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When to Rebalance a Passive Portfolio?

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When you have a diversified portfolio of funds, you’re going to experience variations in the values of these investments. Some will grow fast. Some will grow slow. Some will lose money. The whole point of having a balanced portfolio is to control risk and allow you to reach your goals.

I’ll give you a portfolio that I’m currently following and what I aim for when it comes to balancing the funds.

  • 25% – S&P/TSX Composite Index
  • 25% – DEX Universe Bond Index
  • 25% – S&P 500 Index (in US Dollars)
  • 25% – MSCI EAFE Index (it’s international)

I just gave the indexes that my investments follow instead of getting into the actual funds/ETFs that I hold. This portfolio is something designed for the long term, hence why I have only 25% in bonds.

The fund allocations I have aren’t even close to meeting that goal. Some of the funds are at 37% of the total portfolio, while others are at 18%. I do have one at 25% though.

The question now is when should you rebalance and the answer is probably going to have a little more market timing than I’d normally want. I’m not going to go into the details because there are other passive investing blogs on the internet that have done these calculations.

Rebalancing at the end of the year

This is probably a pretty passive and objective move. It will keep your risk tolerance in line exactly how you like it. The problem with this type of rebalancing is that when there is a bull market you often miss out on a lot of gains. The reason for this is that you’re most likely selling your equities (which are growing) and buying bonds (which are slow). Over a long enough run you’re missing out on a lot of gains.

So if you look up the stats for a person that invests for retirement and over the years there are more bull markets than bear markets you’ll find that they’d be ahead if they didn’t rebalance.

Never Rebalance

Like I mentioned in the previous point, bull markets will yield you a better result. There is another side of the coin and that’s when you tend to be in a bear market or an uncertain market. The more you rebalance in this market the better off you are.

Use New Money to Rebalance

This is something that I’m currently doing to rebalance my portfolio. I can get away with this because I’m younger and I don’t have a massive net worth built up over decades. I do think this is a good approach. You’re balancing your portfolio without actually changing things around and potentially selling a winning fund to rebalance.

What should you do?

I really can’t answer this question for you because it’s up to you to figure out. It really boils down to how much you value your risk tolerance. We all know that riding out the storm or the bull is the way to go. I plan to just keep pumping money in and try to rebalance that way. I know that can be a losing battle when you’re up several hundred thousand dollars, but it’s fine. I’ve heard that you should rebalance every 4 years, but who knows.

The point is that you have to come up with an objective way of looking at it. You can’t make rash decisions. I like the 4 year one because it allows the market to run the course and takes a lot of reaction away from us.

Active Managed Fund Advertising – Watch Out

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It is pretty tough to be a Canadian passive investor because you don’t have many options available to you and the active mutual fund industry is massive. The amount of advertising that goes around is amazing and sometimes you don’t realize it until you look into it. I recently took on a new job at a company that has an RRSP matching program with Manulife. You open up the book on investment options and you see all these amazing returns. The MER (Management Expense Ratio) is pushing 2%, but with those returns you would think it was worth it.

It’s all objective data, but you can choose how to present and really make any fund look profitable. I was in a discussion with someone about this very thing and he was comparing his fund against the S&P/TSX index. The fund had a 1.24% MER and here is the graph he shared with me.

I hid the fund name, just to be safe against any sort of “legal” type of attack. Looking at that graph you think that this fund is amazing. It did a really good job and definitely outperformed the TSX Composite Index. In fact, the last few years it seems like it greatly outperformed the market and this must be a good fund.

This is the type of advertising I’m talking about. It’s not a true representation of facts. If there was an industry standard for presenting this information you would be able to see the differences.

The big thing for me is what they’re actually trying to present. From what I can tell, this isn’t real returns, but if you invested at the start of the graph, this is where you’d end up compared to the TSX. In fact, the last three years the TSX outperfomed this fund for the most part, yet you don’t see it on the graph. You can click here to see the last three years.

Also something that isn’t reflected in the graph is the MER of the fund. The fund would have to beat the S&P/TSX by more than 1.24% each year to actually make a gain.

Despite the fact that the last three years (which is as far back as I can go with Google Finance) shows the TSX beating it out, there is something that many people don’t think about and typically the people against passive investing (and love mutual funds) miss; is it right to compare the S&P/TSX Composite Index with this fund?

