Investing Risk: What is there to lose?

For most investors, risk means the chance of loss of part or all of their investment. In some imaginary world, we could all become rich with no risk in our investments. But, as the expression goes, "no risk, no reward". In order to reach future goals, whether it be retirement, education, a house, most people need to do more than merely save. They need to have their savings grow through investment. The ability to understand and control investing risk, taking appropriate risks in the context of those goals and one's personal circumstances, is essential for investing success. To that end, we break down investing risk into its main components and explore ways to counter each one by interpreting our deliberately ambiguous title What is there to lose? in three ways.

1) What do I have to lose?
The significance of risk depends in part on the impact on the investor. Circumstances unique to the investor heavily affect the decision on how to deal with the risks - to accept, mitigate or transfer the risk to someone else (for a price, of course).

• Time Horizon - How long before you will, or might, need the money strongly influences whether certain types of investment and their inherent risk characteristics are acceptable at all, and what counter-measures make sense. Many people will have multiple time horizons, for example, retirement and a house or a legacy. Retirement itself will involve spending year by year, from the immediate to the, hopefully(!), far distant. Some of the external risks we discuss below can effectively be dealt with if a person has a long term horizon and can simply ride out what may be very severe but passing non-permanent losses.
• Wealth - The richer you are, the more you can afford to take some losses or wait out short-term market volatility. A $10,000 or even a 10%, loss for a multi-millionaire hurts him/her a lot less than the same loss for an average wage earner.
  

2) How can various types of investments lose?
Bad things can happen in the financial world. Some happen steadily and predictably every year, others suddenly and violently. Some are quite visible, others much less so. Some cause irreparable damage, others only temporarily. Some are unavoidable, others resulting from investor panic reaction.

• Volatility - Daily, weekly and monthly price movements downwards can look worrisome on account statements e.g. as we write, the TSX is in a "correction" - down more than 10% from the previous high. Most people do not panic and sell in reaction to such a decline, but doing so will lock in losses if they end up buying back in at higher level once the correction ends. As David Parkinson tells us in Correction: Signs of doom have been greatly exaggerated in the Globe and Mail, corrections happen more years than not and the recovery is normally quick. Counter-measures: Short-term - buy put options on your holdings, which perfectly counter-balances any decline, but why bother if you can simply do the following. Long-term - continue to hold. Diversification - holding many types of asset classes in a portfolio will dampen swings. The S&P 500 index is down much less than the TSX and bonds are up so a portfolio with all three would not be down much.
  
• Default / No Repayment - The chance that you may not get your money back despite explicit promises to do so by companies and governments applies mainly to fixed income investments. Such promises are only as good as the organization making them and times can change. If the promising organization runs into financial trouble, it may not be able or willing to repay all or part of the principal. Some people think US Treasury Bonds are not as safe as they have been up to now. Twenty years ago, the Canadian government's ability to pay prompted derisory descriptions of it as the northern peso but now Canada's finances are among the strongest in the world. In the case of common equity, there is not even a promise to repay, only residual rights to whatever is left after all other claims have been paid off (mainly bondholders, taxes, employees). Sometimes governments simply expropriate companies for political motives and do not offer fair compensation. Counter-measures: Diversification - multiple holdings in a particular asset class spreads the risk and lessens the impact of any one holding going bad. ETFs and mutual funds offer this quality to investors. Bond ladders can help somewhat but it takes a sizable portfolio with many holdings to reduce the impact of any single holding enough. Due diligence - Credit rating agencies publish their opinion on the likelihood of fixed income corporate and government securities being able to meet their promises as we discussed in Seeking Safety. Credit raters do get things wrong. For individual securities, the investor would be advised to develop skills in reading financial statements and keep abreast of developments in the subject organization to get his/her own idea of evolving safety.
• Business Cycles - Economies and business go through constant though irregular cycles of expansion and booming times followed by recessions and retrenchment. Investments respond and follow suit, or more exactly, anticipate such cycles, which can stay for several years in upward or downward movement. Counter-measures: Diversification - Holdings across different sectors and countries even out and dampen the effects since business cycles are not in perfect sync or severity across such boundaries. Continue to hold - As with shorter term volatility, stay invested and the drop will be recovered, especially when one holds broad-based passive funds that more or less cover the whole market. Trying to time the cycles - selling before the drop to buy in again at the bottom - is so difficult, most professionals don't try it as the consensus is that you cannot win consistently.
  
