Motivated by the limits of certain types of registered accounts as well as a growing portfolio that is now large enough to access new options, I’m planning to make a few portfolio changes this year:
1) We’re moving from TD e-Series funds to ETFs. The commission-free ETF purchases at Questrade provide one good way to do this and we’ve already opened a couple of accounts there. I’m not sold on Questrade yet so we’re changing the TD accounts over to give us access to online trading, which will let us move those to ETFs. That will leave less than 10% of our portfolio in traditional index mutual funds.
I’ll work with both Questrade and TD for a while to see which one seems like the best option. Questrade is definitely cheaper but there are a few potential concerns. TD offers some options to help reduce the trading costs so it may win out in the end.
2) Now that we have access to more options I’m starting to look at fundamental indexes. I can see the danger of ETFs since I’ve already had to restrain myself to only buying a few. However I’ve been interested in fundamental indexes for a while. I’m currently reading Rob Arnott’s book on the topic and it adds a lot of evidence to the basic idea that I’ve always liked.
I’m not completely convinced that they can keep doing as well as they have in the past. The fact that you can invest in a fundamental index now may change market behavior. But the basic idea is rooted in investors making simple mistakes that seem likely to continue. Whenever I hear about how the average investor under-performs by making a certain type of mistake, I try to do the opposite of that. Fundamental indexes may be a good way to do that. I’m looking at using them for a portion of the portfolio at first.
3) We’re running into the limits of the current tax shelters we’re using. There are some that I don’t want to use fully, particularly on the RRSP side, because they can turn out to be false savings for various reasons. This year I’ll be looking at a few including variations of the Smith Maneuver and corporately-held investments, which can work similar to RRSPs in many ways but don’t have the same low limits. The only potential issue with corporate investments is that they may require a tradeoff between higher fund fees and higher taxes.
As a last resort we can turn to regular unregistered investments. A lot of people talk about long-term returns there being close to 0 after tax but I’m not sure if that’s very accurate. It may look that way at the moment due to the generally low returns available, but it’s still better than not investing.
I just read this news report saying that you can now pay your taxes using a credit card. At first this sounded exciting. Like many people who have their finances under control, I use credit cards for everything possible to get the bonuses that come with it and have a one-month interest-free buffer on payments. However the article mentions that you can’t pay the CRA directly. Instead, a company called Plastiq allows you to make a payment with a credit card and they then send it to the CRA.
That’s where it gets less appealing. The service comes with a 2% fee, which will be more than the rewards most cardholders get (and presumably allows Plastiq to pass the full amount on to recipients that aren’t willing to pay credit card processing fees). I believe you are also required to pronounce “Plastiq” with a French accent and/or Zoolander voice when making a payment.
With a fee like that, the service is turning away from the good uses of credit cards (getting rewards without paying interest) and the marginal uses (keeping your cash for a bit longer) and encouraging the worst uses (paying a lot of interest because you were unprepared).
We have an Aeroplan card with a return that I estimated long ago at 1.8%. The flights we booked last month matched this perfectly even after accounting for the international fuel costs and fees we had to pay (only $700 to get free flights!). That doesn’t count the annual fees which will eat up some of those returns, which could be anywhere from 1/3 to 1/2 depending on the time between trips.
Paying a 2% fee to get those rewards would be a decision nearly as bad as paying interest on a credit card balance. I haven’t shopped for credit cards in a while but if anyone is getting more than 2% back on their card this might be an interesting option.
On an interesting side note, we got a Costco membership today and they were pushing an American Express card with no fees and 1% cash back. I can’t imagine that this saves them money in any way since they already don’t accept other credit cards. The only reason I can see for this is that American Express is paying a commission back to them in hopes that the card will be used for other things. It does have rewards of 2-3% on certain categories of purchases but they are mainly things that we don’t use much like restaurants.
Among wise index investors (is that too repetitive?) the common view of currency fluctuations with regards to international investments is that it’s a potential risk but it’s a very minimal risk over the long term since they tend to cancel out. So we conclude that we can tolerate it and it might even help with rebalancing. But is currency risk actually a good thing for investors? It is possible.
