Do most financial advisors know what they're talking about?

Napoleon Bonaparte famously said "Never ascribe malice to that which is adequately explained by incompetence". This is a way of thinking known as Hanlon’s Razor, and it can help us interact with the world more favourably.

There is an established body of evidence that high fees and active management are not in the best interest of investors. Commissions are often blamed for influencing the questionable advice that many financial advisors give, but there may be a much more innocent explanation.

As of December 2017, 89% of Canadian investment fund assets were invested in mutual funds, with the remaining 11% invested in ETFs. A 2017 Morningstar study of the Canadian mutual fund landscape showed that the majority of mutual fund assets in Canada are in commission-based products. These are typically actively managed mutual funds that pay a trailing commission to the financial advisor that sold them. It’s probably safe to conclude that many Canadians are still relying on the advice of financial advisors selling commission based products.

The lack of a fiduciary duty for most financial advisors is often blamed for the generally poor financial advice that many retail investors receive. A 2015 study commissioned by the Canadian Securities Administrators showed that Canadian financial advisors are likely influenced by commissions. Similar studies in other countries have concluded the same thing, leading some countries to ban mutual fund commissions altogether.

Commissions do seem like a sensible explanation for the bad financial advice that so many Canadians receive, but what if there is a bigger issue? We know that the barriers to entry for becoming a financial advisor are quite low. If financial advisors don’t necessarily have a great understanding of investing and portfolio management, it is feasible that their bad attempts at giving good advice are simply misguided.

A 2016 study titled The Misguided Beliefs of Financial Advisors looked at this exact issue. The study looked at more than 4,000 Canadian financial advisors, and almost 500,000 clients, between 1993 and 2013. By comparing the accounts of the advisors to the accounts of their clients, the study authors were able to test whether advisors were also acting on the advice given to their clients in their own personal accounts.

If, for example, financial advisors were selling expensive actively managed mutual funds to their clients while investing in low-cost index funds in their personal accounts, we would suspect a conflict of interest. If advisors were buying expensive actively managed funds in their own accounts, we would suspect that they really believed that to be a wise investment.

The data show that both advisors and their clients tend to exhibit performance chasing behaviour and an overwhelming preference for actively managed mutual funds. They also both had poorly diversified portfolios and owned funds with high fees, but the advisors own portfolios actually had worse diversification and higher fees than the clients. All of these tendencies are well documented as being detrimental to long-term returns. The study also shows that financial advisors typically continue with these behaviours once they have retired, ruling out the possibility that they hold expensive actively managed portfolios only to convince clients to do the same.

This evidence makes a strong case that the many financial advisors selling expensive actively managed investment products may be doing their best to give good advice based on their own misguided beliefs. None of this should come as a surprise. A license to sell mutual funds is not terribly difficult to obtain, and fund companies pour resources into convincing financial advisors that they should be selling actively managed products to their clients.

The possibility that many financial advisors are misguided in their beliefs has important implications for investors. A 2017 white paper from Vanguard titled Trust and financial advice shows that one of the most important factors that investors consider in assessing the trustworthiness of their financial advisor is the expectation that the advisor will act in their best interest at all times.

Of course having someone looking out for your best interests should be valued, but well-meaning advice from a misguided financial advisor is just as damaging as malicious advice. If you need financial advice, seeking out a financial advisor with advanced financial education and an understanding of the evidence supporting the use of index funds could be a sensible solution.

It is always a good idea to ask your financial advisor what they think about index funds. The right answer, and there is a right answer, is that index funds are the most sensible approach to investing for most people.

Do You Need Alternative Investments? Part III: Hedge Funds

I’ve talked before about the tendency of investors to feel like they deserve more than the plain old market return. This seems to be especially true as people build more wealth. Anybody can buy index funds. More sophisticated investments have high minimums, or require you to be an accredited investor. The pinnacle of what I am describing is investing in hedge funds. Hedge funds are exclusive, elite, expensive, and lightly regulated financial products.

