Announcing Changes to MoneyGeek's Regular Portfolios

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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At the beginning of every month, I brief members on how MoneyGeek's regular portfolios have performed and comment on the state of the financial markets. In this update, Ill explain my rationale behind the changes to MoneyGeeks regular portfolios.

Performance of Regular Portfolios

The performance of MoneyGeek's regular portfolios for the month of January 2016 were as follows:

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

MoneyGeek's regular portfolios outperformed their competitors in January. In comparison to our competitors, our regular portfolios allocate a higher proportion toward U.S. stocks (i.e. CAPE and BRK-B), as well as towards Canadian oil and gas stocks (i.e. XEG).

January was a relatively rocky month for stock markets globally. Both Canadian and U.S. stocks went down, but U.S. stocks went down by more, even when currency effects were factored in. However, both CAPE and BRK-B did better than the broader U.S. stock market, and XEG outperformed the Canadian stock market. The combination of these factors were responsible for MoneyGeek's outperformance last month.

Reintroduction of QVAL and IVAL

A couple of days ago, I emailed existing members about the changes to the regular portfolios. Let me explain why I made those changes.

About a year ago I replaced CAPE with QVAL, and XEF.TO with IVAL; however, I reversed those changes upon realization that QVAL and IVAL were ineligible for registered accounts such as TFSAs and RRSPs. Purchasing these ineligible ETFs was a big mistake on my part. as Canadian law stipulates that there is a large penalty for those who purchase ineligible investments inside their registered accounts.

Fortunately, after almost a year of lobbying the Canadian government, QVAL and IVAL became eligible as of Dec 31, 2015. I'm not a lawyer, but I believe that this means those who bought QVAL and IVAL last year in their registered accounts won't be penalized for their purchases.

Now that QVAL and IVAL are eligible, I've chosen, once again, to bring them into the regular portfolios. I explained why I like these ETFs in this announcement a year ago, so I won't repeat them here. If anyone wants to really understand how these ETFs work, I would strongly recommend reading the book called Quantitative Value, which was written by the creators of the ETFs. It's my hope that these ETFs will stay a part of the regular portfolios for many years to come.

Introduction of ZPR.TO

As the second significant change to the regular portfolios, I introduced a new ETF called BMO Laddered Preferred Share Index ETF (Ticker: ZPR.TO). As the name suggests, ZPR.TO contains hundreds of Canadian preferred shares from a diverse set of companies, including banks, utilities, and more.

I wrote an article about this ETF many months ago. Back then, I cautioned investors against expecting the current high dividend payments to continue indefinitely. To summarize my argument, dividend yields on preferred shares reset about every 5 years. Since the yields are tied to interest rates, and since interest rates have been going down, I expected dividend yields to go down. When yields did in fact start to go down, investors, whom I suspect were mostly dividend investors looking for increasing yields, sold ZPR.TO and its price fell.

However, theres also another reason why ZPR.TO's price went down. Currently, some 18% of preferred shares that make up ZPR.TO are those issued by oil and gas related companies. I don't need to remind you that oil and gas companies in general are going through hard times, which is part of the reason why investors sold off ZPR.TO. Because of these two reasons, ZPR.TO has lost over 35% of its value over the past year.

However, I believe that investors have overreacted, and I now believe that ZPR.TO represents a good opportunity today. Let me explain why.

First, let's talk about the riskiness of ZPR.TO. While it's true that 18% of ZPR.TO consists of oil and gas related companies shares, that doesn't mean they are necessarily risky. Most of these companies are pipeline companies like Enbridge and TransCanada who don't make any money from drilling for oil. Rather, they provide pipelines for companies that want to transport oil and gas.

Revenues from the pipeline business depend on the volume of oil and gas transported through their pipelines. It doesn't depend on the price of such commodities. Therefore, while such companies are suffering slightly during this downturn as the volume of North American oil and gas production is going down, the decline in revenue won't be nearly as great as those experienced by oil producers.

Most of the rest of the preferred shares in ZPR.TO have been issued by large, stable companies. Almost 60% of the shares were issued by large financial institutions like RBC, while another 9% were issued by utilities like Brookfield, and another 7% were issued by telecoms like Rogers. Companies only tend to suspend dividend payments on their preferred shares when they're in financial distress. Judging from the list of companies, the likelihood of that happening is low.

Also, though I believe that the yields on preferred shares will continue to decrease, even the decreased yields will be attractive. This becomes apparent when you look at individual preferred shares more closely.

Take, for example, Enbridges Series B Preferred Shares. These shares are currently the third largest holdings of ZPR.TO, with about 1.5% of the ETF invested towards them. Ive chosen to use this preferred share as an example, because its dividend will be reset relatively soon, in June 2017.

According to the prospectus of Enbridges preferred shares, when the reset date arrives, the dividend yield will be set at the 5-year Government of Canada Yield on the Fixed Rate Calculation Date plus a spread of 2.40%. Since the 5-year Government of Canada Yield is roughly 0.7% per year right now, that means the dividend yield will be set to 3.1% per year if it were to reset today. In dollar amounts, since the principal value of the preferred share is $25, that means holders of the preferred shares will receive $0.775/year (25x0.031), which is significantly below the current rate of payment of $1.00/year.

At this point, I think its worthwhile to revisit what 3.1% per year really means. That number means that if we bought preferred shares at the principal amount (i.e. $25/share), the dividend payments would represent 3.1% per year of our purchase price. But what if we dont buy the preferred shares at the purchase price?

As of the time of this writing, Enbridges Series B preferred shares are trading at $12.30/share. However, this doesnt change the fact that if the dividend yields were to reset today, it would start paying $0.775/year. This is because the dividend payments are calculated based on the principal value of $25, which doesnt change.

A payment of $0.775/year relative to the purchase price of $12.30/share represents a real yield of 6.3% per year. In other words, if we bought the Enbridge preferred shares today and if the shares dividends reset, we will receive a rate of return of 6.3% per year for the next 5 years, assuming Enbridge keeps paying us.

You may wonder if Enbridge is a special example, given that it is an oil and gas related company. However, Ive found that preferred shares issued by other companies are still cheap, even if those companies are considered to be very safe.

For example, RBCs preferred shares series BD pays a dividend that resets every 5 years at the 5-year Government of Canada Yield plus 2.74%. If the dividend were to reset today, that means the series BD would start paying 3.44% per year (i.e. $0.86/year) . However, since the preferred shares are trading at just $18.40/share, investors who buy shares will really receive 4.7% per year (i.e. 0.86/18.4).

Given the attractiveness of these yields, and given the low risk profile of preferred shares, I have decided to include them in MoneyGeeks regular portfolios. As always, if you have a question, please dont hesitate to ask me at our Q&A forum.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.