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Controversial University of Boston finance and economics professor Zvi Bodie is in Toronto today to give a talk to a conference held by the CFA Institute. We've featured Bodie [pictured] several times in columns and this blog and this morning he'll continue to question the financial industry's most-cited contention that stocks become safe in the long run because of time diversification, or that the only way to reduce risk is diversification.

In his presentation at 10:30 am, Bodie says the simplest way to reduce risk is to hedge, insure or hold safe assets. He continues to stand by the recommendations he made in his book, Worry-Free Investing. In particular, he continues to make the case for inflation-indexed bonds: Real Return Bonds in Canada; Treasury Inflation Protected Securities (TIPs) in the United States. In order to eliminate currency risk, he has said Canadians should stick with RRBs and Americans with TIPS.

"Stocks do not become safe even in the long run," Bodie maintains, "If they did, they would not have a risk premium."

The presentation, entitled The Future of Life-Cycle Investing: The Retirement Phase,  looks at such life-cycle investment products as target-date retirement  and target-date college tuition accounts and health savings accounts. These share some characteristics: they have a special purpose (i.e. retirement or college), specific maturity dates and are tax-advantaged.

"The trouble with mutual funds" 

However, most of the money in these accounts is invested in mutual funds. And the "trouble with mutual funds" is that they are not matched to the purpose or the target date of the account. "For a matching strategy, the basic building blocks must be denominated in units that match the purpose and have known maturities."

In a portion of the talk entitled Safe Investing in Risky Times, Bodie says conventional investment advice is based on the "mistaken principle" of time diversification. This leads to portfolios that are "riskier than consumers realize." Therefore, he argues, the starting point should be "100% inflation-proof, guaranteed annuities." Investors can hope for the best, he says, but must "prepare for the worst."

A basic economic principle is there is no free lunch, Bodie says. "The present value of achieving a future target cannot be lowered by taking risk." However, it can be lowered through contingent contracts that only pay off when needed. He cites as an example life annuities, which pay off only if the annuitant is alive.

High risk requires high-cost guarantees

Bodie also has some interesting views on risk and guarantees. A guarantee transfers risk from a client to the investment firm. On the one hand, if risk is truly small, then the cost of the guarantee will be low. On the other, if the cost of the guarantee is high, then the risk is obviously NOT small, he warns. Risk is most efficiently managed by investment firms, not clients. Bodie questions whether clients can trust firms that do not guarantee its products. 

You can download Worry-Free Investing for just . 

P.S. Added Thur., May 6th. My column based on the actual talk and a subsequent interview with Zvi appeared today in the FP under the headline Our faith in stocks misplaced and in various Canwest dailies as Don't put your faith in stocks for the long run, guru says.  

--62--

While the ongoing retirement and pension debate has focused on the existing three pillars -- OAS/GIS; CPP/QPP and employer pensions and RRSPs -- a whopping rdaddphp.7 trillion is held in non-registered investments and the new Tax Free Savings Accounts that the mutual fund industry calls the "fourth pillar."

The Investment Funds Institute of Canada posted its submission to the Department of Finance on Friday and issued a press release yesterday. [Note the change of the senior communications manager.]

Its 23 page submission commenting on Ottawa's consultation paper -- Ensuring the Ongoing Strength of Canada's Retirement Income System --  can be found by clicking on IFIC's web site here. The Finance paper is here.

Methinks they protest too much on fees and value of advice

I wouldn't call it an interesting read but it is fascinating in some respects. It spends far too many pages justifying the high Management Expense Ratios (MERs) on its (mostly) actively managed mutual funds. It spends just as much time defending the advisor-driven distribution system that contributes to those high costs.

On the other hand, I tend to agree with its top-line conclusion that the system works pretty well as it is and that all that's really necessary is to tweak the tax system to introduce a little more parity between private-sector workers and government workers. Thus, IFIC provides four reasons why there's no need to "enhance" the Canada Pension Plan (CPP) and reiterates a half dozen suggestions it made previously.

Solid arguments for boosting RRSP limits and flexibility

To recap, IFIC thinks RRSP contribution rates should be raised from the current 18% of prior year's earned income to 34%, something the CD Howe Institute has also called for. It also makes some sensible suggestions to provide more flexibility through a lifetime RRSP contribution limit or letting people who temporarily leave the work force for childcare or job loss to accumulate more RRSP room. It thinks the self-employed and those whose incomes vary widely year by year should have RRSP room based on average income. And it calls for some unspecified "relief" for those whose RRSPs were torpedoed by market losses in 2008 -- relief comparable to what members of DB plans enjoyed.

It also makes sense to reduce RRIF minimum withdrawal requirements and to increase limits for transfers between DB plans and RRSPs. As IFIC notes, Income Tax Regulation 7308 should be rejigged to reflect an older population, longer life spans and historically low interest rates. It also wants to eliminate the double taxation of dividends in registered plans.

It doesn't appear to call for similar expansion of the new TFSAs, although this blog has previously noted suggestions to increase TFSA room through retroactivity or a similar lifetime contribution limit. Even so, it's clear IFIC views the growing prominence of TFSAs as central to its future. In the press release, IFIC president and CEO Joanne De Laurentiis (pictured right and right in the top photo) notes that the retirement debate must include discussion of all potential retirement assets and "this fourth pillar, with its significant asset base, can only serve to enhance the retirement income of Canadians."

