Should you buy Bitcoin?

In my last video I told you about Bitcoin. What is it? Bitcoin is a relatively new thing called a cryptocurrency. Some people think that you can compare it to a traditional currency, or gold, while others describe it as a new asset class. Whatever it is, excitement about its potential for future adoption has lead to a rapid increase in price, which has a lot of people wondering if they should be buying in.

How Bitcoin is going to perform in the long-term is anyone’s guess. Without long-term data on Bitcoin, or any other cryptocurrency, it is not possible to make an evidence-based decision about investing in it.

Let’s look at Bitcoin from the perspective of it being a currency. Are currencies good investments? Traditional currencies do not have a positive expected return. In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that over the last 115 years, currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another.

Bitcoin has also drawn comparisons to gold. Unfortunately, that does not mean that you should buy bitcoin. The evidence for gold as an investment is not very good. Some people argue that gold is an inflation hedge, and that bitcoin could be the same. In a 2012 paper, Claude Erb and Campbell Harvey found that while gold has been an inflation hedge over the very, very long-term, “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

So if Bitcoin is a currency, it probably isn’t something that you want to invest in. The price volatility of currencies, and gold, does mean that while they do not have a positive expected return as a long-term asset, you may still be able to profit by trading them - buying low and selling high as the price fluctuates. Of course, the problem with trading currencies is that they are random and volatile, leading to extremely unreliable outcomes.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. Much like stocks and bonds currently serve public companies, Ludwin writes that cryptocurrencies are assets that serve decentralized applications. A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party.

While decentralization sounds like a good thing, there is a catch. By nature of being decentralized, decentralized applications are slower, more expensive, and less scalable. They also have worse user experience, and volatile and uncertain governance. When a service is completely decentralized, there is no customer service center. There is no help line. There is no way to get your bitcoin back if you lose it. In contrast, if you damage your US dollars in a fire, you can bring the scraps to the US government and they will try to identify the bills and reimburse you. That type of centralized service is lost with decentralization.

Ludwin explains that bitcoin isn’t best described as “Decentralized PayPal.” It does not compare to PayPal in terms of user experience or efficiency. It’s more honest to say it’s an extremely inefficient electronic payments network, but in exchange we get decentralization. The obvious question follows: who cares about decentralization enough to put up with a slow, inefficient, and inconvenient method of payments? The most obvious answer is people who want their transactions to remain anonymous and who do not want to be censored by, say, a government.

Based on Ludwin’s arguments for bitcoin as a separate asset class that serves a decentralized payments application, its value will be derived from the adoption of Bitcoin as a means of exchange. Buying bitcoin in hopes of benefitting from its widespread adoption, keeping in mind the very specific type of person that would value bitcoin enough to put up with its shortfalls, would be very speculative.

In an interview with Coin Telegraph, Eugene Fama, the father of modern finance, explained he believes that bitcoin only has value to the extent that people will accept it to settle payments. He explains that if people decide they don’t want to take it in transactions, it’s value is gone. When Fama’s interviewer tells him that bitcoin also derives value from its censorship resistance component, Fama says “I guess that for a drug dealer that has a lot more value. But otherwise, I don’t see the big value about that.” While Fama’s answer may seem flippant, it touches on the same point that both that Ludwin made - Bitcoin’s price depends on its adoption.

So why has bitcoin’s price seen such a sharp increase? It's safe to say that the future supply and demand of bitcoin are highly uncertain, but the expectations of future supply and demand are factored into the current price. Each time someone pays a little more to own a bitcoin, they are injecting their future expectations into the price. The recent rapid price increase is due to people’s expectations that bitcoin will be widely adopted in the future. The fact that the number of bitcoins can reach an upper limit is an often-used argument that bitcoin will retain its value over the long-term. That may be true in isolation, but the future supply of cryptocurrencies is a big unknown. New cryptocurrencies have emerged that attempt to improve on bitcoin's design, potentially reducing the demand for bitcoin as a payment system.

Bitcoin is either an inefficient currency in the early stages of adoption with plenty of disadvantages and one big advantage over traditional currencies, or its a new type of asset that serves a decentralized payments application. In either case, the long-term value of bitcoin will mainly be derived from from its adoption as a mainstream currency by the people who value decentralization enough to put up with all of the downsides.