• Asset Crashes and Financial Crises - These are severe negative events for investors. They frighten by their speed and sudden onset and depress by their duration, whose after-effects can extend to a decade or more. In the case of the 2008 financial crisis, we are still living with the consequences three years later. The systemic and structural defects await to be fixed and government debt loads from bailouts or the property crash remain extremely high or are climbing to unsustainable levels. As we saw when we reviewed the situation in Tech Stocks Revisited, tech stocks still had not recovered as a whole ten years after the Internet mania. Contrary to what some hope or mistakenly believe, such crashes are not once-in-a-hundred-years occurrences - more like every ten years since the 1970s. Counter-measures: Diversification - That includes holding a certain amount of cash and the safest government T-bills available, which these days for a Canadian means those issued by the federal government. See our post The 2008 Crash - Case Study in Diversification on what worked during the most recent episode of an extreme market downturn. Though the cash and short-term government debt should always be in a portfolio, the next crash will no doubt be somewhat different such that another asset mix will hold up better than what worked in the past. Thus, holding a variety of asset classes adds protection. Rebalance - When there are drastic drops in some or many asset classes, the ultra-safe ones will hold their value as the 2008 experience demonstrates. That is the time to re-establish the portfolio proportions according to the intended asset allocation.
• Unexpected Inflation - The current expected medium to long term inflation of around 2%, which is the Bank of Canada's explicit target rate for the country, is already incorporated into rates. If inflation were to jump upwards to 5%, whether due to sustained increases in commodity prices, as currently seems to be the main source of such concerns, or something else, the value of fixed income holdings in particular would fall drastically. Equities would too, at least for a time while companies adjusted their pricing to recover lost profits. Counter-measures: Real Return Bonds - These federal government bonds (and some provinces offer them too) continuously ratchet up the interest paid and the principal value in line with CPI. No need to guess about future CPI, though they will pay a bit less as a result. Equities - Though they suffer in the short term, the ability of companies to increase prices to maintain profit margins means they will cope with unexpected inflation in the longer term.
• Fees & Agent Costs - The management fees charged by mutual funds or ETFs and the salaries/bonuses paid to company management & employees reduce the returns going to the investor. The risk is that such costs will be excessive - that the profits go to these agents instead of the investor. Fees are too often hidden or difficult to see. A 2% annual fee seems small, which is the reason most investors don't get alarmed. But such seemingly small annual fees can add up significantly over the years as Independent Investor shows. The effect after 20 years can reduce a portfolio's value as much as the most severe market crash. It is just in slow motion not fast. Counter-measures: Shop-around for low fees - There are low cost funds around and efficient companies. Do some research. This blog attempts to contribute to this process by taking fees into account when assessing ETFs or other investments. The playing field is not level so it can really pay off to take steps to keep fees low. Very few high fee funds outperform and justify their high fees. High fees mean a high risk of significant portfolio loss for the long term investor.
• Required Return - The return expected or demanded by investors as a whole, i.e. the market, varies up or down. The same company's shares or bonds with the same continuing business outlook may be valued less and fall if the market demands a higher return. This may happen independently of both inflation and official Bank of Canada interest rates. The cause may be higher risk aversion or risk perception but the effect is that prices drop. RetailInvestor.org explains this factor, which he calls Interest Rate Risk, in detail. Counter-measures: Floating rate debt, Rate reset preferred shares - These securities include automatic or investor-choice adjustment to higher rates as market rates change. Short-term debt - The frequent rolling over of such debt allows the investments to be reinvested at higher rates as they change, though that also means the possibility of going down too and the rates will be lower than longer term options. Equities with pricing power - When required returns go up, companies with pricing power can increase prices to offset their rising financing costs and boost returns.
• Foreign Currency Shifts - When the Canadian dollar (CAD) is rising against the US dollar or other currencies, the net return on foreign investments after translation back into Canadian dollars is reduced. A strong CAD may even turn a foreign profit into a loss. Counter-measures: Hedge - Many ETFs and mutual funds invested in foreign securities takes measures to eliminate the effect of currency movements. Recently, we took a close look at two such ETFs that track the US S&P 500 Index. Retail Investor's How to Hedge Foreign Currency describes several other methods an investor with the time and interest can use to do so him/herself. We discussed the pros and cons of hedging in To Hedge or Not to Hedge.

3) Why should I bother worrying about it?
The carefree and careless attitude typified by this last form of the question is a sure-fire way to turn the above uncertain risks into certain losses. One cannot be fatalistic. Counter-measures: Plan and review - Set up a portfolio and an investment plan adapted to life goals, as we wrote about in the very first posts of this blog here, here and here. Follow that with a regular but not too-frequent review (otherwise it becomes obsessive and creates un-necessary worry in the day-to-day noise), such as we discussed in Annual Investment Review. The philosophy to adopt is to seek continual improvement. Scenarios and Too-small-to-fail - Taking a look at market history gives an idea of the possible extreme downside results that various asset classes and securities might produce. Consideration of the impact of the ultimate downside where an investment is wiped out helps inject a proper degree of caution. No single investment should be large enough to cause catastrophe for the investor.

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.

Dual Class Shares - Are they Ok or to be Avoided?

One person, one vote is a fundamental principle of democracy. Presumably it should also apply in stocks as one share, one vote. After all, if one takes the risk of owning common stock, it is only right that there should be an equal say in the affairs of a company. Yet that is not the case amongst many companies listed on the Toronto stock exchange which have two classes of common stock, one with lesser or no voting rights and the other with multiple or all voting rights. As of February 2011, there were 83 such companies, or about 6% of TSX listings, according to papers posted on the website of the University of Toronto's Capital Markets Institute. Very often the reason invoked to create dual shares is to allow continued founder control over a company to keep it growing and to maintain a long-term outlook while injecting new equity capital instead of debt financing.

Dual Class - Not Automatically Bad!
It is not necessary for the individual investor to automatically bypass such shares. The most recent substantial - and impartial - research on the subject by Ben Amoako-Adu, Brian F. Smith, Vishaal Baulkaran of Wilfrid Laurier University (paper available here from the CMI) notes that "Investors in dual class companies do not earn a lower risk-adjusted return than those in single class companies with concentrated ownership". Their recommendation upon studying thirty-two companies that unified (eliminated) dual class shares in Canada from 1989 to 2010 is that they nevertheless serve a useful role: "Dual class shares should continue to be issued to finance growth without the fear of losing control until the firm is matured".

Caveats - The Devil in the Details
Dual class share structures are not always good however, and the researchers' additional recommendations tell us key features to watch out for since, unsurprisingly, rights and privileges of the "lower class" shares can and do vary considerably, as we show below.

1. Coattail protection - These rights allow holders of non‑voting or restricted-voting shares to participate equally with the holders of the superior‑voting shares in a formal company takeover bid for superior-voting shares i.e they get the same deal. The TSX made this condition a requirement for new listings as of 1987 but older companies got a grandfather clause exemption. Some of the exempt companies are Rogers Communications Inc., Astral Media Inc. and Shaw Communications Inc.
2. Maximum 10:1 Voting Ratio - The superior shares should not have more than 10 times the vote per share of each subordinate share.
3. No Non-voting Shares - Each share should have some voting rights, though limited.
4. Sunset Clause Upon Founder Retirement - Since dual class shares often come about in companies with a founder-owner, it is a good idea to set an end to the dual class shares at a time when the structure should no longer be useful or necessary for company progress. Moreover, the terms and conditions for special compensation of the founder should be written down. This condition might be called the Frank Stronach test for the outrageously high payout ($983 million or 2063% return according to the authors) the Magna founder and controlling shareholder extracted from the company upon its conversion to a single common share class in 2010.

