Our focus for this episode of the Rational Reminder is split into two sections; first, we cycle through our regular features, looking at a number of studies and articles of interest, the market during the pandemic, and our bad advice segment, and then Benjamin is joined by Tim Nash to talk about ethical investing and comment on Wealthsimple's new sustainable portfolio. We start off our weekly round-up talking about the idea of broadening a knowledge-base and how reading widely and diversely on all manner of subjects can influence and benefit your investing. From there, we turn to the topic of quantitive easing before exploring Tim Wu's thesis about information empires and how they cyclically influence economics. We then dive into the Ontario Securities Commission Investor Experience Study and Lubos Pastor's paper, 'Mutual Fund Performance and Flows During the COVID-19 Crisis'. Both of these shed light on investor behaviour and market performance during 2020 and also offer some interesting findings on the strength of some active management. Daniel Crosby has laid out what he calls '22 Behavioral Nudges to Optimize Client Outcomes', which we then run through, touching on each of his ideas and commenting where necessary. Our bad advice of the week comes from TikTok, and we listen in on two, worryingly misleading clips from TikTok personalities — the social platform may not be the best place to find sound financial advice! For the last part of the show we hear from Tim Nash; he shares his thoughts on Ken French's appearance on the show recently and what the pandemic has proven about sustainable funds going forward. So for all of this and a whole more, in a jam-packed episode, be sure to listen in with us!
Key Points From This Episode:
The importance of a wide range of reading material and looking at Peter Thiel's Zero to One. [0:03:35.2]
Quantitative easing and the important work that Frances Coppola has done on the subject. [0:09:22.8]
Tim's Wu's economic theory around the cycle of information empires. [00:11:49]
Takeaways from the Ontario Securities Commission Investor Experience Study. [00:13:53]
Narratives about actively managed funds during the COVID-19 crisis. [0:20:04.1]
The performance and flows of mutual funds; looking at Lubos Pastor's paper. [0:28:35.7]
Sustainable funds during the crisis — the past research that this now underlines. [0:38:03.3]
Looking at the 22 behavioural nudges identified by Daniel Crosby for optimizing client outcomes. [0:43:23.7]
Bad advice of the week: A couple of concerning clips of financial of content on TikTok. [0:58:46.2]
An introduction to Wealthsimple's new sustainable model portfolio. [1:03:45.5]
Tim weighs in on what this progressive portfolio really means. [1:08:32.7]
A response to the conversation we had with Ken French about ESG. [1:11:44.1]
The increasing prioritization of sustainable companies during the pandemic. [1:16:47.8]
Read the Transcript:
Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision making for Canadian, hosted by me Benjamin Felix and Cameron Passmore.
Cameron Passmore: Did you tell me earlier that you ordered a 3D printer?
Ben Felix: Yeah, I mentioned it in passing. I realized now that you're asking me that I didn't actually tell you that I did it. Yes. After my...
Cameron Passmore: I know you talked about it a while ago on the podcast, but I had not heard any more about it.
Ben Felix: I got a Prussia I3 MK3S, which based on my research is one of the best units out there period and for the price is, just seems to be the one to get. I ordered it. Takes a bit of time for them to actually ship it, but I think that was a few weeks ago now that I ordered it, so I should get it soon.
Cameron Passmore: What do you plan on making with it?
Ben Felix: Well, the most pressing project that we have in mind is a 3D printed weapon for the Lego Battlebots that we often build. We have a couple of weighted Lego pieces that came with an old boat set that I had when I was a kid. They're designed to balance the boat to keep it stable. They have, I don't know, some kind of metal weights in them. We often make weapons out of those. It's like a spinning weapon. It's called a kinetic weapon for a battlebot. It works pretty well. But the problem is it's Lego right? If you build a big Lego brick with weighted pieces on the end, as soon as it hits something, it starts to break apart pretty quickly.
Cameron Passmore: Yeah.
Ben Felix: We're going to try and 3D print a solid piece that works with Lego. Anyway, that's our first project idea.
Cameron Passmore: Pretty cool.
Ben Felix: I might custom build a foosball table with my dad and 3D print the men. It's another idea we have.
Cameron Passmore: That's a great idea. That'll be fun.
Ben Felix: Yep.
Cameron Passmore: Awesome. On my front, I just hit my 300th ride on Peloton.
Ben Felix: Wow.
Cameron Passmore: If anyone out there is an active Peloton rider and you want to connect, I'm CP313. Maybe we can do some live rides together, which are always fun. A little bit of competition is good. Also wanted our weekly shout out to recent, really kind reviews that people are leaving. Shout out to KayFay, Nick2020 and Ola, who left nice reviews for us. Also wanted to highlight for the bad advice of the week. We've been getting some great examples of bad advice from listeners. There's some chat going on Twitter as well from friends and listeners of the podcast.
Cameron Passmore: If you send them our way, and if we use the one you send us, I'll ship you off a Rational Reminder hoodie. Seems like a pretty fair exchange, so just DM me on Twitter or send me an email with the article or as you'll see this week a TikTok. Daniel from Mancell Financial Group in Tasmania, Australia, Ben is one who sent us the TikTok we'll talk about today. Right now there is a hoodie somewhere between Ottawa and Tasmania.
Ben Felix: They're very nice hoodies too.
Cameron Passmore: They're super comfortable.
Ben Felix: I don't think I have the blue one yet. Do I get a blue one?
Cameron Passmore: I'll check the stock, if you want one, sure. We got new charcoal ones in as well as charcoal. They're almost black. They're really nice. Just get some help to find some bad advice of the week, and I'm sure listeners will be great help in doing that.
Ben Felix: Not that it's ever been a problem to find bad advice.
Cameron Passmore: No, but you never know where it's going to come from. It's fun to get, just to build the community and to share examples.
Ben Felix: It is. Oh, it's great.
Cameron Passmore: Anything else to add?
Ben Felix: I don't think so. Let's go to the episode.
Cameron Passmore: Okay, great. Thanks for listening. Okay, so here we go Episode 115. I must say, Ben, you had me thinking with your comment a couple of weeks ago about the value in reading these autobiographies, and how they're really one off stories, and how much of value are they compared to the evidence-based thinking that we usually talk about. It's coming, rolling around in my head and then there's a Morgan Housel tweet on this, if you can believe it this week, and here's what he tweeted.
Cameron Passmore: A hard thing about trying to learn from successful businesses is that the same traits necessary for outlier success, are often the same traits that increase the odds of failure. The line between bold and reckless can be thin. Same thing for investors.
Ben Felix: Makes sense. Taking more concentrated bets seems sensible.
Cameron Passmore: I just find them really interesting and maybe it's just a phase I'm going through now. The reality is, our lives are full of randomness and more we can, I think learn from other people. I think a lot of what I've been reading just seeps into your minds, you never know when it's going to pop up as you make decisions in your own life. I think about a recent interview that Shopify founder Toby Lutke had with Patrick O'Shaughnessy, just talking about the benefits of reading all sorts of different books and ideas, because you never do know how it's going to filter its way through and help you create your own story.
Ben Felix: I think that's probably even true beyond autobiographies. It probably even extends into nonfiction.
Cameron Passmore: Absolutely.
Ben Felix: Or fiction, sorry.
Cameron Passmore: For sure. Anyways, I've been reading a ton of these as of late. The one I wanted to talk about this week, which was of interest to me because of his name in the investment industry. The book is called Zero to One: Notes on Startups, or How to Build a Future by Peter Thiel. I'm sure many people have heard of Peter Thiel, but may not know much about him. I've heard of him for years, I don't know much about him at all. But he's a German born Silicon Valley billionaire and venture capitalist. He's a co-founder of PayPal, as well as Palantir Technologies.
Cameron Passmore: He's also very well known for his VC fund, The Founders Fund, which get this, has invested in companies such as Airbnb, Stripe, SpaceX, Spotify, Lyft, Oculus, Credit Karma, and many others. It's a pretty crazy list of companies. He was also Facebook's first outside investor back in 2004. He put in $500,000 and it became worth a billion dollars in 2012.
Ben Felix: Geez.
Cameron Passmore: Yeah, it's amazing that he's been the center of a lot of this. Story gets better. But anyways, the point of Zero to One is, it's all about innovation. He says the kind of change and innovates you can have and how to question what is possible, can lead you to these unexpected outcomes. He believes that innovation can happen in any industry. He's not just talking about tech led, but it's all about thinking differently and creating something that can be totally different in the marketplace. He says that tomorrow's champions will not win by competing in today's marketplace.
Cameron Passmore: He says, "You have to do something completely new in order to go from zero to one." He gives all kinds of examples. For example, imagine deciding today, "Okay, I think we can compete in the search engine function." Well, not very likely, or the on-demand streaming service, not likely. But those companies went to a place that they saw something that was missing and created it. In terms of examples of Zero to One, get this, Peter Thiel is part of what's been called the PayPal mafia, which is a group of employees at PayPal that after they left PayPal, they went on to found other companies and get this for a list.
