August 13, 2020

Economics, Financial Planning, Portfolio Management

Episode 111: Gold, Insuring your Insurance, and Bank Sales Pitches

August 13, 2020

Economics, Financial Planning, Portfolio Management

With the gold price reaching record highs, we revisit the contentious issue of whether you should add gold to your portfolio. Before mining that topic, we talk about Super Pumped: The Battle for Uber and Am I Being Too Subtle? — our book recommendations of the week. We then touch on key news stories including how the recent Apple stock split has affected its position in the Dow index. After fielding a listener question about why central banks care about deflation, we share the reasons for and against investing in gold. We discuss where gold derives its value along with the concept of the ‘golden constant’ which states that the value of gold will keep pace with inflation in the extreme long-term. Host Benjamin Felix brings in research to show why gold is a bad inflation hedge due to its short-term price volatility. He also brings in data to look at how gold performs under hyper-inflation and then speculates on how supply shock from finding new sources of gold would impact its market value. Often used as a reason to invest in gold, we provide our take on John Bogle’s statement that you should invest 5% of your portfolio in gold. Despite seeming to be a middling investment, we then talk about why so many central banks own gold. Near the end of the episode, we briefly explore the life insurance organization Assuris and which account you should draw from when buying a home. Lastly, we draw insights from this episode’s bad advice of the week. Tune in to hear more rational reminders from the investment world.

Key Points From This Episode:

Media recommendations ranging from Too Much and Never Enough to Ray Donovan. [0:01:39]
Updates on the model portfolios being written by Ben. [0:02:58]
This week’s book recommendations: Super Pumped and Am I Being Too Subtle? [0:04:40]
Dives into key stories of the week; Apple’s share split and Vanguard Investor’s trading practices. [0:09:13]
Answering a listener question about why central banks care about deflation. [0:11:13]
Introducing this episode’s portfolio topic; should you invest in gold? [0:13:52]
An overview of the arguments for and against investing in gold. [0:15:05]
How gold’s value derives from its scarcity, malleability, and symbolism. [0:15:46]
Gold’s value as an industrial and collectible commodity and pricing in the ‘emotional dividend’. [0:17:18]
Where the demand for gold comes from — it increases with its price. [0:20:00]
The concept of the golden constant and how gold maintains its value in real terms. [0:21:23]
Drawing conclusions about the value and portfolio benefits of gold from the 2013 paper, ‘The Golden Dilemma’. [0:22:31]
How gold has performed in periods of hyperinflation. [0:28:19]
Further unpacking the idea of a golden constant and the expectation of receiving zero return. [0:32:00]
Summarising why investors are attracted to gold; it’s tangible and scarce. [0:34:50]
Speculation around asteroid and ocean mining in the far future and how this might impact gold prices. [0:36:01]
How central banks off-loading their gold reserves will affect the gold price. [0:38:30]
Why gold returns look so good at the moment and why this can’t be trusted. [0:40:03]
The paper, ‘The Long-term Returns to Durable Assets’, conclusions about the gold’s pricing. [0:41:00]
Why John C. Bogle invested 5% of his portfolio in gold and why it’s not necessarily a good idea. [0:42:01]
Answering why central banks hold gold in the first place. [0:43:23]
Exploring Assuris — an organization protecting Canadians when their life insurance policies fail. [0:47:40]
Which account to draw from when buying a home when you have equal amounts in your TFSA and RSP accounts. [0:52:30]
Bad financial advice for the week; PWL Capital versus funds chosen by a big bank. [0:55:02]
The importance of understanding the decision-making behind developing your portfolio. [1:04:35]

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: Okay, so let's clear something up right away. Yes, you do the intro custom every time. It's a new intro every time and, yes, Ben is a real person.

Benjamin Felix: Oh, you're saying that because I messed it up last time?

Cameron Passmore: Well, some people, I mean, we tried to clean it up, but we decided to leave it, but some people saw on YouTube how the video was choppy, so someone commented that, "Wow, Ben is a real person," but I think a lot of people didn't know that you do a custom intro every time.

Benjamin Felix: Yep.

Cameron Passmore: The other thing going on is you're finally wearing Rational Reminder swag, which other people were asking about how come I'm always in the swag and not you.

Benjamin Felix: Well, you look so good in it that what was I supposed to do?

Cameron Passmore: We got new swag and we're going to be getting the merch store up and running soon.

Benjamin Felix: Are we?

Cameron Passmore: Hopefully.

Benjamin Felix: What's the timeline on that?

Cameron Passmore: Hopefully within the month. Our ace marketing person extraordinaire Angelica's working on that now, so hopefully we'll have something shortly because I know there is some interest. I don't know how much, but we'll see. It'll be fun to get going.

Benjamin Felix: It is nice stuff, it is nice stuff.

Cameron Passmore: It's kind of funny looking at us. We're both in sweatshirts today and it's like record heat in Ottawa. I guess we both have solid air-conditioning running.

Benjamin Felix: I do, yep.

Cameron Passmore: So, you're on vacation now. You kindly came in to record this, but I was off at a cottage.

Benjamin Felix: Came into my house.

Cameron Passmore: Well, yeah. You went to a different room, but you joined us here.

Benjamin Felix: Yes.

Cameron Passmore: But we were off in a cottage last week. Amazing week, amazing time. It was fantastic. Lisa and I both read Mary Trump's book, Too Much and Never Enough, so it's the story, quote here, "How my family created the world's most dangerous man." So we decided we'd read a book at the same time on vacation. Wow, what a story. What a crazy story. It makes you understand where Trump comes from. This is Donald Trump, President Trump's niece, Mary Trump, who is also a psychologist and she's a good writer. It's a good book. Somewhat linking to that, have you seen the docuseries at Netflix called Fear City?

Benjamin Felix: No. They tried to make me watch it by showing the exciting little montage, but I didn't click it.

Cameron Passmore: What a story, how New York City brought down the mob. It's the incredible story of SDNY and Rudy Giuliani back in the '80s and how they brought down the mob. Great, it's only three episodes. Really worth watching.

Benjamin Felix: All right. Maybe I'll watch it. You know that I watched Animal Kingdom on your recommendation and that was oof, that sucks you in.

Cameron Passmore: Yeah, but did you like it?

Benjamin Felix: That's what I mean, we couldn't stop watching it.

Cameron Passmore: Have you started Ray Donovan?

Benjamin Felix: No.

Cameron Passmore: Oh, Ray Donovan sucks you in too. We just finished that last week.

Benjamin Felix: Okay, I'll have to check that out.

Cameron Passmore: Really good. I want to give a quick shout out to some kind people who put some nice reviews online. So Damien de Boston, Aptheny Storatano, Johnybgood2, and EV1212 were very nice to leave some nice reviews. We appreciate that.

Benjamin Felix: The model portfolios, I know, people ask in the comments.

Cameron Passmore: There's a lot of people wondering, where are you?

Benjamin Felix: But they're done, which is going to make people even more frustrated that I haven't actually released them yet, but I'm working on a whole paper, which is also almost done, kind of surrounding the methodology and the thinking behind the model portfolios. But part of that is doing some analysis around things like the impact of currency exchange costs, which is a question that I got a lot last time we released model portfolios. Okay, I see these factor tilts, cool, but they're US listed. Is it worth it for me to do currency exchange in order to access them? I think that's a very valid question, so I want to do some modeling around that just to help people think through that, so I'm not answering the question a bunch of times afterwards.

