Cap-Weighting Problem - the Market Overpays for Growth (and by a lot)

Two recent fascinating papers in the Journal of Portfolio Management - Clairvoyant Value and the Value Effect and Clairvoyant Value II: The Growth/Value Cycle written by Robert Arnott, Feifei Li and Katrina Sherrerd at Research Affiliates - effectively knock the "wisdom of the market" in pricing stocks. The papers take a time-traveling investor back to 1956 and give him perfect powers of foresight (thus the word clairvoyance in the title) to know exactly what actual cash flows, mainly dividends but also buyout premiums upon takeovers, the companies of the S&P 500 would have distributed from 1956 to the present day (1956 was chosen because that is when the S&P data starts). The reasoning is that a company is ultimately only worth what it gives back to an investor. A 1956 investor with perfect knowledge of the future (at least up the present) would only have been willing to pay the discounted net present value of the cash flows, which includes the price today as the best available terminal value. The second paper examines whether the 1956 start date somehow was unique. It was not - in the long term of 20 or more years the market is always shown to have overpaid in terms of realized value.

Note that the authors all work at Research Affiliates which sells its fundamental indexing methodology for weighting stocks in a portfolio, claiming this this does better than cap-weighting (and which, to give full disclosure, I too am convinced is a better method, to the extent of switching from cap-weighting to such investments myself). Unless they have fudged the numbers, which I doubt, and unless their reasoning of using discounted actual cash flows to establish realized value is wrong, the results must be accepted.

Some of the results (using JPM page numbers in the pdf):

• the market consistently picks out which companies will grow faster, better even than a strategy based on weighting on company size fundamentals, but the market really overpays for that growth - by about 50%! (p.24, paper 1)
• this conclusion holds for the vast majority of starting years from 1956 forward - for 20-year forward views of future cash flows, only in the three years 1964-66 did the market underpay for growth stocks (those defined as having multiples of metrics like Price/Earnings, P/Sales, P/Dividends, P/Book value)
• but, "It takes a long, long time for the market to correct pricing errors relative to Clairvoyant Value, because Clairvoyant Value cannot be known for a long, long time." (Clairvoyant Value is the value the prescient investor would have been willing to pay) (p.148, paper 2)
• the over-payment for growth stocks is the same whether the company is large or small (p.149, paper 2)
• the spread for over-payment is getting worse in recent years, not better (p.149, paper 2)
• a portfolio based on the economic size / fundamental weighting of companies doesn't do nearly as well as the portfolio based on clairvoyance, not a surprise given that the clairvoyance value is based on perfect foresight of future cash flows, but it does substantially better than a portfolio based on cap-weighting (p.151, paper 2); the annual return difference of company size weight vs cap-weight is 1.3% according to exhibit 4, paper 2
• "... a Cap Weighted portfolio puts the majority of money in stocks that subsequently prove to have been overvalued." (p.155, paper 2)
• the amount of overpayment for growth stocks and underpayment for value stocks has varied considerably through time i.e. there have been bubbles! When the gap between growth and value is the highest, that's the time to invest in value stocks since their returns will be much better in the subsequent time. The converse is true too - when there is a very small gap between value and growth, it is time to buy growth stocks since they are destined to do much better in the for some time following. (pp.155 and 156, paper 2)
  

To me, it all adds up to more evidence against cap-weighted indexing as an investment strategy. Put your money in a cap-weighted index and you will suffer long-term under-performance compared to RAFI or other non price-biased portfolio selection methods. It is a shock for those who believe that the market is on the whole right to learn that the market for the past 50+ years has been over-paying for growth stocks in a chronic, virtually continuous, general, excessive and non-accidental manner. And, it seems to be getting worse, not better. Caveat emptor.

Beware the M2 Credit Card

I got caught out! Here is what I learned the hard way about credit cards and interest charges on late payments.

