How can the Rational Reminder Podcast get even better? By bringing back one of its most beloved voices, Dan Bortolotti, also known as "The Spud." In this exciting episode, hosts Ben Felix, Cameron Passmore, and Mark McGrath announce that Dan, the mind behind the Canadian Couch Potato Podcast, will now be a regular guest, contributing segments like "Bad Investment Advice" or "Ask the Spud.” Before Dan joins the conversation, we have an insightful discussion with Håkon Kavli, CIO of Reitan Kapital. Håkon shares how his team manages the wealth of one of Norway’s most prominent families, comparable to Canada’s Weston family. We discuss Reitan Kapital’s evidence-based investing approach, their robust methods for overcoming portfolio optimization challenges, and much more. Håkon also sheds light on their upcoming investing conference in Norway, featuring speakers like our very own, Cameron Passmore, and Marcos López de Prado. Following this, Dan kicks off his return by dissecting an article that advocates going all-in on the QQQ ETF in an RRSP, exposing the dangers of such a concentrated and risky strategy. He contrasts this approach with the wisdom of diversifying across global markets, using examples like Vanguard’s VEQT ETF, which offers exposure to over 13,000 stocks worldwide. Additionally, if you’re a financial advisor interested in joining a planning-focused, fiduciary firm like PWL Capital, we encourage you to reach out. Our team is growing, and we’re looking for like-minded individuals to join our mission. Tune in for a rich mix of expert advice, thoughtful discussions, and exciting announcements!
Key Points From This Episode:
(0:00:28) Announcements: a new regular guest, PWL’s call for like-minded advisors, and more.
(0:04:15) Introducing Håkon Kavli, the Reitan family, and the origins of Reitan Kapital.
(0:08:06) Reitan Kapital’s investment philosophy and asset allocation strategy.
(0:10:29) The biggest differences between a Reitan Kapital portfolio and a market portfolio.
(0:13:19) Capital market assumptions; how they influence Reitan Kapital's investment process.
(0:20:38) Portfolio optimization challenges and Reitan’s robust methods for addressing these.
(0:35:06) The role of private equity in a diversified portfolio and how it differs from public equity.
(0:38:40) Fee structure significance in private equity investments and their impact on returns.
(0:40:38) Risks associated with private equity and how they compare to public markets.
(0:43:36) Reitan Kapital’s view on how private equity fits into a diversified portfolio.
(0:49:08) Challenges of investing in private equity for retail investors.
(0:50:26) Why so many institutions and firms have substantial allocations to private markets.
(0:53:58) An overview of the research Håkon is most excited about.
(0:56:20) Details for the upcoming conference in Norway, featuring Cameron Passmore.
(0:59:16) Dan’s Bad Investment Advice segment; going all-in on the QQQ ETF in an RRSP.
(01:13:12) Our aftershow segment: listener feedback, our next meetup in Ottawa, a shoutout to Jason Pereira, and more.
Read the Transcript
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from three Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, Portfolio Managers at PWL Capital and Mark McGrath, Associate Portfolio Manager at PWL Capital.
Cameron Passmore: Welcome to Episode 321, and this is a great episode, guys. Super exciting. We have a great guest, which is a bit of a backstory. Then we have a special new regular guest. The spud is back, which I think is super exciting and really fun. It's great to have Dan Bortolotti, our colleague from Toronto, is going to be joining us fairly often, I think, every us episode, as much as you can, with a rotation of either Bad Investment Advice, or Ask the Spud, or something else that might come up, and that was an idea you came up with, Ben.
Ben Felix: Yeah. Dan and I were at a dinner together, and we were just chatting about the Canadian Couch Potato Podcast, which was wildly successful when it was being published on a regular basis. Then Dan ended up stopping doing that, because it was a huge amount of work, and we chatted about that. I was like, it's a shame. Then we'd obviously had Dan on episode 308 of this podcast, which was fantastic. Dan said like, “If there's a way that I could do content,” I don't know if people realize it, but at the time, Dan was doing a lot of his own production for the podcast. We have the conversation, like, if Dan could get back into doing content, without it being the time commitment that it used to be, that would be awesome.
I heard Dan say that, and I took it away. Then I said to Cameron and Mark, “What do you guys think about having a regular segment with Dan?” Of course, everyone loves the idea. I asked Dan. Also loved the idea. It just became this obvious thing that we should do. Then we did it. Dan's going to be a regular on the podcast.
Cameron Passmore: As you said, this is all just a grand experiment anyway.
Ben Felix: The whole podcast.
Cameron Passmore: All of it.
Ben Felix: We don't know what we're doing.
Cameron Passmore: Before Dan, we have an amazing guest. We're joined by Håkon Kavli, who is the CIO of Reitan Kapital from Norway. He's joined us to have an incredible conversation about the process that they use to manage family office money in Norway. I'll tell more of the backstory in the intro. But Ben, you connected with him after I had agreed to go to a conference and got him to come on, which is so cool.
Ben Felix: Yeah. He was a really great guest. You had sent me one of his research papers, really research summary on private equity. I read it and I was like, “Wow, this is really good.” I don't know if it's my idea, your idea, but we decided it might make sense to have him join us.
Cameron Passmore: After I went to the after show, we got a good after show, that they were pretty good follow up on your GIS comments, Mark.
Mark McGrath: Yeah.
Ben Felix: Yup. I think it’s good. Good discussion. Worthwhile to follow up on it.
Cameron Passmore: I just want to mention that we're actively looking to meet like-minded advisors. In fact, I've had a bunch of advisors lately reach out to me. I'm getting more and more, almost a couple every week, either people who are advisors now, or people looking to jump into the industry. So many people are pinging me on LinkedIn just to talk shop for a bit. Just let it put it out there that we are open to meeting advisors who think they might fit inside our company.
If you've listened to the podcast at all, you know who we are, how we operate, and how we think. If you think you are someone who would fit in that environment, please do reach out. We are looking to grow. I, to my core, believe that Canada needs more advisors, like what we represent, fiduciary, do the right thing, planning-centric, believe that markets work, fiduciary firm. I think there's an opportunity for more and more of people like that to come together in a scaled fashion, because there really isn't any scale, to my knowledge, scaled firm, like what we represent in this country. If you are interested, please do reach out. We can have a conversation. You can reach out to any one of us anytime and be happy to follow up.
Ben Felix: Definitely.
Cameron Passmore: Anything else to add, guys?
Ben Felix: Nope. Lots of good content coming up. So, I hope people enjoy it.
***
Cameron Passmore: Okay. Welcome to episode 321. I'll do a quick queue up of our first guest. Early January this year, I received a message on LinkedIn. It was from Håkon Kavli, who is the CIO of Reitan Kapital in Norway. This is a family office that manages the liquid capital of the Reitan family, who are owners of, among other things, but the largest grocery store chain in Norway, and perhaps, other Scandinavian countries, I'm not certain. It was effectively Canada's Weston family would be, I think, a fair Canadian comparable to them.
Håkon was telling me about, they have this ambition to have a conference, and this will be the inaugural one in October, to try to spread the word of this evidence-based, resource-based philosophy around managing assets. They have nothing to sell. This is not going to be a vendor-driven conference. It is information for information's sake, with I think the ultimate goal is to get some cluster of thinking around this way of managing money in their region. They've invited a bunch of people in the industry, peers and other people to come out to this conference. They sent a invite out to me, but I know the invite would be passed on to you, too, as well.
They said, they want it from my perspective, a more common person, practitioner view of this world. They know I'm not an academic. But there's going to be some interesting other academics there, so they've asked me to be on a panel, as well as give a brief presentation on my view of the industry and Canadian perspective of what we all believe in and how it applies to retail investing in Canada. It's going to be amazing.
Also, there's going to be Professor Marcos López de Prado and past guest, Antti Ilmanen is going to be there. It'll be super fun to get to meet two incredible professionals in this space. Very much looking forward to it. It is going to be in Trondheim, Norway at the end of October.
Ben Felix: Super cool.
Mark McGrath: Very cool.
Cameron Passmore: It's very cool. I mean, Håkon is a great, great communicator. You'll see here in a minute that we're so lucky to have him on.
Ben Felix: Yeah.
Cameron Passmore: Ben, anything else to add to that conversation, or we should just go to the conversation with Håkon?
Ben Felix: I think we can just go to the conversation with Håkon.
***
Cameron Passmore: Håkon Kavli, the CIO of Reitan Kapital, welcome to the Rational Reminder Podcast.
Håkon Kavli: Thank you very much for having me.
Cameron Passmore: Great to see you again, and I look forward to seeing you in a few weeks. Right off the top, what is Reitan Kapital?
Håkon Kavli: Reitan Capital is a family office based in Oslo, Norway. Fully owned by the Reitan family. I think it's worthwhile just commenting on the background of the family. They have become an important family in Norway. They started from scratch, grocery, retail, now also convenience stores and retail company. A chain that the world group companies is now one of the 10 largest private and public companies in Norway. They've built up, obviously, some excess liquidity over the years, and that's the part that we manage in Reitan Kapital. We are the investment arm of the company.
I also would like to mention the one brother. The family, the owners split equally between the father and two brothers. The one brother, Magnus Reitan, has a very strong passion. I would say, he's always been a nerd about finance and really about the driest, most boring parts of finance, the portfolio theory, index replication, rebalancing rules, costs, that stuff. It's maybe not the exciting stock picking that gets most people into finance. He is truly a nerd about this, and that's what's so great. That's effectively, once the liquidity was there, the capital was there. He got the opportunity to start this family office.
Ben Felix: Okay. That fills in a lot of questions that I had, because it's not common to see an investor, like Reitan Kapital having the type of investment philosophy that I know you guys have, which we'll talk more about in a second. That makes sense. It takes someone like that to champion this philosophy, because it's so uncommon in that space to invest this. Anyway, so what is Reitan Kapital's investment philosophy?
Håkon Kavli: Well, from the beginning, it has been based on evidence theory research data. Every investment decision, investment process, it should reflect the best available research theories, academic and industry research. It should reflect the available data and it should be consistent with theory. That has been the process and the philosophy. The philosophy didn't have a name at Reitan Kapital until quite recently.
When I actually read Cameron Passmore’s bio on PWL Capital versus evidence-based investing, and I read that. This describes exactly what we do. That's what we now call it, evidence-based investing. Written down in our investment strategy and in our material. I think, it sums up very well the philosophy. We also have principles. We have a mission statement and so forth. We can talk about that also, but the philosophy is the evidence-based investment.
Cameron Passmore: Well, the founder of the family office, how did they come to meet you and have you lead this group?
Håkon Kavli: For a long time, it was among the CEO and one of the three owners who ran this as a one-man shop, effectively. With a significant amount of capital to be fair. He did everything himself and he realized that to build a truly diversified portfolio that he thought was optimal, he needed some more resources. Then yeah, it was no magic behind their typical recruitment process. Recruiters go out, try to find someone who has the academic interest, someone who has some experience with the theory, the portfolio theory. As I mentioned, it's not so common to actually implement the portfolio theory in practice, so it's not that great pool of people to choose from, and I happen to have that background.