The answer to this question is no. This fund actually holds onto a higher number of financials and lower numbers of energy, utilities, materials when compared to the TSX. It’s just not a real comparison.

What I’m trying to say is that you need to watch out for the mutual fund advertising trying to show you how much money you can make if you just pay an extra fees for their superior product. The likelihood of it being superior is just about nil. You’ll find that if you investigate into what an active managed fund is trying to tell you, you’ll see that the picture isn’t as rosy as it seems.

Saving Early is the Key to Success

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I think everyone goes through a phase where they learn to smarten up and get real. We all have that stupid period in our life where we don’t use our money efficiently. Well the earlier you end up having this revelation, the more your net worth will grow. Starting is the hardest part because you’re not really growing your money. If you save $1000/mth for a two years, you’re probably going to have about $36,000. If it is in an investment account, or index funds it doesn’t matter. The long term growth of your money is the returns of large sums.

Let me give you a perfect example of this. Let’s say we have “Person A” who is 25 years old and starts to save immediately from scratch. Let’s say we have “Person B” who is 45 years old and finally realized they need to get their act together. Let’s say that they both save $1000 a month, except that Person A only earns 5% return annually and Person B earns 10% return annually.

Person A

 
Retires at 65 (40 years of savings)
Starts: $0.00
Monthly Contribution $1000.00
Total Saved: $480,000.00
Value of Saved at 5%: $1,522,000.00
Interest: $1,042,000.00

Person B

 
Retires at 65 (20 years of savings)
Starts: $0.00
Monthly Contribution $1000.00
Total Saved: $240,000.00
Value of Saved at 5%: $756,000.00
Interest: $516,000.00

As you can see, Person A has twice as much as Person B. What I’m trying to illustrated with this example is the fact that starting early works. I know we can point out that Person A has been saving for 20 years longer than Person B, but the fact remains that starting early is far better. Person A was calculated at half the return annual return value as Person B. Even with an overall below average return you’re still earning over a million in just interest alone as Person A.

In reality Person A and Person B would earn about the same amount on the market. But as you get older you should be making more and can hopefully contribute more every month (assuming you haven’t debted yourself up on new expensive vehicles and a house that’s really too expensive for you).

Person A

 
Retires at 65 (40 years of savings)
Starts: $0.00
Monthly Contribution $1000.00
Total Saved: $480,000.00
Value of Saved at 7%: $2,563,000.00
Interest: $2,083,000.00

Person B

 
Retires at 65 (20 years of savings)
Starts: $0.00
Monthly Contribution $1500.00
Total Saved: $360,000.00
Value of Saved at 7%: $789,000.00
Interest: $429,000.00

So when we look at it now they both start at their original times for savings, but this time they have the same market return and Person B is going to contribute an extra 50% each month. As you can see, the vast majority of Person A’s money is the interest. In fact, two million dollars worth of it. Whereas Person B’s originally invested money amounts to 46% of the value of the total.

I know that these numbers are simple and life is more complicated. At 40 you’re going to have a house that has nice equity. You’re going to have “human capital” value with your job. But the raw numbers illustrate that the sooner you’re start the better off you are. The more time your money can compound, the more your money is working for you. This is very important to understand especially if you want to do passive investing. So definitely start soon and get going on it. Pay off your consumer debts and student loans, so you can start saving your money.

Canadian Claymore ETFs – Worth It?

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Like most of us, passive investing in Canada makes us subject to a very slim and noncompetitive options. I think with Claymore entering the market up here has really opened the door to more competition and that is really what we need at this time. Whether they’re good or not, having more choice on the market really gives you a chance to try out new things. I know I was pretty excited when I first saw them come on the market and there was a lot of excitement on forums on the internet.

If I was to lead with the positives, Claymore offers a lot of niche type of funds that allow you to get into some interesting. Some of the big ones that pop out for me is the Claymore Oil Sands Sector ETF and the Claymore S&P Global Water ETF. They’re definitely pretty interesting areas of the market and allow you to diverse up your total portfolio that way.

Another big benefit upon release is that Scotia iTrader offered the funds at commission free. This is definitely the competition that we all want to see enter this market. And I can only hope that more competing funds will end up doing the same thing.

