Canadian Mining Companies - How do they rate on Sustainability, Environmental, Social and Governance issues?

Many investors cast an interested eye on how well their potential purchases perform beyond purely financial factors - they want to know whether a company is adhering to a higher standard than mere conformance to the law with respect to environmental protection, treatment of communities where the company operates, inclusiveness from the bottom workers to the upper reaches of the boardroom and worker safety. At the same time, companies are recognizing that their long term future sustainability depends on retaining a social mandate to operate. Such considerations are given the term Socially Responsible Investing (SRI), or Environmental, Social and Governance factors (ESG), or simply Sustainability.

Previously we have looked through this lens at Canadian Oil and Gas stocks and Consumer stocks. It is easy to also imagine that Sustainability would concern the mining industry, as the big employer in many small communities undertaking dangerous work with a huge potential impact on the physical environment. And as we noted in the previous posts, it is worthwhile for investors to pay attention. 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 practices. 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 ... products significantly depend upon extracting large amounts of natural resources ...".

Finding the stocks
As before we used the TMX Money Stock Screener and picked the metals and mining industry, taking the largest companies by market cap. Then we added two fertilizer miners, Potash Corp and Agrium Inc. Three companies - Silver Wheaton, Franco-Nevada and Royal Gold - were eliminated since they do not operate mines, only invest in others to pay out income streams or royalties to investors. The remaining list of 17 companies comprises eight gold producers, two uranium producers, four multi-metal miners, one silver miner and the two fertilizer producers.

The ESG Criteria
The first three critical assessment factors are taken from the above-cited Harvard article. To get the answers in the table we had to do a lot of digging through each company's website and in its annual Management Information Circular (aka the Proxy Circular on the regulator Sedar.com website where the official version is always to be found when it is not on the company website):

• Board Committee dedicated to Sustainability - The involvement of the highest level of the company ensures real action and commitment.
• Executive compensation tied to Sustainability - Linking executives' pay to results is the next step towards results.
• Formal stakeholder engagement processes are in place - The existence of mechanisms like surveys, focus groups and audits, to engage with suppliers, with customers, with employees, with the communities where they operate reduces risk and improves adaptability of the companies. We looked for evidence of planned, pro-active, focussed programs seeking feedback and involvement, not merely unidirectional "spreading the company word" outward communications.

We have added several other criteria to the list:

• Stock selected by the iShares Jantzi Social Index® Fund  (TSX symbol: XEN) - It's a plus if the company has been evaluated as conforming to "... a higher standard of environmental and social performance" and is in the XEN portfolio.
• Rating in the Board Shareholder Confidence Index of the Clarkson Centre for Business Ethics and Board Effectiveness - This helps us know whether the company's board of directors adheres to best practices for corporate governance. C is the lowest / worst and AAA+ is the best.
• Number of women on the board - As we wrote about here and here, it is an advantage for companies to have women directors. This is a hot topic in governance these days - see the Financial Post's recent article here and the Ontario Securities Commission's request for comments on whether and what it should force companies to do.
• Recognition, awards, disclosure practices and reports, standards pursued relating to ESG action or achievements by the companies - We have highlighted in green text what look to be the most exacting norms according to the Canadian Business for Social Responsibility, which is a non-profit organization promoting corporate social and environmental sustainability in Canada. The chart below comes from its CSR Frameworks Review for the Extractive Industry.

• For those who may wish to look at the details, here are the sources:
  Extractive Industries Transparency Initiative (EITI)
  Clarkson Centre for Business Ethics and Board Effectiveness
  Corporate Knights Global 100
  Corporate Knights 2013 Best Corporate Citizens Canada
  Corporate Knights 2012 Top 10 Canadian Mining Companies
  Global Reporting Initiative (GRI)
  Dow Jones Sustainability Index (DJSI) - usually gleaned only from the company's own website since the index provider only reveals constituent companies to paying customers
  Carbon Disclosure Project (CDP)
  Business for Social Responsibility (BSR) - different from the CBSR
  International Cyanide Management Code (ICMC)
  International Council on Mining and Metals (ICMM)
  Mining Association of Canada member, which includes mandatory Towards Sustainable Mining (TSM) participation

Who's the greenest of them all?

Green is good and the more green in our comparison table below the better. We have roughly sorted the table putting the best at the top.

Big Canadian mining companies generally take Sustainability seriously - There is a lot of green in our table. Except for the bottom three or so, every company is evidently devoting a lot of board and executive management time and effort to ESG and the results are visible to external ratings organizations. Comparing the results of our previous examinations of Consumer and Oil and Gas companies, these Mining companies generally look better. However, the companies at the bottom of the list, whose ESG characteristics are not quite as good as those above, are also the smaller companies. There are scores of mining companies listed on the TSX and we suspect, though we have not compiled the data, that as companies get smaller, the poorer the ESG performance is likely to be.

In short, our findings are very encouraging, both for those investors who explicitly want to hold high ESG performers and for those who view ESG ratings simply as an extra tool to finding good long term investments.

ESG is not the only thing that makes a good investment. Another key question is, of course, how the financial numbers for these companies stack up. A quick look at the performance of various indices for metals, mining and gold producers shows hefty declines year-to-date and for the past year. Are there buying opportunities? Which companies look best? We'll take a look next week.

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.

Postscript: TD Economics' Special Report The Greening of the Canadian Economy reviews the environmental performance of the Canadian mining industry.

