Will the Low Volatility outperformance "anomaly" continue? BMO says Yes

Finding opportunities through the low-volatility anomaly from BMO Capital Markets in the USA looks at the long term historical outperformance of low volatility stocks and asks whether it is likely to continue. BMO says a combination of behavioural factors and institutional investor incentives suggest it will.

Meanwhile, author and value analyst James Montier says derisively in Smart Beta = Dumb Beta + Smart Marketing that low vol investing is just snake oil, a marketing term for repackaged value and small cap factor tilts.

Sticks and stones will break my bones, but words etc - I quite like my Canadian version of snake oil so far ... BMO's low vol ZLB ETF (disclosure - I own some ZLB) vs standard cap-weight XIU (don't own any)

Mutual Fund Risk Classification Methodology - a modest proposal

Regulators are looking for a methodology to stick a label on mutual funds that tells ordinary joe investors how much risk they are taking on if they buy into the fund. The regulators want something that is easy to understand, easy to calculate and implement, stable through time, easy to monitor and uniformly applicable to all types of funds. The proposal is to use monthly volatility over the last ten years, expressed annualized, either of the fund itself if it has enough history, or its benchmark index to make a five level Low to High risk scale.

My modest alternative proposal: take the fund's annual (total) Expense Ratio as follows (maybe adjust the boundary numbers somewhat since this is kinda back of the envelope)

• Low Risk - under 0.5%
• Low-Med - 0.5 to 1.0%
• Med - 1.0 to 1.5%
• Med-High - 1.5. to 2.0%
• High Risk - 2.0% & over

Why do I think it's better?

1) It's even simpler and more straightforward to do all the regulators want. There's no fudging about which index to apply to new funds.

2) The general results will in any case be pretty close to the received wisdom about relative risk categories - bond funds have much lower expense ratios than equity funds.

3) It meets a criteria that I found to be curiously missing from the list - the ability of the risk measure to predict the chance and the size of potential loss. Low Expense index funds consistently outperform on average higher cost actively managed funds. The Case for Indexing paper by Vanguard in the USA found "... evidence for the inverse relationship between investment performance and cost across multiple categories of funds, including both indexed and active mandates". Retire Happy blogger Jim Yih compiled some Canadian numbers in Management Expense Ratios Do Matter and found that the longer the investment period, the more strongly low cost funds performed better than higher cost funds. It wasn't a guarantee of outperformance as he points out but we are talking about a risk indicator aren't we? Blogger Michael James on Money did a few calculations on the S&P 500 with various MERs at MER Drag on Returns and found effects that far outweighed Internet Bubble crashes and Credit Crisis tumbles over the long term. Unlike temporary market volatility, MER money is gone, permanently lost to the investor, it's withdrawn every year. 

4) The rating scheme could be extended to ETFs. I have to admit though the scheme is not foolproof. There would need to be a rule that any fund using leverage is automatically in the highest risk category.

Jeremy "Stocks for the Long Run" Siegel says US Stocks Not Over-Priced

Professor and author Siegel lays out a reasonable case in this hour long video lecture that his thesis still holds that stocks provide the best returns in the long run compared to bonds or T-Bills. Apparently the 5th edition of his famous book is to be out soon with updated data contained in the lecture. In the lecture he argues that there is a flaw in the earnings calculation by S&P which biases earnings down and thus inflates the current P/E calculation in Robert Shiller's well-known CAPE (Cyclically Adjusted Price Earnings, which uses an average of earnings for the past ten years instead of only the past year). Siegel says the gigantic writedowns by a handful of financial companies in 2009 following the financial crisis created a huge earnings hole that overwhelmed the continuing profits of most of the S&P 500. The earnings hit overall just wasn't as bad as the S&P calculation portrays. That 2009 hole will persist in the CAPE average for another five years. He says that as a result the oft-cited over-valuation of the S&P 500 based on current CAPE around 25 is wrong and CAPE is actually below the long term average. He blames the messing up of CAPE on 1993 and 2001 FASB accounting rule changes forcing earnings recognition of writedowns (see around minute 43 of the video).

The State of Risk Profiling in Canada - Ouch!

FinaMetrica provides a risk profiling tool to the financial advisory industry worldwide and a version to individual consumers. Here is what they had to say about the state of affairs in Canada in Risk Profiling: Art and Science:

"...

In countries like Canada, the regulator appears to be significantly behind many other countries. The regulatory framework in Canada is complicated with disputes between  the provinces and federal government over jurisdiction and a recent Supreme Court decision recently delayed or derailed attempts at a single regulator. Regulation of mutual funds, stock brokers, banks and insurance firms all fall under different regulatory bodies in Canada further complicating the picture. The investment  regulators in Canada are still substantially focused on product level risk assessments  with little or no framework to look at the client holistically."

Sadly, not very flattering.

Financial Certifications Glossary from IIROC: a Useful Start though More is Needed

The Investment Industry Regulatory Organization of Canada's online glossary of about 40+ financial titles and designations is a good step forward towards lessening the confusion confronting the average person looking for expert advice. The direct weblinks to all the sponsoring / certifying organizations' websites is itself a big timesaver. The listing of education requirements for each designation gives an impression of how substantial and deep the required knowledge base is for each.

My suggestions for additional info for the glossary:
1) Standard of Care provided to Client - does the holder of a designation undertake to provide advice under a fiduciary duty best-interest standard or a suitability standard or something else? This is a hot topic these days as the Ontario Securities Commission considers whether to impose best-interest standards on people who call themselves financial advisors. The glossary indicates whether each designation has an ethics code but it doesn't, and could and should, say what each code promises on this critical point.

2) Subject Matter Expertise - the one thing I as a consumer want to know is "who do I ask about what?" Suppose I want advice on improving tax efficiency of my investments across types of accounts (RRSP, TFSA etc). The designation titles are suggestive but inadequate. Do I look for a CA, a CGA, a CIM, a CFA, a CFP or any of about a dozen or so other possible designations? Is the Distinguished Financial Advisor Tax Services Specialist going to provide me with sound advice? I'd guess not as the impression from the webpage is that they are competent in filling in T1 and T2 tax forms but that's it. A Chartered  Accountant or maybe a Chartered Investment Manager would be a much better bet, despite the absence of the word tax in the title. The head of IIROC says in a Morningstar video interview that they don't want to judge the various designations but surely they can compile and condense into some sort of searchable system what each designation claims to be able to do. Every solid designation should have and should publish its Body of Knowledge such as the CFA does.

Banana Beta: Monkeys Generally Out-Perform the Market

So much for the smug superiority of index investors constantly boasting how active mutual funds fail to beat the market. Yes, that's right, new research is showing that randomly chosen stock portfolios, aka those picked by dart throwing monkeys, would have beaten a market-cap index. Andrew Clare, Nicholas Motson and Stephen Thomas of Cass University tell us so in a two-part study (part 1 and part 2) titled An evaluation of alternative equity indices.

The researchers test a bunch of alternative equity index strategies - equal weighting, diversity weighting, low volatility weighting, equal risk contribution, risk clustering, portfolio minimum variance weighting, maximum diversification weighting, risk efficient weighting in part 1 and fundamental weighting in part 2. For US stocks from 1968 to 2011, the alternative strategies all beat the market-cap index by a substantial amount - 2% per year in several cases - whether risk-adjusted or not. Only in the decade of the 1990s (at the end of which the Internet bubble had not yet burst) did market-cap do best. In the 2000s, market-cap was plain bad while the other index methods did ok.

The simulated army of ten million random-picking monkeys are not to be trifled with, however. As well as knocking the stuffing out of market-cap indexing (I propose we call this "banana beta" to differentiate it from plain ole beta and the new improved smart beta), the monkeys also beat, on average, several of the alternative indices!! Equal weighting barely beats the simians. Equal risk, low volatility, risk efficient and fundamental indexing beat almost all the monkeys convincingly. These, plus maximum diversification, produced risk-adjusted (Sharpe ratio) results much superior to monkeys.

