Welcome to this week’s episode of the Rational Reminder! Today, we get stuck into a commonly asked about investment topic – socially responsible or sustainable investing. The show kicks off with Cameron sharing some fantastic insights he gained from a book he recently finished, The Undoing Project. We then delve into the CalPERS story that was in the spotlight at the end of 2019. After that, we move the planning portion of our show, where we tackle the topic of sustainable investing. Many prominent Canadian pension funds have said that sustainability will be a core part of their investing going forward. We explore why sustainable investing has to mean lower returns, how this kind of investing affects social change, and what the amount you need to give up to feel good about your investments is. We also look at the subjectivity of ESG ratings and how this relates to your values. Ultimately, sustainable investing is about balancing the continuum of views and values, how closely they can be matched, and how you can do that in a diversified way. The sustainable label may not meet your expectations of sustainability which is why finding the balance can prove to be challenging. We round off the show by sharing our thoughts on how to restructure your portfolio when it comes time to live off of it. You don’t want to miss out on this interesting show, so tune in today!

Key Points From This Episode:

• A book Cameron recently finished and how he applies these lessons to his work. [0:01:08.0]

• More about the CalPERS story that broke in December 2019. [0:05:50.0]

• Insights into active managers and actively managed funds. [0:07:40.0]

• Vanguard is the first asset manager to surpass the six trillion-dollar mark and other stats. [0:10:30.0]

• Portfolio topic: The growth of socially responsible investing in North America. [0:12:10.0]

• The main considerations to account for when looking at socially responsible investing. [0:14:09.0]

• Two main sustainable investing strategies: negative screening and ESG integration. [0:15:01.0]

• The relationship between ESG and expected returns when controlling for common risk factors. [0:17:13.0] 

• The importance of ESG risk factor – where does the negative premium come from? [0:19:45.0]

• Differences between exclusion and investor tastes and their influence on expected returns. [0:21:40.0]

• Why the dispersion of preferences in the ESG industry is so important. [0:25:14.0]

• Does sustainable investing lead to positive social returns? [0:27:05.0]

• Two ways the lack of diversification of ESG investing hurts investors. [0:30:25.0] 

• Understanding the trade-off between values: do all companies use the same ESG filters? [0:31:42.0]

• The two major problems of not having consistent ESG rating metrics. [0:33:54.0]

• Two things to consider when the time comes to live off of your portfolio. [0:36:47.0]

• Deciding how to change your asset allocation and figuring your safe spending rate. [0:39:05.0]

• Why selling shares rather than receiving dividends does not make you worse off. [0:42:23.0]

• Final thoughts on spending income and dividends. [0:45:06.0]

• ‘Bad advice of the week’. [0:46:03.0]

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, Benjamin Felix, and Cameron Passmore.

Cameron Passmore: Exciting week this week. We have new microphones. 

Ben Felix: Ah, I was going to say that. Yep. I hope we sound better. 

Cameron Passmore: I think it always sounded reasonably good, but these are nice new mikes. So it's our first small step towards our studio, hopefully in the next few months. Anyway, this is a long episode, so we'll make the intro quick. Big focus was on ESG investing. 

Ben Felix: I think that's it. Let's fire up the episode.

Cameron Passmore: Fire it up and let it go from there. Some interesting things on fees too that came up from a recent article. And yeah. But it's a long one. But we went slowly so that you could appreciate all the research that Ben has done in ESG investing. So with that.

Ben Felix: What is at the very end, we had a pretty interesting discussion about where you should pay your fees from. So hopefully you can get through to the end because there's a good discussion there. 

Cameron Passmore: Thanks for listening. 

Ben Felix: Welcome to episode 82 of the Rational Reminder Podcast.

Cameron Passmore: It sure is number 82.

Ben Felix: Yes, it is. 

Cameron Passmore: So off the top, I just finished a book by Michael Lewis, The Undoing Project.

Ben Felix: You've mentioned this book before, I think as you were reading it.

Cameron Passmore: It's a phenomenal story in a way that really only Michael Lewis I think can tell a story like that. I'm sure you've read maybe his past books like Money Ball or The Big Shorter, Flash Boys. He takes these events and ideas and stories and just weaves them into an incredible book about the impact that these two behavioral psychologists had, Amos Tversky and Daniel Kahneman. 

I know we've talked about for sure, Kahneman in the past. He wrote the book Thinking Fast and Slow. And it was an amazing story about how these two guys came together like in the '60s in Tel Aviv, I believe. And over time they just became, Michael Lewis describes it almost like a love affair. They were together all the time, like six hours a day, every day for so long. And did you know that Kahneman spent time at UBC?

Ben Felix: Oh, I did not know that.

Cameron Passmore: Yeah. Between there and Michigan, as well as time in California. It's amazing what these guys discovered and how they worked off each other to discover these biases that we all suffer from and heuristics that we have. I saw a recent interview with Kahneman and even he said, "Well, I was with Shane on the Knowledge Project," talking about even he, after being a so-called expert on this for so long, he still falls prey to these issues and these biases.

Ben Felix: Does he catch himself, at least?

Cameron Passmore: I don't think he does actually. He doesn't think he has any greater insight than anybody else. And some of the examples that they talked about, representative bias. People misjudge the odds of a situation all the time. Your judgments are totally distorted. You make serious errors. Availability. Systematic biases that are caused by our judgment being distorted by the memorable things that we saw recently or we remember.

Conditionality that people don't know what they don't know. They also don't factor in their own ignorance into their judgments. And one of my favorites is the anchoring bias. And we've done this in a seminar a while ago, where if you spin a wheel that has between one and a hundred as an example, and depending what that number comes up, that will often guide people into how they answer a question such as what percentage of African countries are in the UN. So if you happen to have a spun a higher number, you're going to guess a higher number for the membership level.

Ben Felix: Fascinating. 

Cameron Passmore: And the book is loaded with examples. But how they discovered, I mean, I think it's fair to say they discovered this entire field of behavioral psychology. Kahneman won a Nobel Prize for that. But how they worked off each other to develop ideas and questions and tests, there's all kinds of risk profiling type questions, loss aversion questions that they came up with. And it's just how they interacted that just created this incredible body of research.

Ben Felix: Like a once in a lifetime relationship kind of thing.

Cameron Passmore: And to tweak the interest of Michael Lewis for him to actually go ahead and write the book, quite something.

Ben Felix: So you read like way more than I do and probably way more than most people. And I know you always say it's because you don't have kids at home. And it's true because I spent a lot of my weekend playing with the new hot wheels track that we got with my kids.

Cameron Passmore: I'm bringing my kid's hot wheels track to Value Village.

Ben Felix: You still have it?

Cameron Passmore: Yeah. Help yourself.

