Thursday, 25 June 2009

Generating Cash: Asset Allocation with the Global Couch Potato Portfolio

Following on the last post's examination of the High-Yield Couch Potato portfolio example of how to generate cash from a portfolio, this post looks at the asset allocation method using the Global Couch Potato portfolio. The basic idea of the asset allocation method is that the target cash amount is attained by selling whatever amount of securities are required to make up the difference with the interest and dividends received automatically from the investments. This is done simultaneously with sales and/or purchases of all securities in the portfolio as needed to bring the proportions back to the target allocation.

Hypothetical Scenario:
  • $240,000 starting amount invested in a non-registered taxable account
  • $13,000 annual cash to spend as retirement income must be generated
  • fictitious one year market price changes - Global rises to $258,000; arbitrarily chosen to demonstrate how the asset allocation method would work
  • recent actual cash yields of the various ETFs to bring out the differences between the two methods.
Global Portfolio
This portfolio contains three diversified equity ETFs:
  • a broad Canadian market fund (TSX: XIC
  • a broad US market fund traded in Canada (TSX: XSP)
  • a broad fund of Europe, Australasia and the Far East (TSX: XIN) and
  • the same Canadian bond fund XBB
The Global portfolio is estimated to provide $7,536 in dividend and interest cash based on current payouts. The rest of the $13,000 needed would have to come from sale of some of the ETFs. The following chart shows how this is achieved in the course of rebalancing to maintain the target asset allocation in the portfolio at the end of the year. It is a bit of work to figure out how much to buy and sell of each security in the portfolio. But the amount of cash generated will come out exactly to the target amount of $13,000 since the net sale of securities will simply be the difference between the automatic cash received from dividends and interest and the target.

Riskiness - this portfolio is diversified with holdings of companies around the complete developed world so that reduces risk ... somewhat. As the credit and financial crisis showed, the whole world can go down drastically at the same time. Equities are especially prone to swings and this portfolio is 75% equities versus 60% for the High-Yield. That can hurt very much when sales of securities are needed, as in this case, to make up the difference to reach the income target. The portfolio may never recover.

Taxes - the Global portfolio does appreciably better on saving taxes with an average tax rate of only 18% due to a big dose of lower taxed capital gains in its income. The 7% tax rate difference means an extra $700 in the pocket for every $10,000 of income in the Global portfolio and is akin to moving down several income tax brackets.

Inflation - the same comments apply as for the High-Yield portfolio, except that there is less of the bond fund XBB so this portfolio will suffer less from inflation in the long term.

Which portfolio, Global or High-Yield, is best for generating cash? Neither is perfect, as the above discussion shows, and there are many other portfolios that could do well too. The intent of the above is not to be an investment recommendation but to bring out key elements to consider.

A big caveat is that the withdrawal rate of 5.4% ($13k / $240k) is too high to be sustainable and the portfolio would be depleted in 10, 15, 20 years - 4% is the maximum rate (see for example Sherry Cooper's book The New Retirement). The beginning size of the portfolio would have to be $325,000 to sustain 4% withdrawal rates indefinitely (4% of $325k is $13k).

Tuesday, 23 June 2009

Generating Cash: Income from Securities with the High-Yield Couch Portfolio

The last post outlined two basic approaches to generating cash to spend from investments: A) buy the type of securities that produce a lot of cash or, B) take whatever cash is needed from rebalancing an asset allocation portfolio. The next two posts take a look at examples, conveniently provided by the famous Couch Potato portfolios as shown on the Canadian Moneysaver website. The cash income version is the High-Yield Couch Potato and the asset allocation version is the Global Couch Potato.

Hypothetical Scenario:
  • $240,000 starting amount invested in a non-registered taxable account
  • $13,000 annual cash to spend as retirement income must be generated
  • fictitious one year market price changes - Global rises to $258,000; arbitrarily chosen to demonstrate how the asset allocation method would work
  • recent actual cash yields of the various ETFs to bring out the differences between the two methods.
Today's post reviews the ...

High-Yield Couch Potato
This minimalist collection of four securities, all ETFs, consists of:
  • a Canadian dividend fund (TSX: XDV)
  • a US dividend fund (NYSE: VYM),
  • a Canadian income trust fund (TSX: XTR) and
  • a Canadian bond fund (TSX: XBB),
The Couch High-Yield is assembled for yield and it certainly delivers. Yields are so high at the moment, the cash objective would be more than met - $15,300 in annual dividends and interest. It is hard to predict exactly how much cash will be received with dividends as companies raise or lower them according to their business success. Thus, in different years the expected cash yield may be above or below the target. The table below shows the portfolio contents and hypothetical cash flows, including taxes.

Riskiness - The big question - will the yields be sustained? Note the Income Trust holding XTR, which has a very high yield of over 12%. The recession and lower oil prices are causing many Income Trusts to cut distributions. Yields are relatively high because prices have fallen so much. The next chart from Google Finance shows how much of a drop there has been for three of the four securities - XDV, XTR and VYM have declined anywhere from 26 to 42% since 2006. That wouldn't be very comforting to the investor who started out in 2006.

Taxes - High-Yield does ok but not great on taxes with a weighted average tax rate of 25% due to the 70% of cash that comes from highest taxed interest / ordinary income, which includes all the US dividends since they do not benefit from the preferential lower rate on Canadian dividends.

Time and Effort to Maintain - initial set up would be dead easy, taking a few minutes to buy equal amounts of four ETFs with really no on-going maintenance to do. Cash would come automatically into the account four times a year based on the distribution frequency of these ETFs.

Inflation - three of the funds are equities and should be able to adjust for inflation by raising distributions / dividends. The bond fund XBB is not inflation-indexed and would suffer.

The next post covers the Global Portfolio and compares it with the High-Yield.

Thursday, 18 June 2009

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.

Tuesday, 16 June 2009

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.

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.

Monday, 8 June 2009

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 - 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:

Tuesday, 2 June 2009

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.