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.
Showing posts with label portfolio. Show all posts
Showing posts with label portfolio. Show all posts
Thursday, 8 August 2013
Tuesday, 20 March 2012
Fundamental vs Cap-Weight Portfolio: Still Neck and Neck after 20 Months
No Clear Winner Yet - Last time I reported on the contest in August 2011, the cap-weight portfolio had jumped into an inconclusive lead. The contest between portfolios made up of either fundamentally-weighted or cap-weighted ETFs continues without a clear winner. The portfolios, shown in detail in the Google Docs spreadsheet at the bottom of this blog page, have been updated with all distributions up to and including February 2012. The $85 separating the two portfolios' values is a miniscule 0.07% difference. Three of the fundamental ETFs are in the lead against their cap-weight rivals while four of the cap-weighted ETFs are ahead, but by lesser amounts.
Every Asset Class is Up - Our contest start date of June 2010 must have been a good time to get into the market since every ETF is above its initial start value. The portfolio as a whole has gained 16%, a very satisfactory result for less than two years in the market.
No Rebalancing Yet Required - None of the ETFs has deviated beyond the limit (more than 25% away from its target allocation e.g. a 4% holding can go up to 5% or down to 3% before our rule kicks in) we set for forced rebalancing. That has been the case since the start. Both portfolios are quite maintenance-free. There is cash building up however, and come the June anniversary date, it will be time to invest that cash into the ETFs that lag their target the most.
Lack of Automatic Reinvestment Warps the Comparisons - One of the difficulties with making head to head fundamental vs cap-weight comparisons between ETFs within an asset class is that the cash distributions do not get reinvested within the ETF. The market hype of the ETF providers use total return calculations which assume that the distributions do get reinvested when received. Our growing cash pile includes an important part of the ETFs' returns but the cash doesn't show in the current market value of the ETF shares that we use to do the Red vs Green who-is-ahead comparison. Since the ETFs do not distribute the same amount of cash, the total returns can be a fair amount out of whack with the Red vs Green indicator on my spreadsheet e.g. PXF distributed USD$404.82 in 2011 while its counterpart VEU paid out USD$644.80; VEU is much further ahead at the moment than the $124 showing in the spreadsheet. The truest comparison of my test is at the total portfolio level.
The best direct head to head matchup is between Canadian equity ETFs CRQ and HXT since in those cases, the dividends do get reinvested. In HXT's case, the construction of the ETF itself as a total return swap ensures that HXT's value reflects reinvested distributions. In CRQ's case, Claymore's free DRIP program buys new shares for the investor so all but a few dollars each quarter gets reinvested. Right now CRQ, despite its much higher MER, is winning the race by 2.6%.
Every Asset Class is Up - Our contest start date of June 2010 must have been a good time to get into the market since every ETF is above its initial start value. The portfolio as a whole has gained 16%, a very satisfactory result for less than two years in the market.
No Rebalancing Yet Required - None of the ETFs has deviated beyond the limit (more than 25% away from its target allocation e.g. a 4% holding can go up to 5% or down to 3% before our rule kicks in) we set for forced rebalancing. That has been the case since the start. Both portfolios are quite maintenance-free. There is cash building up however, and come the June anniversary date, it will be time to invest that cash into the ETFs that lag their target the most.
Lack of Automatic Reinvestment Warps the Comparisons - One of the difficulties with making head to head fundamental vs cap-weight comparisons between ETFs within an asset class is that the cash distributions do not get reinvested within the ETF. The market hype of the ETF providers use total return calculations which assume that the distributions do get reinvested when received. Our growing cash pile includes an important part of the ETFs' returns but the cash doesn't show in the current market value of the ETF shares that we use to do the Red vs Green who-is-ahead comparison. Since the ETFs do not distribute the same amount of cash, the total returns can be a fair amount out of whack with the Red vs Green indicator on my spreadsheet e.g. PXF distributed USD$404.82 in 2011 while its counterpart VEU paid out USD$644.80; VEU is much further ahead at the moment than the $124 showing in the spreadsheet. The truest comparison of my test is at the total portfolio level.
The best direct head to head matchup is between Canadian equity ETFs CRQ and HXT since in those cases, the dividends do get reinvested. In HXT's case, the construction of the ETF itself as a total return swap ensures that HXT's value reflects reinvested distributions. In CRQ's case, Claymore's free DRIP program buys new shares for the investor so all but a few dollars each quarter gets reinvested. Right now CRQ, despite its much higher MER, is winning the race by 2.6%.
Monday, 8 August 2011
Fundamental vs Cap-Weight Portfolio: Surprise Performance Reversal after Year One
The first year has now passed in the head to head contest between the fundamentally-weighted portfolio and a parallel portfolio with the same asset allocation based on traditional cap-weighting. Both portfolios started out with $100k last June - see original post announcing the contest.
Both Portfolios Have Gained - up about 10% to $110,000 or so as of August 5th, though it was higher at the 1-year anniversary since the past few weeks have not been kind to market values. Every single asset class is higher than the value at inception. I note that our hypothetical investor is not panicking and is not / has not sold anything, unlike those mythical investors (why doesn't the press just call them speculators, anyway?) who have been obeying the chicken-little sky-is-falling market forecasting gurus.
Cap-weight Ahead Slightly! - Surprise, surprise, after being behind pretty well the whole year, sometimes by more than $1000, or 1%, the cap-weight portfolio spurted ahead in the last month or so and now leads by about 0.6%. I think the quick shift was the European banks getting hammered in the PXF vs VEU category but need to look further into this. Whatever the reason, this contest doesn't look very conclusive so far.
Rebalancing - After accumulating cash from most of the ETFs for the past year our policy called for review and reinvestment of the cash at each year anniversary. Note: Claymore CRQ ETF has automatic DRIP with distributions so I've tracked the reinvestment for CRQ. BMO also does auto DRIP but when BMO switched to monthly distributions with ZRR and ZRE it has not been worth my bother to do all the tracking of reinvestment for single share purchases, so I've simply tallied up the cash. Not one of the ETFs / asset classes had come near to the forced rebalancing point of 25% deviation from its target allocation in the portfolio. None are off even 10% from allocation target.
Nevertheless, to put the cash to work but not pay too much in commissions to rebalance small amounts, and to keep the asset class by asset class contest going, I've split the reinvestment cash to put another $1000 each into CRQ and it cap-weight rival HXT. The remainder has gone into XBB for each portfolio. These were the two asset classes with largest dollar amount divergence so it works out neatly as a quite realistic action.
More shares of XBB have been purchased (all purchases done at closing market prices of August 5th) because the cap-weight ETFs have paid out more than their fundamental weight counter-parts. That's interesting because the fundamental weight ETF holdings are supposed to be selected and weighted in part according to dividends. However, the higher MER's of the fundamental weight ETFs (about 0.5%) have to be paid. That's a cost performance drag of the real world for the fundamental ETFs that their superior index returns do not reflect. Our contest tests whether the stock performance is strong enough to overcome this impediment.
Fundamental DRW Replaces Cap-Weight RWX in the Fundamental Portfolio - Long ago reader Jordan suggested Wisdom Tree's Global ex-US Real Estate Index ETF (symbol DRW) as a fundamentally-weighted alternative to RWX. Now the switch is done it's done and there can be a contest in that asset class too.
As ever, the two portfolios can be seen side by side at the bottom of this blog page.
Both Portfolios Have Gained - up about 10% to $110,000 or so as of August 5th, though it was higher at the 1-year anniversary since the past few weeks have not been kind to market values. Every single asset class is higher than the value at inception. I note that our hypothetical investor is not panicking and is not / has not sold anything, unlike those mythical investors (why doesn't the press just call them speculators, anyway?) who have been obeying the chicken-little sky-is-falling market forecasting gurus.