There's one other thing in there too. I can't remember what it was now. The foreign exchange ... Oh, and withholding tax, because there are some withholding tax implications for using these US list, the ETFs particularly for international and emerging markets securities. So again, I'm trying to do some modeling around that, and it's not like it's taking me forever to do the modeling, it's just like you said, I've been on vacation, so I'll get to it. But I've also been working on stuff like this gold research and there's a couple of other interesting concepts. We're going to come back with another discussion on dividends, which I think is going to be ... I think we've had pretty good dividend discussions, but I think we're going to come back with a way to frame the whole thing in a way that I don't think people have heard before, which should be good.

Cameron Passmore: Awesome.

Benjamin Felix: Yeah. Anyway, I got some other stuff I'm working on too, but those are the big ones.

Cameron Passmore: Terrific. Go to the episode.

Benjamin Felix: Let's go.

Cameron Passmore: Here we go.

Okay, so let's get going with episode 111. We'll kick it off this week with a couple of excellent books. Highly, highly recommend, especially this first one called Super Pumped: The Battle for Uber and it was written by Mike Isaac. Do you know the Uber story?

Benjamin Felix: You told me a little bit about it after reading this, but yeah, not super well.

Cameron Passmore: I didn't know the Uber story, and I will not give it away for those who have not read the book, but this is an incredibly meticulous report into how Uber became what it is now going right back to the founder Travis Kalanick, how he had this vision for it. Started getting interest in Silicon Valley, how he raised the capital. It gets into personality of who he is and how it took that kind of really aggressive fearless personality to pull this off because when you think about Uber going global, he had this vision for pretty much what Uber became right down to food delivery and product delivery, but he knew he would be up against this persistent battle against all these different cities, and taxi unions, and city councils and residents, but he ... No fear, just aggressively went after it. There's all kinds of stories that caused a lot of changes in the company, shall we say, but it's an amazing look at the whole thing. Board makeup, governance, the power plays that happened behind the scenes, money, so many of the names in Silicon Valley. So a really fascinating story. Couldn't put it down.

Benjamin Felix: Yeah, it does sound good.

Cameron Passmore: The next one is a book called Am I Being Too Subtle?: Straight Talk From a Business Rebel, and this is the Sam Zell story, and he wrote the book, his autobiography I guess. So I heard him interviewed by Barry on Masters in Business, I think it was last fall, and he's a really outspoken brash guy who certainly does not fit the mold of typical Wall Street. Anyways, he's the founder and chairman of a company called Equity Group Investments, which he founded over 50 years ago and was basically the genesis for three of the largest real estate companies in history. Absolutely huge in real estate. In fact, he's been called the founder of the modern real estate industry. So he talks about how and he gives his family's story, which is an amazing story how he ended up, how his family ended up in the States and survived the Holocaust, which was a very emotional story. Then he was born in the States, but he talked about ... I remember him discussing this with Barry, how he went to law school and he'd always been doing all kinds of real estate type transactions from property management.

He started from nothing. He got his law degree and tried to get a job at a law firm and they said, "Nah, you're never really going to fit here, you're a deal maker. You're not a typical lawyer." And so he took that and went out and created this unbelievably huge real estate firm. An interesting story is that he sold his equity office part to Blackstone in 2007, right at the peak of the real estate market, and was one of the largest if not the largest leverage buy-out ever. So I mean, lately the book I'm reading now is a Steve Schwarzman book, which I'll talk about in a couple of weeks. So he's the founder of Blackstone, and it was Blackstone that bought the Sam Zell deal. So it's interesting to read back to back two books talking about both sides of this transaction. Really interesting story. Huge dollar, I think we're talking like a $38 billion transaction.

Benjamin Felix: Wow.

Cameron Passmore: It's an incredibly small community when you hear each of those authors talk about their world and the people they did financing with, and all the banking leaders, really, really fascinating. Anyways, so Sam Zell went on to invest in other things beyond real estate like Chicago Cubs, the Chicago Tribune, Schwinn bicycles, very successful multibillionaire. Another fabulous book, fabulous read. He's very irreverent. He has a motorcycle, only wears motorcycle riding, only wears jeans, not the typical Wall Street role model at all, but great book.

Benjamin Felix: Yeah, it sounds like it.

Cameron Passmore: It's one of these that we were saying kind of before we started recording, when you work from home there's so much extra time, and my kids are obviously older than yours, I got a lot more time in my hands. I'm just cranking through books.

Benjamin Felix: Yeah, that was true before this too though.

Cameron Passmore: I was really amped up. I just find I'm so turned off by television. I don't watch network television anymore. I just love it. There are so many books now on my Kindle, it's nuts. So you want to crank off a couple of news stories of the week?

Benjamin Felix: Yep.

Cameron Passmore: How about this first one was neat. So with the Apple recently announcing a four for one share split, it makes you think about the Dow index, right? Because the Dow is a price-weighted index. So just by going for four for one split, therefore a share price is one quarter, it will reduce the weighting of Apple in the Dow index 73%. From 11% of the index to 3%. So it moves from number one spot to number 16. Incredible.

Benjamin Felix: It is, yeah. I think it was NPR Planet Money that did a piece a while ago on why the Dow is just the most useless index.

Cameron Passmore: Yeah, and it wasn't intended to be an investable index, right? Which we talked about with David Blitzer last summer. Another neat story I came across was titled Vanguard investors sat on their hands. So only 17% of Vanguard self-directed investors traded at all during the February to May timeframe, and less than half percent actually went to cash. In the defined contribution group only 5% of the DC members did any trades, and less than half a percent went to cash. Pretty good testament I think to certainly the cohort of investors at Vanguard, the self-directed investors for sure.

Benjamin Felix: Yeah.

Cameron Passmore: But very patient, which is fabulous.

Benjamin Felix: It'd be interesting to see if people stopping their ... Well, what have been their regular contributions are reflected in that?

Cameron Passmore: In like the DC plans?

Benjamin Felix: Because it does seem like a low percentage of people trading. 5% of people did any trades at all.

Cameron Passmore: Yeah, I would assume that doesn't include the regular purchases, and I would think that most people in DC plans it's kind of a set it and forget it. I mean, that's one of those famous nudge exercises that Dick Thaler studied, right? By just putting in auto-enrollment, enrollments went up dramatically.

Benjamin Felix: Right.

Cameron Passmore: Anything else to add to that?

Benjamin Felix: No. I did have one listener question that I wanted to touch on, which was about deflation, and the question is basically why do central banks care about stopping deflation? Right, it's a good question. We talked about quantitative easing recently and all of the measures that central banks take to try and maintain a level of inflation. But why are they so scared of deflation? I was listening to a macroeconomics podcast just because I've been interested in that stuff recently. I can't remember which one it was or who the guest was, but they said something interesting, which was that when you get into deflation it's effectively the same thing as tightening monetary policy. A deflation area environment is effectively the same thing as increasing interest rates.

Cameron Passmore: And that's because the revenue to the companies is going down?

Benjamin Felix: It's because in real terms if you've got a bond that's yielding 1% in deflation it's also 1%, your bond is yielding 2%.

Cameron Passmore: Right.

