What if investing right before a market crash isn’t that bad?

Imagine having $1,500,000 of cash. With a long time horizon, and no immediate needs, you decide to invest $500,000 in a globally diversified portfolio* consisting of 80% stocks, and 20% bonds. It is March 1, 2000. Within days, the dot com bubble bursts, followed by the terror attacks of September 11, 2001. By the end of September, 2002, your invested portfolio has dropped from $500,000 to $480,724.

By May of 2007, the $500,000 that you have invested is worth $992,714. You make the decision to invest another $500,000 on June 1st, 2007, increasing your market portfolio to $1,492,714 on that date. The global financial crisis swiftly ensues, seemingly vaporizing your additional $500,000 investment, and dropping your portfolio’s value down to a low of $891,013 in February of 2009 – a drop of 40.3% from the 2007 high.

At the end of July, 2011, your portfolio is worth $1,448,537, and you decide to deploy your remaining $500,000 on August 1st, 2011, resulting in a total portfolio value of $2,006,521 on that date. The market declines sharply for several months. At the end of September, 2011 your investments are worth $1,754,722.

On November 30th, 2015, your portfolio has increased in value to $2,670,809. In hindsight, you have invested immediately before each market crash in recent history. Despite your poor timing, you have earned an average money-weighted rate of return of 5.82% per year, compared to the S&P 500’s 4.16%, and the Canadian Consumer Price Index’s 1.94% over the same time period.  A luckier person may have outperformed you by not investing at the worst possible times, but you undoubtedly outperformed the person sitting in cash on the sidelines.

Without the ability to predict the future, long-term investment assets are better off in the market, even if the market is about to crash.

*The portfolio returns come from the Dimensional Global 80EQ-20FI Portfolio (F). Where fund data is not available, Dimensional index returns net of current fund MERs are used.

Original post at pwlcapital.com

Forget about fees: new research highlights a compelling reason for active manager underperformance

In a recent paper, Heaton, Polson, and Witte set out to explain why active equity managers tend to underperform a benchmark index. It is commonly accepted that the driving force behind active manager underperformance is high fees, however new research suggests that there may be another culprit. The research concludes that “the much higher cost of active management may be the inherently high chance of underperformance that comes with attempts to select stocks, since stock selection disproportionately increases the chance of underperformance relative to the chance of overperformance.”

This conclusion is based on the empirical observation that the best performing stocks in an index perform much better than the remaining stocks in that index. Worded mathematically, the median return for all possible actively managed portfolios will tend to be lower than the mean return. In plain English, the average performance of an index tends to be attributable to a small number of stocks. While choosing a subset of the total available stocks in an index (as an active fund manager does) leads to the possibility of outperforming the index, it also leads to the possibility of underperforming the index, where the chance of underperforming is greater than the chance of outperforming.

This can be (and is in the paper) explained with a simple mathematical example:

If we have an index consisting of five securities, four of which will return 10% and one of which will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of one or two securities, there will be a set of fifteen possible actively managed portfolios. Ten of the fifteen portfolios will earn a 10% return due to omitting the 50% stock, and five of the fifteen portfolios will earn either a 30% return or a 50% return due to holding the 50% stock, depending on whether it is a one or two security portfolio. In this example, the mean average return of the stocks in the index, and all active fund managers, will be 18% (before fees), while the median will be 10%; two-thirds of the actively managed portfolios will underperform the index due to their omitting the 50% returning security, which is always included in the index.

We have been aware that higher explicit fees are a major factor in active manager underperformance, but the risk of missing top performing stocks due to holding only a subset of the total market may be an even bigger hurdle for active managers to overcome.

Original post at pwlcapital.com

If interest rates have nowhere to go but up, do bonds still have a positive expected return?

In answering this question, the first thing to note is that interest rates could remain where they are currently, or go lower. There are already instances of negative bond yields across the globe. However, for discussion, we will assume that interest rates have nowhere to go but up.

The factors that matter most are the magnitude and time span of the interest rate increase, and the average duration of the bond portfolio. If interest rates were to increase by 0.5%, the effect on bond prices would be minimal. If interest rates increased by 10%, bond prices would be impacted significantly. If interest rates climb to a peak over the course of one month, the impact on bond prices will be more pronounced than if it occurs over a number of years. Large, short term increases in interest rates will likely result in negative performance for fixed income holdings. These negative effects become more pronounced as the duration of the bond portfolio increases.

Price risk is top of mind in a low interest rate environment. If interest rates can only go up, it seems like fixed income returns have nowhere to go but down. However, as interest rates go up, new bonds are issued at the new higher rates. As a bond portfolio receives coupon payments from the bonds that it owns, these coupon payments are reinvested in new bonds, at higher rates. Bond prices may decline with rising interest rates, but over time it is expected that purchasing new bonds with higher coupons will result in positive performance. Expected returns are independent of future interest rate scenarios, but realizing an expected return may come with periods of bond price volatility. As interest rates rise, a bond portfolio may exhibit negative performance over the short term, however, as coupon payments and principal repayments are reinvested at the new higher rates, the bond portfolio will be positioned for recovery.

If an investor is concerned about large negative returns in their fixed income portfolio, it is advisable to tend toward shorter-maturity bonds. Diversification can also help, reducing the bond portfolio’s dependence on any single country’s interest rate environment. In a rising rate environment, a globally diversified short-maturity bond portfolio is positioned to benefit.

If they’re so great, why doesn’t everyone invest in passive/index funds?

First off, in the U.S., everyone is investing in passive funds. Massive inflows into passive funds and outflows from active funds have continued in 2015. The story is not the same in Canada.

It is easy to talk about the merits of a passive, evidenced based investment philosophy, and, when presented with the evidence, people tend to agree that a passive investment philosophy is the only responsible approach to financial markets. However, in Canada, the vast majority of retail money is not invested this way. Despite the clear evidence that it is a losing game, investors tend to direct their money into actively managed strategies that claim to outperform the indexes, and provide downside protection in turbulent markets. Canadians tend to be intelligent people, but we face some road blocks in embracing evidence-based investing.

