On today’s episode, Benjamin and Cameron are talking real estate, specifically mortgage rates and REITs. For the first time since the early 90s, fixed mortgage rates are lower than variable ones, which have always been the popular choice. However, due to the fact that Canada’s yield curve is inverted, short term rates higher than their long-term counterparts. This is not usually the case, which makes it a great time to consider a fixed term mortgage, bearing in mind that it requires some lifestyle considerations. Benjamin and Cameron also provide some insights into the rental property market changes since 2015, with some astonishing figures. They then discuss REITs, which many think should be considered their own asset class. While it is often recommended to have REITs in your portfolio, research is starting to show that you are taking a great deal of risk you are not being compensated for. This means you may be better off investing in other options such as high exposure bonds which bear much less risk. For all this and much more, join us today!

Key Points From This Episode: 

• Why fixed-rate mortgages are now lower than variable-rate ones. [0:03:58.0]

• Interest rates went up, but the shape of the yield curve changed as well. [0:06:25.0]

• Property prices have almost doubled relative to rent since 2015. [0:07:12.0]

• What a rental wage is. [0:12:48.0]

• What a REIT is and the benefits of investing one in your portfolio is. [0:17:05.0]

• Why the risk of a REIT may not be justifiable. [0:21:01.0]

• Variable annuity investors routinely outperform mutual fund investors [0:26:23.0]

Read the Transcript:

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

Something that we have been really bad at and are going to get better at is using our rationalreminder.ca website, which is a website that’s been up for a while. We’re going to get better about posting the episodes there.

One of the main motivations for us to do that is that as some of you probably know, because you’re probably listening on a platforms, our episodes automatically get posted on YouTube when we close them, and that’s great. There’s about a 100 people that listen on that platform. The really cool thing about YouTube is that you can comment. On iTunes you can’t comment. We get, even though it’s a relatively small subset of our listeners that are listening on YouTube, we get great comments and great questions and great interaction.

Cameron Passmore: It would be great to get the comments all on the Rational Reminder site. 

Ben Felix: Right. Every time we post an episode, it goes up on the rationalreminder.ca website. You can click on the post and you can comment down in the bottom when you scroll down. It’s got notes about the show and we’re going to start putting the links to the content that we talk about up there but you’re also going to be able to comment. We’re hoping that some people will go to the rationalreminder.ca website. If they have something to say or a question to ask with an episode that they will do it there.

As great as it is when people send e-mails, if you comment on a post, that’s way cooler, because then other people can see it too and they can see the discussion and the follow-up. I guess, that’s our request; if you have something to say, or something to ask, if you can do it on the rationalreminder.ca website on the episode that you’re talking about, that would be awesome.

Cameron Passmore: Yeah. Look forward to that for sure, because the chat that happens on your YouTube channel for example, is really interesting; a lot of good engagement and discussion.

Ben Felix: I take away a lot from that too. I learn how people are thinking about things.

Cameron Passmore: Today’s podcast has a lot of cool topics, mainly on real estate, mortgage rates, REITs. 

Ben Felix: I love the discussion on REITs. It’s a factor discussion. 

Cameron Passmore: Yes, it is. It’s a good factor to discuss and with good takeaways.

Ben Felix: That’s it. We’ll go to the episode. 

Welcome to episode 58 of the Rational Reminder Podcast.

Cameron Passmore: Yes. Before we jump into the normal items that we do every other week, I just noticed walking into the room today that Berkshire Hathaway, and this goes back to our discussion a couple weeks ago about reliability, Berkshire Hathaway stocks a class A shares have underperformed the S&P 500 index year-to-date by 18%. Not that it's a bad stock, but it's unbelievable. It shows you when you concentrate on something how you may not end up with as reliable an outcome, which has been I know one of your perpetual points are always making it's all about reliability and using the evidence at a more reliable outcome, as opposed to having something with high-tracking errors, so trying to hit it out of the park.

Ben Felix: Yeah. I mean, it'll be really amazing to see how Berkshire does over the next 10 or so years. I mean, Buffett's aging obviously.

Cameron Passmore: He's 89 I believe.

