Leave me a note, and I will get back to you. 


Ottawa, ON
Canada

613 868 3950

The Canadian Financial Advisor

Spotting subtle conflicts of interest with your financial advisor

Benjamin Felix

In Canada, it is currently up to the investor to ensure that their interests are truly being put first when they are receiving investment advice. Most Canadian financial advisors are held to a suitability standard, rather than a best interest standard – meaning that as long as their advice is suitable, it does not have to be in the best interest of the client. Conflicts of interest are generally subtle, and they are ingrained in the way that many Canadian financial advisors do business. I often hear disbelief when I explain to someone that the advice they have received was likely influenced by an incentive (commission) for the advisor. Financial advisors do not generally have malicious intent, but they are often in a situation where the nature of their compensation puts their interests at odds with the interests of their clients.

A financial advisor licensed to sell mutual funds might receive 1% per year on the investment assets that they manage. However, rather than earn 1% throughout the year, the advisor has the option of generating a 5% up front commission at the time that they invest a new client’s assets, plus 0.5% per year ongoing. This is referred to as a deferred sales charge (DSC) or back end load. The catch for the client is that only funds with high management fees offer the DSC form of compensation for the advisor. Low-cost index funds and ETFs do not offer large DSC commissions for financial advisors. We know, from academic research, that fees have been the best predictor of fund performance through time, but most financial advisors are oblivious to the fact that high fee products are likely to do more harm than good for their clients. Their heads are full of attractive sales pitches and compensation structures from fund companies instead of the academic evidence that should be driving decisions in the client’s best interest. Any time a financial advisor mentions DSC, low load, or back end load, it is a red flag. It means that the advisor is going to earn a large commission, and the client is going to be locked in to a high-fee fund for at least three years.

When receiving investment advice from a financial advisor that is only licensed to sell insurance, the investment vehicle that they are likely to recommend is a segregated fund. Segregated funds are insurance products that are effectively similar to mutual funds, with some insurance features. The insurance features usually include a death benefit guarantee, maturity guarantee, and the ability to assign a beneficiary for the assets on death. To pay for these features, segregated funds tend to have higher fees than mutual funds. The reality is that the features of segregated funds will usually be unable to justify their significantly higher fees. If a financial advisor is recommending segregated funds, it is likely because that is the only thing that they are licensed to sell, even if it may not be the best thing for the client. Any time an advisor is recommending segregated funds, it is important to understand exactly what their reasoning is, and why a mutual fund or ETF is not a better solution. If you ask the butcher what you should have for dinner, they are unlikely to recommend salad.

There are plenty of financial advisors in Canada who are good people with good intentions, and who are trusted by their clients. A significant portion of these financial advisors are in situations where their advice is naturally conflicted due to their compensation structure; they may not even be aware that they are giving conflicted advice. In my experience, the advisors giving conflicted advice have done their own version of due diligence (maybe something like finding funds with good past performance to justify higher fees) in order to rationalize the advice that they are giving, making it even harder for a client with limited investment knowledge to notice that something is not right. By looking out for DSC funds and segregated funds, and asking questions about them when they come up, investors are in a position to spot some of the most common conflicts of interest.

 Original post at pwlcapital.com

Smart beta is growing rapidly, but who’s reviewing the research?

Benjamin Felix

Dan Bortolotti’s April 1st post about Dr. Molti Fattore’s data mined index strategy was an April Fool’s joke, but the beauty of the post was that it could have easily been true. Some ETF providers were likely drooling at the thought of a “factor lasagna” that they could package and sell for 0.75%.

Data around the average active managers’ failure to outperform a low-cost index fund has resulted in investors’ assets shifting into low-cost index funds. Market cap weighted index funds have quickly become commodities, resulting in the lowest fund fees in history. An S&P 500 index fund with a 0.05% MER was once an anomaly, and it is now an expectation. In an effort to differentiate their products, index providers have started producing factor-based research which can be implemented in smart beta index portfolios, or funds which have been designed to outperform a simple cap-weighted index by capturing a specific part of the market. Of course, a smart beta fund is no longer a commodity and will accordingly command a higher fee.

The problem with the rapid proliferation of smart beta products is that mashing a handful of back-tested factors together does not necessarily result in a robust portfolio. The research behind the factors needs to be impeccable, and the implementation of the research requires significant care and expertise.

Momentum and quality are two factors that have been showing up in smart beta and factor ETFs. The momentum premium has been well-documented but it does not have a sensible explanation, raising the question of whether it is likely to persist. Momentum as an investment factor also decays quickly, making it very difficult to capture without a high level of portfolio turnover. High turnover increases costs and erodes any premium that may have been available. This is an obvious challenge with implementation.

Quality, based on earnings variability, has presented a past premium. However, when profitability is controlled for unusual items and taxes on the income statement, the variability of profitability contains little information about future profitability. In short, the quality factor does not have significant explanatory power over returns compared to well-documented factors such as size, value, profitability, and investment, and it is not useful to add it as an additional factor in a portfolio.