Good advice is hard to find. The financial services industry is wrought with conflicts of interest, and Canadian financial advisors are not immune. In many cases, the people holding themselves out as financial advisors are in fact salespeople pushing financial products to earn a commission. What does this have to do with index funds? Index funds and similar low-cost products do not pay the big upfront commissions that traditional financial products do. Most financial advisors are not even taught to recommend passive investment products because they are not profitable for the firms that they work for.

We rely on our Big Banks. Our banks are trusted and expected to be fiduciaries. But the banks suffer from the same conflicts of interest that the rest of the financial services industry suffers from; the financial products that are profitable for them are detrimental to their clients. However, to remain profitable, they need to sell these products. People tend to assume that when they walk into the bank they are getting advice that is in their best interest, but that is not the case. Bank employees are trained to sell profitable products, extol the skill of their fund managers, and entice clients away from those boring index funds.

It looks like someone is always making money. Traditional high-fee investment products still attract assets because they can leverage performance outliers. In any given year, some investors and mutual funds will significantly outperform the average. For example, so far this year the AGF U.S. Small-Mid Cap Series Q has returned 42.40%, compared to 1.25% for the Russell 2000 U.S small cap index. Why bother with index funds when active fund managers can produce such stellar returns?

This is where the evidence is important; the vast majority of active money managers consistently underperform their benchmark index over the long-term, predicting which active managers are going to outperform in a future year cannot be done consistently, and strong past performance is in no way an indication of future performance. Embracing a passive investment philosophy is obvious when the data is considered, but the data is often hidden behind sales pitches. As a result, passive investing has not yet gone mainstream in Canada.

Original post at pwlcapital.com

Expected Returns vs. Hoped for Returns

Expected returns stem from the idea that investors need to be paid a return for taking on the risk of owning securities. No investor would own securities without having the expectation of returns, and as the securities being owned get riskier, the investor will expect increasingly higher returns. If there were no reason to expect higher returns for holding riskier investments, investors would only hold less risky investments. Stocks are risky investments, and investors have been compensated well for owning them. Bonds are less risky investments, and investors have not been compensated as well for owning bonds as they have been for owning stocks. Expected returns are based on the risk of the overall market (systematic risk), assuming that the risk associated with any individual security (non-systematic risk) has been eliminated through diversification. This is an important distinction; the securities of any individual company are exposed to random error (CEO gets sick, hurricane knocks out the manufacturing plant, etc.) and do not have an expected return. The stock can either go up, or it can go down, and the average of its expected outcomes is zero.

Investors who minimize their costs and capture the returns of the global markets with a well diversified low-cost portfolio are able to expect returns. Capital markets research has even shown that specific parts of the market have higher expected returns than others. This is discussed in detail in Larry Swedroe’s new book, The Incredible Shrinking Alpha, (request a copy here) but a simple example is: stocks have higher expected returns than bonds, value stocks have higher expected returns than growth stocks, and small stocks have higher expected returns than large stocks. Based on this, a properly diversified investor can structure a low-cost portfolio in such a way that they can expect to earn higher returns than a market index, like the S&P 500. Interestingly, most people don’t invest like this, but they do try to beat the S&P 500.

The majority of mutual fund assets invested in Canada are invested in actively managed mutual funds. An actively managed mutual fund is led by a fund manager who is responsible for predicting which stocks and bonds are going to perform well, with the goal of beating their relevant benchmark index (S&P 500 for a US equity fund, S&P/TSX Composite for a Canadian equity fund etc.). Unlike the well-diversified investor holding a market portfolio, who can expect to earn a long-term return for taking on the risk of the market, investors in actively managed mutual funds can only hope that their fund manager will pick the right securities to give them a return. Even if a fund has performed well in the past, there is no expectation that it will continue to perform well in the future, and most actively managed mutual funds in Canada underperform their benchmark over the long term. Many investors are realizing that it is better to expect returns than to hope for them, but a staggering 98.5% of mutual fund assets in Canada are still invested in actively managed mutual funds*.

*Investor Economics data as of June 19, 2015.

Original post at pwlcapital.com

The Cost of “Tax-Free” Corporate Class Fund Switches

A mutual fund can be structured as a trust or as a corporation. While most mutual funds in Canada are structured as trusts, it is common for financial advisors to pitch their clients on the merits of corporate class funds. When mutual funds are structured as trusts, each fund is its own separate entity. When mutual fund families are structured as corporations, each fund in the family is a class of shares within a single corporation. The pitch for corporate class funds is that within a fund family the investor is free to move their capital across the various mutual funds without triggering a taxable disposition. The disposition will only occur when the investor eventually sells shares of the corporation, leaving the fund family altogether. Although the idea of tax-deferred switching between funds is a good sales pitch, the wise investor will look deeper.

Mutual fund investors realize capital gains in two ways:

When the fund manager sells a security held by the fund at a gain, it is distributed to unit holders as a capital gains distribution at the end of the year (type 1 gains);

When a mutual fund investor sells units in a mutual fund for more than they originally bought them for, they realize a capital gain (type 2 gain).

Mutual funds use something called the capital gain refund mechanism to reduce the potential for double taxation of unit holders. It has the intention of reducing capital gains distributions (type 1 gains) by the amount of gains realized by the investors who sold their holdings of the fund (type 2 gains). Under the trust structure, any time a unit holder moves out of a fund, their realized gains (type 2 gains) will reduce the amount of capital gains distributed to remaining unit holders (type 1 gains); in a mutual fund trust type 2 gains reduce type 1 gains. Under the corporate class structure, unit holders can switch between funds without having to sell, eliminating much of the type 2 gains. Reduced type 2 gains increases the amount of type 1 gains that must be distributed to unit holders at year end.

The ability to switch between funds without incurring taxes sounds good, but it is ultimately just a gimmick shifting how and to who capital gains will flow. Corporate class funds create an environment where type 2 gains are being deferred at the cost of higher type 1 gains.

This blog post is based on a white paper from Dimensional Fund Advisors, download the full paper here.

