ETF Risks - Which Matter, Which Don't, What to Do

Ever read the prospectus that must accompany every ETF by law and that is thus posted by every ETF provider on its website? The prospectus tells investors how the ETF is run and always includes a key section, often titled Risk Factors, which identifies the dangers the fund faces.

Since not all risks have the same importance (and since many investors' eyes probably glaze over if they ever open up a typical prospectus of 100+ pages) let's run through the various risks and attempt to pick out those that are both most likely to occur and most harmful. For each risk, we'll identify measures that the investor can take to mitigate the damage. It is obvious that the universal fail-safe anti-risk measure is simply not to buy ETFs at all, but keeping your money safe in cash or GICs will not produce much return either, especially when taxes and inflation are taken into account. To keep things simpler we'll focus on the most serious risks facing equity ETFs. Click on the two table images below for details of all the risks named in a typical ETF prospectus - red colour text highlights the worst risks, orange is medium and black text shows low risks.

General Equity Risks
These are risks that apply to equities in general and thus they apply to any ETF that holds stocks.

1. Economic Conditions: The most dangerous of these harmful events are recessions, depressions and bursting market bubbles which can and regularly do destroy shareholder wealth on a scale ranging from discomfort to catastrophe. Since the economy has inevitable peaks and valleys, the harm is sure to occur. The only question is how severe the effects will be and how much the market will fall over how long a period before recovery takes hold. My Money Blog posted an informative table on this subject with US data titled Stock Performance During Recessions sourced from Fidelity Investments. An investor can cushion the blow, though not eliminate the fall entirely, by ensuring that his/her portfolio holds a good proportion of bonds. Diversification using a number of asset classes in a portfolio helps a lot. Our post The 2008 Crash - Case Study in Diversification showed how beneficial government bonds in particular proved to be. Investing for the long term to ride out the lows is another powerful tool for prospering despite severe downturns.
2. Inflation and Rising / High Interest Rates: These two factors are often inter-related. Interest rates are made to rise deliberately by the central bank when a nation's economy gets over-heated or when inflation takes hold. Though inflation has been held in check at low rates for eighteen years now, there is no assurance that it cannot rise again to the persistent high levels of the 1970s, when stock market returns were very low for a decade. Periods of extreme out-of-control hyperinflation do the worst harm. For more, see Crossing Wall Street's How Does Inflation Impact Stock Prices and Investopedia's How Interest Rates Affect the Stock Market. The two best ways to counter inflation and interest rate risk are: include an allocation to real return bonds which automatically rise in value with CPI and, diversify amongst multiple countries, since not all countries experience high inflation/interest rates at the same time.
   

ETF-Specific Risks
These risks result from the way ETFs are built and operated. Most are minor but one is especially noteworthy and investors should consider it closely when selecting ETFs for their portfolio.

1. Index Replication Error: This is a curious name for the fact that management fees, taxes and transaction costs incurred by ETFs unavoidably reduce return below that of the index each ETF aims to track, such as the TSX Composite. The higher the fees, the lower the investor's net return. The solution is thus to pick low cost ETFs within an asset class. That's why our previous posts comparing ETFs include this factor - USA S&P 500 or Similar Equity Index Funds, USA Total Market Equity, Emerging Market - US Traded and Canadian Traded, Canadian Large Cap Equity and Investing in China.

Canadian ETF Provider Prospectus Links

• Horizons BetaPro
• iShares Canada
• Claymore Canada
• BMO Financial Group

The fact that risks are inevitable with equity ETF investing does not mean that all risks and all ETFs are equal - some risks are worse than others, some ETFs are better than others and some strategies to control risk work better than others too. To recognize risk and take reasonable counter-measures is the mark of prudent investing.

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.

Deflation, Inflation - Which is coming and What to do?

The economic turmoil following the credit crunch and financial crisis continues and one of the ongoing debates of significance to investors is whether we face a period of deflation or a renewal of inflation.

Why it matters to investors
It matters because different types of investments (stocks, bonds) and different companies (sectors and individual characteristics) do better if the economy experiences the falling prices of deflation or the opposite, the rising prices of inflation.

