Tuesday 30 October 2007

Why an Emergency Fund? Part 2: Job Loss

This is the second in a series looking at the need for a special emergency fund to tide one over through various crises. Part 1 looked at Death.

Today's installment examines involuntary job loss, aka layoff, firing, redundancy, downsizing - take your pick, they all can hurt just as much financially and perhaps emotionally as well. Maybe some forms of suddenly voluntary quitting a job, like abuse or harassment, can be included too, the principles and effects are the same.

In keeping with the pattern of the series, I'll first look at the probability of the event, then the potential cost/consequences and finally the alternative risk responses to decide whether an emergency fund is needed at all and if so, how much is needed for this component. At the end of the series, I'll add the results up and deal with what form the fund (if any) should take.

Event #2 - Job Loss
Probability - There is no single answer for everyone, it depends on your circumstances and you must figure the chances for yourself.

If you are retired, then it's pretty hard to get laid off, no? Cross yourself off as needing an emergency fund because of job loss. Even the 17% or so of retired people who do work mainly seem to do so because they enjoy it, not because they need to, according to the Fidelity report I blogged about a few days ago.

Similarly, if you are self-employed you cannot really fire yourself, though a lack of work caused by external forces can happen and variations or gaps in income are part of the landscape for most. The self-employed contractors and individual consultants that I know tend to keep a financial reserve to even out cash flow from assignment to assignment. But what follows is mainly about and for those working for an organisation as an employee.

The chances of permanent layoff vary a lot according to a number of factors, as revealed in Stats Can's study Permanent Layoff Rates. Here is a rough summary:

Chance of being laid off within the next year -
  • men 7-8%
  • women 3-4%
Relative to the average, + = higher chance, - = lower
+ for younger people
+ higher paid
++ small firm, i.e. double the chance in a large firm
+ manufacturing (the rising loonie effect)
++ primary and construction industry
- public services
- highly educated

The chances of being laid off changed very little (less than a percentage point) between 1989 and 1999, both good periods for the economy. As the study says but doesn't quantify, layoffs rise during recessions. The study only states the risk of layoff within the next year, not a whole working career, which must be a lot higher. In sum, there is thus a significant chance that a person, on average, will be laid off sometime in their career. The risk is not negligible.

Special circumstances may arise at any individual organisation that can cause a very high risk of being laid off. I'd say that almost always, those periods of threat are very visible to the average employee and are also known many months, often years ahead. In my own case, I have been laid off two and a half times in my career - once, in a federal crown corporation that was abolished through a policy change, which took years from idea to action; once, in the high tech meltdown when the internal rumblings and the external slaughter started 8-10 months ahead of my own walk down the plank, and a half once (through an internal transfer I was able to escape my abolished job), at a municipal government where the council's budget problem was highly public knowledge six months ahead. When those storm clouds start building, don't ignore them!

Cost - The impact of job loss is without question enormous for everyone (again excluding retired people) as one's pay is the largest, most often the only significant, source of income to live on. Take your net pay and that's the effect you will feel. It is thus the multiple to use in figuring how many months - from zero upwards - you will need.

Risk Response -
How long will funding be needed?
Before looking at alternative responses, you need to estimate for how long you might need funding. That's a tough one because getting a new job and ending the emergency depends a lot on how much smart effort you expend on the job search and a little on luck (not the other way round ... remember the quote, ''The harder I work, the luckier I get'' attributed to both film mogul Samuel Goldwyn and golfer Gary Player?) It is possible to be out of work for a year or more. An often quoted rule of thumb is about 1 month of search for every $10,000 in salary. My own two layoffs lasted eight months and zero months.

I'd say a year is the maximum I would consider a job loss emergency to last. Beyond that it's no longer a short-term emergency, it's a major life crisis and much more drastic action than a simple emergency fund will be required - e.g. selling and moving home to a new city, career change. Of course, long term, short term it doesn't matter, one still might need to live without a job income and the possibility of such events is a compelling reason to save and invest money. Retirement isn't the only time in life when a person might want to live off savings.

What sources of funding do you automatically receive? These obviously reduce the need for a fund.
In Canada today, we are lucky to have sources of income support to which we are entitled:
  • severance pay - for salaried workers in a permanent job, there is a rule of thumb of about one month's pay for every year of service, or for unionized workers it is normally stipulated in the labour contract
  • Employment Insurance (EI) - the federal government's program kicks in when your severance expires (i.e. right away if you don't get any severance at all) and if you have worked long enough to meet the qualifying requirements detailed here; only about 20% of people who lose their jobs are ineligible for EI according to this 1999 Stats Can study; some of the key points of the EI program are:
    • two week period at start of no benefits - the deductible
    • max 28 days or less before the first cheque arrives
    • payments last from 14 to 45 weeks
    • pays 55% of insurable earnings (capped at $40,000 p.a.) up to a max of $432 per week
In other words, these two sources might take care of the funding requirement by itself, as it did for me.

Responses -
  1. Reduction of household expenses - most budgets have quite a lot of discretionary spending but of course this is only a partial solution; battening down the hatches is better done once the warning signs appear not when the storm breaks of course
  2. Job loss insurance - some companies in Canada offer interest protection on line of credit borrowing e.g. the Bank of Montreal's Disability Plus Insurance, some offer balance protection on credit cards e.g. TD Visa's, and others mortgage interest payment insurance e.g. Canada Mortgage and Housing Corp's Mortgage Loan Insurance, Reliant Insurance's Job Loss Program or North Shore Credit Union's Mortgage Insurance; you can thereby obtain cover on loans for house and car, which are the most important and largest expenses, apart from food, that any family is likely to have. Job loss is one of the main causes of foreclosures in Canada. You will be obliged to get insurance if you have a high ratio mortgage but if you are not, get it anyway, it's worth it. Apartment dwellers can obtain lease insurance, such as that of Canada Life.
  3. Enhance your own human capital - capital is a store of wealth and just as you can have financial capital you can make yourself a more valuable commodity by constantly upgrading skills, competencies and job experience. Your usefulness is what organisations pay for and instead of waiting for an organisation to direct you, take charge, look around and get going where the demand will be and where you have an interest. You might either avoid layoff within the organisation where you are presently or be able to bail out faster at the signs of trouble. Job loss may then even become an opportunity - a programmer who reported to me was also laid off like everyone else, received his severance and then discovered he could make a lot more money as a contractor, pick the jobs he enjoyed and which enhanced his future marketability. He also made sure to set aside time and money for technical training to make sure he would stay in demand. So much for a need for an emergency fund for him!
  4. Diversify - whether it is having both partners in a couple earning or having more than one source of income yourself, that can reduce the impact of the job loss. Whether it is investing in real estate to rent out, turning a hobby interest into sideline business or something else it is an extra, independent source of income
  5. Family - sometimes mom and dad, or other family members, are able to help out; for some younger singles, moving back home until a new job is found can become the solution
  6. Don't take a job you hate just because it offers job security - you will be miserable every day, that's not what life is about
In short, for a minority (less than 20%), depending on their circumstances, there may be a need for an emergency fund of up to a year to cope with job loss. For me, an emergency fund for job loss has never made sense even though I was laid off twice because I received severance packages and I had other savings by the time it happened.

