When Active Managers Win

Fidelity has a massive billboard up in Toronto to promote one of their portfolio managers, Will Danoff. Danoff has managed the U.S. based Fidelity Contrafund since 1990; it is the largest actively managed fund in the world managed by a single person. The Contrafund has performed well – well enough to beat its benchmark, the S&P 500. Benchmark beating performance attracts assets. It also gives Fidelity the opportunity to advertise to the world how great their star manager is. The problem for investors is that an active manager posting strong performance numbers, even over long periods of time, does nothing to indicate for how long that performance will persist.

Less than half of the equity mutual funds that existed in Canada a decade ago continue to exist today. If a fund has several years of poor performance, its assets will decline as investors move their money elsewhere. Eventually, the fund will close. If an investor is looking at the universe of mutual funds that are available to them at a point in time, they will only be seeing the funds that have done well enough to survive. Survival may be an indication of a truly skilled manager, but it could also be dumb luck. A 1997 peer reviewed paper by Mark Carhart titled On Persistence in Mutual Fund Performance looked at 1,892 U.S. mutual funds between 1962 and 1993. The conclusion of the paper was that there was no evidence in the data of skilled or informed mutual fund portfolio managers. In other words, good performance is most likely explained by luck.

Between survivorship bias and the lack of evidence of manager skill, it should be no surprise that many great fund managers have had dramatic falls from grace. The following examples are borrowed from Larry Swedroe’s The Incredible Shrinking Alpha.

In the 1970s, David Baker managed the 44 Wall Street fund to market beating performance for ten straight years. The following decade, it was the single worst performing fund, dropping significantly while the S&P 500 gained. Even more impressive was the Lindner Large Cap Fund, which beat the S&P 500 for the 11 years ending in 1984. While this market beating performance no doubt attracted attention, the fund spent the following 18 years being decimated by the S&P 500. If 11 years wasn’t enough to weed out the lucky managers, Bill Miller’s Legg Mason Value Trust Fund beat the S&P 500 for the 15 years ending in 2005. It suffered miserably against the index for the next seven years before being taken over by a new manager in 2012. Possibly most impressive of all is the Tiger Fund – a hedge fund formed in 1980. It spent 18 years averaging returns over 30% per year, and its assets had grown to a hefty $22 billion by 1998. Over the next two years the fund lost $10 billion, and closed its doors in 2000.

The odds of outperformance are slim, but some active managers do beat the market. The challenge for investors is identifying winning managers before they win. Unfortunately, finding a manager that has done well in the past is not helpful in finding a future winner.

Original post at pwlcapital.com

91.11% of Canadian Equity Funds Underperform Over 10-Years

A staggering majority of Canadian mutual funds have underperformed the index over the past decade. This data comes at a time when U.S. investors are pulling billions of dollars out of active funds managed by stock pickers, instead favouring low-cost passive index funds. Canadians are not following this trend, adding roughly equal amounts to both active and passive funds in 2016.

In the ten years ending December 2016, 91.11% of Canadian Equity mutual funds trailed their benchmark index according to the SPIVA Canada 2016 Year-End report. For the first time since it has been produced, the report shows ten years of Canadian data. Similar U.S. data for U.S. Equity funds shows that only 82.87% were outperformed by their benchmarks. As of 2015, Canadian mutual funds had the highest fees in the world, while the U.S. had some of the lowest. Fees are known to be one of the best predictors of future performance.

The idea that active managers are not able to consistently beat the market after fees is not new – it has been demonstrated in academic research papers consistently over the last 40 years. Recently, many investors and advisors have arrived at the same view.

The SPIVA Canada report showed ten year data for four fund categories, none of which posted impressive results. Against their benchmarks, 91.11% of Canadian Equity funds underperformed, 75.44% of Canadian Small/Mid Cap Equity funds underperformed, 100% of Canadian Dividend & Income funds underperformed, and 98.28% of U.S. Equity funds underperformed.

Despite the poor performance, Canadian investors continue giving their money to active managers. In 2016, U.S. investors pulled $326 billion from active funds and added $490 billion to passive funds while Canadian investors added $10 billion to active funds and 10.9 billion to passive funds.

