Tuesday, 23 October 2007

Q&A on IFA, DFA with Michael Hill

Readers of this blog may be aware that I consider the website of IFA Canada to be one of the best for the quality and quantity of investment information, a mix of financial theory and practical application of significant usefulness to the DIY investor.

At my invitation, Michael Hill of DeThomas Financial, who also represents IFA Canada, has written responses to my questions on IFA and DFA. Note that I do not own any DFA funds, nor do I have any business relationship with DeThomas or IFA. I just borrow their ideas, which they willingly offer to everyone - even their competitors(!) - as you will read below.

1) What is IFA Canada and what is the difference or relationship between IFA, Dimensional Fund Advisors (DFA) and De Thomas Financial? What about other financial advisors such as
Milestone Financial who also say they offer DFA funds?

IFA Canada is an educational company which provides information, data and portfolio allocations and design as well as a proprietary Risk capacity survey which allows Canadian investors to fully understand the power of index investing. IFA Canada's mandate is to "Change the Way Canadians Invest." This is accomplished by providing peer reviewed, empirical evidence showing the results of index based portfolios. The Risk Capacity Survey further refines the investor’s knowledge in directing them to the proper portfolio allocations. Although Index Funds Advisors Canada may provide data, information, and content relating to investment approaches and index mutual funds, you should not construe any such information or other content available through the Site as legal, tax or investment advice. You should not consider any information on www.ifacanada.com as an offer to sell or solicit for sale any securities listed or mentioned on the website. Securities may only be sold by qualified licensed broker/dealers in Canada.

There is a distinct difference between IFA Canada, De Thomas Financial and Dimensional Fund Advisors (DFA). IFA Canada as described above is an independent company separate from De Thomas Financial and DFA.

De Thomas Financial Corp. is a licensed mutual fund dealer in BC, Alberta, Ontario and soon Quebec. De Thomas Financial acts as a Certified Broker/Dealer given authority to use IFA Canada's portfolios for their clients. IFA Canada has criteria for Certified Broker/Dealers and all dealerships in Canada are eligible to use the IFA portfolios should they agree to fulfill the obligations of a Certified Broker/Dealer. http://www.ifacanada.com/brokerdealers/index.asp IFA Canada does not charge investors a fee or commission for use of its data or Index folios. Certified Broker/Dealers agree to pay a monthly fee to IFA Canada for use of their portfolio allocations and data. These costs are fixed and NOT passed on to clients or investors.

DFA is a provider of index mutual funds for most IFA Index folios. Dimensional Funds Advisors Canada is the manager, trustee, principal portfolio advisor, and promoter of the funds, while Dimensional Fund Advisors (US)acts as sub-advisor for each of the funds.

Other dealerships in Canada many offer DFA funds, but only Certified Broker/Dealers may use the IFA portfolios legally for their own investor clients. The advantages of using the IFA Portfolios are many:

· No minimum limits (as imposed) by DFA on investments per fund. (DFA and others have a $10,000 minimum investment per fund)

· 80 years of back tested data showing the advantages of proper asset allocation using index funds

· Lower MER costs per fund as per exclusive IFA Canada portfolio allocations then other retail Brokers (see web)

· None, absolutely no trading costs for purchases, sales, rebalancing or withdrawals.

· Constant maintenance and auto rebalancing to original IFA portfolio allocation.

· Reduced fees and tax considerations.

· All fees for non-registered accounts completely tax deductible.

· Lower minimum to invest $100,000.00 at a cost of $1,000.00 per year not $5,000.00 annually.

There are other dealers in Canada who sell DFA funds but nobody in Canada has compiled an 80 year data base of 20 index portfolios specifically matched to an investor's Risk Capacity.

2) Are the funds offered by IFA mutual funds or ETFs?

Again, IFA Canada does not "offer" any investments; the investments used to build the portfolios are index mutual funds not ETFs. We chose DFA's index funds for a number a reasons, value, small cap, reduced tracking error and low cost, but also because we would be able to compile and execute the portfolios with no trading costs. ETFs have trading cost each time one buys, sells or attempts to rebalance, the IFA Index folios are designed with no trading fees- over time this saves clients money and keeps them in line.

3) Why do you think IFA's offering is superior to other investment possibilities, whether mutual funds or ETFs? Your website says IFA focuses on passive investing using index funds - how is this different or better than ETFs?

There is a distinctive difference between Index funds and ETFs, and it is for these reasons the IFA portfolios are built with index funds.

· ETF's track a particular index as closely as possible if not almost exactly, but of course there are costs involved. MER's range from .17 to .25 or more plus it costs each time to trade.

Aside from these costs, perhaps more important is a concept called tracking error. You may look here for a detailed description, but suffice to say tracking error costs investors between 0.75 and 1.5% per year.

Another reason for Index Funds over EFTs is securities lending. Index funds such as DFA lend securities out of their holdings and earn income for the unit holders from these transactions . This can amount to 0.25 to 0.50% per year.

