Lunch Is Still Not Free, Even If It’s Potatoes

I occasionally hear from readers who want to know which ETF or index fund portfolio would be a suitable place to stash their short-term savings. Inevitably I disappoint them with my reply: “Short-term savings belong in a high-interest savings account or GICs.”

With even ING Direct and Ally paying just 1.5% to 2% in savings accounts these days, it’s tempting to look at an ETF of real-estate investment trusts (REITs), preferred shares or high-yield bonds and try to pull down 5% to 7%, or more. It’s also a terrible idea for short-term investors.

The Couch Potato strategy works over the long-term because it dramatically reduces fees and provides broad diversification. However—and this is a critical but often misunderstood point—an index strategy offers absolutely no protection from falling markets. Indeed, it may offer less protection, since actively managed funds have the option to move into cash when markets are volatile. Index funds are as fully exposed to the market as a streaker on the TSX trading floor. That’s why index portfolios are not appropriate for people who want to protect their capital for a couple of years as they save for a house, or a vacation, or their child’s education.

Using diversified ETFs and index funds can eliminate the risk that any single security will torpedo your portfolio. Buying a fund of REITs, preferred shares or high-yield bonds is certainly less risky than trying to pick two or three individual winners. But your fund can hold hundreds, even thousands of individual names and still plummet in a market downturn. There’s only way to eliminate market risk, and that is to get out of the market.

Imagine that you were saving for a down payment, or for your 14-year-old’s university education, in early 2007. One-year GICs were paying well over 4%, but you wanted more. So you put your savings in the iShares S&P/TSX Capped REIT Index Fund (XRE) in February 2007, attracted by its generous yield. Well, you would have watched it fall more than 60% in two years.

Had you invested in the Claymore S&P/TSX Canadian Preferred Share ETF (CPD) or the iShares iBoxx High-Yield Corporate Bond ETF (HGY) around the same time, you’d still be down over 16% after more than three years. Dividends and interest would have reduced these losses, but only if you somehow managed not to panic and sell in 2008 or early 2009. Either way, your plans for buying a house or paying for your daughter’s university would have been wrecked.

In general, if you need your money in less than five years, none of it should be in stocks, and that includes equity index funds and ETFs. With interest rates at record lows, it’s possible that even a bond a fund could lose money over a period of a couple of years. Meanwhile, a five-year GIC from Ally today will earn you 3.75% with zero chance of losing your principal. If you prefer, a five-year GIC ladder will earn you about 3% this year and give you an opportunity to take advantage of rising rates in the future.

In a period of 1% inflation, that’s not bad for a guaranteed investment. And like or not, that is the price of safety.

Note: My earlier post about doomsayer Paul Farrell is featured in this week’s Carnival of Personal Finance by Live Real, Now. “End-of-the-world predictions are always fun,” says the site’s author. “I mitigate that risk by investing heavily in precious metals: primarily brass and lead.” Nice!