A Bit of History

There has been a lot of talk about automation and how it might affect the global economy. Some people are worried about how these potential changes could affect their portfolio, especially if they passively own the whole market. The thinking is usually that if an industry disappears due to automation or some other factor, and you own that industry, then you might take a loss. While it may seem like this is a disadvantage of passive total market investing, it's actually an advantage. There is no way to tell which industries will fail, or which industries will appear to replace them. Without knowing the future, the most sensible thing to do is participate in global capitalism by owning the whole market.

Just as we expect the world to change going forward, it has changed a lot since 1900, when nobody could imagine that email would replace the telegraph, or that air travel would connect the globe. Technology has transformed the way that we work and live, and globalization has moved many industries out of the developed world and into emerging markets.

As you might expect, those changes are largely reflected in financial markets. In 1900, 80% of the U.S. market's value was concentrated in industries that barely exist today. Below are two charts showing the industry weightings of the U.S. financial market at the end of 1900 and at the end of 2015. Despite all of the changes in how the world works, a dollar invested in the U.S. market in 1900 had grown by an average of 6.4% per year net of inflation by the end of 2015. Of course, there is some survivorship bias here. The U.S. market has been exceptional. In 1900, it was only 15% of the global market capitalization, and at the end of 2015 it was 52.4%. The UK was 25% of the global market in 1900, and 7.1% in 2015. In 1989, Japan was 45% of the global market while the U.S. was 29%. The U.S. has continued to outpace the world. 

Data source: Dimson, Marsh, Staunton (2002, 2015); FTSE Russell 2015. Chart adapted from Financial Market History - Reflections on the Past for Investors Today, CFAI Research Foundation.

Despite the U.S. being a clear case of survivorship bias, global markets have done pretty well in aggregate too. Even when we include two markets, China and Russia, that at one point failed completely (meaning investors lost 100% of the money invested in those countries) a dollar invested in the global market in 1900 would have grown by an average of 5% per year net of inflation by the end of 2015. The world is always changing. Some countries dominate over some periods of time, and falter later. The same goes for industries. It is impossible to know what is going to do well, which is why it makes sense to own the market and stay disciplined.

In 1900 it was not possible to buy an all-world index. In 2017, that technology is available through low-cost ETFs to anyone with a brokerage account. Passively participating in global capitalism has never been easier.

The Bank May Not Be Your Best Bet For Investing

The big Canadian banks have come under fire recently for their aggressive tactics and, in some cases, claims of unlawful behaviour by stressed employees chasing sales targets. Most of the media attention has focused on customers being pushed to increase credit limits and overdraft protection, or apply for a more expensive credit card. But there is another product that banks have been aggressively selling for years while only attracting a bit of attention: High-fee mutual funds.

‘Suitable’ investments

Walking into a bank branch and asking to speak with a financial advisor about investments will likely result in a recommendation to purchase the bank’s high-fee actively managed mutual funds. Asking for low-cost passive index funds might be answered by a slick rebuttal focused on how well the bank’s fund managers have done in the past.

The advisor will generally be licensed to sell mutual funds – a registration that requires them to make suitable recommendations to their clients. A suitable recommendation is permitted to be a better deal for the bank, as long as it matches your risk profile and circumstances. This is true despite the evidence that higher cost actively managed funds, while more profitable for the bank, are likely to underperform lower cost passive index funds over the long-term. You do not want suitable advice.

The friendly financial advisor at your bank is probably not malicious. They’ve been taught that the bank’s funds are excellent. It’s also unlikely that they’re familiar with the large body of academic research discrediting the claim that active fund management adds value over time.

There are other options

Canadians seem to be happy to take suitable investment advice for now – they added $10.9 billion to passive funds and $10 billion to active funds in 2016.  In contrast, Americans added $490 billion to passive funds and removed $326 billion from active funds over the same year. This may be driven by the growth of registered investment advisors in the U.S., who are legally required to act in the best interest of their clients.

There are financial advisors in Canada who are held to this higher standard. A Portfolio Manager is a regulated title in Canada with a legal duty to put the interest of their clients ahead of their own. Similarly, CFA charterholders are held to a code of ethics and standards of professional conduct which require clients’ interests to come first.

Of course, if you want to cut advice out of the equation entirely you can also try your hand at managing your own couch potato portfolio.

Investing in the banks’ mutual funds is more likely to help them post record profits than help you meet your long-term goals, but you will get a much rosier story from their financial advisors. Buyer beware.

