Category: Investing

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Investing

RRSPs for Younger Investors

We recently received a question from a reader whose name is Samantha. Samantha asked about the benefits of contributing to a RRSPs (401k for our American readers) for younger investors under the age of 30 who have other debts. My first reaction was – how would I know? It’s been almost a decade since I turned 30, but then I calmed down and looked at her situation and came up with a few suggestions. In addition to my own suggestions I contacted Preet Banerjee of WhereDoesAllMyMoneyGo.com who is much more knowledgeable than myself in these matters, to get his opinion as well. You can think of it like a Pros vs. Joes match! 🙂 A big thanks to Preet for helping out with this one.  If you are wondering when the rrsp contribution deadline is then check out my RRSP  deadline page.

First let’s take a look at her situation:

Samantha is 25, married with a steady job.

Debts

Mortgage – $212,000

OSAP (student loan) = $28,000 at 8% – minimum payment is $309 per month.

Income

Samantha makes $34,500 and her husband makes $49,000.

Other facts

She has an employee match of 100% for up to 3% of her salary in a group rrsp. Currently her rrsp is about $300 (hey, she’s young!).
Samantha basically asked two questions

  1. Should she focus more on debt rather than rrsp? Since she is young she has lots of time to contribute to the rrsp later.
  2. Should she contribute to the rrsp to get the employer match?

The first question is the old “debt vs investment” question which I won’t get too far into since the answer is that in a lot of cases it doesn’t really matter where you put your money since both rrsp and debt reduction are very positive actions. Her student loan does have a higher interest rate (8%) but since student loan interest is tax deductible in Canada, the effective interest rate should not be excessive. It’s possible that the rrsp will outperform the interest rate of the loans but since we can’t predict the future, there is no point in guessing.

A couple of exceptions to the previous statement are:

  • If you have excessive debt where the payments are crushing your lifestyle then perhaps the debt repayment should get priority.
  • If you have very little savings then you might want to contribute more to an rrsp since it can act as a safety blanket if times get tough.

What Preet said:

At $34,500 her marginal rate is 21.05% in Ontario which means her after-tax interest cost on the student loan is 6.32%. If cash-flow is tight (normally the case at that age), then they could consider shopping for new financing on the loan for less than 6.32% with a similar (or shorter term), or for more flexibility they could even pull that into the mortgage (you’d have to check to see the costs for doing so, namely if you have to pay a top-up premium for CMHC premiums). If the mortgage rate is under 6.32% they would free up a fair bit of cashflow. It is important to note that the debt now becomes longer term, so if considering this you would want to make sure the savings are re-directed into something beneficial (mortgage top-up payments, savings, etc.).

If the husband is not maximizing his RRSP contributions, they would yield an extra 10% for spousal RRSP contribution refunds if he makes them to her spousal RRSP account as his marginal tax rate is 31% versus her 21%.

If they do end up consolidating debts, the extra cashflow (perhaps $150 to $200/month) could additionally be used for further RRSP contributions with the refunds going to accelerating the mortgage (or paying down vehicle loans, credit card balances etc.).

Employee match

The question of contributing to an rrsp with an employee match is a no brainer – there are very few circumstances where you should not be contributing to an rrsp with an employer match. To do so is leaving money on the table, so if nothing else – contribute enough to get the match.

What Preet said:

I would most certainly take advantage of the matching – that is free money! Don’t even think about it, just do it.

Summary

Both Preet and I agree that utilizing the 3% employer match on her rrsp should be a top priority.

After that she can split her extra money on debt repayment and rrsps. The exact proportion will be up to Samantha, but considering that her rrsp is very small, she might consider giving more money to the rrsp at first in order to build up a bit of a safety net. Preet made a great suggestion that the husband should be making the extra rrsp contributions into a spousal rrsp since he is in a higher tax bracket. In other words Samantha should make the 3% contribution to get the employer match and then after that, any contributions will go into the spousal rrsp account.

Preet also came up with the suggestion of consolidating their loans which might free up cash flow to further paydown debt.

Anybody else want to add to this?

Please note that I am not a financial advisor so it’s important to do your own due diligence (sorry Mr. Cheap).

Feel free to check out Preet’s personal finance blog.