The point is made very neatly in The New Pension Strategy For Canadians where the author points out that investors in Canada tend to pay their bills in Canadian dollars, and therefore investments denominated in Canadian dollars have the least risk. However when we go out and buy something, it’s typically from a store that imported it from another country. So our expenses, or in other words our inflation, are vulnerable to changes in exchange rates. If the Canadian dollar falls we expect that we’ll have to pay more for every day expenses. If the Canadian dollar rises in value… hahaha you didn’t really think retailers would pass that on did you?
One of the advantages of investing in foreign countries is that the currency risk in the investment will mirror the costs of importing goods and services. A falling Canadian dollar would mean that buying gets more expensive in CAD, but getting dividends from an ETF like VTI would pay you correspondingly more.
Based on this the ideal investment strategy would be not to move all your investments back to domestic assets as you get older, but to allocate them according to the countries where your spending money ends up (or maybe not, if you like Aegean cruises). Unfortunately this is hard to predict in the distant future. For now it’s best to accept currency volatility. When you have a better idea of what your retirement will look like you can start to take advantage of it.
I recently finished reading Anti-Fragile, the follow-up to The Black Swan and Fooled By Randomness. It’s the kind of book I like where I can nod along with half of what it’s saying and violently disagree with the other half. It is a bit strange at times – for example the author says at the start that “this time I don’t care and I’m going to call out everyone who is wrong”, and then he proceeds to use pseudonyms for many people. There are also many points in the book where he says “before I claimed I was going to be technical but I was lying, and now I’m really going to get technical” – and it turns out to be superficial again. Amusingly there is a section at the back that claims to explain things in graphs for people who don’t like words; my estimate is that 20% of the space there is graphs and 80% is writing.
I’ve explained before some of the author’s ideas that I disagree with. However in the back of the book there is a great analysis of why Modern Portfolio Theory is wrong, and the reasoning applies to a lot of other methods people use to make investment decisions. The way MPT is usually applied is to optimize a portfolio by using the past correlations of the asset classes to find the ideal mix that will give you the maximum return for a given amount of risk. At one time there were claims that you could use this to create a mix of stocks that were as safe as bonds. I stopped hearing that around 2008 for some reason.
I’ve been aware of some shortcomings for a while. One is the measure of risk, using volatility to express how risky a portfolio is. This doesn’t cut it for many people. I like volatility because it creates opportunities for profit. The only real risk for me, and many others, is not having enough money whether that’s from actual losses or from subpar investment returns.
Another concern with MPT is that it’s too precise. You can calculate probabilities to 10 decimal places but the result isn’t really meaningful since the uncertainty overwhelms the precision. But the biggest problem goes beyond this. If you calculate the correlation between assets you can get a precise number, but you will find that calculating it over different time periods gives you different results. This means that there is no one right answer and your results could change based on how you choose to do the calculation, which sort of defeats the whole purpose.
Anti-Fragile chimes in with another criticism of MPT that is often overlooked (and Taleb claims that a proper analysis of this error would have prevented the Nobel prize awarded for the idea). The mathematical way to explain it is that using an average value as an input to a function gives you different results than if you compute the function for several possible values and then take the average of those results. To put it more simply, the problem comes from using averages as an input to the formulas.
For a simple example let’s say we expect the S&P 500 index to return 7% in an average year, and bonds to return 3% in an average year. Based on that and known correlations you might say that you want 80% of your portfolio in the S&P 500 and 20% in bonds. Now let’s break down the averages. Let’s say we expect stocks to have returns anywhere from -20% to 34% in one year, and we expect bonds to have returns anywhere from -4% to 10% in one year. If we look at the extremes, in years when stocks return 35% and bonds return -4% we want 100% in stocks. And in years where stocks return -20% and bonds return 10% we would want 100% in bonds. The average of those two allocation is 50% in stocks and 50% in bonds.
The result is is that the average of the allocations you would want in different years is not the same as the allocation you would want in an average year (and average years are rare since approximately 2/3 of years have stock returns that are either negative or above-average). If you apply this reasoning it could lead to all sorts of different conclusions, from a shifted allocation to deciding that you don’t want to own stocks at all because the results in some years are unacceptable even if the average is good. And that all comes from understanding that the real world is messier than the neat calculations used in MPT.