There are about 3.3 trillion dollars invested in hedge funds globally, and they continue to grow as an asset class, despite suffering from continued performance that lags a portfolio of low-cost index funds.

The first hedge fund was set up by Alfred W. Jones in 1949. His fund, A.W. Jones & Co, was the first fund to invest in stocks with leverage while using short selling to remove market risk. He structured the fund as a limited partnership to avoid regulation. None of this innovation would have mattered except for one important detail: the fund did really really well. We know that funds that have done well in the past are no more likely to do well in the future, but Jones’ success was publicized in Fortune magazine, and hedge funds were born.

Today there are a lot of different hedge fund strategies. They are typically designed to have performance that is uncorrelated with the market. The Credit Suisse hedge fund index shows that hedge funds have done an okay job at accomplishing this goal. While relatively low correlation with other asset classes can be seen as a good thing in an overall portfolio, the high costs, low returns, and additional risks of owning hedge funds must be considered.

Hedge funds command high fees due to the supposed skill of their managers. They will typically charge 1-2% of the assets under management, plus 20% of any excess performance. In a 2001 study Hedge Fund Performance 1990 - 2000: Do the ‘Money Machines’ Really Add Value Harry M. Kat and Gaurav S. Amin found that the weak relationship between stock returns and hedge fund returns is not attributable to manager skill, but to the general type of strategy that hedge funds follow. Any fund manager following a typical long/short type strategy can be expected to show low systemic exposure to the market, whether he has special skills or not. This leads to the question of why investors would pay such high fees.

The exclusive nature of hedge funds would lead most people to believe that they must also have high returns. This is refuted by the data. The Credit Suisse Hedge Fund Index shows an annualized return of 7.71% from January 1994 through November 2017, while a globally diversified equity index fund portfolio returned 9.19% over the same period. Even a much more conservative index fund portfolio consisting of 60% stocks and 40% bonds outperformed the hedge fund index, returning an average of 7.75%.

Between high fees, lacking evidence of manager skill, and low average returns, hedge funds aren’t sounding so good. Wait until I tell you about the risks.

Hedge funds do not have the same kind of liquidity that an ETF or mutual fund has. Investing in a hedge fund will typically involve a lock-up period during which your funds are not accessible. After the lock-up, hedge funds can suspend investors’ ability to withdraw from the fund at their discretion. That would typically happen at the worst possible time, like if the fund is crashing.

One of the pitches of hedge funds is that they are less risky than stocks, as shown by their relatively low standard deviation of returns. Standard deviation does not tell the whole story. Hedge fund returns exhibit negative skewness and high kurtosis. In plain english, that means that most investors lose while a few winners win big, and the funds exhibit exceptionally high and low returns with greater frequency than would be expected in a normal distribution.

One of the reasons that they seem exotic is that hedge funds can invest in anything. It might be cool to tell people about over dinner, but in reality it means that the riskiness of the underlying assets can be more extreme than you might expect. A 2000 study by AQR Capital Management found that many hedge funds were taking on significantly greater risk than their benchmarks by investing in illiquid assets.

Illiquid assets could result in outperformance due to the illiquidity premium, but investors may have been taking on far more risk than they realized. Hedge funds also employ leverage. The combination of illiquid assets and leverage can be disastrous for hedge funds during bad markets, especially if investors ask for their money back. A worst case scenario would see the hedge fund having to unwind illiquid positions at a significant discount, resulting in losses for investors.

Despite the hype about low correlation, hedge funds are a poor combination with equities. While we know that hedge funds have a somewhat low correlation with the stock market, that correlation can become high at the worst possible times. This is exactly what happened in both the 1998 and 2007 financial crises. So while the correlation data may look good on paper, it may not be very useful in practice.

Even if there are hedge funds out there with great returns, remember that past performance is a terrible predictor of future results. One prolific example of this is the Tiger Fund. It was formed in 1980 with ten million dollars and went on to average returns over 30% for the next 18 years. Wow. By 1998, it had over 22 billion under management, most of that coming from new investments wanting to get in on the performance. Tiger then stumbled badly, losing ten billion dollars, before closing in 2000. The funny thing is that while the fund still shows a 25% average annual return, it is estimated that most investors lost money because they invested after all of the great returns had been earned.