Original post at pwlcapital.com

Smart investment decisions are simpler than you think

Do you ever wonder what it’s like to be a smart investor? Chances are that you do; most Canadians own investments that underperform the market. If a financial advisor says that they know when to buy gold, they may be perceived as smart, and their clients will likely listen to them. The ability to predict is associated with investing intelligence. This approach to investing is known as active management – figuring out which stocks or assets will do well, or knowing when to get in and out of the market. As intelligent as it may seem, there is no evidence to support its efficacy.

Most Canadians own mutual funds, and pay over 2% per year to have their mutual fund assets actively managed. The idea behind that fee is that the fund manager will be able to outperform a benchmark index; it makes sense to pay a higher fee for better performance. This would be great if mutual fund managers delivered above-benchmark returns, but year after year the data on mutual fund performance is disappointing. Most funds underperform over any given time period. What about the good funds? Unfortunately, funds that have done well in the past are no more likely to do well in the future. Stock prices move randomly based on the development of new information. No amount of analysis or intelligence can predict randomness. If knowing when to buy gold doesn’t make you a smart investor, how does anyone do well with investing?

Luckily, there is an investment strategy that some of the smartest people in the world agree on. Four winners of the Nobel Prize in Economic Sciences, and Warren Buffett, one of the most successful and well-known investors in history, are proponents of investing in low-cost index funds. An index fund passively owns all of the stocks that represent a market, for a fraction of the typical 2% cost of a mutual fund. Being smart by avoiding prediction altogether, and eliminating the high fees and commissions associated with trying to make the right calls, has proven over time to deliver excellent results.

One of the greatest challenges for Canadians is that, in general, those providing financial advice do not have an incentive to recommend index funds. Unlike actively managed mutual funds, index funds do not pay commissions. When many financial advisors earn their income based on commission, asking them what they think about index funds is like asking the butcher if you should eat salad for dinner. Try as your financial advisor might, there is no way to refute the evidence. The simple investment strategy of owning low-cost index funds is the smartest thing that you can do with your money.

It’s not your fund manager, it’s you.

Actively managed investment strategies are not inherently bad, they just introduce a different kind of risk to the investment experience. A well-diversified passive investor chooses to own the market as a whole, taking on market risk. An active manager is making a promise to not own the market as a whole, but to instead select a subset of securities within the market that they believe will perform better than the market. The additional risk added by not owning the market as a whole is called active risk.

Active managers themselves are not bad people. They will likely work extremely hard to research securities and trends in their effort to deliver above-market returns. The problem that active managers have is that, statistically, it is extremely unlikely that they will be able to deliver on their promises. It is by no lack of effort or resources, but simple mathematics. Active investors invest in the market. In aggregate, the average return of all active investors will be the return of the market, less their fees. Based on this simple arithmetic, less than half of active managers should be expected to outperform the market after their fees.

Further to this, we know empirically that in any given year a disproportionately large portion of market returns come from a small number of the stocks in the market. This makes outperforming the market a greater challenge as it requires the identification of the relatively small number of stocks that can drive outperformance.

Fund performance data backs these assertions up. As at June 2016, the S&P SPIVA Canada Scorecard shows that only 28.77% of Canadian domiciled Canadian Equity mutual funds have outperformed their benchmark index (S&P/TSX Composite) over the trailing five-year period. In the Canadian domiciled US Equity mutual funds category, 0.00% of actively managed funds were successful in outperforming their benchmark index (S&P 500 in CAD) over the trailing five years.

This information is available to everyone, but, based on the dollars invested in actively managed funds compared to passive index funds, most Canadians continue to invest their money in actively managed strategies. The decision to invest this way is either driven by a lack of information, or greed. In either case, when Canadian investors inevitably suffer from poor investment performance and high fees, they are themselves as much to blame as anyone else.

Original post at pwlcapital.com

Tracking error is not a risk, you are

Research has shown that small cap, value, and high profitability stocks have higher expected returns than the market. They also exhibit imperfect correlation with the market. Building a portfolio that tracks the market, and then increasing the portfolio weight of small cap, value, and high profitability stocks increases the expected return and diversification of that portfolio. From a human investor’s perspective, the problem with higher expected returns is that they are expected, not guaranteed. And that imperfect correlation? It looks great on paper, but it means that when the market is up, the portfolio might not be up as much, or it might even be down. Performance that is different from a market cap weighted index is called tracking error. For the investor comparing their performance to a market cap weighted benchmark, negative tracking error can be unnerving, especially when it persists for long periods of time.