Original post at pwlcapital.com

Investing with the Big Canadian Bank Brokerages

As an independent wealth management firm, there is no question that some of PWL Capital’s most aggressive competition comes from the Big Bank brokerage houses: TD Waterhouse, BMO Nesbitt Burns, CIBC Woodgundy, Scotia McLeod, and RBC Dominion Securities. This competition has become increasingly noticeable as the bank brokerages strategically advance their offering into the realm of wealth management. With their established brands and elitist feel, it is obvious why high net worth investors can be attracted to the perceived prestige and safety of dealing with the big name institutions. There may be some very good people giving wealth management advice within the bank owned brokerages, but there are inherent problems with their structure which is to the detriment of their clients.

One of the most obvious issues is conflicts of interest. Conflicts arise due to the integrated nature of the banks’ operations; if the institution decides that there is a product or stock that needs to be moved, one of the most accessible sales conduits is the clients of the bank-owned brokerage. Sales pressure from within the organizations has the potential to result in investment recommendations that may not be in the best interest of the clients. The core function of the bank-owned brokerages is not wealth management; they are sales channels and profitability centers serving the shareholders of the banks.

Beyond the conflicts of interest, the bank brokerages are hindered by their lack of a unified investment philosophy. At any of the bank brokerages there will be a large number of portfolio managers and investment advisors each implementing their own strategies. Some may use the bank’s proprietary mutual funds, some may pick individual stocks, while others may use the bank’s wrap account program. There may even be portfolio managers within the bank brokerages that use low-cost index funds, but without a unified philosophy guiding their investment decisions, advisors at the bank brokerages are more likely to recommend the flavour of the month mutual fund or the latest hot stock issue to their clients.

Dealing with an independent advisor-owned firm eliminates these issues. A firm like PWL Capital is designed to avoid conflicts of interest. We are paid by our clients, and there is no pressure to push any stock, mutual fund, or ETF at any given time to any given party. Under our structure, our only goals are to grow the assets of our clients while providing the ongoing financial planning advice that helps us maintain lasting relationships. With a unified, science-based, firm-wide investment philosophy, there is never a question of whether or not we should be using the latest financial innovation or buying the most exciting new stock in our client portfolios. Our disciplined approach is guided by academic research and evidence from the history of markets.

Despite PWL Capital’s intellectual integrity and dedication to doing what is right for clients, and the reasonably obvious profit-seeking nature of our competitors, some high net worth investors are inevitably swept off their feet by the Big Bank brokerages.

Original post at pwlcapital.com

If you think you need an options strategy, a hedge fund, or an active fund manager, you probably just need to revisit your time horizon

I often hear the phrase protect your downside. It’s the sales pitch that a large part of the investment management industry thrives on, and it plays to the myopic loss aversion that most investors exhibit. Myopic loss aversion is the tendency of investors to evaluate their portfolios frequently with greater sensitivity to losses than gains, causing them to act as if their time horizon is much shorter than it actually is. Let’s look at the example of John who wants to invest for his retirement 30 years from now. After happily watching his portfolio increase with steady returns for a few years, he panics when the market trends down slightly for a week. He knows that he doesn’t plan to touch the money for a long period of time, but the thought of a decline, even over a relatively short period of time, makes him feel sick. He may even pull his money out of the market until things feel safe again.

An obvious path to safety would seem to be hiring a person or a company that knows how to protect your downside, and the investment industry has answered this calling. John Wilson’s Sprott Enhanced Equity Class “provides downside protection through the use of option strategies and tactical changes to the amount of its equity exposure...”, while Cecilia Mo, MBA from Dynamic Funds “focuses on delivering consistent strong performance while providing downside protection”. If these sales pitches were not enough to satisfy our myopic loss aversion, Jeffrey Burchell, Portfolio Manager and Co-CIO for Aston Hill Asset management makes it clear that he’d “rather make less money than lose money!”

These sales pitches may give confidence to the naive investor, but downside protection strategies inevitably add significant costs to the portfolio over the long-term, resulting in performance that lags a benchmark index. The funny thing about this is that over long periods of time, say 10+ years, global financial markets have tended to increase in value. Lets reflect on that; we are accepting additional costs and underperformance to avoid short-term declines, but we have a long-term goal, and over long periods of time the short-term declines are just noise because the market tends to increase in value given a long enough period of time. Many portfolio managers will have you believe that it makes sense for long-term investors to accept lower returns in order to avoid being witness to short-term, albeit unrealized, losses; this sentiment can’t be expressed any more explicitly than “I’d rather make less money than lose money!”

What’s an investor to do? The risk of losing your money is only real if you need to sell investments while they are worth less than what you bought them for. Investing requires putting thought and care into matching your portfolio with the time horizon associated with it. If a short-term loss is intolerable because you might need the money soon, then investing in stocks and bonds is probably not the appropriate course of action. As for using options and tactical allocation for downside protection, long-term investors are better off minimizing their costs and capturing the returns of the global markets using index funds and ETFs. If short-term declines cause an emotional issue, you can simply increase your exposure to bonds.

Original post at pwlcapital.com

The TFSA Should Not Be Overlooked by Incorporated Individuals with Long Time Horizons

When people have corporations it is common for them to retain all earnings in excess of their living expenses inside of their corporation to avoid paying personal tax. This seems logical. By leaving the money in the corporation there is more money to invest in the corporate investment account, and we know that about $50,000 of dividends can be taken out of a corporation nearly tax-free, making the idea of leaving everything in the corporation until it’s time to draw a conservative retirement income appear very attractive.

With the TFSA’s annual contribution room now sitting at $10,000 per year, we thought it was time to put this common logic to the test. Does it make sense for incorporated individuals to withdraw additional dividends in excess of their living expenses to contribute to the TFSA? To answer this question we modeled the total after-tax value of $1 of active small business corporation income in the personal hands of the individual. The individual can retain the $1 of excess earnings in the corporation, pay the 15.5% small business corporation tax, invest $0.845 in the corporate investment account, and eventually pay personal tax on the withdrawal of a dividend. Alternatively, they can pay small business corporation tax on the $1, take out a dividend (paying personal tax at 38.29%*), and invest $0.521 in the TFSA where there are no tax implications on an eventual withdrawal.

