Cap-Weight vs Fundamental Portfolio after 3 Years (July 2013) - Tight Race Continues

Three years after launching in June 2010 a realistic portfolio simulation (which includes trading commissions, actual prices, distributions, foreign exchange fees for converting CAD vs USD) of traditional cap-weighted ETFs pitted against fundamental factor-weighted ETFs, the race continues to be very close.

Neck and neck contest - tiny differences in total portfolio value
2010 Year-end - dead heat: 0.1% difference
2011 August - cap-weight slight lead by 0.6%
2012 March - dead heat, 0.07% difference
2013 August 7 - fundamental slight lead by 0.6%

There isn't a huge divergence in any asset class either, the largest gap being the 10% ($500) advantage of PDN over EFV in the small- to mid-cap developed markets holding.

First ever portfolio rebalancing
For the first time in three years, some of the asset classes finally exceeded the policy limit set at portfolio creation that rebalancing should occur when any asset class strays more than a quarter from its allocation. The strong performance of the US equity market and the weakness of emerging markets and bond market caused a big enough imbalance to exceed the threshold in both portfolios. It was a good time in any case to invest the accumulating cash balances.

Perhaps counter-intuitively to some, the portfolio rebalance policy is obliging sale of recent winners US equities (PRF & PRFZ and VV & VBR) and purchase of losers bonds (XBB and ZRR), emerging markets (PDN and EFV) and commodities (UCI).

Solid performance by both - up about 26% in total over the three years, or 8% per year compounded. That may be the biggest lesson of this exercise - a diversified portfolio works well.

The current market value of holdings in the two portfolios is shown in the spreadsheet at the bottom of this blog page. Between updates like this one, which I do every six months or so, the monthly distributions are not reflected in the portfolio cash holdings so the total portfolio value may be slightly under-stated for both. The spreadsheet is still a pretty good reflection of the current status of the contest since the distributions of the two portfolios are quite similar i.e. the current market price of the ETFs creates most of the difference.

Cap-Weight vs Fundamental Portfolios: 2010 Year End Update

Last June I created two parallel test portfolios to determine whether Fundamental Weighting really does a better job than a Cap-Weighting as proponents like Robert Arnott say. The two portfolios have the same asset classes and proportions invested in each asset class. As much as possible, the portfolios mirror the investor experience, as I described in the initial post about this mini project.

The 2010 year end has come and the cash distributions have been received by the portfolios in a mix of Canadian and US dollars. Where offered by the ETF vendor - BMO and Claymore only - the distribution has been reinvested in its ETF. Per the intention announced in the October update, in the Cap-Weight portfolio, I've now sold the iShares S&P TSX 60 Index ETF (symbol: XIU) and bought in its place Horizons BetaPro S&P TSX 60 Index (HXT), which cleverly uses swap derivatives to track the same index but with the key difference that it implicitly automatically reinvests distributions. That will make a fairer comparison against Claymore Canadian Large Cap ETF (CRQ) which has a DRIP.

The Competition Results:

• It is still more or less a dead heat overall between the two portfolios - only $128 dollars out of a portfolio total value of $113,400 or 0.1%;
• Fundamental Weighting leads in four asset classes and Cap-Weighting leads in two (I ignore RWX since it is the same ETF in both portfolios and the Cap-Weight portfolio has one more share so it will always be ahead by that one share)
• Cap-Weighting is ahead in Canadian large cap equity but Fundamental Weighting leads by a significant margin in the two small cap equity ETFs for the USA and for Developed Markets. It is curious that Fundamental Weighting leads by most in two of the asset classes which have had the biggest increases. Cap-Weighting is supposed to be the bubble follower I thought. Maybe it's a sign that the rise in those stocks is not a bubble at all, that in fact the previous weightings were out of whack - Cap was too high - and now Fundamental has been catching up.
  

General Investing Results:

• Both portfolios are up a healthy 13% since June, when we pretended to invest $100k
• Every asset class is up by double digits, except Bonds
• The rise of the Canadian dollar has reduced foreign returns but they were still much stronger than those of Canadian holdings after conversion
  
• None of the asset classes is anywhere near the threshold set for rebalancing (1/4 of its allocation percentage), which we said anyway we'd only do after a year.
• Cash inevitably has started to pile up unproductively in these accounts as in real life when distributions are not immediately reinvested. The Fundamental portfolio has $1767 in cash (1.6% of its total value) and the Cap portfolio a bit more at $2066 / 1.8% (since fewer of its ETFs offer a DRIP). This brings out the real-life no-perfect-answer dilemma of having idle cash vs paying too much in trading commissions to reinvest small amounts. At the year anniversary in July after two more quarterly distributions by the ETFs, there will be more cash and we'll reinvest & rebalance per our portfolio policy.
  

The details of the two portfolios are in a Google spreadsheet at the bottom of this blog page.

Cap-Weight vs Fundamental Portfolios: Q3 Update, Guess Who Leads

Regular readers may recall that a few months ago I started a contest to see whether a portfolio based on Fundamentally-weighted ETFs would do better than the traditional standard Cap-weighted index ETFs. This contest is meant to be as realistic as possible using actual funds, including trading commissions, currency effects, distributions, DRIPs etc.