The Deflation is likely camp
Well-known economist David Rosenberg of Gluskin Sheff in the Globe and Mail article 'Another day older and deeper into debt'
Inflation, Deflation? in the Financial Post

Inflation is still a threat adherents
The Bank for International Settlements 'Warns of rising inflation threat' in the International Business Times
Canada Economic Outlook by BMO Capital Markets
Investor & author Marc Faber warns that inflation will come to the US in this article in the Financial Post

Those who aren't sure
'The Economy: What's the story: inflation, deflation or ...?' with a handy historical international perspective in the International Business Times
'Inflation, deflation or just 'lowflation'?' by Shane Oliver of AMP Capital

Inflation / Deflation Price Indices - The Official Reality up to today
Canada: 1.8% as of July per Bank of Canada CPI
USA: 0.3% as of July per US Bureau of Labor Statistics CPI-U
OECD Countries: average 1.5% ranging from a high of 8.4% in Turkey to a low of -0.9% in Ireland as of June per OECD Stat Extracts; among key non-OECD countries are India at 13.7%, Russia at 5.8% and China at 2.8%

What to do to protect against, or benefit from ...
Deflation - Click through to our previous post Investing During Deflation
and the Wall Street Journal's How to Beat Deflation

Inflation - See our previous post Investments to Protect Against Inflation

Either / Or - If it isn't clear to you which way things will go and you want something that will do ok in either environment, then the classic solution is to pick a bit of everything, i.e. to diversify - cash, normal and real return bonds, stocks in all sectors, perhaps gold and commodities in a low-fee portfolio that is periodically rebalanced. For ideas on a starting point and specific holdings, see Simple Portfolios Compared.

Whatever comes to pass and when, the Scout Motto embodies the right attitude to the inflation vs deflation question - "Be prepared"!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above notes 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.

Protection for the Online Investor Against Insolvencies and Defaults

Times are tough, business failures have risen and even some governments sit on the brink of financial failure. It's hard enough earning the money to save and invest without it disappearing in flash. Can you get your money back? Let's look at the mechanisms that help protect the online investor in cases of default, insolvency and bankruptcy. The possibilities vary, depending on the situation. A chart below summarizes the protection offered for each type of investment, how the protection is backed up and by whom.

Broker goes bust
The failure of your broker should not mean the loss of any of your securities or cash (both Canadian and US dollars) due to the presence of the Canadian Investor Protection Fund, which will provide compensation of up to $1 million per account for holdings not handed back to you. To back up its promise, the CIPF collects fees from broker members and has a fund amounting to $359 million as of December 2009. It seems to have worked so far as the 17 broker insolvencies requiring $36 million in payouts since 1969 have easily been covered.

ETF and Mutual Fund provider hits the wall
Suppose Black Rock Asset Management, the managers of the popular iShares Canada ETFs were to fade to black, would you as an owner of iShares S&P/TSX 60 Index Fund (symbol: XIU) be stuck with worthless shares? The answer is no. Every XIU shareholder legally owns his or her proportional amount of the total holdings in the fund. The XIU holdings are kept in trust. In case of Black Rock failure, the assets could be distributed pro-rata among the XIU shareholders if XIU were to be dissolved but more likely another fund company would be brought in to take over management of the fund. All ETFs and mutual funds in Canada have the same basic trust structure as XIU.

Bond issuer failure
When the issuer of a bond goes into default by the failure to pay promised interest or principal, or by violating other terms of the bond indenture that sets out all its terms and conditions (see Wikipedia's Bond article), the bond investor is usually able to recover some value. Bondholders come before shareholders (but after banks and their loans, employees for their pay and governments for taxes) in claims for the remains of a corporation. Secured bonds include a claim against specific assets that may be sold while debentures hold a general claim. Another frequently seen form of recovery is that debt is converted into equity in a re-incarnated company, an example being when General Motors went into bankruptcy in 2009 according to this Wall Street Journal news item. The Financial Times' Downturn hits rates of debt recovery showed how bondholders in the past were able to recover as little as under 20% in severe economic downturns vs the 40% historical average. These are averages for all defaults and the experience for individual companies could of course vary from 0% to close to 100%.

