The battle is joined. Should commodities figure in a portfolio? It is to be expected that there be a big division and difference of opinion between investors with an active strategy trying to beat the market and those with a passive, market index allocation strategy. But commodities seem to be controversial even amongst the passive index asset allocation crowd, in which I count myself.
Pro Commodity
Main proponent: Larry Swedroe, best-selling author and principal of Buckingham Asset Management
Arguments: collateralized commodity future funds provide positive return, that is negatively correlated with both stocks and bonds (i.e. a strong diversification benefit), as well as protection for unexpected inflation, which together are excellent portfolio insurance
Anti Commodity
Main proponents: Rick Ferri, author of several "All About ..." books, and head of Portfolio Solutions LLC investment advisors and managers; William Bernstein, author of The Intelligent Asset Allocator and The Four Pillars of Investing amongst others; Kenneth French, renowned finance prof and researcher.
Arguments: commodities have no real expected return net of inflation and the backtested returns on various commodities indexes are essentially trading strategies, not passive market investments in an index, whose future success in uncertain
The Debate:
Rick Ferri and Larry Swedroe go head to head in a discussion hosted by Hard Assets - The Great Commodities Debate part 1 and part 2
Kenneth French video interview on Yahoo Finance Why Investors Shouldn't Own Commodities
William Bernstein writes on his Efficient Frontier website "On Stuff"
Dimensional Fund Advisors quotes paper by Truman Clark on their website
The Research
Hard Assets Investor lists a half dozen seminal papers on the Hard Assets University page - see the Grad School section which links to free downloads from SSRN. Must read: The Tactical and Strategic Value of Commodity Futures by Claude Erb and Campbell, 2006, which everyone seems to quote. It's almost a book at 61 pages but a very worthwhile couple of hours of slow reading. Around pages 39-40 there is a great general explanation of the beneficial effects of negative correlation, variance and number of securities interacting with regular rebalancing in a portfolio. HAI also has useful primers, interviews, current news.
My Take
Despite his being outnumbered, my reading of Erb and Campbell tells me that I believe more Swedroe's conclusion. Commodity ETFs/ETNs do depart from the purist passive asset allocator model, being essentially active portfolio strategies based on futures (i.e. derivatives) but there is good reason to believe that the diversification return of around 3% will continue and the powerful portfolio risk reduction effect from (most of the time) negative correlation makes them worthwhile. I don't believe in the inflation protection benefit. An allocation of about 5% of my portfolio seems reasonable. So I'm sticking with my holding of DJP, the iPath Dow Jones-UBS Commodity Index Total Return ETN (recently renamed, replacing the AIG reference in the name with UBS).
The Truman Clark paper cited by Dimensional, which seems to have no visibility (or credibility?) amongst the other researchers on commodities, being cited by none of them, seems too impossible to believe - how could there be no reduction in portfolio standard deviation, as it concludes, when negatively correlated commodity assets are added? It seems to be a mathematical impossibility the way covariance works.
Wednesday, 29 July 2009
Tuesday, 28 July 2009
Market Timing Can Work ... If You Wait a Few Decades
Mebane T. Faber shares his intriguing market timing system in A Quantitative Approach to Tactical Asset Allocation on SSRN (original 2006, revised February 2009). His system produced significantly higher compound returns and much lower volatility / standard deviations over many time periods and multiple asset classes (US equities, MSCI EAFE international equities, US REITs, US government bonds and commodities). The intriguing aspect is that the paper was originally published in May 2006 and went through the trial by fire of 2008, during which it performed beautifully and would have protected an investor. Instead of the 37% loss of the S&P500 with buy and hold, Faber's method would have given a 1% gain!
Faber's buy-sell rules are ultra-simple: buy when the month-end price of the asset is greater than the 10-month moving average and sell when it is less, keeping the money in cash until the signal changes. That would have kept an investor in the five asset classes he looked at invested about 70% of the time and generated less than one portfolio turnover per year (i.e. minimal effort and low transaction costs required). It's a system akin to Larry Macdonald's One-Minute Portfolio for Canadian RRSP investors, which also escaped 2008 relatively unscathed with only a 10% decline according to his Dec. 18th update.
The downsides?
Faber's buy-sell rules are ultra-simple: buy when the month-end price of the asset is greater than the 10-month moving average and sell when it is less, keeping the money in cash until the signal changes. That would have kept an investor in the five asset classes he looked at invested about 70% of the time and generated less than one portfolio turnover per year (i.e. minimal effort and low transaction costs required). It's a system akin to Larry Macdonald's One-Minute Portfolio for Canadian RRSP investors, which also escaped 2008 relatively unscathed with only a 10% decline according to his Dec. 18th update.
