Financial Jungle

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All right, that’s it! Those ETF bullies have tormented us dividend stock pickers long enough. I’m retaliating. My headgear is on. My gloves are strapped. Give me your best shot.

1. Less MER - In fact, buy-and-hold dividend investors pay no MER at all. Regrettably, iShares CDN LargeCap 60 ETF (XIU.to) and TD Canadian Index eSeries seize 0.17% and 0.31% respectively. Which means, dividend investors have a 0.17% to 0.31% head start each and every year.

2. More Diversified - Most investors refer to the other types of diversification: by sectors and by geographical locations. This is a non-issue for investors with 30 or more stocks. As long as your eggs are properly spread amongst different baskets, the portfolio will achieve similar volatility as the general market. At least one study found that 90% of the unsystematic risk can be diversified away with as little as 12 stocks.

Sure, diversification does alleviate uncertainties in a portfolio due to particular sectors or countries, but there is a much bigger monster in the room, and that is market sentiment. No matter how much you slice and dice your portfolio, all sectors are still subject to market sentiment. The past few months are a testament of how every sector limps along while the market is howling over its PMS. No one can escape the carnage. The way I see it, dividend investing is the only remedy to help us cruise through the turbulence while remaining fully invested in the stock market. Just look at Bank of Nova Scotia. It’s basically the same old boring bank as yesterday, last week, last month, last quarter and last year, but its 1 year chart resembles 6-flags roller coaster. All that while, their distribution policy is steady as she goes.

So, dividend investing offers you another dimension of diversification by easing reliant on market speculations, and rewarding you with real hard cash straight from the operations of your high-caliber businesses.

3. More Tax Efficient - A $35,000 salaried British Columbian profiting from a $5,000 capital gain must pony up an extra $615 in taxes. The same British Columbian receiving a $5,000 dividend would pocket a $175 tax refund. (That’s almost enough to pick up 4 more BNS shares!) So, ETF investors must overcome both the MER and the tax refund every year.

4. Extended Investment Horizon - Due to market sentiment described in point 2, ETF investors must gradually shift their equity exposure toward bond to protect their nest eggs from market volatility. Consequently, a 25 year old ETF investor may only have a 30 to 35 year weighted investment time horizon before reaching 65. This is a double whammy for them: the investments have less time to compound, and the turnovers create tax-drags against the portfolio return. And don’t forget that bonds are taxed as regular income.

On the other hand, dividend investors can prolong a carefully crafted portfolio because dividends are never at the mercy of market turbulence. By sticking to stocks with a history of rising dividends, or businesses that provide essential goods and services, you can afford to hang on to the portfolio longer. I think the best defense is the best offence. If anyone can prolong a dividend portfolio for 40 years, the dividend compounding coupled with the preferential tax treatment will deliver enough capital cushion to hold to the stocks forever.

5. Less Market Timing - Contrary to popular belief, a thoroughly hands off approach to investing is an illusion. Eventually, a retired ETF investor will have to live off his equities. Unless he turns over 100% of his portfolio to bonds (I smell capital gain taxes), the 4% withdrawal rule is going to pinch during bear markets. If hysteria sinks the market down 15%, can he afford to devour another 4% and erode his already undervalued capital? If euphoria drives the market up 15%, should he take out a little more in anticipation of a trend reversal? You see? There are so many crucial market timing decisions. Doesn’t sound to me like a relaxing golden age.

A retired dividend investor doesn’t need to fiddle with his portfolio whether the market is sad or happy, because the dividend stream is more dependable even when the market is tumbling. And courtesy to points 1, 3 and 4, a dividend portfolio should enter retirement with a much larger base and yield, and be able to outpace inflation and cushion any unforeseen dividend cuts.

Further reading: A brief history of high yield stocks

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I was quite skeptical when Horizon BetaPro released this leveraged ETF at the beginning of this year. It promises to double the TSX 60’s daily volatility before various fees. For instance, if the index is up 1%, the ETF rises 2%. Conversely, if the index is down 1%, the ETF dips 2% as well.

Despite Horizon’s emphasis on daily performance, I believe the ETF should emulate two-times the index’s long performance provided that (a) the short-term amplifications remain consistent, and (b) the volatility is tame.

On the surface, this strategy is more electrifying compared to the alternative of direct leveraging. Let’s assume you like to double your TSX 60 holding with borrowed money at 6% prime. If the index is up 10% over the next 12 months, then your return on investment is 14% (10% plus the 4% on the borrowed money after paying for interests). With BetaPro, your ROI is 20%. Sweet! Secondly, with borrowed money, you can lose more than your ante, if the index tanks by more than 50%. With BetaPro, you only lose what you invested.