Conversion Bonus - Speculative Opportunity
Researchers have also found that amongst the actual conversions from dual class structure to single common class, subordinate shareholders benefited by an average 8% increase in stock price upon conversion. Ironically, "... the worse the job that the controller does, the greater the buyout premium!" according to Prof. Jeffrey MacIntosh of the University of Toronto in this presentation. Those who wish to engage in stock speculation can buy shares in badly run companies in anticipation of a conversion to single class since elimination of the dual classes will cause improved management and higher profits.

Example: Dual Class Shares Amongst Dividend Growers
We came across a number of dual shares in our recent postings on stocks with the attractive feature of growing dividends - the Low-Yielders and the High-Yielders. That gives us ten companies to compare in terms of the voting privileges, controlling shareholder, rights of subordinate shareholders, governance rating (from the Clarkson Centre for Business Ethics and Corporate Governance), 5-year dividend growth and 5-year total stock appreciation and dividend return. As a rough benchmark for returns, we include the performance of the popular iShares S&P TSX60 ETF (symbol: XIU).


Observations:

• Best Returns Have Worst Protection - Rogers and Shaw look to have the most ominous rights for the subordinate shareholders yet the returns for both are the best in our table and exceed XIU's by a good margin. Go figure.
• Best Rights Have Excellent Returns - Metro has the best minority rights, in fact the subordinate MRU.A shareholders, control almost all the votes. Metro also exhibits excellent performance, beating XIU in both dividend growth and total returns.
  
• Occasional Extra Dividends for Subordinate Status - Some companies - CCL, Corus, Shaw and ShawCor - offer more dividends to subordinate shares than to the controlling shares.
• Take Your Pick of Voting or Non-Voting - Many of the companies have both classes of shares available for public purchase on the TSX, though the dominant / multiple voting shares trade in much smaller volumes. What is not feasible for institutions who need high volume liquidity may be accessible and possible for an individual.
  

Finding Info on Dual Class Shares

• Companies - There seems to be no ready-made source list of the afore-mentioned 83 dual share companies in Canada. Such shares can however be identified by a suffix - .A or .B or .X - attached to a ticker symbol. There is no convention for whether the subordinate shares should have .A or .B. As we saw in the sample stocks, it is easy to find both.
• Share Structure and Rights - To find out the rights for each class of shares, go to Sedar Search Database and pull up the Annual Information Form for the company, then within it go to the part on Share Capital Structure.

Bottom Line
The biggest lesson is that subordinate rights vary a lot from company to company. When considering a company's shares, along with the prospects and position of the business itself, proper due diligence must consider the share structure and the rights of each class.

Further Reading:

• Primer - Dual-Class Share Structures and Best Practice in Corporate Governance by Tara Gry from the Canadian Library of Parliament
• Pros and Cons - Dual Class Shares - Not the Enemy by lawyer Barry J. Reiter

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.

S&P 500 Currency Hedged ETFs - How Well do They Work and Which is the Best?

The ordinary investor's goal for including an ETF that hedges currency while investing in an S&P 500 index tracker is to gain exposure to diversification and the returns of the US equity market while removing the possible damaging effects of a climbing Canadian dollar. There are such two ETFs available in Canada, both traded in Canadian dollars on the TSX:

• iShares S&P 500 Index Fund (CAD-Hedged) (symbol: XSP) - the giant leader, launched in May 2001, with $1505 million in assets
• Horizons S&P 500 Index (C$ Hedged) ETF (HXS) - only $21 million in assets, just launched in November 2010

The inner workings have some similarities and some marked differences, some good and some bad for the investor and some surprising characteristics that reduce their effectiveness exactly at the wrong time while enhancing returns at other times. Our chart below provides details of these key points.


MER, including the new in 2010 HST - each fund has a management fee, HXS' a bit lower than XSP's, but that is just the beginning as MER is a minor drag on returns compared to other factors

Swap Fee - 0.30% for HXS only, none for XSP. HXS obtains the returns of the S&P 500 through an agreement with the National Bank in which the Bank swaps the return of the S&P 500 index in exchange for the swap fee and interest on cash held by HXS. Canadian Capitalist described this ingenious method of tracking an index, much practiced in Europe, in this post.

Residual Currency Effect - Here is the first zinger. The constant movement of both currencies and the stock market means that it is impossible to hedge perfectly at every moment. Find out how and why in An Imperfect Hedge: The Limitations of Currency Hedging by Philip Falls and Dino Bourdos in the April 2010 Pension & Benefits Monitor and Currency Hedged S&P 500 Funds: The Unsuspected Challenges by Raymond Kerzérho of PWL Capital. The bottom line is that hedging works least well precisely when investors want it most - at periods of extreme stock and currency volatility, such as during the 2008 and 2009 financial crisis. The crisis period gave the worst tracking results vs the benchmark index. There is some debate whether the right benchmark is the native US dollar percentage returns of the S&P 500, which is the simple objective of an ordinary investor, or the percentage returns of the hedged S&P 500 index, which both iShares and Horizons insist is the right way to track. Using either index the results are bad, it just looks far worse when the Canadian investor's hedged percentage returns in CAD are compared to the "native" S&P 500 percentage US dollar results such as a US investor would have obtained - see Canadian Capitalist here for some of the ugly numbers. Ironically, when both the USD and the S&P 500 are dropping simultaneously, the hedged tracks the native results very closely! Big sudden moves in opposite directions are what hurt most. At present the environment looks quite tame and both HXS and XSP in the last six months (see table below) have been only 0.1 - 0.25% below both the S&P 500 hedged index and the native index.


