Thursday, November 15, 2018

Is it Worth it to Hold U.S.-Listed ETFs?

Index investors in Canada who own Exchange-Traded Funds (ETFs) have a choice to make with their U.S. and international stock holdings. They can either buy an ETF that holds U.S. and international stocks but trades in Canadian dollars (such as Vanguard Canada’s VXC), or they can buy U.S.-listed ETFs that trade in U.S. dollars. This choice is a trade-off between cost and complexity.

It’s certainly a lot simpler to own VXC. With U.S.-listed ETFs, you need to find an inexpensive way to exchange Canadian for U.S. dollars, such as Norbert’s Gambit. But, as Justin Bender explained, the cost of VXC is higher than the cost of owning U.S.-listed ETFs. This higher cost comes from a higher Management Expense Ratio (MER) and U.S. dividend withholding taxes.

For the mix of U.S.-listed ETFs that I own (VTI, VBR, and VXUS), the blended MER is 0.09%, which is 0.18% lower than VXC’s MER. Less obvious, as Justin calculated, is the fact that U.S. withholding taxes of 0.35% cannot be recovered for VXC. This tax is not charged to VTI, VBR, and VXUS when they’re held in an RRSP. There are international dividend withholding taxes that apply to both VXC and VXUS.

From this total of 0.53% in lower costs for U.S.-listed ETFs, we need to subtract the added costs of currency exchanges. In my case, this averages about 0.01% per year using Norbert’s Gambit. However, this cost would be higher for smaller portfolios and much higher for investors who don’t use Norbert’s Gambit. In total, my costs would be about 0.52% higher each year if I owned VXC.

I plugged this higher cost into my retirement spending spreadsheet and found that my estimated lifetime retirement income derived from my portfolio declined by 5.6%. So, for example, if my portfolio was going to produce $50,000 per year, this would drop by $2800 per year if I owned VXC instead of my U.S.-listed ETFs.

Now that I’m comfortable managing a portfolio that includes very infrequent Norbert’s Gambit currency exchanges, I find the added complexity of dealing with U.S. dollars to be worth it for the extra income, but your mileage may vary.

Monday, November 12, 2018

The Value of Delaying CPP and OAS

Few people realize that you can delay receiving CPP and OAS until age 70 in return for permanently higher payments. Among those who know this is an option, very few choose to wait. I went through the exercise of calculating my safe level of annual spending when taking CPP and OAS at different ages and found that I can start spending more today if my wife and I wait until age 70 for our pensions.

You can start CPP anywhere from age 60 to 70, and OAS can start anywhere from 65 to 70. I created a spreadsheet that calculates our CPP and OAS payments for chosen starting ages of these pensions. Then the spreadsheet calculates our estimated safe annual spending level throughout retirement.

Consider two scenarios:

Scenario 1: We both take CPP at 60 and OAS at 65
Scenario 2: We both take CPP and OAS at age 70

In both scenarios, we’re both retired now with no expectations of earning income in the future. The results were that Scenario 2 allows us to spend $3920 more per year (starting right now) compared to Scenario 1. This breaks down as $3100 per year extra for delaying CPP and $820 per year for delaying OAS.

To be clear, the $3920 per year is not how much the pensions increase due to taking them at age 70. In fact our total annual pension payments are $16,900 higher (in today’s dollars) in Scenario 2 than they are in Scenario 1.

Delaying our government pensions has two main effects:

1. We will dip more heavily into our savings during our 60s.
2. We’ll need to spend less of our savings after age 70.

Because we have to make our savings last in case one of us lives to be quite old, the total extra we spend from our savings in our 60s is less than the total of the boosted pension payments we’ll enjoy after age 70. This is what leads to being able to spend $3920 more per year (adjusted for inflation), starting right now.

It’s paradoxical that delaying receiving money leads to being able to spend more this year and every year going forward, but that’s what happens. Knowing that sizeable pensions are coming at age 70 makes it safer to spend more today.

Our circumstances don’t apply to everyone. Delaying government pensions won’t work if you don’t have enough savings to live on comfortably until age 70. If you’re so sure that you’ll die before you’re 80 (and your spouse will die young as well) that you’re willing to spend all your savings before you’re 80, then delaying taking government pensions doesn’t make sense.