The downsides?
- Will the future be like the past and will the system continue to work? Fitting a system to past data can be made to work - it is a statistical version of "hindsight is 100% accurate". Faber's worked in 2008, after he had developed the system in years prior, but what about the future? One never knows for sure.
- In strong upmarkets such as the 1990s (Faber is upfront about this in the paper - see Appendix D on pages 39-40 for the S&P500 vs the timing system stats decade by decade), the system underperforms, and can do so by a lot. Could you stand being left behind over the two decades of the 1980s - by 2% annually - and the 90s - by 5% a year? How much return should one sacrifice for disaster crash avoidance? After 2008, many "deferred-retirement" folks might regretfully say Faber's system is worth it. Just because we've had one shock in 2008 and things seem to be on the rebound for now, that doesn't mean we couldn't have another big drop soon (e.g. suppose the swine flu gets deadly in the fall, then as they say, "you ain't seen nothin' yet" for market turmoil).
Wednesday, 22 July 2009
Inflation for Retired Canadians - Some Surprises
Back in May, my post Inflation Ain't What It Used To Be mentioned that inflation for US seniors / retirees has been consistently higher than for the average population by about 0.5% per year. I speculated that Canada might be similar but had no proof. I was taken aback a bit when Stats Can said they had no information on this topic. That's not true. I've now found some.
The May 2005 issue of Stats Can's CPI Review contains a research article Is Inflation Higher for Seniors? by economist Radu Chiru. Its overall conclusion about the period 1992-2004: "...the Consumer Price Index tracked very closely the inflation experienced by seniors as a group". Over the whole 12 years, inflation for seniors was 26.1% versus 24.4% for the Canadian average / official CPI, a difference of 0.11% per year. Apparently, things that cost seniors more or that they buy more of were more or less offset by things that went up less or that they use less. For instance, cable TV was a bigger ticket item for seniors and it went up far faster than most other items, costing seniors more, but tuition went up really fast too, and they pay much less of it.
However, an average can mask divergences - remember the old joke about putting one foot in the oven and the other in the fridge and being comfortable on average? This study's surprises:
Another study published in the December 2006 issue of Canadian Public Policy generally seems to corroborate Chiru's conclusions - Matthew Brzozowski, Does One Size Fit All? The CPI and Canadian Seniors. The abstract says: "... the CPI inflation rate overestimated the average inflation rate faced by Canadian senior households during the 1970s and the 1980s but has accurately measured average inflation for such households during the 1990s."
That comment about the 1970s and 1980s reminds us the future might not be like the past - if CPI previously overestimated seniors inflation, in future it could underestimate the rate by a lot more than the small amount it did between 1992 and 2004. Items that seniors consume in much greater proportion like food, shelter and health care compared to the general CPI weighting (see Radu paper for breakdown) are the ones to watch in balance with the ones used a lot less, like cars, alcohol/tobacco and recreational equipment.
The May 2005 issue of Stats Can's CPI Review contains a research article Is Inflation Higher for Seniors? by economist Radu Chiru. Its overall conclusion about the period 1992-2004: "...the Consumer Price Index tracked very closely the inflation experienced by seniors as a group". Over the whole 12 years, inflation for seniors was 26.1% versus 24.4% for the Canadian average / official CPI, a difference of 0.11% per year. Apparently, things that cost seniors more or that they buy more of were more or less offset by things that went up less or that they use less. For instance, cable TV was a bigger ticket item for seniors and it went up far faster than most other items, costing seniors more, but tuition went up really fast too, and they pay much less of it.
However, an average can mask divergences - remember the old joke about putting one foot in the oven and the other in the fridge and being comfortable on average? This study's surprises:
- seniors renters (22.7% inflation) came out much farther ahead than home owners (28.1%); shelter is a much bigger chunk of spending for seniors; mortgage costs are not really to blame (few seniors have mortgages and rates were low) so the likely culprit is zooming property taxes! I note that the "renters are winners trend" has continued unabated as the latest annual CPI shelter costs show howmeowner costs racing upwards while rental costs crawl up, way below the overall inflation rate.
- the lowest income quintile (20% of the population) seniors actually experienced lower price rises than the highest income quintile (maybe because they would mostly be renters?) - amazing, the poor became relatively richer and the richer became poorer!
