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Last week's look at the environmental, social and governance aspects of Canada's largest mining companies found most to be taking such matters seriously. It's a good start but an investor wants to know whether there is money to be made. How are they faring financially and is now a good time to buy shares?

A cyclical industry that is currently out of market favour
Mining, whether of gold, silver, uranium, base metals or fertilizers, is highly cyclical. It is dependent for profits on the big swings in prices of those commodities. Whether for different reasons amongst the different products, currently the whole mining industry seems to be in a down cycle and out of favour in stock markets. The graph below shows the big decline in prices of such stocks, using the example of a few of the companies in our list and a popular ETF that holds a basket of such stocks, iShares S&P/TSX Capped Materials Index Fund (TSX symbol: XMA). Compared to the overall TSX index, which has been relatively flat, the Google Finance chart shows the miners' poor performance for almost three years, since the end of 2010.

Financial stability - some are faring ok, some are hurting
If prices of metals and minerals are down and compressing profits, a company needs to have a low cost structure and sustainable levels of debt. Our table shows good numbers in green and bad in red.

In the two debt columns, we see some bad performers:

Barrick Gold (ABX) has a very high level of debt in relation to equity on its balance sheet, much higher than any other company. A recent Globe Advisor column discusses how this makes Barrick very exposed to any further decline in the price of gold. On the other hand, any rise will boost shareholder gains faster. Debt, aka leverage, is a double edged sword. The company is already taking action to curtail the large recent net losses.
Newmont (NMC), Tahoe (THO) and Turquoise Hill (TRQ) have lots of debt in relation to the cash flow being generated and this is reflected in net losses.
Goldcorp (G) and Kinross (K) display negative operating margins (operating income divided by sales) i.e. losses from operations that does not include interest or taxes. Both are experiencing substantial net losses, though Kinross is a lot worse off. Until the latest 12 months, Goldcorp had managed to make profits every calendar year. Goldcorp has just reported more problems with its operations and costs. Kinross has had recurring trouble with only four years with profits out of the last seven.

And there are some companies that look good too, with reasonable debt loads, healthy operating margins, consistent profitability, even in current conditions:

Agnico Eagle Mines (AEM), Agrium (AGU), Cameco Corp, Eldorado (ELD), First Quantum (FM), Lundin Mining (LUN), Potash Corp (POT), Teck Resources (TCK.B) and Yamana Gold (YLD)

Value - whether stock price is a cheap not an easy thing to assess!

The classic value method of looking at a company starts with looking for a low Price to Earnings ratio (P/E) but with mining, whose earnings can vary tremendously with the price of their gold, silver etc, a P/E may be lowest at the peak of the cycle when the earnings denominator is highest. Conversely, a high P/E may happen at the bottom of the cycle, when earnings are really low and the expectation of better future results justifies a higher price. That may be the case today, where we seem to be more at the bottom than the top of a cycle. Agnico Eagle's P/E of 27.4 may reflect more future earnings growth expectations than over-enthusiastic pricing. Yesterday's huge 17% price jump by Agnico, despite falling profits year over year, suggests expectations are at work.

Price-to-Book may give a better indication of value for more mature companies

Using a company's book value of its assets, which does not change constantly with commodity prices, may help provide perspective, especially where a company has been in business for many years, through several commodity price cycles. Our comparison table above shows in green the companies whose current P/B ratio is either very low at 1.0 or below, or is at the lowest end of the historical price range. On that basis, almost all the stocks appear to be quite cheap and only one - Tahoe Resources - looks expensive.

The whiff of changing sentiment

Possibly the winds are changing, or at least for some miners. Thursday's quarterly results from Teck were down from the previous year but better than analyst forecasts, which prompted a 3.8% rise in the stock price and a Globe article announcing that mining stocks are on the mend.

Potash facing a new normal of a broken cartel

Potash producers Potash Corp and Agrium face a different future, brought about when Russian producer Uralkali announced on July 30 its withdrawal from the potash selling cartel. Though Potash Corp is still very profitable, it's results are down and it has lost its market darling status of the last many years. The big question for investors is whether this will continue as the new normal, or whether basic demand for fertilizer will restore previous profitability. Agrium is less affected by the potash price drops resulting from the cartel breakup since potash makes up less of its product mix.

Bottom Line - several worth buying, some not

We have sorted our comparison table from the best at the top down through slightly less attractive but reasonable choices based on the information we have compiled. The promising choice list comprises ten companies.

At the bottom of the table, below the blank line, are the six stocks with too much red for our taste. Before making a purchase we would want to read more annual and quarterly reports of the ten good-looking companies, along with analyst commentary to see if there are other problems we have not yet uncovered that are particular to a company that would prevent it from rising in the upward cycle.

Disclosure: this blogger directly owns shares of Potash Corp, and Teck Resources apart from holding virtually all the companies in various ETFs.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

When we reviewed the investing practices of Canada's three largest pension funds a few years ago, we discovered a number of ideas useful to individual investors. However, we also found that some of their strategies - pursuing absolute return strategies, making large private equity investments, direct investment in infrastructure or timberland - are really not available to the average individual investor. Step forward the national investment fund of Norway, the Government Pension Fund Global (GPFG). It was set up to invest Norway's oil money, to ensure that the oil wealth would be maintained for the long term to benefit future, as well as present, generations of Norwegians. GPFG happens to be the world's second largest retirement fund according to Pensions and Investments, with assets of $712.6 billion, dwarfing the Canada Pension Plan's $184.4 billion. And it has been quite successful. In their excellent review paper The Norway Model, business professors David Chambers, Elroy Dimson and Antti Ilmanen call it "... an exemplar for investors around the world". Best of all, its methods are very simple, a model that can be reasonably easily emulated by ordinary investors.

Pursue the market return
Starting with a belief that markets are largely efficient, GPFG follows a coherent set of policies:

Use market cap benchmarks to guide investments, in the case of equities this being the FTSE All-Cap indices and fixed income Barclays Capital Aggregate indices, to seek so-called beta or market return instead of alpha or market-beating performance. A key risk objective and control measure for GPFG is that its own returns should be within 1% of the indices. They are essentially not trying to beat the market, mostly to get the market return. Another result of the policy is that developed economies of North America, Europe and Asia constitute 90% of equities, while developing markets like China, Brazil and Russia are only 10%. It's a cautious allocation, no big bet on these often-hyped countries.
Invest in publicly-traded stocks and bonds, unlike many other gigantic funds like Canada Pension who have significant investments through private channels, GPFG owns publicly traded stocks almost exclusively. GPFG owns shares directly because it is so large and can do this cheaply, whereas we individual investors are better off in funds.
Diversify. As of mid 2011, GPFG owned shares of 8400 companies and 7945 bonds worldwide. The shares represented over 1% of the value of each and all of these stocks worldwide and over 2% in Europe. GPFG literally owns an appreciable chunk of world securities. The list of equity holdings as of 31 December 2012 shows 273 Canadian holdings, more even than the 239 in the broadest ETF, the iShares S&P / TSX Capped Composite Index Fund (TSX: XIC). Individual investors in an ETF will own several decimal places less of the total market but the idea can be the same.

Equities provide most of the return not bonds

Another key belief is that equities, albeit riskier, will provide more return over the long run than fixed income. GPFG's policy is to allocate 60% to equities and 40% to fixed income. The fixed income is 99% investment grade (rated BBB- or better), lower yielding but safer. Up to 2007, the allocation to equities was only 40%, but was then increased to 60%. This allows GPFG to more confidently pursue its 4% long term real return objective.

The investment policy allows Real estate to form up to 5% of the total asset allocation, taken out of fixed income's 40% target. Individual investors can take away the idea that a diversified balanced asset allocation works well.

Slow evolution of investment policy
Another idea that individual investors can apply from GPFG's example is that its investment policy has evolved very slowly, as the chart below from the Chambers paper shows. GPFG is only now dipping its toe into Real estate despite a policy change dating back to 2008 - the share today is only 0.9% of the portfolio, well below its allowed target. The decision to shift upwards from 40% to 60% allocation took nine years. The GPFG has a lot of studies on its website on other possible investment strategy changes, such as tilts to small caps and value stocks, but it is moving slowly to implement them. The deliberateness helps ensure the strategy is followed, especially in times of market turmoil. Once a good basic strategy is in place, the idea of thinking twice and making changes slowly is a sensible example for us all.

(click on image to enlarge)

Leverage avoided

Though its policy allows up to 5% leverage, GPFG currently has none. The idea of trying to boost returns by leverage is shunned. If the GPFG can achieve a 4% real return without leverage, why should individual investors bother?

Volatility and tracking error help manage "stay the course risk"

The GPFG belongs to all the people of Norway and the arm of the central bank that manages the fund makes a lot of information available. High transparency is an explicit aim and that allows deep public scutiny. During the 2008 financial crisis, GPFG under-performed both its equity and fixed income benchmarks by quite a bit, which caused much public criticism. The public debate that included proposals to de-risk the fund's strategy took some time. Meanwhile, the GPFG kept to its asset allocation policy, including rebalancing, and by the end of 2009 it had recouped all its losses and kept going strongly in 2010.

The immediate public pressure was relieved, but a key lesson came out of this that is highly applicable to individual investors. Setting reasonable expectations is a critical step to being able to keep to a plan - knowing how much the total portfolio could drop (it was down 23.3% in 2008) despite diversification and a sound conservative plan; investing in markets entails facing volatility and the more every investor, whether Norwegian or Canadian DIY online investor, recognizes it, the less likely panic reactions and selling out at the worst time will occur. Surprises, especially nasty surprises, cause extreme irrational reactions. The GPFG publishes its quarterly estimate (see slide 10 of the latest 3Q2013 quarterly report here) of how much the fund value could vary within the next year).

Investing to a benchmark is another clever and effective technique for controlling bad reactions - if everything is down and one's own portfolio is down the same, the pain is a lot less - misery loves company. For an individual, investing in a broad market ETF means doing no worse than the average and that means plenty of company.

Part of the reasonable expectations should be the fact that a 4% return is to be achieved over the long term, not each and every year. There will be considerable ups and downs quarter to quarter and year to year, even for a balanced fund like GPFG, as slide 8 of the same quarterly report shows.

Rebalancing is an essential discipline

A big part of the reason that the GPFG bounced back so quickly is that it followed its rebalancing policy, which sets a limit of +/- 4% from the policy targets of 60% equity, 40% fixed income. Such a policy-spurred rebalancing has happened only twice since 2002. One of the fund manager's research notes shows that the rebalancing policy boosted returns. The constant inflow of new oil money added to the under-weight asset class, just like an individual investor would do with contributions to his/her account, allows regular small-scale rebalancing. In other words, an easy to monitor, simple, mechanical rebalancing policy works quite well.

No currency hedging

The GPFG does more or less zero hedging of the currency fluctuations of its vast portfolio, 100% of which is foreign. The exposure to the variation of 35 international currencies against the Norwegian kroner at different times boosts, or reduces returns, as this chart image taken from the 3Q2013 quarterly report shows where the light blue kroner rate changes in each quarter vary between positive and negative.

If an investor has a well diversified portfolio with exposure to many currencies and is willing to withstand more short-term volatility, perhaps it is not necessary to buy currency-hedged ETFs.

Low costs are key

A critical part of the strategy to obtain the market return is to not have it eaten away by costs and fees. The GPFG is managed almost entirely internally, while individual investors must use funds to gain broad diversification, but the fund puts great emphasis on keeping its costs as low as possible, achieving 0.09% management costs since 1998. There is more than $2 billion managed by each employee on average. When searching for funds, we investors should always look favorably towards lower MERs.

Environmental, social and governance aspects are integral to investment decision-making

Though it is mainly the public will of ultimate owners Norwegians imposed through the political process that accounts for the GPFG's active consideration of ESG factors, the professional fund managers believe paying explicit attention to six key areas of ESG will enhance long run fund performance. GPFG managers are active shareholders, not only voting at annual meetings of companies but also lobbying them to make improvements and changes. It is possible and likely financially worthwhile (see references in links below) for an individual investor also to factor in ESG, either through ETFs based on these factors, or to do this directly for separate companies, as we have explored with REITs, consumer-facing firms, oil and gas and mining companies.

A caveat with ESG is that everyone may not always agree on what constitutes good/bad behaviour. The GPFG has only a handful of companies it excludes from its portfolios due to bad behaviour. Two of that tiny (52 companies worldwide) shunned minority happen to be Canadian mining companies we have examined in the last few weeks and found to be quite pro-active in implementing ESG - Barrick Gold and Potash Corp! Yet both these figure in multiple "ESG best" lists and Potash Corp is even part of the iShares Jantzi ETF (TSX: XEN) selected for ESG superiority.

Implementing these ideas

How to create a simple written Investment Policy
Some Simple Portfolios we reviewed, some even simpler Single Fund Portfolios reviewed by Globe writer Rob Carrick or in our One-Stop Investing post

Investing in equities that meet ESG / SRI criteria is well established in Canada. Investors can pick from a reasonable smattering of mutual funds and ETFs, or pick out companies that either rate better than others (e.g. our posts on mining companies, oil and gas producers, and consumer stocks). Beyond companies that adhere to a higher standard, it is possible to choose those that specifically provide products or services directly benefiting the environment e.g. see the 118 TSX Clean Technology index members. But equity capital is not the only way to invest.