Cameron Passmore: Tesla, SpaceX, LinkedIn, YouTube, Yelp and Yammer were all created by people that worked at PayPal.
Ben Felix: Crazy.
Cameron Passmore: Isn't that crazy?
Ben Felix: Yeah, that is.
Cameron Passmore: Anyways, quickly go through, ne of the big takeaways for me was how he describes the seven questions every new business must answer. Number one is the engineering question. Can you create a breakthrough technology instead of just incremental improvements? The timing question, is now the right time to start your particular business? The monopoly question, are you starting with a big share of a small market, the minimum viable product idea? The people question, do you have the right team?
Cameron Passmore: The distribution question, do you have a way to not just create, but deliver your product? The durability question, will your market position be defensible in 10 and 20 years in the future? The secret question, have you identified a unique opportunity that others don't see? He asked this question in the book, what is something that you think is true, but the most people disagree with you on? If you just think back to when companies like Tesla, like Google, were being created, just imagine how they thought about that question back then, before they actually became what they are today.
Ben Felix: Yeah.
Cameron Passmore: All companies are different. He explains, he says, "Each one earns a monopoly by solving a unique problem." He says, "All failed companies are the same. They fail to escape competition." The four main rules he suggests to follow are, make incremental advances. It's kind of a James Clear Atomic Habits idea. Stay lean and flexible, improving the competition and focus on product, not on sales.
Ben Felix: I like that.
Cameron Passmore: Anyways, it's a really good book. I enjoyed it. It's a neat story for someone who's new ... You and I've heard his name for a long time. But I wanted to learn more about him so I recommend it.
Ben Felix: Cool. I didn't put it in our notes Cameron but I have a couple books that I've read. One that I've read and one that I'm in the process of reading. There's one book by Frances Coppola, who's a journalist or a writer in the UK, but she came from a banking background. When I was going through that whole phase of research and quantitative easing in the financial market and economic impact of that, I read a lot of her articles and then I found out that she had a book that came out in 2019, titled The Case for People's Quantitative Easing.
Ben Felix: The premise of the book is basically some policy suggestions, on how quantitative easing could have been done better. Because at the end of the day, quantitative easing in 2008 ended up resulting in a big wealth transfer to, well, to the banking system, to the banks and to the corporations, to the people that held government securities that could be purchased through bank reserves. I think Jim Stanford talked about this when we had him on to, is the potential for increasing inequality from quantitative easing.
Ben Felix: Anyway, the main premise of her book is to suggest some alternatives, one of which I think would line up with what's been happening this time around, where the government has been distributing large amounts of cash directly to people through stuff in Canada, like the CERB and all the other benefits that have come out, I think. This book was written in 2019 obviously, before all this happened. My guess is that if we asked her, is what the government's doing now closer in line with what you were thinking?
Ben Felix: My guess is she would say yes. Anyway, the best part of the book though, is not actually the policy discussion, which was interesting and gives you a lot of context to think about how all these mechanisms work together. But the most interesting part, was just her discussion on how the monetary system works and how quantitative easing fits into it. Kind of like the thing we did on the podcast a while ago where I tried to explain it. When I mentioned Jim Stanford's book goes over this, I mentioned pragmatic capitalism but again Colin Roche that goes over the same thing.
Ben Felix: Her book, People's Quantitative Easing, its overview of the monetary system was as good, if not better than any of the other ones that I've read so far.
Cameron Passmore: Did anything in that book conflict with what you'd learned-
Ben Felix: Not at all.
Cameron Passmore: ... in your deep dive? So just cemented it?
Ben Felix: Cemented it further.
Cameron Passmore: Excellent.
Ben Felix: More context, more reiteration of the same ideas. Now, to be fair, she was the source for a lot of my research to begin with. A lot of her articles helped me think through all of this, so it makes sense that it didn't disagree with anything that I thought I understood.
Cameron Passmore: Great. There's another book that we all love to read.
Ben Felix: That's a really good one, and I got one more.
Cameron Passmore: Fire away.
Ben Felix: A podcast listener sent me a suggestion for a book called The Master Switch: The Rise and Fall of Information Empires by Tim Wu. The reason they suggested it was our discussion on the largest companies, historically and AT&T being specifically covered in this book, The Master Switch, but it talks through the different information empires that have existed over time, television, radio, telephones. I haven't read the whole book yet. But the premise is fascinating. His economic theory is that there's something that he names the cycle.
Ben Felix: The cycle can happen or has happened, the same for every information technology that has existed in the past. His hypothesis is that the same thing is going to happen with the internet. Basically, it starts out as a very open technology that's that open source idea and easily accessible to everyone. But then over time, economic forces drive it toward being a very closed system, like we've seen with cable television and radio and all that stuff. You end up with this consolidation and these extremely large players that control the whole ecosystem, and it stops being open and free and that drives people to create a new technology, which is what the internet is now.
Ben Felix: But his like in the introduction of the book, the last sentence is fascinating, the last couple sentences. He talked about the cycle time, we're going to read last couple of sentences. He says, "In fact, the place we find ourselves now is a place we have been before, albeit in a different guise. Understanding how the fate of the technologies of the 20th century developed is important in making the 21st century better." He's basically saying like, what has happened with past technologies as different and unique as we think the internet is, it's not.
Ben Felix: It's just like everything else before it, just a different technology. He's saying, the world is not so different as we think it is, and Google's not so unprecedented as people tend to think it is when you look at past information empires.
Cameron Passmore: Interesting. We will add that to our book list.
Ben Felix: I've got to finish reading it, but just the premise alone was very interesting.
Cameron Passmore: Awesome. In other news, you wanted to talk about the Ontario Securities Commission Investment Experience study.
Ben Felix: Yeah, I just thought it was interesting to talk about. It was an online survey of 1,942 Canadian investors conducted between April 1st to 12th, with a bit of a ...
Cameron Passmore: A [inaudible 00:14:14]. That's a really interesting time to have done this. Because that is three and four weeks after or not even two and three weeks after the crisis when it hit the markets the worst.
Ben Felix: Yep, which is probably why I'm guessing why they did it because there were questions related to the crisis. To qualify for the responses to be counted, the respondents had to own at least one of the following stocks ETFs, including read ETFs, Canada savings bonds, bonds, mutual funds, guaranteed investments, segregated funds, a pension plan through their employer, or other types of securities and derivatives. If they only had Canada savings bonds, segregated funds or a pension plan, only one of those things they were excluded from the survey.
Ben Felix: Then they had to invest in one of the following ways, with an adviser, with an online investment service, which I'm guessing is a robo advisor or as a self directed investor, so the three main types, I guess of investors. It seems a lot like, if people remember when Preet Banerjee was on as a guest, the research that he was talking about for his PhD dissertation or DBA dissertation was a lot like this, although I'm sure his is more in depth, anyway. Some of the key takeaways from the survey, 68% of the respondents own mutual funds, 48% own stocks, 46% have a pension plan, 37% of GICs, 19% of ETFs.
Ben Felix: Interesting there to see the relatively low weight in ETFs compared to mutual funds, which lines up with the asset weights that exist.
Cameron Passmore: A much higher weight and pension plans than I would have guessed. Now I know they're not all DB plans, but still 46% in a pension plan is higher than I would have guessed.
Ben Felix: Yeah. The percent working with an advisor was also interesting. It may speak to, again the massive weight we have still in commission based mutual funds in Canada. 77% of respondents have an advisor. Of the 23% that don't, 38% of those say that it was because the advisors are too expensive. 25% say it's because they don't trust financial advisors.
Cameron Passmore: Ouch. But a pretty high satisfaction number 74%, were very are somewhat satisfied with only 6% somewhat or very dissatisfied. That's a good news story, I guess.
Ben Felix: You know what, we cut out something else that we thought we might talk about, which was the title regulation in Ontario for the title of financial planner. That actually ties in really well with this survey, with that relatively low trust level based on this survey for the financial advice business. While Ontario is rolling out, we're starting to roll out legislation that will protect the title of a financial planner and financial advisor. You'll actually have to have some credentials to say that you are one of the things.
Cameron Passmore: We'll keep that on the agenda for two weeks. Done the road we will [inaudible 00:17:01] details on that. But it's good to see those initiatives coming. 55% have never switched advisors, but 7% would like to. That number has come down. I remember a number, I'm sure it's 10, 15 years ago where the number that wanted to switch was, I believe was over 20% wanted to switch in a survey back then. 83% are satisfied with a service and advice from their advisor, and 50% of investors have their financial advisor as their primary source of information for buy or sell decisions.
Cameron Passmore: When you look at a number of different aspects, including overall return, performance versus goals, fees, change the value of each investment and return in comparison to other similar investments, get this, this is the thing that blew me away. The average investor spends 170 minutes per month monitoring these five items. That's almost three hours a month.