There is a tremendous amount of data available about markets, and it is relatively easy to find patterns that appear to point to higher expected returns based on a factor. Implementing an investment portfolio based on this type of research requires significant due diligence to mitigate the risk that observed differences in returns have not simply happened by chance. An excellent example is the Scrabble score weighted index reported in this paper by Clare and Motson. They found that if they weighted an index based on the Scrabble score produced by the ticker of each stock, they significantly outperformed a market cap weighted index. The Scrabble factor is, of course, not reliable data, but not all poorly thought out smart beta strategies will be so easy for investors to spot.

Original post at pwlcapital.com

The TFSA is not a Toy

Benjamin Felix

It may be a flaw in the name. The government-intended use of the registered retirement savings plan is clear, retirement, but the tax free savings account is less commonly viewed as a long-term savings vehicle. I often meet investors who are using their TFSA to trade individual securities; the TFSA is their ‘play’ account. They are likely acting under the influence of their own overconfidence bias, imagining the large tax-free profits that they are going to make when their bet on a stock pays off, and not considering the significant negative consequences of taking unrecoverable losses within the TFSA.  An unrecoverable loss occurs when a security loses its value and never recovers, something that can easily happen when trading individual securities.

Something lost, nothing gained

If a stock picker loses on a bet in a taxable investment account, they are able to claim a capital loss which can be used to offset a future capital gain, dampening the blow of the loss. When losses are taken within the TFSA, this is not the case. Just as capital gains are not taxed in the TFSA, capital losses cannot be claimed. Assuming an investor is taxed at the highest marginal rate in Ontario in 2016, and they have taxable capital gains to offset, a $1,000 capital loss is worth about $268 in tax savings. Losing out on this tax savings makes an unrecoverable loss in a TFSA about 37% more damaging than an unrecoverable loss in a taxable account.

It’s all fun and games until someone loses their TFSA room

Any amount withdrawn from the TFSA generates an equal amount of new room the following calendar year. For example, if a $5,500 TFSA contribution was invested and grew to be $6,500, the full $6,500 could be withdrawn before December 31 and $6,500 of new room would be created on January 1 of the following year. Conversely, in the event of an unrecoverable loss, the amount of the loss will permanently reduce available TFSA room. If a similar $5,500 investment in the TFSA decreases in value to $4,500 and never recovers, there is only $4,500 available to be withdrawn, and the TFSA room has suffered a permanent decrease.

Losing a bit of TFSA room may seem trivial, but consider that $5,500 invested in a well-diversified portfolio* held in a TFSA for 30 years would be expected to grow to about $34,000, while the same investment in a taxable account would be expected to grow to about $15,000 assuming the highest marginal tax rate in Ontario in 2016. A seemingly meaningless loss of TFSA room today has meaningful long-term repercussions.

Between the significant future value of properly used TFSA room, and the lack of recourse for losses in the TFSA, it is an especially risky account to gamble with.

*80% globally diversified equity, 20% globally diversified fixed income, 6.11% return comprised of 1.94% interest, 0.49% dividends, 1.84% realized capital gains, 1.84% unrealized capital gains, net of a 1% management fee.

Original post at pwlcapital.com

Don’t follow the crowd into cash

Benjamin Felix

It’s easy to imagine that when markets are declining everyone is selling their stocks and hiding cash under their mattresses. Sensationalist news reports will often reference increasing cash balances as nervous investors rush for the exits. While this perception is common, it misses half of the story; for every seller there must be a buyer. Cash isn’t piling up everywhere while everyone waits on the sidelines. For each nervous seller running for the hills, there is a level-headed buyer capturing the equity premium.

When contemplating the action of selling investments to hold cash in anticipation of a market crash, one must consider the following:

Do you know more than whoever is on the other side of the trade? Someone is happily buying the securities that you are in a hurry to sell. In 1980, 48% of U.S. corporate equity was held directly by households, and by 2008 that number had dropped to 20%*, meaning that the someone buying your securities is likely a skilled professional at a large institution; do you know something they don’t?

When are you going to get back in? Markets deliver long-term performance in an unpredictable manner. Over the 264 months from January 1994 – December 2015, a globally diversified equity portfolio returned 8.51%** per year on average. Removing the five best months reduces that average annual return to 6.46%. That is a 24% reduction in average annual returns for missing 1.9% of the months available for investment. Peter Lynch famously stated "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."

Should you have been in the market to begin with? If you need your cash in the short-term, it probably shouldn’t be invested in stocks and bonds. If a portfolio has been properly structured to meet a specific financial goal, it should remain in the market regardless of the market conditions. Portfolio volatility can be controlled by selecting an appropriate mix of stocks and bonds, not by jumping between stocks and cash.

A positive investment experience is largely dictated by discipline. There is no evidence that market timing results in better returns, and plenty of evidence that it is detrimental. While it may sometimes seem like everyone is going to cash to avoid a downturn, they’re not. Those choosing to go to cash are effectively being exploited by those taking a disciplined approach, rebalancing into stocks when stocks are declining.

*Investment Noise and Trends, Stambaugh http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2374103

**Dimensional Returns 2.0

Original post at pwlcapital.com