Fixed income investment - buying the debt issued by such companies - is an option too. In some cases, the lending is tied to a project with specific environmental benefits and they are called Green bonds. Such bonds are mainly from companies in transport (rail, electric vehicles, mass transport) and energy (renewables like hydro, solar and wind) with a tiny portion in forestry. As with all debt, holders take precedence in getting paid before equity holders receive dividends so the investor has greater security. Yields from Green bonds will be in line with their credit rating.

TD Economics' 1st November report Green Bonds: Victory Bonds for the Environment gives an overview of what's happening with Green debt, as do Sustainable Prosperity's June 2012 briefing, ClimateBonds.net's Bonds and Climate Change: The State of the Market in 2013 and their joint Canadian update of September 2013.

Worldwide Market - US Dollar, Euro, Pound Sterling Bonds
Most of the Green bonds in existence have been issued by large international financing institutions such as the World Bank (rated an ultra-secure AAA), which lists its Green bonds here, the European Investment Bank, the International Finance Corp, the Kommunalbanken AS, the African Development Bank, the European Bank for Reconstruction & Development, the Asian Development Bank and the Nordic Investment Bank. The main currencies of issuance have been US Dollars, Euros and Pound Sterling.

Discount brokers such as TD Direct Investing and BMO InvestorLine at the moment unfortunately do not appear to hold any bond inventory of these big international issuers. It may be possible to phone the broker's bond desk and ask them to find such bonds but since Canadian discount brokers deal only with Canadian and US dollars we should only expect to get USD bonds, if any.

Canadian Dollar Bonds and Debentures
A better bet, though still likely hard to find, is to buy bonds issued in Canadian dollars on the Canadian market. In Canada, the Green bond market is still in the early stages, so there's not much available yet. The main issuers and issues on the market include the following. Most are investment grade, meaning that they are rated BBB or higher by ratings agency DBRS.

The biggest issuer (per this report) is apparently Brookfield Renewable Energy Partners (DBRS Credit rating BBB). The company builds and operates hydro power, primarily and some wind power plants. Issues include: five medium term notes maturing in 2016, 2018, 2020, 2022, 2036; long term in 2053
The two national railways since rail is such a low-carbon transport method: CN Railway (rated A low). Morningstar has a handy list of its bonds here. Canadian Pacific Railway (rated BBB low) lists its long term debt on page 104 of the 2012 Annual Report. Note that ClimateBonds.net in its list of Green bond issuers includes CNR but excludes CPR for unspecified reasons.
Northland Power produces electricity from biomass, solar, wind and hydro sources. Most of its debt appears to be privately placed and is unlikely to come on the market. It has issued convertible subordinated debentures (that can be exchanged for common shares under certain conditions - see p.32 of the Annual Information Form) that are traded on the TSX under symbol NPI.DB.A. This debt is not credit rated.
St Clair Holding Inc (rated BBB) operates a solar energy site near Sarnia in Ontario. The facility was bought in 2012 by NextEra Energy, whose renewable energy portfolio is about a quarter nuclear, which may not fit some people's definition of environmentally friendly. Does a bond dedicated to a solar facility still qualify as Green? It's up to each individual investor decide. The $175 million bond matures in 2031
Canadian Hydro Developers was acquired by TransAlta (rated BBB) and relaunched as TransAlta Renewables (TSX: RNW) in mid 2013 with a mix of wind and hydro power assets added from TransAlta's other assets - see investor presentation here. TransAlta retained 80% ownership.
Newalta Corporation provides industrial waste management services (rated BB high, one level below investment grade)
Boralex is a producer of all types of renewable power, except nuclear (not rated)
Run of River Power, operates hydro power (not rated)
Innergex Renewable produces hydro, wind and solar power. It also has convertible subordinated debentures traded on the TSX as INE.DB (rated BB high, one level below investment grade)
New Flyer Industries makes buses. It's USD denominated convertible debentures mature in 2017 and trade on the TSX under symbol NFI.DB.U
Capstone Infrastructure, which acquired Sprott Power Corp a few months ago, is another renewable power generation company. It has one small bond maturing 2016.
Millar Western Forest Products has a callable bond with an 8.5% coupon maturing April 01 2021 (not rated)

A future possibility is that the Ontario Government (rated AA low) has just proposed to issue green bonds in 2014 to fund mass transit projects in the province.

Brookfield, CNR and CP Railway bonds should be the easiest to find; they will be listed in the fixed income section at discount brokers. The Northland, Innergex and New Flyer debentures are readily available through the equity trading section. Other debt issues in the list are likely to be difficult to find. Though the debentures are debt and pay interest the fact that they are convertible into common equity is the reason they are traded on the stock market.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

It is standard best practice for a professional financial advisor to understand a client's risk tolerance. Since we, as DIY investors, have to be our own financial and investment advisor, that means we should be able to understand our own risk tolerance and apply the knowledge to achieve the same result. The desired end result is simply an investment portfolio that best suits our financial goals. A critical part of building an investment portfolio is to decide on an asset allocation, the mix of domestic and foreign stocks, bonds, GICs, cash (T-Bills or money market funds), real estate, commodities (gold or other) and risk tolerance plays an important role in that process. So how does risk tolerance fit in and contribute?

Risk tolerance vs Risk capacity vs Risk perception
A) Risk tolerance is an attitude, the preference a person has towards the balance between the chances of loss against potential gain. It is a psychological trait that is quite stable through a person's life, generally set by early adulthood, though it can change as a result of major life events, or evolve through the years, for example, as people get older their risk tolerance tends to decline. Everyone is different. Men tend to be more risk takers than women. Couples need to recognize that they are likely not to have the same attitude towards financial risk. Finding out differences and coming to an accommodation ahead of time within a couple will avoid strife down the road under the pressure of events. That's surely a big benefit on its own of obtaining a reliable measure of risk tolerance.

The people of some countries are more risk averse than others - apparently, Australians are more willing to take on financial risk than Americans who are more willing than the British, according to FinaMetrica in On the Stability of Risk Tolerance, which has collected hundreds of thousands of standardized surveys across these these countries. Another interesting point is that risk tolerance can differ markedly for a person towards physical, social, ethical, health and financial matters. The physical dare-devil might be a financial wimp, or vice versa.

The key result of matching risk tolerance with an eventual portfolio structure is that the investor should be comfortable with the portfolio. When the portfolio varies with market events there is less chance of a bad reaction when the portfolio behaves according to its matching risk level. The bad reaction can consist of emotional turmoil or it can consist of hasty ill-timed actions such as the notorious example of selling out after a temporary market plunge. However, as FinaMetrica note in their document on how to interpret the results of their risk tolerance survey, there is not an automatic consistency between the way someone reacts to an actual bad event, which they call "loss tolerance", and the risk he/she was willing to take.

B) Risk capacity measures the ability of a person to withstand negative outcomes before a person's standard of living is materially affected. It measures facts, most typically:

Time horizon (the longer before you need income or the capital back the higher the risk capacity),
Wealth (the greater your assets, the more you can lose before it hurts)
Other Income (again the higher this is, the greater the risk capacity)

The UK regulatory body, the Financial Services Authority, says in its publication Guidance Consultation Assessing Suitability, that it is important to measure risk tolerance separately from risk capacity. Otherwise it is impossible to know which aspect is being measured. Part of the job is to compare and reconcile risk tolerance and risk capacity. Lots of tolerance with low capacity is a big danger while low tolerance and high capacity means missed opportunity e.g. the opportunity to earn higher returns and a better lifestyle in retirement or a greater legacy to leave behind.

C) Risk perception is the conception a person has of the actual risk with regard to different types of investments. Perception can change a lot through time and it may change quickly in contrast to true risk tolerance. The tendency of investors' mood to track rising and falling equity indices is sometimes termed changing risk tolerance but the re-interpretation, in the face of the stability of real risk tolerance, is that such tracking is due to changing perception of market place risk. In rising markets, people begin to feel there is less risk. For an instructive discussion of the difference, see this post on leading retirement researcher Wade Pfau's blog. The antidote to mistaken ideas of risk for all investors:

Investment Knowledge (being aware of past market history and how much and what kinds of risk there is in various asset classes, which this blog tries to address constantly and through specific posts such as this series of risk posts in July 2011)

Figuring Out Your Own Risk Tolerance

While we may have a general idea of our own financial risk tolerance, in order to compare it in any organized way with risk capacity and the portfolio options that are likely to produce required returns to meet financial goals, it is necessary to put numbers to risk tolerance. The way to do it is through a rated questionnaire. Taking into account the comments on best practices by the UK's Financial Services Authority, who examined and found wanting many questionnaires, there aren't many good choices. Two we found are:

FinaMetrica - self-administered online version (evidently the same questions as the pricier version for use in volume by advisors), along with the user guide that shows the mapping to portfolio asset allocation ranges and a Risk and Return Guide for various portfolios oriented to Canadian investors that itself has links to the historical results for the various portfolios. The company actually has posted the questions for various countries as a downloadable pdf on this page but of course you don't get the scoring and interpreted results. There is a $45 charge to fill out the questionnaire and get the results, all in about 20 minutes, but it can be worth it to get the greater output detail compared to the free Oxford questionnaire. It has 25 questions. Part of the output report looks like this -

Oxford Risk - developed by the University of Oxford, it is free here on the Standard Life website; it has 10 questions and takes only a couple of minutes to complete. The entire output looks like this -

This blogger filled in both questionnaires (paying the $45 for the former) as honestly as possible for myself and found they gave the same results (a bit above the middle risk tolerance), which is encouragingly as it should be if they work properly. Other free online questionnaires we found did not give the same results. The questionnaires with erratic results all seemed to violate the Financial Service Authority's best practices by confounding risk tolerance with capacity, or by being ambiguous asking several questions at once which left a feeling that no answer could be right for some questions. Such short and easy questionnaire tools would seem to be an obvious thing to do to make a significant step towards investing peace of mind, though not assured success, by proper alignment between one's inner attitudes and investing activity.

There are other questionnaires that measure risk capacity. Next week, we'll have a look at those to find the good ones.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Last week's post on risk tolerance mentioned that an investor's own financial situation can create more or less leeway to withstand the bad effects of poor investing results without permanent catastrophic harm, a feature we called risk capacity. We promised to look at what exists online to help an investor assess his/her own risk capacity, so here we go. The ultimate goal is to find the best investing strategy, specifically the mix of different types of investments, asset classes like cash / Treasury Bills, domestic or foreign equities, corporate or government bonds, REITs, or commodities, to combine into an asset allocation for the portfolio.

Risk Capacity - the key aspects

Time Horizon(s) - The longer before you need any or all of the money, the higher your risk capacity. Equities have historically on occasion gone through long periods of ten or fifteen years being underwater following market collapses. It is a big plus to not be obliged to cash in equities after a horrible down year such as the 40% 1973 dive of the TSX Composite and to be able to wait through the six year recovery period ( as bad as it was, the 2008 crash was only 34% and a mere two year recovery). Recognizing different time horizons for different goals e.g. house purchase in five years, university education in 18 years and retirement starting in 30 years pulls risk capacity in different directions. Tools or questionnaires that recognize such circumstances will produce a truer assessment. Some questionnaires ask too ambiguously about "when the money is needed back". It's not necessarily all or none - in retirement, one may turn an RRSP into a RRIF and withdraw small amounts to spend while continuing to seek some growth.
Wealth - No doubt the world's richest investor Warren Buffett has little need to hold bonds or T-Bills to protect his modest lifestyle in case of a stock market decline. Conversely for someone with no other savings, a $1000 decline in a $10,000 portfolio verges on calamity. The more you have, the more you can put afford to put at stake, or as is often said, afford to lose. It's net worth, after deduction of debts, that is the relevant figure. Having to continue making payments on debt like a mortgage but not needing to count on the investment portfolio to provide cash is one reason we often hear the advice to always hold three to six months emergency cash reserves.
Other Income & Human capital - Economists call our lifetime earning power human capital. The higher your non-investment sources of income like salary the more likely it is there is a surplus or savings that buffers against any need to liquidate investments in a down market. Of course it is possible to use up any amount of income with too lavish a lifestyle, which is why some questionnaires go a step further and ask about your current savings rate. The other important aspect of the other income is how stable it is. A tenured professor has great job security while teachers and civil servants rate high as well but a commission salesperson or an hourly paid worker in a cyclical industry has a much less secure and reliable income stream. Professor and author Moshe Milevsky elaborates on the investing consequences in his book Are You a Stock or a Bond? (yes he does rate himself a bond) A secure income is equivalent to bond income while the less secure among us are the stocks. Given the huge proportion of almost everyone's personal lifetime income that comes from work earnings, factoring in your job to the decision of how to structure your investment portfolio, is a critical step. How much time you have left to earn makes a big difference too. Many questionnaires will therefore ask about your age and/or time before retirement. Some questionnaires will also use age to draw conclusions about time horizon though that is not the best way to do it. Salary is not the only possible source of other income. Canadians have access to Canada Pension Plan and Old Age Security payments after retirement. Some fortunate workers may be part of a solid defined benefit pension plan. Owning rental properties is yet another source. All these sources serve to increase the capacity to withstand bad effects when investment risk happens.

Figuring Out Your Own Risk Capacity
Questionnaires combine risk attitude and capacity - Unlike the questionnaires devoted only to risk attitude/tolerance, there are no questionnaires for risk capacity alone. Even the better questionnaires on risk capacity that we found all mix in risk attitude and some risk perception as well. It is therefore more difficult to discover any marked divergence between risk attitude and capacity, which is what we want to find out in order to think about and reconcile the two.

