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What if investing right before a market crash isn’t that bad?

Benjamin Felix

Imagine having $1,500,000 of cash. With a long time horizon, and no immediate needs, you decide to invest $500,000 in a globally diversified portfolio* consisting of 80% stocks, and 20% bonds. It is March 1, 2000. Within days, the dot com bubble bursts, followed by the terror attacks of September 11, 2001. By the end of September, 2002, your invested portfolio has dropped from $500,000 to $480,724.

By May of 2007, the $500,000 that you have invested is worth $992,714. You make the decision to invest another $500,000 on June 1st, 2007, increasing your market portfolio to $1,492,714 on that date. The global financial crisis swiftly ensues, seemingly vaporizing your additional $500,000 investment, and dropping your portfolio’s value down to a low of $891,013 in February of 2009 – a drop of 40.3% from the 2007 high.

At the end of July, 2011, your portfolio is worth $1,448,537, and you decide to deploy your remaining $500,000 on August 1st, 2011, resulting in a total portfolio value of $2,006,521 on that date. The market declines sharply for several months. At the end of September, 2011 your investments are worth $1,754,722.

On November 30th, 2015, your portfolio has increased in value to $2,670,809. In hindsight, you have invested immediately before each market crash in recent history. Despite your poor timing, you have earned an average money-weighted rate of return of 5.82% per year, compared to the S&P 500’s 4.16%, and the Canadian Consumer Price Index’s 1.94% over the same time period.  A luckier person may have outperformed you by not investing at the worst possible times, but you undoubtedly outperformed the person sitting in cash on the sidelines.

Without the ability to predict the future, long-term investment assets are better off in the market, even if the market is about to crash.

*The portfolio returns come from the Dimensional Global 80EQ-20FI Portfolio (F). Where fund data is not available, Dimensional index returns net of current fund MERs are used.

Original post at pwlcapital.com

Forget about fees: new research highlights a compelling reason for active manager underperformance

Benjamin Felix

In a recent paper, Heaton, Polson, and Witte set out to explain why active equity managers tend to underperform a benchmark index. It is commonly accepted that the driving force behind active manager underperformance is high fees, however new research suggests that there may be another culprit. The research concludes that “the much higher cost of active management may be the inherently high chance of underperformance that comes with attempts to select stocks, since stock selection disproportionately increases the chance of underperformance relative to the chance of overperformance.”

This conclusion is based on the empirical observation that the best performing stocks in an index perform much better than the remaining stocks in that index. Worded mathematically, the median return for all possible actively managed portfolios will tend to be lower than the mean return. In plain English, the average performance of an index tends to be attributable to a small number of stocks. While choosing a subset of the total available stocks in an index (as an active fund manager does) leads to the possibility of outperforming the index, it also leads to the possibility of underperforming the index, where the chance of underperforming is greater than the chance of outperforming.

This can be (and is in the paper) explained with a simple mathematical example:

If we have an index consisting of five securities, four of which will return 10% and one of which will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of one or two securities, there will be a set of fifteen possible actively managed portfolios. Ten of the fifteen portfolios will earn a 10% return due to omitting the 50% stock, and five of the fifteen portfolios will earn either a 30% return or a 50% return due to holding the 50% stock, depending on whether it is a one or two security portfolio. In this example, the mean average return of the stocks in the index, and all active fund managers, will be 18% (before fees), while the median will be 10%; two-thirds of the actively managed portfolios will underperform the index due to their omitting the 50% returning security, which is always included in the index.

We have been aware that higher explicit fees are a major factor in active manager underperformance, but the risk of missing top performing stocks due to holding only a subset of the total market may be an even bigger hurdle for active managers to overcome.

Original post at pwlcapital.com

If interest rates have nowhere to go but up, do bonds still have a positive expected return?

Benjamin Felix

In answering this question, the first thing to note is that interest rates could remain where they are currently, or go lower. There are already instances of negative bond yields across the globe. However, for discussion, we will assume that interest rates have nowhere to go but up.

The factors that matter most are the magnitude and time span of the interest rate increase, and the average duration of the bond portfolio. If interest rates were to increase by 0.5%, the effect on bond prices would be minimal. If interest rates increased by 10%, bond prices would be impacted significantly. If interest rates climb to a peak over the course of one month, the impact on bond prices will be more pronounced than if it occurs over a number of years. Large, short term increases in interest rates will likely result in negative performance for fixed income holdings. These negative effects become more pronounced as the duration of the bond portfolio increases.

