The hunt for returns

Buy low, sell high; it would be an easy path to investing success if people knew how to control their own behaviour. Investors may know that they want to buy low, but there is no way to determine when low has happened. “I’ll get back in as soon as things start to turn around,” they might tell themselves. People will read this and think, “I don’t do that,” but this data from the Investment Company Fact Book, published by the Investment Company Institute shows that most people do. The green bars show the net cash flows to US domiciled equity mutual funds, and the brown line shows the total return of global equity markets.

Source: Data from the 2014 Investment Company Fact Book (www.icifactbook.org). For the most up-to-date figures about the fund industry, please visit www.icifactbook.org or www.ici.org/research/stats.

When equity markets perform well, people are investing in equities. When equity markets perform poorly, people are pulling out. This is real data demonstrating real behaviour, and it shows that investors tend to buy high and sell low. If they know that what they are doing is wrong, why are they doing it? Equity mutual funds offer investors the opportunity to invest in countless different strategies implemented by just as many managers. Implementing a handful of different strategies in an attempt to beat the market plays directly into bad investor behaviour. Based on the data, when a strategy doesn’t work, investors think it’s time to sell (selling low), and when something does work, investors think it’s time to buy more (buying high).

These poor decisions can be attributed to the lack of a sound investment philosophy. When a sound philosophy is guiding the construction of a portfolio, investment decisions are based on goals, risk tolerance, and time horizon rather than performance. A guiding philosophy instills confidence in the strategies being implemented, and down markets become opportunities to rebalance instead of reasons to jump ship.

With a sound philosophy guiding portfolio structure, the investor’s focus is shifted from chasing unpredictable short term returns to staying disciplined and following a long-term plan.

original post at pwlcapital.com

Benchmarking: Avoiding the blinders of positive accounting profits

To understand the importance of benchmarking, it is necessary to understand the concept of economic profit. Economic profit is found by subtracting opportunity costs from accounting profit. Imagine quitting your job and investing $200,000 to start a business. At the end of the first year your net business income is $250,000; you have earned $50,000 in accounting profit. If the job that you quit to start your business would have paid you $70,000 in that same year, you have incurred an economic loss of $20,000.

This same concept can be applied to evaluating the performance of an investment portfolio. In the context of financial markets, opportunity cost is the performance of a relevant benchmark. If your portfolio returned 18% net of fees last year, you achieved a seemingly attractive accounting profit of 18%. If the benchmark that your portfolio is evaluated against returned 38% in the same year, you have experienced a significant economic loss of 20%. Very simply, a positive economic profit occurs when a portfolio beats the benchmark index, and an economic loss occurs when the benchmark index beats the portfolio.

It is very easy for an investor to be blinded by positive accounting profits while enduring economic losses. This is particularly salient after a year like 2013 when many investors received positive returns reflective of the positive performance of markets. While an investor may be pleased with a 7% return on their Canadian equity portfolio, the S&P/TSX 60 was up over 13%. Assuming that the S&P/TSX 60 can be bought through an ETF for around .18%, there has been somewhere around 6% of return left on the table – a 6% economic loss.

This situation arises when a portfolio aims to beat its benchmark index. A portfolio that is trying to beat its benchmark index will hold a subset of the securities within the index that are predicted to perform better than the index itself. In a year like 2013 when the whole index is up, there is a good chance that the subset of the index held within the portfolio is also up. It is very important for investors to understand that even if their portfolio has been producing positive returns, if the benchmark is doing better than their portfolio, there is opportunity being lost.

Original post at pwlcapital.com

SPIVA® Canada Scorecard 2013 (Infographic)

"Investing success isn't about beating the benchmark, it's about not losing money"

A couple of months ago I saw John Wilson, CEO of Sprott Asset Management, speak at an alumni dinner; we both graduated from the Sprott School of Business at Carleton University. Despite our common education, we come from different schools of thought on investing. When John was speaking, I tweeted some of the things that he said. Looking back, one quote that I find particularly interesting is, “Investing success isn’t about beating the benchmark, it’s about not losing money.”

I understand John’s sentiment from a behavioural point of view, people don’t like to see the value of their account decrease. It is, however, imperative for investors to have an understanding of the difference between volatility and risk in order to have a successful investment experience. Although a riskier investment will tend to display higher volatility, there is an important distinction to be made between the two terms.

