That message seems to well understood, but a related issue has come up a few times with clients of our DIY Investor Service. We’ll be working with a client who has a nine-to-five job, and when it comes time to implement the portfolio he’ll ask whether we can make the trades in the evening, after the markets have closed. Wouldn’t the orders just be filled the next day after the opening bell, he’ll ask? They might, but you may not like the results.

Prices that go bump in the night

It’s quite common for companies and governments to make important announcements in the pre-market or after hours, which may causes price of securities to open sharply higher or lower than their previous closing price. When that happens, market orders could get filled at a price much higher or lower than you expected. And even though limit orders are safer, they may go unfilled if an ETF’s price opens well above or below its previous close.

International equity ETFs can be especially vulnerable, since their domestic markets are open when North American exchanges are not. When the opening bell rings in Toronto or New York, market makers need to update prices based on what happened during the night.

And as I’ve discussed before, an ETF’s market price will occasionally diverge from its net asset value. This is most likely to cause problems in the first few minutes after markets open and the last few minutes before they close. If you place an order after regular trading hours it will be executed as soon as the market opens the following day, exactly when the likelihood of a price distortion is highest.

The Toronto and New York stock exchanges are open on weekdays between 9:30 a.m. and 4 p.m. Eastern Time, which admittedly can create a narrow window for those in other time zones. If you live in British Columbia, the markets close at 1 p.m. local time, while Nova Scotians can’t place a trade until 10:30 a.m. But even if these times are inconvenient, ETF investors should make an effort to work within them—or they may wake up to an unpleasant surprise.

Most investors understand that when interest rates rise, bond prices fall. But there are many different interest rates, and they all affect your bond fund in different ways. The shortest of short-term rates is the target for the overnight rate, which is set by the Bank of Canada to control monetary policy—in other words, to keep inflation low. This rate influences the prime rate banks use to price variable-rate mortgages and lines of credit, so it’s the one most widely discussed in the media.

The Bank of Canada has kept the target rate at 1% since September 2010: that’s more than 32 months, the longest period it has ever remained unchanged. Meanwhile, the prime rate has held firm at 3% during this same period. I’ve been asked by some investors why they’ve seen their bond holdings fall when “interest rates haven’t gone up.”

But as I’ve mentioned, this short-term benchmark is only one of many interest rates. The yields on two-year, five-year, 10-year and longer-term bonds move independently of the target rate, and these are the rates that affect your bond index fund. They’re rarely reported in the financial media, but you can follow them on the Bank of Canada’s website.

The chart below shows the yield on several benchmark Government of Canada bonds over the last two months:

Notice that all of these rates moved upward in May, and the steepest line belongs to 10-year bonds, which have seen yields jump from 1.68% at the beginning of the month to 2.07% on May 29. As a result the iShares DEX Universe Bond (XBB), the BMO Aggregate Bond (ZAG) and the Vanguard Canadian Aggregate Bond (VAB), all which have an average term of about 10 years, saw their market prices fall significantly during the month:

The price is only half the story

There’s another extremely important point to understand. Whenever you look up bond ETFs using a tool like Google Finance, as I did above, the results are highly misleading. These charts show only the change in market price, not the interest payments paid to investors in cash, so they do not reflect the total return of your bond ETF.

These days, with virtually all bonds trading at a premium, you should expect the market price of your fund to fall even if interest rates hold steady. However, the cash payments from the underlying bonds is in the neighbourhood of 3% to 3.5% for broad-based index funds, which will offset at least some of that price decline. Indeed, the three ETFs above each delivered a total return over 1.5% during the 12 months ending in May, even though their market prices fell considerably during that time.

Remember this when you look at brokerage statement. Say you bought ZAG on May 31, 2012, and paid $15.96 per unit. Exactly one year later its price was $15.70, so your statement would show a loss of –1.63%. However, the fund’s total return over that period was +1.62%, because the interest payments more than offset the price drop. You didn’t lose money, even though I’m sure some investors thought they did.

