Canadian Capitalist

Claymore Canada has introduced a couple of ETFs that track interesting asset classes: Claymore Global Real Estate ETF (CGR) and Claymore Global Infrastructure ETF (CIF). CGR tracks the Cohen & Steers Global Realty Majors index, which is composed of 75 securities representing the US (40%), UK (10%), Japan (13%), Hong Kong (10.5%), Australia (11%) and minor weighting to other countries. The MER for the ETF is 0.65% and yields 4.4%. The major alternatives, all of which trade on the US exchanges, are: Cohen & Steers Global Realty Majors ETF (GRI, tracks the same index as CGR and has a MER of 0.55%, First Trust FTSE EPRA/NAREIT Global Real Estate Index Fund (FFR, MER of 0.60%) and SPDR DJ Wilshire International Real Estate ETF (RWX, MER 0.60%).

While CGR is much more diversified than the iShares CDN REIT ETF (XRE) and has a decent yield, I wonder if it is appropriate to add foreign real estate to a portfolio, considering that most investors’ allocation to REITs is already small, say 5% to 10%. In any case, there is reason to adopt a wait-and-watch stance because according to the prospectus, the ETF will track the underlying index’s returns through derivatives and incur expenses in addition to the MER. Moreover it is not clear if a market for CGR can be sustained because global real estate is cooling (down 20% over one year) after extremely good returns over a five year period.

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After reading Rob Carrick’s article in the Globe and Mail on a study commissioned by the Federal Government on Registered Education Savings Plans, I went looking for the report. Fortunately, it is available online, provides a wealth of interesting information and explains various RESP options available to parents in a clear and straightforward manner. As Mr. Carrick has highlighted the shortcomings in the design of group RESP plans in his column, I am going to focus on interesting tidbits in the report:

• Participation in RESPs is low: only 35.2% of children aged 0 to 17 years received a Canada Education Savings Grant.
• The Canada Learning Bond provides $500 for low-income families to establish a RESP account and allows for an annual contribution of $100 thereafter but the participation rate is a miniscule 8%. The CLB program has paid out a paltry $24 million to date.
• The biggest “complaint” against RESPs offered by banks and brokerages is that they are not “vigorously” marketed.
• It is shocking that 3.2% of group RESP plans were cancelled or terminated in 2006. Even more shockingly, 1.9% of group scholarship plans were closed by the group RESP vendors and subscribers paid the price: “When the group scholarship provider closes a group plan, the subscriber can reclaim the contributions, and these are then returned net of fees and without the investment income. Closing also means the grant and bond are repaid to the government, and these cannot be earned back later if new contributions are made for the same beneficiary.”
• The report notes two benefits of group scholarships: the mandatory contribution schedule may force some people to save for their child’s education and the proactive marketing of these plans may result in higher participation in RESPs.
• Corporate governance of scholarship trusts leaves much to be desired and there is no disclosure of executive compensation.
• The criticism that scholarship trusts have high fees is justified. The report notes that in 2006, some 20% of gross contributions went towards fees. Granted some of the enrolment fees may be refunded but the present value of the refund is quite small.
• If a group RESP subscriber is unable to continue contributing, they can transfer to an individual savings plan instead of terminating the program and keep the principal, grants and income. Termination, on the other hand, will result in refund of contributions less the enrolment fee. The report points out that 1.9% of plans were terminated even when a better option is available.

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Sometimes, the active versus passive debate is a bit like the movie Rashomon, in which different characters recall wildly different versions of the same incident. Take the S&P Passive versus Active (SPIVA) report card on mutual fund returns during the last bear market from August 2000 to December 2002. The report points out that just 39% of active funds beat the TSX Capped Composite Index but concedes:

A bright spot for active funds was equal weighted and asset weighted returns over the period. Active Canadian Equity funds exceeded the S&P/TSX Capped Composite returns. This would imply that a few funds were able to beat the index by a large margin thereby pulling the average equal and asset weighted returns higher. However, given that investors are limited to investing in a small number of funds, the outperformance figures better represent replicable performance by the average retail investor.

An indexer wouldn’t be surprised even if majority of funds beat the index during a bear market. After all, the cash held by mutual funds provides a cushion in falling markets (and it must be said, a drag in rising ones). But active funds and their cheerleaders make a virtue out of this necessity. In a recent column in The Toronto Star, Rudy Luukko, an investment funds editor for Morningstar Canada writes:

But active managers, according to both S&P’s numbers and Morningstar’s, generally fared better than the Canadian index funds during the 2000-2002 study period. Active managers were able to build cash reserves if they couldn’t find any bargains. And the active funds were less likely to risk holding 10 per cent or more in a single stock.

