Today is such a beautiful day in West Vancouver that I'm actually sitting outside while I write! Unfortunately I have a lot of work to do so I'll make this shorter than normal.

From Around The Blogoshpere

Michael James On Money finds that the average market average is not very average!

Zahid Jafry is concerned that Certified Financial Planners are writing FEWER financial plans than before.

While many personal finance bloggers abhor active management, Financial Jungle discusses some managers that have "skin in the game" and beat the market too. 

And finally, Mike from The Quest For Four Pillars asks why some parents are morons. 

This Week's Racing Video

In the spirit of brevity, this video is a Formula One pit stop during which all four tires are replaced and a simulated full tank of fuel added in mere seconds (this was just a practice stop, but they kept the car in place and simulated the time required to fill it up). I would actually enjoy filling up at the gas station if it was like this!

I received an email a few days ago from a reader who asked about hedging a portfolio, specifically using HXD which is the Horizons BetaPro S&P/TSX 60 Bear Plus Fund. What a mouthful! For those who are not familiar with double and double inverse ETFs, essentially they provide 200% of the daily performance of an underlying index which in this case is the S&P/TSX 60 index. (Click here to read a more in-depth description I wrote a while back)

The regular Bull ETF will return 2% when the S&P/TSX60 is up 1%, and will return -2% when the index is down 1%.

The Bear version gives you 200% of the inverse performance so if the S&P/TSX is up 1%, the Bear ETF IS DOWN 2%. If the index is down 1%, the Bear ETF is UP 2%.

Here is the original email:

I enjoy your blog and wonder if you would consider a column on the ins and outs of using a hedge (notional or formal) to reduce investment risk. A concrete example might be based on a primary investment in the TSX index with a hedge using the Horizon S&P TSX Bear Plus ETF(HXD). Or bonds. Or ishares XIN. Or ...? When is it a hedge and when is it diversification? How much is enough? etc.

Hedging is the complete opposite of Speculation. Another way to put it is that speculation is the taking on of risk in the hopes of a higher reward, and hedging is the elimination of risk and the elimination of higher potential rewards. The two are diametrically opposed.

Let's assume that our test investor invests in XIU - which is the iShares ETF that tracks the S&P/TSX60 index. In order to completely hedge the portfolio (reduce all risk), he would need to hold 1/3 of his portfolio in HXD (the double inverse ETF that tracks the same underlying index). While he was doing this, his portfolio will be a flat line (actually it will be a slightly negative line over time as the MERs of each ETF will create a small drag on the portfolio). If he only wanted to reduce a portion of the volatility he could use smaller amounts of HXD. The graph below shows the the effects of different levels of hedging.

You can see that holding 33% HXD completely removes risk from the portfolio and completely removes all returns as well. This is a perfect hedge. By using smaller percentages of HXD you can reduce the level of volatility (and corresponding returns) as much as you want.

So when would you hedge? Clearly from above, it would make sense that long term investors would not need to hedge their portfolios. If the goal is to reduce volatility ONLY, then as a long term investor you would look for other investments that had similar return expectations and low or negative correlation to your existing assets. That is diversification and it is different from hedging specifically because you are only trying to reduce volatility, not returns (hedging does both).

I've added a new feature to this blog today: Skribit. If you look on the right hand side you will see a new widget that says "What should I write about?". If you ever want to make a suggestion for a topic that you would like to read more about, just click on the widget and enter in your suggestion. For example, you could click and then write something short like:

TFSA
Option Strategies
Market Action
RRSPs
Budgeting
etc.

You can also vote for topics that are listed - so if someone suggested 'option strategies' and then 50 other people voted for it, you can be sure to see more blog posts about option strategies on this blog since my goal is to more fully engage all the readers and deliver content that you want to see.

NOTE: You can make your suggestions and votes anonymously, but I believe you can set up an optional profile with Skribit as well. (I'm still figuring it out). If you sign up for a Skribit profile you can choose to be notified when I write a post based on your suggestion. If you are a regular reader though, I wouldn't bother since you'll see it posted anyways and as I'm new to Skribit, I can't recommend the service yet.

