As the expression goes, another day, another dollar. Today’s episode is a roundup of news and analysis with deeper dives into behavioural and risk-based market explanations, active management, and endowment investing models. We open with a book review of Essentialism: The Disciplined Pursuit of Less by Greg McKeown, a book that’s getting a lot of attention at the moment. Another topic that’s getting a lot of attention, we discuss how Tesla’s huge market cap growth makes it feel like it’s 1999. We also offer our opinions on why Tesla has been so highly valued despite increasing competition in the electric car market. Answering a listener question, we explore how Robinhood makes money through ‘payment for order flow’ and the debate about if this is in the retail client’s best interest. Following another listener question, we answer if the podcast suffers from confirmation bias and how you can never know the ‘why’ behind stock returns. We talk about risk versus behaviour market explanations and use sound clips from previous episodes to present views on this subject. We then discuss Yale and David Swensen’s endowment investment model, focusing on his strategy of finding uncorrelated asset classes and then hiring active managers to meet target allocations. We look at the model’s benefits and its similarities to Canada’s CPP before examining how Norway invests based on oppositional ideas of the marketplace. Near the end of the episode, we continue our conversation on spousal loans by listing more family income splitting strategies. Tune in to hear more from the financial world.
Key Points From This Episode:
A quick book review of Essentialism: The Disciplined Pursuit of Less by Greg McKeown. [0:03:25]
Key ideas of this book; being busy isn’t always a positive, and if you don’t prioritize your life then someone else will. [0:06:02]
Why Tesla surpassing General Motors’ market cap makes it feel like it’s 1999. [0:07:32]
Opinions on why Tesla has experienced such incredible growth. [0:09:06]
How Robinhood makes money if they don’t charge any trade fees. [0:12:15]
Discussion on whether Robinhood’s service benefits the end-user. [0:13:19]
Dave Nadig’s take on Robinhood and why it’s a “tempest in a teapot.” [0:15:46]
Answering the question; “does the podcast suffer from confirmation bias?” [0:17:30]
How the podcast’s stance on behavioural versus risk-based explanations have softened. [0:18:38]
Sound clips from previous episodes on the reasons for different stock returns. [0:21:00]
Examining a paper arguing that active management can create value for investors. [0:23:10]
Deep dive into our portfolio topic; Yale and the endowment investment model. [0:27:30]
Why it’s so difficult to replicate David Swensen’s endowment investment success. [0:32:00]
The correlation between endowment size and allocation to alternative asset classes. [0:34:30]
How many endowment investment portfolios have performed poorly. [0:36:35]
Differences between the Yale and Canadian endowment investment models. [0:40:15]
How Norway operates the biggest wealth fund in the world. [0:45:40]
How Norway’s model is completely at odds with the Yale endowment model. [0:48:20]
Family income splitting opportunities in Canada that attract less tax. [0:52:00]
Why you should seek legal counsel when setting up family trusts and using family income splitting strategies. [1:00:05]
Hear the crazy, bad financial advice of the week; Ponzi schemes are still selling. [1:06:15]
Read the Transcript:
Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. You're hosted by me, Benjamin Felix, and Cameron Passmore.
Cameron Passmore: So regular listeners will notice that we got some new theme music.
Ben Felix: Yeah, that's right.
Cameron Passmore: I think it's pretty cool actually. And it's something we've wanted to do for a while. And we wanted something upbeat, Canadian sounding. So there's places you can go to get music made, I guess, for podcast. But I kept thinking about, "Well, there's got to be a solution that we can come up with." That's when I reached out to a long time friend, a musician, Trevor May, whose part of the local Ottawa band called the Cornflower Blue. And I said, "Look, we want something blue rodeo, tragically hippish." And this is what he came up with. And I think it's pretty good. What do you think?
Ben Felix: Oh, it's very Canadian.
Cameron Passmore: Anyways, Ben, let me choose it. He's very kind at let me choosing music. So I love it. Trevor's a cool guy. I don't know if I told you this, but he's actually in the high end Hi-Fi equipment and he has really cool speakers. And for those who are into audio file sound, you might want to check out his website, mayflyaudio.com.
Ben Felix: Yeah. I started looking at this stuff after I saw your notes up here. They look super cool.
Cameron Passmore: Super cool. He's getting lots of accolades from around the world, actually. So, yeah. Anyways, you want to give a shout out to some contributors?
Ben Felix: Yeah. So in the Rational Reminder discussion on our ratioanalreminder.ca site. I mean, first of all, we appreciate everyone participating and there's great discussion. I'll go check sometimes in the morning and whole discussions have happened that I've just not even been a part of, which is awesome. And there's a lot of people asking great questions, but then there's also a lot of people giving great responses.
And I hope I don't alienate anyone that I don't single out here. But I did want a single a few people out for making just great contributions to the discussion. So Braden Warwick, Sean Kaye and John Jay, those three people have been great. I mean, jumping in to answer all questions. But not just answering, giving really good, intelligent, well thought educated answers to other people's questions, which is great and appreciated.
Cameron Passmore: I guess it makes our life a little bit easier too, because I honestly don't have enough time to devote to it as I like to. Because you can become completely engrossed in it. There's so much going on in the different spaces there. And now we're getting on the YouTube side as well. There's comments over there.
Ben Felix: Yep. It's good to see the discussion take a life of it's own. And I actually saw it for the first time somebody commented... On an old discussion thread, someone commented that they had successfully used control F to find a topic, which I thought was pretty smart. There's no way to search by topic but you can use control F to search, which apparently works.
Cameron Passmore: Anyways, not the shortest episode today, but that's okay. Lots of great content. I thought your discussion-
Ben Felix: I talked with the light. Don't talk with the light-
Cameron Passmore: Different models is great. [crosstalk 00:03:19]. Anyways, here you go. Enjoy it and we'll go out with this snappy new music. Welcome to episode 107 of the Rational Reminder Podcast. So quick book review this week, something I heard about mentioned on various matches in business, in his interview with Ron Carson and also on Patrick O'Shaughnessy's, Invest Like The Best. So I thought after hearing on two podcasts, I better check out this book called Essentialism: The Disciplined Pursuit of Less by Greg McKeown. And I really liked it.
It got hammered pretty good on Goodreads for some reviews, but in a world where we live with so much information, so much content, so much feedback and so many busy people trying to do it all. I thought it was a refreshing reminder that the cost of doing it all is losing focus on your own priorities. So it basically gives you permission to say, "You know what? I'm going to focus on what I'm really good at and what's important to me and not let it risk other things in my world." Now you just started reading it as well, I think, right?
Ben Felix: Yeah. Well, you mentioned it and had been mentioned in a bunch of places, so, I guess, I thought the same thing as you that I better give it a look. Why did it get hammered on Goodreads?
Cameron Passmore: Well, one of the reasons was if the book's about essentialism, why is the book so long? And I must admit it, does seem to go on for a little bit. I reached chapter 16, it's like, "Okay, I get the point of it now." But I really did enjoy it. I mean, as the author says, "Essentialism is not about how to get more things done. It's about how to get the right things done. It doesn't mean just doing less for the sake of less either, it is about making the wisest possible investment of your time and energy in order to operate at our highest point of contribution by doing only what is essential."
And not all of us live in a world where we have that much freedom, certainly in our day-to-day jobs, but it is worth considering as you take on more and more tasks. I mean, he talks about in the book, how if you become the go-to person in the office because you get stuff done well, that can really lead to a dilution of your true value out in the office environment. So it's worth thinking about, I think.