One big problem is that in practise I would guess those who could most benefit from an emergency fund are the least able to save to have one: younger workers in cyclical, non-permanent jobs.

In anticipation of the discussion on how to provide the fund, one thing I would not recommend in the job loss situation is to rely on a line of credit. Not knowing when a new job will be found and the emergency will end makes the possible accumulation of debt open-ended. There is a limit to what lenders will give out. And it is stressful enough to be out of work without having the worry of a growing pile of debt.

Monday 29 October 2007

The Lowdown on the Most Popular Canadian Financial Comparison Websites

Oops sorry, this is going to be a short post, there seems to be only one, the http://www.moneytools.ca/ of the federal government's financial and consumer agency of Canada. (Thank you to fellow blogger Million Dollar Journey who posted about this site back in March) It is really a rather feeble attempt as it only compares actual products for bank accounts and credit cards, and even then the data is not real time up to date. The only hard fact comparison of discount brokers seems to be on a blog - Million Dollar Journey's post here.

Readers will note my post of yesterday on such websites in the UK, which has a wide range of very good sites. What is wrong with Canada that we don't better? One thing for sure is that the financial services and products market in Canada is pathetically thin and uncompetitive in comparison to that of the UK.

Sunday 28 October 2007

The Lowdown on the Most Popular UK Financial Comparison Websites

Just came across a fabulous report - Compare and Contrast: How the UK Comparison Website Market is Serving Financial Consumers - released by the Resolution Foundation on October 11, 2007.

The report assesses the eight most popular financial comparison websites serving the UK market along with that of the regulatory agency itself, Financial Services Authority:
The areas assessed include: mortgages, credit cards, loans, savings and car insurance. From reading the report it seems that mortgages and car insurance are especially tricky areas to get accurate and complete quotes online as many questions need to be asked to get it right and the various websites vary in how well they do it.

Though it specifically states that the aim of the study is not to determine which is the best, the detailed and impartial comparisons give a consumer a pretty good idea of which one is good or not so good in which area. I really like that the comparison dimensions used in the study are all of critical importance to a consumer: accuracy, completeness and impartiality of the information provided, explanation of technical terms, relevance of fact finding to provide an accurate quote, consumer ease and flexibility in searching and sorting results of the website and facility to contact the providers directly. Interesting factoid: not all providers participate in the comparison websites - Royal Bank of Scotland does not, per the report.

The report does conclude, however, ''there was no “all round best performer”''. It does say the websites perform a very valuable service (i.e. they are not slimy, evil things to be avoided), a re-assuring statement since so many people use them and since the number and complexity of financial choices keeps rising. In fact, some of the sites were found to provide better information on secured loans than the providers themselves! The main criticism is that some of the websites don't properly disclose when their editor's choice or best buys are actually the result of commercial sponsor ties and not the objective best value product.

Here's my summary (caveat emptor, it may not be 100% the way you would read it or the way the authors would say it) of the results:
1) Accuracy of product info - the best: moneysupermarket and MoneyExpert; FSA and uSwitch the worst
2) Accuracy of product quotes - the best: MoneyExpert and Moneyextra; Kelkoo is awful
3) Completeness of info - varies between products more than sites; info on mortgages ''generally poor''; Kelkoo weak across the board
4) Relevance of fact finding - generally poor across all sites for mortgages, credit cards and savings; Motley Fool, MoneyExpert and Kelkoo miss key info in every product
5) Terms explained - moneysupermarket best due to forums where people can ask experts; Motley Fool, uSwitch and FSA explain all terms while Kelkoo explained none and has no product guides
6) Consumer experience - MoneyExpert the best by a lot; Kelkoo is c-r-a-p
7) Flexibility - Moneynet the best, Motley Fool not far behind; MoneyExpert the pits, while moneysupermarket is not much better
8) Market coverage - no one wins but Kelkoo loses with ''low coverage''
9) Impartiality - Motley Fool and uSwitch exemplary by being ''frank and open''; moneysupermarket, Moneynet, MoneyExpert and Kelkoo are completely unforthcoming about their editor's choices as being based on commercial relationships
10) Ability to act on info - Motley Fool, MoneyExpert and FSA are the leaders; the others all only give contact info for affiliated providers (is it so hard to look them up yourself if you have their name?)
About my only overall conclusion is to not bother with Kelkoo; it scores lowest on too many dimensions and is really good in none.

Now that you be aware, you can also beware.

Well done to the Resolution Foundation, an organisation devoted to improving the financial capabilities of the low and medium income person.

Update October 29 - we used moneysupermarket today to get car insurance quotes and found one that has saved us several hundred pounds for the coming year. It was very slick, we were even able to complete the deal directly with the provider by phone after generating the quote online using a quote. There were no less than 26 different quotes and there would have been more except a bunch of providers don't want to insure recently arrived Canadians. Very impressive, took about 30 minutes from start to finish.

