Wednesday, November 5, 2014

A Deeper Look at My Portfolio

I recently revealed my portfolio’s asset allocation and the reasoning behind it. It consists of just 4 Exchange Traded Funds (ETFs). This might make some think that I’m not sufficiently diversified. To explain why this isn’t true, I’ll take a deeper look at these ETFs. I’ll also go over many of portfolio costs that investors face.

The following chart gives some basic information about the ETFs in my portfolio:

ETF Allocation Asset Class # Stocks MER Purchase Currency
VCN 30% All Cdn Stocks 248 0.05% C$
VTI 25% All U.S. Stocks 3772 0.05% US$
VBR 20% All U.S. Small Cap Value Stocks 812 0.09% US$
VXUS 25% All World Stocks ex. U.S. 5783 0.14% US$

Diversification

If we focus initially on the “# Stocks” column, we see that each ETF contains within it a large number of individual stocks. For example, VCN holds 248 stocks and is intended to be representative of the entire Canadian stock market. Similarly, VTI holds 3772 stocks and represents the entire U.S. stock market. With even more stocks is the international ETF called VXUS at 5783 stocks. These three together cover the whole world and form the core of my portfolio. This is extremely broad diversification with a total of over 9500 different stocks.

The remaining ETF, called VBR, could be considered somewhat narrow because it contains only U.S. small capitalization value stocks. However, even this ETF holds 812 stocks. The style of stock is somewhat narrow, but the number of stocks is high. Overall, holding only 4 ETFs is misleading when it comes to the optics of diversification. I’m well diversified and hoping that the historical outperformance of small cap value stocks continues into the future.

Portfolio Costs

The blended Management Expense Ratio (MER) of my portfolio is 0.08%. This means that I pay $80 per year on each $100,000 I have invested. For the lucky among us who manage to amass a million-dollar portfolio, this is $800 per year. If I were invested in typical mutual funds in Canada, this would be more like $20,000 per year. More savvy investors who seek out professional portfolio management for a million-dollar portfolio still pay about $10,000 per year.

Another cost I have is international withholding taxes on dividends from VXUS. When spread across my entire portfolio, this adds about another 0.09% per year in costs. The U.S. has dividend withholding taxes as well, but fortunately, a tax treaty with Canada eliminates U.S. withholding taxes in RRSP accounts. This doesn’t apply to TFSAs or non-registered accounts, though. I’d have to pay taxes in non-registered accounts anyway. So, my main rule for “asset location” is to never hold VTI, VBR, or VXUS in a TFSA.

Other costs are very small for me. ETFs and mutual funds have internal trading costs that are not part of the MER, but these are very small for my 4 ETFs. However, I’ve seen trading costs in the 0.25% range for some actively-managed mutual funds, so investors can’t just ignore this cost. I also have to pay trading commissions ($10 each), and I lose half of the bid-ask spread on each trade. Fortunately, these costs are very low for me because I rarely trade.

Currency Exchange

Another category of costs is currency exchanges. Notice that 3 of my ETFs trade in U.S. dollars. This means that I can’t buy them directly with Canadian dollars; I need to exchange Canadian dollars for U.S. dollars first. All currency exchanges cost money. Unfortunately, this cost is usually hidden in the quoted exchange rate.

A good way to tell what currency exchange costs you is to look at a round trip: Canadian dollars to U.S. dollars and back to Canadian dollars again. If you lose 2% on a round trip, then each exchange costs you about 1%. That’s a $100 cost on a $10,000 exchange. This isn’t too far off what most of the big banks charge. When you make a trade and click the “settle in Canadian dollars” button, it’s easy to forget about this hidden cost.

There is a great way to save money on large currency exchanges called the Norbert Gambit (see Canadian Couch Potato’s detailed explanation). I use a variant of this method using Royal Bank’s interlisted stock instead of using the ETF called DLR. My way is a little cheaper but a little riskier because it involves holding Royal Bank stock for a few minutes.

