Monday, 16 March 2015

Investment Advice Trust Index - A Simplistic but Simple Retail Investor Guide

Whose advice can you trust? It's complex and confusing but you cannot wash your hands of getting an idea of whom to trust because a mistake can be extremely costly, as in having your retirement savings wiped out.

There are titles galore in the financial and investment industry that we individual investors must deal with. Some titles mean something, others are just fluff to impress us.

The key idea is that only a few select people we might deal with are obliged to act first and foremost in our best interest, what is called behaving according to fiduciary duty. Most are held to a much lower standard, such as suitability, for instance in the Mutual Fund Dealers Association Member Regulation Notice on Suitability. That allows the industry professionals to behave with great latitude and often in their own best interest, mostly as salespeople, as long as their "advice" is not outright fraudulent or misleading.

Two documents from official regulatory sources provide a means to narrow things down to a list that has substance:

1) Canadian Securities Administrators Understanding Registration, a one-page list of all the types of people and firms that can sell or offer advice on securities (mutual funds, ETFs, stocks, bonds). Acknowledgement to the Small Investor Protection Association, where I found this link.

2) Canadian Securities Administrators Consultation Paper 33-403, The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best Interest Duty when Advice is Provided to Retail Clients, a 37-page legalistic, technical document (why is it that such important consumer information is only to be found buried in such a user-unfriendly place?). Page 9 of the pdf contains the following chart; most of the entries in the fiduciary duty columns have a No, few a Yes and several It Depends.


What is your firm's and your personal registration category? This is the first question to ask. Check the registration here. If the answer is "not registered", run for the hills!

Only three categories of individuals matter.

Ninety percent of people who call themselves financial advisor, investment advisor, financial planner, wealth advisor or some variation of such are Dealing Representatives, which as we see from the charts, are actually salespeople selling mutual funds. Caveat emptor! Assume they will not necessarily provide recommendations or plans that are best for you (except in Quebec where they are obliged by law to always act in a client's best interest). 

Advising Representatives and Associate Advising Representatives almost all work for Investment Dealers or Portfolio Managers. If they have explicit authorization to buy and sell in your account i.e. a Discretionary account, they have a clear responsibility to act in your best interest (the Yes entries in the second table). Of course, that does not negate human nature and some bad apples might still do lots of trades to generate extra commission income for themselves.

The "It Depends" situations are very problematic for the individual investor. You have a Non-Discretionary account and still have final say on buying and selling. But you may be reliant on the advice given, which may mean you can or cannot count on that advice being in your best interest, depending on how the five determining factors (vulnerability, trust, reliance, discretion, professional rules or codes of conduct) cited in the CSA consultation paper pan out. In the case of dispute, usually when it's too late and and bad things have happened to the investor, the only way to find out for sure is to go to court at great cost of money, time and effort. The ambiguity, which usually works to the benefit of exploitative abusive firms and investment professionals, is a big reason for the long-standing but so far unsuccessful push to have a much broader best interest fiduciary standard imposed on the investment management and advice industry. Therefore, as a pre-cautionary rule of thumb, assume the "It Depends" will not necessarily provide recommendations or plans that are best for you.

For all my dislike of the provincially-partitioned investment regulation in this country, I wish the other provinces and the CSA would do what Quebec has done and clear up the ambiguity by statutory imposition of the best interest fiduciary standard.

A source of much un-necessary confusion is the proliferation of so-called financial certifications and designations, some much flimsier than others. Even for the more substantial ones amongst those listed here on the IIROC site, there is a wide range of best-interest related clauses in the codes of ethics or conduct. Trolling through any one of them to know the exact legal ramifications of each code is time-consuming and of uncertain value. Therefore, ignore designations and stick to the above basic approach.

That says who you should be able to trust, legally speaking. But even then, there are a few bad apples, so it is of course necessary to keep a watchful eye and be aware of a gut instinct that says something may be wrong.

As for me, I know where I stand. The Discount brokerage entries show a clear No in both columns. I know I'm on my own. If I mess up my investments, it's all my fault.

Saturday, 14 March 2015

More reasons to buy an annuity

Last post, I came to the conclusion that buying an annuity makes sense given a couple of guiding principles and the contrasting alignment of annuities vs my present stock/bond portfolio against key retirement risks and desired features.

That's not quite the whole thinking, however. Some additional motivations are driving me towards annuities.

Not burdening my children or the state - I want make sure I have enough income throughout my life not to oblige my children to pay for my upkeep. Call me old-fashioned but I also don't want to count on the government to bail me out at age 85 either.

Wish and project as we might with the best financial planning, monte carlo software and projections based on historical data, there's always a residual chance that an invested stock/bond portfolio subject to withdrawals might run out except at ridiculously low withdrawal rates or impossibly long planning horizons. But the slower and safer I withdraw, the more chance the money is never withdrawn, so I don't get to enjoy a lot of it. Which complements my next motivation ...

The inheritance I leave will be what's left over, not any specific planned amounts - I (and my wife) have already given the kids a good legacy by supportive parenting and a solid education that seems so far to be enabling them to make their own way.