Ben Felix: Oh, absolutely. I hear it had a diagram in the book where it's got a circle with a bunch of arrows pointing out of it in all different directions, short little arrows. And then beside that, there's a picture of another circle with one big long arrow pointing up. And it's basically trying to show the benefit of focusing on doing one thing well as opposed to trying to do everything. Yeah. Conceptually, it makes a lot of sense. I like the premise of the book. I don't know if I'll read the whole. Especially, after your comment just now.
Cameron Passmore: Well, I think the premise is great. And, I mean, he also questions why do we celebrate being busy? I mean, so many people you ask how they're doing, they say, "Oh, so busy. I'm so busy." Almost like that's a badge of honor. And it's like, "Well, what if we stopped being so busy and had more time to focus on listening, pondering?" He suggests meditating. Just enjoying time with the most important people in your lives, as opposed to just being busy.
And in this world we're all connected to our cell phones and all the other devices. And especially, this is work from home environment, it can be really cautious not to get dragged in because almost as we've said at work, "All the days mashing together now." Right? Your office is right in your home and that's so easy just to keep doing it. Especially, I would say we're fortunate you and I we love what we do and we do spend a lot of extra time doing this, but I think you'd agree it doesn't necessarily feel like work to us.
Ben Felix: Yeah. I do agree.
Cameron Passmore: Anyways, main point he says, "If you do not prioritize your life, someone else will." And he says, "Your highest priorities should be to protect your highest priority." So, I think it's worth reading. Another interesting quote that he mentioned is that the word priority came into the English language in the 1400 and it was singular. It meant the very first or prior thing. He said, "It stayed singular for the next 500 years." Only in the 1900 did we pluralize the term and start talking about multiple priorities.
Ben Felix: That is interesting.
Cameron Passmore: Worth reading. I'm enjoying it.
Ben Felix: Worth reading 16 chapters at least.
Cameron Passmore: Okay. Onto the next topic. This one is from the fields like 1999 file and the Tesla's share price in a while. I've been working on this story since last Thursday, Friday, and today it just kept on rolling. Did you read that Tesla's market cap increased today? So this is Monday, July 13th, more than it's total market cap was last October, when the grade fan for the market cap at Tesla surpassed the market cap of General Motors.
Ben Felix: Yep. I did read that in Tin's message from you this morning.
Cameron Passmore: That's today. Elon Musk's net worth has passed Warren Buffett's over 70 billion now. But this past week, so this is before today, the past week Tesla's market valuation is added the combined value of the Detroit three. So GM, Ford and Fiat Chrysler in just five trading days. Tesla's grown by an average of $14 billion in each of those days. And then today the 13th it has $35 billion in market cap today. Isn't that wild?
Ben Felix: Big growth expectations to deliver on built into the price there.
Cameron Passmore: It's unbelievable. So it's reached 322 billion in market cap. And that market cap exceeds the market capitalization of all but nine of the companies in the S&P 500. Incredible. Just the increase this year was bigger than all the 30 of S&P 500s. And interestingly, it's the largest company by far that is not in the S&P 500 index. And did you know there's not a single car company in Dell 30?
Ben Felix: No.
Cameron Passmore: So do you have a theory why it's rising so much?
Ben Felix: Well, my theory doesn't matter. I don't know. I mean, it's a growth stock. The market's seen this before. Tesla's is not the first growth stock to go to the moon. But, we also know how the growth story ends, which is in the value premium, eventually.
Cameron Passmore: Not that you're predicting anything, of course. But I mean, some of us said is the part of the narrative and it is a great story, no doubt about it. Another comment I read was, "It's not a traditional company." So how do you put a traditional measure on it?
Ben Felix: You ever heard that before?
Cameron Passmore: No. Never. Of course not. I remember back in the late '90 people were talking about, was it peg ratios? Price divided by earnings growth rates. [crosstalk 00:09:56]. So the silly book to market, what not. Those things are all so posse. And it's also, our speculation that it will be included in the S&P 500. So I think a lot of people might be trying to pick it up thinking that all the index funds will have to pick some up.
But I read one comment that disagreed with the assessment saying, "These managers did not understand that this is not a winner take all industry, that those names are in knowing that there are more than 180 electric cars that are slated to come up 2025." This is the part that gets me, as great as Tesla is and clearly it's a phenomenal product, but man there's a lot of competition. Some very big competition. And you've got to think that they're not going to let Tesla eat their lunch. Maybe and I can be totally wrong, but boy, there's a lot of serious capitalization companies competing there.
Ben Felix: That's what I mean when I say that it's got some big growth expectations built into the current price. That's a lot to deliver on. And like I said before, glamor stocks or growth stocks whatever you want to call them have been studied pretty extensively. Part of the basis for the concept of a behavioral story for the value premium is this, is the overpricing of glamor stocks.
People pay on average too much for gross stocks, it's the behavioral story. I mean, it's been studied empirically and proven to be arguably true. So is this company different? Is the explanation different than the explanation for most glamorous stories? I mean, maybe is the right answer. It could be. But this is not the first time something like this has happened in the stock market.
Cameron Passmore: Well, here we are July 13th, 2020, and is treading just below $1,600 of US share. So we'll see. They'll back on this someday. We are not predicting anything. This is simply an observation.
Ben Felix: But it doesn't even have to come down as the thing, right? It could grow into it's price over the next 10 years. I doubt this is going to happen, but the returns could be flat or just lower for the next little while.
Cameron Passmore: There's a ton of good news being priced in this and a lot of expectations priced into this. So we shall see. Question we wanted to follow up on from our discussion two weeks ago about Robinhood. We had a couple of people ask if Robinhood and other brokers don't charge any trade fees, how do they make any money? So I had a chance to do a little bit of digging into this as something I did not know a lot about. But one way they do make some money is called payment for order flow, PFOF.
So there's been a ton of chatter about this lately on Twitter. So here's an example of what order flow is. So for example, a US retail investor sends out an order to buy or sell a stock through their brokerage account. They may think it heads directly to the New York Stock Exchange, but this is what I learned, that's really true. Instead, these electronic wholesale firms often end up carrying out these trades and in most cases, these firms will pay the retail brokers for the right to execute these trades in what is known to be payment for order flow.
So the system has been credited with lowering trading costs for typical retail investors, but there is a lot of discussion by regulators about wondering if it's in the end client's best interest. This brings a lot of debate, and I don't know enough about it to know which side to come down on. Does it lead to more market efficiency, more pricing efficiency, therefore delivering better value to the end user? Or is it scraping off a few pennies per share that should have been in the retail investors hands? Do you have an opinion?
Ben Felix: I don't know enough about the underlying structure. I mean, it seems like it shouldn't matter either way. You're paying for the trade one way or the other.
Cameron Passmore: But one in five trades in the US are handled by these wholesalers according to the research from [Tab 00:14:06] Group. Three of the best known brokers firms are the big ones in the US which are E*TRADE, TD Ameritrade and Charles Schwab. Get this, took him more than $300 million in revenue in Q1 2020 for order flow. Robinhood received over $90 million of PFOF and Q1. Another thing I didn't know, order flow was pioneered by Bernie Madoff, of the famous Ponzi scheme notoriety.
Ben Felix: That was interesting.