But tracking error is not risk. Risk is the probability of not achieving a financial goal. Diversification is well-established as a means to reduce risk, but it does not result in higher returns at all times. When a globally diversified portfolio underperforms the US market, it is not a reason to forget about International stocks. When stocks underperform bonds, as they did in the US between 2000 and 2009, we do not abandon stocks. Dismissing small cap and value stocks after a period of underperformance relative to the market is no different. They are factors that increase portfolio diversification and expected returns, leading to a statistically more reliable investment outcome. This remains true through periods of underperformance.

The real risk is investor behaviour. Think about enduring portfolio underperformance relative to the market for ten years or longer due to a small cap tilt. You made a conscious decision to tilt the portfolio based on the academic evidence, but there are no guarantees of outperformance. If an investor chooses to abandon their tilted portfolio after a period of underperformance, it is akin to selling low. If they subsequently invest in a market cap weighted portfolio, they are selling low and buying high. That increases the probability of not achieving a financial goal. That is risk.

We do not know how different asset classes will perform in the future. You may always wish that you were overweight US stocks before the US outperformed or underweight small caps before small caps underperformed. Hindsight is pretty good. Looking forward, all we can reasonably base objective investment decisions on is the academic evidence. The evidence indicates that, over the long-term, stocks can be expected to outperform bonds, small stocks can be expected to outperform large stocks, value stocks can be expected to outperform growth stocks, and more profitable stocks can be expected to outperform less profitable stocks. Tilting a portfolio toward these factors is expected to achieve better long-term results, but it will almost definitely result in tracking error relative to the market.

Bad investor behaviour due to tracking error is a real risk that needs to be managed in portfolio construction. If it can be managed, the door is opened to a statistically more reliable long-term investment outcome.

Original post at pwlcapital.com

Should you make RRSP withdrawals in a no-income year to contribute to your TFSA?

This common question usually arises when one spouse has retired while the other is still working. The spouse that has retired has no income, and they see these years as a good opportunity to make RRSP withdrawals before CPP income and RRIF minimums bump them up into a higher tax bracket. Knowing that you can earn up to $11,474 of income without paying Federal tax, it seems like an obvious decision. Take $11,474 out of the RRSP at a 0% tax rate, contribute it to your TFSA, and when you take it back out of the TFSA in the future, you won’t pay any tax. Seemingly the perfect move.

As with many things in personal finance, this is more complicated than it seems. In any year that you have no income, your spouse is able to claim something called the spousal amount on their tax return. It’s kind of like that $11,474 that you can earn tax-free transfers to your spouse if you have no income in a given year. This applies at both a Federal and Provincial level, though the amount is smaller at the provincial level. The result is a Federal tax credit of $1,721, and a provincial tax credit of $429 – that reduces the amount of income tax that your spouse has to pay by $2,150. On top of that, on $11,474 of income, you would still owe $74 of provincial tax.

Let’s say that your RRSP has $11,474 in it and you decide to leave it there, earning 5%. Your spouse has also saved $2,150 in tax, which we can deposit in a TFSA, also earning 5%. Five years later the RRSP is worth $13,497, and the TFSA is worth $2,703. Now it’s time to make an RRSP withdrawal to supplement income. We will say that income is taxed at 30%, and we are below the threshold for OAS claw-back. Withdrawing the full $13,497 results in an after-tax value of $9,763. The total after-tax combined value of the RRSP and TFSA $12,466.

Alternatively, let’s say that you decide to take the $11,474 in your RRSP as income. It is your only income source for the year. We will ignore withholding tax on the RRSP withdrawal. The value of the RRSP drops to $0, and the TFSA is worth $11,474. With the loss of the spousal credit, your spouse now has to pay an additional $2,150 in tax, and you owe $74. We will deduct these amounts from the value of the TFSA, leaving a balance of $9,250. After five years at 5%, this is worth $11,243.

It can be seen from the calculations that we were better off leaving the money in the RRSP. However, this changes if we factor in OAS claw-back. When your income is above a certain threshold, you lose $0.15 of your OAS pension for every dollar that your income exceeds that threshold. The number is $73,756 in 2016, but it is indexed each year, so we do not know what it will be five years from now.

