Thursday, 28 June 2007

BMO Investorline and Foreign Exchange Trades in Registered Accounts

Little did I know when making this post complaining about BMO's policies regarding foreign exchange rates when buying and/or selling US securities in a registered account that much has already happened.

First, there was the $100 million dollar class action lawsuit launched back in August 2006 against BMO claiming that BMO has illegally forced customers to change foreign currency from Canadian dollars into US dollars or vice versa in registered accounts since June 2001 when the tax laws changed and began allowing foreign currency to be held in such accounts. You can register with the lawyers Paliare Rolland to be kept informed of the case's progress. Or you can sit back and keep an eye out for news, or just wait - I'm betting years - for a letter from BMO or the lawyer, saying the case has been settled for x amount and here is what you get.

The second development is the internal memo issued by BMO and reported by the Toronto Star in April this year to allow clients who trade in and out of US dollars on the same to take a single exchange rate for both the buy and the sell and thus avoid the buy-sell spread and/or any fees for the conversion. There is also a lower fee structure - down to 75 basis points (0.75%) or 70 basis points for all you folks who have trades over $30million. There isn't any notice or warning on the website about this situation, so BMO clients be aware - you must phone and ask for the single rate out of and into US dollars.

Maybe someday the big bank brokerages will manage to convince their software supplier to make the necessary changes to the program they all use in common to manage registered accounts. Apparently the bottleneck is the software and the supplier just won't change it (no it isn't Microsoft). Those of you at all familiar with the world of IT will not laugh and scorn but will quote the old saying, "God could not have created the world in seven days if he had had an installed base." Some who have had similar experience with the bugs that follow on new versions of software might just wisely note, "be careful of what you wish for, you just might get it."

Monday, 25 June 2007

The Slippery Meaning of "Value" in ETFs and Indexes

Investing in Value stocks through an ETF brings diversification and higher returns to an equity portfolio. That has been proven in finance research published by Fama and French in their famous three factor model of stock returns, available in all its mathematical glory at the Social Science Research Network. The implications for investing are explained in english language at the Index Fund Advisors.

As the old saying goes, there's many a slip between the cup and the lip. When the research-proven notion of Value, which is simply that the price of a stock is cheap based on the ration of the stock's market price to the company's book value (p/b)(book value is simply assets minus liabilities in the financial statements), the meaning of Value gets transformed and expanded by index providers. Index-based ETFs need to have a reference index and they take them from such providers as Morningstar, Russell, MSCI, Standard & Poors and Dow Jones/Wilshire.

The best explanation of the way Value, and other indexes such as large vs small cap are constructed, is here at the Moneychimp.

So what do we find that the index providers have added to the original p/b measure? First, there are additional historical price measures like price/earnings, price/sales and dividend payout ratio. That might not be so bad as the basic principle that the stock is somehow low-priced compared to a fundamental historical measure is still respected. But where the definition of value really starts to take on hocus-pocus falsity is those indexes that include forecasted of such numbers as earnings! What lunacy! That replaces the best guess, as expressed in the price, of the market, whose guess is better, as shown time and again by research, with the guesses of analysts who are more wrong than right,

How do the index providers stack up?
The Bad
  • Russell - "...the Price-to-book ratio and the I/B/E/S forecast long-term growth mean"; affects IWM, IWW
  • MSCI - p/b, dividend yield and 12-months forward earnings /price; affects VBR, VTV
  • Morningstar - 50% weighting on forecasted estimates; affects JKL
  • Dow Jones/Wilshire - uses p/b and p/ projected earnings (see the Moneychimp link above); affects XCV
The Good
  • Standard & Poors - uses p/b, p/cash flow, p/sales and dividend yield; affects IJS, IJR, RZV
It's very disappointing that Vanguard has chosen such a flawed index for its Value funds since the company's funds are better in other respects than those of the competition by having lower fees and greater diversification. VBR and VTV will be leaving my portfolio as a consequence next year.

Friday, 22 June 2007

ETFs, ETNs and Commodities Reading Material

Inside the Research Magazine Guide to ETF Investing 2007, there are a couple of articles I found to be quite useful for a deeper understanding of my portfolio holding in DJP the iPath DJ-AIG Commodity ETN. One article on page 10 compares ETFs to Exchange Traded Notes (ETN) and the other on page 12 describes and compares the various commodity funds one can buy. Good stuff for those who want to include commodities within their portfolio. Barclays Bank iPath website also describes ETNs and its own products.

Don't Tell Your Wife!

Came across this amusing slide in a downloadable presentation by Moshe Milvesky, given recently at the MFC Global Expo 2007 in Hong Kong. Guys, better make sure you keep your wife very happy!

The rest of the slides are, as usual for material from Mr. Milevsky (see my reviews of his books), full of interesting and thought-provoking material on financial issues of retirement.