First, there is no evidence that active managers are any good at building cash reserves in anticipation of bear markets. If anything, evidence suggests that mutual funds cash holdings are low at market peaks and high at troughs. Second, regulations restrict mutual fund holdings in a single stock to 10%, to which Mr. Luukko retorts: “However, in looking at historical holdings, I found that many actively managed funds were either holding much less than 10 per cent in Nortel, or not holding any of it. This risk-reduction decision paid off”. Mr. Luukko’s argument is meaningless because he doesn’t quantify how many of the 90 mutual funds that S&P counts as Canadian Equity he looked at (how many is “many”?).

None of the objections to index funds are valid: yes, a majority of active funds may occasionally beat the index but John Bogle estimates the odds of an index outperforming an active fund at 85% over 5 years, 91% over 10 years, 95% over 20 years and 98% over 50 years. A carefully diversified portfolio holding some bonds and cash will provide the “smoother ride”, if that’s what investors are looking for. And yes, index investors should pay attention to costs too and pick the cheapest available fund with the lowest tracking error.

The trouble with active management isn’t that a few funds beat the index some of the time. It’s picking the fund that will outperform the index ahead of time and telling the difference between skill and luck after the fact. Of course, there is no shortage of vendors to help us pick the good managers. Like, Morningstar, for instance.

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It started with a Goldman Sachs paper that popularized the term BRIC, referring to the emerging markets of Brazil, Russia, India and China. The paper projected that by 2040 the combined BRIC economies will be larger than the developed economies of the US, Japan, UK, Germany, France and Italy. BRICs would have remained nothing more than a catchy concept but the subsequent eye-popping stock market returns in these countries led to a predictable result: the fund industry is churning out products to ride the trend and investors seem to be chasing returns. Over the past five years, Brazil, Russia, China and India have returned 52*, 30%, 22%, 35% respectively (in US dollar terms) compared to 7% for the S&P 500.

A frequent justification for investing in BRICs is the rapid GDP growth experienced by these economies. However, in this article, William Bernstein advises caution in inferring stock market returns from economic growth pointing out that if anything, there seems to be negative relationship between growth and returns. Bernstein also notes the paucity of data on risk / return characteristics of emerging markets in general, never mind the BRIC markets.

Another reason for caution is the sorry history of foreign investing “concepts” — Japan in the eighties and the Asian Tigers in the nineties. Is there any reason to believe that this time will be different?

BRICs do have a role in a portfolio — as a part of a broad emerging market holding such as the Vanguard Emerging Market ETF (VWO). But there is no reason to believe that an allocation higher than their 5.4% weighting in the world stock market is warranted.

* Using iShares MSCI Brazil ETF (EWZ), Templeton Russia & East Europe Fund (TRF), China Fund (CHN) and India Fund (IFN) as a proxy for the Brazil, Russia, China and India markets respectively.

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1. Mark Hulbert writes in The New York Times that stocks are a good inflation hedge because though future earnings are discounted at a higher rate when inflation is higher, corporate earnings tend to grow faster than inflation. Investors worried about the first effect ignored the second, offsetting effect in the past and drove stock prices so low that valuations became very attractive. Could history repeat itself? Could investors make the same mistake again? The paper (”Inflation Illusion and Stock Prices”) referred to in the article can be found here.
2. Via rail is offering a 50% discount for purchasing a comfort class ticket at the regular adult fare using a Visa card. Thanks to Tyler for this tip.
3. Forbes Magazine takes a look at how people in different countries allocate their budget to eleven consumption categories: Food, Alcohol, Clothing, Housing, Maintenance, Health, Transport, Communication, Recreation, Education and Eating out. The National Post ran a story on this topic.
4. Amidst all the gloom and doom, Larry MacDonald wrote a post on a money manager who is extremely bullish on stocks.
5. Insightful articles, media interviews and blog posts by financial advisors from PWL Capital, which manages investments based on a passive philosophy using index funds from Dimensional Fund Advisors, can be found on the firm’s website.

Blog roundup will be posted over the weekend. Have a great weekend everyone!

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Despite the gloom and doom about the US economy and its currency, the US stock market is faring relatively better (down 19% from its previous peak) compared to other markets. The MSCI EAFE Index which tracks stock markets in other developed markets in Europe and Japan is down 30.5% off its recent peak in U.S. dollar terms. Emerging markets measured by the MSCI Emerging Markets Index have taken a similar tumble by falling 29%.

Valuations are compelling — according to Vanguard, the current P/E ratio for VWO (Vanguard Emerging Markets ETF) is 12.24 and even lower for VEA (Vanguard Europe Pacific ETF). By contrast, the P/E ratio for the US market is 17 and 10-year Canada bonds are yielding 4.25%.

After red-hot returns for years, emerging markets are starting to look attractive. But these stocks are so volatile that a 30% drop might be just a warm up act. Due to the relatively low weighting to these stocks in the world capital markets, despite the volatility, this might be not be a bad time to get market weight exposure (5% in the Sleepy Portfolio) to this asset class or at least place it in a watch list.