If we run the same two scenarios again with OAS claw-back factored in, assuming that every dollar of RRSP income will trigger OAS claw-back, leaving money in the RRSP becomes less favourable. OAS claw-back will remove an additional $2,092 from the equation, dropping the value of the RRSP and TFSA to $10,374 in the case of leaving the money in the RRSP. The scenario where we moved money from the RRSP to the TFSA is not affected by OAS claw-back because TFSA withdrawals are not taxable income.

If there is no OAS claw-back, we prefer to leave the funds in the RRSP in a no-income year. If OAS claw-back will be a factor, moving money from the RRSP to the TFSA can be a good strategy. This leaves us with two unknowable variables: what will your taxable income be in retirement, and what will the threshold for OAS claw-back be at that time. Making an RRSP withdrawal in a low-income year is not as obviously beneficial as it seems.

Original post at pwlcapital.com

Spotting subtle conflicts of interest with your financial advisor

In Canada, it is currently up to the investor to ensure that their interests are truly being put first when they are receiving investment advice. Most Canadian financial advisors are held to a suitability standard, rather than a best interest standard – meaning that as long as their advice is suitable, it does not have to be in the best interest of the client. Conflicts of interest are generally subtle, and they are ingrained in the way that many Canadian financial advisors do business. I often hear disbelief when I explain to someone that the advice they have received was likely influenced by an incentive (commission) for the advisor. Financial advisors do not generally have malicious intent, but they are often in a situation where the nature of their compensation puts their interests at odds with the interests of their clients.

A financial advisor licensed to sell mutual funds might receive 1% per year on the investment assets that they manage. However, rather than earn 1% throughout the year, the advisor has the option of generating a 5% up front commission at the time that they invest a new client’s assets, plus 0.5% per year ongoing. This is referred to as a deferred sales charge (DSC) or back end load. The catch for the client is that only funds with high management fees offer the DSC form of compensation for the advisor. Low-cost index funds and ETFs do not offer large DSC commissions for financial advisors. We know, from academic research, that fees have been the best predictor of fund performance through time, but most financial advisors are oblivious to the fact that high fee products are likely to do more harm than good for their clients. Their heads are full of attractive sales pitches and compensation structures from fund companies instead of the academic evidence that should be driving decisions in the client’s best interest. Any time a financial advisor mentions DSC, low load, or back end load, it is a red flag. It means that the advisor is going to earn a large commission, and the client is going to be locked in to a high-fee fund for at least three years.

When receiving investment advice from a financial advisor that is only licensed to sell insurance, the investment vehicle that they are likely to recommend is a segregated fund. Segregated funds are insurance products that are effectively similar to mutual funds, with some insurance features. The insurance features usually include a death benefit guarantee, maturity guarantee, and the ability to assign a beneficiary for the assets on death. To pay for these features, segregated funds tend to have higher fees than mutual funds. The reality is that the features of segregated funds will usually be unable to justify their significantly higher fees. If a financial advisor is recommending segregated funds, it is likely because that is the only thing that they are licensed to sell, even if it may not be the best thing for the client. Any time an advisor is recommending segregated funds, it is important to understand exactly what their reasoning is, and why a mutual fund or ETF is not a better solution. If you ask the butcher what you should have for dinner, they are unlikely to recommend salad.

There are plenty of financial advisors in Canada who are good people with good intentions, and who are trusted by their clients. A significant portion of these financial advisors are in situations where their advice is naturally conflicted due to their compensation structure; they may not even be aware that they are giving conflicted advice. In my experience, the advisors giving conflicted advice have done their own version of due diligence (maybe something like finding funds with good past performance to justify higher fees) in order to rationalize the advice that they are giving, making it even harder for a client with limited investment knowledge to notice that something is not right. By looking out for DSC funds and segregated funds, and asking questions about them when they come up, investors are in a position to spot some of the most common conflicts of interest.

 Original post at pwlcapital.com

Smart beta is growing rapidly, but who’s reviewing the research?

Dan Bortolotti’s April 1st post about Dr. Molti Fattore’s data mined index strategy was an April Fool’s joke, but the beauty of the post was that it could have easily been true. Some ETF providers were likely drooling at the thought of a “factor lasagna” that they could package and sell for 0.75%.