Thursday, 21 June 2007

Mortality Swaps aka Back-to-Back Annuity and Life Insurance

In a comment on my latest book review Insurance Logic, Mike asked what a Mortality Swap is. The insurance industry apparently uses another term for this investment strategy - Back-to-Back Annuity and Insurance.

The concept is relatively straightforward. Here is an excerpt from the research paper titled Mortality Swaps and Tax Arbitrage in the Canadian Insurance and Annuity Markets by Narat Charupat and Moshe Milevsky:
"We show that by engaging in seemingly counter-intuitive transactions involving two insurance products, one can create a risk-free portfolio whose after-tax return is greater than that of available risk-free securities. The two insurance products in questions are (i) a standard term-to-100 life insurance policy; and (ii) a single-premium fixed immediate life annuity with no guarantee period.
Consider an individual who invests $100,000 in a fixed immediate life annuity, and then uses part of the periodic income from the annuity to pay the premium on a life insurance policy whose death benefit is also $100,000. This 'back-to-back' transaction, which we shall henceforth refer to as a "mortality swap", will create a constant periodic flow of income and will return the original $100,000 upon the death of the policy owner. This payoff pattern is similar to that of a risk-free investment such as a bank deposit whose principal is redeemed (by the individual's estate) at the time of death."

Another description is here.

The Insurance Logic book provides an an example for a 65 year old female based on actual quotes from insurance companies at the time. The risk-free rate of return pre-tax for the assumed 50% marginal tax bracket was 8% and was described as "much higher than comparable bond yields". The rate of return for this strategy was higher the older the age of the woman, using a joint and last survivor policy with the spouse and using leverage (i.e. borrowing to buy the annuity. The basis for the profitability of the whole thing is apparently that only a "relatively small portion" of a prescribed annuity is taxable.

This strategy came up for discussion in the Financial Webring - see the post by jiHymas on Dec.29, 2005 for an opinion on some cons. I had an amusing time phoning the CCRA today trying to get information to confirm whether this is still a kosher strategy but no one over there seems to have heard of it. They suggested asking an insurance company. Guess that would be the logical next step since they are the ones selling this, though an insurance broker who could arrange the two sides (insurance and annuity) from the required two separate companies would also likely be a good source.

Overall it seems that this could form part of the low-risk part of a retirement cash flow, replacing T-bills or money market funds.

Canada vs UK Tax Comparison Updated for 2007 and 2008

Back in March I posted a comparison of various personal tax rates for Ontario Canada and the UK using 2006 rates. Here's an update based on the 2007 rates.

This chart shows the rates for 2008-09. Not much change , the UK is still lower for every level of employment income except for a narrow sliver at around $75,000 taxable income where the top UK rate of 40% is a tiny bit higher than the Canadian 39.41% rate. Woohoo!

This time I've coloured cells green where one country or the other has better / lower rates. I've made a correction on the dividend tax for the UK - there is actually no exemption, the 10% rate applies as soon as tax kicks in up to the start of the highest band where it becomes 32.5%. This correction changes the advantage such that Canada generally comes out ahead with respect to dividends for almost every income level. With virtually everything else, the UK is better and usually by quite a bit, a seen by the content of the green cells. With respect to capital gains, though the rate is lower in Canada in low to middle income brackets, the availability of an annual exemption of almost Cdn$20,000 probably means the effective tax rate for a large proportion of UK investors is zero. For example, if a £100,000 portfolio has net 10% of £10,000 gains in a year, the £9200 exemption would mean almost no tax to pay. Adding the availability of tax-exempt ISA accounts in which up to £7000 can be placed annually, it is likely that all but the rich won't pay any capital gains tax in the UK.

A lot of UK interest income would likely be effectively tax-exempt within ISAs too, though not dividends because the tax is deducted before payment is made to the investor and it is not recoverable / claimable. The comparative Canadian RRSP account temporarily shelters interest, dividends and capital gains from tax of course. However, when I came to the point in my career/life where I could start saving larger amounts for retirement, my RRSP was maxed out so I had to put most of the annual savings into a non-registered taxable account. I really have been paying tax on those investments. Were I a UK taxpayer, my savings could have been absorbed by an ISA.

The conclusion I reached in March still holds - the UK is the clearly superior country when it comes to personal taxes.

Source for UK tax information: UK DirectGov website.
Source for Canadian tax rate: TaxTips website.

Wednesday, 20 June 2007

Travel Costs for Visitors to the UK / Scotland

CTV's new story Canadian cities cheap in cost-of-living was a reminder and a confirmation of what I experience every day here in Scotland - it's expensive to live here. In the rankings, the most expensive Canadian city is Toronto, 82nd on the list with an index of 78.8 points while Glasgow, near where I live, or "stay" as they say here, is 36th with an index of 88.1. The company that compiled the data is Mercer and more details are here. It's hard to tell how to interpret the index but if it is meant to be linear - i.e. an index number twice as high means twice the cost of living - then I don't think the survey quite captures the reality. My experience is that things in Scotland and the UK cost about twice as much as in Canada, not the 10-15% the Mercer numbers suggest. My rule of thumb is £1 here buys more or less what $1CDN buys in Canada. Clothing, hotels, food at grocery stores or in restaurants, gas (petrol), golf - just about everything is costlier (The only thing about the same price is booze - it is an essential of life here - most Scots can outdrink Canadians by a mile!). The pain has been lessening somewhat in the past few months as the exchange rate has fallen from around $2.30/£1 to about $2.10 but travellers and vacationers be forewarned in your budgeting.