The largest reasons though we use DFA funds are that they are tilted towards value and small cap, when all other index funds or ETFs are not. (This is all based upon the Fama/French Work). The chart below provided by DFA will help in understanding why we use their investment products to build the Index folios.

Dimensional Management Compared to Traditional Portfolio Management



Management and ETFs

Assumes markets work.

Assumes markets don't work.

Assumes markets work with no liquidity cost.

Captures specific dimensions of risk identified by financial science.

Attempts to beat the market through security selection and market timing.

Allows commercial benchmarks to dictate strategy.

Minimizes transaction costs and enhances returns through portfolio design and trading.

Generates higher turnover, transaction costs, and taxes due to speculative trading.

Accepts high transaction costs and turnover in favour of tracking.

4) What are the fees charged individually and in total by DFA, IFA and De Thomas?

First, all returns posted on IFA Canada are net of fees, meaning all MERs, management fees, auxiliary fees and advisor fees are subtracted before returns posted. The fees breakdown this way:

· IFA fees to investors. 0.0%. IFA charges no fees to investors as it is not a dealership or advisor. IFA receives fees from Certified Broker Dealers for use of the data.

· Index Fund fees (DFA etc) range from 0.25 to 0.70% - See http://www.ifacanada.com/indexfolios/indexes/#CC

· The De Thomas Fee 1.0%

5) What does the client investor get for each set of fees?

What do they get?

· IFA: superior and vast investor education

· DFA (etc):, Custodial services, fund access and research, record keeping, legal and tax filings, audit and valuation.

· De Thomas: access, support, brokerage, portfolio development, trading and research and distribution reporting, planning and more.

6) Is it true the minimum account size you will take is $500,000? Why so much?

No, $500,000.00 is not our minimum investment level. To complete an IFA Canada Index folio, the minimum is $100,000.00, yet we realize and understand that not all investors have $100,000.00; therefore, we have developed the Easy Chair Portfolio using the same concepts as IFA Canada, but with less administration for accounts beginning at $25,000.00. The Easy Chair website is not yet completed but when ready we will send you a link. The portfolios are complete, and we are accepting investment, but the website and brochures are not ready.

7) Any suggestions for investors with smaller portfolios?

See #6 above.

8) Does IFA / De Thomas handle all types of accounts, taxable, RRSP, LIRA etc and if so does this change the asset allocation?

De Thomas Financial is a full service broker dealer. We have a great deal of experience with all types of accounts including but not limited to RRSP, RRIF, LIRA, LIF, Open Cash, RCA and IPPs. In fact, De Thomas Financial has just reached an agreement with Canadian Western Trust and West Coast Actuaries to provide the IFA Canada portfolios for IPP (Individual Pension Plans). The purpose for this is to create in Canada the most efficient, low cost and transparent IPP. In fact, IPP investors can now save over $20,000.00 or more per year on their IPP plans. Yes it does make a difference in the allocations as each plan type has a different goal, income, savings, tax deferrals, pension building and income splitting.

To add to the answer- Yes it makes a difference in the type of account, in particular whether the account is an open cash account or a registered account. We like to treat the entire portfolio as one entity, meaning that all accounts would be looked at as a whole and allocated across all investments as if they were one portfolio, but sometimes this is not possible as in withdrawal accounts (RRIFs) or open accounts since taxes will play a large role. For open accounts we like to have a higher equity portion and in registered accounts more of the fixed income, since they are non-taxable. We also attempt to rebalance open cash accounts with new capital rather than sell then buy as new capital allocations do not create taxable events and sells and buys do. Thus if an account had too high a weighting in Emerging Markets for the risk capacity they need, we may deposit into all other funds except EM to rebalance the account and thus avoid a taxable event.

In general each account does not change the allocation of the overall plan, but may change to allocation to each type of account. Some clients find it easier to just have a similar account allocation in all plans suited to their risk capacity.

9) Why has DFA/IFA structured all its portfolios on the basis of geography and not, for instance, sectors such as financial, industrial, mining etc?

We are asked frequently about geographical allocation verses sector allocation. Our view and the view of IFA Canada, DFA as well as the empirical data suggest that global indexing and sector investing are very similar. Consider for a moment the TSX. If, and it does, our Core Index covers the entire universe of the TSX then we will have:

· Financial

· Mining and Minerals

· Industrial Products

· Consumer Products

· Agriculture

· Other (Energy, gold, real estate, income trust, health care etc.)

US and International investments have the same outline and thus by allocating on a Geographical basis we do cover each sector. What we will not do is overweight or underweight a sector in hopes our guess is correct.

10) Why do Canadian Index Folios contain a significant Canadian equity component while those of the
US site for US investors don't have that? Wouldn't financial theory suggest that the optimal proportions of any portfolio be the same world portfolio according to market value?

