Investment returns must be calculated after-tax

One critical consideration of computing returns is that pre-tax is an easy calculation, but after-tax involves a bit more effort.

In Canada, interest income (and distributions of income from trusts) is taxed at your marginal rate. Foreign dividends are also taxed at your marginal rate. Dividend income from publicly traded Canadian companies are taxed at a very favorable rate. Capital gains are taxed at half your marginal rate.

As a result, portfolios should be structured such that income is maximized in sheltered vehicles (RRSPs, TFSAs) while Canadian dividends and capital gains are preferentially outside the RRSP and TFSA.

Your marginal rate depends on what province you live in and also what income bracket you are in.

So if you live in British Columbia, and make a taxable income of $50,000, your marginal rate rate on an extra dollar of interest income would be 29.7%. So to realize a 10% after-tax return on investment, you need to earn 14.2% on a pre-tax basis. Alternatively, you could also earn a 11.7% return via capital gains, or a 10.1% return via eligible dividends. It all amounts to the same: a 10% after-tax return.

The following tables are a simple illustration of the required pre-tax returns required to achieve a 10% after-tax return:

BC 2010 Tax Rates 10% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 12.5% 11.1% 8.9% 10.4%
$ 35,859 $ 40,970 12.9% 11.3% 9.2% 10.8%
$ 40,970 $ 71,719 14.2% 11.7% 10.1% 11.9%
$ 71,719 $ 81,941 14.8% 11.9% 10.6% 12.5%
$ 81,941 $ 82,342 15.7% 12.2% 11.2% 13.3%
$ 82,342 $ 99,987 16.2% 12.4% 11.6% 13.7%
$ 99,987 $ 127,021 16.9% 12.6% 12.1% 14.3%
$ 127,021 and above 17.8% 12.8% 12.7% 15.1%
BC 2010 Tax Rates 10% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 12.5% 11.1% 8.9% 10.4%
$ 35,859 $ 40,970 12.9% 11.3% 9.2% 10.8%
$ 40,970 $ 71,719 14.2% 11.7% 10.1% 11.9%
$ 71,719 $ 81,941 14.8% 11.9% 10.6% 12.5%
$ 81,941 $ 82,342 15.7% 12.2% 11.2% 13.3%
$ 82,342 $ 99,987 16.2% 12.4% 11.6% 13.7%
$ 99,987 $ 127,021 16.9% 12.6% 12.1% 14.3%
$ 127,021 and above 17.8% 12.8% 12.7% 15.1%

The following is for an 8% after-tax return:

BC 2010 Tax Rates 8% after-tax equivalent
Marginal Cap. Eligible SB
Low Range High Range Rate Gains Dividends Dividends
$ $ 35,859 10.0% 8.9% 7.1% 8.3%
$ 35,859 $ 40,970 10.3% 9.0% 7.4% 8.6%
$ 40,970 $ 71,719 11.4% 9.4% 8.1% 9.5%
$ 71,719 $ 81,941 11.9% 9.6% 8.4% 10.0%
$ 81,941 $ 82,342 12.6% 9.8% 9.0% 10.6%
$ 82,342 $ 99,987 13.0% 9.9% 9.3% 11.0%
$ 99,987 $ 127,021 13.5% 10.0% 9.7% 11.4%
$ 127,021 and above 14.2% 10.2% 10.2% 12.1%

The kiss of death – a mention in Forbes Magazine

I notice with amusement an article in Forbes – “Five Canadian Trust Survivors“, where the author basically states the following will still give out “solid” distributions after distributions are taxed in 2011:

Baytex Energy Trust (BTE.UN)
Cineplex Galaxy Income Fund (CGX.UN)
Vermilion Energy Trust (VET.UN)
Brookfield Renewable Power Fund (BRC.UN)
Keyera Facilities Income Fund (KEY.UN)

There is only one good that can come out of this article: it saves you the time from having to bother even looking at these companies. Just scratch them off your candidate list – if Forbes magazine is extolling the virtues of these companies, then it is a virtual guarantee that you are likely to be paying fair (if not greater than fair) value.

I wonder how many people actually base their purchase decisions on magazine articles such as these.