The results of the analysis are intuitive. While using  the TFSA involves taking a significant haircut upfront, all future growth will be tax-free. This means that the rate of growth in the TFSA will be higher than the after tax rate of growth of the corporate investment account. Given a long enough period of time, the TFSA will overcome its initial tax hit and surpass the after-tax value of the corporate investment account. The TFSA has no time restrictions, and can remain untouched to eventually pass to a beneficiary tax-free on the death of the individual – depending on the age and health of the owner, it can have a very, very long time horizon.

These issues are discussed in more detail, alongside similar analysis for the RRSP, in our recent whitepaper, A Taxing Decision.

Note that to maximize the $10,000 annual TFSA limit, the individual would need to start with $19,193.86 of excess earnings in the corporation.

*The examples discussed consider an individual with income between $150,000 and $220,000 in Ontario in 2015.

Original post at pwlcapital.com.

Ignoring the Shiller P/E

Back in August of 2014, I wrote a post titled Is it time to get out of the market? At that time, the Shiller Cyclically Adjusted Price Earnings Ratio, or Shiller P/E, a price earnings ratio based on the average inflation adjusted earnings from the previous ten years, stood at a level of 25.09 (vs. a long-term mean at that time of 16.54). Investors were feeling nervous, and headlines like It’s the worst possible time to buy stocks weren’t helping. Since August 2014 the S&P 500 Index is up 9.77% in USD, and a whopping 27.33% in CAD; getting out of the market, or waiting for a lower Shiller P/E before investing, would have resulted in significant missed opportunities.

At the time of writing this post the Shiller P/E stands at 26.33, and investors are again feeling nervous about an overvalued market headed for a major correction. Larry Swedroe recently wrote about why the Shiller P/E is may not be a valid method for comparing past and current market valuations – I have summarized his points.

• The U.S. market has improved regulation, a more experienced Federal Reserve, and greater overall wealth. It makes logical sense that the cost of capital in a more developed financial market is lower (meaning the Shiller P/E is higher) than it was when that same market was less developed. A Shiller P/E higher than the historical average should not come as a surprise.

• The Financial Accounting Standards Board changed the rules around writing off goodwill in 2001 resulting in the current valuations of stocks appearing to be more expensive relative to the past than they actually are. Swedroe writes that adjusting for this accounting change would lower the current Shiller P/E by about 4 points.

• For fair comparison of past and present Shiller P/E ratios, they must be normalized for differences in dividend payout ratios. Dividend payout ratios today are significantly lower than payout ratios in the past. Adjusting for this differences explains about 1 point of difference between the historical and current Shiller P/E.

• Cash on balance sheets increases P/E ratios, debt decreases P/E ratios, and relative to history, U.S. companies are holding more cash and less debt than they have in the past. This pushes up the Shiller P/E.

• The liquidity premium for holding stocks has decreased as bid-offer spreads narrow due to things like the decimalization of stock prices and the additional liquidity provided by high-frequency traders. Index funds and ETFs have also given investors the ability to indirectly hold illiquid stocks, reducing the sensitivity of their returns to liquidity.

Adjusting for these factors, Swedroe estimates that a Shiller P/E very close to the current level of 26.33 should be expected. When the current historical mean of the measure (going back to the late 1800s) is 16.61, it is very easy to get nervous about a mean-reverting market correction, but when this mean is adjusted for current market conditions, the U.S. market no longer appears to be overvalued. It is important to note that based on this analysis, and barring a market correction, the expected returns of U.S. stocks are expected to be lower going forward than they have been in the past.

While the Shiller P/E provides some interesting data for discussion, allowing it to influence investment decisions is unlikely to result in a  positive investment experience. Ignoring the noise and staying invested is an approach much more likely to result in both investing success and peace of mind.

Original post at pwlcapital.com

After-tax returns of currency-hedged global fixed income

Fixed income securities play an integral role in almost every investor’s portfolio. It is common to see a fixed income allocation mostly denominated in the investor’s home currency, as foreign currency denominated bonds can add unwanted volatility to a portfolio. Limiting a fixed income allocation to bonds denominated in the home currency creates limitations on opportunities for diversification. Currency hedged globally diversified fixed income allocations are the logical solution.

 Currency hedging has limited benefits in equities because equities and currency tend to have similar volatilities, and imperfect correlation. Maintaining currency exposure can actually decrease equity volatility due to currency diversification. Adding a currency hedge to an equity allocation removes the currency diversification benefit and can increase volatility.

 Like with equities, currency has imperfect correlation with fixed income, resulting in a similar positive diversification benefit. However, currency is much more volatile than fixed income, and as a result the positive effect from currency diversification is not enough to offset the relatively large volatility introduced by currency fluctuations. Adding a currency hedge maintains the low volatility that makes fixed income attractive.

 A currency hedge is executed in practice with forward exchange contracts. This entails entering an agreement to exchange CAD for a foreign currency at a predetermined rate, on a predetermined date. The following example involves a Canadian investor buying a USD denominated bond, and hedging their currency exposure.

• The Canadian investor converts their CAD cash to USD, purchases the US bond in USD, and simultaneously sells short a corresponding amount of USD in the forward market.
   
• At the maturity of the forward contract, if the currency has increased (decreased) in value relative to CAD, the investor will be at a loss (gain) when they deliver the USD they have sold short to the counterparty.
   
• Any loss (gain) on the currency contract will be offset by a corresponding gain (loss) on the CAD value of the US bond.
   
• The effects of currency are being removed from the picture, resulting in pure exposure to the returns of the fixed income security.

The hedge-bond maturity mismatch

 Currency hedged fixed income results in smooth pre-tax returns, but can result in lumpy after-tax returns. It is common to use one-month forward contracts to hedge currency exposure. In a bond fund, most securities will have maturities longer than one month. The result is a maturity mismatch between the hedge and the bond. If a bond is held for four years before it is sold, forty-eight forward contracts are required to hedge the currency exposure over the bond’s holding period. Each time a forward contract matures, the resulting gain (loss) is booked as a realized gain (loss) while the corresponding bond carries an unrealized loss (gain) until it is sold or matures.

