Institutional Investors Lose Money Just Like Individual Investors

Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors by Scott D. Stewart, John J. Neumann, Christopher R. Knittel and Jeffrey Heisler in the Nov/Dec 2009 issue of the Financial Analysts Journal tells us that pension plans, endowments, foundations and other large pools of assets ($10 trillion in 2006) make exactly the same mistakes and get the same poor results as individual investors. "Much like individual investors, who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions." In fact, the study shows they lost money and lots of it.

This is despite the fact that "Pension plans, endowments and foundations are typically staffed with professionals with years of experience and advanced degrees."

Index investing with a fixed asset allocation seems more sensible every time a new study comes out.

I am left with this question - if individual investors lose money on average over extended periods and the pros do too, who the heck IS making money?

PS - acknowledgement to Index Funds Advisors whose excellent newsletter included the link to the study.

PPS just realized that I've been doing this blog for three complete years now. It is a sort of full circle in that my second post on Feb.1, 2007 was about a paper on the same subject as today's. The 7 Deadly Sins of Investors seems to apply as much to institutional investors as individuals.

IFA Calculator Demonstrates the Diversified Portfolio Superiority

Those who want to check the advantage of a diversified international portfolio may want to try out the superb IFA Index calculator over at IFA.com. Though addressed to US investors using US dollar data, the principles and the nature of the results for Canadians would be largely the same.

The folks at IFA have incorporated several unique and valuable features:

• inflation (US data) button to see real returns
• dividends included to get total returns not just the index value increase
  
• long history back to 1928 extending right up to October 2009
• time period selectable of any duration - find the best or worst case scenario that has happened in the past
  
• regular (annual) deposits in dollars or percentage can be added, or
• regular (annual) withdrawals in dollars or percentage too, making this especially useful for a retiree (if you use this option be sure to turn off the "adjust for inflation" in the returns section at step 4; otherwise you would be double counting inflation)
• realistic portfolios with a wide range of asset classes and weights for any from the ultra-cautious 85% fixed income to the ultra-aggressive totally equity portfolio allocation or,
• individual asset classes (21 altogether) like REITs, emerging markets, US and international small cap and value, with reconstructed historical data (these are synthetic and thus not fully realistic but IFA appears to have tried very hard to line them up properly)
  
• annual rebalancing of every portfolio
• tax calculation option for funds in a taxable account (US tax rates)
  
• portfolio returns adjusted for the maximum annual fees of 0.9% that IFA charges its clients
  

It all adds up to being able to model the past in a very realistic manner unlike so many other calculators I have come across. This calculator is not world class, it is the best anywhere on the Net.

Portfolio Advantages:
One of the comparator asset classes is the S&P500 index (in step 1, scroll down the Indexfolio list to the bottom to get it). I used the worst ever 20 year rolling period of 1962 to 1981 (yup, it even beats 1929 to 1948 if you look at the handy 20-year chart from AllFinancialMatters blog on S&P500 Rolling Period Total Real Returns; call this the "financial death by inflation" period of modern history). The comparison of a conservative middle of the road portfolio - IFA's Index 45 - to the S&P500 shows the following:

1) Simple buy at the beginning and hold throughout

• S&P500 - total return 15.56% or 0.73% per year compounded with standard deviation 14.72%
• 45 portfolio - total return 68.34%, or 2.64% p.a. and 9.12% std dev
• the portfolio got much higher return at much lower risk

2) Buy $1000 at start and invest $10 real per month ($120 annually) (i.e. rising with inflation)

• S&P500 - total return 261.71% / 6.64% annualized and 14.57% std dev
  
• 45 portfolio - total return 426.93% / 8.66% annualized and 8.88% std dev
• the advantage of the portfolio is even greater than buy and hold

3) Retiree starts with $120,000 and withdraws $400 real per month (i.e. $4,800 per year = 4% of initial capital, which is the rule of thumb sustainable withdrawal rate)

• S&P500 - same % return and std dev as for additions (it's just the mirror image); whew! the rule works as after the worst ever period, the S&P500 only investor has weathered the storm and the portfolio survived with a balance of $144,000 in December 1981and better times ahead, though he/she doesn't know it ... by 1991 the balance is up to $299,000
  
• 45 portfolio - returns are higher here too and the end balance is $263,000; just for fun, I played with numbers to see how much could be taken out to end up with the same as the S&P500 - and the figure is around $6,300 per year, a whopping 37.5% more money for the retiree to spend! That is a 5.25% withdrawal rate. The money would have run out in April 1997, so a person could have spent 35 happy years in retirement.
  