ETF Comparison: Developed Country Diversified Equities

Equities of developed market countries such as Japan, Great Britain, Germany etc (about 25 in all) should be a key part of every Canadian investor's asset mix. The diversification into economies that are not entirely in sync and into industries and companies that differ from the heavy resource structure of Canada's can add stability to a portfolio. By their ability to offer such an investment in a large number of companies and countries at low cost, ETFs are an ideal vehicle. This week we will therefore review the strengths and weaknesses of the leading ETFs for this asset class. Our objective is to look for an ETF that can be a good long term holding with broad coverage of countries, industry sectors and companies.

As with our recent review of Emerging Markets ETFs, we used ETF Database to find and get data on the US-traded ETFs in the category. For Canadian-traded ETFs, we used a combination of BMO InvestorLine (reviewed in our ETF Screeners post) and ETF Insight.

Two sets of ETF choices ...
As with Emerging markets ETFs, the largest divide in the options is between traditional passive, cap-weighted index portfolios and those based on a variety of alternative strategies that have been gaining popularity - such as fundamental accounting data weighting, high dividend payout and low portfolio volatility.

1) Traditional Cap-Weighted Index ETFs
Some are traded in US dollars on US stock exchanges, others in Canada on the TSX in Canadian dollars, though they all ultimately hold equities of developed markets countries. Thus, the risk, including any currency risk, is of those countries, not the USA. As our comparison table below shows, the asset base of US ETFs dwarf those of Canadian ETFs.

• Vanguard FTSE Developed ex North America Index ETF (NYSE symbol: VEA) and its two Canadian clones which hold VEA but are traded on the TSX under symbol: VDU in a non-hedged version introduced this past August and VEF in a currency hedged version
• Schwab FTSE International Equity ETF (NYSE: SCHF), which includes of fair dollop of Canadian companies
• iShares MSCI EAFE Index Fund (NYSE: EFA), the grand-daddy behemoth of developed market ETFs and its currency-hedged Canadian clone XIN
• iShares Core MSCI EAFE ETF (NYSE: IEFA) introduced only a year ago and catching on fast due to its lower MER fee cost and wider diversification than EFA; has an unhedged Canadian clone XEF.
• BMO MSCI EAFE Hedged to CAD Index ETF (TSX: ZDM), which is not a clone but is hedged

Comparison Tables (click to enlarge)

Assets, MER, Performance, Taxes 

Country & Sector Holdings

 2) Alternative Strategy ETFs
There is also a mix of Canadian and US-traded ETFs in this group.

• iShares MSCI EAFE Minimum Volatility Index Fund (NYSE: EFAV) and its Canadian clone XMI. The strategy of these funds is to minimize volatility of the ETF as a whole.
• iShares International Select Dividend ETF (NYSE: IDV) has become popular in the USA but there's no Canadian clone so far. Holdings include Canadian companies. Consistent high dividend payers are what it holds.
• iShares International Fundamental Index Fund (TSX: CIE) whose strategy is to select and weight stocks based on sales, cash flow, dividends and book value. It is not hedged. Interestingly, for a foreign country fund sold to Canadians, it includes Canadian stocks.
• PowerShares FTSE RAFI Developed Markets ex-US Portfolio (NYSE: PXF) uses the same stock selection strategy as CIE but the country breakdown is quite different. Also includes Canadian companies.
• SPDR S&P International Dividend ETF (NYSE: DWX) another high dividend seeker that includes Canadian stocks.
• Wisdom Tree DEFA Fund (NYSE: DWM) holds consistent, not necessarily high, dividend payers and excludes Canadian stocks.

Comparison Tables (click to enlarge)

Assets, MER, Performance, Taxes 

Country & Sector Holdings

Country coverage - beware which countries are included or excluded
USA out - We have avoided ETFs containing a heavy component of US equities since we assume that investors will set aside a separate ETF holding for the equities of the world's biggest economy. Besides, many of the good ETF choices are offered on US stock markets and they exclude the USA.

Canada maybe in, maybe out - For Americans and US-based ETFs, Canada is a foreign country, thus many of the US-traded developed market ETFs contain Canadian equities. Our tables below show whether and how much Canada comprises of the total in each ETF. Though it is preferable to not have any Canadian holdings in these ETFs, since we believe investors should and probably have a separate Canadian equity ETF, the problem is not fatal. Canada is usually a fairly small portion of the ETF. Thus, if the developed country ETF is 20% of the overall portfolio, a 5% weight of Canada in the developed ETF means that another 20% x 5% = 1% is held in the overall portfolio. To compensate, an investor could reduce the main Canadian equity holding by 1%.

South Korea maybe in, maybe out - Major index provider MSCI considers South Korea to be a developing country so any ETF using MSCI as its base index provider excludes this country. Meanwhile, other major index provider FTSE says South Korea is a developed markets country. We believe that the world's 15th largest economy merits representation somewhere. The simple way to ensure it is not absent in a portfolio is to choose ETFs for developed and emerging markets (which we reviewed a few weeks back) using the same index index provider. It helps that usually FTSE or MSCI appears in the name of the ETF. Last year when major ETF provider Vanguard announced a change from MSCI to FTSE as its index for these funds, we put together this guide to the geographical structure of ETFs, a number of which we review today.

Japan and Switzerland should be in - Our desire for broad coverage means that Japan, the world's third largest economy and home to many major corporations, must be represented. Similarly, Switzerland, though a small country is home to major corporations as well, including Nestle, which is the single largest holding of a number of our ETFs. However, a couple of our ETFs - IDV and DWX - have little or none of these countries represented, a serious flaw in our view.