Ben Felix: Can you talk about what Reitan Kapital's asset allocation is?
Håkon Kavli: Yeah. The benchmark is based on the risk tolerance of the owners. It's a 60-40 benchmark. A 60% in the MSI all-country world investable markets index, so the broadest index of the public list stocks. The 40% allocation to fixed income, that's the Bloomberg Multiverse Index, which also is pretty much the broadest fixed income index there is.
That 60-40 allocation, we stay very close to that. There are some deviations. We can talk about that later. But the asset allocation always will be very close to a 60-40. That's also because that benchmark was chosen for a reason. We believe that the broader public equity index is probably, it's very hard to beat and it's very should be if you don't have any strong view to do something otherwise and meanwhile, on the fixed income side. It reflects the belief in efficient markets effectively. Yeah.
Cameron Passmore: What are the biggest differences between the Reitan portfolio and a market portfolio?
Håkon Kavli: Well, the market portfolio has a lot more private assets in it if you think of the true market portfolio of all investable assets. It depends what you should include there. I mean, you could say, you should include all family and founder-owned private companies. You might include all kinds of alternative assets, commodities, and so forth. If you compare to that, then you should probably compare that market portfolio to the total Reitan group portfolio, where they actually have still the majority of their investment in their grocery retail, in a family-owned private company. You have that block very much covered. They have a very large property company. Private property is also very much covered already in the Reitan group investments.
In Reitan Kapital, for us, the relevant market portfolio is the investable semi-liquid markets. Our benchmark does leave out quite a few important asset classes. That, for example, private equity is not in our benchmark. Now, I'm talking more suddenly about private equity funds. That is investable for us. It is not in the benchmark, but we have a very small allocation to it. Also, within the equity index, it's not the truly market weighted index. For example, China has a lower weight than its market capitalization would imply. We have made some adjustments to actually get closer to the market portfolio than our benchmark is.
It's an interesting question. What's the difference between our portfolio and the market portfolio? I think, we typically look at deviations from our portfolio to our benchmark, but most of those deviations bring us closer to the market portfolio. Typically, what we've done so far when we deviate from the benchmark is to add back something that's missing in the benchmark that we think has a relevant role in the market portfolio.
Ben Felix: You mentioned private equity, which I want to come back to later. Do you do anything else, like tilting toward smaller companies, or lower priced companies?
Håkon Kavli: We have a small tilt towards low-volatility companies. To me, that's one of the factors that I think is very appealing in the mean variance framework. We don't have any other tilt within the public equity space. We do have a significant tilt in the fixed income portfolio, towards some alternative assets. First of all, it's stopped us missing from the multiverse. You have, for example, inflation in bonds. It's not in the multiverse index. It makes sense to look at adding some of that, and we do have a small allocation here.
Also, within emerging markets, local currency, our currency bonds that are not fully in the benchmark that we added. Then the alternatives, we have some catastrophe bonds. As an asset class, I find very fascinating. They actually truly get a risky compensation for a very idiosyncratic risk. A risk that has nothing to do with just global macro conditions, or markets. There are some deviations like that. It’s overall a very close to index portfolio.
Ben Felix: Very cool. How important are capital market assumptions to your investment process?
Håkon Kavli: It is very important. It’s actually very central as the first step in our process. We outline our processes as first defining our view on each asset class, or at least evaluating each asset class. The product of that is the capital market assumptions. Then we have third steps later that we can talk about. On that first step for our process, first of all, defining them, having a model, writing down a document gives some discipline to the expectations. We need to have some expectations. We need to have some view of risk. We need to know what is the risk we expect in this portfolio? How do we expect to improve diversification? How do we expect to add risk at risk of return?
We need some view and we have found that being evidence-based also requires that we actually build proper discipline models, or quite systematic about it and document it and write it down. We're a very small team, but we try to really, we first do something to put in the effort to effectively impose that discipline on ourselves by documenting it. Yeah, it's important for those purposes, but the direct use of the CMA, capital market assumptions, is as an input into the next steps, which is about the portfolio construction.
Cameron Passmore: How do you approach developing the capital market assumptions for equities?
Håkon Kavli: For equities, we tend to have two approaches. One which looks at the empirical history and one which looks at fundamental data, the pricing. The empirical history, we need as long history as possible for it to be meaningful. Past 20, 30 years, doesn't really tell us anything about the next 20 years. I can discuss that now, but we look at history as far back as we can get. We have the [inaudible 0:15:02] type 130, or 125-year history. The great thing about that history is that it includes a range of different market regimes. You have two world wars in there. You have, I was going to say, the rise and fall of empires might be exaggerating. We at least have the fall of the Austrian empire, which actually had a big market caveat in the beginning of that sample.
You have hyperinflation. You have extreme monetary policy of two major financial crises. You have a lot of events, and then you have fantastic economic growth, also, during that sample. That sample gives us a fairly broad representation of possible outcomes that might happen again in the future. That becomes an anchor point for expected returns going forward. They shouldn't deviate too far from that observed history.
The problem is that the history is the past and we know some information about market pricing today about what has driven those past returns. That information, we don't want to ignore that. We think that information is important. Then the approach becomes more about trying to understand what drove past returns, thinking a bit about, is it reasonable to expect that to continue? If you look at the history, the last 30 years have had fantastic returns in equities, especially in the developed world, especially in the United States.
If you look at what explained those returns, if you decompose them, a lot of it, practically all of it can be explained by falling interest rates, which one, increases valuations, but it also increases earnings. I mean, you have much lower interest cost. Your margins effectively increase just from interest rates falling. Corporate tax rates have declined drastically over those 30 years, effective corporate tax rates. That also is very visible in the numbers. The top line revenue hasn't grown that much, but the profit margins have grown significantly. Pretty much all that growth in margins comes from interest rates and taxes. Those two forces are not likely to just continue. We can't project those into future tax rates. There's only so low they can go. Most likely, they will mean revert something back to history. At least that's what the pressure seems to be with the OSCD agreements.
Interest rates also, they are mean-reverting. Yes, they can. We have learned now, they can go below zero, but you can't project that trend forever. There is very good reason to expect these forces to mean revert. That reduces our expected return going forward, simply because it reduces our expected earnings per share for a given growth in revenue. Revenue growth is very hard to say something about. There, we tie that to expected GDP growth. There's nothing magical, or fancy there in our models, but we need to tie it to something.
Anyway, so we start with revenue growth. Expect some mean-reversion in margins. Gives us an spend real time, just for dilution, look at the total pay-out ratio, and then we get an expected future dividend. Then from that, we effectively use the Gordon Growth Model to back out what becomes implied return from these processes.
I think what makes it very different from a lot of the CMAs you read out there is that it's quite common to project earnings directly. The problem with that is that it assumes that either those trends that talk about the rates, taxes, either you assume that they continue, or you just have to have some other force that brings earnings growth on that same trajectory going forward. That might be happened. That might be AI, or something, but you need something else to step in for that value driver.
Ben Felix: Super interesting arguments, just on what's driven valuations to date.
Håkon Kavli: It's quite surprising. Yeah.
Ben Felix: It is a little scary, I think, for people who maybe assume US stocks are going to keep delivering 10% forever. What about fixed income? How do you approach capital market assumptions there?
Håkon Kavli: There, the pricing becomes more important. I mean, history tells us a lot, especially about cash rates. It's a building block approach in fixed income. We start with the real cash rates, add inflation on top of that, add a term premium on top of that for bonds that have some maturity duration, add credit spread, then you have to add some credit loss, and some valuation change. The valuation change becomes small in the long run. It matters in the short-term, it becomes small and longer. It's a building block approach.
Effectively, just to go into a little bit of detail on it, cash rates, we know what cash rate is today. We know what the market price is in for expected cash rates going forward. It can be backed up off the curves. We do think that the very long-term history on cash rates tells us something about the terminal rate. Effectively, then just project interest rates expected from today via market pricing towards the terminal rate. That's determined more by the long-term history.
Then the term structure is very much based on the New York Fed models, the Adrian models that are available, that back out the expected future curve and the expected short premium. The credit spreads, there we have quite a basic mean reversion model. You run a regression on the past, the pace of mean reversion in credit spreads. We know they are mean-reverting. We don't really know how fast. That's what we estimate based on history. From all of this, we can affect and project all the building blocks. We get future expected yields and we can back out, with one method, the implied returns going forward. I mean, it's a lot of components, it's a lot of uncertainty obviously, but it's fundamentally sound, it makes sense.
Ben Felix: Yeah, super interesting stuff. You're right up on [inaudible 0:20:16] market assumptions is incredible. Is that something that ever gets published? Listeners could see?
Håkon Kavli: Yeah. The one I shared with you is not published. We have published a mini version, more of an easier, superficial version of it. I really would like to write up the one I've shared with you for the public. I think that should be done within the next six months hopefully.
Ben Felix: It's so good. I hope you do it.
Håkon Kavli: Thank you.
Ben Felix: Worthwhile reading.
Cameron Passmore: Can you talk about the role that portfolio optimization plays in the investment process you follow?
Håkon Kavli: Yes. It's something we spent a lot of time on and it is important. It has several roles. Strategic asset allocation, long-term asset allocation, that is one use where it's more of a guide towards the expected direction of travel for our portfolio. We don't implement that directly, but we run an optimization with quite tight constraints. In the strategic setting, we accept that it takes time to build up illiquid positions. We accept that other positions are illiquid today, but can be altered over time. It's a very flexible optimization. It's never really implemented.
Then we run optimizations that actually are intended to be implemented. Those will reflect more short-term constraints, like liquidity, transaction costs, so where the portfolio is today becomes very important and it's very tight constraints around that. Sometimes, typically, it becomes relevant if we have a large flow in or out of the portfolio. That means that our illiquid positions today will either become bigger or smaller as their share of the total, and we need to adapt the rest of the portfolio to that. Then optimization is very useful for finding out how do we adapt to this new size that illiquid investments gets.
Sometimes if a new investment opportunity arises, we use optimization to find out what's the best way of financing this, should we want to buy, let’s say, a new asset class we don't have today. It needs to come out of something else. How do you know what other asset assets you should sell down in order to buy this new one? Well, in that setting, optimization becomes very useful. Yeah, we always discuss the proposal that the optimizer gets. It's an iterative process. It's not blindly implemented. In the end, we iterate it so that the optimized portfolio is the one that actually is implemented very accurately, actually.
Ben Felix: Yeah, that is interesting. Can you talk about the challenges with traditional portfolio optimization routines?
Håkon Kavli: Yes. There are a lot of them. Some of them are very problematic, very challenging. The most common is in all statistical models, garbage in means garbage out. It is a famous saying. In optimization, it's much worse than that. I would say, even just slightly polluted input gives you total garbage out. That is a problem. Luckily, there are some ways of overcoming it, but it is a problem.