Cap-weight Ahead Slightly! - Surprise, surprise, after being behind pretty well the whole year, sometimes by more than $1000, or 1%, the cap-weight portfolio spurted ahead in the last month or so and now leads by about 0.6%. I think the quick shift was the European banks getting hammered in the PXF vs VEU category but need to look further into this. Whatever the reason, this contest doesn't look very conclusive so far.
Rebalancing - After accumulating cash from most of the ETFs for the past year our policy called for review and reinvestment of the cash at each year anniversary. Note: Claymore CRQ ETF has automatic DRIP with distributions so I've tracked the reinvestment for CRQ. BMO also does auto DRIP but when BMO switched to monthly distributions with ZRR and ZRE it has not been worth my bother to do all the tracking of reinvestment for single share purchases, so I've simply tallied up the cash. Not one of the ETFs / asset classes had come near to the forced rebalancing point of 25% deviation from its target allocation in the portfolio. None are off even 10% from allocation target.
Nevertheless, to put the cash to work but not pay too much in commissions to rebalance small amounts, and to keep the asset class by asset class contest going, I've split the reinvestment cash to put another $1000 each into CRQ and it cap-weight rival HXT. The remainder has gone into XBB for each portfolio. These were the two asset classes with largest dollar amount divergence so it works out neatly as a quite realistic action.
More shares of XBB have been purchased (all purchases done at closing market prices of August 5th) because the cap-weight ETFs have paid out more than their fundamental weight counter-parts. That's interesting because the fundamental weight ETF holdings are supposed to be selected and weighted in part according to dividends. However, the higher MER's of the fundamental weight ETFs (about 0.5%) have to be paid. That's a cost performance drag of the real world for the fundamental ETFs that their superior index returns do not reflect. Our contest tests whether the stock performance is strong enough to overcome this impediment.
Fundamental DRW Replaces Cap-Weight RWX in the Fundamental Portfolio - Long ago reader Jordan suggested Wisdom Tree's Global ex-US Real Estate Index ETF (symbol DRW) as a fundamentally-weighted alternative to RWX. Now the switch is done it's done and there can be a contest in that asset class too.
As ever, the two portfolios can be seen side by side at the bottom of this blog page.
Wednesday, 11 May 2011
Bank Research Views on Inflation, Future Rates of Return and TSX Profits
Grist for the planning / expectations mill:
- Inflation - BMO Capital Markets Economic Research in the May 6 Focus on pages 5-6 weighs up likely changes to the Bank of Canada inflation targeting mechanism and 2% target and concludes that for now it will all remain the same, though in few years the BOC might move to a lower target since "CPI provides an upward biased measure of the true cost of living (because people tend to substitute lower- for higher-priced items and many new tech-type goods exhibit significant price decay)".
- Future rates of return - TD Financial Group Economics in the March 17th An Economics Perspective On Long-Term Financial Returns estimates that a long term investor with a diversified portfolio could expect 5 to 7% returns (before inflation, which they estimate at around 2%) on average, with big swings above and below that year by year as the usual result of business and market cycles. The breakdown: T-bills 3.4%, Universe (whole of market) Bonds 4.0%, Canadian/US/International Developed Equities 7.5%. Emerging markets equities get a one-line comment - "the MSCI Emerging Market Index could deliver an annual return of 11% to 12%"
- TSX profit margins - CIBC World Markets in the April 29th TSX Earnings: At the Margin figures that profit margins of companies on the TSX look strong overall in relation to the S&P 500 and their rising trend has some potential to advance yet more. Sectors differ considerably however, with a range of hot 20+% margins in metals and mining at the top of the table to woeful 2% margins in airlines and in machinery.
Monday, 7 March 2011
Book Review: The Power of Passive Investing by Richard Ferri
If ever there was any question or hope that a person could succeed in beating market returns (or their fund equivalent, market-cap weighted low-fee index funds) through investing in actively managed mutual funds, this book utterly destroys the notion. In The Power of Passive Investing author Richard Ferri presents piles of research results that slice and dice the data backwards and forwards, inside and out, upside and down. Whether it is high- or low-fee funds, past-winners, before- or after-tax, bond or equity funds, foreign or domestic investments, large funds or small, portfolios of funds, manager qualifications, Morningstar ratings, risk-adjustment that is used to select a mutual fund, none of it works better than cap-weighted index funds.
Worse, Ferri gives us the disquieting evidence that individual mutual fund investors get significantly poorer returns than even the average under-performing mutual fund because of bad trade timing.
It is thus difficult to dispute the practicality of his advice that individuals should buy passive index funds and focus their efforts instead on an asset allocation, matched with long term goals and personal circumstances (emotional strength aka risk aversion, age, wealth, job, health etc), that should change infrequently - only when the goals and circumstances do.
Ferri says it is not just individual investors who will be better off following that strategy. He makes an argument that charities, personal trusts, pension funds (especially small ones) and financial advisors should do the same to best carry out their responsibilities.
The referencing, presentation, writing style, grammar, diction and organization of the book is thankfully up to snuff (much better than another of his books that I reviewed).
That's the good stuff. Here is what I didn't like.
1) The big one:
Dismissal of active management and fundamental indexing - Showing that actively-managed mutual funds are, on average, losers, does not mean that active management, the seeking of "alpha", cannot ever work. Ferri indirectly and inadvertently (I think) recognizes such when he quotes (p.149) famed Yale University endowment manager David Swensen: "Low cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions". Or, on page 112, "Most of the great managers aren't for hire by the general public. The truly talented managers like to fly under the radar ... ". Or, again, on page 128 where he discusses where the dumb-money investors' money goes: "Much of it went to brokers, brokerage firms, and their trading desks. Another portion went to a handful of talented money managers who skillfully separate investors from their money". (my bolding)
He might admit that such managers really do exist (eg. Warren Buffett isn't just on a long lucky streak) but in effect says that we small-fry investors cannot tell them apart. Perhaps with active mutual funds that is so, but is it true with fundamental indexing, which he summarily dismisses on pages 75-76 with a stream of invective instead of looking at evidence? The historical performance evidence, along with the theoretical dissection of why fundamental indexing makes sense, presented most notably by Robert Arnott (whose book The Fundamental Index I reviewed here) deserves more attention than that from a smart guy like Ferri. The fact that some high-powered and neutral researchers like the EDHEC Risk Institute have effectively been trashing the value of market cap-weighted indexes for practical and theoretical reasons, suggests strongly that we, including Ferri, need to pay attention to this particular innovation, especially when it comes offered in reasonably low cost funds. The big question is whether the higher fees or tracking error of such funds (e.g. the US equity ETF from PowerShares PXF's 0.39% MER vs the classic S&P 500 ETF SPY's 0.0945%) offsets any alpha they might generate. That question is why I have the little practical side-by-side experiment going at the bottom of this blog (so far, fundamental is winning).
2) Minor annoyances:
- the mysterious 1:2 winner to loser ratio - all through the dismemberment of mutual fund performance, Ferri keeps emphasizing that the ratio of winners to losing funds in various studies settles around 1:2 (except even more mysteriously, that the bond fund ratio is even worse at 1:4), but he never explains why. There must be a Dan Brown novel in this!
- the big-5 lifetime financial liabilities in chapter 10 misses health costs - especially in the USA, and less so in Canada, health care costs, most likely in retirement, need to be a prime financial factor to be dealt with somehow
- the suggestion that it is too difficult to implement passive investing on one's own (page 191 chapter summary) - "The mechanics for prudent asset allocation and investment selection are more involved than how they are presented in this book. More reading is required to a portfolio is much easier said than done. Do-it-yourself investors often do not complete the process or maintain it well." Ok, here goes: US investor - 50% VTI (or PXF), 50% AGG; Canadian investor - 50% XIC (or CRQ), 50% XBB. Rebalance annually, or never, if you are really lazy. Add money by topping up the one below 50%. Withdraw money by selling off the one over 50%. Is that simple enough? It's only a good enough, not nearly optimal solution, but it should be possible for anyone to follow.