Hedging vs Non-Hedging - perhaps beneficial in the short term but a serious return drag in the long term
As in our discussion about this question in the Emerging markets ETFs post, the results for cap-weight ETFs EFA and XIN, as seen in the dark yellow outlined cells of the uppermost table, show a bit better results (higher one-year return, higher Sharpe Ratio - return over volatility - and lower volatility) for XIN than its internal holding EFA. The falling Canadian dollar over the past year has boosted EFA's value within XIN. But over the longer term, the returns for XIN continually lag EFA's due to the costs of hedging. For hedging to be beneficial for a Canadian investor, the considerable costs of doing it would have to be less than the drag of a sustained long term rise in the Canadian dollar against the many currencies of the developed countries, primarily the euro, yen, pound sterling, swiss franc, australian dollar etc.

Returns, Yields, MERs, Price/Earnings, Volatility - no clear picture
It is hard to discern a clear winner amongst the variety of ETFs, as the mix of green (i.e. stronger or better) and orange (comparatively weaker) numbers down and across the tables illustrate. Some ETFs have outstandingly low MERs and huge asset bases that keep bid-ask spreads tight, others better returns or Sharpe ratios, or more attractive Price/Earnings and Price/Book Value valuations. Short term returns look better for some while longer term 5-year returns look better for others. What the results will be in the very long term of decades is hard to tell, especially between the traditional cap-weight ETFs and the alternative strategy ETFS.

The portfolio volatility-minimizing objective of EFAV seems not to be very well in hand as its 1-year standard deviation is as high or worse than many of the other ETFs.

Foreign Witholding Taxes - be careful which ETF goes in which account
As we explained in Pros and Cons of Cross Border Shopping for ETFs in the USA, the clone versions of ETFs are susceptible to unrecoverable US witholding taxes in registered accounts on top of similar witholding taxes levied in the home country of the under-lying equities. Foreign non-US witholding taxes are completely lost to the Canadian investor, i.e. not avoidable and not claimable on a Canadian income tax return as a credit for foreign tax paid, in all registered accounts and for all types of ETFs. In our tables above, red text shows unrecoverable double taxation (US and other foreign), "neutral" means US tax is avoidable or Canadian tax credit is available and green text indicates US tax is avoidable and other foreign tax is claimable as a credit. Green only applies when the ETF is Canadian-traded and directly holds the equities - only CIE and ZDM are green and only in a regular taxable account. The impact is this: if an ETF distributes 3% cash and loses the standard 15% witholding tax, that is a constant 3% x 15% = 0.45% yearly return reduction. That's like doubling or more the fund's MER.

Holdings - some ETFs lack diversification
EFAV / XMI, IDV and DWX have a small number of companies in their holdings along with quite a high concentration in the top ten holdings in the latter two.

VEA / VDU / VEF, EFA / XIN, IEFA / XEF, ZDM and DWM have the convenience advantage of systematically excluding Canada from their holdings.

Bottom Line
Of the 16 ETFs under consideration, it seems a process more of elimination than selecting one or two best choices. EFAV / XMI, IDV and DWX do not achieve the diversification objective and so would be off our preferred list. We prefer non-currency hedged versions of funds but other investors may disagree and for those who do want hedging, ZDM works best from a tax viewpoint. Beyond that, the choice gets to the possible longer term benefits of alternative strategies against cap-weighting (see our post on New Improved Model Portfolios). However, the remaining choices look reasonable and the important step is to acquire and maintain a portfolio allocation in developed country equities.

Disclosure: This blogger owns some PXF.

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. 

Preferred Shares with High-Yield, Safety and Fixed Maturity

A few weeks back we compared fixed income investments and discovered that a couple of preferred shares from split share corporations offered the highest rates available for investments maturing in the next couple of years. Today, we'll update our September 2012 review of preferred shares, looking for promising investments by seeing how preferred shares with a great degree of safety and a fixed maturity date match up across the whole range of years ahead.

What we mean by "safe"
We want to minimize the chance of not getting our money back, so we select only preferreds with an investment grade rating from ratings agency DBRS of Pfd2-Low or higher (see table of ratings in Appendix B of Raymond James July 2013 Preferred Share Report).

Getting your money back also means knowing what you will receive when
Like GICs and bonds which promise to return a fixed amount at maturity, we pick the subset of preferred shares which promise to return a definite amount at a certain time in future.

Unlike bonds and GICs, several of our preferred shares, shown by green highlight cells in our comparison table, have a sliding scale of the amount to be returned. As with virtually all preferred shares, the company issuing the share has reserved the right to buy the shares back earlier than the ultimate maturity date. But in the case of this subset of preferreds, the price paid back is higher the earlier the re-purchase, which is termed a call or redemption by the issuer. For instance, CGI Series 4, 3.75% (TSX symbol: CGI.PR.D) may be forcibly repurchased from an investor owning it at a price of $26.00 till the 15th of June, 2019, then at $25.75 till 15 June, 2020, then at $25.50 till 15 June 2021, then at $25.25 till 15 June 2022 and finally at $25.00 from then till final maturity on 15 June 2023. It is a bit complicating that each preferred share has its own schedule so it is necessary to consult a source such as Prefinfo.com, which maintains an up to date list of all preferred shares. The July 2013 CIBC Wood Gundy Canadian Preferred Shares Report also has those details grouped together by type of share.

