Part IV – Real Estate: Creating Cash Flow from the Proceeds from Selling Your House

Prior to selling your home, we encourage you to have a clear plan of what the next stage would look like.

If that next stage is renting, then meeting with your advisor ahead of time is recommended.   Once you sell, the good news is that you no longer have to worry about costs relating to home ownership, including property taxes, home insurance, repairs and maintenance.

Budgeting, when your only main expense is monthly rent, makes the process straight forward.  The key component is ensuring the proceeds from selling your house will be invested in a way that protects the capital and generates income to pay the rent.

The first step is determining the type of account in which to deposit the funds. The first account to fully fund is the Tax Free Savings Account (if not already fully funded). Then open a non-registered investment account for the proceeds.  Couples will typically open up a Joint With Right of Survivorship account.  Widows or singles will typically open up an Individual Account.

The second step is to begin mapping out how the funds will be invested within the two accounts above. A few types of investments that are great for generating income are REIT’s (Real Estate Investment Trust), blue chip common shares, and preferred shares.  Not only do these types of investments offer great income, they also offer tax efficient income, especially when compared to fully taxable interest income.

When you purchase a REIT, you are not only getting the benefit of a high yield, but you are generally getting part of this income as return of capital. The return of capital portion of the income is not considered taxable income for the current tax year.

As a result of receiving a portion of your capital back, your original purchase price is therefore decreased by the same amount. The result is that you are not taxed on this part of the income until you sell the investment at which point if there is a capital gain you will be taxed on only 50% of the gain at your marginal tax rate. You have now effectively lowered and deferred the tax on this income until you decide to sell the investment.

Buying a blue-chip common share or a preferred share gives you income in the form of a dividend. The tax rate on eligible dividends is considerably more favourable than interest income.

Another tax advantage with buying these types of investments is that any gain in value is only taxed when you decide to sell the investment and even then, you are only taxed on one half of the capital gain, referred to as a taxable capital gain. For example, if you decide to sell a stock that you purchased for $10,000 and the value of that stock increased to $20,000, you are only taxed on 50% of the capital gain. A $10,000 capital gain would translate to a $5,000 taxable capital gain.

We have outlined the approximate tax rates with a couple of assumptions.  Walking through the numbers helps clients understand the after-tax impact.

To illustrate, Mr. Jones has $60,000 in taxable income before investment income, and we will assume he makes $10,000 in investment income in 2016.  His marginal tax rate on interest income is 28.2%, on capital gains 14.1%, and only 7.56% on eligible dividends.

If Mr. Jones earned $10,000 in interest income, he would pay $2,820 in tax and net $7,180 in his pocket.  If Mr. Jones earned $10,000 of capital gains, he would pay $1,410 in tax and net $8,590 in his pocket.  If Mr. Jones earned $10,000 of eligible dividends, he would pay $756 in taxes and net $9,244 in his pocket.

The one negative to dividend income for those collecting Old Age Security (OAS) is that the actual income is first grossed up and increases line 242 on your income tax return. Below line 242 the dividend tax credit is applied.  The gross up of the dividend can cause some high income investors close to the OAS repayment threshold to have some, or all, of the OAS clawed back which should be factored into the after tax analysis.  The lower threshold for OAS claw-back is currently at $72,809.  If taxable income is below $72,809 then the claw-back is not applicable.  If income reported on line 242 is above $72,809 then OAS begins getting clawed back.  Once income reaches $118,055 then OAS is completely clawed back.

The schedule for dividend payments from blue chip equities and preferred shares is typically quarterly.  For REIT’s, it tends to be monthly. Once you decide on the amount you want to invest, then it is quite easy to give an estimated projection for after tax cash flow to be generated by the investments.

Preparing a budget of your monthly expenses makes it easy to automate the specific cash flow amount coming from your investment account directly into your chequing account.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria.  His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Let’s make things perfectly clear

CAPITAL MAGAZINE

When hiring an accountant or lawyer, you’re billed after services are rendered. In the investment world, it’s not so transparent. With embedded costs, market-value changes, withdrawals and deposits, it hasn’t always been clear exactly what you’ve been charged.

The introduction of fee-based accounts and recent regulatory changes are making significant strides in providing better transparency to investors.

In the past, most types of accounts were transactional, wherein commissions are charged for each transaction. With fee-based accounts, however, advisers don’t receive commissions. Instead, they agree to a set fee schedule, usually charged on a quarterly basis. This fee is normally based on a portfolio’s market value and composition. Buy and sell recommendations are based on the client’s needs and goals. If an investor’s account increases in value, so do the fees paid; conversely, if an account declines in value, fees go down.