So, I'll try out this new feature for a while and see how it goes. As always, if anyone has suggestions or wants to otherwise get in touch with me, you can always send me a private message as well.

The TSX closed the Monday May 12, 2008 trading day at 14,666.07 marking a new all-time high for the barometer of Canadian stocks. The index had flirted with the 12,000 level in late January and of course the talk of the town has been the sub-prime mortgage meltdown and on-again, off-again recession in the United States.

If we look beyond just the index numbers we'll see that there hasn't been a broad based recovery so much as there have been a few sectors that have really picked up the slack of the rest of the index. Energy and commodity based companies have been on a tear while the financial sector is still well off the highs of the past year. Hear are the highs, lows and current prices (as of May 12, 2008) for the big five banks:

Bank Of Montreal
52 week high: $71.48, 52 week low: $38.00, Current: $49.12

Bank of Nova Scotia
52 week high: $54.67, 52 week low: $42.00,  Current: $48.37

CIBC
52 week high: $107.45, 52 week low: $56.25, Current: $73.30

Royal Bank
52 week high: $61.08, 52 week low: $42.82, Current: $48.74

TD
52 week high: $77.10, 52 week low: $58.57, Current: $67.05

The book giveaway is now over and after using a random number generator I'm please to announce that the winner of the KMPG: Tax Planning For You And Your Family 2008 book is "Elizabeth" (commenter #10). I will be contacting Elizabeth via email to get her shipping details and the book will be sent out accordingly.

In total there were 55 entries for the contest and you can visit the original contest post by clicking here. 

Congratulations Elizabeth and thank you very much to all those who entered. In only a few weeks I'll start the next installment of the Money Movie Giveaway so stay tuned and make sure to enter that contest for your chance to win a DVD copy of a movie about money! 

In Canada, most mutual funds pay what are known as 'trailers' to firms and advisors. It is a cost that can be embedded in the MER (Management Expense Ratio) of a fund through the 'service fee'. While there are a handful of mutual funds that do not charge a service fee (and resulting trailers), most of them do. (Note that F-Class funds represent versions of mutual funds that have the trailers stripped out of them so that they can be held in special 'fee-based' accounts where the service fees are charged separately.)

For the funds that do have service fees, there may be five different versions of the same fund: Front-End Load, Back-End Load, No-Load, the newer Low Load (sometimes referred to as Level Load as well), and finally the F-Class versions. Let's examine the differences by seeing how a representative sample fund can be sold under each option.

The Representative Sample Fund

Our sample fund is a Canadian Equity mutual fund that has a management fee of 1.25% and 'other fees and expenses' of 0.25% (brokerage costs, administration expenses, etc). Therefore the mutual fund manufacturer's fee to operate this fund is 1.50%. The manufacturer is the company that actually picks the investments and runs the portfolio.

The manufacturer also adds a 'service fee'. It is this service fee from which commissions are generated. The typical 'service fee' is 1.00%, with a few exceptions as noted below.

To make a long story short the MER of this fund would be 2.50% which is made up of the management fee and other operating expenses (1.50%) plus the service fee (1.00%).

Front-End Load Mutual Funds

A front-end load version of this mutual fund pays an ongoing trailer to the advisor of the typical 1.00%. This means the advisor will receive 1.00% of the average value of your investment in this fund over the course of every year. The reason that it is called a front-end load version is because the advisor additionally has the ability to charge you a front end sales charge between 0% and 5% which gets deducted from your investment immediately. In many cases, fund companies will limit this to a maximum of 2% instead of 5%. (Further, many advisors will sell a front-end version of a fund with a front-end fee of 0% - they would do this when there is no specific 'no-load' version of the same fund available and they would like the features associated with that type of version of fund.)