 Over the long-term, the currency related gains and losses will negate each other. It is the requirement for funds to annually distribute realized gains that makes the maturity mismatch noticeable to taxable investors. In years where there are net realized capital gains, the fund must make a taxable capital gains distribution. In years where there is a net realized capital loss, the fund carries the loss forward to offset future realized capital gains.

 This perspective can be applied to the apparent trend of increasing tax efficiency in DFA231. The fund has mostly maintained a decreasing tax cost ratio for the past 10 years.

 After-tax returns of DFA231

Source: Dimensional Fund Advisors Canada, CanadianPortfolioManagerBlog.com

The trend has been caused in part by fortunate timing of capital loss carry forward due to currency fluctuations. This effect occurred randomly, and cannot be counted on as a continued trend. It is still expected that DFA231 will maintain relative tax efficiency as it aims to hold low-coupon bonds in any environment, but the current level of tax efficiency is exceptional.

 Taxable investors should take note of this effect as currency-hedged global fixed income products become more popular.

U.S. firms don’t put their money where their mouth is

The large brokerage firms in the United States have had their blunders, most notably the 2008 financial crisis that almost crippled the world economy. These firms have massive conflicts of interest with their clients, and they put forth great effort to cover this up through advertising.

The United States, like Canada, does not hold brokers to a fiduciary standard; they are required to make suitable recommendations, but do not need to act in the best interest of their clients. This legal nuance is exploited through misleading advertisements that make it appear as if advisors are obligated to do what is best for their clients, while the firms maintain that they are not legally required to do so.

Evidence of this deceptive marketing was put on display in a recent report by Joseph C. Peiffer and Christine Lazaro for the Public Interest Arbitration Bar Association. The legal positions of these investment firms have been taken from legal documents submitted in arbitration proceedings where investors suffered major losses due to conflicted advice.

Allstate

Advertisement: “You’re In Good Hands”

Legal position: “Allstate Financial Services owed no fiduciary duty to Claimants, and, therefore, no such duty was breached.”

UBS

Advertisement: “Until my client knows she comes first. Until I understand what drives her. And what slows her down. Until I know what makes her leap out of bed in the morning. And what keeps her awake at night. Until she understands that I’m always thinking about her investment. (Even if she isn’t.) Not at the office. But at the opera. At a barbecue. In a traffic jam. Until her ambitions feel like my ambitions. Until then. We will not rest.” (Emphasis in advertisement).

Legal position: “[A] broker does not owe a fiduciary duty to his customer in a nondiscretionary account.”

Berthel Fisher

Advertisement: “We are committed to maintaining the highest standards of integrity and professionalism in our relationship with you, our client. We endeavor to know and understand your financial situation and provide you with only the highest quality information and services to help you reach your goals.”

Legal position: “Respondents deny that they owed fiduciary duties to Claimants.”

Ameriprise Financial

Advertisement: “Once you’ve identified your dreams and goals, and you and the advisor have decided to work together, you can count on sound recommendations that address your goals. You’ll be able to clearly see and discuss how the actions and decisions you make today will affect your tomorrow. You can expect to hear about the options you have and any underlying factors to consider. Our advisors are ethically obligated to act with your best interests at heart.”

Legal position: “Respondent owed no fiduciary duties to Claimants and, even if it did, no such duties were breached.”

Merrill Lynch

Advertisement: “It’s time for a financial strategy that puts your needs and priorities front and center.”

Legal position: “Respondents did not stand in a fiduciary relationship with Claimants.”

Fidelity Investments

Advertisement: “With millions relying on us for their savings or the growth of their business, we handle every action and decision with integrity and personal attention to detail. Getting things just right doesn’t mean we’re perfect, but rather setting high standards, refusing to cut corners, and believing that every product, every experience, and every outcome can always be better.”

Legal position: “Claimants first claim fails because Fidelity did not owe [the investors] any fiduciary duty.”

With their clever wording, these firms paint the rosy picture of a fiduciary standard without actually being legally bound by one. When clients suffer financial losses due to conflicted advice, the firms throw their hands in the air and say that they never claimed to be fiduciaries.

There are no Canadian examples here, but similar marketing claims can be found around the world. Without a regulated fiduciary standard in place, investors must proceed with caution.

After tax returns of DFA Five-Year Global Fixed Income

The notion that premium bonds are highly tax inefficient has been written about extensively by Justin Bender and Dan Bortolotti. In a recent blog post, Justin used his after tax rate of return calculator to demonstrate the tax efficiency of the First Asset strip bond ETF (BXF). BXF was in a league of its own in 2014 with a tax cost ratio 33bps lower than its closest peer – the tax cost ratio can be thought of as an additional MER that the investor pays in taxes. Justin compared ten short term bond ETFs, and BXF had the highest before and after tax returns of the set. The DFA Five-Year Global Fixed Income Fund (DFA231) was not included in Justin’s ETF comparison.

Unlike the ETFs examined by Justin, DFA231 is not an index fund. It is a short term fixed income fund that shifts its holdings based on changes in the yield curve, while keeping the maturities between one and five years. If the yield curve in a country is upward sloping, the fund will hold longer maturity bonds in that country as the risk of holding longer maturities is being rewarded. If the yield curve is flat, the fund will look similar to the index as there is no significant benefit to holding longer maturities. If the yield curve is inverted, the fund will hold very short maturities. The fund has the flexibility to find opportunity in yield curves around the world, and it is hedged back to the home currency (CAD) allowing global bonds to be pursued without adding volatility due to currency fluctuations. The fund, as at September 30, 2014, had just over 10% of its holdings in Canada, while more than 26% were in the United States, and Australia was also notable at 8%. DFA puts forth an effort to keep the coupons low, reducing the tax issues presented by premium bonds.