If we're at 90% replacement rate why are we debating retirement income at all? 

Even without the expansion of RRSP or TFSA room, IFIC thinks retired Canadians are doing pretty well. It cites data from the OECD that retired Canadians have an average income replacement of more than 90% (of the incomes they had when working). This beats the UK (73%, rounded), Australia (70%) and the US (86%). It also says that the OAS/GIS system has kept the elderly poverty rate at 6%, half the OECD average of 13% and well below the 24% of the US and 27% of Australia.

At the other extreme, IFIC cites data from Ipsos Canadian Financial Monitor that shows that assets held in the fourth pillar (non-registered and TFSA) rises with income level, due to "the limiting effect of RPP/RRSP dollar limits."  Thus, in 2009, households with income of 0,000 or more had average non-registered assets of 7,717. 

Is this the place for the eternal debate on indexing vs active and value of advice?

IFIC then spends several pages explaining why Canada has "done so well," and attempts (not convincingly, in my view) to defend its cost structure. It hotly disputes other comments in the federal consultation paper that assign "a zero value to the role that advice plays" in helping Canadians prepare for retirement. As evidence, IFIC cites a recent Ipsos Reid study that found households with financial advisors have almost double the participation in RRSPs, TFSAs, RRIFs and RESPs than households without advisors. It also cites the finding that these "advised" households had less money in "conservative" fixed-income investments -- i.e. they had more in stocks and equity funds [which conveniently pay advisors more, but IFIC doesn't say that].

IFIC really falls into self-serving mode in sectio...

Recent repeated hikes in Canadian mortgage rates seemingly are telegraphing a rise in interest rates some time this summer. In a piece flagged by AdvisorAnalyst.com -- The Bond Roller Coaster --  Tacita Capital's Michael Nairne warns "the good times for bonds couldn't last forever" and suggests investors recognize that "in the next year or so the bond roller coaster is about to get underway."

Nairne [pictured left from a Wealthy Boomer video with me] says investors have enjoyed an unprecedented three-decade bull market in bonds  since long-term government bonds peaked at 14.8% in September 1981. If you're a baby boomer, that 30-year stretch probably constitutes most of your awareness of financial markets and investing. Click on Nairne's article and you'll see some interesting charts on long-term government yields versus inflation.

Unfortunately, a roller coaster implies you don't know when the rises and falls will occur. Many advisors I've talked to -- notably ValueTrend Wealth Management's Keith Richards, who I quoted in this piece in March -- have been counselling clients to reduce exposure to long bonds since they are most likely to fall in price as interest rates rise. However, Nairne cautions that "some longer-term bond exposure is needed today as a hedge against a deflationary scenario."

Even if you dump long-term bonds, the problem arises of what to do with the proceeds. You can sit in cash and money market funds and earn virtually nothing while waiting for a rate rise that may or may not come. Or you can take more risk and stretch for yield in dividend-paying stocks, income trusts, preferred shares, REITs and alternative investments. 

Rate hike could also derail stocks in next year or so

The problem is, as Kiplinger Personal Finance notes in this piece Friday -- What a rate hike means for investors -- an interest rate rise will eventually also derail the bull market in stocks. The writer, senior associate editor Andrew Tanzer [pictured, right], predicts this may not happen until early 2011:

 "There's little doubt that rates are heading higher. After a three-decade decline, they have nowhere to go but up. For stock investors, what matters is how high and how fast."  One of his sources thinks the trigger for a stock slump would be a 5% yield for 10-year treasury bonds.

But how likely are 5% yields given a fragile housing market, stubborn unemployment and limited bank lending? The Federal Reserve Board still insists that very low interest rates are justified "for an extended period," given the shaky economy and expectations that inflation will remain benign. 

Why a laddered approach to bonds still makes sense

I'll point readers to one more web link: the presentation from Odlum Brown Ltd.'s fixed income strategist, Hank Cunningham: Risks to Fixed Income Portfolios.  I mentioned this in last week's blog about the firm's equity ace, Murray Leith, but Cunningham -- author of In Your Best Interest -- is certainly worth listening to as well, especially if you're an older investor heavily invested in bonds.  In the column in the paper cited above, Cunningham cautioned against Richards' "sell long bonds" stance by advocating fixed income portfolios balanced by diversifying credit risk and investing in a "laddered" broad spectrum of maturities.

Cunningham -- pictured left -- notes that as the economy started to grow, the spread between 10-year Government of Canada bonds and two-year bonds peaked in January at 231 basis points and has since narrowed to 180 basis points. The yield curve flattened because the two-year yield rose: "Simply put, the market is not waiting for the Bank of Canada to raise rates."

But he adds that the U.S. yield curve remains mired at its all-time high, "indicating that their recovery is not getting underway."

Little evidence inflation pressure merits overexposure to Real Return Bonds

Despite "media hysteria" over inflation, Cunningham sees little evidence a sharp rise is imminent. In fact, there are pockets of deflation, notably in Japan and some of the PIG economies of Europe (Portugal, Ireland and Spain). Cunningham therefore expects positive returns from a "laddered portfolio of conventional, investment grade, corporate bonds."