Ben Felix: Wow, at average investor.
Cameron Passmore: I don't believe it.
Ben Felix: That's the average [crosstalk 00:18:00].
Cameron Passmore: I don't believe it, but maybe. Another good news piece in here is that the majority find it easy to find information. However, 68% have at least one challenge with the biggest challenge being the need for more knowledge.
Ben Felix: We should tell them about our podcast.
Cameron Passmore: Yeah. We talked about frauds and scams quite a bit on this podcast. Now their stat here, only 10% believe that they're likely to fall for a fraud or scam.
Ben Felix: There's some COVID specific data, which was quite interesting. 74% of respondents had had communication from our discussions with their advisor during this crisis period, which means 26% had none.
Cameron Passmore: Now, think of the timeframe though, this is pretty, pretty fresh after the crisis happening. I think 74% getting communication that quickly is pretty good.
Ben Felix: Yeah. True. 81% of investors rated the advice that they received as excellent, very good or good. That's good. I wonder if we would agree. I wonder if we would look at the advice that they've received and agree whether it was good or not.
Cameron Passmore: Keep going.
Ben Felix: I think that's enough for this survey. Were there any other main ones that you wanted to touch on?
Cameron Passmore: Well, the one that caught me is, they asked a bunch of skill questions. There's five different skill questions like inflation number, a growth number, and there were five relatively easy questions. Only 23% got all five questions correctly, and only 35% of people knew that bond prices fall if interest rates rise.
Ben Felix: Yeah, makes me wonder, again, if the people that said that the advice they receive is good, I wonder if we would agree given the chance.
Cameron Passmore: Then there's a attitude toward risk question in one of those gambling questions that we talked about in the past. Only 17% of respondents acted rationally on the bad question. Again, not necessarily surprising, but I would have guessed that more people not acted rationally, mathematically. Interesting survey. We'll have it up in the show notes. Do you want to jump to the main portfolio topic?
Ben Felix: Yep, sure. It is cool just as a side note that the OSC is conducting surveys like this, kind of neat. Okay, yeah, so for our portfolio topic, I wanted to talk about actively managed funds versus the COVID-19 crisis.
Cameron Passmore: Where did this question come from?
Ben Felix: It's been rattling around in my head for a while. I've been looking for stuff like this Beaver Report or something to come out, so that I actually had some data to speak about it. I guess I could have built my own data set of Morningstar, but it's a bit of a monster to try and do that well. But I've changed and why I decided to cover this now is that Morningstar released their Active/Passive Fund Barometer, which has a lot of similar-ish data to these Beaver reports, which was good. Then the other thing that really kicked me into gear to cover this was, a paper from a couple of people at the University of Chicago, of course, analyzing exactly the question, how have actively managed mutual funds done throughout the COVID-19 crisis?
Ben Felix: We'll talk about that paper and the Morningstar Active/Passive Fund Barometer as well as a couple of other data points [crosstalk 00:21:12].
Cameron Passmore: But, intuitively you can think of a lot of investors might think this should be an easy time to make a lot of money if you time is properly.
Ben Felix: That is the narrative. That's the narrative. That's something actually that I want to do a video on eventually is, is it profitable to buy the dip? Because people never think about the other side of buying the dip. Buying the dip means by definition, you had cash before the dip. I think I built a model about this a while ago, and your opportunity cost if we're sitting in cash outweighs the benefits of being able to buy the dip. Anyway, that's a total digression but that'll be a whole other interesting topic to cover.
Ben Felix: Okay, so the common narratives around active management, it's like what you said Cameron, suggests that periods of high volatility, wider return dispersion across securities, so some stuff doing really poorly, some stuff doing really well, price dislocations or so called price dislocations as I refer to my notes because I ...
Cameron Passmore: Exactly.
Ben Felix: But all those things combined create opportunities for active managers to beat the index, and actively managed funds just happen to be a really nice proxy for active managers in general, because the data is public, data are public.
Cameron Passmore: Of course, you want your active manager to be nimble. You hear people saying, "Now is the time to be nimble."
Ben Felix: Got to be able to respond to those price dislocations.
Cameron Passmore: Quickly.
Ben Felix: Quickly, right. Given that narrative, obviously, as we've been talking about it, you would imagine, and imagine may be the key word there, but you'd imagine the 2020 was or has been the best time in history for active managers. Of course, the point of this section is to see how those narratives stand up to our friend, the data. Take a bit of a step back real quick, just on active management in bear markets in general. There is a paper that Vanguard did in 2019, where they look specifically at Canadian active fund returns for three past market cycles, so two bull markets and one bear market, to see over those time periods did active funds on average beat the index or their respective indexes?
Ben Felix: The results showed a lack of consistency, which is basically what we've seen in past reports like this, in some cycles, some fun categories, more than half beat the index. But in other cycles different categories have the same thing happen. On average it's roughly a coin flip, in these extreme periods in the bull markets and the bear markets. Now they didn't have a ton of data for Canada, so they also as a robustness check, looked at US equity funds over six bear markets dating back to 1980. Again, the results were mixed.
Ben Felix: I think that US data they pulled from a paper that we've cited on this podcast in the past, where it was mixed. Sometimes the average active fund did a little better during a crisis, sometimes it did a little worse. But there's no clear obvious advantage. Then on top of that we no longer term like not just in a crisis, but in general, active funds tend to underperform. But in a crisis, it seems to be a little closer to 50:50 which is interesting.
Ben Felix: I think one of the reasons for that is probably that active funds in general, like not just in a crisis, because they can't time that, but in general, active funds tend to hold cash, because like you said, Cameron, they've got to be nimble, they've got to be ready, looking for opportunities. They'll tend to have higher cash balances than an index fund.
Cameron Passmore: Isn't that dry powder?
Ben Felix: If you think about it ... Yeah, the dry powder. But if the average active fund, I don't know, just as an example, say they're holding 15% cash all the time on average, if there's a sudden unexpected drop, just by nature of that they're going to do a little better than an index fund that holds no cash. That doesn't mean they're going to outperform on average over the long-term, but in a crisis in that extreme drawdown situation, you can see how the average active fund would do a little better than the average index fund.
Ben Felix: They actually don't, it's 50:50. But you could see if the data showed that active funds did a little better, you could see why. It sets the stage. Now let's talk about the Morningstar US Active/Passive Fund Barometer, which I think you can get publicly. I got it through Morningstar direct. I think if you give your email address they'll let you see the report though. This covers 4,400 unique us equity funds. That accounts for $13.1 trillion in fund assets, which is a lot.
Cameron Passmore: Crazy. Yeah it is crazy.
Ben Felix: That's a lot. Active funds performance through the first half of 2020 showed that across all 20 fund categories they examine in the report, 51% of active funds both survived and outperformed their average index fund peer. That's actually an important point. In this study they use active funds against index funds, not active funds against indexes, but against index funds. That's important because obviously index funds have fees and cost indexes don't. 51% of active funds of this year, and in the first half of this year 51% survived and outperformed their average passive index fund up here.
Ben Felix: That maybe speaks to that idea I was talking about a minute ago with active funds tending to hold a bit more cash, which gives them a bit of a cushion in a crash.
Cameron Passmore: Does that number strike as being higher than you would have guessed?
Ben Felix: Well, no, because of what I've been saying about the cash. I think in a quick, unexpected downturn, if the average active fund more cash than the average passive fund, which certainly I don't think that's unexpected, but I think where they get caught is on the recovery. You know what I'm saying?
Cameron Passmore: Mm-hmm (affirmative).
Ben Felix: When things come back. Then the other report talks a little bit more about that. The other report that we'll talk about from the University of Chicago. They also looked at bond funds, and the bond funds were an interesting point.
Cameron Passmore: Well, there's an extreme event that happened right in the middle of that, the week of March 23rd when the spreads widen like crazy.
Ben Felix: Yes, and bond funds don't tend to hold cash like equity funds do.
Cameron Passmore:
Think about what's going on, if there was a demand for redemptions in these funds, on the active fund, it's almost like their performance would be driven more by fund flows than by what their portfolio was actually in, or is that a accurate statement necessarily? You think about the complexity going on there.
Ben Felix: Yeah. I think fire sales could have had a bit of an impact. I actually think that the Chicago study that I mentioned, did talk about fire sales. I don't know if I dug too much into that section of the paper though. Anyway, so 40% of active bond funds in the intermediate corporate and high yield bond category survived, and beat their average passive counterpart, so lower obviously than on the equity side. This study attributes it to bond funds being caught in a period of punished credit risk and rewarded interest rate risk, as credit spreads widened and rates fell.
Ben Felix: That's what they're saying caused the underperformance relative to the passive peers. They also looked at some longer term data in this report. Over the trailing 10 years, the cheapest funds succeeded, and succeeded means survived and surpass their benchmark. The cheapest funds succeeded about twice as often as the most expensive ones, so a 34% success rate versus 16%. Over the 10 year period ending June 30th, 2020, the survival rate was much, much lower as well for more expensive funds.
