With private equity investments increasing in popularity, you may feel the pressure to expand your portfolio. Today’s episode, we look at the data behind private equity returns to see if these investments add something to your portfolio that you couldn’t get elsewhere. But first, we discuss some big news — that slow-moving Dimensional Fund Advisors are entering the ETF marketplace. After looking at the implications of this move, we use a Harvard paper as our springboard into the topic of private equity. By exploring the shift in demand for private equity, the paper establishes the context for why investors, especially institutions, are seeking higher returns. Looking at research from AQR, we talk about their finding that private equity returns are overvalued, despite them being historically good investments. You’ll hear how the risks underlying private equity are obscured by a ‘return smoothing effect’ and why people are willing to overpay to get smooth returns. We examine how the gap between private and public equity returns has narrowed along with AQR’s argument that market changes have caused private equity investments to perform poorly. After AQR, we move onto a paper by Erik Stafford which shows that small-cap investing yields similar returns to private equity — with the advantage that you don’t have to pay high private equity fees. We round off the episode with a discussion on the benefits of spousal loans before talking about this week’s bad financial advice. This is a valuable episode for those wondering about adding private equity to their portfolios. Listen to find out why that might not be in your best interest.  

Key Points From This Episode:

• Updates on our brilliant future guests — Jim Stanford and William Bernstein. [0:01:50]

• That Jim Stanford’s book provides an excellent view of money and banking in capitalism. [0:02:49]

• The big news; Dimensional Fund Advisors are entering the ETF marketplace. [0:04:50]

• The similarity between Avantis Investments and Dimensional Fund’s offerings. [0:06:05]

• Speculation on why Dimensional Fund Advisors are moving into the ETF space. [0:09:06]

• The benefit of ETFs — if you want out, then you have to pick up the spread [0:13:12]

• How ETFs might affect investor discipline and what ETF demand might look like. [0:14:06]

• Other Dimension news; 16 Canadian funds will get a management fee reduction. [0:15:39]

• Corrections to a chart on Twitter showing investors selling their equity holdings. [0:16:16]

• Hear about Capital and Ideology, Benjamin’s book of the week. [0:17:38]

• How private equity is becoming increasingly popular. [0:19:26]

• Why, generally, you shouldn’t include U.S ETFs in your portfolio. [0:21:20]

• The massive shift towards private equity investment from numerous entities. [0:24:08]

• How the timing has caused large institutions to look for higher returns. [0:25:33]

• Why expected returns from private equity were historically good and why this is no longer the case. [0:27:50]

• How private equity trading results in an artificial ‘return smoothing effect’. [0:29:10]

• That the valuation gap between private and public equity has narrowed. [0:31:40]

• What other mechanisms lead to an overvaluation of private equity. [0:32:28]

• Why IRRs, as opposed to PMEs, can be easily gamed, rendering them unreliable. [0:37:00]

• The historical conditions that led to high returns from private equity. [0:40:50]

• Comparing the expected return for public and private equity. [0:43:25]

• How Erik Stafford’s paper agrees that public equity risk is under-stated. [0:47:06] 

• The difference in dispersion between private and public mutual equity funds. [0:49:30]

• Why private equity past performance isn’t a predictor of future returns. [0:50:55]

• How spousal loans allow your partner to make investments with your money. [0:54:24]

• The potential tax savings that result from spousal loans. [01:01:20]

• Why you should probably include spousal loan debt forgiveness in your will. [01:03:45]

• Hear the show’s bad advice of the week; the return of 90s investment ideas. [01:06:16]

Read the Transcript

Benjamin Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore.

Cameron Passmore: So apparently my pictures I shared on Teams for the office inspired you to go kayak shopping.

Benjamin Felix: Well, a couple of years ago, just so everyone understands, Cameron always posts pictures of himself with his son, James, kayaking on a the weekend.

Cameron Passmore: James loves, loves kayaking. He just got a roof rack for his car. He's crazy, that's his happy place.

Benjamin Felix: And so it's always these pictures of Cameron's feet with the front of the kayak and then trees and water. I grew up in a very small town in British Columbia on the water my whole life. I lived on a Lake until I was 12 and then I lived on the ocean until I left home for university, so I love being on the water. Living in Ottawa I don't get out there that much, so Cameron's pictures always made me jealous. Yeah, so like you said, I went and bought a sit on top kayak like the one that you have and-

Cameron Passmore: So it's enough for you and how many kids?

Benjamin Felix: I can take the two boys with me.

Cameron Passmore: Awesome.

Benjamin Felix: So we all wear life jackets and it's a 12 foot fishing kayak so there's plenty of room for me to sit in the middle and plenty of space for the boys to sit in the front and the back.

Cameron Passmore: Yeah, there's lots of great kayaking places in Ottawa. It's funny you come out of the launch near where I live, I think we were maybe like 500 meters apart without even knowing it on the weekend.

Benjamin Felix: Well, I go there because I went with you two years ago. I came and met up with you, I rented a kayak. So then so I go back to the same place to launch because I don't know where else to go, that's the only place were lots of kayaks I launch a kayak from in the city.

Cameron Passmore: So what we have to do we'll to get you out there and I'll bring the drone. It'll be awesome, the drone, the boys kayaking.

Benjamin Felix: That would be cool.

Cameron Passmore: That's a good idea, super cool. Anyways, I wanted to mention a couple of guests that are coming up because the books are really worth looking into. So first one is Jim Stanford's book Economics for Everyone. Not easy to find, but if you can find it, it's great. That was a phenomenal interview coming up. And also Dr. William Bernstein is coming up, this is a big, big guest. He has a dozen or so books I've read, I don't know, four or five of them, I think they're all excellent.

Benjamin Felix: Pick one.

Cameron Passmore: Pick one, read it, they're incredible books. Incredible interviews coming up.

Benjamin Felix: Yeah, the Jim Stanford one, I think in the interview with him we just talk about how much we loved his book. So I'm going to do it again now, sorry. I've been getting a lot of questions about monetary policy, quantitative easing, and the relationship to asset prices and just money in the banking system in general, I think that it's generally really poorly understood. And I know I've talked a couple of times about how we're planning on doing a podcast episode and probably a video on that topic. The section of Jim Stanford's book on money and banking was the perfect summary of all of the other research that I've done. That there's not a more concise resource to understand money and banking in a capitalist economy than what Jim wrote in his book. So, anyway, for anyone wondering about that or thinking about that, that's one of the best resources that I've found to understand.

Cameron Passmore: We also want to do some more work on the book part of the website, get a more current lists, and perhaps we organize it by books recommended by or written by guests and then books recommended by us. It's quite a long list now, I guess we're doing a lot more reading than or at least being more public about it. So it's a long list of books, but getting lots of great feedback on it, which is nice.

Benjamin Felix: Yeah, we do want to organize it better. Rhe discussion on the rationalreminder.ca website is pretty robust. Every day there are people commenting and I jump in there when I can. I wish I could do more, but obviously time's a constraint. But the other podcast listeners are discussing topics with each other and people are getting really good answers to questions, it's really cool to see. I put a note on top of that page the other day because I was using CTRL F to find common threads on different topics and I realized how well CTRL F worked because it's not a big unorganized thread, you can't sort by section or anything, but CTRL F is a phenomenally good for finding a topic within that big, huge discussion.

Cameron Passmore: Anything else to add?

Benjamin Felix: No. As always, if you want to ask questions about this episode specifically, go to rationalremider.ca/podcast/105 and we'll try to answer you there.