The recent increase in fee-based accounts correlates to the implementation of the second phase of the “Client Relationship Model” (CRM), a regulatory initiative passed by the Canadian Securities Administrators in March 2012. The CRM affects both the Mutual Fund Dealers Association and the Investment Industry Regulatory Organization of Canada.

While the key objective of CRM1 was relationship disclosure and enhanced suitability, CRM2 is designed to increase transparency and disclosure on fees paid, services received, potential conflicts of interest and account performance. All of these mandatory disclosures are being phased in from 2014 to 2016.

Last July, CRM2 mandated pre-trade disclosure of all fees prior to an investor agreeing to buy or sell an investment. With transactional accounts, an adviser must disclose all of the fees a client is required to pay, such as commissions when buying or selling positions. Many investors have complained about hidden fees, especially in mutual funds. With CRM2, all of these fees now have to be disclosed prior to the transaction.

Certain types of transactions had no disclosure requirements in the past. For example, an adviser used to be able to purchase a bond and embed their commission in the cost of the bond on the trade confirmation slip. Now, fixed-income trades also require full disclosure. In other cases, even if there was disclosure in the legal sense of the word, understanding this disclosure required clients to read the fine print in lengthy prospectus documents.

With fee-based accounts, the client has a discussion about fees with their adviser up front, and an agreement with full disclosure is signed by investor and adviser.

Another reason for the popularity of the fee-based platform is that many advisers can offer both investment and planning-related services. Many advisers can offer detailed financial plans and access to experts in related areas, such as insurance, and will and estate planning.

In a traditional transactional account, where commissions are charged for every buy or sell, it has always been challenging for advisers to be compensated for additional services such as financial planning. Consequently, many transactional-based advisers would not offer these services to their clients.

Fee-based accounts also offer families one more opportunity for income splitting by setting up account-designated billing for their fees. The higher-income spouse can pay the fees for the lower-income spouse.

Another benefit of a fee-based structure for non-registered accounts is the ability to deduct investment counsel fees as carrying charges and interest expense. Anyone who has non-registered accounts would be well advised to read Canada Revenue Agency’s interpretation bulletin 238R2. Investment counsel fees cannot be deducted for registered accounts, but there is the benefit of paying the fees for registered accounts from a non-registered account.

Adviser-managed accounts have been the fastest-growing segment of the broad fee-based group. In this type of account, the adviser is licensed as a portfolio manager and able to use discretion to execute trades. In setting up the adviser-managed account, one of the criteria is that the account must be fee-based. Regulators have made it clear a portfolio manager is not permitted to use discretion when it comes to commissions or transaction charges. One of the starting points to setting up a managed account is to get a defined investment policy statement that sets out the relevant guidelines that will govern the management of the account.

Exploring the world of fixed income investments

The term fixed income can be confusing, especially when the financial industry has so many names for the same thing. For someone new to investing I typically draw a line down the middle of a page. On the left side of the page I label this “debt”, and on the right hand side I put “equity”. Debt is another term often associated with “fixed income”. In explaining what debt is I begin by using a simple example, a two year annual pay Guaranteed Investment Certificate (GIC). With a two year GIC you are giving your money to a company and in exchange you receive interest for the use of the capital. You receive your original capital back at the end of two years. You have no direct ownership in the company with debt.

The equity side of the page would have common shares, this is what most people would directly link to the stock exchange. Although some fixed income investments trade on a stock exchange, the majority of listed securities are equities. When the news is flashing details of the TSX/S&P Composite Index, the Dow, or the S&P 500 – these would all be equity indices reflected on the equity side.

Most people would agree that on the equity side of the page it would not be a good idea to put all your eggs in one basket. A prudent approach would be to diversify your equities by holdings various different stocks (i.e. between 20 and 30 different companies) in different sectors and geographies.

All too often I come across investment portfolios that have zero diversification on the fixed income side. As an example, it may be a person that has $500,000 or a million dollars all in GICs. In my opinion the best approach to fixed income is to have diversification – different types and different durations.

If we move back to the left hand side of the piece of paper, underneath debt we have already listed GICs. Let’s list a few other types of fixed income investments including: corporate bonds, government bonds, real return bonds, bond exchange traded funds, notes, coupons, preferred shares, debentures, bond mutual funds, etc.. Over the last decade there has been a huge growth in non-domestic bonds for retail investors. Perhaps one area that is often underutilized by many Canadians is the use of international bonds. Bonds are available in different developed countries. Advisors are able to purchase direct foreign bonds in developed countries and emerging markets. The emerging market bond space has opened up many different opportunities. With certain structured bond investments, these can be hedged to the Canadian dollar or not hedged (you are exposed to the currency risk).

Within each of the above main categories there are sub-categories. As an example, with bond ETFs one could purchase numerous different types, including: floating rate, short duration (example: one to five years), long duration, all corporate, all government, high yield, US bonds, etc.