The Canadian content has been zeroed in on because of its higher than world capitalization content and a lack of disclosure in the IFA (US) portfolios but this apparent disparity has been accounted for. I say apparent because Canada is represented in the IFA (US) portfolios via (International, Small Cap and Value). In the USA, DFA included Canada as foreign whereas here (Canada) we have segregated Canada out as a separate "Core" holding. We (DFA, IFA and others) have noticed that each world area of portfolio development has a "home bias", that is a bias towards having assets based in local currency and in local surroundings. Canada is no different. We looked at the relationship between the TSX and the S&P 500 and found a correlation of 89%. Given this and the home bias which exists, we allocate only up to 20% to Canada in lieu of a greater US content to which IFA (US) has. If one accepts the premise of "North America", then the world and our portfolios are in line with world capitalization.

11) Does IFA/DFA do any hedging of its foreign equity funds? What is the logic for the policy followed?

No, DFA does not hedge currency except for the fixed income investments. Exchange rates are notoriously difficult to forecast. Efficient-market research conducted on exchange rates has found the same random walk phenomenon also occurs in interest rates, stock prices, and many other capital market instruments that are priced by competitive forces in a free market. Furthermore, there is no reliable evidence to suggest that the expected currency return is anything other than zero. Currencies don't produce anything; and although they fluctuate relative to each other, the fluctuation is unpredictable.

All currencies, by definition, can't go up and down at the same time, so the concentrated portfolio of currencies in this example is effectively fully hedged; to do otherwise defies the concept of diversification, especially when you consider the impact foreign exchange rate fluctuations have on the client's overall wealth management goals and corresponding financial needs. In other words, clients consume imports, they travel, and their financial needs are affected in several other ways by foreign exchange rates.

Here are the following key points as to why:


By definition, foreign exchange rates are a zero-sum game, so currencies have a zero expected return.


There is no evidence that foreign exchange rates can be reliably predicted.


Diversification works whether we like it or not.


Maintaining discipline, as always, is a key ingredient of a long-term, successful investment experience.

12) The general investing background information on IFA's website is incredibly detailed and useful. Probably most people who become your clients don't even read a fraction of it, while those who do are probably do-it-yourselfers like me. I really love the website, but aren't you worried you are giving away the shop?

Are we worried we are giving away the shop? Sometimes, but in reality no, we are not giving away the shop. The data, studies and theories exist independent of IFA Canada and thus the shop was never ours to give away. To more fully address the question, investors will fall into three categories in no particular order:

A. DIYs such as yourself.

B. Those who need help, but know the industry is in conflict with them.

C. Those that need help, but don't know about what.

By setting up IFA Canada in the manner in which we have, we are "giving away the shop" but we are resolved that investor education is the most important goal. If any of the above groups learn from IFA Canada then we have accomplished our first priority. If they need or want help our Certified/Broker Dealers are there to provide low cost, high level help in developing their risk adjusted Index folio.

There is one other group using the IFA Canada.com site and this helps to achieve our goal, but in a more round about way. 10-15% of investors are other investment advisors, managers or sales people attempting to figure out what we are doing. If they take our data and use it with their clients so be it. They are helping to educate investors and that is our goal. If the really believe and understand then they may wish to join us rather then try to copy us.

13) Your risk capacity survey on the website includes questions on investment knowledge and reactions to market swings/drops. I presume the implication is that if the investor is ignorant and nervous, he/she gets shunted into a low risk portfolio, which may not be able to meet the investor's long term goals. Shouldn't financial advisers be more like doctors, telling people to take their medicine as their health demands, not as the they feel?

Wow, another great question to which a new thesis could be written. The full answer is here http://www.ifa.com/book/book_pdf/10_risk_capacity.pdf but for purposes of the Q and A, I will outline the theory for our Risk Capacity Survey. There are 10 dimensions of risk which have been identified by theorists and academics. Five have to do with portfolio risk and five with the particular investor attempting to choose a portfolio in which to invest. (Investor Capacity) The five IFA Canada are most concerned with are Investor Capacities. These capacities are time, knowledge, attitude, income and net worth. Your question deals with attitude. You ask if some are ignorant or nervous if they are shunted to a low risk portfolio and that is just not so. The attitude dimension attempts to assess the aversion to risk an investor has, their ability to stomach inevitable declines with the knowledge that risk is the currency returns are purchased with. While a low attitude towards risk will move one down the scale from 100, it only amounts to a small % move and not a full out drop to a lower level. To use your analogy of a doctor, consider a person who has an aversion to needles or cannot swallow large pills. Does the doctor tell them to "do as the feel"? No, they will work out solutions based upon knowledge and the other information gathered to diagnose and create an environment which allows the long term goal to be met, while still allowing the patient to "feel good". Perhaps the pill is broken down, or the needle given in smaller doses over time. It may not be perfect, but two greatly needed goals are met.

1. The patient gets what they need and

2. They do feel good about what they needed and the way it was delivered and become open to new concepts and ideas that they were afraid of before.

Michael's titles and contact details:

Michael J. Hill, CIM, CFP mjh@dethomaswindsor.com
President IFA Canada

De Thomas Financial Corp. (Windsor)

Visit us at www.dethomaswindsor.com
Ph 519-973-5719
Fax 519-973-1845

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