Tax increase risk diversification - Governments can get into financial trouble and may look to the "wealthy" to impose extra taxes, spurred on by social activist thinking such as at the Broadbent Institute. Turning assets into an income stream today reduces the risk of future rising taxation on either accounts (like TFSAs, which are viewed in some politically-correct quarters as accounts benefiting the rich despite the opposite reality) or dividends and capital gains.

Living a longer and happier life - It is well-known by insurance companies that people who buy annuities live longer than the average population. Now, it is comforting to me to think that because I am intending to buy annuities, I will live longer. But it may not just be accidental, that people who are in good health figure the odds are good. It may be causal i.e. buy an annuity and it will make you live longer! Moshe Milevsky's superb summary of annuities for the CFA Institute quotes the research on page 108: "... he found that veteran pensions reduced mortality for both acute and nonacute causes of death ... [and then Milevsky quotes Jane Austen to put it in plain talk] ... All of these findings echo the famous Jane Austen quote from Sense and Sensibility (published in 1811):If you observe, people always live forever when there is an annuity to be paid them.
It's called buying peace of mind. Bill Gates or Warren Buffett don't get disturbed when markets go down because they have far more than they could ever need. But for those of us who have managed a relatively volatile stock-bond portfolio for twenty years and who cannot sustain a prolonged period of poor returns, we can relate to the findings Milevsky quotes.

Wednesday, 11 March 2015

My Retirement - Should I buy an Annuity?

Should I or should I not buy an annuity? (An annuity is financial product in which an insurance company, in exchange for a lump sum today, pays the investor a pre-determined cash amount for life.)

Why am I even considering this step?
First, I'm in my early 60s and no longer earning appreciable employment income. Yup, I'm retired and I would rather not un-retire if I can avoid it.

Second, I'm getting CPP but OAS is a few years off. I do not have any defined benefit pension so my investments in various registered plans, a TFSA and a non-registered account are the only possible sources of living expenses for the rest of my life, though at some point I am likely to receive a lump sum inheritance. Probably I am fairly typical of a growing number of Canadians, for whom the comfort of DB pensions providing assured lifetime income is no longer a possibility.

Third, I aim to follow a couple of simple financial management principles that make intuitive sense:
  • Guiding principle #1 - Match spending liabilities with income assets.
To the extent possible I want my various spending needs for food, housing, recreation, health to align with income sources in terms of timing, amounts, regularity and certainty aka riskiness. Grocery money, electricity and property taxes are essentials and must be matched by equally reliable income. On the other hand, I can put off or reduce travel.

This means matching the characteristics of income-producing assets with retirement financial risks and desired benefits, many of which are unique or especially important to the withdrawal phase of investing and to later life. The following chart summarizes the nature of the two main categories of financial products - i) stock & bond portfolios in the various types of investment accounts like RRSPs, RRIFs, LIFs, LIRAs, LRIFs and Defined Contribution pension savings plans and ii) annuities, CPP & OAS and Defined Benefit pensions.
(click on image to enlarge)


The striking feature of the chart is how well the two categories complement each other. Neither ticks a Yes in every box but where one category falls short with a No, the other in almost every case has a Yes. The two exceptions are inflation protection and tax minimization, where each category can only offer partial protection.

The obvious conclusion is that every retiree needs to have some of both types of products, except perhaps for those lucky or wise few whose 70% of final salary fully CPI-indexed DB pensions are more than adequate and who are net savers in retirement.

  • Guiding principle #2 - Take only as much risk as necessary.
Given that my objective is to maintain the lifestyle I have been happy with through the pre-retirement part of my life, if I can see that risk-free income sources will suffice to fund that lifestyle, why should I take any more risk?

Since my present CPP and even including my eventual OAS fall far short of my essential needs, the above considerations naturally lead me to plan for an annuity.

The next steps, for future posts to explore, is to decide:
  • how much to annuitize
  • when - now or later, when I'm 65, 70 or later, or whether to buy today a deferred annuity that only starts paying (how many?) years hence
  • which bells and whistles to buy, like guaranteed minimum payout periods, annual payout increases, death benefits
  • whether to use money from a registered account, which offers a higher payout, or a non-reg / TFSA account, where a prescribed annuity offers a tax advantage

Tuesday, 3 March 2015

Size doesn't matter (in investing)

Small-cap stocks no better than large caps - It is a waste of time to add a separate small-cap ETF or "tilt" to a portfolio since the extra return from small cap stocks can no longer be observed in the USA where it was first named, nor in any other market around the world, as Vitali Kalesnik and Noah Beck write in Busting the Myth about Size.

Worth a tilt - The tried- and still-true sources of equity premiums are market (the basic one that we get when we buy a total market ETF), value, momentum and low volatility, which Jason Hsu and Vitali Kalesnik conclude in Finding Smart Beta in the Factor Zoo. One interesting note they make is that while value and low volatility are amenable to low cost, transparent, rules-based, low turnover investing (such as in ETFs), capturing the momentum factor is best done through active alpha managers.