The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).

However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.

Other observations:

• Strong portfolio gains: both portfolios up almost 10% since June!
• Correlated asset classes can be good: every single ETF / asset class in both portfolios has gone up since June. That's highly unusual and sure not to continue for very long. The value of having a diversified portfolio is still evident in the large disparity between the gains amongst the ETFs. If one had only been invested in Canadian large cap equity with a 4% gain and bonds with a 2% gain, the overall portfolio gain would have been somewhere in that low range. Emerging markets, Developed markets ex-US, international real estate, commodities and Canadian small cap and REITs all contributed percentage advances of triple or more Canadian large cap's. Another way to look at it is that not having a diversified portfolio means having to pick which asset class will go on a tear next in order to get good gains. Diversification = not as good as the best but better than the worst.
  
• Fundamental winning in most asset classes vs Cap-weight - leading by 5 to 2. It is still early days in our contest but this is going in the direction I would expect. ... However, where Cap-weight is winning (Canada large equity and Emerging markets equity), it is by enough to more or less balance things at the portfolio total. As I wrote about here, in the Canada equity case, I believe the difference is due to the ongoing Potash Corp takeover bid.
  
• No re-balancing required: in neither portfolio is the actual value of any asset class anywhere near to going beyond the 1/4 away from target that we said would be our rule for re-balancing; the Cap-weight percentages are slightly more out of whack compared to target, which is what we would expect from indices that rely on market prices - fundamental accounting weights should evolve more slowly. That will be interesting to watch as we go along. (in the updated spreadsheet that appears live at the bottom of this blog, I've inserted a new column in the individual portfolio spreadsheets that shows the ratio of each asset class' actual to target)
  
• Currency has reduced returns: the Canadian dollar has risen about 1.4% vs the USD since our launch, reducing our net returns on US denominated holdings and that is the same for both portfolios.
  

The contest continues ...

Cap-Weight vs Fundamental: Live Realistic Portfolio Showdown

In recent months I've converted my passive index portfolio strategy from one based on capitalization-weighted ETFs to fundamentally-weighted ETFs in the expectation that this will pay off with higher returns and lower volatility. The theory and the back-tested data notwithstanding, the proof is in the pudding so I've constructed two parallel portfolios which are permanently posted at the bottom of this blog. I'll hopefully see how my new portfolio fares in comparison to what might have been - it's either public embarrassment or triumph that is in store for me down the road.

Since pudding is something you can actually eat, the portfolio will be as realistic as possible, what an actual investor will experience, as opposed to so-called index returns one typically sees in the financial press, which exclude various MERs, commissions, tracking errors, currency exchange fees, taxes etc.

Here is how these portfolios will operate:

• $100,000 Initial Capital - though most people must gradually build up a portfolio, I've started with a lump sum to invest; to convert my own portfolio I've actually had to pay an extra 7 trading commissions ($70) to sell off the cap-weight ETFs that no longer fit but I have ignored this cost.
• Trading Commission - $10 each trade, so the initial total value of the portfolio has lost $120 for the 12 trades to establish each portfolio
• Asset Allocation - both portfolios have the same basic percentages allocated by geography and asset class (see the breakdown in the tab AssetAllocation-ETFs) with one prime difference - the cap-weight portfolio includes Value ETFs for USA Small-Cap equity (VBR) and for Global Developed equity (EFV) following the cap-weight view of the world that one adds Value stocks as a tilt. Meanwhile, the Fundamental portfolio simply includes Smaller company ETFs, according to the fundamental metrics NOT cap-weight, for the same USA and Global geographies. In the Canadian REIT class, I have chosen the brand new BMO ETF (ZRE) which equally weights its holdings, since equal weighting also breaks the over-investment in growth stocks that corrupts cap-weighting. In several asset classes no fundamental ETFs are available so we are restricted to using cap-weight ETFs, like XMD (Canadian Small), RWX (Global REIT) and DJP (Commodities). This asset allocation difference is the essence of the divergent approaches.
• Real Prices - I used actual market quotes during the day yesterday June 9th as my buy prices. Note how the real investor cannot buy exactly the number of shares to place the exact amount allocated to each asset class. Through the magic of GoogleFinance and Google Docs, I have created a spreadsheet that automatically and continually retrieves current market prices so that a very realistic picture of the portfolios can be seen at any time.
  
• Rebalancing - will be reviewed once a year in mid July after semi-annual distributions have been received and rebalanced if holdings are more than 1/4 from their target value e.g. for RWX whose allocation is 2%, that is a 0.5% up or down deviation. Even with a fairly big $100k portfolio, it is not desirable to rebalance too often with too small buy-sell amounts - even 0.5% of the initial $2000 allocation is $500, so a $10 trade is a 2% cost. For 12 annual rebalancing trades or $120, the cost to the $100k portfolio is a 120/100000 = 0.1% extra annual cost. Such seemingly small differences do matter over the long run.
  