A very interesting other result of the papers is that a very simple momentum following market timing rule would have improved performance tremendously by more or less halving the maximum drawdown of the equity portfolio. Who would have not wanted to avoid the 40% value reduction after the 2008 crisis and only seen a 20% drop? Using this rule, the Market-cap index catches up to the alternative indices. The rule even looks potentially practical for a retail investor, though it would take some conviction to go from 100% in equities to 100% in T-Bills, or vice versa, depending on the signal.

It is isn't possible to invest in ten million monkey portfolios. And judging by their relative performance, I am reassured that low volatility equity ( I own some of BMO's ZLB) and fundamental equity (and some Invesco Powershares PXC) are a reasonable bet. As these researchers also found, I need to remind myself that the alternative indices have not and won't always out-perform every year or over even multi-year periods.

Thanks to Peter Benedek's RetirementAction weekly roundup of news for the link to Larry Swedroe's post on the same study.

Another Way to Invest in ETFs - Buy BlackRock Shares

Believe in ETFs? Want to bet on their continued growth at the expense of mutual funds? Then buy shares in the world's largest provider of ETFs BlackRock (BLK). Today's announcement of a 14% growth in Q3 net income, "... driven mostly by the asset growth of its ETF business..." is rather impressive given the enormous size of the company. Of course, the potential danger is that managers / employees may take most of the ETF-generated profit growth at the expense of shareholders. Or that competition may reduce profitability. But so far that seems not to be the case. BLK's 5-year return is 132% while one of BlackRock's flagship ETFs, the S&P 500's IVV is up 106% and another, the Canadian S&P / TSX 60 XIU is up a mere 51%.

Conference Board Shows Us the Mutual Fund Footprint

The Conference Board of Canada's Making Dollars and Sense of Canada's Mutual Fund Industry tells us that the industry is gigantic. How ironic and perverse. According to the definition of value added on page 2, the more the industry charges over its cost, the more it adds value. Bring on 10% MERs, that would make the industry even more valuable! The more inefficient it is, the better? There is a big missing piece. There needs to be consideration of the cost and value to consumers.This key issue is raised in this quote, "Fund management creates value in the economy through portfolio management activities, distribution channel creates value through the advice a fund dealer provides when selling a mutual fund to an investor". But then the report avoids assessing that critical aspect. Portfolio management that doesn't beat the index - that's value added? Advice from too many fund dealers that consists mainly of selling effort - that's value added?

In the terminology of the report, the industry has a huge economic footprint. Unfortunately the footprint falls heavily on the back of Canadians trying to save for retirement.
(Thanks to Ken Kivenko for the link to the report)

Canadian DB Pension Plans Faring Much Better but DC Plans Only a Little Better

This article at Pension and Investments says rising stock markets and interest rates have really helped Defined Benefit Pension plans in Canada return much closer to long term viability lately, but another article laments the marginal improvement in the situation of Defined Contribution savings plans. However, there is a telling note that fully inflation-indexed plans, the kind people really need, aren't much better off since new actuarial rules are making them recognize their huge liabilities (Keith Ambachtsheer's fine book Pension Revolution - reviewed here - shows the significance of inflation indexing).

CalPERS provides superb reading list database on Corporate Sustainability research

Kudos to pension fund giant CalPERS for making available a fantastic resource for investors wanting to find out how long term company success and stock returns can be influenced by paying attention to sustainability factors like governance, social responsibility and environmental performance, especially climate change effects. CalPERS has compiled a searchable database of 700+ papers on the subject and it has produced a review report with concise summaries of the most relevant / cited papers.

I have not had time to go through it all yet, but one interesting tidbit is that three years ago it decided to stop "naming and shaming" companies on its Focus List and instead undertake direct confidential private engagement. The new tactic pays off much better in the stock returns of target companies. (I bet CalPERS is the organization Dimson et al used in their study, which we noted in this post a few days ago.)

Evolution beyond traditional investment principles at pension fund CalPERS

The California Public Employees' Retirement System (CalPERS, 6th largest pension fund in the world, a lot bigger than Canada's national CPPIB), new guiding investment beliefs, includes some thought-provoking elements:

• Liabilities must influence the asset structure - CalPERS has a large and growing cash requirement and inflation-sensitive liabilities; assets that generate cash and hedge inflation should be an important part of the CalPERS investment strategy
• CalPERS is willing to be activist, preferably by direct engagement, where it can make a material difference to portfolio return or risk (like governance especially, plus social and environmental factors that affect long-term sustainability) and where it has a chance of success
• Strategic asset allocation is the dominant determinant of portfolio risk and return ... but Risk to CalPERS is multi-faceted and not fully captured by volatility or tracking error e.g. climate change and natural resource availability are considered long term risk factors; the path of returns matters
• Costs matter and need to be effectively managed, including alignment of compensation between fund interests and those of staff or external managers

These principles would seem pertinent, partly for my own retirement investing. But they also would apply, I believe, to assessing the characteristics of proposed pension reform options in Canada - which of PRPPs, DC pension funds, CPPIB conforms best?

Active ownership pushing Corporate Social Responsibility pays off

When companies are pushed by institutional investors to improve their governance practices and to do something about climate change, they tend to actually do something. And shareholders benefit with better operating performance by the company and stock price gains. So conclude Elroy Dimson, Oğuzhan Karakaş, and Xi Li in Active Ownership.

There is now quite a lot of research showing a positive association between Corporate Social Responsibility action and better accounting performance and stock gains (see literature reviews within the paper) but Dimson et al making a convincing claim that the link is causal i.e. action can produce results. They accessed the records of a big activist institutional investor and linked specific interventions or engagements with subsequent acceptance or refusal by the target corporations and then with the accounting/stock data. Accounting measures they used included return on assets, gross profit margin, asset turnover and sales per employee.

A few types of action matter most ...
There is a whole slew of CSR actions they list but only a few seem to have the most beneficial impact for shareholders.

1. Successful engagements, where the company ends up making a change, garner 4.4% cumulative abnormal positive returns, vs no returns for unsuccessful engagements
2. Corporate governance (+7.1% abnormal return) and climate change (+10.6%!!) successful engagements have the most impact
3. Large, mature, poorly performing firms with poor existing governance who are image sensitive are the best targets
4. Direct engagement like telephone calls and letters do the job. In contrast, traditional shareholder activism like voting on resolutions at annual meetings doesn't.

Today's news in the Globe that Barrick Gold (TSX: ABX) will be making changes to board composition and executive compensation after a group of pension funds complained seems to be a perfect example of what the Dimson study found. There hasn't been a big turnaround in Barrick's stock price yet, so maybe this is the time to buy into ABX. Tangible accounting improvements happen typically within 12 months or so according to the study. Probably the pension funds will be adding to their stakes since the study found that an effect of successful engagements was an increase in activist institutional ownership.

The causal mechanism ... evidence though not proof
How does company performance and share price improve, the authors ask? As they cautiously note, their findings are "consistent" with:

• increased customer loyalty, which gives the company pricing power
• virtuous companies attract a clientele amongst CSR-activist investors
• increased employee satisfaction / loyalty, which helps efficiency 

A challenge to passive index ETF investing and traditional active funds too
Correct me if I'm wrong but passive index ETFs are, um, passive. They don't do this kind of active intervention. Note who approached Barrick - Canada Pension Plan Investment Board, the Ontario Teachers’ Pension Plan and Caisse de dépôt et placement du Québec, as well as Alberta Investment Management Corp; British Columbia Investment Management Corp; Hermes Equity Ownership Services; Ontario Municipal Employees Retirement System; and Public Sector Pension Investment Board (from Toronto Star April 19, 2013). ETFs just vote their shares following the recommendations of an advisory service or its own policy, such as BlackRock's (provider of iShares) in its Prospectus. But voting is all BlackRock does. And though it voted against (link through to voting records here) Barrick's excessive executive compensation package, it was not part of the group that publicly engaged Barrick. As Dimson et al note, mere voting doesn't work for shareholders.