High profile hedge fund failures have not stopped many investors from allocating capital to hedge funds. One of the largest failures, Long Term Capital Management, cost billions of dollars and almost resulted in a global financial crisis. That was in the ‘90s, and hedge funds have continued to grow.

In 2014, CalPERS, a massive California pension fund and one of the leaders in the institutional investment space, made the decision to exit hedge funds as an asset class in their portfolio. They made the decision to shut down their hedge fund program primarily due to the program's cost, complexity, and risk. Other large pension funds have since followed suit.

Eugene Fama, Nobel Prize winner and the father of modern finance, said “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question. Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds.”

Warren Buffett famously won a 10-year million dollar bet against a hedge fund manager who was allowed to select five hedge funds to beat the S&P 500 index. The index won out easily. Buffet can’t predict the future, but the odds were certainly in his favour.

The Case For Renting A Home Part 2

In my last post, I told you that renting is not throwing your money away, and home ownership may not be all that it’s cracked up to be. Renters take less risk, have predictable costs, and have no illusion that their housing is an investment. The cost of home ownership is high, and long-term real estate returns have not been as good as many people like to think.

Let’s crunch some numbers to further the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth.

Let’s look at an example. Imagine someone who decides to purchase a $500,000 home with a $100,000 down payment. Between legal fees, land transfer tax, and other purchase costs they might have to come up with another $6,000, for a total cash cost at purchase of $106,000.

We can assume that the rest of the purchase is financed with a 25 year mortgage at a 3% interest rate, resulting in a monthly mortgage payment of $1,893. The buyer will also budget for property taxes at 0.75% of the value of the home per year, maintenance costs at an annual average of 1.5%, and home insurance at $200 per month. All things considered, the annual cash cost of owning this $500,000 home is around $37,000. We can assume that real estate grows at 3%, beating inflation by 1%.

Alternatively, this person could take the $106,000 cash cost of buying a home and invest it in an aggressive portfolio of index funds. They could rent a comparable home for $1,875 per month, and pay a less expensive $100 per month for renter’s insurance. Their total annual cost of housing would be about 24,000.

The renter could take that $13,000 annual cost difference between renting and owning and add it to their portfolio of index funds each year. We can assume that the portfolio is held in a taxable investment account, and consists of 90% stocks and 10% bonds with an expected annual pre-tax return of 6.6%. After fees on the index funds and taxes, the annual return might be closer to 5.3% assuming fees at 0.20% and tax at the rate for income between $75,000 and $85,000.

Fast forward 25 years. Owning the home would result in a real estate asset worth $1,046,889, which would be reduced to $994,545 after 5% selling costs. Selling the principal residence would not result in any taxes owing. Renting and maintaining a disciplined investment schedule would result in an investment portfolio worth $1,016,977, but selling the portfolio would trigger some taxable capital gains.

After-tax, the portfolio would be worth $987,579. The difference in ending wealth between the renter and owner is a negligible $6,966 in favour of the owner. If instead of investing in a taxable investment account the renter invested in the RRSP and TFSA, the scale tilts heavily in favour of the renter.

We just used reasonable assumptions to show that renting and owning can both result in substantial wealth accumulation over time. It is possible that reality will differ from our assumptions, tilting the advantage toward either renting or owning over some time periods. Many of the variables we cannot control: asset returns, inflation, and interest rates will be what they will be. Other variables are within our control. If a renter keeps their investment fees low, invests in an aggressive portfolio, and maintains strict discipline, they are putting themselves in the best possible position to build wealth that meets or exceeds the wealth of a homeowner.

I have shown you quantitatively that there is nothing wrong with renting from a financial perspective. I have nothing against home ownership, but I do believe that renting a place to live deserves equal consideration as a sensible financial decision.

For more on this see my PWL Capital white paper The Case for Renting.