Ben Felix: Well, he's still at the helm. It'll be very interesting to see. From a data perspective, it'll be interesting to see what happens with fed security.

Cameron Passmore: They have a 114 billion dollars of cash and they're picking up 25 billion a year of free cash.

Ben Felix: Yeah. Well, we're going to see. I mean, that's why I say in the next 10 years or so, it's going to be pretty obvious. Well, maybe it's not going to be obvious. That's not fair to say, but it's going to be – we're going to be able to observe the skill that's gone into the past returns. Because as of today, Berkshires trailed the S&P by a decent chunk, like over a percent, annualized for more than 10 years now, and so is value stocks. We have value stocks. It's not fair to just lump Buffett and say it's his fault, honestly.

Cameron Passmore: No, that's not the point. The point is about reliability and how much of the return can come from such a small part of the market.

Ben Felix: That's exactly. Say value comes back, how much does Berkshire come back? Does Berkshire beat the S&P if value comes back? That's what I want to see.

Cameron Passmore: It will be interesting.

Ben Felix: All right, well that was our pre –

Cameron Passmore: Our pre-current topic-topic. The current topic is about mortgage rates and something that's happened recently, where the fixed rate for mortgages is now lower than the variable rate, which has not happened I believe since the early 90s. I mean, it's been a consistent theme through my entire career that you'd be smart to go variable all the way along. Rates rise, rates drop. It would have been better for you. Of course, you've had a falling interest rate environment for the past 25 years, so that's obvious in hindsight. The whole thing has completely changed now. 

Ben Felix: At this moment. Yeah. It all relates back to the Canadian yield curve, I guess is inverted at the moment. Meaning that short-term rates are higher than long-term rates, which isn't normal. Normally, you'd expect to have higher yields on longer-term fixed income, because you're taking more risk by holding longer bonds. That's an upward sloping yield curve. That's a normal yield curve, but at the moment it's inverted.

Cameron Passmore: Yeah. The variable rate is linked to Prime, right? Right now, Prime is 3.95 in Canada and the five-year variable rate, when I just did a quick search, is around 2.9%.

Ben Felix: That’s right.

Cameron Passmore: You had a five-year fixed right now at 2.69 is what I saw.

Ben Felix: Yeah. I mean, it changes the whole conversation for the moment about fixed versus variable mortgages.

Cameron Passmore: Yeah. Now we know you're a renter and we'll talk more about that after. If you were a buyer, what would you do now?

Ben Felix Yeah. I mean, it's tough to say. It's pretty compelling to go with a fixed-rate mortgage when it's lower than variable and it's fixed. You're not at risk of interest rates rising and affecting the rate on your mortgage.

Cameron Passmore: Yeah, and assuming you're committed to being in that house for a long period of time, I think it makes a lot of sense. I'd be in a fixed camp for sure. That's a great rate.

Ben Felix: Yeah. It's a low rate. It is an interesting broader discussion just about the yield curve in Canada. We talked in our last episode where was just the two of us about bond returns in Canadian. Well, global bond return has been great. Canadian bond returns have been great as well. A lot of that relates back to this, what we're talking about the mortgage rates, because it all has to do with the yield curve. The yield curve flattens longer bonds. If the yield on bonds drops, it means the price on bonds went up.

Cameron Passmore: Which has happened in portfolios so far this year. We've got remarkable returns in fixed income.

Ben Felix: Yeah. You just look at the Vanguard bond index funds for Canada, they're 7% returns this year. It's all got to do with the shape of the yield curve. That ties back again to the GIC discussion that we had a couple weeks ago, where that term structure affects your return. If the term structure changes, you can have really great fixed income returns and you don't get Trinity to participate in that with the GICs. You don't get that exposure to the term premium. People always say, “Well interest rates go up, that means bond returns have to be bad.”

This year we've had rising rates and high fixed income returns. It's because of the changes in the shape of the yield curve. Yes, interest rates went up and that people are like, “Well, that must mean negative bond returns.” Interest rates went up, but the shape of the yield curve change as well.

Cameron Passmore: It depends on the duration of the bonds, and if the duration match up to where the interest rates are falling.

