Archive for April, 2013

The Tax Drag of Dividends

April 23, 2013 Leave a comment

It is regularly pointed out that stock market dividends have fallen significantly from what they were 20, 40, or 60 years ago. At one time it was normal for stocks to yield more than bonds. That didn’t happen in major markets from the 60s up to 2010. But that dividend yield in 2010 that once again topped the bonds was much lower than the dividends you could get even 20 years ago. It’s now normal for US stocks to yield about 2% and other markets about 3 – 4%.

Some people react to this by saying that stocks are simply overvalued because investors are willing to accept such a low yield. If prices fell by a lot then the dividend yield could rise to a good 4 – 6% as it did in 2009. While that is true, it doesn’t mean that stock markets are about to crash. This analysis is overlooking the fact that part of the lower yield is intentional. In recent years preferences have turned to capital gains over dividends, and a major reason is taxes.

Dividend Taxes

I’m not familiar with all the US tax laws but it sounds like the tax treatment of dividends has varied quite a bit over the past decade, from being favorable to being one of the worst forms of income. Here in Canada, of course, dividends are a long-favored form of retirement income because of their consistently low taxes. In the end that isn’t as good as it sounds since individual investors are just being taxed for the corporation’s pre-tax earnings and part of that tax has already been paid. Like many other things there is a hidden tax that most people aren’t aware of.

Capital gains have consistently had tax advantages in both countries (again the US has varied more). Because of this and the fact that dividend taxes have to be paid every year while capital gains taxes are only paid at the time you sell an investment, dividends often result in paying more taxes earlier than an equivalent amount of capital gains. This is complicated even further by tax shelter accounts.

Tax Free (Except For…)

In Canada it is very tricky to navigate the various combinations to avoid paying taxes on foreign dividends. In a TFSA you will lose some taxes on any foreign dividend, and sometimes get taxed twice (yes, double taxation in the Tax Free account exists) if you’re holding a US ETF with international stocks. In an RRSP you can avoid the US taxation but you still lose most international taxes.

I’ve been going through the options to figure out which ETFs we want to buy and where. As a result the RRSP account holds VXUS (total stock market, non-US) since it has the highest yield of the foreign indexes we want to own and the RRSP avoids US taxation. The TFSAs have more VXUS, VTI (US total stock market), and the Canadian ETFs ZCN and ZRE. Only those Canadian ETFs will be truly tax-free. This seems like the best way to minimize taxes on dividends which is a funny thing to have to do in a tax-sheltered account.

The taxes involved here aren’t very large. The US withholding amount typically seems to be 15% and that’s only on the dividends. Other countries may take different amounts. I’ve heard the average withholding tax on the EAFE index is around 12% or less. If you held $100,000 of VXUS in a TFSA at a dividend yield of 3%, the withholding taxes might cost you $810/year. In an RRSP you would only lose $360/year. To put that in perspective, switching $100,000 from the e-Series EAFE fund to VXUS would save you $350/year in management fees.

I don’t think this taxation is enough to switch to all Canadian stocks and lose the diversification. An international portfolio which can hold 9000 stocks in 2 ETFs, while ZCN has less than 300. It is worth avoiding that US withholding tax wherever possible though. If you’re holding ETFs in a taxable account then you can get most or all of the withheld taxes back, but it takes more work and you still end up having to pay the regular tax on the dividends.

Capital Gains Save Money

As this shows minimizing the taxes on dividend income can range from difficult to impossible. This is one reason that investors and corporations, especially in the US, are favoring capital gains instead. Corporations can convert dividends to capital gains by using their cash to invest in the business, buy other companies, or buy back shares instead of paying a dividend. With these options the corporation can also defer taxes (I think share buybacks are the exception).

This move to prefer capital gains should save investors from some taxes. However dividends have one big advantage: putting cash in your account that dumb executives can’t lose. With the increasing reliance on capital gains we have to trust that the company’s stock price and earnings are reasonable and accurate and that it is well-managed. When I’m allocating these ETFs I’m glad that the dividends are fairly low, but that means I’m relying a lot more on someone else being willing to buy at a higher price in 10 or 20 years. That is an increased risk to investors no matter how you look at it.