IFA does tout that its funds and portfolios outperform on both risk and return what a DIY investor might be able to achieve using index ETFs or mutual funds like those of Vanguard so the actual numbers and potential withdrawal rates might not apply to an individual DIY investor. Nevertheless, the calculator provides a powerful argument for the value of holding a diversified portfolio.

Many thanks to IFA advisor Brad Von Grote who pointed out the calculator and spent a considerable time on the phone chatting with me. In case anyone wonders, IFA hasn't paid me to praise their calculator and I am not a client of theirs though I think a person could do far worse than sign up with them. I only wish they would create something similar for their Canadian audience.

Investing an Inheritance: How to do a "File and Forget for Forty Years"

Most of us save for retirement in tax-deferred accounts like RRSPs and LIRAs. But what happens when you suddenly receive a large lump sum and you do not have RRSP contribution room, in other words you must invest in a taxable account?

Here's a situation I've come across recently that got me thinking and researching. (Initially, I thought it was simple but it has taken me some time to figure it out to get the practical details right.)

Situation:

• $50,000 inheritance, specified in the will to be "for retirement"; a very wise thing the person who died has done, creating a very strong moral, if not legal impediment to spending the money since half the battle of saving is actually doing it; I would note in passing that the person receiving the inheritance does not have to include the amount in income and pay tax since that would already have been done in the process of settling the estate; I would also note that it is not a testamentary trust, which could absolutely ensure that the money not be touched till retirement.
  
• 40 years till retirement; the person is in his twenties so the planning horizon is at least that long; due to the above-noted restriction on the lump sum, it is highly likely that the actual time horizon will correspond to the planned horizon - in other words, people frequently suddenly decide that their "retirement nest egg" needs to be cracked open for an omelette craving today, thus blowing the value of a long term approach to smittereens.
  
• No RRSP room: the inheritance must go into a taxable account, which means that income taxes for various types of investment returns (interest, dividends and capital gains) can play a crucial role in net returns, especially over the long term; though the person could or should intend to move the investments progressively into an RRSP as his career advanced and contribution room became available, in this case, his apparent career orientation into government or educational jobs suggests that one of those golden defined benefit plans will use up most or all of tax-deferred pension room, so it is better to plan as if it will not happen
• Maximize net after-tax wealth: obviously ... but he is not interested in high-risk investments that may suffer absolute final losses, as opposed to waiting through market ups and downs, and subject to the following constraint,
  
• Zero maintenance and attention portfolio: the person would ideally like to have to do nothing at all for forty years! No buying and selling, no rebalancing, nothing, if at all possible; unfortunately, it is still required to file a tax return every year, so tax reporting simplicity is a consideration. As a consequence, things should be as simple as possible - few holdings at one broker.

General Principles: these should always apply to investing

• low costs - paying higher fees for others to manage your investments is a sure way to end up with less; 0.1% less per year can add up to many thousands difference after 40 years - 4.1% return compounded will see $50k reach $240k while 4.2% yields $249k; high MERs = low net returns; this eliminates from consideration all equity mutual funds except index trackers
  
• diversification - the "not all eggs in one basket" and "some go up while others go down" factors entail being invested in many assets with as low as possible correlation with each other; this ensures that there is a net gain, not a loss, over the long term
• tax-effectiveness - deferring and reducing taxes means a greater net in the future; tax rates in Canada are lowest on dividends, higher on capital gains and highest on interest as this previous post on tax rates shows. There is a significant advantage to dividends for all taxable income up to the mid-$70k range, which is where our person is most likely to end up based on his career path. However, the portfolio diversification principle must be respected - meaning that it is not acceptable to ignore the fixed income component of a well-structured portfolio merely to avoid taxes. Fortunately, there is a way - substitute preferred shares returning dividends for bonds returning interest income.
  

The Proposed Solution: this is necessarily a combined solution of portfolio and broker/financial service provider due to the practical constraints outlined below; theory may tell us to do things a certain way but it is not quite possible in practice.

There are three good alternative solutions, the best ranked first.