• Taxes - I am assuming the portfolios are within registered accounts that qualify as retirement accounts under US rules (RRSP, RIF, LRIF, LIRA but not TFSA or RESP) so that there is no 15% withholding tax deducted from distributions received from US ETFs
  
• Distributions - I will add cash distributions to the portfolios as they are received. To keep things a bit simpler I will assume that USD cash will remain as USD and not be converted into CAD (thus avoiding the attendant built-in currency exchange fee). This is in keeping with the slow trend by discount brokers (Questrade, RBC and some others do so today) to enable USD to be kept as USD in registered accounts.
  
• Foreign Currency - the value in Canadian dollars (CAD) is what counts to me and to most Canadians so the net value of USD-traded ETFs is converted back into CAD automatically through the use of the ETF CurrencyShares Canadian Dollar Trust (FXC), which tracks the value of CAD in USD pretty closely. None of the foreign holdings in either portfolio are hedged since I believe the costs of hedging and the tracking error of hedged ETFs outweigh the benefits in the long run. Conversion of CAD with USD is assumed to cost 0.9% (about what I seem to pay with my broker).
  
• DRIP - CRQ, ZRE and ZRB offer automatic free reinvestment of distributions so I will calculate that; for the others, the cash balance will accumulate for a year until rebalancing is done. Since I cannot figure out how much interest the cash would collect - a minimal amount if any these days - I won't include any interest for now but if interest rates start to shoot up, I'll try to do an estimate based on rates I see in my own account.
• Tracking Through the Months and Years - to get an idea of the relative volatility of the two portfolios (I don't expect too much difference since the fundamental indexers themselves have figured out that there is a high correlation between the ups and downs of the funds ... but we shall see), I'll take a month-end snapshot of the portfolio totals and begin graphing them. In ten years, it should be interesting! (If that seems too long, maybe we can take comfort in the fact that Charles Darwin took twenty years to continue his research before publishing his book after he had developed the theory of natural selection).
  

Over time, the Fundamental Weight ETFs should all sooner or later establish a lead over the Cap-weight ETFs - shown in Red numbers in the middle column of Fund-vs-CapWt-MktValue spreadsheet - that will eventually be large enough never to be overcome. That is my expectation, hope and prayer! Go Reds, go!

Two of the New BMO ETFs Worth a Look

Amongst BMO Financial Group's latest batch of new ETFs announced May 26th, are two that look pretty good - BMO Equal Weight REITs Index ETF (ZRE) and BMO Real Return Bond Index ETF (ZRR).

Why ZRE? First, real estate is considered (by most people and by me) to be a separate asset class, so unlike the growing number of sub-sector ETFs there is justification for a separate holding of a REIT ETF such as ZRE. ZRE competes with the well-established iShares REIT index ETF (XRE). Second, both have the same 0.55% MER but the crucial difference is that BMO will equally weight the REITs held within ZRE, instead of the traditional cap-weighting within XRE. For those who accept the evidence that cap-weighting is inferior to equal weighting (or fundamental weighting, as I said March 8th), ZRE becomes the best choice. (Disclosure: I've already sold off my XRE and replaced it with ZRE in my portfolio.)

And ZRR? For an investor who uses real return bonds as an asset class (see various links on the Real Return Bond page by Bylo Selhi) and wants to be able to rebalance easily, ZRR is better than iShares' real return bond ETF (XRR) on two important measures - lower MER of 0.25% vs 0.35% and the ability to reinvest interest received automatically at no cost - the BMO DRIP program which applies to all its ETFs. For more comparison, see HowToInvestOnline's Which Way is Best to Invest in Real Return Bonds - Direct, ETF or Mutual Fund?

Global Investment Returns Yearbook - More Great Stuff in 2010 Edition

The 2010 edition of the justly renowned Credit Suisse Global Investment Returns Yearbook compiled by Elroy Dimson, Paul Marsh, Mike Staunton and Jonathan Wilmot is now available here (pick UK as your download country of origin as it blocks downloads to Canada for 'legal reasons'). As in past editions, it provides the individual investor with insight into global equity markets from a long term perspective. This year it takes a special look at:

• emerging markets,
  
• economic growth and stock market returns
  
• US equity returns
  

Along the way it provides excellent primers on each subject and is definitely recommended reading.

Some highlights:

Emerging Markets

• countries that are emerging tend to stay merging and don't move up into developed very often (only 6 in 110 years), and can just as easily slip back down into "frontier" territory. why not? - dictatorship, corruption, civil strife, wars, communism, disastrous economic policies and hyperinflation - "emerging markets have been accident prone in the past"
  
• "more emerging markets have been downgraded to frontier than have been upgraded to developed. S&P’s downgrades include Argentina, Colombia, Jordan, Nigeria, Pakistan, Sri Lanka, Venezuela and Zimbabwe."
• "... China expected to displace the USA as the world’s largest economy by around 2020, and with India overtaking the USA by 2050."
• "In the late 1970s, emerging markets gave similar returns to those of developed markets, but they underperformed in the 1980s and 1990s. In the 2000s, however, they beat developed markets by 10% per year."
• "... the emerging markets index has been consistently more volatile than the MSCI World"
• higher risk of emerging markets should be worth up to 1.5% per annum extra return compared to developed markets
• correlation of returns between emerging and developed markets has been rising steadily for 30 years but are still low enough to provide significant diversification benefits to the global investor
• there was a big jump up in correlations from about 80% to 90% as a result of the 2008 crash so future correlations should be lower than 90% unless another similar crash comes along
• surprise! the country with the highest return of any during the decade 2000-2009 was .... drum roll please - COLUMBIA!! at over 30% or so annualized return
• from the March 2009 bottom to Dec.31st, a whole raft of emerging countries had phenomenal gains of 100% or more
  
