we could reduce volatility by about half, a very good result. The Simple Recipe portfolio that we used to illustrate had to undergo a drastic shift in allocation away from equities to the bond ETF to attain that stability at some loss of long term return. Let's now see how two other portfolios we proposed back in March - the Swensen Seven and the Smart Beta - fare compared to the Simple Recipe. We have compiled the following comparison table using the InvestSpy.com calculator.
Does we see the same pattern of portfolio volatility reduction when we equalize the volatility / risk contribution of the holdings?
The answer is an unequivocal YES. In each portfolio, when we adjusted the asset allocation percentages to get closer to an equal share of risk from each ETF holding, there was a marked reduction in both the annualized portfolio volatility and the daily Value at Risk (VaR - a measure of how much the portfolio could lose in any given day taking into account its past volatility over the specified time period of 1-, 2-, 5-years). For instance, the Swensen Seven portfolio's annualized volatility for the past year goes down from 5.2% to 4.4% after adjustment and its VaR declines from 0.8% to 0.6%. Risk is not decreased by half but it it's still an appreciable difference.
The volatility reduction applies for any and all time periods we tested - the past year, two years, five years, maximum data available. Equalizing volatility contributions of holdings is a consistent and reliable way to reduce volatility of a portfolio.
It's encouraging that the reduction improvement was least for the Smart Beta portfolio, which we had built by guesstimating equalized volatility contributions. Our guesstimate helped a lot but we did not have the benefit of the InvestSpy.com calculator when writing that post so we can see the usefulness of the tool.
Which portfolio got the biggest volatility reduction?
The Simple Recipe gained the most - it had the largest reduction in both risk measures, e.g. its trailing one-year annualized volatility went down from 4.5 to 2.9% and VaR from 0.7 to 0.4%. Not only was its reduction the largest, it had the lowest absolute volatility after the adjustment e.g. the 2.9% volatility is against 4.4% for the Swensen and 3.6% for the Smart Beta.
Does that mean the adjusted Simple Recipe is the best?
It's certainly a strong plus in its favour but we notice that the method to achieve the reduction was to boost the allocation to fixed income (the bond ETF with symbol XBB) at the expense of equity. The Swensen Seven also improved by increasing fixed income, though by not nearly as much, while the Smart Beta did not touch the fixed income allocation. Instead it moved money from volatile ETFs RSP, EFAV and PXH to more stable ZLB and ZRE. A higher bond allocation is not the only way to reduce portfolio risk.
After adjustment both the Swensen Seven (45% allocation) and Smart Beta (40% allocation) have an allocation to fixed income significantly less than Simple Recipe's 75%. That leaves more in higher returning (on an expected basis at least) equities. Yet Smart Beta's one- and two-year volatility is not that much higher than Simple Recipe's. Our point in the original post linked above about the Smart Beta portfolio was that it could well offer an improvement over traditional portfolios through a more balanced structure and more efficient ETFs. The balance for different economic growth, market, crisis, inflation and currency environments of the Swensen Seven and the Smart Beta is retained while the Simple Recipe is decidedly unbalanced towards fixed income. Volatility risk reduction has come at a cost. If future bond returns are weak because of rising interest rates, the unbalanced Simple Recipe could lag considerably.
We believe the trade-off looks favourable to Smart Beta but every investor must decide for him or her self.
Every portfolio is more stable than any of its components, even compared to the ultra stable bond ETFs
It's not much of a surprise to most investors to see in our comparison table that equities on their own, such as ETFs SPY, VTI, XIU and XIC are much more volatile than portfolios that include them along with more stable fixed income ETFs. But some may not realize that even that most stable holding, the broad Canadian bond market ETF XBB is more, not less, volatile than the Simple Recipe portfolio which includes equities along with it. That's right, the portfolio is less volatile than any of its parts. It's not magic or illusion. Why? This occurs through the operation of negatively correlated holdings that move in opposite directions (one zigs while the other zags as the popular expression goes, though both go up in the long term). The overall average ride is smoother. The slide below from this presentation based on the Booth & Cleary Corporate Finance textbook shows how this works.