Volatility relates to the dispersion of market returns over time, or the tendency of the value of securities to move up and down as new information develops. Over long periods of time, the indexes that represent the market have tended to increase in value despite periods of volatility. Investors expect higher returns for holding more volatile investments.

Risk is the risk of losing money, which ultimately means either selling out of the market when an investment’s value is below its original purchase price, or having an investment’s value go to zero. The first risk is behavioural and the second is the specific risk attributed to a particular investment, called non-systematic risk. An example of non-systematic risk is the risk of a company going bankrupt.

The non-systematic risk of any individual investment can be almost completely eliminated from a portfolio through proper diversification. The biggest risk that investors face is themselves, their own behaviour. John Wilson’s idea of ignoring benchmarks in favour of not losing money is feeding directly into the psychology that causes investors to make bad decisions based on their emotions. Buying into this mindset causes investors to accept returns below the benchmark because they do not understand the distinction between volatility and risk.

It is the job of a professional money manager to construct a portfolio with a tolerable amount of volatility over an appropriate period of time for a client’s particular situation and preferences. When this is done properly, the investor will be positioned to capture the returns of the market without the risk of their own behaviour getting in the way.

Original post at pwlcapital.com

How efficient do markets have to be to make picking stocks a waste of time?

Capital markets are a highly competitive platform where millions of buyers and sellers are able to weigh new information and voluntarily enter into transactions. In any transaction, there has to be a buyer and a seller; if there are no more buyers at a given price, the price will go down until more buyers emerge. The same thing happens in the other direction, and that is what makes prices go up and down. Market participants enter into transactions based on some piece of information that is influencing the buyer to think a security is worth more than its current price, and a seller to think a security is worth less than its current price. By entering into transactions, participants are contributing their best guess to the actual fair value of a given security. Neither party may have the exact right price, but the combined guesses of all participants becomes the best estimate of the fair value. In a perfectly informationally efficient market, all available information will be included in the prices of securities, but markets don't have to be perfectly efficient to make picking stocks a loser's game.

The idea of picking stocks revolves around someone's ability to determine that the current price of a security does not reflect its fair value. A person may decide that the current price of a stock is too low in which case it is a buy, or that it is too high in which case it is a sell. When the market corrects itself to reflect the fair value, the investor will profit. The problem with this, though, is that even if it is possible to accurately determine at a given point in time that a security is mispriced, the new information that is constantly being acted on by other market participants will render any prediction at some point in time useless. The ability of anyone to outperform the market will only be realized as randomly as the development of new information which, by definition, is random; we can't predict the future. Even if markets are not perfectly efficient, intense competition gives them the ability to incorporate new information into prices. Under these conditions, picking stocks is foolish at best.

Original post at pwlcapital.com

Google Chromecast and a momentary lapse of reason

My Chromecast came in the mail on Saturday, it really is an amazing device. If you don't have one or haven't heard of it, it's worth a look. I didn't even know that the product existed until last week when a student in a Junior Achievement class that I was teaching made reference to it; not wanting to fall behind the times, I ordered one right away. When I finished setting it up on my TV I was very impressed. The first thought I had was that with this technology cable companies are doomed and I need to go buy Google stock and short sell Time Warner.

When it comes to investing I should be a little bit smarter than that, all things considered. I communicate the concept of market efficiency and the randomness of returns to people on a daily basis, but even with that mindset it is human nature to imagine opportunities to make money in the stock market. Of course, as soon as I had that thought I gave my head a shake and reminded myself that if a 12 year old boy had told me about the Chromecast I didn't have an information edge. Anything that I hear about a stock is already included in the price by the time I hear it, and even if it isn't there are an infinite number of other factors that are moving the price around at random as new information develops.

My own momentary lapse in reason served as a reminder that it is exceedingly difficult to ignore the constant barrage of stock tips and success stories that the media, and people in general, expose us to on a daily basis. People like to brag about their winning stock pick and the media likes to sell their content. Success in investing is much more about ignoring the noise than paying close attention to it.

My prediction on AAPL stock

Almost exactly one year ago I pitched a strong buy recommendation for Apple stock to the Sprott student investment fund. Since I made that buy recommendation, the price has gone from $449 to $633.