1. Portfolio of Four ETFs at Questrade

Portfolio Composition:

• 35% / $17,500 XIC - iShares Canadian Composite Capped Index Fund, MER 0.25% (the alternative is XIU, the TSX 60 fund, which has a lower MER of 0.17% and distributes much less income as interest, but it only includes the 60 largest companies as opposed to the 270+ companies in the Canadian market, which means less diversification as the 60 only account for three-quarters of total market value of the TSX and presents less opportunity to benefit from small company growth, from income funds and from real estate); negatives of XIC are the MER and the fact that some of the annual distributions are higher-taxed interest; XIC exemplifies the simplicity and advantage of a fund that enables one to own a piece of a large number of assets/companies through one purchase; in the proposed portfolio XIC is the Canadian equity asset class
• 15% / $7,500 VTI - Vanguard Total Stock Market ETF, MER 0.07%; this is a broad market index, representing some 95% of the total US market according to Vanguard; it is exposed to USD vs CAD currency swings, which can be good or bad, depending on the direction; to some degree, there is also a diversification advantage (see discussion in a Burgundy Asset Management paper and research by Mark Kritzman - when the Canadian market falls, often the Canadian dollar follows, meaning that a VTI owner will end up with more Canadian dollars (as long as the US market doesn't fall by the same percentage); alternatives might be IYY and IWV, two index ETFs that track the broad US market but they have higher MER of 0.20%
  
• 20% / $10,000 VEU - Vanguard FTSE All-World ex-US ETF, MER 0.25%; provides very broad exposure to some 1300 companies in 47 countries around the world outside the USA
• 30% / $15,000 CPD - Claymore S&P TSX CDN Preferred Shares ETF, MER 0.45%; this is the fixed income portion of the portfolio, in which preferred shares are substituted for the bond funds typically held in registered tax-deferred portfolios; preferrred shares produce dividends so the person in a middle tax bracket will lose only about 8% to tax vs 30% - preferred shares pay less than bonds (James Hymas says about 0.89% for corporate bonds) in an article Corporate Bonds - or Preferred Shares? in the May 2006 Canadian MoneySaver) but compound the tax difference over 40 years and the difference is enormous e.g. 6% gross on $15,000 bonds would net reinvested and compounded after annual tax at above example rates $77,767 in bonds and 5.1% on dividends would net $93,892; note that bond funds always include lower yielding government bonds so this comparison understates the after tax advantage of preferred share dividends; the alternatives to CPD are three closed end funds DPS.UN - Diversified Preferred Shares Trust, PFR.UN - Advantaged Preferred Share Trust and PFD.PR.A - Charterhouse Preferred Share Index Corporation according to Portfolio Construction in the July/August 2007 Canadian MoneySaver issue but a cursory look suggests they suffer from making large distributions of return of capital, which is just giving his own money back to an investor, as well as trading often at well-below NAV.

Why the portfolio allocation proportions and holdings?

This is perhaps the most uncertain area. While the whole world is represented, Canada has a much larger proportion of total equity - equal to the sum of the USA and the rest-of-the-world - than in my own portfolio. The logic is simply that the person is likely to live and retire in Canada and use Canadian dollars. The foreign holdings introduce a significant enough exposure to diversification benefits from the equities themselves and from currency swings, but not too much. I've wrestled with this in the past e.g. this post on IFA Canada's model portfolio and this post on my own portfolio but cannot find the "perfect answer".

What does the above portfolio achieve?

• diversification through diffuse ownership of a large number of companies
• diversification through investment in most areas of the world
• diversification through equity and fixed income asset classes that move in different ways at different times (but which all move upwards over the long term)
• higher net returns through low fees of the ETFs
• higher net returns through use of a discount broker, which will charge nothing for account administration or management and only charges for trading
  
• higher net returns through lower taxes
• zero maintenance through index tracking - the fund managers regularly restructure the holdings to reflect market evolution requiring nothing of the investor
  
• zero market knowledge and investigation required - you get the market average automatically year after year, sometimes that is down but mostly it is up and certainly over the long term it is up
• zero maintenance through automatic dividend/distribution reinvestment by Questrade
  
• minimal administration through the small number of funds requires less work to do annual tax returns for distributions and down the road when they are eventually sold
  

What does it not achieve and what are the risks?

• rebalancing to keep the portfolio proportions the same will not happen without selling and buying by the investor; rebalancing every four years or so, or when one holding gets more than 5% (e.g. XIC goes up to 41% or down to 29%)out of whack, is the optimal strategy (see this post for discussion); over many years, the equity investment growth should far outstrip the fixed income CPD, which will increase the overall riskiness of the portfolio; normally, that's a cause for concern and the reason for rebalancing; in this case it is quite possibly a good thing, a worthwhile natural evolution. Why? As this person gets older and if, as expected, he begins to build up a defined benefit pension plan paying a fixed inflation-adjusted income at retirement, that in effect has increased the fixed income portion of his total personal wealth.
  