Index Fund Advisor Risk Capacity Survey - These US-based fund managers offer a short 5-question survey and a more complete 25-question long survey. It is well worth the extra few minutes answering the 25 question version. At the end, there is a question by question explanation of what your answer means, along with links to other parts of their website with in-depth explanations on the topic. An extract image of part of a sample output is below. The survey concludes with an overall stock vs bond recommended allocation. This is the best and most detailed questionnaire we found.

Mulberry Chartered Risk Profile and Capacity for Loss Questionnaire - This questionnaire is also only in pdf form so one must manually total the score for the 11 questions. Five questions address capacity and six risk attitude. It is meant for use by an advisor with a client so we have to do the usual DIY thing and be our own advisor to draw our own conclusions. Its unique feature is that it rates your capacity for loss separately, on a scale from Low to High.

BMO Insurance Investor Profile Questionnaire - Of the 11 questions, five relate to risk capacity, two to investing goals and the others to risk attitude. The questionnaire is only in pdf form so one must manually add up the score. The slots the investor into one of four types of portfolio - Conservative, Balanced, Growth or Aggressive, but no asset allocation recommendation is given. On this questionnaire we found that the risk capacity sub-total did not align with the risk attitude sub-total. The risk attitude questions seemed constructed in a way that caused our own answers to skew much higher than they should.

Vanguard Investor Questionnaire (USA) - Though Vanguard now has a Canadian arm, the website is not as extensive as the original one in the USA and it does not have a risk profile questionnaire. The US questionnaire consists of 11 questions only, half of which are devoted to risk attitude and the other half to risk capacity. The total score leads to one of nine possible recommended proportions of stocks and bonds, ranging from 100% stocks to 100% bonds. The scoring scheme puts enormous weight on the time left before beginning to withdraw income. There is no explanation of results.

Try all of them and look for consistent results - Rather than rely on any one of them, the thirty minutes or so that it will take to fill them all in lets us see how consistent the results are. Obviously, the more consistent the better since that means the various question wordings don't skew the answers and we can be more confident of being shown the right track.

Risk capacity should align with risk attitude - It's a bit more work to do since we must add up the sub-total score for the capacity questions alone but that gives us the ability to examine the all-important match-up between risk tolerance / attitude and capacity. Compare the capacity result with the tolerance answers from the FinaMetrica and Oxford questionnaires that we wrote about in last week's post. That will go a long ways towards reducing the divergence between what the questionnaires recommend and what investors end up doing. It's an important potential failing of such questionnaires, as Preet Banerjee recently wrote in the Globe and Mail.

When this blogger did a personal comparison with last week's risk attitude questionnaire results, we generally did find convergence towards a 60% stock / 40% bond portfolio. But that is only our personal results for our own situation so every investor should do his/her own.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Risk is always part of investing but how much do you actually need to take? The last component of any investor's risk profile to go along with risk tolerance /attitude and risk capacity is the need to take risk. The illustration below from Vanguard's booklet Investment risk and financial advice shows that all three elements need to be accommodated and in sync.

Trade-offs must be made - Before addressing the question of how to figure out how much risk to take, we must widen the context a bit more to the other key variables about which the investor can make decisions and trade-offs. The diagram below by Rob Brown in Risk Tolerance Questionnaire Failure sums it up - choosing more of one element means more or less of one or more others.

He defines the six inter-twined elements as: 1) Spending - how much is desired / needed to be spent i.e. the financial goal; 2) Savings - how much is to be saved; 3) Timing - when is the spending or savings to occur; 4) Risk - how volatile is the investment portfolio; 5) Legacy - how much is to be left to heirs or a charity and 6) Surety - how certain of the outcome does one want to be. We believe that this diagram could be simplified since Legacy is just another form of spending and Surety is just a net result of all the various risks attached to investing, including volatility and many others. However, the principle remains the same and is very useful for making decisions.

No Single Optimal Solution - The key point is that a person must make trade-offs - a lower spending goal or a higher savings rate means less necessity to take on risk, or deferring a goal, such as delaying retirement, can mean less need for risk too. The result is that there is no cut and dried single optimal arrangement for any investor overall, or even any single goal and no single best portfolio allocation either. There are choices to be made.

Take on only as much risk as you need - It is simple and perhaps blindingly obvious to many readers but why should anyone invest in a portfolio that is riskier than need be? If a high savings rate is joined to modest spending plans, it may be possible to achieve those goals investing in tried and true GICs. Why bother with anything else if that is the case? On the other hand, ambitious spending goals with limited savings may require a very high rate of return, perhaps unrealistically high, and a portfolio whose chances of disappointing are high as well. How does one know what is realistic?

The past as an indicator of the future - Though past investment history is not at all guaranteed to repeat, it can be a very useful guide, especially in seeing the contrast between performance of different portfolio allocations over different time periods, varying through good or poor economic growth, high or low inflation, rising or falling interest rates, wars, recessions and the like. Fortunately, there are several free online resources that allow us to see what happened in the past.
1) FinaMetrica's Investment Risk and Return Guide and Reports for Canada - The Guide gives the breakdown of 11 portfolios ranging from Very Conservative to High Growth, containing a progressive mix of cash, two types of bonds and three types of stocks. The portfolios are realistic and could be purchased today using index ETFs. The downloadable pdf Reports of five pages for each portfolio describes investment outcomes in very informative tables and charts that really gives a sense of the risk involved for the data period covered of 1973 to 2012. An interesting unique feature is that the reports compare portfolio performance to GICs. Below is a sample image of some of what appears in the report for Portfolio 7 (60% equity, 40% fixed income). The 10-year result for an investment starting in 1973 was decidedly disappointing compared even to one starting in 2003. Recall that inflation raged in the 1970s and the bond holdings took a big hit. Do we want to bet that inflation will remain under control and interest rates won't rise a lot, which would again hit bonds hard?

2) StingyInvestor's Asset Mixer - This is an interactive tool that lets anyone enter their own portfolio allocation and time period, the year coverage varying from 1970, for the majority, to as late as 1992 for real return bonds (when they first came to market). It allows the investor to enter a pseudo-MER, in the "alpha" input cell, in contrast to FinaMetrica which used pure index data i.e. no return deduction for management fees and expenses. The results can also be shown in real after-inflation, or nominal terms. Unfortunately, there isn't a box to enter an annual contribution in the model, only an annual withdrawal, which will be useful for those looking at a post-retirement scenario. A screenshot of part of the results for an almost identical 60/40 portfolio to the FinaMetrica Portfolio 7 is below. An investor who had stayed invested for 40 years while rebalancing annually along the way would have done quite well.

3) Index Fund Advisors Index Calculator - This calculator is also inter-active and allows entering an initial lump sum or annual contributions, or withdrawals, and varying time periods, going all the way back to 1928. The IFA tool shows US data for US investors only but since Canada often parallels US markets, though not year by year, over the long term it has experienced close to the same growth. The screen image of the output for a roughly similar (the individual asset classes would be US-oriented) 60% equity 40% fixed income portfolio shows about the same total growth over 1973 to 2012. It's interesting that the US investor's portfolio dropped 28% in 2008, while the Canadian version, according to the Stingy output about, only fell 14%. Recall that during the crisis, the Canadian dollar fell sharply as the safe haven US dollar rose, thereby much limiting the drop in value of US assets when translated to Canadian dollars. Diversification helped!

By experimenting with different asset allocations, initial investment lump sums, savings/contribution rates and withdrawal rates, it's possible to work towards those trade-offs mentioned above. Those who are approaching a crucial point like a retirement date can contemplate what effect another worst case year could have and decide whether a recovery lasting a likely two years (2008 US investor) or seven years (1973 Canadian investor) would cause irreparable financial or emotional harm.

For the future, a big question is whether rates of return will at least match those of the past, or more precisely which past - the boom after 1983 or the decade after 1973 when every portfolio and even T-Bills gained almost zero return in real terms. To see what difference a lower rate of return would make to end values, try a lower than historic growth percentage in a simple calculator such as GetSmarterAboutMoney's RRSP Savings Calculator.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Investors with real estate holdings (REITs) have been feeling the pain of downside through the past year. While the overall Toronto stock market has moved higher, real estate has fallen quite noticeably. The Yahoo chart below shows the price movement of the three Canadian ETFs that track real estate - iShares S&P / TSX Capped REIT Index Fund (TSX symbol: XRE), BMO Equal Weight REITs Index ETF (ZRE) and Vanguard FTSE Canadian Capped REIT Index ETF (VRE) - against the benchmark for stocks - iShares S&P/TSX 60 Index ETF (XIU).

Performance is not quite so bad on a total return basis once distributions are added back to the above price chart but it is still negative. Why? What bad event has affected REITs and what can we as investors expect in future? Is there a buying opportunity?

The primary culprit - a rise in interest rates
REITs are investment vehicles mainly designed to provide steady and relatively high income. As such, they get compared to other income vehicles like bonds. Observe that the big slide downwards for XRE, ZRE and VRE occurred in the spring when interest rates took a leap upwards.

Does that mean if and/or when interest rates rise again REITs will get a further smack? It could be, according to the excellent October 2013 Canadian REITs Monthly report from CIBC (found posted on an Investor Village chat thread where various investors discuss implications - well worth a read). The sharper and faster interest rates rise, the worse the damage. The CIBC analysts estimate that a further 1% rise in the 10-year Government of Canada bond rate could entail an 11 to 12% further drop in REIT prices. That would certainly hurt but the report goes on to point out a lot of positive factors affecting REITs.

Business conditions and operating fundamentals are still favourable for REITs

Demand and supply conditions in the various REIT segments (office, retail, industrial, hotel, apartment, retirement homes) remain positive; there are certainly no big negative changes apparent
Debt refinancing costs at current interest rates are only a threat to increase for REIT's around 2017 and debt loads for most REITs are within prudent bounds
Cash distribution levels look to be sustainable though for many REITs the future will likely see a lower rate of cash distribution increases
REIT yield spreads versus bond alternatives are still high by historical standards and REIT unit share prices seem to be attractively priced; REIT prices appear to have priced-in an expected higher level of bond prices a year from now

Bottom line, it's unlikely there will be a big recovery in REIT prices. But REITs will continue churning out steady income as they were designed to do (and as we saw a few months ago when we compared XRE cash distribution to other sector ETF s and XIU for the past decade).

REIT income has attractive tax qualities

REITs distribute a lot of Return of Capital and Capital Gains. ROC is effectively deferred capital gains (for how this works, see our popular post Return of Capital: Separating the Good from the Bad) and capital gains itself is taxed at half the rate of the ordinary interest income paid by bonds. For holdings in a non-registered taxable account the lower tax rate is a big advantage, as we showed in this post comparing the tax efficiency of various ETFs, including XRE. CIBC's report lists the tax-type breakdown of distributions for individual REITs in 2012 in Exhibit 48, while the distributions tabs for XRE, ZRE and VRE shows the breakdown for every year of each ETF's existence. We can see, especially with XRE which launched in 2002, that ROC and capital gains make up the majority of the income year after year. Note that ROC in a taxable account must be used to reduce the Adjusted Cost Base of the holding and if ever the ACB turns negative, that becomes a capital gain that must be reported and taxed in that year (see a step by step illustration in Appendix 2 of Deloitte's classic 2004 REIT Guide). For an investor in the top marginal tax bracket who may lose half of the income from bond interest to tax, REIT cash distributions can leave significantly more in the pocket than bond cash distributions. The larger REITs are now paying out 4 to 8% cash yields while a bond ETF like iShares DEX Universe Bond ETF (XBB) pays out only 3.2% cash.

Investment options
The easiest and quickest way to buy into Canadian REITs is through the three ETFs we mentioned at the start. The limited universe of REITs in Canada ( for lists of REITs see appendices in the CIBC report, or check a summary by sector in Wikipedia) means there is a lot of overlap in the ETFs but there are appreciable differences in holdings and especially in weightings (see Couch Potato's comparison).

Alternatively, for an investor with enough capital, it is possible to assemble your own basket of REITs by simply buying a piece of each of the biggest ones, much like an ETF. Then again, one can try finding the best value REITs. Certainly the individual REITs have not all gone down this past year by the same amount. Amongst the major REITs, Dundee (D.UN) has fallen the most - a 24.5% one-year price fall and a negative 18.5% total return. Yet it is profitable and its financials look reasonable, except that CIBC expects no growth. A Stockchase thread summarizes what seem to be a mixed bag of analyst opinions on Dundee. Is it a buy? It's hard to tell and more research than we have done here would be required to develop a firmer opinion. Some have even risen in price, like Canadian REIT (REF.UN) up 1.2% in price with 5.0% total return. CIBC gives its ratings in the report but they may not be correct. This recent Globe Investor story suggests that company insiders think REIT are oversold. Opinions abound.

In any case, almost all recommended portfolio allocations beyond the simplest dual stock and bond combination include a 5-10% real estate holding. REITs' excellent diversification qualities by being uncorrelated with stocks (currently close to zero per page 22 of the CIBC report), except at extreme times of financial crisis, justifies that inclusion. Most investors can thus take a long term view, confident that REITs will be around a long time, despite swings of price and interest rates, and rebalance their portfolio when the REIT allocation rises, or in this case perhaps drops, beyond the target limit set by the investor's policy statement.

