Book Review: The Investor's Manifesto by William Bernstein

Author Bernstein's advice in the Manifesto repeats in condensed form what Burton Malkiel says in the classic A Random Walk Down Wall Street - save lots of money to be sure to have enough, set aside an emergency fund, diversify investments and buy and hold passive index mutual funds or ETFs.

Though the advice is very conventional in the above sense, certain passages are very worth reading for their succinct and clear explanations, especially the discussion on how to assess bond values taking account of interest rates and default rates and how to estimate future stock returns using the Gordon dividend yield equation.

The book's style and layout, with sidebars, highlighting, end of chapter summary points, illustrative charts and tables, make it easy to read and understand. In general, the author succeeds in presenting the material at a level for the intelligent but relatively uninformed layperson.

There are certain places where Bernstein introduces things without preparing the reader, which I think could easily leave a non-expert asking him/herself what else is lurking out there that might not have been mentioned. In chapter 6 Building Your Portfolio, Bernstein presents model portfolios for several example investors. The portfolios are excellent in that they get right down to fund companies and fund names. The problem arises in the fact that when discussing Taxable Ted, for example, his model portfolio includes tax-exempt municipal bonds, whose usefulness is indeed properly explained but ... the munis are introduced for the first time in this portfolio and one is left thinking about other possible investor situations and wondering about products not covered in the text that might be helpful.

Age = Bond Allocation and Retirement = Zero Human Capital Arrrgghhh! Bernstein uses these connected, and in my opinion, near useless ideas (p.76) as the starting point for asset allocation. Consider Arthur Rubinstein, great pianist of the 19th and 20th centuries. He gave his last concert at age 89. and died at 95. Given that a) his human capital aka ability to earn money never really stopped and, b) he was likely rich enough to have more than sufficient to fund whatever lifestyle he desired, should he ever have held a bond allocation equal to his age? His case illustrates the obvious fact that almost no one goes brain dead and physically decrepit the day they retire. Why bother with the wrong rule when equally simple questions allow one to go direct to the correct principles - ability to earn cash flow = bond type income, which can be capitalized into a "portfolio allocation" plus, how much of your wealth do you need for essential living expenses? and how soon, which directs you to investments with similar stability like bonds.

Caveat for Canadians - the book is material for a US audience, using references to US mutual funds and products (e.g. tax-exempt muni bonds don't exist here, unfortunately) tax accounts and the like.

Armageddon = 2008 crash? I was really intrigued on reading the book's sub-title "Preparing for Prosperity, Armageddon and Everything in Between". Prosperity is covered in the book. But gimme a break! The word Armageddon means a decisive and catastrophic conflict. 2008 might have been, perhaps was close, but it wasn't catastrophic. Armageddon would have been the case if the financial system had collapsed in the autumn of 2008. How about countries like China, Russia, Germany where revolutions and wars wiped out governments and bondholders along with stock markets? What investments would have provided protection then?

The book (p.9) has a very interesting graph of Venetian bond prices from 1300 to 1500. The Venetian state's bond prices fell from par to as low as 19% of face value after a disastrous war, and did not get back to par for 100 years. Who can wait 100 years for recovery? The book's advice to hold bonds for safety may not be so wise in a context wider and longer than the last century or two of the United States. Are US treasuries / bonds really risk-free? What if they are not, what then should the investor do? One possible investment - gold - receives no attention or consideration. The oft-derided bubble-justification statement that "it is different this time" may not be much worse than the counterpart "it is the same this time", which assumes that market crashes will always mean revert to positive returns in fairly short order (e.g. twenty years or so).

Being prepared for all scenarios, including Armageddon, surely depends on the principle espoused in the book, namely diversification, but on a much wider scale than simply stocks and bonds - assets like gold/silver and human capital enhancement.

Overall, this book is a well-written shorter repeat of Malkiel's Random Walk but has no outstanding features to make it a compelling alternative. My rating - 3.5 out of 5.

Outdated CRA Tax Bulletins and New taxwiki.ca

Something is wrong with this picture: the Canada Revenue Agency wants us to do our taxes honestly and accurately but it deliberately neglects to provide up-to-date information and instructions through its Interpretation Bulletins. U of T law professor Ben Alarie noted this alarming and infuriating practise (which he notes was confirmed by the Auditor General) in Prof. Ben Alarie on Taxwiki.ca. If the CRA knowingly allows IB's to fall out of date, what about the rest - how is the ordinary taxpayer able to use any of CRA's information with any confidence?