However, the most common reason I hear from people for why they want to take their pensions early is that they want to spend some money while they’re young enough to enjoy it. But as I’ve explained, my wife and I get to spend more while we’re younger because we’re delaying our pensions. Your mileage may vary.

Friday, November 9, 2018

Short Takes: Retirement Income, Credit Card Balance Protection, and more

Here are my posts for the past two weeks:

Retirement Income for Life

Bonds can Outperform Stocks for Very Long Periods

The Problem with Bootstrapping

Here are some short takes and some weekend reading:

Dan Bortolotti answers a question from 60-year old Jerry W. about how he and his wife can generate $35,000 per year from their savings (combined $400,000 in RRSPs and $180,000 in TFSAs). Dan makes a number of excellent points, and concludes with “it would be worth considering whether it makes sense for you to take your CPP benefits before age 65.” We don’t know enough details about Jerry’s situation to make specific recommendations, but most people in this situation would actually be better off delaying CPP and OAS until age 70. It seems counterintuitive, but by shifting some longevity risk to the government, retirees who decide to take larger pensions at age 70 can safely spend more money when they’re 60.

SquawkFox explains why you should stay away from credit card balance protection insurance. CBC goes undercover to show that banks will do what they can to get you to buy this insurance.

John Robertson reports that there are new options for where to open an RDSP, including a robo-advisor.

Big Cajun Man has another angle on the benefits of eliminating debt. I get the feeling that he has debt on his mind.

Thursday, November 8, 2018

The Problem with Bootstrapping

If you’ve ever had someone run simulations of your financial plan, the whole process looks wonderfully scientific. Some software takes your financial plan and simulates possible future returns to see how your plans work out. But what assumptions are baked into this software? Here I use pictures to show the shortcomings of a technique called bootstrapping.

With monthly bootstrapping, simulation software chooses several months at random from the history of actual market returns to create a possible future. The simulator repeats this process many times to create many possible futures.

Instead of monthly bootstrapping, some simulators choose annual returns at random. Other simulators collect blocks of consecutive years. All these methods have their problems. Here we show the problem with monthly bootstrapping, but this problem applies equally well to annual bootstrapping.

I started with Robert Shiller’s online return data ( for total monthly returns of U.S. stock from July 1926 to September 2018 (1107 months). I then built 30-year portfolios with 2 methods:

1. Monthly bootstrapping
2. Rolling 30-year periods

For the bootstrapping, I simulated one billion 30-year returns. For each rolling period, I just started at a particular month in stock return history and collected 360 consecutive months of returns. To eliminate bias against months near the beginning and end of the historical data, I used “wrapping,” meaning that some 30-year periods began near the end of the historical data and wrapped about to July 1926 to complete the 30 years of returns.

So, while there were a billion bootstrapped returns, there were only 1107 rolling returns. This is part of the appeal of bootstrapping; you can create as many different possible futures as you like.

The following chart shows what the distributions look like. The distribution of rolling returns is very coarse because there are so few of them available in our stock market history. The bootstrap distribution also has bars, but they are so fine, we can’t see them.

The big thing to notice is that the two distributions don’t match well at all. Both curves have the same area under them, but historical returns are more bunched near the center. In fact, the rolling period results were within one percentage point of the mean return 47% of the time, but the bootstrapping results were within one percentage point of the mean only 28% of the time.

Why is this a problem? Because bootstrapping results are supposed to be realistic possible futures. If bootstrapping results don’t look much like the past, what makes us think they are a realistic model of the future?

Much of the theory of finance is built on a foundation of thinking in terms of annual returns. I repeated the process above for annual returns rather than 30-year returns. The next chart compares the bootstrapping and rolling distributions.

This time, the distributions match reasonably well. Someone who looks at just this chart could be forgiven for thinking that bootstrapping matches reality. But the small difference shown in this annual chart grows to the large difference we saw in the earlier 30-year chart.

Some will defend bootstrapping and claim the difference shown in the 30-year distribution chart isn’t enough to negatively affect portfolio simulations. This isn’t true. Actual 30-year returns are much less volatile than bootstrapping says they are. Testing financial plans with bootstrapping pushes people to higher bond allocations at too young an age.