Benjamin Felix: So it's effectively increasing the cost of borrowing, which is the same thing or similar to tightening monetary policy. So if central banks are in a position where they're trying their best to decrease the cost of borrowing, if deflation kicks in, that's effectively the same thing as increasing the cost of borrowing.

Cameron Passmore: Absolutely, and it's also hurting companies in the revenue side because their revenues are decreasing because of deflation, right? So they're getting squeezed on the other side too, right?

Benjamin Felix: Probably depends. The cost of goods are increasing.

Cameron Passmore: That's true, it's a delta, right? Because your revenue may be down but it depends on your cost of goods sold but you would think there is a general tightening there, yeah. Interesting.

Benjamin Felix: Yeah. So I thought that was interesting. I think central banks generally are very scared of a repeat of the Great Depression where sort of near the end of that, well, depression, recession, whatever you want to call the end of it, they started tightening a voluntary tightening, and that's believed to be one of the reasons that things sort of spiraled downward again, because throughout the great depression there were multiple recessions and recoveries, it was just mostly pretty bad, but I think it was in the '30s there started to be a bit of a recovery and then there was a monetary tightening that sort of caused things to spiral down again. So central banks try to avoid that. Oh, and deflation was a big part of that.

Cameron Passmore: Interesting. On our portfolio topic this week, investing in gold.

Benjamin Felix: Yeah, we've covered this before once in a past episode, and I did a YouTube video on it too. When we did the podcast episode, that was the angriest I've seen our podcast listeners, or a subset of them anyway.

Cameron Passmore: So what made you revive it as a topic now?

Benjamin Felix: When we covered it last time there were a couple of things that I sort of wished that I'd included in that analysis that I didn't. But then the other part of it is that gold has been increasing in price a ton recently.

Cameron Passmore: A ton.

Benjamin Felix: You can argue that these two things are related. So gold's price has been increasing and then everyone is worried about inflation due to the money printer, which we've already addressed a little bit, but then there's also the increasing government debt levels, which I think we've also touched on with the economist we've had on. But in any case, interest in gold has been increasing based on what's going on in the world. At the same time I was going to say that's causing, but I don't know if there's causality there, the price of gold has also been increasing. So I thought it was worth addressing again. So it was the last time we covered this, and this is why people were upset. We basically said that gold doesn't belong in a portfolio, and now I can hear people already getting angry or feel people already getting angry. The basis of the argument is that gold is not a productive asset. It doesn't have a positive expected return. Well, I mean, that's basically it. So from a theoretical perspective there's no reason to hold it.

Now, the counterarguments are things like well, it's an insurance policy against a catastrophe and it's a diversifying asset. If you hold a little bit of it it's not that the drag on expected returns is offset by the diversification benefit. But anyway, so I kind of wanted to back up and think about why is gold valuable in the first place, which is an interesting question that actually has a real science based answer. Gold's more malleable and ductile than any other metal, so it can be stretched into a longer wire and beaten into a thinner sheet than any other metal. It's also extremely resistant to corrosion and it doesn't oxidize. So pretty cool material from a scientific perspective, but then it's also extremely scarce. If gold weren't scarce it would probably be widely used in all sorts of applications, but because it's scarce it has ended up getting a very special place in human history. It's been a symbol of wealth and a means of exchange, depending on where you look in which time period for thousands of years.

Cameron Passmore: That's really interesting to think about. The fact that it could be so much more useful but we're limited by how much of it we have, therefore we can't.

Benjamin Felix: Which makes it a whole other thing entirely.

Cameron Passmore: Yes, yeah, and creates so many stories and fascinating.

Benjamin Felix: Yeah. So today the value of gold comes from its use in industry, like in building technology. It's also valued as a collectible in the form of jewelry, and collectibles have a whole body of research about them, which is also very interesting, which we'll touch on briefly, and then it's also valued as an investment. The investment piece I think I would classify as a speculative investment, but we'll talk more about that too. So if we take the commodity angle, just as a use in industrial applications, the value of gold or the price of gold should tend towards its marginal cost of production, just as a commodity.

Cameron Passmore: It seems like a sensible definition.

Benjamin Felix: Non-value added industrial input. So I looked through Barrick Gold's Q1 2020 report and they had a total cash cost of $692 per ounce to produce, which is obviously a lot lower than the current price of gold. Now, there's a ton of data on gold that you can find online, and one of the charts that I found showed that the demand for gold relative to the price of gold. So for that use for the industrial input or use in technology applications, the demand for gold has historically been effectively immune to price changes. So regardless of the price of gold, the demand in industrial applications has been pretty much constant.

Cameron Passmore: Okay. Industrial application, you're not talking about jewelry and retail application.

Benjamin Felix: Correct, industrial applications, yeah. Yeah, and it is very much distinct from jewelry, which has had a different response to price changes.

Cameron Passmore: Really? You'd almost think that it would be inelastic because it is a luxury item.

Benjamin Felix: Well, also here, listen to this. It's actually really cool. So a lot of the research on things like jewelry and collectibles, art, wine, diamonds I think probably too would fall onto that, antique cars, all of those things derive part of their value from the emotional dividend that the owner receives. That truly is priced in, the emotional dividend is priced in. So consistent with that concept of an emotional dividend, the demand for gold jewelry has historically decreased with increase in gold prices. The way I kind of thought about this was as the price goes up the emotional dividend doesn't change, so the yield, the emotional dividend yield falls with gold price increases.

Cameron Passmore: Only you would...

Benjamin Felix: Well, I think it makes sense.

Cameron Passmore: Of course it makes sense.

Benjamin Felix: The emotional dividend doesn't change with the price. So yeah, you get less, per unit of cost you get less emotional dividend. So anyway, in industry uses there's no change in demand with price. For jewelry demand decreases with price, but then this is the one that's most interesting to me, is that as an investment, and this is all specifically tracked, like where is the demand for gold coming from. Is it coming from use in technology? Is it coming from jewelry? Jewelry is generally the biggest, about 50% of demand for gold comes from use in jewelry. So as an investment, the demand for gold has historically increased with the price, so that's pretty interesting. As gold price increases, the demand for gold as an investment also increases.

Cameron Passmore: You wonder if it's because the power of the story increases too, right? Like anecdotally, and I've lived through this many times, as the price has gone up the passion around the story often increases. Purely anecdotal, of course.

Benjamin Felix: Yeah. Well yeah. I mean, we know momentum is a real thing, although it also can end poorly. One of the papers I read about this, they compared to the US housing situation where house prices kept going up because people thought they were going to keep going up, but that can only happen for so long, bit of mean reversion there, which we'll also talk about in the context of gold. So, I've mentioned that the reason we're talking about this is because gold's price has increased a lot recently, because it seems like gold, or people think, people have the perception that gold is a good hedge against all sorts of stuff, against inflation, against hyperinflation, against financial market collapse, all these different potential uses. So we're going to talk a little bit about the data around most of those things that I just mentioned. So I think inflation is the biggest one, and that's one that's on people's minds right now. There's a concept called the golden constant, which as the name suggests is just the idea that gold maintains its value in real terms, so adjusted for inflation, over the long term. If you own gold it's going to keep pace with inflation and historically that has been true.