Investing in Apple at the time of my recommendation would have resulted in a to-date holding period return of over 40%. My target price at the time had been $550, based on the combination of a discounted cash flow analysis and a relative valuation. Am I a stock picking genius? Should you await my next buy recommendation so that you can partake in the 40% gains that I yield? Absolutely not. I won't be making any more buy recommendations on any individual securities. This report on Apple was the report that made me realize that no matter how much research and information goes into the analysis of a security, the conclusion and recommendation weigh on a mass of assumptions that will differ based on the opinions and style of each analyst. I put weeks of work into this report and I had help from other MBA students and real analysts, but by the time I was ready to present I had come to understand that all I was doing was trying to convince all of the other analysts that my opinion was the right one. Picking stocks is not about scientific objective data analysis, picking stocks is about taking data and subjecting it to opinions and feelings.

It's very easy as an investor to get sucked into the psychology behind seeing a prediction like this, and the media pumps them out constantly. I live in the world of market based investing and efficient markets, but even I have a part of me kicking myself for not buying Apple when I wrote this report. That same part of me wants to buy in now so I don't miss any more gains, but I know better. These emotions are normal for investors; overcoming them is one of the greatest challenges to having success in financial markets.

Pension investing for young professionals

Pensions are a thing of the past.  The young professionals of today are truly responsible for establishing their own long-term savings plans.  When pension plans were commonplace, the money you put away was managed for you. The reality of today is that not only are we in charge of being disciplined savers, we are also responsible for making our own investment decisions. As a young investor entering the market for the first time, what should you do?

Don’t try to beat the market

An index is a grouping of stocks that has been designed to represent a market. The S&P/TSX Composite is the major index used to represent the Canadian market. Beating the market is the action of selecting a grouping of stocks that is different from the index with the intention of having better returns than the index. One of the biggest mistakes that young investors make is using intuition, tips from the media, and other predictive methods to try and beat the market. Very few people (professionals included) have been able to consistently beat the market throughout history, and trying to do so tends to lead to poor performance. Instead of trying to beat the market, you can buy the market using inexpensive tools like Exchange Traded Funds and index funds.

Watch your fees

A large portion of Canadian investment vehicles are actively managed mutual funds. These are mutual funds with a professional money manager and team of analysts deciding how to invest your money in an effort to beat the market. In Canada, these types of funds charge an average fee of 2.5%. That fee comes right out of your investment no matter how the fund performs. It would make sense if this fee could be justified by superior performance, but actively managed funds tend to underperform the index over the long term. Exchange Traded Funds that hold the market index can be bought for as little as .05%. You can pay 2.5% for something that hopes to beat the market, or buy the market for .05%.

Diversify

It’s easy to be attracted to investing in companies that you know in the country that you live in, but there is a world of opportunity out there. We can’t predict the future to determine which types of stocks in a given country will be strong performers, but holding a diverse basket of different types of stocks in multiple countries allows you to capture the performance of markets around the world while reducing the potential impact of any single market performing poorly.

Understand risk and return

Portfolios usually contain both stocks and bonds. A stock is a piece of ownership of a company, and a bond is a piece of debt that a company owes you and pays you interest on. Stocks are riskier than bonds, but they also produce greater long term returns – more risk means more return in the long run. Not everyone can stomach a large drop in their investments, so managing your own behaviour starts with allocating the appropriate amounts to stocks and bonds.

Set allocations and rebalance

When a diversified portfolio is initially constructed there is a decision around how the portfolio will be split between stocks and bonds, and between domestic and foreign content. Once these allocations are set, it is important to rebalance the portfolio. If US stocks perform better than Canadian stocks the US allocation will grow; rebalancing is selling some of the US portion and buying more Canadian to get the allocations back to their original state. Rebalancing is done between the different types of stocks, but also between stocks and bonds, and it serves to decrease the overall volatility in the portfolio while removing emotions from the decision to buy or sell.

Don’t pay for advice unless you need it

Whether the costs are obvious or not, you are paying for financial advice when you meet with an advisor. Unless you have a large amount to invest or have an otherwise complex situation, you can save on the cost of advice until your assets have grown and your situation has become more complicated.

A simple way of implementing these steps can be elusive in Canada because neither financial advisors nor financial institutions stand to make the juicy profits that they are accustomed to when you invest this way. Currently, the two simplest ways to implement this in Canada are Tangerine Investment Funds and TD e-series funds. TD e-series are less expensive at about .45% for an equal mix of US, Canada, and International funds, but rebalancing and diversifying is left up to you. Tangerine will cost you 1.07%, but they take care of the rebalancing and diversification. Both of these options are index based, low fee, don’t have the cost of advice built in.