Data around the average active managers’ failure to outperform a low-cost index fund has resulted in investors’ assets shifting into low-cost index funds. Market cap weighted index funds have quickly become commodities, resulting in the lowest fund fees in history. An S&P 500 index fund with a 0.05% MER was once an anomaly, and it is now an expectation. In an effort to differentiate their products, index providers have started producing factor-based research which can be implemented in smart beta index portfolios, or funds which have been designed to outperform a simple cap-weighted index by capturing a specific part of the market. Of course, a smart beta fund is no longer a commodity and will accordingly command a higher fee.

The problem with the rapid proliferation of smart beta products is that mashing a handful of back-tested factors together does not necessarily result in a robust portfolio. The research behind the factors needs to be impeccable, and the implementation of the research requires significant care and expertise.

Momentum and quality are two factors that have been showing up in smart beta and factor ETFs. The momentum premium has been well-documented but it does not have a sensible explanation, raising the question of whether it is likely to persist. Momentum as an investment factor also decays quickly, making it very difficult to capture without a high level of portfolio turnover. High turnover increases costs and erodes any premium that may have been available. This is an obvious challenge with implementation.

Quality, based on earnings variability, has presented a past premium. However, when profitability is controlled for unusual items and taxes on the income statement, the variability of profitability contains little information about future profitability. In short, the quality factor does not have significant explanatory power over returns compared to well-documented factors such as size, value, profitability, and investment, and it is not useful to add it as an additional factor in a portfolio.

There is a tremendous amount of data available about markets, and it is relatively easy to find patterns that appear to point to higher expected returns based on a factor. Implementing an investment portfolio based on this type of research requires significant due diligence to mitigate the risk that observed differences in returns have not simply happened by chance. An excellent example is the Scrabble score weighted index reported in this paper by Clare and Motson. They found that if they weighted an index based on the Scrabble score produced by the ticker of each stock, they significantly outperformed a market cap weighted index. The Scrabble factor is, of course, not reliable data, but not all poorly thought out smart beta strategies will be so easy for investors to spot.

Original post at pwlcapital.com

The TFSA is not a Toy

It may be a flaw in the name. The government-intended use of the registered retirement savings plan is clear, retirement, but the tax free savings account is less commonly viewed as a long-term savings vehicle. I often meet investors who are using their TFSA to trade individual securities; the TFSA is their ‘play’ account. They are likely acting under the influence of their own overconfidence bias, imagining the large tax-free profits that they are going to make when their bet on a stock pays off, and not considering the significant negative consequences of taking unrecoverable losses within the TFSA.  An unrecoverable loss occurs when a security loses its value and never recovers, something that can easily happen when trading individual securities.

Something lost, nothing gained

If a stock picker loses on a bet in a taxable investment account, they are able to claim a capital loss which can be used to offset a future capital gain, dampening the blow of the loss. When losses are taken within the TFSA, this is not the case. Just as capital gains are not taxed in the TFSA, capital losses cannot be claimed. Assuming an investor is taxed at the highest marginal rate in Ontario in 2016, and they have taxable capital gains to offset, a $1,000 capital loss is worth about $268 in tax savings. Losing out on this tax savings makes an unrecoverable loss in a TFSA about 37% more damaging than an unrecoverable loss in a taxable account.

It’s all fun and games until someone loses their TFSA room

Any amount withdrawn from the TFSA generates an equal amount of new room the following calendar year. For example, if a $5,500 TFSA contribution was invested and grew to be $6,500, the full $6,500 could be withdrawn before December 31 and $6,500 of new room would be created on January 1 of the following year. Conversely, in the event of an unrecoverable loss, the amount of the loss will permanently reduce available TFSA room. If a similar $5,500 investment in the TFSA decreases in value to $4,500 and never recovers, there is only $4,500 available to be withdrawn, and the TFSA room has suffered a permanent decrease.

Losing a bit of TFSA room may seem trivial, but consider that $5,500 invested in a well-diversified portfolio* held in a TFSA for 30 years would be expected to grow to about $34,000, while the same investment in a taxable account would be expected to grow to about $15,000 assuming the highest marginal tax rate in Ontario in 2016. A seemingly meaningless loss of TFSA room today has meaningful long-term repercussions.

Between the significant future value of properly used TFSA room, and the lack of recourse for losses in the TFSA, it is an especially risky account to gamble with.

*80% globally diversified equity, 20% globally diversified fixed income, 6.11% return comprised of 1.94% interest, 0.49% dividends, 1.84% realized capital gains, 1.84% unrealized capital gains, net of a 1% management fee.