Prof. Alarie is responding by launching taxwiki.ca as an online source of updated Interpretation Bulletins and other Canadian tax materials. Like other wikis, it will be publicly-editable so that everyone can add material as they encounter the intricacies of taxes through their personal experience. The added value potential of the taxwiki over and above the updating issue is that it can go beyond the strict tax rules to explaining whether this or that specific set of facts fits into, or not, the eligibility for beneficial tax treatment. For example, as someone who spends a lot of time overseas I found that the IT 221- Determination of an Individual's Residence Status page provides a lot of meaty explanation on the topic.

Of course, quality and accuracy is critical and Prof. Alarie hopes to achieve that by monitoring the content himself (he is a tax specialist) and by recruiting other tax experts as the project grows. There is already substantial detailed content on taxwiki so it is off to a promising start. But as Prof. Alarie said is his email to me announcing the project "... the whole idea is to allow for many hands to make light work for the benefit of all. The benefits of a wiki are magnified as more and more users refer to, modify, update, and streamline its contents." I will give it a shot myself by putting in some of the details encountered in the process of doing my annual online tax software review. A permanent organized repository is a far better place to find tax info than a blog archive, whose past material becomes hard to find, even with Google search ( I sometimes have trouble finding stuff of my own despite knowing I wrote about it!).

Good on the prof for launching taxwiki. Instead of merely whining about the CRA, he's done something positive. As the proverb says, "If the mountain will not come to Mohammed, then Mohammed must go to the mountain."

Mutual Fund Disclosure & Financial Advisors

"Very hard to trust financial advisors though. I left an advisor last year who specialized in SRI, but didn't seem terribly responsible when it came to managing my money." email from reader Audrey (with permission, thanks!)

A few days ago, author and independent (as in non-industry tied) investor Gail Bebee sent me her press release opinion piece Five Crucial Facts the Mutual Fund Industry is Not Telling Investors on some improvements that still could be made to mutual fund disclosure. While I agree with her points and might add some myself, most notably showing a standardized example of net returns after costs and fees as they do in the UK (e.g. page 7 of this Scottish Widows Key Features document for one of their funds), I'd hate to see the Canadian update to disclosure delayed given the unconscionable ten years it has taken to get as far as the draft buried (it took me about 15 minutes of Googling to find a link in Mondaq) in Appendix A of the CSA Staff Notice 81-319 on the OSC website.

But the real issue with disclosure is that, as the UK regulators discovered after studying the situation following years of having new improved simplified documents, "Research suggests the quality of KFDs (Key Features Document) varies considerably from firm to firm and that many KFDs are either not read or are not understood. Instead consumers often rely on an adviser to explain the product." (FSA Good and Poor Practices in Key Features Documents, p.7) The people who bother to actually read them are likely investing nuts like me, who are willing, indeed prefer, to wade through a Prospectus, while those who have neither the time, interest or skills and thus really need to read a simplified disclosure, don't bother to read it.

Which brings me to Audrey's quote and a much more critical problem that doesn't seem to be getting action - financial advisors need to become more trustworthy. Advisors need to become legally liable for a fiduciary duty and regulators need to go after advisors who transgress. As IndependentInvestor.info's Marc Ryan dissected so well recently, the proposed new federal securities regulator fails to address this matter amongst its other investor protection failings.

Fundamental vs Cap-Weight Portfolio - Status after mid-Year Distributions

A while back I came to the conclusion that adopting a passive cap-weighted index portfolio is inferior to a fundamentally weighted portfolio and subsequently on June 9th I set up two test portfolios - one for each strategy - to see which does better in a manner as realistic as possible.

Let's see how things are coming along one month on after the mid-year distributions made by many of the ETFs in the two portfolios. Here is what has happened:

1. on pure market price changes before distributions, the fundamental portfolio is ahead by $244 as of market close today July 7th;
2. the cap-weight portfolio received slightly more - $554 vs $508, or $46 more - in distributions mainly because ZRE in the fundamental portfolio paid out none at all. The folks at BMO who run the ZRE ETF told me that since the fund was only launched at the end of May, there was very little income received up to the end of June and they decided it would be included in next quarter's distribution at the end of September. On a total net basis the fundamental portfolio is still better off by $197.