As an example, if you invested $100,000 into a front end load fund with a front end load of 2%, your initial investment would be docked $2,000 which goes to the advisor leaving $98,000 to be invested and your advisor would further earn a 1% trailer per year of the amount in your account.

DSC Funds or Back-End Load Mutual Funds

Most commonly known as DSC funds, and also as Deferred Sales Charge funds and Declining Sales Charge funds.

Many funds are sold on a DSC basis - the reason for this is because it allows for the biggest up-front commission of any of the other versions (except for the advisor who would actually charge a 5% front-end load - which is pretty rare). It is important to note that DSC funds pay your advisor an up front commission of 5% even though this is not subtracted from your initial investment deposit. Rather, the fund manufacturer pays the advisor in advance for the future service fees that will be generated. The ongoing trailer fee to the advisor is reduced from 1.00% to 0.25% in exchange for the lump sum, up-front commission.

It is also important to note that if you sell out of these funds you are subject to a redemption fee for the first 7 years (plus or minus depending on the fund company). The redemption fee normally starts at 5.0% in the first year and then gradually declines to 0% after 7 years, hence these funds sometimes being referred to as 'declining sales charge' funds. After the 7 years there would be no fees to sell out of these funds.

This redemption fee is basically the fund company's assurance that the up front commission to the advisor will be accounted for should the investor sell out before the future service fees can be generated. Basically, if you sell out of your fund after year 1, you pay a 5% penalty that covers the fund company's initial commission to the advisor.

The service fee charged by the fund remains at 1.00%. The service fee shouldn't be confused with the trailer fee the advisor receives, which for DSC funds is 0.25% as mentioned above. This means there is a 0.75% surplus the fund company is running every year and it is from this ongoing surplus that the up front commission liability is paid off over the course of a little more than 6 years (hence the 7 year redemption fee schedule).

If you invest $100,000 into a DSC fund your advisor generates a $5,000 commission right away, and you still have $100,000 invested. The advisor additionally receives an ongoing trailer fee of 0.25% of the average value of your investment every year. If you sell out of your funds within the first 7 years, you are charged a redemption fee which goes to the fund company to offset it's up front payment to the advisor.

Essentially you are making a promise that you will stay invested for 7 years otherwise you will pay a penalty. Because the fund company has this guarantee from you, they can afford to pay a large lump sum to the advisor right away.

No Load Funds

No load funds have no initial front end fees, nor do they have any DSC fees. In other words you only have to worry about paying the ongoing MER for as long as you hold the funds. The advisor will generate a 1.00% commission every year based on the average value of your investment - they receive no up-front commission for no-load funds, just the ongoing trailer fee.

If you invested $100,000 to a no-load fund, you will have nothing deducted from your initial investment and you advisor will not earn an up-front commission but they will still earn a 1.00% commission based on the average value of your investment every year.

(In some very rare cases, a no-load fund may have a higher trailer than other versions of the same fund - which means it would have a higher service fee as well.)

Low Load Funds (Sometime referred to as Level Load)

Just think of these as a scaled back version of DSC funds, with a bit of a twist. The up front commission is lower, averaging 3% versus the DSC's 5%. The redemption fees start at 3% and decline to 0% after 3 years instead of the fees starting at 5% and declining to 0% after 7 years for DSC funds. But here is the twist: while the trailer fee is initially set to 0.25%, it increases to 1.00% as the redemption fee schedule expires. This is why it is also known as 'level load'.

If you invested $100,000 into a Low-Load fund (or Level Load fund), you are not docked any money up front. Your advisor receives $3,000 as an up-front commission and 0.25% of the average value of your account in the first year. He or she will receive 0.50% of the average value of your account in the second year, 0.75% in the third year and then 1.00% every year thereafter.