Original post at pwlcapital.com

Don’t follow the crowd into cash

It’s easy to imagine that when markets are declining everyone is selling their stocks and hiding cash under their mattresses. Sensationalist news reports will often reference increasing cash balances as nervous investors rush for the exits. While this perception is common, it misses half of the story; for every seller there must be a buyer. Cash isn’t piling up everywhere while everyone waits on the sidelines. For each nervous seller running for the hills, there is a level-headed buyer capturing the equity premium.

When contemplating the action of selling investments to hold cash in anticipation of a market crash, one must consider the following:

Do you know more than whoever is on the other side of the trade? Someone is happily buying the securities that you are in a hurry to sell. In 1980, 48% of U.S. corporate equity was held directly by households, and by 2008 that number had dropped to 20%*, meaning that the someone buying your securities is likely a skilled professional at a large institution; do you know something they don’t?

When are you going to get back in? Markets deliver long-term performance in an unpredictable manner. Over the 264 months from January 1994 – December 2015, a globally diversified equity portfolio returned 8.51%** per year on average. Removing the five best months reduces that average annual return to 6.46%. That is a 24% reduction in average annual returns for missing 1.9% of the months available for investment. Peter Lynch famously stated "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."

Should you have been in the market to begin with? If you need your cash in the short-term, it probably shouldn’t be invested in stocks and bonds. If a portfolio has been properly structured to meet a specific financial goal, it should remain in the market regardless of the market conditions. Portfolio volatility can be controlled by selecting an appropriate mix of stocks and bonds, not by jumping between stocks and cash.

A positive investment experience is largely dictated by discipline. There is no evidence that market timing results in better returns, and plenty of evidence that it is detrimental. While it may sometimes seem like everyone is going to cash to avoid a downturn, they’re not. Those choosing to go to cash are effectively being exploited by those taking a disciplined approach, rebalancing into stocks when stocks are declining.

*Investment Noise and Trends, Stambaugh http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2374103

**Dimensional Returns 2.0

Original post at pwlcapital.com

Canadian investors are slow to adopt evidence-based investing

It is becoming common knowledge that Canadians pay the highest mutual fund fees in the world, and are often receiving advice from commissioned sales people selling expensive actively managed mutual funds rather than fiduciary financial advisors acting in their best interest. Index funds and passive investing have gone mainstream on Canadian personal finance blogs and media outlets, giving the impression that we are becoming sensible investors. The data tells a different story.

In 2008, 6.9% of Canadian mutual fund and ETF assets were invested in passive vehicles, compared to 21% of U.S. assets. At the end of December, 2015, Canadians’ passive investment assets had increased to 12% , while passive assets in the U.S. had climbed to 32%. In the U.S., the market share of passive investment assets has been increasing each year by an average of 1.75%, while in Canada the passive market share has been flat since 2013, and increased by an average of only 0.65% per year since 2008.

Estimated Canada & U.S. Market Share of Passive and Active Funds 2008-2015

Passive investment vehicles in Canada have seen positive net inflows each year since 2008, while flows into active funds have been much more volatile with negative flows in 5 of the last 8 years. The steady flows into passive funds, and the volatility of flows into active funds, support the idea that a passive, evidence-based investment philosophy fosters investment discipline while active management results in performance-chasing behaviour. In 2015, active funds in Canada attracted nearly $15B of assets, while passive funds attracted $8B. Like in Canada, the U.S. has seen consistent positive flows into passive funds, and volatility in active fund flows. In 2015, U.S. investors extracted $207B from active funds, while pouring a near-record $414B into passive funds.

Estimated Canada & U.S. Net Fund Flows 2008-2015 ($ Billions)

The overall trend is that while Canadians are adding assets to passive funds, they are doing so at a much slower pace than Americans. It is possible that this is due to the rise in the Registered Investment Advisor in the U.S.; an RIA is registered with the SEC, is fee-based, and has a fiduciary duty to clients. RIAs tend to use more passively managed investment vehicles. In Canada, the vast majority of investment fund assets are in mutual funds, and the vast majority of mutual fund assets are in commission-based actively managed funds. Most financial advisors in Canada are not legally obligated to act in the best interest of their clients, and their recommendations may be tainted by the need to earn commissions or meet sales targets. Index funds and other low-cost vehicles do not pay commissions.

Original post at pwlcapital.com

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