Ben Felix: It's just like with stocks. You maintain exposure to term and credit and you'll be in pretty good shape.

Cameron Passmore: Exactly. Which leads us perfectly into current topic number two; this was an incredible article that you found from the visual capitalist that looked at Canadian real estate and looked at the prices relative to rents relative to incomes and relative to inflation. I was absolutely stunned by this infographic.

Ben Felix: There's one that I've been referring back to you for years now, that was from The Economist. It ended in 2016. This one went from 2015 to now. I was pretty excited to see it, because I hadn't seen an updated data since that economist chart. In Canada, prices have almost doubled relative to rents from 2015 to now. 195.9.

Cameron Passmore: What has that scaled on? Do you know? Or it’s just a relative –

Ben Felix: What the price is relative to? Rents.

Cameron Passmore: Prices have climbed way faster than rents have. Therefore, affordability of rent is increasing.

Ben Felix: Relatively.

Cameron Passmore: We're one of the highest in the world, right? Just behind, I think New Zealand on that one?

Ben Felix: Yes. Looked at a bunch of countries. I didn't record how many countries they looked at, but New Zealand is the only country that was ahead of us. Their prices relative to rents have grown at 196.8X. It is actually an interesting little quick digression to talk about with New Zealand, because you look at real estate prices in Canada, New Zealand, Australia and other developed countries, but those are the hottest real estate markets. They've just had these crazy, crazy, crazy returns for quite a while now. That we've seen Canada do a few things to try and cool that off and maybe they're working, I don't know. New Zealand has completely closed off their real estate market if you're not a citizen, or –

Cameron Passmore: Resonating.

Ben Felix: Resident. Shut it down.

Cameron Passmore: You cannot buy it as a rental. No foreign money can go into New Zealand real estate.

Ben Felix: There are ways that you can invest in properties. I don't think you can invest in a detached home and you can't buy a vacation home. You have to be a resident in order to purchase a house. If you're an investor and you're going in to build an apartment building that's going to create more housing, then there are a process that you can go through. If you're just a guy that wants to buy a house, you can't do it. We hear and I know this is may be controversial, but all the stories about the Chinese money coming into Vancouver to buy all those houses. In New Zealand, it can't happen.

Another interesting data point that I pulled out of there just on the prices versus rents was that Portugal, their prices have been increasing like crazy, but their rents have also been increasing crazy. Their price is relative to rents. That multiple is nothing like Canada.

Cameron Passmore: Do you think it’s rent control in Canada that keeps the lag there? It must be. Because the only way to go around that, I believe, is to –

Ben Felix: Run evictions.

Cameron Passmore: Yes.

Ben Felix: Yeah. It very well could be. It very well could be.

Cameron Passmore: Because I know with people in Toronto, they can't afford to move because their rents are so low relative to what the market value is. They've been there for so long.

Ben Felix: Depends on the market too. That's why when we talk about that rent versus buy decision, I love that 5% rule idea. Because then, regardless of what prices and rents are in your area, you can just take 5% of the value of a property. If you can rent for less than that, then renting is probably a pretty good idea.

Cameron Passmore: Some other data points you had here, so Canadian house prices have increased 155X relative to incomes since 2015.

Ben Felix: Crazy.

Cameron Passmore: House prices have increased a 124X relative to inflation since 2015.

Ben Felix: Relative to income is a scary one, right? Because you start thinking about the sustainability of the prices. If people are buying these houses as investments to rent them out to get a reasonable return, because you got to keep in mind, this is an interesting thing I would love someone to study. My hypothesis is that landlords, property investors, and I don't know if this is specific to Canada or not, but property investors overestimate the capital return that they're going to get from real estate, which means that they're willing to take a loss.

Cameron Passmore: Oh, absolutely. We hear that anecdotally all the time. No one does. We said many times to proper accounting on what it costs to actually operate at home.

Ben Felix: Yeah. I mean, if you look at the historical data, we've talked before I think about how real estate returns as an asset class, like direct investment in residential real estate has throughout the course of recorded history, outperformed stocks by a bit, but with less volatility. Great. That comes from mostly net rental yield, like the historical net rental yield globally has been 5%, roughly 5%. The capital return globally has been about 1% in excess of inflation.