With government bonds (or shorter term debt like Treasury bills), things are different. There are no secured bonds (forget the idea of buying Greek bonds in the hope of ending up with a piece of a Greek island in the sun!) only a promise to re-pay. Even when governments cannot pay according to the original bond terms and go into default, they have an incentive not to simply stiff the bondholders because they will want to borrow again. The result is a mix of pure loss debt write-off and re-structured easier-to-handle terms.

Guaranteed Investment Certificate issuer inability to pay
The risk of losing your money in GICs is almost non-existent since the Canada Deposit Insurance Corporation stands ready to reimburse principal and interest of up to $100,000 per issuer for any investor should the issuer not pay. It backs this up with funds of $1.88 billion and borrowing capacity of $15 billion.

Caveat: Some GICs provide a return based not on straightforward interest but on a stock exchange index, which means, as GetSmarterAboutMoney.ca's (a website sponsored by the Ontario Securities Commission) How risky is a GIC? explains, you could end up with only your principal.

Segregated Funds sponsoring insurance company goes under
Segregated funds are technically insurance products (see Segregated Funds Come With a Guarantee on the Financial Advisor Association of Canada Advocis website) and they thus qualify for backup against loss due to provider difficulties under the Assuris not-for-profit organization. The coverage rules are a bit tricky so it is worth reading the Assuris website page for details, but the basic guarantee is that it will cover up to $60,000 or 85%, whichever is greater, of what you were promised. Assuris has a $100 million fund ready at hand to pay claims in addition to the power to levy its membership of all Canadian life insurance companies, who are required to be members. There have been only three life insurance company insolvencies since 1990 according to Assuris. As with those failures, rather than a payout to the investor, the more likely result is that the investor's product will simply be transferred to another insurance company.

Annuity and Guaranteed Minimum Withdrawal Benefit provider failure
These products are also provided by insurance companies and receive protection by Assuris of up to $2000 per month or 85% of the promised income.


Stocks - Company insolvency
There is no real protection for shareholders against company insolvency or bankruptcy. Shareholders are last in line with the right to claim against remaining assets and usually end up with little or nothing. Perhaps the best result is a restructured company with consolidated shares that leave existing shareholders with a much smaller proportional ownership after bondholders and new equity providers take over the lion's share. That exposed status is the reason equities should receive substantially higher returns than other forms of investment securities.

You the Self-Directed Investor go bankrupt
The self-directed online investor by definition does not have a relationship with an investment advisor. You are your own advisor. The sacrifice of the possible benefit of advice means not having to worry about fraud or inappropriate advice so we have not covered the various means of recourse involving advisors.

If you do yourself in, there is some protection against yourself! If you go bankrupt registered plans like RRSPs are protected against claims by outside creditors (except for contributions made within the last 12 months before bankruptcy) according to How does bankruptcy affect an RRSP? in Advisor.ca.

Time and Ease of Getting the Compensation Will Vary
As can be inferred from the different mechanisms, some types of protection will operate much quicker and more easily than others. Simple transfers from one provider to another can be relatively painless while court recourse can take years.

The possible angst and distraction of waiting for the compensation can be a significant negative. That's all the more reason for caution before investing to avoid the need for protection in the first place. However, avoidance can never be perfect and it is useful to know beforehand what protection exists.

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.

Exploiting Laziness, Procrastination and Conformity in Investing

Yup, no kidding! Those seemingly negative qualities can be exploited for investing success. The objective is to modify, control and direct our own mistakes through various strategems, tricks and techniques. The last few decades have seen tremendous advances in the field of behavioural finance and economics, which has documented the myriad errors of thinking and emotion that cause the downfall of an investor.

That knowledge can be turned into action to make the right decisions and stop doing the wrong things. But it isn't so simple as recognizing the fault and saying you will or won't do something. The "just do it" or "just say no" approach rarely works. Below are some techniques that go a step beyond and are much more likely to work. Most are taken from the books listed at the end of this post.