The Case for Renting a Home Part I

Canadians really like real estate. It’s hard not to be excited when prices in hot markets like Toronto and Vancouver have been making global headlines. Around two-thirds of Canadians own their home, and the perception is generally held that owning your home is a smart investment.

Many Canadians feel that they need to buy a home as soon as possible because they are throwing their money away by renting. I’m sure you have heard the line that renting is “paying someone else’s mortgage.” On the surface this seems to make sense, but there are some important factors that need to be considered.

Let’s think about the benefits that renting has over owning. If there is a possibility that you could move within ten years of purchasing a home, you are taking on enormous risk. It is true that over the long-term real estate tends to go up in value, but in the short-term, its value can go up or down unexpectedly. Combine this price risk with the fact that most people borrow a significant portion of the money needed to buy their home, and ownership gets pretty risky for anyone with a short or uncertain time horizon.

A renter is paying a set cost in exchange for a place to live. Explicitly knowing the cost of your housing has its advantages, and the predictable monthly expense is useful in planning your finances. A homeowner can easily plan for their mortgage payment and property tax, but they may also have expensive maintenance costs that appear unexpectedly. These unexpected costs may result in the need to borrow money, or the need to carry a large cash reserve - both inefficient uses of capital.

Owners get sucked into the idea that their home is an investment. Based on this thinking, they will often spend heavily on renovation or maintenance projects on the premise that they are increasing the value of their home. Unfortunately, there is no guarantee that expensive home improvement projects will actually pay off. In his book The Wealthy Renter, real estate analyst Alex Avery explains that his “Golden Rule of Investing in Real Estate is that buildings never go up in value. Ever. Period. Only land can go up in value”.

Those were three benefits of renting that are important to keep in mind: Less risk, predictable cost, and no investment illusion. Of course you’re still wondering, isn’t renting throwing money away?

When you’re renting you’re just exchanging money for the use of something without any expectation of a residual value. Paying rent for a place to live is obvious. You give money to the landlord. They give you the keys. You get nothing back. What many people fail to consider is that homeowners are also paying forms of rent. They are renting services from the city in the form of property taxes, they are paying unrecoverable maintenance costs just to keep their house inhabitable, and they are renting money from the bank while they have a mortgage. But surely when the mortgage is paid off a homeowner’s cost of living is much lower than a renter’s. Not so fast.

Let’s think about someone with a paid off house worth $500,000. They could sell that house, keep around $475,000 after costs, and invest the money. Let’s say that they could expect to earn a 6% annual average long-term return on their investments, while the long-term expected return on real estate is closer to 3%. That 3% difference in expected returns is an opportunity cost. The opportunity cost of owning this home is around $14,000 per year. You don’t actually see the opportunity cost in any of your accounts, but it’s there. Add to that property tax and maintenance costs, and we can easily arrive at a total monthly cost of ownership of over $2,000. That’s $2,000 of unrecoverable costs with no residual value. Renting doesn’t look so bad anymore.

So far we have established that renting has some advantages, and owners also have substantial expenses with no residual value, so why does home ownership have such a good reputation?

The real estate and home improvement industries have obvious self-serving motivations to make home ownership look good. The Canadian government has programs in place to encourage home ownership, making it seem like a good idea. Most importantly, there are a lot of people in Canada who genuinely believe that their home has been their best investment. It is common for well-meaning friends or relatives to encourage home ownership based on their perception of their own experience.

It’s no wonder why many people think that their home has been a great investment. The numbers are big, and investment returns are not always easy to understand. The average Canadian home purchased in 1980 for $62,000 would be worth $496.500 in 2017. That seems like a great return. Over 38 years it works out to 5.63% per year on average before costs. When a homeowner is standing back after 38 years and admiring the appreciation in the value of their home, they aren’t usually accounting for the costs incurred along the way, but the costs were definitely there.