Updated Asset Class Correlations and the Commodity Controversy

Richard Ferri's company Portfolio Solutions website has a handy updated 14 page downloadable pdf titled Asset Class Correlations, which updates many of the major asset class correlation numbers up to the fall of 2006. He indicates an intention to do quarterly updates so it promises to be a useful on-going tool. Ferri is the author of the fine book All About Asset Allocation, which I previously reviewed here. The document contains an appendix with a very good explanation of correlation and its part in asset allocation (it looks like it was lifted from the book). Ferri's site also includes, for free, documents that track the long-term evolution of investment indicators, and one of his books called Serious Money, which I have on my list to review.

One of the interesting and controversial parts of the above paper is that Ferri finds that having a commodity holding in a portfolio reduces returns. He doesn't address whether it reduces volatility ... though the chart of returns appears to have less variation in the portfolio that includes the commodity. This is directly contrary to the findings of Roger Gibson in his book Asset Allocation which I reviewed here. What explains this difference I cannot tell - possibly a different time interval for back-testing the "with "and "without" portfolios, the different commodity index each used (GSCI for Gibson, CRB for Ferri) or something else, I cannot tell. Ferri himself says the topic is subject to on-going debate. For now, I've got a commodity holding in my portfolio - DJP, the iPath Dow-Jones-AIG Commodity Index - and it will stay there till next year's portfolio rebalancing at least.

Update June 26: Zephyr Associates has also compiled a series of asset class correlations, oriented to US investors and investments. There is a downloadable pdf here. It is interesting that the correlation of equity returns of every foreign country with the US has increased in the last ten years to the 0.7/0.8 level, which is quite high and lessens the benefits of diversification. Is this a sign of a world economy that is ever more inter-connected and inter-dependent and is thus permanent, or is it just a period that will pass? Correlations of other asset classes with equity like real estate and bonds are much lower and in some cases, widening, making the diversification benefit even greater. The correlations of the overall US market with various equity sectors is also seen to be much lower and again in some cases, widening. Is industry sector asset allocation a more promising strategy? After all, one can hold the entire market split up in different ways; it doesn't necessarily have to be on a geographic country basis. btw, thanks to Canadian Capitalist for the link to Zephyr Associates for his blog posting on the new Invest Skeptically blog where I found the posting with the link to Zephyr.

Tuesday, 19 June 2007

Book Review: Insurance Logic by Moshe Milevsky and Aron Gottesman

The third in the "Logic" series by Moshe Milevsky, this time with co-author Aron Gottesman, Insurance Logic explains all the types of insurance for individual consumers and families (i.e. excluding business insurance):
  • life insurance,
  • longevity insurance / life annuities,
  • health and travel insurance,
  • disability and critical illness insurance,
  • automobile insurance and
  • property / home insurance.
The book begins with basic principles and concepts of insurance, then proceeds to the individual types of insurance. Each insurance area has its own chapter, with a summary of key points, a list of references and further reading and a list of key questions to ask when going to shop for insurance. The authors explain and define terminology of such daunting terms as moral hazard and adverse selection along the way when necessary and appropriate. A glossary at the end lists the terms and their definitions. The approach is introductory in that there is no knowledge presumed of the reader but it is not dumbed-down. Authors Milevsky and Gottesman manage the remarkable achievement of making the highly complex subject of insurance clear and logical. One does not feel overwhelmed and confused. The language is careful and precise but not convoluted. There are few numbers and calculations and no price comparisons of individual companies or products. However, one does feel prepared to discuss intelligently with agents or brokers to shop and buy insurance.

The authors are university professors and the advice they give is impartial. That is quickly apparent anyway in the discussion of pros and cons and in their criticisms (governments, insurance companies and consumers all come for their share, though the tone is mercifully more a description of a sad reality than a diatribe of complaint).