There's a book by a guy named Roy Jastram who is a professor at I can't remember which university, it was a 1976 book titled The Golden Constant: The English and American Experience 1560 to 1976. So pretty good data series. In that book he found that in the short run, being several years kind of thing, gold's been a pretty bad inflation hedge, but over the long run, and this is like hundreds of years, gold's actually been a pretty good inflation hedge. That golden constant concept has been somewhat true over long periods of time but not true at all over short periods of time, and we're going to dig a little bit more into data from different sources on that.

So then I looked at a 2013 paper, and this is we talked about this paper last time we covered this topic, by Claude Erb and Campbell Harvey titled The Golden Dilemma. So in that paper they talk about the evidence that the wage of a Roman centurion was approximately the same as a US army captain's pay today when both are measured in gold. Kind of neat, and then they also show that the price of bread measured in gold thousands of years ago is about the same as what we would pay in gold today if you could pay in gold at an upscale bakery, not at a Loblaws or something, but at a nice bakery. So yeah, kind of neat. Thousands of years gold buys you the same amount of bread. But again, thousands of years, and that's important.

So they also look at 10 year periods and found that gold's been a really bad inflation hedge over or undershooting inflation by a lot. So their paper is from 2013. I updated their analysis to now, to June 2020, and I looked at both 10 year and 20 year annualized numbers. So we can put the charts in the YouTube version of this discussion, but you can see if you look at the 10 year numbers, there've been a couple of periods where CPI changes were the same as gold rate of return.

Cameron Passmore: Oh. So these are rolling 10s?

Benjamin Felix: Yeah. And there've been literally like two or three rolling 10 year periods where gold appreciated at the same rate as CPI, but for most periods it's been way above or way below CPI. Then I thought for 20 year, maybe it gets better over 20 years. It was maybe even worse over 20 year periods where you're massively under or overshooting inflation by holding gold over 10 and 20 year periods.

Cameron Passmore: Was there anything that you could see about the ability to time that, like any sort of reversion?

Benjamin Felix: So that was addressed in one of these papers, and it is something that we'll mention, because yeah, the idea of mean reversion. It kind of ties back to the concept of the golden constant, right? Because if there is a golden constant and gold does overshoot inflation over a period of time you'd expect it to revert back to the golden constant, and that's actually there's another paper by the same guys, by Erb and Harvey that they wrote in 2016 where they address exactly that. Well, I'll talk more about it in a minute. Another important note is that this is all post 1971 data that we've talked about so far, which is important because that's when the US dollar was decoupled from gold.

So anyway, kind of to summarize where we are so far. In the short run gold is very volatile and tends to way overshoot or undershoot. Actually I'll use a quote from Erb and Harvey that I noted down. They said, "So while gold might protect against inflation in the very long run." Keeping in mind this is me talking, not the quote anymore, that the very long run that they found this to be true was over thousands of years. So back to their quote, "10 years is not the long run. In the shorter run gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value." Now, I think that's obviously important for humans with a limited lifespan.

Cameron Passmore: And attention span on investments.

Benjamin Felix: Yeah.

Cameron Passmore: I mean, you say it's highly volatile over 20 years.

Benjamin Felix: Yeah. I mean, gold's always volatile. It way overshoots or undershoots inflation, so I guess what are you benchmarking against, right? If you're benchmarking against inflation, then holding gold can be very hard. If you're holding gold knowing that it's going to be highly volatile, maybe you can live with that. If your expectation is massive volatility, which is what you should expect, I don't see that changing, the real question is the value in a portfolio, which we're going to continue to dig into here. You could argue that it's different for something with a perpetual lifespan, and that's something that we'll touch on later too, because John Bogle, the late founder of Vanguard, he gave a talk in 2018 through can't remember, the MIT Center for Financial Engineering or something like that, they did an interview with him. Andrew Lo actually interviewed him, who is anther very smart financial economist, and the title of the video was like in search of the perfect portfolio or something like that. So he talks about his Blair Academy scholarship fund that he created, and he talks about how he allocated 5% to gold. Anyway, we'll come back to Bogle in a minute.

In another chart in the 2013 Erb and Harvey paper they looked at the year to year changes in inflation relative to gold, and they're trying to add to the question of does gold respond to inflation, because it's one thing for gold to over the very long term maintain its purchasing power. That's very different from inflation explaining gold returns. So they looked at the year to year changes in inflation and found that gold had no relationship to year to year changes in US inflation. So it's not like when inflation goes up, gold prices also increase. There was no statistical relationship at all. Now, that's just regular year to year inflation.

One of the other big ones that I think people worry about is hyperinflation, like the idea of the wheelbarrows full of cash to go and buy your bread. So Erb and Harvey identified that as potentially one of the ways to describe what people perceive as gold's tail risk hedging ability. So they said okay, let's look at hyperinflation and see how gold has done historically when we know that we had a hyperinflationary period. So they found 56 hyperinflationary periods in both major and minor countries throughout the 1900s, and when you hear this it kind of is intuitive, but they found that if you owned gold during historical hyperinflationary periods it may or may not have maintained its real value over the hyperinflationary experience. Now, I said that that's intuitive once you hear it, but it's like we're talking about 56 different countries. Why would you expect gold to respond in any way to the hyperinflation going on in some country? We often take a US centric view when we're talking about data.

Cameron Passmore: Right.

Benjamin Felix: But if you're in, I don't know, I mean, Germany, sure. If you're in Germany when hyperinflation is happening, why would you expect gold to respond?

Cameron Passmore: On a per country basis exactly.

Benjamin Felix: And if it's responding in Germany, then why would it respond in some other country when they happen to be having hyperinflation?

Cameron Passmore: Exactly.

Benjamin Felix: So another quote from Erb and Harvey's paper, they say, "It is also worth reemphasizing that even if one has a firm grasp on the probability of hyperinflation in a country, that says nothing about whether or not the real price of gold will maintain its purchasing power during the hyperinflationary experience." Now, we gave this example last time we talked about this too, so it'll be repetitive for people that've listened to that episode, but Erb and Harvey gave the example of Brazil from 1980 to 2000. I just think this example is so illustrative, which is why I'm repeating it. So over that time period Brazil ... Why are you laughing?

Cameron Passmore: It is so funny, like people remember.

Benjamin Felix: Oh, are you kidding me?

Cameron Passmore: I guess we...

Benjamin Felix: Rational Reminder listeners remember episodes better than we do.

Cameron Passmore: Better than we do, or better than I do, not you.

Benjamin Felix: No, better than me too. This is a total digression from what we're talking about, but in the Rational Reminder discussion sometimes someone will ask a question and somebody else will chime in with the answer and be like, "Oh, listen to this timestamp in this episode." I'm like, "How do you remember that?" Anyway. So Brazil from 1980 to 2000. Brazilian currency, which changed a bunch of times over that period, basically lost all its value. Let's say it went to zero. So if you held Brazilian currency over that time period you lost all of your purchasing power. Now, if you had instead held gold you would've done better, but not by that much. Over that same time period, based on Brazilian inflation, gold lost 70% of its purchasing power based on Brazilian price index, sorry. So you could only buy 30% of the amount of goods that you would've been able to buy at the beginning of the 1980 by 2000 if you'd held gold instead of Brazilian fiat currency. Now, that's better than losing everything. If you kept Brazilian currency the whole time you lost all of your purchasing power, zero. If you held gold you only lost 70%.

Cameron Passmore: Wow.

