Archive for May, 2010

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Under the Hood: BMO Real Return Bond

May 30, 2010

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: BMO Real Return Bond Index ETF (ZRR)

The index: The fund tracks the DEX RRB Non Agency Bond Index, which consists of inflation-linked bonds issued by the Government of Canada. It seems to have been created specifically for this ETF.

The cost: The ETF’s management fee is 0.25%. As with other BMO funds, the actual MER will be higher because it includes GST/HST and some other expenses.

The details: This brand-new ETF (it started trading on Wednesday, May 26) holds five real-return bonds issued by the federal government, each making up about 16% to 23% of the fund’s assets.

Real-return bonds — or Treasury Inflation-Protected Securities (TIPS), as they’re called in the US — are an important asset class, and some financial experts recommend them as a core holding.

Both the principal and the interest payments of real-return bonds are tied to the Consumer Price Index, so they go up with inflation. Here’s an illustration of how this might work, courtesy of Bylo Selhi:

On a $1,000 bond, if the coupon interest rate is 3% and inflation is 1% after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3% by year end, the principal is adjusted to $1,030. You then receive another interest payment of $15.45. Assuming similar inflation over 10 years, you will receive $351.64 in interest payments while the principal will have risen to $1,343.92.

Real-return bonds typically have long durations: the maturity dates of the five in this ETF range from 2021 to 2041. Since real-return bonds were introduced in 1992, the average annual return has been 8.2%, which falls between that of short-term (6.6%) and long-term bonds (9.5%) over the same period.

The alternatives: Real-return bonds are an under-served asset class: until ZRR was launched, the iShares Real Return Bond Index Fund (XRB) was the only ETF of its kind in Canada. There are only two no-load mutual funds devoted to them — TD’s Real Return Bond Fund and Phillips Hager & North’s Inflation-Linked Bond Fund — and both are actively managed.

ZRR has undercut its iShares competitor in price — XRB charges 0.35% — although we’ll have to wait for the first Management Report of Fund Performance to learn what its all-in cost will be. TD’s mutual fund charges an onerous 1.42%; PH&N’s has a super-low fee of 0.53%, but brokers may require a minimum investment of $5,000.

What’s most interesting is that all of these funds have very similar holdings. The reason is simple: there just aren’t many real-return bonds to choose from. The federal government has just five issues, all of which are held by BMO’s fund. These five also also make up 86% of XRB, 60% of TD’s fund, and 80% of Phillips Hager & North’s. The only other significant issuers of real-return bonds are Ontario, Quebec and Manitoba, and provincial governments aren’t included in the index ZRR tracks.

The bottom line: It’s too early to pass judgment on ZRR: it will take at least a year to see if it’s able to keep its expenses down and track its index closely. But if it performs well, it will be an attractive alternative to iShares’ XRB, which currently holds over $594 million in assets. Given the extremely limited inventory of real-return bonds, performance of funds in this asset class really comes down to who can keep their costs lowest.

If you’re considering this new ETF, first look through the prospectus.

Disclosure: I do not own ZRR in my own portfolio. I have a small position in TD’s Real Return Bond Fund (too small to make an ETF cost-effective).

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ShareOwner: A Better Way to Buy ETFs? Part 2

May 27, 2010

Last week’s post was an overview of Canadian ShareOwner Investments, a service that allows clients to buy stocks and ETFs using an innovative trading platform. Investors can place an order to purchase multiple securities for a single $40 commission, and the trades are implemented according to a fixed monthly schedule. Uniquely, ShareOwner also allows investors to hold fractional shares and automatically reinvests all distributions.

Now let’s consider whether ShareOwner offers good value for Couch Potato investors with all-ETF portfolios. My thanks to reader Steve, who recently opened account with ShareOwner and gave me his impressions of its strengths and weaknesses, and to those who shared their own experiences in the comments section of the previous post.