• shifting the portfolio into an RRSP for tax deferment and tax-protected growth as and when that becomes possible can only happen with monitoring and action by the investor; contributing the funds in-kind is possible but that will trigger a deemed disposition and the necessity to calculate and declare capital gains along the way, more work for the investor; the first thing that should go into the RRSP is fixed income, but the CPD should then be sold and replaced by a purchase of a bond fund like XBB the iShares Canadian Bond Index Fund since bonds will produce a higher gross and net (once protected from taxes) yield
• keeping a record of the Adjusted Cost Base of ETFs is a manual procedure as I explained in this post and it is a pain in the you-know-where; it doesn't really need to be done till the ETF is sold and the gain is to be reported on a tax return so maybe it can be put off and done in one massive catch-up session after 40 years but I'd want to not be further than five years behind simply because corporate fortunes rise and fall, companies come and go and records disappear or become hard to find (I had a lot of trouble some years back trying to figure out mutual fund ACBs to do final returns going back a mere 20 years)
• potential instability of the solution is an inescapable risk, especially over forty years, since the practical evolves greatly e.g. forty years ago, index funds did not exist and there was no capital gains tax in Canada; change will happen, it's just not possible today to know where, when and to what degree; one thing to remember is that big does not equal absolutely safe, stable or permanent - the current financial turmoil is affecting most the world's biggest banks, some will fall and over the long term, most will fall (just check the stock listings of the TSX, oops it used to be the TSE, 40 years ago and see how many names you recognize); Questrade is a relatively new, smaller player and going with them entails a degree of risk that it will be necessary to shift the portfolio to another institution if they run into business problems ... or maybe their superior product will see them grow into the dominant broker of tomorrow; is CIBC a good place to be, they seem to keep stumbling? Regardless, it will always be necessary for the investor to keep a general eye on developments for this maximum passivity portfolio.
  

Broker: All ETFs produce cash distributions, either monthly, quarterly, semi-annually or yearly, and there is no option, like there is with mutual funds, to have the ETF manager reinvest the cash automatically. So the investor can do it at his own time and expense or a broker can offer the service. But the objective is to have everything run on autopilot. The choice of Questrade boils down to one thing - Questrade is the ONLY Canadian discount broker I found that could reinvest the cash distributions for all the above ETFs so that the cash would not sit around in the account earning little or nothing. CPD was a particular no-can-do for everyone but Questrade and we see above above, it is a key element of the plan.

2. Portfolio of DFA Mutual Funds described on IFA Canada from Advisor De Thomas Financial.

This approach consists of handing over the $50k to De Thomas Financial for them to invest in the DFA mutual funds described in detail on the IFA Canada website. They follow passive indexing principles to the nth degree, they say convincingly enough (i.e. they back up their assertions with believable data) even more than the various index ETFs. The breakdown of asset classes is more numerous, enabling reductions in volatility and higher returns. Though De Thomas charges a 1% annual fee on top of the 0.25-0.70% embedded in DFA funds, their approach makes up for that 1.25 to 1.7% vs 0.07 to 0.45% ETF fee spread by lower tracking costs, by stock lending revenue and by tax deductibility of the fees (on taxable accounts only). Michael Hill of IFA Canada & De Thomas explained all this in my Q&A blog post of Oct.23. The end result is that the investor should attain a higher net return. The fact that the holdings are mutual funds eliminates the special ACB record-keeping hassle of ETFs, as well as the reinvestment of distributions problem. The rebalancing issue goes away too since De Thomas does it. Finally, part of the De Thomas service is general financial advice (I notice that Mr. Hill is a Certified Financial Planner, one of the better designations) and that may come in handy.

My biggest concern is that all of the portfolios have only bond funds and none with preferred shares and so taxes will be considerably higher. Another is that the "Easy Chair" portfolio for accounts smaller than $100,000 (the minimum required to do the full asset allocation using all the funds) has some limitations but those are not described.