Conclusion

After initial setup, this portfolio has taken very little time to maintain. The main activity comes when I have new money to add. I use a spreadsheet to tell me which ETFs are below my target allocation and I buy them to get back in balance. On the rare occasion that this isn’t enough to keep the balance, I have some rebalancing rules coded into the spreadsheet to make a cell glow red if I have to do something.

Before choosing your own portfolio allocation, make sure your costs are sensible for your portfolio size and that you can truly handle the volatility of the allocation to stocks you choose.

32 comments:

  1. I thought I was the only one nerdy enough to code the spreadsheet to flag for rebalance. (I just used yellow highlight, though) :D

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    1. If that's nerdy, I wonder what I am... My spreadsheet flags for rebalance (both absolute and relative thresholds), computes how much I have to buy/sell of each fund, calculates the effective MER...

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    2. Mine also features:

      - inflation adjusted return on investment (pulls inflation data from bankofcanada)
      - dynamic projection on when networth will reach $1million (base on live calculation of ROI)
      - dynamic projection on when I can retire (base on inflation, return on investment, budgeted savings rate)

      PS: Now if someone can show me how to pull in data for sector breakdown for each ETF, then everything will be automated.

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    3. @Anonymous x 2 and @Jason: It's great to see others using spreadsheets to make portfolio management simpler. If I could get my spreadsheet to send me an email instead of having to open it and look for red that would be great. I've added a lot of extra calculations as well, including a CPP benefits estimator and a reasonable spending rate calculation on my portfolio's current size. This gives me an estimate of the amount I could safely spend each month if I retired today.

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    4. OK you guys win the Nerdy Award, I'm not worthy :)

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    5. Michael, is it possible for you to post your spreadsheets (minus the personal information)?

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    6. @Anonymous: I've thought about doing this and even started once, but it will take some work. My spreadsheet evolved over time and is quite a mess. This is on my list of things to do, but I can't promise a date.

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    7. Michael, if you're using Google Spreadsheets, it is actually quite easy to have it email you when you need to rebalance. I have something like the following (removing my personal information of course):

      function sendEmailUpdate() {
      var spreadsheet = SpreadsheetApp.openById("verylongspreadsheetid");
      var sheet = spreadsheet.getSheetByName("Rebalancing");

      var taxloss = sheet.getRange("W23").getValue();
      var rebalance = sheet.getRange("X23").getValue();

      var email = "myaccount@gmail.com";
      var subject = "Portfolio status";
      var message = (taxloss ? "Tax loss opportunity is available\n" : "") + (rebalance ? "Portfolio needs to be rebalanced\n" : "");

      if (taxloss || rebalance)
      MailApp.sendEmail(email, subject, message);

      }

      I added a trigger for this function to be run once per day, and if something needs to be done, I get an email. If I don't need to rebalance (or harvest a tax loss), then I receive nothing. Naturally, all the intelligence is in the spreadsheet: I have one cell which is TRUE if anything needs to be rebalanced, likely you have something similar. When I open the spreadsheet, I can see which individual security it is, of course.

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    8. @Anonymous: Cool. Thanks for taking the time to explain it. At first I thought there was some way to jam code into a Google spreadsheet, but it seems that this is a script that resides elsewhere that happens to access a spreadsheet. Or maybe I just don't understand yet. This is a common problem for me. I find the logic of programming simple enough. But figuring our how to get started always trips me up. I remember when I first started working in Java I wrote some code and had no idea what to do to cause it to run. The first people I asked couldn't even understand what my question was. I had to resort to saying something ridiculous like "I've got some Java code sitting in a text file. Do I just scream at my computer to execute the text file?" I'm at this stage with your script. I found "Google Apps Script" from an online search. It seems to be relevant.

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    9. Yeah, from your spreadsheet, go to Tools -> Script Editor. Paste it in, save it, then from the code editor, go to Resources -> Current project's triggers.. create a new one, time-based, and say how often you want it to run. The spreadsheet does not need to be open anywhere.. it runs on Google's servers. It's actually quite cool what you can do with Google Docs.