- where you live makes a big difference - Alberta was the inflation champion of Canada with seniors CPI going up 32% and official CPI 30.4% in the 12 years and a quick scan through the CPI by province tables shows that trend continued through 2008. The good places with inflation 4% lower than the Canadian average (mainly due to energy costs, according to the Radu study were Quebec and Newfoundland / Labrador. Quebec had the smallest gap between official and seniors CPI. Through 2008, Quebec was still tracking below Canadian average CPI. If only income taxes (which are not part of the CPI numbers - the Your Guide to CPI says it so eloquently: "Income taxes are excluded because it is impossible to associate
a specific amount of tax paid with a specific quantity of services received." - i.e. one cannot tell how much tax is wasted) were lower in Quebec, it could be declared Canada's retirement heaven.
Another study published in the December 2006 issue of Canadian Public Policy generally seems to corroborate Chiru's conclusions - Matthew Brzozowski, Does One Size Fit All? The CPI and Canadian Seniors. The abstract says: "... the CPI inflation rate overestimated the average inflation rate faced by Canadian senior households during the 1970s and the 1980s but has accurately measured average inflation for such households during the 1990s."
That comment about the 1970s and 1980s reminds us the future might not be like the past - if CPI previously overestimated seniors inflation, in future it could underestimate the rate by a lot more than the small amount it did between 1992 and 2004. Items that seniors consume in much greater proportion like food, shelter and health care compared to the general CPI weighting (see Radu paper for breakdown) are the ones to watch in balance with the ones used a lot less, like cars, alcohol/tobacco and recreational equipment.
Friday, 17 July 2009
Mind of the Turtles book winner - slickvguy
The draw for the free copy of the book Inside the Mind of the Turtles has been done and the winner is slickvguy. Congratulations to you!! Contact me via the email link on the side of the blog with your mailing address and the book will be off to you right away.
Wednesday, 15 July 2009
RRSPs and the Government's Secret Tax Weapon
Jonathan Chevreau posted today on a BMO Retirement Institute survey finding that boomers expect to receive huge amounts of inheritance money to pay for their retirement.
A quick skim of the Passing it on study reminded me that in the case of inheritances "what you see is not what you will get". The example box on page four of the report shows how an estate worth $350,000 at death can be chopped in no time down to $223,500. That's even before lawyer and executor fees, or probate fees (taxes) get taken out. The reason is that instead of inheritance taxes Canada has a nifty little tax rule called deemed disposition, whereby upon death a person is considered to have sold all property at fair market value and to have cashed in all registered plans like RRSPs, RRIFs, LIRAs, LRIFs etc. There is an exception that a spouse can transfer the registered plans into his or her name without tax being triggered, but eventually the spouse too will die. Sooner or later there will tax to pay and since everything enters the person's income all in the same year, for almost everyone that will mean falling into a much higher, if not the highest, tax bracket.
Think about it, how many people die penniless, their registered plans depleted to nothing? You and I may withdraw RRSP money during retirement at lower marginal tax rates than while we were working but it is pretty sure that come death, our estate will be paying top rates. The government will end not only recouping its tax deductions but may well end up with more tax! That's the secret weapon. If you are dead, you may not care about paying unfairly high taxes on your estate and it is certainly difficult to complain at that point, or to vote against the government.
I've tried getting stats out of Stats Can and the Canada Revenue Agency about the extent of the issue - e.g. what is the average size of registered plans at death - but none seem to be readily available. (An indicator that this issue is real is suggested by Stats Can's table Private Pension Assets of Family Units, which shows that elderly families in 2005 had a median of $186,000 in private pension assets. Another table shows that the net worth of families 65 and older was a median $303,000, of which maybe half might be a tax-exempt principal residence, but the rest would mostly be in some form of taxable savings.) Better it not be too well known, I guess. People might get upset. The problem may get worse over the years as the decline of defined benefit plans means RRSP-type savings become more and more important.
This issue is one reason I am using my TFSA first since that account is "tax pre-paid" for contributions and any gains are tax free, even at death. It is also a reason to take money out of the RRSP when my tax rates are low.
Finally it is a good reason to donate money to charity since the tax credit effectively would mean no tax to pay even at the top marginal rate on the donated amount. Maybe that's why significant numbers of seniors are planning to donate parts of their estate to charity, not to bequeath it all to family.
A quick skim of the Passing it on study reminded me that in the case of inheritances "what you see is not what you will get". The example box on page four of the report shows how an estate worth $350,000 at death can be chopped in no time down to $223,500. That's even before lawyer and executor fees, or probate fees (taxes) get taken out. The reason is that instead of inheritance taxes Canada has a nifty little tax rule called deemed disposition, whereby upon death a person is considered to have sold all property at fair market value and to have cashed in all registered plans like RRSPs, RRIFs, LIRAs, LRIFs etc. There is an exception that a spouse can transfer the registered plans into his or her name without tax being triggered, but eventually the spouse too will die. Sooner or later there will tax to pay and since everything enters the person's income all in the same year, for almost everyone that will mean falling into a much higher, if not the highest, tax bracket.