• it is impossible for individuals to invest in emerging markets according to the actual market cap due to restrictions placed on foreign investors or shares being in private or government hands, a prime example being China; moral of the story - market cap weighting is a theoretical ideal that is difficult to even approach
  

Economic Growth and Stock Returns

• "... the link between GDP growth and stock returns is empirically far weaker than many suppose."
• "Looking at 83 countries over 110 years, we find no evidence that investing in growth economies produced superior returns."; the reason is simple, investors predicted and expected higher growth so bid up prices too high to provide good future returns - stock returns are a good predictor of economic growth rather than the other way round.
• however, if you could perfectly predict future economic growth and not base investment on recent past economic growth, then you would make a high return; stock markets seem to extrapolate growth, price it in too high to be able to gain better future returns
• they explicitly liken this to value vs growth investing - fast growing countries are the growth countries while the slow growers are the value countries "In recent decades, investors have historically earned the highest returns - though with greater risk - by adopting a policy of investing in countries that have shown recent economic weakness, rather than investing in those countries that have grown most rapidly."
  
• their conclusion: "Investors should ensure that their global portfolio is diversified across slow and fast-growing economies."

Prospects for US Stock Returns

• "looking forward, it is more likely that real dividends and earnings will grow in line" (with each other)
  
• "... if you believe that America will likely renew itself yet again and deliver trend productivity growth of 2% p.a. in the future then US equities are arguably closer to “fair value” than normal, and nowhere near bubble territory"
• "... given the size of the American market, its importance to emerging country exports and the risk of protectionism in a bad scenario, investing in emerging equities would likely provide no hedge against a steep drop in US consumption, GDP and equity returns."
• "... nearly a quarter of total US profits and about 30% of S&P 500 sales are generated abroad"
  
• "When people assert that the market is overvalued, they are really expressing their skepticism about the future of US productivity growth and/or the future of globalization. Logically enough, the reverse is also true: if you believe in the potential benefits of accelerating technological change and the dramatic rise of the emerging world, then the next decade for US equities is likely to be a bright one."
• the message seem to be, don't count out the USA - as the French saying goes, "plus ça change, plus c'est la même chose"
  

There is also an individual country snapshot for 22 developed countries.

Canada

• real return on equities 5.8% per year since 1900 compared to 2.0% o bonds but ...
• in the last ten years bonds have outdone equities by 2.0%

Australia

• about the only developed country to have a positive real return to equities over bonds (along with Norway) in the "lost decade" from 2000 to 2009 - all of 1.0%
• equities have returned 7.5% annualized since 2009, the highest anywhere

Japan

• the worst performing stock market during 1990 to 2009, losing two thirds of its value in real terms. ouch!

South Africa

• equity returns of 7.2% since 1900, the second best country; both before and after apartheid, the line looks the same, trending steadily ever upwards

Spain

• very volatile up and down historically; they are hurting now, if you have a decade or two to wait, maybe this is a "value play" country?

Sweden

• only country to have returns to its equities, bonds and T-bills all in the top three of the 22 countries

UK

• equity real returns of 5.3% since 1900

World Other Than the USA

• "from the perspective of a US-based international investor, the real return on the world ex-US equity index was 5.0% per year, which is 1.2% per year below that for the USA."

13 European Countries Together

• they under-performed with only 4.8% real equity returns since 1900 vs the 5.4% world average
• possible reasons for the lagging performance that the authors suggest without analysis - wars, resource rich and more vibrant New World economies

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.

ETF Combinations for Tax Loss Selling while Maintaining Asset Classes

This is the time of year when most people think of doing tax loss selling in taxable accounts. Larry Macdonald in Using ETFs for Tax Harvesting: Hidden Alpha? on Seeking Alpha has reminded us that ETFs are a handy vehicle for doing that and last year I posted my suggestions for doing it properly. (In case you are wondering why tax loss selling is worthwhile, something that is rarely demonstrated, check out Tax Loss Selling Explained: What, Why and How on HowToInvestOnline).

For the passive index investor like me, the objective is to stay invested. In order to do that and not run afoul of CRA's superficial loss rule of not buying back the "identical" property within 30 days before or after a tax loss sale, one key test with respect to ETFs is to buy back an ETF that tracks a different index. 30 days later you can buy back the original ETF if that's what you want to hold for the long run. Each trade costs commission of course, so figure out whether the round trip is worth it as a percentage of the holding.

Here is a starter list of some of the main asset classes where multiple ETFs track a different index but are in the same asset class. The functional test of whether it is in the same asset class is correlation - the same up and down performance - which can be quickly eyeballed using Google Finance and graphing the ETFs in question (see my example chart of US total market ETFs below). To save time and space, I've just identified the ETFs by their stock symbol.