Disclosure: This blogger owns holdings in most of the major Canadian REITs, including D.UN and REF.UN and BMO's ZRE ETF.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Today we look at an investing question that divides investing and finance heavyweights like Vanguard founder John Bogle, Wharton School professor and best-selling Stocks for the Long Run author Jeremy Siegel, Princeton professor and best-selling A Random Walk Down Wall Street author Burton Malkiel, Boston University professor and standard finance textbook Investments author Zvi Bodie, Nobel winning economist Paul Samuelson and even 2013 Nobel laureate Robert Shiller, amongst many others. The subject of their dispute: whether an investment in stocks gets more or less risky as years invested rises. Surely such a straightforward question should be easy to answer and not subject to disagreement amongst such smart, well-informed people who aren't cynically trying to deceive us. The answer is important to deciding whether it makes sense to invest more in stocks when one's investing time horizon is longer.

Why the disagreement? It seems that much of it arises from differing meanings of risk. So we shall present the arguments and readers can decide which they think is best.

First, we'll point out that the debate is not about owning the stock of a single company. Companies regularly do go belly up and short term success can turn into total failure and loss of capital and most companies have a relatively short life (and it's been getting much shorter). Rather the debate is about owning a widely diversified index of stocks, such as the TSX Composite in Canada or the S&P 500 in the USA, where the losers like Nortel continually disappear and get replaced by new vigorous upstarts. Owners of iShares S&P TSX Capped Composite ETF (TSX symbol: XIC) or SPDR S&P 500 Trust ETF (NYSE: SPY) may not even notice, and probably don't care, about any of the hundreds of component holdings inside. It's what happens to the ETF over longer and longer runs that matters.

Less risky (Siegel, Malkiel, Bogle)
The justification: History tells us that the longer the holding time period, on a basis of real/inflation-adjusted, buy and hold, total return/ reinvest dividends,
i) the lower is the range of minimum to maximum returns,
ii) the lower is the chance of making a loss,
iii) the progressively smaller is the maximum negative return, turning into a progressively larger positive return.

The chart below, from Siegel's 4th edition (the 5th, updated for data through the recent financial crisis, is to be released in January), shows the numbers from 1802 to 2006 for the USA

Beyond about 17 years holding period according to Siegel, stocks never had a negative holding period return while both bonds and T-Bills did due to high inflation at certain times. Through all this time period, stocks earned an average compound real 6.5% total return following a trend line where some years of deviation above or below meant going the other direction eventually.

It is possible to slice and dice the data differently, for example by starting and ending in a month/year combination (see the IFA Index Calculator and pick S&P 500 in the IFA Index drop-down menu of box 1) rather than the calendar year ends that Siegel uses. Unfortunately IFA doesn't have bond and T-Bill data. But it does have S&P 500 through the financial crisis data up to 2013. The numbers for time periods will vary but the same patterns emerge. An investor in the S&P 500 who had bought 15 years before in 1984 and sold out in panic at the bottom of the credit crisis in March 2009 would still have realized a 3.33% annual compound return.

Start in 2008 and end in March 2013 through the lost decade of the 2000s and the investor would have realized a puny but positive 1.79% compound annual return.

The big questions regarding this argument:

USA stocks have done better than almost every other country over the long term (as can be seen in the Credit Suisse Global Investment Returns Yearbook 2013). Will the future be like the past and that success continue long enough for present-day investors not to worry that all hegemonies eventually end? Could the USA go the route of Japan, whose stocks lost 2/3 of their value in the 13 years between 1989 and 2002 (Global Financial Data Inc describes the wild ride of Japanese stocks through the 20th century). It would be foolhardy to try to assert certainty so stocks can never not be risky in this sense.
Canada has achieved similar though slightly lower long term compound real stock returns than the USA per Credit Suisse at 5.7%, well above the world average of 5.0%. However, there is no Canadian Jeremy Siegel to have provided the detail for this country. Are we another "lucky country"?

More risky (Bodie, Samuelson, Shiller)

Justification #1: The spread of possible ending dollar values gets wider, not narrower, with time. Though the probability of loss may decline and the possible range of rates of return may lessen, the effects of compounding over longer time periods means that the investor faces a broadening fan of ending total dollars accumulated. In the more technical language of a popularized explanation by Northwestern University professor John Norstad, "The standard deviation of the total continuously compounded returns increases in proportion to the square root of the time horizon. Thus, for example, a 16 year investment is 4 times as uncertain as a 1 year investment if we measure "uncertainty" as standard deviation of continuously compounded total return". The theoretical chart he posts is this:

... and a chart published by FinaMetrica from the real world of the widening spread up to 120 months/10 years holding period in Australian stocks (which over the long term bested the USA compound stock returns). Note that after ten years the worst outcome would have seen a real loss, though the amount lessened progressively from 24 through 120 months holding period just like Siegel's US chart.

So the argument is that if stocks behave as they have in the past, stocks are "risky" because holding on for 15+ years means a widening difference between a more and more decent amount of money and filthy to obscenely rich.

Justification #2: Stocks may have lengthy episodes of underperforming bonds or T-Bills. It's true and we have just lived through such a period. The Credit Suisse Yearbook tells us that for the 12 years between 2000 and 2012 in Canada, the TSX underperformed long term government bonds by 3.2% real return annually. However, the TSX did provide a 3.4% positive return per year. Again, it's a case of well off vs really well off. If possibly not keeping up with the Joneses is your measure of a bad outcome, then stocks are indeed risky.

We also note, that starting at ten years holding period, in the chart from Siegel the worst return of stocks at -4.1% turned out better than the worst return of both bonds (long term US government bonds) at -5.4% and US Treasury T-Bills at -5.1%. An investor lost less money with stocks than supposedly safe T-Bills.

Justification #3: The distribution of possible stock values from year to year varies more and more the longer the holding period. The idea here is that market declines any time during the holding period, not just at the end, may matter. Mark Kritzman has highlighted the fact that the longer you are in the market the more likely your are to be exposed at some point to bigger negative returns. Volatility will manifest itself. He says it matters for institutional investors like foundations whose spending is limited by account value thresholds, financial institutions with reserve requirements or hedge funds with margin limits, or for a homeowner whose mortgage requires him/her to maintain a certain net worth.

A corollary is that your actual holding period may be a lot shorter than the intended holding period. You may panic and sell out much earlier than intended. Apparently, research firm Dalbar has found that the average fund holding period of US investors is only 2.5 years (cited by Jack Duval in The Myth of Time Diversification), which is much less than the 15 to 20 years it took historically to always get a positive return from stocks. As the comic strip Pogo long ago said, "we have met the enemy and he is us". Other bad events that could shorten actual holding period like health problems, job loss, unexpected early retirement, disability mentioned by Duval are challenges that we feel should be addressed by insurance, emergency funds or shorter terms assets like GICs. If your risk tolerance and your risk capacity, or your risk need, are not suited to it, you shouldn't own much stocks.

Justification #4: Famous finance professor theorists tell us so. Paul Samuelson (see summary explanation without the math in Duval's paper) uses utility theory and the possible growing magnitude of loss to come to the conclusion that merely increasing time horizon does not justify an increased portfolio allocation to stocks. The crux of the matter is the same as in Justification #1 - is it possible that stocks will deliver a lengthy string of negative returns creating bigger and bigger losses the longer the holding period, instead of what has happened historically as Siegel documents?

Zvi Bodie used option pricing theory to prove in the paper On the Risk of Stocks in the Long Run, that the risk of stocks increases with time because the cost of insuring against earning less than the risk-free rate goes up with time. There are no options on any stock index extending out to 15 or 20 years that would back up the theory with fact, though there is some evidence with LEAPS going out up to three years that the option price does increase for a longer term. This paper is widely cited and for most seems to be the definitive statement though British actuary David Wilkie, musters plenty of math as he disagrees - "Bodie's conclusion is unambiguously wrong". To perplex us all, Wilkie instead concludes that "The risk of stocks may increase with term, or fall, or rise and fall, or fall and rise, depending on the form of the guarantee and the measure chosen to represent risk".

So there it is, the various arguments for why stocks might be more or less risky in the long run. Take your pick. The situation reminds us of that long past TV commercial now on YouTube which debated whether Certs is a candy mint or a breath mint.

Bottom Line: We believe the proposition that investing in stocks does pay off in the long run. We are optimists, as professors Elroy Dimson, Paul Marsh and Mike Staunton painted the dominance of equities worldwide over more than a hundred years in Triumph of the Optimists. However, we think it worthwhile to be cautious and not to invest exclusively in stocks even with a time horizon of decades. Fixed income and cash-like investments make sense for near term spending or if our time horizon gets shortened unexpectedly. Other asset classes also work well in a portfolio to take advantage of rebalancing when they respond differently to varying economic conditions. Diversifying beyond Canadian and US stocks makes sense too.

Disclosure: At the moment, this blogger's portfolio is about 65% invested in stocks and stock ETFs worldwide.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Last week's post on the riskiness of stocks in the long run highlighted the fact that historically equities have performed very well over long holding periods despite being subject to massive gut-wrenching declines in the short term. Today we'll look more closely at the long run risks that can cause significant permanent loss of capital even to stocks (i.e. no bounce back happens!), as laid out in Deep Risk, William Bernstein's new, very readable, mini book. Importantly for investors, equities, bonds and cash / T-Bills behave differently in response to long term risks, which he calls Deep Risk, than short term risk, which he terms Shallow Risk. It's evident that figuring out our own investment horizon is critical to building a portfolio to cope successfully with the relevant risks.

What is long term?
Bernstein means 30 years or more, a very long time but still well within an investor's lifetime horizon, even a retirement horizon nowadays.

What does he define as risk?
It's not a statistical measure like standard deviation; rather, it's an intuitive yardstick focused on the downside, permanent loss of capital, meaning a negative real after-inflation returns after 30 years. Shallow risk happens when the loss is recovered within a few years, such as the 2008 equity market crash. That's what volatility is and where it fits into the risk picture - a short term drop that is quickly recovered. Deep risk is when there is permanent loss. Finally, the measure of risk includes its magnitude - a small though though permanent loss doesn't matter much. It's losses big enough to be devastating to the investor that matter.

The devastating long term Deep risks and the effect on major asset classes
1) Inflation = Hyper/High 8+% price rises sustained for many years. Low steady inflation such as we have been experiencing in Canada for the past 15+ years, doesn't hurt any of the major asset classes.

Losers: long term bonds, T-Bills
Winners: equities, especially commodity producers, real return bonds

2) Deflation = Sustained economic stagnation with associated falling prices, such as the Great Depression of the 1930s. Bernstein thinks that this particular risk is much less likely today since most episodes of deflation, including the 1930s, happened when the world operated on the gold standard and now central banks can counter deflation by printing money.

Losers: equities
Winners: long term bonds, T-Bills, gold gold (now that's a surprise since the popular image is that gold protects against inflation but he cites data showing that it counters inflation poorly; author and financial analyst James Montier comes to same conclusion in No Silver Bullets in Investing; gold is portrayed as worthwhile insurance for times when investors have lost faith in the government, which is more typical of severe economic depressions)

3) Confiscation = Government takes your money, giving pennies on the dollar for assets, or hikes taxes to levels of expropriation. High debt levels and large growing fiscal deficits of governments are obvious warning signs of possible government desperation that might incite confiscation.

Losers: potentially anything can taken, when governments are desperate, nothing is sacred
Winners: foreign-held assets that your own government cannot grab, such as property; alternatively, leaving for another country that will not confiscate assets can work but it's a drastic measure

4) Devastation = War which destroys capital and people. It's the ultimate bad outcome for an investor. Some forms of worldwide devastation, such as potentially harmful climate change, which he names, or pandemics, may offer no place to hide. In that case, total permanent loss of investments wouldn't matter anyway.

Losers: no assets are safe
Winners: foreign assets if the conflict is localized

Of course, in addition to the severity of harm, the likelihood of the threat must be taken into consideration. The good news is that for Canadians, the most likely threat is inflation. With a central bank ever ready to keep deflation at bay by printing money, with a government financial situation among the best in the world and with a stable civil society offering relative peace, inflation is the prime menace. It too seems to be relatively benign at the moment. So, as investors and as citizens, we have much to be thankful for at this holiday time.

Bernstein's parting words are simple and direct: "This booklet's primary advice regarding risky assets is loud and clear: your best long term defense against deep risk is a globally value-tilted diversified equity portfolio, perhaps spiced up with a small amount of precious metals equity and natural resources producers, TIPS [which are the US version of real return bonds], and if to your taste, bullion and foreign real estate." It's interesting that the TSX Composite index is already quite "spiced up" with a heavy weighting in precious metals and resources producers (11+%, vs only about 3% in the US total equity market), so investors with a broad Canadian equity holding like iShares S&P/TSX Capped Composite Index Fund (TSX symbol: XIC) have that part accomplished naturally. Another reason to count ourselves lucky!

Bottom line
The cautious investor has two main action takeaways from a look at long term risks:
i) Match investment assets and spending liabilities - control risk by matching a) near term spending plans with assets that can easily be cashed and are not subject to volatility, which is the main short term risk (e.g. T-Bills, GICs, money market funds, short duration bonds) and b) longer term spending, like a distant retirement, with assets that cope well with the biggest (impact x probability) long term risk - equities.
ii) Diversify - since most people have multiple investment goals and therefore spending horizons, it makes sense to keep some of the several types of assets.

Merry Christmas to readers!

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Forget gold. Laugh if you wish but wine and whisky can also be considered an investment. In The Price of Wine, professors Elroy Dimson, Peter Rousseau and Christophe Spaenjers recently discovered that top grade French wines (Haut-Brion, Lafite-Rothschild, Latour, Margaux, and Mouton-Rothschild) outperformed government bonds with annualized real returns of 4.1% between 1900 and 2012 as the chart below from the paper shows.

