How the investment industry sees advice

A few weeks ago I had the opportunity to speak with John Wilson, CEO of Sprott asset management. We were both attending an alumni dinner, I was there as an alum and he was there as the headline speaker. We bumped into each other during the pre-dinner mingle and took immediate mutual interest due to each other’s name tags. I would have never guessed who he was, so his title of “CEO Sprott Asset management” piqued my interest; John noticed my title of “Investment Advisor” and enthusiastically asked if my firm uses Sprott funds. I almost felt bad telling him that we would never consider using Sprott funds. I explained the idea of a market based investment philosophy and mentioned Dimensional funds and he proceeded to laugh that I had drank the kool-aid. He asked me why I would would want to buy index funds when there are managers that outperform the market? I rebutted that it is next to impossible to consistently determine which fund manager is going to outperform. The conversation went on and finished with John’s final point that it is the job of the investment advisor to find the fund managers that are going to outperform the market. If a client is with a good investment advisor, they will consistently be in the funds that perform well. If their advisor doesn’t pick winning funds, they are not good advisors.

It is not uncommon for advisors to pitch their value as their ability to pick the winning manager ahead of time. Is that investment advice? As a client, do you want the person that you are paying to manage your money to spend their time picking which mutual fund manager is going to be able to beat the market in the future? In reality, investment advice is not about picking the next hot stock or the winning fund manager. Investment advice is about applying an evidence based approach to markets to help people achieve their financial goals while managing their concerns. An advisor that is focused on researching fund managers or picking stocks is only fuelling the emotions that lead to poor investment decisions.

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.

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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.

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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.

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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.

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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.

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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.

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12 Entertaining Finance Movies that will Teach you Finance

Finance is a broad subject with many facets that make learning it a large undertaking for anyone.  These films, watched in order, will lead to a relatively comprehensive understanding of what finance is, how it works, and how it affects our society.

Foundations of money, finance, and the corporate structure:

  1. The Ascent of Money: A Financial History of the World (2009)
    This is literally a full history of how finance has developed through time.  From the first currencies ever used, to financing wars with bonds.  Watching this film beginning to end really does create a strong foundation for understanding how finance has developed through time.
  2. The Corporation (2003)
    One of the most important concepts that drives modern finance is the corporation.  Understanding how the corporate structure influences business decisions is fundamental to grasping the general ideas of finance.
  3. Capitalism: A Love Story (2009)
    The social effects of the corporate structure on a capitalist society are examined in this film.  Widening income gaps have often been attributed to finance.  This film furthers the ideas introduced by The Corporation and applies them directly to a real financial crisis.

    Failures in the financial system, fraud, greed, and regulatory issues:
  4. Enron: The Smartest Guys in the Room (2005)
    A comprehensive look at how a corporation was able to defraud thousands of people with its accounting practices leading to massive changes in the regulatory systems for financial reporting.
  5. Too Big to Fail (2011)
    Understanding the actual finance behind finance is only half of the battle in truly understanding finance.  This dramatization of the fall of Lehman Brothers, and the beginning of the financial crisis, shows how personalities, government decisions, and personal relationships all play a massive role in driving the financial markets.
  6. Margin Call (2011)
    When the US financial institutions began to crumble, they began to unload their worthless securities to other institutions and clients to avoid their own collapse.  This film gives further insight into the decisions that nearly collapsed the financial markets.
  7. Inside job (2010)
    Further reflection on the 2008 financial crisis with insights from global policy makers and academics.  This film further reinforces the concepts introduced in Too Big to Fail and Margin Call, but it is not a drama.

    How financial markets actually work, the buying and selling of securities, and the retail environment:
  8. Floored (2009)
    This documentary looks at floor traders, the people buying and selling securities on an open outcry trading floor.  Although this film gives plenty of insight into this part of the financial markets, floor traders have been replaced by electronic trading.
  9. Money and Speed: Inside the Black Box (2011)
    The level of influence that automated trading has on the financial markets today is intimidating.  This is an area that is constantly evolving and will continue to evolve.  Eugene Fama argues that the algorithms used in this type of trading make markets more efficient.
  10. Boiler room (2000)
    This movie does not by any means depict every stock broker.  It does, however, give insight into the way that the business works at the retail level, and shows how sales driven the industry can be.
  11. Wolf of Wall Street (2013)
    Similar to Boiler Room, this film shows an extreme case of how sales driven financial markets are.  The film is quite wild, but it does offer another opportunity to see how securities are created, bought, and sold.
  12. The Retirement Gamble (2013)
    From the perspective of an investor, this film is the most important.  It shows how all of the pieces fit together to make the investment climate for retail investors extremely difficult to navigate.

Understanding the Stock Market

Why People Invest

I already explained what a stock is, so I should have the foundation to go ahead and discuss what the stock market is in some detail.

