One Limit to Financial DIY - Mental Incapacity

There are limits to everything, including being a DIY investor. One such limit is when mental incapacity strikes. It gets to be a bigger and bigger issue as one gets older. The rising prevalence of dementia and increasing life expectancy ensure that it will become ever more common for retirees to become incapable of managing their own financial affairs.

The problem is that when such incapacity strikes, chances are we won't even be aware of it. Worse, even if we are aware, at the point when we have been medically certified as mentally incapable, we lose the legal power to do all sorts of critical things, as the report Financial Decision-making: Who Will Manage Your Money When You Can't? from the BMO Retirement Institute points out, including:

"• prepare a power of attorney
• make a new will, add a codicil to an existing will or revoke an existing will
• put a bank account into joint names with children
• change the beneficiary of your RRSP/RRIF or an insurance policy that you own
• carry out estate planning, such as reducing probate costs
• give investment instructions to your financial advisor."

As the report recommends, a sensible solution is to put in place, long in advance of anything happening, a Continuing Power of Attorney (CPOA), that kicks in automatically if and when incapacity happens. The report also mentions some obvious qualities the person(s) selected to exercise the CPOA power should have:

• the time and willingness to fulfill the responsibilities (BMO says the average time a person fulfills a CPOA role is four years - if you are well advanced in age, it probably isn't the best idea to name someone the same age as you, like your spouse)
• someone in whom you have complete trust (the CPOA has wide ranging power and possible abuse of the power is a major consideration; sadly, even one's own children can sometimes be less than reliable)
• financially-knowledgeable enough to handle your affairs, or astute enough to recognize the need for professional help (tax, accounting, legal etc)
  
  

An interesting issue is what BMO calls "family dynamics", aka family politics, where other children are jealous because only one child is named as the CPOA attorney. In a sense, being picked as a CPOA person is a badge of honour but there is also work involved and like it or not, children do not always have the same capabilities and talents, not to mention availability. Being a Parent is a lifetime job (!) and making sure peace and fairness are maintained while doing what needs to be done may be a key part of setting up a CPOA successfully.

The BMO website hosts five other short worthwhile videos by lawyer Elena Hoffstein and Dr. Michael Baker talking about topics such as: how to recognize mental incapacity; its effects on ability to marry (you can still do it! I can imagine the smart alec comments that one must already be mentally incapable to get married at all... ) or to make a will and the unintended consequences of the two facts together (you may end up with no will at all); pitfalls of joint ownership (of house, investments, bank accounts etc) as a method to address incapacity.

Investor Fraud: the IFFL Brost Sorenson Case and How to Caveat Investor

The indefatigable Ken Kivenko of CanadianFundWatch.com (I don't know how he manages to keep positive given the seeming endless flood of info he collects and analyzes about the weaknesses of investor protection in Canada) sent along a CTV W5 video link to Who is protecting your investments? on the latest yet-to-be-proven-in-court fraud perpetrated on investors - that of the Institute for Financial Learning (IFFL) operated by Milowe Brost and Gary Sorenson. It's a sad and shocking tale, especially in view of the fact that the RCMP and the Alberta Securities Commission have been completely ineffectual in preventing the fraud. If the past is any guide, little or none of the many millions that have disappeared will be recovered and the perpetrators will not suffer any punishment, except for having to spend years going through the legal system while drinking their pina coladas in Panama or wherever.

It is one thing for us to indulge in gawking at the financial catastrophe of others or to stoke our anger at the various "SOBs" who fail in their duty to protect us. More important is to remind ourselves how to do due diligence or exercise caution before we invest - a penny of investigative prevention is worth a million dollars in lawyer cure.

1) Official Sources like the various provincial securities commissions, the RCMP, e.g. through links in my previous post on this subject Scam and Investor Fraud Alert Sources - Fraudsters often do it again and again so they may well show up in previous judgments (maybe it's the light penalties and sanctions that encourage them? just asking). Do a search for Brost in the ASC website and lo and behold we see him caught doing naughty things way back in 2005.

2) Google search - Ain't the Internet handy, typing in Milo Brost brings up a whole host of links that would or should raise a dubious attitude. One that is wryly amusing is this 2004 Institute for Financial Learning discussion thread on www.scam.com where a certain Winer says the promised 40% return is entirely reasonable and is not a warning flag! The Internet savvy will always have their idiot and BS detectors in operation I hope. Bottom line: Trust, but verify. The more the stakes, the more you need to verify. The hard-hit couple featured in the CTV story did the former but obviously not the latter. It might even be worthwhile to get a second opinion from someone else with your interests at heart and without an interest in the potential investment.