No American Style Management Fees

The thing that upsets Canadians the most that do passive investing is that the MER (Management Expense Ratio) in this country is no where near as cheap as it is in the United States. While Americans can get funds and indexes with 0.10%-0.25% we’re running up into the 0.30%-0.75% range.

I hate to report the Claymore ETFs are mainly in the 0.55%-0.75% range. Most of them are really around 0.65%. The only place that you find very low management fees is with Fixed Income items. In particular, the Claymore 1-5 Yr Laddered Government Bond ETF only has a MER of 0.15%.

My opinion is that it really isn’t worth it. You’re not saving anything by using their funds. You can get by perfectly fine as a small trader using cheap index funds from TD. And if you have more money where buying ETFs is worth it you can go with iShares or something along those lines.

The only reason I would really buy Canadian Claymore ETFs is if I was trying to get into very diverse markets. It seems like a very active choice for me, instead of the passive investing that I’ve chosen to do. You may think that the commission free ETFs are going to make up for it, but if commission costs are eating up too much profit (ie: new investors) you should probably be sticking with index funds that are free to buy.

Buy Low & Sell High With Passive Investing

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When it comes to a passive investing strategy the one thing you’re forbidden from doing is timing the market. The reason for this is that you’re starting to want to beat the market and make active decisions, the same thing that active mutual funds and other big wigs try to do with the market. I had the hardest time understanding this point because I think the most universally accepted view is buy low and sell high.

If you look at the S&P500 and if it falls below 800 points, the only thing that would pop into my head is buy buy buy. I was literally thinking of keeping a nice chunk of cash on the side just in case there was a market crash of some kind. Though I cannot properly predict when a market is going to head south, I could at least buy on the way down and profit.

I know there are many people out there that can’t shake this feeling. But I’m going to challenge you a bit. If you’re going to build up a nice lump sum to dump into a crash, how much are you going to miss out on during the next bull run? Are we going to have a crash in the market soon? I don’t know. No one knows.

Rebalancing is the Key

It took me a while to figure this out, but the act of rebalancing is the key to buying low and selling high. If you have a well diversified portfolio, you’re going to have some items going up and others going down. The act of rebalancing the portfolio is selling some of the higher growth funds/indexes and buying some of the lower growth/loss funds/indexes. In essence, you’re forced to buy low and sell high if you stick with the gameplan (your portfolio balance).

Whether this is more effective then leaving a lump sum of cash on the sideline in order to buy at a more opportune time is up for debate. Big market crashes come, but they don’t come that often. You’ll often miss out of the bull runs the market presents. If you don’t get most of your money in at the bottom than you’re really not going to return more than what a person would of made investing passively in the market.

Also with timing the market you’re becoming much more active with your investing. Like all of us, we like to see our decisions work out well. If you invest your lump sum at a time that turns out to be not so opportune, can you swallow it?

When it comes to actively timing the market in order to buy low and sell high, it just isn’t worth the risk. Even though there is a lot more money to be made if you buy right in at the bottom, the likelihood of you buying in at the bottom is slim.

Passive investing with a defined asset allocation that you objective rebalance is about the best type of buying low and selling high that you can get. I think it is the best choice and I suggest you stick with the game plan.

 

What is a Passive Investing Strategy?

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If you’re someone that has done any sort of research into investing you probably came across the phrase “passive investing” in one form or another. Another name you may hear is “index investing”, but I suppose that could mean other things. In the investing world this really isn’t the most popular strategy. It isn’t a strategy that promises you huge returns. It doesn’t require a lot of sophisticated trading techniques. It doesn’t even involve that much thought at all.

So what is passive investing? Well, it is a game plan where you try to match the market, rather than beat the market. I know this is a lot of you probably put an odd look on your face. “Not try to beat the market?” When I got my first job that actually paid a decent salary, I often envisioned trading stocks on a daily basis, making smart moves. I’m a determined individual and I thought I could learn to best the market.

Why not an Active Investing Strategy?