If you're not getting that 5% net rental yield, then your expected return in real estate asset is – if you're taking a loss on the yield, that's maybe less than inflation. People are willing to accept rent that is low, or making them breakeven, or whatever you want to call it, because they have these high expectations from the future capital returns. Because we've seen that in Canada and other developed countries.

Cameron Passmore: Well, it’s not been my experience owning a home. As somebody just put in, I don’t know, 750 bucks last week just to redo the purging on the house, which is –

Ben Felix: Well, you should've bought in Toronto.

Cameron Passmore: Well, I know I should have, but – Anyways, some other neat data points here. This we live all the time with clients with kids. This comes out of Financial Planning Canada. They did a survey. They interviewed just over 1,500 Canadians just in April this year. They found that, get this, 48% of parents with kids under the age of 18 plan to help the child buy their first home. 24% of parents with kids over the age of 18 have already done that.

Ben Felix: That's crazy. You heard the comment I just made about if people are buying these super expensive houses – I actually don't think I finished that thought. People buying these expensive houses, they've got to rent them out to earn the net rental yield to make their return reasonable, but they can't. Because if incomes don't keep up with what you would need to charge and rent to get a reasonable return on your real estate investment, that shows that incomes aren't keeping up with what you would have with the rents you'd have to pay. That means that the price of the real estate assets is not sustainable. What's going to sustain the price if people can't rent them, then people won't invest.

Cameron Passmore: Okay. Now fold in this data point, four and 10 say they expect that helping their children to buy a home will postpone their retirement.

Ben Felix: Man, that’s scary.

Cameron Passmore: Again, we hear this all the time. Run the plans and plan on giving the child X dollars a certain point in the future. What does that do to success rate of my financial plan? Very common.

Ben Felix: Yeah, it's scary stuff. We'll see what happens, I guess. There was another study on this topic. It's a bunch of stuff. I guess I went down a real estate rabbit hole. The Canadian Centre for Policy Alternatives released this study in July. It was recently and it's called Unaccommodating. They created a metric, the average rental wage, I think that's what they called it. They figured out what is the wage that you would need to be earning in order to rent in various Canadian cities, such that your housing cost would not be more than 30% of your income. They called that metric the rental wage.

Cameron Passmore: There’s a single person or a couple?

Ben Felix: I believe it was a single person renting a two-bedroom. They found that – so average across Canada is $22.4 an hour, which is obviously way more than minimum wage.

Cameron Passmore: 7 bucks over minimum wage, I guess. More or less.

Ben Felix: Okay. That’s what it is. Okay.

Cameron Passmore: Look at the rates for different cities.

Ben Felix: Yeah. Vancouver, $35 an hour you'd have to be making to meet that criteria. To rent a two-bedroom without spending more than 30% of your income in Vancouver, you're making $35 an hour. Toronto it's $33 an hour. Victoria BC $28 an hour. Ottawa was on the list of the top most expensive, 26. Anecdotally, a lot of people are talking about how expensive rent is. I mean, I'm living it I guess. Rent is not cheap.

Cameron Passmore: It's not cheap. We had colleague here help a friend. I guess, it's super tight supply. She was out this past weekend and very hard to find anything.

Ben Felix: Yeah. Vacancy in Ottawa is extremely low for whatever reason. Tight rental market. I thought that was fascinating. I thought it was fascinating just the numbers in general, but the fact that Ottawa is on that list of the highest rental wages. From an economic perspective, this report went into some really interesting detail. They talked about how between 1996 and 2006 in Canada, we had this combination of rising wages, falling interest rates and modest house prices. Those three things resulted in a lot more people buying real estate, which in return caused these price increases that we've seen.

Cameron Passmore: Which completely went against the whole boomer story, which is as the boomers age and not going to want the big houses in suburbia, so that we dump on them. I can member being told, “You got to get rid of the big house, because the crash is coming.” Yeah, not exactly. I also remember going back to 1989 when friends of mine bought places in Toronto and they just got killed, for a long time after owning – he owned a townhome. He was in Scarborough and just got demo’d by end of ’89.

