Wednesday, March 29, 2017

Review: Inflation-Proof Your Portfolio

After so many year's of extremely low interest rates and low inflation, too many have been lulled into complacency that will always be the case. When browsing investing books last month I came across Inflation-Proof Your Portfolio by David Voda.  I have recently finished the eBook version available through my local public library (it is also available as a hard back printed book).  Here are my thoughts on the book.

The Main Messages

The key ideas of the book can be simply summarized:
  • Government debt is growing at an alarming rate (the book is written from a USA perspective, but the argument would hold for many countries including Canada).
  • It is argued that hyperinflation will result (not everyone agrees with this, and Jeffrey Dorfman argues that the high debt will keep interest rates low, the exact opposite of premise in this book). 
  • To help protect against hyperinflation 'exchange dollars for real things.'
  • Under hyperinflation remember that a dollar in the future is worth far less than a dollar now.
  • Since not all countries will simultaneously suffer inflation at the same time and rate, diversify across a number of currencies.
  • The final principle expressed in the book is 'prepare for the worst, but expect the best.'
Most experts would agree with some of the advice in the book, such as lock in your mortgage rate at a long term, low fixed rate. Some of the other advice, such as to buy gold and silver coins, mining companies, real estate, and other commodities, is less universally supported by financial writers.

The Good

It is right that we should be wary of increases in inflation and interest rates, and no reader could leave the book without concern about government debt.

The ideas of diversifying across currencies, holding more of your assets in 'real things', and think about the consequences of rapidly rising interest rates all ring true to me.

There is some good general financial advice (although it is often lost within the political hyperbole of the book).

Each chapter ends with a Key Points section.  I wish all financial books used this structure.

The eBook version has live web links to a large number of cited sources in each chapter.  This makes it easy to check out statements.  The quality of referenced material varies somewhat, from reports to articles of various depth.

The Bad

I found David Voda's writing style too alarmist and political in tone for my liking.

That is unfortunate, since, as indicated above, there are positives in the book. We should all be concerned about rising government and personal debt, particularly when that rise is high compared to the GDP change. There is a case for holding a portion of our portfolio in "real" assets to guard against inflation losses, and for some to consider investing outside the stock and bond market in real assets.

The main problem with the book is that despite the title, there is not much directly related to inflation proofing an investment portfolio in the book. Many opportunities to talk about the type of ETFs that are likely to hold up under inflation are missed. In fairness, the book does not claim to be investment advice.
"This book is neither an economic treatise nor specific investment advice."
I wish there had been more depth on actual inflation proofing portfolio ideas, and less political views and coverage of what I consider to be solutions that would appeal to only a few. Interestingly, the author is not a fan of TIPs and other inflation protected bonds, an obvious topic.

The most current edition of the book was published in 2012 by Wiley, and a more up to date treatment of some of the topics might have added to authenticity.

By wandering into areas that, in my humble opinion at least, have little relationship to the topic of the book (such as protecting your Facebook privacy and preparing to live off the grid if society breaks down), the focus of the book is lost.

So Who Wrote This?

I did not consider who had written the book until after I finished reading the book. Interestingly, their is no author biography on Amazon, unusual particularly for a book published by a major publisher like Wiley.  It does show other books by the author, including a couple on snowboarding, one on real estate, and a recent book on debt and financial planning. A bit of digging did find this biography on the Wiley site for the book.
"DAVID VODA is a writer, businessman, and investor currently living in Boulder, Colorado. He has written on business topics for the Los Angeles Times and the New York Times, was a realtor in Palm Springs, California, and buys and sells real estate for his own account. He was a principal in Yes Yes Productions, which produced the award-winning feature, The Secretary. Most recently, he was producer of PJTV's business and economics show, Front Page."
Some of the best investing books have been written by people with varied professional backgrounds, so I would not hold that against the author.  It is not obvious to me how widely read this book is. I was surprised that Amazon.ca had zero reviews of it.  It states that this second edition, published by Wiley, came after a wildly popular self-published first edition.

Final Thoughts

Early in the book, after a rant in favour of non-interventionist governments,  the author writes "But enough about politics."  Unfortunately, he did not follow his own advice in the rest of the book. This book should have had a title like "One Individual's Concern About Government Debt and Inflation."