I have spent the greater part of the day trying to screen income trusts, and I don’t see any exceptional value out there. The only one (and literally one out of the forty or so that I took a detailed look at) stinks so badly that even I have no idea how their business can be made viable, but at least their market valuation is trading such that they think this company is going out of business really soon.

Canada Interest Rate Projections – March 2010 – Effect on mortgages

With all the talk about the Bank of Canada wanting to raise rates, it is instructive to look at what the futures market is saying about the issue. It should be noted that the next scheduled rate announcements are as follows:

April 20, 2010
June 1, 2010
July 20, 2010
September 8, 2010
October 19, 2010
December 7, 2010

A rate increase on or before the July 20, 2010 meeting is a guarantee. The question is how much?

The markets currently say the following:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AL 0.000 0.000 0.000 99.480 0.000 0
+ 10 MA 0.000 0.000 0.000 99.440 0.000 0
+ 10 JN 0.000 99.320 99.325 99.360 -0.040 21736
+ 10 SE 0.000 98.870 98.880 98.910 -0.040 33614
+ 10 DE 0.000 98.400 98.410 98.450 -0.050 19923
+ 11 MR 0.000 97.980 97.990 98.030 -0.040 6402
+ 11 JN 0.000 97.630 97.640 97.690 -0.050 3215
+ 11 SE 0.000 97.320 97.350 97.410 -0.080 1445
+ 11 DE 0.000 97.040 97.060 97.140 -0.090 707
+ 12 MR 0.000 96.810 96.840 96.910 -0.080 50

The three-month interest rate will be:

June 2010: 0.68%
September 2010: 1.13%
December 2010: 1.60%
March 2011: 2.01%
June 2011: 2.37%

Reading my tea leaves, this would suggest that the Bank of Canada will raise per the following schedule:

April 20, 2010 (No change – 0.25%)
June 1, 2010 (No change – 0.25%)
July 20, 2010 (+0.75% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

It is also likely that by June 2011 that interest rates will be around 2.5%.

The only effect these rate increases will have on mortgages are for floating rate mortgages (ING Direct offers them at prime minus 0.4%). This would mean that rates would go up from 1.85% to 3.35% by the end of the year and roughly to 4.1% by the middle of 2011. For most borrowers on floating rate mortgages, they will likely see their interest payments at least double over the course of the year. As an example, for somebody borrowing $300,000, their interest payments will increase from roughly $450/month to roughly $1000/month by the middle of 2011.

In terms of fixed rate mortgages, rates are essentially set by the bond market, and the bond market has already “baked” in these projected rate increases. The best available 5-year fixed rate mortgage is 3.69% currently. Given a choice between these two options, it is a rare time where taking the 5-year rate would be the prudent option.

It is likely once interest rates start to increase that banks will increase the “prime minus” spread from a typical 0.4% currently to around 0.8% – the peak discount which was seen in the last housing rush.

Either way, the lack of ultra-cheap credit will have an effect of slowing down the housing market considerably.

Psychology of ETF investing

Nelson writes the following:

It seems to me that the financial advisory industry as a whole spends a great deal of time creating instruments and building an investor culture that tries to act as if investing (or trading) can be simplified to a set of easy-to-follow rules and, hey, we’re professionals, so leave your money with us. I think it’s made even easier for them to convince people because the majority of people want to be convinced. They’re not that interested in thinking about how to invest their money — not really — so they do their best to wipe their hands of it, with all the consequences that entails.

This is absolutely correct. The psychology of “easy investing” has not changed since the dawn of cheap trading on the internet – the initial “brain-dead” way to invest was always going with a “trusted professional” (financial adviser, stockbroker, etc.) to make your decisions for you, since they clearly knew more than you did. Then for those that got jaded with the performance of such “trusted professionals” and eventually want to do-it-yourself, you have a whole host of products that essentially boil down to “stock pick” type newsletters (e.g. publications like the Motley Fool and TheStreet.Com, which are really fronts for subscriptions to newsletters). All of these don’t really involve any type of thinking – monkey see, monkey-do – if Cramer’s buying Amazon, might as well buy Amazon, eh?