The Advantages

  • ShareOwner lets investors assemble and maintain a diversified ETF portfolio with much lower trading costs than big-bank discount brokers that charge $29 per trade. First, the service allows you to make individual ETF purchases for $9.95, the same as low-cost brokerages like Questrade and QTrade. Where you can potentially save much more is by buying multiple ETFs for a single $40 commission. (As one commenter pointed out, however, you still need to pay attention to your overall trading costs. A $1,000 order spread across eight ETFs works out to a commission of $5 per fund, which sounds cheap. But a $40 commission on a $1,000 purchase is 4%, which is not a cost-efficient trade at all.)
  • The ability to hold fractional shares allows investors to buy in smaller, rounder amounts, making asset allocation easy and dividend reinvestment more efficient. ShareOwner will reinvest whatever dividend amount you receive, even if it’s enough to buy only a tiny fraction of one share (up to four decimal places).This is especially useful for ETFs that have high share prices and low yields. For example, the SPDR S&P 500 ETF (SPY) trades at over $100 and yields less than 2%, so you’d need more than $20,000 to receive a quarterly dividend large enough to pay for one full share.
  • The strict monthly trading schedule forces investors to stick to a disciplined strategy, which is crucial for Couch Potatoes. As Steve explained: “It seems to me that one is less likely to make spontaneous purchases. It’s like ING Direct, which I use for short-term savings: for some reason, the fact that the money is a day or two away makes me less likely to go to it. Similarly, ShareOwner is forced discipline, because you cannot time the market.”

The Disadvantages

  • ShareOwner has high annual fees for RRSPs ($79) and TFSAs ($50), regardless of account size. Only unregistered accounts have no annual fee. Most discount brokers waive their account fees once you hit a certain threshold: QTrade, for example, charges an RRSP fee only if accounts are under $15,000, while Questrade charges no account fees at all fees.
  • The cost of selling ETFs is higher than buying them — $9.95 per security, with no co-op discounts — and withdrawals cost $12 to $48, depending on the type of account. For long-term investors who don’t trade often, this isn’t a huge disadvantage. However, when rebalancing your portfolio with ShareOwner it would be much more cost-effective to add new money, rather than selling off the top performing funds. See the full schedule of fees here.

The Verdict

ShareOwner is an innovative service that can offer a lot of value to buy-and-hold investors. But I think it’s better suited to stock pickers than to Couch Potatoes for several reasons:

  • For RRSP investors, the $79 annual fee may wash out any cost advantage over low-cost discount brokers. And it makes little sense to pay $50 annually for a TFSA, especially since the contribution limit is just $5,000 a year. If you’re investing in a taxable account, however, you can make a much better case for using ShareOwner.
  • Couch Potatoes with less than $30,000 are often better off staying away from ETFs altogether. Index mutual funds already let you buy fixed-dollar amounts and reinvest distributions, plus you can add or withdraw money with no fees. My first Index Investor column in the current issue of MoneySense discusses this idea in detail.
  • ShareOwner’s DRIP feature is of limited value for Couch Potatoes. Most discount brokers already offer DRIPs on Canadian exchange-traded funds, albeit for full shares only. In any case, there’s an argument to made for taking distributions in cash and using that new money when you rebalance.
  • The real savings from ShareOwner’s co-op trades only come if you’re making a lot of purchases in each order. A stock picker, for example, might have a portfolio have 30 to 40 dividend-paying stocks, which would be very expensive to buy individually. But a Couch Potato portfolio typically includes only four to eight ETFs. In theory, the platform would work well for something like my Über-Tuber portfolio, which includes ten ETFs. But ShareOwner doesn’t offer a wide enough selection of products to build this kind of sophisticated ETF portfolio.

If any readers are using ShareOwner to maintain an all-ETF portfolio, please post a comment and let us know your thoughts.

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ShareOwner: A Better Way to Buy ETFs? Part 1

May 20, 2010

Several weeks ago, a reader named Steve wrote to me about using Canadian ShareOwner Investments to build a Couch Potato portfolio with exchange-traded funds. I had no experience with this service, so I asked Steve to report back after he did his research, and he kindly followed up. In today’s post I’ll describe how ShareOwner works, and early next week I’ll pass along Steve’s assessment of its pros and cons.

ShareOwner Investments (formerly the Canadian Shareowner’s Association) is a dealer that allows investors to trade stocks and ETFs in both registered and taxable accounts. But unlike a discount brokerage, ShareOwner uses a dollar-based trading platform that enables you to buy and sell small amounts, and to own fractional shares. For example, you can place an order for $500 worth of a stock or an ETF, and if it’s trading at $27.36, you’d receive 18.2749 shares. ShareOwner also reinvests all dividends including partial shares, something traditional DRIPs don’t allow.

The other important feature of ShareOwner’s platform is that you can place a single order covering as many securities as you want. If you have $1,000 to invest, you can order $50 worth of 20 different stocks or ETFs, all for a single trading commission of $40.

ShareOwner can do this because it makes large “co-op purchases” of the stocks and ETFs in its inventory at specified times. (The schedule is not based on market timing: orders for ABC Company might be executed every Thursday, for example, while orders for XYZ Company might take place on the fourth Wednesday of every month.) Once a month, each client receives his or her allotment of these bulk purchases, including fractional shares down to four decimal points. In this sense, ShareOwner makes buying stocks more like buying mutual funds.