Overall, I would certainly not place this book in the top 10 (or even the top 25) investment books that you should read. So, if you are just starting out in investing, don't start with this book!

But if looking to explore public finance and interest and inflation rate issues, this may be worth a quick read (it actually does not take long to go through the entire book).  Check if you can get the book at your local library. But read with a critical eye.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a professional financial planner or investment advisor. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  No compensation by any company, organization or individual has been offered, requested or received for writing this column.

Books for Review: I will not promise a positive, or even any, review, but if you wish to submit your investment book for me to consider, contact me rhawkes (at) chignecto.ca. I am particularly interested in Canadian books.

Saturday, March 11, 2017

Can We Talk Bonds?

Now that you have some Canadian equity ETF planted in your investment garden, the next step is to add some bonds. Bonds serve as a buffer against volatility, since high quality bonds usually go up in value when equity prices go down (and vice versa). We will start by describing how individual bonds work, although for most of us a bond ETF makes more sense.

Those of retirement age probably bought Canada Savings Bonds in the past.  You buy a bond with some money, at some point in the future they give you back that money, along with interest along the way.  Bonds work like that. Unless the government or company defaults, your principal (the initial cost) is guaranteed and is returned on the maturity date.  The interest rate is called the coupon in the world of bonds.

Bonds are sold by the Canadian government, the provinces, municipalities, and companies.  We call bonds from companies corporate bonds, while the others are called government bonds (sometimes municipal are split off into their own category). Compared to stocks (equities), most individual bonds are safer, both from absolute loss of principal, and also from deep losses in value.

That is not to say that buying a bond is absolutely safe. The investing world have developed ratings for bonds as a measure of how secure they are.  The most widely used bond rating system is done by Standard & Poor.  The most secure bonds, generally offered by national governments, are given a rating of AAA.  Still very secure, but slightly less so, are AA and then A, followed by BBB.  We show these in the following table. Different terms are sometimes used for the different letter categories, but there is general agreement that BBB and above are investment grade. Note that Moodys have a slightly different bond rating system.

I don't like the term "junk" bonds for those rated BB and below.  I think that has a more negative connotation than is appropriate.  Yes, there is a higher risk than with government AAA or AA  bonds, but junk bonds these are often offered by large stable companies and the odds of them not defaulting are good. The reason to purchase bonds in the BBB to B rating is that generally they pay a significantly higher coupon rate in return for the higher risk that you are assuming.

Many discount brokerage firms allow you to purchase individual bonds and hold them in your account. I am most familiar with Scotia iTRADE.  They make it easy to find bond listings according to the type (e.g. corporate), duration, coupon rate and credit quality.  In terms of pricing you pay a commission at purchase of $1 per $1000 in face value, but with a minimum of $24.99 (and a maximum of $250).  For example if you buy bonds worth $20,000 you will pay $20 in commissions, while if you buy $100.000 you will pay $24.99.  Of  course these may well change, so be sure and check current rates if you are considering purchase of individual bonds.

I have never purchased an individual bond from my discount brokerage.  It seems to me that the commission is significant, especially if I consider that I would want to buy a number of different bonds to lessen the impact if one of them did default.  I think unless you are a huge institutional investor it is better to buy a bond ETF.

The  Freedom Thirty-Five blog has done a really nice job of looking at Canadian bond ETF choices.  As he points out, while cost is important, so is performance. By the way, while on his site, check out his graphic in About Me regarding what others think he does! He points out that there are more than 60 bond ETFs on the TSX, so my analysis below will be highly selective, looking only at broad holdings of primarily investment grade bonds.  We will look at corporate bonds in a future post.

You can purchase bond ETFs with exclusively corporate or government bonds, with long or short durations, or a ladder of purchase dates. You can purchase bonds that will increase in value if interest rates go up (so called real return bonds in Canada, TIPs in US). But in the rest of this column, I am going to narrow the choice to three widely held bond ETFs with reasonable MER values and which hold a mix of government and corporate bonds, mainly of investment quality.