However, here’s the problem: the arithmetic breaks apart in a volatile market. For instance, if your $100 index fund declines 20%, and recovers 30% the next day, the resulting balance is $104 ($100 x 80% x 130% = $104). Effectively, you’re up 4%. On the other hand, when your $100 in BetaPro declines 40% and recovers 60%, the resulting balance is $96 ($100 x 60% x 160%). You’re down 4%, not doubling the index’s return. There’s no free lunch!

Arguably, this could be the most vulnerable time to double your exposure to this index after nearly five-years of uninterrupted prosperity. Investors should thread carefully.

This ETF is only six-months old, but the short history looks promising so far. The MER is 1.15% on your invested capital, or 0.575% when you spread it across the exposure. Since I’m more of a buy-and-hold investor, I may consider this ETF as long as it has the potential to reach my investment goal in half the time. Having said that, I’ll patiently observe how the ETF behaves over a complete market cycle prior to jumping in with both feet.

Sources

• Inverse and Leverage ETFs - Larry MacDonald
• Horizon BetaPro Funds

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The Dividend Guy is rightfully scolding IGM’s Investors Dividend fund for milking $291,117,000 a year in mutual fund fees. I’m both proud and guilty of being an IGM Financial shareholder. I’m proud because IGM has been steadily increasing revenues, profit margins, earnings and dividends, while maintaining Return on Invested Equity above 20%, and decreasing debt levels. I’m guilty because the prosperity rides on the backs of investors’ ignorance. Let’s face it. By analyzing Investors Dividend’s top holdings, one can easily conclude that the Investors Dividend fund is nothing more than a closet index fund with a tilt toward dividend paying stocks. Even an amateur like myself can assemble an index look-alike portfolio. Heck, pay me 1/100th of $291,117,000, and odds are favouring me to beat this fund over the long-term.

Not only is the Investors Dividend the largest mutual fund in Canada, the MER is also a whopping 2.88%. So much for economies of scale. To appreciate just how much investors are forgoing with the MER, let’s compare the performances between Investors Dividend and the TSX total return. The 5-year compounded returns are 9.71% and 12.43% respectively, or a difference of 2.72%. Peculiarly similar to the MER, the point is investors are better off buying cheap index funds and ETFs, rather than enriching IGM Financial with a jumbo MER for inferior performances.

Here is a totally unoriginal idea. Don’t buy this mutual fund. Buy the company that operates the fund. Buy IGM Financial. At 400 shares, this position is spoiling me with $684 worth of dividends per year, and this money is coming out of the $291,117,000 pot. I’m a guilty IGM shareholder, and you can give me some virtual spanking.

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Darren Rowse from ProBlogger is hosting another get-together among bloggers. The mission is to write a top 5 list on any topic relevant to the blog, and the winning price is a cool $1001. But more importantly, I want to elevate Financial Jungle’s presence in the blogging ecosystem, and mingle with fellow bloggers who share similar interests.

A discussion over at MillionDollarJourney prompted me to do a little digging into Market Growth GICs offered by Canadian banks. Many investors are risk-adverse, while not wanting to relinquish the growth potential of the stock market. This is why Market Growth GICs are so seductive. Investors’ original principal is guaranteed regardless of what the market is doing, while the performance is linked to the market indices tracked by the products. Being a cynic, I’ve investigated and uncovered the following five gremlins of Market Growth GICs:

1. No Dividends – They stole my precious!
Although Market Growth GICs do track the underlying index, investors forgo the dividends issued by the securities along with the juicy dividend tax credits. As an example, the iShares S&P/TSX 60 ETF rewards their investors with 1.66%, which isn’t available to Market Growth GIC investors.

2. Higher Tax Rate - Give it to us and wrrrriggling! You keep nasty chips.
Since Market Growth GIC investors don’t actually own a piece of the index, gains on GICs are taxed as regular income instead of the more favourable tax treatments from conventional capital gains. For instance, if you’re in the 40% tax bracket, you owe 40 cents for every dollar made in GICs, while you owe only 20 cents in ETFs.

3. No Tax Deferral - NO! That would kill us. Kill us!
Taxes are due each year with GICs, while you can defer capital gain taxes for as long as you hold the ETFs. Let’s do a quick example. If you start with a $1,000 GIC that returns 10% each year, you keep only 6% after tax. Compound this to 5 years and you’re left with only $1,338. On the other hand, you can zoom ahead with ETFs by deferring taxes until the very last year, and are left with a generous $1,488.

4. Capped Return – Don’t follow the light.
A five-year Market Growth GIC offered by TD Bank caps the cumulative return at 60%. This is an annualized compounded return of 9.8%, which is the approximate long-term return for stock markets. As a result, investors have no upside potential relative to the index, while the down side relative performance is –9.8%.