Avoiding back-tested data mining - There is also a sensible-looking list of criteria for deciding whether some return-enhancing rule discovered in past data is actually an equity premium source / risk factor or just a data mining artifact that will almost surely not work in future:
"
1.    The factor was discovered many decades ago; it has survived numerous database revisions as well as extensive out-of-sample data.
2.    The factor has been vetted, replicated, and debated in top academic journals over decades.
3.    The factor works in non-U.S. countries and regions.
4.    The factor premium does not change materially due to minor variations in the factor definition/construction.
5.    The factor has a credible reason to offer a persistent premium
a.    It is related to a macro risk exposure, or
b.    It is related to a deep-rooted behavioral bias that is present in a meaningful fraction of investors, or
c.    It is related to an institutional feature that cannot be easily changed.
6.     The factor exceeds a more stringent t-stat threshold of 3.5 (preferably 4.0) instead of 2.0 to adjust for data-snooping and other biases evidenced by the recent explosion in factor proliferation."

Tuesday, 3 February 2015

My ETF picking is working better than my stock picking

Michael James' tongue in cheek The Stock Picker's Checklist prompted me to look at one of my accounts at TD where I have bought individual stocks as part of my overall Canadian equity allocation.

On first glance, the screenshot below of my account return against the TSX Composite Index Total Return (which is the appropriate benchmark since the account is entirely Canadian equity holdings and all the stocks, and the holdings of the one ETF, are part of the TSX Composite) makes me look like a rival to Warren Buffett and Charlie Munger.
(click to enlarge)
... but the sudden divergence of the lines around September 2014 made me look a bit closer and the source of the marked difference is the sole ETF in this account, BMO's Low Volatility Canadian Equity fund (TSX: ZLB). ZLB contains much less weight in energy and materials by virtue of its criteria to select low volatility stocks.

The following chart from Yahoo Finance shows ZLB against the TSX Composite and a couple of other ETFs - iShares' XIU, which tracks the TSX 60, and Powershares' PXC, which is a fundamentally-weighted Canadian equity fund. PXC has closely tracked the pattern of the TSX while doing appreciably worse. Meanwhile ZLB works completely differently.
(click to enlarge)





The TD account balance screenshot (edited to remove dollar amounts of my holdings, which unfortunately are nowhere near rivalling those of Buffett and Munger) confirms this. ZLB is about half the holdings and its gain is far ahead of anything else. Its return has dominated the account.
(click to enlarge)






My takeaways:
1) My stock picks so far have been doing about the same - no better but no worse either - than their benchmark. Not much benefit or harm either way.

2) ZLB's low correlation with PXC and the TSX Composite indicates that a portfolio built to include non-cap-weight components (like the Smart Beta described here on my other blog) makes sense. The last three years, market conditions have been such that ZLB is powering ahead. At some point, it will be PXC's turn. All along my portfolio is more stable / less volatile.

Monday, 26 January 2015

Short Selling - Superb "how to" from a pro

Worth reading, even if you have no intention of ever trying to be a short seller - Short Selling: Cleaning Up After Elephants by Guy Judkowski on Seeking Alpha. He describes in understandable, brief yet explicit detail how he did it successfully. It made me realize the exacting, relentless, painstaking effort involved.

Friday, 23 January 2015

CEO Pay - Benchmark this, corporate Canada

The 2015 version of the Canadian Centre for Policy Alternatives report on CEO pay by Hugh Mackenzie revealed a substantial increase in average pay from the year before. The comparison to the pay of employees and all Canadians, who own shares in all these companies through their pension plans, mutual funds ETFs or directly, is shockingly out of whack. Companies justify this through incredibly complex schemes (got to Sedar.com and download a sample Management Information Circular aka Proxy Circular) that basically use peer comparison to benchmark.

So ... let's benchmark this:
  • BBC reports that in 2014 Apple CEO Tim Cook received total compensation of $9.2 million. Apple is the world's largest company (by far ahead of #2 Exxon), with a market cap of $659.21 billion. His pay was 9.2/659210 = 0.0014% of market cap. Cook is not exactly working for peanuts by CEO standards though. in 2013 he earned $73.9 million US, which is about $81.3 million CAD (mostly from stock options), or 0.0123% of market cap.
  • According to the Mackenzie report, the top CEO earner in Canada, Gerry Schwartz of Onex, took in $87.917 million in 2013. Onex's market cap is $7.67 billion. If we apply the Apple Cook percent as benchmark, Schwartz should have earned roughly 0.0014% x $7670 = $107,000 in 2014. Even at 2013 rates for Cook, Schwartz would deserve only $938,000. We'll be watching with high expectations in early April when Onex's 2015 Proxy Circular is filed with 2014 actuals.
Mackenzie is coming at the issue from from an ideologically leftist viewpoint, so those who merely want to invest profitably may want to read investment author and industry insider James Montier's investor-centered case against CEO pay run amok, which he ascribes to a faulty corporate philosophy of shareholder value maximization. One of his conclusions: "
Shareholder’s Lesson
Firstly, SVM has failed its namesakes: it has not delivered increased returns to shareholders in any meaningful way,
and may actually have led to poorer corporate performance!"

Disclosure: I own zero Onex shares and won't be buying any soon, given the pathetic earnings history of the company. I own Apple shares inside the PRF ETF.

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