Ben Felix: Well, there's a great chart that is a real estate agent in Toronto. She seems to be updating it every year or so. It shows Toronto real estate prices from the peak in 1989, because there was a little recession that followed that. If you bought in 1989 in a inflation adjusted terms, you didn't recover the value of the property, or you couldn't sell for what you bought it for in real terms until 2010. 1989 to 2010 in Toronto. We see the current run-up in price.

If you look at that chart actually and I'm not a – everyone knows I don't believe in market timing or technical analysis or anything. You look at that chart and I mean, it's peak-crash, peak-crash. Right now where we are 2019, peak. Well, I don't know what’s a peak yet, I guess.

Cameron Passmore: You don't know.

Ben Felix: Because I can't see the future, but it's high. We’ll leave it high. Just on that bit, concept of real estate prices are being flat real terms in Toronto from 1989 to 2010. I started thinking about for myself, like if we rent a house now, it's a great house. We’re in a three-year lease. We're not going anywhere anytime soon. Am I going to buy after that? Maybe yeah. Who knows, right?

You start thinking about from a financial perspective, to get the expected return on an asset, you've got to hold it for a long period of time, just like that data point of what Toronto real estate shows. If we buy a house three years from now, then my oldest son is going to be eight. Then maybe I've got 10 or 11 years before kids start leaving the house. We bought a house to accommodate our family now. It’s going to be too big presumably within 10, 15, whatever – as long as she wants –

Cameron Passmore: Yeah. I’m going to want the big house for him to come back with.

Ben Felix: I guess so.

Cameron Passmore: His future. A lot of people are like, “Keep the big house through the kids and grandkids.”

Ben Felix: That's true. That's true. It just feels it can have a lot of dead real estate asset.

Cameron Passmore: You’re also extremely rational.

Ben Felix: Well, such a big cost of that. Imagine you have a paid-for house, or a mostly paid-for house that's way too big for you? Imagine the cost of equity is huge. I think that changing life circumstances affect the time horizon for owning a real estate. We see this, people change houses often, more often than they should from a financial perspective. I think that puts a time horizon constraint on real estate purchases, which makes the price risk way more real than most people realize.

Cameron Passmore: Okay, so let's roll over to REITs. This is on the commercial side of real estate, as opposed to personal home ownership. In Canada, I'm sure many of our listeners go to read every single week when they do their groceries. Places RioCan malls, H&R, the smart centers, Choice Properties, which I believe is the Loblaws spin-off. I'm sure both of us go to at least one REIT every single week.

Ben Felix: Yeah. They’re residential REITs too, like CLV Group. I don't remember what their REIT is called. Anyway, their buildings are all over Ottawa.

Cameron Passmore: It’s a great way to get exposure to an asset class, where in one trade you can own a bunch of underlying malls, or apartment buildings, or retirement homes.

Ben Felix: The nice thing about it is you get exposure to that too. Generally, a liquid asset class. If you go and buy a house or an apartment building, that's not liquid, plus it trades in huge transaction sizes. You can access just an index fund. You get a diversified portfolio of real estate assets, but it's also liquid, daily pricing, diversified, all that good stuff.

Cameron Passmore: I can remember when they all came public, or a bunch of them became public 15, 20 years ago. They all had yields of 10%, 12%, 14%.

Ben Felix: Wow.

Cameron Passmore: Yeah. I mean, it was crazy. They're all IPOs, right?

Ben Felix: Yeah. You look at market cap of REITs, so publicly traded REITs is a 3% to 5% globally depending on which country you're looking at. Anytime you own an index fund, like if you own a total market index fund, you own REITs in the market cap weight, whatever it is in the country that you're looking at.

The reason we're talking about REITs for our portfolio section today is that a lot of people will overweight REITs. They'll say, “Okay, I understand the REITs in my portfolio, but I want to have more than market cap weights.”

Cameron Passmore: Largely because you're guessing, they like the cash flow?

Ben Felix: Could be cash flow, a preference for cash flow, but it could also just be the historical returns. REITs have had really good returns pulled the data for S&P global REIT index from 1989 through June 2019. Have returned 9.24% per year on average.