The obvious answer to the CTV W5 title question right now is "you yourself, my friend, you are the only one protecting your investments". Caveat investor.

PS In one of my Google searches for this post, I came across the Behind MLM blog, an amusing anti-scam site. It also displays Google ads, one of which advertized a "200% Return on Investment Exclusive Diamonds from £5k". With the Google good comes also the bad ...

Book Review: The Rules of Risk by Ron Dembo & Andrew Freeman

The book isn't just about investing risk though the book's subtitle is "A Guide for Investors". This must have been added by the influence of the publisher since the more accurate description of the content is on the back cover: "A Dynamic Framework for Forward-Looking Risk Management". Likely the latter would have been judged too technical and jargonish to appeal to a broad book audience.

The book is a broad conceptual guide, and a useful one, to figuring out what to do about various financial risks one faces in life, like house buying, insurance or investing. There is some jargon (do you want to figure out your lambda?) but it presents mostly common sense argumentation and nothing beyond arithmetic in the numerical examples.

Despite some attempt to flesh out their methods, the book falls short of being a practical guide. I find it difficult to see exactly how I could systematically apply, in order to develop an overall financial and investing plan, all of their ideas in their multi-step process, which consists of:
1) Know the value of your holdings today - I'm ok with this one, I think, though an important caveat is the definition of "my holdings", which they do not explore. They seem to think of such holdings as consisting only of a portfolio of financial securities, which I believe is far too limiting. The single most valuable financial asset we own is ourselves, our own money-earning capacity, often called human capital. Unlike almost every other financial risk, which they explicitly define as those subject to changes in the [external] environment (i.e. that we can do nothing about directly), we can enhance, or neglect, our earning capacity through education, diet, health protection etc. I suppose the authors might respond that their book does not intend to go into that detail. And I suppose that doesn't matter as long as this book is only considered a conceptual, not a practical, guide. This book does not hand you solutions on a plate. You would have to do quite a bit of work to apply them to your own circumstances.
2) Pick an appropriate future time horizon - Though Dembo and Freeman acknowledge that most people are likely to have multiple future financial goals (car, House, retirement etc) with different time horizons, they do not flesh out how to deal with the resulting complexity when this fact is added into downstream steps below. Nor do they address at all what to do about the very real fact that life contains surprises and your best laid plans / time horizons may not be the ones that actually happen e.g. a good number of people retire sooner than they thought due to job changes or health. That really complicates the next step.
3) Choose a range of scenarios of the future, making sure to include bad extremes and assign a probability to each scenario - This is the range of future end results for "the portfolio under consideration". Of course there could or would likely be multiple portfolio possibilities an investor might want to consider. This is the point where I'd guess almost anyone trying to follow their method would give up. Huh? How do I make up scenarios and figure the odds? They touch on but do not resolve the issue on page 81: " ... there are many occasions when it is impossible to attach useful probabilities to an unknowable future, then we have to find ways to model the uncertainties we face."
4) Pick a benchmark - The benchmark seems to be a kind of base case to compare the scenario & portfolio combinations (& presumably the multiple time horizons). They say that one can choose whatever benchmark one desires.
5) Value your portfolio and benchmark for time horizons under all scenarios - a lot of mechancial work
6) Compute the appropriate risk measure based on values coming out of step 5 - Here enters one of the intriguing contributions of the book, the idea that something they call Regret is the best measure of risk to use instead of popular commonly used measures like standard deviation (aka volatility) or Value-at-Risk (VAR, used by institutional investors).

Regret, with a capital R, is what I found to be the most useful, as well as the most accessible and natural, concept in the book. It is a way of taking account of potential harmful outcomes to make better decisions. Regret deliberately embodies the emotional impact of negative possible outcomes. A wrong decision, as judged later, can gnaw away at a person forever after. Second, the Regret evaluation process of Dembo and Freeman tells us to assess the cost of preventing the big negative, which in many cases is just insurance. Then we decide whether the cost is worth it considering more the consequences of decisions rather than the probabilities of particular outcomes.