Actively managed mutual funds seem to follow the same tack, of voting and resolutions only (proxy voting policies here). They vote, but when unhappy they sell instead of engaging the company. Update: This Gilson & Gordon paper on SSRN says this: "The business model of key investment intermediaries like mutual funds, which focus on increasing assets under management through superior relative performance, undermines their incentive and competence to engage in active monitoring of portfolio company performance."

Hedge funds are a different animal, whose high-profile activism most often aims at mergers, acquisitions and divestitures. Hedge fund Hershing Square is the one who took on Canadian Pacific, with CPPIB's support. Individual retail investors don't have access to hedge funds anyway.

Pension reform implications?
I think I'd rather have my money in CPPIB than iShares' XIU. It's better for the companies and for me.

The 2008 Financial Crisis - why Canada Got Off Lightly

For those who like their explanations brief, this quote from Gordon Nixon, Royal Bank CEO: "But in my judgment the single most relevant and most important differentiator for Canada was the structure of our residential mortgage market." i.e. no toxic assets (from the Globe and Mail's excellent oral history of the financial crisis)

The world of giant money managers and the advance of passive index ETF investing

The Royal Bank may be the biggest company by market cap in Canada but Manulife is a far bigger money manager according to the 2012 P&I / Towers Watson World 500 list. (Access to most stuff on the Pension & Investments website requires free registration) The year-end 2011 data published last October puts Manulife in 34th spot worldwide with $490 billion vs only #53 Royal's mere $308 billion. Others insurers Sun Life (#37, $456 billion) and Great West (#48, $357 billion) also come ahead of the Royal.

The slide deck also highlights other interesting facts:

• Canada has progressed strongly since 2001 and now looks to be about 6th largest in assets managed by country
• Manulife and Great West have been among the fastest growing asset managers
• passive managers have been picking up share, growing faster than the overall average for years, as shown by the chart below, led by #1 behemoth Blackrock, #3 State Street and #4 Vanguard

 

• the shift to passive index investing is also remarked in this September 16th article based on 2013 6-months data; both Blackrock and State Street folk note the surge in their index funds amongst the overall market 18.4% rise in index assets
• and another article notes that it is ETFs where the growth is occurring

The above rankings do not include big pension funds, which are in a separate list, the P&I/Towers Watson World 300. In that list, published September 2nd this year with data to end of 2012, the Canada Pension Plan Investment Board (CPPIB) comes #9 in the world with a mere $184 billion, with Ontario Teachers #17 at $130 billion, OMERS #46 with $61 billion. There are various other public service plans in the list before one reaches the largest private company pension plan in Canada - Bell Canada #216 in the world with $17.8 billion in assets. The amounts are relatively puny compared to the assets managed by private managers. Manulife and Sun Life alone manage more assets than all the 19 big Canadian pension funds amongst the world's top 300 put together.

Now we know who controls the money but they mostly don't actually manage it since their method is dominantly passive index investing. It would be more accurate to say they administer the money. The pension funds on the other hand are more a mix of active investing, as we have observed at the CPPIB (and increasingly activist too i.e. trending towards responsible investing). So maybe the pension funds do set the direction of markets.

Excellent Primer on Canadian Health Care Stocks

Interested in the investing idea that the ageing baby boomers will create a boom in health care stocks? Want to self-insure by buying shares in a retirement residence company? Read the 2012 Canadian Healthcare Annual Review of January 2013 from TMX Equicom for a good view of the reality and the companies out there, grouped in helpful categories. The paper is a useful primer on healthcare and biotech companies in Canada. Life is not easy for the sector, what with difficulties finding successful products, public healthcare budget restrictions limiting chances even for good new products, generic drug competition, and even competition for required development capital from junior resource companies.

Cap-Weight vs Fundamental Portfolio after 3 Years (July 2013) - Tight Race Continues

Three years after launching in June 2010 a realistic portfolio simulation (which includes trading commissions, actual prices, distributions, foreign exchange fees for converting CAD vs USD) of traditional cap-weighted ETFs pitted against fundamental factor-weighted ETFs, the race continues to be very close.

Neck and neck contest - tiny differences in total portfolio value
2010 Year-end - dead heat: 0.1% difference
2011 August - cap-weight slight lead by 0.6%
2012 March - dead heat, 0.07% difference
2013 August 7 - fundamental slight lead by 0.6%

There isn't a huge divergence in any asset class either, the largest gap being the 10% ($500) advantage of PDN over EFV in the small- to mid-cap developed markets holding.

First ever portfolio rebalancing
For the first time in three years, some of the asset classes finally exceeded the policy limit set at portfolio creation that rebalancing should occur when any asset class strays more than a quarter from its allocation. The strong performance of the US equity market and the weakness of emerging markets and bond market caused a big enough imbalance to exceed the threshold in both portfolios. It was a good time in any case to invest the accumulating cash balances.

Perhaps counter-intuitively to some, the portfolio rebalance policy is obliging sale of recent winners US equities (PRF & PRFZ and VV & VBR) and purchase of losers bonds (XBB and ZRR), emerging markets (PDN and EFV) and commodities (UCI).

Solid performance by both - up about 26% in total over the three years, or 8% per year compounded. That may be the biggest lesson of this exercise - a diversified portfolio works well.

The current market value of holdings in the two portfolios is shown in the spreadsheet at the bottom of this blog page. Between updates like this one, which I do every six months or so, the monthly distributions are not reflected in the portfolio cash holdings so the total portfolio value may be slightly under-stated for both. The spreadsheet is still a pretty good reflection of the current status of the contest since the distributions of the two portfolios are quite similar i.e. the current market price of the ETFs creates most of the difference.

Book Review: Managing Alone by Janet Baccarani & Jennifer Black

What are the financial consequences of death on those left behind? And what kind of actions should one take beforehand to make it easier on them? This book by two financial advisors who focus their practice on the widowed addresses such questions.

The authors take a very informal approach. They present a series of vignettes, mini stories about situations, apparently taken from the experience of their practice, that give the book a very realistic feel. Each chapter is a story about what starts out as a happy couple ... but death awaits. I found myself thinking "who's gonna die this time?" as someone's slight cough inevitably turns fatal or a horrible accident stalks a hunting trip. It's easy and quick reading. Each vignette focuses on a few financial issues related to death - the last will and testament, life insurance, naming beneficiaries of accounts and policies, bank accounts in joint names, sharing knowledge between spouses of financial matters.

Managing Alone serves as an introduction, an awareness-raising exercise, rather than a detailed how-to manual. The book makes the important point over and over that it is a lot easier on those still alive, especially considering the extreme emotional turmoil at the time of death of a loved one, to do things in advance.

The repeated exhortation is to get professional advice, starting of course, since the authors are planners themselves, with a financial planner, who will bring in a lawyer or accountant as needed. This again highlights the importance of the current proposals to make financial advisors duty bound to put the interests of their clients first - people whose life is in major turmoil are probably more vulnerable and need to be able to rely on impartial advice that is totally and solely directed to their benefit.

Though I am a committed DIY-er, it is likely most practical or wiser to involve a professional for certain actions e.g. when my personal situation was quite simple and straightforward I did not bother with a lawyer and wrote up my own holograph will but later on after my first wife had died, when I remarried and there were now two families involved, I used a lawyer to make sure the will accomplishes what I want. It is also true that not all professionals are equally competent and diligent, so one still needs to check their track record.

Some characteristics of the book are awkward or frustrating. Each vignette throws in a list of financial data about the couple, most of which does not enter the discussion and is irrelevant to the chapter's topic. Why bother? Second, on some topics, the authors provide some detail but on several others as a reader I expected more, since the topics feature repeatedly in the book, but did not get it - e.g. who inherits what when a person dies without a valid will, or how to figure out how much life insurance one needs. The uneven amount of detail detracts from the book. There is much discussion of probate tax but little on minimizing investment taxes, the effects of deemed disposition on capital gains and such. Even references to more specialized books could have helped there.