Benjamin Felix: But to say that gold is a hedge against situations like that, while it lost 70% of its purchasing power, I think is a bit tricky. It's a volatile asset. You could hold a lot of different volatile assets instead of holding a currency that's being debased end up slightly better off. But I think that the point of the example there is that even if gold does maintain its purchasing power better than a currency that goes to zero, you're going to get some random outcome because gold is such a volatile asset. Might be a good outcome, it might not be a good outcome. So anyway, tricky to call it a hedge, in my opinion anyway, based on the data that we're talking about here.

Now, the next piece that I think is important is the concept of a golden constant. So this idea that gold will maintain purchasing power over the very long term, which effectively means a real return of zero, which is something that I think based on the last time we talked about this that a lot of the feedback that I got from people was that I know that I'm investing an asset with zero real expected return, but it's a hedge against this, this, this, this, this. So I think this is something that people get. You're expecting zero return over the very long term from gold. So anyway, if we believe that to be true, Erb and Harvey came up with another paper in 2016 where they said what should the price of gold be today if there is a golden constant.

So if we start in 1975, which is when gold futures started trading in the US, what should the price of gold be today if it just increased with inflation over that full time period? I did not recreate their calculation up until today's date, although I don't think would be a whole lot different in terms of the golden constant value, but the actual price of gold today is very different from when they did their paper.

So they calculated in June 2016 in the golden constant value for gold was 840 US dollars, which means that at the current price gold is way above its golden constant value. So Erb and Harvey say in the paper historically below average real gold prices have been followed by above average 10 year real gold returns and above average real gold prices have been followed by below average 10 year real gold returns. So what follows from that is because the real price of gold is currently above its long run average, you would maybe expect lower gold returns in the future.

Cameron Passmore: Right.

Benjamin Felix: And it's kind of crazy to think about too because if you'd invested in gold at the last peak, which was I think 1980 I think, if you'd invested in gold then you're maybe just getting back to par now.

Cameron Passmore: Right.

Benjamin Felix: Which is crazy.

Cameron Passmore: Because right now we're trading above average gold prices.

Benjamin Felix: Way above average, yeah.

Cameron Passmore: Therefore, you would expect based on this to have below average subsequent 10 year returns.

Benjamin Felix: Based on what Erb and Harvey are saying-

Cameron Passmore: Correct.

Benjamin Felix: ... that wouldn't be an unreasonable expectation to hold. Okay, sorry. So there was a peak in 1980. I'm just looking at the historical gold chart, but the value recovered by sort of 2010 when there was another pretty big peak, and now we're above that. So gold prices are historically high at the moment. Erb and Harvey are saying that when that happens future gold returns tend to be lower, which aligns with the idea of a golden constant. So, I think one of the other, well, scarcity which we mentioned, I think that's one of the other things that makes gold attractive to people, is that unlike other stuff, like financial assets or imaginary, or some people would describe them as imaginary. Fiat currencies are imaginary, they're just social constructs, like we talked about in our recent episode, but gold is real, it's tangible, and it's scarce. So those things all make it pretty attractive. This is one of the things that I didn't touch on last time that afterwards I thought shoot, I should've talked about that.

So the US Geological Survey estimates that there are 50,000 metric tons of below ground gold reserves that we know about, which based on the way that their report reads it seems like that's probably all of the gold that we can access with current technologies. So, that's kind of it. I mean, it's kind of like the idea of bitcoin, right? Where you can only mine so many and then it's done, but there are a couple of other curveballs, I guess, with gold which is, and some people might think I'm out to lunch for saying this but I think it's fascinating. So there were, both are now gone, but there were briefly two asteroid mining companies developing technologies to mine asteroids. Now, I mentioned they both are gone now, but it doesn't mean that the technologies can't come back. But it sounds like there was, just from briefly reading about those stories, it sounds like there was a mismatch between investor expectations and the time it was going to take to make these technologies viable. But people have looked at it, and there's an asteroid 433 Eros, which is estimated to contain 125,000 tons of gold.

So if those technologies ever became viable, which is an interesting concept because those technologies becoming viable could mean the technologies become cheap enough or it could mean that the price of gold gets high enough to justify it. Then likewise, the ocean is believed to have massive reserves of gold, way more than we have above ground on Earth at the moment. Likewise, while technologies have been tested to get gold out of the oceans, none of them have been viable. But again, another potential source of gold supply. Erb and Harvey did mention this in their paper too, so this is not just me being totally out to lunch, but the idea of a potential supply shock from gold that we don't really currently know about is something that could affect the price of gold.

Here's the interesting part. This is something that happened before. In the late 15th and 16th centuries the European market was flooded with cheap gold from the Americas when the world was sort of expanding, and that contributed, it wasn't solely responsible, but contributed to a period known as the price revolution, which was characterized by very high inflation for the time, just based on the big influx of cheap precious metals driving up the cost of goods. Now, there's other stuff too like population changes, that probably played into the inflation, but the influx of cheap precious metals seemed to be one of the reasons believed to be responsible for that.

Cameron Passmore: Wow.

Benjamin Felix: So anyway, there is historical precedent for the value of gold being materially affected by changes in supply. Now, a little bit less out to lunch, because I do, I think that the asteroid money and the ocean money are kind of out there.

Cameron Passmore: Like when you said the investor timeframe doesn't quite line up with the ... It's too funny. I think this is the first time you've said asteroid on the podcast.

Benjamin Felix: It's probably true, yeah. So the more maybe realistic version of that is central banks, which currently own I didn't note down the exact percentage, but a good chunk of the above ground supply, central banks hold in reserves. If they or some of them decided to start getting rid of their gold reserves that can very quickly and easily have an effect on the price of gold. Again, that is not unprecedented either, where the Bank of England in 1999 made the decision to start selling half of its gold holdings, which has been noted by some people as being one of the worst financial decisions in history because gold prices just went straight up from there by a lot, but I think the Bank of England stands by their decision.

Anyway, so when they started doing that, when they made that announcement, that had a big downward effect on the price of gold. Actually it was bad enough that a group of central banks at the time, and this agreement was renewed several times, but it's not currently in place, but there is a thing called the Washington Agreement on Gold, where central banks got together and said, "Let's not do that again, let's limit our gold sales because we really don't want to destroy the price of gold." But the fact that they had to do that I find very interesting, just in the context of what's driving the value of gold and what are the factors that could affect it.

So we know it doesn't respond to inflation, that there's a risk that a supply shock from either a central bank or some new source of gold affects the price. To me that sounds like a completely random risk, so I think that just makes it a little bit tricky. Now, one of the other hard parts about this, the narrative which you mentioned, Cameron, and the story behind it are big, but I think what sort of bolsters that is the back tests. There are a bunch of model portfolios online that use gold and look really good in terms of risk adjusted historical returns. The problem though is that most of the back testing softwares that you can get your hands on have the gold time series starting in 1970, 1975. Over that time period, from then until now, gold returns have been uncharacteristically good relative to history, and they've been uncorrelated with stocks. So you mash them together in a portfolio with stocks and long-term bonds and it starts to look really, really good. But I get it, you got to tie it back to the theory. Theoretic okay, we know what this historical period, this subset of history looked like, but theoretically is there a good reason to expect that to go forward?

