Building a winning portfolio: Part 2

In part 1 of this mini series, we looked at how to build the two portfolios every household needs:  an emergency fund and a retirement fund.

Today we’ll look at how to build a ‘vulture’ fund for those interested in looking for real estate bargains once our made-in-Canada real estate binge reaches its ugly end. Tomorrow we’ll look at some often overlooked investment vehicles for your retirement fund as well as some stock picking tips for those looking to bypass the ETF route and build their own portfolio using individual securities.

Building a ‘vulture’ fund

The key to remember when building a vulture fund is your time horizon.  If you are young or have little saved in the way of a down payment, you may have a time horizon of up to 5 years.  In most cases, however, the time horizon is a couple of years.  I don’t expect the real estate bust will be over in a couple of years, but I also don’t think it will be possible to accurately time a perfect entry point.  I rely instead on overall sentiment as a contrarian indicator.  As the old adage goes, buy when there is blood in the streets.  We’re far from that today.  While the peak-to-trough may take 5 years or longer, I plan on starting to look for deals long before then.

So what should your house portfolio look like?  Let’s start by noting that it shouldn’t look anything like your retirement portfolio.  It’s my personal belief that real estate will succumb to monetary deflation over the coming years, while the broader economy will experience deflationary forces followed by significant inflation.  As such, an ideal retirement portfolio is balanced to protect from inflation and protect purchasing power over the period of decades, while a house portfolio will need to do little but hold its ground as its overall purchasing power will increase as house prices fall.  If you’re invested in stocks or precious metals with a time line of only a couple of years, you may find that your purchase power is not there when you need it most.  If you want to dabble with these, limit it to a small percentage of your house portfolio….certainly less than 20%.  While I think it’s VERY likely that silver and gold will be higher in a few years, the volatility is not suited to such a short time horizon.  You may recall that during the credit crisis, both silver and gold were smacked hard, with silver losing 50% of its value in a couple of months.  It has rebounded fantastically since then, but the point here is that you want to preserve your purchasing power in the event that an ‘vulching’ opportunity quickly presents itself.

As an aside, this is what bothers me most about the advice to hold a bucket of preferred shares as part of a house portfolio.  While they certainly are more stable than common stocks and provide tax advantaged dividends, they are prone to seeing their face value decline….sometimes drastically.  In the credit panic of 2008, many preferred shares lost over 40% of their value.  The broad ETF that tracks preferred shares (CPD) lost 35% peak-to-trough.  It went on to recover most of that loss, but that just illustrates my point that they are best held in a retirement fund.

More importantly, as real estate melts and defaults on unsecured debts begin to mount at our banks, all bank stocks will come under pressure, including preferred shares.  Whether or not they ever miss a dividend payment is irrelevant.  Will their purchasing power be intact when you want to take advantage of an opportunity is the big question.  Keep those preferreds as part of a balanced retirement portfolio.

What should you hold in your house portfolio?

1)  Cash. I know it’s boring, but it should make up a good portion of your portfolio…at least 30%.  It’s readily accessible, protects from interest rate hikes (which I don’t see as too likely), and most of all it is precious when a credit crunch hits.  I am concerned that if consumers shun credit en masse, the feedback mechanism will be highly deflationary leading to rising defaults on existing credit and ironically, a lack of available credit by the banks.  At the end of the day, earning 2% on your money when the asset you are saving for is losing 5-10% winds up giving you a pretty stellar return when measured in purchasing power.  It’s far from sexy, but it is an important part of your real estate portfolio with a time horizon of only a few years.  Longer than that and you may want to reduce your cash position slightly.

2)  Short term bonds. I think this should make up the bulk of your portfolio….at least 30% as well.  What is important to remember here is that even if there is a continued selloff in the 5 year GoC bonds leading to a loss of principal, your purchasing power should remain intact.

Residential real estate should, theoretically, be correlated with short-term bond prices.  Because of the new mortgage qualification rules, new buyers seeking to take advantage of a lower variable rate mortgage still have to be approved based on the current 5 year closed rate, which itself is based on the bond market.  So falling bond values create higher yields which push up the interest rate on a 5 year mortgage and limit the amount of mortgage all buyers qualify for.  All things being equal, this should result in lower home prices….anecdotes of rich Asians buying with all cash aside.

Because the principal should hold its purchasing power even in the event of a significant selloff in bonds, and since you are still collecting the interest on the bonds, your purchasing power rises relative to real estate.

The short term bond ETFs like XSB and CLF are best.  A short-term bond ETF that invests in corporate bonds is also worth adding to the mix, though in a smaller weighting.  CBO is a good one.

3)  Real return bonds: Real return bonds are an interesting type of bond that pays a set REAL interest rate.  ‘Real’ just means that it is added on to an inflation adjustment so that both the interest payment and principal rise in relation to the Consumer Price Index.  Basically, RRBs protect bond holders from inflation, which is always the chief concern.  Normally, a 10 year bond pays a certain interest payment for the full 10 years.  At the end of the 10 years the original purchase price is returned to the investor.  The problem is that over those 10 years, inflation has eaten away at the purchasing power of the principal.  RRBs help to solve that problem.  If inflation runs at 2% in a given year, the interest payments are 2% PLUS a small premium.  In addition, 2% is added to the amount owed to the investor at the end of the bond term.

Since inflation is calculated by the BoC as the rise in a basket of consumer products, and since shelter makes up 27% of the CPI, RRBs in theory should also protect your purchasing power over time.