Ben Felix: You got the hot wheels track?

Cameron Passmore: Well, you have to negotiate with James, but yeah, we're loaded with stuff.

Ben Felix: Okay. I'm going to talk to James after this. Carrying on, what I was going to ask you was, so you read all this material. How do you think about applying it to the stuff that we do with clients everyday? Like you go and take in this amazing story about Kahneman and diversity, and you reiterate to yourself all of these biases that you already were aware of, but now it's fresh in your mind. Do you take that and apply it in any way?

Cameron Passmore: I think it gives me a greater appreciation for all these ideas came from. I think we do at some level. Something I've thought about a lot lately, as you consume, we all consume so much material, how do you archive this and how do you recall this so it can be useful in these client meetings or even just day-to-day life? I listened to a fabulous podcast yesterday with Tim Ferris interviewing Bob Iger of Disney. Incredible story how he got to where he is.

But what do you pull out of that? He gave a famous quote by Theodore Roosevelt though. So it's how to recall it. How do you organize it? Actually, that's a question Tim asked him. And he says, "Well, I actually email stuff to myself." So he has a whole email folder. I'm trying to save ideas in my Evernote system and try to categorize them there, but it does become a challenge to organize and recall all this material. 

Ben Felix: Absolutely. Huge challenge. 

Cameron Passmore: So then I've got so many books and ideas backed up to read that it's crazy. I need more time. Anyways, on to the next new story. 

Ben Felix: Yeah. I thought this one was good. It was from December. So it's not super timely, I guess. But it was about CalPERS, the big California state pension fund, California Public Employee Retirement System, CalPERS.

Cameron Passmore: CalPERS, a massive $380 billion pension system, largest in the US. 

Ben Felix: Yeah. So the interesting thing about it is that they have made... And they've been pretty vocal about this over time. I think they've just done another round of firing, but they're getting rid of a bunch of their external active equity managers and bringing a lot of those assets in-house. And when they bring assets in-house, a good portion of that goes into index strategies.

Cameron Passmore: But it's incredible. So the most recent cuts, they cut the number from 17 mandates to just three external managers, and cutting that allocation from $33 billion down to $5 billion out of a $380 billion pension system.

Ben Felix: It's crazy. And they're citing under-performance and they're citing high fees. And those things obviously go hand-in-hand. But it is interesting because, and I don't remember which one, but there was a pension fund that I read an interview from, or the pension fund manager that I read an interview from a while ago, and they were talking about how active has been the best thing ever for them, and they've totally smashed the market.

But you just think with the distribution of outcomes, CalPERS happens to be on one side. But imagine just the impact on the investing community in general if CalPERS had happened to fall on the good side of the distribution and had a great experience with active managers. That could shift the whole needle in terms of this wave of indexing.

Like if a more vocal market participant or a larger market participant happens to have a good experience with indexing, that could shift the whole dialogue. But statistically, that's unlikely. And that's why we're seeing this statistically likely.

Cameron Passmore: Who has a portfolio of that size?

Ben Felix: Right. And so we're seeing this statistically likely outcome, but it was just interesting to think about. There are some pension funds out there that have done well, or at least say they've done well with active management. They're maybe just not as big or not as vocal.

Cameron Passmore: So according to Morgan Stanley, there's been about a trillion dollars of assets that have left active managers. And they say the long-term picture is also grim as in the past decade, only 12% of managers have outperformed the broader stock market. 

Ben Felix: According to The Spear Report, you know what I'm really excited for? If it happens. And I don't know if it's going to happen. But I got an email from somebody who's in our business a while ago. And they were just saying, "Hey, I've checked out your videos and I think they're great." And they're an active manager. But they wanted to say, what do you think of The Spear Report using A-class funds? Which they do. And I've asked them about that in the past to confirm that's what they're doing. 

Cameron Passmore: A-class, having the trailer fee built in. 

Ben Felix: Correct. So if the F class fund, without the trailing commission, costs 1.5% just to manage the fund, there's an additional 1% cost that's designed to pay a financial advisor. 

Cameron Passmore: Did you say F class at 1.5%? 

Ben Felix: Yeah. Just say you take an F class fund at 1.5%.

Cameron Passmore: Could they be that expensive? I guess they could be. Yeah.

Ben Felix: Yeah. Well, you're used to the F class funds that we see that are 30, 40 basis points. Actively managed F class funds are still going to be 1%.

Cameron Passmore: I haven't done any of those in so long.

Ben Felix: Yeah. So the challenge with The Spear Report using the A-class funds is that you're comparing the index, which has no fees, to active funds, which not only have active fees, but they also have trailing commissions for advisors built into them. And it's not a great way to do the comparison. Anyway. So I emailed them and said kind of like, "Hey, we're an indexing firm in Canada and we would love your report, but it'd be awesome if you could run it like this, just to see how it changes the distribution of outcomes."

Because those numbers like that 12% of active managers beat the market over a decade or whatever. People always cite that, but it's using A-class funds. How does the story change if we use F class. It shouldn't change a ton, but it should change a bit.

Cameron Passmore: But as the article goes on, as you know, some analysts believe that this has to turn around. Another act of management says they've been unjustly vilified, and that's so sad. 

Ben Felix: I can see your feelings. 

Cameron Passmore: The thing is, it's more testament to how bright these people are. That's the whole point. They're fighting and the weak competition is being driven out. So you're left with the best competitors. It's a tough game. A lot of very smart people.

Ben Felix: What you said is extremely true, is that $1 trillion that have left active managers, which active managers has left?

Cameron Passmore: Likely the weakest ones, right? 

Ben Felix: Probably the weakest, the least skilled. And the most skilled active managers are keeping more of their clients at least, which means the remaining active managers are competing with each other for alpha or the skilled ones, which means that the skilled active managers no longer have unskilled active managers to exploit to generate alpha. 

Cameron Passmore: That's right. 

Ben Felix: So now they're battling with each other, these two ultra skilled managers, and then you've got the whole paradox of skill problem, where those two ultra skilled active managers, say equally skilled, if they're competing for alpha, who's going to win on the trade? On average, it's going to be determined by pure luck.

Cameron Passmore: So I also liked the article that we dug up from The Financial Times on January 12th. Vanguard to become the first asset manager to break the $6 trillion mark. I thought these are some interesting stats in there. So their net sales in 2019 were $268 billion, 16% increase over last year. However, for the first time in seven years, BlackRock had greater sales than they did. 

So based on the sales of the first nine months of 2019, at $300 billion, they're expected to break the all-time sales record of Vanguard, which they said in 2017 to be above $371 billion. But what is interesting to me is can you believe we're Vanguard sales went? Only 20% went to long-term equity funds. 60% went to long bond funds and 20% went to money market funds. So the CEO of Vanguard said that many of their 30 million clients became defensive after the rough patch in the fourth quarter of 2018, which many people will remember was a rough time.