Cameron Passmore: There you go, enjoy the episode.

Benjamin Felix: Welcome to episode 105 of the Rational Reminder Podcast.

Cameron Passmore: Can you believe the big news last week? At least it was pretty big news in our world, Dimensional Funds announced an application for entry into the ETF market place.

Benjamin Felix: Now I've got a lot of messages from people about that.

Cameron Passmore: Yeah, so I know we have a pretty keen audience on this, advisors and investors included. So we'll go through what we know, what we don't know. But one thing we do know is that they announced on Friday that they filed a preliminary registration statement with the Securities and Exchange Commission in the US for launch of three actively managed ETFs and they're planned to be launched later this year. So we do know is that they will be three all cap core funds, one in the US, one non US developed, and one in emerging markets. So these will all give investors access to Dimensional's approach, including tilting towards the parts of the market with higher expected returns that we've talked about since day one on this podcast. So co-CEO Gerard O'Reilly or Riley last week in an interview on BNN Bloomberg said, "As ETFs have become more important for servicing their clients, our clients have asked repeatedly, 'Can you guys launch ETFs?' We see them as a great compliment to our mutual funds." Is what he said.

Benjamin Felix: One of the parts that I found most interesting about the level of curiosity that people have had about this is the fact that Avantis, which we've mentioned a few times on the podcast, launched in October last year. I don't know how a Dimensional would feel about me saying this, but they're basically the same thing. On implementation and philosophy, they're intentionally pretty close to identical, and Avantis has launched both mutual funds and ETFs. So that's been my response when people ask me how does this affect the market or how does this affect model portfolios or anything like that? It's like from a portfolio execution perspective, Avantis checked all these boxes. Now, I'm saying that we don't actually know what the Dimensional product is going to look like, I don't think that we know what the underlying tilts are going to be.

Cameron Passmore: We do not, we don't know the fees. I've also been asked whether they will have Canadian based ETFs, that's not known either right now, this is only an SEC filing. But to your point, one thing I do know is that a lot of people jumped on the speculation bandwagon on Twitter on the weekend, which was somewhat amusing, I guess, to me. One of them is Avantis, they must be worried about Avantis therefore they came out with ETFs just to beat Avantis. Some people have speculated they could have owned the ETF marketplace had they come out with ETFs earlier. But I think the big breakthrough was the rule that changed last September, which enables them to do custom basket creations. This is somewhat technical and we're going to cover it off in another episode, but this ability to create custom baskets throughout the day is what I think is the breakthrough that enabled them to go ahead with something that will work for them and the way they manage them.

Benjamin Felix: Yeah. It basically allows them to be a little bit more flexible in their trading on implementation than prior to the rule.

Cameron Passmore: Right. So there will be ETFs, everyone who has access to US-based ETFs will be able to get themselves a little bit different than their mutual funds, which are only available through authorized advisors. Even though there are some ETFs available from John Hancock I believe that use those strategies but aren't traded the same way as DFA necessarily would trade them.

Benjamin Felix: So Dimensional is filed for actively managed ETFs whereas, I believe, the John Hancock ones are index ETFs that track indexes created by Dimensional for John Hancock.

Cameron Passmore: Correct, that's exactly right.

Benjamin Felix: So in the John Hancock, those are Manulife ETFs in Canada. And those ones you don't get the daily implementation that we sometimes talk about as being pretty important to capturing the higher expected returns. But with an active ETF, which is also what Avantis is, you get that daily implementation. And where with the custom baskets, it allows the implementation to be even more flexible. So that's likely one of the drivers behind Dimensional entering the ETF space.

Cameron Passmore: Yeah. They had a lot of demand, my guess, this is speculation, I don't know, but if I'm going to enter the speculation game, I think it was demand from advisors who work with Dimensional now who have ETF based portfolios. For whatever logistical reason they only want ETFs, this enables them to include Dimensional in their model portfolios. I think that would be a lot of demand would be my speculation.

Benjamin Felix: And that there's a lot of talk too about the tax efficiency of ETFs, which in the index fund space you could probably argue is an overstated benefit. Not to say that there isn't one, this is specific to US listed ETFs, in Canada we don't have the same potential for a tax benefit. But with the US listed ETFs, they're able to kick out the low cost base shares through transactions with the authorized participant. Which can end up being a tax deferral for a portion of the gains within a fund. It doesn't eliminate the tax because senior holders still end up paying it, but it can be a deferral.

Cameron Passmore: Right. Because that SWAP doesn't change your own cost base of your share.

Benjamin Felix: Yeah. So I think when we hear about demand or if we assume that well, it must be demand driving Dimensional to launch this, otherwise they wouldn't have come out with it. But some of that's probably coming from that view that ETFs are much more tax efficient. But again, I think it's true theoretically, is the magnitude economically meaningful or not? I don't know, that's probably debatable, especially in low turnover funds like Dimensional or other total market index funds. You mentioned people jumping on Dimensional for launching this in response to some external thing, like maybe if Avantis having ETFs and that gives Dimensional a kick in the pants to get into the ETF market. But you think about profitability as a factor which has been known about since 2006, at least published a paper talking about it. And I think it was 2012 that Novi Marcus came up with his paper where he actually identified a way to measure expected profitability. So 2012, and then it was 2014, I think, that Dimensional started rolling out profitability and portfolios.

So that's years of lag time for something that's fundamental to their investment process. So I think the idea that Avantis launched products in October last year and knowing how methodical Dimensional is to think that they all of a sudden decided to rush to create a product to meet market demand, I think is... Or not to meet demand, to combat what Avantis has launched.

Cameron Passmore: That's one of the things we've found for years so appealing about how they operate, everything is so thoughtful, methodical, systematic, and then there's slow moving from and it's been a good thing, right? I've been through many years of fast moving firms, I'll give a good example later in the episode. I like it that way personally, I like to do things carefully, make sure you do it right. But my favorite comment in Twitter this weekend was here's the quote just talking about them getting into the ETF space, so someone says, "It will likely happen over several years when ETF fund flows far outpace advisor mutual fund flows. At that point, DFA will likely go all in on ETFs and there's two stars. This is only my opinion, I know nothing about the inner workings or thinking at DFA." But you still had an opinion. Another one, "More asset grab obsession." Here's another one, "This ship has sailed, somehow we'll have to figure out how to tactically manage or even profit from volatility, buy and hold with pharma factors has been too painful."

Benjamin Felix: So volatility trading. Aimco, the Alberta Pension manager that just lost last week money.

Cameron Passmore: Ouch.

Benjamin Felix: Yes, too soon to make that comment?

Cameron Passmore: Yeah. Anyways, in the end, I don't see this as a negative, it gives more people access. And if you're going to want to... One of the things about limiting access to Dimensional Funds is to basically protect all the investors that are there. And one of the benefits of the ETF structure, we talked about this with Dave Nodding in the past, is if you really want to get out, then you will have to pick up that spread.

Benjamin Felix: You pick up the spread, so that's the huge difference between mutual funds and ETFs. And this is why Dimensional's able to do this without as much concern about the existing unit holders of the fund. Like you said, Cameron, with a mutual fund, what new investors do or what investors leaving the fund do affect the existing unit holders, but with an ETF, it's the authorized participant that bears all of the transaction costs. Now you could still have an impact on the spread which could ultimately still cost people who are transacting in the fund money. But that need to protect the unit holders of the fund by limiting access, a lot of that goes away with the ETF structure.