It may still be true that investment income is taxed more lightly than working income, though part of that is because taxes have already been paid and you just aren’t counting them. It’s certainly not easy to make that a reality for yourself.


Stock Market Mystery Or Everyday Behavior?

April 22, 2013 Leave a comment

The Economist writes today about the mystery of emerging market stock performance. Since emerging markets are believed to be more sensitive to the global economy, many people think they should be doing very well since other markets have had big increases already this year. Instead they are down by over 4% while the global market is up by over 6%.

The mystery is played up with a research note from a big bank that goes into detail on eight reasons for the underperformance. While some of these would be very good reasons for the difference, there is another simpler explanation: emerging market stock prices have gotten ahead of themselves over the last year (or the last few years) while other markets have been held back by bad news, and now investors are repositioning. Stock market activity happens in bursts as much as it does in a smooth progression, so we may have gotten emerging market gains last year and developed market gains this year. This kind of thing seems to be a very common pattern.

The fact that many investors believe emerging markets act as a more extreme version of developed markets may be exactly why they didn’t. Whenever we get to the point of maximum investor belief in any idea, the opposite turns out to be true as some investors lose faith in it and reverse their decisions. This is unpredictable because we never know how many believe it takes to reach the maximum. It can happen in small waves that come and go frequently or the occasional big bang that turns the market upside down. There is no mystery in this, and it’s a good reason to focus on several different asset classes and avoid the ones that have done well recently.

In fact this highlights another useful thing: despite all the talk about correlations rising, we are seeing what we should see here. Emerging markets should not be perfectly correlated with developed markets which means that things like this are expected. The rise of global trade means that many companies around the world are influenced by the same factors, but they still typically have an exposure to local and regional events. That’s why there is still reason to believe that major markets such as the Canadian, US, European, and emerging indexes will not always do the same thing.

Since we have just started buying into emerging markets through the VXUS ETF, it’s exciting to see that they are getting cheaper at the same time that other holdings are rising quickly. If this trend continues it might be worth adding a bit into VWO to increase the weight of emerging markets. Currently I’m leaning in the opposite direction though, and considering putting a bit into VEA since the emerging market component in VXUS is a bit more than we want.

Why Low Return Hedge Funds Are Good

April 19, 2013 Leave a comment

In The New Pension Strategy For Canadians there was an interesting comment about the value of funds with low returns. The author promotes “absolute return assets” as one of the 5 essential asset classes for every portfolio, and lists hedge funds and inflation-linked bonds as the two ways to get that. Now we know that hedge funds have a long record of underperfoming the market just like the mutual funds with slightly lower fees (and hedge funds with truly bad results don’t even need to report them and drag down the average). Why would anyone want that in their portfolio?

I always thought it was pointless to buy into hedge funds, but the author makes a surprising but reasonable argument for buying a low-return fund. If it’s not correlated with other assets, then the advantage you get from being able to rebalance among other asset classes is more than the returns you give up. Absolute return funds in particular are supposed to always produce a positive return which would make them uncorrelated with many other markets.

In the end it’s a lot like bonds. Most people don’t have them in their portfolio for the great returns, they own bonds for the stability. With the right amount you can get a boost from buying into stock markets after they fall. Good absolute return funds might be another way to do that. We know that bonds do sometimes show a correlation with stock market so having only two asset classes might not be enough to get the full benefits of diversification.

That all sounds good, but the truth is a bit more complicated than that. Absolute returns funds do have a history of periodically producing negative returns. If they don’t live up to their promise then they aren’t much use. And there are alternatives such as the inflation-linked bonds and very short-term securities that can produce consistently positive returns. Even regular cash has to get a nominal interest rate above 0.

In the end I’m not sure that any of these absolute returns funds actually produce risk-adjusted returns that are higher than the alternatives, especially after their fees. I’ll continue avoiding that type of investments. But the book does make a good point that just having two asset classes may not give you the best diversification. The other two that it mentioned were real estate and cash. I’m now adding REITs (only a small amount because of the run-up in prices) and I’ll look at including real return bonds once they get a bit more attractive.

