Investing Risk: The Ouch from Management Costs and Taxes

Next in our rundown putting numbers to the magnitude of investing risks comes the combined effect of the management fees (MER), salaries, trading costs, administrative costs, commissions, trading spreads, price premiums over fund Net Asset Value and taxes. Unlike the more sudden and dramatic single events of most other risks, this type of risk mainly happens slowly and often obscurely but the cumulative effects can cause losses that are severe and permanent too.

Recurring Fees and Costs - Annual recurring charges can significantly damage the value of mutual fund, closed-end fund or ETF investments. Whether it be a fund's MER, trading costs or advisor wrap fees, seemingly modest annual costs of even 2% add up over time.

How bad can the effects be? The chart below from Bylo Selhi displays how much an investor is left with after deduction of annual fees. In order to isolate and reveal the fee effect, the chart is before investment returns, i.e. assuming 0% market returns. Market returns must overcome the constant drag of fees if the investor is to make any headway.

Are fees really as high as the worst numbers on the chart? Unfortunately, in many cases the answer is yes. A search in the Globe Investor Fund listing tool selecting funds where the MER, which is usually the main component of total annual costs, is 3% or more, brings up 2621 funds. Morningstar's report Global Fund Investor Experience 2011, linked to by Canadian Capitalist in his blog post Morningstar Grades Canada an F calculates that the median Canadian equity mutual fund charged 2.31%, while median fixed income fund expenses were 1.31% and money market funds were 0.8%. Note that the MER is charged against a fund's total assets, not against profits / returns, so it takes away a chunk of the investment whether or not the fund has made money.

Michael James on Money in MER Drag on Returns in Pictures took the actual returns of the S&P 500 over a 50 year investment period and calculated that a 2.5% annual expense ratio "decimated returns" leaving less than one third the end value of what it would have been with an expense ratio of 0.17% (an expense ratio available amongst the lowest cost index ETFs such as iShares S&P TSX 60 Index Fund, symbol: XIU).

Independent Investor's Cost of Investing (free registration required) shows other examples and studies of the negative impact of too-high fund fees.

Stocks and Salaries - A company's internal cost for management salaries is the individual stock counter-part to fund MER. Just as fund fees can vary, so can the salary burden of a company. It doesn't always follow, despite the oversight role of a company Board in controlling management, that the shareholder owner gets good value for salary. Some companies overpay and all the profit in effect ends up in management hands. At worst, management can bleed a company and leave the shareholder with a bankrupt worthless shell. That risk of loss is one reason for research into a company, including its management's behaviour, before investing.

Taxes - Fees are not the only thorny all-too-present recurring problem. Taxes can drastically reduce returns too. It is quite difficult to generalize about how dire the effects can be since taxes depend heavily on combinations of factors that vary considerably from one investor to another:

• tax bracket of the investor
• tax rates on interest, dividends and capital gains that vary according to the investor's tax bracket
• the proportions of interest, dividends and capital gains created by the investment mix
  
• account type holding the investment - tax-deferred, such as RRSP, LIF, LIRA etc; tax-free TFSA; annually taxable regular account

An example taken from the cited Morningstar report gives an idea of the impact: the effective taxes in Canada consumed 26% (vs only 20% in the USA) of a mutual fund's gains over a 5-year holding period for a couple with $100k income and a $100k initial portfolio composed of 40% fixed income and 60% equities in a taxable account.

Planning and deliberate structuring of investments is the primary way to achieve lower taxes. That can be quite involved and investors may be wise to turn to a professional tax advisor to do it effectively. Amongst those going it alone, a popular planning software is RRIFmetic, which shows how to optimize retirement income flows, factoring in taxes, from different types of accounts during retirement. The Finiki page on Tax-Efficient Investing contains a rundown of practical basic principles to follow.

Some may quibble that costs and taxes are not really a risk at all since there is no uncertainty about them - they always occur. We prefer to include them because, a) their negative effect is considerable and, b) there is great variability in their level. Fortunately, the investor can reduce this risk a lot through advance research by looking at published information on fees and costs and picking investments with lower costs. Costs are a much bigger risk for the unwary, the heedless and the careless.

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.

Investing Risk: Default or, How often do investments go belly up?

Greece has been much in the news lately, scaring investors and governments around the world at the prospect that it will default on its debt. The fright is no surprise as default - not paying money back as promised - is perhaps the most serious and devastating risk an investor can face. But what are the facts? Often fear of the unknown is worse than the real threat itself. This week we therefore try to reduce the unknown and pose the question: what are the chances of default for bonds and stocks, and does default necessarily mean complete loss of funds or has there been some money recovered afterwards?

Bonds
Governments - Greece's predicament is not an isolated incident. Governments around the world have a habit of issuing more debt than they can pay back. University professors Carmen Reinhart and Kenneth Rogoff have looked at records going back hundreds of years. They tell us in Eight Hundred Years of Financial Folly, from which comes the chart below, that there are periods of high financial stress when 40% or more of countries are in default or restructuring their debt.