Michaud, famous 1989 paper, termed that it’s not necessarily a portfolio optimization. It's error maximization. It takes a little error in and it's just exploding. This is something horrible. That is the main problem. That arises from two things effectively. One is that financial data is always polluted with a lot of noise, much more than most other types of data. Financial data often is pure noise. It might not be any signal in there at all. You never know how much signal is there, how much noise is there. This is always a problem. Then you have the added problem that the optimizer can't handle that noise very well. It effectively explodes into completely nonsensical weights. That is the main problem and that is what we're trying to address.
I just want to add one point, which can be confusing. The optimizer does not require a perfect forecast of returns. It just needs a perfect model of that describes their statistical properties, growing distribution, the parameters. That's what we need to have a precise forecast on.
Cameron Passmore: Keep going. What do you do to overcome these challenges?
Håkon Kavli: We can start with the idea that you can either improve the signal-to-noise ratio, or you can have an algorithm that better handles noise. On the signal-to-noise ratio, the inputs that are noisy are affected with the CMA, that is expected return. It's the standard deviation of returns, volatility, and it's a correlations in returns between asset classes. You can try to reduce the noise in those estimates through a variety of methods. The most famous one is maybe Black Letterman, which tries to reduce the noise in expected returns. It's a very elegant solution, where effectively, they assume that the market is efficient and you back out from the market to weight. What are the implied expected returns that would make the market weights the optimal portfolio?
In order to back that out, you need to actually already have a view of what the market thinks the correlation matrix is. It's very hard to back out. I worry that you put in noisy assumptions one place to remove them somewhere else and it doesn't get much better. That is a very famous and very elegant approach, but it's not very easy to use in practice. You can shrink the expected returns, or reduce the noise in expected returns, even more aggressively by, for example, assuming the same return in all asset classes, then you effectively optimize for a minimum variance portfolio, so the lowest, lowest variance portfolio.
That happens to be very robust, much more robust than a mean-variance portfolio. Actually, even more surprising in out-of-sample testing, a minimum variance portfolio tends to outperform measured by a short ratio, than a portfolio that's optimized for a short ratio out of sample. It is actually surprisingly robust. That is also Patrick's dream. Effectively, you ignore all assumptions about expected returns, and you no longer have the objective function that might be your mandate. Our mandate in Reitan Kapital is to maximize risk-adjusted return. We would prefer a model where that is actually the objective function that you optimize for what our mandate is.
There are a lot of other methods that do that. You can shrink the correlation matrix. They're the most famous approaches, the Ledoit-Wolf shrinkage effectively just shrinks it towards the identity matrix, effectively then just reducing the correlations, making them closer to zero. In doing that, you do remove noise, but you might also remove some of the signal information in the correlation matrix. Marcos López de Prado recommends combining that with other de-noising methods. The one he recommends, which is also very elegant, and I like a lot is fitting – let me just be technical for two seconds. You fit the correlation matrix, or the eigenvalues of the correlation matrix, to a so-called Marcenko-Pastur distribution. You can forget about why it works. But just, what it does is that you can then see which eigenvalues most likely are associated with signal, with information. They will come outside of that distribution.
From those eigenvalues, you can reconstruct a correlation matrix, covariance matrix, that hopefully should have a lot less noise. In simulated data, that works extremely well, it's harder to evaluate how well it works in real data, but it appears to be very powerful. By having a less noisy covariance matrix, your optimization retainable also be much, much more robust.
Ben Felix: Man, there's all these different approaches to improving optimization. How different are the asset allocation outputs from these different approaches?
Håkon Kavli: There is a lot of variance in weights, depending on method you choose. The purpose of the robustness exercise is to make that variance lower, to arrive at a more stable allocation. It still will depend somewhat on the chosen method. Especially on whether you optimize for a minimum lost objective function, or a minimum variance, or others have these minimax methods where you try to optimize for the best worst-case outcome. Those types of optimizers will arrive at slightly different weights than other robust methods that are, for example, more focused on re-sampling, which actually we use a lot in our approach.
The re-sampling is most very much favoured by Michaud too effectively, actually a trademarked particular approach to do that, which then reduces noise by using Monte Carlo simulations, or bootstrap re-sampling. The nice thing with those is that then you can still use the Sharpe ratio as your objective function that you try to optimize for. I think the whole goal here is that these robust methods should give you more similar weights than the classical version with just slightly variation in inputs. It's still noisy, for sure.
Ben Felix: How do you guys take all that literature and actually implement it? How are you using optimization?
Håkon Kavli: We have tried to learn from the literature, and we implement what we find, firstly, have good evidence of creating a more robust portfolio, and that is consistent with our mandate of maximizing risk-adjusted return. The nice thing about most of the methods I mentioned now, there are several papers that show that they can be combined in various ways, and the combinations typically are better than using just one solution on its own. That we have really taken to heart, and we use the ones that effectively take our inputs without removing too much of the information that we believe is there.
We believe that our CMA has information in it, first of all. We believe that our expected returns are better than just expecting the same across all asset classes. That information we want to keep. We, therefore, don't use the robustness solutions that just ignore expected returns altogether. That leaves us with the models that improve the correlation matrices, so we do use the approach that López de Prado recommends, shrinkage and de-noising. Also, we use a lot of resampling, like Michaud and several other papers after that. Have documented that actually do reduce noise and inputs, and also, better handle the noise that is left.
First of all, we try to make very robust CMAs that also have some model averaging in them to reduce noise, and then we use a factory resampling and shrinkage and de-noising of the correlation matrices.
Ben Felix: Cool. Super interesting. You mentioned Sharpe ratio a couple of times as being the objective function, or maximizing that being the objective function. How do you account for, or how do you think about the effects of serial correlation on long horizon stock returns?
Håkon Kavli: To be honest, we don't have a very direct treatment of that. I would say a few places where it has been implemented. Our 60-40 benchmark, first of all, is based on the risk tolerance of the owners. In that benchmark already, you had very explicitly a discussion about how risky will it be to have 60-40 versus 50-50, or 80-20. In that discussion, serial correlation in returns was central, and also the literature around this focuses very much on long-term returns being effectively less risky than short-term returns, either because you have a negative serial correlation, so that loss of today, I'll earn that back tomorrow. Or, simply because of annualized returns by the law of large numbers, the arithmetic average, at least, will tend towards the average over time. 12-month horizon equities are very risky. On a 30-year horizon, at least arithmetic returns will be closer to the average.
One of the reasons that we haven't explicitly built this assumption into our optimization is that I think it is not obvious that long-term is that much less risky. But I made a point that arithmetic returns become more stable. Annualized returns become more stable. The geometric returns, cumulative returns, a lot of the risk can accumulate. The most extreme is, if you think of compound return over one year in equities, for example, fairly certain it's going to be between minus 50% and plus 50% over one year. Over 100 a period, there's a chance it's zero, because if it hits zero just once – I mean, okay, zero is extreme, but you will never recover from it.
If you have an infinite horizon, the mathematics say, it's probability of one, you're going to hit zero at some point, and then you'll never recover. No matter how good arithmetic return is, no matter how good the average is, you will be stuck with zero. Time does not remove all risks. It does remove risk from arithmetic average, but it does not remove that compound risk that is relevant. I mean, the dollar value in 30 years, that's really the number that counts. Means much more than what the arithmetic average was over those 30 years. The long-term is less risky in some ways, but it's not obvious that it truly is less risky.
Ben Felix: Yeah, you get more variance for sure. What did you think about the episode with Scott Cederburg about the long horizon risks of stocks and bonds?
Håkon Kavli: I think he touched on some of those points, didn't he? I'm trying to really think back now. I did really listen to that just yesterday, I think.
Ben Felix: He does bootstrap with really long horizon data.
Håkon Kavli: And he did the block.
Ben Felix: The block sample, yeah. That’s it.
Håkon Kavli: Yeah. We do the same thing, actually, especially on the correlations. That makes a lot of sense. I really think so. I'm a little bit more sceptical on this negative zero correlation. It's not so obvious to me that it truly is there. I think, I love this approach and I love the discussion you had about the survivorship bias that you have in those long samples. That's something that might be an issue in the way we have used it, to be honest. I mentioned earlier that the Austria-Hungarian Empire had quite a high market cap weight in 1900. If we were to weight the basket by the weight it had back then and then cut the return over the preceding 120 years until today, you will get a very different return than if you use the current market cap weights and cut it backwards. Very good points. There are definitely insights from that episode that I need to revisit in our work. I think there are weaknesses there in the way we have thought about some of that.
Ben Felix: Yeah. It's super interesting to think about. For a family, like the Reitan family, it's like, their time horizon is presumably very long. It's multi-generational wealth. Thinking about the differences in risks over a 100-year horizon versus a 10-year, I think is, yeah, super interesting when it comes to asset allocation.
Håkon Kavli: One thing I remember also from that episode, which was a very important point. Well, I think it was that episode, about domestic stocks versus international stocks. In domestic stocks, there is just so much more risk. Also, if you look at the sample, there are 20-some countries in this sample, and you have a communist revolution in two of the countries and everything goes to zero. Again, compound returns, you have nothing. No matter how much returns are later, you have nothing to grow, so you will never earn it back. Those cases are super important. I think having a globally diversified portfolio almost eliminates that risk.
Ben Felix: Yeah. I think that's right.
Håkon Kavli: Makes it less sensitive. But it was a major lesson from that episode. Having a domestic equity portfolio is maybe home bias can be good for some reason, but 100% domestic, which a lot of people do, that is unnecessarily risky.
Ben Felix: Yeah, and it's not just a total loss. It was the link between domestic inflation and poor domestic stock returns. That was another big piece of that. With foreign currency from international stocks, you don't get that at all, or you get some protection against it.
Håkon Kavli: The exchange rate is actually a major risk-reducing factor for us. The Norwegian Krone, it's south of in stress periods, meaning we get a lot more Krone back for each dollar invested outside of Norway. Our equity is effectively at cancel thought, quite a lot of our equity volatility.
Ben Felix: Interesting.
Cameron Passmore: I'd like to go back to something you mentioned earlier. Can you talk about how private equity is different from public equity?
Håkon Kavli: Yeah, we recently published a note, where we practically tried to review the entire literature on private equity. A year ago, I didn't know much about private equity at all, and then I spent a lot of time reading up everything I could find. That question is great. I mean, it's the same, except the one is traded on stock exchange, and the other is not. That was very much my view as I started this project.
Then I have come to realize that the academic literature is very clear. The portfolio companies, the average portfolio companies in private equity, so that means private equity funds, and I'm really talking about buyout funds. The average companies are different. They behave different. At some points, they are very important, actually. First of all, they tend to be drastically changed after they've been purchased. They go through, effectively, a revolution. Whereas, public companies have a constant evolution of management, of strategy, of whatever.