Bottom line: a brief easily-readable intro to many of the financial issues surrounding death. 3.5 out of 5 stars.

Steps Foundation Stock Contest raising money for financial literacy - how ironic is that!

The other day I received an email from a member of the Steps Foundation, promoting their latest fundraising venture, an online stock contest with play money and real stocks. For a $50 entry the biggest portfolio after 1 month (contest starts June 25, though one can apparently enter late, and ends July 26).wins half the money from the total of entry fees (I cannot find the rules on the website, maybe they appear after one has paid, but I know because the email I received had the rules attached). Now the Steps organization looks legit (yes, I did check it out some since scammers are not confined to Nigeria) and their aim to raise funds to support other organizations that actually teach financial literacy by debt counseling and that kind of thing does jive with what I try to do informally with this blog. So I do have some sympathy for their aims.

However, the contest itself exemplifies the very worst way to approach the stock market, as a kind of short term lottery to make the most money in the shortest time. Maybe the Steps people, who are all financial professionals themselves, intend to write something afterwards to say "don't actually try to invest like this in real life, because you will surely lose all your money in a very short time". Given recent market action, the best strategy might well be to sit tight with the initial play cash anyway. That would certainly be a fitting and truly worthwhile financial lesson if it did happen.

Maybe if they modified the rules so that the winner would be the person with the highest Sharpe ratio aka most return per unit of volatility they might provoke some real financial literacy by obliging people to learn about and to consider that important concept and it might be a good contest too, instead of a pure game of chance.

Pension funds are thinking seriously about sustainable investment

Sustainable investment, aka Socially Responsible Investing (SRI) or Environmental Social and Governance (ESG) oriented investing to many people has the image of being the domain of fringe do-gooders. That's not so if one is to judge by events like the recent workshop held at U of Toronto's Rotman School (that's a management school, not a sociology or arts school). The workshop (U of T press release here) had a lot of pension industry heavyweights from Canada and around the world like the CPPIB, Ontario Teachers, Caisse de Dépôt, TIAA-CREF, CalPERS discussing what was worth doing and how to do it. U of T has made available the workshop notes here. The notes have links to background papers and to headliner Al Gore's (yes the real Al Gore and he actually took part in at least some of the workshop) paper on Sustainable Capitalism.

There is a lot of emphasis on investing with a long-horizon, an idea that seems to unite pension funds and socially/environmentally focussed people in the five main topics the workshop covered - stranded assets (what happens when climate change or price of oil destroys business models), integrated reporting (going beyond financial-only reporting to include social etc), evils of quarterly earnings guidance (stop being so obsessively short-term!), executive compensation (wrongly structured and excessive) and constructive investor behaviour (i.e. acting more like a long-term investor)

Some notable comments:

• executive compensation "...the current executive compensation situation constitutes a ‘market failure’ situation in the sense that there is no obvious relationship today between executive performance and the levels and structures of executive compensation. ... the sense in the room that a strong, coherent collective action initiative is needed " If the big pension funds develop an activist stance on compensation and do it the right way, maybe they can break through the incestuous self-reinforcing cycle of upwardly ratcheting executive compensation, a problem I have written about before.
• constructive investor behaviour "The key concept here is the broad adoption of ‘concentrated long term investment mandates ’ that require investor engagement. This would be a radical departure from the traditional Keynesian ‘beauty contest’ style of active management, and also from the broadly-diversified ‘formula’ style of passive management. A high number of workshop participants judged this to be a potentially high-impact initiative at the individual fund level." In other words, the pension fund people attending think this is worth doing and they see themselves doing it. Unlike joe average investor who can only influence by voting with his/her feet, when a giant pension fund calls, or several do, big-shot CEO and aloof Board are likely to listen. The swipe at passive index-ETF style investing is interesting - most individual investors in such ETFs are probably there because they believe the mantra of investing for the long term yet because of the passivity they can only take what they get, including those companies who operate only with a short-term horizon.

Book Review: Pensionize Your Nest Egg by Moshe Milevsky & Alexandra Macqueen

 Pensionize Your Nest Egg exhorts retirees to ensure that a good chunk of their income comes from sources that promise to pay a regular amount as long as they live. That advice is easy to accept given that one of the main risks in retirement is outliving savings.

The next part of the book's advice - how to do it using a combination of three "products" 1) annuities, 2) portfolio of stocks and bonds, 3) guaranteed living withdrawal benefit (GLWB), a complicated insurance company product - is much iffier. This part of the advice is problematic for three reasons, first because of uncertainties around GLWBs, second because the list of retirement risks is incomplete, and third because the list of products or methods to handle the various risks is incomplete.

GLWBs are worrying because they are complicated. There are various inter-acting moving parts that make them a challenge for the consumer, like resets and ratchets on the payout amount, choice of under-lying fund, initial payout rates, and fees. How can a consumer compare offerings from various companies and know which deal is better? Quite competent folks like Peter Benedek's Retirement Action here, Joe Tomlinson on Advisor Perspectives here and Wade Pfau on Advisor Perspectives here have crunched lots of numbers and the best choice of what to do seems to depend a lot on assumptions.

A key tool created by author Milevsky and promoted in the book, the RSQ and FLV calculator, does not put a GLWB into the mix. It only includes an annuity and a stock & bond portfolio. Why not? We are told it is "beyond the scope of this book". The reader is told to consult a financial advisor. Yet on the same QWEMA website, there is an ad for the PrARI calculator, aimed at financial advisors which does include the missing GLWB component, as well it seems, as other missing pieces like unexpected lump sum expenses. The book and the free tool look more like an illustration of concept designed to drive readers to seek out financial advisors than a practical self-serve solution usable by a DIY investor.

A question I keep asking myself was why I should even be interested in a GLWB. There is an excellent little table on page 66 where annuities, stock/bond portfolios and GLWBs are rated for how they offset the three big risks of inflation, longevity and sequence of returns, and for their benefits of legacy value/liquidity, sustainability and growth potential. Annuities and a stock/bond portfolio have exactly opposite offsetting Yes answers where the other is No, while GLWBs are either similar to one or the other, or in between i.e. GLWBs look superfluous.

It's always interesting to think of the position of the product offeror (the old saying is if you are in a poker game and you don't who the chump is, then it's you), the insurance company that sells the GLWB. GLWBs may (it's hard to tell and that is worrisome - we could call it chump uncertainty risk) be a game in large about stock volatility risk. Benedek's simulations found that a GLWB customer was better off if stock volatility is higher. Similarly, this technical paper by Australian researchers from the insurance company perspective suggest that their profits would be highly sensitive to stock volatility, customer mortality volatility and interest rates. Another thought-provoking piece is about GLWB provider Ohio National's different and supposedly more effective and cheaper method of hedging its own risk. It raises the question whether some insurance companies might be headed for a big fall because they don't really understand and control the risks properly. The fact that Assuris covers GLWB income 100% up to $2000 per month and 85% above that (but this is only mentioned in the book with respect to annuities and not explicitly for GLWB payouts as well) helps on the income side but not on the legacy side if the insurance company screws up. Do we really want to be trying to also assess how well the insurance company will handle the investment account to pick a GLWB?

Retirement Risks to wealth and income surely include more than the three (inflation, longevity and market sequence of returns) the book lists. Unplanned events like one-time or chronic health problems, divorce, (grand)child care, elder care can create large negative financial effects. There may be a need for on-going higher cash flow, or a big lump sum. There is a greater requirement for liquidity and flexibility than only an end of life legacy goal the book discusses. Though the book's stated aim is solely to describe how to create a guaranteed lifetime income, the process it proposes excludes such other considerations. Those considerations cannot be separated when deciding how much to pensionize. If you pensionize too much in order to ensure long term sustainability you may suddenly be caught short. Some things like health risks can and perhaps should be handled with long term care insurance but perhaps not if a greater amount of capital is kept in a stock/bond portfolio or if a no-longer needed house can be sold to pay for LTC.