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Investing

Questrade Announces Slightly Lower Trading Commissions

Last week, (ironically on April 1) Questrade discount brokerage announced a change to their trading price structure. The new trading costs are 1 cent per share with a $4.95 minimum and $9.95 maximum.

I don’t understand

Ok, here are some sample trading costs:

  • If you trade 70 shares then you pay the minimum $4.95
  • If you trade 700 shares they you pay $7.00
  • If you do a trade for 7000 shares (yah right!) then you pay the $9.95 maximum.

How is this different than the old price structure?

Well the old structure was more complicated in that you could choose between two different plans.

The $4.95 plan:

  • 1 cent per share with a $4.95 minimum and no maximum cost.

The $9.95 plan:

  • 1 cent per share with a $9.95 minimum and $9.95 maximum.

The $4.95 plan was better if your average trade was 1000 shares or less and the $9.95 plan was better if you average more than 1000 shares per trade.

Why did Questrade make this change?

If you have read this far, you are probably saying “Mike, I didn’t know what their old pricing was, I really don’t care what the new pricing is, so when is this post going to get interesting?”. Answer = right now! (relatively speaking of course).

My theory on why Questrade changed their pricing structure is that it will save them money – pure and simple.

How does it save them $$?

  • The old structure was somewhat confusing, which probably resulted in a lot of calls to their customer service which cost money.
  • They would have to have systems functionality to handle the two different structures which also costs money.

I suspect that the only investors who would choose the old higher priced option (you need to do 1000+ share trades to make it worthwhile) would be high rollers who do big dollar trades or penny stock investors (since you don’t need a lot of money to buy 1000 shares of a penny stock). The high rollers are probably doing their investing with the big banks since they would get limo rides to their broker’s parties. The penny stock investors are not all that numerous. The fact is that Questrade probably did not have very many clients choosing the $9.95 option so eliminating the option probably does not lower their revenue significantly.

The only investors who will really benefit is some way will be ones who move RRSPs to Questrade and make large initial purchase trades, but then much smaller subsequent trades. When I moved my RRSP, I used the $4.95 plan and paid over $10 per trade on a couple of transactions, so if this policy had been in place at that time, I might have saved about $4.00 in trading costs. I knew I should have waited! 🙂

Summary

This pricing change is fairly insignificant because they already have the cheapest pricing by far in the Canadian discount brokerage industry, and it doesn’t change the trading costs significantly for the average investor. I think the biggest benefit to this move is less complexity for the investor which is always a good thing.

Click here to open an account with Questrade

Some other posts I’ve written about Questrade:

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Investing

Is Lending Club Bankrupt?

Lending Club, the popular peer-to-peer lending site sent out an email this week to members basically saying that they are ceasing to accept any new loans indefinitely. In the email they mention they are filing with the SEC to be able to create a secondary market for their loans, but there isn’t any mention of why they can’t keep accepting new money.

I find this is extremely suspicious behaviour. What kind of company stops selling their product while a new one is being developed?

Over at TechCrunch, there is speculation that Lending Club needs to get a broker-dealer license from the SEC to legitimize its operations. If true then it’s very possible that Lending Club will be back in business, but it doesn’t say much for the company if they didn’t get this license before they started.

Obviously I didn’t anticipate that Lending Club would run into financial trouble but in a post I did recently, I raised a concern about their marketing costs:

Another issue I have is that Prosper and Lending Club seem to be spending a lot of money to get clients – advertising, free money giveaways. Where does this money come from?

Speculation alert!

I think that Lending Club is finished. While it’s possible they can come back from the dead, I suspect they will just sell their portfolio of loans to another company and that will be it.

[edit  – looks like I was wrong!  Lending Club is alive and well]

 Other resources

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Investing

New Vanguard Global Stock Index Fund and ETF

earth.jpg
photo by wwworks

Vanguard just announced that they will be offering a global stock index fund and global stock exchange traded fund (ETF) in the second quarter of 2008.

They will track the FTSE All-World Index which measures the performance of large- and mid-cap stocks worldwide according to their market capitalization weighting.

The fund will be approximately 45% U.S. securities and 55% non-U.S securities.