My rating: 4 out of 5 stars.
Disclosure: Thanks to the author's firm Portfolio Solutions for providing a free review copy.
Saturday, 26 February 2011
Portfolio Cap-Weight vs Fundamental Test and Monthly ETF Distributions
The portfolio contest between traditional Cap-Weight and Fundamental Weight Index ETFs has become a little more tedious to track manually with the switch by both BMO and iShares to more frequent monthly instead of former quarterly distributions on more ETFs.
It also undermines one of BMO's advantages compared to iShares, namely the automatic, free DRIP program since now much smaller amounts are being distributed monthly, which in many cases won't be enough to buy whole shares. Even with a $100k portfolio, the January and February amounts for ZRE are not enough to buy even one share. Since for ZRR both portfolios have the same holding it won't any difference between them. Therefore, I will simply accumulate the cash for both portfolios until rebalancing at the annual anniversary date in mid July presents an opportunity to re-invest it. The spreadsheet at the bottom of the blog now includes the cash for both January and February distributions (which is anticipating a bit since BMO only distributes the cash March 7th but again it doesn't make any comparative difference).
Cash or no cash, it is quite interesting to see that the Fundamental portfolio has now opened up a significant lead of $1602 since the beginning of the year. It's easy to spot that it is because of the huge leap of the Developed Markets Fundamental fund PXF over its Cap-Weight rival VEU. Both portfolios have positive returns in every asset class! It's just that "some are more equal than others" with bigger gains. That includes Canadian Bonds where the price level of XBB is flat but the cash interest distribution would push its return into plus territory. Nothing is really close to the 1/4 share out-of-whack rebalancing trigger point though XBB is starting to get down there with 21.5% versus its target 25%. If interest rates start to rise then XBB is likely to start falling though equities might too.
It also undermines one of BMO's advantages compared to iShares, namely the automatic, free DRIP program since now much smaller amounts are being distributed monthly, which in many cases won't be enough to buy whole shares. Even with a $100k portfolio, the January and February amounts for ZRE are not enough to buy even one share. Since for ZRR both portfolios have the same holding it won't any difference between them. Therefore, I will simply accumulate the cash for both portfolios until rebalancing at the annual anniversary date in mid July presents an opportunity to re-invest it. The spreadsheet at the bottom of the blog now includes the cash for both January and February distributions (which is anticipating a bit since BMO only distributes the cash March 7th but again it doesn't make any comparative difference).
Cash or no cash, it is quite interesting to see that the Fundamental portfolio has now opened up a significant lead of $1602 since the beginning of the year. It's easy to spot that it is because of the huge leap of the Developed Markets Fundamental fund PXF over its Cap-Weight rival VEU. Both portfolios have positive returns in every asset class! It's just that "some are more equal than others" with bigger gains. That includes Canadian Bonds where the price level of XBB is flat but the cash interest distribution would push its return into plus territory. Nothing is really close to the 1/4 share out-of-whack rebalancing trigger point though XBB is starting to get down there with 21.5% versus its target 25%. If interest rates start to rise then XBB is likely to start falling though equities might too.
Wednesday, 12 January 2011
Cap-Weight vs Fundamental Portfolios: 2010 Year End Update
Last June I created two parallel test portfolios to determine whether Fundamental Weighting really does a better job than a Cap-Weighting as proponents like Robert Arnott say. The two portfolios have the same asset classes and proportions invested in each asset class. As much as possible, the portfolios mirror the investor experience, as I described in the initial post about this mini project.
The 2010 year end has come and the cash distributions have been received by the portfolios in a mix of Canadian and US dollars. Where offered by the ETF vendor - BMO and Claymore only - the distribution has been reinvested in its ETF. Per the intention announced in the October update, in the Cap-Weight portfolio, I've now sold the iShares S&P TSX 60 Index ETF (symbol: XIU) and bought in its place Horizons BetaPro S&P TSX 60 Index (HXT), which cleverly uses swap derivatives to track the same index but with the key difference that it implicitly automatically reinvests distributions. That will make a fairer comparison against Claymore Canadian Large Cap ETF (CRQ) which has a DRIP.
The Competition Results:
The 2010 year end has come and the cash distributions have been received by the portfolios in a mix of Canadian and US dollars. Where offered by the ETF vendor - BMO and Claymore only - the distribution has been reinvested in its ETF. Per the intention announced in the October update, in the Cap-Weight portfolio, I've now sold the iShares S&P TSX 60 Index ETF (symbol: XIU) and bought in its place Horizons BetaPro S&P TSX 60 Index (HXT), which cleverly uses swap derivatives to track the same index but with the key difference that it implicitly automatically reinvests distributions. That will make a fairer comparison against Claymore Canadian Large Cap ETF (CRQ) which has a DRIP.
The Competition Results:
- It is still more or less a dead heat overall between the two portfolios - only $128 dollars out of a portfolio total value of $113,400 or 0.1%;
- Fundamental Weighting leads in four asset classes and Cap-Weighting leads in two (I ignore RWX since it is the same ETF in both portfolios and the Cap-Weight portfolio has one more share so it will always be ahead by that one share)
- Cap-Weighting is ahead in Canadian large cap equity but Fundamental Weighting leads by a significant margin in the two small cap equity ETFs for the USA and for Developed Markets. It is curious that Fundamental Weighting leads by most in two of the asset classes which have had the biggest increases. Cap-Weighting is supposed to be the bubble follower I thought. Maybe it's a sign that the rise in those stocks is not a bubble at all, that in fact the previous weightings were out of whack - Cap was too high - and now Fundamental has been catching up.
- Both portfolios are up a healthy 13% since June, when we pretended to invest $100k
- Every asset class is up by double digits, except Bonds
- The rise of the Canadian dollar has reduced foreign returns but they were still much stronger than those of Canadian holdings after conversion
- None of the asset classes is anywhere near the threshold set for rebalancing (1/4 of its allocation percentage), which we said anyway we'd only do after a year.
- Cash inevitably has started to pile up unproductively in these accounts as in real life when distributions are not immediately reinvested. The Fundamental portfolio has $1767 in cash (1.6% of its total value) and the Cap portfolio a bit more at $2066 / 1.8% (since fewer of its ETFs offer a DRIP). This brings out the real-life no-perfect-answer dilemma of having idle cash vs paying too much in trading commissions to reinvest small amounts. At the year anniversary in July after two more quarterly distributions by the ETFs, there will be more cash and we'll reinvest & rebalance per our portfolio policy.
Friday, 22 October 2010
Cap-Weight vs Fundamental Portfolios: Q3 Update after DRIP
The live updated spreadsheet at the bottom of this blog, which shows the on-going contest between a cap-weight portfolio and its fundamental weight counterpart, has now been updated to include the automatic reinvestment of dividends where the ETFs offer that feature.
The DRIP purchases included the following:
Fundamental Portfolio
I'm going to substitute the new Horizons BetaPro TSX 60 tracker ETF (symbol HXT) in the cap-weight portfolio since its total return swap construction reflects implicit automatic DRIPing and I want to find out about the difference in weighting strategy not the effects of DRIP, which will always be beneficial to the ETFs that do it in rising market.
The net difference between the two strategies is pretty slim, with each one ahead in 3 holdings (I ignore the RWX since they both hold it and the Cap-weight is ahead merely and always because it holds one more share) and the Fundamental Weight portfolio is in the lead overall by only 0.1% or so ($171 on a $111,000 portfolio). It's a tie so far.
The DRIP purchases included the following:
Fundamental Portfolio
- CRQ - Claymore Canadian Fundamental Index Equity large cap - 6 extra shares
- ZRE - BMO Equal Weight REIT - 2 shares
- ZRR - BMO Real Return Bond - 6 shares
- ZRR - BMO Real Return Bond - 6 shares
I'm going to substitute the new Horizons BetaPro TSX 60 tracker ETF (symbol HXT) in the cap-weight portfolio since its total return swap construction reflects implicit automatic DRIPing and I want to find out about the difference in weighting strategy not the effects of DRIP, which will always be beneficial to the ETFs that do it in rising market.