For a while I’ve used rules like this in many areas. It might seem too conservative (or sometimes even too risky). But it pays off when something unexpected happens. And something unexpected always happens; if you look back at the biggest drop in the stock market, it was unexpectedly large since there had never been a drop that large before. This tells us that the biggest fall in the past is not the biggest one possible.
Instead of needing endless calculations with precise results that only make sense if everything happens as predicted, I prefer knowing that I’m prepared for just about anything that could happen. That doesn’t necessarily mean a portfolio with lots of bonds and gold. Right now I have very little in bonds because I would rather own stocks even if they are falling. I’m comfortable with the full range of possible outcomes from owning stocks but not all the potential outcomes from owning bonds. This principle is the reason I can stick to my decision even if everyone else is saying it’s not optimal.
Many thoughtful investors believe that holding bonds at the same time that you have a mortgage doesn’t make sense. The common reasoning is that they are perfect opposites: with bonds you lend money and receive interest, while with a mortgage you borrow money and pay interest. That means the net benefit (or cost) to you is the difference in the interest rates multiplied by the amount you hold in bonds or the amount of your mortgage, whichever is smaller. Typically this is a cost since mortgages are likely to have higher interest rates than bonds. For example the DEX Universe bond index currently yields around 2.5%, while our mortgage rate is 2.99% and many people are paying even higher interest rates.
On that analysis you might conclude that we would pay less interest by using the bond capital to pay down the mortgage. However there is an additional factor in this equation: changing interest rates. We know that interest rates are more likely to go up than down in the future. When interest rates goes up, the effect does not cancel out cleanly. The bond owner will lose money since the value of existing bonds goes down when interest rates goes up. And the mortgage holder loses money since mortgage payments go up when interest rates go up. In this sense bonds and mortgages are worse than opposites: they both lose money at the same time.
With a fixed rate mortgage this could leave the bonds yielding more than the mortgage interest rate for a few years. However there would also be a capital loss on the bonds. A rule of thumb I’ve heard is that the duration tells you the number of years it takes for the higher yield to pay back the drop in the price. With a duration of 6 – 7 years our bond holdings are not attractive by that measure.
All of this makes a pretty compelling argument to not hold bonds when you have a mortgage unless you happen to find some fixed income that yields well over your mortgage interest rate, like our MIC holding that’s giving us 5% now. The downside is a lack of flexibility in rebalancing since you can’t easily increase your mortgage to invest more in stocks. However if you have substantial monthly contributions to your mortgage and investments, like we do, you can redirect those as appropriate based on changing conditions.
Based on this I’m considering moving all our bond holdings into stocks. We don’t want to pay down the mortgage too fast at this point (it has under 15 years left) since the interest rates are so low. Bonds are only a small part of our portfolio so they don’t have a major impact but getting rid of them would put us right where I want to be: paying very low interest rates while maximizing the amount we have in equities to earn long-term returns.
Mr Money Mustache posted a commentary on recent stock market commentary this week, and among there discussions there was an interesting suggestion from one person who said that he buys put options that protect him from a loss greater than 10%, at a cost of 1-2%/year. I wanted to see if the gains from the insurance could be more than the costs, so I pulled up historical data provided by Libra Investment Management and ran some tests.
Past Performance – Long Term
I started with a simple test that assumed the insurance cost the maximum 2% every year, meaning the total value could not go down more than 12% in a year (the losses on the actual stocks are limited to 10%, plus there is the 2% cost of insurance). With this model you would be put everything in stocks and buy puts at the start of each year.
When I ran this on the nominal TSX returns from 1970 – 2009, the final value with no insurance was 4023% of the starting value. With insurance the final value was 3537% of the starting value. Overall this wasn’t a win but you would be ahead from 1974 – 1979 using insurance.
I then tried it on the nominal S&P 500 returns in CAD (a bit esoteric but it’s the data I have). The final value was 4208% with no protection, or 3570% with protection. Again not a win but you would be ahead from 1974 – 1983 with the insurance.
I repeated the experiment with an insurance cost of 1% each year. In this case the final values were around 5100% for both cases which is better than not having the insurance.