I do still think that you just hope that investors do a good job if they're going to use these products of staying disciplined. I think all of those ideas of stay invested and all that stuff, the core fundamental concepts of passive investing in general. I think those get more extreme when we start talking about the tilts because it's one thing to hang on through bad market returns when everyone else is having bad market returns. But to hang on through subpar portfolio returns when the market's doing pretty good, like we've had for the last decade with small cap and value trailing, I think that's a lot harder to hold on through. It's like that tweet that you just quoted, that it's been too painful to implement from a French factors. And that's always going to be true, pain that's why you have a positive expected return.

Cameron Passmore: I'd be surprised if there's a groundswell of demand from typical do it yourself investors, there might be but I doubt it.

Benjamin Felix: No, there won't be.

Cameron Passmore: There's no shortage of product out there now in this space. And you can debate what is better or worse, but there's not a ton of demand, there is so many of these factory type funds out in the marketplace now.

Benjamin Felix: But Avantis is the perfect sample. If we're going to think about how do we think these Dimensional products are going to do, Avantis has gathered, what a billion dollars in assets I think?

Cameron Passmore: I think a billion and a half, something like that.

Benjamin Felix: So it's not like they're exploding, and I think that they've launched a very good product. And no doubt Dimensional is going to launch a very good product too, but I don't think this is earth shattering in any way.

Cameron Passmore: No. And in other Dimensional news probably worth mentioning that they announced recently that they're going to be reducing their management fee on 16 other funds in Canada. May not sound like a big deal, is between one and five basis points. So if you look at a typical 50-50 portfolio, the prepackaged portfolio, the F class management fee goes from 30 basis points down to 26 basis points. Which again, four basis points isn't selling much, but it's a 13% cut in fees so I think this is a good thing.

Benjamin Felix: Of course it's a good thing, absolutely.

Cameron Passmore: And last little bit of news before we go in to your main investment topic today, so there was a chart that was all over Twitter a couple of weeks ago showing that a third of all investors in Fidelity over the age of 65 had, and I quote, "Sold off all of their equity holdings." It was a pretty staggering number, but it was everywhere. Anyways, accidentally I came across a correction that I saw in the Wall Street Journal last week. So instead of seeing that one-third of all investors in Fidelity over the age of 65 sold off all of their holdings in the recent downturn, it should have said of the 7.4% of investors aged 65 and up who made a change to their portfolio between February and May, nearly a third moved some money out of stocks. Also, of the 6.9% of investors across all age groups who made a change, 18% moved some money out of stocks. So the original tweet and chart that was everywhere just showed those high numbers, a third moving all their equities out. So it's not nearly as dramatic as was originally reported.

Benjamin Felix: Interesting. Yeah, I remember that chart being everywhere, but the correction has not been everywhere. Funny how that works.

Cameron Passmore: It is not. I don't know about you, but I have no books of the week. I know we're getting more and more people commenting that the talk we mentioned about books.

Benjamin Felix: I got a book I started reading. It's heavy in the literal sense that it's a large book, but it's also the concepts in the book are heavy. It's called Capital and Ideology by Thomas Piketty, who's a French author.

Cameron Passmore: How did you find it?

Benjamin Felix: Someone told me about it. I have his previous book, which is called Capital in the 21st Century. I've only read the beginning of the book. Just listen to this though, you'll understand what I mean by heavy. I'm quoting the introduction of the book, just the very first sentences, "Every human society must justify its inequalities. And less reasons for them are found, the whole political and social edifice stands in danger of collapse. Every epoch therefore develops a range of contradictory discourses and ideologies for the purpose of legitimizing the inequality that already exists or that people believe should exist. From these discourses emerge certain economic, social, and political rules which people then use to make sense of the ambient social structure. Out of the clash for contradictory discourses, a clash that is at once economic, social, and political, comes a dominant narrative or narratives which bolster the existing inequality regime."

Cameron Passmore: Wow, and that's the introduction.

Benjamin Felix: That's the first opening sentences of the book. But Capital in the 21st Century, his other book, it's this again, physically large book a lot about inequality, but everything is data, it's a data based book as is this one. Anyway, there's my book recommendation.

Cameron Passmore: Wow. We'll wait till you've read more of it to get the full recommendation, but we'll talk about it next time. Onto our portfolio topic this week, private equity. So we talked about this earlier this year, how popular private equity is getting. At the time we talked about how Vanguard is getting into the private equity business with a relationship with HarbourVest Partners, which is a Boston-based private equity firm. So you did some digging into this topic?

Benjamin Felix: Yeah. And Vanguard, when I was researching this topic again, I think an important point about the Vanguard and I'm sure we mentioned this last time we talked about it, but they only made this product available to their institutional customers. So it's not like you can go and buy a Vanguard private equity ETF, at least not for now. So according to PitchBook, which is a Morningstar data service focused on well, VC and private equity, private equity attracted 301 billion of new assets in 2019, which broke, and I think I remember talking about this last year or earlier this year maybe, anyway, so that broke the previous record for private equity new assets, which was in 2007 with 267 billion of new assets.

Cameron Passmore: So what's your objective when you dug into this? Did you have a thesis in mind of where you're going with it?

Benjamin Felix: About private equity?

Cameron Passmore: Yeah.

Benjamin Felix: No. A lot of this research is actually research that I did for a client earlier this year. And I've just known that I've had it sitting there dormant and haven't gotten around to make it into a YouTube video, so I thought it would be a good-

Cameron Passmore: You don't set out to disprove it or explain it by factors, you just go where the research takes you or did you have an idea in mind of where it would end up?

Benjamin Felix: Well, it all comes back to asset allocation. Like anytime that we're researching a thing, it's like, does this thing belong in portfolios? Sometimes that comes from our own questioning, like when Avantis launches products and all of a sudden there's a US listed ETF version effectively of Dimensional Funds, even though that's not exactly what it is, that spurs research into does it make sense from a portfolio efficiency perspective to include these US listed ETFs in portfolios? So that was an internally motivated research project in that case.

Cameron Passmore: So you're looking to do research on whether it makes sense to include this in your asset allocation not necessarily pass judgment on this as an asset class on it's own.

Benjamin Felix: No, I don't care, I mean I do care. If it's something that makes sense for clients to hold, then we should be including it in portfolios. Now, in a lot of cases, I'm making an assumption without doing the research that it doesn't make sense to include just because it wasn't previously included in portfolios. Like PWL has been managing portfolios since long before I arrived, we don't include private equity. You have a bit of a preconceived opinion on private equity, so you assume that it doesn't make sense. But then you get a question from a client specifically asking why aren't we doing this? And then all of a sudden, it's not enough to say, well, that's just the way we do it.

Cameron Passmore: And you're lousy at winging answers, with all due respect, it's not your forte.

Benjamin Felix: Is that like our... What did we try and call those? The rapid fire listener questions that ended up not being so rapid fire.

Cameron Passmore: Okay, dig in.

Benjamin Felix: To answer your question though, the basis of the research is should we allocate to this in portfolios? Is it adding something to portfolios that you couldn't get otherwise? You think back to the research on REITs, we did a video and talked about REITs on the podcast a while ago, and it's the same fundamental question. Like, should you hold REITs in excess of market cap weights in that case? Another way to think about that is are REITs a distinct asset class, are you getting something by over allocating to REITs that you can't otherwise get from a more diversified portfolio? And the answer in the case of REITs is no, you can get REIT factor exposure. This is the same economic drivers of REIT returns you can get from a better diversified portfolio of small cap and value stocks and some credit, some investment grade bonds. Anyway, so I go into thinking about private equity in the exact same way, is there something we can be getting out of this asset class that we're not currently getting out of the factor tilted portfolio?