Alternative products and methods to address income/lump sum needs are incomplete. The single best inflation protection product is inflation-indexed aka real return bonds, yet they are not discussed or incorporated into the planning.

The historical stock & bond return and volatility characteristics in the book are taken as given and baked into the RSQ-FLV calculator, yet new portfolio construction methods offer convincing promise to significantly lower volatility (e.g. see this individual investor Smart Beta portfolio). The pension fund and institutional investor world has moved to controlling risk/volatility to improve the return vs risk ratio and individual investors can too to some degree. Even a traditional but more diversified portfolio (i.e. more varied asset classes) will improve the return vs risk figures used by the authors. Changing the  historical assumptions about an investment portfolio's performance can appreciably reduce the likelihood of running out of money using a systematic withdrawal plan, improving its attractiveness in the product allocation structure the book presents.

That's what the book is missing in my view.

What the book does discuss is really well done and worth reading. The writing aims at a general audience. It has lots of good illustrations, clear uncomplicated explanations without difficult technical or mathematical material, very much like Milevsky's other excellent books that simplify and explain potentially confusing subjects. The free online RSQ-FLV calculator still provides insight despite its limitations. Another calculator created by Milevsky the book refers to, the Implied Longevity Yield calculator on Cannex, is very helpful for trying to decide whether current annuity payout and interest rates are propitious for buying an annuity now or later.

The book is to be applauded for forcefully making the critical point many people do not seem to realize that an RRSP balance (or the proposed PRPP) is merely a savings plan, not a pension, since it produces no automatic, guaranteed lifetime income. And they also make the equally critical point that most people need and should have real pension income (except those like Warren Buffett who has so much money he could never possibly run out).

Bottom line: pensionization via product allocation is a worthwhile approach but what the authors leave out is too important to make the book's content good enough for practical retirement income planning. 3 out of 5 stars.

Mutual Funds - what's wrong and what needs to be done

Long time investor advocate and member of the Ontario Securities Commission investor advisory panel Ken Kivenko tells us how the mutual fund sales, distribution and advice system in Canada is fundamentally and critically flawed and what needs to be done about it in his latest post Eliminate embedded commissions and professionalize advice.

I must admit that I haven't paid much attention to mutual funds and have not owned any for many years since I became aware of the issues Ken so succintly and forcefully summarizes. So I was surprised to read in his piece that despite the industry going on about how the invisibly embedded commissions pay for advice, there is actually nothing in the industry standards about how and what advice must or even should be given.

FAIR Canada in its submission on mutual fund fees to the too-numerous (but that's another problem) Canadian securities commissions provides a longer and more detailed take on the required reforms.


There is lots more support for change on blogs and in the press, e.g. links in on the FAIR website, so maybe there is hope for change. Should reform happen, I might even consider mutual funds again.

Ontario Securities Commission Wants to Hear from Us Retail Investors

The OSC will be holding three sessions in June to seek retail investor input on some significant current issues: mutual fund fees, crowdfunding aka investing in small and medium size companies and advisor fiduciary duty.

The OSC's webpage here has time/date and location details as well as some excellent background papers on the issues. Even if you cannot attend, express your opinions to InvestorOffice@osc.gov.on.ca.

There are encouraging signs that the OSC is starting to pay more than lip service to retail investor issues, what with sessions like these, the appointment of folk like Stan Buell and Ken Kivenko to the OSC's  Investor Advisory Panel and the recent creation of a new internal full-time Office of the Investor headed by Eleanor Farrell (see this article on what she aims to accomplish).

Goodness knows change is required, given such evidence as the failing grade given to Canadian mutual fund fees by Morningstar.

How to tell if you will be fine financially in retirement

Never mind all those complicated calculators, spreadsheets, assumptions about stock returns, interest rates, asset allocation models, taxes, risk tolerance questionnaires, longevity assumptions etc etc. Nope, all you have to do is to be able to answer these three questions correctly and you will do fine in retirement!

1) If the chance of getting a disease is 10 percent, how many people out of 1,000 would be expected to get the disease?
2) If 5 people all have the winning number in the lottery and the prize is 2 million dollars, how much will each of them get?
3) Let’s say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?

Who says so? Professor Olivia S. Mitchell of the Wharton School at the University of Pennsylvania, in Implications of the Financial Crisis for Long Run Retirement Security. According to the paper "... these three financial literacy questions turn out to be incredibly good predictors of whether middle-aged people plan for retirement, save for retirement, and do well at retirement".

Those who can, do, and those who can't, don't.

Capital Cost Allowance in need of reform says CGA

A camel is a horse created by a committee goes the old saying ... or is it the other way round? It doesn't matter because the point still applies. Something that started out in 1949 being a nice simple method for the income tax system to take account of and treat capital depreciation fairly has transmogrified into a complicated mess doing things it wasn't designed or suited to do.

It's not dumb ole me saying this, it's the Certified General Accountants of Canada, which has just released a study that describes the problems - Is the Capital Cost Allowance System in Canada Unnecessarily Complex?. 

Among the particular issues:

• proliferation in the number of classes from 12 originally to 56 in 2012
• more complex and confusing wording for the classes
• changing rates from year to year for the same thing e.g computers (I've encountered this myself trying to do my taxes in claiming computer equipment and it is frustrating and time consuming to figure out.)
• special classes that misuse the CCA system to achieve industrial policy or economic incentives for certain industries

The end result, according to the CGA press release quoting Rock Lefebvre, FCGA and vice president of Research & Standards at CGA-Canada: “... it has added increased complexity to the tax system and the many changes introduced weakened the system’s equity and neutrality.” 

Good on the CGA for raising the issue. It's a little bit altruistic considering that the more complicated the tax system is, the more we have to pay accountants who know all the infuriating gotchas.

Let's hope that the federal government folks in Ottawa are listening and that if they act they do not give rise to a new saying going something like "a naked mole rat is an improved rat created by a government reform". See photos of the naked mole rat here.

WaterFurnace Renewable (TSX:WFI) 2012 Results Show Disappointing Weakness

In mid-March, WaterFurnace published its 2013 Annual Report along with the Annual Information Form and the Information Circular. The results were disappointing for investors, though we should not have been too surprised, as the last quarter exhibited a continuation of significantly slowing sales (down 13% for the total of 2012) and earnings (down 27%) that had been evident through earlier quarters.

Among the not so impressive details:

• Inventory rose 15% and the finished goods portion was up 29%
• Operating expenditures as a percent of sales rose from 18% to 20%
• Employee compensation was up 4% (i.e. more than inflation) and executive compensation rose 49%, or 60% if director compensation, which stayed constant, is excluded; much of the exec comp came from shares issued, which diluted earnings per share a full penny; what in heaven's name justifies that sort of increase?
• Warranty claims expense had a big jump up due in part to rising claim rates, not just additional units under warranty, which makes me wonder if management is building a warranty cookie jar in this non-cash item so that later the claim can be reversed with wonderful instantaneous effect on earnings.

A few positive notes:

• the joint venture in China seems to have got underway quickly and successfully, being relatively close to breakeven despite a bunch of one-time startup costs
• the Hyper subsidiary acquired a few years ago, contributed more to the bottom line, though it's still not large
• Cost control on the manufacturing side partly offset the Opex rise

On the conference call, CEO Huntington and CFO Andriano were predictably optimistic. However past calls have conveyed the same "the light is just beginning to dawn and we are now facing an upward trend" message without coming to pass as we know.

Should we believe this optimism? A supposed key driver of sales in the USA doesn't seem to be working as the WFI managers think and say:

• Housing starts - this is said to be the key for residential sales which have dropped steadily. How does falling sales jive with this YCharts graph which shows US housing starts going up slowly for the past two years.