Cameron Passmore: Right. That's what you'd expect.
Ben Felix: Yeah. Okay, I think that's good for that report. I also look at the European Active Passive Barometer. Same idea, and I won't go through all the details of this report, but it looked at nearly 22,600 unique active and passive European domiciled funds that account for €3.7 trillion in assets. In this case for the same period, so for the first six months of 2020, only about half of active stock funds and one third of active fixed income funds, so similar-ish to the US data beat their average passive peer over the period. It's pretty much what you'd expect.
Ben Felix: The next piece is the paper titled Mutual Fund Performance and Flows during the COVID-19 crisis. This is published in August, not peer reviewed yet, so fresh off the press pre-peer review or any publication and I like that. But it's from a couple of people at the University of Chicago. One of them is Lubos Pastor probably butchered the pronunciation of the name, but he's written many, many papers that we've cited in the podcast and using different pieces of research.
Cameron Passmore: How did you find this paper?
Ben Felix: I think because this has been rattling around in my head, I've been doing intermittent Google searches and SSRN searches for active fund performance during COVID-19, and this is just the first time that I actually got enough meaningful results to cover as a topic. The premise of this paper is that they're testing the hypothesis that investors are willing to tolerate ... This is actually really interesting. They're testing the hypothesis that investors are willing to tolerate active management's underperformance, because active funds outperform in periods that are particularly important to investors like a crisis.
Ben Felix: That's an interesting concept. One of the things they talked about in the introduction of this paper is why is the active management business still so huge if it underperforms? Everybody knows it, and there's an obvious alternative in index funds.
Cameron Passmore: One might be, I'm willing to have an active manager because they do hold dry powder in case of a crisis. That's a preference I might have.
Ben Felix: Yeah, probably not even dry. I think it's probably less on the opportunity side, like I want to take advantage of a crisis and it's probably more on the ...
Cameron Passmore: Protection?
Ben Felix: Yeah, on the not wanting to lose all of your money in a crisis would be my guess. Like we've talked about as we introduce this section, the authors of the paper suggests that this crisis was as good as anything in history to test this hypothesis, because there was a big output contraction, there was the fastest increase in unemployment on record, we had the so called price dislocations in asset prices. It's easy to see how this could be considered a great opportunity for active managers. They talk about the price dislocations and they give a couple of examples, which I wanted to mention.
Ben Felix: They talk about how the S&P 500 index experienced its steepest drop in living memory, losing 34% of its value between February 19th and March 23rd, before bouncing back by over 30% by the end of April. Everyone lived through that. This is market history at this point. Well, I guess it is history, but very recent history. They talked about how in the bond market liquidity evaporated, like you mentioned that Cameron in March 2020 for corporate bonds, and for US Treasuries, which was unusual. They're usually very liquid.
Ben Felix: The Federal Reserve stepped in to resolve some of that, but before they did, there were some pretty serious what you might call pricing anomalies, like the corporate bond market, which I think you were talking about when you're mentioning the redemptions, Cameron. The bonds were trading at big discounts, two credit default swaps.
Cameron Passmore: Incredible week that was to see the eight, 10 12% spread, just what people were willing to give up in terms of liquidity.
Ben Felix: Yeah. Now again, to reiterate, this would be an active managers dream if assets are departing from their true values, if there are these pricing dislocations. You might expect that to be a way to find alpha. But it did make me think also about our conversation with Dave Nadig in episode 71 of this podcast, where he talked about for ETFs, when the underlying assets and the ETF unit values diverge, he talks about how the ETF structure is not broken and it's not a problem with pricing. But the liquid ETF structure is creating a secondary pricing vector for the less liquid underlying assets.
Cameron Passmore: That's exactly ...
Ben Felix: If you take that view, the bond prices aren't right, and the ETF value is wrong, it's really the bonds aren't getting priced because they're not trading, and the ETF values are reflecting what the bonds would be trading at if they were trading. Dave Nadig gave an example when he was a guest of Uptime when that happened with I think, some municipal bonds or something. But that's a different perspective to take on this, which is interesting.
Ben Felix: Then I guess the extension of that would be that if these price dislocations are happening, if the underlying securities aren't actually trading, then there would be no opportunity to exploit them, which is actually exactly why that would happen, why that price dislocation would happen, because the authorized participants in the ETF world, if they're not arbitraging away those pricing discrepancies, it means that there are no actual opportunities to arbitrage them away because of a lack of liquidity. Anyway, so but we'll go with this idea that there are some arbitrage opportunities for active managers. Now in the introduction to the paper, the author's give away the conclusion. They say contrary to the hypothesis that all of these ... I think these are my words actually, contrary to the hypothesis that all these things have created opportunities for active managers to show their worth. The authors find that active funds underperform the passive benchmarks during the COVID-19 crisis.
Cameron Passmore: Again, no real surprise.
Ben Felix: No real surprise. The crisis period as defined in this paper is between February 20th and April 30th, 2020, which is a period that is roughly evenly split and this is why they chose the period, between the crash and the recovery. Their evidence is based on daily returns of US active equity mutual funds. Then they measure the performance three different ways. They compared equity mutual funds to the S&P 500, but these aren't all US equity mutual funds. That's not always going to be a fair comparison.
Ben Felix: They compared to Morningstar designated, FTSE Russell benchmarks, so those should be more appropriate. They compared to fund designated perspectives benchmarks, so the benchmark that the fund itself has chosen as its benchmark. Then they use factor model benchmarks, which as you can imagine, was my favorite part. For S&P 500, as the benchmark, they found that 74.2% of active funds trailed the S&P 500. I think that's probably an artifact of the S&P 500 or the US stock market generally doing relatively well over this period.
Ben Felix: The recovery in US stocks was quite strong. Compared to Morningstar designated benchmarks, 57.6% of funds trailed. That's getting a little closer to be in line with the data that we were talking about before in the Morningstar report. Compared to the Prospectus Benchmarks, so the benchmark that the funds themselves have chosen, 54.2% underperformed, still pretty bad. As far as testing the hypothesis of active managers adding value in the crisis, this is not promising.
Cameron Passmore: I know but we're all waiting for the factor numbers, because we know you're getting to them.
Ben Felix: Yeah, it's coming. They used CAPM, the single market beta factor, Fama-French-three factor, Carhart four-factor, Fama-French-five factor, and Fama-French-five factor plus momentum, so a little Fama-French, Carhart blend there.
Cameron Passmore: Otherwise known as Ben's happy place. Yes, keep going. They're on to you. They're om to who you are. They're getting you.
Ben Felix: That's why they're listening. They like to hear about factors. 80% of funds had negative CAPM alphas, 70% had negative three factor alphas, 60% had negative four factor alphas, 68% had negative five factor alphas and for the five factor plus momentum, 60% had negative alphas.
Cameron Passmore: Okay, plain English. What does that mean?
Ben Felix: Based on the amount of risk that the funds were taking in these various models, the alpha is how much worse they were doing relative to the amount of risk they were taking. On average in all the different models of risk, funds were doing worse, relative to the amount of risk they were taking, no matter how we try to measure risk. I think of all of the benchmarking exercises, that's probably the most statistically meaningful. But the results actually are not a whole lot different, no matter how we do the benchmarking. To put it in short terms, they found that most active funds perform poorly during the crisis.
Ben Felix: They also found that active fund performance during the crisis was substantially worse than it was before the crisis. I wasn't surprised to read this, but it was nice to see the data. But there was an interesting thing that came out of this report that I wasn't necessarily expecting. It ties in with, at the end of the episode; we're going to have a few words from Tim Nash, who people that listen to the podcast regularly have heard on here before. He's been on once as a guest and once as a special appearance at the end of an episode like we're going to have today.
Ben Felix: He'll touch on this too, but this study looked at sustainable investing. We just saw that active funds on average did poorly. But they also asked, did sustainable funds do anything different? They did. Maybe it's not enough data for this to be super meaningful, but it's still fascinating. Morningstar assigns globes ... They assign star ratings to their funds, or to funds in their database. They also assigned globes and the globes denote sustainability. One globe is less sustainable than five globes. Five globes is the most sustainable.
Ben Felix: They found in this study that funds with more globes as of January 31st, 2020, had higher benchmark adjusted returns throughout the crisis. This is the part that's really interesting. The relationship is monotonic across the globe categories. Five global funds outperform four globe which outperform three globes and so on. It's a monotonic relationship, which is, yeah, fascinating. The highest globe funds, so those with three, four or five globes significantly outperform the remaining funds within the same investment style, by an annualized 14.2% with a high T stat.
Ben Felix: I thought this is fascinating. If we think back, so I mentioned that we've talked about papers from Lubos Pastor in the past, one of them was a paper we talked about in Episode 82, sustainable investing in equilibrium, where they developed an asset pricing framework to take this into account. But with their model, their model implied that assets with high sustainability ratings have lower expected returns than assets with low sustainability ratings. People may remember us talking about this.
