In Part 1, Luigi and Maria Lasagna had purchased an up-down duplex in Toronto. They lived upstairs and rented out the main floor. The rent from their tenant covered much of the mortgage expense. We then looked at other income-producing investments, to see how they compared to rental real estate. I call this approach "a rental duplex without the stopped-up toilet".
Suppose Maria, Luigi and Uncle Antonio had purchased a parcel of farmland that they thought they could develop and subdivide some day. The Royal Bank won't lend money against vacant land, so they had to pledge some other collateral to get the financing. Now they have debt payments, but no offsetting income.
We can do the same thing with mutual funds, but we have an advantage. While Maria and Luigi are strictly speculating (they are hoping that City Council will approve their development application), we can examine a historical track record. The track record will give us a feel for the level of return that we might expect in the future, and the level of uncertainty that surrounds our investment.
Track Record of Global Equities
When investing for growth using borrowed money, I prefer using global equity funds for several reasons. Most important, we want performance, and global equity funds have had stronger performance in the past than Canadian funds. Diversification across the economies of the world should reduce country-specific risk, and allow investment into sectors not well represented in Canada. Finally, the Canadian dollar has fallen steadily since 1972 and I see little possibility of a turnaround with our current federal government in power. I'd rather borrow in Canadian dollars, but invest outside the country.
Let's look at some of the track record of global equity investments.
- The MSCI World Equity Index is the most-recognized benchmark of world stock market performance. Since January 1974, the MSCI World Equity Index has risen by 14.7% annually in Canadian dollars. Furthermore, that increase has been remarkably uniform. The red line on Chart 1 shows this:
The Templeton Growth Fund is Canada's longest-running global equity fund. Templeton Growth Fund started in 1954 so has a 46-year record. Over almost a half-century, it has averaged 14.8% compounded annually. Chart 2 shows this long-term performance.
It would appear, then, that if we can purchase a good global equity fund and hold it for a long time, we might get returns in excess of 14% compounded annually! That means our investment has the potential to double in value every 5 years. This sure sounds like a "can't lose" proposition!
However, before mortgaging the house to buy a global equity fund, we had better look at the downside. This is where the problems lie.
Table 1 indicates the best and worst performance for the MSCI World Index (C$) since 1969, and the best and worst performance of the Templeton Growth Fund since 1954. The results are annualized for holding periods longer than 1 year.
|MSCI World Index (C$)
1969 - 2000
|Templeton Growth Fund
1954 - 2000
|Best Case||Worst Case||Best Case||Worst Case|
The record tells us that while the long term average for global equity investments is satisfactory, these investments are subject to significant volatility. Who among us would be willing to hold an investment that lost 3% annually over 5 years, and our initial $10,000 has become $8,500? Especially if we had borrowed the $10,000, and we've been making interest payments on something that's done nothing but go down (Be honest, now)!
If we have borrowed money using the investment as collateral, drops in the order of 22% in a month or 40% in a year are sure to trigger a margin call. What would you do if you received a call from your banker when the market has just fallen by 20%?
Tax efficiency is another issue that we need to consider. We do not want to be paying capital gains tax on an investment that we haven't sold! Even though capital gains tax rates have gone down (taxable capital gains are 50% of the total capital gain), they can still hurt both the pocketbook and overall performance. There are wide variations in tax efficiency between mutual funds.
Most mutual funds have a trust structure. A trust has to distribute all of its profits to the beneficiaries each year to avoid taxation within the trust. The unitholders therefore receive annual tax bills, whether or not they have sold any units of the fund. Occasionally, they can receive a tax bill even if the fund lost money during the year!
A few mutual funds have a corporate class structure. The corporate structure allows switching between share classes without triggering a capital gain. For example, we could move our investment from a global equity "share class" to a money market "share class" without triggering any tax consequences. The corporate structure also allows the investment manager to calculate profit across the entire corporation, and not individually for each share class. This has traditionally allowed mutual funds with a corporate structure to have little or no distribution each year.
The Income Tax Act states that interest costs are a deductible expense where the investment was made for the purpose (or expectation) of earning income. Court challenges have indicated that investments for which capital gain is the primary motive also qualify for interest deductibility. Interest costs are deductible against other sources of income.