This screenshot of the InvestSpy results for the trailing one-year performance of the adjusted Smart Beta shows the desirable negative correlations amongst the various ETFs.
Bottom Line
Adding ETFs to a portfolio that produce positive returns and are un- or negatively-correlated with other holdings, such as the bond funds and ZLB in the Smart Beta portfolio, adds greatly to return reward vs volatility risk performance.
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.
(click image to enlarge)
Does we see the same pattern of portfolio volatility reduction when we equalize the volatility / risk contribution of the holdings?
The answer is an unequivocal YES. In each portfolio, when we adjusted the asset allocation percentages to get closer to an equal share of risk from each ETF holding, there was a marked reduction in both the annualized portfolio volatility and the daily Value at Risk (VaR - a measure of how much the portfolio could lose in any given day taking into account its past volatility over the specified time period of 1-, 2-, 5-years). For instance, the Swensen Seven portfolio's annualized volatility for the past year goes down from 5.2% to 4.4% after adjustment and its VaR declines from 0.8% to 0.6%. Risk is not decreased by half but it it's still an appreciable difference.
The volatility reduction applies for any and all time periods we tested - the past year, two years, five years, maximum data available. Equalizing volatility contributions of holdings is a consistent and reliable way to reduce volatility of a portfolio.
It's encouraging that the reduction improvement was least for the Smart Beta portfolio, which we had built by guesstimating equalized volatility contributions. Our guesstimate helped a lot but we did not have the benefit of the InvestSpy.com calculator when writing that post so we can see the usefulness of the tool.
Which portfolio got the biggest volatility reduction?
The Simple Recipe gained the most - it had the largest reduction in both risk measures, e.g. its trailing one-year annualized volatility went down from 4.5 to 2.9% and VaR from 0.7 to 0.4%. Not only was its reduction the largest, it had the lowest absolute volatility after the adjustment e.g. the 2.9% volatility is against 4.4% for the Swensen and 3.6% for the Smart Beta.
Does that mean the adjusted Simple Recipe is the best?
It's certainly a strong plus in its favour but we notice that the method to achieve the reduction was to boost the allocation to fixed income (the bond ETF with symbol XBB) at the expense of equity. The Swensen Seven also improved by increasing fixed income, though by not nearly as much, while the Smart Beta did not touch the fixed income allocation. Instead it moved money from volatile ETFs RSP, EFAV and PXH to more stable ZLB and ZRE. A higher bond allocation is not the only way to reduce portfolio risk.
After adjustment both the Swensen Seven (45% allocation) and Smart Beta (40% allocation) have an allocation to fixed income significantly less than Simple Recipe's 75%. That leaves more in higher returning (on an expected basis at least) equities. Yet Smart Beta's one- and two-year volatility is not that much higher than Simple Recipe's. Our point in the original post linked above about the Smart Beta portfolio was that it could well offer an improvement over traditional portfolios through a more balanced structure and more efficient ETFs. The balance for different economic growth, market, crisis, inflation and currency environments of the Swensen Seven and the Smart Beta is retained while the Simple Recipe is decidedly unbalanced towards fixed income. Volatility risk reduction has come at a cost. If future bond returns are weak because of rising interest rates, the unbalanced Simple Recipe could lag considerably.
We believe the trade-off looks favourable to Smart Beta but every investor must decide for him or her self.
Every portfolio is more stable than any of its components, even compared to the ultra stable bond ETFs
It's not much of a surprise to most investors to see in our comparison table that equities on their own, such as ETFs SPY, VTI, XIU and XIC are much more volatile than portfolios that include them along with more stable fixed income ETFs. But some may not realize that even that most stable holding, the broad Canadian bond market ETF XBB is more, not less, volatile than the Simple Recipe portfolio which includes equities along with it. That's right, the portfolio is less volatile than any of its parts. It's not magic or illusion. Why? This occurs through the operation of negatively correlated holdings that move in opposite directions (one zigs while the other zags as the popular expression goes, though both go up in the long term). The overall average ride is smoother. The slide below from this presentation based on the Booth & Cleary Corporate Finance textbook shows how this works.