Cameron Passmore: He was paying firms like Charles Schwab and Fidelity a penny or two for the right to make their trades. So is it a good thing or bad thing? I'm not totally certain. I don't believe it's permitted in Canada. I read some discussion about, because it's not permitted here that a lot of order flow goes direct to the US from Canada for AngelList listed stocks. Happy to be corrected on that if someone has extra information.
On the institutional side, allowing market makers some optionality around retail orders. Some argues made the market less risky and likely drives to lower spreads, which some say is good for everyone. Another article I had read about said that it gives added competition among trading firms. This resulted in price improvement for end clients. In terms of how much money we're talking about, one analysis I saw suggests that wholesalers make about three basis points.
So that's about $7.50 per $25,000 of trade, and pay about 0.8 basis points or on $2 to firms like Robinhood. So we're talking for the typical retail investor, pretty small dollars here. But you do enough trading volume, it becomes real money.
Ben Felix : Yeah. So I remember you posted this last time. We were going to record an episode and we ended up not covering it. I should have put this in our show notes. But I remember just doing some searching about it and Dave Natick had posted an article about this specifically. Because I was just thinking like, "Do I have an opinion on this? Who would? Dave Natick would." And he does. And he basically says in his article, well, he refers to it as a tempest in a teapot.
So he's saying that the dollars and cents that we're talking about are so small in the grand scheme of most trades, that it's not really going to make a difference either way. But he does say, "But what if you are an Robinhood trader?" Actually, you know what? I've read something else about the order routing for Robinhood. I should have dug more into this, but it was something along the lines of... And I don't even know what I'm quoting here, so don't quote me. But it was something along the-
Cameron Passmore: But you can quote you?
Ben Felix: Something along the lines of the way that Robinhood routes orders ends up amplifying the market impact of the trades of people on Robinhood. So if you got a bunch of people on Robin hood speculating on Tesla shares, the way the orders are routed could end up amplifying the market impact of those trades.
Cameron Passmore: Anyways payment for order flow. It's a thing. It's a big thing for these companies. And the other way they make money too, I would think is on cash balances, getting the interest rate spread on cash balances.
Ben Felix: Yeah, but it sounds like from Dave Natick, it's not a big deal. And if you're in Canada, it doesn't matter regardless because this is not a thing.
Cameron Passmore: Not a thing here.
Ben Felix: But I do think that the market impact pieces is a little bit interesting.
Cameron Passmore: So you wanted to jump into a listener question we had last week?
Ben Felix: Yes. We had a very good listener question. It was asked in the discussion on one of the episodes, not in the main discussion. So they asked, "Is it possible that you two are suffering from a heavy dose of confirmation bias?"
Cameron Passmore: Oh, interesting.
Ben Felix: It is. It is possible. It's puzzling to me how often you easily dismiss behavioral finance with passing comments when the behavioral phenomenon has been experimentally and in some cases empirically proven to exist in financial markets. Funny enough, I just referenced the glamorous stock behavior story. I wasn't actually thinking about this before I talked about that. Anyway, moreover, I'm sure you have both experienced investor over and under reactions many times yourselves with clients. Surprisingly, not that often, but the conversations do happen. So anyway, they posted a paper about active management, which is a paper that we have read, and we'll comment on that in a second.
But it's a paper called Challenging the Conventional Wisdom on Active Management, a review of the past 20 years of academic literature on actively managed mutual funds. And it's a literature review and discussion. So we will share our thoughts on that in a second. But I think just on the behavioral finance portion of the listener question, like I just alluded to inadvertently by talking about the behavioral story for glamor stocks.
Are our stance on behavioral versus risk based explanations has definitely softened. I remember even talking about a study that tried to prove that value was purely a risk story using some statistical method. My window anyway, into a lot of this stuff started with Dimensional's Research. And Dimensional by nature of the way that they've structured their business and their philosophy and the way that they convey their knowledge comes from the efficient market risk based story. So a lot of the knowledge that I started with came from there. And I'm sure somewhat similar for you, Cameron.
Cameron Passmore: Absolutely.
Ben Felix: But I think as we've continued to expand our knowledge, including we're interviewing people on the podcast, that's, yeah. Well, like I said, my stance has softened a lot. There's no way to know. And it's more likely it's a combination of both. Even in the behavior case. One of the other things that we've talked about in the past is that if it's a behavioral story then it could be arbitraged away. But there's a whole limits to arbitrage story that says that, that is not true.
Cameron Passmore: But in the end you don't know the true cause of these different sources of returns. You don't know.
Ben Felix: No, you can't. You can't.
Cameron Passmore: So I don't think we've ever been that dogmatic about it. But certainly talking to different people over the years but especially over the past two years on the podcast, we have a much greater appreciation of the different nuances behind the sources of different pieces of return.
Ben Felix: Yeah. And even just to say, you can't know. You can try and make the argument that it's a purely risk-based story. But it would be a foolish argument to try and make. But I think that we have taken a harder stance on that in conversations on the podcast in the past, Cameron. But I don't think that's the right way to approach it. So anyway, I mentioned that conversations on this podcast with guests have been part of the reason that we've softened on that position.
So we wanted to play a couple clips from people who are much smarter than us and were more formally educated than us on as a pricing theory. And in these clips, they're saying that it is probably both or that you can't think it's one or the other. So anyway, first we're going to play this clip from Marlena Lee who's the head of investment solutions at Dimensional Fund Advisors. And this was from episode 79.
Marlena Lee: I think that there's actually a lot of different reasons why stocks may have different returns. Certainly risks are part of it, but you can have investors have different tastes or preferences for certain stocks over others. And that would be just one more reason to expect differences in returns. I actually don't think of it necessarily as risks or behavioral. I think of it as risks and behavioral, because both contribute or potentially contribute to driving differences in expected returns.
Ben Felix: And know we're going to play clip from episode 93, with Cliff Asness from AQR.
Cliff Asness: Truth, interpretation and what you believe matters. But so many of these things in financial economics, these so-called anomalies or risk factors can work for a variety of reasons. For instance, value. There are three possible reasons value has worked for the last 100 years. One is, it represents a pure rational risk premium. Cheap stocks are riskier in some sense than expensive stocks and you get paid for bearing that risk.
The next is irrationality. Cheap stocks are cheap, at least partially by era and vice versa. The third is it was all dumb luck and it's never going to work again. I always have to throw that one in to be intellectually honest. I don't actually believe that one. And Gene works very closely with Dimensional Fund. The firm I respect the hell out of. And I doubt many people there only believe in one explanation and I certainly don't. But if they think it's mostly a risk premium.
And I think it's mostly, which would probably be going too far for me. But if I think it's more than they do a behavioral effect, we don't do anything radically different with that information.
Ben Felix: And then finally from our episode 100 with Ken French, where he talks about the lack of a risk based story for the Momentum Premium.
Ken French: Well, first I'm with you. It's really hard for me to reconcile Momentum with a risk based story. So I never argue prices. All prices are right. I think there probably are mistakes in prices. My trouble is, I don't know which ones are too high and which ones are too low.
Cameron Passmore: So now that we've listened to those, do you want to talk about the paper a bit?
Ben Felix: Yeah. So not too much. I didn't do a big writeup or analysis or anything like that. But when I did read the paper, when it came out, the big challenges that I had with finding it useful, or that it was a selection of papers arguing in favor of active management, being discussed in the paper that we're talking about. But there was no clear selection criteria for how these papers were selected, which I mean, I'm not saying that it was intentionally set up to appear in favor of active management.