Big banks, especially in Canada, will have you sit down in a branch with a “financial adviser” (who is really a salesperson for the funds the bank sells) and get you to fill in a simple questionnaire, which asks many questions to put you in one of three risk categories. If you were high risk (likely a “young” investor), you were suggested to invest 70% in equity funds, and 30% in bond funds. If you were medium risk, you are suggested to invest 40% in equity funds, 30% in “balanced” funds, and 30% in bond funds. If you are close to retirement and low risk, the suggestion will be 10% equity, 40% balanced, and 50% money-market funds. More “modern” suggested asset mixes may include 10-15% for “commodities”. Simple formulas to make investing easier.

Unfortunately, such cookie-cutter solutions will never provide superior returns. In fact, they will dramatically underperform. The reason is because of the fallacy that asset mix determines 90% of portfolio performance and neglecting to look at valuations.

Once an investor starts to realize that there is no informational benefit to newsletter-type subscriptions, or mutual funds, they will eventually shift to another form of control – exchange-traded funds, which essentially are mutual funds that are easier to buy and sell by virtue of being exchange-traded and not having to deal with an annoying bank middle-man. Once you give up and realize you can’t beat the market (the literature that suggests this starts to be compelling when you suffer losses), you will invest in the S&P 500 index fund, which apparently has slipped the actual index by 0.19% (which is actually not that bad, but slippage should be less than 5 basis points for such a large fund).

Even investing in different ETFs you have to do your homework and cannot apply a “cookie cutter” solution. There is no better example than with commodity-based ETFs.

Commodity-based ETFs that invest in underlying commodities with futures are very bad products. They experience huge trading losses when they have to rollover front-month contracts – the biggest culprit so far has been UNG, the United States Natural Gas ETF. Traders have absolutely ripped UNG’s investors to shreds, and rightfully so – investing in futures is not the same as investing in the commodity itself.

Commodity-based ETFs that invest in the underlying commodity (not futures) are legitimate long-term investment products – the best example is the Gold Trust (GLD), which invests in the physical metal. Your cost of investment is 0.4% per year instead of taking delivery of a gold bar and storing it in your own safety deposit box.

Note that I am making no opinion on the future pricing of natural gas or gold – I am just using these ETFs as an example. If I wanted to bet on a higher price of gold over the long run, I could consider the Gold Trust ETF. If I wanted to bet on a higher price of natural gas over the long run, I would not use the UNG ETF.

I have no issues with investing in ETFs – they provide much cheaper coverage than most mutual funds do, although there are some ETFs out there that are clearly geared towards traders/gamblers than actual investors. People that invest in most ETFs would likely be much better off looking at the top ten holdings and just investing proportionally in the common shares of such companies and will be able to save significant amounts of money from management expense ratios.

Just as an example, if you think energy will be a hot product in the future and choose to invest in XEG.TO (a Canadian energy sector fund), we see the following as the top 10 holdings:


The MER of the fund is 0.55%, so if you invested $10,000 in XEG, you are paying roughly $55/year for management of the fund. This $55 is reduced from the dividend payments you would otherwise receive had you been invested in the common shares (which is a tax-inefficient way of paying for management expenses since such dividends are tax-preferred eligible dividends – a better way would be to bill ETF holders directly and they can take a full deduction for this expense from income). If you can scale into the 10 positions for less than $55 (which is easily done at a properly selected brokerage firm) then with a little mouse-clicking, you can save money on your long-term investments. Since 74% of the fund is invested in its top 10 holdings, the tracking error is trivial since the top 10 securities (74% of investments) are likely to be highly correlated investments to the other 26% in a sector fund.

The conclusions are fairly clear – for most passive index funds out there, it is better to just invest in individual components unless if you are dealing with small amounts of money, or small amounts of time.

True out-performance is difficult to achieve – it requires research, work, and sharp decision-making. It is very unlikely that Joe Investor out there will be able to outperform without going into microscopic details of individual securities. This requires skills such as being able to read financial statements, and knowledge of the sector. Not many people will want to do this – and thus, they will dump their RRSP money in some index fund since it is an easy decision to make and will likely underperform since others will be doing the same thing.