(click image to enlarge)
This screenshot of the InvestSpy results for the trailing one-year performance of the adjusted Smart Beta shows the desirable negative correlations amongst the various ETFs.
(click image to enlarge)
Bottom Line
Adding ETFs to a portfolio that produce positive returns and are un- or negatively-correlated with other holdings, such as the bond funds and ZLB in the Smart Beta portfolio, adds greatly to return reward vs volatility risk performance.
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, 21 May 2013
How to Minimize Portfolio Volatility and Sleep (a lot) Better
That an investor is able to sleep well at night matters. It matters first for peace of mind, since the sickening feeling of a threatened retirement resulting from plunging markets is not what life is all about. It matters also to prevent the rash reaction of selling out at precisely the wrong time, after a plunge and before recovery has come about.
Many portfolio structures that are described as conservative or balanced are actually quite volatile. Let's explore how to adjust a portfolio to reduce volatility. We'll use two free online tools - the Stingy Investor Asset Mixer, which provides long term return data of the main asset classes, and the recently launched InvestSpy Calculator, which provides market price volatility data. Both allow the user to enter various combinations and percentage allocations over different time periods, a very useful feature for "what if" testing.
Test Portfolio - The Simple Recipe Portfolio
We'll examine a classic simple portfolio, one of a bunch of such portfolios we compared here. The Simple Recipe has only four ETF holdings, three equity (Canadian TSX Composite ETF: trading symbol XIC, USA S&P 500: symbol SPY and international developed country MSCI EAFE: symbol EFA) and the Canadian bond universe (both government and corporate): symbol XBB. Assuming a 50 year old investor, the Simple Recipe allocates 50% to XBB, 25% to XIC, 8% to SPY and 17% to EFA. Those are the numbers we entered into the two tools to get the results of the Pre-Adjustment version of the portfolio.
Reduce volatility by equalizing the Risk Contribution of each holding
Beginning with the InvestSpy tool we enter the initial Pre-Adj allocations and find that almost all the volatility in the portfolio, as seen in the Risk Contribution result column, comes from XIC and EFA. XBB provides a powerful offsetting negative volatility reduction (see screen shot of results below).
The source of this effect is revealed in XBB's negative numbers in the correlation matrix.
Next we reduce the overall portfolio volatility by changing the allocation to each ETF to try equalizing the Risk Contribution. That means boosting XBB's percentage and reducing both XIC and EFA. Remember that playing with the numbers is not a matter of trying to find the exact perfect minimum volatility. There really isn't such a thing as an optimal solution, since what works best for the past one year goes out of kilter for the past two years, five years or the entire price history. Volatility and correlation has changed over time and will continue to do so in future. In addition, SPY and EFA are traded in US dollars so that currency shifts with the Canadian dollar will alter the results. We are merely looking for something more stable than the initial portfolio, knowing that it also won't be perfectly adapted to the future. The before and after-adjustment results are summarized in the table below.
Our Volatility-adjusted allocation reduced volatility by about half compared to the initial portfolio allocation! That includes the period of the financial crisis in 2008-2009. One big takeaway is therefore - increasing the bond allocation brings much stability to the portfolio.
What happens to the returns, do we lose half the returns too?
To find out we entered both pre- and volatility-adjusted allocations in Stingy Investor for various time periods. The Stingy tool has the merit of taking account of currency shifts by converting returns to Canadian dollars, i.e. we assume that the investor does not hold a CAD-hedged ETF. The negative numbers in the Alpha input column approximate ETF expense ratios (we entered current MERs for our ETFs), which reduce returns. This is necessary to get a reasonable estimate of what would have happened since Stingy does not use actual ETF data. ETFs did not even exist in 1970. Looking at the longer historic time data helps us see how our portfolio allocation would have fared through more economic and market environments like the high inflation 1970s oil crisis and the 2000 Tech bubble. Unfortunately, all the data is only year-end annual so we cannot see what happened day-to-day during any year. However, it's better than nothing. We online investors must make do with what we can get, knowing in any case that we are always approximating, since the future is never exactly like the past.