Things that surprised me:
  • the probability of disability hitting people sometime in their adulthood is quite high, so high in fact that doing something to mitigate the effects with insurance is a very good idea;
  • making a number of small claims is worse than one big claim and could result in the insurance company cancelling your policy or refusing renewal;
  • car insurance rates vary a lot from company to company for any one driver and the same company might be cheapest for one type of driver and most expensive for another;
  • higher deductibles are a good thing for a consumer;
  • property crime is rampant in BC compared to other parts of Canada;
  • top-producing agents are more likely to engage in deceptive practises with consumers (there's a good question to ask your agent "are you a top-producing agent?"!)
Interesting Quotes
  • "... purchasing insurance is implicitly a hedge, not an investment." (page xiv)
  • "... the credit rating of the company selling you the policy (a life annuity) is extremely important." (p.38)
  • "... the out-of-country protection provided by public health insurance is insufficient." (p.54) (especially in the US)
  • "... disabilities lead to almost half of all mortgage foreclosures." (p.80)
  • "... insurance policies are extremely complex and difficult for consumers to understand." (p.156) (you're not kidding - can I submit this for the under-statement of the year award?)
  • "... most Canadians are solidly against insurance fraud, even though many practise it." (p.171) (by padding claims, apparently)
Suggestions for improving the book
  • add more content on travel insurance requirements in the USA;
  • add more references - though there already are some - for the reader who wants to go to the intermediate/expert level;
  • add a table to compare the features and pros and cons of disability versus critical illness insurance;
  • update table 12 Minimum Compulsory Automobile Insurance (which is dated April 2004); perhaps a connected website with up-to date figures on all the charts could be created?
  • include an annotated sample policy with explanations alongside the actual clauses
My take-aways and items for action
  • insurance is a valuable and essential part of an overall financial plan, dealing with financial protection
  • it is possible to have too much as well as too little insurance
  • shop around for car insurance rates, it's really worth it - more than 50% difference in quotes worth hundreds of dollars, (or even thousands for younger drivers) are possible
  • forget insurance on small items, like extended warranties at electronics stores, it's a waste of money
  • investigate doing a mortality swap (sounds like a good opening line at a cocktail party - "did you know I've just done a mortality swap?" ;-)
Every Canadian adult should buy this book, read it and keep it on the shelf for reference and selective re-reading whenever a new stage in life is reached or a major financial decision looms. The book is that useful and that important. Five out of five stars.

Buy this book at

Monday, 18 June 2007

North American Automakers Best Japanese at Last!

No, it's not a joke. There really is something where Ford and GM are superior to Toyota and Honda. And it's not something trivial either. What is the mystery characteristic, you ask?

It is all about insurance. While perusing the website of the Insurance Bureau of Canada, I came across a publication called How Cars Measure Up, which contains 87 pages of a table that lists and rates vehicles according to four different cost indices and two theft indices. The table is easy to read because the results are colour coded - red = bad, green = good, though one has to refer to the insurance jargon glossary on the same website to figure out what the abbreviations in the column headings mean.

Taking a quick scan through the table for the best (green across the row) and the worst (red all over), Ford and GMC have more than half of the "greenies" while Honda is the runaway (or should I say, out-of-control?) winner of the flashing red award.

The Best
  • GMC Astro/Safari Wagon AWD 1993-94 and Chev S10/Sonoma 4WD 1994
  • Ford F150 2WD 1993-96 and F250 4WD 1994
  • Ford Ranger 2WD 1993-95, 97-98
  • Ford/Mercury Crown Victoria Grand Marquis 1993-97, 2001
  • and a few others from outside ....
  • Mazda B2300/3000/4000 2WD 1994-96 and Miata / MX5 Convertible 1993-94, 97
  • Mazda Pickup 2WD 1996
  • Subaru Loyale Wagon 1993
  • Toyota Pickup 2WD 1993
The Worst
  • Honda Civic Si 2DR Coupe 1997-98, 2002-04 and Hatchback 2002
  • Honda Prelude 2DR 1993-2001
  • Toyota Rav4 4DR 4WD 2001, 03-05
  • Volkswagen Golf GTI 2DR Hatch 1998-2003
So, forget those testosterone ads for Ford pickups, they're safe and sedate! Stay away - on the lot and on the road - from the souped up versions of those Honda Civics (I do have the impression that most of them seem to be driven by twenty-something guys in ball caps who like to drag race down crowded streets ... maybe the red rating also stands for blood on the street?). Those wanting a sporty but safe car should go for the Miata. The Crown Vic ratings on the other hand fit right in with the "retired couple" image of the car. Do these ratings have more to do with the type of driver each car attracts, or does driving a 1993 make you a safer driver? Rest assured though, that the insurance companies will set your rates in line with these tables.

Friday, 15 June 2007

Scare-mongering on Retirement at CBC and Canadian Institute of Actuaries

Yesterday the CBC posted an article on its website titled "Most boomers aren't saving enough for retirement, actuaries say". When I saw the headline, I figured it looked worth a read but it isn't. Why? No specifics, that's why. It makes vague references to people not saving enough for a "comfortable retirement". What does that mean? One would expect that a reputable organization like the Canadian Institute of Actuaries would fund a meaningful, probably unbiased study. The article does say that the researchers who wrote the study came from the University of Waterloo. However, should you want, as I did, to see the report and the specific calculations that produced that scary headline, it isn't available. There's no link from the CBC and the website of the Canadian Institute of Actuaries doesn't seem to have it either. A news release which has a less scary, more neutral title "Planning for Retirement: Are Canadians Saving Enough?" doesn't provide much more detail, except that it seems that the whole study resides on profiles and scenarios of types of families and not, for instance, on surveys of the actual savings of families. The bottom line is muddled - it seems to be a study that questions more than accuses. It is certainly not worthy of CBC's sensationalized headline. So why doesn't the CIA make the study public?