As the authors say, "It is a sensible rule of thumb that an operation should not take on positions that expose it to the worst possible outcome - that a catastrophic loss might occur, resulting in ruin." This way of thinking would be very helpful in considering, for instance, whether to buy long term care or critical illness insurance. The same loss may matter a lot more to some people than others e.g. Warren Buffett will never be interested in buying long term care insurance since he can easily afford the fanciest care imaginable.

The obverse of Regret is what they call Upside, a positive consequence that can result from a choice. The thinking process is the same - how much could the positive result amount to and is the cost of the "bet to enter the game" worth it?

The book also has several interesting or amusing bits:

• there are a number of praiseful references (this book was written in 1998) to the revised and improved risk management techniques of major investment banks following big losses in the 1980s and 1990s, rather ironic given the 2008 debacle; the notion presented by the book that these financial institutions were really trying to manage risk and avoid disastrous financial consequences instead of going willy nilly for the gigantic gains strikes me as rather naively quaint. Dembo and Freeman's own framework provides a handy simple tool to figure out the big banker's personal risk perspective - lots and lots of personal $$$ Upside with the worst personal Regret being fired and having to look for another job.
  
• Dembo and Freeman show in Chapter 3 that Kahneman and Tversky are wrong to say that people are irrational or making behavioural mistakes when they make choices that violate expected value (EV = probability x outcome) rationality. They also make buying lottery tickets an entirely reasonable and rational decision (spending a few dollars a week won't cause even poor people financial ruin but it could, despite the bad odds, make them rich, so there's lots of Upside and really no potential Regret).
  

Bottom line: Though the framework will get too complicated to apply to a total personal financial planning effort, it can apply to one-off decisions. The Rules of Risk is worth buying for its thought-provoking content and useful concepts.

Rating: 4 out of 5 stars

Mutual Funds Institute Ham-Handed Research Hurts Own Cause

Mutual funds in Canada have been under fire for their high fees and under-performance (hat tip to Canadian Capitalist). The industry body, the Investment Funds Institute of Canada has been attempting to shoot back at mutual funds' main competitor, ETFs. But its latest sloppy and slapdash salvo in the form of the July 2011 report Active and Passive Investing does more to discredit the IFIC and its cause than to help it. How so?

1) Consider the publication of the report itself. Is it secret or not?

• Not Secret - Though I received a copy from Ken Kivenko of CanadianFundWatch.com (thanks, Ken) who forwarded the email attaching it sent out under the signature of IFIC CEO Joanne De Laurentiis.
  
• Secret - The IFIC original email has the warning at the bottom "This e-mail (including attachments) is confidential and is intended solely for the addressee..." Oh really?
  
• Not Secret - Why then does the text from De Laurentiis' say "It is the objective of the Report to clarify and counter misperceptions associated with active and passive investing so that research organizations and public policy makers can be better informed...". That sure looks as though it is intended to be publicly disseminated.
  
• Secret - The IFIC website itself, however, seems not to show the report in any public area, only in a reserved members area (through this search link).
  
• Not Secret - This secret public report meant to be used per De Laurentiis "... as a reference authority in materials developed by you (e.g., articles, reports, etc.)" can actually be accessed through (marvels of the Google and the Internet!) a link at the bottom of this post on Arbetov.ca.

On the whole the image one is left with is that IFIC is trying to feed ammunition to its membership of fund distributors and sellers to have numbers to quote to clients but that it does not want to release the report to wider public scrutiny, including skeptical bloggers!

2) The suspicion of devious intent gets stronger once one looks at the flawed report itself. Its basic approach is to show that passive investing can be expensive, done by trying to show that ETF costs are higher than many people think. However,

• ETF does not equal passive investing (and the flipside is that Mutual fund does not equal active investing). The report throughout treats all ETFs as if they are the same as passive index investments. That might have been a fair generalization ten years ago but today ETFs have become very diverse. Many high cost, poor-quality, narrowly focussed ETFs have come on the scene, some even with explicit active strategies.
  
• Mixing all ETFs together and calculating average costs raises the apparent cost of a passive index (i.e. a broadly based market-cap) strategy. Transaction costs, bid/ask spread and tracking error, which the report says add up to 1.2% ETF under-performance relative to index, is at most 0.1% for a fund like Vanguard's Total (US) Stock Market ETF (VTI) or the grand-daddy biggest-of-them-all SPDR S&P 500 (SPY). The true lesson is not that passive indexing is expensive, it is that today investors need to be just as careful picking ETFs as mutual funds. ETFs that are too small, too narrow and only sample stocks instead of replicating an index are prone to index under-performance from large tracking error.
• The 1% that IFIC says goes to providing advice to mutual fund investors, which ETF investors do not get, and therefore causes ETF under-performance by that amount, rests on the dubious conclusion that investors get 1% worth of advice. The previous IFIC report The Value of Advice (which also seems to be hidden away in IFIC's website) it cites as evidence received a thrashing on its release in 2010 - e.g. see Canadian Capitalist's Readers Rip IFIC Report to Shreds.
  
