It is true that an investor can obtain spectacular returns by picking the right penny stock. If you had picked up Aber or Aurelian Resources back when they were penny stocks, your investment would have become a ten bagger many times over. But that’s a bit like saying if you pick the right combination in the LottoMax draw, you can turn a $5 “investment” into $50 million. The key question is how likely is it that an investor will pick a winner out of the thousands of penny mining stocks that trade on the Venture exchange?

Research into penny mining stocks is hard to come by but I did find one study that looked at returns on stocks trading in the over-the-counter (OTC) markets in the US. The study covered a 9-year period and examined the returns from more than 7,000 stocks that traded in the OTC. The findings in the paper, titled Do investors overpay for stocks with lottery-like payoffs? An examination of the returns on OTC stocks, will be sobering for investors interested in penny stocks. It found that more than half the stocks in the sample lose more than 95% of their value (and in the interest of fairness, it must be mentioned that slightly less than 1 percent of the stocks in the sample returned 1,000 percent or more) and average annual returns were -30 (minus thirty) percent. A $1,000 investment in OTC stocks would, on average, turn into $30 over a 10 year period.

If penny mining stocks were to have similar return characteristics as US OTC stocks, an investor can, on average, expect a total loss of the capital allocated to the risk portion over time. One would hope that this particular risk barbell strategy does not require an investor to regularly rebalance her portfolio!

Related Reading:

• Bogle’s Estimate of the Behavioral Gap
• The Dogs (of the Dow) Don’t Bark
• Mensa’s Poor Investment Record
• Emotions affects fixed income investors too
• Morningstar study on investor returns

Do Penny Mining Stocks count as Investments? is brought to you by Canadian Capitalist — Helping you to invest & prosper.

Thanks to the new Horizons U.S. Dollar Currency ETF, Norbert’s gambit is now easier than ever. This ETF is available in two versions. The first, with the ticker symbol DLR, is bought and sold in Canadian dollars, while the second, DLR.U, trades in U.S. dollars. The difference in price between the two versions reflects the current exchange rate: at press time, DLR was trading at $10.18 Canadian, while DLR.U was priced at $9.96 U.S.

Here’s how you can use this ETF to exchange $10,000 Canadian:

1. Get a quote for DLR and calculate how many shares you can buy for $10,000 Canadian.
2. Place an order for that number of shares. The trade will settle in Canadian dollars.
3. Call your discount brokerage’s customer service desk and ask them to take your DLR shares and “journal them over” to the U.S. dollar side of your account, where they should show up as DLR.U.
4. Place an order to sell all of your DLR.U shares. The trade will settle in U.S. dollars.

You’ll pay two commissions and lose a little on the bid-ask spread, but you’ll still save big overall. Note that this technique only works if you can hold U.S. dollars in your account. Most brokerages don’t allow this with RRSPs.

Let’s start with cash. Today, the net return on a money market fund is practically nil. If you deposit your savings in a one-year GIC, you’ll be lucky to get 1.25%. With inflation running at about 3% so far this year, you are losing close to 2% in purchasing power each year. That’s a high price to pay for safety.

What about government bonds? The benchmark 10-year Government of Canada bond yield as of early November was 2.15%. Again, with inflation at about 3%, your net annual purchasing power loss is almost a full percentage point. And that doesn’t include fund fees.

These low yields might be a fair price if they came with peace of mind. They don’t. The important thing to remember with bonds is that your long-term return is mostly determined by the prevailing yield at the time of buying. Yes, you may have temporary capital gains if yields decline, or capital losses if they rise. However, those gains or losses disappear as you approach maturity. The major risk with bonds today is that if inflation stays high or rises further, you will be stuck with negative real returns.

There is one investment that gives you the best of both worlds: safety and inflation protection. It’s called a real-return bond (RRB), or inflation-protected bond.

Before I elaborate, let me explain how RRBs work. Traditional bonds have a “coupon,” which is the annual interest rate you receive on the principal. If the bond’s principal is $100 and the coupon is 1%, you’ll receive $1 in interest every year. (More properly, you’ll receive 0.5%, or 50 cents, every six months.) When the bond matures, you get your $100 returned to you.

With RRBs, the coupon always stays the same, but the principal gets adjusted every six months based on the rate of inflation, as measured by the Consumer Price Index. For example, if you invest $100 in an RRB and inflation is 2% during the period, the principal grows to $102. Your semiannual interest payment is based on that adjusted amount: you’d receive a payment of 0.5% of $102, or 51 cents. That goes on until the bond matures, at which point you receive the inflation-adjusted principal.