Another example of subcategories can be explained using preferred shares as an example. Preferred Shares are generally classified as “fixed income” even though they pay dividend income (similar to common shares that are on the equity side of the page). For clients who have non-registered funds, a portion of your fixed income in preferred shares can be more tax efficient than interest paying investments. The main types of preferred shares are retractable, fixed-reset, floating rate, perpetual, and split. All have unique features that an advisor can explain to you.

When equity markets perform well it is natural that they become overweight in a portfolio. We encourage clients to periodically rebalance to their preferred asset mix. In good equity markets this involves selling some of the growth in equities and purchasing fixed income investments. When equity markets are declining, the process of rebalancing could result in selling fixed income and purchasing equities at lower levels.

The idea of adding “fixed income” is not that exciting in this low interest rate environment, especially when many “equity” investments have yields that exceed investment grade short duration bonds. Opportunities still exist in fixed income for reasonable yields, especially when you explore different types of fixed income. One always has to assess the risks they are comfortable with. As an example, I ask clients what they feel is the greater risk, stock market risk or interest rate risk. By stock market risk, I define this as the risk that the equity markets will have a correction or pull back (say, 10% or greater). By interest rate risk, I mean that interest rates will jump up materially and do so quickly (in a short period of time).

Every model portfolio I manage has fixed income. This is the capital preservation and income side to a portfolio. The percentage in fixed income really comes down to a clients risk tolerance and investment objectives. Time horizon and the ability to save additional capital is also a key component in determining the allocation to fixed income. It is important to first determine the right amount to allocate to fixed income, and second, to diversify it to enhance liquidity and overall returns.

Kevin Greenard CA FMA CFP CIM is a Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week in the TC. Call 250-389-2138.

 

Behind the scenes with trade execution

If we define every transaction in an account as a trade then we can start a conversation about the basics of trade execution.

Some people may believe that trading is executed through a primary stock market. If we keep this article specific about Canada, the primary exchanges are Toronto Stock Exchange and the TSX Venture Exchange (for small and medium sized companies). Both of these exchanges have trading hours between 9:30 am and 4:00 pm eastern time, Monday to Friday, with the exception of certain holidays. In British Columbia, this means the primary exchanges close at 1:00 pm.

Over the last decade new marketplaces have emerged in Canada, these have been referred to as Alternative Trading Systems (or ATS). These systems at first grew in popularity because brokers were able to avoid paying the exchange trading fee. Also, an ATS may have different hours of operations than the primary exchanges. The Investment Industry Regulatory Organization of Canada (IIROC) regulates the above noted primary exchanges and the following ATSs: Canadian Securities Exchange, Alpha Exchange, Bloomberg Tradebook, Chi-X Canada, CX2 Canada ATS, Instinet Canada Cross Limited, Liquidnet Canada Inc., Lynx ATS, MATCH Now, Omega ATS, and TMX Select.

When an advisor enters an order it may be executed on the primary exchanges, an ATS, or a combination of both. The main factors effecting where the trade is ultimately filled is best available price, historical liquidity, and likelihood of execution. If a Canadian trade is executed on just one exchange then your confirmation slip would have a message something like “AS AGENTS, WE TODAY CONFIRM THE FOLLOWING BUY/SALE FOR YOUR ACCOUNT ON THE TORONTO STOCK EXCHANGE/CANADIAN VENTURE EXCHANGE/ALPHA/OMEGA/ etc.” If the Canadian security transaction was executed by a combination of exchanges/ATS then the message on the confirmation slip would reflect this by stating something like “AS AGENTS, WE TODAY CONFIRM THE FOLLOWING BUY/SALE FOR YOUR ACCOUNT ON ONE OR MORE MARKETPLACES OR MARKETS. AVERAGE PRICE SHOWN. DETAILS AVAILABLE UPON REQUEST“.

For example, a client wants to sell 2,500 of ABC Company at market after watching BNN and seeing the the price per share at $15.59. If all the shares were sold and executed at this price, the proceeds would be $38,975. The actual value once we enter the order is almost always different. The reason for this is both depth of quote and dark liquidity.

Depth of quote is when we can see the quantity of shares available and the current bid and ask at each price level. Prior to the above trade execution I outlined the depth of quote with my client (see table below). Advisors assisting retail clients typically have what is called Level II quotes where they can see both bid and ask at different price levels – I refer to this transparent part of the market as the “lit” system. Using the above example of a client wanting to sell 2,500 shares of ABC Company at market, the beginning few lines of the bid side of a depth of quote/level II would provide the following information:

Depth of Quote/Level II

Orders          Size           Bid

14                       700            $15.57

22                     1,600           $15.54

  9                     4,200           $15.50

  3                      9,000           $15.40

15                    10,000           $15.37

Orders represent the number of limit orders entered on the lit system. It is possible for the same client to enter multiple limit orders. Size is the number of shares available at the bid price on the lit system.