If inflation did start to heat up, bond investors would get some protection from Real Return Bonds (or in the U.S., TIPS or Treasury Inflation Protected Securities). But Cunningham would not put 100% of a bond portfolio in RRBs or TIPS because there is still the risk of deflation and real yields could rise, producing negative performance. "Our view is that conventional bonds will outperform RRBs for the foreseeable future."  Also, because of their long durations, RRBs can be volatile.

On the currency side, Cunningham says Canadian investors should brace for "sizable swings" in the loonie. He recommends that fixed income investors remain in C$-denominated bonds if they plan to retire in this country.  In his presentation, Cunnigham shows a portfolio of domestic cor...

For our "weekend read" on this blog, I've once again handed The Wealthy Boomer over to a guest columnist. David Christianson is a fee-for-service financial planner and portfolio manager at Wellington West Total Wealth Management Inc., based in Winnipeg. He's also a personal finance columnist for the Winnipeg Free Press.

On Friday in his blog, Christianson published a piece under the title Why ETFs are starting to scare me. The newspaper ran it under the headline ETFs running off in all directions. The theme is similar to what I've written before -- that ETFs are starting to replicate the sins of the mutual fund industry it seeks to displace. This week's announcement of four new foreign leveraged ETFs only reinforces this trend.  On Twitter, I "tweeted" that there are now four more ways to blow up your portfolio.

But I'm not a fee-only advisor.  David's essay speaks for itself. To make clear his authorship, I've put his essay in Italics, beginning with the text across from and below his photo. I've added a few subheads in bold. Over to you, David:

Most 20-year olds scare me just a little bit.  They are very clever, tech-savvy and often worldly, with opinions on almost everything.  They can even be intimidating, in that you think they must know something you don't.
 
Many seem to believe they know an awful lot, and we old fuddy-duddies are either scared or lazy in our unwillingness to  jump off any metaphorical cliff they think looks attractive.
 
ETFs just turned twenty.  Like many human "youngsters," they were pretty well behaved till about 16, then seemed to turn a little wild, using their new knowledge and tools to run off in all sorts of untested directions.
 
Exchange traded funds are a great tool.  We use them all the time in our investment management practice, and have for a number of years.  For many uses, I prefer them to conventional retail mutual funds.
 
They became popular for a number of good reasons. An ETF allowed you convenient access to a basket of stocks (or other investments) with one purchase.  That single stock or unit could be bought and sold on the stock market at any time during the trading day. 
 
The basket of underlying investments was picked on pre-set and transparent criteria (like the TSX 60 index, for example, which is published daily), so you could always know what you owned.  I contrast this with an actively-managed mutual fund, where the manager has to delay release of his exact portfolio, to keep trade secrets and keep competitors from stealing ideas.
 
Another contrast with mutual funds is the fees.  Traditionally, ETFs have charged between .30% and .50% per year for access to a passive index, while the average actively-managed fund costs more like 2% to 2.5% per year, including advisor compensation (or about 1% less without advisor compensation). Some cost more; a few cost less.
 
Index-based ETFs are also usually low turnover vehicles, and therefore quite tax-efficient.

Flavour-of-the-month ETFs introduced just because they will sell

So, why does this 20-year-old now scare me so much?
 
My main concerns centre around the explosion of ETF varieties, the use of misunderstood leverage in some ETFs, access to increasingly quirky and risky investments and the rabid introduction of flavour-of-the-month options, with no apparent raison d'être other than being saleable. 
 
This recent movement by innovative product-developers uses the well-earned popularity of ETFs to sell access to things like water and agriculture investments, commodities, two and even three-times leverage returns (which provide unexpected results if not actually sold daily), hedge fund types of active management with performance fees in the fine print, and a batch of modified index ETFs that sell based on selective time-period track records.  As well, fees on some of these can approach mutual fund fees, and even exceed those of direct sale manufacturers like Steadyhand, and large account options like Standard Life Legend Series.
 
Many of these products are poorly understood by both investors and advisors (not to mention personal finance writers, who help hype these new introductions).
 
An ETF investor now needs to ask a whole bunch of new questions, like:

·        Is this ETF currency hedged?
·        Does it use leverage?
·        Does it own derivatives?
·        Will there be liquidity when I want to sell?
·        Etc., etc. 

New ETFs stark contrast to traditional low-cost access to broad indexes

These new products stand in stark contrast to the traditional benefits of ETFs -- low cost access to indices in which the risks are clear and understood -- into fringe investments of the sort that have traditionally caused surprise and disappointment for investors who knew not what they had purchased.  I have seen many a marketer ruin a good basic product over the past three decades.  (They will also call me a fuddy-duddy.)
 
Some of these new ETFs are very innovative, and some are going to be very useful in our practice, if we...

As we looked at in depth in Wednesday's column -- Filing by Friday is Number 1 priority -- if you owe Ottawa taxes for the 2009 tax year, the deadline is midnight tonight to file. That's the "Taxman" image used in the marketing materials of DioGuardi Tax, who were quoted in the article.

You can be sure that today of all days, The Taxman is Watching  (the title of a book by Paul Dio Guardi.)

But most of us will be receiving a refund, on average rdaddphp,400. According to a poll being released today by BMO Nesbitt Burns, 48% will use that refund to pay off credit card debt and other bills -- wise behaviour in my opinion. Almost as wise -- especially if you're free of high-interest debt -- are the 4% who plan to pay down their home mortgage.