F-Class Funds

The 'F' stands for 'Fee based accounts' funds. These are relatively new types of accounts that charge clients a transparent fee that is easily seen on statements (called the Client Advisory Fee). This was introduced to address complaints of investors not knowing what they were paying their advisors as the compensation was essentially hidden and not well disclosed. For the F-Class version of a fund there is NO service fee. So for our sample fund that would mean that the MER of the fund has been reduced from the 2.50% in all the previous cases to 1.50%. BUT to make an apples to apples comparison, you would need to add the Client Advisory Fee to this amount to determine your all-in cost. While a fee-based account provides more transparency, it may not necessarily be cheaper. Typically the Client Advisory Fee for F-class funds is set to 1.00%, therefore it is exactly the same as a no-load fund in terms of cost and flexibility (i.e. no charges to buy and sell), although a bit more transparent.

There is one important advantage of fee-based accounts for non-registered investment portfolios in that it is possible to claim the Client Advisory Fee as a tax-deduction on your tax return (you need to have your accountant verify this for your own situation to be sure). In this case, if your marginal tax rate was 40%, then the after-tax Client Advisory Fee would be effectively 0.60% instead of 1.00%, meaning your out-of-pocket costs for an f-class version of a fund in a non-registered account would be 2.10% versus 2.50% for all the other fund versions.

If you invested $100,000 into an F-class mutual fund, your initial investment would not be docked any up-front charges, and your advisor would not receive any up front commission. The advisor would receive a percentage (typically 1.00%) of the average value of your account every year. There would be no cost to sell out of the f-class fund. For non-registered accounts, your Client Advisory Fee may be tax-deductible (check with your accountant).

The Commissions and Trailers are Split by the Advisor and His/Her Firm

As a final note, all the commissions noted above may not necessarily go to the advisor but may be split between the advisor and the advisor's firm. Depending on the situation the advisor normally receives between 40% - 80% of the commissions generated, although percentages below and above this range is also possible in certain situations.

Don't forget to enter the draw for the 2008 KPMG Tax Planning book. Click here to enter. 

In highschool and university I was a trekkie. Not a defcon-5 kinda trekkie who actually made it out to a convention, but I was a fan. One of the fictional races in the Star Trek universe was the Ferengi who were known as being mega-capitalists more than anything else - their government and religion was based around "profit", and they all lived and died by "The Ferengi Rules Of Acquisition". I thought I would share some of the 285 rules with you. The ones here are pretty good and might be transferable to the real world:

#8. Small print leads to large risk.
#9. Opportunity plus instinct equals profit.
#34. War is good for business.
#35. Peace is good for business.
#48. The bigger the smile, the sharper the knife.
#59. Free advice is seldom cheap.
#125. You can't make a deal if you're dead.
#141. Only fools pay retail.
#194. It's always good business to know about your customers before they walk in your door.

And here are some of the more humorous ones:

#1. Once you have their money, you never give it back.
#11. Even if it's free, you can always buy it cheaper.
#23. Nothing is more important than your health. Except for your money.
#50. Never bluff a Klingon.
#77. Every once in a while, declare peace. It confuses the hell out of your enemies.
#89. Ask not what your profits can do for you, but what you can do for your profits.
#112. Never have sex with the boss's sister.
#113. Never have sex with the boss's daughter.
#114. Never have sex with the boss's wife.
#115. Always have sex with the boss.
#189. Let others keep their reputation. You keep their money.
#255. A wife is a luxury... a smart accountant, a necessity.

 Don't forget to enter the free draw for the 2008 KPMG Tax Planning Handbook, click here to enter.

Don't forget that I'm giving away a free copy of KPMG's Tax Planning For You and Your Family 2008 - entry deadline is this Sunday at midnight - you can enter by clicking here for details. I'm enjoying my pseudo time off in Vancouver where I've realized that I'm very much sleep deprived. It's amazing how a 'Control-Alt-Delete' on life re-energizes you. :) Without further adieu...

A Lap Of The Blogs

Investizmo is new to the blogosphere so I thought I would point to his entry on how Microsoft has switched its sights from Yahoo! to Facebook. The blog's author is a trader for a big Bay Street firm and so far his blog is focused more on market news and musings in a very readable tone. Good luck with the blog!

