Newsletter September 29, 2019
Investing using Exchange Traded Funds
All self-directed investors should be making use of Exchange Traded Funds at least to some extent. This is most especially true for newer self-directed investors.
The simplest way to invest is to buy a single ETF that is diversified across countries and which contains a mix of fixed income and equity stocks and where the equities are well diversified across the various industry segments. For Canadians, Vanguard provides four such diversified ETFs with the fixed income component set at 60% (VCNS), 40% (VBAL), 20% (VGRO) or 0% (VEQT). iShares has has a very similar set of funds XCNS, XBAL, XGRO and XEQT.
The Vanguard products hedge away the currency risk (or reward) on all the investments outside of Canada while the iShares products expose the investor to the currency risk (or potential currency reward). Correction: Neither iShares nor Vanguard hedges the currency risk on the equities portion. That is appropriate as currency fluctuations adds to the desired diversification. Vanguard hedged the currency risk on the fixed income portion perhaps to make that portion even more “Fixed” – though it is still subject to fluctuations related to interest rates and credit risk. iShares does not hedge any of the currency risk (or possible reward).
For newer investors as well as any investor with a relatively modest portfolio, a very reasonable strategy would be to choose just one of the above funds and invest the entire portfolio in that one ETF. These funds are widely diversified and so additional diversification is not strictly necessary. Due to the size of Vanguard and iShares and due to regulations and the manner in which these investments are held, there is likely virtually no risk that these giant fund companies would fail AND that this would lead to (other than modest and temporary) losses for the ETF investors.
Financial theory suggests that holding a broadly diversified portfolio such as the above funds provides the best expected return for a given level of risk.
However, many investors would want to to use multiple ETFs to construct a more customized but still balanced and diversified portfolio. For example, for those with taxable as well as non-taxable accounts, the single ETF approach would be less tax efficient. Such an investor might want to include a preferred share ETF in the taxable account. And some investors would prefer a different geographic allocation and/or different weightings to various industry segments.
Our updated ETF Portfolio article provides more detail on the single ETF approach and provides a short list of low-fee ETFs that can be used to create a more customized balanced and diversified portfolio. It also has some suggestions on appropriate allocations to each ETF, but that would vary greatly based on individual circumstances.
Of course, many of us prefer to invest largely in individual companies. But in that case ETFs can be used to get exposure to particular segments and geographies and to help to make the portfolio more balanced. Our Canadian ETF article has just been updated and contains details on many ETFs including even some for commodities (Gold, Silver, Oil and Natural Gas).
INDICATORS POINT TO A SOFTENING ECONOMY
In addition to this web site, I am also a contributing editor to Gordon Pape’s The Internet Wealth Builder. The following is an article that I recently wrote for that publication:
There are many indicators that can provide clues as to the state of and direction of the economy. The following are a few of the key ones that I follow.
GDP growth. Real Gross Domestic Product growth is the broadest measure of economic growth. In the United States, real GDP (before inflation) grew at an annual rate of 3.1% in the first quarter of this year but then slowed to 2% in the second quarter. The slower growth in the second quarter was attributed to “downturns in inventory investment, exports, and nonresidential fixed investment”. This data suggests that the U.S. economy has been relatively strong, but that growth is slowing.
In Canada, real GDP for the first quarter grew at an annual rate of 0.5% but this rose to 3.7% in the second quarter, driven by higher energy exports.
Railcar loadings. Warren Buffett has often pointed to railcar loadings as one of the very best and most current indicators of how the economy is doing. Conveniently, the Association of American Railroads provides a timely chart that shows railcar loadings for the U.S. and Canada on a weekly basis with a comparison to the three prior years. The latest data is for the week ended Sept. 14.
For the United States, the chart shows that total weekly railcar loadings have been running noticeably below the corresponding week in 2018 virtually every week this year. For the past fifteen weeks the levels have also slipped below the corresponding 2017 levels. And in the latest two weeks, the 2019 level even slipped down to the 2016 level. This weakness was fairly consistent across all commodities with the exception of petroleum car loadings. They were materially higher virtually every week in 2019 but then slipped back to or below the 2018 level in the latest three weeks. This data strongly suggests the U.S. economy has softened broadly in 2019 and that it is getting softer as the year progresses.
For Canada, the chart shows that railcar loadings have been running at similar levels to 2018. Forest product shipments were the weakest category and have been running noticeably below the levels of any of the past three years. Non-metallic mineral volumes have been running below the 2018 and 2017 levels but above the 2016 levels. Petroleum and petroleum product volumes have exhibited, by far, the most growth in 2018. The remaining categories were relatively similar to the 2018 levels. This data presents a mixed picture but overall suggests a relatively flat Canadian economy compared to 2018.
Manufacturing sales. U.S. manufacturing sales for July rose 0.3% versus June on a seasonally adjusted basis and 1.3% versus July 2018.
Canadian manufacturing sales decreased 1.3% in July which followed a 1.4% decline in June. The declines were broad based, with lower sales in 11 industries that represent two-thirds of total manufacturing sales.
FedEx. FedEx is often considered to be a bellwether indicator for the economy. This week it announced poor results for its latest quarter, highlighting weakening global economic conditions driven by increased trade tensions and policy uncertainty.
Buffett businesses. Warren Buffett has often said that Berkshire Hathaway’s vast array of operating businesses provides him with an excellent window into the health of the American economy. In the first half of 2019, volume at many of its operations was down. Its railroad car loadings were down 4.5% in the first half of 2019. Same-store volume at its residential real estate brokerage operation was down 8% year to date. Industrial manufacturing revenues were up 0.6%. The number of manufactured homes it sold at retail declined 6%. Revenues at its travel trailer division fell 13%.
Revenues at its service businesses (primarily related to aviation) were up 4.6%. New auto sales were down 3%. Home furniture revenues were down 3%. Berkshire also owns 25% of Kraft Heinz, which has experienced lower revenues in 2019. While revenues were up modestly in its railroad and utilities operations and at some of its other businesses, the overall picture indicates a slower economy in the first half of 2019.
Overall, the above indicators suggest that the U.S. economy is clearly softening, and that Canada’s economy is relatively flat compared to 2018. Investors can prepare for a softer economy by reviewing their asset allocations and by lowering their exposure to the most economically sensitive companies. An increased emphasis on more stable investments including short-term cash deposits may be warranted.
STOCK MARKET VOLATILITY
With the economy softening, and given trade tensions, it is a good time to think about potential declines in the stock market.
“Volatility” – that’s the euphemism that the financial markets use to refer to market value losses. Technically, market gains are also “volatility”, but gains are never referred to in that way. Equity investors are always aware that volatility and losses are a possibility at any time. But it’s typically only after a material amount of loss has happened that we start to focus a lot more attention on volatility and how to avoid it.
At the end of the day there are two broad choices when it comes to volatility:
- Minimise it with action before the fact. This can be done by constructing a safer portfolio, which includes a material allocation of assets to non-volatile assets including cash, GICs, and shorter-term bonds. And with equity investments that are well diversified and perhaps mostly concentrated in lower volatility stocks.
- Accept the risk of volatility. This means accepting that a higher level of exposure to equities is extremely likely to result in higher long term returns but at the probably unavoidable cost of higher volatility and periodic losses over shorter periods of time.