If you have no debts, the best thing to do with your refund is to pump it back into the next RRSP contribution, a virtuous circle we looked at in this blog last weekend. Leger Marketing found 21% do indeed plan to do this, or just as good, the new TFSAs.

But a significant number -- for shame! -- plan to indulge in various forms of conspicuous consumption: 15% for home renovations or household expenses and 12% for travel or leisure.

John Waters, BMO Nesbitt Burns' manager of tax planning, offers the following five top tips for putting your 2009 tax refund to good use.  Since I consider all five "good" tips not involving spending, I've taken the liberty of publishing them unaltered here. Starting with the words across from and below his photo, the words are his, not mine [ending with Tip 5]:
 
1.) Pay down your RRSP loan or make your 2010 RRSP contribution now

If you took out a BMO RRSP Readiline loan to maximize your RRSP contribution and generate a larger refund, use your tax refund to pay down the loan.  If not, consider making your 2010 RRSP contribution now instead of waiting until the deadline next year.  This will allow you to benefit from almost an extra year of tax-deferred growth!
 
2.) Pay down credit card debt

Interest on some credit cards can eat away at your savings.  Reduce the cost of credit by using your tax refund to reduce or pay down your credit card balances, targeting the highest rates first.
 
3.) Lump sum mortgage payment

If you have a mortgage, it is a good idea to use your tax refund to make a lump sum payment. Applied directly to your principal, a lump some payment (BMO allows you to pay up to 20 per cent of your original mortgage principal per calendar year) could save you significant dollars in interest costs over the life of the mortgage.
 
4.) Top-up your TFSA

If you are not carrying any extra debt then make your refund work for you. Contributing to a Tax-Free Savings Account (TFSA) can let you grow your money tax free. Even if you maxed out your TFSA contribution in 2009, you have room for an additional ,000 this year.
 
5.) Save for education

An education can be an expensive thing. Contributing to a Registered Education Savings Plan (RESP) can help alleviate some of the pressure that all parents feel when planning for their children's future. Consider opening an RESP using your income tax refund. A file=Wealthy-Boomer_keyword_rss.php,500 dollar contribution to an RESP can earn a 0 grant from the government. Maximize your contributions every year and you could earn up to ,200 in lifetime grants for every child.

-----

The cost of compliance with our cumbersome tax system

There's an eye-opening piece on the FP Comment page today (FP11) entitled Our costly taxes.  It's a precis of a Fraser Institute paper released yesterday, entitled The Costs of Complying with Personal Income Taxes. You can can find it here. The authors estimate the annual cost to comply with the tax rules at between billion and .8 billion. On average, a Canadian spends on payments to tax professionals and purchasing tax software. Fraser Institute vice president Niels Veldhuis [pictured, left] estimates that when it's all added up, it costs 5 per citizen to comply with the regulations when you factor in costs, time and effort to prepare tax returns. He suggests a simple flat-tax filed on a postcard-size tax return would make more sense. 

But perhaps then we'd have a national unemployment problem for accountants, tax lawyers and tax preparation firms? 

--62-- 

Talk about timing. On the heels of yesterday's blog about American mega-cap stocks -- Best returns for next decade: would you believe American blue chips?  -- a high-net worth survey released today from BlackRock Asset Management Canada Ltd found 67% of wealthy investors are "very confident" about the Canadian markets and "far less confident" about investing in the U.S.  Half thought emerging markets are a good investing opportunity right now while only 39% feel the same about the U.S.

I don't know about you, but I'd think such data suggests the contrary view espoused by Odlum Brown's Murray Leith [pictured, left] may turn out to be right. As noted yesterday, while enthusiastic about the Emerging Markets/China story, Leith was loath to put all his eggs into that one basket. Canada is itself a play on China, he noted, but he wants to hedge his bets by investing in the many good-valued U.S. megacaps that can be found today.

Appalling financial literacy from the wealthy

Whether or not Leith's call turns out to be correct, I was appalled at the level of financial literacy revealed in the BlackRock survey. While almost 80% of High-Net-Worth (HNW) investors place "a great deal of importance on learning about new financial products and solutions from their advisors," almost half (47%) of the HNW investors who owned mutual funds believed their funds did not charge management fees. Another 9% were unsure. 

Earth to HNW investors: if you're still investing in broker-sold mutual funds charging 2.5% a year as a Management Expense Ratio, then you're paying ,000 a year on each rdaddphp million of assets.  You'd think these financial advisors they appear to value so much would at least acquaint these well-heeled clients with the basics of how they're compensated -- and the extent to which this "embedded compensation" derives largely [completely?] from the clients' wealth.

True, BlackRock -- via its iShares exchange-traded funds business in Canada -- is largely in the business of providing low-cost ETFs that make most mutual funds look like highway robbery by comparison. As iShares managing director Heather Pelant [pictured, right] says in a press release, advisors should be elevating the conversation with their clients by "carefully explaining different and/or other sound investment vehicles, such as ETF."

It seems ETFs are still a foreign concept to many wealthy investors: one in four didn't know if they are a good investment or not and only 27% of wealthy investors with an advisor or broker said an ETF had been recommended. Worse, only 12% already own ETFs in their portfolio.  Among investors 65 or older, 71% were unfamiliar with ETFs, compared to under a third of investors 50 or younger.