The data is very clearly supporting this. There's a paper, quite recent, 2022 paper in American Economic Reviews, literally number one journal in economics by Davis, and some other authors. They go through five, six million US companies, and look at the ones that were bought by private equity, and the ones that were not. Look at how do they differ. The rate of investment in high growth areas of the business is twice as high in the private equity on companies than in the others. The rate of shutting down science factories, whatever, is also much higher in the private equity on companies than in the others.
The employment growth in the high-growth segments of the business is much higher in private equity owned companies than in others. Effectively, that's true on average across the five, six million companies, like in America. They argue, shows that there is a difference here. The companies are affected by being purchased by a private equity company. The company changes. It becomes a different type of company. It becomes a company that goes through more change.
In their dataset, they find that this actually does improve operating margins. There are other studies in top journals that find the same result. There’s another famous one called in 2022 in Review of Finance that looks at one niche at restaurants. Then in their words, they become better maintained, safer, and more profitable. I don't remember exactly how they phrased it, but this surprised me, because the industry has a bad reputation. It does actually create a lot of value. What also happens is that the GPs take pretty much all that value to themselves in peace, but that's beside the point. How is it different from public equities? Well, the securities are traded one test and the others are not. But the portfolio companies actually do behave differently. I think that is important to accept.
Ben Felix: It makes sense. One of the things that I've always found striking about the private equity literature is that if you can say that net of fees, you're getting roughly public equity returns, and we'll talk more about this in a second, I'm sure. If you can say that, but you can also say that they're charging ridiculously high fees, it means they're generating a tremendous amount of value. That just has to be true.
Håkon Kavli: It's interesting. I mean, you have professors who are extremely sceptical of the industry, like Phalippou, for example, I also listened to his episode. It was great. I love his research and I love the episode. It's funny to me how his research also effectively accepts that they do create value, but the GP takes all of it. He might be very critical of that part and therefore, have questions about whether or not it makes sense as an investment. The fact is that even the most critical voices, they agree that value is created. That is easy to forget, actually.
Ben Felix: How much does it cost in terms of fees to the limited partner to invest in private equity funds?
Håkon Kavli: Yeah. It depends on a lot of assumptions. First of all, because the typical fee structure is you have between 1.5 and 2% management fee, 2% is the most common, but the average is slightly lower than that. Then pretty much all funds have a 20% performance fee. I can talk a little bit about how the different types of performance fees also, because it matters. Then you have these other more hidden fees.
The performance fee can become a very big expense if the fund performs very well. That creates some variability in what you should expect. The more hidden fees, like transaction fees, monitoring fees, they are totally unknown before you invest. The monitoring fees, so that is effectively a fee that the portfolio company pays to the GP. Those fees are not known at all before each individual transaction is done. That's when the GP writes a contract, a service agreement with the portfolio company about what they can charge in the monitoring fees. You just cannot know at the time of signing an LPA, an agreement with the GP. You don't know. But on average, the literature really have based this on two major studies, Metrick and Yasuda and Sensoy and Robinson, I think it was.
If you combine these numbers from the two studies, our expectation is that you pay on average between 3% and 4% of net asset value every year for a complete portfolio of overlapping funds. That is also based on relatively modest return expectations. If you expect the 25% IRR that they present you in their material, well, then you should also expect to pay much more than 4% fees, because then the performance fee becomes a big element.
Ben Felix: Super interesting. Again, just to reiterate, if we're saying the total fees are 4%, and they're roughly delivering market returns, that's incredible.
Håkon Kavli: They have delivered more than market return, but they have also taken more risk. Yeah.
Cameron Passmore: How risky is private equity compared to public?
Håkon Kavli: Yeah. Another good question that should be easy to answer. Surprisingly, it's not so easy. If you measure the volatility of reported NAVS, it tends to be roughly 10% volatility, and that's still not quite a harsh way of measuring it. That is not the true volatility. That's not the true risk. I'm sure you’ve had other people on talking about volatility smoothing and all of that, and we can get into that a bit. I think the most credible papers and the most recent papers seem to converge to a higher and higher number, that's closer to 30%, around 30% annual standard deviation, annual volatility in the value of very broad protective portfolio. That is the assumption that we have made, 30% standard deviation in returns of private equity. That's our expectation.
That is twice as high as in public equities. Why should it be twice as risky? Why is that a reasonable estimate? It is not obvious either, because, yeah, you could say they are more leveraged. They used to be very leveraged compared to public companies. It's not so much the case anymore. They are slightly more leveraged. I mean, each transaction is clearly leveraged. Typically, they buy companies that don't have much leverage to begin with, and then they take some equity from LPs at that and buy the company. After that acquisition, it is much more leveraged than it was prior to that, but they've already selected our companies that have less debt to begin with. They do have more leverage, but that cannot at all explain such a high volatility.
My own personal theory is that it's so risky, because what I mentioned earlier, these companies go through a revolution, rather than evolution. They go through a drastic change in strategy, massive pace of investment, massive pace of disinvestment, new management, a lot of change happening in these companies. It's just natural that their value will also be more volatile. That's purely an untested theory, by the way, and that's not taken from any literature.
Ben Felix: We come in around the same. We don't publish our alternative asset class expected returns, but we do them internally. We're at about 30% standard deviation as well. The thing that I've struggled with is how to model skewness or even just the much wider distribution of fund returns relative to public markets. It's like, we could say what the standard deviation is for private equity funds, great. But it's also really hard to get the average return of private equity funds, because you can't invest in all of them.
Håkon Kavli: Yeah, exactly. That's a huge point. I mean, a lot of the risk comes from selection. In public markets, you can buy the broad market. In private equity, you take so much DP risk. I mean, you don't know if it's going to deliver average or not. I mean, you can, if you're willing to pay the fees, you can build a very broad portfolio. We looked at if you have a portfolio of overlapping fund of funds, for example, or just a broad internal portfolio, you will have thousands of portfolio companies at any point in time in your private equity portfolio. Yeah, you can create almost index-like returns from private equity. You need to have built up a program over a long time.
Ben Felix: Yeah, that makes sense. What's your view? Or what's Reitan Kapital’s view on how private equity fits into a diversified portfolio?
Håkon Kavli: We do believe that private equity has a role, and we believe that private equity, at least historically, has given you exactly the return you should require for the risks that you have taken, net of fees. Then I include liquidity as the risk collector here. That is based on other research. Actually, Phalippou was a co-author, with Aang and others on one of the major papers that we have based this on, where they look at the actual cash flows of all investments across a huge range of wild beasts. From those cash flows, we can back out what's implied loading to the value factor, to the size factor, to the market, and to liquidity, and also, to a private equity factor.
They find that the private equity factor is significant on its own, which is quite interesting. It means that there might be some diversification and new factor here that's actually interesting to have exposure to. I also do believe that private equity does, again, what I mentioned earlier about this revolution, as we call it, instead of evolution. I think that creates a different risk dynamic that might be interesting to have exposure to. It is interesting to me that those studies have found that, yes, private equity has outperformed public equities, but that is due to risks that you have taken. It might not be that it's literally due to the risks you've taken, but you have taken these risks, you got compensated for it.
There's one thing here that, again, is untested, but I do believe that a lot of the returns you get in private equity comes from the value creation that has been proven to take place. The question is, did you get what you got because of the value exposure and the size exposure, or did you get some of it from that other value creation and the GPS took to themselves as much as they could, while still giving the LPs enough return to justify the risks they've taken?
I don't think any individual GP has thought of what was the loading and how much do we need to give them. It doesn't work like that. But I think on average, just like efficient markets, it's not the individual investors being super rational, but the market as a whole seems to equalize around something that makes sense. I suspect that's what happened there, and that means that you get paid for the risks you take in private equity.
If those returns might be slightly more robust, because they have one more leg to stand on, and that is the value creation that GPs do. Then it's another important point when you ask about, does it belong in a portfolio? The market portfolio, if you assume efficient markets, clearly has a lot of private companies in it. If we just look at the companies that are owned by private equity funds that are directly investable for institutional investors, that market portfolio has, I think, a 7 trillion worth of AUM invested in private equity funds, of which public buyout is a big portion.
I'm going to pull out the numbers here, because I did not write them down here. Yeah, so buyout and growth equity is roughly 5.3% of the total equity market, including public and private. 5.3%. A 60-40 portfolio like ourselves, that means that buyout and growth equity should be roughly 3.2%. If you want to be just market-weighted, have no view on it. If your own costs are higher than the average, you should probably have less. If you can access this in a cheaper way, or you have better skill at identifying good GPs, well, then you could have some more, and there is actually some evidence that at least identifying the bottom quartile appears to still be possible. If you've managed to just read that out, which literature seems to still indicate that that's possible, well, then maybe you could actually justify having slightly higher allocation if you do that and still end up at average cost.
Ben Felix: Yeah. I've thought a lot about both of the things you just said. But if I wanted to justify building a private equity program, you can do it pretty easily by saying, “Listen, if we can get access at below whatever, say it's below the 4%, if you can access private equity at 2% because of your scale. If you can avoid bottom quartile managers on expectation based on the literature, your expected return from private equity is quite attractive.”
Håkon Kavli: It is. It's interesting, because, I mean, it used to be the case. At least earlier papers found that you could also identify the top quartile based on past vintages. Again, you can't look at the most recent vintages, because those numbers are just artificial. But truly, fully mature past vintages. They did actually earlier have some information about whether, or not this GP would be in the top quartile in the future. That doesn't seem to be the case anymore, at least not in the more recent papers. But the most recent papers still find and even find an increasing significance of the tendency of bottom quartile managers to remain in the bottom quartile. That should be possible to identify, just literally from looking at past performance. If it is, well, yeah, then you have reason to believe that you should outperform the average private equity investor.
Ben Felix: Yeah, yeah. I wanted to go back to something you said earlier about how GPs might be taking out the fees, so they deliver the returns to investors, so their returns are commensurate with the risk they've taken and then the GPs take out the rest. That's Berk and Green, the 2004 Berk and Green. Yeah, yeah. Exactly, where rational markets for manager skills –
Håkon Kavli: That's more in the public stocks, I suppose, they look at their –
Ben Felix: They look at mutual funds. That paper was just theoretical, too.
Håkon Kavli: Yeah. It's funny, when I read those, I struggle to think that I can't imagine anyone actually behaving in this way, but I think the market as a whole arrives at that point in the end anyways. At least, it's quite a coincidence that the data pretty much confirms exactly what you should expect if you thought the market is very efficient. There's no way the data will reject another hypothesis that the market is efficient. Let’s put it that way.
Ben Felix: We talked about what the market weight is for private equity and how if you have skilled and selective managers, or low-fee access, you may be overweight. What about for a smaller investor, or a retail investor? How do you think it changes for them?
Håkon Kavli: I don't think private equity makes sense for them, to be honest. It's hard to imagine that they could get – I mean, remember, average fees are not the fees that are advertised, because if pay more than the stated fees, but quite a lot of big institutions pay less, or they do a lot of co-investments, or manage internally at lower total cost. The average fee is not $2.20. Then it's, they start really with a disadvantage. I don't think, also, they would have enough access to filter out the bottom quartile. It would be quite random, which fund they ended up in.