Global Stock Index fund and Global Stock ETF fees

The fees are 0.45% for the index fund (available to American investors only) and 0.25% for the ETF which is available to Canadians through your discount broker. I think the ETF fee of 0.25% is a bit high considering that you can buy the American stock ETF with a mer of 0.07% and VEU which is Europe and Asia – mer is 0.25%. If you were to buy those two ETFs for your portfolio – let’s say 50/50 then the mer would be 0.16% plus extra trading fees. The new ETF is definitely more convenient however.

No small cap

One of the drawbacks of this index is that it only includes mid-cap and large-cap companies so there is no representation of small cap companies. According to the FTSE site, this setup encompasses 98% of the world capitalization so you could make a pretty good argument that the small cap companies don’t matter. A lot of investors such as William Bernstein (author of the Four Pillars of Investing) himself believe that small caps will outperform larger companies mainly because they have a higher risk profile and have done so in the past. Personally I’m skeptical because the “small cap will outperform” thing has been so well documented that I don’t believe they still have an advantage.

Home country bias

It’s been well documented that most passive investors will over-weight their home country when planning their equity asset allocation. There are a lot of reasons – familiarity, currency risk are perfectly valid reasons for having more familiar equities in your portfolio. For Americans, those reasons are not all that valid because their equities make up such a large part of the all-world index that they can diversify abroad and have their home-cooked equities as well. Canadians and other small countries can’t do this – in the case of Canada, the market capitalization share is only 3% so to have the proper weighting, a Canadian would have to have almost no equities in their home currency which might not be a great idea for someone who is in retirement and wants to maintain a high percentage of equities. As I discussed, the Canadian index is not just small, it’s not very diversified either which is a common situation for smaller countries.

Should you buy the new global stock ETF?

I think if you are a passive investor and want to cut down on the number of securities that you own then this ETF is worth looking at. Unfortunately, a lot of investors will probably want to buy at least one more ETF to add small cap companies and to increase their home country investing.

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Investing

Hedge Funds – Are We Missing Out?

I had lunch with a friend recently and he mentioned that he thought that hedge funds and private equity funds are the best places to make money. I disagreed with him and said that I don’t think hedge funds do anything any different than a normal investment fund except that they don’t have any constraints on their investment activities.

Most people who want to invest in managed assets are generally restricted to retail mutual funds. These funds usually have mandates which prevent them from investing outside their core area ie an American bond fund would not be able to invest 40% of its money in Mexican bonds. They also have restrictions against things like options, leverage, private investments. So in other words they will generally just buy publicly traded securities which fall under their advertised areas.

Hedge funds on the other hands can invest in the same type of securities as mutual funds but they can also buy option, use leverage, purchase private companies, trade currencies. All of these options can increase their diversification but also increase their risk.

As a fairly hardcore passive investor I don’t believe that anyone can pick investments that will outperform the “norm” for any length of time. When I hear friends tell me that hedge funds can “outperform” because….of some sort of hedge fund magic – I say that I think the people running the hedge funds are doing perfectly normal economically sound investments (they are smart people after all) and the reasons that people think they are doing so well are as follows:

  • Secrecy – most hedge funds don’t say a word to anyone about anything.
  • Performance presentation – mutual funds have to keep up-to-date performance returns so everyone knows how good or bad they are doing. Hedge funds don’t have to so no one knows how good or bad they are doing.
  • Recent history – The last five or six years have been very good for equities. I don’t care how you invested or which brand of dartboard your analysts utilized – it was pretty hard to lose.

My personal opinion on why hedge funds have done so well in the last five years or so is because the markets have been strong and because of a lot of leverage. Hedge funds are renowned for their use of leverage and while I personally don’t have anything against leverage (I use it myself). The reality is that pretty much anyone could have invested in anything over the last several years and done well. If they used a lot of leverage then they would have done exceptionally well.

Compensation

The typical hedge fund compensation scam…err scheme is 2/20. 2% of assets regardless of how good or bad the fund performs. This part is similar to mutual funds that charge a fixed percentage of assets for their management fees. The 20% is 20% of the profits past a pre-determined level. I don’t know what the typical hurdle rate is but the biggest problem with this compensation is that it encourages the managers to “swing for the fences”. Since fund managers make virtually all their money on the upside and 2% of the assets on the downside (enough to pay for the Rolls), why worry about risk management? Go for the big returns – if they work, the managers are rich. If they don’t, then the managers end up making not much less than if they were conservative to begin with.