(click to enlarge)

The wine didn't do as well as British equities on a straight financial basis but it seems that there is a non-financial "psychic return" of at least 1% from the pleasure of owning wines. What stock could possibly give the same fun as owning a rare famous vintage?

Note their finding that the highest rates of appreciation were for young high-quality wines that are still maturing. There are plenty of easily-found online websites selling such wines whose prices range upwards from thousands of dollars a bottle. Or we could do like Chinese billionaires who are apparently snapping up whole French chateau vineyards.

Whisky is well on its way to emulating wine as an investment. The single malts of Scotland, produced in limited quantities and flavoured in subtle ways un-reproducible anywhere else in the world have been growing in popularity by leaps and bounds according to the BBC. The very rare and very old bottlings can command enormous prices - witness the record-breaking bottle of Macallan 64 year old, yes ONE bottle, that sold in 2010 for $460,000 US dollars ($490,000 Canadian dollars). That's more than a famously expensive share of Warren Buffett's Berkshire Hathaway stock. It's liquid gold indeed.

The Current Record Holder - Macallan 64 in a Lalique crystal decanter

It's now possible to find mainstream media articles on the best whiskies to buy as an investment, such as this one from Huffington Post. There are even indices of "investment grade scotch", some of them strongly upward sloping, but others showing losses. Popularity and price can be fickle. Another article asks whether the boom can continue. Of course, apart from the usual investment risks, wine and whisky face a very special risk, chillingly demonstrated in this YouTube video about a special bottling apparently owned by none other than Prince William.

Bottom line: Drink, and invest, carefully and responsibly!

Disclosure: This blogger owns several bottles of fine wine and single malt whisky, though they all succumb to that other behavioural investment risk, consuming the profits.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

The Canadian Centre for Policy Alternatives' Hugh Mackenzie has come out with All in a Day's Work? (CEO Pay in Canada) which shows how much the best paid 100 CEOs of Canada's biggest public companies received in 2012. There is no doubt every one of them was paid a lot, but for the investor, whether that was too much or too little depends on how the company has done for the investor. The report doesn't address that issue so this week, we'll look at those companies who we think have over-paid, those combining Top-100 pay with poor returns. We'll also take a look at the fate of companies that were on our previous list two years ago of the most Over-Paid CEOs.

The Eleven Losers - lousy investor bang for CEO bucks
As can be seen in the table below from GlobeInvestor's WatchList, the stock and company performance numbers don't come anywhere near to matching up with the Top-100 pay of their CEOs. Poor total stock returns along with operating or net losses, no dividend growth, low or negative Return on Equity suggest strongly that the CEO did not earn his, or in the case of TransAlta her, high pay.

(click to enlarge image)

The most egregious transgressor has to be Niko Resources (TSX symbol: NKO). While CEO Edward Sampson has been getting rich, investors have been getting poor. Most galling and surprising, Sampson and Niko were also in the most over-paid list two years ago. Niko's latest quarterly income statements on TMX Money show no sign of improvement. Why analysts would even give this stock as much as a Hold rating mystifies us. The stock has followed a steady downward path for years now as the Yahoo Finance chart below shows.

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Blackberry's (TSX: BB, formerly Research in Motion, which is what appears in the Mackenzie report, though the name change hasn't helped the reality) slide has been a painful public spectacle, painful, to be precise, for investors, but not the 2012 CEO Thorsten Heins. Is the high CEO pay compensation for having to endure the frustration of inability to turn the company around? Heins probably did not get all the $10.2 million in 2012 pay since his $9.5 million award in stock would have gone down too. But his 2013 pay will show handsome recompense as he was given a $22 million settlement when he was fired in November. Looks like a classic "heads, I (CEO Heins) win, tails, you (investors) lose".

The gold stock slump has hit a number of companies in our most over-paid list. Some show bad business performance while others are faring better. Barrick Gold Corp, Turquoise Hill Resources, Goldcorp Inc, Detour Gold and Kinross Gold are uniformly bad - poor stock performance and money-losing business results. Agnico-Eagle Mines and Eldorado Gold have experienced lower profits but they are still profitable. The two companies were among the miners who looked like stronger bets in our recent review.

Similarly, EnCana and TransAlta have gone through slumping business income while remaining profitable. Nevertheless, it sure looks like these CEOs, by remaining in the Top 100, are being paid primarily for the size of their empire instead of results.

Though not in our table, another CEO who received far too much in 2012 is Benoit La Salle of gold miner Semafo, whose $4.0 million included a special payment of $3.0 million, which appears to be a good-bye bonus, when he stepped down as CEO in August 2012. That was just before the ensuing series of quarterly results have reported unrelenting large losses.

The 2012 Over-Paid - How things sort themselves out over time
Two years on, the formerly over-paid have mostly found their proper place in a couple of ways:

1) Falling pay drops CEO out of Top-100 - Yellow Media, Nordion, Air Canada and Cott have all reduced their CEO's pay in absolute terms and relative to other companies. For example, Nordion CEO Steven West's pay of $1.2 million in 2012 is much saner than the $13.1 million handed over to the previous CEO in 2010. Interestingly, its stock has done very well in the past year too. Less pay equals better performance?

2) Better company and stock performance - Cameco, Manulife, Sun Life and Magna have all improved since 2010 so that the balance of pay with results is much less out of whack.

Perhaps RONA will attain this status if new CEO Robert Sawyer (since November 2012) does a better job than Robert Dutton, who received a severance package of $4.5 million. There have been big quarterly losses until the most recent quarter along with much restructuring. We won't know how much Sawyer is paid until the Proxy Circular for the next annual meeting is issued around the end of March. Or perhaps RONA will fall into the next category.

3) Still way over-paid - To Niko, we add Sherritt, the shrinking mining company. Sherritt CEO David Pathe's $2.7 million pay in 2012 puts him a fair distance below the #100 spot's pay of $3.8 million and well below former CEO Ian Delaney's $4.2 million 2010 pay. However, the company is now losing money and having to shed assets.

Outlandish CEO pay can be a warning sign for investors as an indicator of a company run by the managers for the managers and not by the Board for the shareholders. It's another tool in the analysis toolbox.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Last week we threw some mud at companies that paid their CEOs handsomely while investors suffered. This week we look at the good side of the ledger for investors, where CEO and top executive pay may have increased but investors did as well or better. We also look back at our similar 2012 list of companies where pay and stock returns aligned well.

Stocks where the investor reward came first
The data covers up to 2012 only since the original source is the Management Proxy Circular that companies must file with regulators and give to shareholders before every annual meeting. 2013 pay data will start to become available as companies file their reports covering 2013 on Sedar. We copied much data from the report All in a Day's Work? (CEO Pay in Canada) by the Canadian Centre for Policy Alternatives' Hugh Mackenzie since he has done all the laborious grunt work of compiling the pay numbers of the 100 best-paid CEOs. However we also decided to widen the search for good companies to all those in the TSX Composite by looking at the Globe and Mail's Report on Business 2013 Board Games table. In particular the table shows 5-year total returns. We picked out the stocks with the highest returns to see which gave the most investor return "bang" for the CEO pay "buck". Finally, we did our own rooting through Sedar.com to find companies where the pay of the top company executives (called Named Executive Officers or NEOs in the Sedar reports), not just that of the CEO, rose less quickly than the total stock return from 2007 to 2012.

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One of the companies in the above list that illustrates what we are looking for is Cineplex. Its Proxy Circular includes the following graph of stock returns rising much faster than executive pay. Four companies, Cott, Keyera, Canadian National Railway and Yamana Gold, managed to achieve a more extreme outcome - excellent stock returns while executive pay declined over the five years.

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Our list of twenty-three stocks that rewarded investors more than CEOs or executives is not exhaustive. But the margin of reward vs pay was getting slimmer as we worked our way down the list of stocks. Note how Thomson Reuters 5-year stock return at 17% barely exceeded the 8% rise in total executive pay over the period. Thomson is also much higher up the relative pay scale in 2nd spot than the returns scale in 114th spot.

Some idea of other stocks that have achieved a reasonable relationship between shareholder return and executive compensation, based on 3-year data instead of our five years, comes from the following chart in the 2013 Magna proxy circular. The best place for a company to be is to the right of and below the middle diagonal line. Some caution is still necessary. For instance, Eldorado looks ok on the chart, being smack in the middle on the line. However, on a 5-year basis executive pay rose an astounding 1193% while the stock only gained 10%.

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The fate of the good companies in our 2012 post - some are still so, others have gone bad
Eight companies have reappeared - shown in green - from our 2012 post of the good guys at that time. Catamaran, Valeant, CGI Group, Pacific Rubiales, Methanex and Open Text have given their executives what look in some cases like lavish pay increases but investor returns have been even higher. Canadian National Railway and Yamana on the other hand have seen their executive pay decline while stock returns have still surpassed the benchmark TSX Composite's modest 4% total gain.

Many of the other companies on our 2012 pay angels list have fallen badly since. Some have gained more than the TSX but executive pay has risen much faster: Osisko (stock +58%, executive pay +235%), Eldorado (+10% vs 1193%), Westport Innovations (+116% vs 231%) and Alamos Gold (+188% vs 253%). Others like Agnico-Eagle Mines (-45% vs +209%) and SNC Lavalin (-19% vs +24%) have drastically under-performed the TSX and executive pay has continued to rise. Sometimes executive pay has fallen but nearly as much as the stock decline, like Potash Corp (-47% vs -24%).

As before, a favourable balance between CEO and executive pay and shareholder reward is a worthwhile but partial indicator of a company that is well managed by the Board of Directors. Repeat appearances on the good guys list reinforce the notion that a company has a durable good culture in place.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Many if not most investors are aware of the fact that eligible Canadian dividends held in a non-registered taxable account are grossed up before inclusion in income. From 2012 onwards, the gross-up on the actual dividend paid has been 38%. There is a sufficiently large offsetting tax credit such that the investor pays a lot less tax on dividends than on interest or employment income (see our post on how the mechanics and reality of dividend taxes work).

But there is a complication for someone over 65 in retirement. The Old Age Security Pension (OAS), an amount up to $6582 paid annually to over 65s meeting Canadian residency requirements (see TaxTips.ca's explanation and Government of Canada info) and the Age Amount tax credit, worth up to $1028 reduction in tax, are progressively reduced the higher is Net Income on line 236 of a tax return. Thus, $1000 of actual dividends is grossed up 38% to $1380, and the dividend tax credit only gets applied lower down in the tax form. Line 236 includes the grossed-up amount of dividends. The gross-up acts as a penalty. Other types of income, like interest and foreign dividends are not grossed up while only half of actual capital gains are included in income of line 236.

Retired investors, or those soon looking to retire, may wonder if they should dump their Canadian dividend stocks and instead buy foreign stocks (whose dividends are not eligible for the tax credit and do not therefore get grossed-up) or perhaps buy interest generating fixed income in a taxable account. Let's address this question.

TaxTips.ca's handy-dandy calculator

We have used the Investment Income Tax Calculator on Taxtips.ca to demonstrate what is a very simple conclusion - dividends are tax-advantaged enough that they are still better than interest or foreign dividend income no matter the province or your tax bracket. There is a loss of Age credit and/or OAS but much less than the extra income tax on interest or foreign income. However, capital gains are almost always the best way to receive income, if that is possible.

We entered the 2013 maximum amounts of CPP and OAS along with combinations of either interest and/or foreign income, which are both taxed at the highest marginal rate of Other Income, or capital gains, or eligible Canadian dividends, plus withdrawals from a RRIF or other pension plan income.

Scenario 1 - Income high enough to trigger reduction in the Age amount tax credit - $51,732

Capital gains and dividends give pretty close results but interest and foreign income incurs significantly more tax. In Alberta, at these more modest income levels, eligible dividends win by a hair.

Scenario 2 - Income that triggers both an Age amount tax credit reduction and OAS clawback - $73,732

Capital gains clearly is best while interest and foreign dividends engender even more tax. The pattern is the same across all provinces.

Scenario 3 - Income high enough to trigger large OAS clawback - $93,732

The bottom line is the same as scenario 2.

Takeaways

There is no tax reason to alter a retirement portfolio away from Canadian equities because of Age Amount tax credit reduction or OAS clawback. If anything the reverse is true. Portfolio asset allocation and account placement of holdings do not need to change.
The conclusions we reached a few years back about the desirability of dividends and capital gains across provinces hold true for retired investors. As the years are passing and TFSA accounts grow larger with piling up the yearly contributions (there is $5500 contribution room again this year bringing the total since 2009 to $31,000), they can form a significant component of tax planning during withdrawal since any TFSA withdrawal doesn't enter taxable income at all.
Some ETFs that are highly tax efficient may be especially attractive to retired investors, though we found out last year that the best type of distribution in tax terms, Return of Capital which doesn't get included in immediate income and is deferred capital gain, may not be so good in certain ETFs.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tax season is starting. The Canada Revenue Agency will soon open up the NETFILE online electronic tax filing service to receive returns electronically. It's time for Canadian investors to start getting ready for filing their 2013 income tax return. There can be a multitude of slips and receipts to assemble, not to mention older records to dig up and preliminary calculations to do in order to be ready in time for filing on or before the deadline of April 30. We therefore present a collection of resources that should cover the tax information and tools needs of Canadian online investors.