To me, RRBs are a plausible alternative for investors who want the safety of bonds combined with inflation protection. Unfortunately, there’s no such thing as a free lunch. Today, the average yield on Canadian RRBs is 0.85% or so, excluding the inflation adjustment. In other words, 0.85% is your expected real return after inflation, but before management fees. Problem is, the cheapest RRB fund in Canada carries a 0.29% annual fee. So after paying fees, your real return on a bond held to maturity in this fund can’t exceed a paltry 0.56% per year.

That’s not all. The shortest RRB maturity available in today’s market is 10 years, and the average term to maturity of your typical fund is 20 years. Thus, by investing in one you will have condemned part of your portfolio to mediocrity for 20 years or so.

For those reasons, most analysts and advisors have stopped recommending RRBs to their clients. Their argument is simple. Not only is the return mediocre, but the risk, in their view, is high. Over the past 10 years or so, the yield on RRBs has gradually dropped from 4% to 0.85%. If yields revert back to the historical mean, capital losses could be significant. By significant, I mean that each 1% increase in RRB yields would reduce your fund’s market value by 16%.

Okay, that’s the downside. Stay with me though, because there’s an upside too. I personally am willing to live with the risk inherent in RBBs for several reasons.

First, an inflation-safe bond with mediocre returns is better than one exposed to inflation risk. Every investor needs some bonds in his or her portfolio, and I’d rather have the former.

Second, RRBs have an inherent stability mechanism and are therefore not as risky as people fear. The probability of RRB yields rising again is very low in the foreseeable future. Remember that bond yields rise for two reasons: when inflation expectations rise, or when the credit risk of the issuer worsens. With RRBs, the inflation adjustment takes care of the former. As for credit risk, RRBs are primarily issued by the federal (and to a much lesser extent, provincial) governments, all with good credit standing.

Third, bond yields are subject to the laws of supply and demand. Here is the key point: RRB supply is scarce, and when supply is short of demand, prices remain high (and yields remain low). Currently, RRBs represent no more than 5% of the total supply of government bonds. The Canadian government projects this to increase to 10%, but I still believe supply will remain tight.

The fact is, governments have a disincentive to issue RRBs unless they believe future inflation will stay very low. And barring a European-induced financial meltdown, global inflation is here to stay. While they won’t admit it, governments like this combination of low interest rates and moderate inflation because it lightens their debt burden significantly. If you’re paying 2% interest on your bonds and inflation is 3%, your real cost of borrowing cost is negative. If governments can borrow today at negative cost, why would they issue RRBs that close that gap and make borrowing more expensive?

With all of this in mind, putting some of your portfolio in an RRB fund is not a bad idea. But don’t go for the kill. The risk of higher yields—and therefore falling prices—cannot be completely ruled out. More importantly, don’t put in any money that you may need in the next five years. RRBs have very long maturities, and rising interest rates may force you to sell the bonds at a loss.

How much should one invest in RRBs versus regular bonds? Before you decide, understand that RRBs have a built-in inflation expectation. As I mentioned earlier, RRBs yield about 0.85% today, while regular government bonds with comparable maturities yield roughly 2.9%. The difference between those two yields (just over 2%) is what the market expects inflation to be. How much you allocate to RRBs and regular bonds depends on whether you agree with the market. If you expect inflation to be more than 2%, add more RRBs. If you expect inflation will be lower than that, you may want to favour traditional bonds. A balanced approach would include equal amounts of each.

Note that RRBs are not suitable for retired investors who rely on capital withdrawals to supplement their income. The income RRBs spin off is not that rich to start with, because the inflation adjustment is added to the principal, not paid out in cash. RRBs are most suitable for middle-aged investors who are saving for retirement and want to ensure their fixed-income investments keep pace with long-term inflation.

Click image to enlarge

The “Keeping it real” chart lists RRB funds available to Canadian investors. As you can see, most of them are way too expensive. To begin with, there is no value added from active management, because all the fund managers have only a handful of bond issues to choose from. Therefore, the underlying portfolios in these funds are nearly identical. The best choice, therefore, is one of the less expensive exchange-traded funds, such as the BMO or iShares offering.

Both ETFs have very similar portfolios, with an average maturity of 20 years or so. The BMO ETF is entirely composed of federal government bonds, whereas the iShares ETF has a small component of provincial bonds with a slightly higher yield. I expect the two funds to deliver very similar returns over the long term. For the first half of 2011, both have reported a nominal annual income of 2%, made up of coupon payments with the inflation adjustment. I expect that to improve slightly to 2.5% or so in the second half due to higher inflation.

You’ll notice that the total returns on real-return bonds (that is, interest payments plus price increases) have been extremely good in recent years. But please do not be fooled. This is history that is not likely to repeat itself any time soon. As RRB yields kept dropping, bond prices climbed up. But yields have now reached very low levels and have limited room to drop further, unless people decide to start lending to the government for free. Therefore, the potential for any capital gains is much lower. You do not buy an RRB fund in order to make big bucks, but rather to protect your wealth from inflation while earning a small income.