The net difference between the two strategies is pretty slim, with each one ahead in 3 holdings (I ignore the RWX since they both hold it and the Cap-weight is ahead merely and always because it holds one more share) and the Fundamental Weight portfolio is in the lead overall by only 0.1% or so ($171 on a $111,000 portfolio). It's a tie so far.
Wednesday, 6 October 2010
Credit Suisse on Inflation - How It Happens, What to Do
Credit Suisse's Global Investor 1.10 report has a lot of worthwhile content on inflation:
- How Inflation Comes About, a one-page Sim City like picture that shows how the financial system and key bits of the economy interact to create the beast we abhor - from Central banks, through commercial banks, the labour market, the capital market, the goods market. Brilliant communication! There's even a helicopter hovering over the stylized city - a sly reference to Helicopter Ben?
- an assessment of Inflation as the escape route for high-debt countries - they say it is "unlikely" because many countries have "... experienced the painful consequences and destabilizing effects of runaway inflation," and won't want to experience it again; but it's much more likely in emerging market countries and commodity exporters and those least affected by the real estate crisis ... hmmm, sounds a fair bit like Canada
- a sidebar on who is best at inflation forecasting - surprise, it is not that implied by subtracting the yield on real return bonds from the nominal return of government bonds - they were the least reliable! Best at the one-year ahead inflation forecasts were ... drum roll ... the central banks. Note how they all slightly under-estimate actual inflation. Based on the expectations on this Bank of Canada page, which does NOT seem to include a forecast by the Bank itself, 2011 looks like it will be in the 2.5-3% range in Canada.
- an inflation history graph going back to 1500 - inflation was a lot lower and more stable between 1800 and 1900!
- people almost always feel inflation is worse than the official CPI numbers say. Most people are not inflation-conspiracy believers, they simply notice and feel the pain a lot more on the purchases they rely on most. It's a new area of behavioural finance, an extension of the "you feel losses twice as much as gains" idea. Hmmm, maybe that's why I think life is cheap here in the UK compared to Canada because wine is definitely a lot less expensive (lots of good table wine at the equivalent of $6.50 per bottle)
- asset inflation caused by lax monetary policy and boosted by leveraging is very dangerous - no kidding - but take away the leveraging, as in the tech bubble, and the lasting real economy effects are not nearly as bad
- an Adjusting to Inflation article shows different asset classes performed differently in different high-inflation periods . In the 1970s, gold, oil and commodities did best, but between 1986 and 1990 commodities did really well, oil was ok but very up and down and gold did very poorly, much worse than CPI. They then go on with the table below to identify which kinds of assets they think will do well in different economic environments. Their conclusion is one with which I cannot but agree - since you cannot know exactly when and in what form inflation will arise, the best investment strategy is to maintain a balanced diversified portfolio but to be sure to include things like gold, commodities, real return bonds and other hard assets.
- there are personal accounts from three individuals who have lived through either hyper-inflation (Zimbabwe and Argentina), or deflation (Japan) - a strong reminder that we do not want to go there, diversified portfolio or not.
Friday, 1 October 2010
Cap-Weight vs Fundamental Portfolios: Q3 Update, Guess Who Leads
Regular readers may recall that a few months ago I started a contest to see whether a portfolio based on Fundamentally-weighted ETFs would do better than the traditional standard Cap-weighted index ETFs. This contest is meant to be as realistic as possible using actual funds, including trading commissions, currency effects, distributions, DRIPs etc.
The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).
However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.
Other observations:
The contest continues ...
The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).
However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.
Other observations:
- Strong portfolio gains: both portfolios up almost 10% since June!
- Correlated asset classes can be good: every single ETF / asset class in both portfolios has gone up since June. That's highly unusual and sure not to continue for very long. The value of having a diversified portfolio is still evident in the large disparity between the gains amongst the ETFs. If one had only been invested in Canadian large cap equity with a 4% gain and bonds with a 2% gain, the overall portfolio gain would have been somewhere in that low range. Emerging markets, Developed markets ex-US, international real estate, commodities and Canadian small cap and REITs all contributed percentage advances of triple or more Canadian large cap's. Another way to look at it is that not having a diversified portfolio means having to pick which asset class will go on a tear next in order to get good gains. Diversification = not as good as the best but better than the worst.
- Fundamental winning in most asset classes vs Cap-weight - leading by 5 to 2. It is still early days in our contest but this is going in the direction I would expect. ... However, where Cap-weight is winning (Canada large equity and Emerging markets equity), it is by enough to more or less balance things at the portfolio total. As I wrote about here, in the Canada equity case, I believe the difference is due to the ongoing Potash Corp takeover bid.
- No re-balancing required: in neither portfolio is the actual value of any asset class anywhere near to going beyond the 1/4 away from target that we said would be our rule for re-balancing; the Cap-weight percentages are slightly more out of whack compared to target, which is what we would expect from indices that rely on market prices - fundamental accounting weights should evolve more slowly. That will be interesting to watch as we go along. (in the updated spreadsheet that appears live at the bottom of this blog, I've inserted a new column in the individual portfolio spreadsheets that shows the ratio of each asset class' actual to target)
- Currency has reduced returns: the Canadian dollar has risen about 1.4% vs the USD since our launch, reducing our net returns on US denominated holdings and that is the same for both portfolios.
The contest continues ...
Wednesday, 29 September 2010
EDHEC Papers Burst Balloons on Cap-Weighted Indexing and SRI Funds
The EDHEC-Risk Institute, an academic institute with a practical orientation, has put out a couple of papers that knock down some investment wishful thinking.
In Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?, authors Felix Goltz and Véronique Le Sourd, after reviewing the academic literature, answer that question quite categorically - "No, it does not". A cap-weighted index does not represent the market portfolio of finance theory and even if it could, it would not be efficient in a risk-return sense without making highly unrealistic assumptions. As they say, "... from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage". It then becomes a practical problem to construct indices that offer higher return to risk trade-off (as expressed in higher Sharpe ratios). They offer their own Efficient Indices here and when they assess alternatives (Improved Beta? A Comparison of Index Weighting Schemes) like fundamental indexing, equal weight indexing, efficient indexing and minimum volatility indexing, the alternatives all beat Cap-Weighting (e.g. their US Efficient Index has outperformed the FTSE US Cap-weighted index by 2% annually since 2002 while lowering volatility). Of course, not all these better indices are investable for the average retail investor - so far only fundamental and equal-weight funds are available - and the costs of running the index fund could obviate the benefits (witness the sorry story of mutual funds in Canada) if too high (my assessment of US ETFs suggests they do preserve the benefit in real life and I've started a realistic portfolio experiment for a Canadian investor that includes Canadian ETFs).