Tax-specific Websites

Canada Revenue Agency - the official source, with forms, bulletins, guides, helpful videos like a primer on the filing process, due dates, info on tax credits and deductions to keep in mind when preparing a return, instructions on NETFILE to submit a return electronically with list of approved software; good search tools, FAQs and topic directories
Taxtips.ca - rules, tips, tax rates, federal/provincial budgets, accounts (RRSP, RRIF, TFSA etc), glossary, calculators
Taxes.ca - lists of tax professionals by province and/or city, plus formal accreditations

Key Dates - see complete CRA list of dates for individuals

January – mid	CRA pdf tax forms for printing available for download
February - 10	CRA online filing service NETFILE starts accepting 2013 tax returns; last day is January 16, 2015
March – 3	RRSP contribution – last day for making contribution applicable to 2013 tax year
April – 30	CRA – last day to file 2013 return and pay amounts owing to avoid penalties
June – 15	CRA – last day to file 2013 return for self-employed though amounts owing deadline is still April 30
December – 31	RRSP – last day for making an RRSP contribution in the year you turn 71

continual	CRA issues tax refunds, often within days, if return is filed electronically TFSA contributions anytime during year for 2014 or missed past years since 2009

CRA dates are rigid; be late even by a day and you will miss out or suffer penalties. On the other hand the tax documents below relating to the 2013 tax year flood in progressively from mid-January to the end of March. There can be weeks or more of variation amongst companies that issue the slips and receipts.

Checklist and guide for interest, dividends and capital gains

*If your investing involves …*	*look for these documents …*	*from these organisations ....*

Borrowed money to invest	Investment interest expense	on statements from broker for margin, or bank for loan
Canada Savings Bond interest	T5 slip (min $50 interest)	from broker if held in a broker account or from Bank of Canada if bought directly from BOC;
GIC interest	T5 slip (min $50 interest)	from broker if held in a broker account or from bank or trust company if bought directly
T-Bill and Stripped Bond interest	Annual summary of security transactions	Interest = redemption/sale amount – purchase cost; for details see http://howtoinvestonline.blogspot.co.uk/2011/03/how-to-calculate-interest-and-capital.html T5 does NOT show it, even when over $50 e.g. http://www.rbcds.com/TaxReporting/tax-information-checklist.html
Mutual fund distributions	T3/T5 slips	mailed directly by Mutual fund companies, NOT brokers, even when fund is held in a brokerage account
Mutual fund capital gains (sales)	Annual summary of security transactions	from broker if held in a broker account or, from mutual fund company if held directly with the mutual fund company click on links to fund companies at FundLibrary.com and then look for tax or Distribution info see http://howtoinvestonline.blogspot.co.uk/2009/01/etfs-and-mutual-funds-calculating.html
Bond interest	T5 slip (min $50 income)	broker
Bond capital gain or loss (sale or maturity)	Annual summary of security transactions	broker provides statement at purchase year and at maturity or sale; for how to calculate see http://howtoinvestonline.blogspot.co.uk/2011/03/how-to-calculate-interest-and-capital.html
Stock dividends	T5 slip (min $50 income)	broker
Stock capital gain or loss (sale)	Annual summary of security transactions	broker provides statement at purchase year and at maturity or sale
ETF and REIT distributions	T3/T5 slips	broker
ETF, REIT, Income Trust, Closed End Fund capital gain or loss (sale)	Annual summary of security transactions + own records	broker for trading transaction summary Investor must track own adjusted cost base – see http://howtoinvestonline.blogspot.com/2009/01/etfs-and-mutual-funds-calculating.html ETF providers publish tax breakdown of distributions on their website. ETF providers in Canada list and links at http://www.tmxmoney.com/en/sector_profiles/exchange_traded_funds/funds/funds.html Income Trusts and Closed-End Funds - ACB Tracking Inc has a pay service that simplifies the tracking
Split Corporation income	T5	broker

Checklist and guide for account withdrawals, contributions

*If your investing involves …*	*look for these documents …*	*from these organisations ....*

RRSP contributions	RSP Contribution Receipt	RRSP account trustee, be it broker, bank, mutual fund company
RRSP contribution room	various	see four ways to find out - http://canadaonline.about.com/cs/rrsps/qt/rrsplimit.htm
RRSP / RRIF / LIF / LRIF withdrawals	T4 RRSP / RRIF slip	RRSP/ RRIF account trustee
RRIF / LIF / LRIF withdrawal limits	Evaluation letter or phone call	broker
Annuity payouts	T4A and T5 slips	mailed by insurance companies, both for registered or non-registered annuities
RESP withdrawals	T4A Educational Assistance Payment or Accumulated Income Payment slip	brokers or financial institution where RESP is held
Non-resident taxpayer	NR4 slip	broker
TFSA interest, dividends, capital gains, contributions and withdrawals	none	None – happy days! No tax reporting to do
TFSA contribution room and contribution or withdrawal history	phone call or online	Canada Revenue Agency – see http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/cntrbtn-eng.html

Tax News, Tips and Blogs - to remind us of the latest developments, the implications, the gotchas and possible strategies to legitimately minimize what we pay

Grant Thornton Domestic Tax Service - accounting firm provides tax news with tips for individuals
Ernst & Young Managing Your Personal Taxes 2013-14 - includes 13 pages on investing, plus sections for families and retirement in the 108 page guide
Journalists/ Authors - Tim Cestnick, an accountant, author and columnist (Globe and Mail) who did a series of videos on YouTube starting with episode 1, Jonathan Chevreau (MoneySense), Larry MacDonald (Canadian Business), Canadian Couch Potato, Jim Yih (Retire Happy)
Accountants / Lawyers - Canadian Tax Resource, The Blunt Bean Counter, Estate Debate
Individual Bloggers - Michael James on Money, Canadian Capitalist - gain from their experiences but be aware that they are not professionals and their opinions are just that, not advice, as is the case with this blog

Books - buy them online, read them offline at leisure

Tax Planning for You and Your Family 2014 by KPMG accounting professionals from Carswell Publishers - intermediate level; about a third of the book deals with investment-related topics
Tax Guide for Investment Advisors, 2014 Edition by John R. Mott, also from Carswell - advanced level, dense and detailed; everything most investors would want or need to know, short of becoming an accountant
Many starter-level titles are available at Chapters or Amazon
Canadians Resident Abroad 2014 by Gary Duncan, from Carswell - investments are among tax topics covered for non-residents or the many Canadians who have interests in the USA

Software - to prepare and NETFILE income taxes electronically; the best packages guide you and make suggestions to optimize your taxes

List of CRA-certified programs with links to the companies
Wikipedia - basic details on costs, versions, price, limitations, freebies
CanadianFinancialDIY on the web versions - evaluations and ratings on security, user-friendliness, speed, tax-minimization performance

HowToInvestOnline Tax-related Posts - our most popular and presumably most useful tax posts

Tax Calculators - for tax planning, what if scenarios and estimation

Taxtips.ca Canadian Tax Calculators - a Basic version, an Advanced version for all provinces except Quebec, one for Quebec, with all the tax credits and a special Investment Income version that compares different types of income, especially useful for retirees.
Ernst & Young - ultra-simple, enter your taxable income and it shows you by province total tax (using the basic personal tax credit only) as well as marginal rates on ordinary income/interest, capital gains and dividends; very handy when you have a taxable and tax-sheltered investment accounts to see which types of securities should go in which account
RRIFMetic - sophisticated tool (not free, costs $99) for planning and optimizing for retirement income including taxes on types of accounts (taxable, RRIF, LIF, TFSA, RESP) and types of income (dividends, interest, capital gains) plus factors in non-investment cash flows; helps decide how much to take from which account during retirement.

Tax Discussions - read what other people are grappling with and learn from their experience or register and you can take part, ask questions and perhaps get good answers

Financial Webring Tax Forum - active contributors have banded together to produce finiki, a Canadian financial wiki, which covers tax issues amongst financial and investment planning topics
Canadian Money Forum Tax Thread

These resources will make it easier to pay your taxes quickly with minimal frustration at the very least and probably to pay less as well.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

The ETF market in Canada took another step towards greater competition this month with RBC's launch of five new equity dividend-oriented ETFs, covering Canada, the USA (a US dollar version and a Canadian dollar hedged version) and developed countries (EAFE in both a US dollar and Canadian dollar hedged version). Today we'll compare the ETF for Canadian equities, the RBC Quant Canadian Dividend Leaders ETF (TSX: RCD), which started trading January 15, 2014, with its competitors. We'll also see how these ETFs are faring against each other and the broader Toronto Stock Exchange.

RBC Quant Canadian Dividend Leaders ETF

Our comparison table below shows the numbers that lead us to say that RBC's new ETF has:

Low MER - At 0.39% maximum management fees (it isn't clear from the prospectus whether the cap on fees means only the management fee only or all the fund expenses as well, like legal, administrative, trading etc which, if not capped, might mean MER around 0.45%), this is second lowest to Vanguard's ETF of 0.35%.
Fairly conservative dividend seeking - This ETF does not look to be chasing the highest yielding stocks - e.g. only 2% of its portfolio yields more than 8%. It also has about the same proportion of companies that have cut or not increased their dividend as the TSX, as represented by two market benchmark ETFs, the iShares S&P TSX 60 (TSX: XIU) and the iShares S&P TSX Capped Composite (XIC). However, RCD is not entirely conservative since it has a fairly high proportion of companies with high dividend payouts (more than 90% of cash flow) and with dividends greater than trailing twelve month earnings.
Low individual company concentration - Despite not having an explicit cap on concentration, the portfolio as of now is spread out - the top 10 stocks make up only 31% of the total value of holdings, which is at the low end of the spectrum.
Similar company size to the TSX Composite - It is among the closest of the ETFs to the benchmark XIC in terms of the average market cap of its holdings.
High concentration in financials and energy - Offsetting somewhat the good risk spreading across companies, there is still a somewhat uncomfortably high proportion of 70% of holdings in just two sectors. Only Vanguard's FTSE Canadian High Dividend Yield Index ETF (VDY) has a higher sector concentration.

The other Canadian dividend ETFs

iShares Dow Jones Canada Select Dividend Index Fund (XDV) - still the dominant fund; total assets now stand at $1.42 billion
iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (TSX symbol: CDZ) - still second most popular fund with $937 million in assets
iShares S&P/TSX Equity Income Index Fund (XEI) - also from iShares, it has $156 million in assets
Horizons Dividend ETF (HAL) - 4 years on the market yet still tiny with only $12 million in assets
BMO Canadian Dividend ETF (ZDV) - BMO's version has leapfrogged XEI into 3rd place with $315 million in total assets
First Asset Morningstar Canada Dividend Target 30 Index ETF (DXM) - growing very slowly at $36 million in assets
PowerShares Canadian Dividend Index ETF (PDC) - another laggard since its launch in June 2011 with only $20 million in assets
Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX symbol: VDY) now up to $71 million in assets

Dividend ETFs - Portfolio Characteristics

Dividend ETFs - Performance

Dividend ETF performance is impressive but surprising

Total return out-stripping TSX by a lot - Over the year 2013, all but one (BMO's ZDV) of the dividend ETFs outperformed both the large cap XIU or the Composite XIC, most by 3% to 7%. A lot of the return came from capital gains since the difference in dividend yield was nowhere higher than 2.2% (ZDV's 4.9% vs XIU and XIC's 2.7%). One supposedly dividend fund, Vanguad's VDY, actually yielded less at 2.6%, than the TSX! But its capital gains far outpaced the TSX and it was the highest return fund of all. The dividend ETF return advantage manifested itself consistently for those funds - HAL, XDV and CDZ - with a longer history of 3 or 5 years. This is not just one or two sectors, like financials or energy, doing especially well. XDV achieved the outperformance with a high concentration in financials and energy while CDZ achieved it with a markedly lower concentration in those sectors. We note in passing, though again the time frame is too short to be sure, that these results conform to the general findings about superior returns from dividend stocks that we wrote about last July.
Volatility of dividend ETFs is less than the TSX - The numbers on beta, which measures sensitivity to moves of the overall market where a beta of 1.0 equals the market (i.e. XIC) and under 1.0 is less volatile, show that almost all the dividend ETFs are significantly less volatile than the TSX. The figures on absolute volatility of each ETF as measured by standard deviation of its returns compared to XIU and XIC indicate the same result. The Sharpe Ratio, which measures return over standard deviation, i.e. the higher the ratio the better, shows that most of the dividend ETFs did much better than both benchmarks during 2013. More return, less volatility risk, that's a good place to be, if it keeps up.
Some of ETFs' distribution (aka dividend) increases did not keep pace in 2013 - What surprised us even more is that several dividend ETFs in our list did not increase their cash distributions, because their holdings did not, as much as the benchmark ETFs. XDV, XEI, DXM and PDC had significantly lower distribution rises from 2012 to 2013 than either XIU or XIC.
Long term distributions of XDV and CDZ are rising nicely - Perhaps what is most important for the investor seeking the higher distributions is the possibility that such higher distributions can be maintained in the long run. That seems to be the case so far for the two ETFs with the longest track record as the graph below shows. XDV has maintained its lead over XIU and CDZ, after a big drop in 2010 and 2011 when the big banks fell afoul of CDZ's selection criteria by not increasing dividends, seems to be recovering strongly.

Which Dividend ETF is best?

We still don't like HAL much for its high MER, lack of visibility (it doesn't publish its full holdings) and lower distribution rate, nor VDY which looks more like a value-oriented capital appreciation fund. It's hard to pick amongst the rest - good points of each one are offset by some weak points. ZDV would still be a slightly preferred option for those whose purpose in looking to this kind of ETF is to obtain high steady income. It had the highest trailing distribution yield, the tied highest forward looking distribution yield and the second highest increase in distributions in 2013. CDZ is an alternative for a mainstream type equity holding with a slightly higher dividend and perhaps/probably/hopefully better long term returns but the same risk characteristics as the overall market.