But there's no way to evaluate whether that was the case or not. And then one of the other red flags for me was that the one of the authors, Kramers is his last name. He's been a long time advocate of active management. Now that doesn't mean he's not credible. He's got lots of published papers on this. The research that he's doing has gone through a peer review process and come out the other side.
But one example of a research that he did that was debunked, although he did come back and argue against the debunking. This is the guy that had the active share concept that some people may be familiar with. And we've talked about in the podcast in the past. But it's this idea that the more different a fund is from its benchmark index, the higher its active shares is.
And in the 2009 paper, he argued that it's actually a criteria that can help identify better performing funds. So a fund with a higher active share is also more likely to be a fund that produces alpha. Lots of other research has shown not necessarily the opposite, but just showing that higher active share doesn't mean a higher chance of positive alpha. It just means a higher chance at a wider distribution of outcomes.
Cameron Passmore: Interesting. Positive or negative.
Ben Felix: Good or bad, which is what you'd expect. It's a more concentrated portfolio. We've talked about concentration versus diversification in the past. So anyway-
Cameron Passmore: Barry Ritholtz has talked about active share in his interview with me Bill Miller that came out last week, which is a really interesting interview. A legendary active managers and he beat the S&P 500 for what? 15 straight years.
Ben Felix: But then tanked, right? Or the fun tanked, anyway.
Cameron Passmore: Fun tanked and he's got a new firm now. And I believe the returns are good. But interesting how that was mentioned, the active shares mentioned that interview.
Ben Felix: Yeah. So anyway, there's a paper from the folks at AQR that I thought did a pretty good job debunking active share.
Cameron Passmore: So active share really means tracking error.
Ben Felix: Yeah. But you're no more likely to have a positive tracking error than a negative tracking error with a higher active share. They said active share correlates with benchmark returns, but does not predict actual fund returns. Within individual benchmarks, active share is as likely to correlate positively with performance as it is to correlate negatively. Overall, our conclusions do not support an emphasis on active share as a tool for selecting managers or as an appropriate guideline for institutional portfolios.
But anyway, the point is that this is just an example of some of the other research that the same author has done in support of active mutual fund management, which was then debunked by, I guess, people from the competing worldview of markets being efficient and this not being a good approach.
Cameron Passmore: So the question started with dismissing behavioral finance that we may be biased. Therefore, this person set out to see if there's arguments supporting active versus passive. So there's two separate arguments. This isn't an article about behavioral finance. That was just the point that we are somehow biased against behavioral finance. So I get it.
Ben Felix: Yeah. It was two pieces. So the behavioral finance piece, I think we've opened up on. And then the second piece on, could we challenge our bias by finding papers supporting active management? And the answers is, in this paper specifically? I don't think so. In our last episode, I guess 105 with no guests, we talked about how to pick an active manager, which was actually largely inspired by this idea. If we were not to be investing bias in efficient markets biased, how would we approach portfolio construction? So that was the point of that discussion.
Cameron Passmore: All right. Let's jump into the portfolio topic. This is a good one. You've done a ton of work on this.
Ben Felix: There's this idea of the endowment model, which some people might have heard about. And when you think of the endowment model, I mean, what do you think of?
Cameron Passmore: Yale. That's what I think of. I think of Yale. Goes back to our interview with Ted Seides. So a year ago now he used to work at Yale. David Swensen, that's what immediately comes to mind. Then after that I think of Norway.
Ben Felix: Oh, interesting. That's probably because you read my notes though.
Cameron Passmore: No. I've thought about Norway for years. It's just been the largest pool of assets, I believe in the planet over a trillion dollars. What did you think of before you did this research?
Ben Felix: Well, the same as you. But I went into it with the same knowledge. Yeah. So Yale's endowment, which is famously managed by David Swensen. Swensen's approach has become synonymous with the idea of endowment investing. And Swensen's really came up with this model, I think it was the late 1980s. He left wall street, took a big pay cut famously and then started managing Yale's endowment.
And he came up with this theoretically based, well, definitely not efficient market theory. Modern portfolio theory based. So I really a mean variance type framework. Although, Swensen in his book acknowledges the limitations of mean variance optimization. Well, first of all, you don't want to have a high allocation to bonds because they have low expected returns. So take that out of the equation. You want to have lots of stocks.
But you also want to diversify, but markets aren't efficient. So you don't really want to diversify by adding independent risk factors. Although it doesn't preclude that, but that's not the idea. So instead, the idea is to find uncorrelated asset classes. So this is back when Swensen started doing this. University endowments will be holding probably mostly bonds, maybe stocks, domestic stocks. But Swensen started adding in private equity, hedge funds, timber, oil and gas-
Cameron Passmore: Venture?
Ben Felix: Venture capital, yeah. And all of these allocations they're not being indexed. Yale is going out and hiring active managers. That is what they are great at. Setting target allocations for all these different asset classes and then going out and finding the best people to go and generate alpha because markets are inefficient and increasingly inefficient as we get into less liquid markets.
I was reading Yales most recent annual report, even in US equities, which they acknowledge in the report are highly efficient. They're still using active management in that asset class. So Swensen's-
Cameron Passmore: They're very little in US public equities don't they?
Ben Felix: Very little. Yeah. In their annual report they, I don't know who wrote it, say it's Swensen. Swensen talks about how they use a combination of mean variance analysis, which like I mentioned, they know there are limitations to and there definitely are, and market judgment to set target asset class weights. And then they go and fill those weights with the active managers. But, yeah. So the current as of June 2019 allocations in the portfolio are 23.2% in absolute return strategies. So those are hedge funds, 2.7% in US public equities.
Cameron Passmore: Amazing.
Ben Felix: Yeah. 13.7% in foreign public equities, 15.9% in leveraged buyouts, so private equity. 4.9% of natural resources, 10.1% in real estate, 21.1% in venture capital and 8.4% in cash and fixed income.
Cameron Passmore: Incredible.
Ben Felix: Now this is inherently an extremely expensive approach to managing money. I think Ted talked about this when he was on the podcast, one of the things that Swensen and Yale in general has gotten really good at is negotiating the terms with the external active managers. And that ends up being one of the things that you have to be really good at to fill allegations like this.
Cameron Passmore: And then also very good at communicating the belief by what you're doing is that your stakeholders patiently stick with you.
Ben Felix: Yeah. I read an article about Yale and it was titled something along the lines of Swensen has been great for Yale, but terrible for investing or is he terrible for investing or something like that. One of the reasons they've been able to be so successful is that all of the stakeholders have put so much faith... And Swensen now has so much political capital that everyone will just stick to whatever strategy he says is good.
But you compare that to other big institutions, other Ivy leagues even like Harvard, Harvard has got a bigger endowment, but they've had much more manager turnover and that's made it much harder for them to stick longterm with whatever strategy they have in place.
Cameron Passmore: It's fascinating, isn't it?
Ben Felix: It makes it that much harder to replicate. I don't think this is true and we'll talk about why in a second. But even if we made the assumption that with the right people Swensen's strategy can be replicated. Finding the right people is, I mean, it's like finding the perfect active managers. Its the same challenges.
Cameron Passmore: And what was there about Swensen 30 years ago to know he would be this great?
Ben Felix: Right.
Cameron Passmore: What were those variables that you chose that you knew ahead of time would be the variables that would explain this incredible performance?