There is no doubt that bitcoin is based on an exciting new technology with potentially widespread applications. Investing in bitcoin is a bet that this technology will meet or exceed the expectations that current market participants have for it. Just like I would be wary about investing in gold, an individual stock, or a specific currency, I would be very hesitant about buying bitcoin. And I’m not the only one thinking that way. Warren Buffett, one of the greatest investors in history, recently said "In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending,"

If you must buy bitcoin, keep in mind that its market capitalization is still less than 1/3rd of 1% of the global market capitalization of stocks. You might consider allocating bitcoin to your portfolio accordingly.

What is Bitcoin?

It is next to impossible to avoid hearing or reading about bitcoin. Within the past decade, it has gone from being a fringe idea proposed in a paper written by a mysterious author, to being a mainstream technology that some people are treating as a new asset class. Bitcoin is now getting attention from the media, individual investors, and even large financial institutions.

As bitcoin continues to surge in both popularity and price, investors will naturally wonder if they should own some. This is an important question to ask, but to frame the decision about owning bitcoin, we first need to know what Bitcoin is.

Bitcoin is a cryptocurrency. Cryptocurrencies are a relatively new technology that has emerged within the past decade. Unlike traditional currencies, cryptocurrencies do not rely on a central issuing body or sovereign government. Instead they rely on blockchain technology. The blockchain is an open, distributed ledger that records transactions in a way that is public, verifiable, and permanent. While there are now countless different cryptocoins available, Bitcoin was the first, and it continues to be, by far, the largest cryptocurrency by market capitalization.

You can buy bitcoins using traditional currencies, or you can mine them. Mining means receiving newly created bitcoins in return for using your computer power to compile recent transactions into new blocks of the blockchain by solving a complex mathematical puzzle. There is a finite supply of bitcoin, with a total of 21,000,000 that can be mined. More than 16,000,000 of those are currently in existence.

For a long time, cryptocurrencies were pretty obscure, and mostly popular within a very niche crowd. More recently,  the sharp increase in the market value of bitcoin and other cryptocurrencies like Ripple, Litecoin, and Ethereum has contributed to intense attention from the media and investors.

Being such a new technology, it is challenging to draw evidence-based conclusions about what bitcoin is. We can try to work around this issue by finding things with longer histories that bitcoin might share characteristics with. On his blog, Aswath Damodaran, a professor of finance at NYU, explains that things can fall into one of four groups: a cash flow generating asset, a commodity, a currency, or a collectible.

Damodaran goes on to explain that Bitcoin is not an asset, since it does not generate cash flows. It is not a commodity, because, at least for now, it is not raw material that can be used in the production of something useful. This leaves currency or collectible, and of the two it is most likely that bitcoin could be classified as a currency.

A successful currency needs to be three things: a unit of account, a medium of exchange, and a store of value. As a unit of account, bitcoin is as good as anything. As a medium of exchange, bitcoin is still far being accepted as mainstream for transactions, and where it is accepted transaction costs are high. Bitcoin has struggled as a store of value due to its significant price volatility. While bitcoin has room to improve as a currency, we might be able to look at it through this lens.

There is one other currency in particular that draws comparisons to Bitcoin: gold. Gold would be considered a currency, not a commodity, because its value comes from its currency-like functions, not its use as a raw material to produce something useful. Like Bitcoin, the amount of gold that can exist is finite. As a currency, gold also has high transaction costs, and a volatile price. It seems like Bitcoin could be a digital substitute for gold.

But not everyone agrees.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. He does not think that cryptocurrencies should draw comparisons to traditional currencies because their use case is so much different. Ludwin explains that in much the same way that that stocks and bonds serve public companies, cryptocurrencies serve decentralized applications.

A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party. The growth and acceptance of decentralized applications could mean enormous growth in the value of the cryptocurrencies that serve them.

Damodaran believes that Bitcoin could take one of three paths in the future. It could become the global digital currency, in which case its high price could be justified. It could become like gold for Millennials. A seemingly safe place for those who have lost faith in centralized authority. In this case, the price would fluctuate much like gold does. Lastly, it could prove to be the 21st century tulip bulb, a comparison to a speculative asset that soared in the sixteen hundreds before collapsing.

I have just told you that bitcoin can draw comparisons to traditional currencies like gold, but it could also end up being a whole new asset class if decentralized applications take off. Or it could fizzle out. Interesting, right? I know I haven’t answered what you’re really wondering. Should you invest? I will be talking about that in my next video.