I also think it's hard for retail investors to evaluate the LPA, the agreement that you write with the GP, even if you have enough capital. I mean, it's just like we talked about carry, or performance fees. Yeah, it's above a hurdle rate of 8%. But this is 100% catch-up, where it’s not to pay really on everything above zero, or everything above eight? It's not obvious. Or this is the European-American waterfall. There's so many intricacies. Why take that risk of being on the losing end? I don't know. For a retail investor, I just don't see it's worth it.
Ben Felix: I agree with that.
Cameron Passmore: Why do you think so many institutions and firms have such substantial allocations to private markets?
Håkon Kavli: Some of them, I think, are hard to justify it from just looking at evidence alone. Certain endowments and certain pensioners just have a strangely high allocation. I think there are several potentially good reasons. One is that they might have actual skill at identifying top quartile managers, or at least rule out the bottom quartile. I do believe that what I said earlier is that the evidence shows that you can't just rely on past performance to identify the top quartile.
There are papers that show that there is information in the marketing material, in the prospectus, that has some predictive power of future performance of that fund. It's not impossible necessarily to identify the top quartile. It takes resources and it takes a certain skill. It's very hard to evaluate if you have that skill yourself. If they believe so, well, that could justify for them having a higher allocation to private equity. At least, if they think they have the skill to do that in private equity, but at the same time, don't have that skill in public markets. I mean, if you are that skilful, maybe you could pick out the best public market managers and outperform there at lower fees. I don't know. I think, it has to depend quite a bit, believe that you can outperform.
The other thing is lower fees. They might have genuinely lower fees than the average. Certain institutions do have very attractive fees compared to most others. Then you have the more semi-rational, semi-irrational reasons, like volatility smoothing, which I mentioned earlier, that has a real value for at least for the – if you have a principal agent problem, or principal is the owner of the asset and the agent is the manager, if the principal is not truly on top of everything, it might be very comfortable for the manager to go and show various mood returns. That might be a way of preserving their employment security. It's rational for the manager.
Then assumes that the markets are not really efficient. That is bad behaviour. Volatility smoothing has also some true benefits. If you do know that you have the risk tolerance to take the risk, but you also have a tendency to be jumpy and make rash decisions, well, then volatility, or at least being locked in for a long time has some value. Then it's a FOMO. I think, FOMO is part of it. Do you see everyone else doing private equity? They talk about the greater turns in it, and they talk about the greater IRR and don't want to miss out.
Ben Felix: I find that super interesting, because it's not at all obvious that the large institutions with those large allocations to private equity have actually done any better than they could have with a lower cost portfolio, at least from what I've read on that. I did see that the Norwegian Sovereign Wealth Fund, the Ministry of Finance, I guess, rejected the addition of an allocation of private equity. I thought that was pretty interesting.
Håkon Kavli: Yeah. The final word has not been said. But yes, they have for now rejected it. The NBIM, the manager, state-owned manager part of the Central Bank, have effectively recommended that private sector should be part of their universe that they can invest in. They would never go to allocations that you see in some other institutions, but a moderate allocation is probably what they would want, maybe in line with market weights, to be honest. Yeah, that has been for now turned down, but it is an actual ongoing discussion here.
It is interesting. I mean, the nice thing for us, a small investor, relatively, is that when they want to make a decision like this, they commission research from the best in the world, and they had MSI write up a whole report to get a lot of data, and then they just publish it openly for everyone to read immediately. We get a lot of free research that way, so it's a nice benefit.
Ben Felix: That is very cool. What's the most exciting research that you're working on right now?
Håkon Kavli: The private sector research that we just finished and published was for me, an eye-opener going from not knowing much about private equity a year ago, to now feeling like I have read the most important, to have an actual true view and understanding, and some opinions about it. I think, that leads me to a continuation, which is to think about what's it all say about the future of private equity and the role in the current environment.
Does it really matter that there has been so much more influence in the private sector now, all the dry capital? The research we did now, which we have shared openly, is purely literature. We don't do any research. We look at only the literature published in top journals, simply just as a filtering exercise. Otherwise, it's just too much. If you want to look more forward, look at more the current setting, takes years to get published in the top journals, so that will say nothing about the currency. That is one thing that we want to think about, and what does it as a class make sense for us. If so, how should we approach it?
The other is an optimization I should discuss earlier. I'm actually very excited about the research that Marcos Lopez de Prado publishes. I am very optimistic that his nested clustered optimization makes a lot of sense for us. It's a way that it takes in RRSC, made our inputs in a way that I like, and segments the portfolio into groups in a way that makes a lot of sense. I'm very excited to explore that further.
Then overall, this is not in the immediate future, but the holy grail for us is defined a true source of diversification. An asset class that does not depend on discount rate sales much. I mean, the problem is that everything is discounted cash flows. when Rates change, I mean, every NAV changes. Are there better ways of diversifying out that risk? If not, at least finding asset classes that truly diversify, that don't just look like they're diversifying in smoother data, or bad data. This is what I'm asking everyone when I meet people is what's the most exciting, diversifying asset class that I haven't thought about. Maybe you have some. I should ask you now.
Ben Felix: I don't have any. If I did, I don't know if I would tell you. You might ruin it.
Håkon Kavli: Yeah. No, that's a good point. I mean, if it becomes very popular, then it starts trading with the risk sentiment and then becomes correlated. It's true. You don't want it to be liquid, but you don't want it to be too popular among like-minded investors.
Ben Felix: Yeah, exactly. What can you tell us about the event that Cameron's speaking at in October?
Håkon Kavli: As I'm sure you do, we get invited to a lot of conferences and seminars and events, where there's interesting presentations on an asset class, or some topical question, but it's always hosted by an asset manager, or someone who has a product to sell. If you go to a private active seminar, you know that there's going to be a private equity product offered by these companies. You never know truly how unbiased is this really.
We wanted something that really spoke to the most relevant problems that we are facing as asset owners, and we wanted it to be in a setting that has no sales agenda at all. Also, where the presenters have no sales agenda. We wanted to focus on research, then applied research is actually relevant for asset owners, or their managers. We have invited senior investment professionals from the main asset owners in Norway, that is in terms of companies, institutions, family offices, and so forth, and we have also invited academics, professors, and asset managers.
The idea is to have some presentations. Cameron Passmore will be here. Thank you. To talk about evidence-based investing, or experience with that, and also, maybe helping us translate a bit of that research that's presented that day to the investors in the room that might not have the same skill at the more technical side. That’s, I think about you guys are doing on this podcast, it'll be partly his role on that conference. Then we also have Antti Ilmanen coming to talk about expected returns on CMAs. We have Marcos Lopez de Prado, who I mentioned earlier on portfolio optimization. I think he is one of the most exciting researchers out there within quantitative finance. I think he's also literally the most-read author on SSRN or something. He is truly a scoop for us to have there, and I'm very excited to learn from him.
We have also the multi-decade head of external mandates at the Norwegian Sovereign Wealth Fund. I mean, they are one of the absolute largest asset managers, or asset owners in the world, and he has been there for well above 20 years now. They're evidence-based to be fair. They don't say, use those words, but I mean, they get top professors from around the world doing research on topics that are relevant for them, and truly, truly great research being done there. It's very, very excited to hear what he has to say. Cameron will be there, and Katie Martin from the Financial Times will be moderating the event. Yeah. We're super excited.
Ben Felix: That's incredible. Sounds like a great event.
Cameron Passmore: Yeah. Thanks for the invitation.
Håkon Kavli: Very happy that you can come. Then yeah, I want to add one more thing. It's not here in Oslo. It will be in Trondheim, where the family owners of Reitan Kapital are based, and where they started their company. It's at a historic homestead of the first Viking kings in Norway. That's literally their farm.
Ben Felix: No way. Wow.
Håkon Kavli: It's a historic setting also. It'll be fun to have everyone gather in that space. It's super exciting.
Ben Felix: That's incredible. Very cool.
Cameron Passmore: Håkon, well, I guess that's it. I look forward to seeing you in a few weeks. It's been amazing to have you join us. I learned a lot, and it was a great, great conversation. Thank you.
Håkon Kavli: Thank you very much. I love being here. Very cool. Thank you.
***
Cameron Passmore: Well, that was such a great conversation with Håkon. Such a clear communicator, Ben. Wow, what a great idea to invite him on.
Ben Felix: Oh, yeah. That was great. Now we're pretty excited to be welcoming Dan Bortolotti to join us for the first time, but not the last time.
Dan Bortolotti: Right. It's great to be back. Thank you.
Cameron Passmore: Hey, Dan. The spud is back.
Ben Felix: The spud, yeah.
Dan Bortolotti: Back when I was doing the Canadian Couch Potato Podcast, we had a popular segment called Bad Investment Advice. Bad Investment Advice. I used to look at articles, videos, blogs, etc., that offered truly awful suggestions for how you could manage your personal finances. We thought it would be fun to resurrect that segment, because there's certainly no shortage of bad investment advice still out there.
It was an interesting segment that we used to sometimes look at advice from investment professionals that was very obviously done for marketing purposes. It was manipulative. It was self-interested, something I really enjoyed calling out. Other times, it was really just from amateurs. There was no ulterior motives or anything. It was just naive. In many ways, I think it's just as harmful, because a lot of these amateur DIY investors have a lot of followers. That's the category of bad advice that we're going to target today. The article in question is one called ‘An Interesting RRSP Idea – all in on QQQ’.
Now, I'm going to unpack exactly what that means in a minute. Before we do, I just want to say, I'm not going to identify the author, or even the website that the article came from, because I have no interest in personal attacks here. It's not about that. It's really just that he's a DIY investor, that doesn't seem to be any ulterior motive, but it's still pretty dangerous advice. I think it's helpful to pick it apart.
Ben Felix: Yup.
Dan Bortolotti: The main point of the article is he makes an argument that it might make sense to hold nothing but QQQ in an RRSP. Okay. Q, another Q, a third Q, and the Batman symbol. Let's clarify all this straight away. What the heck is QQQ? It's the ticker symbol for a very popular ETF from Invesco PowerShares that tracks the NASDAQ 100 index. The NASDAQ 100 is an index of the 100 largest non-financial US stocks. It includes companies in the banking, insurance, mortgage, investment sectors.
Mark McGrath: Sorry, it includes, or excludes?
Dan Bortolotti: Excludes. I’m sorry. It's made up of all of the other sectors in the economy, except for financials. In Canada, financials make up a huge part of our index. In the US, they make up about 11% of the market, which is a relatively large category. You might think that if you just excluded that 11%, it wouldn't make very much difference. In fact, there's some pretty huge differences between the NASDAQ 100 and the larger US market. Tech stocks, for example, make up about 33% of the broad market in the US, but they make up over 51% of the NASDAQ 100.