The results vary slightly amongst sub-periods and the total time period for which data is available, 1970 to 2012, but a pattern is clear.
The screenshot below shows detailed results for the volatility-adjusted portfolio:
We've taken the results and created the following summary table comparing the pre- and volatility-adjusted portfolio allocation results for the total time period 1970-2012 and the high inflation years of the 1970s, when bonds might have been thought to severely drag down the portfolio performance:
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.
Many portfolio structures that are described as conservative or balanced are actually quite volatile. Let's explore how to adjust a portfolio to reduce volatility. We'll use two free online tools - the Stingy Investor Asset Mixer, which provides long term return data of the main asset classes, and the recently launched InvestSpy Calculator, which provides market price volatility data. Both allow the user to enter various combinations and percentage allocations over different time periods, a very useful feature for "what if" testing.
Test Portfolio - The Simple Recipe Portfolio
We'll examine a classic simple portfolio, one of a bunch of such portfolios we compared here. The Simple Recipe has only four ETF holdings, three equity (Canadian TSX Composite ETF: trading symbol XIC, USA S&P 500: symbol SPY and international developed country MSCI EAFE: symbol EFA) and the Canadian bond universe (both government and corporate): symbol XBB. Assuming a 50 year old investor, the Simple Recipe allocates 50% to XBB, 25% to XIC, 8% to SPY and 17% to EFA. Those are the numbers we entered into the two tools to get the results of the Pre-Adjustment version of the portfolio.
Reduce volatility by equalizing the Risk Contribution of each holding
Beginning with the InvestSpy tool we enter the initial Pre-Adj allocations and find that almost all the volatility in the portfolio, as seen in the Risk Contribution result column, comes from XIC and EFA. XBB provides a powerful offsetting negative volatility reduction (see screen shot of results below).
(click image to enlarge)
The source of this effect is revealed in XBB's negative numbers in the correlation matrix.
Next we reduce the overall portfolio volatility by changing the allocation to each ETF to try equalizing the Risk Contribution. That means boosting XBB's percentage and reducing both XIC and EFA. Remember that playing with the numbers is not a matter of trying to find the exact perfect minimum volatility. There really isn't such a thing as an optimal solution, since what works best for the past one year goes out of kilter for the past two years, five years or the entire price history. Volatility and correlation has changed over time and will continue to do so in future. In addition, SPY and EFA are traded in US dollars so that currency shifts with the Canadian dollar will alter the results. We are merely looking for something more stable than the initial portfolio, knowing that it also won't be perfectly adapted to the future. The before and after-adjustment results are summarized in the table below.
(click image to enlarge)
Our Volatility-adjusted allocation reduced volatility by about half compared to the initial portfolio allocation! That includes the period of the financial crisis in 2008-2009. One big takeaway is therefore - increasing the bond allocation brings much stability to the portfolio.
What happens to the returns, do we lose half the returns too?
To find out we entered both pre- and volatility-adjusted allocations in Stingy Investor for various time periods. The Stingy tool has the merit of taking account of currency shifts by converting returns to Canadian dollars, i.e. we assume that the investor does not hold a CAD-hedged ETF. The negative numbers in the Alpha input column approximate ETF expense ratios (we entered current MERs for our ETFs), which reduce returns. This is necessary to get a reasonable estimate of what would have happened since Stingy does not use actual ETF data. ETFs did not even exist in 1970. Looking at the longer historic time data helps us see how our portfolio allocation would have fared through more economic and market environments like the high inflation 1970s oil crisis and the 2000 Tech bubble. Unfortunately, all the data is only year-end annual so we cannot see what happened day-to-day during any year. However, it's better than nothing. We online investors must make do with what we can get, knowing in any case that we are always approximating, since the future is never exactly like the past.
The results vary slightly amongst sub-periods and the total time period for which data is available, 1970 to 2012, but a pattern is clear.