Cameron Passmore: That's 30 years.

Ben Felix: Well, the MSCI all country world index over the same time period returned 7.77% per year on average, both in Canadian dollars. Better returns. Not only that, they were imperfectly correlated. The correlation was 0.5. I mean, seems pretty good, right? Why would why would you not want to overweight that? Sure, they've had good returns, but where did those returns come from? The real question when you get down to the root of it is our REIT’s a separate asset class. Because if they are, if they're a truly unique asset class that are adding truly unique risks to the portfolio, then sure, make sense to over with.

Just so we talked about over-weighting small cap in value. If it's a truly independent source risk, then yeah, of course you would overweight. There are a couple papers on this. The papers are fascinating. There's a 2018 paper, titled Real Estate Betas and the Implications for Asset Allocation, by a guy named Peter Mladina. He looked at this ,how distinct are the returns of REITs from the returns of stocks and bonds? He used a custom five-factor model that he built for this purpose. The factors use where market beta size value, so those are equity factors that we're all familiar with. He also used term and default. He combined equity and fixed income factors together into the factor model. He looked at the period from 1986 to December 2015.

Cameron Passmore: Most of the period you mentioned, those returns up above.

Ben Felix: Yeah. That's a good point. You're right. Now here's where it gets interesting, is that the returns of the REITs over that time period resembled the returns of a 60% small value, 40% high-yield bond portfolio.

Cameron Passmore: Isn’t that amazing?

Ben Felix: It is amazing.

Cameron Passmore There's always an explanation for returns.

Ben Felix: Right. Yeah, the risk exposure of REITs is effectively the same as holding 60% small value, 40% high-yield bond.

Cameron Passmore: Intuitively, that makes a lot of sense.

Ben Felix: Yes. I mean, it's a hybrid asset class.

Cameron Passmore: There's smaller cap than large caps for sure and they do have a lot of yield.

Ben Felix: Yeah. Mladina found the factors that explain the returns of real estate of priced risk that we know; so the size value term default, all that stuff. Those are all priced risk. We can explain the returns of the REIT asset class with these priced risk, so that's a good thing; risk that you want to be taking, because you're getting a positive expected return.

Cameron Passmore They are not a unique source of return.

Ben Felix: They're not unique. You can get those same risks through stocks and bonds. Here’s where it gets really, really interesting is you're getting exposure to those risk factors through those priced risk factors, but the risk of rates – so we can explain the returns with stock and bond factors, but the risk of rates is primarily explained by the specific idiosyncratic risk of the real estate sector. Boom, mind-blown. You're getting exposure to these equity and fixed income factors that are priced risks, good, check mark, but the risk of the REITs is dominated by the specific risk of the real estate sector, which is not a priced risk.

Cameron Passmore: You're not getting compensated for the idiosyncratic risk of individual REITs, when you could have bought a much more diversified small cap value portfolio with high-yield bonds. Same expected return, much lower idiosyncratic risk, or lower volatility.

Ben Felix: Lower volatility and you're getting compensated for the risk that you're taking.

Cameron Passmore: Eliminating the risk that you're not taking, so it gives you a more reliable outcome.

Ben Felix: Correct. Yeah. Very nice factor reliability. Mladina did this paper and then Jared Kizer and Sean Grover, who are with Buckingham Strategic Wealth, they did a paper in 2017 called Are REITs a Distinct Asset Class? They did the same regression and their numbers were a bit different. They found 67% small value stocks and 33% corporate bonds, but then they did something that Mladina didn't do is they actually built a model portfolio of stocks and bonds that they designed in hindsight, to match the factor exposure of REITs. That was the 67% small value, 33% corporate bonds.

As you would expect based on what we just talked about from the Mladina paper, they were able to get better returns, better risk adjusted returns with the small cap value and corporate bond mixed portfolio. That was better than REITs, which that is consistent with the idea that you're going to get the same factor exposure, but REITs have all this extra non-priced, non-compensated risk.

Cameron Passmore: It's still amazing though, because you would think the small cap value would have very high volatility. Must be the diversification with a fixed income and the rebalancing that really dampens that volatility.