The sliding scale is a plus for the investor, being a disincentive for the company to redeem early as can be seen in the Yield to Possible Early Redemption column of the comparison table. The yield for such sliding scale preferreds would end up being higher for the investor than if the preferred stays in existence till maturity - e.g. Partners Value Split Corp. 7.25% Class AA Series IV (TSX: BNA.PR.D) matures on 9 July 2014 at $25.00 but if the company were to call it anytime beforehand, it would have to pay the investor $26.00 and the yield is almost double.

Comparison Table
The table below of twenty-three preferred share issues includes four sets of important factors to consider - Value, or what will be the yield/return; Call/Early Redemption Factors, or what are the chances the share will be called before maturity; Security, or what is the level of safety and; Liquidity, or how easy is it to buy or sell shares.

(click to enlarge image)

Value
A key question is how much the return will be. Our calculations were done with Shakespeare's free downloadable spreadsheet. We show three answers.

1) Yield to Maturity at Closing Price - the annual return from buying at the market closing price on 3 October 2013 and holding till maturity.

2) Yield to Possible Early Redemption - again we buy at closing price but instead of the maturity redemption amount, we calculate what return would result from the amount promised at the next date at which the company has the right to call the shares. In some cases, like for BNA.PR.D and CGI.PR.D we investors would be happy with a higher return. But in others, such as 5Banc Split Inc (FBS.PR.C), the 2.56% yield to maturity turns into a negative 17.77% return, a big loss. The reason is that paying $10.86 for a share that might be called on 15 December 2013 at $10.00 and pay only $0.13125 dividend up to that date is a losing proposition.

3) Yield to Maturity at Ask Price - It may not be possible to buy the shares at the latest closing price, especially when there is a low volume of shares traded daily. For such shares there is often a large gap between the price on the TSX at which investors are offering to buy, the bid price, and the higher price at which other investors are willing to sell, the ask price. Everyone tries to buy low and sell high! A more conservative estimate is thus the asking price. But that lowers the potential yield, sometimes drastically, as our table shows. Big 8 Split Corp Class C 7.0% (BIG.PR.C) maturing in December 2013 goes from a very attractive 4.65% yield when bought at closing price of $12.07 to a 0.73% loss when the ask price (as of October 3rd) of $12.20 is paid. When the the time to maturity is short and there are not many dividend cash flows to provide return, purchase price matters a lot. As can be seen in the table, there is much less of a hit to yield from paying the ask price for longer maturity securities.

On the basis of yield factors, First Asset CanBanc Split Corp. (CBU.PR.A) and Utility Split Trust 5.25% (UST.PR.B) look to be very unattractive, promising more loss than gain.

Call / Early Redemption Factors
These factors give an idea of the chance that the shares will be called, possibly to the investor's detriment. A danger sign is when the preferred's market price is above the redemption / maturity price, but we need to take account of the sliding scale. Alternatively, for some split share corporations, early cash-out can occur if capital shares are given in by investors forcing preferred shares to be sold. Sometimes capital shares and preferred shares can only be submitted with a preferred share so a premium on one may partly of fully offset the discount on the other for arbitragers seeking to profit from a price below Net Asset Value e.g. CBU.PR.A and UST.PR.B.

Three preferreds appear to be at some risk of early redemption due to a fairly large discount (highlighted in red text) on capital shares that can be submitted for retraction by themselves: Allbanc Split Corp. II (ALB.PR.B), BNS Split Corp. II (BSC.PR.B) and R Split III Corp (RBS.PR.B)

Security
The basic and most important default risk indicator is the DBRS rating, where the CGI Series 3, 3.90% (CGI.PR.C) and CGI Series 4, 3.75% (CGI.PR.D) get the highest rating of the bunch Pfd-1Low. A secondary indicator is the amount of capital share value as a percentage of the total company value. The higher the capital percentage the better. The lowest coverage ratio is Brookfield Investments Corp 'A' (BRN.PR.A) at 45.9%, though DBRS still rates it investment grade. To see that all the preferreds in our list are quite safe, it may be useful to note that preferreds of BCE Inc are rated a notch lower, below investment grade, at PFd-3High.

Liquidity
Many of the preferred shares in our list do not trade in large volumes, often because there are just not many in existence. The result is that it is difficult to buy and sell shares and there is often a big gap between ask (offers to sell) and bid (offers to buy) prices. An investor is wise to trade using a fixed limit price instead of a market price (see BMO InvestorLine's glossary). Our table shows shares with big Bid-Ask spreads and low volume shares in orange text. Poor liquidity is not an insurmountable problem but it can be inconvenient and potentially costly, as the reduced yields using ask price show.

Bottom Line
Putting it all together, we have picked out the preferreds with the best combination of high yield along with good liquidity and protection from the bad effects of early redemption.

• Allbanc Split Corp. (ABK.PR.C)
• Partners Value Split Corp. 7.25% Class AA Series IV (BNA.PR.D)
• Partners Value Split Corp. 4.95% Class AA Series I (BNA.PR.B)
• Partners Value Split Corp. 4.85% Class AA Series V (BNA.PR.E)
• Partners Value Split Corp. 4.35% Class AA Series III (BNA.PR.C)

Our picks show in green text colour in the table and the chart below displays the choices by year of maturity. We have not picked CGI.PR.D maturing in 2023 since there are higher rated corporate bonds offering the same or better yield, which we saw in the September 13 post. One good choice that doesn't fit on the chart, since it has no pre-set maturity, is Brookfield Investments Corp 'A' (BRN.PR.A). Instead, the investor has the liberty to retract it (sell it back to the company) at the price of $25.00 at any time.

Disclosure: This blog writer owns BNA.PR.C shares.