Ben Felix: But they also said in that framework that green assets, so sustainable assets can still outperform brown assets, unsustainable assets, if investor's tastes are shifting toward green assets, or if customer's tastes are shifting toward green products. It doesn't mean expected returns are different. It just means that the tastes have shift further in that direction. That could have been what we were seeing here. It wasn't just in performance, it was also in flows.
Ben Felix: Active funds experienced steady outflows over this period, but the sustained funds, okay, so one, global funds had outflows of 2.6% of assets under management through the crisis. Five global funds had net flows of roughly zero. More sustainable mutual funds had no outflows or very close to no outflows.
Cameron Passmore: Okay, outflows, okay, I get you. One globe funds suffered outflows, so money leaving at 2.6%, got you.
Ben Felix: Of total assets.
Cameron Passmore: Yep.
Ben Felix: The difference was statistically significant inflows. The authors of the paper said it's driven especially by environmental concerns. Funds that apply exclusion criteria, so if they don't own any bad stuff, any sin stocks are unsustainable, whatever you want to call it in their investment process receive net inflows during the crisis, whereas funds with no exclusion criteria experienced outflows. I also think this is fascinating from the perspective of expected returns, for sustainable assets or sustainable funds or assets held by sustainable funds.
Ben Felix: Because that idea of investor tastes and preferences which we talked about, we talked about this in Episode 82, and we covered this, we also talking about it with Ken French in Episode 100, this idea of tastes. It's like a preference to hold an asset that's unrelated to risk and expected return. If people are willing to have that, or people have that taste, if they're large enough in numbers or they command enough assets, they should drive the prices of whatever assets they have a taste for up, reducing their expected future returns.
Ben Felix: You could argue based on what's happened during the crisis, those tastes became stronger, which means future expected returns are even lower. Now, Tim Nash is going to disagree with me on that at the end, which is more interesting perspective to have. Now, one of the other things and I mentioned this in my conversation with Tim at the end before I read this paper, but one of the other possibilities that this paper examined was that, firms engaging in sustainable activities tend to be higher quality businesses.
Ben Felix: You can use profitability and the five-factor model as a proxy for quality. They actually tested that, and they found that that did not explain the difference.
Cameron Passmore: Oh, really? Did not. Interesting.
Ben Felix: Yeah. In the regression model where they were testing for the preference for sustainability, as driving all of the stuff we've been talking about, they added into that model, the factors in the five-factor model, and it did not change the explanatory power of the model. It's that preference for sustainability that was driving the differences in performance and flows based on the analysis in this paper. Pretty interesting. It was interesting to read about the performance or under performance of active funds in the crisis, but that wasn't necessarily unexpected.
Ben Felix: The attack on the concept that sustainable funds are actually doing or did better during the crisis, which interestingly lines up with past research, like other people have found that sustainable funds tend to do better in a crisis. I'd heard anecdotally that sustainable investing was doing really well, like the people that pumped that idea have been celebrating the relative outperformance over this period. It was interesting to see a proper analysis to demonstrate that.
Cameron Passmore: Terrific, great insights. Planning topic?
Ben Felix: Yeah, planning. Real quick just on fire sales, in that same paper they did look at fire sales. They said that their evidence points in the direction of fire sales, but it's not statistically reliable. It's inconclusive that fire sales were driving major price changes.
Cameron Passmore: Terrific.
Ben Felix: Yes, on the planning topic now.
Cameron Passmore: Okay, so you found an article in the August edition of the Journal of Financial Planning, where our friend Daniel Crosby, PhD, talked about in the article called 22 Behavioral Nudges to Optimize Client Outcomes. This is a list of 93 behavioral interventions that was curated by the University College of London, and Daniel took 22 of those nudges and applied it to the world of finance. Daniel Crosby, he was a guest with us on episode 75. He's a psychologist and behavioral finance expert with Brinker Capital in Georgia. We thought we'd go through the 22 pieces quickly and give a little bit of a feedback on each of them. Ready to give it a go?
Ben Felix: Let's go, you start.
Cameron Passmore: Okay, number one, take the long view. People don't get the same emotion. He talks about from thinking about future self versus current self. To make the future more salient, he suggests get more detailed in the description of who you want to become. You found an example, where people who looked at scans of what they look like in the future, actually became more committed to their plans. It's an amazing, amazing idea. People who are actually exposed to age avatars put nearly twice as much money into the retirement fund, as other people did.
Ben Felix: Yeah, it's like they had this cohort of study participants and they took photos of them, digitally age them and then had people look at those pictures, I think half the group had pictures like that, half the group didn't. Then after looking at the pictures, they had to make an asset allocation decision. They had allocate across four buckets, buying something nice for someone special, investing in a retirement fund, planning a fun event or putting money into a checking account. The subject that we're exposed to aged avatars put nearly twice as much money into the retirement fund as the other people.
Cameron Passmore: I think there's actually an app on your iPhone that does that, if you want to see what you're going to look like.
Ben Felix: Pretty fascinating. I think it speaks to the idea of transformation, that if people remember back to the episode when we had Dennis Mosley Williams on, I can't remember which episode number that was, but he was talking a lot about how our role as people giving financial advice is to help people with that process of transformation, figuring out who you want to become and then becoming that person. This idea of not only imagining but actually looking at a picture of your future self, to make thinking about that more psychologically straightforward, is a neat concept.
Cameron Passmore: Number two is, name your dollars and this is something we see a lot. Money is fungible, meaning that any perceived separation of dollars is not real. It's all truly one piece of an overall asset allocation. However, a lot of people do put money into buckets. While it doesn't make sense logically, it can be used to your advantage for better behaviors. The example that I know, I've seen a lot is people receive an inheritance and they want to keep that separate from the rest of their money, because Aunt Mabel wanted you to leave it alone and not touch it until you're retired.
Cameron Passmore: If you know that was Aunt Mabel's gift to you, you're more apt just to leave it alone. It makes no sense to keep it separate, but if it will because better behavior, why not do it?
Ben Felix: Emergency funds are another probably good example of that keeping a separate bucket of cash.
Cameron Passmore: Client directed problem solving. Investors often know what their own problems are, so instead of having someone tell you what they are, start at the source and see what ideas they have for improvements. The one example I thought of is, a lot of people will say, "I know I'm supposed to place a trade if I'm managing money on their own, but I just can't hit the buy button."
Ben Felix: Yeah, I've heard that too.
Cameron Passmore: Discrepancy between behaviors and goals. Are the current behaviors, discrepant with stated goals, for example, you said you want an X but it seems you wanted Y. You have to help me understand why you're behaving contrary to what you said you want to do.
Ben Felix: That's the question we could be asking someone. If someone's managing their own money, they could ask themselves the exact same question.
Cameron Passmore: Well, yeah, these are all directed at us to ask clients, but there's no reason why people can't ask these of themselves. An example could be you say that you're long-term focused and the market volatility is historically normal. Why are you wanting to sell? As we've said many times, it's often the story that drives the behavior. But if you said you knew this volatility would happen and you said you stay long-term focused, why are you thinking about selling? Behavioral contract. Create a written contract specifying what behavior is to be performed and over what timeframe.
Cameron Passmore: Research shows get this, that it's even more powerful when a contract is signed. You can think about an investment policy statement, you sign a policy statement saying that you're going to stick to 60, 40, the next 20 years and you sign it, arguably you're more apt to stick to it.
Ben Felix: I think the investment policy statement is a good example. I also think, maybe even a better example that Michael Kitces brought up when he was on a recent episode was the idea of a withdrawal policy statement. Because that's asset allocation, do people think about changing their asset allocation when the market's volatile? Yeah, I find that conversation to be relatively easy. But with someone who's taking retirement distributions from a portfolio and market start to get volatile, I think that tends to be a lot more psychologically challenging, but using Michael's concept of a withdrawal policy statement, I think is-
Cameron Passmore: A great example.
Ben Felix: ... yeah very, very powerful.
Cameron Passmore: Self monitoring set pre-specified intervals for forced check-ins on progress. We refer to it as the dentist model. Every time I leave the dentist, I set my next appointment six or nine months down the road. You do the same thing, either with your advisor or on your own. You could review your whole plan on for example, your birthday or your anniversary. Had a lot of people do that. Education, look for education opportunities in every meeting, either advisor with a client or client with your advisor. Highlighted is the idea of meta knowledge or knowing what you don't know, always be on the lookout for that.
Cameron Passmore: This is something that I get asked a lot and certain people do it every meeting. They'll ask, "Is there something I should have asked you that I didn't? Or is there something that I should be concerned about that we did not raise? Great questions
Ben Felix: You know what, I'm know a lot of our clients listen to the podcasts and a lot probably don't. But for people that do listen to our podcast, it comes up a lot in meetings where someone will say, "Hey, I remember in one of the episodes you said this or your guests said this. What do you actually think about that? Should we be applying that to our situation?"