Price risk is top of mind in a low interest rate environment. If interest rates can only go up, it seems like fixed income returns have nowhere to go but down. However, as interest rates go up, new bonds are issued at the new higher rates. As a bond portfolio receives coupon payments from the bonds that it owns, these coupon payments are reinvested in new bonds, at higher rates. Bond prices may decline with rising interest rates, but over time it is expected that purchasing new bonds with higher coupons will result in positive performance. Expected returns are independent of future interest rate scenarios, but realizing an expected return may come with periods of bond price volatility. As interest rates rise, a bond portfolio may exhibit negative performance over the short term, however, as coupon payments and principal repayments are reinvested at the new higher rates, the bond portfolio will be positioned for recovery.

If an investor is concerned about large negative returns in their fixed income portfolio, it is advisable to tend toward shorter-maturity bonds. Diversification can also help, reducing the bond portfolio’s dependence on any single country’s interest rate environment. In a rising rate environment, a globally diversified short-maturity bond portfolio is positioned to benefit.

If they’re so great, why doesn’t everyone invest in passive/index funds?

Benjamin Felix

First off, in the U.S., everyone is investing in passive funds. Massive inflows into passive funds and outflows from active funds have continued in 2015. The story is not the same in Canada.

It is easy to talk about the merits of a passive, evidenced based investment philosophy, and, when presented with the evidence, people tend to agree that a passive investment philosophy is the only responsible approach to financial markets. However, in Canada, the vast majority of retail money is not invested this way. Despite the clear evidence that it is a losing game, investors tend to direct their money into actively managed strategies that claim to outperform the indexes, and provide downside protection in turbulent markets. Canadians tend to be intelligent people, but we face some road blocks in embracing evidence-based investing.

Good advice is hard to find. The financial services industry is wrought with conflicts of interest, and Canadian financial advisors are not immune. In many cases, the people holding themselves out as financial advisors are in fact salespeople pushing financial products to earn a commission. What does this have to do with index funds? Index funds and similar low-cost products do not pay the big upfront commissions that traditional financial products do. Most financial advisors are not even taught to recommend passive investment products because they are not profitable for the firms that they work for.

We rely on our Big Banks. Our banks are trusted and expected to be fiduciaries. But the banks suffer from the same conflicts of interest that the rest of the financial services industry suffers from; the financial products that are profitable for them are detrimental to their clients. However, to remain profitable, they need to sell these products. People tend to assume that when they walk into the bank they are getting advice that is in their best interest, but that is not the case. Bank employees are trained to sell profitable products, extol the skill of their fund managers, and entice clients away from those boring index funds.

It looks like someone is always making money. Traditional high-fee investment products still attract assets because they can leverage performance outliers. In any given year, some investors and mutual funds will significantly outperform the average. For example, so far this year the AGF U.S. Small-Mid Cap Series Q has returned 42.40%, compared to 1.25% for the Russell 2000 U.S small cap index. Why bother with index funds when active fund managers can produce such stellar returns?

This is where the evidence is important; the vast majority of active money managers consistently underperform their benchmark index over the long-term, predicting which active managers are going to outperform in a future year cannot be done consistently, and strong past performance is in no way an indication of future performance. Embracing a passive investment philosophy is obvious when the data is considered, but the data is often hidden behind sales pitches. As a result, passive investing has not yet gone mainstream in Canada.

Original post at pwlcapital.com

Expected Returns vs. Hoped for Returns

Benjamin Felix

Expected returns stem from the idea that investors need to be paid a return for taking on the risk of owning securities. No investor would own securities without having the expectation of returns, and as the securities being owned get riskier, the investor will expect increasingly higher returns. If there were no reason to expect higher returns for holding riskier investments, investors would only hold less risky investments. Stocks are risky investments, and investors have been compensated well for owning them. Bonds are less risky investments, and investors have not been compensated as well for owning bonds as they have been for owning stocks. Expected returns are based on the risk of the overall market (systematic risk), assuming that the risk associated with any individual security (non-systematic risk) has been eliminated through diversification. This is an important distinction; the securities of any individual company are exposed to random error (CEO gets sick, hurricane knocks out the manufacturing plant, etc.) and do not have an expected return. The stock can either go up, or it can go down, and the average of its expected outcomes is zero.