US Withholding Tax - XSP owns US shares through its holding of the US iShares S&P 500 ETF (IVV) and the US government deducts the standard 15% withholding tax on distributions. In a registered account (see our dissection of this issue here) XSP shareholders cannot get this amount back, neither as a tax credit, nor by preventing it being deducted. At the current S&P 500 dividend yield of 1.73% that means there is a 0.26% return reduction on XSP in registered accounts compared to HXS, which receives no distributions per se (they are implicitly included in the swap return) and certainly not from the US, only from the National Bank (whether the Bank suffers the 15% tax has no effect on HXS shareholders since the swap provides HXS the index return, which calculates no deduction for tax). In taxable accounts HXS and XSP are equal. HXS has not paid any tax while XSP shareholders can deduct it as a credit against other taxes.

Canadian Income Tax - Here is another big return-reducing area, with significant potential advantages of HXS over XSP in taxable accounts. In registered accounts, neither has a problem since there is no tax levied against any type of gains or income, as is usual.

In taxable accounts, HXS' swap structure means that all returns, both price advances of the S&P and its dividends, a) become capital gains and b) become realized and taxable only when the investor finally sells the HXS shares. In contrast, XSP receives dividends and makes distributions every year, which are a) taxable each year upon receipt and b) taxed at the same rate as ordinary income, which is double the capital gains rate. There is a significant net return reduction to both funds but it is up to double or more for XSP compared to HXS. Our comparison table shows that the advantage of HXS is more pronounced when the S&P 500 dividend yield is higher, the gains are deferred longer and the taxpayer is in a higher tax bracket.

Interest Rate Spread - The use of forward contracts by both funds to implement the hedging creates a net benefit, or cost, to the fund as a result of differences in short term interest rates between Canada (as represented by something called CDOR) and the USA (LIBOR). At the moment, Canadian rates are about 1% higher than US rates, which means HXS and XSP are making money from the forward contracts themselves. That extra return, especially with the difference being quite high right now, could cause the funds to outperform the index! While it lasts, it will at least drastically reduce the historical under-performance of hedge funds noted above.

Of course, in taxable accounts, the extra income gets taxed. In 2010, XSP shareholders had to pay taxes on substantial capital gains generated by forward hedging contracts. HXS will not have this negative since the National Bank does the hedging and although the hedging profit accrues to the fund through returns of the hedged index, the gain is not distributed annually to HXS shareholders and there is not tax to pay immediately. The HXS website and Prospectus has announced the intention not to make any distributions at all.

Investor's Trading Costs - There are several other factors that an investor faces when buying and selling ETF shares which can either boost or reduce returns:

• Bid-Ask Price Spread - Pull up a quote from a website such as TMX.com and it will show the lowest price at which someone is willing to sell - the Ask price - and the highest price someone at that moment is offering to buy - the Bid price. The lowest possible spread between the two is the best - one cent. A big spread represents a cost to the investor. XSP comes out much better than HXS with a much smaller spread on average. The end of trading bid-ask quote on June 10th is significant not so much for the positive or negative sign, since that can and does switch back and forth between positive and negative regularly for each fund. It is more the size of the spread that matters. XSP should almost always have a much smaller spread and that is a benefit to the investor. Its asset size and trading volume ensure a more efficient market than for HXS. It is hard to quantify the impact of the higher spread since it will depend on how much trading an investor does (more trades = more cost) and holding period (longer = less cost because the cost is averaged over more years).
• Price vs Net Asset Value (NAV) Premium or Discount - The ETF size and trading volume also drives this return/cost factor. The market price of XSP or HXS may deviate from the actual fair value of the stocks within the S&P 500 index. It may be higher, which is called trading at a Premium. In this case, the investor who buys at the market price pays more than the stock is worth. Or it may be lower, at a Discount, which means paying less than it is worth. Horizons publishes HXS' updated (every 15 seconds) Intra-day NAV here such that one can compare it with market price in a real-time quote from a broker website (as opposed to the 15-20 minute delayed quotes in TMX, Yahoo Finance, GlobeInvestor and other free public sites), but unfortunately iShares does not publish this data for its ETFs. There are constant fluctuations of price above and below NAV as arbitrage by market players keeps the Premium or Discount down but it will be a lot closer on average for higher volume XSP than for HXS. The lower the deviation, the better for investors so XSP is much better on this factor.
• Dividend Reinvestment Commission - Since HXS incorporates implicit automatic dividend reinvestment as a result of the swap for the total return of the S&P 500 (capital gains plus dividends), it has zero cost for this operation. The XSP investor must remember to reinvest the cash dividends received twice a year, as well as pay the broker commission. HXS is thus superior to XSP on this cost factor.

Risk Factors of HXS - The structure of HXS based on swap derivatives presents several special risks unique to HXS that XSP does not have.

• Counterparty risk - Up to 10% of the value of the positive returns of the S&P 500 could be lost to XSP shareholders in the event of default of the National Bank. It is the returns only, not the principal value of HXS, that is possibly at risk, and only up to 10% of returns, since the Bank must provide collateral beyond that amount, and it is only positive returns, since in the event of losses, it is HXS that must pay the Bank money (the swap tracks the gains and the losses of the S&P 500). How serious a risk this factor represents is a matter of judgment, since the National Bank would have to fail at a time when the market is going up. During the financial crisis, when many banks did fail, the market was going down a lot, not up.
• Swap expiry risk - If Horizons decided to terminate HXS and thus the swap, the embedded capital gains would be realized involuntarily by shareholders. Assuming the market goes up over the long term, that would create a sudden potential tax hit for HXS holdings in taxable accounts. The current swap with National Bank is due to expire in 2015 but Horizons says it intends to renew and roll it over indefinitely so that the tax hit does come about, but the possibility exists. In this blogger's opinion, the small current asset size of HXS makes this risk a concern at the moment.
  

