Canadian Capitalist

2008 marked the first down year for the Sleepy Portfolio since its inception in 2005. The low-cost diversified portfolio constructed using a handful of ETFs was down 20% during the year. Bonds and cash now make up almost 33% of the portfolio, 8% more than the target, suggesting that it is time to rebalance the portfolio back to the original targets.

Our portfolio performance largely mirrored the Sleepy’s — down 22.5% for the year. Here are the returns for the Sleepy Portfolio for previous years:

2005: 12.9%
2006: 14.7%
2007: 0.2%
2008: -19.9%

Any bets on how 2009 will turn out to be?

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Want to get a better handle on your finances? The first step in improving your finances is knowing where you stand. And what better time than the New Year to start afresh! Every January, I compile four financial reports for our household and you may find them interesting and instructive as well.

Income versus Expenses
It’s Personal Finance 101: Spend less than you earn. But how are you actually doing? If you track your finances using software like Microsoft Money, Quicken, Gnu Cash or even trusty old Excel, this part is easy. You simply have to generate the report for Income and Spending for 2008.

If you don’t track your expenses, perhaps you may want to consider doing so in 2009. If you think that this is a boring chore that will suck up time that you’d rather spend doing something more pleasurable, it doesn’t have to be. Most banks and credit card companies allow you to download your monthly statements in a variety of file formats from their website.

Net worth Statement
Is your overall financial situation showing improvement over the years? How does your total household debt compare to your equity? If you track your net worth, you’ll have a clear picture of where you stand and how you are doing over time.

While I still track our net worth, I find it much less useful these days because the bulk of our assets are in stocks and a bad year in equities (and 2008 wasn’t a very good year!) can easily mean negative growth. Still, I find value in writing down all the different accounts we have and how much they are worth as of January. If nothing else, a copy of your net worth statement could form an important part of your estate planning documents.

Portfolio Allocation
How does your current portfolio allocation compare with your targets? If you didn’t rebalance last year, you likely have a much larger portion of your portfolio in fixed income than your target allocation calls for. You can choose to rebalance or channel new contributions to equities over the next year. Being aware of your current asset allocation will also help you avoid chasing “hot” assets by reminding you that you already have enough in that asset class.

I track our portfolio using Microsoft Money and simply export the current holdings to an Excel spreadsheet and use some simple scripts to compute the current portfolio allocation.

Portfolio Expenses
As a percentage of your portfolio, how much do you pay in mutual fund fees, account fees, trading commissions etc.? Studies have shown that expenses are a significant determinant of portfolio returns. — the more you spend on your portfolio, the less your returns are likely to be. The vast majority of our portfolio is in ETFs with rock-bottom expenses but we still have trading expenses to account for. With Microsoft Money, it is easy to see how much your trading commissions are costing you. Export the Investment Transactions report into Excel and add up the commissions’ column. For instance, I found that trading commissions costs (mostly buying) cost us 20 basis points last year.

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As noted in an earlier post, asset class returns were terrible in 2008. Only bonds had a positive year but losses in foreign stocks were somewhat moderated by an 18% drop in the Canadian dollar versus the greenback. Unlike most reports, which reported only the changes in price levels, the numbers published below are total returns and include dividends, distributions and other income. The return calculation for REITs is approximate as I used XRE’s price levels and distributions to arrive at an estimate.

Bonds: 6.41%
REITs: -41.61%
Canadian Stocks: -32.9%
US Stocks (S&P 500): - 22.8% (-36.5% in US Dollars)
Developed Markets (MSCI EAFE Index): -30.4% (-42.75% in US Dollars)
Emerging Markets: -43.72% (-53.10% in US Dollars)

If you are interested in asset class returns for previous years, Norbert Schlenker of Libra Investments maintains a spreadsheet of total returns of various asset classes going back to 1970.

Sources: Bank of Canada, Globe and Mail, PC Bond Analytics, MSCI, Standard & Poors, iShares Canada and iShares US.

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History books will mark 2008 as a year that showed how quickly stock markets can go down. It is hard to believe but as recently as June of this year, the TSX Composite was higher than 15,000 and is trading around 8,830 now. Canadian stocks also have plenty of company — it is hard to find a single asset class apart from Government of Canada bonds that had a positive year.

European, Japanese and Emerging market stocks had a very bad year but US stock returns would turn out to be relatively better (if you can call a 20% or so fall “better”) due to the significant depreciation in the Canadian dollar.

If the rapidity of the stock market decline was stunning, the volatility was remarkable as well. The stock market fell or rose more than 5% all too frequently — especially during the months of September and October.

The bad news doesn’t end with the stock market, of course. With the major economies in recession, businesses started laying off workers and our pay checks were in danger as well. Add it all up and 2008 will end up as a horrible year from a financial perspective.