Does it work?
This fixed income strategy has been successful. In 2014, both the before and after tax returns beat out the toughest competition by a healthy margin. To be fair to the competition, DFA231 tended to have a longer average maturity and duration than both BXF and the iShares Canadian Short Term Bond Index ETF (XSB) through the year. The fund’s higher returns can be attributed to increased risk, the risk was just well compensated over this time period. It is also true that DFA231 carries a higher MER at .38% than BXF at .20% and XSB at .25%, which contributes to its lower tax cost ratio; more of its taxable distributions are absorbed by fees before they reach investors.

2014 was not the first good year
DFA231 has had a long history of outperformance and tax efficiency compared to XSB, a short term bond index fund with a ten year history available for comparison.

There is no way to determine if the strategy will continue to be this successful in the future, but it currently appears to be a tax efficient option for short term fixed income allocations.

Original post at pwlcapital.com

An Open Letter to Active Fund Managers

Dear Active Fund Managers: Please do not give up!

We know that 2014 was an especially difficult year for you, and though it was not the first difficult year that you have endured, it was surely the most public. Do not allow yourselves to feel discouraged by headlines like “The Decline and Fall of Fund Managers” and “The Triumph of Index Funds”; maybe your bets and predictions will be more accurate in 2015.

It cannot be easy watching institutions and retail investors aggressively shift their assets from active to passive funds – Morningstar data for a trailing one year period through November 30th showed that active U.S. equity funds lost $91.9 billion, while passive U.S. equity funds received $156.1 billion. At least there were positive flows of $67.6 billion across all active U.S. domiciled fund categories, though passive funds did see inflows of $385.7 billion despite consisting of a significantly smaller fund universe.

Try not to worry too much about Warren Buffett and CalPERS advocating for index funds. Just because they are two of the most well respected and influential figures in the investment world does not mean that they are always right.

Right now it may feel impossible to pick the right stocks or guess the market direction, but do not let your confidence wane! You see, for everyone else to enjoy an efficient market, at least a handful of you need to continue your vigorous research and due diligence on securities. Each one of you may only get it right sometimes, but the aggregation of your predictions plays a role in getting accurate information into prices.

There will always be some investors eager to pay your high fees in hopes of beating the market, regardless of what the data says – you will never be obsolete. So please, ignore the media, the data, and the thought leaders, and keep up the great work!

Sincerely,

Investors

Original post at pwlcapital.com

Is 2015 the year to fire your financial advisor?

2014 was a strong year for financial markets, capping off a six-year-long bull market that could make anyone look like a star investment manager. As an investor, there are important areas to evaluate beyond positive investment performance to determine the worth of a relationship with a professional financial advisor.

Who are they working for?

A large amount of the financial advisors in Canada operate on a commission basis; they are getting paid by the products or transactions that they are recommending to their clients. This compensation model creates obvious conflicts of interest as these advisors are working for the financial companies, not their clients! The advisor in this model is inclined to make recommendations that will result in them receiving compensation and bonuses. A much more viable relationship exists when the client agrees to pay the advisor directly for their unbiased advice. If your advisor is being paid by the products that they are recommending to you, it might be time to say goodbye.

Are they acting in your best interest?

Financial advisors in Canada are held to a suitability standard. This means that they can legally make recommendations that will benefit them more than you, as long as the investment is suitable. Some firms may choose to hold themselves to a code of ethics, such as the CFA Institute Code of Ethics and Standards of Professional Conduct. If your advisor has not already, and is not willing to, agree in writing to abide by a written code of ethics, they should not be kept around much longer.

Have they built your Investment Policy Statement?

An Investment Policy Statement is a signed document that governs how your money will be invested. One of the most important roles that an advisor plays is determining your short and long-term goals, your required rate of return, and your risk tolerance in order to make an asset mix recommendation. An appropriate asset mix, reflected in the rules written in an Investment Policy Statement, is the foundation of every long-term investment plan. If your advisor is investing your money without having built your investment policy statement, their investment recommendations may not be aligned with your long-term goals.

Are they conscious of your tax situation?

After-tax returns can be significantly different from pre-tax returns, especially if your advisor is not integrating their investment recommendations with your overall tax situation. An involved advisor will be conscious of asset location (which accounts should hold which investments), tax-loss harvesting opportunities, and other unique tax circumstances that may affect your optimal investment portfolio. If you advisor is ignoring taxes to focus on investment returns and picking the next hot stock, they could be doing significant harm to your after-tax returns.

Are they giving you financial advice?

Not all people that are paid to give financial advice actually give financial advice. There are plenty of stock pickers and salespeople parading as financial advisors that do not give advice beyond the hottest new product for your portfolio. Financial advice encompasses the construction of an Investment Policy Statement, integration with your tax situation, and coaching on how to achieve your financial goals. Financial advice can go much further, depending on the expertise of the advisor. It should go without saying, but if your financial advisor is not giving you financial advice, it is probably time to fire them.

Firing a financial advisor can be difficult. Often times advisors work hard to build a personal relationship with their clients, or a personal relationship preceded the professional engagement. As awkward as the conversation and following situation may be, it must be remembered that the cost of poor financial advice can be immeasurably large over a long period of time.

Original post at pwlcapital.com

Stories over Science – Tony Robbins’ Financial Advice

Tony Robbins’ new book, MONEY Master the Game: 7 Simple Steps to Financial Freedom, is full of great stories, knowledge, and ideas that can help people kick-start their financial future. He discusses disciplined saving, and debunks the financial services industry for the average person. He warns readers about high fees, active management, complex financial instruments, misleading past performance, and conflicts of interest. He even goes into detail about the factors that should be considered when deciding on an asset mix, and the importance of asset allocation. Robbins interviewed fifty of the biggest names in investing to research the content for this book. He has repeated his trusted process of finding the best people in a field, unleashing their secrets, and showing the average person how to use them in an actionable way. Robbins is a genius when it comes to harnessing and channeling human emotions. He has a roster of presidents, billionaires, and star athletes that attribute their success and happiness to the clarity that he is able to bring to their lives, and his ability to evoke feelings of elation and motivation through his text and speech is unparalleled. There are thousands of unread books written about personal finance and investing, but this book is written by one of the most famously trusted people on the planet, and it is currently the bestselling book on Amazon. This is a book that is being read.

