Financial advice

The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

Original post at pwlcapital.com

Why a robot will never take my job

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor.  These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost.  Two of the largest providers are Wealthfront and Betterment.  Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k).  Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement.  If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing.  A financial advisor should know your personality, your family situation, your dreams, and your frustrations.  This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields.  When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized.  The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication.  When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that well trained professional financial advisors do for their clients.

Original post at pwlcapital.com

High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

Original post at pwlcapital.com

Does Canada need more investor education, or more advisor education?

At the end of a recent meeting, a client asked me if I ever wonder why everyone in Canada isn’t investing in low cost index based funds.  The conversation usually goes that way when people hear the story of a passive investment philosophy and fee based business model, but it isn’t something that I wonder about.  The vast majority of Canadian investors use a financial advisor to invest, and about 75% of Canadian financial advisors are only licensed to sell mutual funds.  Getting mutual funds licensed is much easier than getting securities licensed, and finding a commission based job selling mutual funds is much easier than finding a job with an independent fee-based brokerage firm.  I started my career in financial services as a commission based mutual fund salesperson.  I will be forever impressed by the quality of sales and financial planning training that was given to newly recruited financial advisors, but there was a massive disconnect when it came time to make an actual investment recommendation. 

Advisors with next to zero knowledge of financial markets are expected to choose from thousands of available funds while under pressure to make commissions.  Making it worse for the client is the fact that only high-fee mutual funds pay the commissions that new advisors need to make a living.  With strong sales skills and a knowledge of financial planning the product becomes less important and being a financial advisor becomes a matter of managing relationships, something that people with little to no knowledge of financial markets can do successfully.  A highly skilled and motivated sales force that does not always fully understand what they are selling, and an investing public with minimal financial education, make it obvious to me why Canadians have been relatively slow to adopt low-cost tools like index mutual funds and ETFs.  I meet plenty of people who are fed up with the fees they have been paying and the service they have been receiving, but the market is still slow to get away from high fee mutual funds sold by commission hungry financial advisors.

Original post at pwlcapital.com

Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

Original post at pwlcapital.com

Searching for yield in all the wrong places

The current low-yield environment has made it very easy for investors to question the value of holding bonds in their portfolios.  With interest rates staying low as long as they have, concerns have surfaced around frustratingly low yields, and the fear of rising interest rates decimating the value of bonds.  If bond yields can be matched by GICs, and GICs won’t lose value if interest rates rise, why would anyone hold bonds at all?  Let’s consider this question while ignoring the interest rate environment altogether. 

Bonds reduce volatility in a portfolio and provide an asset class that does not move in lock step with equities; they are not added to a portfolio to produce higher expected returns, but to allow investors to weather the inevitable swings in the equity markets.  When an investor looks at their fixed income allocation as a source of yield rather than a source of risk reduction, they are looking for yield in the wrong place.

In a strong economy with low yields, some investors begin to feel that they can simply replace their bond allocation with dividend paying stocks.  This strategy eliminates the risk reducing effects of a fixed income allocation and leaves the investor fully exposed to fluctuations in the equity market.  When investors begin searching for yield in their fixed income portfolio, they end up taking on additional risk rather than managing it.  Looking at bonds strictly as a risk management asset class changes the nature of the yield discussion.

Nobody can predict the future.  It is obvious that interest rates are low today, but nobody knows what they will be tomorrow.  When you are building a portfolio, it is important to focus on taking risks that have proven to have higher expected returns on the equity side while keeping a bond allocation in place to manage overall portfolio volatility.  By getting your mindset away from chasing yield in bonds, it becomes possible to construct a bond allocation using investment and higher grade short-term bonds.  These securities will have lower yields than low-grade or long term bonds, but they also carry less volatility.  Implementing this fixed income strategy allows investors to reduce interest rate risk in their bond allocation while also maintaining the liquidity that is necessary to systematically rebalance - something that is lost with GICs.

Every investor should appreciate the effects of exposure to riskier asset classes with higher expected returns, but it is important to understand that regardless of their yield there is no replacement for bonds in a robust portfolio.  So what do you do if interest rates rise and the value of your bond allocation goes down?  Rebalance by buying more high quality short-term bonds at the new, higher rates.

Original post at pwlcapital.com

How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

  1. general information that is widely available to all market participants, and
     

  2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

Original post at pwlcapital.com

Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 


Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

Using Visual Basic for Financial Modelling

I learned a fair amount of programming when I studied mechanical engineering, and it is always fun when I get to apply those skills to problems that I see in finance.

I was recently asked to determine if a particular client would be better suited to deposit money into an RRSP or to leave it in non-registered investments.

The problems I had to solve revolved around the following issues:

  • Minimizing taxes
  • Minimizing OAS clawback
  • Maximizing net income

But which strategy would produce superior cash flows based on these parameters?  I structured my model as I would structure a discounted cash flow analysis for a company, selecting my inputs to match an individual.  Gross income became a proxy for revenue, and then I added minimum RRIF payments after age 71, and CPP and OAS benefits at age 65.  I treated taxes and OAS clawback like cash outflows .  I calculated taxes based on marginal tax rates, and OAS clawback based on 15% of any income over $70,954 in any year OAS is received.

I wrote functions in visual basic to find the appropriate tax bracket for a given income, to find the minimum RRIF payment based on age and RRIF amount, and to find the amount of OAS clawback.  The calculations in the model lead to two numbers: the present value of the free cash flow in each scenario.  I was able to link the difference between these two numbers to a sensitivity analysis; using scenario 1 (no RRSP contribution) minus scenario 2 ($31,000 RRSP contribution) shows that when the result is negative (red) it makes more sense to make an RRSP contribution, and positive means it is better to forego RRSPs.

The value of writing these programs did not come in creating the original spreadsheet; I could have realistically input all of that data by hand.  The value in coding a fully linked model is that it allowed me to perform the sensitivity analysis for varying growth rates, inflation rates, and levels of CPP income.

I had hoped that there would be a conclusive answer to the initial question, but the result shows that it all depends on what the market does.  If market performance is strong, the RRIF becomes so large that taxes and OAS clawback are overpowered, but with lower market returns, the tax savings make avoiding the massive RRIF accumulation a better option.

For some context, the client is 47 today and will live to 100.  They are making a one time $31,000 RRSP contribution.  The RRSPs value today before any new contribution is $100,000.  Earned income is $110,000.

My very boring and simple code is linked here.

The Grossman-Stiglitz Paradox

I have mentioned this paradox before, so I thought it deserved some discussion.  The Grossman-Stiglitz paradox states:

  1. If markets are efficient and securities' prices reflect all available information and,

  2. obtaining information about securities requires resources (time, money)

Then

  1. Why do people commit resources to researching securities at all, and

  2. if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.

I remember a discussion with a Carleton University finance professor where I asked what would happen if everyone started to buy the index and stopped trying to beat the market. Following our discussion, if everyone started to buy the index, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound returns are in building up wealth.

I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have fun spending their clients' money to make bets and predictions, and they keep the markets efficient for the rest of us.  To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.