Thursday 25 October 2007

Retirement Sense and Nonsense from Fidelity Investments

Yesterday, journalist Jonathan Chevreau published an article and a blog post about a report just released by Fidelity Investments Canada, available here under the title The Changing State of Retirement in Canada, which claims that Canadians need to aim to replace 80% of their pre-retirement income in retirement. The post and article do a good job debunking the nonsense aspect of the report, namely the 80% figure, which is too high for a number of reasons:
  • in their fifties, most people finish paying off their mortgage and their kids finish school/university, get a job and move out, all of which significantly reduce the expense side of being able to ''maintain the same comfortable lifestyle'', a fact not addressed in the report
  • that this is so may be indirectly reflected in the report's survey results, which showed that the 55+ age group are on track to have a significantly higher ratio of income replacement - i.e. I would guess they suddenly started to be able to save at a much higher rate and decided to do it
  • since when does need = comfortable? comfortable is perhaps a worthwhile goal but it shouldn't be presented as a minimal/hardship level of income
  • other sources of retirement income are discussed but dismissed - home equity (a much more prevalent form of retirement income here in the UK than in Canada), inheritances (where are all those billions in the preceeding generation to disappear to?) and working in retirement; Fidelity documents the fact of people over 65 (17.8% of those in that age group) continuing to work (primarily because they enjoy it) but doesn't factor that into its calculation of retirement income
Along with the nonsense, there is much sense in the report and several recommendations worth heeding.
  • for individuals: 1) Save!! (duh, but how many people actually don't do it); 2) Plan - try to figure out and budget what you will need, which gives you much more confidence than any rule of thumb, whether it be 80, 70 or 60% income replacement rate; 3) Learn about finances and supplement this with help from a professional planner if you find it overwhelming, to which I would add make sure he/she is a good, unbiased, fee-based planner
  • for government, employers and the financial services industry: public education, including through the school system; higher specialized training and skills related specifically to retirement amongst planners as often there is too much emphasis on the pre-retirement, accumulation phase of investing and planning

Tuesday 23 October 2007

Why an Emergency Fund? Part 1: Death

It seems to be a common truism or rule of thumb that everyone should have at least three to six months of living expenses in the form of cash. A quick Google search uncovers such advice at About.com, Bankrate.com, bloggers such as ChristianPF.com, TheSimpleDollar.com, the StingyInvestor, mainstream financial journalists like Jonathan Chevreau and professional financial planning guides like the CF1 Manual (unfortunately not available on-line) of the Chartered Insurance Institute's Certificate in Financial Planning in the UK. There is at least one dissenting voice at the Financial Blogger who states that one need only put in place a line of credit. But even he doesn't dispute the basic premise that there is such a thing as a financial emergency, an unexpected event that can provoke dire consequences without a fund.

Being the sceptic that I am, I will take a closer look at how unexpected and how dire such ''emergency events'' really are. Risk analysis and risk handling are a well established discipline in industry for project management (I knew that PM certification would serve me well some day...) so why not apply it to personal financial management? That involves identifying risk events, assessing their probability, the magnitude of the negative consequences, the alternative methods of dealing with the risk (which includes everything from preventing or actively reducing the chances of the risk occurring, transferring the risk to someone else at a price or simply doing nothing and accepting the chance).

Event #1 - Death
Probability - Nowadays, the life expectancy at birth is roundabout 80 years for men and women in Canada. That means it is unusual for people to die prematurely, much as we grieve for those unfortunate few. The younger you are, the less chance of dying soon. Insurance companies know this and charge less for life insurance for young people. In his fine book Insurance Logic (which I have reviewed here), Moshe Milevsky presents some data from Stats Canada that shows how rare is premature death. Though the data is from 1996, there probably has not been a big shift to today; if anything, I'd guess early death is a little less likely. Below is the table reproduced. It certainly surprised me.

What is the Probability of Dying Within the Next 10 Years?
Current Age Female Male
30 0.5% 0.9%
40 1.0% 3.0%
50 3.0% 6.0%
60 9.0% 16.0%
70 22.0% 35.0%
80 50.0% 66.0%

Cost - The first direct effect is the cost of the funeral and burial. Estimates range from $4,000 to $15,000 (e.g. Sandra E. Foster in her book, You Can't Take It With You, p.283). It seems the most common number is $5,500 to $7,500. This is a number which obviously can be controlled to a significant degree depending on the options one chooses.

The second effect is the possibility that the person dying may have dependents, for whom the disappearance of the breadwinner may have disastrous consequences.

Risk response -
  1. First, note that by the age when death becomes a much more likely event, people will have reached retirement age and probably have accumulated savings or investments of other kinds to pay for funerals. Financial institutions will almost always allow the executor or family members to access such reserves of a deceased person for funeral expenses so it doesn't have to fall on you to pay for someone else before an estate gets freed up by probate. Investments can be sold within a few days and the money made available long before the bills come due.
  2. Second, as noted above, death expenses can be kept at the lower end and that can decided at the time of the event.
  3. Third, a person can avoid the problem by pre-paying for funeral expenses to a funeral home. The amount put aside can even grow tax-free waiting for your demise, a last comforting thought for those scrooges among us. Since for all but one person in history (and even that is disputed by some), death is a certainty, if you have the capability of putting money aside for an emergency fund then you can also direct that money to pre-paying your funeral.
  4. Fourth, you can buy life insurance or just funeral expense insurance. This can spread the cost out in small monthly payments. Maybe you will even die early and get a bargain.
The response to the support for dependents should be dealt with through insurance, not an emergency fund. Death isn't temporary so a short-term fund of six months of living expenses won't do the job.

In short, death isn't a good reason to have a highly liquid emergency fund.

But there are other possible reasons that I will examine in the next posts: job loss, home repairs, injury or illness, car repairs, divorce/separation, legal problems, care for parents/relatives, pregnancy, wedding. And once all these have been reviewed we'll see where that leaves us overall.

Q&A on IFA, DFA with Michael Hill

Readers of this blog may be aware that I consider the website of IFA Canada to be one of the best for the quality and quantity of investment information, a mix of financial theory and practical application of significant usefulness to the DIY investor.

At my invitation, Michael Hill of DeThomas Financial, who also represents IFA Canada, has written responses to my questions on IFA and DFA. Note that I do not own any DFA funds, nor do I have any business relationship with DeThomas or IFA. I just borrow their ideas, which they willingly offer to everyone - even their competitors(!) - as you will read below.

1) What is IFA Canada and what is the difference or relationship between IFA, Dimensional Fund Advisors (DFA) and De Thomas Financial? What about other financial advisors such as
Milestone Financial who also say they offer DFA funds?