This model doesn’t account for dividends. If you exercised a put and stayed out of the market for the rest of the year you would miss out on dividends. In the TSX cases the puts were exercised 6 times, and in 2 of those times the value of the protection was 0.6% of less which is probably less than the forgone dividends. On the other hand, the losses in down years might be minimized a bit more if you managed to collect dividends before exercising the puts. The S&P 500 triggered the puts in 4 years.
Overall this doesn’t look terribly exciting. If the options are cheap enough you might get some gains. On the other hand, the options might be cheap when you don’t need them and expensive when they will pay off. This is a fairly limited test so there might be other time periods where it performed brilliantly, or conditions only slightly beyond those we’ve experienced that make it look even worse.
In the end you could do worse, for example by buying expensive segregated funds from insurance companies. Those probably just charge a high fee to use a strategy similar to this so you can cut your costs by doing it yourself. If you want to reduce volatility this might be a reasonable way to do it. I prefer to seek additional volatility in hopes of higher long-term returns.
Short Term Advantages
Those who are counting on the portfolio in the short term might have a much stronger need to do this. In fact it might be an interesting alternative to bonds/cash for short-term savings goals since you have higher potential returns with losses limited to 12%, unless there is a string of bad years. Historically the TSX has only experienced 2 consecutive negative years one time since 1970. The S&P500 in CAD has had 2-3 consecutive years of losses on 3 occasions.
In rolling 3-year periods using this strategy on the TSX there were 3 occasions of losses ranging from 18.4% to 3.4%, a further 3 periods with gains ranging from 0.8% to 9.4%, and the other 31 cases had gains over 10% including the big winner with a 133.6% gain from 1978 – 1980. In rolling 5-year periods there were no losses, two periods with gains of 2.1% – 8.5%, and the rest had gains over 10% with a high of 176.8%.
Without a doubt there are risks not expressed in this simulation, but if you’re ok with taking slightly more risks than government bonds this could be an interesting option for medium-term savings. We are starting to put together some cash so that we can buy a vehicle in the future with no loan and possibly move to a more expensive house without increasing the mortgage, or pay down our mortgage further when we renew it at a higher rate.
Since only the mortgage paydown is likely to be in the next 5 years I may have to consider this approach to manage that cash once it grows a bit more. Currently it’s in an ING account where the accumulated interest will be very little. Any gains over 10% for a 3-5 year period would be a bonus. However there would be a tax drag since our TFSA is in use and this would be inappropriate for an RRSP. Since capital gains are taxed at a lower rate than interest and the outcomes seem to be mostly upside, this could still have a good chance of being a positive.
Most investors would agree with the view that stocks and bonds are inversely correlated. The reason we hold both in our portfolios is that we expect on to be going down while the other is going up. In some cases this is true. For example there are times where we can clearly see investors selling off stocks at any price, causing those to go down, and buying up bonds with insulting yields, causing those prices to go up.
However we can’t always expect this to happen. Other than investors trading back and forth, stocks and bonds can be driven by different factors and may go in the same direction at the same time. One simple example is falling interest rates. If interest rates go down, bond prices must go up. But stock prices could go up too for various reasons including companies getting access to cheaper leverage, consumers borrowing more, or even from interest rates falling less than expected and signalling that the economy is stronger than investors previously though.
There are many other reasons that they could move in the same direction. For example, if your portfolio is heavy in government bonds rather than corporate bonds (which many bond indexes are), then those are driven primarily by things like the strength of the governments finances or, in the last few decades, expectations for central bank action based on economic measures.
Stocks, on the other hand, are driven by the strength of the corporate income statements and balance sheets which could look very different from those of the government. It’s entirely possible for corporations to be profitable and have lots of cash while the government struggles (see: today). And even if the economy and consumer spending are declining, corporations could have growing profits for some time. After all some of the most profitable companies are those that are slowly losing their touch.
Unfortunately this doesn’t help predict the market. Any analysis based on one factor is too simple to be accurate, but adding more factors just creates uncertainty since we don’t know which ones will affect the market at what time. The only solution is a sensible asset allocation and long-term commitment that allows you to make a profit regardless of what happens in the markets.