Ben Felix: Yeah. So despite the inherently high costs, the Yale endowment has performed very well for the 30 years. This is self-reported from Yale. There have been some questions around how they report their venture capital returns. So I guess keep that in mind. I don't know if that shows up in this figure or not. For the 30 years ending June 30th, 2019 Yale reports and annualized return of 12.6% with a standard deviation of 6.8%.
So in risk adjusted terms of way better than like a 60, 40 stock bond mix. Their outcome is the reason or largely the reason why people associate the endowment model with Yale. And it's not just the average person, maybe the average person doesn't make that association. The average investment professional aren't the only ones making that association. But other institutions have followed suit and started doing the same thing that Yale is doing. But then the next question is, okay, if other institutions are following Yale's model, are they getting the same results?
Cameron Passmore: How did they do?
Ben Felix: They do get the same results?
Cameron Passmore: No. How do they do? That's the obvious question, right? Everyone wants to copy Yale were they able to pull it off?
Ben Felix: Yeah. So that there've been some pretty interesting studies on this. And I found a bunch, but I found one that was quite recent. It was a 2020 study titled endowment performance by a very credible, independent author. I went and looked at his other work. A lot of it's published. This one has not been published yet. But so he looks at the relationship and this is a well known relationship, his part of the research his not new. He's just stating it to be true, which it is.
Which is that, there's an obvious correlation between endowment size. So specifically for higher education endowments in the United States, there's an obvious correlation between endowment size and allocations to alternative asset classes. And that shows up in returns where larger endowments have higher historical returns and smaller endowments. So they have both these higher allocations to alternatives and also higher historical returns.
So that's so far seems to be validating the Swensen's endowment approach. But a lot of this paper that I'm talking about now, it focused on controlling for risk. So you can say, "Okay, well, they've allocated to alternatives, they've done better. Great. But what if you control for risk? How have they done better in risk adjusted terms?" So in this study they created risk appropriate benchmarks.
It's like if anyone remembers the discussion we had about CPP a long time ago. Or CPP said, look how much better we've done relative to our reference portfolio. And then we went and created a more risk appropriate benchmark and showed how poorly they've actually done. So this study does the same kind of thing. And they find negative alphas across the board, even for the largest funds.
They did find that some funds had positive alphas, but none of the positive alphas were statistically significant. Which is obviously interesting. Now they did find that the largest funds, so they broke it down into six cohorts, the largest cohort, which is funds with over a billion dollars in assets, they had consistently less negative alphas than smaller funds.
Cameron Passmore: Less negative?
Ben Felix: Yeah. So in the paper, the author talks about he uses an analogy for casinos. If the average Joe walks into a casino, they're going to come out a loser, but professional gamblers can sometimes lose less than the average person.
Cameron Passmore: Some kind of analogy.
Ben Felix: Yeah. And so the commentary there is that it may be true that the largest, most well-funded endowments have some skill in selecting managers, but it doesn't mean they're running positive alphas. It means earning less negative alphas, which is, I mean, on average, what you'd expect.
Cameron Passmore: Mainly covered by fees, do you think?
Ben Felix: There's a discussion of fees in that paper. And this shows up in the data to where the study that I'm talking about here, they looked at returns for endowments by decade, going back quite ways. I think to the decade ending 1989 was the earliest one. And historically endowments have matched or even beaten index returns. Not adjusted for risk though, which may be harder to do in the historical data. I don't know.
But it's this most recent decade, which is interesting in the context of the research that we talked about last time on private equity. The last decade they've done horribly. And not only have they done horribly but a public stock bond index has explained all of the returns for even the largest endowments with the highest allocations to alternative investments. So, I mean, if you think about this stuff that we talked about last time on private equity, if it's true that private equity valuations are getting higher and expected returns are getting lower, or that's already happened, it's not happening.
That's happened over the last decade. So if you have high allocations to stuff like that, and if the prices are getting higher then you would expect the returns to be lower, which may be what's showing up in this last decade of returns. And if that continues to be true going forward, then you wouldn't expect to be any better off for allocating to stuff like that.
But when you look at the Ivy league endowment asset class exposures, we can post the image on video version of this, but small allocations to public equities. Big allocations to hedge funds. Big allocations to venture capital, private equity, real estate, all across Harvard, Yale, Princeton, Dartmouth, UPenn, Columbia, Cornell, and Brown. Actually, one of the other interesting things that comes out of this is Harvard, which is the largest Ivy league endowment has the worst performance tied with Cornell for the last 10 years. Yeah.
Cameron Passmore: And where were they compared to 60, 40 again?
Ben Felix: So for the last 10 years, or the 10 years ending mid 2019. 60, 40 was plus 10.5% and Harvard was 8.6%. That's not a risk adjusted figure though. But that relationship between endowment size and allocation to alternatives, so the less than 25 million endowments have on average 7% allocated to alternatives. And there's six scores in total, but I'll jump to the sixth.
So the largest cohort, which is greater than a billion in assets, they allocate on average 51% to alternatives. Across the board pretty much the same risk adjusted returns. So you're allocating all this high cost stuff and getting not a whole lot of benefit. So that's the Yale model and that's the sort of traditional endowment model. The other model that I didn't really know was a formerly recognized model, but it is.
It was in one of the CFA textbook refresher ratings when I was looking into this and it's the Canada model. So obviously people will know about it. I mean, we just talked about CPP investments a second ago. And people in Canada are familiar with CPP and teachers, and almost like all the big Canadian pension funds. So there's actually a globally recognized model called the Canada model, which is largely similar, nearly identical in most ways to the Yale model. Same with the big allocations to alternatives.
Ben Felix: The big difference between the Canada model and the Yale model is that in the Yale model they're going out and hiring external managers and their expertise is in finding those managers. Whereas in the Canada model, they rely more heavily on internally created expertise.
Cameron Passmore: Wonder why. Does it talk about why?
Ben Felix: No.
Cameron Passmore: Wonder what's about Canada, we want our people in the house. Interesting.
Ben Felix: Maybe it's more cost effective. I'm not sure.
Cameron Passmore: And more governmentally run the big pension plans in Canada as opposed to university type in Dallas. I don't know. Most of the big ones in Canada would be [inaudible] teachers, CPP, the case in Quebec. Interesting.
Ben Felix: Yeah. So in the Canada model this is another thing that's a little bit unique, they will generally create a reference portfolio, and this is definitely how CPP investments does it. So they create a reference portfolio of public stocks and bonds. That's been designed to meet the risk and expected return objectives of the institution. So this is when CPP came out with that report or whoever it was. The PBO, I think, came out with a report showing that their actual portfolio is beating their reference portfolio.
That's what they were talking about. That was a real thing. It wasn't like an artificially create a benchmark. It was their reference portfolio, which is a part of their overall strategy. So they build this reference portfolio, but then they go and implement active management. Kind of like the Yale model, I guess, but they go and implement active management to fill those allocations.
They talk about taking a total portfolio approach. Now CPP investments talks about this in all of their literature, but the CFA textbook also talked about this, which I thought was interesting. That it's a characterization of the Canada model. So they take a total portfolio approach, which means the example they use in the textbook is that if they allocate to private equity, it is taken into consideration that private equity is riskier than public equity. And therefore the public equity allocation will be reduced more than the private equity that's being added to the portfolio.
Cameron Passmore: So it's how they spend their risks dollars basically?