An individual fund’s total annual return never appears on your statements, so you should periodically visit your bond fund’s website to see how it’s really doing. Click the “Performance” tab to see the total return on the fund including price changes and reinvested interest payments. Here’s what they look like for ZAG:

If yields continue to rise, bond funds can and will deliver negative returns even after accounting for interest payments, so you should be prepared for that. Remember why bonds are in your portfolio: they lower overall volatility and provide a cushion when equities inevitably suffer a downturn. If bonds do have a difficult year, that’s not a reason to abandon them: it’s an opportunity to rebalance.

Inside the ETF

First Asset tasked PC-Bond with creating the index for their new strip bond ETF. Here’s the basic methodology:

• the ladder will have “term buckets” with bonds of approximately one, two, three, four and five years to maturity
• each bucket will include five individual strip bonds: four provincial (mostly issued by Ontario and Quebec) and one federal (or federal agency)
• the bonds will be selected with liquidity in mind: the issues must be at least $50 million and will be screened for maximum trading volume
• the index will rebalance annually in June: bonds with less than one year to maturity will be sold and the proceeds used to purchase new bonds for the five-year bucket

No surprises so far. But you’ll recall that one of the key characteristics of strip bonds—and the main reason why conventional wisdom says you should not hold them in taxable accounts—is they don’t generate any income. That’s where this ETF is different: it will make quarterly distributions based on the fund’s average yield to maturity, which is expected to be about 1.6%. That means investors can expect a quarterly payout of about $40 on every $10,000 invested.

Where are these distributions coming from if the holdings don’t actually pay interest? Gordon explains that “for the foreseeable future we’ll hold sufficient cash” to fund the payouts. The drag from this uninvested cash should be trivial, since the amounts are so small.

The cost of the new ETF is also a pleasant surprise. First Asset is offering a fee holiday for the first 12 months: that means a 0% MER until July 2014, after which the management fee will be a modest 0.20%.

A premium problem

Justin’s eureka moment came while working with a client who has a seven-figure fixed-income portfolio, mostly in non-registered accounts. GICs are usually the best vehicle for investors in this situation, but they have a few limitations. First, wealthy investors may find it difficult to stay within the CDIC limit of $100,000 per issuer, especially if their brokerage offers a limited menu. The second problem—more relevant to those of us unburdened by millions of dollars—is that they’re illiquid. Because you can’t sell them before maturity (unless you’re using cashable GICs), they’re not helpful if you want to rebalance your portfolio after a downturn in the equity markets.

In theory, a short-term government bond ETF would solve both these problems, but traditional bond ETFs are terribly tax-inefficient. The reason is that virtually all bonds now trade at a premium: they were issued when interest rates were higher, so they’re priced above face value. That’s a bad combination for taxable investors, because it means you pay tax on a high coupon and then get stuck with a capital loss when the bond matures.

An example: the iShares 1-5 Year Laddered Government Bond (CLF) would have provided similar credit risk and better liquidity than a GIC ladder, but Justin’s analysis showed it would have a negative after-tax return. CLF pays out about 4.2% in fully taxable interest, and since its yield to maturity is just 1.4%, you can expect it to suffer significant capital loss every year.

There must be hundreds of millions invested in this tax-inefficient manner. CLF has more than $1 billion in assets, and the iShares DEX Short Term Bond (XSB) is the second-largest ETF in the country with more than $2.2 billion. Surely not all of that is held in registered accounts, which must be making the Canada Revenue Agency dance a little jig.

More tax-friendly than you think

Faced with this problem, Justin thought of strip bonds, which always trade at a discount. With strips you pay tax only on an amount equal to the yield to maturity, not on an inflated coupon. And you won’t suffer a capital loss unless interest rates spike and the bond is sold before maturity.

These tax advantages are overlooked by folks who say strip bonds should never be held in a non-registered account. It’s true they don’t generate income, but if you weren’t planning to spend the interest payments, that’s irrelevant. In any case, First Asset’s new ETF is structured to pay distributions, so you end up with the best of both worlds: tax-efficiency and cash flow.

To sum up, BXF is designed for non-registered accounts where the investor wants a fixed-income product combining the tax-efficiency of GICs and the liquidity and security of government bonds.