Being Lazy is good if you put things on autopilot through:

• Automatic payroll deduction and transfer to your investment account, using even very small amounts if necessary. It is much harder psychologically to write a cheque today than to commit to the deduction tomorrow. One of the worst problems of investing is that people actually tend not to get around to diverting funds from current spending. The earlier in life the money is put to work, the more the long term effects of compounding can operate and the greater the end value at retirement.
• Automatic investment in mutual funds and some ETFs, such as Claymore's, to get the money to work, instead of merely sitting in cash waiting for the investor to make a purchase.
  
• Automatic dividend reinvestment, either through mutual funds, through ETFs such as BMO's and Claymore's, or through the online broker for individual companies which have DRIP programs. As this previous post showed, the reinvested dividends are one of the main sources of long term investment returns. This previous post explained DRIPs.

Procrastination will help if you,

• Wait 24 hours after you have made an investment decision before implementing it, whether it is a buy or a sell. The idea is to let the sense of urgency, the emotion drain from the situation because the emotion will overpower your reason and prevent you from thinking rationally. It may still be the right decision and if it is, it will still be correct the next day. Whatever you lose from the one-day delay will be more than made up from avoiding the bad results of rash decisions.
  
• Park money received as a gift, a work bonus, a tax refund, an inheritance into a bank savings account or money market fund for a week, a month or even longer until it starts to feel, as it will over time, like every other one of your hard-earned dollars. You will be much less likely to spend or invest it recklessly as if it was found money in a special category that isn't as valuable as earnings from work.
  

Being a Conformist can provide the benefit of leading you to,

• Take the middle course by investing in index mutual funds or ETFs, which by definition will return the market average (minus a very small amount for fund management costs). You won't do better but you won't do worse either.
• Do what all experts and advisors suggest and develop a written investment plan (see our previous post on the topic here). Such a plan will give the confidence to weather investment storms and the fortitude to resist temptations to jump into the latest hot investment company or sector. That will mean less trading and hopping about from one company or fund to another, which has been shown to significantly reduce investor returns. Writing it down is a key step since that will raise the personal buy-in. This factor and the previous point can combine to exploit the so-called sunk cost fallacy, a usually-negative factor which keeps people putting more money into an obviously failing project. Sunk cost behaviour will keep you putting more money into temporarily losing asset classes and index funds.

Books with these and other useful techniques

• Why Smart People Make Big Money Mistakes ... and How to Correct Them by Gary Belsky and Thomas Gilovich - one of the original books in this field, revised in a second 2009 edition, very readable and non-technical
• Predictably Irrational by Dan Ariely - author is one of the prime researchers who has taken the time to write a popularized, non-academic version of his research and that of others.
• Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich by Jason Zweig - though still for the mainstream market, Zweig includes details about which parts of the brain and how they change when our thinking goes non-rational before covering things we can do to counter and correct.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

High Yield Bonds - Take a Chance on Them?

In love, hope springs eternal. Abba's classic song Take a Chance on Me expresses the timeless desire that a future romance need not be like the disappointments of the past.

Hope springs eternal in investing too. The recent news in the National Post of Air Canada's issuance of a large dollop of debt at high interest rates ranging from 9.5% to 13% may have raised investor interest given the paltry rates available from GICs and government debt. The main attraction of such bonds is the high return but there is a catch. Air Canada has let investors down in the past - its 2003 bankruptcy.

The Globe and Mail reports a rekindling of interest in high-yield debt in Canada. Should we investors look at such high-yield bonds and Take a Chance on Them?

What is High Yield Debt?
High-yield bonds, also called junk bonds, are those rated below Baa3 by credit rating services Moody’s, BBB- by Standard & Poor’s and BB(high) by DBRS. PIMCO's Bond Basics provides a good overview of high-yield bond characteristics.