Robbins is a master of emotions, but emotions and investment advice do not mix well. In the book, he excels at explaining the importance of an appropriate asset allocation, and then extols one specific asset allocation that has historically “produced extraordinary returns with minimal downside”. Playing into the psychology of an inexperienced investor, Robbins explains that it is smart to “risk a little, make a lot” with things like structured notes (PPNs in Canada), and market-linked CDs (Market linked GICs in Canada), tools that limit downside risk while capping upside potential. He explains, very logically, how an investor should use a mix between a Security bucket and a Growth bucket to match their risk tolerance through time, and then he tells the reader that he has “uncovered the ways in which you can get Growth-like returns with Security Bucket protections”. Robbins does not seem to grasp the idea that market volatility within a well-designed portfolio is not the same the same thing as losing money. He wants investors to seek investments with asymmetric risk/reward, just like the pros do! This theme is present throughout the book to the extent that the focus of an entire chapter is dedicated to “the Holy Grail of portfolio construction,” Ray Dalio’s All Weather Portfolio.

 Robbins artfully tells the story of how he finally convinced Ray Dalio to reveal the magic formula for a portfolio that will serve investors well in any market. He tells the story so well that, despite my skepticism, I couldn’t wait to flip the page and learn about it. Robbins’ masterful presentation of Dalio’s All Weather Portfolio is the epitome of emotion-based investment advice – and the epitome of Robbins’ ability to sell. As great as it sounds, this model portfolio, and Robbins’ premise for finding the perfect investment answer, are not based on the science of markets. The idea of getting  advice from one, or fifty, of the best money managers in the world evokes feelings of hope and excitement for investors, but it is a misguided path to a positive investment experience. The indeterminable line between luck and skill makes the investment industry a very difficult arena to use lessons from the past success of individuals as a guide for the future.

 Ray Dalio’s All Weather Portfolio is as follows:

 30% Stocks (S&P 500 index fund)

15% Intermediate bonds (7 to 10 year Treasuries)

40% Long-term bonds (20 to 25 year Treasuries)

7.5% Gold

7.5% Commodities                                 

I modeled this portfolio, and my back-tested results from 1984 - 2014 were very similar to Robbins’ (we might have used different indexes in our models, or different fee levels). My model posted an impressive compound annual return of 9.87%, with a modest standard deviation 7.19%. This all sounds wonderful, but there is an obvious technical flaw in the portfolio that many bloggers have been quick to point out, as Robbins predicted they would; this long-term bond heavy allocation has been back tested through the longest fixed-income bull market in history. With interest rates at an all-time low, it is unlikely that long-term bonds will produce the same magnitude of returns going forward that they have in the past. Robbins explains in the book that the large allocation to bonds is not a bet on bonds alone, but that Dalio has designed the portfolio to spread risk among the four potential economic seasons (rising economic growth, falling economic growth, high inflation, low inflation) using asset classes that will have a low correlation in each possible scenario. This truly is a great story, and it is coming from one of the greatest historical performers in the investment industry – talk about building credibility through social proof.

I love a good story, but chasing high returns with low volatility is an idealistic and emotion-based approach to financial markets. Removing emotion from the equation, and looking to the evidence from the history of markets rather than to sensationalized stories about past success yields much more logical investment advice. Stocks have outperformed bonds. Small stocks have outperformed large stocks. Value stocks have outperformed growth stocks. These are not magical formulas or stories about low correlations that guarantee downside protection, they are reflections of the higher expected returns associated with making investments in riskier asset classes. Risk and return will always be related, and there is no magical formula to get around that. Rather than listening to stories about low-risk high-return portfolios, smart investors follow the science of markets and build an asset mix to harness the risks that have higher expected returns (equity, size, and value) while managing volatility with fixed income securities.

 Robbins’ heart seems to be in the right place, and he does give a lot of very useful financial advice that is not heard often enough, but his emotion-based approach to investing falls short of what people need to hear.

Original post at pwlcapital.com

The RDSP after age 19

RDSP accounts are eligible to receive funds from the Government of Canada to assist disabled persons in long-term saving. Both a contribution matching grant and an income tested bond can be paid to an RDSP, based on the beneficiary’s family income. If a beneficiary’s family income is over $87,123, they will be eligible for $1 of grant for every $1 of contributions to the account up to an annual maximum of $1,000; if the family income is below $87,123, the beneficiary will be eligible for $3 of grant for each $1 of contributions up to $500 per year, and $2 of grant for each $1 of contributions on the next $1,000 per year. The $1,000 bond is paid in full when the beneficiary’s family income is less than $25,356, paid partially (based on the formula in the Canada Disability Savings Act) if the family income is between $25,356 and $43,561, and the bond is not paid at all when the family income is over $43,561. Knowing these rules, the definition of family income becomes very important.

The income of the account holder of an RDSP does not affect the beneficiary’s eligibility for grant and bond payments. Up until the year that the beneficiary turns 18, their family income is the same family income that determines the Canada child tax benefit; this is the income of the minor child’s legal guardians. In the year that the beneficiary turns 19, their family income is based on their own income and their spouse’s income, but to earn the maximum grant and qualify for the bond based on their own income, the beneficiary must have filed at least two prior years of income tax returns. When this requirement is met, the RDSP benefits shift from being based on the guardians’ to the beneficiary’s income. For a beneficiary that is not able to work and has a very low income, the result of this shift in income testing can be a significant increase in grant and bond eligibility.

If two years of tax returns have not been filed in the year that the beneficiary turns 19, unused grant and bond entitlements can be carried forward for 10 years, starting after 2007. This means that if the beneficiary does not have two years of tax returns filed in the year that they turn 19 and do not receive their full grant and bond entitlement in that year, they will be able to claim the unused amounts in a future year. To maximize the amount of time that the full grant and bond entitlement can be invested and grow tax-free, it is best to have two prior years of tax returns filed in the year that the beneficiary turns 19. This is a small step that can yield large gains for the long-term growth of an RDSP account.