The only trade-off is that strip bonds have a longer duration than traditional bonds of the same maturity, so BXF (with a duration of about 3.6) will be somewhat more sensitive to interest rate movements than CLF (duration 2.5) and XSB (duration 2.8). That means a little more volatility, but if the idea is take advantage of rebalancing opportunities, that’s not necessarily a bad thing.

A strip bond ETF is a useful and innovative product, I’d say. Makes you wonder why no one thought of it before.

Patrick, 38, and Lisa, 37, moved their RRSPs out of a large investment firm to switch to ETFs. They don’t consider themselves aggressive investors. With sons Philip and Jeremy still in grade school, they aren’t expecting to retire for at least 20 years. “I question whether our asset allocation is optimized,” Patrick says. Half the portfolio is in two iShares dividend ETFs (TSX-listed CDZ and XDV), 40% is in two iShares bond ETFs, and the rest is in the iShares Gold Bullion Fund (CGL). They want to cut costs and add exposure to U.S. and international equity income, but aren’t sure how to do it. “My head is starting to spin,” says Patrick.

The fix

The existing 40% bond exposure is about right but Brian Smith, portfolio manager with Fit Private Investment Counsel, recommends lowering Canadian equity exposure to 25% and halving the gold play to make room for 30% international content. Fit provides discretionary investment counsel only in Ontario and B.C. and most client equity portfolios are tilted to higher dividends, Smith says. “Asset allocation targets can be achieved by utilizing new contributions. As the portfolio grows there will be sufficient assets to include more asset classes and specialization.” Smith actively manages asset mix and tactical components as market conditions change but “for investors attempting to go it alone, it makes more sense to stick to the basic building blocks.” Their pensions already hold some global mutual funds and Lisa says she’s comfortable branching out globally. “There’s high risk everywhere. You can’t hide from it.” As their global exposure grows, some ETFs should be hedged back into the loonie. It’s normal to leave the first 20% or 30% of foreign exposure unhedged, but after that Canadian dollar-hedged ETFs should be used, Smith says. Lisa and Patrick are still under 25% foreign exposure, even in the rejigged portfolio. “Cost isn’t everything,” Smith says. “Most important is to build the portfolio. Be conscious of cost but it’s not the only driver.” Apart from Vanguard, most major ETF companies have at least some low-cost offerings, including BMO ETFs and Horizons BetaPro, he says.

Do you want a portfolio makeover from MoneySense? If so, send an email describing your situation to letters@moneysense.ca

I offered a couple of my own: an international equity ETF that doesn’t use currency hedging, and an international bond ETF. As it happens, iShares answered the first call in April with the launch of the MSCI EAFE IMI Index ETF (XEF), which I wrote about here. Vanguard listed an international bond fund in the US last week, though this isn’t suitable for Canadian investors who want to avoid currency risk with their fixed income.

Justin Bender strips for charity

The winning suggestion turned out to be more innovative than either of these ideas, and it came from none other than my colleague Justin Bender at PWL Capital. The new ETF, which will launch in June 11, is called the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF). As the winner of the contest, Justin secured a $10,000 donation for his favourite charity, the Centre for Addiction and Mental Health.

As the name suggests, the ETF will hold a five-year ladder of strip bonds. These fixed income products (also called zero-coupon bonds) do not make semi-annual interest payments like traditional bonds. Instead, you buy them at a discount and they mature at face value. Their yield is calculated by comparing the bond’s purchase price and its future value. For example, if a five-year strip bond with a face value of $10,000 is purchased for $9,057, it has a yield of 2%— because $9,057 invested for five years at 2% and compounded semi-annually would grow to exactly $10,000.

Investors like strip bonds because they remove what’s called reinvestment risk. With traditional bonds, the yield to maturity is only an estimate, because it assumes all interest payments will be reinvested at current rates—and that’s not likely to be the case, since rates fluctuate constantly. With strip bonds, however, there are no interest payments to reinvest, so this risk disappears and the investor knows exactly how much she will receive on the maturity date.

Building a ladder of strip bonds is a popular strategy for fixed-income investors, and it’s one advocated by Hank Cunningham in his excellent book, In Your Best Interest: The Ultimate Guide to the Canadian Bond Market. However, Cunningham points out that such a ladder is only appropriate if you don’t need income (since there are no interest payments). He also argues that strip bonds are unsuitable for taxable investors, and that opinion is widely held. The most common place for a ladder of strip bonds is in a long-term investor’s RRSP.