Ben Felix: Of course. It was a good time to take a defensive position.

Cameron Passmore: Isn't it amazing though, like a group who you would think would have selection bias in their clientele with much more discipline?

Ben Felix: Well, we know that index fund and ETF assets are being used. We don't know actually. We know to an extent they're being used for active management purposes. I don't know what the proportion is of how much is being passively held versus actively traded. I think you had a stat a while ago though, showing that a lot of these total market ETFs, their average holding period is less than a year or something like that.

Cameron Passmore: Oh, way less than a year. I think some of them are in the matter of weeks or days. We looked at that.

Ben Felix: So it's not like people are on average just passively buying and holding these things. 

Cameron Passmore: No. Anything else in the news front? 

Ben Felix: No. I think that's good for the current stuff.

Cameron Passmore: On to the portfolio topic, which is socially responsible investing.

Ben Felix: Yeah. This one's come up... Well, it comes up all the time, and we've talked about it a little bit here and there in the past. But it's becoming an increasingly big deal and we can see that just by the assets. So when you look at US domiciled assets under management, at the start of 2018, it's a bit old now. It's probably higher. At that time, it started 2018, 25% of all US professionally managed assets were in sustainable strategies. That being a very broad term that describes all sorts of socially responsible, environmentally friendly, all that kind of stuff.

Cameron Passmore: That announcement last week by BlackRock was huge, I think.

Ben Felix: Yeah. It was a big announcement because BlackRock is a big company. We'll see how it actually shakes out. I think there was a lot of negative pushback on...

Cameron Passmore: Oh, was there?

Ben Felix: Yeah. I mean, the things that he was saying were not fact-based a lot of them, like saying that, which we're going to talk about, sustainable strategies tend to do better. False.

Cameron Passmore: There's the teaser. 

Ben Felix: Anyway, we'll talk more about that in a second. In Canada, the sustainable assets are about half of the managed market. That's a lot.

Cameron Passmore: It's way higher than I would have guessed. 

Ben Felix: Yeah. $2.1 trillion in Canadian dollar terms. And that number is up 42% since 2016. So that's professionally managed funds in sustainable strategies.

Cameron Passmore: In a sustainable strategy, not just holdings that are deemed to be sustainable.

Ben Felix: Right. And you look at like a ton of the big Canadian pension funds have done things similar to what BlackRock has done, where they've said publicly, "We're going to make sustainability an important part of our investment process." So this idea of socially responsible investing or sustainable. Well, let's call it sustainable for the rest of the podcast. 

That concept is growing in terms of the assets under management. And that fact is extremely important, which we're going to talk about as we go through this segment. So as an investor, when you're thinking about, should I build a sustainable portfolio or should I put sustainability at the forefront of my investment decisions? I think that there are a couple of main things you've got to think about. 

Ben Felix: One of them is what is the impact on your expected returns, which is maybe an obvious consideration. And then the other one, which is probably more important and probably less obvious is, how sure are you that the thing that you are investing in, which may have an effect on your expected returns, a negative one. I spoiled it. This portfolio with a lower expected return by definition, how sure are you that it actually reflects your views and values?

Because you can go and buy this sustainable portfolio that's got the sustainable label on it, but there's a pretty good chance that it's not going to meet your definition of sustainability. And we're going to talk about why that's true. Sorry. I keep getting teasers.

Cameron Passmore: Yeah. And how much impact it's really going to have.

Ben Felix: Yeah. The impact thing is interesting. And I've notes on that too. So maybe just to set the discussion, there are two most common types in terms of assets of sustainable investing strategies. One is negative screening. 

Cameron Passmore: So taking out what you don't like.

Ben Felix: Totally taking it out. And then the other one is ESG integration. So ESG is environmental Social Governance. And the integration strategy is opposed to totally excluding stuff. An integration approach changes the weight of companies. So the highest ESG ratings, the most sustainable companies or whatever you want to call it, they get a higher weight in the portfolio and the worst companies get a reduction.

Cameron Passmore: Some more of what you want, less of what you don't.

Ben Felix: Right. And most ETFs, like if you look at a sustainability ETF, there's a good chance they're going to be using both strategies. It might be an ESG integration approach, but they've completely eliminated like tobacco or weapons or whatever. So in a lot of cases, it'll be both strategies going on at the same time.

Cameron Passmore: Are most companies using a similar type scoring system?

Ben Felix: Oh, Cameron. Good question. We'll cover that in a second though. But it is a really good question. And it's a really important question. No is the answer. Sorry. I guess I really thought through this topic, so I have it all structured in my head. That why I keep giving these...

Cameron Passmore: I don't want to rush you. I know there's a lot thinking over here.

Ben Felix: It's like you've given these teasers by accident. Okay. So if we talk about the effect unexpected returns, and this is one of the most important pieces. Well, it's those two pieces together, I guess, that are jointly important.

Cameron Passmore: But when we're dealing with clients, how often does that consideration come up compared to the desire to have an impact or reflect our values?

Ben Felix: Well, I think it doesn't come up because people don't have the knowledge to even ask that question. What client that is worried about climate change is going to say, "Cameron, will this affect my expected returns?" That's literally the last question they can ask. So I guess what I'm saying is that you're right. That's not what they're thinking about, but I think that's because there's a lack of knowledge. 

And that's why understanding the trade-off between expected returns and reflecting your values is important. And I just want to throw in there, I'm not anti ESG. I think it's fine if you want to do that. But you've got to understand the trade-offs right, which is the point of...

Cameron Passmore: Well, you're just bringing the facts. You've dug through the papers. So fire away.

Ben Felix: Okay. So if we think in broad terms of the effect on ESG scores on stock returns, that was examined in quite a bit of detail in a 2019 paper by Rocco Ciciretti, Ambrogio Dalò, and Lammertjan Dam.

Cameron Passmore: Look at you. You pulled off all three names. 

Ben Felix: Thank you. So they controlled for common risk factors. And I wanted to say this too. This is another really important point. If you don't control for common risk factors, an ESG portfolio can actually look really good compared to the market in terms of returns. And that's important because if you take say just a regular market cap weighted index and compare that to an ESG index, the ESG index may have outperformed the market. Why though? It's because it has excess exposure to certain types of risks. 

Cameron Passmore: Luckily all our listeners get that.

Ben Felix: Right. At this point, probably a lot of them do. So you'll often see like loading to the profitability factor if you invest in an ESG index.

Cameron Passmore: Reinvestment as well, perhaps.