Full disclosure: I am in no way compensated by TD or Tangerine

Original post at theyoungprofessionaltimes.com

Nest Wealth, the start of a Canadian robo revolution?

Canada's investment industry is trailing the rest of the world. Not only do we have some of the highest mutual fund fees, we are also stuck in the age of embedded commissions. These industry issues have fallen under scrutiny from the media and the public causing many investors to seek fee based advice, or avoid working with an advisor altogether. In either case, people want low cost, globally diversified, and rebalanced portfolios. Not everyone needs a professional advisor in their corner, but not everyone is equipped to properly manage their own portfolio, either. The US had similar problems once, but in true capitalist fashion they have seen a wave of start ups appear to fill the gap. Online services like Wealthfront and Betterment offer portfolio construction, rebalancing, and tax-loss harvesting for a fraction of the cost of working with an advisor, but what about us Canadians? We don't currently have an option that fills the gap between paying for advice and managing a portfolio solo, and it really is a problem for small investors. I have seen plenty of people attempt to go the DIY route only to see managing their ETF portfolio become akin to cleaning the garage or doing the taxes.

Enter Nest Wealth. Nest Wealth is an online portfolio manager that should be available to investors later this year, according to moneysense.ca. Nest Wealth is subscription based, so if your account grows your fee doesn't increase. The cost has been set at $40 per month for investors under 40, and $80 per month for investors over 40 with an additional $20 per month for extra accounts like TFSAs and RRSPs. Just like a professional advisor's fee, Nest Wealth's fee is on top of the fees of the ETFs that they use in building their portfolios. For investors, a service like Nest Wealth is an excellent option for professional portfolio management without the cost of high level advice. Nest Wealth is currently only registered in Ontario.

So how does their fee compare with a professional advisor? If we look at a 30 year old investor with $100,000 in savings split between a TFSA, RRSP, and non-registered account, they would be paying .96% per month in fees to Nest Wealth as opposed to 1% per month to work with a professional advisor. The beauty of Nest Wealth, though, is that as the account increases the fee as a percent of assets effectively decreases. At $500,000 the fee has dropped to .19%. As long as investors understand that they are only getting portfolio management and not the thoughtful advice of a professional, this is a great deal. I envision a situation where online portfolio management becomes a pathway for people to build assets to the level where professional advice is warranted.

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.

How do you invest?

What’s the first thing that comes to mind when you think about an investment professional? They must be able to pick the best stocks, the best industries, and the best geographies to invest in over a given time period. “Apple is hot right now”, and “China is going to be huge this year!” might be things that you expect me to be able to tell you. I don’t think that anyone can do that, especially consistently, and the data agrees with me. Only a small percentage of people that try to pick stocks and time the market end up having performance that is better than the market itself, especially after the costs of trading and research associated with this style of investing. Finding the small percentage of people that will outperform the market before they actually do it is equally challenging. So if the traditional method of trying to beat the market doesn’t work, it makes sense to accept the returns of the market at a low cost using inexpensive tools that hold the whole market, like ETFs. That makes sense, and it’s easy to do, but the question of which market we are going to buy comes next. Just like we don’t want to bet on any one stock, we don’t want to bet on any one market. The solution is to build a portfolio that is globally diversified; by not betting on any single market we are reducing the overall volatility of the portfolio while positioning ourselves to avoid missing unexpected growth. Not many people expected US markets to perform so well in 2013, potential for a large missed opportunity. To further eliminate placing emphasis on any single market, we build globally diversified portfolios with equal equity allocations split between US, International, and Canadian markets. Coming back to the US market in 2013, it would have been very easy to become emotionally attached to the strong performance. Buying more US stocks seemed like the smart thing to do. We eliminate emotional investment decisions like that by rebalancing the portfolios back to their target allocations. Rebalancing is a systematic process of selling off asset classes that are performing well and buying asset classes that are performing poorly; it is a rules based system of selling high and buying low, and it decreases portfolio volatility while increasing expected returns.

The last piece of this story comes from robust academic research performed on all of the available data from markets around the world. It has been found that certain types of stocks exhibit stronger performance than others. Research has shown that throughout history, small stocks and value stocks have outperformed the market. When we invest in a market, we add a tilt toward these types of stocks. A tilt is best described as an increased amount of these types of stocks relative to the market. If the US market has 4% small value stocks, our portfolio might have 11%. In the same way, research has shown that large growth stocks have lower expected returns than the market, so we tilt the portfolio away from these types of stocks. If the US market has 17% large growth stocks, the portfolio might contain 5%. Our style of investing is market based, globally diversified and rebalanced, with tilts toward small cap and value.