Bottom Line

• XSP and HXS both will be much more efficient hedging tools and will track the S&P 500 percentage returns much more closely (within 0.3% per year) as long as lower market and currency volatility and higher Canadian vs US interest rates continue.
• HXS has appreciable cost advantages over XSP for holdings in registered accounts and especially for holdings in taxable accounts of high marginal rate investors. However,
• HXS has some extra risk over XSP which counterbalances to some degree the return advantage.

Additional Reading:

• Canadian Capitalist reviews recent actual Performance of Currency-Neutral S&P 500 Index Funds and debates Why Currency Hedging is Necessary
• Canadian Couch Potato's Understanding Swap-Based ETFs and Swap-Based ETFs: What are the Risks?
  
• Dan Hallett of the Wealth Steward discusses the swap structure risks in A Closer Look at BetaPro's Dirt Cheap ETF

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.

Canadian Market Darlings & Dogs Update - Looking for Over- and Under-Priced Stocks

A little over a year ago, we wrote about the market darlings and dogs of the day, the stocks whose market prices implied either optimism or pessimism by the mass of investors. Let's see what has happened since and identify stocks that might be the victim of undue pessimism at the moment and therefore possibly under-valued, or the opposite, the beneficiaries of undue favour.

As before, we compare two large-cap Canadian equity ETFs with similar holdings but different weighting schemes to identify where the market is either pricing above (optimism aka Darlings) or below (pessimism aka Dogs) actual historical results - iShares' S&P TSX 60 Index Fund (symbol: XIU), which is the price-weighted ETF, and Claymore's Canadian Fundamental Index (CRQ), the historical fundamental accounting data-based ETF. The table below shows the companies and the sectors colour-coded - Darlings in Green and the Dogs in Red with the really big differences between XIU and CRQ highlighted in Yellow. The table also shows the change in internal weighting over the past year for each ETF, which tells us stocks and sectors that have been on the up- or down-swing, either in terms of price (XIU) or fundamentals (CRQ).


Financials - Dogs

• As a sector, Financials were Dogs a year ago and are even more so today with a dropping share of both funds, though the pessimism of the market with a faster drop in market cap has outstripped what is justified on the basis of CRQ's adjustments due to fundamentals
• Bank of Montreal (BMO), Manulife (MFC), CIBC (CM) and Sun Life (SLF) are all going in the same downward direction in both CRQ and XIU, indicating that actual trailing results in CRQ back up the direction of the market's forward looking price opinion as seen in XIU. However, is the market pessimism overdone as the drop in XIU much exceeds that in CRQ?
• Royal Bank (RY) on the other hand may be the victim of unwarranted market pessimism as it is going in the opposite directions in CRQ and XIU, rising in CRQ while dropping in XIU. Royal has just raised its dividend for the first time in years but its stock has dropped fairly significantly in the last few weeks and analysts have it rated as 'Hold'. Why?

Energy - Darlings

• The sector was a Darling a year ago, is still a Darling today and is growing even more so
• Some validation comes from the increasing proportion of CRQ for such companies due to elements like rising sales and profits but the optimism in prices outstrips the reality confirmed so far
• One unusual contrary company is EnCana (ECA). It suffers from pessimism in the market - a much lower place in XIU last year that has got worse while its place in CRQ due to better fundamentals has gone up. What does the market know that the accounting results do not show is the critical question.

Telecomms - Darlings

• The sector was a Darling last year and is getting more price affection from the market, contrary to the direction in CRQ
• BCE Inc (BCE) and Telus (T) are the main beneficiaries of this positive market opinion. Again, why so?

Consumer Staples and Consumer Discretionary - Dogs

• They were Dogs a year ago and are Dogs today. Some of the imbalance is due to XIU not including companies like Empire Company (EMP.A) and Alimentation Couche-Tard (ATD.B). There is not much change on the price side but the decline of this sector within CRQ indicates that the market opinion is being proven right by results.

Information Technology - from Darlings to Dogs

• From Darling sector of last year, it is now a slight Dog, XIU having dropped its seemingly undue optimism to the level of reality in CRQ.
  
• Research in Motion (RIM) is the explanation, its fall from lofty heights being widely observed.

Utilities - Dogs

• Dog status is little changed. The market / XIU seems to have little respect for the well-mannered Dogs of this sector as companies that are substantial in accounting terms do not achieve the market cap to be included in XIU but gain entry to CRQ. The list of absentees from XIU includes Canadian Utilities (CU), Emera (EMA) and Atco (ACO.X), the first two of which looked rather attractive in our recent review Electric Power Utility Stocks for the Income Investor?

Are the Darlings worthy of our love and the Dogs of our scorn? The above cursory review suggests a mix of yes and no answers. One can never be absolutely sure and certainly more looking into the circumstances and prospects of the companies would be necessary but our comparison offers a starting point for further investigation and potential investment action. To be really sure of the answers, we would need to wait a year, or two, or ten, but then any opportunities to make a profitable investment would be gone too!

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.

Disclosure: the blogger owns shares of RY and CRQ.

Stocks & Board Governance - Do the Good Guys Finish First or Last?

Many investors take a keen interest in the ethics and business practices of the companies in which they invest. Leading institutional investors think that taking into consideration so-called Environmental, Social and Governance factors and even active involvement with companies to further such goals can enhance long-term investment returns. For example, the Canada Pension Plan Investment Board's pursuit of Responsible Investing evidently takes up much time and effort because it believes that "... responsible behaviour regarding environmental, social and governance factors by these companies can have a positive influence on their long-term financial performance and therefore, to our investment return". Internationally, many major pension funds subscribe to the United Nations Principles on Responsible Investing, as is evident in the reports on the PRI website.

All investors object to being taken unfair advantage of by crooked or avaricious company insiders. To prevent that happening, shareholders rely upon a company's Board of Directors, in other words the Governance part of ESG. In Canada, the Clarkson Centre for Business Ethics and Board Effectiveness within the Rotman School of Management at the University of Toronto publishes annual ratings for Board Shareholder Confidence that assess various aspects of Board best practice and give an indication of how likely it is that a company Board will serve shareholder interests well. There are two sets of ratings: 1) Companies in the TSX Composite Index for 2003 to 2010; 2) Small and Medium companies for 2009 and 2010.