Time To Trade Options!

April 15, 2013 Leave a comment

Although I am a committed long term index investor I do sometimes wonder what else can be done. For the most part I admit that I know nothing about any company’s fundamentals and never keep up with the news (except for my own business). It would be foolish to think that I know more than other active investors who trade the market daily.

But once in a while I wonder if they have different preferences or they are about to change their minds. There are well-documented and widespread actions that many investors use to lose money, so the people on the other side of those trades must be making money. Or there may be opportunities that are simply overlooked because they don’t fit the usual expectations.

A couple of years ago I went after one such opportunity by putting $1000 into a Mortgage Investment Corporation that’s been paying a steady 5% interest since then. That has been less than the return on government bonds until last year, when the MIC outperformed by 2%. It doesn’t trade openly so it doesn’t carry the risk of capital losses, but it does have a fixed term so I can’t withdraw the cash for 3 more years. So far that’s looking like a reasonable but not exceptional performance.

Option Trading

Now it’s time for something new. Earlier I tracked the hypothetical performance of a long/short trade with Apple and Blackberry. At the time I didn’t do anything with my idea which is too bad because the timing of the original posts and the two follow-ups was uncannily good (the timing was just luck of course). A lot of profit would have been made on that idea already so it’s not as attractive now but I’m willing to put in $100 to see what happens.

I’m trying this in the new Questrade RRSP account I opened so shorting isn’t available. In any case I wouldn’t want to take the risk of shorting on something like this. Instead I looked at options. By buying Call options for Blackberry above the current price, and Put options for Apple below the current price, I can profit a bit if the prices get closer together. If one or both stocks actually pass the strike price of the options that could turn into a large gain.

The Trade

To do this with $100 I needed to split that in two, take off $10 for the commission on each trade, and then buy one option contract at a price of $0.40 or less for each stock (since it is for 100 shares that costs me $40). I had been tracking a few options on a watchlist while waiting for Questrade to receive the form that allows options trading, so I ended up buying Apple July 20th puts at $275 (1 contract for $47) and Blackberry June 22 calls at $25 (2 contracts for $18 total). I realized later that I could have bought Blackberry calls at $20 for a cost of about $35 and stayed within the maximum I’m willing to throw away on this.

This is on a day when Apple closed at $427.37 and Blackberry closed at $14.78. I timed the Blackberry options to be after an earnings release in case that turns out to be really good. For Apple the timing didn’t work out as well so they are probably a little before an earnings release. If they come out with results in April and July that are similar to what they did in January, the stock price might take a beating. On the other hand they might find ways to beat expectations a bit this year and bring the stock price back up.

The Results?

Even if the basic idea is right there are a lot of risks in this execution including the trading commissions ($20+ to buy and sell a contract), the limited time frame (more distant options are more expensive), and the high chances that one of both options will be a total loss (if held until expiration and the stock price never reaches the strike price). Those risks are why options have to have a high payoff if they turn out to be useful.

I don’t expect much from this. If the strike price is actually hit each contract would be worth $100 for every $1 that the stock price goes past the strike price (plus or minus a bit for the remaining time, volatility, and transaction costs). That isn’t very likely but it is possible. Even if it doesn’t get there the value could rise or fall by several times the initial cost as I saw when some of the options on my watch list doubled in price from one week to the next.

I’m not doing this because I know better than the market. I have no secret information that tells me Apple stock will close at $198.76 in 3 months (although I would like to see that now). Instead I think that the market has become irrational, driven by emotions and past performance. Some of that has been burned off and counter-trends may happen now. If it turns out well the result may be a few times what I put in. If it doesn’t, I know the maximum loss from the start.

If I see any future situations where the market hype seems to be reaching an extreme I may put a little bit into those and see what happens. I don’t expect to do this regularly because it takes a combination of unusual market hype and me actually noticing that something is happening.

Who Listens To This Stuff?