Thursday, 14 June 2007

Car Ownership vs Rental vs Sharing

As I am not full time in Canada these days, I decided to take a look at alternative ways of having wheels aka a personal vehicle available for my use. Everyone is familiar with the traditional ownership and commercial rental methods of having a car but a friend and neighbour had mentioned trying out a car sharing club membership so I decided to compare the three alternatives.

In a car sharing club, one pays an annual or monthly membership fee to get access to a fleet of cars scattered at locations across a city. Reservations are made for a time and day, one pays an hourly rate and away one goes. The car must be picked and dropped off by the member at the same place at the promised time.

My table of comparison of the advantages and disadvantages of owning vs renting vs sharing shows that the best option depends on individual circumstances, primarily the frequency, duration and distance of driving.

Car sharing is best for infrequent, very short trips of a few hours to a few days within a local area and when one lives in a city core, i.e. close to a car pick-up point. Several of the car sharing websites I came across ( see links in the table) stated that car sharing is cheaper than ownership for anyone driving less than 12,000 km per year. Ownership is best for lots of driving, anything over 18,000 km per year or more than about 120 days of driving. Renting seems to be superior for longer distances up to 18,000 km and up to 120 days driving per year, though I'm not sure if car rental companies would impose punitive disincentive rates for an extended rental of something like a two-month continuous rental. It's interesting that the cost advantage of renting is not dependent on kilometers driven (at least up to 18,000 km per year), it's entirely related to number of days of rental and the number where renting is better than owning - at 120 days per year - is quite high (see my chart).

Part of the decision as to which option to pursue certainly has to consider local factors. For instance, there is a local branch of Enterprise car rental close to my house and they offer free pick-up and delivery services, along with special month or longer rental rates. Also, my credit card offers some form of insurance protection for car rentals though I have to admit I don't really know the details of how good/ useful that is ... material for a future blog post!

The company that operates Car Sharing in Ottawa is vrtuCAR. One of my neighbours has used them and found it worked reasonably well, though collecting and dropping off the car from our suburb required taking public transit, which he said somewhat defeats the purpose.

Another benefit of car sharing and rental is that there are fewer cars on the road overall and people who use these methods of car transport tend to drive less, reducing road / parking congestion and emissions, both good for our environment. Local governments tend to like car sharing in particular and some offer preferential treatment like reserved parking, which can be a big plus in congested big city core areas. Check out the local car sharing websites of your city from links in my tables, or just Google car sharing like I did.

Wednesday, 13 June 2007

Live ETF Portfolio Tracking

It took more than a few hours of experimentation and lots of poking around the Internet but I finally found a way to show my portfolio of ETFs on this blog for one and all to see. You can find it on the bottom of this blog page as a Google spreadsheet.

The portfolio spreadsheet includes:
  • all the Canadian and US holdings together, with the US holdings converted into Canadian dollars;
  • live pricing of all the holdings, courtesy of Google Finance, at least I hope that it updates live as posted; it did while I was editing it on the web; we'll see tomorrow;
  • that includes live conversion of US dollars into Canadian dollars (during the North American trading day at least); this part required a bit of finagling using the FXC Canadian vs US dollar currency ETF as an approximation but there seems to be NO direct way of getting live currency rates into a portfolio calculation on the web at the moment;
  • gains or losses by holding and for the overall portfolio, which can be used to see potential capital gains and perhaps later in the year facilitate some tax loss selling;
  • gains or losses and movements away from the target percentages by asset class, which will enable quick and simple portfolio rebalancing come next May;
  • a separate tab/sheet for the asset allocation model I used, including some notes on how and why I picked the ETFs I did, as well as credible alternatives; note that the allocation percentages get pulled from the this sheet into the main portfolio sheet so if I decide next year to change my percentages among classes, it will be quicker to see what buys/sells are required;
  • another separate tab for tracking the Adjusted Cost Base for Canadian tax purposes - the one on the spreadsheet below is actually an edited one of my own real one, since I am too shy to reveal the details of my financial affairs, but I hope it is of use to others who may be looking for a simple model; here again I've pulled some of the ACB data per share into the main spreadsheet in the "Cost May 23" area; if one is buying holdings at different times, the only way to keep track of the ACB of US holdings for Canadian tax purposes is to do some sort of journal with US exchange rates applied at the time of purchase (not those in effect at the time of eventual sale, unless you either want to make a gift to Revenue Canada, if the C$ continues its upward path, or get in trouble with Revenue Canada, if the C$ starts heading back down;
Comments and suggestions on improvements most welcome. If you want, I believe you can take a copy from here or maybe here (.xls format). One thing I found in copying the spreadsheet back to my own PC (since it's a lot easier to edit than doing so online) is that some formulas disappeared in the transfer, notably the essential =GoogleFinance function that fetches the live quotes (is Google trying to ensure that this function is only used online?).