A Canadian investor mulling over such statistics is no doubt grateful that the most likely destination for their investments, the debt of the federal and various Canadian provincial governments, has not yet seen a default, though the provinces do not enjoy the very highest triple A / lowest likelihood of default rating enjoyed by the federal government. For those interested, a search of ratings agency DBRS for each province will reveal the ratings for each province.

Corporate Bonds - Periodic peaks of defaults also bedevil corporate bonds, especially amongst bonds rated speculative or below investment grade. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows spikes in default rates nearing 6% at times in recent decades.

Speculative grades of corporate bonds show highly variable default cycles. In some years, like 2005, there have been no defaults. In other years, like 1989 and 1990, defaults have spiked upwards to extreme levels - up to 50% default rates, as bond rater Moody's shows in Default and Recovery Rates of Canadian Corporate Bond Issuers 1989 - 2005. Investment grade bonds on the other hand, have been quite stable and have stayed at very low default rates. Of course, that can be deceiving. Buying only investment grade bonds does not necessarily ensure safety, as the rating agencies quickly change their ratings downwards as problems mount at companies so that by the time of default the bonds are no longer investment grade.

Recovery Rates - The same Moody's document mentions the significant fact that all is not automatically lost when a default occurs. Recovery rates vary by the bond's priority of claim. As one would expect, bonds with higher priority have higher recovery rates on average. Senior secured bondholders got 54% of their money back over the 1989 to 2005 period, while senior unsecured bondholders only managed to recover 36.5% (see Exhibit 9 for all the rates by categories). Moody's also states that US and Canadian recovery rates are roughly similar.

Equities - Stockholders are residual owners, having a claim to assets upon default only after all other claimholders have been satisfied. It is seldom that anything is left over for stockholders when a company goes bankrupt. What is more, life for the vast majority businesses is short, much shorter than that of humans. According to the Business Week article The Lifespan of a Company, the average Fortune 500 company only lasts 40 to 50 years. Moreover, the Fortune 500 consists of large successful corporations and thus represents more winners than losers. United Capital Funding's post Small Business Survival Rates in the United States, cites various US government sources that indicate only about a quarter of small businesses last even 15 years.

The situation in Canada is much the same. Though statistics and studies are hard to find, consider the following. In our comparison of the top 25 stocks in the TSX index between 1995 and 2009, we found that about half had disappeared. In the entire TSX index, only about a quarter of the companies from 1995 still appear in 2011. Not all were eliminated in spectacular bankruptcies like Air Canada, Nortel and Canwest that completely wiped out stock value, but a number did. When a company weakens over time and is eventually acquired by another, often the stock will have declined considerably to a tiny fraction of the peak value. This latter kind of "default" loss of capital takes place over months or years.

In short, default risk has been and continues to be a critical risk, requiring the investor's close attention and indicating a serious need for countering action.

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.

Investing Risk: How Badly did Inflation and Currency Hurt Past Returns?

We have been dissecting the impact of various types of risk, seeing what historically has been the worst result for the Canadian investor, starting first with the list of all the main risks, the nature of their effect and counter-measures and then last week with the historical numbers on past market crashes. This week we factor in historical inflation and currency shifts to see what were the net combined worst effects.

Inflation
When Canadian inflation goes up unexpectedly, that is bad for an investor. Though rates have generally been quite stable within the Bank of Canada's target 1-3% range for the last 20 years, data back to the early 1950s shows periods of big jumps and high inflation, such as the chart below from Global-Rates.com. RetailInvestor.org has another chart going back to the 1870s in his discussion of inflation risk. It show huge swings between high inflation and deflation.


Rampant, totally out-of-control inflation can have the same effect as outright default. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows the devastating impact of hyper-inflation on bonds amongst major European countries of France, Italy, Germany and the UK during the 20th century.



Currency Swings
It wasn't just inflation that experienced large swings in the past. An investor in US securities would also have been affected by the shifting value of of the US dollar against the Canadian dollar. Investments in non-US foreign securities, which have become ever more popular and accessible through funds and ETFs in the last quarter century, would also have been strongly affected by the movement of the Canadian dollar against many foreign currencies.

The Oanda website, from which the chart below is copied, shows Historical Exchange rates for major foreign currencies going back to the early 1950s. Retail Investor.org has a chart on this page for the US vs Canadian dollar back to 1925. These charts show major shifts and upward /downward movements lasting decades, which might, at first glance, be thought to depress returns for the Canadian investor caught on the wrong side of the long term trends.



In a summary of the renowned book Triumph of the Optimists by the same authors as the Credit Suisse Yearbook, the CXO Advisory blog notes that once exchange rates and local country inflation are netted out the real equity return is what counted most and "local exchange rate fluctuations have not presented a significant disincentive to diversifying internationally in equities over the long term".

Including both Inflation and Currency, what were the worst returns for a Canadian investor?
The best available free online resource for seeing the combined effect of inflation and currency for the Canadian investor appears to be Stingy Investor's Asset Mixer. By filling in 100% allocations to each asset class in turn, it is possible to see how each fared over the maximum period of available data. Results are in real-after inflation Canadian dollars and assume no fund fees, which we will look at separately in a future post.