Ben Felix: I can't remember. It's been a while since I looked at the... I wrote a blog post a while ago on doing a five factor regression on an ESG index because somebody had written an article saying, "Look, look, ESG index has beat the market." I was like, "Hold on, hold on. Did you run a five factor regression?" Anyway. So in this paper, that paper that I mentioned, they controlled for the common risk factors. 

They looked at 5,972 firms globally. They looked at the data for 2004 through 2018. And they found that companies with higher ESG scores tended to deliver lower average returns. So there we go. There we have it/ Lower historical returns. They found a statistically significant negative premium for the ESG characteristic in a traditional five factor regression.

They also did a six factor regression, including momentum. And they did a seven factor regression, including an ESG risk factor, which we're going to come back to in a second because it's important in a different context. So in all cases, they found that better ESG ratings in stocks produce lower expected returns.

Cameron Passmore: And they included momentum.

Ben Felix: In one of their regressions. They did a bunch of different one.

Cameron Passmore: Just as an aside, I think that momentum going into these stocks now if there's a momentum factor that may be happening.

Ben Felix: That's a good question. One of the papers that I read did talk about that actually. That if there becomes a quick, strong preference for ESG products, that can drive the prices of those securities up, which can make the returns look good, but only for a short period of time. Because once the price has jumped based on the interest, their future returns are now lower. 

Cameron Passmore: Higher the price, lower the expected returns going forward,

Ben Felix: Correct. Which is a theme all the way through this whole ESG conversation. So in the paper that we're talking about, they found that a one standard deviation decrease in the ESG score was associated with a 0.13% increase in monthly expected returns. So it was meaningful. So when they controlled for all of the common risk factors that I mentioned in those different regressions, they found lower historical returns of the ESG characteristic, which is different from the ESG risk factor.

Ben Felix: The reason that the ESG risk factor is important is that they used exposure to that factor to try and determine whether the ESG negative premium is coming from an ESG risk factor or an investor preference. And that distinction is very important in thinking about this. If it's an investor preference, and Fama and French did a paper about this in 2007 called Disagreements, Tastes, and Asset Prices.

But they basically said that if investors have a taste, is what they call it, but if they have a preference that's not related to risk and expected returns for a certain type of assets, they'll be more willing to hold those assets regardless of their risk return profile. 

Cameron Passmore: That makes sense. 

Ben Felix: And if enough wealth is controlled by investors that have that type of taste, and this is why at the beginning of this discussion, I said that the magnitude of assets going into these strategies is important. If enough investors have a specific taste like we're seeing with the sustainable investing movement, that can have a meaningful effect on prices.

Cameron Passmore: Driving them up, you're saying.

Ben Felix: Driving them up, reducing expected returns. 

Cameron Passmore: And that may be okay with those investors. 

Ben Felix: And that's an important part of this whole thing. But another way to think about this is that, and well, it's kind of like what you just said. The investors that have a taste for sustainable investments... Well, this is kind of the inverse of what you said, actually. Investors that have a taste for sustainable investments require higher expected returns to be convinced to invest in an unsustainable company. So now we've got, just say for argument's sake, half the market. 

Cameron Passmore: Is that necessarily true?

Ben Felix: Is what true?

Cameron Passmore: What you're saying that if the sustainable investors are pushing up the prices of the securities they want, are they then setting the other non sustainable investments prices lower, saying we're demanding higher rate of return for us to invest in those just by them not going there? Or could you have a whole cohort of investors that say I just don't want them. Period. Regardless of the expected returns. Therefore leaving an opportunity set for other investors for the non ESG investments.

Ben Felix: So those are two different things. There's exclusion and there's master tastes. And exclusion leads to an actual risk premium because neglected stocks that a large portion of investors will invest in, like you just said, they actually become riskier. And one of the sort of main academics, I can't remember who it was, maybe it was Miller, anyway, or maybe it's Robert Merton. 

Somebody wrote a paper on neglected security as having a risk premium. So if they are neglected, then it's still the same effect. The risk premium increases on the less desirable companies. If it's an effective investor tastes, so half the market is willing to invest in the bad companies, but only if the expected return is high enough, that drives down the prices of those types of companies.

And I guess on the flip side of that, the sustainable investors are more willing to invest in sustainable companies, even if their expected return is lower, which drives up the price of those companies and drives down their expected returns. So I think based on that little bit there, we might have a bit of an understanding that based on an investor tastes, it's reasonable to expect lower returns for companies that are sought after by the sustainable investing group movement, whatever you want to call it.

So then I looked at another paper also from 2019 by a guy named Olivia David's Habib, and he developed an asset pricing model and he included an ESG. He included premiums for exclusion and investor tastes. So when you made that comparison a second ago, this is why I had an answer because I read a paper about it. So he looked at distinctly, what is the effect from exclusion?

So what is the effect on securities that are completely excluded from ESG strategies? And what is the effect of investor tastes? And he's looking at it in the context of differences in expected returns. So he said that the premium for exclusion was related to the increased risk of stocks, which are neglected. That's the thing we were just talking about, based on that paper by the guy that I can't remember the name of.

And then the premium for investor tastes is, and this is very specific language that came from a different paper that this guy cited, but it's interesting language. So the premium for investor tastes is related to the cost of externalities that sustainable investors internalize to maximize their welfare instead of the market value of their investments. 

Cameron Passmore: Okay. Let's run that one again. 

Ben Felix: The premium for investor tastes is related to the cost of externalities that sustainable investors internalize to maximize their welfare instead of the market value of their investment.

Cameron Passmore: Right. So it's the amount they're giving up to feel good about their investment.

Ben Felix: That's a very concise way of putting it.

Cameron Passmore: Which is totally okay. 

Ben Felix: Like we said before, I have nothing against ESG investing. You just have to understand what the implications are. So in this paper, Zabib found that the exclusion effect, and he looked at US stock data from 2000 through 2018, the exclusion effect, so the difference in expected returns between stocks that are neglected and stocks that are not, I guess, was 2.5% per year.

Cameron Passmore: And that doesn't factor in any of the other factors in the Fama French model. 

Ben Felix: No. All of these papers looked at multifactor. 

Cameron Passmore: Okay. Controlling how much you're leaving on the table by excluding them?

Ben Felix: Correct.

Cameron Passmore: Wow. That's a big number.

Ben Felix: So if you go down the path of ESG investing, I'm going to exclude all the companies that I don't like, in this paper, they found it to be about a 2.5% per year opportunity cost, I guess. And then the effect of investor tastes, which is associated with the idea of an ESG integration approach, that was 1.5% per year.

Cameron Passmore: So much you're giving up by focusing on that side of the...

Ben Felix: Correct. By weighting more towards ESG and less... Yeah. 

Cameron Passmore: Amazing numbers.