Property taxes and maintenance could be reasonably estimated at a combined 2% per year reducing the annual return to 3.63% after costs and before inflation. Canadian inflation over this time period was 3%. So that seemingly massive gain from $62,000 to $496,500 was really only equivalent to a 0.63% average annual return after costs and inflation. For context, the S&P/TSX composite index returned an annual average of around 5.9% after inflation over the same time period. The long-term after-inflation returns to US and UK real estate are similarly low, barely beating inflation over the past 115 years, while stocks in those countries have far exceeded inflation.

Hmmm so real estate returns aren’t actually so great. Home ownership does have one big benefit that really does build wealth. A mortgage forces discipline. It is much easier to stop the monthly contribution into your RRSP than it is to miss a mortgage payment. That discipline does pay off over the long-term, but it does not actually make home ownership an inherently great investment. People can be disciplined renters and investors, too.

I have started to make the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth. In my next post, I will lay out the numbers that prove my case.

For more see my PWL Capital white paper on renting.

Debunking Canadian Dividends for Taxable Investors

Canadian eligible dividends are tax efficient for taxable Canadian investors. This is one of the reasons that the mystical dividend investing strategy continues to have a cult-like following. As attractive as the tax rates on dividends are, dividends do still produce taxable income. A dividend-focused strategy will likely have most of its return coming from dividends. This means that even if the portfolio is producing more income than you can spend, you are still paying tax on the excess. There are also structural issues with a dividend-focused portfolio: a portfolio constrained to Canadian dividend paying stocks cannot possibly be sufficiently diversified. Structural issues aside, in this paper we will look at the capacity of a Canadian dividend focused portfolio to build wealth and fund retirement expenses on an after-tax basis.

Making some assumptions

We will assume that a taxable portfolio worth $1,500,000 is the only asset of a 65-year-old individual with the goal of funding a $4,500 monthly after-tax living expense for the next 31 years. We will assume that their expenses are funded from a combination of their portfolio and Old Age Security.

Setting up the analysis

For the first part of the analysis, we will compare the ending wealth, assuming straight line returns, of a Canadian dividend focused portfolio to a globally diversified and rebalanced total market portfolio. In applying the expected returns to the analysis, we assume unrealized capital gains remain unrealized unless a sale in the portfolio triggers a gain. Realized capital gains are assumed to be triggered annually regardless of any specified withdrawals to simulate the tax costs of rebalancing. The dividend focused portfolio is assumed to only earn Canadian dividends and unrealized gains.

Table 1 - Expected Returns (Equities)

	Foreign Dividends	Canadian Dividends	Unrealized Capital Gains	Realized Capital Gains
Canadian Dividend Focused	0.00%	4.04%	2.00%	0.00%
Globally Diversified Rebalanced	1.31%	0.80%	1.97%	1.96%

Data Source: PWL Capital

Looking into the future

Running this scenario for 31 years results in an ending net worth of $3.18M for the dividend focused portfolio, and $3.35M for the globally diversified and rebalanced index fund portfolio. This result is primarily driven by the relative tax efficiency of the globally diversified portfolio. While this may seem counterintuitive, the taxation of each scenario can be seen in Table 2. The dividend gross up results in an adverse interaction with both the age credit and OAS clawback.

Table 2 - Income Tax Projection

	Dividend-Focused Portfolio	Globally Diversified Rebalanced
Investment
Foreign Dividends	$0	$19,650
Taxable Canadian Dividends	$83,628	$16,560
Taxable Capital Gains	$0	$14,700
OAS Income	$6,453	$6,453
Total Income	$90,081	$57,363
OAS Clawback	$2,126	$0
Taxable Income	$87,956	$57,363
Federal Tax on Taxable Income	$15,468	$9,169
Tax Credits (Non-Refundable)
Personal Credit	$1,771	$1,771
Age Credit	$0	$641
Dividend Credit	$12,561	$2,487
Total	$14,332	$4,900
Regular Federal Tax	$1,135	$4,296
Ontario Income Tax
Basic Ontario Tax	$7,392	$4,087
Ontario Tax Credits	$8,886	$2,285
Ontario Surtax	$1,619	$0
Total	$2,369	$1,803
Total Tax (Including OAS Clawback)	$6,462	$6,099