Cameron Passmore: True. Next one, anticipate a regret. We're living in an era of fear of missing out or FOMO. As awareness of what others are doing has never been more transparent. Turn this into a nudge by imagining a future that you don't want to miss out on. I guess it's about creating an illusion of your future. Kind of going back to that first example, create a fear of missing out on what your future might be if you behave better. Number nine, systemization. Humans systematically overestimate their willpower and discipline. Automation makes this issue go away.
Cameron Passmore: Automation takes away the human tendency to be lazy. For example, set the regular monthly contributions. Increase the contributions as soon as you receive a pay increase. Number 10, goal setting. Start and end every conversation with a focus on goals. This will drive the interaction to the specifics of accomplishing the goals. Goals are often very motivational. Since they trigger emotion, they should lead to better behavior. Number 11, look for emotional triggers. We all have triggers. What is yours?
Cameron Passmore: Do you envy when you hear a friend bought Tesla shares four months ago? That comes up a fair amount. Certainly there's a lot of chatter on Twitter about it. Shopping when you had a bad day at work. Try to understand the situation that lead to these triggers and try to either avoid or manage these situations.
Ben Felix: Oh, Jesus stay off in Wall Street bets on Reddit then.
Cameron Passmore: I guess so. Renews negative prompts. Willpower is weak therefore, it is better to avoid temptation than to rely on willpower to protect you.
Ben Felix: That's a good one.
Cameron Passmore: I do it at home. I just don't buy the stuff I know that it was here I would eat. If it's not here I can't eat it. Number 13, behavior substitution, going cold turkey on anything is very difficult. This is true of bad financial behavior. Instead of going cold turkey, why not try to replace it with a something else, such as healthier behavior. If you have a hard time, one example I thought of if you have a hard time saving up your regular say $24,000 for RSP contribution, so instead of shocking the system and saving $2,000 a month to get there after a year, maybe start lower and just build it up over time, because too much of a shock to the system may cause you to abort the plan.
Cameron Passmore: Habit formation and shaping. This is right out of James Clear's book Atomic Habits. Take your goal and sub divided down into a bunch of smaller steps. Don't look at that big number you necessarily need to retire. Break it down into annual or monthly behaviors to get there. Number 15, behavioral rehearsal. Certain types of behaviors lend themselves nicely to a rehearsal. For example, having a hard conversation about money with a loved one. Daniel says rehearsal will reduce the nerves, increase proficiency and anticipate problems before they come up. This one I must admit, I find a little strange. I can't imagine rehearsing conversations like that. Can you?
Ben Felix: I don't know. I don't know. I also thought about rehearsing other bad situations like market downturn, but I think it's pretty hard to predict how you're actually going to feel in that that type of situation. For this crisis, like I also have investments in dimensional equity funds, and when they dropped however much they dropped, I didn't feel a thing. I always kind of wondered how I feel in a downturn. Not a thing.
Cameron Passmore: I don't think any listener is surprised.
Ben Felix: Did you?
Cameron Passmore: No, that didn't faze me at all. I even watched my son who's been very aggressively saving. He was down obviously a fair chunk, he sol equity. He told me a few weeks ago, he's back to break even because he kept buying all the way through, so great experience for a young investor like James.
Ben Felix: I did to. That's a benefit of automation, I guess. Kept on going with the regular savings.
Cameron Passmore: Do you want to go through a few here as well?
Ben Felix: Sure, yep. Consider past outcomes. There's a quote that Daniel had from Mark Twain, history doesn't repeat itself, but it sure rhymes. This is for the advisor to do, but I think people can apply to themselves, like we've been saying. He's saying that you should look to a client's past financial decisions to understand how they reacted to certain events. That helps you to inform how they might behave in a future event. I think it speaks to that idea of us not really knowing ourselves that well. But if you looked at how you actually behaved in a real bad situation in the past, that's probably a better indication of how you're going to behave in the future, than how you think you'll feel.
Cameron Passmore: I love hearing people describe what they learn from past especially crises. How did you behave in 2008, 2000?
Ben Felix: Yep, pros and cons. It says, "In a decision if you're making a financial decision, something as simple as making a simple T chart with pros and cons can be useful." I think that speaks to just the idea of managing tradeoffs anytime you're making a financial decision." That's what we spend so much of our time doing is understanding what the tradeoffs are in the first place, which isn't always easy and then helping people decide which is often very subjective between a set of tradeoffs that are available. Comparative imagining of future outcomes.
Ben Felix: Daniel says that you can paint a picture of two paths that their financial life can take, and then let them imagine what each one would look like. I think we do that. Whenever we're going through the financial planning, the projection portion of the financial planning process with a client, we'll often do that. I don't think we ever framed it as imagine these two potential future selves, but we definitely go through the quantitative aspect of that. That makes you think of another thing Michael Kitces was talking about, was the improper approach of thinking about retirement as an end, when it's not really, it's just a transition.
Ben Felix: The idea that there are a lot of alternatives, like instead of doing the fire lifestyle and saving as much as you possibly can, another alternative would be finding something that you could do earning less income, and maybe save less, but work longer. Anyway, comparing imagining future outcomes like that. Stress Management. Daniel had a statistic in here that I hadn't seen before. But he said, "Under stress, we lose 13% of our cognitive capacity." You have the least access to your ability to think when you arguably need it the most.
Cameron Passmore: I love this example apple. I think it's so good.
Ben Felix: It is good. His suggestion is that stress management, which is not necessarily related to your finances, but things like working on your wellbeing, your diet and exercising, which are all useful for managing stress can all be really important in making better financial decisions. It takes the whole idea of financial wellness full circle. Framing, we talked about this in a past episode. I can't remember which one, but the idea that the way that a decision is framed will affect what someone decides to do.
Cameron Passmore: It absolutely will. The example that he gave was when asked if they can save 20% of their salary, most people say, "No way. I can't say that." But when asked if they can live off 80% of their income, most said, "Sure."
Ben Felix: So good.
Cameron Passmore: It's incredible. The one that we live off in is disability insurance. How many people say, "Oh, I can't afford that cost for disability insurance," and it's like, "Think about it. If you can't afford to get it, how can you afford not to get it? Because if you become disabled, you have no income." It's a great irony, right?
Ben Felix: Yeah.
Cameron Passmore: Carry on.
Ben Felix: Identification of self as a role model. Daniel says, "People often act recklessly towards themselves, but far more generously towards others." On our own, we may be more reckless but if others are watching us, then we might treat things more seriously. There's an opportunity to view yourself the way that you would want other people to view you, I guess, which might lead to better decision making. The last one of this list of 22 nudges was to conduct a pre-mortem. Instead of a post-mortem, where you're looking at why things went wrong after they've happened, the pre-mortem is looking at what things could possibly go wrong, and maybe put a plan together to address that.
Ben Felix: We talked with Pattie Lovett-Reid read in our past episode about that idea of having a backup financial plan. We've actually talked to Pattie about a lot of these things. Anyway, that's it, 22 nudges that can help you be a better investor.
Cameron Passmore: Shout out to Daniel for that. Under bad advice of the week, we had some fun a couple weeks ago talking about that TMZ article. On the similar vein, this week we're talking about a couple of pieces of financial wisdom from TikTok. I'm not an avid TikTok user, my daughter is. Do you use TikTok Ben?
Ben Felix: No.
Cameron Passmore: Are you a TikToker or not? I don't know if that's what it is or not. Anyway, so apparent there a whole Twitter feed of people giving you financial advice on TikTok. Anyway, so we're going to play a couple of audio clips. The first one is from Dan in Tasmania. Then after that is one from Jason. There was a couple shared with me this week, I thought we played them both then we get the TikTok thing over with, and then we talked about on the other side.
Dan: Only hundreds of them look at this. 300 stocks, this was before the market closed Friday, and they've all done up 6%. If you deposit $100 into an app like Weeble or RobinHood, you're going to turn that $100 into $20,000 if every day you catch one of these stocks that goes up by five, 6%. 6% growth over 90 days, turns $100 into $20,000. Don't believe me? Open the calculator. Type in 100 and then multiply that number by 1.06 90 times.
Dan: You'll be surprised how fast this money adds up. If you want to find how I'm bidding all these stocks every night or learn more about how to start investing your money, make sure you follow because we're going to be posting nightly watch lists that have the stocks that are ready to blow up and make you rich.
Jason: $100 into a million dollars in one year just by doing this. What we're going to do is, I'm going to teach you how to trade options in the stock market with proper risk management and trading large companies such as Apple, Microsoft, Facebook, Tesla, Amazon, and so on. No penny stocks, no small stocks, we're going to trade large companies and we're going to aim for 20% return every single week. In the options world it is very doable to do it. What we're going to do as $100 turns into 120, then 144, then 172 by week four doing 20% consistent gains, and by the end of the year a million dollars in your account.