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.

Hedging Foreign Currency Exposure - Is it worth it? CalPERS Changes Tack and ETF Case Studies

A few weeks ago, the California Public Employees' Retirement System (CalPERS) reviewed its Currency Overlay Program review and decided to stop hedging its foreign currency exposure. Hedging aims to eliminate the effect of foreign currency swings on the returns of foreign holdings, especially to mitigate the steady appreciation of one's own currency which reduces foreign returns. That the sixth largest pension fund in the world, which is about 50% bigger than Canada's national CPPIB fund, has made that decision should cause us to reflect.

Currency hedging has not helped CalPERS
CalPERS' aim when it set up the program in 1992 was to reduce the volatility of the total fund portfolio arising from the rise and fall of foreign currencies against the US dollar associated with its substantial foreign holdings. But CalPERS has found that ... "There are no statistically significant benefits, such as • Decreases in volatility, and • Increases in net returns". In addition, they have found that the hedging is costly and complicated to carry out.

Pension fund peers for the most part do not hedge either
Part of CalPERS decision process was to review what other pension funds are doing about their foreign investment currency exposure. More than half, according to Appendix 2 (image below) of the Currency Overlay Program document, don't have a policy to hedge and of those that do, only apply it to specific types of assets like fixed income or a minor portion of equity. CalPERS itself only hedged 15% of its foreign positions up to the change.

(click on image to enlarge)

Canadian Dollar-Hedged ETFs are popular in Canada
There are quite a few Canadian-based ETFs that hedge their foreign currency exposure. A search on ETF Insight for US equity ETFs traded in Canada pulls up 41 ETFs, of which more than half - 21 - hedge against US dollar shifts. The ETF with the largest assets by far - iShares S&P 500 Index Fund (CAD-Hedged) (TSX symbol: XSP) - is hedged. Similarly, the largest foreign equity developed country ETF - iShares MSCI EAFE Index Fund (CAD-Hedged) (XIN) - is hedged. (Important note: the hedge in XIN is against the currencies of the under-lying foreign countries like Euro/Yen/Sterling versus the Canadian dollar, NOT the US dollar, even though XIN holds the US dollar-traded iShares MSCI EAFE (EFA) - Canadian Couch Potato explains the idea and CanadianFinancialDIY gives a numerical example.)

Why are hedged ETFs so popular?
Likely it's the reaction of investors to the trend in the Canadian dollar (CAD) versus the US dollar (USD), shown in the Trading Economics chart below. The chart line displays the number of Canadian dollars per USD. The rising line up to about 2002 meant that it took more and more CAD to buy one USD, the peak being around $1.60 CAD per USD i.e. CAD depreciation. Depreciating CAD means an investor's USD investments are worth more when translated back into CAD. That boosts returns in terms of CAD. Thus, we have labelled that part of the line with green text since it is beneficial for a Canadian investor. Conversely, since 2002 CAD has been appreciating vs USD (fewer CAD required to buy one USD). The line has been generally trending down and that has had a negative effect on a Canadian's USD investments - thus our red text. The trend was temporarily interrupted during the 2008 financial crisis as the flight to the safety of the USD caused a large spike of USD appreciation/CAD depreciation. That turned out to be hugely beneficial for Canadian investors with USD holdings since it offset a significant portion of the equity market drop, as we wrote at the time and show below in discussing an investment in the S&P 500.

S&P 500 Case Study
How would a Canadian investor in the main US equity benchmark the S&P 500 have fared? Would it have been better to hedge against currency effects or not? We'll use the Stingy Investor Asset Mixer tool, which gives us historical results and conveniently has a selector to display returns either in CAD (i.e. unhedged) or in USD (hedged). The tool allows selection of start and stop years for annual returns back to 1970. We'll compare results against the most popular CAD-hedged S&P 500 ETF mentioned above, iShares' XSP, which has now been in existence for ten years.

The results are in the comparison table below. As usual green numbers are good, red are bad and the red outline cells are especially shocking.

Returns in the last ten years (2003-2012) have been better for a CAD-hedged S&P 500, which jives with the return-sapping effect of a Canadian dollar that appreciated during that period. That first line of our table, highlighted in yellow, shows the benefit of hedging. But note the red outline cells - the actual compound return of XSP the ETF falls way short of its CAD-hedged index. Why? The idea of hedging is simple but it is very challenging in practice to carry out effectively. It's one of the reasons CalPERS cited for abandoning its hedging program.

A second result of note is that the non-hedged S&P 500 experienced much less volatility and a much smaller drop in 2008 when translated into CAD.

The third point we note is that in the long term (we've used the maximum data available from Stingy Investor of 43 years from 1970-2012), things even out a lot. There hasn't been a huge difference in returns between hedging and not hedging ... except that the results are before the practical difficulties and the return reduction from implementing hedging are factored in. The Stingy tool uses index returns so it is useful for comparing two indices but not for what actual ETF results will be.

MSCI EAFE Case Study
The same pattern of results comes from comparing the developed country MSCI EAFE (Europe, Australasia, Far East) index and its Canadian hedged version from iShares (TSX: XIN). 1) The hedged index return exceeds the non-hedged index in the short term of the last ten years but in the long term it evens out considerably; 2) the worst drop was much less for the non-hedged vs the hedged EAFE; 3) the actual ETF XIN's return is substantially below that of its index and on the basis of return to risk / volatility the unhedged version does better. A non-hedged EAFE ETF will not incur the large and chronic return reductions from the practicalities of the hedging activity, as we note when comparing the index vs ETF actual results for the under-lying fund of XIN, the iShares MSCI EAFE (NYSE: EFA). EFA's 10-year compound total return up to the end of 2012 was 5.27% and its index was 5.32%, a much smaller shortfall than XIN's.