Data Source: NaviPlan

Sequence of returns

We have now seen that a dividend focus is not a sure-fire way to build after-tax wealth. One of the other risks that dividend investors are exposed to is a false sense of safety. The notion that you will be paid to wait by collecting dividends when stocks are down can make dividend paying stocks seem safer than they are. Dividend stocks are still stocks. Based on the history of the DJ Canada Select Dividend Index we can estimate an annual standard deviation of 11.80%. That’s a lot of volatility for a retiree, but volatility is only one measure of risk. A more tangible measure of risk might be the risk of running out of money. From this perspective we can use Monte Carlo analysis to compare the outcome of an investor using an all-equity dividend focused strategy to an investor using a globally diversified 60% equity 40% fixed income portfolio.

It is clear that, on average, an all-equity dividend-focused strategy can be expected to outperform a 60/40 portfolio on an after-tax basis in terms of building wealth. This is simply due to the higher expected returns of stocks more so than the tax attributes of dividends.

Table 3 - Expected Returns (60/40)

	Foreign Dividends	Canadian Dividends	Unrealized Capital Gains	Realized Capital Gains
Canadian Dividend Focused	0.00%	4.04%	2.00%	0.00%
60/40 Portfolio	1.70%	0.48%	1.33%	1.33%

Data Source: PWL Capital

Based on these expected return assumptions we would expect an ending net worth of $3.17M for the dividend investor, and $1.95M for a globally diversified 60/40 investor.

The story gets much more interesting when we also consider the impact of the expected volatility on the long-term outcome. The Dividend-focused portfolio has an expected return of 6.04% with a standard deviation of 11.80%. The 60/40 portfolio has an expected return of 4.84% with a standard deviation of 7.09%. Based on a $4,500 per month draw, we can compare the results of relying on each of these portfolios using Monte Carlo analysis.

Table 4 - Probability Analysis

	Goal Success Rate	90th Percentile Ending Wealth	50th Percentile Ending Wealth	10th Percentile Ending Wealth	Earliest Age Assets Depleted
Canadian Dividend Focused	94.40%	$6,198,188	$2,182,697	$312,337	83
60/40 Portfolio	98.40%	$3,063,997	$1,544,148	$458,468	91

Data Source: NaviPlan

Despite a lower average return and therefore lower average ending wealth, the 60/40 portfolio offers a higher probability of achieving the ultimate goal of funding retirement expenses until death. The 60/40 portfolio also offers a higher average ending wealth in the 10th percentile of outcomes. Most importantly, in a worst-case scenario, the 60/40 portfolio lasts 8 years longer than the dividend-focused portfolio. If the primary goal is to build wealth, then it is true that an all stock portfolio is likely to provide the best result. However, the volatility of equities may be sub-optimal for funding retirement income.

Idiosyncratic risk

So far, we have shown that a dividend-focused Canadian equity strategy is suboptimal in terms of building wealth (compared to other equity portfolios) and funding retirement goals (compared to a 60/40 portfolio). The other risk that needs to be considered is idiosyncratic risk. It is not possible to sufficiently diversify using only Canadian stocks that pay dividends. Idiosyncratic risk cannot be planned for or modelled, but it can quickly wipe out a portfolio.

Conclusion

As we have seen from the preceding analysis, a Canadian-dividend-focused investment strategy does not necessarily result in superior tax efficiency. We have also seen that the statistical reliability of an all-equity portfolio may be suboptimal for a retiree. Finally, the idiosyncratic risk of a dividend portfolio is a substantial risk that is easily mitigated through proper diversification.

Not all index funds are created equal

I talk a lot about index funds in this video series. I have told you that low-cost index funds are the most sensible way to invest, and that you should do everything that you can to avoid the typical high-fee mutual funds that most Canadians invest in. Great, well that’s easy then. Buy index funds. Where do I sign up? Unfortunately the financial industry does not like making things easy for investors.

With the increasing popularity of index funds, index creation has become big business. There are sector index funds, smart beta index funds, equal weighted index funds, and many others, making it that much more challenging for investors to make sensible investment decisions.