Think about it, how many people die penniless, their registered plans depleted to nothing? You and I may withdraw RRSP money during retirement at lower marginal tax rates than while we were working but it is pretty sure that come death, our estate will be paying top rates. The government will end not only recouping its tax deductions but may well end up with more tax! That's the secret weapon. If you are dead, you may not care about paying unfairly high taxes on your estate and it is certainly difficult to complain at that point, or to vote against the government.
I've tried getting stats out of Stats Can and the Canada Revenue Agency about the extent of the issue - e.g. what is the average size of registered plans at death - but none seem to be readily available. (An indicator that this issue is real is suggested by Stats Can's table Private Pension Assets of Family Units, which shows that elderly families in 2005 had a median of $186,000 in private pension assets. Another table shows that the net worth of families 65 and older was a median $303,000, of which maybe half might be a tax-exempt principal residence, but the rest would mostly be in some form of taxable savings.) Better it not be too well known, I guess. People might get upset. The problem may get worse over the years as the decline of defined benefit plans means RRSP-type savings become more and more important.
This issue is one reason I am using my TFSA first since that account is "tax pre-paid" for contributions and any gains are tax free, even at death. It is also a reason to take money out of the RRSP when my tax rates are low.
Finally it is a good reason to donate money to charity since the tax credit effectively would mean no tax to pay even at the top marginal rate on the donated amount. Maybe that's why significant numbers of seniors are planning to donate parts of their estate to charity, not to bequeath it all to family.
Thursday, 9 July 2009
Book Review and Giveaway: Inside the Mind of the Turtles by Curtis Faith
Risk: exposure to the consequences of uncertainty.
Using the above definition, stock market trader and entrepreneur Curtis Faith describes how he thinks about and handles risk, both in the stock market and in life. The book does not deal with the technical aspects of risk like probability and correlation. Instead it focuses of the psychological and behavioural and offers seven general rules for taking on the appropriate amount of risk: 1) overcome fear; 2) remain flexible; 3) risk the right amount; 4) prepare to be wrong and to change course; 5) actively seek reality before and especially after making a decision; 6) react quickly when reality changes; 7) focus on making the correct decision, not the outcome.
Few would dispute the list and indeed, I could only agree with it despite my own reticence to engage in active trading such as that practised by Faith. Each principle is clearly and entertainingly explained through stories and examples from the author's own experience. There are many quotes from famous people that summarize the ideas with wit and charm. The book is an enjoyable and quick read at only 200 pages.
The idea "appetizers" were excellent but I would have wanted more of the "main course", meaning direct explanations of how to shape one's own mind to properly handle risk. After explaining how fear works, it is not enough to say "just do it, be brave". There is a bit of advice - start small and work up to get familiar with how the mechanics work. But the method for dealing with the biggest and hardest fear - irrational, emotional fear that is so detrimental to investors in times of markets crashes - is only described. I hate those questionnaires which assume that a person's current risk aversion level, which is often mainly based on irrational fear, is correct and appropriate. The thesis of this book that one should embrace and welcome appropriate risk, is one with which I wholeheartedly agree. I only wish Faith had gone a little further in telling us how to overcome fear and in providing more detailed practical advice on how to achieve the other principles. There is some of it, just not enough. What we need is the equivalent of Peter Block's classic step by step guide called Flawless Consulting.
Nevertheless, I found value in the book, in particular, the reminder to continually seek confirmation that an investment decision is going the way I thought. Last Fall, for instance, I much reduced my holdings in US investments on the expectation that the US market would remain muted for years and that the US dollar would weaken against the CAD. So far, that still seems to make sense but I pay attention whenever anyone comments on the subject.
In addition, I liked the author's support of diversification to control risk and his exhortation that people should take control of their own fate and not leave things in the hands of supposed experts.
Faith also offers opinions on how the education system, corporations and governments should foster taking more risk in order to ensure continued prosperity for the USA. It's time for you to get into politics, Curtis!
My rating: 3.5 out of five stars.
Giveaway: The publisher McGraw Hill has graciously provided me with a copy of the book to give away to blog readers. If you want to be in the draw for the book, submit a comment below under a unique name (i.e. not Anonymous). The giveaway closes at midnight Thursday July 16th. I will then do a random draw and announce the winner on the blog, asking the winner to provide me with a name and mailing address by private email. The information will not be used for any other purpose. For those so inclined, say in the comment whether you think people tend to take on too little or too much risk investing.
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