Cameron Passmore: Right, is there a unique source of risk and return?

Benjamin Felix: Yeah, exactly, a unique source of expected return or an uncorrelated source of expected return. Now, I just talked about the data from PitchBook that last year private equity attracted the most assets ever, at least as far as it's been recorded. A similar thing has been happening in the pension space, there's a paper from a couple of Harvard professors titled Looking for Alternatives: Pension Investments around the World, 2008 to 2017. And they showed a similar effect where large institutions have increased their allocations pretty significantly over that time period to private equity. CPP Investments, they just changed their name from CPPIB.

Cameron Passmore: No.

Benjamin Felix: They've rebranded, it's called CPP Investments now. So the entity that manages Canada pension plans assets is now called CPP Investments, they used to be the CPP Investment Board. Anyway, so they're mentioned in this paper from the Harvard professors about one of the large institutions that's increased their weight to private equity. So here's just a quote from the paper, "On average in the 10 years following the financial crisis, and the timing is important, allocations to private equity and real estate nearly doubled representing about 20% of assets under management in 2017 for pensions in many of the largest economies. Our sample indicates a $1.8 trillion shift to alternatives between 2008 and 2017."

Cameron Passmore: Wow.

Benjamin Felix: So big shift.

Cameron Passmore: Big shift in demand, which you would think must drive up prices, reducing expected returns if nothing else.

Benjamin Felix: We'll get to that, but you're right. Now, I said the timing was important, and it's tough to prove, I guess. But one of the sensible explanations, I think, for the increase weight in private equity is institutions seeking higher expected returns. And the timing is important because when pension assets took a big hit in '08, interest rates also fell so the potential for large unfunded liabilities for pensions increased pretty significantly. So all of a sudden to make things work, you need higher expected returning assets, which private equity have historically been. And we'll talk more about the historical data in a minute.

Cameron Passmore: Because with fixed income returns falling, you need more assets to get the same return. So are there more assets getting that lower return or passes getting higher other returns?

Benjamin Felix: Yeah. But for pensions too, it's like discount rates have fallen, which means the liabilities have risen. So you're getting hit on both sides pretty hard, which is I guess the same for everybody, it's just the pension liability is more explicitly stated. We mentioned Vanguard, that was one of the points I had Vanguard getting into the space, which does speak to just the idea that... What is your water bottle saying?

Cameron Passmore: So someone talked about Rational Reminder water bottle and my new sweatshirt.

Benjamin Felix: Someone said it was funny that Cameron always drinks from Rational Reminder bottle with the Rational Reminder label on the side perfectly positioned.

Cameron Passmore: Here we are plugging our YouTube channel, shameless plug.

Benjamin Felix: Oh yeah because this is a video for some people that are watching it. So the big question is, does private equity offer something special? Clearly some people think it does, but does it actually? So there's a paper from some of the folks at AQR titled Demystifying Illiquid Assets: Expected Returns for Private Equity. The paper is fantastic, they explained that, and it's your comment exactly Cameron, that private equity expected returns and realized returns actually since about 2006 have deteriorated pretty significantly. But despite that, new allocations, like the data we just talked about, new allocations to private equity have been increasing. So you go back far enough, the historical data on private equity is actually pretty great.

So where the historical expected returns, so not the actual realized returns, although those were good too. But if you go back in history and use the methodology that AQR used, that we're going to talk more about in a second, if you use that methodology to the past, expected returns for private equity were substantial. So substantially higher than for public equities, but more recently that has changed and so we'll talk about. Their whole paper was basically this framework for evaluating current expected returns for private equity.

Cameron Passmore: Do you have any sense of the breakdown or is it mainly institutional buyer's getting into this space? Do you have any sense of retail exposure to this? Any data come across?

Benjamin Felix: I didn't look so I don't know. It's probably a little harder for retail investors to access, I would think.

Cameron Passmore: Yeah, I don't know if there's retail products in high net worth space, perhaps you get rolled up, I don't know.

Benjamin Felix: Yeah, I don't know either. That would have been the direction that I took this if I had decided private equity made sense, but spoiler alert, it doesn't. So I never got to product because product didn't matter if it doesn't make sense theoretically. One of the most interesting things about what the AQR paper talks about is that they say that... So I talked about the higher expected returns being one of the reasons people might be seeking out this asset class, that's one of them. But the other one that I find really interesting is the concept of artificial return smoothing. And what that means is because private equity is not marked to market, it's not traded daily on the exchange and you don't get to see the fluctuations daily in your online account or on your statement or whatever, you get a smoothing effect where the returns can look smoother than they actually are, which is interesting. So the AQR paper suggests that that could be one of the reasons that people are attracted to the asset class. And that actually has a really interesting implication for expected returns as well.

Cameron Passmore: They're also marketed to a long-term patient capital. There's a certain amount of pride that I think people take in having long-term patient capital. Something like a brain checks out of that investment for a decade or longer. Just from a market to market stand point not in the investment, just on the value of the investment.

Benjamin Felix: Yeah. And one of the interesting things about that is when you're doing that, you would expect a premium, an illiquidity premium, but that has not showing up. And the reason I'm giving away my... I had a methodical approach to going through this, but it's fascinating. So the AQR paper suggests that what should be there as an illiquidity premium is washed away by the fact that investors have a preference not related to risk and expected return, they have a preference for smoothed returns.

Cameron Passmore: So they give up expected returns for that?

Benjamin Felix: They're willing to give up expected returns.

Cameron Passmore: For a smoother ride?

Benjamin Felix: In exchange for what appears to be a smoother ride. Even though the economic risks are still there, on paper, it can look smoother. So their suggestion is that the reason that the illiquidity premium has not shown up in private equity is because people are willing to overpay for it to get smooth returns. So you'd be like, well, because what you said is true, Cameron, you got to lock your money up for 10 years or expect to make a private equity investment, which should result in a premium. But historically that portion of the premium is not showing up. And you can decompose the returns by factors to show that, which is what the APR paper did. So anyway, private equity can look less volatile and less correlated to the public stocks because of the return smoothing, which makes it look like a pretty great asset class on paper.

Now, on the other things, and this again speaks to what you said earlier, Cameron, is that the valuation gap, and this is when I talked about expected returns changing over time, this is a big piece of that. The valuation gap between private and public equities has narrowed substantially over the last 20 or so years that they looked at in this paper 30 years, almost. Which may speak to that willingness of investors to overpay for artificially smooth returns because you would expect a valuation gap to always be there just based on illiquidity. But right now, when you look at private versus public valuations, there's basically no valuation gap or it's very small anyway. So this paper went through three different approaches to estimating expected returns for private equity. And they looked at US buyouts, which is important. So this is not venture capital, this is just buyouts in the US.

So the three approaches they took were theoretical required returns, historical returns, and a yield based analysis, like the Shiller Cape idea for public equities. So theoretically, and they said that they based this on economic intuition and empirical evidence, they said that they expect the private equity asset class to have excess exposure over the market to equity risk, so a higher equity beta, an illiquidity premium size, so smaller companies tend to be the ones being bought out, and value because again, cheaper companies tend to be the ones involved in buyouts.

Cameron Passmore: Oh, interesting because you're falling private equity through the buyout stage.

Benjamin Felix: This is looking only at buyouts as a proxy for private equity, US buyouts.