IFA Canada is an educational company which provides information, data and portfolio allocations and design as well as a proprietary Risk capacity survey which allows Canadian investors to fully understand the power of index investing. IFA Canada's mandate is to "Change the Way Canadians Invest." This is accomplished by providing peer reviewed, empirical evidence showing the results of index based portfolios. The Risk Capacity Survey further refines the investor’s knowledge in directing them to the proper portfolio allocations. Although Index Funds Advisors Canada may provide data, information, and content relating to investment approaches and index mutual funds, you should not construe any such information or other content available through the Site as legal, tax or investment advice. You should not consider any information on www.ifacanada.com as an offer to sell or solicit for sale any securities listed or mentioned on the website. Securities may only be sold by qualified licensed broker/dealers in Canada.

There is a distinct difference between IFA Canada, De Thomas Financial and Dimensional Fund Advisors (DFA). IFA Canada as described above is an independent company separate from De Thomas Financial and DFA.

De Thomas Financial Corp. is a licensed mutual fund dealer in BC, Alberta, Ontario and soon Quebec. De Thomas Financial acts as a Certified Broker/Dealer given authority to use IFA Canada's portfolios for their clients. IFA Canada has criteria for Certified Broker/Dealers and all dealerships in Canada are eligible to use the IFA portfolios should they agree to fulfill the obligations of a Certified Broker/Dealer. http://www.ifacanada.com/brokerdealers/index.asp IFA Canada does not charge investors a fee or commission for use of its data or Index folios. Certified Broker/Dealers agree to pay a monthly fee to IFA Canada for use of their portfolio allocations and data. These costs are fixed and NOT passed on to clients or investors.

DFA is a provider of index mutual funds for most IFA Index folios. Dimensional Funds Advisors Canada is the manager, trustee, principal portfolio advisor, and promoter of the funds, while Dimensional Fund Advisors (US)acts as sub-advisor for each of the funds.

Other dealerships in Canada many offer DFA funds, but only Certified Broker/Dealers may use the IFA portfolios legally for their own investor clients. The advantages of using the IFA Portfolios are many:

· No minimum limits (as imposed) by DFA on investments per fund. (DFA and others have a $10,000 minimum investment per fund)

· 80 years of back tested data showing the advantages of proper asset allocation using index funds

· Lower MER costs per fund as per exclusive IFA Canada portfolio allocations then other retail Brokers (see web)

· None, absolutely no trading costs for purchases, sales, rebalancing or withdrawals.

· Constant maintenance and auto rebalancing to original IFA portfolio allocation.

· Reduced fees and tax considerations.

· All fees for non-registered accounts completely tax deductible.

· Lower minimum to invest $100,000.00 at a cost of $1,000.00 per year not $5,000.00 annually.

There are other dealers in Canada who sell DFA funds but nobody in Canada has compiled an 80 year data base of 20 index portfolios specifically matched to an investor's Risk Capacity.

2) Are the funds offered by IFA mutual funds or ETFs?

Again, IFA Canada does not "offer" any investments; the investments used to build the portfolios are index mutual funds not ETFs. We chose DFA's index funds for a number a reasons, value, small cap, reduced tracking error and low cost, but also because we would be able to compile and execute the portfolios with no trading costs. ETFs have trading cost each time one buys, sells or attempts to rebalance, the IFA Index folios are designed with no trading fees- over time this saves clients money and keeps them in line.

3) Why do you think IFA's offering is superior to other investment possibilities, whether mutual funds or ETFs? Your website says IFA focuses on passive investing using index funds - how is this different or better than ETFs?

There is a distinctive difference between Index funds and ETFs, and it is for these reasons the IFA portfolios are built with index funds.

· ETF's track a particular index as closely as possible if not almost exactly, but of course there are costs involved. MER's range from .17 to .25 or more plus it costs each time to trade.

Aside from these costs, perhaps more important is a concept called tracking error. You may look here for a detailed description, but suffice to say tracking error costs investors between 0.75 and 1.5% per year.

Another reason for Index Funds over EFTs is securities lending. Index funds such as DFA lend securities out of their holdings and earn income for the unit holders from these transactions . This can amount to 0.25 to 0.50% per year.

The largest reasons though we use DFA funds are that they are tilted towards value and small cap, when all other index funds or ETFs are not. (This is all based upon the Fama/French Work). The chart below provided by DFA will help in understanding why we use their investment products to build the Index folios.

Dimensional Management Compared to Traditional Portfolio Management



Management and ETFs

Assumes markets work.

Assumes markets don't work.

Assumes markets work with no liquidity cost.

Captures specific dimensions of risk identified by financial science.

Attempts to beat the market through security selection and market timing.

Allows commercial benchmarks to dictate strategy.

Minimizes transaction costs and enhances returns through portfolio design and trading.

Generates higher turnover, transaction costs, and taxes due to speculative trading.

Accepts high transaction costs and turnover in favour of tracking.

4) What are the fees charged individually and in total by DFA, IFA and De Thomas?

First, all returns posted on IFA Canada are net of fees, meaning all MERs, management fees, auxiliary fees and advisor fees are subtracted before returns posted. The fees breakdown this way:

· IFA fees to investors. 0.0%. IFA charges no fees to investors as it is not a dealership or advisor. IFA receives fees from Certified Broker Dealers for use of the data.

· Index Fund fees (DFA etc) range from 0.25 to 0.70% - See http://www.ifacanada.com/indexfolios/indexes/#CC

· The De Thomas Fee 1.0%

5) What does the client investor get for each set of fees?

What do they get?

· IFA: superior and vast investor education

· DFA (etc):, Custodial services, fund access and research, record keeping, legal and tax filings, audit and valuation.

· De Thomas: access, support, brokerage, portfolio development, trading and research and distribution reporting, planning and more.

6) Is it true the minimum account size you will take is $500,000? Why so much?

No, $500,000.00 is not our minimum investment level. To complete an IFA Canada Index folio, the minimum is $100,000.00, yet we realize and understand that not all investors have $100,000.00; therefore, we have developed the Easy Chair Portfolio using the same concepts as IFA Canada, but with less administration for accounts beginning at $25,000.00. The Easy Chair website is not yet completed but when ready we will send you a link. The portfolios are complete, and we are accepting investment, but the website and brochures are not ready.

7) Any suggestions for investors with smaller portfolios?

See #6 above.