Inspired by the upcoming start of the 22nd Olympic Winter Games in Sochi, we decided to look at what's inside the Canadian equity dividend ETFs that we reviewed last week to pick out the athletes (companies) who qualify for gold, silver and bronze medals. Our selection method is similar to many Olympic sports like figure skating and freestyle skiing - the judges decide, in this case the managers of the various ETFs. Who scores the most points, i.e. which stocks show up in the holdings of the most ETFs? These stocks can be good candidates for investors who want to directly build a portfolio of solid dividend payers.

The 15 Medalists are (please stand for the national anthem) ...
Gold
It's not who you might think, like the Royal Bank, Canada's largest company by market capitalization, or any of the other banks, though there are a bunch in the medals. The one and only gold medal, since it is the only stock that appears in every single dividend ETF, goes to IGM Financial Inc. (TSX symbol: IGM) manager and distributor of financial products, mainly mutual funds under banners such as Investors Group, Mackenzie and AGF.

Silver
There are nine stocks in this group (it must be other countries who won the gold) as all but one of the ETFs, or seven out of eight, hold them:

Corus Entertainment (CJR.B)
Shaw Communications (SJR.B)
Bank of Montreal (BMO)
Bank of Nova Scotia (BNS)
CIBC (CM)
Great-West Lifeco (GWO)
Power Financial Corp. (PWF)
Rogers Communications (RCI.B)
TELUS Corp. (T)

Bronze
The competition is fierce and there are only five stocks that appear in six out of eight of the ETFs:

Canadian Oil Sands (COS)
Enbridge Income Fund Holdings (ERF)
Royal Bank of Canada (RY)
BCE Inc. (BCE)
Emera Inc. (EMA)

Our comparison table below shows which stocks appear in which ETFs. It confirms that most of the ETFs are quite alike for a good chunk of their holdings, the exception being iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ) whose selection criteria based strictly on increasing dividend payers has excluded most of the big banks since the 2008 financial crisis.

To get an idea of what might make these stocks so attractive, we created a watchlist in Globe Investor's old WatchList tool, entered the stock symbols and manipulated the columns with the result in the screenshot below. All the stocks have healthy five-year returns and a higher than average (the TSX Composite is about 2.7% at the moment) dividend yields that look quite sustainable given payout ratios. Only two stocks - COS and GWO - are very volatile compared to the market, i.e. sport a beta much over the market average of 1.0.

We note in passing that we investors should always be aware that data errors can creep into any source - Bank of Nova Scotia does not have negative cash flow!! If some number looks odd, it is well worth digging into. We also found a bunch of companies that had actually increased their dividends over the past five years, unlike what the Globe WatchList says. In this and the honourable mention list below, this includes ticker symbols RCI.B, CPG, MIC, MTL and RUS. Raw basic data generally is ok, it is derived values like ratios and growth rates where things get messed up. Globe and other resources like online brokers rely on outside data gathering companies who have a difficult job to compile the huge amounts of data investors want so errors do occur regularly.

Close but no medal
There is also a group of strong competitors, the chasing pack one might say, who appear in at least half the ETFs. The list of twenty-five stocks looks as follows:

We finally see stocks in sectors not represented at all amongst the medal winners, such as real estate, materials and industrials.The ETF CDZ widens its difference with the other ETFs, with even less of its holdings over-lapping.

The data for these stocks looks generally positive too, though returns haven't been as uniformly good, there are more volatile stocks and some have very high Price to Earnings ratios.

When it comes to stocks held by a minority of the ETFs, there is much less agreement. The ETFs spread over 122 stocks for their remaining holdings. CDZ is very much the most unique - it has no less than 29 stocks, 45% of its total number, that no other ETF holds. The next closest, PDC, has only 11% of its stocks held by no other ETF. The most conforming is ZDV, which holds not a single stock that no other ETF holds.

Bottom line:
The above stocks are a pretty good starting list for assembling a dividend portfolio. But it's good to keep in mind what can happen in the Olympics, especially when judges are involved - the winner isn't necessarily the best, only the one they liked the best. There may be one-performance wonders too. Be your own judge, as we are sure everyone likes to do anyway when watching the excitement of Olympic competition.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

February 14th being Valentines Day, it's a good time time for our semi-annual look at the Canadian equities market to see which sectors and companies the market loves (the Darlings) or shuns (the Dogs). To do that we don't count flowers, champagne or chocolates, we compare the relative weightings of sectors and stocks in two ETFs:

the iShares S&P/TSX 60 Index Fund (TSX symbol: XIU), which selects its holdings and weights based on market capitalization and thus tracks market sentiment, against
the iShares Canadian Fundamental Index Fund (CRQ), which chooses holdings based on past hard accounting results likes sales, dividends, cash flow and book equity value

We will also examine interesting changes in the Darlings and Dogs from previous comparisons in August 2013, February 2013, August 2012, January 2012, June 2011 and the original post in April 2010.

The Numbers
The table below shows the companies and the sectors colour-coded - Darlings in Green and the Dogs in Red. The table also shows the change in internal weighting over the past six months for each ETF, which tells us stocks and sectors that have been moving up or down, either in terms of price (XIU) or fundamentals (CRQ). The bigger shifts are highlighted in Bold.

(click on table image to enlarge)

As a cross-check to be sure the sector differences are not due to the fact that CRQ has 28 more holdings than XIU's 60 (which might tend to result in XIU being more concentrated and have higher individual percentages than CRQ) we've re-calculated weights for CRQ using only its top 60 holdings like XIU. This adjustment for the most part makes little difference to the results but it does matter a lot for the Consumer Discretionary, Information Technology and Utilities sectors and two banks - TD and Scotiabank.

Financials - Continuing the trend we noted last August, the convergence of the market view and the fundamental view is almost complete on an individual stock basis. Today there are no real Darlings amongst Financials, and there are only two Dogs - Manulife (MFC) and Sun Life (SLF). That CRQ continues to have a much heavier weighting in our table in the Financials seems to be a quirk of XIU's construction. Several Financial companies that are in CRQ such as Great West Life, Power Financial, Fairfax Financial Holdings (see the list of the main stocks not held by the other fund at the bottom of the table) don't even figure in the XIU portfolio even though those companies are firmly within the top 60 largest market cap stocks on the TSX.

Energy - The situation is much like August. There has been no further convergence of market view with fundamentals. CRQ still has more weight in Energy than XIU, thus keeping the sector as a Dog. However, one big company - Enbridge (ENB) - is still a market Darling. Encana (ECA) meanwhile remains as the perpetual and the most extreme Dog, with the largest difference in weighting between XIU, where it is in 21st place at 1.28% and CRQ, where it is 7th at 3.67% adjusted weighting.

Materials - Not much has changed in this sector either. Perpetual Darlings Potash Corp (POT) and Goldcorp Inc (G) remain so with stock prices at levels significantly higher than accounting fundamentals justify. Apart from those two stocks, the difference in weight between XIU and CRQ is due to the fact that XIU includes several miners excluded from CRQ, and whose cap weight is not in the top 60 anyway.

Telecommunications - As the expression goes, plus ça change, plus c'est la même chose - the two Darlings BCE Inc (BCE) and Telus (T) continue to be the object of market desire, being vastly overweight in XIU compared to CRQ.

Industrials - Canadian Pacific Railway (CP) continues its resurgence as a Darling, which along with perpetual Darling - Canadian National Railway (CNR) - makes the whole sector so.

Consumer Discretionary - This sector has fallen out favour and is now a mild Dog. Despite having two extra sector companies in XIU that add 1.18% in weight, the sector has less weight than it does in CRQ. Magna International (MG) is the largest example of the unloved in this sector.

Consumer Staples - It's steady-as-she-goes in this neutral sector. Individual companies themselves remain in balance too.

Health Care - The market loves both companies in this sector - Valeant Pharmaceuticals (VRX) and Catamaran Corp (CCT). By fundamentals, Catamaran is too small even to be included in CRQ yet it is the 32nd largest holding in XIU.

Utilities - Though there is one extra utility in CRQ, it puts a lot more weight in this sector. The market thinks the sector and individual companies are Dogs.

Information Technology - Blackberry (BB) continues its fall. As the fundamentals are catching up with the market view, it is less of a Dog.

The Darling and Dog sectors and stocks since 2010
Most sectors and companies are still in the same position of being either Darlings - Materials (Potash Corp and Goldcorp), Healthcare (Valeant) and Telecommunications (BCE and Telus) - or Dogs - Financials (Manulife and Sun Life) and Encana. Utilities and Consumer Discretionary are back to being Dogs. The brief moment last August when Darling sectors outnumbered Dogs has ended and there are now five Dog sectors and only four Darling sectors.

(click on image to enlarge)

How do the Darlings and Dogs stocks' numbers look?
As before, we checked the stocks in a Globe&Mail WatchList to see recent stock and company financial performance. This time we have a bit of a surprise. The table screenshot below shows surprisingly that Dogs Manulife and and Sun Life both have performed well! Manulife in particular looks interesting. It has just reported good earnings, continuing its recovering financial performance. Yet it's Price/Earnings is reasonably low at 14. As we said last August, perhaps there is more value yet to be recognized.

(click on table image to enlarge)

Valeant is the other end of the spectrum. To use our Valentine's Day theme, it is like an exciting affair, losing money but on an aggressive acquisition strategy that seems to enthral. Will it turn out to be long term love or just a disappointing affair?

XIU and CRQ, or other broad market funds can also be used directly as diversified investments for those investors who do not feel confident, or who don't have the time, to investigate individual stocks. The differences in weightings and holdings are only a couple of aspects in comparing the two ETFs. See our previous posts reviewing Canadian equity ETFs here, here and here.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Many years ago a famous TV commercial for Certs featured a debate as to whether it is a candy mint or a breath mint.

The answer was that it is both at the same time - "two, two, two mints in one".

Step forward the investing equivalent, the convertible debenture, a hybrid security that has features of both debt and equity. It is a debenture debt which promises to make fixed regular payments and has a defined maturity date. But it also is convertible into equity of the company under certain conditions. When it works well, it provides the steady income of debt repayment with the potential for capital appreciation if the common stock rises in the market.

Our simple description above inadequately describes the many details and variations possible with convertible debentures. To ease into the subject, we suggest reading:

1) A Primer on Convertible Debentures - by Hank Cunningham, author of the book In Your Best Interest: The Ultimate Guide to the Canadian Bond Market; includes a brief intro to assessing convertibles

2) Convertible Debentures for Income & Growth - on the Income Research website, which charges a subscription for access to its ratings and ratio calculations for the various issues on the market

3) Convertible Debenture Overview - by ScotiaMcLeod

4) Convertible Bonds: Combining the Advantages of Stocks and Bonds in One ETF - by Barrry Gordon of ETF provider XTF in CanadianETFWatch.com

List of Canadian Convertible Debentures

The Financial Post publishes a freely available list under Market Data. The screenshot below shows part of the list of almost 190 issues on the market.

(click image to enlarge)

The detailed conditions for each issue may be found on the company website, though the authoritative comprehensive source is the relevant Prospectus that issuers must file on SEDAR.com. Click on Search Database then Public Company Documents, then enter the Company name in the search box and Prospectus in the drop down box.

USA Convertibles

An easy way to get a list of convertibles of US companies is to download the holdings of an ETF focussed on that segment, such as the SPDR Barclays Convertible Securities ETF (NYSE symbol: CWB), which holds 100 of the largest issues.

Canadian ETFs, Closed End Funds and Mutual Funds

iShares Convertible Bond Index ETF (TSX symbol: CVD) - MER 0.49%; tracks 60 of the more liquid Canadian issues
First Asset Canadian Convertible Bond ETF (CXF) - MER 0.81%; holds 36 of the largest and most liquid Canadian issues
First Asset Diversified Convertible Debenture Fund (DCD.UN) - MER 2.58% in 2012; actively managed closed end fund contains both Canadian and US issues
Canadian Advantaged Convertibles Fund (ADC.UN) - last year's federal budget shut the loophole that underpins the tax advantaged distributions so this fund is likely to disappear when its forward agreement expires in 2015
North American Advantaged Convertibles Fund (NCD.UN) - same story as for ADC.UN, its forward agreement expires in May 2016
Canadian Convertibles Plus Fund (CCI.UN) - MER 1.89% in 2012; actively managed closed end fund of primarily Canadian issues
Pathfinder Convertible Debenture Fund (PCD.UN) - will terminate in November 2014
FundLibrary.com provides a list of Canadian mutual funds that focus on convertibles

A few examples of debenture price action

1) Far out of the money, a "busted convertible" - Debenture price behaves according to bond value

Advantage Energy's conversion price is far below the current stock so the convertible AAV.DB.H hardly budges , there's no reaction to stock price movements and its value to an investor is the yield to maturity of 4.30% as the TMX Money chart below shows.

(click image to enlarge)

2) At the money, where stock and conversion price are quite close - Algoma Central's common stock price is slightly above the conversion price. In the last few months especially as ALC has risen, the price of its debenture ALC.DB has moved a lot more in sync with ALC.

3) Deep in the money, where the stock price is far above the conversion price - Just a few days ago Cargojet (CJT) announced a huge contract and the stock price skyrocketed. So did the debenture's price, as seen below, to the point that the yield to maturity on the debt is a big negative 8.09%. That doesn't matter since debenture holders are now making a large capital gain based on the stock price. From now on till conversion into equity, CJT.DB.A will bounce up and down in tandem with the stock price.