Let’s start with the basics. An index is a grouping of stocks that has been designed to represent some part of the stock market. Most of the indexes that you hear about day to day are market capitalization weighted. Standard and The S&P 500, an index representing the US market is a cap weighted index. This just means that the weights of the stocks included in the index reflect their relative size. A larger company, like Apple, holds more weight in the S&P 500 than smaller companies, like Under Armour.

You can buy a fund that just buys the stocks in the index. When the index changes, the holdings in the fund change. This all sounds great so far. Low-cost index investing is what it’s all about. One problem for investors is that the big name indexes like the S&P 500 only track large cap stocks. Historically, large cap stocks have had lower returns than small and mid cap stocks, so excluding them from your portfolio could be detrimental.

The Center for Research in Security Prices, or CRSP, is another index provider. The CRSP 1 - 10 index is a market cap weighted index covering the total US market. While the S&P 500 offers exposure to 500 stocks covering 80% of the value of the US market, the CRSP 1 - 10 offers exposure to over 3,500 stocks, covering the vast majority of the value of the US market, including the smaller stocks missed by the S&P 500.

An index fund tracking the CRSP 1-10 is what you would call a cap weighted total market index fund. This is the building block for an excellent portfolio. There are total market indexes, and index funds that track them, available for Canadian, US, International, and Emerging markets stocks. The MSCI All Country World Index is.. What it sounds like. A total market index covering the whole world. An ETF tracking this index can be found in the Canadian Couch Potato ETF model portfolios. Total market index funds are well-diversified and extremely low-cost to own. That is exactly what you want as an investor. The Canadian Couch Potato ETF model portfolios, which are globally diversified total market index fund portfolios, have a weighted average MER of around 0.15%.

That is exactly why fund companies have had to come up with other index products to try and sell you. They need a reason to make you pay higher fees. One way that fund companies have been able to increase the fees on their index funds is by focusing on indexes that track specific sectors. The Horizons MARIJUANA LIFE SCIENCES INDEX ETF captures a sector that many people are interested in right now. It has an MER of 0.75%. There is no rational reason to buy this ETF other than to speculate on a hot sector, but Horizons is cashing in.

Another buzz word that fund companies have been using to charge higher fees on index funds is smart beta. Smart beta funds attempt to find characteristics of stocks that seem to have explained higher returns in the past. Some of these factors are extremely well-researched.

A 1992 paper by Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” pulled together past research to present the idea that a large portion of stock returns could be explained by company size and relative price. In 1997, Mark Carhart, in his study “On Persistence in Mutual Fund Performance,” added to the Fama/French research to show that momentum further explains stock returns. Finally, in 2012, Robert Novy-Marx’s paper, “The Other Side of Value: The Gross Profitability Premium,” showed that profitability further explains stocks returns.

Together, those characteristics are responsible for the majority of stock returns, so owning more stocks with those characteristics in your portfolio might be a good idea. Fund companies have tried to build products around this research, but the execution has not always been great.

In a 2016 blog post, my PWL colleague Justin Bender analyzed the iShares Mutifactor ETFs, ETFs tracking indexes that target some of the well-researched factors. Justin found that they did not deliver on their promise of factor exposure - disappointing considering their relatively high cost compared to a total market ETF. There are other fund companies, like Dimensional Fund Advisors, with a long history of capturing the well-researched factors. recommend products from Dimensional Fund Advisors in the portfolios that I oversee.

I keep saying well-researched factors because there are companies building indexes based on factors that are not as well-researched. They may be based on bad research, bad data, or data mining. In their 2014 paper, “Long Term Capital Budgeting,” authors Yaron Levi and Ivo Welch examined 600 factors from both the academic and practitioner literature. Not all of these factors would be expected to give you a better investment outcome, but they do give fund companies a reason to charge you a higher fee.

For most investors, a portfolio of market cap weighted total market index funds is all that you need. Many of the other index fund products out there claiming to track some special index are gimmicks designed to convince you to pay extra.