5. No Capital Tax Loss Saving - Stupid fat hobbit, it ruins it.
In the event the market is still down after five years, the principal protection feature kicks in and you recover your loses, however you waive the tax-loss saving to offset capital gain taxes of your other investments.

Principal protection to me is an illusion, because inflation alone will erode the future purchasing power, which is ultimately what you’re trying to protect. If maintaining purchasing power is your objective, stop fooling around with Market Growth GICs, and buy a traditional a 5-year GIC instead at 4.47%. If you still want some exposure to the stock market without exposing yourself to market setbacks, segregated funds are good alternatives. Even though they’re somewhat expensive, you’re compensated with other benefits, which include estate planning advantages, automatic reset of death benefit guarantee, and creditor protection. An example of a segregated fund is CI Signature Dividend GIF which has a price tag of 4.18% MER.

Further readings:
- TD Canada Trust Market Growth GIC.
- How Segregated Funds Protect Your Investments (CI)
- How segregated funds work (Million Dollar Journey)

ps. thank you Canadian Capitalist for bringing this event to my attention.

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I recently came across a Claymore Canadian Preferred Share ETF article written by Rob Carrick of the Globe And Mail. Although I’m by no mean a preferred share guru, I can’t help but feeling leery about the impeccable timing of this release. Just a few months after our finance minister derailed the income trust gravy train, income-seeking investors are now crying for second best options. There is one important lesson I learned during the dot com era: the financial industry creates new products for investors who are too late in the game. This trend never fails. You have technology in the late 90’s, resource and income trusts in early 2000, and now preferred shares. Who knows? Maybe this time is different, but James Hymas from Hymas Investment Management doesn’t think so. To quote Mr. Hymas, who is a formidable force in preferred share:

This construction difference is apparent from the release. The top three constituents are GWO.PR.X, BCE.PR.A and BCE.PR.C. You know what I like? I like indices that are easy to beat, that’s what I like. I might even be able to earn my fees just by avoiding those things and closet indexing the rest of the portfolio!

Unlike common shares, the preferred share world is complex, illiquid and inefficient. This is one of those rare cases, where I believe active management by a preferred share veteran like James Hymas can add value. Too bad I don’t have the net worth or minimum income required to buy his funds.

The preferred share index that the ETF is tracking is yielding 4.66%. In theory, if you subtract the 0.45% MER from the yield, you net around 4.21%. In other words, the ETF gobbles almost one tenth of the dividends before distributing the rest to you. That’s sounds like a lot to me, but I’m not sure if it’s the going rate. Having said that, I’m still interested in adding a preferred share ETF/mutual fund as part of my diversified portfolio, although I may want to proceed after the frenzies cool off.

Folks. Do you have a suggestion or two for me? Feel free to write me a few comments.

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For investors who don’t have the inclination or time to study the stock market, there is a terrific alternative that is easy, cheap and tax-efficient: buy a basket of low cost Exchange Trade Funds (ETF). An ETF is a security that tracks an index, such as the TSX 60 and S&P 500. You can trade them just like regular stocks through your brokers. Many studies cite the vast majority of actively managed mutual funds have under-performed their passive counterparts. Personally, I’m not a believer in the Efficient Market Hypothesis, but ETFs have other merits. For one, you can easily diversify across the entire globe with a few simple mouse clicks. Secondly, ETFs are many times cheaper than actively managed mutual funds. Thirdly, ETFs’ low turnover rates allow your portfolio to compound tax-efficiently.

Just for fun, I assembled this passive model portfolio consisting of 100% ETFs. The weighted average Management Expense Ratio (MER) is a rock bottom 0.1535%, instead of 2%-2.5% for most other actively managed mutual funds! I’ll be using Morningstar.ca to track and report the portfolio return once a month or so.

ETF	MER	Purchase Price (C$)	Shares	Current Price	Market Value	Weighting
iShares S&P/TSX 60 (XIU)	0.17%	$77.800	642	$77.800	$49,947.60	50%
Vanguard Total Market (VTI)	0.07%	$164.083	151	$164.083	$24,776.47	25%
Vanguard Paicific (VPL)	0.18%	$78.364	127	$78.364	$9,952.29	10%
Vanguard European (VGK)	0.18%	$83.574	119	$83.574	$9,945.28	10%
Vanguard Emerging Markets (VWO)	0.30%	$93.004	54	$93.004	$5,022.24	5%
Portfolio	0.1535%	n/a	n/a	n/a	$99,643.88	100%

Some awesome links on ETFs:

• Smart Money
• Morningstar
• ETF Connect
• Vanguard
• iShares Canada

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I don’t know about you, but I’m frightened by universal life insurance. Once you sign the dotted line, it becomes a life-long commitment that comes with a hefty early termination fee. The existing term insurance policy which we currently hold is pretty flexible, since we are free to adjust the insurance premiums in accordance to our needs.