Thursday, 7 June 2007

Retirement and Rewards thereof

Just a quick post today since I'm off shortly to enjoy one of those benefits of retirement. It's a lovely day out here in Scotland and those are not to be missed (at some points during the past winter, one had the impression that it was time to start building an ark, though my scottish friends assure me it wasn't normal weather) so I'm going golfing this afternoon, a last minute decision that comes with the freedom of time allocation to do things when one wants.

I want to welcome a former work colleague to the fold of retirement. Well done and congratulations, B! Enjoy. Life is not worry-free, though it pretty well will be on the financial side with the inflation-indexed pension for life. We can all appreciate things more having experienced and observed the downsides of life, as we have with another work colleague who had an accident recently. Get well soon, H!

Carpe diem!!

Wednesday, 6 June 2007

BMO Investorline Modifies Foreign Currency Notice

Back on May 27th I posted this complaint about BMO Investorline's lack of disclosure with regard to the foreign exchange rates used when one trades in foreign securities, like those on US markets, on top of the fact that BMOIL does not allow foreign currency to be held within registered accounts, so making unjustified profits for BMOIL in the obligatory two-way currency exchange. Curiously, upon login to my account this morning, I discover that a new notice has suddenly appeared on BMOIL's webpage (see graphic).

Probably this is a coincidence since it is highly unusual for a big organization to make any change in response to an individual's complaint (large organizations by their nature only respond to an appropriately large stimulus, like losing a major lawsuit, getting into major financial problems etc). This notice doesn't provide any better disclosure, it merely says BMOIL can set whatever foreign exchange rates it likes on transactions. That neatly covers their liability, of course, which is BMOIL's primary objective. But it doesn't help investors trade accurately by having exact rates at the time of transactions. Nor does it seem fair for BMOIL to set whatever rates it likes, particularly since BMOIL only sets the rates at the end of the day, long after the trade has been committed. That BMOIL is trading the foreign currency for its own profit makes this unfairness even worse.

Another curiousity is that the link to the full agreement takes one to a pdf document dated March 2007. If there is something "new" in the agreement, wouldn't a more accurate date be June 2007, or is it allowed to retroactively change agreements? Just asking....

Tuesday, 5 June 2007

The Best US Large-Cap Index ETFs Compared

Back in May in my post on the complete overhaul of my portfolio, I showed a chart of my selected ETFs along with some credible contenders in several asset class categories. In one of these, US large-cap companies, my choice was Vanguard's offering, the Vanguard Large-Cap Index Fund (ticker VV), over some very good other choices, the iShares S&P 500 Index Fund (ticker IVV) and the grand-daddy of ETFs, the SPDR aka Spiders (SPY). Along with those, I've included the iShares Canada S&P 500 currency hedged version (XSP) and the TD e-Series S&P 500 currency hedged fund (fund symbol TDB904) for the benefit of Canadian investors like me who don't want to face the negative consequences of a Canadian dollar continuing to rise vs the US$.

The chart illustrates the factors that I believe justifies the conclusion that Vanguard is the best, though not by a great deal. I've coloured the cells light blue where the particular factor favours that ETF. The visual impression is a bit misleading since a number of cells at the bottom all have to do with tax efficiency.

Vanguard's VV is better on:
  • MER, or Management Expense Ratio, which is the overhead paid to Vanguard to manage the fund - the lower the number, the better it is for the investor
  • on the premium/discount, in this case the discount, which is the average amount the market price of the ETF deviates from the Net Asset Value (NAV), the value of the under-lying stock holdings; the smaller this number the better, the investor neither gains nor loses as the fund is fairly priced; in this case VV is tied with SPY for the best
  • 3-year performance, which is higher in VV's case; now some will note that VV uses a different index than all the others, which use the S&P 500 and thus the result should not therefore be comparable. I'm going to stick my neck out a bit by saying that the others suffer from using the S&P 500, a flawed index (as noted by Peter Bernstein in his book, which I reviewed a few days ago). Check out the text below on the S&P 500's flaws and see if you agree with me. The fact that everyone uses it, as they do the far worse Dow, doesn't make it good!
  • all the various tax efficiency measures; especially note that the ratios at the bottom of the table, higher in VV's case, mean that the investor loses less to the government through taxes on VV than the other funds. Canadians should note that the source of this is US websites like Vanguard and the absolute numbers reflect US taxpayers but I believe the relative advantage of VV is still there. The size of the 2006 distribution by VV, which would be a highest-rate income item for a Canadian, compared the that of IVV, confirms this conclusion.
There are a bunch of blank cells in the table, where I could not find the numbers despite hours of searching. Canadians will note more blanks for XSP and TDB904, where the available data on comparative websites like Morningstar, GlobeFund and those of the providers iShares Canada and TD Asset Management don't seem to be very forthcoming with data. I had to email iShares Canada to learn why their 3-year performance figure on their website differed so markedly from the S&P's results - turns out they only started hedging XSP in November 2005. Therefore, all note, the numbers may not be 100% accurate!