Ben Felix: Yes. Now, one of the other really interesting things about this whole discussion and it, again, speaks to the importance of the size of the ESG industry, but it's that the dispersion in ESG preferences is extremely important. And what that means is if everybody, all of the investors in the market had the same ESG preferences, the same willingness to own bad companies if the expected returns are high enough and the same willingness to hold sustainable companies even if the expected returns are low, if everyone had the exact same preferences, there would be no ESG industry.

Their products wouldn't exist, which means there's no dispersion of preferences. The industry doesn't exist. The differences in expected returns don't exist if there's no dispersion and preferences. And this is from a paper by Pastor, Stambaugh, and Taylor, and they've written some other fantastic papers in the past. But they took a theoretical approach. The other papers that we talked about were empirical. And they found with their theoretical approach that firms with higher ESG scores have lower expected returns. No news there from the empirical stuff we've talked about. And those expected returns get lower when risk aversion is low and ESG sensitivity is high.

So if risk aversion is low, sustainable investors are more willing to hold riskier stocks, despite lower expected returns, which changes that difference in expected returns between sustainable and non-sustainable companies. Anyway. So the dispersion and the strength of the dispersion is an important component of the differences in expected returns. 

Cameron Passmore: A whole lot to think about.

Ben Felix: Yes.

Cameron Passmore: I mean, this is going to be a longer topic than normal, but I think it's worth all the go through slowly. I know we've had a lot of feedback from people that don't just rush through in-depth topics. So I think we're going to try to keep going through this carefully. 

Ben Felix: DO you think we've been careful enough so far?

Cameron Passmore: I think so. It's going be longer than normal. I think we're good. Okay. Unless someone really doesn't like it, they can hit the little fast forward.

Ben Felix: The 30-second thing? Yeah. So we talked about expected returns. The other piece is social impact. And we're going to touch on expected returns one more time, but social impact for a second. So in the Pastor, Stambaugh, Taylor paper, they found in their theoretical model that sustainable investing does lead to positive social impact by encouraging sustainable firms to invest more, which makes sense. 

Ben Felix: We're talking about the cost of capital for these sustainable firms declining. Their required rate of return for investors to invest in them is lower because people are internalizing the positive externalities while discouraging unsustainable firms from investing for the same reason. So their cost of capital is getting higher and higher. So now for an unsustainable company to invest in a project, they've got to have a really high expected return to make that investment.

Cameron Passmore: Naturally.

Ben Felix: Right. Which if you own that company, that's not necessarily a bad thing because your expected returns are higher. But if you're running the company, it kind of sucks. Which is the point, that's creating positive social impact. Now, where it gets tricky is that based on what I just said, you can affect social change with your investments, which is good. 

But the important part is that you are doing so at the expense of your expected returns. And I think that has to be true. And it has to be true because if there's no dispersion in ESG preferences, the thing that we just talked about with the higher cost of capital for unsustainable companies, if there's no dispersion in ESG preferences, that effect is not going to exist.

So for sustainable investing to work the way that you want it to, in terms of social impact, it has to be true that you accept lower expected returns on a risk-adjusted basis. If that's not true, if you don't accept lower expected returns, then the social impact piece mechanically can't be functioning, can't be working.

Cameron Passmore: I can see everyone kind of scratching their head. 

Ben Felix: Okay. Well, you try? 

Cameron Passmore: No, no. Keep going.

Ben Felix: Well, how would you explain what I just said?

Cameron Passmore: No better than that. I'm just saying it's so counterintuitive.

Ben Felix: I mean, for the whole thing to work, like why are we doing social responsible investing? Maybe you want to feel good about ourselves. Maybe you actually want to have an impact. If you actually want to have an impact, and if that impact is going to work, it is going to work because you're getting lower expected returns.

Cameron Passmore: More demand for the securities means lower cost and capital, easy to raise money, lower expected returns, positive impact. Change should come.

Ben Felix: Right. You're encouraging good companies by giving them your capital. But if everybody is doing that...

Cameron Passmore: Right. And if there's less demand for the so-called bad companies, their cost of capital has to go up there for higher expected returns.

Ben Felix: Positive social change.

Cameron Passmore: Which is why I've heard some people say, "Well, I want to own those things and take those higher expected returns and go and make a donation to make an impact." Because someone has to own all the stocks all the time.

Ben Felix: As I was going through this research, that's one of the things that popped into my head is like, if you decide that I'm going to be the sustainable investor and you accept that you're going to have lower expected returns, which I think must be true both theoretically and empirically. If you're willing to do that, you're knowingly giving the people, who by definition don't share your beliefs, higher expected returns.

And if we assume just from an economic perspective, that means they're going to have more wealth.

Cameron Passmore: That assumes those companies survive. 

Ben Felix: Fair enough. Yeah. I mean, if the portfolio is diversified enough, it should be all right. So if we assume that the people investing in the unsustainable companies are going ultimately have more wealth, then they may also have more control to do things that maybe by definition of the difference in preferences you would disagree with. Maybe they take their wealth and go buy another SUV. And you've paid for that. Maybe I'm pushing that too far. I don't know.

Cameron Passmore: It may be. 

Ben Felix: Okay. So differences in expected returns is a big piece of ESG investing or sustainable investing, I said I was going to call it. But the other piece is that it must be less diversified than the market. That's a requirement. And that hurts from two perspectives. It hurts from the perspective that you own the part of the market that has lower expected returns. So you're giving up on a portion of the market that has a higher expected return. And you also have a fewer number of securities.

Cameron Passmore: Therefore reduce the reliability of your outcome. 

Ben Felix: So not only do you have lower expected returns, you also have a less reliable outcome. So it's kind of a double whammy of pain. And then fee is the other one. If you look, iShares has a suite of ESG products in Canada, and you could build a portfolio like a globally diversified index portfolio for 28 basis points.

Cameron Passmore: Which is still remarkably cheap.

Ben Felix: It's cheap, super cheap. Well, we'll talk about those products again in a second. People might shake their heads a little bit. But to do the same thing with an iShares ETF portfolio that does not have the ESG screen, you're going to pay 12 basis points. So it goes from still pretty cheap to like ridiculously cheap. But you're right. The difference is not...

Cameron Passmore: Negligible. 

Ben Felix: Yeah. Not huge. Now, the other piece, and this comes back to that reflecting your values idea, is that these things exist on a continuum, where to get more hardcore ESG preferences, you must give up more diversification and you're probably also going to have higher fees. Now, the big piece is that trade off between views and values. So then you ask this question about, do they use the same...

Cameron Passmore: Filters. The same ESG filters or framework. 