8) Does IFA / De Thomas handle all types of accounts, taxable, RRSP, LIRA etc and if so does this change the asset allocation?

De Thomas Financial is a full service broker dealer. We have a great deal of experience with all types of accounts including but not limited to RRSP, RRIF, LIRA, LIF, Open Cash, RCA and IPPs. In fact, De Thomas Financial has just reached an agreement with Canadian Western Trust and West Coast Actuaries to provide the IFA Canada portfolios for IPP (Individual Pension Plans). The purpose for this is to create in Canada the most efficient, low cost and transparent IPP. In fact, IPP investors can now save over $20,000.00 or more per year on their IPP plans. Yes it does make a difference in the allocations as each plan type has a different goal, income, savings, tax deferrals, pension building and income splitting.

To add to the answer- Yes it makes a difference in the type of account, in particular whether the account is an open cash account or a registered account. We like to treat the entire portfolio as one entity, meaning that all accounts would be looked at as a whole and allocated across all investments as if they were one portfolio, but sometimes this is not possible as in withdrawal accounts (RRIFs) or open accounts since taxes will play a large role. For open accounts we like to have a higher equity portion and in registered accounts more of the fixed income, since they are non-taxable. We also attempt to rebalance open cash accounts with new capital rather than sell then buy as new capital allocations do not create taxable events and sells and buys do. Thus if an account had too high a weighting in Emerging Markets for the risk capacity they need, we may deposit into all other funds except EM to rebalance the account and thus avoid a taxable event.

In general each account does not change the allocation of the overall plan, but may change to allocation to each type of account. Some clients find it easier to just have a similar account allocation in all plans suited to their risk capacity.

9) Why has DFA/IFA structured all its portfolios on the basis of geography and not, for instance, sectors such as financial, industrial, mining etc?

We are asked frequently about geographical allocation verses sector allocation. Our view and the view of IFA Canada, DFA as well as the empirical data suggest that global indexing and sector investing are very similar. Consider for a moment the TSX. If, and it does, our Core Index covers the entire universe of the TSX then we will have:

· Financial

· Mining and Minerals

· Industrial Products

· Consumer Products

· Agriculture

· Other (Energy, gold, real estate, income trust, health care etc.)

US and International investments have the same outline and thus by allocating on a Geographical basis we do cover each sector. What we will not do is overweight or underweight a sector in hopes our guess is correct.

10) Why do Canadian Index Folios contain a significant Canadian equity component while those of the
US site for US investors don't have that? Wouldn't financial theory suggest that the optimal proportions of any portfolio be the same world portfolio according to market value?

The Canadian content has been zeroed in on because of its higher than world capitalization content and a lack of disclosure in the IFA (US) portfolios but this apparent disparity has been accounted for. I say apparent because Canada is represented in the IFA (US) portfolios via (International, Small Cap and Value). In the USA, DFA included Canada as foreign whereas here (Canada) we have segregated Canada out as a separate "Core" holding. We (DFA, IFA and others) have noticed that each world area of portfolio development has a "home bias", that is a bias towards having assets based in local currency and in local surroundings. Canada is no different. We looked at the relationship between the TSX and the S&P 500 and found a correlation of 89%. Given this and the home bias which exists, we allocate only up to 20% to Canada in lieu of a greater US content to which IFA (US) has. If one accepts the premise of "North America", then the world and our portfolios are in line with world capitalization.

11) Does IFA/DFA do any hedging of its foreign equity funds? What is the logic for the policy followed?

No, DFA does not hedge currency except for the fixed income investments. Exchange rates are notoriously difficult to forecast. Efficient-market research conducted on exchange rates has found the same random walk phenomenon also occurs in interest rates, stock prices, and many other capital market instruments that are priced by competitive forces in a free market. Furthermore, there is no reliable evidence to suggest that the expected currency return is anything other than zero. Currencies don't produce anything; and although they fluctuate relative to each other, the fluctuation is unpredictable.

All currencies, by definition, can't go up and down at the same time, so the concentrated portfolio of currencies in this example is effectively fully hedged; to do otherwise defies the concept of diversification, especially when you consider the impact foreign exchange rate fluctuations have on the client's overall wealth management goals and corresponding financial needs. In other words, clients consume imports, they travel, and their financial needs are affected in several other ways by foreign exchange rates.

Here are the following key points as to why:


By definition, foreign exchange rates are a zero-sum game, so currencies have a zero expected return.


There is no evidence that foreign exchange rates can be reliably predicted.


Diversification works whether we like it or not.


Maintaining discipline, as always, is a key ingredient of a long-term, successful investment experience.

12) The general investing background information on IFA's website is incredibly detailed and useful. Probably most people who become your clients don't even read a fraction of it, while those who do are probably do-it-yourselfers like me. I really love the website, but aren't you worried you are giving away the shop?

Are we worried we are giving away the shop? Sometimes, but in reality no, we are not giving away the shop. The data, studies and theories exist independent of IFA Canada and thus the shop was never ours to give away. To more fully address the question, investors will fall into three categories in no particular order:

A. DIYs such as yourself.

B. Those who need help, but know the industry is in conflict with them.

C. Those that need help, but don't know about what.

By setting up IFA Canada in the manner in which we have, we are "giving away the shop" but we are resolved that investor education is the most important goal. If any of the above groups learn from IFA Canada then we have accomplished our first priority. If they need or want help our Certified/Broker Dealers are there to provide low cost, high level help in developing their risk adjusted Index folio.

There is one other group using the IFA Canada.com site and this helps to achieve our goal, but in a more round about way. 10-15% of investors are other investment advisors, managers or sales people attempting to figure out what we are doing. If they take our data and use it with their clients so be it. They are helping to educate investors and that is our goal. If the really believe and understand then they may wish to join us rather then try to copy us.

13) Your risk capacity survey on the website includes questions on investment knowledge and reactions to market swings/drops. I presume the implication is that if the investor is ignorant and nervous, he/she gets shunted into a low risk portfolio, which may not be able to meet the investor's long term goals. Shouldn't financial advisers be more like doctors, telling people to take their medicine as their health demands, not as the they feel?