One disappointment for me in all this is how much one loses in buying XSP or TDB904 for currency protection. There's a big performance loss. It's curious that XSP managed in 2006 to distribute some of its distribution as capital gains instead of income, better because of the lower tax paid on capital gains over income. The tracking error of TDB904 at 6+% is abysmal. I had to calculate that one myself so it may be wrong but the high cash holding of 4% of assets, which came from Morningstar Canada, is consistent with such poor tracking.

The suggested weaknesses of the S&P 500 as a market index include:
  • it is really only a large cap index with about 75% of the total market value of US shares
  • it weights the companies within the index based on the value of the public float in the judgement of the Standard and Poors selection committee, so this biases the index away from a true market cap weighting that follows from financial theory
  • some non-US companies are still in the index, having been grand-fathered upon moving away from the US
  • some US companies that are illiquid are excluded like Warren Buffett's Berkshire Hathaway, a gigantic omission as it is a huge company
  • delays in adding new companies in new sectors distort the true market weighting – it took a while before Google entered the S&P 500
see and a letter by Darren Bramen on this page

Sunday, 3 June 2007

Book Review: Capital Ideas by Peter Bernstein

This is a book nominally for finance aficionados, those interested in the theorists who explained stock and bond markets and laid the basis for index funds, portfolio construction and the explosion in derivatives. Capital Ideas is about the history of the thinkers and some implementers of modern capital markets.

Peter Bernstein, not to be confused with the other popular financial author, William Bernstein (he of Four Pillars fame), writes in a non-technical way about the theories. This is quite an accomplishment, given that modern finance is highly mathematical. In fact, there is only one brief formula in the book, which Bernstein throws in just to show us how complex a formula can be. The Black-Scholes formula for pricing options is the only one in the book (228). There might have been a few more, if only to make a deeper impression on the reader about the difficulty of the intellectual work involved. When doing my MBA in 1982, we went through the mathematical derivation of the Capital Asset Pricing Model, another core financial theory, and I remember feeling quite smart merely at being able to understand and follow the logic. UBC did that because it was a fairly quantitative business school. Most MBA schools at the time did not even go that far, merely presenting the final formula with words to describe its meaning. The Black-Scholes was another order of magnitude more difficult than the CAPM with its reliance on Ito's lemma for the solution and we did not attempt the math. However, to really understand any formula properly in order to apply it intelligently, I maintain that you must be able to do the math, otherwise the intricacies and subtleties are lost. There are likely even today, 30 years later, no more than a few thousand people in the world who truly grasp how options pricing works. Though I consider myself to be of reasonable intelligence, particularly in an academic sense, I feel in awe of the finance theorists that Bernstein pays homage to. It is hard to comprehend the abilities of these individuals. On reading that some of these guys came out of physics, I was reminded of my late wife, who had a doctorate in nuclear physics. She described how she used to pass undergrad physics exams – go to class, listen very carefully to understand what the teacher was saying, remember a few basic principles and formulae, then go to the exam and re-derive whatever additional formula a particular problem might require! It's like any field of endeavour – think what Tiger Woods does with a golf ball - the best are simply amazing to anyone with ordinary abilities. Bernstein might have imparted more of the sense of awe that we should rightly feel.

One of the lasting impressions of the book is amazement at Bernstein himself and his ability to understand and explain the many theories, some of them quite subtle indeed. Not everyone seems to get the message of modern financial theory however, as Bernstein describes in the last chapter. There are many portfolios being managed in the institutional world, which is supposed to be professional, in un-diversified, active trading. Some of the managers probably don't understand the theory properly and so mis-apply it.

There are a number of delightful snippets of information and quotes to give a reflective reader something more to think about:

  • The long run returns of the US market of about 8% annually on a real, after-inflation basis, are unique to the United Sates in the 20th century. No other country has done as consistently well, due to disruptions such as wars, famines, revolutions and the like. (A recent paper by Bernstein suggests that using the number as an assumption about the future rate of return is probably much too high.)

  • Or, for us index investors, the S&P 500, is not a very good index. It doesn't represent the market very well, which is what finance theory says a good index should. Bernstein calls the S&P 500 a “a capriciously structured portfolio” (page 248).

  • Change in financial markets, and in the practices of those in the business, tend to change after major disruptions like the 1973-74 and the October 1987 severe drops. In the interim, people are smug, fat, happy and resistant to change.

  • Financial theorists have been almost exclusively English and American scholars, though that seems to be changing now. And they have been 100% men. Not a woman figures among Bernstein's pantheon. So many theorists were converted engineers, physicists and mathematicians (I think that's where the “improbable origins” subtitle of the book comes from; these guys were just looking for some good problems to work on). It's the ultimate nerd activity.