My three choices are shown in the following table. For each I give the name, fees expressed as a MER, the assets held in the fund (e.g. 385M$ means that $385 million dollars are invested in XQB at the time of writing), the average daily volume at the current time (e.g. 65k means about 65000 units of VAB are traded daily), and the spread between bid and ask prices on open orders.  Note that all of these change over time, so if important to you should be checked through a source such as morningstar.ca at the time of investment.
Note that although ZAG has a formal MER of 0.23 based on audited financial statements, its MER currently and going forward will be 0.10. We explain all that here.

I did some searching, both directly from the companies themselves and from third party assessments, and the portfolio holdings reported for the same product seemed slightly inconsistent.  I expect this is due to how bonds with a federal agency that is a crown corporation are reported (is that corporate or government?), and the changes from different reporting periods.  In any case, all three hold a mix of government and corporate, with roughly 60 to 70% government and 40 to 30% corporate.

While any of these are good choices, there are some differences.  As indicated in the table, the effective durations are not quite the same, with XQB slightly shorter duration.  ZAG is a fund of funds, which means that rather than holding a number of individual bonds, as VAB and XQB do, it holds in varying amounts 10 other BMO bond funds.  In this way it is arguably more fully diversified than the other two. While all three are high investment quality, XQB contains nothing below A, while VAB does have just under 10% at BBB.  This helps the investment yield, at only a tiny amount of higher risk.

If you are a Scotia iTRADE account holder, there is an advantage of XQB in that it is on the list of commission free trades.  This means that it is a good choice if you are purchasing your bond ETF in a number of small transactions, which would not be efficient if you needed to pay commissions with each purchase. It is also helpful for annual strategic rebalance, since there is not a commission charged for XQB sale or redemption in an iTRADE account.

There are other broad Canadian ETFs not covered here. iShares XBB has more than $2.3 billion in assets, and has been a mainstay for many years, but with its MER of 0.34% I find it currently uncompetitive. If you desire a swap-based product that does not pay out annual dividends, then HBB (MER of 0.17%) is worthy of consideration.  Many suggest that in the current climate you give up a little bit of return and buy shorter duration ETFs to guard agains interest rate fluctuations. Vanguard VSB would be a good choice (MER 0.11%) as would iShares XSB (although at a higher MER of 0.25%).

My final views?  If your discount brokerage is something other than Scotia iTRADE, I would probably choose ZAG.  I like the stability of the "fund of funds" approach, it has a marginally higher yield, and a marginally lower management fee going forward.  The Canadian Couch Potato have currently selected it for bond holdings.  The differences are not enough to move ETFs if already invested in one of the others, however. If you are a Scotia iTRADE customer, I would use XQB.  You will more than make up for the slightly higher MER through saved commission fees.

As with any financial decision, it is always wise to seek qualified investment counsel prior to purchase. I suspect the 2017 edition of the Globe and Mail Buyer's Guide to ETFs should be out shortly after this is published, and that is a valuable and comprehensive source of information for Canadian bond ETFs.

The fees are now remarkably low for bond ETFs.  With XQB a Scotia iTrade customer can hold $10000 in bonds, spread across high quality federal, provincial and corporate bonds, and pay only $13 a year in fees, and no commission charges for purchase or redemption.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account: VAB and XQB.  I use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.






Saturday, March 4, 2017

Some Canada For Your Garden

It's about time we got down to some specifics in terms of what investments to consider for your funds garden. We will start with Canadian equity (stocks). using ETFs as our investment vehicle.

It is generally agreed that Canadian stocks should be a core component of a Canadian portfolio.  For most individual investors, rather than holding those stocks directly, it makes sense to use an ETF.

Another option would be Canadian stock index mutual funds, but that will result in a higher MER.  If you don't want to bother with a discount brokerage account, mutual funds might still be a good option for you. Also, if you are funding your investments in small amounts at a time, mutual funds will avoid the discount brokerage commissions on ETF purchases. We will cover Canadian stock index mutual funds in a future post.

Fortunately, there are a number of great Canadian stock ETFs with very low management expense ratios (MER).  At the time we are writing this (early March 2017) the information on the most popular choices in this category are given in the following table (click on it to make the image easier to read).