Do active managers really protect your downside?

Active money managers want you to believe that they can act defensively to mitigate the downside of stocks during a market downturn. This is one of the ways that active managers may try convince you that index funds are too risky. No investor likes the idea of passively sitting by while their portfolio falls with the market.

Investing in index funds means accepting the market through good times and bad, but active managers claim that there is a better way. Should you listen to them?

An index fund will continue to own all of the stocks in the index regardless of the external environment, meaning that when stocks are falling in value, you will continue to own them, and your portfolio will fall in value. An active manager will claim that they can reduce your losses by making changes to the portfolio.

Remember that investing is a zero sum game. If one active manager is able to beat the market during a downturn, it means that another active manager is underperforming. This simple rule invalidates the claim that active managers will always be able to protect you when the market is falling.

Most actively managed funds underperform the market over the long-term, but active managers claim that in anticipation of a downturn they might sell some of the stocks in your portfolio to insulate you from the expected losses. You can always find active managers prognosticating the next market crash, and explaining what they are doing to prepare for it. Maybe they are holding cash, or only buying certain types of stocks.

If you can find an active manager that can offer protection in bad markets, that would truly be an advantage. The problem is that there is no evidence of the ability of active managers accomplish this consistently. During the 2008 US market downturn, 60% of actively managed US equity funds in the US outperformed the market. In the 1994 European bear market, 66% of funds were able to beat their benchmark. That seems promising. Better than a coin flip, anyway.

As promising as that may seem, a 2008 white paper from Vanguard looked at active manager performance during bear markets between 1973 and 2003. Of the 11 bear markets examined, there were only 5 instances where more than 50% of active managers outperformed. There is no evidence that active managers, on average, have been able to produce better performance than index funds in down markets.

Vanguard’s research did not stop there. The paper goes on to examine what happened to the funds that were able to outperform during bear markets in subsequent bear markets. The results showed that outperformance in one bear market had no statistical relationship to outperformance in other bear markets. This is an indication that the funds that did outperform were merely lucky as opposed to skilled. This result was corroborated in a 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns. They found that, on average, U.S. equity mutual funds do not demonstrate evidence of manager skill.

More recent research, again from Vanguard, examined the performance of flexible allocation funds in bull and bear markets between 1997 and 2016. Flexible allocation funds are able to change their allocations at will to try and time the market. During that period there were three bull markets and two bear markets. During bull markets, only between 31 and 36 percent of the funds were able to beat their benchmarks. The numbers were better in bear markets, with 65% of funds beating their benchmark in the 2000 to 2003 downturn, and 45% of funds beating their benchmark in the 2007 to 2008 downturn.

While active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets in this sample. The cost of active management is a heavy cost to carry for what might be a slightly greater chance at outperformance during bear markets. In the 10 years ending June 2017, only 8.89% of Canadian mutual funds investing in Canadian stocks were able to beat their benchmark index, and only 2.54% of Canadian mutual funds that invest in US stocks were able to beat their benchmark index.

Does income investing really increase your income?

In my last two videos I talked about high yield bonds and preferred shares. These are two alternative asset classes that investors venture into when they are seeking higher income yields. I told you why you might want to avoid those asset classes. Today I want to tell you why focusing on investing to generate income is a flawed strategy altogether, and why a total return approach to investing will lead to a more reliable outcome.

Investors often desire cash flow from their investments. There are blogs, books, newsletters, and YouTube channels dedicated to income investing. Income investing means building a portfolio of dividend paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain a desired lifestyle. The idea is that if you have enough income-paying securities in your portfolio, you will be insulated from market turbulence and can comfortably spend your dividends and coupon payments regardless of the changing value of your portfolio.

There is a perception that if you never touch your principal, you won’t run out of money. It seems like a fool-proof retirement plan. But is it, really?

Let me start off by saying that there is no evidence that dividend paying stocks are inherently better investments than non-dividend paying stocks. There are five factors that explain the majority of stock returns. Dividends are not one of these factors. For example, we know that if you gather up all of the small cap stocks in the market, they will have had higher long-term returns than all of the large cap stocks. Based on this, company size is one of the factors that explains stock returns. The same evidence does not exist for dividend paying stocks.