I mean, we've already talked about the golden constant idea and how gold investors tend to believe that they're going to maintain purchasing power, not get equity like returns, which I think makes the back test data problematic because it looks like you're going to get higher expected returns than you might actually expect. So there's a 2016 paper by a guy named Christophe Spaenjers and he pulled gold data going back to 1900 and a couple of other durable assets, it's actually a pretty good paper, the long-term returns to durable assets. So he found over 1900 until 2016 the annualized return for gold was 0.7% in real terms. So you're kind of getting that maintaining your real purchasing power over that period you got a little bit more. Now, he does caution in the paper that for most of the 20th century the price of gold was fixed in nominal terms and this is all measured in USD. So that probably skews the data, obviously skews the data, but the point is from 1975 until now is a pretty small sample set to test something with no real theoretical underpinning.

Okay, so now Bogle, come back to him, in the interview that I mentioned, which is a cool interview and people should watch it, we can put a link to it in the notes, he says to Andrew Lo, the guy doing the interview, he's kind of like, "Now, you're not going to believe this, but 5% in gold." And people have kind of taken that and ran with it as a justification for holding gold. Well, Bogle said you should do it. Which yeah, I get it, and Dalio says the same thing, Dalio says five to 10%, but Bogle in a different interview specific to investors, as opposed to the endowment that he was talking about in that case. He said, and this is an interview with The Globe and Mail report on business, I've got a quote from him here. So he says, "In the long run it, it being gold, in the long run it's a loser's game. It has no internal rate of return, bonds have interest rates, stocks have a dividend yield or earnings growth. Gold has nothing like that. It's complete speculation. If you're enamored with gold, 5% of your portfolio is okay." So now we've gone from Bogle saying you should have 5% in gold to saying I think this is the worst idea ever, but if you really want to do it, don't go over 5%, which I think makes a lot of sense.

Cameron Passmore: I'm guessing that's where you end up on this.

Benjamin Felix: If you have to have it, sure, 5% is, yeah. I have a lot of trouble rationalizing why you would want to hold it. I think the stuff about the price revolution that I found pretty striking, and the central bank gold agreements also pretty, pretty striking. Actually we can tie that back to the next thing I want to mention on this topic, which is why do central banks hold gold. We mentioned the fact that they own a pretty good chunk of the above ground gold that exists and they made the central bank gold agreement to not depress the gold price, but why do they hold it in the first place? It's a tricky question to answer. I think one of the important parts of the answer to that question is that a lot of central banks don't hold any gold, zero, and that includes Canada, New Zealand and Norway. They just don't hold gold. The US does hold a lot though, 8,000 tons approximately, and Russia and China have been buying gold, adding to their reserve. So why do central banks, why do countries do this?

There is a 2013 press release from Deutsche Bundesbank which is Germany's central bank and they are the second largest sovereign gold owner in the world and they gave four reasons that central banks own gold. Diversification, universal acceptance, robustness against country and exchange rate risk and trust. Seem like pretty good reasons.

Cameron Passmore: Pretty powerful.

Benjamin Felix: Yeah. They do seem powerful. There was a 2013 paper from a guy named Dirk Baur who is in Australia, he was testing the hypothesis that central banks hold gold to build trust and he actually found that if they are doing that, if they believe they're doing that or that's one of the reasons that they have to hold gold, that it doesn't make a lot of sense because he said that based on a heterogeneous panel of countries and a large number of econometric specifications Baur found no clear evidence that supports the hypothesis that gold reserves lower government bold yields, which would be a proxy for trust, and lower exchange rate risk. So that kind of kills that, but diversification, universal acceptance, those are relatively hard to argue with.

There's another paper by Joshua Aizenman and Kenta Inoue titled Central Banks and Gold Puzzles, and they were trying to figure the same thing out, why do central banks hold gold. So in this case they ran a panel regression based on macroeconomic variables, financial variables, institutional variables and dummy variables to control for individual economy's characteristics, and they used this analysis to try and figure out what drives gold allocations to central banks for 22 developed countries what they were looking at. Their conclusion was from a household perspective not very useful, I don't think. I mean, it's good paper, don't take that the wrong way. But they found that a central bank's gold position retains the stature of signaling economic might, the intensity of gold holding is correlated with global power, by a history of being a past empire or by the sheer size of a country, especially by countries that are or were suppliers of key currencies. So signaling economic might I don't think is something that households need to do, I don't think. Maybe I'm wrong. I guess a lot of households do still try to signal economic might in different ways.

Cameron Passmore: Fascinating dive.

Benjamin Felix: Yeah, so that's it. I mean, I think the biggest takeaways for me in kind of revisiting this topic where the price revolution and the concept that if it were to happen that there were new supplies of gold discovered or we gain the technology to get other supplies of gold that we already know about, that could potentially have a meaningful depressing effect on the price of gold.

Now, it could go the other way too, like in the Erb and Harbie paper one of the things they talk about is Dalio's idea that gold is underowned, basically everyone should own five to 10% of their portfolio in gold. If it were to happen that everyone said, "Yeah, let's do that. That's a good idea." The price of gold would go through the roof, and likewise the central banks decide that they want to start holding more gold, the price of gold could go through the roof. So I'm not saying the price of gold is falling, I'm not saying I think it's going to fall, but the whole point is that it's a speculative outcome based on a whole bunch of random variables. If there is a golden constant that you can expect to give you real value over the very long term, the very long term is probably longer than any of us have to realize the benefits. No change in my view on gold, just a few more inputs to come to the same conclusion.

Cameron Passmore: Amazing. Good to move on to our planning topic?

Benjamin Felix: Let's do it.

Cameron Passmore: We'll give your voice a bit of a rest here. So we are often asked in our world how clients are protected for their investments, but there's another whole layer in Canada of protection for your insurance solutions, and it's from an organization called Assuris. So I thought it'd be worthwhile to do a quick review of the insurance protection that policyholders have the benefit of in Canada. So Assuris is the not-for-profit organization that protects Canadian policyholders if their life insurance company fails. It's an organization created in 1990. It is industry funded and every life insurance company in Canada is required by ever provincial, federal and territorial regulator to be a member of Assuris.

Benjamin Felix: So it's like CIPF for insurance.

Cameron Passmore: Exactly. So if you're a Canadian citizen or resident and purchase from a member company you're automatically protected.

Benjamin Felix: All right.

Cameron Passmore: Okay. So the coverage basics are the higher, and this is key, it's the higher of 85% or for death benefit $200,000. So if that company fails and you had life insurance with them you have a $200,000 policy, you're covered up to $200,000 when another company takes over your policy. If it's more than 200,000 you're guaranteed to get at least 85% of the coverage up to whatever that amount happens to be. That's your minimum. The company that takes over the insolvent company's policies may end up getting you a full coverage. On the health expense side this would be supplementary medical insurance, travel insurance, group health insurance, critical illness. It's the higher of 85% of coverage or $60,000, whichever is higher. On the monthly income, and this one is most people would have, disability insurance either group or personal, long-term care insurance or annuity payments, 85% of the coverage or 2,000 a month, whichever is higher. On cash value, so these would be segregated funds, universal life and whole life cash values, the cap it's up to $60,000. So 85% or 60,000, whichever is higher.