My opinion on leverage is that it should be used to increase the risk level of your portfolio if desired. Some investors like to increase their risk by investing in riskier securities. I like to buy safer investments and use leverage on top of that.

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Investing

Strategies for ETFs and Index Funds

In my last ETF vs Index Funds post I concluded that I really didn’t know what the best way to approach the decision between buying ETFs (exchange traded funds) or index funds.

I was trying to show that some investors with small portfolios would be better off starting out with more expensive (because of trading costs) Exchange Traded Funds because eventually they will save money, rather than go with index funds first and then switch to ETFs because if they don’t switch to ETFs later on then the index funds will eventually be a lot more expensive.

As I wrote the post however it hit home that my approach was somewhat flawed because ETFs are quite a bit more work than index funds so someone who can’t be bothered doing a transfer to a discount brokerage probably isn’t going to be interested in logging into their discount brokerage account every month or two and buying more ETFs.  Figuring out the best solution to index funds vs ETFs is not a simple process.

So to clear up the whole issue once and for all, I have come up with a brand new strategy which actually applies to anyone – lazy or not! Please delete my last post on this subject from your brain and read on….

A bit of background

Buying ETFs is always a manual process – first you have to log into the trading platform of the discount brokerage. Once you check the current price of the ETF (you need to know the symbol) then you enter an order which hopefully gets filled. It’s not a lot of work and I find it quite enjoyable, but for an investor who wants a hands off strategy then it might not be the best approach.

Buying index funds (or any mutual funds for that matter) on a regular basis is sooo easy. This is the big reason why ETFs will never be as popular as mutual funds – most people won’t do the work involved to buy ETFs. With an index fund you can set up a monthly purchase plan (often called a PAC) to take a set amount of money out of your bank account each month and purchase various index funds in the proportion you want. For example if you want to buy $100 each of TD e-fund bond, Canadian equity, US equity funds every month then you set that up once and from that day on, $300 will get taken from your bank account each month and a $100 purchase for each of those funds will get completed. Unless you change bank accounts or want to change something such as asset allocation or portfolio rebalance, you never have to lift a finger. I’ve recently found out that Questrade is planning to allow regular debits from your bank account which will fund your account on a regular basis. You would still have to purchase the ETF manually however since they trade like stocks.

New (and improved) Strategy

What I suggest (until next week when I come up with something better) is do your accumulation of assets at TD using their index funds and automated purchases, and then once you have enough assets to make ETFs worthwhile, transfer those assets over to a discount brokerage (I use Questrade ). Once the assets are at the discount brokerage then you buy ETFs. The trick is to continue to do your accumulation at TD.

What happens if you already have a fair bit in assets? No problem – put the assets you have in the discount brokerage and buy some ETFs. Then set up the TD account and follow the accumulation and eventual transfer procedure as described above.

Variables

One question you might ask is about the transfer fees to move assets from TD to the discount brokerage. I would say that should be factored into the equation but also to try to get the discount brokerage to pay for the transfer. If you are moving big bucks ie $100k then I think your odds are pretty good of getting some or all of a transfer fee paid for – even to an existing account. Keep in mind that transfer fees for rrsps are generally no more than $150.

The next question is – at what point of accumulation do I move the assets to the discount brokerage? $25k, $50k, $14 million?

The answer is a bit tricky. You have to calculate the MER being paid at TD and the MER on the ETFs that you would buy at the discount broker and also include the trading fees that you will probably incur at the discount broker – but since the trades aren’t going to be very frequent they can almost be ignored.

For example in my last post I calculated a potential TD MER of 0.44% and a Questrade MER of 0.19%. If you ignore trading and transfer costs then it makes sense to move assets to Questrade every month. This won’t work of course because of the transfer fees and hassle – plus it’s just dumb.

What I would suggest is to transfer assets to Questrade at a point when you can either get a free transfer or the difference in MER is equal (or close to) the cost of the transfer. Now mathematically this doesn’t really work out since you should really be transferring money as soon as you have enough that the difference in MER for several years is equal to a transfer fee, but the other cost in a transfer is the hassle of actually doing the transfer so it might not be worthwhile to do it too often.