Ben Felix: And the answer is no. So this is, again, a 2019 paper. There was a bunch of papers on this, I guess last year by Florian Berg, Julian Koelbel, and Roberto Rigobon. And they looked at the ESG ratings from five prominent ESG ratings agencies. So these would be the agencies that index providers are using to build their index products. And they found an average correlation of 0.61 for ESG ratings, which is low.

Cameron Passmore: That said, it sounds low.

Ben Felix: Yes. And so for context, I can't remember if this was from the paper. Yeah. I think this was from the paper. For context, Moody's and Standard and Pores, for their credit ratings, have a 0.99 correlation. 

Cameron Passmore: Wow. 

Ben Felix: So there's a lot more subjectivity, it looks like, in the ESG ratings than there is in something like a credit rating. So the average correlation 0.61 with a range between 0.42 and 0.73. Now, if we look at the MSCI Canada IMI Extended ESG Focus Index, which is the index that one of those iShares ESG Canada ETS tracks, I said we're going to come back to that product. 

So the index takes an integration approach combined with total exclusions for tobacco, controversial weapons, and producers of or ties with civilian firearms and businesses involved in severe controversies. So you got the integration and you got some exclusions. So one of the largest holdings of that index and therefore the ETF tracking it is Suncor, which is a Canadian energy company specializing in synthetic crude production from oil sense. And Suncor aside, more than 16% of that index is made up of energy companies. 

Cameron Passmore: I know some day you just show that to clients who want to have this preference and they're shocked by the holdings.

Ben Felix: Right. So then you look around and say, "Well, that kind of sucks." You look at FTSE, which is a different index provided that Vanguard uses, and FTSE ESG indexes do exclude oil, gas, and coal companies. They don't exclude downstream companies like pipelines, but still better than no exclusion at all, if that's your thing. Now, energy specifically is apparently based on that paper I mentioned about how different companies rate stuff. 

Energy is one of the biggest points of disagreement, which had an average rating correlation of only 0.29. So I guess no surprise that the indexes are treating it differently based on how the ESG rating agencies are treating it. Now, this poses two major problems. One of them is what we've been talking about, is that you as the investor might be investing in a product that you think aligns with your views and values, but it actually doesn't if you didn't look at the holdings. And that sucks. That's too bad.

Ben Felix: You're accepting lower expected returns for something that you would have been sad about owning anyway. But then the other big problem is that we talk about that social impact piece. Are you really having a social impact? If companies don't know which ESG behaviors are going to be rewarded in terms of what ESG rating agencies are going to say...

Cameron Passmore: Oh, interesting. 

Ben Felix: Right. So if I'm a corporation and I do, maybe my company does want to improve our ESG rating for whatever reason, maybe because we want our stock price to go up, maybe because we're altruistic, whatever. But if that corporation is using ESG ratings to try and improve themselves.

Cameron Passmore: And they're getting mixed signals from the marketplace.

Ben Felix: Right. So now investors are allocating their capital where if companies realize based on what we've been talking about, companies realize that there's a market impact of these sustainable investors. So they want to align with them, but they don't actually know what to do because the rating agencies are all giving mixed signals.

Cameron Passmore: So interesting. 

Ben Felix: So that gets pretty messy. 

Cameron Passmore: Or you go back to the Suncor example, maybe they're the best of the worst in some people's eyes. Like you don't know perhaps what caused them to be included in that rating selections.

Ben Felix: Yeah. Sure. And that actually speaks to, the way that I wrap this topic up is that approaching sustainable investing, it's all about precise management of the trade-offs between the implicit and explicit costs we've talked about and your specific set of views and values. It's all about managing those trade-offs. And I've spent some time talking to Tim Nash a while ago, and I have no idea what he's going to think about this episode. 

I don't know if he'll like it or not. He explained to me that his role as a fee-only consultant for people that want to invest this way, his role is 100% about managing trade-offs. So he takes his knowledge set and he tries to figure out how severe are your biases against these certain things? And okay. If they're extremely severe, that means your portfolio is going to look like this. It's going to be three stocks or something. That's obviously an extreme example. 

But then someone like Tim would be saying a three stock portfolio is pretty undiversified. So we might want to shift a little bit. But it's all about managing that continuum of, what are your views and values? How closely do they need to be matched? And how can you do that in a way that is still diversified and still has a reasonable expected return that's going to let you meet your goals.

Cameron Passmore: Some reliability and reflects your preferences. 

Ben Felix: Yeah. So I know that that was a big topic, but I think it was worth discussing. It comes up a lot.

Cameron Passmore: It comes up a lot, especially now after the big announcement last week.

Ben Felix: I don't know what other contexts you could have to think through that question of, should I be a sustainable investor? I think we give all the context. Maybe all is…

Cameron Passmore: You gave enough for now, I think it's safe to say. Onto the planning topic. Another one that you chose for this week. So spending from an index fund portfolio, which is, again, another question we get quite often, how should I structure my portfolio when it comes time to actually start living off of it? 

Ben Felix: Yeah. And I think there are two main things that it speaks to. One is asset allocation. So I think when people ask this question, there may be partially thinking about, how should my mix between stocks and bonds change over time? Or even how should my mix between total market and dividend stocks change over time? I'm not saying that's the way you should be thinking about it, but that's what some people might think. 

Cameron Passmore: And again, listeners know your point on that. 

Ben Felix: Maybe. Some of them.

Cameron Passmore: And also some rules of thumb that I know drive us all crazy.

Ben Felix: Yeah. So I think people are thinking about, what should my asset allocation be? And then they're also thinking about, how do I actually get the cash out of my portfolio, which I think speaks to that mental accounting capital versus income discussion. On the asset allocation piece, I think like you said, Cameron, the rules of thumb are pretty brutal, like reducing your equity exposure over time based on your age, like a hundred minus your age, whatever it is. 

Cameron Passmore: Now, having said that, if you follow that, you did keep yourself out of trouble. I know some people that did follow that in 2008. So it's better than not. Better than getting in over your head with an equity allocation that you can't live with.

Ben Felix: For sure. And asset allocation is always going to be somewhat subjective. There's always that risk aversion piece that plays into it. But there is some interesting research. Some of it has actually come from Graham in our PWL Waterloo office on glide path investing versus constant equity allocation. And that research has found that there's no expected benefit to using a glide path. So that's consistently decreasing your equity exposure over time.

There's no benefit to that compared to holding the time-weighted average asset allocation of the target date, of the glide path fund. So if on average you own a 60/40 portfolio based on your glide path, you could have just owned a 60/40 portfolio the whole entire time.

Cameron Passmore: Stay 60/40 all the way through.

Ben Felix: And been just as well off. Now, it doesn't mean your asset allocation should never change. I think that you can be. And we talked about this in the investment with leverage discussion that we had a while ago and then the YouTube video I did, where, well, in their suggestion, you're using leverage to get your future savings into equities as soon as possible. And then you're decreasing your leverage. 