Cameron Passmore: So if you're bought out, you're going to be on the cheaper end, interesting.

Benjamin Felix: Cheaper and probably smaller too.

Cameron Passmore: Small cap value, interesting.

Benjamin Felix: So that's their economic intuition and empirical evidence. And we'll talk actually about a different paper and a bit about that empirical evidence. I'm not sure if the AQR paper referenced that or not, anyway. So they give the estimated equity beta between 1.2 and 1.5. Now this again speaks to the return smoothing. If you do what they call a naive regression, which is just a regression based on the raw data for private equity, the beta looks as if it is less than one. But they go through a process that I didn't dig into exactly how it works, but they unsmooth the returns of the private equity asset class.

And so once you've done that, you should be seeing a truer economic risk profile or return profile. And so when you do that, you get an equity beta between 1.2, 1.5 versus the natural unsmooth beta of less than one. But you start to see how this could look like a really good asset class on paper if you're not digging into the deeper layers. So the obvious implication is that, well, that's what I just said, it looks less risky on paper, but in reality it is more risky than the market.

Cameron Passmore: That just shows you once again, and we talk about this all the time, how at the surface something can look really good but if it's not your domain of expertise and you don't dig into the corners and understand what's going on, you would never know this.

Benjamin Felix: Now, here's the other interesting thing about that though. And this, again, ties back to that preference for smooth returns. Some people might want this, some people might look at that, maybe they do know how to look at it, they do want smooth it, and they say, "Hey, I'll take a 1.2 beta that looks like a 0.8 beta."

Cameron Passmore: For sure.

Benjamin Felix: Because you can get the higher expected return without the [inaudible]. Which is why people are willing to overpay for it which affects the valuation. Crazy, right?

Cameron Passmore: Mm-hmm (affirmative).

Benjamin Felix: So I already mentioned the part about the illiquidity premium going away because of the preference for return smoothing, that's a really important piece and we already talked about the economic intuition of smaller value companies being targets for buyouts, so we don't need to go over that again. They briefly mentioned venture capital and the evidence on that is mixed in terms of whether it's a value or a growth play. But this paper again is focused on bio, it's not private equity.

Okay, so that's the theoretical approaches that basically what we're looking at is a leveraged portfolio of small cap value stocks. And they use that information to look at historical private equity returns and that's where they get the idea that there is no liquidity premium or illiquidity premium because you can fully explain private equity returns with public small cap value companies that leave it up a bit, so that's the theoretical piece. Then they looked at the historical data. So for this, they use the Cambridge Private Equity US Buyout Index, both a smoothed and unsmoothed version of the index and they compared that to regular public market indexes from July, 1986 through December 2017. Now this is a speaks to, I just mentioned a second ago.

So the P index actually did worse than a basket of small cap value stocks over the same time period. And that's where they get the idea that there's no illiquidity premium for private equity. Now, this part's really interesting, for the data that I just mentioned, they used IRRs, which is the available data for private equity fund returns. But they go into a whole commentary on the game ability of the IRR. Have you heard about this?

Cameron Passmore: I have not. I saw the notes, it's shocking.

Benjamin Felix: Okay, so I'm quoting the AQR paper here. So they said, "IRRs are not time-weighted and are affected by both the magnitude and timing of cash flows. Larger cash flows have greater effects on IRRs and IRR calculations embed a non innocuous assumption that interim cash flows can be reinvested at the IRR. Thus PE GPs can time capital calls from LPs as well as deal exits so as to boost IRRs."

Cameron Passmore: We should have given a nerd alert before reading that, but that's really fascinating.

Benjamin Felix: Well, basically you can-

Cameron Passmore: Gain the numbers.

Benjamin Felix: Yeah, you can gain the numbers. If you're managing a PE fund and deploying money and exiting deals, you can do that. Maybe not everyone's doing this, probably not. What's that, the Hanlon's razor mental model that assume people inherently have good intentions or whatever? But the fact is it's possible to game IRRs which makes them unreliable. So then they introduced this measure called the public market equivalent, the PME, which they say is more common in academic research that's looking at private equity. This involves comparing the amount of capital generated by the private equity strategy relative to a public equity benchmark, assuming similar amounts were invested with the same timing. So it's an ungamable, it's like comparing the actual results of the private equity investment relative to a public market index.

And so a PME, public market equivalent, of one would mean that the private equity fund delivered the same returns as the public equity benchmark over the given time period. And so they have some charts which we can post in the show notes and we'll show them on the YouTube video, if you're watching this you'll be able to see them. But they looked at the PMEs, the public market equivalence again, for a bunch of private equity vintages from 1998 to 2018. And then they have a chart along with that one showing the valuation gap over the same time period. Now, based on these charts, it seems obvious that there's a relationship and it makes sense just through common sense, whatever you want to call it, that higher value... What do we know from the Shiller price earnings for public equities? A higher valuation should lead to lower expected or lower future returns, which is exactly what we see in the data here.

And the wording they use is the X and D evaluation has a strong relationship with the X post performance. So at the time of making the investment, before we know the results, the valuation at that time is directly related to the performance later on.

Cameron Passmore: For sure.

Benjamin Felix: Similar to the intuition that we have from public equities. Now, in the charts that we're talking about here, they use both S&P 500 for the public market equivalent, the S&P 500 and they also use a leverage size and sector adjusted S&P 600 index. So this is that small cap value E leveraged index. And when they're using that risk appropriate index, the public market equivalent of private equity was less than one for most vintages except for one period from about 2000 to 2005, which has also coincides with the period where the ex ante evaluation gap between public and private equity was the widest. So it started starting to build some intuition here, it's like historically there have been some periods where private equity did really well.

Over the full set of data, it's done no better than a leveraged portfolio of small cap value. While over some periods of time it has done better than a portfolio small cap value stocks. Those periods followed times where the valuation gap between... But buying public equities was relatively much more expensive than buying private equities. Proceeding periods where private equity did extremely well relative to public equity.

So that pricing piece, the evaluation piece starts to become pretty important, which makes sense just intuitively. Because now when you look at that data on valuation gap, as of 2018 when they had this paper, September, 2018, the EBITDA over EV over enterprise value was higher for private equity than it was for the S&P 500, so pretty crazy. And based on this, the AQR paper argues that under normal circumstances, they put a fair amount of weight on the historical experience of an asset class, but specific to private equity because the market has changed so much in terms of demand and interest and access to the asset class, that they think that the most ten-year period during which private equity has not done very well at all, that period's probably more characteristic of the expected returns for the asset class.

Cameron Passmore: The last decade is?

Benjamin Felix: Correct.

Cameron Passmore: Wow.

Benjamin Felix: And if you look at the PME, the public market equivalent in the chart that we have here, since then, since about 2006, private equity has been about the same as S&P 500. It's had a PME of about one since 2006, but if you compare it to the more risk appropriate benchmark of the leveraged small cap value, it's been underwater relative to that since about 2006. So then the final metric they use is the yield based approach, which is that thing that I mentioned earlier, that's like looking at the Shiller price earnings for public equities. Their methodology was pretty involved so I'm not going to go through the whole thing, but they basically just built it a framework to create assumptions for yield growth rate, leverage cost of debt, multiple expansion, and fees. And they use that to do a yield based approach that feeds into their expected returns model for private equity. They had an estimate for fees, which they sourced a couple of other papers on.

Cameron Passmore: Here we go.