New Hybrid Funds will cloud waters further

But that's about to change and the timing gets stranger still. At the start of this week, this blog reported on the second new major entrant to hybrid ETFs by a major Canadian mutual fund company. Both Invesco Trimark PowerShares Funds and now BMO Guardian provide a way for compensation-hungry financial advisors to introduce the idea of ETFs in a way that will compensate them more than "pure" ETFs.

Because of course these mutual fund/ETF hybrids have built-in trailer commissions [I use this phrase instead of trailer fees in deference to a request by fee-based advisor John De Goey] of 0.5 to 1%. The result of this embedded compensation is MERs that are much higher than what a discount brokerage investor would pay for ETFs directly, albeit a tad below the MERs of most actively managed mutual funds. 

No doubt a year from now the followup survey will reveal the wealthy flocking to these hybrids and still declaring that, like other mutual funds, they charge no management fees. So much for the popular notion that wealthy investors are "trendsetters." As Pelant notes, HNW investors "have as many questions and concerns about their financial situation and investment trends as anyone else."

Certainly this group has become more cautious in the light of the 2008 crash and subsequent shaky economy: as the slide at the top of this blog illustrates, 73% said they had changed their investing style, with most "becoming more cautious."

60% of young investors thought advisors provide no more value than the Internet

Ominously for advisors, a majority of those under age 35 agreed it's " not worth paying advisors or brokers for fees or transactions" while only a minority of older investors felt that way. About a quarter of the under-35s already use only a self-directed online discount brokerage account. 

The study of 500 Canadians with at least 0,000 in financial assets was conducted in the second half of March by the Gandalf Group. If you're an advisor counting on older clients not knowing mutual funds or hybrid funds charge management fees, you'd better hope this study is not "statistically significant."

--62--

Over the last ten years, U.S. stocks came dead last compared to stocks in the rest of the world, and against bonds, U.S. REITs and other asset classes. Yet at the turn of the century, Canadian investors were anxious to add American technology stocks and other large U.S. stocks to their portfolios -- even though firms like Coca Cola, Wal-Mart and Johnson & Johnson were trading at 40 or 50 times earnings, or twice what would have been considered fair value.

Unfortunately, today many Canadians have a bad taste in their mouth over this experience, since they bought expensive stocks with what was then an undervalued currency.

If you'd listened to GMO's Jeremy Grantham a decade ago, you would have benefited from his 10-year forecast about the dismal performance of U.S. stocks.

Today, Grantham has a new 7-year forecast and it's almost the opposite of what he said in 2000. Now he's predicting U.S. high quality stocks will top the asset charts in the next seven years, with real [nominal minus inflation] returns approaching 7%.

These forecasts are the centerpiece of a recent set of presentations made in British Columbia by Odlum Brown Ltd.'s director of research, Murray Leith [pictured, left]. The above slide shows Leith pointing to the kind of U.S. (and a few foreign and Canadian) quality stocks he's loading into his model portfolios these days at Odlum Brown.

Leith admits he was a little early on this theme. In an interview today, he says the U.S. large-cap theme was on his mind as long ago as 2006 when it came to the health-care sector. "Before that, the model portfolio was never more than 10% outside the country. As the dollar got to 85 cents and some of these big companies came down to very attractive levels, we picked away at them and have now built the foreign content to 45% of the equity component."

Most U.S. megacaps are global plays

While many of these household names are ostensibly U.S. companies most are foreign multinationals that do as much or more of their business outside the U.S., including the Emerging Markets. Some Canadian investors may fear these names because of currency risk, assuming a domestic stock like TD Bank has less currency risk than a Coca Cola. In fact, Coke is more than 80% outside the U.S. and TD has a lot more exposure to the U.S. market than investors may think.

Many of the picks above -- like 3M, J&J and Wal-mart -- are components of the elite 30-stock Dow Jones Industrial Average. Some, like Colgate Palmolive or UPS, are not Dow Stocks per se but are certainly well-known megacap stocks in the S&P500. All are, in Leith's opinion, trading at a discount to intrinsic value. "My error in my earliness is that they were overvalued a decade ago, then came back to fair value and continued to overshoot on the downside, which often happens. This has gone on longer than I thought but I think it sets the stage for a long period of relatively good performance. The starting value is good, which is what really matters."

Throw darts at the Dow and you'll do fine in ten years

In the interview, Leith says only half in jest that "frankly, you can throw darts at these big stocks and you'll be absolutely okay in five or ten years. Pick any of them."

Or, I suggest, you could buy all 30 Dow Stocks with a single trade: the Diamonds (DIA/NYSE) or if you want them hedged back to the loonie, through the new BMO ETF, the BMO Dow Jones Industrial Hedged to the CAD Index ETF (ZDJ/TSX).

However, there is a reason to cherry-pick certain names, which is of course what Leith does for his clients at Odlum Brown. Refer to the slide at the bottom of this blog, which shows why Canadians can benefit from exposure to these American multinationals. The domestic market is heavy in financials and resources but has only minimal exposure to consumer stocks, health care and technology. Keep that in mind if you choose to pick some of these large-cap U.S. stocks: you might want to downplay U.S. financials if you have heavy exposure to Canadian banks; and underweight U.S. oil stocks if you already have plenty of exposure to Canadian energy and materials stocks.