The other foray into clarifying reality vs wishful thinking is The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis by Noël Amenc and Véronique Le Sourd (again! does she like setting people straight or what?). Comparing the performance of SRI funds in France, they cannot really find any significant difference with ordinary funds in terms of risk-return efficiency. During the period of the financial crisis, SRI funds provided no better protection against the downturn. A subset of SRI, Green (environmental) funds, compared to best-in-class ordinary funds "... reveals, over the long term, higher alpha for green funds, with higher risks, including higher extreme risks." The paper's findings will give some comfort to the SRI-minded investor with its evidence that the investor need not lose out by going SRI. However, it does also remind us that SRI is no investing philosophy panacea either. I am currently reading Confessions of a Radical Industrialist by Ray Anderson and he leaves an over-the-top impression that going green is a sure-fire route to greater profitability. That may be so if you do it right but I daresay there are well run and badly run SRI and green companies, just as in any human activity (as an illustration of the principle for those with a reflective bent, I highly recommend the book Albert Speer: His Battle With Truth by Gita Sereny; it tells the story of a highly intelligent but amoral organizational genius who put his talents in the service of evil as the mastermind of Hitler's war production machine)
In Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?, authors Felix Goltz and Véronique Le Sourd, after reviewing the academic literature, answer that question quite categorically - "No, it does not". A cap-weighted index does not represent the market portfolio of finance theory and even if it could, it would not be efficient in a risk-return sense without making highly unrealistic assumptions. As they say, "... from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage". It then becomes a practical problem to construct indices that offer higher return to risk trade-off (as expressed in higher Sharpe ratios). They offer their own Efficient Indices here and when they assess alternatives (Improved Beta? A Comparison of Index Weighting Schemes) like fundamental indexing, equal weight indexing, efficient indexing and minimum volatility indexing, the alternatives all beat Cap-Weighting (e.g. their US Efficient Index has outperformed the FTSE US Cap-weighted index by 2% annually since 2002 while lowering volatility). Of course, not all these better indices are investable for the average retail investor - so far only fundamental and equal-weight funds are available - and the costs of running the index fund could obviate the benefits (witness the sorry story of mutual funds in Canada) if too high (my assessment of US ETFs suggests they do preserve the benefit in real life and I've started a realistic portfolio experiment for a Canadian investor that includes Canadian ETFs).
The other foray into clarifying reality vs wishful thinking is The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis by Noël Amenc and Véronique Le Sourd (again! does she like setting people straight or what?). Comparing the performance of SRI funds in France, they cannot really find any significant difference with ordinary funds in terms of risk-return efficiency. During the period of the financial crisis, SRI funds provided no better protection against the downturn. A subset of SRI, Green (environmental) funds, compared to best-in-class ordinary funds "... reveals, over the long term, higher alpha for green funds, with higher risks, including higher extreme risks." The paper's findings will give some comfort to the SRI-minded investor with its evidence that the investor need not lose out by going SRI. However, it does also remind us that SRI is no investing philosophy panacea either. I am currently reading Confessions of a Radical Industrialist by Ray Anderson and he leaves an over-the-top impression that going green is a sure-fire route to greater profitability. That may be so if you do it right but I daresay there are well run and badly run SRI and green companies, just as in any human activity (as an illustration of the principle for those with a reflective bent, I highly recommend the book Albert Speer: His Battle With Truth by Gita Sereny; it tells the story of a highly intelligent but amoral organizational genius who put his talents in the service of evil as the mastermind of Hitler's war production machine)
Monday, 6 September 2010
Investment Banks and Hedge Funds: the Bubble of the Past Quarter Century?
The Credit Bubble leading to the Crash of 2008. Who profited and where did all the money go? That's a question I have been asking myself since 2007 and the start of the credit / financial crisis. The answer I now believe is a) employees of investment banking; b) managers / employees of hedge funds; c) shareholders with stakes (i.e. whether as separate entities or whose profits flow up to a parent entity) in investment banking and hedge funds.
The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."
In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of WhereDoesAllMyMoneyGo.com for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the Advisor.ca website - N.B. I have added to Research Affiliate's chart the red Bubble line)
The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.
When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.
I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.
What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".
And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at FT.com, others at FT.com, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).
It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.
Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.
Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.
Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.
The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."
In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of WhereDoesAllMyMoneyGo.com for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the Advisor.ca website - N.B. I have added to Research Affiliate's chart the red Bubble line)
The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.
When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.
I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.
What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:
- USA - in Vanguard's Market Cap VTI, Financial Services = 16.4% as of 31 July 2010 vs Powershares RAFI PRF = 20.9% as of 31 Aug 2010
- Canada - iShares TSX Composite XIC = 29.6% vs Claymore Canadian Fundamental Index CRQ = 45% as of 3 Sep 2010
- World - Vanguard All-World ex-US VEU = 25.8% as of 30 April vs PowerShares Developed RAFI ex-US PXF = 28.9% as of 3 Sep 2010
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".
And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at FT.com, others at FT.com, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).
It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.
Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.
Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.
Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.
Friday, 25 June 2010
Possible Effects of Global Imbalances on Investors
McKinsey & Company's Globalization's critical imbalances in the McKinsey Quarterly report provides a readable summary of those issues along with some implications that, though they are directed at a corporate audience, provide food for thought for individual investors.
Here are a few parts I think to be pertinent:
Here are a few parts I think to be pertinent:
- "it would be wise to be prepared for the high probability of future financial shocks. To do so, most companies need to become more adept at risk management and to err on the side of being overcapitalized, overliquid, and overprepared." By shocks they mean what is described in the next quote below. To me the implication is to hold a higher amount of fixed income with special regard to credit-worthiness. Canadian government debt seems to me to be a good bet, even better than US Treasury debt.
- "... companies should engage in serious scenario planning around “unthinkables.” These might include the potential for significant, rapid shifts in currency values (for example, a 30 percent decline of the dollar versus emerging-market currencies); an exit from the euro by some nations; dramatic, rapid changes in commodity prices (for example, oil prices spiking to $200 a barrel); or defaults on debt by major nations." Hello major volatility in different parts of a portfolio. Currency exposure may well account for most of the variation in an internationally-diversified portfolio in future. If CAD remains strong because of Canada's production of commodities and because our government's fiscal situation is strong too (thanks again to Paul Martin and Jean Chretien who did the dirty work back in the 1990s that we benefit from today), there is a good possibility we Canadian investors won't gain much overall from such shifts, maybe even lose due to US and European holdings even though emerging markets holdings might rise even more strongly. Since emerging markets are typically a small (only 5% in my portfolio) portion, does that mean one should depart from the traditional backward-looking passive allocation according to current market value and increase the allocation looking forward. Or, an investor has two other choices - 1) try to avoid currency volatility by buying hedged funds but the question is whether such funds are effective given their typical high overhead cost and the tracking error; 2) stay exposed to currency, monitor the portfolio closely and be ready to do major rebalancing. Hmmm, what to do .... cannot say I've decided but just ignoring this stuff isn't smart.
Thursday, 10 June 2010
Cap-Weight vs Fundamental: Live Realistic Portfolio Showdown
In recent months I've converted my passive index portfolio strategy from one based on capitalization-weighted ETFs to fundamentally-weighted ETFs in the expectation that this will pay off with higher returns and lower volatility. The theory and the back-tested data notwithstanding, the proof is in the pudding so I've constructed two parallel portfolios which are permanently posted at the bottom of this blog. I'll hopefully see how my new portfolio fares in comparison to what might have been - it's either public embarrassment or triumph that is in store for me down the road.
Since pudding is something you can actually eat, the portfolio will be as realistic as possible, what an actual investor will experience, as opposed to so-called index returns one typically sees in the financial press, which exclude various MERs, commissions, tracking errors, currency exchange fees, taxes etc.
Here is how these portfolios will operate:
Since pudding is something you can actually eat, the portfolio will be as realistic as possible, what an actual investor will experience, as opposed to so-called index returns one typically sees in the financial press, which exclude various MERs, commissions, tracking errors, currency exchange fees, taxes etc.
Here is how these portfolios will operate:
- $100,000 Initial Capital - though most people must gradually build up a portfolio, I've started with a lump sum to invest; to convert my own portfolio I've actually had to pay an extra 7 trading commissions ($70) to sell off the cap-weight ETFs that no longer fit but I have ignored this cost.