If they aren’t better investments, why do people like them so much? In a 1984 paper, Meir Statman and Hersh Shefrin offered some potential explanations for investors’ preference for dividends. If they have poor self control, and are unable to control spending, then a cash flow approach creates a spending limit - they will only spend income and not touch capital. Another explanation offered in the paper is that people suffer from loss aversion. If their stocks have gone down in value they will feel uncomfortable selling to generate income. On the other hand, they will happily spend a dividend regardless of the value of their shares.

As much as a dividend may seem like free money, the reality is that the payment of a dividend decreases the value of your stock. If a company pays twenty million dollars to its shareholders as a dividend, the remaining value of the company has to decrease by twenty millions dollars. The investor is no better or worse off whether the company that they invest in pays a dividend or not. This is known as the dividend irrelevance theory, which originated in a 1961 paper by Merton Miller and Frank Modigliani.

I have just told you that whether returns come from dividends or growth does not make a difference to the investor, but there is an important detail for taxable investors. There is no difference whether returns come from dividends or growth on a pre-tax basis. On an after-tax basis, the investor without the dividend is in a better position because they could choose to defer their tax liability by not selling any shares if they don’t need to cover any spending. The dividend investor is paying tax whether they spend their dividend or not. This is a big problem for an investor who does not need any income at that time.

About 60% of US stocks and 40% of international stocks don’t pay dividends. Investing only in the stocks that do pay dividends automatically results in significantly reduced diversification. Dividend investing can also lead to ignoring important parts of the market. There are plenty of great companies that do not pay dividends. Ignoring them because they do not pay a dividend, which we now understand is irrelevant to returns, is not logical. A good example of this is small cap stocks. An income-focused investment strategy will almost certainly exclude small cap stocks, few of which pay dividends.

Now, don’t get me wrong, dividends are an extremely important part of investing. One dollar invested the S&P/TSX Composite Price Only Index, excluding dividends, in 1969 would be worth $14.37 today. The same dollar invested in the S&P/TSX Composite Index, including dividends, would be worth $64.59. If you are investing in Canadian dividend paying companies, you also receive favorable tax treatment on your dividend income. You should want dividends - they are an important part of stock returns. But you should not want to focus on buying only stocks that pay dividends.

Dividend paying common stocks are an important part of a portfolio, but a dividend-focused portfolio leads to tax-inefficiency for taxable investors, poor diversification, and missed opportunities. A total-return approach, accomplished by investing in a globally diversified portfolio of total market index funds, results in greater tax efficiency, better diversification, and the ability to capture the returns that the market has to offer.

Why I prefer to avoid preferred shares (Alternative Investments, Part 2)

This is the second video in a multi-part series about alternative investments. In the first video in this series, I told you why high-yield bonds fall short on a risk adjusted basis, and should only be included in your portfolio in small amounts through a well-diversified low-cost ETF, if at all. If you haven’t watched it yet, click here. And BTW, I do not recommend high yield bonds in the portfolios that I oversee.

Alternative investments are generally sold on the basis of exclusivity to wealthy individuals. Warren Buffett said it best in his 2016 letter to shareholders: “Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice.”

In addition to high yield bonds, income-seeking investors may turn to preferred shares.

Preferred shares typically offer higher yields than bonds. They also have some tax benefits for Canadians who own Canadian preferred shares. While these benefits are attractive, preferred shares also come with additional risks and complexity that bonds do not have. Remember, risk and return are always related.

Preferred shares are equity investments in the sense that they stand behind bond holders in the event of bankruptcy. In a bankruptcy, debt holders would be paid first, followed by preferred shareholders, and then finally common stockholders. Typically, preferred and common shareholders will receive nothing in a bankruptcy. Where preferred stocks differ from common stocks is that they do not participate in the growth in value of the company. The return on preferred stocks is mostly based on their fixed dividend.

Unlike a bond, preferred shares do not generally have a maturity date. This makes them effectively like really long-term bonds. Unfortunately, fixed income with long maturities tends to have poor risk-adjusted returns. Long-term fixed income also exposes you to a significant amount of credit risk. Can the issuing company pay you a dividend for the next 50 plus years?

Like a bond, if interest rates fall, the price of perpetual preferred shares can increase. While this sounds good, the problem is that perpetual preferred shares typically have a call feature. If interest rates fall too much, the issuer will redeem the preferred shares at their issue price. The same thing can happen of the credit rating of the issuing company improves, allowing it to issue new preferred share or bonds at a lower interest rate. This creates asymmetric risk for the investor. They get the risks of an extremely long-term bond, but have their upside capped.