Before I do that, I need to explain why we want to invest in the first place.  In the chart below you can see some different lines.  The ones to focus on for right now are the orange line, which is a representation of a dollar invested in the US stock market, and the light green line, which is a representation of a dollar invested in US treasury bills.  It is obvious that a dollar invested in the stock market will grow more than a dollar invested in a treasury bill, but why is that?  A treasury bill is issued by the US government and is what is referred to as a risk free investment because it is very unlikely that the US government will fail to pay someone holding a treasury bill.  Being invested in the stock market is riskier because you are owning pieces of companies which can go down in price, even go to zero if the company goes bankrupt.  Investors need to be compensated for taking risks when they are investing in companies, otherwise they would only invest in the treasury bills.

The difference in returns between the treasury bills line and the stock market line is called the market premium, or the amount of investment return over and above a risk free investment that can be expected for investing in stocks.  So when you are saving for a long-term goal, it can make sense to invest in stocks because they will give you a higher expected return over time.  The chart below shows the returns of the total US stock market minus the returns of US treasury bills every year from 1927-2012.  On average, the market premium was 8.05%.  This means that on average, being invested in stocks meant that you could expect a return 8.05% higher than the return from being invested in treasury bills.  Notice that the red bars are years where stocks had negative returns; that is the risk of being invested in stocks rather than treasury bills.


The Market

We know stocks are pieces of ownership of companies that allow individuals to partake in the company's growth and losses.  Partaking in the growth and losses of a company by buying an ownership stake is called investing in the company, and investors receive higher expected returns for being invested in companies because of the risk involved.  All of the investors that buy stocks need a place to buy and sell their stocks, and that is where the idea of the stock markets becomes important.  If there was not a stock market, people that wanted to buy and sell stocks would have to find each other manually; it would be like Craigslist for stocks.  Having consolidated public stock exchanges makes it much more certain that a stock will be available to buy when you want to buy, and you will be able to sell when you want to sell.  This makes stocks much more liquid, or much easier to convert back into money.  If stocks became illiquid they would go down in value drastically because people would not be able to convert their ownership in a company into money when they need to.  The integrity of the stock market is a very important part of investing, and there are safeguards built into public exchanges to ensure that the markets remain liquid.  So it's easy enough to understand that the stock market is just a big public marketplace where investors can buy and sell stocks, but what are people talking about when they say the market is up or down?  Or when they talk about beating the market?  There are different stock markets around the world, and within different markets there are different stock exchanges.  So what is the market that people talk about in the media?

To explain this further I need to explain what an index is.

How an Index Works

You might have heard about the S&P 500, or the S&P/TSX Composite.  These are indexes.  An index is a grouping of stocks that has been selected to represent a particular market.  The S&P 500 is one of the best known indexes in the world; it is 500 stocks that have been selected by Standard and Poor's (a financial research company) to represent the US stock market.  When you hear that the S&P 500 is up, it means that the overall value of all of the 500 stocks included in the index is up.  It is important to keep in mind that although the S&P 500 has been selected by the very smart people at Standard and Poor's to represent the US market, it only contains 500 of the largest, most well known companies that are traded on public exchanges in the US; overall, there are about 5000 companies with stock that trades on public exchanges in the US.  One of the major uses of an index like the S&P 500 is benchmarking.  Benchmarking is using the performance of an index as a tool to compare the performance of other groupings of stocks, or individual stocks.  When you invest in a mutual fund, or have a broker tell you that they will build you a portfolio that will beat the market, they are saying that they will pick a stock or a grouping of stocks that is different from their benchmark index that they think will allow your investment to perform better than investing in the companies in the index.  If a fund invests in American companies it will likely use the S&P 500 as a benchmark index, and a fund that invests in Canadian companies will likely use the S&P/TSX Composite as a benchmark index.  The whole idea here is that if someone has the ability to predict which companies within a market will perform well, they can buy those companies instead of buying the companies in the benchmark index so that their fund will perform better than the index.  Now, because there is a lot of research involved in deciding which stocks will do well and which ones will do poorly, there are fees that have to be paid to the investment manager if they are going to try and beat the market for you.

Investing in the Market

You can choose to invest in an index that has been built to represent a given market for a very minimal cost, or you can choose to pay a significant cost to invest in a fund that is going to try and do better than the index.  It is very easy to invest using both of these methods.  You can buy something called an Exchange Traded Fund (ETF) which will track an index, or an index mutual fund which will do the same.  Companies like Vanguard and iShares allow people to invest in an index of their choice for a very low cost; you can choose to invest in the S&P 500 which we know is 500 of the largest companies listed on US exchanges, or the Russell 3000 which is an index that is designed to represent all  of the companies in the US market, or the MSCI EAFE which represents all developed markets outside of the US and Canada, and the possibilities of indexes to invest in go on forever.  Investing in a fund that will try and beat the market is equally easy to do, companies like Fidelity have plenty of different funds with different strategies designed to outperform a given index.  To illustrate the difference in cost of these two strategies, the Vanguard Total Market Index which invests in 3000 American companies designed to represent the total US market costs you .05% of your investment account to hold, and the Fidelity US All Cap fund which is designed to "seek the best in US equity opportunities" costs you 2.4% of your investment account to hold.  Both of these funds allow you to invest in the American market, but one is designed to do whatever the market does, and the other is designed to beat the market.