Ben Felix: Well, REITs are volatile too though. Can't forget that.

Cameron Passmore: Yeah, we've gone through an era where rates have fallen, so you would think that would be helping the price appreciation of the REITs. Rates have fallen, not REITs.

Ben Felix: Well, if you think about the real estate crash in the US, that's not going to help their rate data.

Cameron Passmore: No, that’s true. That’s true. It's super fascinating data.

Ben Felix: Yeah. In the way that Dimensional thinks about this, is that they actually exclude completely REITs from equity portfolios. I mentioned earlier that if you buy a market cap weighted ETF, REITs are in there at market cap weight. Dimensional strips them out completely and builds a portfolio of stocks based on the factors of higher expected returns. Then just adds REITs and a market cap way to diversified index portfolio as a separate component.

Cameron Passmore: Yeah, on a market cap basis.

Ben Felix: Correct. They do that, because the same weighting towards small cap and value and all that stuff, doesn't work the same way for REITs, so they just rip it out. In the portfolios that we're using, they're just held in market cap weights. I think the conclusion for that discussion is that if you want to overweight REITs to get exposure to those risks that are present in REITs, the priced risks, the best way to do that is to seek exposure to small value and high-yield, or corporate bonds.

Cameron Passmore: This is just a rational reminder to consider that as an alternative, as opposed to investing directly in REITs.

Ben Felix: Right. If you invest in REITs, maybe you'll get a great outcome, but maybe you won't, but you are taking a lot of risk that you're not going to be compensated for. That's the catch with REITs.

Cameron Passmore: The planning topic this week, so there's a great article that's been retweeted, I can't even imagine how many times, but I know it's been in my Twitter feed a lot this week. In the New York Times from Jeff Sommer, discussing the Dalbar report, which is a report that's been coming out forever, talking about how well investors do compared to the investments they're in. Do they do as well on their own in the investment compared to the actual investment themselves? It's always coming up with the same story that investors’ behavior cost them to weigh underperform the actual investment they are in.

Ben Felix: There are all sorts of criticisms of the Dalbar report, but I think the message is generally probably fine. I don't know if the magnitude of the data that they talk about is necessarily correct.

Cameron Passmore: Yeah, we could do with that another podcast. It would be cool to dig into the criticisms of it. It's a huge margin. The one that they found was 5.88% annualized.

Ben Felix: Equity investors trailed the S&P 500 by 5.88% annualized over 30 years.

Cameron Passmore: For 30 years. That's a massive amount of cost of behavior.

Ben Felix: I think one of the most sensible criticisms of the Dalbar is that we don't know why people are moving their money around. People could just be naively bad investors, but it's not because they're freaking out when the market is down, it’s because they needed to pay for their kids’ education, or they decided to pay off their mortgage as opposed to leaving their money invested. It just happened to be at the wrong time. I don't think that the Dalbar report corrects for that.

Cameron Passmore: A thing that blew both of us away and here's the quote.

Ben Felix: This is amazing.

Cameron Passmore: Amazing. We compare the returns of investors in variable annuities to the investment of the variable annuity.

Ben Felix: I don't think we have a variable to do like that –

Cameron Passmore: It is a guaranteed minimum withdrawal benefit type investment. Those insurance products with high fees and high loads, I think. A lot of very large investment firms in the US absolutely hate variable annuities. This is not a commentary on variable annuities at all. It's quite the opposite actually. The performance of investors in variable annuity funds, which are higher fee lock-ins, redemption fees and whatnot.

Ben Felix: Actively managed probably, like ugly stuff.

Cameron Passmore: Probably. Ugly stuff with high commissions. There's a quote. “Despite the extra fees and penalties, perversely it seems because of them, investors in variable annuities outperformed those in mutual funds over 12 months, as well as over 3, 5, 10, 15 and 19 years.”

Ben Felix: That is fascinating.

Cameron Passmore: You throw handcuffs on people and it ends up, they behave better.

Ben Felix: You'd love to see that data on DSC mutual funds. I don't know if that's ever been done.