Wow, another great question to which a new thesis could be written. The full answer is here http://www.ifa.com/book/book_pdf/10_risk_capacity.pdf but for purposes of the Q and A, I will outline the theory for our Risk Capacity Survey. There are 10 dimensions of risk which have been identified by theorists and academics. Five have to do with portfolio risk and five with the particular investor attempting to choose a portfolio in which to invest. (Investor Capacity) The five IFA Canada are most concerned with are Investor Capacities. These capacities are time, knowledge, attitude, income and net worth. Your question deals with attitude. You ask if some are ignorant or nervous if they are shunted to a low risk portfolio and that is just not so. The attitude dimension attempts to assess the aversion to risk an investor has, their ability to stomach inevitable declines with the knowledge that risk is the currency returns are purchased with. While a low attitude towards risk will move one down the scale from 100, it only amounts to a small % move and not a full out drop to a lower level. To use your analogy of a doctor, consider a person who has an aversion to needles or cannot swallow large pills. Does the doctor tell them to "do as the feel"? No, they will work out solutions based upon knowledge and the other information gathered to diagnose and create an environment which allows the long term goal to be met, while still allowing the patient to "feel good". Perhaps the pill is broken down, or the needle given in smaller doses over time. It may not be perfect, but two greatly needed goals are met.

1. The patient gets what they need and

2. They do feel good about what they needed and the way it was delivered and become open to new concepts and ideas that they were afraid of before.

Michael's titles and contact details:

Michael J. Hill, CIM, CFP mjh@dethomaswindsor.com
President IFA Canada

De Thomas Financial Corp. (Windsor)

Visit us at www.dethomaswindsor.com
Ph 519-973-5719
Fax 519-973-1845

Friday 12 October 2007

Bond Index ETF/Funds vs Bond Ladder

A little while back, Mike from QFP asked me to compare my experience using a bond ladder for the fixed income component of my portfolio versus bond funds, which I have just started using this year in the form of ETFs. Good question, here are my thoughts.

Bond Ladder
My holdings look like this:
  • More than ten individual bonds;
  • Different issuers, corporate only, none government, Canadian only, no foreign;
  • Staggered Maturity approximately (at various times throughout the calendar year) one year apart, from 2008 up to 2026
  • Held across two LIRAs and an RRSP
  • No buy-sell, just buy and hold to maturity - when one matures I buy at the long end of 10+ years which gives higher yield - since I've been doing this, the yield curve hasn't gone upside down, where higher yields would be available for shorter term bonds
  • Coupon bonds only, no strips or residuals
  • Investment grade only

  1. Credit risk and diversification is merely ok but not great - I have too few bonds in too few categories to be properly diversified. Though I have bought only investment grade bonds, it happened once that one company had its debt rating lowered and the price took a big hit. It didn't actually go into default but that risk isn't negligible. I didn't lose any money because I held to maturity and the bond was repaid at par. A few years back, Telus had a bad patch, it got downgraded, I nervously bought a bit, management got the ship back on track and lo and behold, I made a very nice gain in addition of course to continually receiving the coupon payments. Nowadays, I'm taking the attitude that I won't presume to judge better the credit risks than Standard & Poors or Dominion Bond Rating Service.
  2. Portfolio rebalancing is more difficult - since I have made myself a policy to rebalance my overall investment portfolio back to target percentage allocation (30% in fixed income) if it comes to pass that equities have a crappy year and I am overweight in fixed income, what should I do - which bond to sell and put a hole in the ladder? As well, bond buy-sell minimums might cause an asset allocation overshoot and the buy-sell spread/commission on bonds adds to costs.
  3. Purchases are lumpy - the minimum bond purchase amount is $5,000 so you need a fairly hefty sum to even build a ladder. The smallest I have seen suggested is a ladder of five bonds, i.e. $25,000, though due to the above diversification considerations, I feel $50,000 is more like a proper minimum.
  4. Limited inventory - the discount brokers don't have a huge selection. Yesterday, when I went through my TD Waterhouse account there was not a single corporate bond of more than eight years maturity. BMO Investorline had a much better inventory, but ...
  5. Commissions can vary between discount brokers - I managed to find the same bond for sale at both BMOIL and TDW yesterday and discovered that BMOIL charges a higher commission than TDW. The GE Capital 4.4% 01JUN14 ask price for the min $5k purchase at BMOIL was 96.46 and 96.257 at TDW, a difference in commission of about 1% vs 0.76%. BMOIL = bigger inventory but higher commissions. TDW also supplies, very conveniently, both the bid/buy (94.757 in this case) and ask/sell prices, which is what allowed me to figure out the mid/average price and the commission.
  6. Commissions and therefore costs can be low if bonds are held to maturity - though the commission on an equity trade of $10/5000 = 0.2% is much lower than the above bond example, there is no recurring admin or management cost on the bond and, if held to maturity, the cost averaged over years goes down to very small amounts, which Shakespeare's primer has conveniently calculated and graphed here. On the other hand, if you start actively buying and selling bonds, your commission costs will be quite high, i.e. my recommendation is that a bond ladder is for holding bonds to maturity.
  7. Commissions do drop with larger purchases and your yield/return rises. For example, today on BMOIL, buying $100,000 of GE Capital DD Call 4.65% 11FEB15 gives a yield of 5.238% while the minimum purchase of $5,000 yields 5.117%, a difference of 0.121%. As they say here, every little helps. Do you have $1mill for your bond ladder to get that extra 0.1%? No? Then just buy another bond that yields slightly higher.
  8. Choice of receiving the return as cash or an ultimate lump sum. Most bonds pay out cash as coupon interest payments every six months, though some do so every month, allowing one to tailor a cash flow if desired. In my case, I really should be buying stripped coupons and residuals instead of regular coupon bonds to avoid having the interest payments sitting idly in cash between my rebalancings and to lock in the yield aka avoid the reinvestment problem. (A really good brief explanation of stripped bonds is BMOIL's on their website at https://www1.bmoinvestorline.com/EducationCentre/FixedIncome/Products.html#3.1 or if you cannot access that page, see Shakespeare's explanation at the link above. I am still accumulating and not withdrawing from my registered plans so I don't want cash, but someone else in retirement and needing to withdraw cash might find that handy.
Bond ETFs
  1. Diversification is easy and assured. With one purchase it is possible to acquire a large number of bonds to cover the whole Canadian market, like XBB, or subsets thereof to reduce individual company credit risks to their minimum. One can acquire a subset that apparently acts as a separate un-correlated asset class - real return bonds, like XRB. One can also buy foreign bonds, like the US dollar AGG, which I have done to further diversify my holdings, or even international bonds, though I have not done that yet. Read this GlobeInvestor article for a rundown of various US and international alternatives.
  2. Rebalancing is easy and precise. Since the ETFs are like a stock, an asset allocation can be set almost to the dollar and it takes only one trade.
  3. Management fees are a bit higher. The annual management fee on a fund, even if it is a passive index-tracking fund like the ones named above, takes a bit away from the return every year. MERs: XBB - 0.3%, XRB - 0.35%, AGG - 0.2%
  4. Interest payments on bond ETFs are received in cash, with the same issues as discussed in the case of individual bonds. Bond mutual funds can reinvest the payments but their MERs are higher, which is a worse problem than receiving cash. If you have one giant holding in an ETF and receive a large cash payment, it may be enough to reinvest immediately instead of waiting months while a reasonable amount piles up.
Most of my fixed income portfolio is in the Canadian bond ladder, but I have smaller holdings in some of the bond ETFs mentioned to facilitate my asset allocation and rebalancing. For me, and I would suggest for anyone, tax considerations don't enter into the picture since my holdings are all in tax-deferred registered accounts. It doesn't make sense if one can possibly avoid it, to have any fixed income in a non-registered taxable account - it's always better to pay taxes later.