Using the above Level II table, 700 shares would be sold (also referred to as filled) at $15.57, 1,600 filled at $15.54, and 200 filled at $15.50. An Advisor could communicate to the client what is visible on the lit system and that the total estimated proceeds would equal $38,863. It is possible that once the sell button is pressed that the actual trade is executed at a higher price as a result of dark liquidity (also referred to as dark pools).

Dark liquidity is a term that relates to traders being able to enter orders without providing the above transparency to other market participants. Effectively, the trades are not transparent or lit; thus the term dark pool came about because the orders can not be seen. Retail clients and advisors typically do not have direct access to entering trades with dark liquidity. Most financial firms have traders that assist Portfolio Managers, Wealth Advisors and institutional clients with larger trades.

Traders can use dark pools on both the primary exchanges and ATS. Dark pool trades in Canada are nearly all limit orders, and are typically done for institutions executing large trades. Using the above table, if an advisor entered an order to sell 100,000 shares at market, the price would immediately get driven down to as low as $15.00 (assuming no dark pool orders to buy). The benefit of dark liquidity for institutions is that they do not have to “show their cards” before they are played. In other words, an institution may want to sell 100,000 shares of ABC Company with a limit price of $15.57. A trader could work the order with acquiring smaller fills without creating big swings in the price of the security. The trader could enter a limit order putting 20,000 shares on the lit system so it shows on level II, enter 50,000 in a dark pool at the same price so it is not displayed, and hold off entering the remaining 30,000 in order to continue to work the order.

Wealth Advisors must verbally confirm each trade with clients and then execute the trade right after they obtain confirmation. With frequent small trades at different points in time, dark pool trades are not generally used in Canada at the retail level. In the US, dark pools are much more common, even for smaller sized trades. Some individual clients may have large holdings in a particular security and the traders are available to assist. Portfolio Managers on the other hand often execute large block trades (combining all the shares for all clients) on a discretionary basis. Once a quantity of shares to buy or sell is determined the Portfolio Manager is often in direct communication with the traders.  Together they can choose to use dark pools, or not.

Dark liquidity is still relatively small in Canada when compared to the United States. Earlier this year, the US Securities and Exchange Commission noted that around 40 per cent of all U.S. stock trades avoid the exchanges. The increase in dark pool transactions make it more challenging to determine the true liquidity and price transparency of a security. Market makers assist in the lit market but are non-existent in the dark pool. The Canadian Securities Administrator and IIROC have already implemented a few rules with respect to dark liquidity and I would suspect that further rules will be unveiled in the future.

 

Kevin Greenard CA FMA CFP CIM is a Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week in the TC. Call 250-389-2138.

 

Portfolio manager can act for clients more quickly than traditional adviser

Over the years, I have had great discussions with people about financial decision-making. It is tough for most people to make decisions on something they don’t feel informed about. 

Even when you are informed, investment decisions can be challenging.

When you work with a financial advisor, you have another person to discuss your options with. In the traditional approach, an advisor will present you with some investment recommendations or options.  You still have to make a decision with respect to either confirming the recommendation and saying “yes” or “no,” or choosing among the options presented. As an example, an advisor may give you low-, medium-, and high-risk options for new purchases. An advisor should provide recommendations that are suitable to your investment objectives and risk tolerance.

Another option for clients have is to have a managed account, sometimes referred to as a discretionary account.  With this type of account, clients do not have to make decisions. The challenge is that very few financial advisors have the appropriate licence to even offer this option.   To offer it, advisors need to have have either the Associate Portfolio Manager or Portfolio Manager title.

When setting up the managed accounts, one of the required documents is an Investment Policy Statement (IPS). The IPS outlines the parameters in which the Portfolio Manager can use his or her discretion. As an example, you could have in the IPS that you wish to have a minimum of 40 per cent in fixed income, such as bonds and GICs.

Portfolio Managers are held to a higher duty of care, often referred to as a fiduciary responsibility. Portfolio Managers have to spend a significant time to obtain an understanding of your specific needs and risk tolerance. These discussions should be consistent with how the IPS is set up. Any time you have a material change in your circumstances then the IPS should be updated. At least every two years, if not more frequently, the IPS should be reviewed.

The nice part of having a managed account with an up to date IPS is that your advisor is able to make the decisions on your behalf. You can be free to work hard and earn income without having to commit time to researching investments. You can spend time travelling and doing the activities you enjoy. Many of my clients are intelligent people who are fully capable of doing the investments themselves but see the value in paying a small fee. The fee is tax deductible for non-registered accounts and all administrative matters for taxation, etc. are taken care of. A good advisor adds significantly more value than the fees they charge. This is especially true if you value your time.