So using my example of TD MER of 0.44% and Questrade MER of 0.19%, the difference in MER reaches $125 (I’ll assume this is the transfer cost) at $50,000. According to my rule, this is when you should transfer the assets to the discount broker. This is a pretty reasonable rule since for most investors it will take quite a while to get a TD account up to $50k so it’s not like they will be transferring every six months.

Other things to think about

Look at the difference in MERs – in my example I used several low cost ETFs from Vanguard – if you choose to use more expensive ETFs from iShares (for example the currency neutral options) then the MER difference between TD e-funds and the ETFs will be much smaller and you might end up transferring assets at a much higher level (ie $100k or more).

Trading costs – I’m assuming that once you transfer the money to the discount broker, you buy your ETFs (not too many), set up dividend reinvestment plans and then don’t do any more trades.

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Investing

Is VISA a Buy Now?

Yesterday was the highly anticipated initial public offering (ipo) of Visa – stock symbol “V” (you know you are big when you get a single letter) which ended up being the biggest stock IPO in American history. The stock was sold to (already) rich insiders, ie brokers,executives and various other people much richer than I, at a price of $44 per share.

As is often the case with “hot stock ipos”, the price started trading much higher (around $65) than the initial offering price and ended up the day at $56.50. So the huge financial gap between those rich insiders and myself, is ever so slightly larger as I write this.

The success of the VISA ipo is all the more surprising considering the fact that not once did I use my VISA card yesterday, so I’m guessing someone else perhaps took up the slack? 🙂

Is VISA a good buy now?

Hmmmm…..I have no idea. As I mentioned a couple of days ago I think that the amount of hype around this stock makes it a long shot to make money from trading in VISA shares but what do I know?? Well, I do know that if it was a good buy at the ipo price $44 (which apparently it was), it’s a lot less of a good buy at $56 which is quite a bit higher.

Who made money on the VISA ipo?

Not me (thanks for asking), but judging from the fact that 177 million shares were traded today out of a total float of 406 million – I would guess that a lot of the fat cat insiders who were able to order some ipo shares made out like bandits. Too bad the VISA investment bankers were not inspired by the Google Dutch auction system.

Anyone else?

From my extensive research it appears that the following institutions also made out like bandits in this deal:

  • Bank of America (BAC) – $625 million.
  • J.P. Morgan and Goldman Sachs – $500 million in fees.
  • Citygroup Inc. – $300 million.
  • Quest For Four Pillars Inc. -$0.00

Conclusion

The rich got richer, I’m still going to work tomorrow and VISA will probably do ok, but don’t expect the kind of returns that MasterCard has produced.

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Investing

Visa IPO – The Good and the Bad

With the upcoming VISA ipo (initial public offering) I thought it would be worthwhile to write about this event. I’m not really a stock trading kind of guy since I’m generally more comfortable with exchange traded funds, however I like to follow stocks for interest (and the occasional purchase.)

What’s the big deal with the VISA ipo?

This will be the biggest IPO in US history at around 17 billion dollars. In comparison the much heralded Google IPO was about $1.7 billion dollars which was one of the biggest technology IPOs ever.

What exactly do they do again?

They are in a great business where they get paid for processing transactions for banks that have credit cards. Visa does about two thirds of all such transactions in America. A good chunk of the money will go to the member banks which currently own VISA – given how most of them have been hit hard by the credit crunch, the money will come in handy!

Should I buy the VISA ipo?

The problem with this stock is lots of investors get excited about buying stocks in companies that they are familiar with. Here in Canada we had an IPO a few years ago for a company called Tim Horton’s Donuts (THI) which is our best known coffee shop. This ipo had a lot of buzz around it but the stock hasn’t done all well since the financial performance of a stock has very little to do with the public’s sentiment toward the company.

Another easy comparison is Mastercard which has gone up about 400% in the two years since its IPO. As ThickenMyWallet points out, there are significant differences between the two companies such as the market share. Visa already has a good majority of the market so it will be hard for them to improve on that.

Don’t forget – IPO prices are based on supply and demand – if there is enough buzz around the stock then the IPO price will go up and it will be harder to make money from it. This buzz will frequently cause the stock price to rise a lot in the beginning which is when the average investor can buy it so it’s often a classic case of buying high.

On the other hand – investors who bought shares of Google (Goog) have done quite well until recently.

Another post on the Visa ipo.
A good post on the Tim Horton’s mania.