Bottom Line: It does not appear to be worthwhile for the long term Canadian investor to hold currency hedged ETFs. The non-hedged versions, whether traded in Canada or the USA, make more sense.

Further reading -
Globe and Mail article by Andrew Hallam on the practical problems and costs with hedging and why the return drag won't go away

Previous posts on currency hedging:
Foreign Investments: To Hedge or Not to Hedge Currency
The Historical Effect of Inflation and Currency on a Canadian Investor's International Portfolio
Foreign Investments: What does history tell us about hedging currency?

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.

Emerging Markets ETFs Comparison Update - Which is best?

It has been almost three years since we first compared the main broadly-diversified ETFs for US-traded and Canadian-traded Emerging Markets equities. Things have changed with some new entrants and evolution of existing options. Emerging markets like China, Russia Taiwan, Brazil and South Korea are ever more important economic players. It's time for an update.

At the same time we'll integrate information on the pros and cons of buying ETFs on US markets, especially the effect of foreign withholding taxes, that we wrote about here. We'll focus on broadly based ETFs that aim to diversify across all emerging markets countries and all industry sectors and pick the biggest ones amongst the many listed in the USA - see the scores of offerings in the ETF Database list of emerging market ETFs here.

Two sets of ETF choices ...
The largest divide in the options is between traditional passive, cap-weighted index portfolios and those based on a variety of alternative strategies that have been gaining popularity - such as fundamental accounting data weighting, high dividend payout and low portfolio volatility.

1) Traditional Cap-Weighted Index ETFs
Some are traded in US dollars on US stock exchanges, others in Canada in Canadian dollars, though they all ultimately hold equities of emerging markets countries. As our comparison table below shows, the asset base of US ETFs dwarf those of Canadian ETFs.

• Vanguard FTSE Emerging Markets Fund ETF (NYSE in USA: VWO) and its Canadian clone which holds VWO but is traded on the TSX under symbol: VEE
• Schwab FTSE Emerging Markets Equity ETF (NYSE: SCHE)
• iShares MSCI Emerging Markets ETF (NYSE: EEM) and its Canadian clone again holding only EEM traded as TSX: XEM
• iShares MSCI Core Emerging Markets ETF (NYSE: IEMG), also with a Canadian clone holding only IEMG traded as TSX: XEC
• BMO MSCI Emerging Markets Index ETF (TSX: ZEM)

 2) Alternative Strategy ETFs
There is also a mix of Canadian and US-traded ETFs in this group.

• iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSE: EEMV) which follows the familiar pattern of having a Canadian-traded clone TSX: XMM. The strategy of these ETFs is to minimize overall portfolio volatility and it seems to be working so far, as our table confirms - see the row of Volatility numbers,  as measured by standard deviation of stock returns.
• PowerShares FTSE RAFI Emerging Markets Portfolio (NYSE: PXH). Its strategy is to pick and weight stocks by accounting data on sales, cash flow, dividends and book value.
• iShares Broad Emerging Markets Index Fund (TSX: CWO). It uses the same principles and follows the same index as PXH but holds most emerging equities directly, which is an advantage for taxes as we discuss further on.
• WisdomTree Emerging Markets High-Yielding Equity Fund (NYSE: DEM). This ETFs invests in stocks yielding high dividends.

Costs - MER and Bid-Ask Trading Spread
Management Expense Ratios (MER) are very important because they come right off the bottom line of returns to the investor. Since they get charged every year over the long term they can seriously undermine returns. In other words, the lower MER the better. SCHE at 0.15% is the lowest/best of all, followed closely by VWO and IEMG at 0.18%, with EEMV the best amongst the alternative strategies at 0.25%. Unfortunately, the best Canadian ETF VEE is a fair bit higher at an MER of 0.37%.

The gigantic size of the US ETFs ensures plenty of trading volume, which in turn means the spread between bid and ask prices is always very tight. That is a cost to the investor but is a relatively minor factor for long term buy and hold investors.

Cash Yield - a large range and effects of MER
It isn't surprising to see DEM with highest percentage of cash distributed to shareholders over the past twelve months since that is the ETF's strategy. However, it is surprising how little ahead - 3.9% vs 3.7% - it is over VWO, which pays no attention to this factor. It is also surprising to see the big spread of results across the ETFs, even those that use the same cap-weight approach.

All the Canadian clone ETFs have a significantly lower yield than thier respective US holding, illustrating that the higher MER needs to be paid from somewhere. PXH, which weights in part according to dividends, also loses ground from its higher MER.

Sharpe Ratio and Volatility - foreign currency effects have helped recently
Sharpe Ratio (see Investopedia explanation) is a measure of return per unit of risk/ volatility. The higher it is, the better - more bang for the buck risked in effect. XMM with its much lower volatility and higher return wins handily on this measure.

The reason XMM achieved a higher return than its US holding EEMV, is that a falling Canadian dollar over the past year has boosted the value of EEMV within it. Since our table shows returns in the local currency of trading, EEMV's returns are lower in terms of US dollars. But a Canadian holding EEMV would see a higher return once the value of EEMV was translated into Canadian dollars. We discussed the beneficial effect of foreign currency in this long ago post and illustrated how it would have affected a diversified portfolio in this post. Of course, the effect can go the other way and hurt returns if our dollar strengthens against the currencies of emerging countries. The yellow-outlined cells in our table show for one clone ETF pair where foreign currency effects are influencing the differential USA vs Canada ETF figures.