- Trading Commission - $10 each trade, so the initial total value of the portfolio has lost $120 for the 12 trades to establish each portfolio
- Asset Allocation - both portfolios have the same basic percentages allocated by geography and asset class (see the breakdown in the tab AssetAllocation-ETFs) with one prime difference - the cap-weight portfolio includes Value ETFs for USA Small-Cap equity (VBR) and for Global Developed equity (EFV) following the cap-weight view of the world that one adds Value stocks as a tilt. Meanwhile, the Fundamental portfolio simply includes Smaller company ETFs, according to the fundamental metrics NOT cap-weight, for the same USA and Global geographies. In the Canadian REIT class, I have chosen the brand new BMO ETF (ZRE) which equally weights its holdings, since equal weighting also breaks the over-investment in growth stocks that corrupts cap-weighting. In several asset classes no fundamental ETFs are available so we are restricted to using cap-weight ETFs, like XMD (Canadian Small), RWX (Global REIT) and DJP (Commodities). This asset allocation difference is the essence of the divergent approaches.
- Real Prices - I used actual market quotes during the day yesterday June 9th as my buy prices. Note how the real investor cannot buy exactly the number of shares to place the exact amount allocated to each asset class. Through the magic of GoogleFinance and Google Docs, I have created a spreadsheet that automatically and continually retrieves current market prices so that a very realistic picture of the portfolios can be seen at any time.
- Rebalancing - will be reviewed once a year in mid July after semi-annual distributions have been received and rebalanced if holdings are more than 1/4 from their target value e.g. for RWX whose allocation is 2%, that is a 0.5% up or down deviation. Even with a fairly big $100k portfolio, it is not desirable to rebalance too often with too small buy-sell amounts - even 0.5% of the initial $2000 allocation is $500, so a $10 trade is a 2% cost. For 12 annual rebalancing trades or $120, the cost to the $100k portfolio is a 120/100000 = 0.1% extra annual cost. Such seemingly small differences do matter over the long run.
- Taxes - I am assuming the portfolios are within registered accounts that qualify as retirement accounts under US rules (RRSP, RIF, LRIF, LIRA but not TFSA or RESP) so that there is no 15% withholding tax deducted from distributions received from US ETFs
- Distributions - I will add cash distributions to the portfolios as they are received. To keep things a bit simpler I will assume that USD cash will remain as USD and not be converted into CAD (thus avoiding the attendant built-in currency exchange fee). This is in keeping with the slow trend by discount brokers (Questrade, RBC and some others do so today) to enable USD to be kept as USD in registered accounts.
- Foreign Currency - the value in Canadian dollars (CAD) is what counts to me and to most Canadians so the net value of USD-traded ETFs is converted back into CAD automatically through the use of the ETF CurrencyShares Canadian Dollar Trust (FXC), which tracks the value of CAD in USD pretty closely. None of the foreign holdings in either portfolio are hedged since I believe the costs of hedging and the tracking error of hedged ETFs outweigh the benefits in the long run. Conversion of CAD with USD is assumed to cost 0.9% (about what I seem to pay with my broker).
- DRIP - CRQ, ZRE and ZRB offer automatic free reinvestment of distributions so I will calculate that; for the others, the cash balance will accumulate for a year until rebalancing is done. Since I cannot figure out how much interest the cash would collect - a minimal amount if any these days - I won't include any interest for now but if interest rates start to shoot up, I'll try to do an estimate based on rates I see in my own account.
- Tracking Through the Months and Years - to get an idea of the relative volatility of the two portfolios (I don't expect too much difference since the fundamental indexers themselves have figured out that there is a high correlation between the ups and downs of the funds ... but we shall see), I'll take a month-end snapshot of the portfolio totals and begin graphing them. In ten years, it should be interesting! (If that seems too long, maybe we can take comfort in the fact that Charles Darwin took twenty years to continue his research before publishing his book after he had developed the theory of natural selection).
Sunday, 30 May 2010
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):
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)
Thursday, 25 February 2010
Time to Put Some RSP in the RRSP?
Once you deposit cash into the RRSP the question then becomes what to invest the money in. One of the key pieces of most diversified portfolios is US equities and a popular choice is an index fund based on the S&P 500, perhaps the SPDR S&P 500 (symbol SPY).
Here's an intriguing complement or perhaps alternative - the Ryder S&P Equal Weight Fund which has the memorable ticker symbol of RSP (the connection to Canada's RRSP cannot be a coincidence, surely this is a prophetic sign ;-). For those more pragmatic and try-to-be-rational people, like me, a closer look at RSP reveals some tantalizing data.
The RSP is a passive index fund that differs from the traditional cap-weighted SPY by weighting the portion of each stock holding equally - i.e. each of the same 500 stocks in the S&P 500 comprises 0.2% (100% divided by 500) of the total. Keith Hawkins' excellent Investopedia article S&P 500 ETFs: Market Weight vs Equal Weight explains the similarities and the differences between the two approaches. The article compares results based on the underlying indices but what about the actual ETFs?
The simple Google Finance chart below of SPY vs RSP since the 2003 launch of RSP looks mighty good as RSP is up 42% compared to SPY's 12.6%.
But that's not the whole story. First, there is the question of total returns, which takes account of differences in taxes/ turnover/ capital gains, MER, bid-ask spreads, dividends etc. Turning to Morningstar, the Performance tab of the data on RSP and SPY shows us that RSP looks just as good if not better on a Total Return basis - despite an MER of 0.40% vs only 0.09% for SPY and turnover of 22% vs only 7%, RSP outperformed SPY by a massive 2.21% per year (2.08% 5-yr annualized trailing total return for RSP vs -0.13%) from 2003 to date. What is more, RSP's tax efficiency (see Tax tab) as expressed in the lower tax ratio of 0.48 vs 0.57 is better and RSP has capital losses stored up (against which future capital gains will be offset so that no capital gains will be distributed to fundholders causing tax liability) of minus 23% vs a gain of 3% on the books of SPY. Given the much higher turnover of RSP, I'd guess what is going on is that RSP is accumulating capital losses by having to sell losers leaving the S&P500 at the bottom (they sure cannot be obliged to sell by some company moving up, the S&P 500 is the top category!).
That's pretty good, but the second question is critical. Is this outperformance is only a manifestation of the value and smaller-cap tilt inherent in RSP's indexing method or of a fundamentally better method of tracking the market and thus sustainable in the long term through different market cycles and conditions? That the latter might be the case finds support from studies done by the EDHEC who found that cap-weighted indices in the USA, Europe and Japan were inefficient compared to equal-weighted indices they built, which were similar though not identical to RSP - e.g. Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement by Noël Amenc, Felix Goltz and Véronique Le Sour. Standard and Poors' Equal Weighted Indexing Five Years Later on SSRN by Srikant Dash and Keith Loggie also reach the conclusion that equal weight indexing really works both for US stocks and internationally.
If the net effect of equal weight indexed funds is only to under-perform during strong bull markets (and bubbles) and outperform during bear markets, as the commentary by the Rydex's Carl Resnick says in this interview, then that is a very valuable quality, especially for the portfolios of people in retirement, when downside risk is a prime concern.
The big question I have not seen addressed directly, though the Dash-Loggie paper does show the recent varying correlation between the S&P 500 Equal vs Cap-Weight Indices, (it lessened considerably during the tech bubble which is a very good thing), is the correlation of equal-weighted indices with other asset classes. It is the combined effect in the overall portfolio that counts above all. If equal weight is significantly un-correlated with them, the added volatility of RSP on its own is not a concern since the overall portfolio volatility will decline. That characteristic is the reason I think having commodities in my portfolio, among other holdings, is worthwhile.
The idea of putting some RSP into an RRSP merits serious consideration.
Here's an intriguing complement or perhaps alternative - the Ryder S&P Equal Weight Fund which has the memorable ticker symbol of RSP (the connection to Canada's RRSP cannot be a coincidence, surely this is a prophetic sign ;-). For those more pragmatic and try-to-be-rational people, like me, a closer look at RSP reveals some tantalizing data.
