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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2
July-09-10

The Curious World of Bank Brokerage Focus Lists

Most of the Canadian bank brokerages have considerable client assets in a twenty stock portfolio of Canadian equities. Typically, these are called Focus Lists or Core Portfolios. In all cases, the proposition to clients is that the stocks are selected on the basis of a sophisticated analysis of the Canadian stock universe using the skills of the bank’s analysts and economists. The result is an allocation of stocks across different industry sectors and the selection of specific stocks that have the best opportunities for returns. The recommended stocks are revised quarterly with typically 2-3 stocks being replaced.

RBC-Focus-List.jpg

Source: http://dir.rbcinvestments.com/pictures/account-paul.forer/portfolio%20strategy.pdf

The RBC Dominion Securities Focus List was one of the earliest examples and RBC’s literature depicts the performance with charts as illustrated above. It is difficult not to be impressed by 25 years of growth above the S&P/TSX, suggesting that the clever folks at RBC are skilful active managers, outperforming the TSX every year, on average, by 6.6%.

How close is actual investor experience to these charts?  RBC make clear that the “return  excludes dividends and any transactions costs and/or fees” and “the chart is shown only to illustrate the effects of the compound growth rates and are not intended to reflect....returns on investment in the Focus Lists” In other words, investors can’t invest directly in the Focus List. So how do we realistically evaluate what a typical investor experience might be?

Fortunately, the RBC Focus Fund has been used as the basis for mutual funds so we can look at the investor experience with these funds. The RBC Dominion Securities Canadian Focus List Portfolio (“The FT/RBC Focus List Fund“) from First Trust Portfolios Canada has followed the RBC Focus List since 2001.

Annualized-return.jpg

The performance advantage of the RBC Focus list compared to the S&P/TSX market index has shrunk to 2.6% in more recent years compared with 6.6% since 1985. Also, the FT/RBC Focus List Fund trails both the RBC Focus List and the S&P/TSX market index.

There are fees associated with running the First Trust fund that reduce the overall returns. First Trust reports these fees, including advisor compensation, to be 2.05%. We could add this back to the annual returns to get a gross annual for the FT/RBC Focus List Fund of 5.09+2.05 = 7.14%. Even this gross return trails the market index and the RBC Focus List.

Why does the First Trust fund (which is something an investor can purchase) lag the RBC Focus List? Part of the reason may be that the RBC Focus List returns are calculated based on the closing prices at the end of the day before the stock changes to the Focus List are announced. Investors (even well organized ones such as First Trust) may not be able to purchase or sell securities at those prices the following day due to market movements. Just as an analyst downgrade can reduce a stock price, so can changes in the RBC Focus List move the market against the investor.

Scotia McLeod has a similar 20 stock portfolio which is replicated by a First Trust mutual fund. The results are summarized in the Table below.

Annualized-return-SPTSX.jpg

The fund has an annual expense (MER) of 1.94% so this would equate to a gross return of 5.79%, considerably below the benchmark of 10.71%.

Tax considerations

An additional hurdle the twenty stock portfolios offered by the bank brokerages have to overcome is their relative tax inefficiency. For most investors, holding bonds and other interest generating investments within tax deferred structures such as RRSPs makes sense, leaving many equity portfolios exposed to tax on realized gains. From a tax perspective it makes sense to defer tax on gains as long as possible.  

The prospectus for the First Trust RBC fund warns investors to expect a 100% turnover of the fund over 2 years (equating to selling 2-3 positions every quarter). To understand the tax implications we compare two scenarios:

  1. Holding the RBC Guided Portfolio and transacting 50% of the positions every year.
  2. Holding the TSX/60 iShares index ETF for 10 years and then selling all the positions.

Assuming the highest rate Ontario tax rates of 46%, and holding the portfolio for 20 years the tax drag due to realizing gains every year rather deferring for 20 years is 0.43%. Although this may seem small in percentage terms it means that for every $100,000 invested, $31,285 is lost over 20 years because of realizing taxable gains every year.

For simplicity we ignored any capital gains realized from holding the iShares TSX/60 ETF. Since there is some movement in and out of the TSX top 60 companies every year there is some selling and buying, resulting in gains.
As a comparison to the theoretical scenarios above, we calculated the tax actually paid on capital gain distributions for the 5 years from Jan 2005-Dec 2009 from the First Trust RBC Guided Portfolio to be $5,552 for every $100,000 invested, compared with $1,221 for the iShares TSX/60 ETF. This equates to a tax penalty of about 0.86% per year.

Conclusions

Based on the published evidence available, there exist a substantial performance gap between the gross return of the RBC Focus List and that realized by investors in a mutual fund that buys and sells the same positions. Fees account for approximately half the observed differences.

Comparing the performance of investable securities over the past five years suggest that both the RBC Focus list and the Scotia Canadian Core Portfolios under-performed a comparable index. When taxes are included, the high turnover of the bank brokerage portfolios imposes a tax drag of between 0.43% (estimated) and 0.86% (calculated using 2005-2009 data).
 

By: Graham Westmacott | 2 comments