So in addition to these coverages they also guarantee 100% of your accumulated value benefit it's called up to $100,000. So these would be the universal life overflow account where you've overfunded it or a dividend deposit account in a life insurance policy. So if your insurance company happens to fail, Assuris will seek to transfer your policies to another solvent life insurance company. So Assuris guarantees that you'll retain at least 85% of your insurance benefits that you're promised. This has actually happened three times, and I remember one of them well back in the '90s. Three insurance companies have gone bankrupt in Canada, Les Coopérants in 1992, Sovereign Life in '93, and the one I remember is Confederation Life in 1994. In each of these failures the policies were transferred to another solvent company and the total cost to Assuris to make good in the guarantees was $205 million.

Benjamin Felix: Wow.

Cameron Passmore: So we used to deal a lot with Confederation Life to administer self-directed RRSP back in the early '90s, so it didn't affect us at all other than having to repaper a lot of it. I can remember vaguely, this is a long time ago of course, but I remember vaguely, it was basically a nonissue. Nobody lost anything when Confederation went under. Now, I stand to be corrected, but I don't remember anyone losing, even up to the guarantee amount, I think everyone got 100% of their coverage and just rolled over to other companies and was pretty much seamless. I remember it being pretty quick too. It wasn't a long drawn-out process. So if you want to know if your current company is a member it's easy to see. I look through all the members online on the Assuris website. There's roughly 70 members I believe.

Cameron Passmore: Now, let's say you buy a policy from a current company that merges with another company afterwards, each policy is protected separately under Assuris, so you don't lose the benefit on a per policy basis if you happen to choose a company that merges afterwards as a business decision. So there you go, there's your quick Assuris update.

Benjamin Felix: That was good. I think it's important for people buying life insurance to know this exists, that you're protected. I think it's probably more psychologically relevant for people buying annuities because that's always a risk that your insurance company goes under and you're "guaranteed" annuity income stops, but it doesn't.

Cameron Passmore (00:52:23):

Or if you're a recipient of disability insurance payments.

Benjamin Felix: Yeah, right.

Cameron Passmore: Big time. So onto the bad advice of the week.

Benjamin Felix: I did have one other planning note that I wanted to mention. I got a question a couple of weeks ago on home buyers plan, and if you have money in your TFSA and your RRSP, equal dollar amounts in the account, which is important. So say $35,000 in your TFSA, $35,000 in your RRSP. Given that situation, which account should you draw from if you're going to buy a home? I hadn't thought about this question in a while because usually I just say, "Well, don't use either. Let your registered money grow and use other cash." You think to this situation with the RRSP, so there's $35,000 in the account, $35,000 in the TFSA account, you don't own all the money that's in your RRSP.

Now, if you take money out of that registered account and use it to increase your down payment you're going to pay less interest on the mortgage. Now, expected returns in the RRSP and TFSA might be higher, but if you're choosing which one to take out, given that you have to choose one I guess, with the RRSP you're giving up the expected returns not on the full 35,000, you're only giving up the expected returns on the after tax portion that you own inside the RRSP. Because if you think about what is actually in the RRSP some portion is the government's money that you never get to touch, and it grows as your investments grow. So it's the deferred taxes. So say a 50% tax rate, you put 35,000 and half of it is the government's right away, half of it's yours. You each get to keep your tax free growth on the gains I think is the most efficient way to think about it.

So if you take money out of the RRSP you're giving up, depending on what your future tax rate is, you're giving up only the gains on your own portion, the after tax portion, whereas with the TFSA you're giving up the opportunity costs on the full amount. But then the second piece that makes it even more interesting is on the other side, on the interest savings side by having a bigger down payment with well, you get the full amount in both cases. You actually get the 35,000 in both cases. So given that you're going to pay it back with the same time period, because obviously the home buyer's plan constrains your repayment, which can make it a little bit trickier. Now, but given that you're going to say pay it back at the same frequency regardless of the account that you take it out from, you'd have a preference for taking it out of the RRSP because your opportunity cost is lower.

Cameron Passmore: Where would you rather forego the grow, in the taxable account or the non-taxable account?

Benjamin Felix: Yeah, that's another easy way...

Cameron Passmore: It comes down to.

Benjamin Felix: Yeah. Anyway, I just thought that was an interesting planning note to bring up.

Cameron Passmore: Okay. Bad advice of the week, this comes from a gift from a big bank in Canada. So we get a chance to look at a proposal comparing our offering to what they were offering. So I thought it might be fun to just take a look at how a big bank would compare and contrast what they were offering to what we would offer. So this was a boutique investment counseling enterprise inside a big bank. So this is apparently quite impressive, very large, very private, very high end, very polished, and since it's from a bank it was perceived to be incredible and also had, in quotes, the highest level of transparency. So it was very impressive to the person that shared this with us. The main point of their proposal when contrasting to what we were offering is that the big bank funds are bottom line better than the solution that we're pitching. So this is not a story about Dimensional funds. We're not here to defend Dimensional funds. We do use them, our listeners know that. This is more about how the big bank took a run at what we were putting forth and how they decided what was in that proposal.

Benjamin Felix: I think it's even bigger than that. It's about how do you evaluate an investment, or even bigger than that, how do you make a decision? It doesn't even have to a financial decision, how do you make a decision?

Cameron Passmore: And how do you communicate that to the person trying to make that decision? This is what was so jaw-dropping in this. So you get down to the basic methodology. They basically demonstrated the funds that they would use and how the funds that they would choose would beat the funds in a Dimensional portfolio over the last one, three, and five years. They don't describe what the methodology was in choosing these funds. Was it past performance? You have to assume so, since that's the only criteria that was given.

Benjamin Felix: Yeah. Well, I mean, in looking through what they presented that seemed fairly obvious that past performance was key in choosing the funds in the proposal. That seemed fairly obvious because we went and ranked all of the available funds from this bank and found that over the time periods that were being presented, these funds were top sort of three or five performers out of a big list of potential funds from that institution.

Cameron Passmore: That's just it, right? How do we know how they chose them? Do we know that these are the funds they would've recommended five years ago? I don't know, show us all the recommendations all through the years. Show us that that person making the recommendation was there five years ago to make the recommendation. It's so easy when you have that many funds to go and pick the top performers. We know from the SPIVA Canada Persistence Scorecard that top quartile funds don't remain top quartile funds. In fact, last year's scorecard showed that the funds that were top quartile in 2015 not one of them was top quartile at the end of 2019.

Benjamin Felix: Yeah. I think that that's a bit of an effect in small numbers because this is the first time that SPIVA has had a persistence scorecard in Canada. In the US usually it's at least a few funds that make it and that stay top quartile, but the story is the same though, where it's highly unlikely for top quartile funds to remain top quartile.

Cameron Passmore: Anyways, and all the funds in the big bank proposal were active funds. There was not a single index or any sort of quantitative systematic factor applicable type portfolio.

Benjamin Felix: But there wouldn't be. There wouldn't be. That would be counter to the proposal because part of the proposal was the benefit of having access to this team of smart active managers. So of course there's not index, right?

Cameron Passmore: Well, in fact, maybe you can explain this quote to me, but one of the criticisms of a Dimensional portfolio was that, and I quote here, "Long-term returns are based on index values rather than actual trading."

Benjamin Felix: Oh, well that's because the Dimensional funds haven't existed for as long as we have performance history. So some of the returns that we use in our model portfolios are Dimensional index returns that have-

Cameron Passmore: But the funds have been around for five years. Anyways.

Benjamin Felix: Yeah. I mean, what they're implying there I think is that in live implementation the results would be different, presumably worse, otherwise it would be a nonissue.