The screenshot below shows detailed results for the volatility-adjusted portfolio:
(click to enlarge)
(click to enlarge)
- Returns for the volatility-adjusted portfolio are still highly positive but reduced by about a half-percent a year BUT
- Downside risk is hugely reduced - fewer downside years, a lot less volatility and especially, worst drop years have very small decreases
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, 13 May 2013
Comparing the Canadian High-Yielding Mortgage Companies
A few weeks back, we introduced the various alternatives for investors to obtain steady dependable income from mortgages. Today let's go a little deeper and compare the seven mortgage-focused companies available through online brokers and traded on the TSX. In particular, we want to see what the chances are that these companies will be able to maintain their current attractive distribution yield rates of 6 to 7%. Many of these companies state outright that they aim to provide a return of 4 to 4.5% over the federal Treasury Bill rate while safely preserving capital. We'll use the excellent guidelines PIC-A-MIC from Fisgard as our checklist of factors to consider.
The Seven Contenders
Tax treatment matters and it differs a lot
A MIC's tax-exemption only means the income is passed along to the investor to be taxed in his/her hands, which in turn could be in a tax-exempt TFSA or a tax-deferred RRSP, LIF, LRIF, LIRA or a tax-advantaged RESP. Since the five MICs in our list all distribute interest income which is subject to the highest tax rate, these stocks should preferably go into a TFSA, RRSP (or the like) or a RESP, or simply in a taxable account.
The other two funds, FN and FNM.UN, are taxable. FN distributes primarily eligible dividends and sporadic small capital gains so it can go well in an investor's taxable account. FNM.UN uses a forward agreement to transform interest income into primarily return of capital distributions. Unfortunately, as mentioned in our previous post, the recent federal budget said it would prevent these arrangements but the company believes the existing FNM.UN will be able to continue till the forward agreement expires in December 2017. Since return of capital is effectively deferred capital gains, investors can continue to benefit for up to almost five years of tax advantaged income. As such, FNM.UN fits nicely into a taxable account.
Trading below or above Net Asset Value (NAV)
Perhaps the uncertainty about FNM.UN explains the fact it is trading at 1.8% below the net asset value of its holdings. In contrast, TMC is trading a fairly significant 7% over NAV and MTG is at 1.6% above NAV. Some investors may be chasing the yield without noticing what each fund is really worth.
Cash yield is often supplemented at year end
The MICs all must distribute all their income to retain their tax-exempt status so they typically set a conservative monthly amount to distribute. Then at year end there is an extra top-up amount to parcel out the remainder, which means the indicated cash yield in our table most probably under-estimates what the investor will eventually get by year end.
Distributions have trended in different directions
Disappointing - TMC and AI have seen their distributions fall appreciably over the past several years.
Pleasing - MKP, FN and FC have been increasing their regular monthly distributions.
The other two don't have a long enough track record to detect any trend.
Dividend reinvestment plans at discounted price
Five funds offer the opportunity to reinvest distributions at no brokerage cost and at a 2% - MKP, FC and AI - or a 5% discount - TMC and MTG - to current market price of the shares.
Risks - Things that could go wrong
Look at any prospectus for these companies on Sedar and there is a long list of factors that can knock down the distributions and the capital value of the shares:
Mortgage portfolio holdings average yield mostly above payout rates
FC, TMC, MTG and AI all sport portfolios whose yields exceed the rate they pay out, which leaves a better chance that after costs are deducted there will be enough to sustain payouts.
In MKP's case, the portfolio yield at end of 2012 was only 5.81%, a lot less than the 7.74% paid out to shareowners. The difference can only come from leverage. But in MKP's case that doesn't necessarily mean huge extra risk. As a deposit taking financial institution, it can, unlike the others in our list, get cheap funding by issuing plenty of low interest term deposits just like the mainstream banks to lend out for higher rate mortgages. The interest rate spread of many such transactions can create a big sum for the many fewer shareholders of MKP shares. The fact that it has been in existence since 1991 and is regulated by the OSFI adds to the comfort that it knows what it is doing and can sustain the business model and the distribution.
Mortgage assets and concentration of loans
A bigger asset base gives more scope for spreading things out and being less exposed to any one borrower or geographic area. Another row in the comparison table shows how concentrated are the portfolios of the various companies. FN and MKP come out looking safest on this dimension.