CRM II Disclosure, low-cost “Robo Advisors”, and expensive mutual funds

There is a shift poised to take place in the Canadian financial services industry. Currently, investors with assets between $5,000, and $150,000 tend to be served by commission based mutual fund salespeople and bank advisors selling expensive mutual funds with the promise of superior performance. There is a tremendous amount of evidence that these types of mutual funds harm investors while lining the pockets of investment companies and financial advisors.

Between 2014 and 2016, the Canadian Securities Administrators are implementing regulatory reform. The reforms are designed to create transparency, increase industry disclosure requirements, and provide more overall information to investors. Some key points from the reform schedule follow:

July 15th, 2014

• Before a trade order is accepted, clients must be informed of all management fees, the cost of selling the investment in the future (if deferred sales charges apply), trailing commissions, front end loads, and the cost of changing investments.
• Benchmarking must be explained to clients. This can be done by adding benchmarks to performance reports and explaining why they are relevant, or it can be done by explaining what a benchmark is and the firm’s view of using them in the Relationship Disclosure document.

July 15th, 2015

• Dealers must start calculating and maintaining performance data using the money-weighted return method (Internal Rate of Return).
• Dealers will be required to show the original cost of each security held in an account.

July 15th, 2016

• It will be a requirement for clients to receive a statement showing all of the fees, commissions, and other charges that they have paid throughout the year in relation to their account.
• All accounts must receive, at minimum, an annual performance report - these reports must include the money-weighted returns.

While all of this regulatory reform is occurring, there are low-cost, online investment management firms popping up around the country (nestwealth, wealthsimple, wealthbar). Firms like these have already taken a strong hold in the US, but are just now coming to Canada. They are targeting investors with assets between $5,000 and $150,000+. They have account minimums ranging from $5 -$25,000, and their fees are significantly lower than the fees that the average investor would otherwise be paying at these asset levels. The online firms are also doing something that commission based mutual fund advisors can’t afford to do for small accounts – they are building well diversified, low-cost portfolios using Exchange Traded Funds. To top all of that off, the online firms claim that they will also offer some level of financial advice.

When July 15th 2016 arrives, we will be in an environment where investors are explicitly aware of how much they are paying for financial advice, they will have had benchmarking explained to them, and they will be shown how their portfolio has performed against a relevant benchmark throughout the year. If it happens (as it should) that the smaller investors see that they are paying a lot of money for mediocre advice and poor relative performance, a low-cost, index-based alternative will be available to them, regardless of their portfolio size.

Sorry, we aren't selling

Jason Zweig once wrote that “good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.” This statement is true in practice.

There are three broad categories of people that consider hiring PWL to manage their portfolios. There are people that have done a tremendous amount of research, followed the mountain of evidence that points to our investment philosophy, and discovered us as a result; there are people that have been told about our sensible investment philosophy, high level of service, and excellent advice by someone that they trust; there are people that find us in a Google search and decide to include us as a candidate in a portfolio manager selection process.

In my experience, the first two types of people are quick to become clients; these people have almost made up their minds about investing with PWL before requesting an initial meeting. They either understand how we invest, or have been referred to us by someone that they trust to make these types of recommendations. The third group of people, the ones that want to include us in their portfolio manager selection process, are much less likely to become clients; these people have not usually done in-depth research on investing and financial markets, and are expecting us to give them the amazing sales pitch that will make their decision easy. This is a problem.

Our investment philosophy does not sound exciting. Effectively capturing the long term returns of an efficient capital market, tilting towards dimensions of higher expected returns, and rebalancing? Logical, not exciting. When someone understands the evidence behind this approach, it is obviously the only sensible way to invest. When someone is looking for an engaging story about the need to hedge against rising interest rates by shorting bonds and buying commodities, our evidence-based approach falls short of their expectations. We do our best to save people from the investment industry, but we aren’t here to sell. We are following the evidence and doing what is right.

original post at pwlcapital.com

Is it time to get out of the market?

We are in the midst of a long Bull Market. Robert Shiller popularized the idea of Irrational Exuberance when he explained that people get overly excited about stocks when stocks are doing well, bidding prices up to an unsustainable level. Shiller’s Irrational Exuberance can be observed using the Shiller Cyclically Adjusted Price Earnings Ratio (CAPE 10), a price earnings ratio based on the average inflation adjusted earnings from the previous ten years. The measure simply shows us how stocks are priced relative to their average level of earnings over time. When prices reach an extreme relative to average earnings, Shiller would say that we are in a bubble. The logic of an investor might follow that when the Shiller PE gets too high, it’s time to bail out of the market and avoid the expected correction, getting back in when things are back to normal.

Data from Robert Shiller's online database

The current Shiller PE is starting to edge up on the high side, relative to history, at 25.09. It was 32.56 before the crash in 1929, it was at 44.2 before the crash in 2000, and it was at 27.53 before the crash in 2008. The overall historical mean Shiller PE is 16.54, and the median is 15.93. So, we are currently well above the historical average, and pushing up toward levels that have preceded a crash in the past. Does this mean that everyone holding stocks should sell into cash until the market has corrected? The data says no.

Tobias Carlisle (@Greenbackd) recently ran an experiment where he back tested the Shiller PE as a mechanism to move a portfolio of value stocks into cash at predetermined levels of overvaluation relative to historical Shiller PE levels. The value portfolio was defined as the Fama and French value decile, and the back test ran from 1926 – 2014. The result? The portfolios that used Shiller PE values to go into cash at various levels above the historical mean underperformed the control portfolio which maintained consistent exposure to the value decile. The underperformance was due to cash drag, and missing out on recoveries.

This doesn’t necessarily tell us that it’s impossible to time the market, but it does show that the Shiller PE is not particularly useful in doing so. Investors need to focus on holding the market portfolio with a consistent tilt toward established risk premiums, and stay invested.

original post at pwlcapital.com