There is one MAJOR caveat.  They are the worst-taxed of all investment vehicles.  Without getting into the tax disadvantage of RRBs, it suffices to say that these should be held in a tax-sheltered account.

4)  Long-term bonds: Long term bonds are a bit speculative and should represent only a small percentage of your overall portfolio.  If interest rates rise or if sovereign bond concerns persist, they will lose their principal.  My view is that as real estate sinks, consumer spending and HELOC growth are choked off, and the economy wilts, the BoC will certainly hold the line on interest rates, if not chop them.  In this environment, long bonds will perform very well.  XLB is a good instrument, but limit it to 10% of your portfolio.

5)  Preferred shares: I don’t hold any preferred shares in my house portfolio, but if you are absolutely convinced that they should be in yours, consider the preferreds of non-financial and non-insurance companies.  Stick with fixed rate preferreds which should perform well in a low interest rate environment.  Keep it to a small percentage of your overall portfolio.

Making use of the First Time Homebuyer Plan

If you are saving for your first home, plan on building your housing portfolio within your RRSP first.  The government will allow you to withdraw 25K penalty free to use as down payment on your first home.  Along the way, you’ll also be taking advantage of some nice tax credits.  As you simultaneously build your retirement portfolio, you’ll simply have to withdraw the house portfolio from your RRSP when the time comes and then transfer the securities from your retirement portfolio in kind back into your account.  If you are just starting to save, this is step one.  Maxing out your TFSAs is step two.  Tax shelter everything you can!

Conclusion

I don’t expect my advice to appeal to everyone, but it is my belief that saving for a home should not involve the same level of risk as saving for retirement.  The time horizons are not the same at all.  Since there are assets that provide the necessary correlation to protect you from both runaway house price inflation and the economic fallout of sinking house prices, it’s not necessary to take additional risk and expose yourself to the prospect of having your purchasing power eroded at a time when a great deal presents itself.

As always, your personal emails and comment feedback are welcomed.  Email me at benrabidoux@yahoo.ca or post a comment below.  I’ll do my best to help you out.  The advice is worth at least the price of admission.

Just a reminder to subscribe to the blog using the subscription tool at the top right hand of this page.  With all the New Year’s fun coming up, you won’t want to miss my upcoming stock picking advice or the economic predictions for 2011.

Cheers

Ben

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9 Responses to Building a winning portfolio: Part 2

  1. Ray says:

    Assuming a 10% savings rate, the average income of $50k means that everyone has $5k to save. At the $50k level you don’t get that much benefit from investing inside your RRSP first anyways, so you put it in your TFSA. Max it out. People that make more than $50k will have that $5k and much more, max out your TFSA naturally, then bring down your taxable income with the remainder in your RRSP. With the TFSA and Home Buyer Plan I see almost zero reason to ever have a taxable account anymore (assuming you make less than $100k). The setup is pretty ideal and I can’t see the government letting us have it forever so take advantage while you can!

    • Great advice, Ray! However, I would point out that tax deductions don’t have to be made in the year the RSP contribution is made. For a prospective home buyer, I would suggest that getting the RSP to 25K is still the #2 priority behind building an emergency fund. Whether they claim the deduction that year is up to them.

  2. jesse says:

    The correlation between mortgage rates and house prices is far from certain. The theory is also questionable: wouldn’t a rational investor pay a price based on inflation adjusted cash flows (which, if you believe long rates, should see close to flat nominal incomes for some time)? The data suggest rational investors are in short supply.

    • Jesse, are you suggesting that the average home buyer purchases a residential home based on inflation adjusted cash flows? I don’t know of a single person who considered that when buying their home. I know plenty who bought a home based on what the banks would approve them for….which we know is now connected to the 5 year GoC bond. The correlation is not perfect, but the directional correlation will be darn close with a slight time lag.

      I do fully agree with your last point though.

    • jesse says:

      Ben I am suggesting a rational investor, whether owner-occupier or buy-to-let, should be looking at future cash flows when determining a reasonable value for any investment. Low rates means low nominal cash flow growth.

      I did an autocorrelation on nominal house price changes and nominal mortgage rates since 1977 for Vancouver, Toronto, and Montreal.

      While it appears interest rates do have some effect, as they should at the margins, it is by no means a slam dunk predictor of future house prices in the long run. I think we can both agree that rates can remain low and prices can fall, and likewise if rates rise affordability is squeezed and prices drops will be exacerbated.

      During speculative bubbles, one can argue the correlation between prices and rates will be higher as debts are taken on based on relative, not absolute, prices.

  3. Pingback: Building a winning investment portfolio: Part 3 | Financial Insights

  4. Nick says:

    I like the house fund. We are using a similar approach. Nothing sexy, just TFSA savings accounts maxed out, a TD Bond Index e fund, and a Money Market fund for the excess.

    One thing to consider about RRSP use is that if you plan to buy a house in the next 3 months, stop contributing. It’s my understanding that the funds have to be in your account for 90 days minimum to qualify for the home buyers plan.

    Most people we know think we’re nuts for renting and saving but when I read blogs like yours I feel vindicated. Thanks for sharing your insights.

    Nick

  5. Toronto says:

    love your post!
    what is the current yield on XRB?

    Thanks

  6. Ryan F says:

    Hi,

    You’re not really clear on how much real return bonds you recommend. If I do the math, you leave up to 30% for real return bonds, but you do say “at least 30%” for both cash and short-term bonds. Is 30% a good rough target, or is that too high?


    Thanks,
    Ryan

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