Mea culpa, through simply not paying attention, I was a day late paying the full balance. Of course, that means interest is charged and not just for the one or two days that payment was late but for the whole time since the purchase date up to the payment date. That hurts, especially considering the usurious interest rates (mine is 19.5%) charged by the card companies, but hey it was my fault. Note to lawmakers and regulators - why is it impossible to set up a pre-authorized chequing payment for the full card balance on the due date so that late payment charges cannot happen at all?

What really aggravates is the gratuitous punishment applied by M2 type credit cards. Read this excerpt from a typical cardholder agreement (in this case a TD Visa card):

"You will lose your interest-free status on all Purchases and fees if we do not receive payment in full of your Balance by the Payment Due Date shown on your current statement. We will then charge interest on all Purchases and fees that appear on that month’s statement as well as all new Purchases and fees. Interest will be charged on the amount owing to us from the transaction date until that amount has been paid in full."

In other words, those words I highlighted in red mean that not only do you get dinged for the purchases on which you missed the payment, but also for purchases afterwards during the next billing period and until you pay the next full statement amount by the due date. Nasty! It's akin to being stopped for a speeding ticket and then being given another ticket for stopping in the wrong place on the roadway.

It does not help, once you know you have missed the payment date, to pay extra to cover the interest on the late payment. That does not stop new interest being applied. If you have paid late, the only fix is to stop using the credit card for the next billing period, or perhaps to make one tiny purchase on the card so that you have something to pay off in full, on which you will be charged a small amount of interest for sure but that will get you through the punitive cycle at minimal cost.

Which cards apply this crafty (if it took an hour on the phone for the Visa customer service rep to herself find out how this works and to explain it to me, what hopes does a consumer have to understand what they are getting into?) and nasty method, you ask? Pretty well all of them is the answer. The Financial and Consumer Agency of Canada publishes detailed comparison tables of all the credit cards here. In the table, look for the code M2 in the column Grace Period on New Purchases. All the major banks - TD, Royal, BMO, Scotia, CIBC - apply M2 across the board, except for National which uses the much fairer M1 method. The M1 method, as another excellent FCAC publication Getting the Most from Your Credit Card explains here, only applies interest on the late payment purchases and not on subsequent new purchases. M1 cards are also available from some other smaller banks and credit unions so check the tables and shop around. Another note to lawmakers and regulators - when next you think of ways to reform credit card practices I'd like to see the M2 method banned.

Interestingly, when I called to ask about the second set of interest charges on the new purchases (the M2 stuff), the TD Visa customer service rep very quickly cancelled the second interest charges citing the fact that I normally pay off the card balance in full. So, if you are in the same situation give them a call and ask.

Update Nov.1, 2010 - Good news. Apparently M2 has gone away - according to the Financial Consumer Agency of Canada website, footnote 5, M1 applies to all cards across Canada as of Sept.1, 2010.

Source for Discount Broker Comparisons

Worth noting .... IndependentInvestor.info has published an article that pulls together various official media sources of recent discount broker comparisons and ratings. There is an especially useful link to a pdf table compiled by a finance student Charles Martineau which contains direct links to the specific sections of the broker websites to get the detail on such things as commissions, account charges, dividend reinvestment policies etc.

Missing from the Martineau pdf are some other comparison factors that are significant like the ability to hold USD foreign currency in registered accounts and/or the implicit commission rates charged by brokers who do not allow foreign currency in such accounts and; for ETF investors, the ability to DRIP, which may not work as easily as for ordinary shares, as I posted about in DRIPing ETFs in Canada.

The information makes clear that there may not be any single "best" broker for everyone since what is important to some, like low trading commissions, may not count for much to someone who needs good customer service or the best DRIP program. Or, as Independent Investor notes, it may that a broker like TDW has the best choice of fixed income. Indeed, the ratings surveys by the Globe and Mail, JD Power and Surviscor come up with quite pronounced differences in rankings.

Book Review: The Fundamental Index by Robert Arnott, Jason Hsu & John West

Ground-breaking ideas with hugely valuable investment potential combine with a critical gap, but it is a must-read for every individual investor. In a revised edition with the additions and fixes that I suggest below, I daresay this would be the most important investing book since Burton Malkiel's A Random Walk Down Wall Street.