The big question is how well do the rankings correspond to investment results? Does governance best practice earn the best returns, or at least good returns? To get an idea, we've compiled a few tables below. Note that it is by no means a definitive scientific answer. A Board that is good today may not have been so five years ago; future results are really what we would need to compare, while we compare with past investment performance. Our unproven assumption is that the best Boards today would generally have been better in past years too as improvement happens gradually.

Investment Performance of Top-Rated 2010 Boards - Mixed Results
Taking all 19 companies in the top two ratings CCBE governance categories of AAA and AA shows us that excellent ratings have not guaranteed success. Four top-rated companies have not even managed a positive total return over the past five years. Manulife (symbol: MFC) has had particular trouble. On the other hand, eight companies of the companies on the list have regularly and steadily increased their dividend payouts, as further detailed below. Almost are solidly profitable and the worst rating by professional analysts is Hold, no Sells at all.


Investment Results of TSX Companies vs Board Ratings Overall - Advantage to the Good Guys
When the latest ratings came out in the autumn, the Globe and Mail's Report on Business published Board Games 2010, a series of articles on the ratings which are well worth reading. The material published includes a different version of the TSX table that includes 5-year returns for each company. Filtering through the list, we find that amongst the top 25 scoring companies, 16%, or four, had negative 5-year returns. However, in the entire list of 187 companies, a greater proportion - 26% or forty-eight companies - had negative returns. The well-governed-Board stocks have done better overall.

Dividend Growers & Board Governance - No Discernible Effect
Since we recently reviewed stocks that have been steadily increasing their dividends - here for low-yielders and here for high-yielders - we decided to look at them too. We added the CCBE rating against this select group of potentially attractive stocks to see if they all have high Board ratings. Result: not so at all, as there are just as many dividend growers with the terrible lowest "C" Board rating as with the high AA and AAA ratings. Nevertheless, all the companies with high rated Boards showed quite healthy five-year returns and none had negative returns while none of the losing negative return stocks had high ratings.


Bottom Line
Good governance seems to have had a mild positive effect so far on stock returns but it is not a guarantee of success. It is a useful addition to the mix of factors for a stock investor to assess. Perhaps its best role is to provide a measure of risk to investors on the chances that bad things may or may not come from within the company, either from management or dominating majority shareholders, at the expense of the average individual investor.

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.

Cross-Border ETFs - Here's a Free Tool to Compare Costs

Our last post ended by suggesting that investors should compare the total costs of investing in US-listed ETFs vs Canadian-listed versions. We've taken up our own challenge and offer a spreadsheet (click here for download) to help readers assess their candidate foreign ETFs. Here is a screenshot of the spreadsheet.


What the spreadsheet does
Our approach is to start with assumptions about growth of an index that two ETFs aim to track and adjust returns taking into account the various factors explained below. The spreadsheet takes into account these factors by allowing you to enter the data for pairs of ETFs and applying costs, taxes, rates and fees that influence net returns.

• US holdings and International holdings - Each type has its own sheet since a) each would be a separate asset class within a portfolio - thus we want to compare within an asset class - and b) the tax consequences are different.
• RRSP (& other registered retirement accounts like RRIF, LIRA, LIF), TFSA, Taxable account choice - Tax consequences differ for each type of account.
• Direct or Indirect ETF holdings - Instead of holding foreign stocks directly, some Canadian ETFs hold US ETFs inside, which we call Indirect ETFs. Again, there are different tax effects.
• Capital gains and Distribution/Dividend yield - The amount and proportion of each source of return affects the net return due to the interplay of the other factors. A usual starting point for picking numbers to enter is historical data. For example, the current distribution yield for the SPDR S&P500 ETF (symbol: SPY) is 1.74%. Estimating Capital gains can be a lot more problematic - are we looking forward to years of low 2-3% growth or higher 5-6% gains? The usefulness of the spreadsheet is that we can quickly plug in different numbers to see if the best choice of ETF and account varies and by how much.
• Tracking error - This is the amount by which the ETF performance differs from its index. Although a very few ETFs may actually outperform the index in the occasional year, the typical and expected result is under-performance over the long term, which is what interests us. A key element of Tracking error is the ETF's Management Expense Ratio (MER) and that figure should be the minimum value to enter. However, it is not the only one and especially with International ETFs or currency-hedged ETFs, not necessarily the biggest component. Other Tracking error sources include: Sampling/optimization or Replication strategy, Rebalancing and Reconstitution efficiency, Cash dividend reinvestment drag, Trading costs, HST (Canada only), Currency hedging costs, Concentration limits on holdings and Securities lending (a source of revenue for many ETFs). Larry MacDonald's Investopedia article ETF Tracking Errors: Is Your Fund Falling Short? explains this topic well. As Tracking error rises to the 1% or more range it starts to heavily influence net results, as playing with our spreadsheet will quickly show. Canadian Couch Potato's tally of Tracking Errors on US and International ETFs listed in Canada shows widely varying errors amongst funds for 2010. Keep in mind that errors can vary, sometimes a lot, year to year. Some ETFs seem to be quite stable, others not. Tracking error very often turns out to be the key factor in differentiating ETF performance.
• International withholding tax - The actual amount paid to foreign non-USA governments varies within various ETFs - often 8 or 9%, but up to the 15% maximum of international tax treaties. In only one combination of circumstances, a Canadian listed ETF that directly holds international securities in a taxable account e.g. Claymore's International Fundamental Index (CIE), can a Canadian investor recover that tax through a tax credit.
• US withholding tax - Though not a variable you need to estimate or change in the spreadsheet as it is always applied at the 15% rate specified in the Canada-USA tax treaty, US withholding tax can have a big influence on performance at times, especially when the ETF distribution yield gets to 2% or more and account type is brought into play.
• DRIP brokerage commission and auto-DRIP - Many brokers now charge $10 per trade so we have set that as the amount in the input cell. If you want to see how reinvesting more often e.g. twice a year or quarterly when the ETFs make distributions, simply enter the total brokerage trading commissions you will incur per year. The same input adjustment can be made if you unfortunately are paying higher brokerage commission rates. Two ETF providers in Canada - BMO and Claymore - will automatically reinvest distributions for free, so our spreadsheet will adjust for that savings too. Some discount brokers even offer a so-called synthetic DRIP for ETFs (call your broker to find out if it offers that service; see also this article from CanadianFinancialDIY), absorbing the cost of distribution reinvestment.
• Transaction fees on foreign exchange - The amount charged by discount brokers to convert Canadian into US dollars or vice versa varies from broker to broker, ranging from 0.5% up to 1.5% - see MillionDollarJourney's broker comparison. Forex can have a significant influence, mainly when Tracking errors of ETFs are close and where Withholding taxes do not differ.
• Annual contribution - See how rich you might get! Just for the fun and as a reference point, since it does not affect which ETF is a better choice, the annual contribution you invest in the ETFs can be varied.