What accounts for the difference we see in the 30-year distribution chart? It turns out that stock returns from one year to the next have correlations that bootstrapping eliminates. After stocks have had a good run, there is a tendency for them to have a below-average year. Similarly, stocks tend to have a good year after a poor run. This effect is too weak to exploit with market timing, but it does build up over the course of decades.

Does this mean we should be doing simulations using returns from rolling periods? Perhaps, but this method has its troubles too. There just aren’t enough rolling periods in history to draw statistical conclusions. The future likely won’t look exactly like any one period from the past.

But this isn’t an excuse to use bootstrapping. Actual returns show correlations over time. Bootstrapping strips away these correlations. There is a good quote William J. Bernstein attributes to Ralph Wagner about returns being like “an excitable dog on a very long leash.” For our purposes, the dog’s owner represents the collective fundamentals of U.S. businesses, and the dog represents stock prices. Fundamentals have volatility, but not as much as stock prices. Over one year, the dog can take you anywhere. The longer you own stocks, the more your returns follow the owner rather than the dog. We’re all still affected by the dog’s wanderings, but bootstrapping is like cutting the dog’s leash and letting it run wild.

None of this is any guarantee that stock market returns will take you where you want to go. There is no perfect way to peer into the future. Simulations that use bootstrapping have the appearance of scientific rigour, but their outputs have more decimal places than anyone can reasonably justify.

Tuesday, November 6, 2018

Bonds can Outperform Stocks for Very Long Periods

It’s widely believed that over 30-year periods, stocks have always outperformed bonds. However, recent research says this isn’t true. U.S. bonds beat stocks over the 30 years ending in 2011, and it happened many times in the 1800s according to retired professor Edward McQuarrie at Santa Clara University. However, the important question is what should we do with this information?

Jason Zweig at the Wall Street Journal reported on this research in his 2018 Nov. 2 article Sometimes, It’s Bonds For the Long Run, a play on the title of Jeremy Siegel’s excellent book Stock for the Long Run. It’s doubtful that Zweig is recommending that investors consider whether bonds are the best source of long-term returns, but his readers could be forgiven for thinking this.

The next chart shows McQuarrie’s data on 30-year rolling periods. This means that the return shown in a given year is actually the average returns over the previous 30 years. So, near the end of the chart where it shows the bond return higher than the stock return, this means that bonds beat stocks from 1982 to 2011 (by a whopping 0.15% per year).

It’s hard to get much of a feel for this information when we talk of average returns. So, let’s switch to dollars. Suppose an investor makes two equal-size investments in stocks and bonds, and lets them ride for 30 years. At the end, what is the ratio of the ending value of the stocks to the ending value of the bonds? The next chart shows this.

Consider our hypothetical investor who made two equal investments in stocks and bonds from 1982 to 2011. If the bonds had finished at $100,000, the stocks would have finished at $95,900. If we repeat this experiment for any other 30-year period in the past century, we get a much different story. The most extreme case is 1942 to 1971 where if bonds ended at $100,000, stocks ended at $2,130,000! For all 30-year periods ending between 1948 and 2001, stocks always more than doubled bonds.

The older data tell a different story. During much of the early 1800s, bonds beat stocks over 30-year periods. Most of the time, stocks lagged by less than 1% per year, but there was one period where bonds outperformed by a cumulative 94%. That would have been a good time to own bonds, but it’s nothing close to the dominance of stocks during most of the past century.

Zweig warns that history may repeat itself, possibly “in a way that investors who have all their money in stocks should hedge against before it’s too late.” Unfortunately, while hedging improves worst-case returns, it hurts long-term expected returns.  Perhaps Zweig's warning is at least partially a commentary on how the bull run in stocks since 2009 has to end in a crash at some point.

So, what should investors do? Should we be increasing our portfolios’ bond allocations? Should we be ready to switch to bonds if we see a repeat of the conditions that led to bond dominance in the early 1800s? For my own portfolio, my answers to the latter two questions are no and no. I already have sufficient fixed income in my portfolio.

Nothing has changed. Stocks are a better bet than bonds over the long run. Bond allocations remain a useful way to control a portfolio’s volatility. For any money I won’t need for a long time, I’d rather ride out stock market volatility than give away expected returns by owning bonds. Your mileage may vary.