Amidst all this doom and gloom, there were some scraps of good news. Pretty much every asset class (again, except Government bonds) is now a lot cheaper now than at the start of the year. Softening home prices should be welcome news for first-time home buyers. And finally, the introduction of the Tax-Free Savings Account will turn out to have a significant impact on our personal finances.

Here’s hoping that 2009 turns out to be a better year. Happy New Year to you all!

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Last year, QuickTax frustrated a lot of loyal customers by drastically reducing the number of returns that can be filed with the Standard version. This year, Intuit seems to have listened to its customers: the number of returns that can be filed with all flavours of QuickTax is back up to 8 for the 2008 tax year. The marketing message is also much improved: the website now makes it clear that the more expensive Platinum and Unincorporated versions provide “enhanced guidance & tax-saving tips for investments and rental properties”. The pricing structure remains the same — Basic costs $19.99, Standard $39.99, Platinum $69.99 and Unincorporated $99.99. The Standard version should suffice for most users who have a bit of investment, rental property or self-employment income and don’t mind interacting with the forms directly.

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Just a quick post to wish everyone a Merry Christmas, Happy Hanukkah and Happy Holidays. There will be no posts next week and regular programming will resume during the week of December 29th when we will wrap up what has been a rather depressing year from a net worth and portfolio perspective.

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Today’s guest post is courtesy of the author of the Thicken My Wallet blog. You can subscribe to the feed here.

I want to thank Canadian Capitalist with giving me the opportunity to guest post on his well-deserved vacation. If you are a regular reader of this blog, you know that Canadian Capitalist is rightfully a passionate supporter of the KISS (keep it simple stupid) principal of personal finance (my words, not his) and that fees destroy returns over the long term.

As this age of financial excess is unwinding itself ever so painfully, it is interesting to note how the smartest guys in the room are probably not the financial wizards the media makes them out to be.

For example, CC wrote a recent series on Manulife’s IncomePlus products — a stunningly successful product for the company. But, as CC noted, the product had many flaws including an outrageous MER of approximately 3.5%. A moderately educated investor could replicate the product’s return using a portfolio of bonds.

So Manulife has designed a fail-proof product for itself and we should invest in the issuer and not the product right? Well… the Globe and Mail ran an interesting article on Manulife’s recent troubles resulting in part from products like IncomePlus.

In the simplest sense, insurance is like banking without money. Like banks, insurers are regulated and the regulators demand that a certain portion of money be set aside to cover its liabilities. Conventionally, an insurer’s largest liability is that all of the insurance policies it underwrote are called at once (analogous to all the bank’s customer’s withdrawing their money at once). The chances of everyone passing away at the same time are quite remote so an insurer’s risk is, statistically speaking, quite low.

But, insurance companies started dabbling into more exotic financial instruments. One such product is something known as viable annuities. Like a regular annuity, an investor pays the insurance company a sum of money in return for guaranteed payments in the future.

However, an investor in a variable annuity is also asking the insurance company to invest the money in the stock market for them and to participate in any profit the insurance company makes (IncomePlus is a variable annuity). The key attraction is that no matter how badly the insurance company invests your money, the investor will be guaranteed a stream of money in the future- so, theoretically, no down-side, all upside.

If you are a regular reader of this blog, you understand that active management of funds statistically underperforms the board based equity index. Thus, even in regular markets, one is already giving money to the “smartest guy in the room” (sorry, they are mostly guys who got us into this mess) to under perform.

In markets such as this? Remember that the insurance company has to guarantee the annuity payment but it has taken the investors’ money and lost a lot of it in the stock market. The only way to make up that loss is to take profits and top up the reserve fund mandated by the regulators to ensure that the annuities are paid on time.

The topping up of reserve funds can only be accomplished mainly through a couple of different methods: (i) issuance of new shares, creating a dilution issue; (ii) raising debt, leveraging the company more; and/or (iii) move profits into the reserve fund, reducing earnings per share. Manulife has done all three and its shareholders have suffered as a result; it posted its first loss ever since the company went public.

Why didn’t Manulife hedge its position? According to the Globe article, it stopped doing it in 2004 (remember they thought they were the smartest guys in the room).

Is Manulife in trouble? It will most likely feel a lot of short-term pain but its trouble pale in comparison to many of its industry counterparts and the money in the reserve funds can be moved back into earnings over time (to be clear, this is an industry issue not particular to Manulife).

Is a Manulife annuity in trouble? Most likely not since it reserve funds have been sufficiently topped up (in other words, it has the money).

The moral of the story?

The smartest guys in the room are not very smart when it is not their money.

The author is a shareholder of Manulife and, obviously, not a very happy one.

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In past posts (Part 1, Part 2) in this series, Reader J talked about his investment goals and his thoughts on his overall asset allocation. In the last post in this series, he discusses which funds he plans on using to capture exposure to different asset classes.