How strip bonds are taxed

Every investor knows that fixed-income investments are best held in registered accounts, because interest is fully taxable at your marginal rate. But with strip bonds, there’s another wrinkle: you pay that tax on income you don’t actually receive. That’s because the difference between your purchase price and the bond’s face value is amortized over the life of the bond and taxed annually as though it were interest.

To return to the example above, let’s look at the tax consequences of that five-year strip bond with a yield of 2%. The bond is purchased for $9,057 and matures at $10,000, and this discount is amortized over five years and taxed annually. Meanwhile the adjusted cost base of the bond increases each year by the amount of this notional interest, until it reaches $10,000 at maturity:

The holder of this bond would therefore pay tax on about $181 to $196 of income annually, despite receiving no cash payments. It’s easy to see why the conventional wisdom says strip bonds should not be held in non-registered accounts.

It turns out, however, that when Justin came up with the idea for an ETF of laddered strip bonds, he was looking to solve a problem in taxable accounts, not RRSPs. And the new First Asset ETF is designed with a couple of surprising features that offer a possible solution. I’ll explain more later in the week.

The troubling Morningstar findings struck a chord with readers, who tweeted, emailed and commented directly on my article. For instance, Sheila Keenan ‏@shadwell123 responded: “I know I should pay more attention to fees, I don’t know nearly enough about them.”

These two important questions were also posed: “Why buy mutual funds when you can buy exchange traded funds (ETFs), which have very low management fees?” Dorothy wrote. And from Lee Anne Davies ‏@agenomics: “Why don’t we change?”

Let’s start with the first question. The simple answer is that sometimes mutual funds just make more sense for certain people—particularly, young or novice investors with little income who want easy access to a diverse holding of funds and the benefits of professional money management. If you buy mutual funds through a bank or mutual fund sales specialist (as many investors do), you’re likely going to be charged management fees (or MERs) well above 2%—but for investors just starting out, those high fees aren’t going to make much of an impact on their fledgling portfolio. Others with more sizable savings may also want to go with mutual funds because they’re either completely incapable or uncomfortable with managing their own finances. Or, maybe they want all or a portion of their portfolio to have a chance at beating the markets through active management—very hard to do, but not entirely impossible. Finally, mutual funds are convenient (thanks to monthly automatic preauthorized contribution plans) and avoid transaction costs.

Regarding ETFs, yes, they’re one of the best things to happen to Canadian investors in decades, but they’re not for everyone. For starters, you normally pay commissions to buy and sell them, which makes them unsuitable for portfolios with less than $50,000 and for those who contribute every month. They’re also fairly complicated for the novice, since they’re basically bought and sold like stocks. While you can enlist professional help, advisers in Canada licensed to sell ETFs often work only with wealthy clients.

These above reasons and more serve as the preamble to a feature article, “The Smart Investors Guide To Mutual Funds,” that will be appearing in the forthcoming Summer issue of MoneySense set to hit newsstands toward the end of June. We’ll be providing a comprehensive overview on how to use actively managed mutual funds intelligently, and how to avoid their many pitfalls. Bottom-line: If mutual funds are a better fit for you, you don’t have to get saddled with outrageous fees provided you’re a discerning investor.

Now, on to the second question: Indeed, why don’t we change? Why are Canadians, on average, paying through the nose for mutual funds? For that, I’m going to defer to former Mercer actuary Malcolm Hamilton, who retired last December after a long and distinguished career (although he’s now a Senior Fellow at the C.D. Howe Institute). The following excerpt is from his forward to MoneySense Editor Jonathan Chevreau’s book, The Wealthy Boomer: Life After Mutual Funds, in—wait for it—1998:

“American investors can find no-load mutual funds with MERs under 0.25%. Canadian investors can’t. For this, Canadians have only themselves to blame. We aren’t price sensitive. We either don’t know what we’re paying, or we don’t care. If the customer doesn’t care what the product costs, the producer has no reason to economize. High MERs mean better incomes for investment managers. They mean bigger profits for fund companies. They mean larger trailer fees for brokers. They mean fat advertising budgets. In the long run, everyone is happy—except the customer. Until investors demand a better product by rewarding those who provide it and punishing those who don’t, Canadian mutual funds will have high MERs. And as long as MERs stay high, using mutual funds intelligently means using them less.”