Wednesday 10 October 2007

Lessons from Who Wants To Be a Millionaire

I love watching the Who Wants To Be a Millionaire quiz show on TV. I have lots of fun trying to do better answering the questions than the contestants.

It is perhaps inevitable that I should make comparisons between WWTBAM and investing. Brace yourselves....

  1. Everyone wants to be rich but almost no one expects to be rich. When asked at the beginning of their turn in the hot seat, no one I have ever seen say they expect to win a million. Most only say they will try their best. Most only desire a sum that will make their present life more comfortable and most only aim for a figure that is achievable, like £32,000.
  2. Almost no one actually wins the million and gets rich. It's hard to find actual statistics on the amounts actually won by contestants on average but of all the scores of watched, in only one episode did someone win the £million. Apparently, it took 264 contestants from the launch of the show before the first person won the jackpot in the UK. The same source says only 1-2% end up winning the big one. My guess from watching the show is that the average take home must be around £16,000 (incidentally, game show prizes are not subject to tax in the UK, so that's one difference with investing).
  3. Success depends mostly on skill but luck counts. Obviously, the more you know, the more success you will have but it is impossible to know everything so the exact questions that come up can make a big difference to the outcome. Perhaps you know Shakespeare but do you know who won the 2002 World Snooker championship? People who tend to do well take educated guesses and take a chance. During the tech boom there were lots of high fliers but even then you had to guess right ... let's see, Nortel or Cisco?
  4. Knowing when to stop and take the money (sell) is critical - e.g. the tech boom and Nortel and Cisco again a good example.
  5. People who are over-confident, which group also tend to be smart, do less well than cautious people who admit the limits of their knowledge.
  6. A very few foolish but extremely lucky people can do extremely well. Most foolish guessers get shot down. But ... there was one very flaky lady who announced at the beginning in the hot seat that she was going to make the most of her chance on the show and intended to win a lot of money. She guessed correctly on about three questions when she admitted not knowing the answer. She did not use her lifelines in situations where she was uncertain, saying that she wanted to save them for later. She walked away with £250,000! Not fair, huh? But that happens on WWTBAM and in the stock market. She is probably claiming today that she knows how to win big on the show. Maybe she has become a stock market commentator.
  7. Neither being a celebrity nor being highly educated makes you better. Versions of the show with celebrities as contestants (I saw a pair of entertasiners get a movie question wrong) and versions with university professors and students ( a team of a student plus a prof) don't seem to do any better than the average guy, just as being a good doctor or engineer doesn't make you a good investor. The fellow who put up the excellent Gummy Stuff website is a retired math professor and he admits in there that all those sophisticated financial tools haven't made him a hugely successful investor. Which is the reason I wonder about celebrities becoming politicians, or are those noble occupations one and the same?
  8. Certain people are more naturally gifted and better trained for the task than others. Some people absorb the trivia required for WWTBAM more easily and some, recognizing their talent, work to develop it to a high degree. There's another show here called Eggheads, in which trivia pros take on amateur challengers. Guess who wins 99% of the time? And so it is in investing. There are not many Warren Buffetts around, who not only has talent but also spends full-time doing what you and I do part-time.
It will not surprise you that taking the comparison a bit further confirms, to me at least, the wisdom of the course I have decided to follow with my investing, whose purpose is to support me since I don't have a pension.

I want and need to play the game but, unlike the show I cannot afford to lose so it would be a big gamble for me to come up against questions I couldn't answer beyond the first two or three really simple ones that are giveaways (though even then, occasionally a stumper comes up). In addition, in the stock market you don't reach minimum take home milestones like on the show. What is the strategy, then?

Unlike the show, there exists in the stock market the equivalent of buying a piece of all the contestants who come on the show, in effect taking the average of their winnings. You will never get the million, nor will you go home with a big fat zero (yes, indeed some poor sods manage to pick the wrong answer before reaching the first guaranteed level of £1,000). If my guess is right that the average is around £16,000 then that's what I'll get, minus a small annual fee for the person who syndicates the investment. Some years when the contestants are stupid or unlucky, I'll make less, others years when they are better, or the questions are made easier to raise ratings (no, not possible! ... though recent game show scandals here make one wonder what kind of manipulations can occur), I'll make more.

Can you guess what I'm referring to? Of the four possible answers, only one is the correct answer. You have three lifelines - ask the audience, phone a friend, or 50/50.
A - Actively- managed equity mutual funds
B - Options
C - Index ETFs or low cost mutual funds, or index tracker funds in the UK
D - GICs

Good luck. The answer will be worth thousands and thousands of $ or £ in your pocket.

And for those who may not have noticed, you can try an online version of the quiz show based on USA culture at the bottom of tis blog page. See if you can win a million. I haven't managed yet ... good thing I'm in ETFs huh?