• Risk, as expressed in volatility, is not or should not be an end in itself, so for IFIC to state that actively managed funds offer investors the risk exposure they wish is beside the point. As books like Richard Ferri's The Power of Passive Investing, David Swensen's Unconventional Success and many others have repeatedly documented in great detail, actively managed mutual funds have performed poorly on a risk vs return adjusted basis. It doesn't help to take on risk if you lose in doing so.
  
• As I said in my review of Ferri's book, the issue is not active investing vs passive investing in principle or in general, it is with the funds actually available to small individual investors and how they perform in reality. That's why I am currently testing the RAFI fundamental strategy, which I think is better in principle and has been shown to be so using (non-investable) index data, against cap-weight using actual ETFs available to investors. A key question is whether the higher fees on the RAFI funds overcome their theoretical advantage and give off lower net returns.
  

There is nothing wrong with mutual funds per se. I don't think that as a technical legal structure they are any better or worse than ETFs. The problem is simply that the current mass of available mutual funds suffer from too high fees that negate their value. They don't add enough value to earn their fees. This lackadaisical offering from IFIC doesn't inspire much respect or do much to help their cause.

New Innovative ETFs that Investors Really Really Need

Sure, there are lots of ETFs and more weird and wonderful concoctions seem to come out every day. Think the financial industry is running out of ideas for ETFs to appeal to every possible interest? Just in case, here are my suggestions for innovative ETFs that could hit the sweet spot for investors.

1. Darwin's Centenarians - "Survival of the Fittest" is the theme of this ETF. Darwin told us that merely surviving is the definition of being fitter. If a company has survived 100 years or more, it has to be fit, right? Twelve Ultimate Buy and Hold Canadian Stocks lists the Canadian stocks to include. Wikipedia's List of oldest companies tells us that no less than 21,666 companies worldwide are centenarians or better exist. That choice is good because diversification through holding a basket of many companies is still required. Age does not guarantee survival - witness the demise in 2006 of Kongo Gumi the oldest continually operating independent company that had been operating for 1400 years. It was a victim of, you guessed it, too much debt.
2. Random Dartboard - We've all read that randomly throwing darts at a dartboard to select stocks works just as well as the average active mutual fund manager. So let's have that fund, please. In order to remove any human bias, and to give the fund a marketing handle, the fund management will consist of chimp Sammy Stockpicker (photo below) along with a human handler. Another advantage - the MER will be peanuts. . This will also help restore a bit of balance in markets, as apparently mathematicians like the one below are taking over trading in markets according to BBC's Quant Trading: How mathematicians rule the markets.
3. High-Yield Sovereign Debt ETF - Nicknamed the "Merkel Put Fund" in honour of the German leader who will be backed into "bailing out" Greece (i.e. having German taxpayers paying for Greek non-taxpayers), this fund will hold the debt of various countries with dubious ability to repay. There are already high yield corporate bond funds like Claymore's CHB so this new fund would only extend the concept. It might be a challenge to define what countries to include since the bond rating agencies' ratings of countries doesn't correspond systematically with countries that pay high yields e.g. Ireland pays quite hefty yields upwards of 8% despite its BBB+ Investment grade rating (see Wikipedia explanation) from Standard & Poors in this list of Credit Ratings by country in Wikipedia. I would propose the "if it looks like a duck and walks like a duck, then it is a duck" method of determining what is high-yield.
4. High Dividend Yield Country ETF - Nicknamed "the future will be like the past" fund, this one will invest in the market basket for the highest dividend yield countries. After all, if famous researchers Elroy Dimson, Mike Staunton and Paul Marsh tell us on page 21 in the Credit Suisse Global Investment Returns Yearbook 2011 (my review here) that an evenly balanced portfolio of the equity index for the highest dividend yield countries handily outperformed for 1900 to 2010 and multiple sub-periods within it, what could go wrong?
5. The Liquid ETF - The ETF Stock Encyclopedia lists a whole range of sector ETFs like retail, telecommunications, oil and gas, mining, utilities, pharmaceuticals, biotechnology, the list goes on and on. Why not set a new direction for themes with a fund that invests in the industries that produce liquids, i.e. a combination of water infrastructure, oil and gas, beer and wine producers. There must be excellent diversification potential as companies are likely to have little correlation with one another.
6. The Global Mega ETF - Finance theory tells us that an investor should hold the market portfolio, which consist of a holding in every available asset i.e. stocks and bonds in every country. Has anyone offered such a fund yet? The answer is No. Vanguard has something called the Total World Stock ETF (VT) but even that only includes 49 countries and no bonds at all. There isn't even a bond fund in its arsenal that tracks a total world bond index.
7. The Celebrity Dream ETF - We cannot all look like Angela Jolie (from Top Beautiful Women blog) or Brad Pitt (from Celebrific.com) but maybe we could invest like them. After all, celebs are wont to give us their opinion on politics, social justice, climate change, etc and with such beautiful faces and acting skills, everyone is convinced they are right. And so they will be regarding investments. Markets will follow them! Their stock picks and predictions will be self-fulfilling prophecies. Besides things always turn out fine in Hollywood. We should remember that though markets in the long term are weighing machines, in the short term they are popularity machines, as all technical traders know. Why bother with charts, statistics, patterns, moving averages and the like when we can go to the next step and actually lead the markets where we want to go? The only possible drawback is that celebs don't come cheap and fees may be high, though surely nowhere near as high as what the typical Canadian mutual fund now collects. So the ETF should still be competitive.