Ben Felix: Correct. Which I think based on the discussion we just had about endowments, that doesn't seem to be as much of a consideration. Because a lot of them are taking a whole lot of risk that doesn't necessarily show up in their reporting. So in terms of asset allocation, CPP is more heavy in public equities, 28.2%, almost 25% in private equities, 12.4% in credit, 11.3% in real estate, 11% in government bonds, 8.6% in infrastructure, 3.9% in real assets.
And for the internal expertise and the external managers, all of the costs, I don't have this figure for Yale, I wish I did. But CPPs total costs come out at about 84 basis points. So they're managing $409 billion and their overall costs come out at about 84 basis points. Now, again, we've talked on this podcast in the past about how much value that's actually adding when you adjust for risk. And we would argue that it's not adding value.
If you've compare it to the reference portfolio, it may be adding value, but that's likely in the context of that discussion we just had about the endowments that's likely explained by higher risk allocations that don't necessarily show up in reporting.
Cameron Passmore: Yeah. And you go back to the listener question about bias. You want to have more systemic bias there is in this whole towards being versus not.
Ben Felix: Yeah. That's huge.
Cameron Passmore: Like the agency risk issue, right? If you're in the business of managing managers, you're probably going to manage managers
Ben Felix: For sure. I mean, you look at the literature from some of the other Canadian pension funds. So not CPP, although CPP says the same thing. Some of them are outright explicit about the fact that markets are inefficient and that they add value through active management. You just throw your hands in there like, "What? What do you mean? Where are you getting your information from?"
So anyway, those are the two probably most dominant in terms of assets endowment models for managing big institutional pools of money. The Yale model and the Canada model, which are largely similar in terms of their large allocations to alternative asset classes. Just the difference being in the governance model, I guess. Or maybe the management model, whatever you want to call it. In both cases, you have a lot of complexity and you have high costs, which come with complexity.
I think it definitely appeals to the agency issue that you were just talking about, Cameron. Now that rightly raises the question of if the smartest largest asset managers in the world are managing money this way, why the heck aren't we? And then why aren't all of the people that are doing index investing? Is it because they don't have enough money? Is it because they don't have access to the managers?
Why should people not be striving to invest the way that these big smart institutions do? And then Norway is the answer. Well, it's not the answer, but Norway has their own answer to that question. So Norway is like you mentioned earlier, Cameron, the single biggest fund in the world at around a trillion US dollars in assets for a single sovereign wealth fund. And that's Norway's budget excesses from their oil revenues.
Cameron Passmore: Saving like crazy. But they own, what is it? 1.4% of every stock on the planet, I believe, on average.
Ben Felix: Something like that. Yeah. So they put their whole structure in place in a way that is basically the complete opposite of the Yale model. In the Canada model. I think some of the Canadian pension funds still have a bit of indexing going on. I've seen some reports that show a moderate percentage of assets being indexed. Norway is the other way around, where it's mostly indexing with a very slight tolerance.
And the way that they measure this is through tracking error. So mostly indexing with a very slight tolerance for tracking error relative to their benchmark. So they set the benchmark index. If they're going to do active management, it's within a tracking error tolerance, which means either not a whole lot of deviation or not a whole lot of assets going into active mandates.
In terms of alternatives, they don't have it. Well, if you include unlisted real estate as an alternative, they allow up to 7% of the portfolio, which is not a whole lot when you compare that to some of the other allocations we were talking about before.
Cameron Passmore: And they build on their own indices, do you know?
Ben Felix: No. I can't remember which indices they follow, but they're public like FTSE indices. Yeah.
Cameron Passmore: With rock bottom fees.
Ben Felix: Well, yeah, that's the other big thing about this model. They also allow up to 2% in unlisted, renewable energy infrastructure. And I think that's more of a philosophical thing. It's not necessarily to maximize the expected returns, I don't think. Because I know being sustainable and responsible is a huge part of their political mandate. So anyway, the stock bond mix ends up being roughly 70, 30, I believe.
And I think the real estate is slotted in with the fixed income. Now, the most interesting part to me, my bias is coming through, is that when you look at their investment strategy, which is set by the ministry of finance in Norway, and then the actual management is done by Norridge Bank but the strategy and mandate are set up by the ministry of finance. They talk about on their website, how their investment strategy is underpinned by a core set of beliefs.
The first one, at complete odds with the Canadian pension funds that I just mentioned, and absolutely at complete odds with the whole Yale model. Their first core belief is that markets are largely efficient, not inefficient. So you can see why that asset allocation flip happens, where they're largely index with slight active, as opposed to largely active with slight index. It's because their belief is the opposite, which I guess makes sense.
The ministry of finance believes that markets are largely efficient. Diversification is absolutely necessary. Which is interesting actually, because you think about Swensen and the Yale model, and that's all about diversification too. But it's a very different approach to diversification. Let's get a whole bunch of different asset classes and then find active managers within each asset class and call that diversification.
Cameron Passmore: Well, it's diversification in the effort to seek risk and return. Whereas the Norway model is diversification to capture what is there to be heard.
Ben Felix: Oh, you know what it is? You've said it fine but Yale is trying to diversify sources of alpha. Norway is trying to diversify sources of beta.
Cameron Passmore: Correct.
Ben Felix: Yeah. And that's actually, so within their mandate or within their stated strategy, a focus on earning risk premium. So not just the equity risk premium, but multiple longterm risk premiums, this part of the mandate. So that's tilting toward value, smaller companies and there was a couple other that they're pursuing too. Having a clearly articulated benchmark, which they have a tight tolerance against.
So very different from CPP, where CPP has a reference portfolio, but then they're going pretty hard on active without a whole lot of concern about how much they're deviating from the benchmark. Obviously, they're hoping to do better than the benchmark in CPPs case. In Norway's case, they have a clearly articulated benchmark with a tight tracking error for their overall strategy.
They do have a commitment to responsible investing built in there, which shows up in the, I think, Credit Suisse annual returns yearbook. I think that's where I saw this. They talk about Norway specifically and how they've lost a bit. A few basis points by having their responsible tilt away from the market. So keeping in mind, CPP comes in at 84 basis points. Norridge Bank comes in at eight basis points in total costs.
Bigger fund, but order of magnitude higher costs for CPP. And Norridge bank has... No, I don't have this number in risk adjusted terms, but their returns have been on par with all of the fancy index or fancy non index managers that we've talked about. I mean, they've gotten the market return, which I guess is what you'd expect considering-
Cameron Passmore: They are the market.
Ben Felix: They're basically an index. So anyway, that's it. Basically, thinking through the idea of, "Why aren't the biggest supposedly smartest managers indexing?" And the answer is, "Well, some of them are." The biggest one, the single biggest one is doing exactly that.
Cameron Passmore: And the ones that are trying to emulate Yale, aren't able to keep up with Yale.
Ben Felix: Yeah, that's right. Yeah. That's one of the other things that came out of that or one of the punchlines that came out of this study that I talked about earlier was that, most of the endowments are underperforming in index.
Cameron Passmore: Fascinating. Anything else to add?
Ben Felix: Nope. Not on this one.
Cameron Passmore: All right. Let's go onto our planning topic. So it's a bit of a carry over from our conversation two weeks ago when we talked about the benefits of spousal loans. So we thought it'd be worthwhile for us to dig into some other income splitting opportunities in Canada. So as we described two weeks ago, income splitting is basically the ability to transfer income from a higher income family member to a lower income family member.