Attractive prices? Weak returns but valuation ratios vary
The trailing one- and three-returns for all of our ETFs look quite low, which would normally make one think a turn-around is in the offing. But valuation ratios of price to earnings at 17+ and price to book value are not that low for most of the ETFs. PXH, DEM, VWO and SCHE are the exceptions with attractive ratios. Some people believe some markets like India are good buy at the moment. Long term investors with a defined asset allocation will know when their portfolio rebalancing threshold is breached.

Foreign withholding taxes - beware which account to hold which ETF
We have copied the results of the discussion in this post about the subtle and complicated effects of foreign withholding taxes on a Canadian investor, depending on which account the various types of ETF are held. Ironically, many ETFs traded in Canada are worse for a Canadian investor! In particular, the clone ETFs which only hold a US ETF get dinged by US 15% withholding taxes that cannot be recovered or avoided when the ETF is in any type of registered account. TFSAs and RESPs are not good places from a withholding tax perspective to hold any emerging market ETF.

Portfolio holdings differ markedly - mind South Korea, Russia, India and sector weights
FTSE does not consider South Korea to be an emerging market country while MSCI does. Depending on the combination of developed market ETFs in a portfolio, an investor might end up having South Korea doubled up or worse, absent, which would defeat the aim of worldwide diversification considering the country is such a large economy. We wrote a guide to figuring out ETF combinations for country coverage when Vanguard decided to change from MSCI to FTSE as its index. In the comparison tables below blue highlighted text indicates where an ETF departs a lot from the weights amongst the group.

Similarly, Russia and India are also major economies, but due to their respective index rules, most of the ETFs have little or none of one or both countries represented. VWO, PXH and CWO are the exceptions with both India and Russia occupying major places, which we believe make them better for doing so. However, PXH and CWO are very concentrated in the six biggest countries. All the market cap ETFs are much less concentrated in terms of top ten company or top six country exposure. Overall VWO wins on balance for portfolio characteristics.

Other cost factors for the US vs Canadian ETF decision
There are other important cost factors that are not incorporated in the table e.g. the cost for a Canadian investor convert Canadian into US dollars or vice versa, which may cost up to 1.5% depending on the broker; the size and frequency of contributions or rebalancing, the level of yield interacting with withholding taxes, ETF tracking error. Canadian Couch Potato developed a spreadsheet to enable investors to crunch numbers with various scenarios but concluded that long term buy and hold investors are better off with US ETFs. We built a similar spreadsheet tool to calculate the cost of US vs Canadian ETFs and we found that the best choice might vary with assumptions.

Bottom Line:  VWO is the default overall emerging market ETF of choice at the moment due to its combination of low MER, low trading (bid-ask spread) costs, tax characteristics for Canadian accounts, good yield, attractive P/E and P/B valuation and portfolio diversification.

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.

Fixed Income - the best rates in Canada across the maturity spectrum

Looking for safety and steady income over a set number of years for your portfolio and want the best rate possible? There is a variety of choices available to the online investor. Though there are additional important aspects to consider (which we have previously explored separately - read the links tagged to the options below for details), today we'll look only for the highest rate available for specific future years to maturity from 1 year to over 20 years considering only investment grade securities i.e. with considerable safety / high credit rating (check ratings for any government/company issuer like the Province of Ontario at DBRS).

Here are the options we've examined:

• High interest savings account - BMO's version (symbol: AAT770)
  
• Guaranteed Investment Certificates (GIC) - our biggest constraint here is to select only from GICs available from our discount broker BMO Investorline, ignoring a few that might have higher rates but which require going direct to the provider
• Corporate, federal and provincial government bonds as individual bonds and in target maturity ETFs, or traditional ever-renewing ETFs (we've included these evergreen ETFs despite lack of a hard maturity date as they have a defined and fairly constant term and duration - see this previous post comparing the ins and outs of fixed income alternatives)
• Preferred shares of individual companies (previous post here) - we have limited our choice to the few securities with a firm redemption date at which the investor gets back a specific principal amount and ignored the many other types of preferreds whose end date depends on the choice of the issuer
• Preferred shares of split share corporations (see posts here and here), with under-lying holdings of either a single company or multiple companies

Comparison Table
The table below shows the best options across each type of security. Different individual GICs and corporate bonds were used to match up the maturities as closely as possible for each credit risk rating. Note that exact numbers shift constantly, making it necessary to double check the rate before buying, though the relationship and magnitude of the differences should be pretty close for a short while after this is posted. Green text shows the best rates.

The first thing we note is that a number of alternatives, shown in red text, at the short end of maturities, such as a high interest savings account, federal government Canada T-Bills or bonds and Province of Ontario bonds, don't even provide a return over the latest 1.3% annual inflation rate. The second thing we see is that there are some dramatic differences between alternatives with the very same credit risk e.g. the top paying 2 year GIC yields 2.11% while a Canada bond pays only 0.69%.

Comparison Chart
The table is quite busy so we have extracted the best rate for each maturity and created the chart below.