The platform was designed as a cheap and easy way to build a diversified stock portfolio, but it’s also ideal for ETF investors. One drawback of ETFs has always been that it is cost-prohibitive to trade small amounts. Commissions make monthly contributions — and even annual rebalancing — too expensive for many investors. Imagine that you’ve decided to set up a Couch Potato portfolio with the following asset allocation:

20%     Canadian equities
20%     US equities
20%     International equities
5%       Emerging markets equities
5%       Real estate
20%     Short-term bonds
10%     Real-return bonds

Building an ETF portfolio like this through a big-bank discount brokerage would incur seven trading commissions totaling more than $200. I use the rule of thumb that a trading commission should not exceed 1% of the purchase or sale. So if you’re paying $29 commissions, your trades should be at least $3,000 or so. The cost of adding money and rebalancing, even once a year, is so high that you’d likely be better off using index mutual funds unless your account is at least $60,000. (If you’re paying $9.95 per trade you could pull it off with less, but it would still be unwieldy.)

Now consider the same portfolio in a ShareOwner account. You’d build it by placing one $40 order that includes all seven ETFs. Using my 1% rule, you’d need only $4,000 to make this cost-effective. After subtracting the $40 fee you’d have $3,960, which you’d allocate like this:

Dollar Current Number
amount price of shares
iShares S&P/TSX Composite (XIC) 20% $792 17.96 44.0980
SPDR S&P 500 (SPY) 20% $792 107.55 7.3640
Vanguard Europe Pacific (VEA) 20% $792 29.03 27.2821
Vanguard Emerging Markets (VWO) 5% $198 36.38 5.4426
iShares S&P/TSX Capped REIT (XRE) 5% $198 11.56 17.1280
iShares DEX Short-Term Bond (XSB) 20% $792 28.97 27.3386
iShares DEX Real-Return Bond (XRB) 10% $396 20.79 19.0476
$3,960

Once or twice a year (or as often as you want) you can add a few thousand dollars and rebalance the whole portfolio in one fell swoop. In the meantime, all of your distributions get automatically reinvested rather than lying around in cash.

ShareOwner is a unique service that promises to make buying ETFs even easier and cheaper for small investors. In my next post, we’ll look at its strengths and weaknesses so you can decide whether it would be the right vehicle for your Couch Potato portfolio. Until then, If you’ve used ShareOwner, please let us know your thoughts in the comment section.

Dollar Current Number
Amount Price of shares
iShares Canadian Composite (XIC) 20% $792 17.96 44.0980
SPDR S&P 500 (SPY) 20% $792 107.55 7.3640
Vanguard Europe Pacific (VEA) 20% $792 29.03 27.2821
Vanguard Emerging Markets (VWO) 5% $198 36.38 5.4426
iShares S&P/TSX Capped REIT Sector (XRE) 5% $198 11.56 17.1280
iShares DEX Short-Term Bond (XSB) 20% $792 28.97 27.3386
iShares DEX Real-Return Bond (XRB) 10% $396 20.79 19.0476
$3,960
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Canada’s Best Investing Blogs

May 18, 2010

The Globe and Mail is running a poll to determine the best investing blogs in Canada, and I am honored that Canadian Couch Potato is on the shortlist. If you’ve been a loyal reader, I would be grateful if you would take the time to cast a vote for your humble spud.

The Globe poll also includes personal finance blogs that cover topics other than investing. You will need to vote for at least one of these in order to get to the investing ballot.

The panel who came up with the shortlist included the venerable Ram Balakrishnan, better known in the blogosphere as Canadian Capitalist, the Globe‘s personal finance columnist Rob Carrick, and Globe contributors David Breman and Chaya Cooperberg.

Many thanks!

[Update on May 25: CCP finished second in the poll behind WhereDoesAllMyMoneyGo.com. Congratulations, Preet!]

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Tips for Trading ETFs

May 14, 2010

I happened to have Google Finance open on my computer last week when the “flash crash” happened. While the market’s whipsaw on May 6 affected almost all stocks, it seems that ETFs were particularly hard hit: I watched my position in the iShares S&P/TSX Capped REIT Index Fund (XRE) fall 15% in a matter of minutes. The ETF, which opened the day at $12, eventually fell to $6.89. I missed that low point, as I was standing on the ledge of my home office window, poised to hurl myself onto the dandelions below.