Replacing ING Direct

The place where I normally park cash is in ING Direct, which has been a mainstay financial institution for myself for a very long time. When they first opened, they were by far and away the best place to park cash. Now they are a mediocre offering of the many online products that are available out there. I am guessing that they achieved their desired level of deposits and have achieved their desired debt-to-equity ratio with their residential mortgage offerings.

ING Direct hasn’t contaminated their customer experience by spamming their customer base with too many useless services, but this encroachment to simplicity has been eroding at a faster pace as of late – see my post about RSP loans, for example. It is simplicity that has caused me to stick around with ING Direct instead of shopping for other services. However, that time has now come.

So today I sent in a cheque to Ally, which used to be known as GMAC. Obviously since GM tarnished their brand with their bankruptcy filing and investing money in an institution that shares the same name with a bankrupt entity doesn’t inspire much confidence, they changed their name in 2009. In Canada, they are run by a firm called ResMor Trust Company, which otherwise does mortgages. In any event, they are CDIC insured and this means that the taxpayers of Canada will be picking up the guarantee for deposits up to $100,000.

Since I will not be depositing more than $100,000 in Ally, the safety issue of the institution is more or less mitigated.

Their peak offering is a savings account which delivers 2% interest (which is subject to change at anytime), but since this is significantly higher than ING Direct’s offering at 1.2%, it is a trivial process to click a few mouse buttons and transfer the money. Every dollar counts.

As interest rates rise, it will be interesting to see the spread between these two institutions since they are competing for the same bucket of capital from Joe Saver.

Knowing the difference between cash and income

One of the most powerful concepts that most beginning investors confuse is the concept of cash flow, and the concept of net income. In capital-intensive industries, an investor must know enough about the underlying accounting in order to make a proper investment decision.

Probably one of the easiest textbook cases for this concept is looking at the year-end report for Sprint Nextel Corporation. For 2009, they reported a net loss of $2.44 billion, but generated about $2.7 billion in cash at the end of the day.

The simple reason for this is that the company made huge investments in telecommunication assets in prior years and is continuing to depreciate those assets – the actual cash has been long since paid and as such, the depreciation expense does not represent a cash transaction.

So while Sprint will be reporting net losses for the foreseeable future, the company will still be generating cash to pay off its debt. Eventually this process will stop when the assets have been further depreciated, but it is up to an investment analysis to decide whether the company will put more cash into more capital projects, or whether to milk their existing investments and just spend money on maintenance.

Telecommunication companies, in this respect, are relatively easy to analyze.

Finally, as a bondholder in Sprint, all I am concerned about is their ability to service debt. The company does not pay a dividend and at the rate they are able to generate cash, will be able to service their debt for the foreseeable future. Back in October 2008 and March 2009, I was busy picking up equivalent units of debt that will continue to give off insane returns on investment (averaging roughly 18% in coupon payments and 5% in annualized capital gains upon maturity). There is no chance that equity will be able to repeat this at the risk I am taking!

Even today, such units are trading at about a 9.3% current yield, and about 1.9% capital growth to maturity, which is likely better than what you would get from equity over the next 19 years.

Merits of the GIC-only investment strategy

I was reading an article on the Globe and Mail about David Trahair, who advocates a GIC-only investment strategy.

Despite the relatively negative income tax implications (the income from the GICs are fully taxable unless if sheltered in an RSP or TFSA), it is not a bad strategy because it can be implemented with a few clicks of the mouse and should provide protection of principal in most situations. It is something even the most unsophisticated investor can perform and you can shop around for the best GIC rates by using a site like as a guideline for where to get the highest rates.

The only relevant risk worth mentioning is that you are exposing yourself to is inflationary risk (loss of purchasing power of principal), but given the relatively low duration of investment (an average of roughly 3, assuming you are using a GIC ladder) should properly capture heightened interest rate expectations if and when CPI inflation does occur. Right now the best 5-year GIC is a good 100 basis points higher than the equivalent Government of Canada 5-year benchmark bond rate (2.47% vs. 3.5%).

The other comment is that James Hymas makes a very good argument for preferred shares in a portfolio that will diversify the risks associated with having a GIC-only portfolio, and makes for a very good read. Implementing such a change in a portfolio does involve quite a bit of financial sophistication for the do-it-at-home investor, however.