Many aging couples have one additional factor to consider. In many cases one person has made all the financial decisions for the household. If that person passes away first, it is often a very stressful burden that you are passing onto the surviving spouse. I’ve had couples come in to meet me primarily as a contingency plan. The one spouse that is independently handling the finances should provide the surviving spouse some direction of who to go see in the event of incapacity or death. In my opinion, the contingency plan should involve a portfolio manager that can use his or her discretion to make financial decisions.

In years past it was easier to deal with aging clients. Clients could simply put funds entirely in bonds and GICs and obtain a sufficient income flow. With near historic low interest rates, this income flow has largely dried up for seniors. When investors talk about income today, higher income options exist with many blue chip equities. Of course, dividend income is more tax efficient than interest income as well. A portfolio manager can add significant value for clients that are aging and require investments outside of GICs.

Try picturing a traditional financial advisor with a few hundred clients. A traditional financial advisor has to phone and verbally confirm each trade before it can be entered. The markets in British Columbia open at 6:30 AM and close at 1:00 PM. An advisor books meetings with clients often weeks in advance. On Tuesday morning an advisor wakes up and some bad news comes out about a stock that all your clients own. That same advisor has 5 meetings in the morning and has only a few small openings to make calls that day. It can take days for an advisor to phone all clients assuming they are all home and answer the phone and have time to talk.

A Portfolio Manager who can use his or her discretion can make one block trade (the sum of all of his clients’ shares in a company) and exit the position in seconds.

Sometimes making quick decisions in the financial markets to take advantage of opportunities is necessary. Hands down, a Portfolio Manager can react quicker than a traditional advisor who has to confirm each trade verbally with each client.

Extra due diligence on private investing

The private market is used by public and private companies to raise money. Most of the money raised comes from investment funds and institutional investors. However, a relatively small percentage is used to finance venture companies and start-ups, which can be risky investments for the average retail investor. This is especially true when compared to investing in long-established companies that trade in the public market.

Private start-up companies have a high probability of failure. It’s also possible for fraudsters to exploit investors who don’t understand this type of investment. However, whether a private market investment is a fraud or simply fails, the financial impact is equally devastating. Investors need to be aware of the risks involved in the private market and protect themselves by researching their investments, and understanding their risk tolerance. When it comes to the private market, don’t invest more than you can afford to lose.

PUBLIC MARKET

The public market is effectively the stock market, where investments trade openly. In order for a company to issue the securities (as part of an Initial Public Offering), they must issue a document called a prospectus. The prospectus includes the company’s audited financial statements, and must disclose aspects of the investment such as relevant risks and material information about officers and directors. The issuance of the prospectus is required for the shares to trade on the stock market. Public companies are also required to make ongoing disclosure of material facts and changes to their business.

PRIVATE MARKET

Also commonly referred to as the exempt market, this is where companies sell their securities under various exemptions from the prospectus and registration requirements outlined in The Securities Act and Rules. Many private real estate investment corporations and mortgage pools would be considered the private market. The Securities Act and Rules provide for a number of exemptions from the registration and prospectus requirements of publicly traded companies. Some examples of exemptions used by the private market include selling to the following individuals: close family, friends, business associates of a principal, people with a minimum of $1 million in financial assets, individuals with net income before taxes of more than $200,000 (or $300,000 when combined with spouse), and individuals with net assets of at least $5 million. One of the bizarre exemption rules is that if you can invest $150,000, and pay cash at the time of the trade, then you are exempt (even if this means that you pulled every dime together to make the purchase happen).

If someone doesn’t qualify for one of the above exemptions, then there is always the offering memorandum exemption. The “OM” can be used to sell securities to anyone, provided the investor sign a risk acknowledgement form. At times, the people selling private investments have abused these exemptions in order to have the uninformed investor become eligible.

RESALE RESTRICTIONS

One of the biggest challenges with private investments is trying to sell the investment after you have purchased it. Private investments are normally illiquid and have restrictions on resale. 

GREATER DUE DILIGENCE

When considering a private investment you should ask if the person is licensed with the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association (MFDA). These can easily be confirmed by phoning IIROC or the MFDA directly. Another method to check registration is to go to the Canadian Securities Administrators (CSA) website (www.securities-administrators.ca). Unregistered salespeople are allowed to sell private securities. Many investors are unaware that unregistered salespeople are not bound by the same suitability requirements as registrants and are under no obligation to ensure that the investment is suitable for your investing needs. You will have very little recourse if the investment goes badly. If you are dealing with an unregistered salesperson then more due diligence is required.