The 2014 CFA Society Ottawa Forecast Dinner was terrifying

Last night I attended the 2014 CFA Society Ottawa Annual Forecast Dinner. I have a tremendous amount of respect for CFA charterholders and the work that the CFA Institute does to further the integrity of capital markets, and I am a CFA candidate. Much of the material in the CFA program is focused on prediction, yet I believe that predicting the future consistently is impossible. Entering the Forecast Dinner with skepticism gave me an opportunity to have a few quiet laughs, but it also allowed me to observe the extent to which people want to invest with their emotions over logic.

The main event of the evening was a panel of three economists; Patricia M. Mohr from Scotiabank, Derek Burleton from TD, and Pierre Cleroux from BDC were each asked a series of questions and given the opportunity to share their insights. Each of these economists play a major role in creating the recommendations that are used throughout their organizations. The thing that blew my mind was that each of these economists had completely different outlooks on some of the issues that were discussed. They had different opinions because they interpret data differently due to differences in their training and intuition. If any single person’s way of thinking is so great that their forecast will surely be correct, why isn’t everyone already following their advice? People are constantly hopeful that they have found the next oracle that will make them rich. The one person that does seem to have the intuition necessary to consistently beat the market is Warren Buffet, but his intuition also tells him that investors should just buy index funds. The more I thought about the way that these economists’ outlooks differed, the more disturbed I became. The emotional attraction to a super star economist or portfolio manager is so strong that people will push their logic aside for a great story. They want someone that will turn their humble investment into a vast fortune. If a person can speak well and has knowledge of economies and markets, they will be able to convince some people that they can predict the future. In the years that their predictions are wrong they will have great explanations for what threw off their forecast. In years they are right they will be heroes.

As an investor I’m sitting there listening to these three intelligent people debate about where different sectors are going, and I’m wondering how I would pick which one I should listen to. How does a portfolio manager decide which one they will listen to? How does an analyst decide whether or not they agree with their lead economist’s outlook on China’s economy? It’s all a big guessing game and even the smartest people with the greatest amount of resources are playing it. The terrifying part is that investors are so easily sucked into the stories that economists and fund managers tell them about what they should be investing in that they continue to follow their advice. It’s comparable to a big group of people throwing darts at a dart board and assuming that the person that hits the bullseye four times in a row will be able to hit it a fifth time. I would be furious knowing that I am relying on this type of prediction when there exists a scientific approach to investing that eliminates the need for this artistry.

In the scientific approach to investing there is a data backed consensus on the single most effective way to invest, while the art of investing contains thousands of different and conflicting opinions. Maybe I'm biased due to my background in engineering, but when it comes to investing I want science, not art.

Original post at pwlcapital.com

Beating the spread

If a bookie presented you with the opportunity to bet on a basketball game between the Raptors with a 5-0 record and the Bobcats with a 0-5 record, which team would you bet on? The obvious answer is that the Raptors with their undefeated record will trump the Bobcats who have not won a game; this outcome is very easy to predict. If bookies allowed people to bet like this they would not make any money, so they use something called the spread. It’s not nearly as easy to predict the outcome If I present you with the same betting opportunity but the Raptors don’t just have to win, they have to win by 30 points. That 30 point differential, or the spread, is what allows bookies to make money. The bookie will go to great lengths to create a spread that has about a 50% chance of being beaten. If this is done properly, the bets on each side of the spread will cancel each other out and the bookie will profit from the premiums people paid to place their bets. When they create the spread, bookies will know everything about the teams in a match; they will know what the star player had for dinner, whose girlfriend is in town, the weather forecast, everything. Once the spread has been set, it will be the new information that develops throughout the course of a game that determines if the spread will be beaten; an injury, a lucky shot, or a bad call could all be the difference makers. In investing, the collective knowledge of the markets is the bookie, and the price of a security is the spread. Every day highly motivated market participants act on massive amounts of information and in doing so they inject the information they have into market prices, effectively setting the spread. It’s easy to look at a company and see that it is well managed, pays a strong dividend, and is positioned to dominate a growing market, but all of this is included in the market price.  Whether the price goes up (beats the spread) or goes down will depend on the development of unpredictable new information. Investing isn’t about picking the winning company, investing is about beating the spread.

Original post at pwlcapital.com

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