Cameron Passmore: And here's anther quote. "Over all periods, and note, sidebar here, they're only using one, three and five years, Dimensional performance is far below that of their benchmarks." Well, this is where you have to be informed enough to know where the benchmarks come from. The benchmarks had to be put in to give a comparison but it doesn't mean it's an accurate representation of the factor loading that's inside the portfolios. So they would put in as their official benchmarks traditional broad-based indices.

Benjamin Felix: Yeah. I mean, understanding benchmarking is a piece of it. I think even more broadly it's understanding the premiums, right? Understanding that yes, small cap in value has underperformed the market for the last decade. So of course if you compare a tilted portfolio to a market cap weighted index of course it's underperformed.

Cameron Passmore: Of course. So let's take a look at that. So we actually, I mean, you worked on this, right? To take a look at the loading on the portfolio, the Dimensional portfolio versus the big bank portfolio. So on the Canadian equity side, the average company size on our portfolio was around 13 billion, big banks was 33 billion. It's almost triple the average size. The price-to-book, this is the area that was the closest, but Dimensional portfolio is 1.18 times the book value price divided by book. The big bank's is 1.37. So definitely more value bias on our portfolios. But get this on the US side. Dimensional average company size was 44 billion, big banks was 220 billion. Huge difference.

Benjamin Felix: But it again speaks to the idea of understanding recent market history and just knowing that okay, well, if you show us a portfolio of large cap growth stocks, like I cut you off, Cameron, but the relative price for the US equity allocation here was 3.69 for the bank and 2.07 for Dimensional. So yes.

Cameron Passmore: Massive difference.

Benjamin Felix: Right, but it's like if you show me whether it's an index or an active fund, if you show me a fund that has a large cap growth bias, especially in the US. Yes, that did better.

Cameron Passmore: Of course.

Benjamin Felix: That did better.

Cameron Passmore: It doesn't mean it was the manager that did it necessarily.

Benjamin Felix: It doesn't mean it was the manager that did it, and if you understand the theory and who said, it was Dr. Bernstein, when I asked him if it was important to understand the theory and he said, I can't remember what he said exactly, but he said it was critical because otherwise you can't understand, you can't think about the stuff that we're talking about right now. It's not only that yes, these funds have done better over the last few years, but theoretically, and I know theory is not always the answer, but theoretically these portfolios with the large cap growth bias should have much lower returns in general but also specifically after this time period where they've had exceptionally high returns relative to history, and the valuation spread between value and growth is getting so much wider.

Cameron Passmore: And this is exactly what happened after the 1990s, everything turned upside down, and we've talked about that many times.

Benjamin Felix: Yeah. So I think that's the biggest issue. With this whole thing the biggest issue that I had was like forget about the active managers. I mean, that's one whole part of the discussion, but separate that out. If you're making a pitch of course you're going to use large cap growth funds right now. I'd love to see though, and you alluded to this earlier, Cameron, but I would love to see if 10 years ago were they using value funds as part of the pitch. Oh, I can't answer that question, but it's an interesting question to think about.

Cameron Passmore: Internationally 13 billion versus 86 billion average company size. Price-to-book just over one for Dimensional, almost four for big bank. Huge large cap growth bias, which of course did great over the past number of years.

Benjamin Felix: I think this is an important conversation for people to hear because who knows how many of our listeners are in a situation where they may be getting pitched by a bank, and these proposals can look pretty slick, but our listeners are a very biased sample of people who are numerate, I think is what Dr. Bernstein used to describe these type of people, good with numbers, can understand numbers. But there are a lot of people who aren't like that, and you see the pitch and you see the good past returns, and you don't know a whole lot about whether five year returns are meaningful or not and it seems pretty compelling.

Cameron Passmore: So when you roll the good returns along with the big bank brand, and safety, and prestige you can see why it's compelling, how can this not make sense. I get it. We've had questions from people saying, "My returns haven't been that great over the past five years." Now, when you explain it and show the structure of the portfolio it's all goes fine if you compare against large cap growth.

Benjamin Felix: But it's all about how do you make a decision. That's what I was alluding to earlier. How do you make the decision to be tilted towards small cap and value? Or how did you make the decision to be tilted toward large cap and growth? Well, I wanted to be in large cap and growth because I've done well over the last five years. Then the question is, is that the best way to make a decision?

Cameron Passmore: Yeah. A couple of the smaller things in that proposal that we wouldn't necessarily agree with. One is they'd be adding in alternatives in the future to enhance returns and improve diversification.

Benjamin Felix: Private equity was a big piece of that, which we've talked about recently.

Cameron Passmore: That's right. And also they talked about how we would improve your after tax returns by splitting the money up your fixed income between TFSA and RRSP. I mean, we talked about asset allocation many times, you've had I think three videos on YouTube that talked about this and a blog post that you did.

Benjamin Felix: Yeah, I mean, the biggest one is the paper that I did on that was ... And actually that's something that is going to be turned into a course for one of the industry publications. So hopefully more people will understand the thing that most people misunderstand which is that adding bonds to your RRSP makes your portfolio more aggressive, not more tax efficient, and that's why the expected returns increase. That's what they are saying in here, they are saying we'll put all your bonds in your RRSP and that makes a portfolio more tax efficient. It actually doesn't, it does not make it more tax efficient. It increases your after tax allocation to stocks by reducing your after tax allocation to bonds by putting in the RRSP, anyway.

Cameron Passmore: Precisely. Let's share the quote from a recent discussion with Ken French here, because he talked about the reasons for not putting a lot of stock into five year numbers. I thought he did it certainly better than we could ever do it, so let's listen to Ken's quote. We'll come back on the other side of it.

Ken French: Five years is way too short to learn very much at all about any of the premiums we're looking at. Five years is also too short to learn much about any manager's performance other than an index fund. With an index fund that's truly supposed to track an index, I can tell pretty quickly whether they're doing that or not, but for everybody else if there's much tracking error at all, it's going to be hard to say anything about what the manager's performance looks like over any five year. I love that there's lots of institutions out there that focus on a three year horizon, and if you can't tell in five years, it's going to be really hard to tell in three years.

Ken French: Now, that's not to say you don't learn anything in three years and you don't learn anything in five years. If you learn something with a million years you must have learned, I mean, if you learned a lot with a million years you must have learned something with five years because lots of five years add up to a million, but people are crazy when they try to draw the inferences that they do from three year, five years, or even 10 years of performance on an asset class or any actively managed fund, or a non index fund. It's very hard to drop really precise inferences that people think they can. I think that's what supports a lot of the active that people are investing in out there. They see five year track record and say, "Aha, I know I have a great manager here." When in fact you learn almost nothing about a manager's skill from five years of performance.

Cameron Passmore: There you go. I don't think we could've said it better. Absolutely spot on, and I think it is a very compelling counterargument to this proposal from big bank. Any closing thoughts?

Benjamin Felix: No, no, I think that's good. Like I mentioned before, I think this is an important thing for people to hear because it's so easy to get sucked into a good pitch when you see good past returns and when there's a good narrative, and you start hearing about alternatives that maybe you weren't thinking about before, but I mean, we do our best to try and educate at least the people that are listening to our podcast about why that stuff is exactly what it is, which is a pitch that looks good but doesn't have a whole lot of backing on the theoretical side or the empirical side.

Cameron Passmore: Seek to understand. Anyways, thanks for listening as always.