Jason: This is very doable, but you have to learn how to trade options with proper risk management. I'm here to teach you strategy on how to do options, and how to do it properly and how to do it for all beginners if you know nothing about the stock market. All you need to do is click on my profile, subscribe to my website; you'll get a welcome email with my free groups links. We have over 34,000 members, and we're all here to help, so I'll see you in there.
Cameron Passmore: I honestly thought these were jokes but apparently not. I don't profess to be the resident TikTok expert. If someone knows that these are hoaxes, please let me know. But wow, unbelievable what people are promoting on TikTok.
Ben Felix: I can't believe that they're not jokes. I feel like we're being trolled and that we're old people that are out of touch with what the young people are talking about and this is all just a joke and now we're going to be foolish for thinking it was real. But I think it's actually real. I don't know. I don't know what to believe.
Cameron Passmore: 100 bucks in a million bucks in one year. 20% every week, very doable. Makes me laugh. Type in your calculator. Take 100 times 1.06 and do it 90 times. Okay, anyways, it's unreal. Clearly we don't think you should get your investment advice from TikTok. Good for entertainment I guess.
Ben Felix: I wonder what's going on over there though. I started seeing these, probably two months ago I saw one, and now they're starting to pop up more and then like you said Cameron, now someone's created a Twitter account is just posting this awful TikTok financial advice. What's going on there?
Cameron Passmore: I don't know.
Ben Felix: I wonder what's going on?
Cameron Passmore: I don't know.
Ben Felix: It doesn't make any sense.
Cameron Passmore: I don't know the revenue model. Does the revenue all go to them if you subscribe? Does TikTok ... I have no idea.
Ben Felix: I don't know. It's absurd. I don't have the name of the Twitter account. But it's unbelievable the stuff that people are putting on the internet. Hopefully not too many people are using it as actual advice. I don't know.
Cameron Passmore: Anyway, good thing is we get a chance to meet Dan in Tasmania for the first one and there you go. It's going around the world. You want to queue up your interview with Tim?
Ben Felix: Yep, so that's it for Cameron and I's part of this episode. But we did have that conversation with Tim that we wanted to include here. I originally wanted to talk to Tim about Wealthsimple's new sustainable portfolios. They've actually created some ETFs that they're using for their portfolio. They didn't feel that they were suitable products to use to create a good sustainable portfolio, so they went and created their own. Obviously, their integration with Power Corp helps them do things like that.
Ben Felix: I think they're actually Mackenzie funds, which is also a Power Corp company. Anyway, so Tim had his feedback on those funds and then we also talked a little bit about just the state of sustainable investing, which we alluded to a little bit in our portfolio topic.
Cameron Passmore: Cool. Well, thanks for listening, and let's go listen to you and Tim's conversation.
Ben Felix: Tim, thanks for coming back on the podcast.
Tim: Thanks so much for having me.
Ben Felix: Lots of people know that we'd like to pick on Wealthsimple's, model portfolios, and they recently released a new socially responsible or sustainable model portfolio. I wanted to have you on to talk about so let's do it.
Tim: Sure. I wasn't a big fan of their first socially responsible portfolio. When they launched it in, I think it was 2016. I opened it up and it really seemed like it was a mishmash of different strategies. They had low carbon ETFs that had tobacco, and gambling and weapons. Then they had a lot of the socially responsible ETFs that got rid of that stuff, but had fossil fuels in there. It was one of these things whereby trying to be everything to everybody, they ended up pissing everybody of, because there was something in the portfolio, whatever your values were, that you would be unhappy with. It was interesting to follow their journey. I think that they recognized that it wasn't perfect. I think they were getting a lot of negative feedback from it. Unfortunately, there weren't a lot of ETFs for a long time.
Tim: It has taken a while for the industry to evolve. They probably hit a tipping point. I don't know where it was, but I would guess about two, two and a half years ago, where they just decided they needed to switch. There were no products that were really a good fit for them at that time, so they decided to build their own ETFs, which is bold. I will give them credit for really going out there and creating something, different business model for them and actually building their own ETFs. I was really excited when they launched. I heard rumors that they were coming. They filed a prospectus and then finally, when they did launch earlier this year, I think it was in June of this year, yeah, mid June and I've just got the methodology in front of me, so I'll just run through it for viewers or listeners real quick. Basically, they get rid of a lot of negative screens here. Big polluters like oil and gas related companies. That means they're also excluding pipelines and refineries, things like that.
Tim: Any companies involved in thermal coal mining or coal power generation, and then they've also admitted the top 25% of carbon emitters in each industry. They go through sector by sector, knock off the bottom 25%. From there, they also get rid of any companies with any major violation, so like human rights or child labor, things like that, as well any defense contractors, weapon manufacturers. They get rid of tobacco, alcohol, casino gaming, adult, nightclub and entertainment companies. This to me is probably the most strict measure that they have, is they only include companies that have either three plus women on the board of directors, or 25% representation on the board of directors. That is just really, really an outlier when it comes to the responsible investment industry. I've seen one ETF on the market that requires at least one woman on the board. This is the first time I've ever seen such strong representation on that issue.
Tim: Really, I would say that is where they're hanging their hat or the hill they're willing to die on, if you want to look at it that way that it really is about gender representation. That does exclude about 60% of the eligible universe, which I know you're not going to be thrilled about. But really, their hope is by shining a light on this, that there will be a little bit of activism involved, that companies are going to be incentivized to be able to have more gender representation on the board. What's interesting is, when they launched it was right, as the racial justice protests were very strong in the US. A lot of questions around that, that that certainly was not part of their lens. They've suggested that they are open to updating their methodology. They're working with a third party index provider called Selective, so they can really customize the index.
Tim: It wouldn't surprise me if it does evolve as time goes on. The end result is that, you do get these two very broad based ETFs, one for North America, one for developed markets Ex-North America. The diversification isn't great. Overall, I think there are about 240 companies across the two ETFs.
Ben Felix: Across both combined.
Tim: Across both combined. The North American one is heavier. The reason they didn't do Canada and US differentiating there, is there weren't enough Canadian companies-
Ben Felix: Sure.
Tim: ... that passed that gender screen. That's why they went the North American route. When you look at the developed Ex-North America, there's a lot of exposure to Northern Europe, so the Scandinavian countries, Northern European countries-
Ben Felix: Make sense, yes.
Tim: ... and less exposure to the other EAFE regions.
Ben Felix: Wow. That's a good recap of what the products are. What are your thoughts and opinions?
Tim: Yeah, I'm thrilled that they did this. I think that they are really pushing the agenda forward, which makes me really happy that I think we need more leaders. Certainly, I would say what they've done here is fairly bold. In terms of what they're doing from the ethical standpoint, it's not perfect. To me, the issues that I have with it is number one, they don't use ESG, broad ESG scores. They would agree with you in the sense that there's so much discrepancy between the different rating agencies, that they're just like, "Screw it, we're not going to use ESG methodology."
Tim: To me, that's a problem because it does mean that certain companies will sneak through if provided they have gender representation on the board, provided their carbon footprints aren't horrible. One of the red flags in there for me, and again, it's not going to be for everyone, but I think it's a telling company is Amazon. When I look at the way Amazon treats their employees, and certainly during COVID, there are some issues here. A lot of those labor rights issues just simply aren't really addressed by the methodology.
Tim: It's never going to escalate to the point where it's like a human rights abuse, but so many of these questions around the gig economy. You're seeing Uber in California right now that is just like I don't know what's going to happen there, as their gig economy workers are being classified as employees, and they're threatening to shut down over that. Is the business model sustainable if those are actually employees and Amazon with their delivery services, things like that? Really, it's not going to be perfect. I would urge people to look at the holdings to see if there are any red flags in there, because there are a few head scratchers in there from my perspective.
Tim: But overall, I'm just thrilled. I think that robo advisors do play a really strong role in the investment landscape. That for a certain segment of people who are just getting started, they are just so much better than mutual funds from a fees perspective. There really wasn't a robo option for people that wanted to divest from fossil fuels and now there is.
Ben Felix: It's bigger to because they made ETFs?
Tim: That's right.
Ben Felix: You can get them through the robo advisor option, but you can also just buy the ETFs right?
Tim: You could just buy them directly. You got it. Now there is more of a landscape. iShares has come up with their fossil fuel free ETFs. There are more options available. The spectrum of options has gotten wider with many more options in there for different investors. This would add to that. They're also very low cost, Wealthsimple. I'm sure these are loss leaders. They are using a multi factor approach. I know in terms of fees, a custom index, all this stuff suggests that they should be more expensive.
Tim: But Wealthsimple is keeping them really nice and cheap, I think around 0.2, 0.25% for the MERs. Really, to me more choice is always a great thing, that the ease of use here is fantastic. I don't really see a downside for them, except that obviously, they're not going to be for every single investor. They will go too far for some of your listeners. They will go not far enough for many of my clients, and so it's really about figuring out where you are on that spectrum and whether these are appropriate for you.