How about it, all you ETF providers out there, innovation has to keep moving ahead, n'est-ce pas?

Passive Indexing Trend Leading to Increased Investment Risk

Too much of a good thing for individuals can be bad for everyone collectively when it comes to passive index investing. James Xiong and Rodney Sullivan explain how this has come about in How Passive Investing Increases Market Vulnerability, available for download here at Top100Funds.com and here at SSRN.

Through a series of statistical tests on US equity data back to 1979, they show how the take-off of passive index investing since 1997 is strongly associated with their disquieting stock effects:

• "... the rise in passive investing meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades" and
• "... the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). The decline in diversification benefits can couple with increased market volatility and firm-specific volatility."

Passive index investments in mutual funds and ETFs by late 2010 reached about a 1/3 share, or $1.2 trillion, of the total in such funds of $3.5 trillion - active investment funds makes up only 2/3 of the total. (The paper also tells us that institutional investors now hold 70% of US equity stock vs 44% in 2000 and only 24% in 1980.)

The chart below from the paper shows the vertiginous rise in correlations between pairs of stocks. Note how the more passively indexed segment, the SP500 large caps, has higher correlations than smaller caps, the non SP500 stocks in the chart.

They checked that the effects were not only manifest during the recent periods of extreme market crisis - the dot com crash in 2001/02 and the credit crisis crash in 2008/09 - when all asset class correlations rose significantly. The same pattern of rising correlations continued through the other more normal years of the study period.

There may still be value for individual investors to buy those passive index funds but the free lunch of passive diversification now appears to be merely selling at a discount. One thing for sure, as I tried to suggest in the thought experiment post What Would Happen if Everyone Did Passive Indexing? the success of passive indexing, when it becomes big enough, does have an effect on markets. In another post last year, Index Investing Becoming a Victim of Its Own Success, I noted research by Jeffrey Wurgler on the S&P 500 that reaches similar conclusions. No wonder the avant-garde of risk-aware, efficiency-aware institutional investors is moving away from cap-weight passive index investing, some to private equity direct investing, such as the big pension funds and others to alternative-weighting indices.

Cool Tool: Stock and ETF Market Visual Heat Maps

Like to get a quick impression of how various stocks, sectors and ETFs are doing today or in the past year? Check out these heat maps, which show through colours - red down, green up - how markets have been doing. On most, you can drill down by clicking on individual trading symbols to get a lot more detail.

FinViz.com - S&P500 grouped by sector, Foreign Stocks (including Canadian) Traded on US exchanges, US-traded ETFs. Data includes performance today to 1-year, P/E, P/B, P/S. Dividend Yield, Earnings

StockMapper.com - NYSE Euronext stocks (which includes 66 largest Canadian stocks), S&P 500, World Regions. Data includes today's percent change, latest news

SmartMoney.com - US stocks "over 500". Data includes daily percent price change organized by sector.