POSITION SIZE

If a client calls with a request to execute an unsolicited buy order on a higher risk stock, I always suggest keeping the position size small. Unfortunately, when it comes to private investments, the above disciplined position size approach is often ignored. Putting all of your savings into one investment is simply not prudent risk management, but this happens more often than it should. The saddest stories involve individuals who were encouraged to take out a home equity loan and use the proceeds to purchase the private investments. It is so important for investors to be honest with themselves about their risk tolerance, and to thoroughly understand the level of risk they are taking on with their investments.

ACCOUNTING

Many private investments do not have audited financial statements provided to investors, although these are required if the investments are sold under an offering memorandum. Compounding this lack of accountability, we often hear of a complex web of companies or transactions that would be impossible for outside investors to obtain a clear picture of the financial stability. A good rule of thumb is to remember that there is rarely a good business case to be made for complexity. If an investment is difficult to understand, or if the person offering it can’t explain it clearly, you might be better to walk away.

SECURED VS. UNSECURED

Prior to investing, understand where you rank in the hierarchy if the investment fails. Owners of common shares are usually the last investors to be paid if things go wrong. Primary and secured creditors (often large financial institutions or institutional investors) will be first in line to be repaid. Primary creditors may have specific security over the main assets. The individuals or companies that are first in line would force a liquidation event on various grounds such as violation of covenants, if they felt they were not going to get their full piece of the pie. This often leaves nothing for the average retail investor.

Before investing in the private market, I suggest reading the BCSC’s Private Placement Guide and reviewing investright.org, the BCSC’s consumer protection sight. If you suspect that an investment may be a fraud and need assistance, phone the commission at 1-800-373-6393.

 

Liquidity in investments

Investments that can be bought and sold easily are considered to be liquid. Investments that are difficult to buy or sell are considered illiquid. Liquidity is one of many important objectives of investing. We can actually look at liquidity in several different ways, and for purposes of this article I’ve broken it down to four general discussion items, as follows: Basic Rules of Settlement, Liquid for a Cost, Exceptions to Liquidity, and Ratio of Liquid to Illiquid.

Basic Rules of Settlement

When buying and selling different investments, there are specific rules with respect to transaction dates and liquidity. Two dates are often used to describe transactions, trade date and settlement date. Trade date is fairly straight forward to understand. It is normally the day your purchase or sell is first executed. If you spoke to an advisor after cut off times (i.e. market hours) and your advisor entered the order for the next market day then trade date would be the next market day. Settlement is a little more difficult to understand and changes with different investments. The following is a chart with the most common investments and the respective settlement dates:

Common Investments

Settlement Date = Trade Date + (below)

Money Market Mutual Funds

1 business day

High Interest Savings Accounts

1 business day

Short Term Bonds (3 years or less)

2 business days

Long Term Bonds (3 years plus)

3 business days

Mutual Funds

3 business days

Canadian and US Equities

3 business days

European and Foreign Equities

Depends on market

To illustrate trade date and settlement date we will use a typical week with no public holidays. Michelle purchases a stock named ABC Company on Monday – this is the trade date. Settlement as per the above schedule for equities is the trade date plus three business days – settlement is on Thursday. What this means is that Michelle does not have to deposit money into her investment account until Thursday, even though the investment was purchased on Monday. If Michelle already had money in a high interest savings account then her advisor could sell a portion of this investment on Wednesday to cover the purchase. The opposite happens when an investment is sold. Let’s assume that a few months go by and Michelle needs some money and sells ABC Company on Monday – this is the trade date. Although we did the trade on Monday, the settlement date is Thursday. We would not be able to transfer funds to Michelle until the settlement on Thursday. We explain settlement to new clients to ensure they give us a few days notice if they require funds.

Liquid for a Cost

At any time you should have the right to make a change in your investments without it costing you a fortune. Having flexibility with investments ensures you never feel like you are backed into a corner with no options. We recommend asking the liquidity question prior to making any investment decisions – what will it cost me tomorrow if I need to sell. Everyone should know the total cost to liquidate an entire portfolio. When I have sat down with people wanting a second opinion the first thing I look at is the types of investments they have and what it would cost to make any necessary changes. I will use Wendy who came in for a second opinion as an example. Wendy was holding a basket of proprietary mutual funds that were originally sold to her more than two years ago on a deferred sales charge (DSC) basis. I explained that with proprietary mutual funds they can not be transferred in-kind (as is). Her only option was to sell the mutual funds, and transfer the net cash after redemption charges, if she wanted to make a change with her investments. In explaining DSC mutual funds to Wendy, she was shocked to know it would cost her four per cent (or $23,200) of her $580,000 investment account to make a change even though she has owned these investments for more than two years. Immediately Wendy felt she was backed into a corner. I explained to Wendy that if she had sold these mutual funds soon after she purchased them two years ago then the cost would have been $37,700. Although Wendy had liquidity, it was liquidity for a cost – she had no idea. In my opinion, every investor should avoid being backed into a corner with excessive liquidity costs.