Remember Efficient Markets?

I write about markets being efficient often.  Remember that if markets are efficient, all available information is included in the price of a stock.  With that in mind, let's look at the idea of trying to pick which stocks will be the best ones to invest in.  The people that are picking the stocks that will be included in a portfolio that is trying to beat the market are using massive amounts of information to make their investment decisions.  These people will know everything that there is to know about a stock before they select a company to invest in.  But think about all information.  That's a lot of information, and there's new information coming out all of the time.  Even if an analyst does know everything about a stock before they buy it, it is impossible to predict all new information, and all new information will be included in the price of the stock as soon as it becomes available to the public.  So, we should try and get information about stocks before the information is public? No.  That is insider trading which is illegal.  Point is, all information is included in the price of a stock, and new information is random, so stock prices are random.  Still want to try and pick the stocks that are going to beat the market?  Good luck.  My opinion is that if you can't beat them, join them.  Indexes are beautiful tools that should be taken advantage of when constructing a portfolio.  Which indexes?  That will have to be another day's post.

Explaining Stocks

I write because it helps me to understand concepts.  I do think it's neat to have a blog so that I have a medium to share my thoughts, but the main purpose is to give myself a reason to write stuff.  I didn't think anyone really read the things I post.

I have now had multiple people tell me that they read my blog posts, and that they actually enjoy reading them.  Too many of the people that told me this said that they enjoyed reading my writing despite not knowing what I'm talking about.  After hearing that feedback, I took it as a challenge to explain the things that I write about in terms that people can comprehend.

I won't stop writing about heavy finance things, but I want to try to bit by bit explain the fundamental concepts of finance to the non-finance people that grace my website with their presence.

Where to start?  I will first give my rendition of what a stock is.  Establishing what a stock is will give me the foundation to go into detail about lots of other things.

What is a Stock?

A stock is a piece of ownership of a company.  When we say that a stock is publicly traded, it means that the pieces (shares) of that company are able to be bought and sold by anyone in the public marketplace, something that we refer to simply as the market.

Understanding that a stock is a piece of a company should be easy enough, but how and why a stock comes into existence is a little bit more complicated.  It all comes back to money (capital).  Companies need capital to do business.  If a company sells coffee they need money to buy coffee beans, cups, machines, and pay employees and rent space.  That capital can come from lots of different places (which I will have to discuss in another post), but once things are going the company should eventually be able to make enough money selling coffee to pay its expenses and buy more supplies to sell more coffee.  If this business decides that it wants to open another location, the capital that the first location is producing by selling coffee might not be enough to open a second location; they need more capital.  To get this capital, they can choose to sell part of their company on a stock exchange.  When a company chooses to do this, they are going public.  A company consisting of two coffee shops would not likely go public, but for the sake of the example they do decide to go public.  When a company decides to go public they have to be underwritten to determine the price that the public might pay for their shares.  This is where an investment bank comes in; so our coffee company would approach Goldman Sachs and tell them that they want to issue shares to the public in an initial public offering (IPO).  Goldman Sachs will examine the company very closely to try and determine how much the public will pay for shares of this company, and then they will either buy all of the share themselves with the intention to resell them to the public (a bought deal), or they will do their best to sell as many of the shares as they can to the public without giving our coffee company any guarantee that all of their shares will be sold.  This initial sale into the market is referred to as the primary market.  Once these shares have been sold into the market for the first time, they can be bought and sold by anyone in the market.  The market after the first sale is called the secondary market, and that is where most people buy and sell stocks.

So now we have these shares, these pieces of a company, that can be bought and sold by people very easily.  As they are bought and sold by people, the price of these shares will move based on a bunch of factors.  It's like  anything else that can be bought and sold, the more people want to buy it, the more the price will go up.  There is an infinite amount of information that can affect the price of a stock, and there are people researching as much of the information as they can all the time to try and predict where the price of a stock is going to go so that they can make money by buying it at one price and selling it at another.  It is also possible to make money by betting that a stock will go down in price, but that is another story.  I often write about efficient markets, and when you understand how stocks get their prices the idea that markets are efficient makes a lot of sense.  If markets are efficient it just means that all available information has been taken into account in the price of any stock at any given time.  This happens because of all of those people that are out there researching stocks to try and make money; they collectively influence the price of a stock until it ends up at a value that reflects how much all of the people in the market will pay for it based on all of the information that is available.

I feel like that was harder to explain than I wanted it to be.  If you read this explanation and have questions, please ask me,  I love answering questions about this stuff.