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The U.S.-based Humble Dollar financial site published an interesting guide to index investing on Wednesday with some good advice.

The column includes three basic guidelines. The first is to develop an investment policy statement to keep investors on track regarding their portfolio choices. The second rule is to set a firm rebalancing strategy – the timing and process for setting portfolio holdings back to preferred weightings.

The third rule – establish criteria for new investments – is the one I want to talk about because it gets to an inherent contradiction in indexing or passive investment. Should index investors be buying anything except more of the same index fund?

Strictly speaking, the only true passive Canadian investors hold one position – an S&P/TSX Composite exchange-traded fund. Anything beyond that involves making decisions, and decisions involve market timing.

I’m not suggesting anyone hold only a TSX ETF. Our benchmark is famously volatile because of the large weighting in resources and, missing significant exposure to sectors like health care and high quality retail, it also lacks diversification.

Most investors hold U.S. equities – an S&P 500 ETF – along with Canadian stocks for diversification. But how much is the right amount?

There are calculations that can be done to help Canada/U.S. portfolio allocations. The Sharpe Ratio, which measures return per unit of risk (higher is better), has been a popular and successful strategy in recent years. A simplified formula for Sharpe Ratio is average annual return minus risk-free bond rate (three-month government bond yield), divided by standard deviation (volatility).

According to Bloomberg calculations, the S&P 500’s Sharpe ratio – risk-adjusted return – was 80 per cent better than the S&P/TSX Composite Index over the past five years.

This doesn’t mean, however that a prudent Canadian investor should invest 80 per cent of their assets in U.S. equity ETFs and 20 per cent in the TSX. That strategy assumes the U.S. equity market’s outperformance will continue far into the future – and that is the type of forecasting that passive investing is supposed to allow investors to avoid.

It’s also the case that five years of data is not enough to make long-term asset allocation decisions. There is no agreement, however, about the correct time period to use. The past 10 years of history is problematic for domestic investors because it would also favour a big overweight in U.S stocks versus domestic. The S&P 500’s 17.9-per-cent average annual return over the past decade (in Canadian dollar terms) easily outdistances the TSX’s 11.0 per cent annual.

All of the research in finance concludes that passive investing strategies are the best for the vast majority of investors. Passive, however, does not mean easy. None of this is straightforward, and it’s very difficult for investors to sidestep portfolio decisions that, whether they know it or not, are actually attempts to time the market.

-- Scott Barlow, Globe and Mail market strategist

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Stocks to ponder

Alimentation Couche-Tard Inc. (ATD-B-T). This stock appears on the positive breakouts list (stocks with positive momentum). The stock has a unanimous buy recommendation from 13 analysts. For the past three consecutive quarters, the company has delivered better-than-expected earnings results that has sent the share price soaring the following trading day with a gain ranging between 4 per cent and 7 per cent. On March 19, the company is set to announce its quarterly earnings results. The company may report yet another earnings beat driven by strong fuel margins, which may send the share price surging on the news.

Restaurant Brands International Inc. (QSR-T). John Heinzl explains why he is adding more of this stock to his model Yield Hog Dividend Growth Portfolio, and he recaps the portfolio’s recent performance. Last August, he added Restaurant Brands to his model portfolio, and since then the shares have delivered a total return of about 10 per cent. Much of that gain happened in January, when the owner of Tim Hortons, Burger King and Popeyes Louisiana Kitchen served up a juicy 11.1-per-cent dividend increase and announced that same-store sales grew at each of its chains during the fourth quarter ended Dec. 31. He believes Restaurant Brands has a lot more growth to offer. (For subscribers).

Norbord Inc. (OSB-T). The U.S. housing market sent troubling signals toward the end of 2018, walloping companies with direct ties to the home-building sector, but also creating some great buying opportunities for anyone who likes beaten-up stocks. Norbord Inc. is a name to watch here. The Toronto-based company, which makes oriented strand board (OSB) used in home construction, has a particularly volatile relationship to U.S. housing numbers: The share price fell nearly 45 per cent between June and October, 2018, and has been coasting along two-year lows for most of the past four months. David Berman reports (for subscribers).