Investors who minimize their costs and capture the returns of the global markets with a well diversified low-cost portfolio are able to expect returns. Capital markets research has even shown that specific parts of the market have higher expected returns than others. This is discussed in detail in Larry Swedroe’s new book, The Incredible Shrinking Alpha, (request a copy here) but a simple example is: stocks have higher expected returns than bonds, value stocks have higher expected returns than growth stocks, and small stocks have higher expected returns than large stocks. Based on this, a properly diversified investor can structure a low-cost portfolio in such a way that they can expect to earn higher returns than a market index, like the S&P 500. Interestingly, most people don’t invest like this, but they do try to beat the S&P 500.

The majority of mutual fund assets invested in Canada are invested in actively managed mutual funds. An actively managed mutual fund is led by a fund manager who is responsible for predicting which stocks and bonds are going to perform well, with the goal of beating their relevant benchmark index (S&P 500 for a US equity fund, S&P/TSX Composite for a Canadian equity fund etc.). Unlike the well-diversified investor holding a market portfolio, who can expect to earn a long-term return for taking on the risk of the market, investors in actively managed mutual funds can only hope that their fund manager will pick the right securities to give them a return. Even if a fund has performed well in the past, there is no expectation that it will continue to perform well in the future, and most actively managed mutual funds in Canada underperform their benchmark over the long term. Many investors are realizing that it is better to expect returns than to hope for them, but a staggering 98.5% of mutual fund assets in Canada are still invested in actively managed mutual funds*.

*Investor Economics data as of June 19, 2015.

Original post at pwlcapital.com

The Cost of “Tax-Free” Corporate Class Fund Switches

Benjamin Felix

A mutual fund can be structured as a trust or as a corporation. While most mutual funds in Canada are structured as trusts, it is common for financial advisors to pitch their clients on the merits of corporate class funds. When mutual funds are structured as trusts, each fund is its own separate entity. When mutual fund families are structured as corporations, each fund in the family is a class of shares within a single corporation. The pitch for corporate class funds is that within a fund family the investor is free to move their capital across the various mutual funds without triggering a taxable disposition. The disposition will only occur when the investor eventually sells shares of the corporation, leaving the fund family altogether. Although the idea of tax-deferred switching between funds is a good sales pitch, the wise investor will look deeper.

Mutual fund investors realize capital gains in two ways:

When the fund manager sells a security held by the fund at a gain, it is distributed to unit holders as a capital gains distribution at the end of the year (type 1 gains);

When a mutual fund investor sells units in a mutual fund for more than they originally bought them for, they realize a capital gain (type 2 gain).

Mutual funds use something called the capital gain refund mechanism to reduce the potential for double taxation of unit holders. It has the intention of reducing capital gains distributions (type 1 gains) by the amount of gains realized by the investors who sold their holdings of the fund (type 2 gains). Under the trust structure, any time a unit holder moves out of a fund, their realized gains (type 2 gains) will reduce the amount of capital gains distributed to remaining unit holders (type 1 gains); in a mutual fund trust type 2 gains reduce type 1 gains. Under the corporate class structure, unit holders can switch between funds without having to sell, eliminating much of the type 2 gains. Reduced type 2 gains increases the amount of type 1 gains that must be distributed to unit holders at year end.

The ability to switch between funds without incurring taxes sounds good, but it is ultimately just a gimmick shifting how and to who capital gains will flow. Corporate class funds create an environment where type 2 gains are being deferred at the cost of higher type 1 gains.

This blog post is based on a white paper from Dimensional Fund Advisors, download the full paper here.

Original post at pwlcapital.com

Investing with the Big Canadian Bank Brokerages

Benjamin Felix

As an independent wealth management firm, there is no question that some of PWL Capital’s most aggressive competition comes from the Big Bank brokerage houses: TD Waterhouse, BMO Nesbitt Burns, CIBC Woodgundy, Scotia McLeod, and RBC Dominion Securities. This competition has become increasingly noticeable as the bank brokerages strategically advance their offering into the realm of wealth management. With their established brands and elitist feel, it is obvious why high net worth investors can be attracted to the perceived prestige and safety of dealing with the big name institutions. There may be some very good people giving wealth management advice within the bank owned brokerages, but there are inherent problems with their structure which is to the detriment of their clients.