Up to 3 years maturity, ultra safe GICs, such as Equitable Bank or Manulife Bank, beat out just about everything. The exception is two split share corporation preferred shares, both from the same issuer - Partners Value Split Corp. Preferred Shares 4.95% Class AA Series I (BNA.PR.B) and Partners Value Split Corp. Preferred Shares 7.25% Class AA Series IV (BNA.PR.D). They have very high yields near 5%. Though their credit rating if Pfd-2 low, equivalent to BBB low for bonds, that is still considered investment grade (see Appendix B in this recent Raymond James report on preferred shares). BNA.PR.B and BNA.PR.D look like a very enticing option.

For maturities near 7 years and up to 10 years, corporate bond ETFs, notably BMO's Mid Corporate Bond Index ETF (ZCM), or individual bonds, such as the Great West Lifeco (AA low) 13Aug2020 maturity yielding 3.4% and the Bell Canada (A low) 11Sep2023 yielding 4.6%, become competitive to GICs.

It looks as though there is little benefit to buy very long maturities of 20 years or more as the yield is the same as for 10 years.

The final observation we make is that there is a much steeper increase in yield from 3 to 7 years maturity than at the short end of 1 to 3 years. Fixed income maturities of 5 to 10 years appear to be the best reward vs risk trade-off. If inflation heads back up to 3% or so, which is the top end of the Bank of Canada's target range and thus entirely reasonable to expect, at least the alternatives will keep pace and not lose real purchasing power.

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 TSX Composite - Which are the real blue chips?

A "Blue-Chip" stock is supposed to be a solid, dependable, financially sound company that has been around a long time. Let's have a look backwards at the biggest companies on the TSX to see which ones can claim to have performed like a blue chip. We'll go back to 1995 since that is the first year available in the University of Western Ontario annual lists of the TSX Composite Index component companies. Four years ago we did a similar review, so it will be interesting to see how the situation has evolved since. We'll broaden our review to the top 50 companies instead of only the top 25.

The Top 50 in 1995 - Creative destruction at work
The idea of capitalism being a system of creative destruction, where progress happens when the "newer better" replaces the "older less efficient" seems to have been at work on the TSX since 1995. As our table below shows with blue text companies being those still around in 2013 and the normal text being those that have disappeared in one way or another, there has been a lot of change. Less than half - only 23 companies - are still there in their old 1995 recognizable form. Half (25) were bought out or merged into larger entities. Two, in red text - Nortel and Loewen Group - went bankrupt.

The biggest slide in relative market size was BCE Inc (TSX symbol: BCE). Its market cap dropped from 5.07% of the TSX Index in 1995 to 2.25% now. Some 1% of that can be attributed to its spinoff of ill-fated Nortel in 2000 but the company lost ground in the Internet and mobile telephone revolution. Interestingly, it has recovered 0.6% of that lost ground since 2009 so maybe there is hope yet. Perhaps it is finally adapting to the new reality. A couple of other companies have seen their market cap share drop substantially - Barrick Gold (ABX) and Canadian Pacific (CP). In CP's case, some of that decline was due to various spin-offs but part was also due to poor performance of the remaining railway against recently privatized and surging Canadian National Railway (CNR). Barrick just seems to have had poor performance as it combined with #9 Placer Dome and still lost ground.

Another company that has destroyed value is Kinross (not shown at #98 on the 1995 list). It is notable for having acquired two companies - TVX Gold and Echo Bay - in the top 50 and still lost ground.

The greatest destruction happened amongst forestry companies as former giants MacMillan Bloedel (#31), Avenor (34), Abitibi-Price (37) shrank and merged and were bought out. Today there is not a single forestry company in the top 50.

The Top 50 in in 2013 - Banks become more dominant and many new players
"What financial and credit crisis?", the banks and their shareholders might be asking. As our second table below of the top 50 in 2013 shows, all but one (CIBC) of the big 6 banks have gained in relative market weight and rank in the TSX.

The second dramatic change is the arrival in top of the TSX of a whole raft of companies that did not exist or were at the bottom of the table in 1995. Starting with the privatized CNR (later in 1995) currently at number six by market cap and proceeding down through Valeant Pharmaceutical (VRX) whose predecessor Biovail was only first listed on the TSX in 1996, there are no less than 20 companies in the top 50 today that were ranked 200 or below in 1995 (to give a rank difference to those not even present in 1995, we have arbitrarily assigned those companies the lowest 1995 rank of 300). The new entrants are in every sector, except banking, where the dominant players are unchallenged.

Overall there is only a handful of nine companies that lost market cap weight or position from 1995 and still managed to stay in the top 50 in 2013. When a leading company weakens it tends to get bought out.

The Blue Chips - those who have stood the test of time
!) The big banks appear to be the bluest of the blue chips
...  but there are other notables that have been able to improve or hold their position -
2) Suncor (SU)
3) TransCanada Corp. (TRP)
4) Potash Corp (POT)
5) Telus Corp (T)
6) Rogers Communications Inc
7) Encana (ECA)
8) Teck Resources (TCK.B)
9) Power Corporation Canada (POW)
10) Shaw Communications (SJR.B)
11) Fairfax Financial Holding (FFH)
12) Cameco Corp (CCO)
13) Power Financial Corp (PWF)

The big question is whether they will continue to perform or whether some of the new players will prove to be better blue chips for the future. The past may provide some indication of a durable corporate culture and product but it is not a guarantee.

Those who do not want the trouble of trying to figure out which will be the blue chips may simply wish to buy an index ETF, such as the BMO S&P/TSX Capped Composite Index ETF (ZCN), which holds all the TSX Composite Index or the iShares S&P/TSX 60 Index Fund (XIU), which holds the 60 largest companies. These ETFs automatically add and remove those stocks that no longer qualify, giving the average performance of the good and the bad.

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.