Canadian Equity

• XIU - S&P TSX 60
• XIC - S&P TSX Composite
• ZCN - DJ Canada Titans 60
• CRQ - FTSE RAFI Canada; fundamental indexing will cause returns to differ significantly from the above market cap weighted ETFs
  

US Equity - since the large caps represent about 3/4 of the US market, one might consider swapping total market for large cap or vice versa, especially if it just for the short term
1) Total Market

• IWV - Russell 3000
• VTI - MSCI US Broad Market
• TMW - SPDR DJ Wilshire 5000
• IYY - DJ US Total Market

Source: Google Finance

2) Large Cap

• VV - MSCI US Prime Market 750
• IVV - S&P 500
• SPY - S&P 500
• IWB - Russell 1000
• ZUE - DJ US Large Cap, hedged to Canadian dollars - so returns will differ from above non-hedged ETFs; traded on TSX
  

US Bond Total Market

• AGG - Lehman US Aggregate Bond
• BND - Lehman US Aggregate Bond
• GBF - Lehman Brothers U.S. Government/Credit (holds both govt & corp bonds)

Emerging Market Equity
1) Traded on US exchanges

• VWO - MSCI Emerging Markets
• EEM - MSCI Emerging Markets
• PXH - FTSE RAFI Emerging Markets
• ADRE - BONY 50 ADR
• GMM - S&P Emerging BMI

2) Traded in Canada on TSX

• ZEM - holds VWO plus other funds, enough to make a substantial difference
• CWO - holds VWO but is 100% hedged
• XEM - holds only VWO but is non-hedged; whether currency exposure difference with CWO counts enough for CRA I cannot tell (and they will, in their inimitable fashion, not tell, if you ask them) but the returns sure will differ

US Real Estate

• VNQ - MSCI US REIT
• RWR - DJ Wilshire REIT
• ICF - Cohen and Steers Realty Majors
• IYR - DJ US Real Estate

Global Equity
1) Traded in US

• VEU - FTSE All-World ex-US
• ACWX - MSCI All Country World ex-US
• GWL - S&P/Citigroup BMI World ex-US

... Developed Country (i.e. ex Emerging Markets)

• EFA - MSCI EAFE
  
• ADRD - BONY Developed Markets 100 ADR (large cap)
• IOO - S&P Global 100 (large cap)
  
• EEN - Robeco Developed International Equity
  

2) Traded in Canada

• XIN - holds EFA only but hedged to Canadian dollar, so returns will differ from above two ETFs
  
• CIE - FTSE RAFI Developed ex-US 1000; fundamental index - returns will differ from market cap funds
• ZDM - DJ Developed Markets ex-North America ; hedged to Canadian dollar so returns will differ

For other (sub)asset classes not covered above, like commodities, small cap and value ETFs, a good place to look for ETFs and the index of each is Stock-Encyclopedia.com. It groups ETFs by categories which roughly correspond to asset classes and the index is shown in the summary for each ETF - e.g. see IOO.

There are some asset classes where I could not find any reasonable ETF combo alternatives - notably Canadian real estate and Canadian bonds. If anyone has any suggestions, please comment.

Foreign Diversification Cognitive Dissonance

Take a look at this chart and tell me what the heck is going on?

Isn't diversification into foreign equities supposed to reduce portfolio volatility and increase returns through non-correlation and rebalancing? Yet the simple all-Canadian portfolio with 5% T-Bills, 30% All Canadian Bonds and 65% TSX Composite Equities would seem to have done about the same as an international portfolio with the same fixed income but with equity holdings of 25% TSX, 15% S&P 500, 15% MSCI EAFE developed country and 10% Emerging Markets. The cumulative compound return of the two portfolios after 22 years ended up almost identical - the Canadian portfolio at 250% and the International at 256%.

Twenty two years is starting to be a long time waiting for international diversification to help a Canadian investor. Is the data somehow wrong? I used financial advisor and frequent Financial Webring contributor Norbert Schlenker's downloadable time series spreadsheet from his Libra Investment Management website. The data (unique and no doubt compiled with considerable effort) has been adjusted for inflation and converted back into Canadian dollars from unhedged foreign holdings.

This graph goes against the conclusions in such classic books as Roger Gibson's Asset Allocation (my review) to the effect that international diversification helps considerably. Gibson figured things in US dollars instead of the Canadian dollars in this data. Is Canada somehow special and its equity market a mirror of an international portfolio?

Why Jumping on the China, India, Russia Investing Bandwagon Might Not Work

Countries experiencing rapid economic growth like China, India and Russia should be a good place to get higher stock market returns than stolid slower-growing places like Europe, right? Oops, not so fast.

Apparently, it ain't so. There is no relationship between a country's high GDP growth and stock market returns, especially not in the long run and only weakly in the short run. In Economic Growth and Equity Returns from SSRN, professor Jay Ritter calculated that there was in fact a negative relationship between economic growth and stock returns in 16 major countries (including Canada and the USA) over the period 1900 to 2002 - this chart is taken from the paper.

Other people have found the same thing, focusing on the USA - Crestmont Research's It's Not the Economy has a decade by decade chart showing the unpredictable differences in the same or opposite directions. CXO Advisory in Update: GDP Growth and Stock Market Returns tried calculating leads and lags to see GDP predicted the US market or vice versa and found that didn't really explain much either. In Canada, CIBC's Economic Insights of August 25th has this scatter plot which again demonstrates the same point.