Asset Allocation
So based on my hare-brained idea of mixing indexes I’ve got to split the overall allocations further into the actual ETFs that will make it up. I don’t know the best way to do it properly, so I’ve often taken the coward’s way out and split it at arbitrary amounts. The equities are shown broken down into the % of the asset class and % of the portfolio as a whole.

Canadian Allocation
I’ve split this allocation right down the middle, half for the standard S&P/TSX Index and half for a value / small cap equities. For this second part, I used 35% of a RAFI fundamental index, which apparently has more of a value tilt and then 15% small cap:

50% / 8% — iShares Composite Index (XIC)
35% / 5.6% — Claymore Canadian Fundamental Index (CRQ)
15% / 2.4% — iShares SmallCap Index (XCS)

United States Allocation
This split was even murkier because the Total Stock Market has exposure to all US stocks (small, mid, large, growth and value), I wasn’t sure how to tilt it to value & small cap. The super-low fees are awesome and make it even harder to justify combining with a fundamental index which costs nearly ten times more (MER of 0.65% vs. 0.07%). Also it should be noted the RAFI fundamental index is hedged in Canadian dollars and as explained earlier, my hope is that this allows the portfolio to carry a lower percentage of Canadian equities without as much currency risk.

In previous revisions, I had selected 2 different small-cap funds. The Russell 2000 index was eliminated because apparently right before the index is reconstituted it would be subject to price volatility that would drag performance by 1-2%. Then the iShares S&P SmallCap 600 was eliminated simply because Vanguard’s MER of 0.1% was half as expensive.

48% / 13.2% — Vanguard Total Stock Market (VTI)
40% / 11% — Claymore US Fundamental Index (CLU) - Hedged
12% / 4.13% — Vanguard Small Cap (VB)

International Allocation
Vanguard has great fees, so it’s an easy choice for a standard cap index. The interesting thing here is the RAFI fundamental index doesn’t hedge the currency. I found out even though these funds are in US dollars there is no US currency risk, the currency risk should be less volatile because it is actually Canada against a basket of currencies. I haven’t been able to find a small cap international index.

60% / 14.55% — Vanguard Europe Pacific Index (VEA)
40% / 9.7% — Claymore International Fundamental Index (CIE)

Emerging Markets Allocation
Vanguard has the lowest fees for international and there doesn’t seem to be much else I can do to add a value / small cap tilt, especially since the allocation is such a small part of the portfolio.

100% / 4.25% — Vanguard Emerging Markets (VWO)

REITs
I’ve split Real Estate into 75% Canadian, 25% International. The question here comes from iShares REIT Sector Index XRE. It has a high MER of 0.55% but only a few equities. With my estimated starting allocation of around $30,000 it might be best to unbundle and save a bit on fees. This is appealing because I’ve never bought and sold stock myself, this could serve as an interesting lesson. The next idea is what about owning REITs in a DRIP plan which has no fees, plus lots of real estate trusts give drips a 3% or more bonus/discount. It would be more work and harder to rebalance, is it worth it? Would a REIT portfolio try to mirror the cap weighted index or evenly spread out between different types of trusts (malls, offices, senior’s homes, residential, etc). Is it worth it?

75% / 6% — iShares REIT Sector Index (XRE)
25% / 2% — Wisdom Tree International Real Estate Index (DRW)

Cash & Bonds
For the cash component of the portfolio I feel safer having 6 months of core living expenses in a cash emergency fund in high interest savings accounts, current this is about $16,000 or 4% of the total portfolio.

The remaining 16% is going to be invested in short term bonds with the goal of lowering equity risk. The Sleepy Portfolio uses the iShares Bond Index (XSB) but I am planning to use the lower cost Claymore 1-5 Year Laddered Government Bond ETF (CLF). Since it lacks higher yielding corporate bonds present in XSB, so would it make sense to split the bond allocation further with 80% CLF and adding 20% of iShares Corp Bond Index (XCB)? Combined the weighted MER would be 0.2%, instead of 0.25% for XSB. Is it worth it?

How and at what point should you buy real bonds directly?

40% / 8% — Claymore 1-5 Year Laddered Government Bond (CLF)
10% / 2% — iShares Corp Bond Index (XCB)
50% / 8% — High Interest Bank Accounts

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Reader J has set himself a goal of being financially secure in another 10-15 years. In Part 1 of his financial plan, he talked about his investment goals and today he shares his thoughts on his asset allocation strategy.

Ready, Set, Go
Now I am at the point of transition, where I actually craft an asset allocation and implement it. I find this step to be rather difficult, so I will share my thoughts and hopefully get some feedback.