April 12, 2013 2 comments

I try to ignore most of the media most of the time, but once in a while something slips through and I read it long enough to remind myself why it’s such a waste of time. Here are a few investment-related examples:


CBS News Article: I’m familiar with CBS News’ online articles because I occasionally see Larry Swedroe’s great writing here… and then there’s this guy. It’s not clear whether this is about rebalancing, cutting back sharply, or selling out of stocks completely, but the article does claim that the market is overvalued. His proof? It has risen by 17% over 5 years. That’s the total, not the annualized return. Ok, that’s a little underwhelming so he backs it up with some mumbo-jumbo about government debt. What’s the stock ticker for the US Government again?

Oh, wait, you’re telling me that I can only invest in companies that have nothing to do with that drama? And they’re currently doing far better than the government with record levels of cash and profits as well as falling borrowing costs that allow them to access cheap leverage? And you further claim that the stock market is a leading indicator for the economy and it may be 3 – 12 months before we really understand why it went up but that doesn’t mean there is no good reason?

I would stay away from that too. Especially since this guy, if you believe his chart, has bought exactly at the last two bottoms and sold exactly at the top and now he’s selling. Three perfect market timing decisions is enough evidence for me that he’s a genius. He can’t just be someone who got lucky, grew overconfident, and is going to lead readers into big mistakes because it looks like he knows better than the market.


Globe and Mail column: I agree with many others that value investing sounds good in principle. But when you look at how investors actually practice it you find things like this. A minimally-qualified journalist heard about a hot stock with a high yield. For confirmation that it was sustainable he trusted securities analysts who, as we know, are paid to promote stocks and will rarely say anything bad about them (not to mention their herd/trend following instincts). He writes that he had to rely on their opinion because he “didn’t really have a good idea of the company’s sustainable competitive advantages” and wanted to buy anyways. The thinnest positive information would apparently be enough to confirm his decision.

In turn tens of thousands of people trust his advice because, after all, he writes for the newspaper so he must know what he was doing. Once it was revealed that most of the company’s reports were fraudulent those readers lost big. Judging by a few comments readers may have lost hundreds of thousands of dollars if not millions based on this recommendation. The author himself apparently only lost $4,000 on this. Some, though, stayed out because they noticed a few things such as rising receivables, quickly falling cash balances, and the company borrowing a lot to pay a dividend. Surely finding that information can’t have taken more than 30 minutes, and yet many investors seem to think that reading a newspaper column in the “investment ideas” section is sufficient research. Starting from a few weeks before he told readers this was a good stock, the price has gone down by approximately 98%.

Although these recommendations are worse than worthless, the good thing about this article is that it gives people a more realistic view of investing. Most of the time people only talk about a trade that went well, ignoring 10 others that ended like this and making it sound like it’s easy to make money by trading.


Same Writer, New Target: Not to be discouraged by his admitted lack of knowledge, he keeps on going. This time it’s about a new stock that is currently trading close to $5 and will soon reach $50. Now that’s a pretty big claim. Not to worry though, it’s totally going to happen soon. After all it went up to $80 a couple of years ago when commodity prices spiked, and in the writer’s own words “It’s fair to say Molycorp should never have traded at $80” but it will at least get to $50 or $60 because that’s a much better value. The company’s products sell for about 20% of the price they fetched during the last run-up of the stock and the company has invested billions of dollars in projects that just don’t make sense at today’s prices, therefore it must have a bright future.

Further proof of this comes in the fact that “the U.S. Securities and Exchange Commission is formally investigating the company’s disclosures”. The company may have hidden bad news in the past, but now we can rest assured that it has told investors about everything that could go wrong and it’s really hiding good news that will cause the stock price to shoot up. That’s how it works right? No executive who owns options for their company’s stock would think of broadcasting the good news while hiding the bad…

Are you worried that other investors will drive up the price before you have a chance to get into this hot stock? That would be a silly fear since the new CEO of the company comes from Canada which means that, according to the article, “we have a shot at understanding this story before the Americans.” This stock really can’t fail. After all some guy in the newspaper wrote about it…

The Benefits and Downsides of Modern Portfolio Theory

April 9, 2013 Leave a comment

I’ve been reading The New Pension Strategy for Canadians which looks like a decent introduction to investing ideas for non-technical people. However early on the book it starts talking about how Modern Portfolio Theory is the absolute best way to manage your investments. As I wrote about earlier there are some potential issues with using MPT too aggressively.