Exceptions to Liquidity

Not every investment will be easily converted to cash. Your principal residence is one investment that is not easily converted to cash. Many assets that people buy either have restrictions on when they can be sold or take significantly longer than the settlement dates for common investments noted above. Examples of investments that are not easily liquidated include: infrastructure assets, private real estate investments, antiques, art work, private companies, hedge funds, flow-through investments, venture capital funds, etc.. Some investments have in the fine print that they reserve the right to suspend redemptions under certain circumstances. It can be very frustrating for people who have invested in illiquid investments and would like their money back. Prior to purchasing any investment you should determine if it is liquid, illiquid, or has the possibility of becoming illiquid. If it is illiquid you should be prepared to hold it until key dates are reached or a liquidity event occurs.

Ratio of Liquid to Illiquid

A good exercise for all individuals is to list all of your investments and categorize them in the liquid or illiquid category. In my opinion, everyone should have some liquid investments, including cash as an emergency reserve, or investments to either obtain income, growth, or a combination of both. There is no set rule on what ratio of liquid to illiquid investments people should have. As a general guideline, younger individuals may have more illiquid investments, especially if they have real estate with debt or the higher risk tolerance to invest in illiquid investments. Another general guideline is that as people age, or if they have a lower risk tolerance, the ratio may favour liquid investments.

Timing stock markets is always a challenge

At any point in time the stock market can either go up, stay at current levels, or decline. However, over time the stock market has an upward bias. During the last twenty years the TSX/S&P Composite Index has increased annually 8.19 per cent in spite of volatility during this period. When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens. It sounds easy when you’re looking in the rear view mirror. Timing when you’re in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long term vision and goal. Short term emotional thinking can cloud long term investment decisions.

The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested. Mr. Wilson has $1,000,000 invested and is currently earning $40,000 in annual income from dividends and interest. In addition to this income, Mr. Wilson’s investments fluctuate in value based on the markets which create either capital gains or losses.

Mr. Wilson decided that he wanted to be a market timer. By market timer, I mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets. If Mr. Wilson sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $12,500 per year, assuming that savings accounts are earning 1.25 per cent. The downside to savings accounts is that interest income is fully taxable each year. Mr. Wilson currently has the majority of his investments earning tax efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 2.75 per cent (4.00 – 1.25). For purposes of this article, we have assumed that both interest income and dividend income are equal.

Mr. Wilson should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments. If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold. If Mr. Wilson has a stock that has declined in value and he realizes a loss then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.

From an income standpoint, Mr. Wilson will immediately see his income drop $27,500 a year ($40,000 – $12,500). The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. Wilson. Has Mr. Wilson made the right choice to liquidate? If the markets increase then Mr. Wilson clearly made a mistake. If the markets remain flat then Mr. Wilson still made a mistake as his income will drop $27,500 a year.

If the stock market goes down it’s not necessarily a given that Mr. Wilson will benefit from having liquidated his account. If Mr. Wilson makes a correct prediction that the stock market declines then for him to benefit he has to also make another correct timing decision to buy back into the market at lower levels to potentially be better off. If the markets decline and Mr. Wilson does not have the insight to buy back in (before it rises back to the level that Mr Wilson originally sold at) then he would still be worse off. In essence Mr. Wilson has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.

Mr. Wilson should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs and no tax impact to the trades for simplification purposes. The difference between the current income Mr. Wilson is earning of 4.0 per cent and the new income of 1.25 per cent if he converts everything to cash is 2.75 per cent. Depending on how long Mr. Wilson is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful. Let’s assume that Mr. Wilson waits six months, one year, two years, and three years before buying back into the stock market. If every year Mr. Wilson is losing 2.75 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point the markets would have to decline 1.38 per cent (2.75 x .5) or greater, at the one year point the markets would have to decline 2.75 per cent (2.75 x 1) or greater, at the two year point the markets would have to decline 5.5 per cent (2.75 x 2) or greater, and at the three year point the markets would have to decline 8.25 per cent (2.75 x 3) or greater.

Making two right short term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem.

Retiree’s glass half full when interest rates rise

Since the early eighties interest rates have been on a general descent, with a few small variations along the way. For anyone who purchased annuities years ago, or owned longer term bonds, the returns were much higher than today. In July 2012, the Government of Canada 30 year bond rate fell to 2.2 per cent – a historic low. We are beginning to see longer term interest rates beginning to climb from these historic lows. One question I have been asked many times is why existing bonds decline in value when interest rates rise, and vice versa. This inverse relationship is confusing for investors not familiar with bonds.