The Fundamental Index is a way of forming an investment portfolio that weights its component stocks not according to the traditional market capitalisation of each stock but according to a combination of the size of sales, cash flow, book value and dividends of companies, which the authors term as being their economic weight.

The book claims that investing by the Fundamental Index (in capitals because the authors have trademarked the term through their company Research Affiliates, which commercializes the resulting RAFI indexes) will produce higher long term returns than investing using passive cap-weighted indexes such as the S&P 500. That claim is backed up in convincing fashion with actual past returns going back to the 1960s, with discussion of the flaws of cap-weighting and its under-lying assumptions and with rebuttal of the often-strident criticisms thrown at the method by some quite-distinguished (like an economics Nobel winner or two) academics.

Along the way, there is a very useful discussion of how to estimate future stock returns, as well as results for developed and emerging market countries, including Canada, all but one of which (Switzerland) showed Fundamental Indexing outperforming cap-weighting. The authors address what kinds of situations (bubbles aka stock market returns over 20% per year) and changes (pricing errors do not happen in the first place or do not get eliminated / no reversion to the mean; market becomes systematically and persistently pessimistic and under-prices future actual fair value).

The first and lesser flaw in the book is that their rebuttals of criticism are framed in general terms and not at specific published critical writings, most notably that of André F. Perold, Finance Professor at Harvard, in Fundamentally Flawed Indexing. From reading and re-reading that paper and then various passages in the book, it appears that the whole foundation of the Perold criticism, never mind the mathematical elegance of the "proof", lies in the critical assumption which the Fundamental folks deny, stated best in the book's Foreword by their Nobel winning supporter Harry Markowitz: "... classical finance theory is largely built on a foundation of efficient markets under CAPM assumptions, which implies that future prices are randomly distributed around current price. We are subtly changing this assumption. In fact, we are assuming the opposite: current price is randomly distributed around fair value."

The major gap is the too-brief and incomplete discussion of how the Fundamental Index works in practice - considering expense ratios, trading costs, tracking errors and taxes of actual ETFs or mutual funds that apply the concept. An index is not an investable product that an investor can buy. If the practical costs and performance drags outweigh the performance gain there is no advantage for an investor. (My own limited examination of US Fundamental ETFs suggests that there is still about 1% per year difference.) Related is the fact that an investor who seeks to diversify and take advantage of the value and small cap effects must buy and juggle several more funds so a portfolio comparison of costs would alter the calculation again. Finally, the correlation of Fundamental Indexes with other asset classes needs to be laid out so that investors can see how to fit them properly into a portfolio. Adding this material in another edition would fully earn the book its sub-title "a better way to invest".

I used to believe, like the current critics, that Fundamental indexing was nothing more than a value tilt. Well, the book has changed my perspective. It's a value tilt with differences - first, it includes all stocks from the whole market all the time, instead of separating Value from Growth and second, it dynamically adjusts the amount of tilt according to the gap between stock market prices and the fundamental factors (e.g. refusing to follow bubbles on the way up).

The text reads smoothly, there is lots of illustrative material in helpful charts and tables (and no math). Well footnoted and referenced, it provides the background and under-pinning references to sell the case (but not the articles critical of Fundamental Indexing).

The Research Affiliates website has other Fundamental Index publications a link to other reviews of this book here.

Because of its missing pieces, the book earns 4 out of 5 stars. For its ideas, the book earns 6 out of 5 stars, for an average of 5 out of 5.

Globe Mentions this Blog, ahem!

It was very pleasing and flattering to note the mention today of this blog as one of the best investment blogs in the national media leader Globe here in its online edition. It's amusing that the writer of the number one Canadian blog of all, Ram of Canadian Capitalist, was one of the panel doing the selection. As they say, thanks for the mention. Will be continuing to do my best....