One of the most common types of preferred shares in the Canadian market are fixed reset preferred shares. These have a fixed dividend for 5-years, which is then reset based on the 5-year government of Canada bond yield plus a spread. Investors are able to accept the new fixed rate, or convert to the floating rate. This process continues every 5-years. In 2015, rate reset preferred shares dropped in value significantly, causing the S&P/TSX Preferred Shares index to fall 20% between January and September 2015. Hardly a safe asset class.

Preferred shares have some other characteristics that make them risky. A company is usually issuing preferred shares because they want to raise capital but are not able to issue more bonds. This could be because they can’t pile any more debt onto their balance sheet without getting a credit downgrade. Companies also have a much easier time suspending dividend payments on preferred shares, which they can do at their discretion, than they do halting bond payments, which would mean bankruptcy. These characteristics might cause an investor looking for a safe asset to think twice.

Enough negativity. Why does anyone invest in preferred shares? I’ve already mentioned the higher yields that preferred shares offer compared to corporate bonds, making them attractive to an income-oriented investor. Canadian preferred shares also pay dividends that are taxed as eligible dividends in the hands of Canadian investors. This might make preferred shares a good candidate for the taxable account of an investor that pays tax at a high rate. Preferred shares do also have returns that are imperfectly correlated with other asset classes, meaning that there can be a diversification benefit to including them in portfolios.

So, should you invest in preferred shares? For their few benefits, preferred shares have substantial risks. In Larry Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes that “The risks incurred when investing in preferred stocks make them inappropriate investments for individual investors.”

I do not recommend preferred shares in the portfolios that I oversee. In a 2015 white paper my PWL colleagues Dan Bortolotti and Raymond Kerzerho recommend that if you are going to invest in preferred shares, you should only use them in taxable accounts, limit them to between five and fifteen percent of your portfolio, and diversify broadly. They also emphasize that you should avoid purchasing individual preferred shares due to the complexity of each individual issue.

Do You Need Alternative Investments? Part I: High Yield Bonds

At a certain point, good old stocks and bonds might start to seem a little bit boring. There has to be more out there, especially when you start to build up substantial wealth. These other types of investments are often referred to as alternatives. They sound much more exciting and exclusive than stocks and bonds, and are typically sold as having higher potential returns or diversification benefits that plain old stocks and bonds can’t offer. As Warren Buffett explained in his 2016 letter to Berkshire Hathaway shareholders:

“In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”

Alternative investments are a broad category, so I have split this topic up into multiple parts. In Part One, I will tell you why high yield bonds don’t quite yield enough to justify their risks.

In our low-interest rate world, investors tend to seek out the opportunity to earn higher income yields from their investments. Two of the most common ways to do this are through high-yield bonds and preferred shares.

High yield bonds are riskier bonds with lower credit ratings and higher yields than their safer counterparts. Standard and Poors rates all bonds between AAA, the highest rating, and DD, the lowest rating, based on the bond issuer’s ability to pay back their bond holders. High yield bonds have a rating of BB or lower, defined by Standard and Poors as “less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial, and economic conditions.”

Remember that you typically hold bonds in your portfolio for stability. High yield bonds are too risky to serve this purpose. In fact, a 2001 study by Elton, Gruber, and Agrawal found that the expected returns of high yield bonds can mostly be explained by equity returns. In other words, high yield bonds contain much of the same risk as stocks. Only 3.4% of high yield bond issuers have historically been unable to pay back their bond holders, but when they are unable to pay, bond holders have typically recovered a little less than half of their investment.

It is true that, in isolation, high yield bonds have had high average returns in the past. However, including high yield bonds in portfolios has been less exciting. In a 2015 blog post, Larry Swedroe compared four portfolios, one with all of its fixed income invested only in safe 5-year treasury bonds, the other three with each an increasing allocation to high yield corporate bonds. He found that while the portfolios with high yield bonds did outperform by a narrow margin, between 0.2 and 0.5 percent per year over the long-term, they did so with significantly higher volatility than the portfolio containing only treasury bonds. On a risk adjusted basis, the high yield bonds did not add value to the portfolio.

In Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes “Investing in high-yield bonds offers the appeal of higher yields and the potential for higher returns. Unfortunately, the historical evidence is that investors have not been able to realize greater risk-adjusted returns with this type of security.” In his book Unconventional Success, David Swensen, the chief investment officer of the Yale Endowment, similarly denounces the characteristics of high yield bonds, writing that "Well-informed investors avoid the no-win consequences of high-yield fixed-income investing."