The Toronto Stock Exchange (TSX) actually has two branches. the main TSX which with 1561 companies listed, and a venture category for smaller and newer companies, that as of the time of writing, had 2424 listed companies.  You might be surprised by these numbers, since most financial news talks about either the TSX composite, that contains about 250 of the larger companies from the entire TSX, or the TSX 60 which, as the name implies, is the 60 largest companies.  As companies grow, or reduce in net worth, the exact companies on the two lists change slightly from time to time.

Is it better to hold an ETF that tracks the TSX 60 or the TSX composite? The advantage of the TSX 60 is that they are all large, for the most part very stable and well established, companies. This is very much a 'blue chip' list, and most of the companies are household names. It is important to realize that the TSX, and especially the TSX 60, is far from diversified, however.  For example, at the current time the three largest companies are all banks (Royal, Toronto Dominion and Bank of Nova Scotia), and together they account for almost 24% of the entire TSX 60 value!  Even in the broader TSX composite, these three companies represent nearly 18% of the index value.

The main Canadian stock ETFs track either the TSX 60 index or the TSX composite index. From the ETFs shown in the table, VCN, XIC and ZCN track the composite index (or a slight alteration of it), while HXT, VCE and XIU track the TSX 60. As you can see, competition in this investing space has resulted in very low and similar MER of 0.06 on most products (XIU being the exception).

If MER is not a distinguishing characteristic, how do you choose between the ETF options?  The simple answer is that the products are very similar, will yield nearly the same performance, and really you should not worry too much about which to choose.  

There is one significant difference between HXT and the other offerings in the table, however.  All of the others hold the actual TSX stocks. That is, they take the funds invested in the ETF, and then buy proportionately the different stocks in the index.  The down side of this is that when the index changes, the fund will need to do a bit of buying and selling, triggering some capital gains, and for short periods of time drifting very slightly from the index. The plus side, though, is that you really are owning the actual stocks by holding the ETF. 

The HXT product is an example of what is called a swap-based ETF.  Rather than buying the stocks, it gives the money to a bank that agrees to return to HXT the return of the TSX index over the period of time. The process is well explained in this post from the Canadian Couch Potato site (note the MERs have changed in the several years since that post was written, but the explanation of how the swap works is still valid). 

There is an important tax (and income) difference that should be understood as you make the choice between HXT and one of the other Canadian index ETFs.  No dividends are paid by HXT, although they are worked into the appropriate changing price of the ETF.  This means that swap based products are not good choices when you want a regular income stream.  There is a potential tax advantage, though, in that you do not need to pay annual tax on dividends earned. It is important to realize that you will still be taxed, but as a capital gain when you sell your units of HXT. What you are really doing is deferring the tax, and it will appear as a later capital gain rather than as a regular annual dividend. Whether this is a positive or negative will depend on your personal financial situation.  Swap based products are good if your income from other sources is variable, and you can cash in the  HXT units in a tax year when your other income is relatively low.

For any ETF, a consideration is how widely traded the product is.  We have shown (using data from morningstar.ca) the mean daily volume of each ETF.  For example, the mean number of units of HXT that traded in a day were 212000 (we have written this as as 212k, with k meaning thousands, in the table).  We also show the total assets held in each of the ETFs - e.g. ZCN has about 2.4 billion dollars invested in the fund.  Both of these numbers will change over time, so you should check for current values if this information is important to you. These are all pretty widely held, however, and the concerns about specialized ETFs that are only lightly traded do not hold for any of these products.

 I have also included in the table (using morningstar.ca data) the spread between the mean ask price at which the ETF is offered for sale, and the price being bid by someone looking to purchase the ETF.  A smaller spread is desired, since that implies it will be easier to quickly buy or sell the ETF without paying a premium on the transaction. Naturally widely held ETFs with high daily trading volume are generally expected to have a lower spread. The figures here represent a snapshot at the time I am writing this post, and would change from day to day according to overall trading volume and other factors.  By showing patience and using limit orders you can usually get a stock or ETF at a fair price.

Some of these products have been around much longer than others - e.g. iShares XIU entered the Canadian ETF space earlier, as one of the first Canadian ETFs, and that largely accounts for the fact it has much more money in assets.