Of that, even the top 10 holdings, which as you can imagine, are Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet, the usual suspects, they make up half the index. Let's understand here, we're saying the top 10 holdings have the same influence as the other 90. Now, the US market is already very top heavy. The 10 biggest stocks in the S&P 500 are about 30% of the index. Concentration is not really unique to the NASDAQ 100, but this ETF QQQ, takes an already pretty significant problem and just makes it all that much worse.
If it's such a big problem, why is this author recommending that we go all in on this ETF versus RRSP? You've probably figured out, we're talking about tech stocks. I mean, they've been the heroes of the last few years. What we're seeing here is just flagrant performance chasing. I mean, he's pretty explicit about it. I'll just read from the article directly. He says, “Why would we consider going all in on QQQ? Because QQQ is done very well historically, compared to the major US and Canadian indexes. In the last 20 years, QQQ has had an annualized return of 14.03%. And an annualized return of 18.12% in the last 10 years.” Now, very tempting returns. I think we can all agree on that. Why not go all in, put your entire RRSP into QQQ and expect another 14% annually over the next 20 years?
This is really a great example, I think, of when you need to look at the period of performance that somebody is holding up as an example. Now, I don't know whether the author did this intentionally. I don't think so. But it's certainly convenient to say the last 20 years, because that period would have started in 2004. For those of you not old enough to remember, there was a little event called the dot-com bubble that occurred just before that. To back up from the mid-1990s until around March of 2000, the tech stocks and the NASDAQ 100 had a tremendous run, even better than what we've seen in the last 20 years.
Guess when QQQ was launched? 1999. Very close to the peak of the bubble. It's not surprising for ETF providers to create products to exploit past performance. I would not be surprised if more than a few people went all in on the NASDAQ in 1999. Well, we know what happened then. Over the next two and a half years, early 2000 to about 2003, the NASDAQ 100 lost more than 75% of its value. You were pretty close to being wiped out if you were all in on that strategy during that period.
Now, let's be clear. I'm not predicting a tech crash. I'm not calling a bubble. I don't do that. But anyone who understands the most basic stock market history knows that individual countries, sectors, companies will enjoy a period of exceptional outperformance, but it's not sustainable indefinitely. If you're going to make a recommendation to go all in on QQQ, based solely on past performance, you can't really sidestep the decline that would have devastated people who had followed the same strategy in the late 1990s and early 2000s. I do want to be fair to the author. He does acknowledge that QQQ, it's one of my favourite lines, he says, it's not all that diversified, which is an understatement to say the least. He does note that even after the crash, the fund didn't recover for about 14 years.
It's acknowledged, but it's a token few lines. In fact, another of my favourites, is he says, that the biggest case against this strategy is that it would take a big hit to his dividend income, because these tech stocks don't pay dividends. I say, I think the risks are a little more significant than a reduction in your dividend income. Look, there's no perfect investment strategy. We can all agree on that, but there are a lot of terrible ones. I think at the top of the list of terrible investment strategies is choose one economic sector in one country that performed the best over the last 20 years, and then bet your life savings that it's going to be repeated over the next 20 years.
You could have made similar bets with Canadian bank stocks with Vancouver real estate, which a lot of people did. It worked out really well over some periods. It's very naive to assume that in the whole universe of investments, your best hope of success is to concentrate on a very small number of stocks in the same industry, in the same country, exposed to the same risks.
I want to propose another interesting idea for your RRSP. How about diversifying across every economic sector, every investible stock market in the world? While you're at it, maybe throw in some bonds and GICs as well. Just to give you a little bit of context and compare that strategy to the all-in on QQQ strategy, have a look at a fund Vanguard's VEQT. It's one of the popular global equity ETFs out there. Holds over 13,000 stocks, large, mid, small companies, 51 countries. Yeah, it holds all those same big tech stocks, too. Nobody's saying those shouldn't be part of your portfolio, but it also has a 20% allocation to financials. It has a 13% allocation to industrials, consumer discretionary. Every other sector is in there as well. As far as I'm concerned, instead of going all-in on QQQ, I would rather go all-in on global capitalism.
Ben Felix: Love it.
Cameron Passmore: VEQT and chill.
Dan Bortolotti: Exactly.
Ben Felix: This is some of the most common bad advice, though. It is everywhere. I see Reddit posts all the time of like, “Should I add some SPY to my QQQ per diversification?”
Dan Bortolotti: There is definitely a tendency to see people doubling up on holdings. Like you said, holding the S&P 500 and the NASDAQ, forgetting that all the NASDAQ stocks are also in the S&P 500. You're just buying more of the same.
Cameron Passmore: I'm glad you referred back to the downside that happened back in the early 2000s, that 75% drawdown. It takes some conviction to stick with that 25 cents in a dollar to write it back within the next 14 years, just to get back to break even.
Dan Bortolotti: Yeah. I don't imagine a lot of people would have had the patience to do that. In fact, I talked to investors who are a little bit older, who have said, it took them a few years just to get back into the stock market, period.
Cameron Passmore: Exactly.
Dan Bortolotti: After that point, they were so scared off the whole idea that they were all out for a few years. Of course, when that happens, you're going to miss the early recovery. You'll eventually get back in, but the early recoveries were some of the biggest gains occurred.
Ben Felix: There's a 2007 paper in the American Economic Review by Ilia Dichev, where they look at the difference between buy and hold returns and dollar-weighted returns for a bunch of different markets and indexes, including the NASDAQ. It's basically, like the performance gap for these different indexes. It's older. They look at that ending in 2002 in the paper, but the return gap for the US market, for the NYSE MX, was 1.3%, but for the NASDAQ, it was 5.3%.
Mark McGrath: Annualized?
Ben Felix: Yeah, that's right. Big return gap.
Mark McGrath: Yeah. It's not surprising. Dan, while you were discussing this, I just pulled up Y charts and looked at MSCI World, which essentially, tracks in US dollars the entire, well, mostly the entire global stock market, versus QQQ, and just shuffled the periods around looking at 20-year periods. To your point, if you look at 2000 to 2019, MSCI World outperformed QQQ. Ben, Cameron, you guys have seen this back in the mid-2000s, late 2000s. You have the last decade in the US. Nobody's talking about going all in on US stocks, or all in on QQQ. They're talking about, oh, if you're not 50% emerging markets, then you don't know what you're doing. It's just this flavour that, if it was only as easy as looking back at the last 20 years and buying what performed the best, then we will be very wealthy people. It's just not that simple.
Dan Bortolotti: Just need a time machine and you'd be the ideal investor.
Cameron Passmore: Can you imagine?
Mark McGrath: There's a great narrative around this too, right? If you talk to people who are doing this, their viewpoint, I find this is totally anecdotal, but is that investing in technology can't lose. That all companies are becoming technology stocks. The stories and narratives behind the Magnificent Seven are just so compelling, and so obvious to people that these are the companies that are going to dominate for the next 100 years. Even if that's true, though, you have to look at price. If that's so obvious to everybody in the market, why would we expect higher returns from those stocks in the first place?
Dan Bortolotti: I would argue in that sense too, it's not that AI, or other technologies won't be transformative, because I'm sure they will be, but we don't know how. It may not be that the biggest winners in this game are the technology companies themselves. It may be companies in other industries who transform the way they do business because of those new technologies. We don't know what those might be. Maybe they will be financial companies. Maybe they will be insurance companies. Maybe they will be automotive companies. We don't know. But if you hold everything, then you know that you're going to have the winners in your portfolio.
Mark McGrath: Yeah. Ben, you've done research on investing in technological revolutions. It's just not that obvious that you should be always investing in the hottest trend.
Ben Felix: Yeah, it's more than not that obvious. It's usually pretty bad investment outcomes that people get for investing in the newest technology.
Cameron Passmore: I listened to a podcast this week interviewing an expert in the whole world of AI and LLMs. The difference between this revolution and the revolution in the late 90s, early 2000s is that the amount of investment it takes to continue to get to scale. Is it Moore's law, like that doubling of output issues, unbelievably massive? If you believe that scale's going to continue. There's a big difference this time around. What that means for markets and returns, I have no idea, but it's a very different environment.
Mark McGrath: Having said all that, I did buy TQQQ in my son's little test account that I have for – TQQQ is triple leveraged QQQ. He's six, right? I have a little Wealthsimple account, or whatever. I'm trying to teach him about volatility and stocks and stuff. I was like, “All right, let's amp things up.”
Cameron Passmore: That may do it.
Mark McGrath: Yeah. He does have the time horizon on his side anyway.
Dan Bortolotti: That's true. That's true.
Cameron Passmore: Shall we go to the after show? Daniel, you're going to stick around?
Dan Bortolotti: Sure.
Cameron Passmore: I think if you stick around, we might get the numbers up to what guys? Six, seven listeners?
Mark McGrath: It's a big jump.
Cameron Passmore: Maybe eight. Okay. Someone wanted to talk about, is taking GIS unethical? What's the story behind that?
Ben Felix: I always feel so clueless after stuff like this happens, where we'll talk about something I think is pretty benign, and it turns out to be this massive trade issue for a lot of people. Then the comments to an episode are, I'm like, “Whoa. I just didn't expect that.” In the last episode where Mark talked about the RRSP versus the TFSA, which by the way, it was an all-star episode. People loved it. Mark made a quip about taking GIS if you're a wealthy person, if you have a high net worth, but not a high income and therefore, qualify for GIS, that that's gross, in Mark's words. That upset a lot of people. But a lot of people also agreed with Mark. I don't know. I just thought it was worth bringing up in the after show. Mark, any thoughts?
Mark McGrath: I didn't even think of it when I said it. I didn't think of it.
Ben Felix: I didn't either, when you said it.
Mark McGrath: Let me be clear. I didn't mean to judge any individual, if that's the planning that they're doing it. I'm sure it came across that way. From the comments in the forum, it didn't come across that way. I don't need to judge any individuals. I find that type of planning, I use the word gross. I'm not going to walk that back. I don't want to double down here either. I still don't like that type of planning. I don't think that's the intended purpose of a program that is designed for specifically bringing low-income seniors, essentially, above the poverty line and people taking advantage of that program when they otherwise shouldn't qualify.
Okay. Personally, I'm not going to do that. I'm not going to plan for my clients to do that. If you want to do that yourself, that's fine. I will say, that there were a lot of great comments. There were very respectable comments in the community. Some of them had me rethink that position a bit. I think the main ones are, whether the entire transfer system of taxes should be bucketed in essence. Should you look at those buckets? If we're all contributing to one pool, should you then parse those pools into different buckets when looking at who should be qualifying and who shouldn't?
I think the main one was around CCV, the Canada, the childcare benefit. One of the commenters said, “Well, how is this any different than making RRSP contributions to bring your income down to qualify for more of that benefit?” I thought that was a really great point. It was a good discussion. There were people that agreed with me, people that vehemently disagreed. Like anything, good learning experience for me. I'm not going to walk my comments back. At the same time, I think the forum made some good points.
Ben Felix: Yeah. We had a good discussion with some of the other financial planners that we know, too, and the views there were also mixed.