I’m not sure we’ll ever know the full story behind the madness of May 6, and for long-term investors it’s probably not worth fretting about. But the day was a reminder that ETFs, unlike mutual funds, are potentially vulnerable to the insanity that occasionally plagues stock exchanges in this era of automated trades. If you’re building a portfolio of ETFs in a discount brokerage account, here are a few suggestions to make sure your trades go smoothly:

Choose frequently traded ETFs. In theory, ETFs are supposed to be infinitely liquid: that is, you should be able to buy or sell units at market prices very close to the net asset value (NAV). But unpopular ETFs may be subject to wider price fluctuations and higher overall expenses. This is not an issue with the broad-based equity funds from iShares or Claymore: any ETF that trades at least a few thousand shares every day should not cause concern. But some of the newer and more specialized ETFs are traded very infrequently: the iShares Portfolio Builders have days when only a few hundred shares change hands, and some of BMO’s new ETFs go entire days without a trade.

Look for a tight bid-ask spread. The bid-ask spread is the difference between what you pay for an ETF when you buy it and what you’ll receive when you sell. Ideally, this spread should be one or two cents: any more and you’re paying too much to the broker. ETFs with high trading volumes usually have tight spreads, but not always, so check before you enter your order.

Make sure the market price is close to the NAV. When you research an ETF on the provider’s website, both the net asset value (NAV) and yesterday’s closing price are listed. The NAV represents the per-unit value of the underlying securities, so in theory it should be what investors are willing to pay for one share of the ETF. But again, that doesn’t usually hold true in practice. Most ETFs trade at a slight premium or discount to the NAV. If you can buy an ETF for less than the NAV, you should be pleased. Paying a few cents over the NAV price is not a big deal, but occasionally you’ll see ETFs trading at a premium of 2% or 3%. Do you really want to pay that much more than the underlying securities are valued at?

Watch the clock. Differences between the NAV and the market price tend to be widest in the first half-hour after the markets open, and in the 30 minutes before they close. So if you’re buying or selling an ETF, do it toward the middle of the trading day to ensure that price discrepancies are minimized. If you’re buying an ETF that holds European stocks, consider making your trade between 10 and 10:30 am EST: this is the only window during which both the North American markets and European markets are open, which can also reduce price discrepancies.

Don’t trade on days with high volatility. If the markets have been experiencing wide daily swings — as they have been lately — avoid buying and selling ETFs altogether. Both the bid-ask spreads and the difference between NAV and market price can widen during volatile market days. If you’re adding money or rebalancing your portfolio, just wait until the markets are calmer.

Use limit orders. A limit order is an order to buy or sell an ETF only at a specified price or better. Buy setting the exact price at which you’re willing to buy or sell, you can avoid surprises caused by wide spreads or sudden price movements. Be aware that your limit order may be only partially filled, or may not be filled at all.

Don’t use stop-loss orders. Some people view stop-loss orders as a form of insurance: if an ETF’s price falls to the level you specify, a sale is triggered automatically and you’re protected for further losses. But think about how that would have worked last week. Had I placed a stop-loss order to sell XRE if it fell by 10%, that sale would have been triggered on May 6 and I would have liquidated my whole position. I’d have been left with a significant loss even after the ETF’s price normalized just minutes later. The best way for long-term investors to manage their risk is by setting an appropriate asset allocation, not by relying on a panic button.

Trade less. The keys to being a successful Couch Potato are choosing excellent ETFs (or index funds), building a well designed portfolio and only trading once or twice a year when you’re rebalancing. If you stay focused on the long-term you can ignore short-term market madness, even bizarre events like the “flash crash.”

Still, just to be safe, I’m moving my office to a windowless room on the ground floor.

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Indexing’s Dirty Little Secret

May 10, 2010

“Most actively managed mutual funds underperform the market.” Couch Potato investors sing this refrain all the time in defense of ETFs and index funds. I’ve done it many times myself — a bit smugly, I confess. My FAQ page points out triumphantly that 92.6% of actively managed Canadian equity funds have trailed the S&P/TSX Composite over the last five years, according to Standard & Poor’s, which issues a quarterly report on active funds versus the indexes.

But here’s the part that S&P and most indexing advocates usually leave out: the vast majority of ETFs and index fund underperform their benchmarks, too. So it’s not fair for index investors to imply that they earn market returns, because they almost never do. Call it indexing’s dirty little secret.

This inconvenient truth is discussed in an excellent article by Scott Ronalds, published in this month’s Canadian Money Saver. Ronalds is manager of research and communications with Steadyhand Investment Funds. His article doesn’t disparage indexing, nor does he pull out the red herrings that Mackenzie Financial and others use to criticize ETFs. He simply points out that a true apples-to-apples comparison would pit actively managed funds against ETFs and index funds in the real world, not against hypothetical benchmark returns. “The all-in costs of ETF investing are not immaterial. Yet, they are often downplayed, if not completely ignored, in most comparisons of passive vs. active investing… The S&P scorecard exaggerates the outperformance of passive investing by ignoring the issue of fees.”

