Canadians are fed up with the stock market – why buy a broadly diversified ETF or low-cost mutual fund when you could put all your eggs in the housing market? Many investors may be surprised at how well the Canadian stock market has performed over the past decade (or more), relative to the Canadian housing market.
In the chart below, I’ve compared the growth of $1 invested in the S&P/TSX Composite Index (total return) to the growth of $1 invested in the Teranet-National Bank House Price Index for three separate Metropolitan areas; Montreal, Ottawa, and Toronto:
Sources: Teranet and National Bank of Canada, Dimensional Returns 2.0
For the September 1998 to August 2011 period, the results would indicate that Canadian stocks were the overall winning investment (albeit with higher volatility). While this may not be the case going forward, diversification is one of the few remaining “free lunches” in the investment world, and should not be cast aside for hot real estate tips from your brother-in-law.
Although high-yielding bonds are expected to have a higher return, relative to high-quality bonds, the addition of them to a portfolio creates more equity-like risk. If you decide to include them in your portfolio, consider carving a portion of the allocation out of the equities in your portfolio. In Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan, the rule of thumb he suggests for the percentage of your high-yield bonds to allocate to equities is given below:
As an example, consider a Canadian investor who would like to include an allocation of 10% of his portfolio to either the iShares U.S. High Yield Bond Index Fund (CAD-Hedged) (XHY) or Claymore Advantaged High-Yield Bond ETF (C$ Hedged) (CHB) - his portfolio is currently comprised of the following securities:
Using the most current credit quality ratings available on the company’s websites, this method would entail allocating approximately 30% of either high-yield bond ETF to the equity portion of the portfolio, and 70% to the fixed income portion. In other words, the investor’s new allocation would look something like this:
Sources: BlackRock Canada, Claymore Investments, The Only Guide You’ll Ever Need for the Right Financial Plan by Larry Swedroe
Higher-yielding bonds are a bit of a “Catch-22” – their fixed income-like characteristics (i.e. higher interest income) would imply that a registered plan would be the preferred account to house them, while their equity-like characteristics (i.e. higher volatility) would indicate a non-registered account would be the ideal garage to park these investment vehicles (in order to take advantage of tax loss selling opportunities). This “hybrid” structure makes them very tax-inefficient vehicles for investors. So should you invest in higher-yielding bonds?
Portfolio 1: 40% DEX HYBrid Bond Index + 60% MSCI Canada Index
In answering this question, I decided to take an entirely Canadian perspective. The DEX HYBrid Bond Index is used as the proxy for Canadian higher-yielding bonds (it is technically a combination of the lowest investment grade bonds as well as some high-yield “junk” bonds). By combining 40% of the DEX HYBrid Bond Index with 60% of the MSCI Canada Index (Portfolio 1), the hypothetical portfolio would have produced an annualized gain of 7.50%, with an annualized standard deviation of 9.43%. The worst 1-year return over the period studied (January 2002 to September 2011) was -23.48%.
Portfolio 2: 40% DEX Mid Term Federal Bond Index + 60% MSCI Canada Index
If we had instead decided to remain extremely conservative with our fixed income allocation, we could have allocated 40% of the portfolio to the DEX Mid Term Federal Bond Index (all AAA bonds) and 60% to the MSCI Canada Index (Portfolio 2). As can be seen in the chart below, the return would have been identical but the standard deviation would have decreased to 8.44%. The lowest 1-year return would have also been more tolerable, at -18.51%.
Portfolio 3: 40% DEX Mid Term Federal Bond Index + 15% MSCI Canada Index + 15% MSCI Canada Value Index + 15% MSCI Canada Small Cap Index + 15% MSCI Canada Small Cap Value Index
For most investors, their fixed income allocation is meant to add stability to their portfolio during periods of volatility in equity markets. If an investor prefers to take on more risk, a more tax-efficient use of their “risk dollars” would be to tilt toward value and small cap stocks (Portfolio 3). By keeping the fixed income portion conservative, and increasing the risk of the Canadian equity allocation, we would have been able to increase the annualized return of the portfolio to 8.54%, while decreasing the annualized standard deviation to 8.71% and lowest 1-year return to -19.66%, relative to Portfolio 1.
Sources: BlackRock Canada, BMO Financial Group, Dimensional Returns 2.0