What the spreadsheet does NOT do

• Compare different indices - It is assumed the ETFs compared track the same index. Different ETFs, even within the same asset class, such as US equity, can produce markedly different returns and portfolio growth. Look at the variability of fund returns in 2010 in Couch Potato's Tracking error article we cited above. If you compare ETFs with different indices, remember that you are only comparing costs, not total returns.
• Exchange rate variability - There is no attempt to incorporate effects of changes over time in the value of the Canadian dollar against the US dollar or international currencies. Year to year and over multiple years, the evolution of currencies strongly affects foreign investment net returns. Whether to hedge or not is a fundamental choice for the investor and comes before the choice of a specific ETF.

Examples (numbers in the download spreadsheet)

US Holdings

• US-listed = PowerShares FTSE RAFI US 1000 Portfolio (PRF)
• Canadian-listed = Claymore US Fundamental Index (non-hedged) (CLU.C)
• Forex fee = 1.0%, rate applied at big bank brokers
• Distribution yield = 1.5%, current rate per PowerShares; could also try 1.99% cited on Claymore (rate as of end of March)
• Account type = 1 RRSP
• ETF type = 4 Direct i.e. CLU.C directly holds shares of companies, not a US ETF
• Auto DRIP = 1 since CLU.C is a Claymore fund
• Tracking error US ETF (PRF) = -0.48%, estimated using historical results on page 11 of the 2010 Annual Report here on the PowerShares website
• Tracking error Canadian ETF (CLU.C) = -1.5%, estimated future error. The 2010 error was a horrible -2.3% from page 12 of the Annual Report here on Claymore's website, but in future it should be much lower as the ETF switched to full replication in September 2010, holding all 1000 stocks in the index, instead of the partial replication by 400 or so stocks it had previously carried.
• Bottom Line = Under the above assumptions, PRF gets ever further ahead till it is up more than 20% over its competitor after 30 years due to the harmful effects of CLU.C's high tracking error.

International Holdings

• US-listed = PowerShares FTSE RAFI Developed Markets ex-US 1000 Portfolio (PXF)
• Canadian-listed = Claymore International Fundamental Index (CIE)
• Forex fee = 1.0%, rate applied at big bank brokers
• Distribution yield = 3.2%, current index rate per Claymore; could also try 2.3% cited on PowerShares though that is net of international non-USA withholding taxes already deducted
• Account type = 2 Taxable
• ETF type = 4 Direct i.e. CIE directly holds shares of companies, not a US ETF
• Auto DRIP = 1 since CIE is a Claymore fund
• Tracking error US ETF (PXF) = -1.2%, estimated using historical results on page 11 of the 2010 Annual Report here on the PowerShares website
• Tracking error Canadian ETF (CIE) = -1.5%, estimated future error. The 2010 error was a terrible -2.1% from page 9 of the Annual Report here on Claymore's website, but in future it should be much lower as the ETF switched to full replication in September 2010, holding all 1000 stocks in the index, instead of the partial replication by 300 or so stocks it had previously carried.
• International withholding tax = 9%, estimate from Foreign Tax Paid actuals on page 123 of the Annual Report
• Bottom Line = Under the above assumptions, CIE comes out a constant 3% or so better than PXF. Put the CIE into a TFSA, however, and its advantage grows over the years, reaching over 10% after 25 years. Beware of withholding taxes!

There you have it. Use the spreadsheet to see which costs matter and which don't under reasonable assumptions, or to check how far things would have to change to make a difference in choosing ETFs and which account to put them in.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Calculations and formulas are believed to be accurate but are not guaranteed to be so. Use at your own risk. 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.

Pros and Cons of Cross-Border Shopping in the USA for ETFs

Cross-border shopping in the USA has long been a favorite activity of Canadians when the exchange rate vs the US dollar has swung in our favour. Investors looking for ETFs can shop cross-border too, as online brokers all provide seamless access to US stock markets with a click of the mouse on a drop down menu. What are the possible advantages and drawbacks of buying ETFs on US markets instead of the TSX in Canada?

The high Canadian dollar is not a reason to buy in the USA - The rise in the Canadian dollar does not create the same bargains in ETFs as it can in shoes. Buying the same thing in the USA and in Canada will not present the same bargains in ETFs because the much greater speed, volume and ease of moving money brings about a high degree of stock market efficiency – the same thing will at every instant cost the same amount, factoring in the exchange rate, on both sides of the border.

Pros – Reasons that favour buying ETFs in the USA

1) Management expense ratios – The lowest MER for an asset category is most often found in a US-based ETF. A good example is a fund that tracks the flagship large cap equity S&P 500 Index or something very similar. In Canada the lowest MER is Claymore's CLU.C with an MER of 0.71%, while in the US, the SPDR S&P 500 tracker (SPY) has a 0.09% MER.