Tuesday 9 October 2007

New Feature - Survey

New fun feature added today, a survey of what you my readers think. No logging of your identity or info takes place, just your reply. Google has recently added a small survey tool to the capabilities of Blogspot so let's try it out. Maybe it will give me more topics to write about, though goodness knows I have a backlog of topics I want to look into and blog about.

As for this first survey, the stuff I find most complicated is definitely insurance. Looking forward to everyone's answers.

Monday 8 October 2007

Book Review: Juggling Dynamite by Danielle Park

Let us begin with a quote from the Preface: ''This book is not a financial planning book or a finance text.'' It is rather a polemic, a book that puts forth controversial opinions, much of which I agree with and one of which is dangerous to investors. To use the analogy in the title of Ms. Park's book, if investments are dynamite, then she advocates becoming good at knowing when to hold onto the dynamite and when to run and hide, i.e. she is an ardent advocate of market timing.

As an industry insider with experience working for an investment dealer and now running her own company managing the portfolios of private investors, she is in a good position to warn about mistakes often made by the investing public and dangers of the investing industry, things like:
  • ''the key to lasting financial success is constant, conservative, diligent discipline and self-restraint''
  • a primary objective must be not to lose one's capital
  • be wary of media hype on hot companies and stocks
  • avoid debt and be very cautious about leverage
  • avoid putting much, most of your money into one investment - diversify
  • avoid mutual funds that charge high fees and use low cost index ETFs instead
Park puts forth the assertion in the book that the reality of economic cycles and of market bubbles and of purported long- term economic cycles and of secular trends means that an investor should vary the amount invested in equities and cash accordingly to preserve capital and make higher returns. This is contrary to mainstream financial theory, which maintains that markets are generally efficient and reflect available information, including public data on economic activity and cycles. Park herself admits the controversy of her assertion:
''There seems to be vehemence on the part of many mainstream financial commentators to refute the notion that anyone can use market timing to the investor's great benefit. I have tried to understand why this might be the and confess I have no clear explanation.''

Unfortunately, the bulk of finance research indicates no benefit to market timing from the various systems and trading rules proposed. Park does not back up her assertion with evidence, nor does she reveal the rules she would propose to use so that the possibility she does have a system capable of beating the market could be examined. Failure to do so voids the promise on the back cover, namely that: ''This book will equip you with the tools to make your portfolio grow using active investing and market timing.''

To be more than fair (why didn't she quote this kind of stuff?), there is some research that indicates some people or some systems can successfully time the market. One is called trend following, which exploits the documented tendency of market returns to persist or to have momentum for several years. The paper by Mebane T Faber titled A Quantitative Approach to Tactical Asset Allocation, available here at the Social Science Research Network describes the ability of the rule to buy/sell equities using the 10-month simple moving average to reduce portfolio risk (aka volatility) while maintaining the same returns as buy and hold. Or, the paper The Market Timing Ability of UK Equity Mutual Funds by Cuthbertson, Nitzsche and O'Sullivan also available at SSRN, describes how a small number of fund managers demonstrate market timing ability. I didn't find any papers that use economic cycle indicators as Park proposes but maybe there is some system that can apply them successfully. The point is that the burden of proof lies on Park in addressing the reader.

Two critical problems arise, however, for the individual investor in trying to apply market timing. First, is the constant effort to track the market for the buy/sell signal and then carry out the trading required. Second is the difficulty revealed by the Cuthbertson study - a much larger number of the professional equity fund managers (10-20% vs the 1.5% who did well) did worse and subtracted value by their market timing efforts. In short, the average individual investor is almost surely best off with the passive index investing of a balanced portfolio that is occasionally re-balanced.

For what it's worth, on page 41 Park makes the bold prediction that 2000 marked the start of a 20 year bear market for equities. She recommends on page 46 holding various forms of cash, plus commodities, gold, metals and minerals but to do this with ''a timing strategy employed with discipline.''

The writing itself is uneven, sometimes ungrammatical, often inadequately labelled, documented and footnoted. The book suffers from awkward diction and phrasing that makes it seem like a first or second draft, not a polished final product. This undermines the credibility of her message.

Once again, thank you to Mike at the publisher Insomniac Press, for providing me with a complimentary copy of the book to review.

You can buy the book at Chapters.ca

Overall, there is a fair bit to like in this book, but the impractical advice to use market timing mars its usefulness for the DIY-investor. My rating: 3 out of 5 stars.

Saturday 6 October 2007

US Value Indexes - If it Ain't Broke, Don't Fix It

A comment was left on my posting The Slippery Meaning of Value in ETFs and Indexes stating that there was a problem in 2000-2002 that revealed the weakness of the simple price/book metric used by S&P for its Value indexes, which led to the inclusion of all sorts of other metrics to better assess 'value' by Russell, MSCI, Morningstar and Dow Jones/Wilshire. The comment concluded that I should compare the Russell with the S&P ETFs to see how the S&P underperformed compared to them and to the index. So here are some comparisons based on charts from Yahoo.

Large Cap
Both IVE, the iShares S&P Large Cap Value fund, based on the p/b metric, and IWD, the iShares Russell 1000 Large Cap Value fund, based on all sorts of other metrics, far outstrip the S&P 500 index, though the Russell is ahead during the period 2000-2002 but pretty well only during that period. see this first chart.

Small Cap

Again, both IJS, the iShares S&P 600 Small Cap Value fund, the one based on the p/b metric and the IWM iShares Russell 2000 Value fund (the small cap fund most comparable to IJS) outstrip the S&P 500 index. IJS outperformed IWM particularly in the 2000-2002 period. It is interesting that IWM tracks the overall market value index IWW, the Russell 3000, much more closely than IJR. see this second chart.

What does all this tell us? First, in the grand scheme of things, the seven years from 2000 to today isn't very long, so any conclusions are rather tentative. Second, both the large and small cap iShares ETFs seem to have return streams significantly enough different from the overall S&P 500 to make them useful diversifiers, as do the Russell funds. Third, the divergence of the large cap version IVE seems to have been temporary and confined to the period 2000-2002. Fourth, the similarity of performance of IWM and IWW seem to make IWM less useful as a diversifier for small caps.

Overall, the iShares value ETFs, using the original value measure of price to book ratio as uncovered in financial research, seems to have done the job, especially for small caps, though less so for large caps. In that light, why develop all these fancy, complicated alternate measures of value, none of which are proven in the long term?

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