The book exposes another common misconception that comes from MPT. One of the main ideas is that risk and return are the same thing, since you need to get a higher return for taking on risk and those selling securities will offer a lower return if they have lower risks. Mean people take this too literally and think that it’s a universal rule. It is a useful guideline, since in most cases an investment that offers higher returns has to have some risk for it. However as the original MPT paper stated 60 years ago:

“For any level of risk (volatility), consider all of the portfolios that have that volatility. From among them, select the one that has the highest expected return.”

This is admitting that there are many options that have the same risk but different returns, or the same returns but different levels of risk. If you already have the best possible portfolio and you want to change it, you need to make a tradeoff between risk and return. But if you have a bad portfolio (and there are many many of these) then you can increase returns and decrease risk at the same time.

Aside from that the author highlights one major benefit from the spread of MPT: pension funds moved around that time from looking at individual investments and managers to thinking of the portfolio as a whole. This is always a good move. I track our investments as one combined portfolio to see the real allocations and total returns, and the returns of any single investment or account are mostly irrelevant. Compare this to the online discussions a few months ago about returns in 2012 where people would say “I made 70% in my TFSA and  lost 20% in my RRSP” – if their RRSP is a much larger account and important to their future finances, that’s a portfolio that did poorly.

Another good point in the book is that although short-term volatility is a poor measure of risk, many pension funds measure long-term volatility which is much more important. Knowing that my portfolio could return 2 – 8% per year over the next 30 years is different from knowing that it could return -6 – 14% per year over that time. There are still limitations to what we can predict but at least applying the volatility measures over the right time frame gets closer to the right answer. I’m not in the pension world so I’m not sure what percentage of funds measure risk in comparison to their true liabilities. Hopefully most do.

Overall Modern Portfolio Theory seems to have introduced some useful ideas. Those good ideas can be used without the precise and sometimes overly-sensitive math. Many investors and mangers are probably better off using it rather than the alternatives though, as long as they understand what it can and can’t do.

Still a Great Stock Picker

April 6, 2013 2 comments

Back at the end of the year I read about Joe’s stock picks for a contest at Timeless Finance and decided to see if my skills still hold up, by picking a few stocks everyone loves to hate on the off chance that people get tired of the hating and decide we can all just get along after all. It actually took a bit of work to come up with all 4, which shows you how much I pay attention to the news.

So how did I do at picking the biggest losers? Let’s see the total returns in the first quarter:

  • BBRY: +21.74%
  • YHOO: +18.24%
  • BP: +3.00%
  • BAC: +5.00%
  • Average: +12.00%
  • S&P 500: +10.49%
  • VTI: +10.96%

I consider VTI to be my benchmark for the US market since it’s what I use. This shows that I’m clearly a master of the market! It works out to an annualized excess return of 4.7% over the market which so far makes me a legendary mutual fund manager (as long as I can continue that for another 15 years).

Rob Arnott’s book on fundamental indexes points out an interesting twist to this. Since fundamental indexes historically have a higher return, lazy fund managers could run a “closet fundamental index” to get higher returns, and then use the regular index as a benchmark so they can claim that the normal outperformance of fundamental indexes is their own work.

To test this idea I looked up an ETF for the FTSE RAFI US 1000 index. It had a return of 12.59% in the first quarter. According to the fund data there was no tracking error over this time period so the index return was exactly the same as the ETF’s return. This doesn’t look so good for me, but as long as no one realizes this I am still better than the average active manager or indexer!

I wanted to test one other idea along with these. At the start I wondered what would happen if you went long Yahoo and short HP, since HP’s board seems to be running up the score on bad decisions lately. It turns out that HP had a first quarter return of 67.29%, so this trade would be standing at a net loss of 49.06%.

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