And in Canada, at least we have marginal tax rates. So clearly the more you make the higher rate of tax you pay on that last dollar of income. So it can be very valuable to push income from the higher income family member to a lower income family member. And notice, I did not say spouse because you can but there are some ways to split income with your children. So let's run through this list.
Number one on the list. This is pretty basic. It will be to have the higher income spouse in this case, cover all living expenses and thus allowing the lower income spouse to build up all the savings. Now you have to agree to that regime. I know a lot of couples have different ways of splitting expenses at home, but that is one way to build up more assets. That would attract less marginal tax at the lower income spouse's tax level.
Ben Felix: That's where this topic came from. From listening to our last question about spousal loans, someone asked in the comments, "Well, what about this?" And that give us the idea to cover this off as a broader topic.
Cameron Passmore: All right. Number two, you can give money to your kids that are over age 18. And when you do that, there's no attribution. So if I give my 21 year old son a bunch of money, he can take it and invest it, buy a house, do whatever and there is no attribution back to me for any income that he happens to earn. Now, one thing you can do to protect yourself, and I've seen this a number of times over my career, where often parents will give their adult children money for a down payment on a house.
And then in the event of a relationship breakdown that can get muddied up in the division of assets. So one way to protect yourself there is to do a documented loan to the adult children, so that protects the asset.
Ben Felix: Because if you give a gift to a child and then they get married or start a relationship after that, unless they put that money into the matrimonial home-
Cameron Passmore: Correct-
Ben Felix:... you'll be excluded from the separation.
Cameron Passmore: Exactly. But it gets muddy when it gets put into the house. That's something you see so often, right? My kids are buying a house, I want to give them money for their house, right? Number three. You want to kick off number three?
Ben Felix: Informal trust accounts. So that's something that you can do at many financial institutions, but I mean, it's what it sounds like. You can open an investment account in-trust for a child, with a parent or guardian or otherwise, I guess, dictating what happens with the money. In that situation income is still going to attribute back to whoever gave the money.
Cameron Passmore: That's right.
Ben Felix: Capital gains can accrue to the child, which leads some people to ask, well, I could just buy a growth stock and hope that it's true that you're taking on a lot of risks.
Cameron Passmore: But at least you control the asset because as soon as you put it into an in-trust for account, it becomes their money, even though there's not a formal trust deed. It is still valid trust.
Ben Felix: They can claim it when they reach the age majority.
Cameron Passmore: Correct. Now some parents say, "Well, I'll never tell them." Well, it doesn't really matter. Age and maturity technically does become theirs. So and we have very few in-trust for accounts that we've set up over the years. It used to be very popular 20 plus years ago. And you have to put your contributors sitting there [inaudible 00:55:56] the income comes back to the contributor. The capital gains go to the child. Anything else to add to that?
Ben Felix: No, I think that's good for that one.
Cameron Passmore: Another one that we do a lot of is RDSP, what we call super funding. So if you set up an education savings plan for your child, there's a $50,000 lifetime limit, and there's a grant limit of $7,200. So to get the maximum grant you have to put in $36,000 of contributions over the years and the maximum per year is $2,500 to capture that grants. So it takes just over 14 years to get the maximum grant.
But, there's an extra 14,000. The difference between the 36,000 to get the grant and the 50,000 lifetime, you can put that into the RDSP and that income will attribute to the child upon withdrawal once they go to school down the road. So for people who have maximized everything and they've got their mortgage under control or paid off and just have excess cash, doing the RDSP super funding, I would say is the last proverbial no brainers.
Ben Felix: Yeah. It ends up being income splitting with the child once they go to post secondary education. If they do, I guess. That's all the questions people have with that one too, is what happens if they don't?
Cameron Passmore: In that case the 14 comes back to you as the contributor. Yup. Next one's spouse RRSP. And there's lots of confusion around this. But this is where the higher income spouse makes a contribution to the lower income spouse using the higher income spouses RRSP room. I mean, there's confusion both ways, right? Well, who contributes to and whose number are you using? It's the contributors room that you're using to contribute typically to lower income spouse.
So it's not as big a deal as it used to be because RIFF income, registered retirement income fund when you're retired can be split. But still it's wise for couples to get to retirement with similar pools of assets. So if one person has a pension, the other person doesn't, while the person with a pension might want to consider doing spousal RRSP, contributions to their spouse.
Ben Felix: I've also heard some people say that there's no guarantee that we're going to keep income splitting forever.
Cameron Passmore: Absolutely.
Ben Felix: And so therefore it makes sense to equalize the RRSP accounts.
Cameron Passmore: I agree. You only have to watch too, is the three year attribution rules. So any money that comes out of a spousal RRSP goes back taxable to the contributor. If they made a contribution in that year or the prior two years up to the limit of the contribution, of course. But it follows the last and first out accounting methods. So just be really careful. And that's why some people leading up to retirement will often do their RRSP contribution near the end of the year, as opposed to the first 60 days of the year to buy themselves a year sooner, being able to take the withdrawal out down the road. So keep an eye on that.
Ben Felix: Yep.
Cameron Passmore: Next one is the prescribed rate loan planning. So this is what we talked about two weeks ago with the spousal loan. And this is where the prescribed rate is set by CRA every quarter and it just dropped down to 1% for the quarter that just started on July 1st. Make sure you pay the interest. This is where a higher income spouse lends money to a lower income spouse. It's got to be properly documented.
Interest on that loan has to be paid back by the borrowing spouse to the lending spouse by January 30th of the following year. So this is a spousal loan we talked about. But in addition to the spousal loan, you can also do a prescribed rate loan to a family trust. And we highly suggest you work with your tax and legal advisors. But this is where you're able to add members of your family and other family members to your trust, to be able to possibly split income with them on any money that's earned over that 1% spousal loan rate that currently is.
Ben Felix: Even on spousal loans. You mentioned talking with your tax and legal advisors. Even on spousal loans it's crazy how there's lots of little detail and nuance that can happen when you do any planning like this. Yeah. We discovered some stuff recently. Maybe we'll talk about it in a future episode, but not on this one.
Cameron Passmore: You can throw a teaser out like that, you might as well...
Ben Felix: Well, I mean, we'll leave it at there are some estate planning considerations that come up when you're making a spousal loan, but should be addressed in a state planning.
Cameron Passmore: Get your professionals on site, your financial advisor, your tax advisor, your legal advisors. And everyone's aware of exactly what's going on. So everyone's got everything properly covered off. And we talked about the forgiveness rules last time. Complicated, you want to make sure they're properly done.
Ben Felix: Spousal loans still should be addressed with all of the relevant professionals. The family trust, that one definitely would have other professionals involved because it's fairly complex planning from both the tax and a legal perspective. And at that time you're probably redoing your role, anyway. But a trust, it's technically not an entity, it's actually an agreement.
It's an agreement between the subtler and the trustees. So the subtler technically puts property into the trust and then mandates the way that the assets are to be managed in the trust agreement, and delegates that responsibility to the trustees. And that's funny how this happens in practice, is the subtler takes a $10 bill literally and settles the trust with the $10 bill, which then gets stapled to the back of the trust agreement to prove that the trust was settled and that it's a legal trust.
Once the agreement has been made between the subtler and the trustees, the subtler's out of the picture. And more assets can be added to the trust, which the trustees then manage on behalf of the beneficiaries or for the benefit of the beneficiaries, I guess.