Ritter's explanation is that consumers and company managers get the benefit of GDP growth, not stockholders.

He also makes the dramatic statement that past stock returns are of no use in predicting future returns!

The main metric that does predict future returns according to Ritter is the smoothed earnings yield (taking a 10 year average of earnings to eliminate business cycle effects) i.e. Earnings / Price. "A low smoothed earnings yield does, however, predict low real stock price growth over the following ten years. In other words, P/E ratios revert towards the mean through price changes rather than earnings changes." The only caveats that could derail that relationship would be: if managers and employees take the profits due to shareholders (are shareholder rights well protected?) and; if some catastrophe like war, revolution, hyperinflation destroys the value of financial assets. Based on the numbers in 2004, Ritter said that real annual compounded stock returns would average 4.5% instead of the historical 7%. Crestmont's little blurb attached to their chart also says it's the P/E that matters.

Wish I had the data to do the calculation for today's markets. The Price part of the equation is down quite a bit, such that the E/P will be lower but is it enough to produce good future equity returns?

In any case, these studies suggest strongly that the assumption that China's rising economic success means assured investing success is wrong and likely to disappoint.

Book Review: Are You a Stock or a Bond? by Moshe Milevsky

The top financial concern about retirement is not to run out of money. How can that be achieved? That's the question addressed in this book.

Author Moshe Milevsky, a finance prof at York University and one of the world's leading experts on pensions, insurance, and personal financial planning, has distilled the latest research and principles into a readable, non-technical guide for the proper way to select and balance financial products to achieve financial security.

His starting point is the demonstration that the person him/herself is the most important financial asset (You Inc) by far at the start of a working career due to the many years of salary ahead, which he terms human capital. I had a laugh at the You Inc analogy as he spun it out: "You Inc. will eventually consider merger opportunities, otherwise known as marriage. Marriage is the largest merger and acquisitions activity undertaken by You Inc. and may occur more than once." This light-hearted depiction leads to the quite serious demonstration that life insurance may be a highly worthwhile risk mitigation financial product when a lot rides on You Inc's human capital. He discusses the odds of living or dying at various ages and rules of thumb to decide whether life insurance is advisable or not and if so, how much is needed.

He covers in turn the importance of diversification, both across asset classes and internationally as a risk reduction method, He explains how non- or negative correlation are the mechanism that makes diversification work and extends that idea to You Inc by saying that people should think how their own human capital/job is linked to investment asset classes. Had I considered this ten years ago I would not have invested in shares of Nortel when I worked there - when the tech bubble burst my job loss was highly correlated with investment losses!

Milevsky's advice gets further from popular concepts when he looks at debt and concludes that debt in retirement is NOT necessarily bad. It may be good if it is used for investment where the return is greater than the cost of borrowing and where the borrower can withstand financial shocks and still pay the interest i.e. if you have the stable characteristics of a bond. He says a tenured professor such as himself at age 45 should have a 280% allocation to equity (i.e. have borrowed the amount over 100%) because he is a triple A bond. Along the way he trashes a common rule of thumb: "the age-old general rule that you should allocate your numerical value to bonds - or 100 minus your age value to stocks - is somewhat meaningless at best, and wrong at worst."

Three chapters are devoted to each of what he says are the key risks to financial security in retirement: inflation, longevity and sequence of investment returns (which is having a series of bad years near or at the beginning of retirement). Here again he debunks with a detailed example a common idea - the notion that one can best counter sequence of return risk by setting aside several years of cash to live off (what he calls the buckets approach) instead of maintaining a constant portfolio asset allocation. The failing of the buckets approach is that it does not withstand a prolonged bear market. One is reminded of the famous quote of John Maynard Keynes "The market can stay irrational longer than you can stay solvent." Irrationality can work both ways, optimistic or pessimistic.

When it comes to the latter chapters where he develops integrative solutions that consider all the risks and factors together, he proposes a unique and innovative way of calculating whether one is likely to run out of money given a spending rate (e.g. 5% of portfolio withdrawn each year) and investment assumptions (rate of return and volatility). Instead of the usual Monte Carlo simulation he has developed two equations, alpha and beta, that use the aforementioned inputs, along with median remaining lifespan (how long half the people your age will live according to mortaility statistics) to create a cross-table with varying probabilities of success.

Using a simple bond and stock portfolio, Milevsky performs other calculations that show that the optimal asset allocation whether a person is 55, 65 or even 75 is about 60 to 70% equity. He explains this as the result of the higher long term rate of return on equities more than counter-acting their high short-term volatility.

The concluding chapters present the essential characteristics of annuities and show how to combine them with an investment portfolio to control the three retirement risks. He differentiates standard (not inflation-indexed) lifetime payout income annuities (LIPA) from those which provide riders for a guaranteed withdrawal benefit (GMWB) or a guaranteed income benefit (GMIB). The final bits of integration include retirement goals: liquidity for unforeseen expenses, estate bequests and prevention of behavioural mistakes (i.e. if you have an annuity you are locked in and cannot mess things up but if you have a portfolio it is easy to make all those investing errors of judgement).