The Canadian Capitalist asserts that currency hedging has its costs and might not be worth it in the long run. Personally, I believe that since the recent past has shown that hedging might have been nice with the run-up of the loonie, that's exactly why you might not want to hedge for the next while anyways.

Canadian Financial DIY gives his two cents on why Standard Deviation and Correlation are not useless tools as espoused by the author of another website (linked from within the blog post).  

The Quest For Four Pillars would like you to know that 'it's the thought that counts' with Mother's day around the corner and provides some suggestions for gifts that won't break the bank.

Thicken My Wallet suggests that you shouldn't judge your advisor when things are going well, but rather you should judge them when things are going wrong. That's Gold Jerry! 

Canadian Dream: Free at 45 has some 'Strange Thoughts' that he would like to share. They are actually not so strange, but definitely thought provoking! The author just welcomed a new baby into the family, so congratulations are in order too!

Michael James On Money writes about one of Warren Buffett's latest investment strategies. He and I continue the discussion in the comments section.

The Million Dollar Journey has a great post that summarized the different types of retirement investment accounts and their differences between Canada and the US.

This Week's Racing Video

So who are the craziest racers in the world? Consideration must be given to the participants of the annual Isle of Man TT Race - over 100 years there has been over 2 deaths per year in this famous event in which motorcycle racers drive as fast as they can through a 37 mile course through a small city. This is a 9 minute video, but just when you think you've seen crazy - it's gets even better! How about doing a wheelie at 300 km/h, and passing a guy on the outside of a corner with walls on either side? Does that qualify as crazy?

Don't forget to enter the draw for the free KPMG: Tax Planning For You and Your Family 2008 book by clicking here. 

Many people are surprised to learn that it is possible to purchase insurance on your investment portfolio. For long term, buy-and-hold investors it's probably not worth it, since with any insurance you have to pay for that protection. The costs ultimately create a drag on the portfolio's long term return (since over very long periods of time markets are expected to go up and so will your basic, simply-diversified portfolio if you can just sit on your hands and ride out the tough times).

Nonetheless, there may be situations where it does makes sense... and come to think of it, if holding the insurance means you are less likely to sell off your portfolio at inopportune times then it can indeed be a great investment in and of itself.

So What Is It?

Portfolio Insurance is actually provided in many different forms, but the one I'm going to focus in on is the Purchasing of Put Options.

First, we must define what a Put Option is: A Put Option is a contract which gives the option holder the right, but not the obligation, to sell an underlying security (stock, bond, ETF, etc) for a set price during the life of the contract. Okay, so what the heck does that mean... Let's explain with an example.

Let's suppose that you own a stock that is currently trading at $50/share. If you own it, that means you think it should probably go up, right? Well, you also know that stocks can move either up OR down in price and sometimes bad news can bring a stock's price down in a hurry. If you wanted to protect against a decline in price you would purchase a put option on this stock. Perhaps you would purchase a put option that gives you the right to sell this stock for $48/share at any point in the next 6 months. You have to pay for this option however, and the price might be $1/share. This means that if the stock suddenly fell in price below $48/share in the next 6 months, you wouldn't particularly care since even if the stock was trading at $40/share you could exercise your option to sell the stock for $48/share to the person you bought your put option from.

If the stock never trades below $48 and you never exercise your option during the life of the contract that's fine - the contract just expires worthless. Whether you exercise your option or not, that price you paid for that contract ($1/share) is forever lost. And if you wanted your portfolio "insured" at all times, you would have to buy a new put option contract when the old one expires - which in this case would cost your portfolio 4% per year. That is a significant drag on your portfolio when the markets are moving up, however it's a perfectly acceptable cost when the markets are dropping and it works in your favour, right? Well, since the markets tend to go up 2/3 of the time and down only 1/3 of the time it may not be worth using on a constant basis.

The graph below show the profit-loss of just buying our example stock for $50 (shown in the dashed grey line). You can see that the break-even point is the $50 mark of course (since you are neither up nor down at this point). If the stock's price goes up, so does your profit. If the stock goes down in price, you could lose up to $50/share if the stock became worthless (or 100% of your investment).