None of the distribution money has been reinvested yet as the cash total is still too small and the commission to purchase would represent too much cost. In neither portfolio are the asset classes enough out of whack compared to their target allocation (must be more than 1/4 above or below the target percentage - see above linked post for details) to justify rebalancing anyway despite some quite drastic market moves during the past month.

Though it is early days, so far so good for fundamental weighting. No regrets yet about making the change in my portfolio.

UK & US Banks: Profits Down while Staff Salaries Rise

BBC journalist Robert Peston's Will banks' medicine kill them (and us?) notes a link to the Bank of England report The resilience of UK banks which contains the troubling chart copied below.

Huh? Salaries on a steady and quite rapid rise as a percentage of revenue? It seems that UK bankers - the people not the institution - are avoiding the financial pain imposed upon the rest of the public from the crisis. The bankers, the individuals, the people at the banks who made the monumental errors of judgment, or who perhaps in some cases deliberately ignored the risks they took because it was a no-lose situation for them personally, are not suffering. They continue to power ahead, siphoning off an ever greater share of bank revenue.

It appears that it is much the same with US banks - this January 2010, NY Times story Ailing Banks Favor Salaries Over Shareholders finds the same pattern with a number of the major US banks.

Meantime, Canada's biggest bank RBC paid out 35% of revenue in 2007 on staff costs but only 31% in 2009. Without knowing exhaustively whether this pattern holds true for all Canadian banks over more years, one wonders if a reason Canadian banks fared so much better than UK and US banks also had something to do with bank "culture" where employees and managers think of themselves differently and act accordingly.

Unfortunately, the financial system reforms (bank taxes and increased capital requirements) the G20 / 8 countries are looking at seem unlikely to influence a change in the self-enriching, risk-taking behaviour of bankers in the UK and the USA. If the individuals don't get hammered when they screw up, why would they change their way of doing things? There is a great ad byline from Dofasco that goes "our product is steel, our strength is people." Sadly, for many banks, that thought instead is, "our product is lending, our weakness is people".

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:

• "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.
  

Socially Responsible Investing: another Take from the Globe and Mail

A few months ago I had posted here and here about the difficulties and quirks encountered by investors interested in investing according to what are termed socially responsible principles. The Globe and Mail has come along and published another view in its Report on Corporate Social Responsibility based on research done by Corporate Knights. The approach taken differs fairly significantly from that of Jantzi Sustainalytics. Whereas Jantzi screens out "bad" companies in gambling, armaments etc and screens in "good" companies improving the environment etc, Corporate Knights seems to simply rate all companies according to quantifiable measures of environmental performance (4 indicators for energy consumption, carbon emissions, water usage, waste production), social performance (5 indicators for CEO to lowest paid ratio, employee safety, taxes paid, presence of a DB pension plan, funding adequacy of DB pension) and corporate governance (board committee on social responsibility, diversity of board membership, executive pay linked to social responsibility).

The Globe's effort is much better in my opinion - the ratings criteria are actually published unlike the vague Jantzi "we won't tell you because it is proprietary" message, the ratings criteria are clear and quantifiable and the criteria make sense. They even allow you to download the whole table of ratings for all the TSX 60 companies. Kudos to the Globe!

The Globe comes up with different results than Jantzi too. We previously noted that George Weston failed to make the grade in the Jantzi method (but we aren't told why) but in the Globe's ranking they are right up there in number 2 spot. Unfortunately, Tim Hortons is still a bad guy but now the Globe tells us why - they don't actually disclose any of the required data on the environmental factors. It's time to fess up Timmy.

FWIW, there are nine Canadian companies in the top Global 100 Corporate Sustainability ranking by Corporate Knights, a number far above Canada's economic weight (the US has only ten companies in the list). Take a pat on the back Canada for its corporate do-gooders. That is nowhere near the best country of all, the UK with 21 companies in the top 100 (no, BP is not amongst them).

For investors who want to take their socially responsible investing decisions seriously and not take the lazy "anything labeled socially responsible will do" route, the Globe's list is still not the final answer. Take Barrick Gold for instance - our previous post noted that there is controversy about the company's activities but it is ranked quite high at 19th best out of the TSX 60. Caveat emptor as always.