Benjamin Felix: It's staggering, really. And this plays right into AQR's expected return estimate because it's a net of fee expected return estimate. So they estimate private equity fees, including a 2% management fee, 20% carry, hurdle rates, and other fees combined in annualized terms. So in the same way that we see mutual fund fees and stuff like that, in annualized terms, they estimate private equity fees to be 5.7%.

Cameron Passmore: Wow.

Benjamin Felix: Yeah, wow was right. So take all of the frameworks that AQR put together to estimate expected returns for private equity for US buyouts and they got after fees, 3.9% as an expected return. And their public equity, just regular US stocks, is 3.1%. So it's still unexpected premium, just not an enormous premium. Oh, and I also mentioned showing the expected returns, so falling the exact methodology, the expected returns going back in time. I know I mentioned this earlier, so I'm repeating myself. But it's crazy to see how it used to be much higher just based on all the factors that we've talked about being different then, but now the expected premium for private equity is barely above market-cap-weighted public equities, and probably below one more risk appropriate.

Cameron Passmore: Like a leverage small cap value.

Benjamin Felix: Right. So we think the thing about, okay, back up, what's the decision we're making? Should we allocate to this asset class? Well, if we can achieve a similar result with a more diversified, lower cost portfolio just by owning small cap value equities, why would we allocate to private equity? And the answer is that we wouldn't. One more quote from the AQR paper and then I have one more paper to mention. So they said, "Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective. Institutional interest in private equity has increased despite its mediocre performance in the past decade versus corresponding public markets, and weak evidence on the existence of an illiquidity premium. Although this demand may reflect a possibly misplaced conviction in the illiquidity premium, it may also be due to appeal of the smoothed returns of illiquid assets in general."

So it comes back to the theme of people will still own this stuff even if it's no good because you get smooth returns. I think actually Cliff asked this a while ago, a couple of years ago on, I think it was Cliff, made a joke about wanting to create, and just did it, an index fund that was locked up for 10 years that didn't report it's returns daily because he thought that would give investors a much better result. But he said that the SEC didn't like his idea.

Cameron Passmore: Actually not a bad idea.

Benjamin Felix: Yeah. So if we wrap all of that up, well, it's what I just said, that private equity ends up being buyouts anyway, and this is maybe a little bit different from other things like venture capital, it's a whole other thing. But if we're talking about private equity funds, really we're talking about buyouts. It ends up being a repackaging of the economic drivers of return for small cap value stocks and you end up with an illiquid asset with no liquidity premium, which is a pretty bad trade-off. You do end up with smooth returns, which was any agency issues involved, like if you're reporting to someone else, I guess this could even be applied to us, although I would never use it as a reason to use the asset class. But if you're reporting your returns to somebody else, this could be a way to make them look better, which is according to this research, arguably one of the reasons that the expected returns for the asset class have declined.

So this is the other paper that I was going to mention. It's a 2017 paper from Harvard's Eric Stafford titled Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting. So basically what I was just saying. And in that paper he found that private equity returns can be replicated using a leveraged portfolio of public small cap value stocks. He looked at that same US private equity index from Cambridge Associates. And he also, this was interesting, in this paper, Eric Stafford looks at the Yale Endowment buyout portfolio. So the Cambridge Associate's US private equity index as an aggregate index, but then also specifically at the Yale Endowment buyout portfolio, so those are the proxies for private equity. He agrees in his paper with what AQR said, not specifically agreeing with them, but he comes to the same conclusion. That large institutional allocations to private equity are largely driven by that under-reporting of risk, that smoothed returns.

And then his argument to that, which I guess we've alluded to is that you end up with an over-allocation to assets that look less risky on paper but are actually risky in reality. Which again, as I mentioned before, that for some people me say it's a good thing, but I think in general unless you really understand what you're doing it's probably not a good thing. So I pulled one quote from the Erik Stafford paper that I thought was really good. So he says, "Popular stories suggest that private equity investors add value through operating improvements, preferred access to financial leverage, and improved monitoring and governance." If you think about that, that's a really good narrative, to think that these smart private equity investors are going to go and improve the company and make operating improvements.

I'm back into the quote, "These stories most clearly map into private equity investments delivering higher mean returns than similarly selected public equities held with similar amounts of leverage, but this does not appear to be the case before fees. After paying fees, which are estimated to be 3.5% to 5% per year," so his estimates a bit lower than the AQR one, "investors who agree that the risk-match between the private equity index and the two replicating portfolios is appropriate are considerably underperforming the feasible alternative of investing in similar passive replicating portfolios. So he's basically saying small cap value with leverage maps really well to private equity historical returns. And if you buy that, why would you pay private equity fees which are really high?

Cameron Passmore: That's the bond.

Benjamin Felix: That's how I would summarize his thing. Oh, I do have a couple more points on private equity. So if you're investing in private equity funds as opposed to an index, I guess to the extent that I don't know how investible the total market private equity index actually is, could be interesting for future research, but anyway, there's a report from McKinsey, their 2019 private market report that looked at, and I thought this was fascinating, looked at Morningstar data on the dispersion of returns for private equity funds versus public equity mutual funds. I have a chart here, which again we'll post in the video. But the difference in dispersion is enormous.

Cameron Passmore: It's got to be a huge dispersion on the private equity funds.

Benjamin Felix: You can see the chart there?

Cameron Passmore: I can, but intuitively, that's what you would expect.

Benjamin Felix: Yeah. So massive dispersion like the fourth quartile versus the first quartile for private equity is vastly different. Whereas for mutual funds, relatively, it's really tight. And so the obvious next line and thinking as well, okay, if there's huge dispersion, then you just have to find the winning private equity manager. So I thought about that and then I found a paper to help me think about it. But there's a paper on persistence in private equity fund performance, and this paper that I found looked at private equity managers from 1974 to 2012.

And they found that over that time period, and this again speaks to the idea that private equity is becoming a more popular asset class, so they found that the persistence of fund managers has substantially declined as the private equity sector has matured and become more competitive. Private equity has therefore largely conformed to the pattern found in most other asset classes, in which past performance is a poor predictor of the future. But the fascinating part is that as the space gets more competitive, that becomes increasingly true where you'd be less likely to have persistent success as a private equity manager. So now we've got this big dispersion and past performance is no predictor of the future.

Cameron Passmore: So more money, more investments, more people chasing, more analysis, tighter spreads that are available, but yet wider dispersions.

Benjamin Felix: Lots of dry powder out there, lots of private equity funds with a lot of cash to invest, lots of public companies that are competing with private equity funds to buy up other businesses. But it's just fascinating to think that an asset class like this, that today looks like a less regulated version of public equity, but in terms of the empirical evidence on the returns of the asset class looks remarkably similar to public equities. But the interest in the asset class is driven by the historical performance, which occurred when the asset class was structurally totally different. Like the relative valuation of a private company 25 years ago was so much lower than a public company that it arguably made sense just purely from a rational expected returns perspective to make the investment if you could get into it.

But now there's so much money chasing the private equity investments so that from a valuation perspective, it's no longer an attractive opportunity. And then you tack fees onto that, you tack difficulties and diversification on top of that, and then dispersion on top of that, I don't know how you could make an argument that this makes sense, from an expected returns perspective. That's not to say, and we see this in the dispersion data, that's not to say some private equity managers won't do well. And some investors and some private equity funds I'm sure they will have great outcomes. Some will have really bad outcomes, which is the nature of the dispersion.

Cameron Passmore: Right.