The colourful line which goes from red to green shows the profit-loss profile of buying the stock and buying a put option  with a $48/share strike price with a cost of $1/share. The investor is protected from ever losing more than $3/share - this is made up of the distance of the purchase price of the stock ($50/share) from the strike price of the put option ($48/share) PLUS the cost of the put option ($1/share). The cost of the put option also moves the breakeven point to the right to $51/share (purchase price of stock plus cost of the option), and it also creates a drag on the upside performance (just the cost of the option). In this case, the downside is limited while the upside is again unlimited, albeit with a slight drag.

If you are thinking about implementing portfolio insurance, there are a couple of things you can do to lessen the drag on your portfolio:

First, you can purchase a put option with a lower strike price, of say $42/share. This represents insurance that protects your investment from dropping more than 16% as opposed to 4% as would be the case with a $48/share strike price used in the above sample case. If you own an individual stock or even a broad market optionable ETF, a 4% movement (in either direction) is par for the course on a regular basis. I would rather buy a put with a strike price that you know would make you jittery if the underlying stock ever fell to those levels. You would dramatically cut the cost of the insurance (and resultant drag on the portfolio), and you wouldn't worry about a regular correction (since you are protected), meaning you are less likely to sell at the wrong times like most people.

Second, you can pick when to implement the insurance. When the markets have just tumbled, option prices go up for puts as there is more volatility and fear. You probably don't need the insurance after a correction just happened anyways, so I wouldn't be buying puts right now for example. On the other hand, when your portfolio has been growing faster than the long term average you expect for your portfolio, it might be a better time to consider the puts. When markets are chugging along, there is less fear and put options may be cheap to buy.

However, irrespective of put option pricing, i.e. even if puts always cost the same, I would still recommend giving more thought to puts after your portfolio has been on an upward tear as opposed to after it has tumbled - you are more likely to need the protection reverting down to the mean and less likely to need it after a market correction has just happened.

I think I'll stop right there since this has been a fairly lengthy post, but we have only begun to scratch the surface! I'll write more about options and strategies in the future if you guys are interested. As a final note, I should point out that 1 option contract is for 100 shares of the underlying security so if you wanted to buy 1 put option contract for $2/share you would want to own 100 shares of the underlying stock and the cost of the option contract would be $200 + commissions (maybe $15 at a discount brokerage).

Also, remember to enter the contest for the free tax planning book: click here. 

Win a Free Copy of KPMG's Tax Planning For You and Your Family 2008! 

Just arrived in sunny Vancouver today for two weeks of visiting with my parents and with my BC clients, so I needed a quick post to whip up! As luck would have it, someone sent me an extra copy of KPMG's Tax Planning For You and Your Family 2008, so I thought I would give it away through a contest on the blog.

Every year I keep the updated copy with me almost at all times (home or work), and to be honest, I do even read it at night for fun on occasion. The book is not daunting at all, it's actually set up mostly in a point-form format with very quick and succinct information that is surprisingly easy to read. Anyone who has an interest in personal finance should consider buying a copy. I think most people would find a few tips that will save enough taxes to cover the purchase.

However, you might want to wait a few days before running off to make that purchase because you'll want to see if you won this giveaway contest that I'm running first. :)

Easy Rules:

• Just leave a comment on this post by midnight (EST) on Sunday May 11th, 2008 (scroll down to see the comment link below) for a free entry.
• Bloggers can earn a second free entry by providing a link to this contest post on any regular blog entry between now and midnight on Saturday May 10th, 2008 (and drop me a line, or let me know through your comment below that you did so, or are planning to so I know to look out for it and count it).
• Random draw for the winner will take place at midnight on Sunday May 11th, 2008 with the winner announced on Monday May 12th, 2008.
• You must provide a valid email address in the comment form (don't worry it is kept private and not shown to others)