Ben Felix: That's awesome. Okay, that was great. Now, before we end this, I know you had some comments on, when we had Ken French on for episode 100, he spoke about ESG that I know you wanted to respond to that a little bit, so if we could do that too that'd be awesome.
Tim: Absolutely. First of all you guys have been getting some awesome guests lately. I'm enjoying the podcast so much.
Ben Felix: Great.
Tim: It's been great. To get Ken French for your 100th episode, I don't know how planned that was or whether it was serendipitous, but that was just so cool. Really have so much respect for him and I loved his answer. First of all, I was thrilled you asked him. I was really happy about that. Then I loved his answer. He really wore two hats. He said, "As a human, I love it. Sustainable investing, this is important. This is great. I'm all for it. This is great. But as a finance professor wearing that hat, I've got some problems with it."
Tim: To me, that is the fundamental issue that and I was so happy to hear him have those two different hats as I like to call them, because really, it speaks to me the problem of mainstream finance as it relates to ESG. Really what happens is that, as soon as he puts on that finance professor hat, it becomes a very simple equation for him. Even spoke to this, that there's one diagram which is that as there is a higher preference that pushes up prices, which lowers long-term expected returns.
Tim: The problem with that overly simple formula is that it makes a very common mistake, which is to completely ignore social and environmental issues and dismiss them as "externalities." Whereas in my mind, and so much evidence is starting to show that these are financially material issues, that these are not externalities, that they have a bearing on a company's profitability and share price performance. To me, it just ... I was a little bit disappointed that really, I felt that the thinking on this issue is overly simplistic, that as we start to move towards a more sustainable society.
Tim: I think that COVID has really shone a light on a lot of the income disparity issues. I think we're going through a fundamental re-pricing of assets, such that things like tech and education and healthcare are so much more valuable. We're starting to realize that actually these are more valuable, and that also on the climate change side that, we really have seen a decline of the broad energy sector, where the carbon bubble is deflating. I don't think it's popped. But when you look at all the right nouns of all these assets that a lot of these projects are just not going to get built.
Tim: They're just not profitable anymore. To me, there is this broader societal shift happening. I really love the long-term approach that he takes and so I'm a little bit hesitant to talk about short-term politics. But I will say that it looks like the Canadian government is going to be moving towards a green recovery. I want to knock on wood. I don't want to jinx anything with the US election. But Joe Biden has presented a $2 trillion climate plan, that really I think that we are about to go through a major re-pricing of assets that incorporate both the social and environmental lens.
Tim: To use an overly simplistic model that completely dismisses those, in my mind very material issues, to me misses a big part of the theory behind why ESG investing I think is so popular, is growing so quickly and could be very profitable. The last thing I'll say is that, I do appreciate this perspective that it is a preference, and he did admit there is utility for people to feel good about their investments. Thank you for acknowledging the warm fuzzies, as I call them, are a real thing and there is value there.
Tim: But I would also say that if your fear is that those preferences have taken over and the assets are overpriced, to me you really have to look at the overall market, to see how much those preferences have crept in. There is a chart that came out by Morningstar showing assets flowing into sustainable funds. This is a record year that last year was $20 billion, which was massive. We've already had $20 billion so far this year, whereas previous to this, I think the record was around 4 billion. It really is that massive growth, but the overall market for ETFs is still $4 trillion.
Tim: To put that 40 billion in context, I really think we're still in, I would say, the second inning of this rise of ESG preferences. It'll be interesting to see over the long-term, his theory might come true that there might be a bubble and overpricing there. I still think we're a long way from that. I would argue that the market is going through a fundamental re-pricing of assets, such that companies that take these issues seriously and are ahead of the curve will continue to see their share prices appreciate.
Ben Felix: I think sustainable companies as a category have done quite well. Not that we can draw a ton of insight from a couple of months, but it is interesting to see. I actually came across a paper just right before we started talking that address mutual fund performance and flows during the COVID-19 crisis, and they also looked at sustainable funds. One of their conclusions was, fund outflows surpass pre crisis trends for active funds, but not dramatically.
Ben Felix: Investors favor funds that apply exclusion criteria, because ESG exclusion, and funds with high sustainability ratings, especially environmental ones, are finding that investors remain focused on sustainability during this major crisis suggests that they view sustainability as a necessity rather than a luxury good. I thought that was pretty interesting.
Tim: That's it to me that, I think in the 2008/2009 crisis, sustainability got thrown on the back burner. It just wasn't important. People were like, "No, we've got bigger fish to fry." This time it's staying on the front burner, which to me is so exciting. It's been really interesting to see this idea of consumer staples and a lot of these more defensive sectors. It's understandable that they would do well during a pandemic. Part of it is luck. Part of it is the fact that I think that investors are more loyal, that when there is a values component, if someone I remember Kevin O'Leary had his mutual funds before, someone's going to invest in a fund from that guy. All they care about is financial performance.
Tim: A couple bad quarters, and they're done. Whereas really, when it comes to these values based approach, I think there is a longer term perspective, and there is more loyalty and there is stricter adherence to this buy and hold psychology, which is obviously a huge barrier for DIY investors. That can be a huge problem. By connecting it to their values, I think there's a huge advantage here for advisors that want that client loyalty over the long-term, that if you can connect with people on that more ethical level, that you're going to have a client for life.
Ben Felix: Which is fascinating too, as it relates to the Ken French type theory because that's exactly what he's saying, that people will be more willing to hold those assets separate from their risk and expected return characteristics, which does help with adherence for sure, but also how has a theoretical effect on expected returns, which is the point that you're just talking about anyway. Totally fascinating stuff.
Tim: It's going to be interesting. It's still early days and there's not a huge amount of research. We're just now getting the point where, we do have some historic data. I'll admit that it is still a little bit of the Wild West out here, when it comes to this stuff, but I do spend a lot of my time working through tradeoffs, and understanding that these things aren't perfect and preferences are a huge part of that. But really, I'm super encouraged just both by the financial performance, that everything is performing, my thesis is holding true.
Tim: But also in terms of the psychological that I've long felt that the barrier to adoption of ESG investing is not a financial thing, it's a psychological thing, that there really are these mental barriers, and specifically this myth that returns are going to be awful. I think you and I are going to disagree about long-term expected returns and exactly where it's going to be, but I think we can both agree now that you certainly haven't had to sacrifice financial returns. That if there is an emerging preference for these issues, that investors who get in early are going to be ahead of that curve.
Ben Felix: It's so tricky with expected returns too, right? A lot of the times these sustainable ETFs will have tilts toward known factors that do drive differences in expected returns. Even if there's a preference based reduction in expected returns, if you compare a sustainable ETF to just a market cap weighted ETF, just the additional factor exposure might bring it back to even in terms of expected returns or more. I don't think it's as easy as saying; they're going to have lower expected returns, especially when you're comparing it to a market cap weighted index. It's like a theoretical risk adjusted lower expected return, but that doesn't necessarily equate to lower investor returns.
Tim: Actual returns for people who have invested. It's going to be interesting, but I just love that the conversation is continuing to drive forward, I'm seeing a lot of encouraging signs, when it comes to markets really adopting this. The task force for financial related climate disclosures, this awful acronym that now I can look at banks balance sheets, and see what their carbon risk exposure is, that the amount of data that I have available to me now is great. I'm just hoping that academic researchers are picking up on this as well. I'm sure they are. But I think over the next few years, we're going to start to see more academic papers, we're going to start to see more of this deeper analysis.
Tim: We never know where things are going. Either one of us has that crystal ball. But I think that I'm certainly very encouraged having been looking at this for 10 or 12 years now, that really finally, I do feel the momentum is here, that this is the conversations that are happening are so much more informed, and so much more fruitful than they were even just a few years ago.
Ben Felix: Yeah. All right. Let's leave it there. Thanks, Tim. We really appreciate you coming on now.
Tim: Thanks so much for having me.
Books From Today’s Episode:
Zero to One: Notes on Startups or How to Build a Future — https://amzn.to/3ifHaBY
Atomic Habits — https://amzn.to/2Ra5NnF
The Case For People's Quantitative Easing — https://amzn.to/35lADSI
The Master Switch: The Rise and Fall of Information Empires — https://amzn.to/3h8CRXO
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
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Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron on Twitter — https://twitter.com/CameronPassmore
'Sustainable Investing in Equilibrium' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3498354
'Mutual Fund Performance and Flows During the COVID-19 Crisis' — Mutual Fund Performance and Flows During the COVID-19 Crisis by Lubos Pastor, Blair Vorsatz :: SSRN
'22 Behavioral Nudges to Optimize Client Outcomes' — https://www.financialplanningassociation.org/article/journal/AUG20-22-behavioral-nudges-optimize-client-outcomes