And then you're finally, when that's done, adding in your fixed income. I think equity investors can do something similar, where you have your aggressive portfolio for a period of time and then transition maybe near retirement. But just that glide path concept isn't necessarily what you have to do. I think changing asset allocation should be based on other stuff. Like if you have a windfall, that's a reason to change your asset allocation.

Cameron Passmore: Or if you don't need to take on the risk. If you have enough saved up.

Ben Felix: That's what I was getting at.

Cameron Passmore: That preference, right? I know we're going to talk about this, but aware of what your longterm financial plan is and the kind of volatility that you have a preference for.

Ben Felix: I mean, if you think about it, once you're at the point where you're making the decision that you're ready to retire, it by definition means that you have enough financial capital to fund your future expenses. Otherwise, you would not be retiring.

Cameron Passmore: Correct. But you can make choices at that point to reduce the variability in your portfolio if you wish.

Ben Felix: That's what I'm saying. Exactly. Once you reach that point of capitalization, you can do exactly what you're saying. Now, I guess if you have more capital, which maybe speaks to the windfall point I was trying to make, if you have more capital, you can afford to take even less.

Cameron Passmore: Or even more. You can go both ways, right? We have some clients that have way more than they'll ever need that have gone all equity because they can afford to. Even if it does fall by half, they're not in trouble. But they know over longterm higher expect to return.

Ben Felix: So that speaks to the point of why rules of thumb are not useful for asset allocation.

Cameron Passmore: Trade-offs.

Ben Felix: Yeah. Okay. So the other piece of this question I think is spending policy, where people have this portfolio of index funds and they pay some distributions from dividends and interest, but that's probably not enough to live on. And I think this is why income investing in general is so attractive to a lot of people is that you get this fixed amount, or not fixed, but you get this amount of income paid by distributions. And if that's enough to live on, cool.

Cameron Passmore: And you're not selling stuff.

Ben Felix: And you're not selling stuff. But having a spending policy as a retiree, I mean, it's a key part of retirement, and the spending policy should not be dictated by the dividend policy of the companies that you own.

Cameron Passmore: That's a key line. Although people love dividends. We've talked about that forever.

Ben Felix: They're not investment returns.

Cameron Passmore: Don't let that dictate your spending policy.

Ben Felix: Right. Dividends are not returns. So you've got to figure out how much you can spend from your portfolio. It's not something that we can give you the answer to because it's like one of the biggest problems in finance. I think Merton Miller might've said that. But you can use stuff like Monte Carlo, a model to approximate how much you can spend. You can use historical worst-case scenario analysis, like how the 4% rule was developed.

Cameron Passmore: So Monte Carlo is basically stress testing your returns with some variability in those returns over your lifetime. 

Ben Felix: Yeah. If we simulate a thousand lifetimes, how many of the thousands simulations did you not run out of money? That's Monte Carlo. But you can do the same kind of thing with historical analysis. So take all the historical time periods using US stock data or something that you can get for free online. Anyway. So you can use those things to figure out what your safe spending rate is. And then once you know that number, you can spend some combination of income and capital, as long as you stay within your spending rule.

Cameron Passmore: Correct. Because what matters is total return and variability of the prices.

Ben Felix: Right. When a dividend is paid to you, that your capital decreases must be decrease mechanically by the amount of the dividend that was paid. And so it's no different. Receiving a dividend is no different from making your own dividend and selling some stock. I just have to throw this into this discussion because it comes up on the dividend YouTube video that I posted a while ago. But when you sell shares...

Cameron Passmore: It ferociously comes up in the comments.

Ben Felix: Like all the time. Man, I thought I answered this already.

Cameron Passmore: It's not debatable. It's tautology.

Ben Felix: Yes. So the thing that comes up that we're talking about being tautology is that people seem to think that if you reduce the number of shares that you own, which you would do if you're selling shares, as opposed to receiving dividends, if you reduce the number of shares that you own, you're shooting yourself in the foot. You're now worse off. You're in a worse off position to accumulate future capital. 

If you think about an example. So if you start with a hundred shares, worth $1 each, so you've got a hundred dollars in your portfolio of total value, and the shares pay a $0.10 dividend. You've got a hundred shares and they're worth 90 cents each now. 

Cameron Passmore: $90.

Ben Felix: $90 portfolio. And you've got $10 in cash from the dividend. Now, alternatively, if you would not receive the dividend because your shares didn't pay dividends and you instead same value for the shares. And you had sold 10 shares to create a $10 cashflow because you needed some income. You would now have 90 shares. So instead of a hundred shares worth $0.90 each, you've now got 90 shares worth $1 each.

So portfolio is still worth $90. Now, in either case, whether you own less shares that are worth more or more shares that are worth less, if the future return like tomorrow there's a 10% return, a 10% jump in the market, the value in both cases increases by the exact same dollar amount. The number of shares that you own does not have any impact on your returns, especially now that you can trade fractional shares. It really doesn't matter. It used to matter a little bit because at some point you would have to sell your last share, I guess. But with fractional shares, it doesn't matter now.

Cameron Passmore: It's the number of shares times the current value that it determines your portfolio value. 

Ben Felix: Yeah. I think just one more thing to touch on, on this income topic is that what a lot of people will do to make it easier to think about is build a GIC ladder. So you've got five GICs maturing one each over five years. And the thinking goes that you can just spend those GICs.

Cameron Passmore: And you don't worry about the market. So you basically give yourself peace of mind that you don't have to worry about the market for five years. But that's not necessarily true.

Ben Felix: Well, it's not true because when you're GIC matures, you have to replenish it to keep your asset allocation the same.

Cameron Passmore: Well, that's just it. So as you spend down those GICs, overall your equity exposure, all things being equal, is increasing because you're reducing your fixed income. And I can tell you very few people look at it that way. They just compartmentalize it. I'll leave my 60/40 loan over here and I'll have all five years of GICs in this other account. Therefore, if I don't touch one, now you can really whatever, some other asset mix. 

Ben Felix: Now all of a sudden three bad years in the market and yeah, now you're at 80% equity. And who's to say the fourth year is going to be good and not bad. Well, we've talked about this with Alexander McQueen a while ago. That the GIC ladder concept is basically irrelevant for that purpose. Anyway. 

And then the other piece of this that I think people struggle with, and this is one of the other questions that I get a lot on this topic, is that if you have a balanced ETF, like say you retire with VBL and that's your only asset, and there's this perception that you're required to sell stocks when they're down. If you think about it, if you owned 60% in your portfolio in a stock ETF and 40% in a bond ETF, if stocks are down, you can just sell some of your bonds for income to rebalance. And that's fine. You end up back with your 60/40 mix. But if you own VBL, you have to sell stocks when they're down, but that's not how it works. If stocks are down, VBL's rebalancing, which means...