Canada a play on China but don't bet it all on that one story

Not that Leith is down on Canada. He says a "textbook economic recovery is underway" and the "stars are aligned for Canada ... the Canadian economy, our stock market and our currency will continue to behave favorably." Even so, he cautions, "It would be a mistake to bet too heavily on Canada, as we do have some vulnerabilities." One is high levels of consumer debt and an inflated housing market. Another is an overly strong loonie, which doesn't help exporters.

The Canadian stock market hangs on China's fortunes, which makes it both an opportunity and a risk.  China is a "great story," but so was Japan in the 1980s -- it turned out to be a horror story. In short,  China does have "some risk and I think you should be careful not to have too many eggs in the China basket," Leith says in the presentation, "That means...

Since the Halloween Massacre of 2006, income trusts have been a forgotten investment by many. After all, on January 1st of 2011 -- some nine months from now -- most income trusts will be subject to Ottawa's new SIFT Tax, which stands for Specified Investment Flow-Through.

But Leslie Lundquist, the long-time manager of Bissett Income Fund [pictured] is convinced the general investor lack of interest is an opportunity. In a presentation on a swing through Toronto this week, the Calgary-based fund manager says "income trusts are evolving, NOT dying."

While some believe 2010 will be remembered as the year income trusts faded away because of federal tax policy, "WE believe 2010 will be remembered as the year that income trusts provided competitive total returns for contrarian investors who ignored corporate structure and found strong businesses trading at attractive prices as a result of one easily identifiable risk that would soon be resolved."

True, Bissett Income Fund has less money invested in it than when trusts were flying high before the tax was announced. In its heyday there was more than rdaddphp billion in the fund, versus 0 million today. 

Income Trusts have beaten the TSX ever since the 2006 Halloween Massacre

But investors who hung in have been amply rewarded with a 36.3% return in calendar 2009, compared to 35.1% for the S&P/TSX composite total return index and 43.8% for the Scotia Capital Income Trust index. So far in 2010, trust investors have also beaten the TSX: in the first quarter Lundquist's fund returned 6.7% and the trust index 7.2% versus just 3.1% for the TSX. Compare to the 5.4% the DEX Universe Bond Index returned in 2009 and 1.3% in the first quarter.

In fact, Bissett Income Fund has beat the TSX every year since trust taxation was announced in 2006. That's Finance Minister Jim Flaherty pictured on the right, the politician income trust fans love to hate. Of course, during the 2008 bear market, it was more a question of losing less than the index -- that year the TSX lost 33%, the trust index lost 27.1% and Bissett Income Fund lost 25.3%, all while the DEX Universe Bond Index fund gained 6.4%.

Trusts are high-yielding equities that can complement a bond portfolio

Which underlines the point that trusts are indeed equity investments carrying with them commensurate risks. Income trusts have more risk than bond funds but also have higher yields, making them potentially a complement to fixed income portfolios.

Lundquist is beating the drum for yield-oriented investors looking for higher returns in an era of low but rising interest rates. For a typical balanced investor 60% in stocks to 40% bonds, Lundquist says she'd think "long and hard" about investors taking on more risk. But for a very risk averse investor already 100% in bonds, she defers to the managers of the Franklin Quotential program,  who believe moving 20% of such a fixed-income portfolio to equities can generate more returns over time without extra risk. With interest rates threatening to rise, proceeds could be raised by selling off bonds with longer maturities.

60% of fund's trusts will maintain or increase distributions in 2011

Lundquist says about 60% of the fund's current holdings are likely to pay the same or higher cash distributions in 2011 than today, while the rest may need to reduce distributions over the next year. This is why in January the fund made a preemptive move of cutting its monthly distribution from 8 cents to 5.5 cents. However, it may pay out more than that if things work out by sweeping out excess cash once a quarter and passing it on to unitholders.  

By 2011, the market will have realized that concerns over trusts in 2010 were overblown, Lundquist says. And as more trusts convert to regular corporations, the presence of the Dividend Tax Credit will make distributions more tax efficient for investors taking the cash or planning for retirement. 

Low correlation with bond indices

Lundquist's presentation contains an interesting slide on correlations between the fund and bond indices. As of March 31, 2010, the three-year correlation to Canadian bonds was zero; to high yield bonds 0.28; to short-term bonds minus 0.3, to corporate bonds, plus 0.31, to U.S. bonds 0.12 and to global bonds minus 0.56.

The top ten holdings all yield 6.4% or more, with a 9.2% yield for Morneau Sobeco Income Fund and 8.9% for Pembina Pipeline Income Fund. Another small-cap name Lundquist likes is Badger Income Fund (7.4% yield), which owns hydrovac trucks that provide a less destructive excavation method than backhoes. 

Lundquist believes the income trust/high yield equity market is "generally fully valued" today but that uncertainty over some trusts' distributions is providing some pockets of opportunity, particularly smaller cap trusts like Badger and Morneau Sobeco. For Bissett, the opportunity as income trusts evolve into a high-yield equity market is to evolve the fund into a high yield equity program. It will continue to invest i...

BMO Guardian Funds is launching six new ETF mutual fund classes today, the second major Canadian mutual fund company to embrace a hybrid ETF structure. Invesco Powershares Funds were the first, as we reported here in November 2009

In a press release, BMO said the new fund classes "combine many of the benefits of ETFs with a mutual fund in a simple, easy to use investment option."  The funds are available for sale today (Monday).
 