Benjamin Felix: But as an asset class, in terms of an expected return profile for an asset class and whether or not it makes sense to add to portfolios, nope, wouldn't touch it.

Cameron Passmore: And that is the ultimate punchline. On to our planning topic.

Benjamin Felix: Yep.

Cameron Passmore: Okay. So I'll give you a break a bit here. So this week we're looking into something we talk a lot about with clients, which is the topic was spousal loans. So many investors certainly have a goal to reduce their overall tax rate, rural tax bill. And one way for a lot of couples to do this is to do what's called a spousal loan. So this involves one spouse, often you have a situation where one spouse has higher income and has higher asset levels. So what the CRA allows you to do, our tax authority allows you to do is to make a prescribed rate loan where the higher income spouse will lend money to the lower income or lower assets spouse for a prescribed rate of interest. So that interest currently for this current quarter is 2% and is falling to 1% for the next quarter, starting well, when this episode airs.

Cameron Passmore: So you can make that loan, it's a demand loan at what will be 1%. So this the lower-income, lower asset level spouse pays the other spouse 1% interest every year and all the gains above that are tax in the hands of the borrowing spouse. So it's a way of getting the income off that asset of the higher income bracket spouse, pretty common planning.

Benjamin Felix: Is it worth mentioning just the concept of attribution?

For sure. So the reason is you cannot simply give your spouse that money to invest. So if you had a million dollars, Ben, you simply can give your wife. If you earned that million dollars, you can't give that money to your wife and have her earn it or grow that money because any income from those investments come attributed back to you. So attribution rules is a big thing to watch for. I think a lot of people aren't aware of that, they just give their spouse some money or you put it in your account, you invest it. No, you can't do that.

Benjamin Felix: That's a common one of just common, I won't even call it a misconception, but a common error that people make is assuming that a joint account is automatically split 50-50.

Cameron Passmore: No.

Benjamin Felix: Putting money into a joint account is not tax planning. Still, it attributes the income and gains in the case of the spouse, still attribute back to the person who the money originated from. So a gift to a spouse is not income splitting, it has to be a loan at the prescribed rate.

Cameron Passmore: And that's... Go ahead.

Benjamin Felix: That piece on capital gains attributing back only is for a spouse, actually I don't know why this is true but it is true, for a child, attribution still applies. If you give money to your child and in invested in an account that's in trust for them, the income attributes back to me, the capital gains actually attribute to the trial for tax purposes, which is interesting. For a spouse it's the income and the gains. But in both cases, you can make that go away by making a loan at the prescribed interest rate.

Cameron Passmore: And that rate is set, as we said, every 90 days, it's set by CRA based on the average rate of 90 day T-bills sold during the first month of the proceeding quarter rounded up the nearest percentage point. So for the longest time, it was 1% and that popped up to 2% and now it's falling back down to 1%. Now you have to watch that you make those payments, so the interest must be paid by January 30th of the following year. So if you were to make a loan today, you have to make that six months of interest by January 30th of next year. If that interest is not paid, then any income earned by your spouse may be attributed back to you.

Benjamin Felix: For the life of the loan too I think, right? It's a pretty steep, pretty ugly if you miss that.

Cameron Passmore: It's a very steep penalty. But what's cool is when you do the spousal loan at 1% next week, that interest rate is set for the life of the loan.

Benjamin Felix: But it is cool at 1%, at 2%, it was less cool.

Cameron Passmore: Yes, it's cooler.

Benjamin Felix: But it introduces an interesting scenario, where if people had made a loan and we are still suggesting to clients to do spousal loans at 2% because there's still, if you include capital gains, there's definitely an expected advantage. Even just on the income yield from a portfolio, say it's 2.6% on average for a portfolio split between Canadian and US international stocks, they're still a 0.6% that's being split.

Cameron Passmore: On income. And that 2.6% is coming to you anyways, so why not do the loan and only 2% is going to come back. So you're pushing 0.6% to your spouse plus any gains.

Benjamin Felix: Right, that's compelling for sure. Not as compelling though as 1%. So now the question becomes-

Cameron Passmore: So we have four scenarios here, right? First of all, does this make sense to do? Let's forget about the change in interest rates. So let's say it makes sense for you but you have in your portfolio a large unrealized gain, should you do it? Because if you have that amount of money in your hands bound with large unrealized gain, is it worth triggering those gains to lend the money because you can't just go and give that asset and the cost base to your spouse. So you have to do some tax calculations there of the present value comparison between paying that tax now and the expected benefit of doing the loan and pushing the income to your spouse after paying that tax. So a little bit of spreadsheet work for that.

Now what about if you have a large unrealized loss, should you do it? And that's where we have to be really careful because if you trigger the loss and your spouse goes and buys the exact same property in 30 days and the capital loss is denied and they end up with your cost base. That may not be the end of the world though, right?

Benjamin Felix: Yeah.

Cameron Passmore: Again, the to fire up the spreadsheet.

Benjamin Felix: Well, yeah. So you might accept the superficial loss. The other tricky one in that case of a loss, what if the amount in the portfolio is not sufficient to pay back the loan?

Cameron Passmore: Well, that's usually what's coming up now.

Benjamin Felix: Yeah, okay.

Cameron Passmore: So let's say you did a loan at 2% and there's an unrealized gain, should you repaper it? That's in the realized gain, so the borrowing spouse that trigger the gain payback the loan, reborrow the money, likely to be out of the market for at least four days just because of money has a properly flow during the proper accounts. So you have to figure out, okay, how much tax is due on that gain you're going to trigger and compare that to the benefit of only pushing 1% now to your higher income spouse and keeping more of the income in your hands. So again, you have to do some calculations.

But what if you're upside down on that loan? So you've borrowed a million, is worth $900,000, so you have an unrealized capital loss, you sell, you pay back $900,000 of the million, you borrow back $900,000. So now you're left with $100,000 at the old 2% and $900,000 at the 1% triggered the loss. But then you buy back the same security, so now you have to track two different loans, the old $100,000 loan and the new $900,000 loan, you have to watch your day counts carefully because now you have, I think everyone gets this, you have six months at both loans. When you make your payment by January 30th of next year, you better make sure you're doing this. This is careful finicky, it's not complicated, but it's careful and finicky type work that you have to do this properly. And highly recommend you seek advice from your tax and legal advisors.

Benjamin Felix: I don't even know if I would say that it's not complicated. It's not hard, maybe complicated is not the right word, it's intricate, tedious.

Cameron Passmore: It is, it's this Smith maneuver when we talked to Robinson. People get it but it's finicky, fussy type work, worth it, worth it.

Benjamin Felix: We have a calculator that we built to assess whether or not this makes sense for clients just to make it quick. And the present value, I can't just throw a number out there because it's obviously dependent on each individual situation. But in a lot of cases, the present value of expected tax savings is close to or above $100,000 over the lifetime of a loan. So it's not jump change. And that might be an extreme case like if one spouse isn't working and one spouse has the income at the highest tax rate. That's what you got to do.

Cameron Passmore: You also have to look at what will their tax rates be in the future because if you end up in the same tax rate, say in five or 10 years and the benefit isn't as long, of course, the present value of the benefit will be lower. So there's so many factors that go into the tool that we've built, that is complicated. There's also a lot of debt forgiveness rules, a lot. But there are debt forgiveness rules, so if you happen to be upside down, you don't have sufficient capital to repay the loan, part of the loan may be deemed to be forgiven, and that's when debt forgiveness rules apply.