On top of all of this, high yield bonds are tax-inefficient. They pay relatively high coupons, which are fully taxable as income when they are received. As an asset that behaves similar to stocks, high yield bonds are a very tax-inefficient way to get equity-like exposure.

High yield bonds do have some proponents. Rick Ferri, a well-respected evidence-based author and portfolio manager, does include high yield bonds in his portfolios.

I do not recommend high yield bonds in the portfolios that I oversee. If you do choose to include high yield bonds in your portfolio, they should only make up a small portion of your fixed income holdings. Due to the risk of default and relatively low recovery rate, it is also extremely important to diversify broadly with a low-cost high-yield bond ETF. I would never suggest purchasing individual high yield bonds.

Should You Currency Hedge Your Portfolio?

There is no question that investing globally is beneficial. Diversification is the best way to increase your expected returns while decreasing your expected volatility. Diversification is, after all,  known as the only free lunch in investing. When you decide to own assets all over the world, you are not just getting exposure to foreign companies, but also to foreign currencies.

If you own an investment in a country other than Canada you are exposed to both the fluctuations of the price of the asset in its home currency, and the fluctuations in the currency that the asset is priced in. For example, if a Canadian investor owns an S&P 500 index fund giving them exposure to 500 US stocks, and the S&P 500 is up 10%, but the US dollar is down 10% relative to the Canadian dollar, then the Canadian investor will have a return of 0%.

To avoid the impact of currency fluctuations, some investors choose to hedge their currency exposure. If our Canadian investor had purchased a hedged index fund, eliminating their currency exposure, they would have captured the full 10% return of the S&P 500 index without being dragged down by the falling US dollar. Of course, the same thing could happen in the other direction, increasing returns instead of decreasing them.

Before I continue, I want to be clear that I am talking about adding a long-term hedge to your portfolio. Trying to hedge tactically, by predicting currency movements, is a form of active management which you would expect to increase your risks, costs, and taxes. Now, on with the discussion.

Multiple research papers have concluded that the effects of currency hedging on portfolio returns are ambiguous. In other words, with hedging sometimes you will win, sometimes you will lose, but there is no evidence of a right answer, unless you can predict future currency fluctuations. With no clear evidence, and an inability to predict the future, the currency hedging decision stumps many investors.

The demand for hedging tends to rise and fall with the volatility of the investor's home currency. If the Canadian dollar strengthens, investment returns for Canadian investors who own foreign equities will fall, which might make the investors wish they had hedged their currency exposure. While it may seem obvious that a hedge would have made sense after the fact, hedging at the right time is impossible to do consistently.

In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that between 1900 and 2015 real exchange rates globally were quite volatile, but did not appear to exhibit a long-term upward or downward trend. In other words, over the last 115 years currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another. This was demonstrated in Meir Statman’s 2004 study of US hedged and unhedged portfolios over the 16 year period from 1988 to 2003. The study concluded that the realized risk and return of the hedged and unhedged portfolios were nearly identical. One study

If there is no expected benefit to hedging your foreign equities in terms of higher returns or lower risk, why would you hedge at all?

It is always important to remember why we are investing. Most people are investing to fund future consumption, and most Canadians will consume in mostly Canadian dollars. Hedging against a portion of currency fluctuations might help investors capture the equity premium globally while limiting the risks to consumption in their home currency. It is typically not a good idea to hedge all of your currency exposure because because currency does offer a diversification benefit.

Well, it seems like we’re back to square one, trying to decide whether we should hedge or not. There is no evidence either way. You would not expect a difference in long-term risk or return from hedging. Currency hedging at least a portion of your equity exposure has the benefit of keeping some of your returns in the same currency as your consumption, but too much hedging removes the diversification benefit of currency exposure.

In the absence of an obvious answer, I think it makes sense to take a common sense approach. If you’re going to hedge, don’t hedge all of your currency exposure - I wouldn’t hedge more than half of the equity portion of your portfolio. If you don’t want to hedge, that is okay too. Remember that there is no evidence in either direction.

Whatever you choose to do, understand that there will be times when you wish that you had done something different. If the Canadian dollar rises, you might wish that you had hedged. If it falls, you might wish you were not hedged. At those times, the worst thing that you can do is change what you are doing. The best thing that you can do is pick a hedging strategy and stick with it through good times and bad.

