The One-Minute Portfolio (Summer 2013 edition): Larry MacDonald

Rebalancing and foreign diversification.

(Photo: Will Crocker/Getty)

(Photo: Will Crocker/Getty)

The One-Minute Portfolio (OMP), launched in 2003, is regularly updated on the Canadian Business website. In this update, we look at recent performance and discuss some aspects of the portfolio’s design, particularly the rationale for going without foreign diversification.

Presently, the OMP is slightly above break-even on a year-to-date basis. Longer term, the average annual return since inception continues to edge down and now stands at 8.3%.

The slight gain in OMP so far this year reflects a small increase in the iShares S&P/TSX 60 Index Fund (XIU), which offset a modest decline in the iShares Canadian Bond Index Fund (XBB). The OMP is made up of just these two exchange-traded funds (ETFs).

Having only two ETFs keeps things simple and requires little time to manage. About the only task is to rebalance XIU and XBB annually, around the end of the year.

The rebalancing rule is up to the individual investor and can be the standard practice of buying and selling units in ETFs to return to a target asset allocation. However, the OMP follows a rule that, more than the conventional rebalancing practice, seeks to “buy low and sell high.” Its strategic asset allocation is 60% in stocks and 40% in bonds but there is scope for it to be varied in response to market conditions, as inspired by Ben Graham’s recommendation in his book The Intelligent Investor.

The OMP rebalancing rule is different in design from Graham’s, partly because ETFs were not around in his time. Specifically, the OMP rule prescribes a lower relative weight for XIU if its annual return exceeds the historical average for stocks of 7% to 9%. If it slips below that range the relative weight for XIU is increased. To minimize false signals, a 2- to 3-year moving average of XIU returns can be used.

The magnitude of the weight change depends on how much XIU is above or below the historical average. Currently, the OMP assigns a 70% weight to XIU and a 30% weight to XBB—having changed since 2008 from 40% and 60%, respectively.

It may be noted that the OMP in some respects replicates a balanced Canadian mutual fund. But it has a much lower cost (about two percentage points annually) and allows the asset allocation to be set by the investor.

Why no foreign diversification?

One reason is that the OMP is designed for a middle-aged person who intends to retire in Canada and doesn’t want to take chances with currency moves, regardless of what back-testing studies show (which have their critics).

Another reason is that foreign diversification takes the OMP away from its focus on simplicity. U.S.-listed ETFs come with currency-conversion costs (averaging about 1.5% a trade in Canadian-dollar accounts). They can be avoided by applying the Norbert Gambit, but this is on the tricky side for the average do-it-yourself investor.  If Canadian-listed ETFs are used, many come with currency-hedging costs that can drag down returns substantially. Other complications are U.S. estate taxes and withholding taxes. The end result: a substantial increase in work load and level of complexity.

However, with the Canadian dollar highly valued against the U.S. dollar, there has been ongoing consideration of amending the OMP to include foreign equities. That’s because foreign diversification usually works best when the Canadian dollar’s purchasing power can buy more foreign assets. And if the Canadian dollar subsequently falls back, foreign assets held by Canadians will be worth more.

But considering the execution burden and risks (heightened potential for missteps), is foreign diversification really necessary for Canadian do-it-yourself ETF investors? According to a recent study by PWL Capital Inc., adding U.S. and international stocks to a portfolio of Canadian stocks and bonds increased average annual returns from 9.1% to 9.3% (during the 1980 to 2012 period).

Most investors don’t need annual returns greater than 5% to 7% to achieve their desired retirement fund. So why be concerned about picking up another 0.2% around the 9% level?

There will be times when Canadian assets underperform foreign assets. Indeed, U.S. stocks are further ahead this year. But over the longer term, Canadian portfolios should average out pretty close to each other, with or without foreign diversification.

 Larry MacDonald is a former economist who manages his own portfolio and writes on investment topics. He is the author of several business books and tweets at @Larry_MacDonald.