Cameron Passmore: You've been buying all the way along.

Ben Felix: Right. Which means say it happens in a single time period. Stocks drop. Inside a VBL they're selling bonds to buy cheap stocks. And then you go and sell your unit of the fund. You're selling the cheap stocks that they just bought. It's not like you're buying stocks low. You're selling stocks low. You're buying them low and then selling them low. But you're not losing out on anything.

Cameron Passmore: No. In fact, you're going to have better tracking to the asset makes you want it all the way along as opposed to when you decide to take money out. 

Ben Felix: Yep. I mean, yeah, figure out your spending policy, sell your assets as needed, use income distributions to...

Cameron Passmore: And use Monte Carlo to find out the asset mix that's appropriate for you and your own preferences.

Ben Felix: Yeah. Asset mixing the spending policy. 

Cameron Passmore: Anything else on that topic?

Ben Felix: Nope. 

Cameron Passmore: So we'll quickly go on to the bad advice of the week. This one came from a Globe and Mail article of December 18th, why investors should pay for all investment fees out of non-registered accounts. And this generated quite a bit of discussion around here. And we thank a regular listener for sending in the article to us. So I know you're listening, Mike.

This goes back to a letter, I guess, from the recent Department of Finance Canada letter to CRA stating that paying investment fees for your registered accounts, your RSP, your TFSA, out of your non-registered account. So have your trading account pay for your RSP and TFSA fees does not constitute a tax advantage for investors. So the article says, "Therefore, you are now free and you should pay all your investment costs from your RSP and your TFSA out of your trading account.

Ben Felix: Right. So you're paying fees in your RSP and TFSA, but instead of taking the cash to pay those fees from those accounts, you take them from your taxable account.

Cameron Passmore: So if you go back to basics, any fees paid from non-registered accounts for that account are tax deductible. So your trading account pays those fees as a tax deduction for you. But any fees paid from an RSP for the RSP are not tax deductible. They used to be many, many years ago, but they no longer are. Same thing for TFSA. However, you are effectively using pre-tax dollars to make that payment. That's the benefit of using the cash in your RSP to make the trustee or the management fee payments. Those are pre-tax dollars.

Ben Felix: If you think about it, we've talked about the RSP in the context of asset allocation. You should use the after-tax value of your RSP for asset allocation. Fees are calculated based on the pre tax value of an RSP. So if you think about it, you have say your tax rate is 50%, you have twice as much in your RSP account than you actually own, but you're still paying fees on the full amount.

So you're paying fees on the portion of your assets that the government owns or is entitled to. And if you pay those fees from inside the RSP account, the government's paying half your fees and you're paying half your fees. If you pay those fees with after-tax dollars from your taxable account or from wherever, you're paying your portion of the fees and you're paying the government's portion of the fees and you're not getting a tax deduction for it. And when you withdraw the money from the RSP in the future, you're going to pay tax on the full amount.

Cameron Passmore: And that assumes that your service provider can partition those fees. So they produce an accurate receipt so that your trading account fee is deductible, but the RSP fees paid from your trading account are not deductible. So I'm not sure if systemically the industry can do that, perhaps they can.

Ben Felix: I'm sure a keen DIY investor could figure out how to partition their own fees out.

Cameron Passmore: But still, it doesn't make any sense. Now, it does make sense for the TFSA to have your trading account pay for the fees as opposed to your TFSA.

Ben Felix: Yeah. Because in that case, you're paying fees on the after tax amount. So you're not paying the government's portion of the fees.

Cameron Passmore: It's after tax on both sides. 

Ben Felix: And the more you can leave the TFSA to compound, the better. And we have to do a little bit more work on this because I'm not sure if there's some break point where it does make sense to pay RSP fees, like if you have a long enough time horizon. 

Cameron Passmore: Yeah. To compound enough of the fees that are left behind, but it'd be a long time if it does work.

Ben Felix: Maybe it's a thousand year time horizon than the RSP, it makes sense to pay it out of the taxable account.

Cameron Passmore: The article didn't talk about the deductibility of the fees, and that's kind of the point of this.

Ben Felix: If you Google around on this, nobody's talking about that. And I actually saw a post on Reddit that I responded to just because I read it and I was like, "Oh, come on. I can't just let this one go." Because people seem to think that they could deduct all of the fees. But the letter from finance to CRA, which it's called a comfort letter, it addressed Income Tax Act 207.01(1), which relates to the advantage, so this used to be considered an advantage, the advantage of paying fees from a registered account.

So they're saying that's no longer an advantage. You can do it. But it's a completely different section of the Income Tax Act that relates to the deduction of fees. So that's Income Tax Act 2120(1)(bb), which addresses the ability to deduct fees. And then the other piece that's important is Income Tax Act 18(u)(u), which addresses specifically the limitation for deducting fees paid for services in respect of the RSP and TFSA. So 207.01(1), which is the thing that's been addressed in this comfort letter and that's been talked about, only addresses where you can pay the fees from.

Cameron Passmore: Not the deductability.

Ben Felix: Correct. The deductability is a completely different section of the Income Tax Act. Now, I'm not that confident in my ability to interpret the Income Tax Act. So I did ask one of our CPA friends and he confirmed that that's the way it is. 

Cameron Passmore: Okay. So end of the day, it looks like for now use the RSP to pay the RSP fees if you can't get the TFSA fees. Typically they're much smaller, but paid for by your trading account. And leave the trading as is for deductibility. 

Ben Felix: And we have a couple of analysts working on building a more robust model so we can build some parameters around, does it ever make sense to pay fees for the RSP out of the taxable account? So if we find any groundbreaking conclusions that we didn't expect, we'll relay them to our faithful podcast listeners. 

Cameron Passmore: Anything else? 

Ben Felix: Nope. Long episode. Sorry everyone. 

Cameron Passmore: Great. Thanks for listening.

Books From Today’s Episode:

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'Why Investors Should Pay for All Investment Fees Out of Non-Registered Accounts' —  https://www.theglobeandmail.com/investing/article-why-investors-should-pay-for-all-investment-fees-out-of-non-registered/

'Aggregate Confusion: The Divergence of ESG Ratings’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533

'Sustainable Investing in Equilibrium' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3498354

'A Sustainable Capital Asset Pricing Model (S-CAPM): Evidence from Green Investing and Sin Stock Exclusion' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3455090

'Disagreement, Tastes, and Asset Prices' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=502605

'The Contributions of Betas versus Characteristics to the ESG Premium' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3010234