Are too many people investing in index funds?

The idea of index funds was conceived in the 1970s, and received immediate support from some of the smartest academics and economists in the world at the time. Industry practitioners on the other hand, laughed at the idea. Index funds were even called un-American. Who wants to be average?

The first index fund that could be accessed by retail investors was launched by Vanguard in 1975. Despite the long-term existence of index funds, actively managed funds have completely dominated the investment fund market until recently. In the U.S., passive funds have doubled their market share since 2006 – increasing from 17% to 34% of the investment fund universe at the end of 2016. A similar trend has been present in Canada, with the market share of passive funds increasing from 6% in 2007 to 11% at the end of 2016.

People in general are becoming increasingly aware of fees and performance, and there is ever-mounting evidence that favors index investing as the most sensible approach. So what happens if everyone invests in index funds?

The failure of actively managed funds has played a significant role in the growth of index funds. Most active managers underperform their benchmark index. One of the explanations for their underperformance is that markets are efficient, a term that was coined by Nobel Laureate Eugene Fama. It means that security prices reflect all available information. In an efficient market, an active manager does not have an information edge because anything that they can know about a stock is already included in the price. The only way to beat an efficient market is to accurately predict the future, which is very hard to do consistently.

Most people that believe in market efficiency do not believe that markets are perfectly efficient. They believe that markets are efficient enough to make it extremely difficult to know when someone who profits from a trade was skilled, or just lucky.

The way that markets get efficient is by having a lot of people buying and selling stocks based on the information that they have. All of the active managers who are spending resources to research stocks in an effort to make a profit are injecting the information that they have into the price. These aren’t mom and pop operations either. The largest and most sophisticated investors in the world are the ones placing most of these trades.

If markets are efficient, you can’t beat the market consistently, and indexing is the smartest way to invest. But markets can only be efficient if there are enough people trying to beat the market. That’s a paradox, and it has a name. It is called the Grossman-Stiglitz paradox. It was introduced in a 1980 paper titled On the Impossibility of Informationally Efficient Markets.

Let’s think about this practically. If everyone really did switch to index investing, markets would lose some of their ability to accurately set prices. If that happened, there would be inefficiencies in the market and active managers would be able to swoop in and make big profits on mispriced securities. That action of them swooping in and profiting would attract other active managers to do the same.

It’s like an equilibrium. If too many people index, some active managers may profit, but by doing so they will push the market back toward being efficient. Markets are probably not perfectly informationally efficient all of the time, but they are efficient enough that it is very difficult to beat them consistently.

There is no way to know exactly when markets would cease to be efficient in a way that could be exploited consistently, but Eugene Fama, the guy that introduced the idea of market efficiency, explain in a 2005 paper Disagreement, Tastes, and Asset Prices that it depends on who turns to passive investing.

If the misinformed and uninformed active managers turn passive, then market efficiency will actually improve. If the well-informed active managers turn passive, then markets could become less efficient. But even if an active manager with good information turns passive, the effect might be very small if there is still sufficient competition among the remaining active managers. The paper also explains that costs are an important factor. If the costs to uncovering and evaluating relevant information are low, then it doesn’t take much active investing to get markets to be efficient.

In a 2014 paper, Pastor, Stambaugh, and Taylor explained that skill and competition have both been increasing in the world of active fund management.

Index investing is growing, but it’s still small in comparison to the long-entrenched world of active management. Even if index funds continue their current growth trajectory, there will always be investors who are motivated enough to absorb the additional risks and costs of active investing in an attempt at achieving higher returns. With the decreasing costs of information and increasing skill and competition among active managers, it is likely that markets will remain mostly efficient for a long time.

The TFSA Is a Give-away, But It’s Not a Toy

How often does anyone, especially the government, give you something for nothing? Canada’s Tax-Free Savings Account, or TFSA, is the rare exception. Introduced in 2009, your TFSA lets you save and invest after-tax assets that then grow tax-free. Both the principal and earnings also remain tax-free upon withdrawal. The government even throws in more “room” each year for you to add more – currently up to $5,500/year.  

It’s a sweet deal, for sure. But too often, I see people using their TFSA like it’s a toy instead of as the incredibly powerful financial tool it can be.