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    10. @Anonymous: Thanks. That's simple enough. I had seen "Script" under "Insert" and it wasn't immediately obvious how to proceed.

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    11. One other thing: after you update the script with your spreadsheet id, email and cell references, make sure you run it once manually (Tools -> Script Manager)... the script may need permission to access your spreadsheet/email, and by running it manually, you will be prompted to approve that. This method also gives you a chance to test it with an obvious rebalancing case (i.e. fake data) to make sure it works as well.

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    12. @Anonymous: Good advice. I tend to be paranoid about these things. In addition I'll probably put in fake data once in a while just to make sure it's working. A big part of coding is anticipating all the ways that things can play out differently from what you'd expect.

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  2. Interesting that you're using RY instead of DLR for Norbit Gambit. How come with this method you don't need to journal your RY shares from Canadian exchange to US exchange?

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    1. @Tawcan: I've never had to explicitly journal the shares. My account just shows a positive number of RY shares in one currency and a negative number in the other currency until the day after the trades settle when BMO Investorline has automatically "flattened" them. Unfortunately, I sometimes get hit with a spurious interest charge sometime in the following month or so, and I have to call them to get it reversed. From the excellent guide described at Canadian Couch Potato, it's clear that the process is quite different at each discount brokerage. I can't guarantee that your experience would be the same as mine at BMO Investorline either.

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    2. Hi Michael,

      I have recently moved accounts to BMO Investorline but haven't performed Nobert's Gambit there yet.

      Can you outline the steps that you follow using RY? I thought a call would be necessary for some kind of journaling so that RY can be sold on a US exchange.

      Thanks.

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    3. @Be'en: I describe the process I use in the following post:

      http://www.michaeljamesonmoney.com/2014/06/currency-exchange-using-royal-bank-stock.html

      I haven't had to take any explicit action to journal the shares; it happens automatically the day after the trades settle. I just make the trades in quick succession and my account shows simultaneous long and short positions in RY until they automatically get "flattened".

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  3. Cool post. One question, do you find you end up with >4 positions? In my portfolio, I use 6 different ETFs only (similar to yours, plus a Bond and a REIT ETF).

    However despite the fact that I only use 6 unique ETFs, between my and my wife's accounts, we actually hold about 14-18 positions. Same ETFs, I am just forced to hold some in different accounts (his and hers RRSP, his and hers TFSA, unregistered accounts, workplace accounts, etc). I find this can add to the trading costs a little... but not a big thing.

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    1. @Anonymous: Yes, even though I have only 4 ETFs, I currently have 17 positions across 9 accounts. You're right that this can add an extra trade here and there, but not a big added cost.

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  4. Read your post and white paper on Re balancing. My inner nerd lives it. I was wondering if you could give some data point as to how often this formula has triggered events for you? Ie did the recent market move in October trip your threshold? How long have you been using that formula and how often has it triggered?

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    1. @Anonymous: I just found this long-lost comment. My response is a couple of comments down.

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  5. Where do you folks pull your live (up to date) data from? I have always looked for a web service that would send back an individual stock's stats.

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    1. @Anonymous: I use the spreadsheet in Google Drive. There are built-in functions to get live data (actually delayed 20 minutes or so). For example, you can get the price of RY in Canada with

      =GoogleFinance("RY.TO","price")

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  6. An anonymous comment seems to have become lost:

    "Read your post and white paper on Re balancing. My inner nerd lives it. I was wondering if you could give some data point as to how often this formula has triggered events for you? Ie did the recent market move in October trip your threshold? How long have you been using that formula and how often has it triggered?"