Investment focus, term duration, loan-to-value ratio and 1st vs 2nd proportions exhibit trade-offs of one factor vs another
What they may lack in strength from concentration or smaller size, the other companies make up for with more protection in the form of shorter lending term, lower loan-to-property value and greater proportions of higher ranking first mortgages.
Portfolio impairment and loan losses across the board look to be acceptably low
The proof of lending quality, or deficiencies therein, ultimately comes out as repossessions, foreclosures and losses on loans. None of the companies seems to be facing any serious losses at the moment.
Expense ratios high for two companies
TMC, at 2.6%, and FNM.UN, at 2.5%, appear to be on the too-high end of expenses compared to the others.
Management skin in the game varies from none to dominance
When there is significant share ownership by the executives and directors who run the company, outside investors get more reassurance that attention will be paid to keeping the company profitable and the cash flowing. MKP, FN and AI look especially good on manager ownership stakes. It is interesting also that the three companies with the higher expense ratios - FNM.UN, TMC and MTG - seem to have no shares owned by the managers/executives.
Amount of leverage employed varies from zero to several multiples
TMC is the one company that so far refuses to use any leverage to boost returns. Its only borrowing is strictly to facilitate timing differences in cash flows. The others run the gamut from modest 5.8% liabilities vs assets at AI to 83% at MKP. However, as noted above, the borrowing base of term deposits is very cheap and stable at MKP so it isn't clear the risk is much more, if any.
Bottom Line
It's hard to say that any company stands out as especially weak-looking overall. MKP noses ahead to grab best choice in our opinion for its combination of pluses - starting with a high base cash yield, that has grown steadily over the years, a long track record of profitability, a dividend reinvestment program, low loan losses, a very diversified loan portfolio and a significant management stake.
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.
The Seven Contenders
- MCAN Mortgage Corp (TSX symbol: MKP)
- First National Financial Corp (FN)
- First National Mortgage Investment Fund (FNM.UN)
- Firm Capital MIC (FC)
- Timbercreek MIC (TMC)
- Timbercreek Senior MIC (MTG)
- Atrium MIC (AI)
(click image to enlarge)
Tax treatment matters and it differs a lot
A MIC's tax-exemption only means the income is passed along to the investor to be taxed in his/her hands, which in turn could be in a tax-exempt TFSA or a tax-deferred RRSP, LIF, LRIF, LIRA or a tax-advantaged RESP. Since the five MICs in our list all distribute interest income which is subject to the highest tax rate, these stocks should preferably go into a TFSA, RRSP (or the like) or a RESP, or simply in a taxable account.
The other two funds, FN and FNM.UN, are taxable. FN distributes primarily eligible dividends and sporadic small capital gains so it can go well in an investor's taxable account. FNM.UN uses a forward agreement to transform interest income into primarily return of capital distributions. Unfortunately, as mentioned in our previous post, the recent federal budget said it would prevent these arrangements but the company believes the existing FNM.UN will be able to continue till the forward agreement expires in December 2017. Since return of capital is effectively deferred capital gains, investors can continue to benefit for up to almost five years of tax advantaged income. As such, FNM.UN fits nicely into a taxable account.
Trading below or above Net Asset Value (NAV)
Perhaps the uncertainty about FNM.UN explains the fact it is trading at 1.8% below the net asset value of its holdings. In contrast, TMC is trading a fairly significant 7% over NAV and MTG is at 1.6% above NAV. Some investors may be chasing the yield without noticing what each fund is really worth.
Cash yield is often supplemented at year end
The MICs all must distribute all their income to retain their tax-exempt status so they typically set a conservative monthly amount to distribute. Then at year end there is an extra top-up amount to parcel out the remainder, which means the indicated cash yield in our table most probably under-estimates what the investor will eventually get by year end.
Distributions have trended in different directions
Disappointing - TMC and AI have seen their distributions fall appreciably over the past several years.
Pleasing - MKP, FN and FC have been increasing their regular monthly distributions.
The other two don't have a long enough track record to detect any trend.