Cameron Passmore: And to make it all worthwhile, I think most advisors say it should be at least what? 1.5 to $2 million probably to make the effort worthwhile, with all the legal [crosstalk 01:01:55] agreements, accounting. Because there is compliance work to do with it a family trust.
Ben Felix: Yeah. So when we're doing the calculations to determine if it makes sense or not, we use $2,500 a year as the compliance costs, but the tax filing and advice cost. And we use $5,000 as the initial setup cost. That seems to be in line with what we see when people are actually doing this plan. But, yeah, for sure it has to be worthwhile. You're probably right, the $1.5 million is the mark where it makes sense. I used 2 million in some just sample calculations to give people a feel for the numbers.
But if we imagine a scenario where one spouse has their personal income above the highest tax bracket, other spouse has no income. And we'll imagine that there are two minor children with no income in the scenario. Oh, and one of the things on the trust, one of the tricky things about it is that after 21 years, the trust has a deemed disposition, which means that it's as if the trust sold all of its assets. It doesn't actually have to sell them. But for tax purposes, it realizes all of the gains that have occurred in the trust.
Cameron Passmore: Brings your cost base up to market value.
Ben Felix: Right. So that's included in the numbers that I'm about to mention here. So if we assume the spousal loan scenario. Oh, there's a $2 million portfolio. I don't know if I said that. A $2 million taxable portfolio owned by the higher income spouse. So in the scenario where the higher income spouse loans that to the lower income spouse at a 1% prescribed interest rate, the net present value of the benefit of the planning, I was using a 70, 30 portfolio in this example. So this is the net present value discounted at the rate of return of a 70, 30 portfolio. Ends up being $271,000 over 21 years.
Cameron Passmore: And this for a spousal loan?
Ben Felix: For a spousal loan.
Cameron Passmore: Correct.
Ben Felix: Meaningful. And if we expand that to a family trust, including all the costs that we mentioned when there are two child beneficiaries in addition to the no income spouse. And then we can strain the kids' income to $11,000 per year, which is a basic personal exemption. Now, there are two reasons you would do that. One is, they won't pay much or any tax on $11,000 of income.
The other one, and this is one of the other planning implications of the family trust, is that, everything that you allocate to the child in terms of income, you get the benefit of them paying tax and the income with their tax rate. But the cost, I guess, you could call it, is that, that income is now the child's. And when they turn 18, like the in-trust for account that we mentioned, they have claim on that assets.
Cameron Passmore: Exactly. So you have to be covered with them getting those assets at the end of the day, right?
Ben Felix: Which is why you might capital at 11,000. Some people might say, "Well, I want the maximum tax savings and plan on giving my child $100,000 when they turn 18, anyway." Then great, you might up that to 30 or $40,000 per year or more. So anyway, if the was capital 11,000 the net present value of the planning increases to $311,000. So I have $2 million with two children in the picture. The trust, I mean, it's pretty clear it makes sense from a dollars and cents point of view.
Cameron Passmore: And then there's also income splitting that you can do after retirement. Number one is you can split your pension at any age. So the spouse receiving the pension can push up to half of it to the spouse. Potential serious savings there. Once both spouses are over the age of 65, you can split RIFF or RRSP annuity payments between you two. And the other one that's very common as well as it split CPP.
So once you're both receiving your CPP benefit, you can then split it. So higher income, lower income, take the two of them together and split them in half. Again, an easy way to shift income from the higher income spouse to the lower income spouse. Those are pretty basic straightforward things to do. The big thing there is the age 65. A lot of people don't know that you can only split riff with income once you're both over the age of 65. Anything else to add?
Ben Felix: No. That's a good overview of the different ways that you can split income in Canada.
Cameron Passmore: Okay. Let's do the crazy bad advice of the week. This is a quick one. I don't know if you saw this story or not, but man, you really have to shake your head at this one. It's an article that came across in the Toronto Star, June 26th entitled 'Ponzi scheme' created by a cop ensnares dozens of OPP and municipal officers." It's just unbelievable this actually happens. So dozens of officers with the OPP and some municipal forces have been caught up in what considered to be a Bernie Madoff style Ponzi scheme run by a cop.
He promised unbelievable returns of 21 to 26% suggesting in email that, "If your advisor is not providing a minimum 10 to 12% return, you need to fire them." 40 officers and a number of civilians invested between 15 and $20 million. But the whole thing recently collapsed as the article says when the global pandemic stopped new investors from contributing money, which is what is needed to keep the Ponzi scheme running.
There's a quote, "Trust and greed are the two essential elements required of a Ponzi scheme." Said one person with intimate knowledge of the situation. This had both. In addition to the high rate of return police officers were told in emails that if they brought in a new client, they would get a financial bonus worth 5% of the total new investment. So the OPP anti-rackets squads launched an investigation and apparently the OSC is also investigating. The whole thing is just crazy to me, that people could fall for this, just lies like this. 5% bonus and earning 21 to 26%.
Ben Felix: It's crazy to you. People don't know though.
Cameron Passmore: Obviously. And that's what the article was on to say, that these things happen because in you have a combination this one, you have a combination of greed and trust. I mean, he's cop. How would you not trust him? He's a cop, right? But it's so easy. We said this, I'm sure half a dozen times on the podcast. It's so easy to go see if your advisor is registered, if the firm is registered. Who's the custodian? Where are the assets held?
Ben Felix: That's the big one. Yeah. I mean, I was pretty close to one of these happening on BC. Close in the sense that I knew people were involved. That was the Harold Backer store that we talked about a while ago. I don't even know where that's at now. Yeah. Same kind of idea. In that case, I think he was actually registered but the custody of the assets that were being swindled was not being done through the registered firms that he was a part of. [crosstalk 01:08:51] statements and stuff.
Cameron Passmore: Yeah. People aren't trusting and they want to trust, I get that. But what's the old saying, trust but verify?
Ben Felix: The custody piece is huge. Our clients can log into national banks portal, completely separate from PWL and see all of their accounts.
Cameron Passmore: Yeah, and we're not allowed to take checks payable to us or even to our family. We don't take checks. So it seems straightforward to us, but clearly it's not. So there's a real life lesson that it's what to look out for and it's easy to check. Anything else to add today?
Ben Felix: No. I mean, on the Ponzi scheme stuff, if anyone ever proposes 21 to 26% expected returns, I mean, I don't know. You can maybe get that on Venture Capital before fees.
Cameron Passmore: Or Tesla last week.
Ben Felix: I don't know if I'd call that a 26% expected return. That's a 26% ex-post return.
Cameron Passmore: True.
Ben Felix: Those are easy to find.
Cameron Passmore: All right. With that, thanks for listening.
Book From Today’s Episode:
Essentialism: The Disciplined Pursuit of Less — https://amzn.to/3fsJILA
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Benjamin on Twitter — https://twitter.com/benjaminwfelix
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'Robinwho? A Long Term Investor’s Guide to Order-Flow Selling' — https://www.etftrends.com/robinwho-long-term-investors-guide-to-order-flow-selling/
'Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356
'David is Great for Yale. Is He Horrible for Investing?' — https://www.institutionalinvestor.com/article/b1gj523tmfl2tt/David-Swensen-Is-Great-for-Yale-Is-He-Horrible-for-Investing
'Ponzi scheme’ created by cop ensnares dozens of OPP and municipal workers' — https://www.thestar.com/news/canada/2020/06/26/ponzi-scheme-created-by-a-cop-ensnares-dozens-of-opp-and-municipal-officers