The wishful thinking goes something like this: “If I use my TFSA to ‘play the market’ and I happen to win big, it’ll all be tax-free. Yippee!” But as I explain in today’s video, there are important reasons you are far more likely to lose out on important tax savings than you are to hit pay dirt by turning your TFSA into a fanciful playground.

Bottom line, the essential laws of Common Sense Investing still apply in your TFSA, just as they do in any other financial account you may hold. Would you like to keep those essentials coming your way? Be sure to subscribe here and click on the bell.

Original post at pwlcapital.com.

Bond Index Funds in Rising-Rate Environments

In past videos, I’ve been covering the benefits of using passively managed index funds for your stock/equity investing. But what about bonds/fixed income? Since interest rates essentially have nowhere to go but up, could an active manager protect you from eventually falling prices?

Here’s the short answer: For stocks and bonds alike, we recommend a low-cost index approach over active attempts to react to an unknowable future. As a Common Sense Investing fan, though, you might want to know more about why this is so.

Think of it this way: If the markets were a three-ring circus (which they sometimes are!), stocks are your high wire acts of daring. Bonds are more like your wise old elephants. When you hear scare-stories about rising rates leading to plummeting yields, first, remember, a sturdy bond portfolio shouldn’t have that far to move to begin with. Second, despite the label “passive,” bond index funds don’t just sit there when rates change. They’ve got a balancing act of their own, but it’s based on patient persistence instead of a bunch of clowning around.

Want to keep your Common Sense Investing act in the center ring? Subscribe here, click on the bell, and the show will go on.

Original post at pwlcapital.com.

Why Your Financial Advisor Doesn’t Like Index Funds

As reported in a 1988 New York Times exposé, in the 1950s, “independent researchers began publishing major studies on the health hazards of smoking.” How did the cigarette companies, respond? To their credit, they substantiated the same findings, and tried to create safer smokes. Unfortunately, as The New York Times revealed, they did this work in secrecy, while “publicly denying that any hazards had been established.” So much for offering them a Good Citizen Award for their efforts.

What does this have to do with today’s Common Sense Investing video, “Why Your Financial Advisor Doesn’t Like Index Funds”? It’s an out-of-sample example of how we humans (including financial advisors) are often unable to make changes for the better. Even when the evidence tells us it’s high time. Even if – in fact especially if – our livelihoods depend on it.

The challenges of facing up to common-sense reality are as real for today’s advisors who refuse to switch to index funds as it is for cigarette manufacturers who still haven’t given up the ghost. Today’s video offers four compelling reasons why this is so. While these reasons may not be enough to change your advisor’s mind, I hope it will convince you that active investing is hazardous to your wealth. Stop doing it today.

Instead, keep watching my Common Sense Investing videos by subscribing here. I expect you’ll find them good-habit-forming.

Original post at pwlcapital.com.

Is Now a Good Time To Invest?

“Tactical” is a great word, isn’t it? It sounds smart. It sounds hands-on. It sounds like you’ve got everything under control, come what may.

Too bad, it’s such a bogus idea when it comes to investing.

The truth is, “tactical” is a fancy way of saying you’re going to try to come out ahead of the game by consistently nailing the best times to get in and out of the market. It’s another name for market-timing and, call it what you will, it’s still a bad idea.

So when should you actually invest in the market? Common sense tells us: Invest whenever you’ve got the money to do so. But what about dollar-cost averaging? Are you better off diving in all at once with your investments, or periodically dipping in your toe? That’s a great question to cover in today’s Common Sense Investing video, “Is Now a Good Time to Invest?”

Now that we’ve sorted out when to invest, don’t forget to subscribe here for more Common Sense ideas on how to do it. That’s one tactic worth taking.

Original post at pwlcapital.com.

How does a financial advisor decide what to invest your money in?

As I described in my last video, not all financial advisors have the range of credentials and experience you might expect from someone telling other people how to invest. So it’s no surprise that the investments they recommend may also be less advisable than common sense would prescribe.

The culprit here isn’t necessarily the advisors themselves. They’re often simply pretty good people with pretty good intent. But they’re also often caught up in an industry that permits if not encourages “suitable” advice to supersede “best interest” advice.

To the untrained ear, “suitable” versus “best interest” advice may sound about the same. But, believe me, there’s a wide moat between them in which everyday investors are too often left to sink or swim. How do you ensure an investment recommendation is in your best interests? Check out today’s video and subscribe here to keep building your bridge of understanding.

Original post at pwlcapital.com.

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