Dividend reinvestment plans at discounted price
Five funds offer the opportunity to reinvest distributions at no brokerage cost and at a 2% - MKP, FC and AI - or a 5% discount - TMC and MTG - to current market price of the shares.
Risks - Things that could go wrong
Look at any prospectus for these companies on Sedar and there is a long list of factors that can knock down the distributions and the capital value of the shares:
- credit risk assessment poorly organized or controlled resulting in higher defaults on loans and losses
- liquidity risk or cash flow control that does not match up incoming with outgoing cash or put adequate just-in-case sources of funds in place
- changes in real estate values
- concentration and composition of the portfolio
- economic conditions and cyclicality of residential and commercial real estate causing slowdowns in loan growth and rises in bad loans
- actions by higher-ranking debt holders
- leverage magnifies the downward as well as upward returns
- mortgage holdings may not be very liquid / easily saleable
- increasing price competition from other lenders that reduces profitability
- interest rate decreases reduce possible returns and increases can hurt the value of existing holdings, especially as term to maturity of holdings increase
- availability of investments
- mortgage extensions that go bad
- foreclosure costs
- litigation costs
- reliance on key personnel
- failure of internal computer systems
- changes in legislation or taxation
- environmental liabilities on repossessed properties
- natural disasters, wars, terrorism
(click to enlarge)
Mortgage portfolio holdings average yield mostly above payout rates
FC, TMC, MTG and AI all sport portfolios whose yields exceed the rate they pay out, which leaves a better chance that after costs are deducted there will be enough to sustain payouts.
In MKP's case, the portfolio yield at end of 2012 was only 5.81%, a lot less than the 7.74% paid out to shareowners. The difference can only come from leverage. But in MKP's case that doesn't necessarily mean huge extra risk. As a deposit taking financial institution, it can, unlike the others in our list, get cheap funding by issuing plenty of low interest term deposits just like the mainstream banks to lend out for higher rate mortgages. The interest rate spread of many such transactions can create a big sum for the many fewer shareholders of MKP shares. The fact that it has been in existence since 1991 and is regulated by the OSFI adds to the comfort that it knows what it is doing and can sustain the business model and the distribution.
Mortgage assets and concentration of loans
A bigger asset base gives more scope for spreading things out and being less exposed to any one borrower or geographic area. Another row in the comparison table shows how concentrated are the portfolios of the various companies. FN and MKP come out looking safest on this dimension.
Investment focus, term duration, loan-to-value ratio and 1st vs 2nd proportions exhibit trade-offs of one factor vs another
What they may lack in strength from concentration or smaller size, the other companies make up for with more protection in the form of shorter lending term, lower loan-to-property value and greater proportions of higher ranking first mortgages.
Portfolio impairment and loan losses across the board look to be acceptably low
The proof of lending quality, or deficiencies therein, ultimately comes out as repossessions, foreclosures and losses on loans. None of the companies seems to be facing any serious losses at the moment.
Expense ratios high for two companies
TMC, at 2.6%, and FNM.UN, at 2.5%, appear to be on the too-high end of expenses compared to the others.
Management skin in the game varies from none to dominance
When there is significant share ownership by the executives and directors who run the company, outside investors get more reassurance that attention will be paid to keeping the company profitable and the cash flowing. MKP, FN and AI look especially good on manager ownership stakes. It is interesting also that the three companies with the higher expense ratios - FNM.UN, TMC and MTG - seem to have no shares owned by the managers/executives.
Amount of leverage employed varies from zero to several multiples
TMC is the one company that so far refuses to use any leverage to boost returns. Its only borrowing is strictly to facilitate timing differences in cash flows. The others run the gamut from modest 5.8% liabilities vs assets at AI to 83% at MKP. However, as noted above, the borrowing base of term deposits is very cheap and stable at MKP so it isn't clear the risk is much more, if any.
Bottom Line
It's hard to say that any company stands out as especially weak-looking overall. MKP noses ahead to grab best choice in our opinion for its combination of pluses - starting with a high base cash yield, that has grown steadily over the years, a long track record of profitability, a dividend reinvestment program, low loan losses, a very diversified loan portfolio and a significant management stake.
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.
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