Cameron Passmore: Oh, interesting.
Ben Felix: Some planners, who we both respect a lot and are great planners said, “There are cases where I wouldn't plan for this for a client, if it makes sense to do so.” Anyway, interesting.
Cameron Passmore: You say, it’s more client demand-driven?
Ben Felix: Well, in that case, the guy that we spoke to said, there was a case where it just made sense to do this planning. The client had a high net worth. But for whatever reason, they had a low taxable income, so it made sense to do it. They didn't have ethical issues with it. That's really the core of the discussion is the system works the way it is. It's legislated the way that it is. Should you have ethical qualms about using it the way that it works, even if that's not necessarily the intent?
Cameron Passmore: Dan, any thoughts?
Dan Bortolotti: It's definitely a slippery slope, right? I mean, if you're going to draw the line at GIS. I don't necessarily disagree that shouldn't be a fundamental planning principle to try to get wealthy people to collect GIS. But we do it for old aid security all the time. That means a fundamental retirement planning strategy to keep a client's income under 90,000 or so, in order to maintain all the GIS. Many of those clients, or individuals don't need “OAS.” A lot of it's just ending up in their bank accounts and piling up.
Unfortunately, that's the way the system is created. If you're going to criticize one tax reduction strategy, there are a dozen others that are equally questionable. Yeah, I think a lot of it, for us, it just comes down to what feels right for you. I agree, the GIS is probably at the extreme end of the spectrum.
Mark McGrath: Yeah. I made a similar comment about there's a line somewhere, I think, and for everybody, that line might be in a different place. Personally, I think my personal ethical line is drawn at GIS, but that's not the case for every advisor, or every potential investor, and that's totally fine.
Ben Felix: I think one of the reasons people got upset about it, it was in particular because it came from you, Mark.
Mark McGrath: Probably.
Ben Felix: Who was very vocal about the tax changes for physicians. People were like, you're so upset about doctors having to pay a little bit more tax, but this is where you draw the line?
Mark McGrath: Fair enough. To be clear, I walked back a little bit, my distaste for the tax changes after we spoke with Professor Kevin Milligan. Also, after I modelled these tax changes, and realized that the impact over long time frames was actually less than I expected, even for incorporated professionals. The impact is meaningful, but it's not the difference between meeting your retirement goals and not. That's a fair comment. Maybe it's, again, cognitive dissonance on my part, or maybe it's just a gut feeling reaction to certain things. I speak before I think sometimes, unlike you, Ben, but here we are.
Cameron Passmore: The word of the day is nuance, perhaps.
Ben Felix: The other one that I wanted to touch on is average versus marginal tax rates. That was, again, from your talk, Mark, on RRSPs versus TFSAs. What is that argument again?
Mark McGrath: Yeah. To be clear, this isn't an argument I necessarily fully buy into. I lobbed that one out there, because I do know there are a number of planners that I do respect it think of it this way, and then others that I respect that just can't wrap their heads around this. I don't really know where I stand. Essentially, the argument is that when you contribute to an RRSP, you are contributing at your marginal tax rate. You are reducing income from the top, and you're getting a deduction on your income and a tax refund based on your marginal rates at the time of the contribution.
The argument is that when you withdraw from an RRSP, you can think about it as being withdrawn at average, or effective tax rates, not at your marginal tax rate. I think the thinking there is that if you have other sources of income, like CPP, old age security, obviously your RRSP’s may be a defined benefit pension. Why are you intentionally stacking RRSPs in that order throughout your marginal tax brackets? Why are you stacking RRSPs at the top? You should think about all of those forms of income as being taxed at your effective, or average tax rate.
My view on this was essentially, that there's a marginal decision that you're making when you're contributing to an RRSP that you're going to then defer the taxes to the future. You can decide to, or to not contribute to the RRSP and that decision you're making, I think is fair to compare them at marginal rates. Whereas, other fixed income, old age security, or CPP, for example, you largely can't opt out of those are true fixed income. Whereas, RRSP, you're actually deciding what to do. That's what the argument is. Again, I'm not convinced one way or the other. But again, people I respect on both sides of the argument.
Ben Felix: I don't know. I didn't think it made any sense when you're talking about it during the episode. One of the guys that you respect who made this argument to you and convinced you of it, or at least had you willing to believe it.
Mark McGrath: I wouldn't say, I was willing to believe it, but I thought that this person is what I would consider to be a walking financial planning encyclopaedia.
Ben Felix: I agree.
Mark McGrath: One of the brightest people I know. If that genius thinks about it this way, what am I missing?
Ben Felix: He changed his mind. You were there. Were you there for that conversation?
Mark McGrath: I was. Yeah. I don't really changed his mind, but I think he changed the framing of it maybe a little bit.
Ben Felix: Yeah. Okay.
Mark McGrath: Regardless, it wasn't that I believed it. It was like, what am I missing? How is it that this genius thinks this way and everyone else doesn't? I must be missing something, because it's not him that's wrong.
Ben Felix: I don't think you can look at average tax rate on one side and marginal on the other side to make an argument for, or against the RRSP. How it affects your overall tax rate is what matters on both sides. Any thoughts on that, Dan? Have you heard that idea before?
Dan Bortolotti: I heard it when you first discussed that I'm trying to get my head around it, too. I would agree with you, Mark, that the decision to make an RRSP contribution is a decision. You can do it, or you cannot do it. But once the funds are in the RRSP, especially after age 72, the decision to withdraw it is no longer optional. There is some logic in considering marginal tax rate on the way in and average tax rate on the way out. That's even a stronger argument for contributing to an RRSP in most situations, is it not? If your marginal tax rate is always going to be higher than your average tax rate.
Mark McGrath: Yeah, and that was just it. That's an argument in favour of the RRSPs. I might have made this comment on that episode that I could potentially see that argument being stronger for just the minimum withdrawals that you're required to take from the riff, but any excess withdrawals from the riff, I think it's then hard to argue. Harder to argue, I should say that it's average tax rate. Because again, that's a decision you're making on the way out with the riff.
Dan Bortolotti: I think that's correct. Yeah. Anything beyond the minimum is a conscious decision and has to be thought of as a withdrawal at your marginal rate.
Cameron Passmore: Yeah. Choice in, choice out of the margin. You guys want to talk about the FHSA?
Mark McGrath: I thought I would just bring this up quickly. It was a really interesting question that I got from somebody. I wasn't sure of the answer at first and I had to do a bit of digging on this. Somebody emailed me asking if I knew the answer to this question. They talked to some CPAs, some accountants who, I guess, didn't know the answer, and so they emailed me, a follower of mine, I think, on some social media platform. The situation for them is that they have an FHSA, a first-home savings account, which is an account, a new account that we can use to save for a home, if you're a first-time home buyer. Great little account. You get the tax deduction for contributions, like you would with an RRSP. But if you withdraw it for a qualifying home purchase, then it's tax-free on the way out, like a tax-free savings account. It combines benefits of both plans. When that works out, it's one of the only pure tax-free pass-throughs that we have in this country. Great little account.
Now, their situation was they were going to enter into an agreement to purchase a home from their parents at below market value, and they were going to move in in about three years. That's the plan. They couldn't move in right away, because of something to do with their children, schooling. They needed to stay where they were, and this home is in a different city. They were going to move, but the timeline for moving was around three years. There's two things. One, buying the property from the parents below market value, and it was significantly below market value. The home is valued around 2 million dollars, and they had an agreement to purchase for $800,000.
The question was, can you use the first-home savings account, or the home buyer's plan as a qualifying withdrawal for a home that you do intend to move into, but not for three years? Where this gets interesting is CRA’s language around qualifying withdrawals says, you must occupy, or intend to occupy the residence. When you look at the government website for qualifying withdrawals for an FHSA, you must need a number of criteria to qualify, and there's an interesting timeline here. This is straight from CRA’s website. It says, you must have a written agreement to buy or build a qualifying home with an acquisition, or construction completion date before October 1st of the year following the date of the withdrawal.
If I withdraw from my FHSA today, we're recording this on August 29th, I have until October 1st of next year, which in this case is more than 12 months, to have a written agreement to buy or build a qualifying home. Then the second timeline is you must occupy, or intend to occupy the qualifying home as your principal place of residence within one year after buying, or building it. In this example, now we're looking at October 2026. We're actually more than two years from the withdrawal, and you can potentially still qualify.
Now in this case, this individual needed three years, so they still wouldn't qualify based on this timeline. I reached out to a friend of ours, Aaron Hector, who is by far the most knowledgeable person I know on the first-home savings account. First, I asked him, “Is this timeline correct?” He said, yes. Then I asked, “How do they qualify the intention to move into a home?” He sent me a tax interpretation from CRA around this.
Cameron Passmore: Of course, he did.
Mark McGrath: Of course, he did. Yeah. I was Googling for hours and I never found it. He probably had it screen-shotted from yesterday, because he was reading it. I don't have it in front of me. But essentially, what CRA came out and said is that, yes, there must be an intention to move into the home. You have to declare that intention when you withdraw from the FHSA. I haven't personally seen an FHSA withdrawal. I don't know, Dan, if you have, or Ben, or Cameron, if you've seen one, but I guess you declare when you make the withdrawal that you're either moving in, or have the intent to move in.
But CRA has then said, that you don't actually have to move in. If there's some circumstance that then prevents you from moving in, they won't disqualify the FHSA withdrawal. If it was obvious that at the time that you made the withdrawal, you weren't actually going to move in in that let's say, you've got a family of six and this was a one-bedroom condo, like there was something that would actually constrain you from moving in, then they can look at disqualifying. But they don't actually force you to prove that you did move in later on.
In this case, I mean, I'm not suggesting anybody does this. You're clearly misleading CRA if you declare that you intend to move in when you don't, but it was interesting to see how CRA might look at a withdrawal in this individual's case, where there is absolutely an intention to move in. They're going to actually spend a lot of time in this property, because they're buying it from their parents. They've got bedrooms set up there. They're going to be visiting a lot. They will eventually move in. That was the one interesting part.
The second interesting part is buying the home below market value. I've written about this on Twitter, but there's this tax function called inadequate consideration, which applies when you buy property from somebody who's not at arm’s length, which is generally a family member and that transaction takes place below market value. Now, in the case of principal residences, this is usually not an issue, because the principal residence is tax free. In the case where there's a rental or vacation property, this can become a problem. Or if you then turn a property into a rental or a vacation home later on, it can be a problem.
Here's how CRA sees this. In this case, the value of the home is 2 million dollars, and the kids were going to buy it for $800,000. CRA will deem this transaction to occur at 2 million dollars, regardless of the fact that it was an $800,000 transfer of cash. For the buyer, in this case, the kids, their cost basis on the property will be $800,000, which is the value that they actually exchanged. If this were a secondary property, no principal residence were to apply, the exemption were not to apply in this case, CRA would deem this to be a 2 million dollar transaction. If any capital gains applied at that time, they would apply to the parents who were selling it. But the son who's buying it would have a cost base of $800,000 on a property that's actually worth 2 million.