Bad things can happen

If a company begins to get into financial difficulty, the stock price will go down, not increase, eliminating any possibility of capital appreciation. If the difficulties get too bad, the risk of default may impair the value of the debenture. As the primers above point out, an investor needs to assess credit risk among other things. And as the type of companies that issue debentures are usually smaller and not rated by the credit rating agencies such as DBRS, the self-directed investor must do more work him/herself. The provisions of each issue can vary considerably so it's a very good idea to check the Prospectus on SEDAR.

Nevertheless, convertible debentures can offer a solid way to invest in a security that offers the dual properties of equities and fixed income. The analogy with CERTS isn't perfect however, since you cannot be sure in advance whether it will be a candy mint, a breath mint, a bit of both, or even at times a possible sour taste.

Some investors, especially those in high income brackets or those who save a lot, may have run out of RRSP and TFSA room, yet still want or need (e.g. because of a target asset allocation) to hold interest-paying fixed income in a non-registered taxable account. What are the options for such investments and how do they compare? A prime consideration is naturally after-tax income - which gives the best return after-tax and how much difference do the options generate? How do the options compare regarding other factors such as credit risk and interest rate risk and ease of portfolio management?

A couple of new ETFs - BMO's discount bond fund and First Asset's strip bond fund
A brand new ETF entered the scene just a few weeks ago, the BMO Discount Bond Index ETF (TSX symbol: ZDB). It holds a basket of high quality investment grade bonds whose key differentiating characteristic is a discount price to par value. That means return is partly capital gains as the bonds return to par value at maturity. On the web page of ZDB, the fact that the weighted average (of the holdings) coupon rate currently at 2.34% is less than the weighted average yield to maturity of 2.5% tells us so. (Note: The latter number is not yet posted on the fund's webpage, though the ETF's fund profile contains the 2.5% figure. BMO says the number will be posted and updated daily after the fund makes its first distribution on March 6.)

Back in June 2013, First Asset launched the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF). It holds a basket of coupons and residuals that pay no interest; they only pay their principal back at maturity. Taxes are levied annually on the annual yield of each coupon or residual as if it were interest. The way the implicit interest is calculated and tax reported on an accruing rising basis (see TaxTips.ca explanation and example here) there is some tax efficiency in that more of the interest is reported in later years. BXF is thus a bit more tax efficient than a GIC. But it does not defer tax or pay out part of its return as lower-taxed capital gains. BXF primarily avoids the big problem today, that the vast majority of bonds are premium bonds that pay out more in interest coupons than the yield. Canadian Couch Potato recently posted a good explanation of the discount bond benefit for taxable accounts and a review of ZDB, with links back to a previous post on BXF.

Bad Effects of Premium Bonds and Good Effects of Discount Bonds in a Taxable Account
We've taken a mix of a high interst savings account, GICs with terms ranging from one to ten years, individual bonds, the two ETFs mentioned above and as a benchmark, the iShares DEX Universe Bond Index Fund (XBB). Our comparison table below shows the results, before tax, such as would be achieved holding such investments in a registered account, and after-tax in a taxable account.

(click on image to enlarge)

Discount bonds help mostly by avoiding the premium bond penalty
ZDB and the individual discount bonds save only a little on tax compared to what the investor would pay if all the return was taxed at the rate of ordinary interest income. The green highlighted cells show a benefit of 0.04% to 0.17% extra return - not much. In contrast the benchmark XBB, which contains a preponderance of premium bonds, suffers a bigger 0.24% return penalty and one highly premium bond, the Canada 1 June 2019 maturity paying a 3.75% coupon and only yielding 1.51%, suffers even more.

Things would change if interest rates rose appreciably
It doesn't look as though interest rates in Canada are poised to rise anytime soon (2015 at the earliest, per the Bank of Canada) but if they did rise by 2% tomorrow, the advantage would shift strongly to discount bonds, as the lower half of the table shows. The ETF holdings don't change, so the coupon rate would stay quite stable in the immediate term (as we discussed in our review of XBB in a climate of rising interest rates). But the 2% risein required yield would mean that many premium bonds' falling price would make them discount bonds. XBB itself would become a discount bond fund. ZDB would even beat out after tax a GIC whose rate had gone up 2% to 5.45%.

BXF would shed its discount bond advantage much more quickly than ZDB and XBB since it only has a five year ladder and replaces about one fifth of its holdings every year, while the other two ETFs hold a vast range of bond maturities and they replace a much smaller proportion of their holdings annually. The more strongly interest rates / required yields rise, the more discount bonds there will be around and the bigger the discount, giving ZDB an increasing attractiveness.

Benefits of discount bonds vary a lot by Province
The relatively low taxation of interest in Alberta and Nunavut means that residents of those Provinces will gain much less from discount bonds than the highly-taxed residents of Quebec and Nova Scotia.

(click on image to enlarge)

After-Tax Returns not very good - most options can't beat inflation
At any maturity, our summary table of all the results shows that the best quality credit risk fixed income options provide weak returns - in most cases not even beating the latest low inflation rate of 1.5%. Only a couple of GICs do so along with one Province of Ontario bond.

(click on image to enlarge)

The GIC beats them all after tax
From the 1-year GIC on up to the 10-year GIC paying 3.45% interest, each has an appreciably higher return after-tax than any other option with comparable maturity. That's considering pure return only but there might be other reasons an investor might need or want to pick a fund instead of using GICs in a ladder.

Other considerations - GIC vs a discount bond fund

Rebalancing a portfolio to maintain an asset allocation easier in a fund - ETFs can be bought or sold in quantities as small as single share units while GICs are all or none, and the higher GIC rates come with non-cashable conditions. It's not possible to predict when rebalancing will need to happen, so matching GIC maturities with planned rebalancing, such as a yearly schedule will work somewhat. But the last time fixed income and equities went out of whack in a major way was during the 2008-09 financial crisis and who saw that coming?
Reinvesting interest / distributions easier in a fund - BMO's funds all offer automatic dividend reinvestment (DRIP) whereby distributions are reinvested in the fund at no commission cost. iShares and First Asset also offer a DRIP program.
GICs have CDIC coverage limits - Rock solid AAA deposit guarantees only apply on GICs up to 5 years. After that the longer term versions rely on the credit quality of the issuer, generally one of the big banks. There is also a limit of $100,000 covered per financial institution. High net worth investors may need to spread investments amongst several institutions, an inconvenience.
Controlling maturity and duration to match spending easier in a ladder - For investors with a definite date and intended amount of spending, using individual GICs (or bonds) can enable control of the effect of interest rate changes. The duration of any fixed income investment is equal to, or less than, its term. Recalling (explained in this post) that duration means the time at which the investor obtains the promised initial return no matter what happens to interest rates, a ladder of GICs can be adapted to planned spending. Meanwhile ZDB's duration of 6.7 years means an investor must stay invested at least that length of time to be sure of gaining the 2.5% yield to maturity. XBB's duration is about the same at 6.8 years. On the other hand, an investor in the savings phase of life with many years to planned spending may find the never-reducing multi-year duration of fixed income ETFs to be quite acceptable.
Diversification not really an issue - With such high credit ratings, holding a lot of different issuers, such as Provinces plus the federal government, doesn't reduce risk appreciably, it probably makes it worse. From a portfolio correlation perspective as well, GICs will be about as uncorrelated with equities as it gets. Holding an ETF with lots of bonds that have the same uncorrelation with equities but are highly correlated with each other won't help the portfolio.

Bottom Line - Discount bonds help boost after-tax returns in taxable accounts though GICs produce higher returns at the moment. In addition, the discount bond benefit is not very pronounced right now but the more interest rates rise, the greater will be the effect, especially in higher tax Provinces. ZDB will provide stronger benefits to taxable investors than BXF.

PS Thanks to reader sleepydoc for suggesting the topic.

When we last wrote about the T1135 Foreign Income Verification Statement, the form required by the Canada Revenue Agency when certain specified foreign assets of a Canadian taxpayer exceed $100,000 in cost, things were complicated enough. Well, things have got worse. The CRA is now requiring a lot more detail on the foreign assets and the rules as to when exactly the detail is needed or not have become even trickier.

A selection of articles on the T1135 trauma

Accountant and blogger The Blunt Bean Counter saw trouble ahead in The Revised T1135 – This Could Get Ugly for Taxpayers, Investment Advisors & Accountants and didn't find much comfort in CRA's follow-up in T1135 Foreign Reporting – This is Relief?
Advisor.ca asked, probably slightly tongue in cheek, Is Updated T1135 Cause for Celebration?
BDO accounting firm described the changes in UPDATE: TAX ALERT - CHANGES TO FOREIGN INCOME VERIFICATION STATEMENT - FORM T1135: TRANSITIONAL RELIEF ANNOUNCED FOR THE 2013 TAXATION YEAR
CRA itself told us about the T1135 in Foreign Income Verification Statement and Revised Form T1135, Foreign Income Verification Statement and Questions and Answers about Form T1135.

Investors may well cry out - help! how do I escape this? Below we offer some suggestions for equity ETFs that escape the CRA net yet still provide foreign holdings for a portfolio. But first we need to narrow the task.

Amidst all the complexity, a few things are clear:

1) Most notably for the majority of taxpayer investors, is that holdings within registered plans like RRSPs and other forms of registered retirement plans - LIFs, RRIFs, LIRAs etc, TFSAs, and RESPs are exempt from the necessity to report on the T1135, no matter what their value.

2) Apart from these exempt accounts, what matters is not the currency of the holding, nor whether the broker is Canadian or outside the country, nor the stock exchange where the investment is bought or sold. Canadian company bonds denominated in US dollars are still Canadian. Royal Bank stock traded on the NYSE is still Canadian. US company stock held in a taxable Canadian discount broker account is still foreign.

What matters is the domicile of the security, where it is registered. A mutual fund or ETF registered in Canada that holds foreign bonds or equities is still Canadian.

Equity ETFs that avoid the T1135 rigmarole

We've sifted through the various ETF providers, like iShares Canada, BMO Financial, Horizons and Vanguard Canada who create bonafide Canadian registered funds that cover the broad passive equity indices covering the USA, Developed countries and Emerging Market countries worldwide. There are certainly many other qualifying ETFs from other providers such as First Asset, RBC, Invesco Powershares - see them all listed here on TMX Money - but we focus on the mainstream basic non-currency hedged portfolio building block funds.

In the comparison table below, the T1135-avoiding funds are in green text. The three funds we like best within each geographic category are highlighted in green background.

(click on image to enlarge)

Note that many of the Canadian substitutes for US-registered funds have higher MERs and as a consequence have a higher tracking error i.e. tend to under-perform their respective index by a greater amount. On the other hand Canadian registered funds offer some advantages that enhance net returns, such as:

automatic, free distribution reinvestment;
avoidance of the need to exchange foreign currency since the ETF trades in Canadian dollars and handles the exchange internally much more cheaply than an individual investor can achieve (though a couple of the ETFs, ZSP-U and HXS-U, trade in US dollars in Canada on the TSX, and would thus not confer that benefit)

We did a few calculations using our free ETF comparison tool and found that the combined effects of all factors often gave quite close to the same net return for the Canadian-based and the US-based funds.

Our three favorites are:

US equities - Horizons S&P 500 Index ETF (TSX symbol HXS)

Though it has a higher total expense load due to the combination of the management fee and the swap fee, the deferral of any tax until the investor sells shares plus the transformation of what would be annual foreign income distributions into capital gains can be very attractive in a taxable account. A Horizons fact sheet shows the benefit through a simple example.

International Developed / Europe Australasia Far East equities - BMO MSCI EAFE Index ETF (ZEA)

The fact that it has a) a competitive MER plus, b) recovery of international non-USA foreign withholding tax by directly the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside, is what wins for this fund.

Emerging Market equities - BMO MSCI Emerging Markets Index ETF (ZEM)

The reasons are the same as for ZEA - competitive MER plus no loss of withholding tax.

It should be noted that this fix for needing to fill in the T1135, if a person now already has assets that breach the $100k floor for reporting, cannot work immediately for a 2013 tax return, or even for a 2014 return. It can only be effective starting in 2015, since the rule is that it is the cost at any time during the year that matters, not what may be there at the end of the year.

Canadian Mining Companies - Is now a good time to buy?

Investing Ideas from Norway, Home of a Humungous Pension Fund

Green Bonds - The Fixed Income Way to Invest by ESG/SRI Principles

Risk Tolerance: Why and How to Measure Your Own

Risk Capacity: What is your capacity and does it match your tolerance?

Risk Need - Figuring out how much risk you need to take

What's up, or should we say down, with REITs?

Are Stocks less, or more, risky in the long run?

What are the important long term investing risks? (Volatility is NOT one of them)

Holiday cheer alternative - Investing in wine and whisky

Top-100 Canadian CEOs Update: Who is the most Over-Paid?

Canadian CEO Pay Update: Who earned their pay by rewarding investors?

Tax Planning for Investors in or near Retirement: Age Credits and OAS Clawbacks

Taxes 2014: Compendium of Links & Resources for Filing 2013 Income Tax

How does RBC's new Canadian Dividend ETF compare?

Dividend Stock Olympics - The 15 Canadian Medalists

Canadian Equity Market Darlings and Dogs: February 2014 Update

Convertible Debentures: the Certs mint of investments

Tax-efficient Fixed Income for Non-registered Taxable Accounts

How to Avoid the Misery of T1135 Foreign Holdings Disclosure