Suffice to say, the rules are complex and I'm reading here. But in general, the amount not repaid will be deemed to be forgiven and first used to reduce certain tax attributes of your spouse, so the lending spouse if available. The tax attributes that will be reduced include, and this is in order, non-capital losses, farm losses, restricted farm losses, allowable business investment losses, and net capital losses carried forward in that order. If your spouse's losses are insufficient to absorb the forgiven amount, they can then choose to reduce other specified tax attributes such as the adjusted cost base of certain property held by the lending spouse. If there is still a forgiven amount remaining, then 50% of that amount will have to be included in your spouse's taxable income in the year the unpaid amount is forgiven.

Benjamin Felix: I'm shaking my head. This stuff makes me sick. This is the kind of thing that makes me very glad to have someone on our team who is a CPA with immense tax expertise.

Cameron Passmore: Now, what about if you die? So if your spouse dies while the spousal loan is still in existence, the loan becomes a debt of your spouse's estate, and it becomes a debt of the spouses of state and needs to be repaid. If there are insufficient assets in the estate to repay the loan and the loan has to be forgiven by you, then the debt forgiveness rules would apply. However, if a spousal loan is forgiven in your will, the debt forgiveness rules do not apply.

Benjamin Felix: So you want to make sure it's in your will if you...

Cameron Passmore: You want to make sure it's in your will according to the research that I did on this, you bet.

Benjamin Felix: Wow.

Cameron Passmore: The debt forgiveness rules can result in unintended consequences, and for this reason it's essential that you consult with a professional tax and legal advisor if you intend to forgive a spousal loan, that's from the article I read.

Benjamin Felix: If you intend to forgive a spousal loan. Which inherent in that statement is probably if you intend to make a spousal loan because you don't know whether or not it would have to be forgiven in the future. There's no way to know, unless you make a strong assumption about positive expected returns I guess.

Cameron Passmore: Exactly, not that you expect negative returns, but stuff happens, right?

Benjamin Felix: You never know, yeah.

Cameron Passmore: But point being, it's a simple concept that a lot of people are aware of, whether it makes sense for you is not simple and-

Benjamin Felix: How many people are aware of it though, the idea of prescribed rate planning and spousal loans? I'm sure maybe listeners to our podcast where it's a bias sample. But in general, having conversations with people, I don't know.

Cameron Passmore: I know people would have done it that don't have the loan agreement haven't made the payments.

Benjamin Felix: Well, yeah I'd given money to a spouse for sure. Oh, with that conversation I mentioned earlier, been fairly...

Cameron Passmore: I'm saying doing it as a loan, not just a gift, a loan.

Benjamin Felix: But an unpaid loan with no interest payments.

Cameron Passmore: Correct.

Benjamin Felix: Sounds like a gift. Sounds like a gift to me.

Cameron Passmore: Anyways, anything to add to this topic?

Benjamin Felix: No. I think that the reason that we brought it up in the podcast is that the prescribed rate is falling from 2% to 1%. Which like we mentioned earlier makes this type of planning go from pretty good and worth considering for the right situation to being really good and nonsensical to not consider. We won't go into any detail about it, but the extension of the idea of loaning to a spouse is the idea of setting up a family trust, which is a whole other topic.

Cameron Passmore: That's another week.

Benjamin Felix: If there are kids in the picture, then you can take the idea of a spousal loan and expand that to dependent children.

Cameron Passmore: Okay, don't spill all the candy in the lobby. Okay on to bad investment advice of the week quickly. And this one is from the, here we go again file. So this week I had some fun on Twitter with some industry peers or colleagues, Jason and Dan. So we had some, I guess, nerdy laughs at the expense of our industry from two decades ago. So Dan had reached out, he remembered some of the fund manager names I couldn't recall when we recorded two weeks ago. And we just were laughing amongst each other about some of the ideas that came out like 20 years ago by the fund industry. Then they go and market these ideas like crazy. Names like, we were, discussing CI Boomernomics, tell this New Economy Fund.

And lo and behold, this week, the industry serves up another one which mind-boggling to me. So the thesis is this, the idea is people are living longer than ever before and CI Investments thinks certain companies will be able to cash in on this trend. So they recently launched what's called the Global Longevity Economy Fund will be available as a mutual fund or an ETF. And the fund invests in companies like, "That are benefiting from changes in consumer behavior, technology, and healthcare resulting from the trend towards longer, healthier lifespans." According to their release. So of course the Cue the author, Cue the book. So the new offering is being inspired by the insights and research from Joseph Coughlin, who is a global expert on demographic change and author of the book, The Longevity Economy: Unlocking the World's Fastest-Growing, Most Misunderstood Market. This is right out of the '90s, it feels so much like the '90s.

"Given the broader trends and demographic shifts occurring around the world, we're providing investors with the opportunity to invest directly in companies that are poised to thrive in the longevity economy." The CI CEO said in the statement. So once again, take an idea, make a product, throw it on the shelves, and see how it sells. It literally is the mid '90s all over again.

Benjamin Felix: I'd love to see data on survivorship. Like we know for just average mutual funds, survivorship is about 50% over 10 years. I'd love to see thematic or whatever you call this, survivorship.

Cameron Passmore: We'll get Dan, Dan will go and work on it sure. I know Dan listen's so he'll be getting a good chuckle now.

Benjamin Felix: It has to be lower than 50%. You'd expect that because trends come and go, obviously.

Cameron Passmore: Right.

Benjamin Felix: Brutal.

Cameron Passmore: Brutal. Here we go again. Anyways, that's not judgment on the author, I'm sure the book is fabulous, at all, I'm talking about the benefit of wrapping that up in a product and selling a product around it.

Benjamin Felix: Nothing can be as acute as the marijuana boom in terms of product proliferation. It was probably closure, I haven't checked up on how many of those products have closed now.

Cameron Passmore: We've had nanotechnology, global telecom, global health, gosh, we had them all, right? Medical discoveries, interesting exercise that we had a couple of days of free time just to go through past history.

Benjamin Felix: If it's that disconnect that we've talked about in the context of economic growth versus stock market returns. We had disconnect between expected future growth of a thing, economy, industry, whatever you want it to be, the disconnect between that and expected stock returns for that thing. For the economy, we even found in that research that it was negatively correlated because people overestimate growth.

Cameron Passmore: Right. It's a good story though. Anything else to add?

Benjamin Felix: Nope, I think that's good for this week.

Cameron Passmore: As always, thanks for listening.

Books From Today’s Episode:

The Four Pillars of Investing — https://amzn.to/2AJc0lO

Capital and Ideology — https://amzn.to/2WnzPaK

Links From Today’s Episode:

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/ 

Shop Merch — https://shop.rationalreminder.ca/

Join the Community — https://community.rationalreminder.ca/

Follow us on Twitter — https://twitter.com/RationalRemind

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Benjamin on Twitter — https://twitter.com/benjaminwfelix

Cameron on Twitter — https://twitter.com/CameronPassmore

'Looking for Alternatives: Pension Investments Around the World 2008 to 2017' — https://www.hks.harvard.edu/centers/mrcbg/programs/growthpolicy/looking-alternatives-pension-investments-around-world-2008-2017

'Demystifying Illiquid Assets: Expected Returns for Private Equity' — https://www.aqr.com/Insights/Research/White-Papers/Demystifying-Illiquid-Assets-Expected-Returns-for-Private-Equity 

'Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting' —https://www.hbs.edu/faculty/Pages/item.aspx?num=50433

'How persistent is private equity performance? Evidence from deal-level data' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X16301775