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Recently a friend asked about a “tax scheme” that claims to buy medicines for AIDS patients (”Fight AIDS Save Taxes” is its slogan) in Africa and provides a tax receipt for four to five times the donation amount. While stiffing the government, helping AIDS patients and putting some money in the pocket may sound like a win-win situation all around, participating in a tax shelter scheme is asking for trouble. The Canada Revenue Agency has a clear position on these schemes and titled a recent alert, “Warning: Participating in tax shelter gifting arrangements is likely to result in a tax bill!” The text of the alert also provides no room for confusion:

New schemes are being marketed that claim to be different from those for which the CRA has previously issued warnings. Taxpayers should avoid all schemes that promise donation receipts for 3 to 4 times the cash payment. It is the CRA’s position that the proposed legislation, effective since 2003, will apply to reduce the donation credit to no more than the actual cash payment. Furthermore, as indicated above, completed audits have shown that there was effectively no gift being made in many cases, and as a result, the donation was reduced to zero.

The Toronto Star ran a series of investigative pieces on charity scams last year available here, here and here. An accompanying graphic to the story illustrates the risk involved in these schemes. A taxpayer made a donation of $10K and received a tax credit of $21K (probably adjusted for the original donation), got audited and the taxman wants $35K in back taxes, interest and penalties. Despite the CRA warnings and media coverage, it appears that many are falling for these schemes — the aforementioned “charity” claims to have raised $165 million so far.

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While there is healthy competition with many players offering high-interest savings accounts at attractive interest rates and features, President’s Choice Financial is pretty much the only game in town if you want a no-fee chequing account. Not for much longer. Nancy Zimmerman, who is a Bank Evangelist at Citizens Bank (and a money coach and blogger), broke the news that as of mid-September, her employer (an online, national bank formed by Vancity, which already offers a competitive high-interest savings account), will be dropping the $8 monthly fee on their current chequing account, and offer the following features:

• Free personal cheques.
• Unlimited Interac transactions and unlimited cheques and bill payments.
• Online access and online bill payments.
• Unlimited free ATM transactions throught the Exchange network run by most credit unions, National Bank, HSBC etc.
• No international ATM charges by Citizens Bank (there may be a charge by the bank running the ATM network).

While the international ATM transactions are a nice bonus and will be very attractive to frequent travelers, the other features make Citizens Bank account equivalent to PC Financial’s. Still, I’ll be sticking with PC Financial because it is convenient to withdraw cash while shopping for groceries. However, it is nice to know that there is a strong alternative now.

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We might do all the right things in investing – keep expenses low, not chase performance, stick to the plan even when markets are terrible – and still get low returns just because our investing career coincided with a time period in which market returns were much lower than we expected at the outset. In his book, The Intelligent Portfolio (review), Christopher Jones makes this point:

Even for this conservative allocation [90% fixed income and 10% equities], the range of potential outcomes (in today’s dollars) is relatively wide, especially as the horizon increases. At 30 years out, you could expect to see portfolio values [of a $10,000 initial investment] fall in the range of $13,000 to $31,000 about 90 percent of the time. That is not a trivial spread of potential outcomes.

How does an investor insure against such an eventuality? Unfortunately, not much because any cure (such as investing in low return assets such as bonds) might be worse than the disease as we’ll be exchanging the low probability of a poor outcome for a near certainty of (perhaps) a slightly better one.

If equity returns does turn out to be much lower than we expected ex-ante, we simply have to adapt to it. We may have to:

Save more: Instead of saving, say 10% of our income, we might find that we need to save 12% to make up for crummy markets. Granted, it means we should save 20% more that we planned to but saving money is under our control, market returns aren’t. Or we may opt to save the same as before and revise our plan and spend less in retirement.

Retire later: There is no law requiring that we retire on the exact date that we planned. If markets did not co-operate, we can opt to remain in the workforce for a couple more years, which would give us the opportunity to add more to the portfolio and allow it to grow at the same time. If the thought of retiring later depresses you, remember that a favourable outcome is just as likely with stocks: our returns might be better than our reasonable expectations.

Ease into retirement: Another option is to work part-time, which would allow us to delay tapping the portfolio or at least withdraw less in the initial years. As an added bonus, it would let us test drive retirement on an installment basis.

In other words, when investing, like life, hands us lemons, we can turn it into lemonade.

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Many thanks to Noreen Rasbach for featuring this blog in her weekly column titled “Investor’s Diary” in The Globe and Mail. If you discovered us through the Globe website, feel free to poke around the site - we are closing in on one thousand posts and tens of thousands of comments. You can also subscribe to our feed and get full posts delivered FREE through your favourite reader. If you prefer to have posts delivered to you FREE via e-mail, you can sign up here (your e-mail is not shared with anyone. We have a strict privacy policy). It should be noted that we are not financial advisors.

She also mentioned The Wellington Fund Blog. The author Mark McQueen’s series of posts on the Decade of the Daddy Mirror Fund would be funny until you realize that real people are investing in junk like this.

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