Some Possible Global Equity Funds
When we choose our investment, we want the global equity fund to have a well-defined investment style, so that we have some indication of future performance (particularly portfolio turnover and volatility). We want performance that is comparable to the MSCI World Index, preferably with less volatility than the index. We want our investment to be tax-efficient.
Table 2 indicates some global equity mutual funds that might meet our needs. With one exception, all have at least a 10-year track record. I've shown the 5-year and 10-year compound annual returns and the annualized standard deviation over the past 5 years. The standard deviation is a crude measure of the volatility of the fund that we can use to indicate downside risk. In roughly 1 year in 6, the fund is likely to be down more than the 5-year average, less 1 standard deviation. For example, using Templeton Growth Fund once again, we need to be prepared for Templeton to have a return worse than (10.3 - 12.9) = -2.6% about once every 6 years.
The Quartile Score indicates the average quartile ranking, where 1 means the fund ranks in the top 25% of all global equity funds, and 4 means the fund ranks in the worst 25% of all global funds. A quartile score below 3.0 indicates that the manager has tended to out-perform his peers, while a score below 2.0 is outstanding. All of the funds shown in Table 2 have exceptional performance!
Table 2 also shows a Tax Efficiency score over the past 5 years. The Tax Efficiency value represents the average capital gains distribution that one could expect from the fund each year, expressed as a percent of assets held in the fund. The actual distribution tends to vary widely, ranging from zero to roughly twice the average. For example, if your investment is worth $10,000 and the tax efficiency is 5%, you can expect to receive a T3 with a capital gains assessment of between $0 and $1,000 from the fund company each year.
|5-year Ave CmpdReturn3||10-year Ave Cmpd Return3||5-year Std Deviation3||5-year Tax Efficiency||5-year Quartile Score||10-year Quartile Score|
|MSCI World Index (C$)||12.9%||13.5%||13.1%|
|AGF Int'l Value Fund1||21.3%||20.9%1||15.3%||5.0%||1.4||1.71|
|CI/BPI Global Equity Fund2||14.7%||13.0%||17.8%||5.1%||2.0||2.5|
|CI Global Sector Shares||14.0%||13.8%||15.8%||2.9%||1.8||2.1|
|CI Global Managers Sector Shares||N/A||N/A||N/A||N/A||N/A||N/A|
|Fidelity Int'l Portfolio Fund Class A||12.5%||12.8%||13.7%||1.2%||2.0||2.3|
|Templeton Growth Fund||10.3%||13.8%||12.9%||5.7%||2.4||2.1|
|Trimark Select Growth Fund||11.3%||15.3%||12.1%||4.0%||2.6||2.1|
1 Charles Brandes has managed the AGF International Value Fund since 1994. I have used the Brandes Global Equity Composite (US$) as a proxy for the 10-year numbers of the AGF International Fund.
2 Dan Jaworski assumed management of the BPI Global Equity (Value) Fund in 1997, taking over from Lazard Freres. This fund is now also available as part of the CI "sector" corporate share structure, so future tax efficiency is likely to be different from past efficiency.
3 5- and 10-year performance data is for periods ending 28 February. Performance numbers quoted are after all fees and expenses. Past performance is no guarantee of future performance. Data in all other columns are for calendar years.
I have included CI Global Managers Sector Shares on Table 2 despite its lack of a track record. Global Managers is a multi-manager global equity fund; two of the four managers of Global Managers manage funds that are on my list in Table 2. Bill Sterling is manager of the CI Global Sector Shares, and Dan Jaworski is manager of CI/BPI Global Equity (Value) Fund.
Here are a few suggestions that increase the probability that borrowing to invest in a global equity fund will be a rewarding experience:
- Do not use the investment as collateral for the loan. You do not want to ever receive a margin call!
- Your commitment must be for at least 5 years. You must be able to comfortably afford the interest payments without constantly worrying about the market value of the investment.
- It is probably best to start your investment program when the markets are down and looking as if they will stay down forever. As Sir John Templeton has said, "the best time to invest is at the point of maximum pessimism".
- Invest when interest rates are declining. This has two benefits: if financing using a floating-rate loan, your carrying cost will go down over time; secondly, stock markets do best during times when interest rates are falling.
- Tax efficiency is important. You do not want to be paying capital gains tax on an investment that you haven't sold!