Ignore Market 'Experts'

People want certainly. David Freedman, in his 2010 book “Wrong” offers the example of a person suffering from back pain. He visits two doctors to review their MRI. One doctor says that he has seen many similar cases and that it’s hard to say exactly what’s wrong. He suggests trying out a treatment and going from there. The other doctor says that he knows exactly what is wrong and knows what to do. Which doctor do you choose?

Most people will choose the doctor who seems certain about his diagnosis, but that doctor may very well be wrong. As much as we crave certainty, it rarely exists, and it definitely does not exist in the world of financial markets where returns are driven by events that cannot be consistently forecasted. Market experts want you to believe that their insight can help you make better investment decisions. Sell this, buy that [point side to side for animations of stocks to buy].

It may be interesting to listen to market experts, but should you actually believe anything that they say?

Let’s start off by remembering that there is a tremendous amount of evidence that actively managed funds, on average, consistently fail to outperform their benchmark index. Actively managed funds are groups of market experts working together to outsmart the market, and, on average, they are not able to make the right calls based on their own predictions. So why would some person claiming to be a market expert online, on the radio, or on TV be any different? Well, guess what? They are not any different.

There have been two comprehensive efforts to aggregate and analyze the predictions of stock market gurus. One data set from CXO Advisory Group looked at the forecasts of 68 stock market experts spanning 2005 through 2012. They collected a total of 6,582 forecasts for the U.S. stocks market. Some of the forecasts had been made as far back as 1998, ending by 2012. The forecasts were then compared to the S&P 500 over the future intervals relevant to the forecast. The analysis found that the aggregate accuracy of all forecasts was less than 50%.

The other study of predictions is called the Gurudex. It looks at the 12 month period ending in December 2015. Rather than focusing on individual market gurus, the Gurudex looks at the stock predictions of large institutions. Not only does the Gurudex assess the accuracy of the forecasts, but it also compares the return of an investor who had acted on all of the predictions to the return of the S&P 500 over the same period.

For the twelve months ending December 2015, the Gurudex shows an average stock prediction accuracy of 43% for the 16 institutions that they tracked. It’s not like these are no-name institutions, either. RBC Capital Markets, BMO Capital Markets, Goldman Sachs, and UBS were all included. Only 4 of the 16 institutions had greater than 50% accuracy over the 12 month time period. One of those four, a Japanese institution, batted 60%, while the other 3 were right 53% of the time, barely better than a coin flip. The accuracy numbers drop sharply from there.

If an investor had acted on each of the stock predictions that these large institutions made in 2015, they would have earned a -4.79% return while the S&P 500 was relatively flat at -0.69%.

In an attempt to explain such low accuracy for these supposed experts, the author of the CXO Advisory analysis points out an important perspective on forecasts. The market expert making a forecast may have motives other than accuracy. For example, some market gurus may be making extreme forecasts to attract attention to their institution or publication. This is an important thing to keep in mind when you read or listen to market experts - they don’t care about you. Their motivation might be driving traffic to their publication, or bringing attention to their product or service, but their focus is almost certainly not on giving you financial advice that is in your best interest.

One notable market expert, Andrew Roberts, the Royal Bank of Scotland’s research chief for European economics and rates, made headlines in early 2016 by advising investors to ‘sell everything’ in preparation for a ‘cataclysmic year’. This was sensational enough to be picked up and written about by the Telegraph, CNN, the Wall Street Journal, and the Financial Post, among many other publications. Of course 2016 went on to be an excellent year for investors. So did 2017. Woops.

Warren Buffett famously said “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

While it may be tempting to listen to those who prognosticate the best stocks to buy or the future direction of the market, it is important to remember that the data refutes their ability to improve your investment decisions. Market experts are not regulated. There is no licensing body or minimum level of education to call yourself a market expert and start making predictions. Even if there was, the evidence shows that no level of education or intelligence makes it possibles to beat the market consistently. Market experts should be viewed as nothing more than they are: a source of entertainment.

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.