I’ve looked at the tracking error of S&P 500 currency-neutral funds in past years but the tracking errors in the iShares CDN MSCI EAFE 100% Hedged to CAD Dollars Index (TSX: XIN) remained a mystery because I didn’t have the annual return data for the MSCI EAFE Index* in local currency. XIN holds the iShares MSCI EAFE Index fund (NYSE Arca: EFA) and hedges the foreign currency exposure that EFA’s holdings are denominated in, so that the returns of stocks will not be impacted by changes in the exchange rates between Canadian Dollars and Yen, Pound, Euros and other currencies. (As an aside note that even though EFA trades in the US, Canadian investors holding EFA are not affected by fluctuations in the exchange rate between the CAD and USD but are exposed to the fluctuations between the CAD and a basket of currencies such as Yen, Pound, Euros etc.).

Fortunately, MSCI Barra reports the returns of MSCI EAFE and other MSCI indices in local currencies on their website. Armed with that data, we can look at how well XIN tracks the MSCI EAFE in local currency terms. The following table shows the annual total returns of MSCI EAFE Index in its local currencies (column 2) with XIN (column 3). The results are consistent with our earlier analysis of the tracking error of XSP. XIN shows an annualized tracking error of 1.30%, which is lower than the tracking error shown by XSP but still wide enough to suggest that currency hedging is highly likely to be unprofitable.

 
When a Canadian investor holds a foreign investment directly, they take on the risk that currency fluctuations will affect their returns. Sometimes, the fluctuations will be in the investor’s favour. Other times, as Canadian investors directly holding US securities can readily attest to, fluctuations will hurt returns. Canadian investors in the iShares MSCI EAFE Index Fund (EFA) would have experienced a significant boost from the currency effect. In local currency terms, the MSCI EAFE Index lost 17.3% over the 2006 to 2011 period. Since investors in XIN trailed the index by an annualized 1.30%, XIN’s loss over the same six year period is 23.73%. However, a Canadian investor holding EFA directly would have a loss of 13.91% over the same time period.

The verdict on currency-hedging then (based on an admittedly short history of just 6 years) is clear: Long-term investors are highly unlikely to profit from hedging their currency exposure because currency effects have to overcome significantly large tracking errors simply to break even. When currency effects are negative (as it was the case of the CAD/USD and US markets over 2006 to 2011), currency-hedging still did not show a profit due to tracking error. With positive currency effects (as was the case with CAD/basket and EAFE index over 2006 to 2011), currency-hedged investors are trailing even more because investors did not get the currency boost and paid for their hedging efforts through tracking error.

* – MSCI EAFE Index tracks stock markets in Europe, Australasia and Far East and holds securities that trade in countries such as Japan, the UK and Germany.

Related Reading:

• The Costs of Currency Hedging
• A Tour of ETFs: iShares MSCI EAFE Index Fund
• Comparing Currency-Hedged and Unhedged Holdings
• Flavours of an Index Fund
• Performance of Currency-Neutral S&P 500 Index Funds

Performance of the Currency-Neutral MSCI EAFE Index Fund is brought to you by Canadian Capitalist — Helping you to invest & prosper.

These days, advisers who sell actively managed mutual funds are being peppered with questions from an investing public that is finally waking up to the fact that they’re often being poorly served. Here are the most common objections you’re likely to hear from advisers if you ask about index funds, and some suggestions for how to respond.

“Index funds offer no chance of beating the market.”

This is true. Index funds are designed to track their benchmarks closely, but they aren’t free, so they almost always lag slightly. The point is that actively managed funds usually underperform by even more. Well-run index funds routinely finish in the top quartile over any period longer than a few years, meaning they beat at least 75% of their peers.

Actively managed mutual funds do offer the possibility of outperformance. The question is, what is the probability? According to Standard & Poor’s, less than 20% of Canadian equity funds outperformed the S&P/TSX Composite Index in 2010. Over longer periods, that percentage drops even lower. During the last five years, just 2.5% beat the market. Over 25 years, the odds your portfolio will outperform resemble your nine-year-old’s chances of playing in the NHL.

“Average fund performance may be mediocre. But we select only the best managers.”

It’s amazing that there are billions of dollars invested in poorly performing mutual funds in Canada, but no adviser ever admits to recommending them. They all live in Garrison Keillor’s Lake Wobegon, “where all the children are above average.”

Advisers love to build portfolios with five-star funds and tell their clients they own the best in the business. The question is, did they start recommending those funds before they posted excellent results? If your adviser tells you that your fund has beat its benchmark over the last 10 years, ask him whether he was recommending it in 2002.