The RSP is a passive index fund that differs from the traditional cap-weighted SPY by weighting the portion of each stock holding equally - i.e. each of the same 500 stocks in the S&P 500 comprises 0.2% (100% divided by 500) of the total. Keith Hawkins' excellent Investopedia article S&P 500 ETFs: Market Weight vs Equal Weight explains the similarities and the differences between the two approaches. The article compares results based on the underlying indices but what about the actual ETFs?
The simple Google Finance chart below of SPY vs RSP since the 2003 launch of RSP looks mighty good as RSP is up 42% compared to SPY's 12.6%.
But that's not the whole story. First, there is the question of total returns, which takes account of differences in taxes/ turnover/ capital gains, MER, bid-ask spreads, dividends etc. Turning to Morningstar, the Performance tab of the data on RSP and SPY shows us that RSP looks just as good if not better on a Total Return basis - despite an MER of 0.40% vs only 0.09% for SPY and turnover of 22% vs only 7%, RSP outperformed SPY by a massive 2.21% per year (2.08% 5-yr annualized trailing total return for RSP vs -0.13%) from 2003 to date. What is more, RSP's tax efficiency (see Tax tab) as expressed in the lower tax ratio of 0.48 vs 0.57 is better and RSP has capital losses stored up (against which future capital gains will be offset so that no capital gains will be distributed to fundholders causing tax liability) of minus 23% vs a gain of 3% on the books of SPY. Given the much higher turnover of RSP, I'd guess what is going on is that RSP is accumulating capital losses by having to sell losers leaving the S&P500 at the bottom (they sure cannot be obliged to sell by some company moving up, the S&P 500 is the top category!).
That's pretty good, but the second question is critical. Is this outperformance is only a manifestation of the value and smaller-cap tilt inherent in RSP's indexing method or of a fundamentally better method of tracking the market and thus sustainable in the long term through different market cycles and conditions? That the latter might be the case finds support from studies done by the EDHEC who found that cap-weighted indices in the USA, Europe and Japan were inefficient compared to equal-weighted indices they built, which were similar though not identical to RSP - e.g. Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement by Noël Amenc, Felix Goltz and Véronique Le Sour. Standard and Poors' Equal Weighted Indexing Five Years Later on SSRN by Srikant Dash and Keith Loggie also reach the conclusion that equal weight indexing really works both for US stocks and internationally.
If the net effect of equal weight indexed funds is only to under-perform during strong bull markets (and bubbles) and outperform during bear markets, as the commentary by the Rydex's Carl Resnick says in this interview, then that is a very valuable quality, especially for the portfolios of people in retirement, when downside risk is a prime concern.
The big question I have not seen addressed directly, though the Dash-Loggie paper does show the recent varying correlation between the S&P 500 Equal vs Cap-Weight Indices, (it lessened considerably during the tech bubble which is a very good thing), is the correlation of equal-weighted indices with other asset classes. It is the combined effect in the overall portfolio that counts above all. If equal weight is significantly un-correlated with them, the added volatility of RSP on its own is not a concern since the overall portfolio volatility will decline. That characteristic is the reason I think having commodities in my portfolio, among other holdings, is worthwhile.
The idea of putting some RSP into an RRSP merits serious consideration.
Friday, 12 February 2010
The 4% Retirement Withdrawal Rule Gets Potshots from Nobel Laureate
Came across The 4% Rule—At What Price? by Jason S. Scott, William F. Sharpe, and John G. Watson (SSW) on the A Loonie Saved blog (who posted some interesting comments on the paper). Sharpe won the Nobel Laureate for Economics in 1990 so it behooves us to pay attention, especially when he deals, along with his co-authors who, of course, should share the credit equally, with the critically important topic of how to manage one's finances and investments in retirement.
The 4% rule states that a retiree can withdraw 4% of portfolio value, adjusted upwards for inflation each year, based on the portfolio at the start of retirement. This provides a constant real spending amount. The portfolio is assumed to be a mix of about 40% bonds and 60% equity. Based on the past history of the US market going back as far as the late 1920s, various researchers have found that no portfolio would ever have run out of money in 30 years or less. Who can argue with that?
SSW have harsh words for the 4% rule, calling it wasteful, inefficient, fundamentally flawed. Their main criticism: "A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform, and in any case, could likely purchase exactly the same spending distributions more cheaply." And the cause they say is the bad strategy of trying to match volatile investments with a desired fixed income stream. They claim that even highly diversified low volatility portfolios have some risk of running out early in a 30 year retirement horizon - a 3.9% risk for a portfolio with 9% standard deviation. They also say that portfolios waste10-20% of the initial funds generating un-necessary surpluses and another 2-4% spending money the wrong way. They ask, why bother with the 4% rule when a risk-free inflation adjusted bond (RRB) can guarantee 4.46% for 30 years?
My comments
The logic is fine as one would expect, but are the assumptions complete and correct and do practical realities affect the bottom line? To some degree I think they do.
There is much sense to SSW's basic idea that one should match the nature of asset (income generating) cash flows with liability (living expense) cash flows. Essential living expenses in retirement need to be supported by an equally solid and steady income stream. RRBs and government CPP and OAS/GIS fit into the highly certain category. Non-essential / luxury retirement spending is quite flexible and controllable and that's the bit a portfolio can fund, whether it's according to the 4% rule or other types like 4 or 5% of year-end portfolio value, or year-to-year floor and ceiling limits.
The 4% rule states that a retiree can withdraw 4% of portfolio value, adjusted upwards for inflation each year, based on the portfolio at the start of retirement. This provides a constant real spending amount. The portfolio is assumed to be a mix of about 40% bonds and 60% equity. Based on the past history of the US market going back as far as the late 1920s, various researchers have found that no portfolio would ever have run out of money in 30 years or less. Who can argue with that?
SSW have harsh words for the 4% rule, calling it wasteful, inefficient, fundamentally flawed. Their main criticism: "A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform, and in any case, could likely purchase exactly the same spending distributions more cheaply." And the cause they say is the bad strategy of trying to match volatile investments with a desired fixed income stream. They claim that even highly diversified low volatility portfolios have some risk of running out early in a 30 year retirement horizon - a 3.9% risk for a portfolio with 9% standard deviation. They also say that portfolios waste10-20% of the initial funds generating un-necessary surpluses and another 2-4% spending money the wrong way. They ask, why bother with the 4% rule when a risk-free inflation adjusted bond (RRB) can guarantee 4.46% for 30 years?
My comments
The logic is fine as one would expect, but are the assumptions complete and correct and do practical realities affect the bottom line? To some degree I think they do.
- Life expectancy - Will you live exactly 30 years? Do you want to plan retirement based on that certainty? At age 65, there is a 6% chance that one of a couple will still be alive 30 years later. After 30 years, the real return bond is done, there is no money left with 100% certainty but a portfolio will survive (... most likely? [there being arguments about whether 4% is sufficient to guarantee perpetual life, according to market history, or possibly less than that using Monte Carlo simulation]). If you die before 30 years, then you also have a "wasteful surplus" using an RRB. The waste label applied to a portfolio compared to an RRB only is true in the context of a retirement spending plan which lasts exactly 30 years.
- Surplus = Legacy - maybe the implicit spending on surplus isn't so bad since many people want to leave money to the next generation. Any money left over is not therefore wasted. With the RRB method, one would need to decide at retirement how much bequest money to leave and set that aside, which would of course mean a reduction in net funds available to live off, i.e. a lower withdrawal rate
- Returns - SSW assume a 2% return on RRBs. At one time that may have been true and it may happen again, but right now Canadian Fixed Income is showing yields on Canada RRBs ranging from 1.36% to 1.60%. The little chart below shows how withdrawal/income rates change according to yield and length of retirement. So, if you pick 1.4% as the current base and 35 years to be safe(r) the withdrawal rate is 3.63%. The 4.46% RRB withdrawal rate that SSW cite doesn't seem so available any more.