Sadly, Hamilton’s very blunt and accurate assessment was as true 15 years ago as it is today. Many Canadians who use mutual funds are either investing blindly or are completely apathetic to the enormous fees they’re being charged. If that sounds harsh, just remember that losing a big chunk of your returns every year to inflated fees is far worse than some financial tough-love advice.

Canadian mutual fund investors, it’s time to wake up and start pushing back.

I’m not endorsing any of these investments: I don’t use any of them myself, and although I’ve made an effort to understand what they have to offer, I haven’t performed any due diligence on them. You’re responsible for thoroughly checking out any investment before adding it to your portfolio.

Canadian equities

The iShares Jantzi Social Index Fund (XEN), launched in 2007, tracks the best-known SRI benchmark in Canada. The Jantzi Social Index excludes companies involved in military contracting, nuclear power and tobacco, as well those involved in “significant controversies” such as environmental spills. The index includes 60 companies and is designed to roughly mirror the sector weights of the S&P/TSX 60. For what its worth, XEN has outperformed the iShares S&P/TSX 60 (XIU) over the five years ending in April despite is much higher fee (0.55%).

The Meritas Jantzi Social Index Fund tracks the same index, but the manager has also “added further screens in the areas of alcohol, gambling and pornography.” This mutual fund is a lot more expensive than its ETF counterpart: the A Series has an MER of 2.23% plus loads, and the F Series charges 1.30%. But it has a much more activist mandate that some SRI investors may be willing to pay for. Meritas has a long record of shareholder engagement, which the iShares ETF does not share. The fund also allocates a small share of its assets to community development investments that “foster sustainable social and economic well being.”

US equities

The US family of iShares ETFs offers two index funds for socially responsible investors. The iShares MSCI Socially Responsible ETF (DSI) holds 400 large, mid and small-cap stocks screened for “positive ESG [environmental, social and corporate governance] performance relative to their industry peers.” The index gives the boot to companies involved in “alcohol, tobacco, firearms, nuclear power, military weapons and gambling.”

The iShares MSCI Select Socially Responsible ETF (KLD) focuses on fewer and larger companies: it includes about 130 stocks with a median market cap about twice as large as that of DSI. It also screens for companies with high ESG ratings, though the only business activity specifically excluded is tobacco.

The sector breakdown in these two indexes is roughly the same as the broad market so they “exhibit risk and return characteristics similar to the MSCI USA Index.” The MER on both funds is 0.50%.

Importantly, these iShares ETFs have a clear proxy voting policy “consistent with the principle that ‘socially responsible’ shareholders are concerned not only with economic returns and sound corporate governance, but also with the ethical behavior of corporations and the social and environmental impact of their actions.”

International equities

When it comes to SRI index funds tracking companies outside North America, the pickings are slim. The only ETF that fits the bill is the Pax MSCI EAFE ESG Index ETF (EAPS). The index is designed to mirror the popular MSCI EAFE Index, so the largest country allocations are Japan and the United Kingdom, and the largest sector weights are financials, consumer retailers, and health care. From a universe of almost 1,000 stocks, the index screens for the top 150 or so with the highest ESG ratings. The ETF’s management fee is 0.55%.

“Pax World has been in this space for a very long time, and they also perform shareholder engagement, which is why I really like them,” Tim Nash told me in our interview. But this ETF very small, with just $30 million in assets. Indeed, one potential problem with SRI funds is they’re often slow to attract investors and are vulnerable to closure: Pax World used to offer a North American equity ETF with a socially responsible screen, but that fund was shuttered in March. (If a fund closes you don’t lose your money: you’re just forced to liquidate. But in a nonregistered account, a forced sale can stick you with capital gains taxes.)

Later in the week I’ll look at fixed income options for socially responsible Couch Potatoes.