    I've been using my rebalancing thresholds for about 2 and a half years now. I think it has only tripped twice now if I remember correctly (and neither was during this past October). There are two reasons for this infrequent activity. One is that I'm adding new money fairly frequently that keeps bringing my allocation percentages back in line. The other is that I don't hold any bonds. Stocks of the world have been moving together to a fair degree over the last couple of years. Rebalancing between stocks and bonds is likely to happen more often.

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    1. Theoretically, wouldn't adding say 10% of Bond actually increase your return as you'll then be force to sell stocks if they're and buy bonds and vice-versa?

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    2. @R: Averaged over a long period of time, rebalancing between stocks and bonds has not delivered higher returns than owning stocks alone. There have been periods where 90/10 has beaten 100% stocks, but over recorded investing history, 100% stocks has given higher average returns. The rebalancing boost has not made up for the opportunity cost of holding bonds instead of more stocks. The reason to hold some bonds is to control volatility.

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  7. Looks like a simple and well diversified portfolio. I also use DLR for my currency conversion. It helps save on those extra currency fees that Questrade charges. I hold a small basket of dividend stocks at the moment but will be looking to add more ETFs in the future so I can adopt my own version of the couch potato investing strategy

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    1. @Dan: I used DLR for my first few gambits but I now use RY because it's a little cheaper and at Investorline it saves me a phone call. Good luck with your transition to a couch potato approach. It took me quite a while to make a complete transition.

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    2. Michael,
      I will try this one more time. Diversification by country does not work any longer. Companies are too diversified to say they are in only one country.
      You want 25% of your investments to be in the US. A stock like McDonald's, a great US stock, only has 31% of it's sales from the US, 40% comes from Europe and 23% from China and emerging markets. How is this considered a US stock?
      I believe you are invested at a much higher percentage of International sales and profits than you want.
      Other than a Canadian ETF for home bias, why not just use one world wide ETF and be done with it.
      Regards
      Just

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    3. @Just: It's true that U.S. companies get some of their revenue from outside the U.S. just as it's true that international companies get some of their revenue from the U.S. For your assertion that I have more international exposure than I want to make sense, it would have to be true that VTI and VBR have higher international exposure than a world-wide ETF would have. This is obviously untrue. A portfolio with just one Canadian ETF and one worldwide ETF is certainly a reasonable approach, but I prefer to have a U.S. bias, which I have.

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  8. "So, my main rule for “asset location” is to never hold VTI, VBR, or VXUS in a TFSA."

    This implies that you hold VCN in the TFSA? Do you have non-registered accts? If so, this implies then that VCN is held in TFSA, while one or more of VTI, VBR or VXUS are held in Unreg?

    Realize the three US-listed ones are subject to the FWT issue in TFSA. But isn't this a case of cutting off nose to spite face, since all distributions from those three are treated as income in Unreg?

    In other words, unless you have very low or no income and are in a very low tax bracket (guessing not?) then holding any of VBR/VTI or VXUS would result in about 1.8-2.5ish% being treated as "income" in unreg? Whereas holding VCN in Unreg would have the 2.5ish% yield treated as "dividends", and I would think that for any moderate to high income, the math would favor holding VCN in Unreg due the better tax treatment or distributions, even if it did mean holding VTI in TFSA and giving up 15% of the distributions.

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    1. @Anonymous: To the extent possible, I want all of VTI, VBR, and VXUS in RRSPs. But it doesn't all fit. So some VTI, say, has to go into either a TFSA or a non-registered account (with more VCN going into the other account).

      If the excess VTI goes into the non-registered account, its dividends get taxed as income (the U.S. withholding tax produces a tax credit). If the excess VTI goes into a TFSA, I pay the 15% U.S. withholding tax, and I pay the dividend tax rate on the VCN dividends.

      Based on the tax rates in Ontario and the dividend yields of VCN and VTI, I worked out that I'm slightly better off with VTI in the non-registered account. But the difference is small. (If you think the balance actually tips the other way, I'm interested in hearing about it.) The main rule is that I want as much VTI, VBR, and VXUS in RRSPs as possible.

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