Saturday, June 4, 2011

Part 3b) ETF Strategies

Following up on the passive/passive discussion in the previous blog, the focus of this blog will be on the DIY investor and the passive approach.  Keeping with proper investment protocols we first look at the Investment Policy Statement or , as it is commonly known, the IPS.

Investment Policy Statement: As a general rule, if you do not have a written investment policy statement, you do not have an investment strategy. If you do not have an investment strategy you are not an investor. So what are you? If you are managing your own investments, likely you are either 1- a gambler who unknowingly takes risk in the markets; or 2- you are frustrated and often find yourself frozen and not knowing what to do next.   The vast majority of investors without an IPS are “customers”! They trusted an advisor/planner and thought that they had a strategy. They are caught in the overlapping active/active or active/no strategy categories and are seeing modest market returns eaten up by excessive active management fees (well, not actually seeing that happen as most fees are hidden, but you know what I mean).
Developing an IPS is a blog for the future so for now suffice to say, you need to know your asset allocation targets and ranges. Specifically, what percentage of cash, fixed income, equities and any other asset classes you wish to use in constructing your portfolio. In our basic passive/passive strategy  we will fill the asset requirements with broad based ETF Index funds.

Example only.

Money market account, high interest savings acct
Fixed Income
1-5 year bond ladder or GIC ladder, Dex Universal Bond Index, Corporate bond index, government bond index
Canadian Equity
TSX 60, TSX Composite Index
U.S. Equity
Dow Jones Industrial Average, S&P 500, Russell 2000
International Equity
EAFE, World Index (ex North America)


The above is an example of a "basic broad based passive strategy" that would be fairly easy to build with common broad based and low cost ETF Index funds.  The characteristics of this strategy are very positive: low management expense costs, very low trading cost, low tax impact (due mainly to the low trade characteristics of Index funds), broad diversification, and high liquidity. In fact this basic approach will meet the needs of the vast majority of investors and very likely out- performs an existing mutual fund portfolio over time.
While the broad based strategy is highly recommended, it does also have its weak points.

1-      The risk level in a broad based strategy has a beta of one. That level of risk is too high for some investors. As a general rule, if the risk is too high you can lower the equity components (which reduces return and risk), or you can reduce diversification by adding lower beta securities such as replacing part of a broad based index with a lower risk sector fund having a beta of less than one. ( a utilities sector fund might have a beta of approximately 0.5%)

2-      Broad based strategies generally will have less income potential than a dividend focused equity fund. Again, the solutions seem obvious (add a dividend fund) but the consequence is reduced diversification and overweight holdings as the dividend fund replicates a portion of the broader index fund.

3-      While the strategy is low tax, it is not the lowest possible tax strategy. For those willing to sacrifice some of the benefits of the broad based portfolio, you can pay for securities that offer greater tax relief, such as "corporate class funds".

A Word On Tax Strategies:
ETPs have a very useful tax profile for higher income earners. In fact, after fees and performance benefits, the tax benefits are the next  best feature of exchange traded products (ETPs). Most investors in active Mutual Funds do not understand how tax inefficient mutual funds often are. Funds are legally established as trusts and as such are required to flow through income to the unit holders (you). Each active trade has the spin off outcome of generating a) trade costs charged to the fund, b) a capital gain or loss recorded on the fund tax slips. As well, stocks held in the funds spin off dividends that are also recorded on your annual tax slip. With active funds often trading 50-100% of the securities they hold each year, these tax events are very common regardless of whether the fund is making any market gains or not. When funds face high redemption levels securities are sold and again generate capital gains and losses to all fund holders. As you can see, structurally active mutual funds are not able to remain very tax efficient.
ETNs are even more tax efficient as they entail use of contracts that reflect dividend payouts but do not actually receive nor distribute dividends to unit holders. The dividend value is reflected in the "contract" maturity value of the fund. The value of dividends are treated as a distributed capital gain only upon the sale of the units or contract maturity date. For high income investors looking to defer taxes and earn income as tax favoured capital gains, the ETN is a great security. Obviously if you are seeking income via dividend distributions, these notes are not for you. ETNs also carry default risk not generally associated with typical ETFs.

Cautions: Tax strategies are often a means of disguising poor investments as a “strategy”. Who has not been burned by “labour sponsored funds” sold strictly as a tax strategy!

ETPs As Portfolio Insurance

When discussing ETPs it is good to remember that many of the strategies are used by professional traders and portfolio managers. As “exchange traded” securities, you can trade ETPs on the stock exchange. That means you can “short” the securities or you can buy inverse versions of many ETFs. For professionals that may result in long/short strategies where, as an example, a trader buys a stock long (say RBC) and then shorts the financial sector. This attempts to select the winners (RBC)  and discount the less attractive sector players (the other major banks), thus removing market risk from the final trade outcome.
Portfolio Insurance: If an investor has a large net gain in a Canadian stock portfolio, they want to protect the gains but may not want to sell the securities and face a capital gain tax. In this scenario the investor might short the Canadian market ETF to insure their capital gains against a market drop. If the market, including the investor's securities, drops 10% then they make up for the stock losses with the gains on the short position. Rather than buying a short position against every stock held, the investor could simply short the broad based stock index using an ETF Index fund.

Interest Rate Anticipation Strategies: A number of investors are concerned about interest rates rising and hurting returns on fixed income portfolios. Within the ETP product scope, investors can customize interest rate sensitivity (measured by duration) by mixing fixed income ETFs with a variety of durations. Purchasing a Dex Universal ETF Index is the broadest based Canadian bond index fund. By mixing in a ladder strategy (Claymore has popular laddered ETFs) or using the BMO Index funds, an investor can mix long, short and medium term Fixed Income ETFs. By doing so you can shorten the duration and thus lower the interest rate sensitivity of the fixed income holdings.
ETF Passive/Passive: The "broad based strategy" outlined in the chart provided, is the preferred approach for most DIY investors. It is a simple approach with few securities and few moving parts for an investor to monitor. While variations exist, an ETF Index portfolio utilizing 5 funds remains the most basic strategy with the greatest diversification and the most bang for your buck.

Some investors use this as a core strategy within a "Core & Explore" portfolio. With the bulk of the portfolio in the well diversified broad ETF strategy, the "explore" portion of the portfolio (10-20% as an example) can pursue other strategies without tilting risk too far off the intended levels. This approach works well for those that want to mix a little personal stock picking or additional diversification (say gold bullion) into the portfolio, without letting the riskier components distort the overall strategy.
That wraps up the basic ETF review discussed in the last four blogs. Hope it helps you better understand the ETP world!