If you use Scotia iTRADE as your discount brokerage, HXT can be bought and sold without commission.  I believe that QTrade Investor and Virtual Brokers also offer HXT without commission, but check with them to be sure.

Personally I prefer the slightly broader holdings of the composite index. Within that space I see little difference between VCE, XIC and ZCN - I personally use XIC, but that is mainly because I was invested in XIC units before the other two started operation.  I do like for some accounts (e.g. my TFSA) the swap based HXT. Also if I am investing in small amounts. I use HXT since it is commission free in my Scotia iTRADE account.

There are a number of other ETFs that operate in the Canadian equity index space, and we may cover some of them in future posts.  For most investors, however, we feel that one or more of the options shown in the table would well serve your needs.

You should discuss with your investment advisor which of these products are best for you, and have her/him explain in more detail the implications of swap-based vs. directly held ETFs. Your investment advisor can also help you determine how much of your portfolio to hold in Canadian equity ETFs or mutual funds.

Before ending this posting I want to stress how incredibly low the MER are for these products.  You can have $10000 invested across about 250 different companies in the composite TSX index, and your annual fees are $6.00.  That is truly good news for investors!

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account: HXT, VCN, and XIC.  I also use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.




Friday, March 3, 2017

Should You Buy Only Stocks You Understand?

Like many good questions, the answer to the question posed in the title is yes, but also no.  Let's elaborate.

Before we start, we assume that you have decided to hold some individual stocks in your portfolio, and that is a good choice for your financial situation.  That decision is a whole question in itself, and not a simple one to answer, and we will deal with in a future post.

Perhaps Warren Buffett is the best known proponent of the idea that you should only invest in what you really understand. Indeed number 7 on a list of Buffett investing quotes is "Never invest in a business you cannot understand."  Berkshire Hathaway Inc. invested mainly in big name companies operating in areas that he understood. Also, while others were rushing into technology stocks, Berkshire Hathaway Inc. stayed largely on the side (although recently holdings of Apple have been significantly increased).

It seems obvious that you should really know a company before you invest in that company.  No matter how many balance sheets you examine, how many analyst reports you read, it might be argued that you must understand the field the company operates in to truly understand it at the deepest level. It is only through that knowledge that you can reasonably predict how the company's financial situation is likely to change in coming years. Do you really understand fuel cells at a scientific and engineering level, if not why are you considering buying stocks of Ballard? Do you really know the pharmaceutical industry? If not, why are you considering Valeant?

So let's say you  have extensive work experience and academic background in the banking business.  You understand banks and insurance companies at a deep level.  More than any other area of the stock market, you feel qualified to choose which companies have a bright future, and which not so much. Indeed as Alexander MacDonald has pointed out, if you had invested only in Canadian Banks you would have out performed an other North American sector over the past 25 years.
The problem with that approach, however, is that it totally lacks in diversification, and therefore your investment portfolio is expected to be more volatile. A second possible problem is that you might depend too much on your personal expert viewpoint, and not give sufficient weight to the views of investment analysts. The 2008 financial crisis emphasized this point.

However, it is important to think about diversification across your entire financial holdings.  For example, if you have TFSA, RRSP and unregistered accounts, it is not necessary that each be fully diversified, but rather that in total your holdings are. There may well be tax reasons why your holdings in unregistered are different than in the RRSP.  The fact that TFSA accounts are not part of international tax treaties means that certain types of holdings should not be held there (more on that in a future post).

So back to our question on stocks.  If you do decide to hold a number of stocks in one or a few categories, because that is what you understand well, make sure that you balance that with broad holdings in the rest of your portfolio. Not only should no one stock represent a large part of your portfolio, but also no stock category should be a major part.

Some will work in companies where stocks in the company are either part of your compensation, or offered at an attractive price.  While it makes sense to hold those stocks, make sure that it does not represent all or most of your investment holdings. There is a good article on this topic by Eric Rosenberg here.

What are your thoughts on this topic?  Why not leave a comment?  As always, thanks for reading!

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column has not received any compensation from any financial company for writing this column, and has no association with any company mentioned.  I do hold a small number of individual stocks, but neither of the two mentioned by name in this column.