The best managers can only be identified in hindsight. Advisers can sell past performance, but unfortunately their clients can’t buy it.

Musson’s Mackenzie Ivy European Class Series A mutual fund is up 4.7% year-to-date (as of Nov. 7), almost 10 percentage points better than the benchmark MSCI Europe index in Canadian dollars, according to Morningstar. His strategy? Musson and co-manager Matt Moody look for companies with good competitive advantages, strong balance sheets, lots of free cash flow and reasonable valuations. About half have no debt.

Many are multinationals that benefit from better growth prospects beyond Europe. The fund has little exposure to banks, or companies located in the distressed European countries known as the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

Musson’s fund has invested in such companies as Hennes & Mauritz AB (H&M), a Swedish-based global clothing retailer with a reputation for low-priced fashion; William Morrison Supermarkets PLC, a U.K. food retailer known for creating market-like retail environments with reasonable prices; and Unilever NV, a Netherlands-based multinational with more than half its sales in emerging markets.

While Musson wants to remind investors that there are no guarantees when buying stocks, he does believe there are still some good opportunities among the less cyclical European equities, mainly in consumer products and health care. “As long as you’re careful, you have a long-term view and you know how to value a business, hopefully you’ll do well.”

However, Musson believes prices of many cyclical European stocks are overvalued, as they don’t fully reflect weak economic prospects yet. As a result, 16% of his fund is currently in cash. Musson has his eye on a number of top quality industrial stocks which he hopes to buy, “but only when we feel the price is right.”

US stocks provided a welcome surprise in 2011. The S&P 500 returned a total of 2.11% in US dollar terms. Since the Canadian dollar depreciated by 2.2% against the US dollar, US stock markets provided meaningfully better relative returns for Canadian investors. Other major stock markets for Canadians were negative: the TSX Composite was down 8.9%, developed markets excluding the US were down 10.16% and emerging markets were down 16.58%.

CAD/USD -2.2%
DEX Universe Bond Index 9.67%
DEX Short Term Bond Index 4.65%
DEX Real Return Bond Index 18.35%
Canadian REITs 24.17%

TSX 60 -8.93%
TSX Composite -8.89%

S&P 500 (in CAD) 4.41%
MSCI EAFE (in CAD) -10.16%
MSCI Emerging Markets Index (in CAD) -16.58%

If you are interested in asset class returns for previous years, Norbert Schlenker of Libra Investments maintains a spreadsheet of total returns for various asset classes going back to 1970.

Sources: Bank of Canada, PC Bond Analytics, MSCI Barra and Standard & Poors.

PS: Note that percentage returns are inclusive of dividend or interest or distributions.

Related Reading:

• Asset Class Returns for 2010
• Asset Class Returns for 2009
• Asset Class Returns for 2008
• Vanguard to Introduce Six New ETFs
• Investing in Emerging Markets

Asset Class Returns for 2011 is brought to you by Canadian Capitalist — Helping you to invest & prosper.

iShares recently introduced a Floating Rate Note ETF (Factsheet, Prospectus) that mostly holds federal and provincial bonds that pay a variable coupon that is referenced to a specified market interest rate and adjusted regularly. iShares says that the rationale for owning floating-rate securities is to minimize losses in the bond portion of the portfolio in a rising interest rate environment. The ETF’s management fee is 0.20% and iShares will be waiving the management fees for an introductory period.

Traditional fixed income securities typically decrease in value when interest rates rise and increase in value when interest rates decrease. Floating-rate bonds, on the other hand, are less sensitive to interest rate fluctuations but the income stream from floating-rate securities will fluctuate based on prevailing interest rates. Currently, XFR sports an yield-to-maturity of 1.46% and the duration is just 0.13 years (duration is a measure of the sensitivity of a fixed-income security to interest rate changes). In other words, XFR offers cash like exposure.

Given XFR’s cash-like risk/return profile, it seems to me that investors have better options. High Interest savings accounts offered through discount brokers currently offer an yield of 1.25%, which is pretty much exactly the same as XFR’s yield of 1.46% less the management fee of 0.20%. However, unlike an ETF, the high interest savings accounts can be bought and sold without incurring a trading commission.

Related Reading:

• A Tour of ETFs: iShares Bond ETFs (XSB, XBB)
• Mortgage Rates: Fixed or Floating
• Short-Term versus Long-Term Bonds
• Claymore 1-10 Year Laddered Government & Corporate Bond ETFs
• Natural Gas: Fixed or Floating

iShares DEX Floating Rate Note ETF (TSX: XFR) is brought to you by Canadian Capitalist — Helping you to invest & prosper.