The Rundown

Slumping global economy isn’t all doom and gloom for TSX

Downward revisions to expectations for global economic growth continue and this is a bad sign for Canadian investors, even those entirely concentrated in domestic stocks. The Organization for Economic Co-operation and Development on Wednesday downgraded its forecasts for worldwide gross domestic product expansion to 3.3 per cent (from 3.5 per cent) for 2019 and to 3.4 per cent (from 3.5 per cent) for 2020. Ominously, the OECD added “downside risks continue to build” in a suggestion that this is not the last cut to forecast growth. Scott Barlow reports (for subscribers). Scott Barlow explains (for subscribers).

What a VP of a $13-billion Canadian money manager is buying, selling and telling investors about building wealth

Murray Leith is often asked the same question: “Is now a good time to invest?” Regardless of what’s happening in the markets, his answer is: “It’s almost always a good time to own great businesses.” When it comes to generating wealth, the executive vice-president and director of investment research at Odlum Brown Ltd. says investors should think like business owners, not traders. “If you’re really serious about building wealth, you don’t want to have this attitude that you can time the market and jump in and out of it,” says Mr. Leith, whose Vancouver-based firm manages about $13-billion in assets. Brenda Bouw spoke to Mr. Leith about what he’s buying and selling. (for subscribers).

‘If a recession is coming, should I just own some GICs?’

There are solid reasons to avoid the risk of investing in stocks and instead hold guaranteed investment certificates. Deking around the next recession is not one of them. A 60-something reader recently raised the idea of GICs as a recession refuge. The Canadian economy came close to stalling in the final three months of 2018, growing just 0.4 per cent on an annualized basis. Economists have been talking a lot about slowing growing growth and the Q4 report on GDP is bound to increase speculation. But making a drastic change in asset mix to respond to a potential downturn seems unwise. It’s just as likely the economy regains its equilibrium and continues along the slow-growth track it has been on for a while now. GIC rates simply aren’t high enough to satisfy investors who are used to long-term average annual stock market returns in the 6 to 7 per cent range before fees. Rob Carrick reports (for subscribers).

Others (for subscribers)

‘Canada is not at immediate risk of recession’

Bulls on Wall Street become an endangered species

‘The most important investment chart in the world’

‘The worm is turning’: More Canadians are going broke, defaulting on their debts

Thursday’s Insider Report: CEO invests over $500,000 in this Big 5 bank stock

Wednesday’s Insider Report: CEO of this large-cap stock pockets nearly $13-million

Thursday’s analyst upgrades and downgrades

Wednesday’s analyst upgrades and downgrades

Others (for everyone)

How the U.S. bull market kept running and stampeded the doubters

Bullish calls for Canadian dollar linger as risk appetite perks up

Elon Musk and the conundrum of regulatory conformity

Ask Globe Investor

Question: John Heinzl has written about ETF distributions on a number of occasions but I am still confused. With a couple of ETFs I own in my registered retirement income fund, I noticed they paid a capital gains distribution and then they reinvested the same amount but I didn’t receive any additional units. My online broker claims it’s just a rebalancing and says I shouldn’t worry about it. Is that true? And is it better to not hold ETFs in a RRIF since there is no benefit from capital gains distributions?

Answer: ETFs typically declare reinvested – or “phantom” – distributions at year-end. These distributions do not consist of cash and do not affect the value of your holdings. Basically, they are just an accounting move to transfer the capital-gains tax liability, which arises from the fund’s transactions throughout the year, to the unitholder. Technically, you do receive additional units, but only briefly: Immediately after a reinvested distribution is “paid," the ETF provider consolidates the number of units outstanding. The end result is that you have the same number of units, each with the same net asset value, as before the distribution. So, yes, it is fair to think of it as a “rebalancing.” Holding the ETF in a RRIF (or other registered account) is still advantageous, however, because you’ll avoid paying capital gains tax on the reinvested distribution.

--John Heinzl

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What’s up in the days ahead

This weekend, we mark the 10th anniversary of the bull market with a look back at lessons learned, and how the TSX was transformed into a financial services powerhouse.

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