If they went to then sell it down the road, they would incur another capital gain on that property. You get taxed twice, potentially, in scenarios of where you're transferring property below market value to non-arm’s length parties. Again, principal residence exemption will largely solve this. But if they then moved out and turned it into a rental years from now, they might have an issue with capital gains taxes. Just a really, really deep, interesting question that took a lot of research in me talking to good folks, like Aaron Hector to sort it out.
Cameron Passmore: That's really interesting. Any on that, guys?
Ben Felix: Nope. After that.
Cameron Passmore: We wanted highlight, we have a meetup coming up in Ottawa in a few weeks. There'll be a lot of people in town around then, so late September. In fact, it's Wednesday, September 25th, we're going to have a meetup in Ottawa for our listeners and friends of ours, who I think will be in town, who I know will be in town. Also, hoping to get our friend Dan Solon out that day, which would be super fun to see him and get him a chance to meet a lot of local listeners.
Mark McGrath: Yup. I'll be there making the trek across the country.
Cameron Passmore: Ben will be there. I'm sure Angelica will come out. Okay, you want to dive into some reviews? Ben, you want to kick it off?
Ben Felix: We have a bunch of reviews. Yup. Rare from Canada says, “Simply the best personal finance podcast. I love personal finance. After going through dozens of podcasts on the subject, this one is by far the best balance between variety and complexity of subjects. I also love the fact that your content is always backed by academics, or data. This podcast is always the first resource I share with friends, family and colleagues that are looking to educate themselves on the subject. Thanks for the outstanding, often Canadian content you put out there. Hope to be hearing from you again for a while.”
Cameron Passmore: Awesome. Here's one, Olivier from Gatineau, which is just north of Ottawa. Hopefully, we'll see Olivier at the meetup. “Great podcast. The content is extremely relevant. The information is based on empirical studies and not opinions and anecdotes. I studied finance in university, and worked in the field. Yet, I learned a lot of information that changed my vision of finance and influenced my personal portfolio management. The topics also influenced my personal view of finance and helped me in my decision making. This is a podcast to listen for anyone looking for quality content.” Mark.
Mark McGrath: Yeah. This one's from Alec Landgraf from the US. “I'm here for the after show.” People are here for the after-show, Cameron. “I first came across Ben on YouTube talking about small cap value and came to enjoy his mix of academic and pragmatic approach to investing. This podcast grew to include so much more. Goal setting, the role of financial advisors, the intersection of happiness and wealth. I find myself recommending this podcast weekly. If you ever opened an office across the border, I'd be your first customer. From Alex, a mid-DIY investor.”
Cameron Passmore: A mid. Yeah, I had a text from long-time client and good friend of ours in the pod, Bruce, who just wanted to let us know that he is another one of the after-show listeners. Anyways, Ben.
Ben Felix: That's why it's the joke. I think a lot of people really like the after show. It's funny to say there's only three people left. But we had a guest episode with Assia Billing from Canada’s Chief Actuary. After that episode, there are people commenting either in YouTube, or in the community saying, “Hey, there is no after show.” I had to explain that Mark and I are both confused about our episode formats. I was trying to explain this to Dan earlier too, that we have a format for guest episodes, where we ask the guest questions and then that's it. Then we have a format for episodes without a guest where we have the intro and the after show and stuff. Guest episodes don't have an after show. But then sometimes in a regular episode, we also have a guest, like to follow the format for like today. Anyway, it's all very confusing.
Mark McGrath: I still don't know the difference between guest episodes and episodes like today. I have no idea. I've been listening since 2017. No idea.
Cameron Passmore: There's a lot of broken eggs in the background. Dan, as you know from your time making the podcast, it's a lot of stuff goes on to have this come out.
Dan Bortolotti: It's hard to piece all those segments together and do it in a consistent format, because sometimes you have good content with one category and not with another, so you just try to put out a good episode every week and not worry too much about consistency.
Ben Felix: Yeah. Okay, Lucas from Germany says, “Best podcast about financial topics by far. I've been listening for several years now and I really love your podcast and the high-quality information you provide. What really makes you special is you pursue information before everything else. Guests with different opinions to yours are invited and you allow them to communicate their arguments. The questions you ask are then to get a better understanding of their viewpoint and not to falsify it, because it's different. This, combined with your nice personalities and the resources you link for deeper dives into the topics is just awesome. Big thanks from Germany.”
Mark McGrath: Nice. We've got one more from Brian in Sacramento, California. “RR is a national treasure. You guys bring me peace. You bring a meditative quality to rational discussions around academic thought process. It's getting funnier, too. I literally laughed out loud for a long time when Ben read aloud that he's a hot national treasure.”
Cameron Passmore: Global treasure.
Mark McGrath: Still the greatest review of all time. It's perfect. “P.S. I'm not jumping ship from factors over the Andrew Chen interview. He might be helping to preserve the premiums by scaring some folks away. Just kidding. Big thank you for all you guys do.”
Cameron Passmore: I don't know. Mark is mid is still pretty funny, from Eugene Fama.
Mark McGrath: Oh, I don't even remember what they said. Oh, they said I was mid, right?
Cameron Passmore: You're a mid.
Ben Felix: He said, Cameron and Ben are 11 out of 10. Mark is mid.
Mark McGrath: Yeah. Then they said it was from Eugene Fama. Have you guys seen this mid graph account that follows me around Twitter?
Cameron Passmore: No.
Mark McGrath: I don't know. I'm talking about this now publicly, but there's this account called –
Ben Felix: Why are you promoting it?
Cameron Passmore: Bleep that out.
Mark McGrath: It's pretty funny that there's an account called Mark Mid Graph. Hilarious. I know. The only thing they do is post the word mid on my content. That's it. Nothing. No context. No nuance. Just mid. The profile itself is hilarious. My profile on Twitter, my banner says, “Financial planning for Canadian physicians.” That's been my niche for a number of years. This individual, their banner on Twitter says, I think, “Financial Planning for Canadian Naturopaths.” Their profile picture now is literally just a zoom in on my moustache. I also do this thing on Twitter, where if I use a third-party tool for writing and if a post of mine gets, I think, it's something like a hundred likes, it adds another post with a link to book a meeting with PWL. It says something like, “If you want to see what real financial planning looks like in Canada, click here.” They've put the same thing in their bio. It's a very funny rip off of my account.
I was certain I knew who it was, because there's a friend of mine who always chirps me on Twitter. This individual has now confirmed and sworn to me it's not them. I have absolutely no idea who is behind this account.
Cameron Passmore: See what you're missing, Dan, on Twitter.
Mark McGrath: It's great.
Dan Bortolotti: I'm okay, actually.
Ben Felix: Yeah. Don’t do it. You're smart, Dan. You're smarter than all of us. Twitter's terrible.
Cameron Passmore: Yeah. I haven’t posted in a long time. I'm almost done with it. Are you guys getting swamped with marketing companies reaching out and saying, they can help us build their profile and generate leads? Also, people want to help us find guests. I don't know if you're getting it, or just me, but my LinkedIn is just full of this stuff.
Ben Felix: No. I don't get that. I get the impersonation accounts on Twitter, though.
Cameron Passmore: Oh, yeah.
Mark McGrath: Oh, yeah. You do. Lately, I’ve had quite a few.
Ben Felix: People send me messages every day saying, “Hey, just so you know, this person's impersonating you on Twitter.” I'm sorry. I can't stop them all. I don't know what to tell you.
Mark McGrath: Yeah. To be clear, any of us here on Twitter are never going to reach out and try to sell you something crypto, or anything like that. That's usually a pretty good indicator that you're being spoofed is when they DM you after they follow you with some message about, “Hey, how's your trading going?”
Ben Felix: Yeah, that's what they do. They ask about your trades.
Mark McGrath: Yeah, yeah, yeah.
Ben Felix: Yup.
Mark McGrath: One other thing before we ship off, I have this running joke about our friend, Jason Pereira, on the podcast. I pretend like I don't know who he is. See, I don't know why this is so funny to me.
Cameron Passmore: The name somewhat rings a bell.
Mark McGrath: It makes me laugh every time.
Cameron Passmore: Dan, do you know him? You heard of him?
Dan Bortolotti: It sounds vaguely familiar, but I can't figure out who you're talking about.
Cameron Passmore: Go ahead, Mark. Sorry.
Mark McGrath: It's still hilarious to me. I will absolutely continue to run this joke where I pretend I don't know who he is. I just want to be clear. Jason Pereira is one of the brightest financial planners in the country, massive advocate for consumers. He's a friend of ours. Great, great guy. When I'm joking about Jason Pereira, it is absolutely a joke. He's fantastic. I will continue to make this joke. If we ever get him on the show, I'm going to really double down on those jokes, but I just wanted to clear that up.
Cameron Passmore: He's far too shy, Mark. He's way too shy.
Mark McGrath: That's true.
Cameron Passmore: He would never do this.
Mark McGrath: Of course. I just wanted to get that off my chest.
Cameron Passmore: Anything else on your minds, guys? Dan, great to have you. Super fun to have you back on the airwaves. I think it's great.
Dan Bortolotti: Yeah, it's great to be back on the airwaves. Thanks.
Cameron Passmore: You'll be a regular guest going forward.
Ben Felix: Looking forward to more.
Cameron Passmore: Absolutely.
Dan Bortolotti: Once we figure out the format.
Ben Felix: Oh, geez. Don't.
Cameron Passmore: It's the eternal hunt for the format.
Ben Felix: Stress me out, Dan.
Cameron Passmore: Okay, any final thoughts?
Ben Felix: Nope.
Dan Bortolotti: No.
Mark McGrath: That’s it for me.
Cameron Passmore: Okay, everybody. As always, thanks for listening.
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Papers From Today’s Episode:
‘Estimating Private Equity Returns from Limited Partner Cash Flows’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2356553
‘Mutual Fund Flows and Performance in Rational Markets’ — https://www.nber.org/papers/w9275
‘What are Stock Investors' Actual Historical Returns? Evidence from Dollar-Weighted Returns’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=544142
Links From Today’s Episode:
Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/
Rational Reminder on X — https://x.com/RationalRemind
Rational Reminder on TikTok — www.tiktok.com/@rationalreminder
Rational Reminder on YouTube — https://www.youtube.com/channel/
Rational Reminder Email — info@rationalreminder.ca
Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/
Benjamin on X — https://x.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/
Cameron on X — https://x.com/CameronPassmore
Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/
Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/
Mark McGrath on X — https://x.com/MarkMcGrathCFP
Dan Bortolotti — https://www.canadianmoneysaver.ca/authors/dan-bortolotti
Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/
Canadian Couch Potato Blog — https://canadiancouchpotato.com/
Canadian Couch Potato Podcast — https://canadiancouchpotato.com/podcast/
‘An interesting RRSP idea – all in on QQQ?’ — https://www.tawcan.com/all-in-on-qqq/