Not so much a final answer as a way of thinking about things, this book broadens one's perspective to a holistic view of assets with financial value. It provides invaluable insight and tools for an individual to understand how to cope with various financial risks throughout life.

The final table in the book, table 11.2 is a chilling assessment of the amount of financial wealth required to sustain an income level when guaranteed government pensions and/or private defined benefit plans will only provide a small portion of the needs. Planning to withdraw from a portfolio at a 5% annual rate or even a 4% rate, which is that most commonly cited as providing indefinite sustainability, still means in his opinion that one should buy a substantial amount of annuities to protect against longevity and sequence of returns risk.

Quibbles:

• the USA is used as the context throughout, with references to US inflation and mortality statistics, US market returns, US retirement plans like 401k and IRA; Milevsky is a Canadian teaching at York University and he uses a lot of the research he and others have conducted at the IFID center in Toronto (where if you wish to do so you can obtain most if not all this book's content for free download, though it is not organized and structured with the convenience of the book); admittedly such references are not material to the principles he expounds in the box since,
• tax optimization is not considered (he deliberately and explicitly sets it aside) - after-tax returns, which is what a retiree investor cares about, may differ greatly with the same investment portfolio size; whether income comes from a tax-deferred account like RRSPs and LIRAs or is tax-advantaged like dividend income, matters a lot. $5000 of interest pulled from an RRSP taxed at a marginal 30% rate is only $3500 in spending, while $5000 in dividends in a taxable account to a taxpayer in the same 30% bracket in Ontario pays about 7% tax, resulting in $4650 available to spend. That's why this book's contribution is not a final answer but a useful set of principles.
• asset classes are ultra-simplified to "cash (US T-bills), stocks (US S&P 500) and bonds (US aggregate)" from which is taken the investment portfolio assumption used throughout - stocks give off 7% average (arithmetic mean) annual return with 20% volatility; the beneficial effects of further diversification with real estate, international equities and bonds, commodities, real return bonds are not examined.
• high spending rate assumptions; everywhere the book uses high spending rates in retirement from 5 to 9%; it would be helpful to have shown the 4% rate in the sustainability tables on pages 135-6. As it turns out there is such analysis in Milevsky's 2007 paper A Gentle Guide to the Calculus of Sustainable Income on the QWeMA website. QWeMA is the company set up and headed by Milevsky to market his research ideas and turn them into tools for insurance and investment companies. This led me to the Manulife Retirement Solutions Center where the Milevsky's ideas are being put into practice to inform advisors with a variety of video clips and short background information (it is telling that this simplified information is prepared for financial advisors!). It features a free to use online product allocation tool where you can plug in your own numbers, fill-in budgeting worksheets and a retirement savings calculator whose results you can print. They even use Canadian facts and figures.
• sensitivity analysis is not performed; since one cannot know if the future will repeat the past in financial markets, the section on the effect of asset allocation on sustainability of spending rates would be more convincing if various return and volatility scenarios showed the same result. The Gentle Guide paper provides such data in tables 3 and 4 showing how dramatically a reduction of volatility can reduce chances of ruin - with 23 years of retirement ahead at a 7% expected portfolio return, the chances of ruin fall from 15.1% to 3.0% which seems to suggest that one's problem can be solved by diversification ... but the same table shows that if returns disappoint for the whole period at only 5%, the likelihood of ruin only falls from 27.5% to 8.8%, which is only on the edge of safety as far as I am concerned. The numerical assumptions are critical! One cannot merely trust the past averages to repeat themselves.
  
• the product allocation algorithm is not revealed and is proprietary (to QWeMA) - what is the magic and art being concealed one wonders
• preservation of human capital aka working part-time in retirement should form an active part of retirement financial planning. One doesn't suddenly go brain dead and become physically incapable the day after pulling the plug on full-time employment. It was instructive to learn from my daughter the new doctor that some recently retired physicians decided to mitigate the recent bad sequence of returns of the financial crisis by going back back to work temporarily doing locums. The book mentions the possibility of prolonging work but doesn't analyze the effects. Every dollar earned saves a dollar coming out of a retirement portfolio, in effect reducing the withdrawal rate, which much prolongs a portfolio's sustainability.
• cutting back on spending is a very effective wealth preservation method and when it comes down to the crunch, a lot of spending that is deemed necessary becomes discretionary. That's why few people actually ever run out of money, they just keep downsizing their lives.
• yearly iterations and repeated re-consideration of plans is not discussed, yet circumstances will change. Retirement finances shouldn't be done as a one-time forever decision. Optimal product allocations may shift back and forth.
  

Milevsky also mentions a few other topics he feels should be included in a complete financial plan:

• consideration of life insurance for maximizing a estate value
  
• use of home equity loans or reverse mortgages as another "product"
• long term care insurance to control risk from health
  

The bottom line is that this book helps you figure out whether you are in the "no hope", the "no worries" or the "no guarantees" zone of retirement sustainability. If it is the latter, I am convinced by the book that annuities should form part of a financial arrangement for retirement.