  • The value and significance of research is not immediately apparent, recognized or adopted: Markowitz' paper on portfolio selection languished nearly 10 years after its publication before people took much notice. Or, Black and Scholes submitted their paper on options pricing first to a Chicago University journal and then to one at Harvard, who both promptly rejected it. (220)

  • Things can change permanently: in the years after the 1929 crash stocks were considered so risky that the dividend yield on stocks was nearly three times the interest on savings accounts. In the the 1950s stock prices overtook bond prices for the first time in the history of over 100 years of the US market. That relationship has never returned. “Growth had replaced solvency in market valuation.” (160)

There are amusing and useful sayings for the investor:

  • “Diversification depends more on the way individual securities perform relative to one another than it does on how many assets the investor owns. In Markowitz's terminology, “It is necessary to avoid investing in securities with high covariances among themselves.”” (50)

  • “Diversification takes all the fun out of investing.” (53)

  • “The riskiness of a portfolio depends on the covariance of its holdings, not on the average riskiness of the separate investments. A combination of very risky holdings may still comprise a low-risk portfolio so long as they do not move in lockstep with one another – that is so long as they have low covariance. (54)

  • The market is so hard to outguess because so many people are out there doing the guessing. (134)

  • “The only thing the investor should worry about is how much any asset contributes to the risk of the portfolio as a whole.” (188)

The book has an extensive bibliography with details of all the major papers and books, providing a handy reading list for the essential sources of modern finance up to the date of the book, which was published in 1992.

Buy the book at

Tech Stock Accounting Foresight in Hindsight

Those interested in tech stock investing, or indeed in buying shares of any individual company, should run through this column on devious tech accounting methods, written at the beginning of the tech bubble in 1999 by tech commentator/blogger Robert X. Cringely. It foresaw and forecast the coming accounting fiascoes with tech and Internet companies such as the one where I worked for a while, Canada's darling Nortel (mea culpa, I drank John Roth's cool-aid too). It reminds me of something I read years ago to the effect that the real financial analysts read annual reports backwards - starting with the footnotes at the end, where the financial dirt is hidden.

Cringely is always a good read for anyone who likes technology. That he has been around for ten years on the Internet as a columnist is an impressive achievement,, which I can better admire having blogged for several months now. The quality and value of his writing is consistently high. I take him as a role model to emulate in that way - to write original, well-researched, topical and forward-looking material.

Anyone have a financial columnist/blogger to suggest as their hero?

Friday, 1 June 2007

Why Management Expense Ratio is So Important

One tenth of one percent (0.1%) seems like a trivial number not worth bothering about when it comes to the expenses charged by fund companies to manage our money in mutual funds or Exchange Traded Funds (ETFs), doesn't it? The expense ratio (ER or MER) is the amount levied by the management company as a percentage of net assets in the fund. It is not in any way dependent on the investing success or performance of the managers (see the Wikipedia post on mutual funds for details).

Another way to look at the ER is that it is a reduction in the net return available to fundholders. Managers must make up their percentage fee and better in order to make money for you and me. For example, if the fund is $100, the ER is 1% or $1 per year, in order to gain 6% net, the fund must go up by 7%/$7. Alternatively, the same net gain can be achieved with a lower investment gain and a lower fee. Or, to put it yet another way, with same investment gain, as I am illustrating in this post, and a lower fee, the net gain is higher. In the case especially of passive index funds whose aim is to replicate the gains (and the losses when they occur) of an index such as the S&P 500 or the TSX, there shouldn't be a lot to pick from between various ETFs or funds. Therefore, the lower the expense ratio, the more of the index gain is left for the investor. Since the MER is a known, predictable expense, the opportunity to lower it is pretty well a guaranteed, risk-free return. In short, the lower MER, the better, other things being equal (and they aren't always but interestingly those funds with lower MERs tend to be better in those other things too).

So how much does it matter? I've created a simple table in the accompanying graphic to show the numbers and the results are dramatic. The table shows percentages which are to be understood as the difference in rates of return - i.e. the effect of extra or less MER. Thus the table shows what an ETF/fund that charged 0.1%, 0.2%, 0.5%, 1.0% or 2.0% more would have produced. For example, the Vanguard FTSE All World ex US (VEU) has an MER of 0.25% while the iSharesMSCI EAFE (EFA) has an MER of 0.35%. They are not exactly the same index but the effect of difference of 0.1% in MER will amount to $201.91 after 20 years for every $10,000 invested, as shown in light blue cells of the graph. Multiply by the size of your portfolio to see the total amount.

$201.91 is a relatively small difference but the other columns show how significant the compounding effect can be for long periods and bigger MERs. The 2.0% column is of special interest to Canadians who pay the highest fund expense fees, which are high by something approaching 2% in my view. The moral of the story is to pay close attention to MER - the lower the better.

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