They include two tactically managed funds and four strategically managed risk-differentiated portfolios. Each BMO Guardian ETF Mutual Fund is a series of BMO Global Tax Advantage Funds Inc, which allows for switching among other Class Advisor Series Funds without incurring a taxable event.

Survey finds 56% of Canadians have never heard of ETFs

A recent survey conducted by Leger for BMO found 92% of consumers are familiar with mutual funds but only 44% have "some level of familiarity" with ETFs and only 7% are "quite familiar" with them.  In fact, the majority of Canadians -- 56% -- have never even heard of ETFs. That's a sad commentary on the current state of financial literacy in this country, given the long-term wealth creation potential of ETFs -- not to mention their cost advantages and tax efficiency merits relative to regular mutual funds. Indeed, the Leger survey found 62% would be more likely to add ETFs to their portfolios once they understand these benefits.  [While on the topic of ETFs and low levels of financial literacy, I might add that ETFs are explained in my financial novel, Findependence Day, as are the new Tax Fee Savings Accounts].

No surprise then that BMO believes the more Canadians learn about the benefits of ETFs, "the more likely they are to consider including them in their portfolios."

Serge Pepin, Director of Investments at BMO Investments Inc. [pictured above] says ETFs have received much attention from the media as investors look for additional investment options. BMO is already the first and so far the only Canadian bank to offer ETFs through its BMO ETFs unit, even though it already sells its own no-load mutual funds and actively managed BMO Guardian Funds. TD Bank briefly offered a small family of ETFs but subsequently withdrew from the market.

An early experiment in mutual fund use of ETFs was the Spectrum Tactonics Fund, which held several ETFs but which slapped on a Management Expense Ratio that effectively eclipsed the cost advantage of the underlying ETFs. The next major move was Invesco Trimark's PowerShares, which introduced the usual advisor compensation device of the trailer fee. The result was again a product that was more expensive than regular ETFs, although somewhat lower cost than Invesco Trimark's regular actively managed mutual funds. 

As I wrote at the time, regardless of what you think about higher-cost ETF/mutual fund hybrids, the PowerShares Funds were a watershed development if only because it showed how the mutual fund industry had at long last "blinked" when it came to the ETF threat. You could argue that the rationale for Invesco Trimark and now BMO Guardian is that if you can't beat them, join them. When PowerShares was alone in the market, the product seemed a strange anomaly but now that BMO Guardian Funds has joined them, the trend is clear. 

Normal trailer fees paid to advisors

The press release makes no mention of advisor compensation but focuses on the need for investors and advisors to access "the growing ETF market."  However, in an interview on Friday, Pepin confirmed that -- as with Invesco Trimark PowerShares Funds and Claymore Investment's Advisor Class ETFs -- the new BMO hybrids pay normal trailer fees to advisors: 1% for front-load and low-load; 50 basis points for Deferred Sales Charge funds. The underlying ETFs are BMO's own family of 22 BMO ETFs. Each hybrid is in effect a fund [or "portfolio"] of ETFs, with the number ranging from five to eight depending on the portfolio.

The MERs on the A series range from 1.58% to 1.73%, Pepin said an on the F series (fee-only) 0.74% to 0.89%. Those fees are "competitive" (i.e. slightly lower than) Invesco Trimark's PowerShares Funds, Pepin said.

Asset allocation decisions will be actively managed by Jones Heward Investment Counsel Inc. for BMO Guardian Canadian Tactical ETF Class and by Pyrford International Ltd for BMO Guardian Global Tactical ETF Class.  The four risk-differentiated ETF portfolios will be strategically managed with ongoing portfolio monitoring and rebalancing.

 The full names of the new funds are:

BMO Guardian Tactical ETF Classes

·        BMO Guardian Canadian Tactical ETF Class Advisor Series

·        BMO Guardian Global Tactical ETF Class Advisor Series

BMO Guardian ETF Portfolios

·        BMO Guardian Security ETF Portfolio Advisor Series

·        BMO Guardian Balanced ETF Portfolio Advisor Series

·        BMO Guardian Growth ETF Portfolio Advisor Series

·        BMO Guardian Aggressive Growth ETF Portfolio Advisor Series

P.S. Added April 27: The "column" ve...

On Wednesday's column in the paper -- Turn tax refund into virtuous circle -- I looked at what to do with this year's tax refund, assuming you qualify for one. If you're unsure what a virtuous circle is (or indeed its cousin, the vicious circle) check this entry from Wikipedia. The above graphic is courtesy of Wikipedia.

Coincidentally, the very next day after the column appeared,  the refund cheque arrived, as it may well have for any reader who NetFiled early in April. 

Instead of the industrial example in the graphic, imagine one circle as a tax refund, the next as the RRSP contribution generated by that tax refund, then a year later the tax refund arising from that RRSP contribution etc. The key is to pump the refund directly back into the next RRSP contribution: immediately, before the temptation to spend it on something else occurs.

How to make ,000 from a one-time ,000 RRSP contribution

In the original column , space precluded elaborating on an example but blogs have no such limitation. Here's an example that I bounced off tax guru Evelyn Jacks, author of Essential Tax Facts, 2010 edition.