ING Direct trying to trap capital in TFSA accounts

I noticed at the start of the year that ING Direct was offering a 3% 90-day GIC for RRSP accounts (no transfers required) and also 3% for a TFSA account, but with the rate subject to change at any time.

Anybody with an RRSP in ING Direct would do well to lock in the 90-day rate as soon as they can; even though they stated they will offer it until March 1st, they could revoke it. The difference between a 3% rate and a 1.25% rate (which is more representative of the current market rate for a 1-year GIC) is $43.15 on a $10,000 investment. It is not huge money, but it is more money nonetheless.

The 3% TFSA offer is quite a lure, but it is designed to trap as much money before they reset the rate back to a lower rate. The trick with the TFSA is that once customers have deposited their money into the TFSA, it is a lot of unnecessary paperwork to get their money out of the TFSA account once the rate resets to something lower. If customers decide to withdrawal the TFSA once the rate goes lower, then they lose the contribution room into their TFSA until January 1, 2011.

For those people that want to keep their money in a risk-free instrument (e.g. a GIC), use the ING Direct TFSA at your own peril. As a matter of financial planning, the TFSA should not be used as a risk-free account anyhow, but some people will want to use it to park idle cash.

ING Direct used to be the undisupted best place to save money, but over the past few years they have become just “normal”. They are still excellent with respect to having a no-fee operation and this works to their benefit – if money is easy to get out of them, then I feel much safer keeping money with them. For matters such as RRSP and TFSA transfers, however, there is a real bureaucratic cost associated with these and it is not worth it to capture an extra 0.5% elsewhere for the dollar amounts in question that people typically deal with.

If ING Direct wanted to raise a lot of longer duration capital, they’d do fairly well if they offered a 5% 5-year GIC.

Chasing yield is easy until the party ends

I have successfully liquidated my debentures in Harvest Energy (series D and E) for 101.5 and 102.0, respectively. Since they are trading above the 101 that will have to be offered after the takeover, it is unlikely that investors will tender the debt. I am happy to be rid of the bonds so my capital can find some more productive areas. My opportunity cost of this transaction is giving up about a 6% yield, but there are equivalent risk instruments that the money can be parked in the interim.

I have another issue (Bellatrix Exploration, formerly True Energy Trust) that has seen its equity rise about 400% over the past four months and its bonds have correspondingly traded near par. It is very close to my liquidation point and there will be a high probability it will be sold very soon.

As such, my portfolio is starting to look cash rich. While cash is good, it is also earning a return that is less than flattering (mainly zero) and while I can shift the funds into a short term savings account for 1.2% (or 2% if I shopped around) I am always looking for a better place to put my money – something that will give a yield.

In my tax sheltered accounts, I am looking for investments that will generate income. Outside the tax sheltered accounts, I am looking for investments that can generate capital gains (taxed at half the rate) or eligible dividends (taxed significantly less depending on what income bracket you are in).

Most of the income trusts have been bidded up to yields that are not representative of the risks embedded within the company – for example, a trust that is always on my watchlist (but I never get around to purchasing) is A&W – currently yielding about 8.01%. This is not adequate compensation for a company that is distributing more cash than its distributable cash allotment. It is possible that A&W could trade higher (and yield lower) but this is essentially the equivalent of gambling and could just as easily go to 8.5% ($14.82/unit) as it could to 7.5% ($16.80/unit). I do not want to get into coin flipping competitions with the market.

Since my hurdle rate is above 8%, I am forced to lower my standards if I am to seek a home for my cash. This means either accepting higher risk, or accepting a lower rate of return.

Right now if I accepted a lower rate of return, I estimate I could generate about 10% a year with debentures, but this is still a relatively low rate of return in consideration of the risk taken.

As such, I must broaden my search to more obscure securities and companies. This will also require some research and time. It will also require appropriate market conditions when people are less confident.

Fortunately, time is on my side – while the cash is sitting there, earning nearly nothing, it will at least be there when I need it. The temptation to quickly deploy cash is one of the most destructive psychological behaviours one has while investing.