The market is a harsh place and thoughts of beating the market are often stuck in your imagination. Reality comes crashing down pretty quick. Active investing is a very simple way of saying that you try to pick winners and losers in the market to earn more money. This applies to your own personal stock picking and also applies to mutual funds that do the same. Here are a few things to consider:

  • Market Gains are Zero Sum – If the stock market goes up 5% on the year, that means 5% more wealth has been created. If someone beats the market with an 8% return, that means someone else under perform by 3%. We all can’t be winners.
  • 70-80% Can’t Outperform the Market: It isn’t a matter of having one winner and one loser. Most people end up losing. Active mutual funds that try to beat the market will usually fail about 80% of the time. Not only will they fail, but they’re going to charge you higher fees for it too.
  • Winners are Random: Research has shown that you can’t look at a mutual fund’s past performance to get an idea of how they’re going to do next year. Typically the one at the top of the pack, is the loser next year.

If you’re looking for information on research that backs up these claims than I suggest you take a look at “The Power of Passive Investing” by Ferri. He did a really good job showing the main points I listed above.

Why Use Passive Investing?

Like I mentioned earlier, most people will fail to beat the market. And over a long enough time line the winners will turn to losers. Passive investing just follow the bench marks, so that is the type of return you expect. As you know, following the S&P500 and S&P/TSX Composite will produce great results on their own.
At the end of the day, you’re more likely to lose playing the active investing game. The more stocks and funds you add to the portfolio the more the odds of you losing increase. Here are a few positives to consider:

  • Cheap MER for ETFs and Indexes: MER stands for Management Expense Ratio. Essentially it is the cost of owning a fund be it a passive index mutual fund/ETF or an active mutual fund/ETF. Since a passive fund doesn’t need to hire overpaid stock pickers they can really reduce the cost of the fund. In Canada passive index will run in the range of 0.30-0.50%. Where as an active index mutual fund will run in the range of 2%.
  • A lot Less Work:  Since you don’t have to try to pick winners and losers you can save a lot of time doing other things. The process becomes the process of just putting the money into your account and following your simple passive asset allocation. More or less you’re just sticking to the plan and putting your money in.
  • Less Trading Commissions: Every time you buy a stock you’re going to pay a commission. If you receive dividends, you need to reinvest the dividends and that’s another commission (except in certain situations). The same is true for a passive ETF, but you really only need to own a handful of funds to be well diversified. Think of how many stocks you’d need to own to be diversified. Indexes at some of our banks don’t even have commission prices.

As you can see the passive investing strategy is really quite effective. Instead of playing to win (with high odds of losing), you play to get market returns. Instead of having to invest a lot of time picking winners and losers, you just put your money in to invest to your asset allocation. The key word here is that it is simple and simple works, especially over the long term with your investing.

There are a lot of books that could be written on this subject, but this discussion was a quick overview of what passive investing is and why a lot of people choose to use it.

Stop Saving Money with your TFSA

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In Canada, our two main tax structures for our money is the RRSP and TFSA. The RRSP is a pre-tax tool and the TFSA is a post tax tool. Aside from a few other tax structures I won’t go into, these a the two at our disposal. But nothing annoys me more than those people that use their TFSA as just a regular old savings account. I know that they call it a “Tax Free Savings Account“, but this is really tax structure more people need to take advantage of for better returns.

I know that a lot of people like to save up for vacations in this account. I used to keep my emergency funds in the account too. But this is all so useless. The fact is that you’re really not saving a lot of tax in this account. Saving money with your TFSA is really a tedious process. Depending on how much you keep in there, you probably only make about $50-$100 a year.

Currently the best interest rate that I know of right now is at Ally, which is 2% as of October 11, 2011. If you keep $5000 in there you’re going to earn $101 dollars for the year. And if you’re in the 32% tax bracket you saved yourself $32 in tax. Most people that use the TFSA as in an in and out type of account (like saving for vacation) you’re going to have only a few months with a lot of money and the rest of the year will be building up.

A TFSA is a Favorable Tax Structure

What I’m trying to get it is that your TFSA should be used for something that generates more potential returns. It’s a great account for investing in because you aren’t taxed on what you earn. When you take the money out, it doesn’t count as your income. Instead of saving up a little money in it, try to take full advantage of it.

If you have nothing else to put in the account than by all means stick your savings in it and earn a few interest points. But if you are interested in investing than take full advantage of your account. Keep your cash savings in a regular high interest savings account and pay the tiny amount of tax on it.

This website is about passive investing strategies and I think that you should at least give this a try. You can read further discussions on the types of low cost investment options are available to you. Most investment accounts that are available to your RRSP are going to be available to your TFSA. Take advantage of it.