To illustrate this inverse relationship we will use two 30 year Government of Canada bonds with a face value of $100,000. Let’s assume Bond A was issued one year ago with a coupon rate of 2.20 per cent, and Bond B was issued today with a coupon rate of 2.95 per cent. Unlike common equities, once the coupon of a bond is set it does not change. When bonds are initially issued they have a par value of 100 and will mature at 100 par value. Throughout the life of a bond it will trade at either at a discount (below 100) or at a premium (above 100). All else being equal, if current market rates are higher than the bond’s coupon, it will trade at a discount. If current market rates are lower than the bond’s coupon, it will trade at a premium.

Going through the calculations will also help with understanding the inverse relationship of bonds. Bond A pays income of $2,200 per year. For a 30 year bond, this equals $66,000 (30 x $2,200) in total income during the full term. Bond B pays income of $2,950 per year. For a 30 year bond, this equals $88,500 (30 x $2,950) in total income. Bond B will pay $22,500 more in interest than Bond A ($88,500-$66,000). In order for someone to sell Bond A today they would have to accept a price of 77.50 par value, or 77,500. The second buyer of Bond A would purchase the bond for $77,500 then receive $100,000 at the end of the 30 years. The second buyer of Bond A would have a capital gain of $22,500 plus interest income of $66,000 which would equal the $88,500 in interest income that the holder of Bond B receives. These calculations are overly simplistic and do not factor in the time value of money or taxation items, both of which are important concepts in bond valuations. The time value of money is the notion that a dollar today is worth more than a dollar tomorrow. The calculations above would be different if these items were factored in.

The number of years that a bond has before it matures may be referred to as “term” or “duration”. The longer the duration of a bond, the more it will fluctuate in value if interest rates change. Let’s use Bond A and B again but assume that the term is ten years and not 30. Bond A pays income of $2,200 per year. For a ten year bond, this equals $22,000 (10 x $2,200) in total income during the full term. Bond B pays income of $2,950 per year. For a ten year bond, this equals $29,500 (10 x $2,950) in total income. Bond B will pay $7,500 more in interest than Bond A ($29,500-$22,000). In order for someone to sell Bond A today they would have to except a price of 92.50 par value, or 92,500. The second buyer of Bond A would purchase the bond for $92,500 then receive $100,000 at the end of the ten years. The second buyer of Bond A would have a capital gain of $7,500 plus interest income of $22,000 which would equal the $29,500 interest income that the holder of Bond B receives.

The loss on the value of Bond A incurred in the ten year example is $7,500 after one year, which is significantly lower than the $22,500 loss on the 30 year bond. Investor A only lost $5,300 if the interest income of $2,200 received in the first year is factored in. When investors feel that interest rates may rise, one strategy is to execute a switch trade and simultaneously sell longer term bonds, and purchase shorter term bonds. The downside to this strategy is that short term bonds have lower current yields and rates may not rise. Investors shifting to shorter term bonds will sacrifice a lower yield today to lessen the risk of an even larger decline in value of the bonds if interest rates rise.

Much attention has been placed on the negative impact on existing bonds if rates rise. If we flip the conversation and discuss the benefits for investors – the glass is half full when rates rise. To illustrate we will use a recently retired investor named Charlie who has a corporate bond portfolio valued at $500,000 today and is yielding 3.5 per cent. Annually Charlie is currently earning interest income of $17,500. If interest rates rise to the point where Charlie can earn 5.0 per cent on his corporate bonds then Charlie is clearly a winner in the long run as his annual income jumps up to $25,000. For Charlie to benefit in the long run with rates rising it is important to ensure that he does not incur a significant loss on his existing bond portfolio in the short term.

After a thorough discussion with Charlie we mapped out a few trade ideas. We sold a couple of his longer term bonds and reduced his overall fixed income by ten per cent. With the proceeds from selling the fixed income, we allocated some to increasing cash and the remainder to equities. We explained to Charlie that the downside to increasing cash is that it currently earns only 1.25 per cent. After Charlie pays the 30 per cent tax on the interest income his after tax rate of return of 0.875 per cent is less than the rate of inflation. On this portion of Charlie’s portfolio he will not be earning a real rate of return; however, Charlie understands that this is intended to be a shorter term strategy. In managing risk, we felt that a small after tax return would be better than a negative return on his longer term bonds if rates rise. As Charlie requires income from his investments some of the proceeds from selling two of his bonds went to purchase lower risk dividend paying equities. Charlie was pleased that these trades actually increased his after tax rate of return once the dividend tax credit was factored in. The potential for the value to increase through capital gains was also appealing. The downside that needed to be weighed is that equities and the stock market could decline.