Canadian T-Bills

• Worst drop 1971 -11.6%, recovery 11 years
• Total down years 9 / 41 or 22%
  

This is quite a contrast with the finding in our previous post that T-Bills, in nominal terms, had never had a down year. Inflation can be a harsh risk. It undercuts T-Bills' oft-cited safety. T-Bills may be safe but they are still risky!

Canadian Bonds 1970 to 2010

• Worst drop 1980 -10.9%, recovery 2 years
• Total down years 5 / 41 years or 12%

Canadian Stocks TSX Composite 1970 to 2010

• Worst drop 1973 -39.6%, recovery time 6 years
  
• Total down years 13 / 41 or 32%
  

US Bonds 1971 to 2010 - corporate and government bonds together

• Worst drop 2003 - 26.9%, still recovering; next worst 1972 -25.5% recovery time 12 years
• Total down years 17 / 40 or42%

US Stocks S&P 500 1970 to 2010

• Worst drop 2000 -49.7%, still recovering 11 years later, next worst 1973 -49.1%, recovery time 10 years
• Total down years 13 / 41 or 32%

The 2008 drop only amounted to -23.5% in Canadian dollars. The S&P 500's enormous drop of -40.3% in US dollars was significantly cushioned by a simultaneously falling Canadian dollar as we discussed at the time in this post. However, the opposite happened in 2000. The 39.7% drop of the S&P 500 in US dollar terms was made much worse - down 49.7% per the above figure - by the currency movement at that time. Currency is a double-edged sword.

Developed World Stocks EAFE 1970 to 2010

• Worst drop in 1973 -45.8%, recovery time 5 years, next worst 2000 -42.1%, still recovering
• Total down years 14 / 41 or 34%

Emerging Market Stocks 1988 to 2010

• Worst drop in 2008 -43.1%, still recovering, next worst 2000 -35.6%, recovery time 5 years
• Total down years 8 / 23 years or 35%
  

Currency has accentuated the downward extremes of foreign stocks for the Canadian investor. The good news is that it exaggerated the upside too. We previously showed how this has worked within a portfolio combining multiple asset classes in Historical Effect of Currency and Inflation.

Bottom Line: Currency and inflation contribute to return downside over periods of up to a decade. The investor must be able to exercise patience.

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.

Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises

Last week, we explained how the various investing risks come about but only gave a general idea of their extent and magnitude. It's time to rectify that by attaching some numbers to the risks. History will be our guide. We'll cover the risks in several posts. This first post will deal with downward market moves.

Rather than try to split hairs about what distinguishes short-term volatility from business cycle moves, crashes or crises we have lumped all these market events together. The important thing to know is: how far down can down be and how long does it take to recover losses?

Stocks
S&P 500 USA 1928 to 2010 in US dollars, i.e. not converted into the Canadian dollars that a Canadian investor would experience

• Worst one-year drop: -43.8% (1931) then -36.6% (2008)
• Max peak to bottom drop (drawdown): -79% real/inflation-adjusted (1929-32) shown as blue area in the chart below; Recovery period to 1929 peak - 1945 / 16 years
• Tech Bubble Crash: -52% real drawdown 2000 to 2002, Recovery not complete
• Financial Crisis: -48% real drawdown 2007 to 2009, Recovery not complete
• 

TSX Composite Canada 1958 to 2010 -

• Worst one-year drop: -33.0% (2008), then -25.9% (1974)
• Worst drawdown real/inflation-adjusted: -39.6% (1973-4), Recovery period 6 years
• Total down years nominal dollars (1958 to 2010): 14 years / 26%
• Total down years real/inflation-adjusted (1970 to 2010): 13 years / 32%

T-Bills -
Worst year USA (1928 to 2010): 0.03% return (1940)
Worst year Canada (1970 to 2010): 0.5% return (both 2009 and 2010)

Treasury Long Term Bonds -
Worst one-year drop USA (1928 to 2010): -11.1% (2009)
Worst one-year drop Canada (1970 to 2010): -7.4% (1994)
Maximum real drawdown USA (1900 to 2010): -67% (1940 to 1981) shown as red area in the chart above, Recovery period to 1991 - 51 years!
Maximum real drawdown Canada (1970 to 2010): -37.9% (1973), Recovery period 12 years

Some of the above numbers look quite scary indeed, especially the effect of drawdowns and extended recovery periods. One might be tempted to invest only in Treasury Bills. They are low risk in terms of annual nominal returns ... but there is also inflation to consider, which creates losses in real value in many years. Inflation is another risk we will quantify in a another future post.

It's also good to remember that the above are the worst historical results. Averages over extended periods of years are positive and many years or periods offer large upward moves.

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.

Sources:
USA Returns: Aswath Damodaran, Professor of Finance, NY University, Historical Returns on Stocks, Bonds and Bills - United States
USA Drawdowns: Credit Suisse Global Investment Returns Yearbook 2011, compiled by Elroy Dimson, Paul Marsh and Mike Staunton
Canada Returns: Libra Investment Management, Spreadsheet of Annual Returns
Canada Drawdowns: Stingy Investor, Asset Mixer
World Stock and Bond Drawdowns: Wade Pfau's Retirement Researcher blog post 13 January 2014

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.