Dimensional Fund Advisors
Several smart people I’ve bumped into lead me to the path of a slightly different indexing strategy by Dimensional Fund Advisors that isn’t cap-weighted. Their research and track record in the US looks very promising that they can build a better index with lower risk and higher returns. Being a [new] money nerd, I get turned off their requirement to only sell through advisors — I have a bad history with them; from now on I want to be more involved. DFA Canada also doesn’t seem to be performing as well as its US parent, but if I had the choice to use them to build my own portfolio held at a discount brokerage, I would have. In fact the first step to choose my risk tolerance comes from the quiz I took from the IFA website which only sells DFA funds. I fit into the “Indexfolio 70” which gives me a start to my asset allocation with 20% bonds, 80% stocks. In stocks I’ve tried to keep generally the same allocation as follows:
16% — Canadian stocks
27.5% — United States
24.25% — International (developed)
4.25% — Emerging Markets
8% — Real Estate
20% — Bonds & Cash

Fund Selection
Without DFA my fall back choices are using traditional low costs indexes from iShares, Vanguard and maybe also “Fundamental” indexes from Claymore which are sort-of like DFA. Vanguard is instantly appealing because of their great history and ultra-low fees. I just wish they operated in Canada. iShares seems pretty good and has fairly low fees. Claymore costs more, is less liquid, and seems like more of a risk because their implementation hasn’t performed as well as their back-testing, but hopefully over the long term they will outperform a normal index. I’m hoping that by mixing these different styles of fund I can lower the weighted MER and possibly a little get a better return and/or little less volatility.

Amateur Versus Sleepy
Compared to the sleepy portfolio this allocation has significantly less Canadian exposure. I understand that based on the cap weighting Canada only makes up about 3% of the global market, but we overweigh it because of home bias, currency risk and local dividend tax advantages. But where does a 24% or 16% allocation number come from? I generally agree that currency hedging is a performance drag, but is it possible that by using some indexes with a currency hedge to US/foreign markets that this would in a way help bridge the 16% to 24% currency risk discrepancy of Sleepy vs. Amateur?

Do any nerdy individual investors go so far as to do mean variance optimization as described in the Intelligent Asset Allocator? Is there some a practical way to build and test asset class correlation and other metrics like alpha, beta, standard deviation? Without knowing how to do this myself, I’ve decided to copy IFA which probably has measured these technical indicators to back test their risk based performance.

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Reader J is 26 years old, married, has two kids and dreams to be financially secure with a paid-off house and enough investment income to support his lifestyle in 10-15 years. It is an aggressive goal but he is off to a great start and has accumulated a tidy nest egg for someone his age. He has devised a detailed financial plan and wants feedback on his investment strategy. Part 1 is featured today and I’ll run the rest of his plan in the near future.

I’ve known of passive investing with index funds for several years, but I’ve never trusted my own intuition to do it. Even though my gut was telling me my “financial advisor” wasn’t adding value and wasn’t able to time the market, I never spent enough time to really research indexing enough to make my mind agree with my gut. I felt at the time it was better than nothing since I was preoccupied with work and family.

Starting in 2008 I made it my goal to begin to manage my own personal finances. I quickly found out it is actually a very interesting topic and a natural extension to my nature of being a “saver” and a nerd. So I’ve spent much of year reading books and blogs, taking my time to understand and not feel rushed into making any decisions. As Buffet says, it’s better to “move like a sloth”.

I’ve not invested anything extra with my advisor for probably 2 years, so at the beginning of the year one of my major concerns was “time risk” of investing a lump sum of cash. As we see now that risk was very significant, and just by pure dumb luck, I missed a lot of the pain. I feel like there needs to be more information on how to make this transition. I probably would have used dollar cost averaging or value averaging, but now that the market is already so much lower I think the risk is much tolerable and timing won’t make a significant impact on future returns.

Reason for Sharing

What I’d most like back from posting my plan is just feedback of any sort. Let me have it, the plan is personal but put yourself in my shoes and let me know why it doesn’t make sense or that you think it’s a good idea. I wish there was a place to post and compare investment plans and asset allocations, leave comments and track the performance over time.

Investment Goals

Before writing this plan down on paper I was talking about “the 10-year plan” that we would continue saving but also buy a house with a 10-year fixed-rate mortgage that we would aggressively pay down in those 10 years. The goal being we would have the safety and shelter of a paid for house plus by that time our investments and savings would have grown at an assumed 8% real return to provide enough income (assuming a continued 8% return) to “financially retire” with a modest life style living on $40,000 in today’s dollars.
But is that really retiring when most people only assume a 4% real return / withdrawal rate in retirement? Doesn’t that mean in years like we are currently in the retirement would fail and necessitate new income from “having” to work again? Is it possible to retire extremely early if you have to assume this rate of return, or should I be more realistic and say the goal is “early semi-retirement”? It’s a personal question, but I still wonder which is appropriate since I’m so far outside the normal realm of how average people save, invest and plan to retire.

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