Instead I believe it's that low natural gas prices have kicked the bottom out of the economic argument for installing a ground source heat pump system as opposed to one based on natural gas. There are a few brief comments here and there in the documents and the call about natural gas competition. Interestingly and perhaps tellingly, the AIF does not include natural gas a risk factor. Does management of the Board not believe or want to admit it? In the call, Huntington predicts natural gas prices will go up as everyone adopts it and says they have already started to firm up. Huh? Doesn't look much like it in this chart from the US Energy Administration Administration.

WFI was not alone in its 2012 difficulties as competitor LSB Industries' climate control division suffered lower sales and income, though not as much.

Bottom line: Unless the joint venture in China pays off big time and quickly, we investors (yes, I still own the stock) need to be prepared for falling sales and earnings, or stagnation at best, and probably a dividend cut from the $0.96 per share to something like $0.60. In 2012, the dividend per share was 17% more than earnings.

On that basis,
- Middle estimate: with no future growth at all and a cut in dividend to $0.60, the stock is worth around its current $16 market price.
- Low estimate: If earnings fall 5% a year on average for 5 years, WFI is only worth about $13.50.  
High-estimate: With no growth for ten years, then 3% per year growth after that for ten years, WFI's value is $20.70 or so. (figures calculated using the discount model in this downloadable spreadsheet from McGraw Hill Investments book that I used in my original post on WFI in September 2010)

Which is more likely? Maybe the China venture will offset the US sales decline. Don't really know. Maybe I need to face sober reality, but like the alcoholic who keeps saying just one more drink, I'm still hangin' in.

TurboTax Giveaway Winners!

The random draw for the TurboTax web version has been done and the two winners are:

• Erick
• SWT

Would these lucky winners please contact me by the email link in the right hand column of this blog page so that I can send you the access code. Congratulations!

TurboTax for Canadians Giveaway

The April 30th deadline for filing a tax return for 2012 is fast approaching and to help procrastinating readers take that final step of actually filling in the numbers we are offering a giveaway.

Thanks to Intuit, makers of TurboTax, I am giving away two codes for the online web version of their personal tax preparation software for Canadians. That's a value of $17.99. With the online version of TurboTax you can use the Canada Revenue Agency's NETFILE online tax submission service instead of mailing paper forms. It's quick and convenient.

Here are the details of the giveaway:

• To enter submit a comment on this post below - use a unique name (Anonymous won't suffice!) so I can distinguish people
• One entry per person please
• Entries close Friday, April 12th midnight EST
• I'll do a random draw of two (2) names from amongst the entries after the deadline
• Winners will be announced on the blog and asked to contact me via email with their own email address so I can reply with the code to enter in the TurboTax software (your email will not be used for any other purpose than to contact you as a winner)

Best of luck everyone!

New US Equity Low Volatility ETF from BMO

This past week BMO announced the startup of a bunch of new ETFs. The one that intrigues me the most is the BMO Low Volatility US Equity ETF (Symbol: ZLU). It is described as being constructed with the same method as the BMO Low Volatility Canadian Equity ETF (ZLB) that uses beta (stock price movement relative to the market average) to pick stocks that are less volatile i.e. low beta stocks.

As I blogged about just recently, passive rules-based alternative selection & weighting schemes (so-called smart beta) are coming to be accepted as being superior to traditional market-cap passive indices as an investment strategy. ZLU fills a gap in the smart beta space for US equities for an ETF using beta instead of simple price volatility e.g. funds like SPLV. Russell had some low beta US equity ETFs on the market for a while but closed them down due to lack of uptake. A mix of funds with different non-market cap weighting schemes in a portfolio is the way to go (e.g. this relatively simple smart beta portfolio), so ZLU is a useful additional component.

It is interesting to see how different market conditions in Canada vs the US are affecting low beta/volatility funds in comparison to the market-cap benchmarks. US equities have been on a tear recently as we read about all-time market highs. High beta ETFs like SPHB have been outstripping the market in the short term, such as the past 6 months, but low volatility funds like SPLV are handily ahead of both SPHB and SPY over a year or longer. The reason - SPLV doesn't spurt ahead in big leaps but its dips are much less pronounced. see the Yahoo Finance chart below. Slow and steady wins the race, huh?

Though BMO's Canadian equity low beta fund ZLB has been growing slowly since its launch in October 2011, I would have thought those return-chasing investors would have leaped on board this performance vs its market cap rival XIU.

Another interesting feature of ZLU, traded in Canadian dollars despite holdings of US traded and US-dollar denominated equities, is that it also comes in a US-dollar version traded in USD on the TSX under symbol ZLU.U. Given that ZLU and ZLU.U are in effect the same fund, just with two different prices, one in CAD the other in USD, it might even be possible to do low cost currency exchange using Norbert's Gambit as described on Financial Webring, which is often done with DLR and DLR.U.

NB I have voted with my money some time ago and own a fair chunk of ZLB and no XIU.

Budget Shoots Down Tax Advantaged Swap and Forward-based ETFs

Expect to see a few ETFs disappearing in the next few years. The federal budget delivered yesterday by Minister Flaherty announced that the clever conversion of interest into capital gains (or temporarily, return of capital) through the use of forward contracts or swaps would soon become invalid. The Investment Executive article on the proposed measure makes it clear existing funds that have to renew at some point get caught as well. If I am not mistaken, that would cover pretty well all such funds as the prospectuses I have read include a fund termination date, which would require renewal / extension at that time.

Some of the funds whose days would appear to be numbered:

• all of the former Claymore, now iShares, Advantaged ETFs that Canadian Couch Potato listed and described here.
• various Horizons ETFs like the Horizons S&P/TSX 60™ Index ETF ( symbol: HXT), which I will need to remove as the Canadian equity component from my cap-weight portfolio contest at the bottom of this page, and the Horizons S&P 500® Index (C$ Hedged) ETF (HXS)

Of course, it's a loss for investors when tax benefits are pulled away. On the other hand, with all the moving parts to figure out in such ETFs, which does not necessarily result in a better choice for the investor, as I discovered in this post on HowToInvestOnline comparing one of the iShares Advantaged ETFs to a plain old GIC, maybe it's not such a big loss after all. Chasing investments merely for tax reasons is generally a bad idea.

...  addendum
Horizons has put out a press release saying its fund HXT will NOT be affected by the tax change. The press release does not mention HXS but it works the same way as HXT as a total return swap. The budget document itself on page 353 of the pdf refers to transactions that change ordinary income into capital gains which HXT as an equity fund does not primarily do, so maybe HXT and HXS will escape. We'll have to keep monitoring to see exactly how this pans out.
... addendum 2
BlackRock says in a press release that the rule change will affect several of its funds - CAB, CVD, CHB, CHB.U, CYH, CBR, CMF and CMF.A

Smart Beta vs Cap-Weight Investing - No Longer "Whether" but "How" to Do It

The EDHEC-Risk Institute's March 2013 paper Smart Beta 2.0 contains much worthwhile info for the individual investor:

• Smart Beta index investing beats cap-weighting; (Smart Beta is an umbrella term for various alternative stock selection and weighting schemes, such as equal weighting, fundamental accounting factors or low volatility); there is little or no doubt amongst academics about the inferior efficiency - return bang for risk buck - of cap-weighting (e.g. their comments on page 5) and almost half of institutional investors have adopted an alternative index scheme. That cap-weighting isn't the best doesn't deny financial theory about an efficient market - a footnote tells us "... the efficiency of the benchmark is moreover totally independent of the existence or otherwise of an efficient market ..."with a reference to another of their papers on that point.
• Smart Beta 1.0 indices, upon which present-day ETFs are based, can be improved upon - thus the 2.0 in the paper's title. The authors state that biases and tilts with the alternative indices, which they call systematic risks of the Smart Beta indices, can be corrected and removed while still maintaining almost all of the outperformance - e.g. the small cap bias of a low volatility index can be removed by restricting stock selection to the largest cap stocks. Magic! The sector bias to utilities can be largely removed by constraints on the holdings in that sector. Maybe we cannot buy 2.0 ETFs yet but to me this presents a method for building a reasonably efficient portfolio of individual stocks e.g. pick low volatility large cap stocks while ensuring sector balance.
• Smart Beta 1.0 indices and the ETFs based on them (like some of my favorites with symbols PXC, ZLB, PRF, PDN, RSP) have in the past, and likely also will in future, despite outperforming in the long run, experience periods of 2-3 years of underperformance vs a cap-weight index. On top of that, the worst lag in performance, what they call relative drawdown, can reach 12-13% as the table below copied from the paper shows. That will certainly test an investor's confidence and resolve but proper expectations are a significant help to weathering that psychological storm. In fact, the authors recognize the "dare to be different from your peers" risk as a major obstacle for institutional investors. Fear not the EDHEC wizards propose a solution to this risk by techniques that they show can reduce the tracking error difference with the cap-weight benchmark by about half, again without eliminating the outperformance, though there is a much bigger performance hit than for the bias adjustments. 