- Transaction costs - will also affect net returns; to be realistic, one would have to get real data on rebalancing costs, purchase and sale of securities and I am not sure how it would work out in a stock/bond portfolio vs RRBs. Maybe it would not even be possible to buy a complete ladder of RRB strips for the time required. The longest maturity Canada RRB is 2036, only 26 years away. What would you do, put 4-5 years worth of money in a money market fund with about 0% effective yield?
- Taxes - it doesn't matter in a tax-deferred account since all returns are treated as income and only when withdrawn, but in a taxable account the favourable tax rates on capital gains and dividends that would come from a portfolio mean better after tax money to spend. RRBs in Canada in a taxable account get taxed on the interest (or imputed interest) and the inflation adjustment component and that happens every year so net returns are reduced quite a bit.
There is much sense to SSW's basic idea that one should match the nature of asset (income generating) cash flows with liability (living expense) cash flows. Essential living expenses in retirement need to be supported by an equally solid and steady income stream. RRBs and government CPP and OAS/GIS fit into the highly certain category. Non-essential / luxury retirement spending is quite flexible and controllable and that's the bit a portfolio can fund, whether it's according to the 4% rule or other types like 4 or 5% of year-end portfolio value, or year-to-year floor and ceiling limits.
Tuesday, 8 December 2009
IFA Calculator Demonstrates the Diversified Portfolio Superiority
Those who want to check the advantage of a diversified international portfolio may want to try out the superb IFA Index calculator over at IFA.com. Though addressed to US investors using US dollar data, the principles and the nature of the results for Canadians would be largely the same.
The folks at IFA have incorporated several unique and valuable features:
Portfolio Advantages:
One of the comparator asset classes is the S&P500 index (in step 1, scroll down the Indexfolio list to the bottom to get it). I used the worst ever 20 year rolling period of 1962 to 1981 (yup, it even beats 1929 to 1948 if you look at the handy 20-year chart from AllFinancialMatters blog on S&P500 Rolling Period Total Real Returns; call this the "financial death by inflation" period of modern history). The comparison of a conservative middle of the road portfolio - IFA's Index 45 - to the S&P500 shows the following:
1) Simple buy at the beginning and hold throughout
Many thanks to IFA advisor Brad Von Grote who pointed out the calculator and spent a considerable time on the phone chatting with me. In case anyone wonders, IFA hasn't paid me to praise their calculator and I am not a client of theirs though I think a person could do far worse than sign up with them. I only wish they would create something similar for their Canadian audience.
The folks at IFA have incorporated several unique and valuable features:
- inflation (US data) button to see real returns
- dividends included to get total returns not just the index value increase
- long history back to 1928 extending right up to October 2009
- time period selectable of any duration - find the best or worst case scenario that has happened in the past
- regular (annual) deposits in dollars or percentage can be added, or
- regular (annual) withdrawals in dollars or percentage too, making this especially useful for a retiree (if you use this option be sure to turn off the "adjust for inflation" in the returns section at step 4; otherwise you would be double counting inflation)
- realistic portfolios with a wide range of asset classes and weights for any from the ultra-cautious 85% fixed income to the ultra-aggressive totally equity portfolio allocation or,
- individual asset classes (21 altogether) like REITs, emerging markets, US and international small cap and value, with reconstructed historical data (these are synthetic and thus not fully realistic but IFA appears to have tried very hard to line them up properly)
- annual rebalancing of every portfolio
- tax calculation option for funds in a taxable account (US tax rates)
- portfolio returns adjusted for the maximum annual fees of 0.9% that IFA charges its clients
Portfolio Advantages:
One of the comparator asset classes is the S&P500 index (in step 1, scroll down the Indexfolio list to the bottom to get it). I used the worst ever 20 year rolling period of 1962 to 1981 (yup, it even beats 1929 to 1948 if you look at the handy 20-year chart from AllFinancialMatters blog on S&P500 Rolling Period Total Real Returns; call this the "financial death by inflation" period of modern history). The comparison of a conservative middle of the road portfolio - IFA's Index 45 - to the S&P500 shows the following:
1) Simple buy at the beginning and hold throughout
- S&P500 - total return 15.56% or 0.73% per year compounded with standard deviation 14.72%
- 45 portfolio - total return 68.34%, or 2.64% p.a. and 9.12% std dev
- the portfolio got much higher return at much lower risk
- S&P500 - total return 261.71% / 6.64% annualized and 14.57% std dev
- 45 portfolio - total return 426.93% / 8.66% annualized and 8.88% std dev
- the advantage of the portfolio is even greater than buy and hold
- S&P500 - same % return and std dev as for additions (it's just the mirror image); whew! the rule works as after the worst ever period, the S&P500 only investor has weathered the storm and the portfolio survived with a balance of $144,000 in December 1981and better times ahead, though he/she doesn't know it ... by 1991 the balance is up to $299,000
- 45 portfolio - returns are higher here too and the end balance is $263,000; just for fun, I played with numbers to see how much could be taken out to end up with the same as the S&P500 - and the figure is around $6,300 per year, a whopping 37.5% more money for the retiree to spend! That is a 5.25% withdrawal rate. The money would have run out in April 1997, so a person could have spent 35 happy years in retirement.
Many thanks to IFA advisor Brad Von Grote who pointed out the calculator and spent a considerable time on the phone chatting with me. In case anyone wonders, IFA hasn't paid me to praise their calculator and I am not a client of theirs though I think a person could do far worse than sign up with them. I only wish they would create something similar for their Canadian audience.
Tuesday, 10 November 2009
Foreign Diversification Cognitive Dissonance
Take a look at this chart and tell me what the heck is going on?
Isn't diversification into foreign equities supposed to reduce portfolio volatility and increase returns through non-correlation and rebalancing? Yet the simple all-Canadian portfolio with 5% T-Bills, 30% All Canadian Bonds and 65% TSX Composite Equities would seem to have done about the same as an international portfolio with the same fixed income but with equity holdings of 25% TSX, 15% S&P 500, 15% MSCI EAFE developed country and 10% Emerging Markets. The cumulative compound return of the two portfolios after 22 years ended up almost identical - the Canadian portfolio at 250% and the International at 256%.
Twenty two years is starting to be a long time waiting for international diversification to help a Canadian investor. Is the data somehow wrong? I used financial advisor and frequent Financial Webring contributor Norbert Schlenker's downloadable time series spreadsheet from his Libra Investment Management website. The data (unique and no doubt compiled with considerable effort) has been adjusted for inflation and converted back into Canadian dollars from unhedged foreign holdings.
This graph goes against the conclusions in such classic books as Roger Gibson's Asset Allocation (my review) to the effect that international diversification helps considerably. Gibson figured things in US dollars instead of the Canadian dollars in this data. Is Canada somehow special and its equity market a mirror of an international portfolio?
Isn't diversification into foreign equities supposed to reduce portfolio volatility and increase returns through non-correlation and rebalancing? Yet the simple all-Canadian portfolio with 5% T-Bills, 30% All Canadian Bonds and 65% TSX Composite Equities would seem to have done about the same as an international portfolio with the same fixed income but with equity holdings of 25% TSX, 15% S&P 500, 15% MSCI EAFE developed country and 10% Emerging Markets. The cumulative compound return of the two portfolios after 22 years ended up almost identical - the Canadian portfolio at 250% and the International at 256%.
Twenty two years is starting to be a long time waiting for international diversification to help a Canadian investor. Is the data somehow wrong? I used financial advisor and frequent Financial Webring contributor Norbert Schlenker's downloadable time series spreadsheet from his Libra Investment Management website. The data (unique and no doubt compiled with considerable effort) has been adjusted for inflation and converted back into Canadian dollars from unhedged foreign holdings.
This graph goes against the conclusions in such classic books as Roger Gibson's Asset Allocation (my review) to the effect that international diversification helps considerably. Gibson figured things in US dollars instead of the Canadian dollars in this data. Is Canada somehow special and its equity market a mirror of an international portfolio?
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