3. Portfolio of TD Canada Trust e-Series Mutual Funds

This portfolio mimics the ETFs in the first portfolio with the difference that they are mutual funds available only through having an account at TD Canada Trust. The funds are:

• TDB900 - TD Canadian Index Fund, MER 0.31%, tracks the TSX Composite Index (it doesn't appear to be a capped fund like XIC, which limits any stock to no more than 10% of the fund; this shoudn't cause any difference or problem as long as there is no tech bubble II where Nortel gets up to 30% of the total value of the TSX!)
• TDB902 - TD US Index Fund, MER 0.33%, tracks the S&P 500, which is only three quarters or so of the total US market and really only tracks large companies, a disadvantage since small company stock returns historically have outperformed large company returns
• TDB911 - TD International Index Fund, MER 0.48%, tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index("MSCI EAFE Index"), which is probably quite a bit less diversified ( we cannot tell because TD's fund information on the above website is too incomplete) than VEU
• TDB909 - TD Canadian Bond Index, MER 0.48%, tracks the Scotia Capital Universe Bond Index ("Universe Bond Index"); because it's a bond fund in a taxable account this is much less desirable than CPD
  

The TD funds do offer the advantages of mutual funds over ETFs already noted above but the higher MERs and a bit less ideal diversification characteristics promise lower long run returns. The biggest negative is the absence of a preferred shares fund. Of course, it would be possible to take the $15,000 for fixed income, go to Questrade and have an account only for that holding there. But why start to complicate life with accounts here and there if there is a better overall solution with Questrade?

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
Dimensional Management		Active Management		Index 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:

	1.	By definition, foreign exchange rates are a zero-sum game, so currencies have a zero expected return.
	2.	There is no evidence that foreign exchange rates can be reliably predicted.
	3.	Diversification works whether we like it or not.
	4.	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

Internationally Diversified Portfolios from IFA - US vs Canada

Now that Index Fund Advisors has opened up shop in Canada, there is the chance to see how some real experts approach the issue of building an internationally diversified portfolio based on principles of modern finance in two different countries - Canada and the USA. The websites of IFA Canada and IFA USA each present a series of twenty model portfolios with varying amounts allocated to various fixed income and equity asset classes.

For comparison, I've chosen a portfolio allocation that interests me - 70% equities and 30% fixed income - but you could pick any range from 0 to 100% for either asset class. It is extremely interesting that the Canadian version includes a hefty 16% Canadian equity allocation while there is zero separate Canadian allocation in the US version. This is apparently in keeping with the home company bias every country has. It isn't justified by finance theory that says a country's weight should approximate its value portion of the whole world, which is 3-4% in Canada's case. However, this makes no effective difference to the risk/volatility profile or the diversification effect since Canada's long term correlation with the US market is in the mid 90% area. It's a good illustration of the principle that in order to be an asset class, a grouping of equities needs to move up and down differently than, aka be uncorrelated with the other.

Another big difference is that Emerging markets is completely absent from the Canadian portfolio while it takes up 8% of the US portfolio. This time the problem is apparently that it is impossible at the moment to create the Emerging markets component in Canada ... it is apparently to be resolved by next year. Similar difficulties must explain the lack of breakdown in the fixed income portion into Global and Government components seen in the US version. The total number of holdings in the Canadian list is 12,924, much less than the 16,540 in the US list but it is still an awesome number.

IFA has just barely launched in Canada so it is a player worth watching and considering, given the high quality of its products in the USA.

Jonathan Chevreau Report: Index Fund Advisors come to Canada

Just came across the news on reporter Jonathan Chevreau's blog here that says the US firm Index Fund Advisors has expanded into Canada at this site. Anyone interested in passive portfolio index investing based on strategic asset allocation offered by real experts should take note and visit them, for ideas and background information if nothing else. IFA offers only funds created by Dimensional Fund Advisors, the Board of which includes a veritable who's who of modern investment research - such as Eugene Fama, Kenneth French, Roger Ibbotson, Myron Scholes, Robert Merton!!! IFA Canada will work with De Thomas Financial Corp. IFA will provide the website, educational material and portfolio construction while De Thomas will deal with customers.

To start off the minimum account size (to enable proper diversification) will be CDN$150,000 (vs $100,000 in the US - hey, our dollar has gone up lately!) though later there is an intention/hope to accept clients with $25,000. As in the US it will be mandatory to use the advisor (De Thomas in Canada) with the associated 1% advisor fee on top of the MERs of the DFA funds themselves, which range from 0.25 to 0.45%. For that, clients get guidance for their risk/volatility tolerance and corresponding optimal portfolio.