RBC Poll on Retiree Regrets: Health, Wealth and Travel

Received a PR notice about a recent RBC-commissioned poll (RBC has other polls and its retirement advice here)... retirees seem most to regret not having taken care of their health, not saving enough and not traveling enough. The good news is that only slightly more than half have any regrets at all - 95% say they are having a successful retirement. Apparently pre-retirees feel a lot more anxiety about retiring than actual retirees. Yup, as a semi-retiree, I can say that if you pay attention to living properly, watching your finances and enjoying people, things will work out.

Market Integrity and Today's Free-fall Drop

Today's mind-blowing momentary stock market plummet is more significant than just a record. It is extremely troubling to me as an ordinary investor.

Why? It is the patently unfair decision to cancel trades executed during the momentous drop. If I have a brain fart or a fat finger moment, my brokerage doesn't say, "oh yeah, that's ok, we accept that you didn't really mean it and send me back to where I started." The CTV news report Markets sent reeling after possible trading error says that automated programs caused or accelerated the fall. Well, if the people and companies who build and use such programs get a speed advantage over me then it is only fair that they suffer the deficiencies as well. If a few companies get wiped out by their unwise reliance on program trading then others will be a little more careful about testing and putting limits on them. Let's remember, someone else was on the other side of those trades, buying when the machines did their panic selling. Why should they be denied their opportunistic profits? Caveat emptor is a basic principle of commerce. Having made the oops trading mistake myself, I am a lot more careful to check what I am doing before pressing the "Trade" button.

The fact that all markets suffered the same drop at the same time means that it wasn't a problem with markets functioning incorrectly (indeed, Nasdaq is quoted in the CTV news item as saying its systems worked properly). It was big trading house computers bailing out in a crash before the ordinary joe. There cannot be two sets of rules for different types of investors.

Retirement System Redesign Ideas

Some readers may have noticed that Canadian Finance ministers are speechifying these days about possible changes to the retirement system. Blogger / web commentator Peter Benedek's succinct statement of proposed fixes took the words right out of my mouth in this posting at his website Retirement Action.

A few of my own riffs on Peter's, er, principles:
1) Participation could be mandatory but it would be just as effective to have the more politically correct solution of automatic enrollment as the default (i.e. people would have to deliberately opt out) since most people go with the flow, as books like Nudge point out.

2) Longevity risk - the possibility that you will live unexpectedly too long and run out of retirement money - cannot be solved by an individual, only by a collective scheme. Annuities cannot cut it because of higher fees and too many confusing useless options (justified under the guise of choice), more limited risk pools, inferior investing and probably a shorter investing time horizon. There is too much temptation for the insurance industry to concoct high hidden cost complex products few customers can possibly understand.

3) The investment arm - and it must be at a national level to get the global economies of scale - is the only way for an individual to get access to the huge and profitable domain of private equity. The governance of the investment arm is critical - the CPPIB seems so far to have been very successful, as opposed to Quebec's Caisse de Dépôt, which for a time became captive to self-aggrandizing, savings-destroying idiots.

4) The target income replacement level should not exceed 50%. That is enough to ensure a decent standard of living. If people want more luxury, they should save privately with RRSPs, TFSAs or taxable accounts. Or to leave an inheritance, it could also be the family house.

McKinsey: Professional Equity Analyst Forecasts Chronically Over-optimistic

Maybe it isn't a surprise to read evidence that professional equity analysts almost always predict much higher EPS growth amongst companies on the stock market than actually comes to pass. McKinsey & Company took the trouble to compile the numbers and the ugly truth is revealed in its April 2010 McKinsey Quarterly report Equity analysts: Still too bullish (free registration required to view the brief report but the three graphs are worth at least 1000 words and many more dollars each). Only the odd year does the market actually meet or exceed analyst forecasts. You would think the analysts would learn after 25 years of over-estimating results, or maybe it is just deliberate hype.

Given the amount of salt that would therefore be recommended to consume while reading such analysts reports, maybe the best investment diet strategy would be to avoid ingesting them altogether. Who wants a choice between investment bad taste from over-cooked reports or high blood pressure from too much salt?