 

• Alternative indices have different factors, which EDHEC calls specific risks, that could make them (or the ETFs based on them) not work in the future. Some indices depend on correctly estimating one or more of return, volatility or correlation to outperform, a kind of garbage-in garbage out problem (such as fundamental weighting or low volatility) while others don't estimate anything but may turn to be a very inefficient portfolio, such as equal weighting (and cap-weighting). It's a trade-off - a good model with possibly poor inputs or a crappy model requiring no inputs. Now here is what to me is a significant practical message - they find that diversifying this risk through a mix of alternative weighting schemes outperforms (in a return vs risk sense as expressed by a significantly higher Sharpe ratio) any single method. In other words, for Canadian equities we should hold a 1/3  each mix of low volatility ZLB (or TLV or XMV), fundamental-weighted PXC and equal-weighted HEW.

Business opportunity for mutual fund company - Instead of gouging ordinary investors with high fees for ineffective or fake (closet indexing) alpha outperformance, there is potential real added value for a mutual fund to offer an automated low cost Smart Beta product to Canadians (maybe we could be first with innovation as we were with ETFs in the form of TIPS). At the end of their paper EDHEC mentions that "More generally, beyond a static diversification approach, one may also implement an improved dynamic diversification approach based on making the allocation to various smart beta benchmarks conditional upon market conditions such as average correlation levels, volatility levels, etc." Jacques Lussier, in his new book Successful Investing is a Process, says the same thing. That's exactly where the leading institutional investors heading. Individual investors can do static allocation (see my suggestion here on HowToInvestOnline). But individual investors don't have the data or expertise to do dynamic allocation.

In the free-for-all that the ETF space has become, it is perhaps understandable that ETFs using index weighting schemes other than the traditional market value capitalization-weighting, such as indices based on fundamental accounting factors or low volatility, will get dismissed as mere marketing gimmicks. And there is that danger since, as the paper also points out, the alternative index construction methods and past data are not available to all to probe and test. EDHEC itself is a pretty thorough impartial prober and they show that details like the exact month chosen to rebalance or reconstitute an index can make a lot of difference to performance in any given year. If the complete index rules are not available, they say it's impossible for an investor to make an informed choice or for others to figure out if the past outperformance is likely durable or just a one-off result from cherry-picking a certain time period, for example. They show that the outperformance of fundamental weight indices is mostly, but not all, explained by the Tech bubble when it would have avoided the crazy Internet stocks. That may cause some to dismiss fundamental weight ETFs, though for me, avoiding buying into the next bubble stocks and profiting from the crash, is an attractive idea.

Thanks to Ken Kivenko for the link to the Smart Beta paper.

H&R Block Tax Software Giveaway Winners!

The random draw for the H&R Block online tax preparation software contest announced last week has been done and the winners are:

• Traciatim
• Jade
• M

Would these lucky winners please contact me by the email link in the right hand column of this blog page so that I can send you the access code. Congratulations!

Decling Decision-making ability - It's not age, it's disease that matters

"Age is not a disease"

Phew! The third richest man in the world, legendary (and still active) investor 82-year old Warren Buffett will be relieved. Health Brains, Health Decisions puts an important new slant on the issue of the vulnerability of seniors to financial fraud or merely self-inflicted harm from poor decisions. The study found that age per se is not the problem, as men and women in their late 70s did as well as 50 year-olds in making financial decisions. "Older decision-makers were as logically consistent as younger decision-makers. Increased age alone — from the early 50s through the late 70s — was not a key factor in predicting impaired decision-making capacity".

Note for the regulatory folks like the Ontario Securities Commission, the Canadian Securities Administrators, etc > "... policies aimed at protecting those most vulnerable to poor decision-making should focus on disease, rather than age itself, as a risk factor". To which I would add, in particular, dementia and Alzheimer's, the disease that will become more and more prevalent in seniors. Throwing a big protective blanket over seniors, 87% of whom (among those 65+) are cognitively healthy according to the National Institute of Aging as cited in the study, would be un-necessarily broad. But for the cognitively diseased segment, whether over or under 65, I would guess present protection isn't sufficient. Worsening financial decision-making is often a sign that cognitive impairment may be starting.

The study also offers a hopeful message. We can help ourselves by paying attention to and cultivating two key skills that they found improves decision-making: 1) Strategic Learning (the ability to determine and use a strategy to sift more important information from less important information); 2) Conscientiousness (being careful and organised in regard to finances). We need to exercise our brains, just like our muscles, to keep them strong.

How exactly that can be accomplished, that's not addressed, but the study authors claim so - "prior research has also shown that short-term intensive brain training can strengthen and even restore abstract thinking and strategic learning capacity in cognitively healthy adults". (Some healthy brain suggestions at The Science of Learning blog: healthy food; physical exercise; practising the activities you want to be good at, like music or, ta-da - managing your finances and investments! ... but not watching lots of TV or incessantly playing video games)

It's not just Warren Buffett as an old fart who's rather good at financial decision-making. The Forbes list of billionaires on Wikipedia seems to have a strong preponderance through the years of over 50s, 60s, 70s and 80s, all of whom seem to be vastly increasing their wealth year by year instead of frittering it away.

CPPIB Investment Turns to Private Deals and Infrastructure

The other day I read RetirementAction Peter Benedek's explanation of why he decided to take his CPP pension at 65 instead of his original plan of 70. One of the points he makes is that CPPIB's investments are becoming increasingly opaque and therefore riskier due to a shift to private deals, since they are hard to value. The fact of the shift is undeniable (they say it themselves at CPPIB), the question is whether risk is actually higher. Consider this brief video interview conducted last September by McKinsey with CPPIB CEO Mark Wiseman. In it he describes how CPPIB looks at private infrastructure deals like buying a toll road as buying into a quarter century of cash flows from sticking with the investment through its full life and not as an opportunistic trading asset to flip for a quick profit. In that perspective, the risk becomes whether CPPIB has done its homework so that projected cash flows actually happen and whether the governance and supervision mechanisms of the CPPIB prevent too much capital ending up in any one holding or connected groups of holdings. In contrast as well, I wonder if any mutual fund held in the average RRSP would take the same view, given the pressure to show annual performance in order to promote themselves and collect or keep assets. I dunno about others but I don't find the CPPIB's private infrastructure deals too troubling.

H&R Block Tax Software Giveaway

Now that RRSP season is over, it's time to start thinking of preparing a tax return for 2012 even though the deadline for submission is a seemingly distant April 30. The Canada Revenue Agency's NETFILE online tax submission service is open for business and the CRA is ever more enthusiastic to receive the return via electronic means instead of on paper.

Thanks to H&R Block, I am giving away three codes for the online web version of their personal tax preparation software for Canadians. That's a value of $13.95 up to March 13 and $15.95 thereafter.

Here are the details of the giveaway:

• To enter submit a comment on this post below - though you don't have to, I'd be interested in your comments on tax prep software since I am again working on my annual review of all the CRA NETFILE certified packages (last year's review here); use a unique name (Anonymous won't suffice!) so I can distinguish people
• One entry per person please
• Entries close Tuesday, March 12th midnight EST
• I'll do a random draw of three (3) names from amongst the entries after the deadline
• Winners will be announced on the blog and asked to contact me via email with their own email address so I can reply with the code to enter in the H&R Block tax software (your email will not be used for any other purpose than to contact you as a winner)

Good luck!