Say you contributed ,000 to an RRSP in 2009, and that it's going to create a ,600 tax refund for you in the next week or two, assuming you're an Ontario resident in the top tax bracket.  Even if you never put any new money into your RRSP from this day forward, here's what should happen: the ,600 tax refund is pumped into your 2010 RRSP contribution. This time next year, that ,600 RRSP contribution generates a new tax refund of file=Wealthy-Boomer_keyword_rss.php,116. That becomes your 2011 RRSP contribution, which generates a 3 tax refund in April of 2012. Pump that into your 2012 RRSP contribution and you have a 8 tax refund in 2013.

And so it goes. True, the amount gets smaller and smaller each year because of the nature of the arithmetic but remember this is what happens just to that one-time contribution of ,000. All the while, the original ,000 is still there  in your RRSP, growing in value if it's invested properly, and the subsequent contributions generated by the refund-pumping
routine will take your RRSP value even higher. 

"A total of over ,000 from a single ,000 investment," Jacks commented, "That's before earnings on the investment. Not a bad return of your own hard-earned dollars." 

Think how much better it gets if you put in a new ,000 each and every year or whatever the maximum amount you're permitted (possibly ,000!). Each additional contribution sets up a new virtuous circle that proceeds in parallel with and on top of the earlier contributions.

Yes, to do this you have to resist the temptation to spend the refund on something else -- on "stuff" -- but as you can see from the example, the virtuous circle results ultimately in financial freedom. 

That's why I use the slogan "Freedom, Not Stuff."  

--62--

As we examined last weekend, both in the paper and this blog, there are some radical complex pension reform proposals flying out there -- most of them involving building on the base of the existing Canada Pension Plan (CPP).  These may or may not be a good thing but one thing is certain: the bigger the proposed reform, the longer it will take to debate the wisdom of such moves, then ultimately implement them.

In the meantime, there's a strong argument that the existing system works just fine but can be improved to reflect the developments of the 21st century. These include such realities as extended longevity and the sad fact that the baby boom generation have been terrible savers.

Yes, Defined Benefit plans offered by employers seem to be going the way of the dodo and yes, Defined Contribution Plans and group RRSPs expose employees to more market risk. But the way the retirement income system is set up, those without DB or DC plans or group RRSPs can save way more in an RRSP. The instrument for keeping the playing field level is the Pension Adjustment, seen on your T-4 slip. The more money you can salt away in an employer pension, the higher the P.A. and the less you can contribute to an RRSP.

There's no way a high-earner with a pension plan will be able to contribute ,000 a year to an RRSP but someone without a pension who earns enough (2,222 a year) can indeed sock away that kind of money in an RRSP. So while the pension consultants and lobbyists make their case for radical pension reform, there are several "no-brainer" adjustments to the RRSP and RRIF system that could be implemented relatively quickly just with a few strokes of the pen as it relates to the Income Tax Act.

This morning BMO Financial Group's BMO Retirement Institute released a paper by director of retirement strategies Tina Di Vito [pictured above] outlining five such simple changes. Those who read Tina's paper in the March issue of Policy Options may already be familiar with them. While I've borrowed the ideas from the paper, the exact wording here below is mine. You can find Di Vito's original here.

1.) Remove age restrictions for RRSPs

Currently, RRSPs have to be converted to annuities or RRIFs at age 71, or cashed out with a big tax penalty. This makes little sense in a world where mandatory retirement is a thing of the past. If Ottawa wants us to live longer and save more, it's sending us the wrong message in legislating unnecessary and unwanted RRIF payments that are fully taxable and may trigger OAS clawbacks. I agree with BMO that Canadians should decide when they need to withdraw the money from their RRIFs to live on -- it's inevitable that they will one day need to do so and when they do, the government will get its coveted tax bonanza.

2.) Reduce taxes on RRIF withdrawals

RRIF withdrawals are taxed as if they were interest/salary income even if the growth was derived from some combination of dividends and capital gains. We looked at this topic and Andrew Dunn's suggestion for fixing it in this blog last week. Di Vito is singing from the same song sheet and notes that had such growth been achieved outside registered plans, the income would have received preferred tax treatment and resulted in a lower tax rate. The current tax treatment "skews" investment behaviour in favor of sheltering the highest-taxed but lowest-yielding fixed income investments. At today's low interest rates, such retirees may not even keep up with inflation. The fix is to consider only the original RRSP contributions as "deferred employment income" while the growth in the plan should be taxed at a rate that mimics non-registered investments.

3.) Broaden opportunities for tax-free RRSP/RRIF rollover on death

Ottawa gets a big tax bonanza when a RRIF holder who is the second spouse to die passes away: the plan balance is included as taxable income in the year of the death. BMO suggests a tax-free rollover to the next generation's RRSP or RRIF. This would have huge implications for the much ballyhooed "trillion-dollar " intergenerational transfer of wealth. Of the five proposals this is the one Ottawa may balk at most and I'd think the industry would be content if 1,2, 4 and 5 were adopted at the expense of conceding number 3.

4.) Lower the rate of mandatory RRIF withdrawals

Seniors get understandably upset by the requirement to withdraw -- and be taxed on -- at least 7.38% of a RRIF's balance every year, a percentage that rises to 20%  in one's 90s. These requirements were designed during an era of high interest rates but at current rates means retirees are in danger of outliving their money in old age. As medical science advances and longevity rises further, current policy puts those in their 90s at peril. As BMO says, "it is highly unlikely in today's investment world that investment returns will keep pace with the withdrawals" -- especially if invested in fixed income. To point number 2, seniors would have a better shot at it if invested in stocks but cur...