What does it take to become a financial advisor?

Have you ever wondered what qualifies someone to use the title Financial Advisor? The short answer is nothing - Financial Advisor is not a regulated title. Anyone is free to use it.

Most of the people that do use the financial advisor title are licensed by a provincial regulator to sell certain products. They might be licensed to sell insurance, mutual funds, or stocks and bonds. The licensing process differs depending on the products that the advisor is able to give advice on. Some licenses are easier to obtain than others, and it’s not always easy to tell who is licensed to sell what.

Many so-called financial advisors are only licensed to sell insurance products. For the unwitting investor, this will not always be immediately clear. An insurance agent is usually able to sell life and health insurance, segregated funds, and annuities. Some of these products can be sold as investments, but they come with hefty fees, and will often result in penalties if you want your money back.

An insurance agent gets paid when you buy an insurance product, so they are motivated to sell insurance products. Getting an insurance license requires completing a training course, passing a closed book exam, and obtaining sponsorship from an insurance company.

There is nothing wrong with being licensed to sell insurance. But when you are seeking financial advice, you might want to know that your advisor has more qualifications than a license to sell you insurance.

Another common license that a so-called financial advisor might have is a license to sell mutual funds. Similar to an insurance license, a mutual funds license limits the advisor’s tool box. Mutual funds can be great in some cases, but the vast majority of the mutual funds sold in Canada have high fees and, on average, returns that trail the market.

Getting a mutual funds license involves one exam, and a period of supervised activity. The licensing process for mutual fund salespeople is fine, but it is important to understand that the license is for selling mutual funds, and that’s it. If you are seeking out financial advice, a license to sell mutual funds may not be a sufficient qualification.

The most challenging form of financial licensing to obtain is the securities license. This license permits giving advice on mutual funds, stocks, bonds, and ETFs. Obtaining this license requires passing three exams, undergoing a period of supervised training, and completing a 30 month proficiency course on wealth management. This is a little bit more robust, but it is still just a license to sell securities.

Someone who is licensed to sell securities can take their registration a level higher by becoming a Portfolio Manager. Unlike financial advisor, Portfolio Manager is a regulated title - it can’t be used by just anyone. A Portfolio Manager has to meet a 5-year experience requirement, and have earned either the Chartered Investment Manager or Chartered Financial Analyst designation. Both of these designations require hundreds of hours of study in order to pass multiple exams.

Between the experience and education requirements, the Portfolio Manager is actually in a position to offer financial advice, rather than just sell products. They are also legally required to act in the best interest of their clients, which is not the case for the other licensing categories that I have mentioned.

Separate from a license to sell or recommend any type of product, a Certified Financial Planner is someone who has passed multiple exams and met a professional experience requirement. Many Certified Financial Planners may also be licensed to sell some type of financial products, but it is not a requirement.

So, what does it take to be a financial advisor? Technically, nothing. But if you are a person seeking financial advice, it’s a good idea to look for a Portfolio Manager, or someone who has earned the Chartered Investment Manager, Chartered Financial Analyst, or Certified Financial Planner designation.

But my advisor has shown me lots of funds that outperform.

Are you seeing your investment returns through rose-colored glasses? Most investors are … and it’s often because their advisor has provided them with a skewed view.

Besides, colorful past performance doesn’t tell you much about your future prospects anyway. Let’s bring in a little common sense, and put investment performance in proper perspective.

Since at least 1962, a growing body of evidence has informed us that most incidents of investment outperformance are probably luck, not skill. Still, advisors pursuing active investing continue to trot out exceptional past performance as a reason to pile into past winners (especially when there’s a nice commission in it for them).

Even if we ignore the random nature of most outperformance, there’s another reason to be wary of past results. There’s a sneaky little thing called “survivorship bias,” causing the funds that “make it” to appear larger than life.

Check out today’s CSI and subscribe here if you want to get wise to these and other tricks of the trades.

Original post at pwlcapital.com.

Do I need downside protection?

There’s no doubt about it: Losing money hurts. Even the fear of losing money is unpleasant. The financial industry is well aware of this, and sends out its sales force to peddle a comforting idea. It’s called “downside protection.” It’s supposed to allow you to continue enjoying the market’s expected returns while simultaneously dodging its correlated risks.

Or so the story goes. But when it comes to principal protected notes and other forms of downside protection, it’s usually not your interests being protected. Common sense tells us why.

The truth is, market risks and expected future returns are related. If you don’t take any risk, you should expect very low returns. This is why long-term investors are better off minimizing their costs, capturing the returns of the global markets using low-cost index funds, and controlling their level of risk through their mix between stocks and bonds.

The rest of any other sales pitch is costly smoke and mirrors. Want to see behind the subterfuge? Watch today’s CSI, and I’ll walk you through the numbers. And subscribe here if you’d like to remain in the clear moving forward.

Original post at pwlcapital.com.

Why Is It So Hard To Beat the Market? part II

In my last video, I talked about some of the challenges that active managers face in outperforming the market. It boils down to their relatively high fees, and intense competition from other managers.

There is another, less obvious reason that active managers have so much trouble beating the market. We know empirically that a small number of stocks in an index tend to drive the performance of that index. So trying to select stocks in an index dramatically increases the probability of underperforming. When trying to pick stocks in an index in an effort to beat the index, the likelihood of underperforming is much greater than the likelihood of outperforming.

If we look at data on market returns, the basis of this research is clear. Most of the market’s returns come from a small number of stocks. Let’s look at an example using data from global stock markets between 1994 and 2016.