Cameron Passmore: I've no idea DSC being deferred sales charge, so that funds that lock you in for five or seven years and charge you if you leave in that period, which I think is not used very much anymore, but it's amazing how behavior is everything. Behavior is the story.

Ben Felix: That point. I mean, who knows how reliable this data is and I don't know what went on behind the scenes to calculate those numbers, but assuming the relationship is at least reliable, that variable annuity investors outperformed mutual fund investors with the higher fees and all that stuff, that is a huge testament to the importance of discipline, which I think people often discount.

Cameron Passmore: Well, look at our day-to-day. Often, we hear things like the market’s frothy and I'm just going to sit in the sidelines and I don't care if I miss some of the return. Look at the returns so far this year, they're staggering. It wouldn't been hard to convince people in December to sit on the sidelines. December was ugly. You missed one of the best six months we've had in ages. Jonathan Clements who was on the podcast three weeks ago, I guess, put on another article last week talking about the 15 most important notions that are important to making our lives better.

Number one on that list was humility. I think when it comes to portfolio management, his point is you need some humility and not try to time the mortgage and get fancy. Just stick to your strategy and focus in the long-term.

Bad advice of the week. Yeah, there's an article I just saw in Institutional Investor. I don't know if you got a chance to read it or not. The title of the article was There Is No Better Time To Be An Active Manager. The thesis of the person that was interviewed is that in a market dominated by passive funds and other quant strategies, there is a way to create opportunity for actively managed funds.

Here's the quote, “There is no better time than now, and even more dramatic in the value space,” says Warren Koontz, who's the Head of Value of Equity at Jennison Associates. This is no small shop. They manage a 176 billion dollars for PGIM it’s called, which is a very large insurance company in the US. It manages over 1 trillion dollars. This is a huge operation. They were recently interviewed on Barry Ritholtz, his podcast, a month or so ago.

I just found it interesting how there's an article that says, there's no better time to be an active manager, but there's absolutely no data in this. He's watching fund flows in and out of a variety of different ETFs and said, that's giving him signals of when to trade. He says, “If you're someone like me who is a value manager focusing on the intrinsic value of companies, you have a top-down force that's driving a whole group of stocks out of favor. It creates wonderful opportunities to invest.” Great story, but where's the data?

Ben Felix: There isn't any.

Cameron Passmore: There isn't any. It’s a throwaway article. As long as there's people like that, that's the point, right? People often ask what if the whole world index, or everyone's indexing there's no one left to do the fundamental research? I just don't see it happening. There's so many people like this. We have a long way to go before we have to worry –

Ben Felix: It’s only doing like that. The trading even with indexing at 50% in the US, the trading is still done 95% of it by the ACTA managers. It’s like, they're decreasing in assets, but their ability to set prices is not dependent on the magnitude of the assets they manage.

Cameron Passmore: Correct. Because you might have 40% that are indexed, but as trading volume is very low. It's all about price discovery on the trades.

Ben Felix: Then it comes back to who's competing with who. If there are just a couple of active managers left, or if they're both really, really skilled, then they're going to be able to make the market efficient. Just those last two of them, battling it out. Even those two, even though they're both skilled, you have that whole paradox of skill, where two skilled active managers as skilled as they are, if they're both as skilled as each other, the winner of each trade is going to be based on luck, if they're equally skilled.

Cameron Passmore: The takeaway I think for listeners, is you see an article like that, look for a little bit of data that's at least somewhat scientific. There's not a scintilla of data in this article. It's a belief and that's fine. As an investor making decisions on your portfolio, be critical of it.

Ben Felix: Yeah. That's the whole behavior piece. It's really not easy. There's so much information out there. So much of it is even directly attacking indexing, saying why it's bad and why it's going to break the market and why you shouldn't be doing it and all that stuff. It's like, “Man, where's the data to back any of that up?”

Cameron Passmore: This was not an attack. It's basically saying, because of what’s happening in the passive side, I can capitalize on that.

Ben Felix: That's still an attack though. It's saying that you shouldn't index, you should do what I'm doing, because look at all the opportunities all those silly indexers are creating. Like you said, show me the data. Prove it.

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