Ronalds is right. After all, the MERs on index funds are much lower than the average mutual fund, but they’re not zero. The trading expenses aren’t zero either. There are a host of other factors that can be a drag on returns, too, as I’ve discussed in several recent posts. And, of course, buying and selling ETFs incurs commissions. All of this means that it’s typical for a Couch Potato portfolio to underperform the broad-market indexes by 0.5% to 1% every year, and sometimes by much more.

I don’t agree with all of Ronalds’ arguments. While he’s right that the S&P scorecards ignore the cost of index investing, they also ignore some of its benefits. The greater tax-efficiency of ETFs, for example, isn’t measured by S&P’s survey, but it can have a big effect on net returns. Neither do the scorecards account for the corrosive front-end loads and deferred sales charges levied by many active funds. Indeed, the real problem with actively managed mutual funds is not their investment strategy: it’s that they’re hawked by commissioned salespeople who are in an inherent conflict of interest because of this fee structure.

I still believe that the Couch Potato strategy is the best hope that investors have for earning close-to-market returns over the long term. But all index investors should acknowledge and learn from Ronalds’ arguments. I took away three important points:

Tracking error is the enemy. Couch Potato investors should never assume that index funds and ETFs deliver market returns minus only the MER. That’s just not true. Many passive funds that track the broad Canadian equity and bond markets do so extremely well. But Canadian ETFs that track the US and international indexes are dragged down by factors such as currency hedging, withholding taxes and poor sampling. Couch Potato investors should therefore choose their international funds carefully: US-listed ETFs from Vanguard and iShares have a much better record of tracking their indexes than their Canadian counterparts.

Advisors who use passive strategies may be just as expensive. Do-it-yourself Couch Potatoes can easily keep their annual fees well below 0.5%, including fund MERs and a few trades a year. But DIY investing requires knowledge and commitment that not everyone has: there is a role for advisors, and if you need one, she deserves to be paid. Many advisors embrace ETFs and passive strategies, but once they add their own fees to the MER of the portfolio, any cost advantage over active management may disappear. If a fee-based advisor builds you an ETF portfolio that costs 0.5% but then adds another 1% annually for her own fees, is that fundamentally better than using active funds that charge 1.5%? Maybe, but I would challenge the advisor to justify it.

What is clear, of course, is that paying MERs in the range of 2.5% to receive cookie-cutter services from an “advisor” who is nothing more than a salesperson is always a bad deal. So is paying front-end loads or deferred sales charges, which are never justified. No exceptions.

The key is sticking to the strategy. Successful investing is not just about choosing the right strategy: it’s about sticking to that strategy. Active investors can do just fine if they stick to no-load, low-MER funds (like those offered by Phillips Hager & North, Mawer and Steadyhand) and hold them for the long term, through all market conditions. By the same token, investors who build so-called passive portfolios but then try to time the market are probably doomed to fail. I get emails all the time from investors who call themselves Couch Potatoes because they use ETFs, but then they talk about using leverage, chasing hot sectors and altering the strategy based on predictions about where the markets are headed in the next six months. A passive strategy only works when it’s truly passive.

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New Couch Potato Column in MoneySense

May 6, 2010

If you’re a reader of MoneySense, you may have a noticed a new column in the May issue. I’m pleased to be contributing a new column to the magazine called Index Investor, where I’ll offer practical advice for fellow Couch Potatoes. My first column (not available online, unfortunately) offers suggestions for investors who are just getting started. I explain that trading commissions make ETFs a poor choice for small portfolios, especially if you contribute a small amount each month rather than an annual lump sum. The issue is available on newsstands now.

If readers have any ideas for subjects they’d like me to address in future MoneySense columns, please let me know. I’m especially anxious to hear from mutual fund refugees who would be willing to share their (anonymous) stories.

As a complement to the new column, Canadian Couch Potato is now being mirrored on MoneySense.com. Visitors to the magazine’s site can view my blog feeds and add comments in the MoneySense template. Note that the Canadian Couch Potato site remains unchanged, so readers can view the posts in whichever format they prefer. The blog will also remain completely independent: I have full editorial freedom.

Finally, I’m proud to announce that my article How I Became a Couch Potato, which was published last year in MoneySense and ultimately led to the creation of this blog, has been nominated for a National Magazine Award. Let’s hope the judges aren’t mutual fund salespeople.