One of the most obvious issues is conflicts of interest. Conflicts arise due to the integrated nature of the banks’ operations; if the institution decides that there is a product or stock that needs to be moved, one of the most accessible sales conduits is the clients of the bank-owned brokerage. Sales pressure from within the organizations has the potential to result in investment recommendations that may not be in the best interest of the clients. The core function of the bank-owned brokerages is not wealth management; they are sales channels and profitability centers serving the shareholders of the banks.

Beyond the conflicts of interest, the bank brokerages are hindered by their lack of a unified investment philosophy. At any of the bank brokerages there will be a large number of portfolio managers and investment advisors each implementing their own strategies. Some may use the bank’s proprietary mutual funds, some may pick individual stocks, while others may use the bank’s wrap account program. There may even be portfolio managers within the bank brokerages that use low-cost index funds, but without a unified philosophy guiding their investment decisions, advisors at the bank brokerages are more likely to recommend the flavour of the month mutual fund or the latest hot stock issue to their clients.

Dealing with an independent advisor-owned firm eliminates these issues. A firm like PWL Capital is designed to avoid conflicts of interest. We are paid by our clients, and there is no pressure to push any stock, mutual fund, or ETF at any given time to any given party. Under our structure, our only goals are to grow the assets of our clients while providing the ongoing financial planning advice that helps us maintain lasting relationships. With a unified, science-based, firm-wide investment philosophy, there is never a question of whether or not we should be using the latest financial innovation or buying the most exciting new stock in our client portfolios. Our disciplined approach is guided by academic research and evidence from the history of markets.

Despite PWL Capital’s intellectual integrity and dedication to doing what is right for clients, and the reasonably obvious profit-seeking nature of our competitors, some high net worth investors are inevitably swept off their feet by the Big Bank brokerages.

Original post at pwlcapital.com

If you think you need an options strategy, a hedge fund, or an active fund manager, you probably just need to revisit your time horizon

Benjamin Felix

I often hear the phrase protect your downside. It’s the sales pitch that a large part of the investment management industry thrives on, and it plays to the myopic loss aversion that most investors exhibit. Myopic loss aversion is the tendency of investors to evaluate their portfolios frequently with greater sensitivity to losses than gains, causing them to act as if their time horizon is much shorter than it actually is. Let’s look at the example of John who wants to invest for his retirement 30 years from now. After happily watching his portfolio increase with steady returns for a few years, he panics when the market trends down slightly for a week. He knows that he doesn’t plan to touch the money for a long period of time, but the thought of a decline, even over a relatively short period of time, makes him feel sick. He may even pull his money out of the market until things feel safe again.

An obvious path to safety would seem to be hiring a person or a company that knows how to protect your downside, and the investment industry has answered this calling. John Wilson’s Sprott Enhanced Equity Class “provides downside protection through the use of option strategies and tactical changes to the amount of its equity exposure...”, while Cecilia Mo, MBA from Dynamic Funds “focuses on delivering consistent strong performance while providing downside protection”. If these sales pitches were not enough to satisfy our myopic loss aversion, Jeffrey Burchell, Portfolio Manager and Co-CIO for Aston Hill Asset management makes it clear that he’d “rather make less money than lose money!”

These sales pitches may give confidence to the naive investor, but downside protection strategies inevitably add significant costs to the portfolio over the long-term, resulting in performance that lags a benchmark index. The funny thing about this is that over long periods of time, say 10+ years, global financial markets have tended to increase in value. Lets reflect on that; we are accepting additional costs and underperformance to avoid short-term declines, but we have a long-term goal, and over long periods of time the short-term declines are just noise because the market tends to increase in value given a long enough period of time. Many portfolio managers will have you believe that it makes sense for long-term investors to accept lower returns in order to avoid being witness to short-term, albeit unrealized, losses; this sentiment can’t be expressed any more explicitly than “I’d rather make less money than lose money!”

What’s an investor to do? The risk of losing your money is only real if you need to sell investments while they are worth less than what you bought them for. Investing requires putting thought and care into matching your portfolio with the time horizon associated with it. If a short-term loss is intolerable because you might need the money soon, then investing in stocks and bonds is probably not the appropriate course of action. As for using options and tactical allocation for downside protection, long-term investors are better off minimizing their costs and capturing the returns of the global markets using index funds and ETFs. If short-term declines cause an emotional issue, you can simply increase your exposure to bonds.

Original post at pwlcapital.com