2) Range of choice – US financial markets are many times larger than Canada's and that results in a much greater selection of ETFs. Whether it is US equity, international equity, emerging market equity or bond funds, there are more ETFs available. Sometimes there isn't even a comparable ETF in Canada for a key category, e.g. a whole of market US equity fund. Other worthwhile categories where there is a dearth of ETFs available in Canada include: Value stocks, Small cap stocks, foreign bonds.

3) High liquidity, reduced bid-ask spreads and lower tracking error – The size of the US market is reflected in the size of ETFs sold in its markets. Often the net asset value of a US fund is many times greater than that of a Canadian alternative. Trading volumes are consequently much higher and that tends to keep these sources of cost down and allow the investor to achieve returns that are higher and closer to the index they aim to track. For instance, the tracking error of Claymore's International Fundamental Index ETF (CIE) came out to 2.1% below its index in 2010 according to this Couch Potato blog post while the parallel US ETF, PowerShares' FTSE RAFI Developed Markets ex-US fund (PXF) has been tracking only about 1.1% below the same index. That amounts to a 1% extra “cost” of using CIE instead of PXF. It's worth checking several years of tracking error to see if it has varied a lot or if the pattern is consistent.

4) Unhedged versions of US and international funds – Due to anxiety amongst Canadian investors that our dollar will keep rising, it seems that almost all foreign equity ETFs sold in Canada come only in versions that hedge against currency shifts. Whether that is the best approach or even necessary is not cut and dried (see our post here on the pros and cons). Also, Canadian Capitalist has discovered that hedged ETFs are prone to especially bad tracking error.

5) US 15% withholding tax charged in registered accounts (RRSP, TFSA, RRIF, LIRA etc) – For Canadian-listed ETFs with foreign holdings consisting of US ETFs, such as iShares' MSCI Emerging Markets Fund (XEM) which holds only the US-listed EEM, the US government levies a 15% withholding tax on distributions that cannot be recovered. The constant reduction in net return is the 15% withholding tax times the fund dividend/distribution rate – e.g. 0.15 x 2% = 0.3% less. Other ETFs with this return-reducing problem include: Claymore's Emerging Markets (CWO), iShares Canada's S&P 500 (XSP), Russell 200 Index (XSU), MSCI EAFE Index (XIN), China Index (XCH), World Index (XWD). Our table below shows the various situations that can arise in ETFs regarding withholding tax. Green boxes show the minimal tax situation, red is bad with two layers of (US and international) withholding taxes that cannot be avoided or claimed as a credit against Canadian taxes and the clear boxes are where one withholding tax applies.


Cons – Reasons against buying ETFs in the USA

1) Currency exchange costs – Buying a US-listed ETF means having to pay in US dollars. The swap of Canadian dollars to buy the US currency can cost the individual investor up to 1.5% commission depending on the broker. Within a Canadian-listed ETF, the fund does the buying at lower institutional rates, which are usually so low as to be not worth worrying about. The problem is worst for registered accounts since selling the US ETF will result in conversion back to Canadian dollars at most brokers, a second big hit. The same hit happens to distributions by the ETF. An investor who wants to rebalance his/her portfolio by buying and selling might incur several round-trip currency conversions, each time with a return-reducing fee incurred. The problem is alleviated to a degree in several ways: by the fact that some brokers now allow US dollars to be held in a registered account after a sale; by many brokers allowing wash trades or by a fancy trading manoeuvre called Norbert's gambit (see Couch Potato's suggestions for reducing Forex fees)

2) Hedged ETFs not available – Despite the costs, some investors, such as those who are convinced the Canadian dollar will continue to rise or whose time horizon is too short for perhaps decades-long cycles to even things out, may still wish to diversify into foreign markets but with hedging against currency swings. In that case, US-listed ETFs are not the place to look – the only hedged US ETF hedges the US dollar against the rest of the world for the benefit of US investors.

3) Possible exposure to US Estate taxes – Only those whose worldwide assets exceed $5 million need to be concerned, but owning US ETFs makes one subject to US laws on estate taxes as we explained last December.

4) Automatic free dividend reinvestment, pre-authorized chequing purchases and systematic withdrawals – These extra services, available only in Canada from the likes of Claymore Canada and BMO Financial for their ETFs, avoid the costs of commissions on smaller purchases or sales and avoid having cash sitting around uninvested. Saving a $10 commission on a $200 purchase (a $10,000 holding with a 2% distribution gives off $200 a year) is a $10 / $10,000 = 0.1% saving on the holding's total expenses.

5) Withholding tax in a TFSA or RESP account – The US government levies a 15% withholding tax on distributions from US-listed ETFs to TFSAs, RESPs or non-registered taxable accounts i.e. anything other than accounts it recognizes as legitimate retirement accounts, such as RRSPs, RIFs, LRIFs, LIRAs, LIFs. That's on top of what the foreign countries already deducted in withholding tax. A Canadian-based ETF with direct international holdings such as BMO's International Equity Hedged to CAD ETF (ZDM), since it has nothing to do with the US, in contrast pays only the original foreign withholding tax and that tax shows up on T slips issued by the Canadian ETF provider as a foreign tax paid credit that can be used for taxable accounts. The RESP and TFSA still lose that amount but at least there is only one layer of taxation. How much can that reduce returns? Using for example a 2% distribution rate from the ETF holdings, the first level of withholding tax reduces it to 2% - (2% x 0.15) = 1.7% and the second level to 1.7% - (1.7% x 0.15) = 1.4%.

Bottom Line
Ask yourself whether you really want or need currency hedging. If yes, then Canadian-listed ETFs are the only option.

Otherwise, when there are directly parallel Canadian- and US-listed ETFs, add up the hard plus and minus costs associated with MER, Foreign exchange fees, Withholding tax, DRIP commission and Tracking error.

Happy cross-border comparison shopping from the comfort of your own computer!

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.