Good Corporate Environmental, Social & Governance Performance is Good for Investors

Worth reading - a couple of studies suggesting that companies which rate highly on ESG factors will outperform financially and on the stock market.

1) The Value of Governance by professor Anita Anand of the U of Toronto on the website on the Canadian Coalition for Good Governance - "there is a strong consensus in the literature that corporate governance is linked positively to firm value"
 
2) The Impact of a Corporate Culture of Sustainability on Corporate Behaviour and Performance by professors Robert G. Eccles, Ioannis Ioannou, George Serafeim of Harvard U. - "High Sustainability companies significantly outperform their counterparts over the long-term, both in terms of stock market and accounting performance. The outperformance is stronger in sectors where the customers are individual consumers instead of companies, companies compete on the basis of brands and reputations, and products significantly depend upon extracting large amounts of natural resources". In true academic cautious fashion, they stop short of claiming that the adoption of ESG policies causes the outperformance, as opposed to merely being associated with it, which is what they emphatically demonstrate. However, the study shows that the High Sustainability behaviour preceded in time the outperformance, which is highly suggestive of causality.

Unfortunately for those looking for investment leads, there is no list of the 180 companies they found to be in the High Sustainability group.

Worse, the intricate and extensive rating process to figure out which companies are high-ESG is beyond the reach of average joe investor. We cannot hope to collect the data, which comes in part directly from the companies and in part from laborious combing through company reports. Nor can we afford to buy the data from the various specialized ESG rating shops like those on page 13 of this Bloomberg slide pack or Bloomberg or Thomson Reuters. And it's not provided by discount brokers or on free stock search websites.

Our only recourse is to buy, or look at the holdings of, ESG-based ETFs like iShares Canada's XEN or the various US-based ETFs such as those in ETF db's Socially Responsible category. Since the message of ESG studies seems to be that high-ESG pays off on average over a long period of years, for small investors an ESG fund with many holdings is probably a better option. As usual the problem with these specialized ETFs is that their MERs are higher (by 0.4% or more) than plain old index funds, which will put some people off.

Worse still, as the big institutional investors round the world have become convinced that ESG pays and are making it an integral part of their investment selection process (e.g. see the Canada Pension Plan Investment Board blurb on why and how they do ESG), individual retail investors have so little enthusiasm for such ETFs that one of them - Pax World's North American NASI - is closing in mid-March! XEN itself has a puny $18 million in assets despite being in existence since 2007 and outperforming the gigantic market benchmark iShares TSX 60 XIU by almost 0.5% on average per annum after fees (1.91% vs 1.44%) over the past 5 years.

Gold titillation

For all the constant chatter about gold, I had never seen the real thing in such vast amounts - the Bank of England's gold vault in a Wimp.com video. The scene is so weirdly banal. The weirdness is only accentuated by the incoherent  explanation of the reason that the BOE keeps gold.

A Tipping Point in the CPP Expansion Debate?

Surprise and initial disbelief was my reaction upon reading the headline "Canadians should be allowed to contribute more to CPP to ‘reignite a culture of savings,’ urges CIBC chief" yesterday in the Financial Post. But it's true - the head of one of Canada's banks has come out in support of an idea that has been portrayed by some as the stupid notion of an ill-advised anti-business left-wing labour movement but which actually makes a lot of sense (as I have blogged about comparing CPP to RRSPs and the like, in relation to retirees' needs, comparing to the proposed PRPPs). It is quite significant when a major bank head publicly expresses support. After all the banks make a lot of profit from RRSPs, mutual funds and would do so from PRPPs that are the private sector alternative to CPP. So kudos to CIBC and CEO Gerry McCaughey for saying something that may not be in their narrow best interest but which is good for Canada and average Canadians.

A fine but critical point of potential disagreement with what McCaughey said is that the voluntary participation in the expanded CPP should be made the default option i.e. people should be automatically included though they could opt out if they deliberately chose to leave it. That way, just about everyone would be in it. To offer participation as a voluntary opt in, where you have to take action to join, would be next to useless as too few people would join. People need a Nudge as Thaler and Sunstein tell us in the eponymous book.

Disclosure: I own bank shares directly and in ETFs (and so does just about every Canadian in their equity mutual funds or ETFs) and I will be getting CPP, though not any expanded benefits if it is expanded on a pre-funded basis as I believe it should be done.

Pure Dead Brilliant!

Though Scots have a wonderful way with expressions and a great sense of humour, I'm pretty sure the one who first came up with "pure dead brilliant" to describe something fabulous were not contemplating death. But the expression fits perfectly to memorial diamonds.

Yes, Virginia, technology has moved forward and lockets of hair of a dear departed are passé. Get your hair or your ashes turned into a diamond. (no joking, it's a real business as the innovative first company to offer this unique product LifeGem has been joined by others) Forget the complications and uncertainty of reincarnation. Since diamonds are forever you can be present forever.

It's convenient for the living too. No messy ashes that could spill. No having to visit a far away grave, the loved one is ever present on your finger. Just give him or her a wee affectionate rub once in a while. And it's very discreet too, unless you want to brag how the person was a cut above the rest. Not only that, but one person can easily be used to make several diamonds - very convenient for each member of the family to get their very own piece of grand-dad.

Since any dead thing made of carbon can be turned into a diamond, consider also the mixing & matching possibilities - gran and grand-dad united forever, mom and her favourite cat etc.

Perhaps the only downside is the obvious one mentioned by lawyer Ian Hull, on whose blog Toronto Estate Law I found this idea. You could lose the diamond! (Sure hope there weren't any amongst the gigantic heist today at Brussels airport).

Fundamental vs Cap-Weight Portfolio: Still Very Close after 2 and a Half Years

Early in 2010 I became convinced that indices based on fundamental accounting numbers made more sense as an ETF investment strategy than the traditional indices based on market capitalization. The research seemed convincing but would real world investing see the same results I asked myself. To try answering the question, in June 2010 I created two parallel portfolios with the same initial pretend capital of $100,000 and the same asset class breakdown to pit ETFs based on each type of index in a head to head battle.

Past updates on the contest:

• June 2010 - initial post with all the portfolio rules
• August 2011 - Cap-weight portfolio ahead by 0.4%; both portfolios up about 10%
• March 2012 - Cap-weight portfolio ahead by 0.07%; both are up 16% in total

Today (see bottom of this blog page for the Google spreadsheet with details of the current portfolio):

• Cap-weight still ahead in total by a slight 0.5% 
• Both have gained over 22% since inception
• Every asset class / ETF holding has made gains
• Asset class gains are unequal as expected but none has yet gone beyond the automatic rebalancing rule of a quarter deviation over/under its initial share (e.g. a 5% holding going above 6.25% or below 3.75% of the total portfolio)
• In some classes the cap-weight ETF is ahead, while in others it is the fundamental index ETF

Recent Substitution trades

• In May 2012, the fundamental ETF PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) replaced the iShares Canadian Fundamental Index Fund (TSX symbol: CRQ) since it tracks the identical Canadian equity index but has a much lower MER (see post discussing the two)
• In January 2013, the commodity ETN UBS Bloomberg Constant Maturity Commodity Index Total Return ETN (UCI) replaced iPath DJ-AIG Commodity Index Total Return (DJP) because of what I found out in this post on my other blog, basically that UCI employs a much superior futures rolling method)

Bottom line

• The jury is still out with such a tiny total cumulative difference, though I am a bit surprised the fundamental side isn't pulling ahead. 
• Having a portfolio with a mix of asset classes really works well - note how the total portfolio is up 22+%. By comparison, the TSX Composite Capped index is up almost the same at 21%, almost the same but the ride has been a lot smoother with both our portfolios