Credit / Default Risk
The higher probability that companies (or governments) will default on their debt and not pay investors the interest promised or part or all of the principal is the key factor driving the juicy interest rates on offer. Default happens constantly even in good economic conditions but the rate jumps up orders of magnitude in recessions. This 2004 slide presentation by NYU professor Dr. Edward Altman showed how US corporate annual default rates since 1971 varied from a low of 0.16% in good times to a high of 12.8% in recessions. 2009 has followed the recessionary pattern according to Bloomberg as default rates on high-yield class companies rose to a peak of 9.8% on a global scale and 9.5% in the USA. But conditions have been improving and default rates have declined a few percent already with forecasts predicting a rate of about 2% by year end.

The default rate is critical since such losses comes straight off the top of the yield for a fund holding a number of bonds. For instance, if the combined average yield of a fund is 10% and the default rate is 8%, the fund's net return is only 2%. When markets / investors get worried about default rates, even before actual default rates begin to rise, the price of bonds and the fund will fall accordingly to compensate. For new investors, that is fine, the new lower price is protection for what is expected but an existing investor who bought in a while back experiences negative returns. High-yield bond fund prices and returns can thus be extremely volatile.
The difference between the average yield on bonds in a high-yield fund and investor returns from holding the fund can be seen in figures for the ETF iShares iBoxx $ High Yield Corporate Bond Fund which holds US bonds (symbol: HYG). The average yield to maturity of bond holdings is 8.35%. At the same time, the total 3-year return is only 3.54% and the 1-year return is 21.5% due to the combined effect of price changes and defaults.

Possible Diversification Benefits
There is an argument made, e.g. by PH&N in The Case for Investing in High Yield Bonds and BMO's Diversify Your Fixed Income with High Yield Bonds that high yield bonds may behave in different patterns than other asset classes and thus provide a diversification benefit in a portfolio that is regularly rebalanced.

How to invest in high-yield debt
The sensible way for individual investors to buy high-yield debt, unless there is a willingness to take on the even greater risk of seeing the individual company become one of the defaulters and possibly losing everything, is to diversify by investing in a high-yield sector mutual fund or ETF (e.g. HYG has 351 holdings). If you really want to buy high-yield bonds of an individual company from an online broker, you would need to phone the bond desk since the bonds listed online consist only of investment grade rated bonds.

Most of the holdings in funds are bonds of US corporations, simply because there has been relatively little issuance of such bonds in Canada in recent years, though the Globe article cited above mentions a big rise in activity recently.

ETFs:
Canadian-traded - Both ETFs below eliminate the foreign exchange risk by hedging the US dollars of the holdings to Canadian dollars (though this comes at a cost and will reduce returns). The ETFs passively track an index, though each follows a different one.

• Claymore Advantaged High Yield Bond ETF (Symbol: CHB) - MER 0.5%, 130 holdings of US company bonds. New as of January 2010
  
• BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY) - MER 0.65%, holds only JNK. Launched October 2009
  

US-traded - Stock Encyclopedia's Bond ETF list includes the following high-yield funds. All trade in US dollars, which means a Canadian investor is exposed to currency shifts as well as bond-specific factors.

• iShares iBoxx $ High Yield Corporate Bond Fund (HYG) - MER 0.5%, 351 holdings providing best diversification
  
• SPDR Lehman High Yield Bond ETF (JNK) - MER 0.4%, 158 holdings
  
• PowerShares High Yield Corporate Bond Portfolio (PHB) - MER 0.5%, 50 holdings
  
• High-Yield Municipal Index ETF (HYD) - lowest MER at 0.35%, 76 holdings
  

Mutual Funds - All mutual funds available to Canadian investors come from Canadian providers since US-based mutual funds may not be sold in Canada. A search using GlobeInvestor's Fund Filter with High-Yield Fixed Income set as the asset class turned up 138 funds. MERs range from 0.87% to 3.25%. Most such mutual funds employ an active management strategy in an attempt to obtain even better returns but, as usual, the result is that there is a huge range of performance - 1-year returns range from 5.8% to 45.5%.

Whether or not to buy in
Is the time right and will default rates continue to fall, or will the double dip recession be upon us to wipe out the higher yield through persistent high default rates? As with love, so it is with high-yield debt. To take the chance or not? If you do, there is a chance you may suffer a broken heart, but if you do not, you cannot find happiness. We must make our own choices.

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.