For instance, if we allocate $400 per month of spare cash, we can purchase a million dollar policy with $100, and invest the remaining $300 into any securities of our choice. Should we be lucky enough to self-insure later on, we can cut off the insurance premiums, and invest the full $400.

Insurance can be too complex of a topic to explain over the dinner table by an insurance agent. I recommend taking the materials home, and spending some time doing a little critical and independent thinking. Since insurance agents are generally commissions driven, it is in your best interest to consult an independent financial advisor to verify if this is the right product for you.

How does a universal life insurance policy work?

When you buy universal life policy, not only are you paying for your insurance premium, you’re also contributing to an investment portfolio. In effect, the insurance company is underwriting your insurance and managing your retirement nest egg simultaneously. For instance, the company takes your $400 spare cash, and split it between the insurance premium, administration fee, and investment contribution. The company then offers you a limited list of investment vehicles. Sounds like a rip off if they charge you the extra administration fee and reduce your investment options, but …

What are the benefits?

1. The portfolio grows tax-free. This is similar to RRSP and RESP, where you can switch between different mutual funds without triggering capital gain taxes. This is different from a taxable account where capital gain tax can cut into your capital. The smaller the capital you have, the less it will compound.
2. The portfolio and the face value of the insurance policy go to the beneficiaries tax-free when you pass away.
3. Unlike taxable accounts, there are no probate fees. This can save as much as 5% of your total assets.
4. The portfolio is creditor proofed. This is useful for anyone concerned about lawsuits. (Does anyone know if RRSPs are creditor proofed too?)
5. The portfolio can be used as a collateral for loans. The loans can be repaid by the policy, but that will reduce the death benefits.

What are the key drawbacks?

1. Again, the investment options are limited, and often expensive.
2. You are committed to buying insurance for life even when you have no more dependents.
3. Early termination fee is steep.

Am I better off with universal life insurance?

To find out if universal life is better, we need to explore the alternatives. Most Canadians don’t max out their RRSP. If you still have RRSP contribution room, then I think you’ll get better bang for your bucks by contributing your free cash flow into RRSP. Since the $300 is after-tax money, the pre-tax equivalent is $400 if you’re in the 25% tax-bracket. Most payroll departments let you deposit pre-tax income directly into your RRSP brokerage account. Next step is to pick an investment vehicle, and what’s a better way to show off your patriotism by investing in the Canadian TSX index. Since you’re investing on your own, you’re able to shop around for the cheapest index fund or ETF. The cheapest Canadian index fund that I am aware of is the TD Canadian Index e-series fund with an MER of 0.31%, while the cheapest ETF is iShares’ XIU with an MER of 0.17%. Since XIC trades like regular stocks, you’ll have to pay transaction fees to buy. Refer to my previous post on Interactive Brokers.

As a comparison, Sun Life universal life insurance policy offers their version of the Canadian index fund with MER of 1.50%.

Let the race begins

If you invest pre-tax $400 worth of TD Canadian Index fund (MER = 0.31%) inside RRSP and assuming the market compounds at 10% over the next 30 years, your portfolio balance will grow to $6,413 before tax. The highest marginal tax rate for British Columbia is 43.7%. If you liquidate the entire RRSP account at once, you’ll receive at least $3,636 after-tax. This is the worst-case scenario, since the RRSP can be transferred to the surviving spouse tax-free. The freedom you enjoy with a term life insurance is you can terminate the policy once your dependents leave the nest. By then, you won’t need supplemental insurance. This unleashes bonus cash flow to excel your RRSP portfolio further. I have not factored in the probate fee, since it depends on the lawyer and if your beneficiaries are willing to handle the paper work.

If you invest after-tax $300 worth of Sun Life Canadian index fund (MER = 1.5%) over the same 30 years, you portfolio will grow to $3,467 tax-free. Based on my understanding, this is on the optimistic side for two reasons. First, I’m ignoring the administration fees. Secondly, the insurance company withdraws portions of the portfolio to offset your rising insurance premiums. Please feel free to complete my math if we have an insurance expert here.

What if I have no more RRSP contribution room?

If you’re in a high tax bracket, pay down your mortgage. This strategy saves you in the neighbourhood of 5%, or 8.33% before-tax assuming your marginal tax-rate is 40%. Although this not as sexy as Sun Life Canadian Index fund’s 8.5%, it is a guaranteed return instead of a projected return.

Is universal life good for anything?

My opinion is that universal life is third in line after RRSP and mortgage. It cannot be emphasized enough. I’m not a certified financial planner nor an insurance expert. Materials are presented here for discussion only.