Over that time period, global stocks returned an average of 7.3% per year. Not bad at all. If we remove the top 10% of stocks in that global market portfolio, the average annual return drops to 2.9%. Excluding the top 25% results in the average annual return dropping to a much less exciting -5.2%. Of course it would be great if active managers could identify only the top performing stocks, but we have seen the data around their ability to do so - it doesn’t look good.

We know that, in most cases, active managers’ performance can be attributed to luck rather than skill. A lucky manager has been fortunate to randomly select stocks that have done well. In their paper, Heaton, Polson, and Witte lay out a very simple example explaining the challenge that active managers face based on what we know about market returns.

If we have an index consisting of five stocks, and assume that four of them will return 10% and one will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of either one or two of those stocks, 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 stock portfolio. In this example, the average return of the stocks in the index, and all active fund managers, will be 18% (before fees).

Just like we would expect, all active managers together get the return of the market. But when we look at each portfolio individually, two-thirds of the actively managed portfolios will underperform the index due to their not holding the 50% returning stock, which is always included in the index.

Closet indexing is the result of active managers owning the market like an index fund, but charging active management level fees. Some active managers will pitch themselves as having high conviction, or high active share, meaning that they are very different from the index. The implications of this research are that even if you are able to find an active manager that is truly active and has low fees, there is a relatively low probability that they will be able to deliver market beating performance. With this high probability of underperformance, finding a skilled manager, which we already know to be beyond challenging, becomes increasingly important.

Fees typically take the blame for the systematic underperformance of active managers, but this research demonstrates another big hurdle that needs to be overcome to beat the market. If active managers miss out on the relatively small proportion of top performing stocks, they are at significant risk of trailing the market.

In my next video, I will be talking about downside protection, one of the most prolific sales pitches in the investment management industry. Do index funds protect your downside? Join me to find out.

My name is Ben Felix of PWL Capital and this is Common Sense Investing. I’ll be talking about this and many other common sense investing topics in this series, so subscribe and click the bell for updates. I’d also love to hear from you as to what topics you’d like me to cover.

Original post at  pwlcapital.com .

Why Is It So Hard To Beat the Market?

The data is in and, for fund managers who are still trying to “beat” the market, the numbers are still not on their side. As talented as active players often are at slicing and dicing the data, and as mightily as they may try, there’s considerable evidence that passive players continue to have the last laugh. Why is that? As usual, it has a lot to do with common sense.

It begins with simple math. Canada’s particularly high fund fees (on average) tend to add up fast. The challenge is further muddied by a tendency for investors to mistake lucky winning streaks as reliable results. Finding managers who have outperformed their highly competitive peers in the past – and will continue to do so moving forward – is far closer to a gamble than a guarantee.

Bottom line, after costs, it’s incredibly difficult to out-smart highly efficient capital markets that represent the collective wisdom of all market players, of all stripes. There are additional compelling reasons this is so. For example, have you ever heard the term “closet indexer”? To find out what that is, subscribe to Common Sense Investing and stay tuned for my next post.

Original post at pwlcapital.com

Why Aren’t More Canadians Switching to Index Funds?

First, the good news: At the end of 2016, 11.3% of Canadians’ investment fund assets were held in index funds and similar passively managed products. That’s a start. But compared to our U.S. neighbors at 34% of the same, we’re slow on moving away from over-priced, underperforming actively managed funds and into index funds.

Why are we lagging behind? In large part, I believe it’s because your banker or commission-based advisor is often failing to recommend the solutions that are in your best interests. Their complex compensation models aren’t encouraging them to sit on the same side of the table as you. And regulators aren’t sufficiently requiring them to do so.

 For indexing to become the same movement here that it’s become in the U.S., we’ve got to talk about simple fees versus complex commissions. We need to differentiate fiduciary from merely suitable advice. We need to continue promoting clear versus confusing cost disclosures. 

Most of all, we need people like you and me to recognize there’s a better way, and insist that we get it. Common sense? You bet. To join our movement, check out today’s video, subscribe to Common Sense Investing, and send me your own questions to address.

Original post at pwlcapital.com

Introducing: Common-Sense Investing with Ben Felix, MBA, CFA

The truth is easier to keep track of than a pack of lies. That’s just common sense. So is most of investing, even though many in the financial industry would have you believe otherwise. To help you separate financial facts from sales-oriented fiction – and then invest accordingly – I am pleased to host PWL Capital’s newest YouTube series: Common-Sense Investing.

As the name implies, you don’t need to chase fancy, complex strategies to invest safely and sensibly toward your financial goals. Nor should you let the forces found on Wall Street and Bay Street try to convince you otherwise.

Instead, by understanding a thing or two about the science of sound investing, you can build a bulwark of basic knowledge, and learn how to separate common sense from nonsense. In this series, I’ll focus on straightforward answers to your critical questions, such as:

• Index funds seem so simple. Can they really outperform a more active approach to investing?
• Is it really that hard to beat the market?
• What are some of the biggest market myths out there?
• How can you distinguish best-interest advice from veiled sales pitches?

While you don’t need a science degree to make good use of the science of investing, my own studies in mechanical engineering have helped me ground my financial career in logic and evidence. I’ve combined that with an MBA, being a CFA charterholder, and plenty of hands-on experience as an associate portfolio manager at PWL Capital. Plus, any advice I offer will be backed by peer-reviewed academic research, solid data, and clear logic.

Of the myriad ways people try, but often fall short of making money in today’s markets, there is one way that will never lose its luster: investing with common sense. Are you ready to learn more? Subscribe to “Common-Sense Investing” (and click on the bell). And if you’d ever like to see me take a common-sense approach to one of your questions, send it over.

Original post at pwlcapital.com

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