Read this book if you want, as you should in my opinion, to take any hand in planning and constructing your financial future as you enter retirement. Its short 200 pages are rich in high-value, well-explained, well-illustrated content.

Despite my extensive quibbles, some of which (taxes, sensitivity analysis on assumptions) I think are quite important to constructing an actual plan, this book sets out such important and powerful principles that I have to give it my highest rating, five out of five stars.

Summary of Book on Foundation and Endowment Investing

Retirement Action has posted a useful summary of the book “Foundation & Endowment Investing” by Lawrence E. Kochard and Catheleen M. Rittereiser. University foundations and endowments provide ideas for investing strategy retired people since there are common characteristics and goals - a long time horizon, the need to pay expenses from income/gains/capital with possible yearly variations (increases for special events, painful decreases when capital suffers in bad markets to protect long-term viability), possibly no new capital.

Some points that I found interesting:

• a perception by the funds that asset classes are blurring or merging
• the significant proportion of equity / non-fixed income
• the importance of re-balancing
• a disbelief in market efficiency and totally passive index investing
• investment portfolio allocated to perform certain functions- e.g. real return bonds to protect against inflation, foreign equity for currency diversification and higher growth, rather than a simple division according to market value of non-correlated assets

Will be adding this book to my reading list. Reviews in Amazon seem to be very positive.

TD Bank Estimates Future Long Run Returns of T-bills, Bonds and Stocks

A couple of weeks ago, TD Bank Financial Group published the six page report Evaluating Long-run Returns in Uncertain Times. The report suggests to expect the following annual rates of return for a time horizon (holding period) at least a decade beyond the next three years of "uncertain times".

4% - Cash / T-bills
5.25% - Bonds
8% - Stocks

These returns are before inflation, which they assume to be 2%, or around the average of the last 15 years or so, and before taxes, fees and foreign exchange effects.

Within stocks, TD estimates that the US will slightly outperform Canada and EAFE countries (rest of the developed world) by 0.5% or so.

TD also presents how this would produce a combined total return of 5.8% to 8% for several sample portfolios with various mixes of cash, bonds and the three equity classes.

It is interesting that these are more optimistic, especially for Cash, when compared with other estimates I have found:

• Review: Bradford Cornell in his book The Equity Risk Premium - Cash was only 0.5%, Bonds only 2.5%, Equities 5 to 7.5%
• Post: Credit Suisse Global Investment Returns Yearbook 2009 - Equities for Canada 5.9% and USA 6%
• Post: Canada Pension Plan (after inflation) - Canadian Equity 4.6%, Foreign Equities 5.0%, Bonds 3.4%, Cash 1.5%; US Social Security Administration Chief Actuary - Long Term Treasury Bonds 3.0%, Equities 3.0 to 6.5%; Author Richard Ferri / Portfolio Solutions LLC (after inflation) - USA Cash 0.5%, Long Term US Treasury Bonds 2.0%, US large cap 5.0%, Foreign Developed Market Equity 5.0%

It is always worthwhile to get a different perspective on what is a critical assumption for long term investment planning towards a sustainable retirement. My own view is to use the lower figures and hope the higher ones come about.

Book Review: The Empowered Investor by Keith Matthews

Professional financial advisor and portfolio manager Keith Matthews has written a darn good book, one that should be useful to most individual investors. The book explains many important principles - both things to do and things to avoid - to build a sound portfolio. At 184 pages it is concise enough for most everyone's attention span, especially those who need his advice most and are not especially interested in making a hobby of investing and spending massive amounts of time on it.

This book demonstrates successful investing based on:

• diversified passive index funds
• asset classes identified as 1) equities - broken down into Canadian, US value, large and small cap, International (he doesn't specify but presumably meaning developed economies) - value, large and small cap, and Emerging Market countries; 2) Real Estate Investment Trusts (REITs) - Canadian, US and Global; 3) Fixed Income - broken down into government and corporate bonds and real return bonds
• low fee/cost funds after-tax
  
• a written investment policy that considers one's life plan
  

I liked the visual presentation and spacious formatting of the book, its use of pertinent tables and graphs, the references to sources and further reading material.

Several things I looked for but did not find would improve the content.

• Discussion of rebalancing the portfolio over time as asset classes move out of their initial proportions. What are practical rules - e.g. time-based once a year, or when a class varies more than a certain percentage?
• Explanation of real return bonds as asset class, using the same illustrations and tables as for the others
  
• Show sample portfolios with actual ETF ticker symbols and percentage allocations with a line or two mini-case explanation. Some people, like me, like to learn by example. On pages 57-59, the discussion of Dimensional Fund Advisor mutual funds should mention more explicitly that these funds are not available to self-directed investors, and can only be bought through advisors.
  
• Chapter 12 on pension funds cursorily mentions a few principles for determining how much (what percentage) to put in each asset class. This topic is so fundamental that even an an overview book such as this must address it in more detail. I think the approach must derive from a person's overall financial condition, including his/her occupation, its stability, income level and pension plan. For example, a 55 year old civil servant with 30 years service has high job security, and a defined benefit inflation-adjusted lifetime pension plan sufficient for retirement that is equivalent to a gigantic real return bond (e.g. the present value of a perpetual $50,000 income stream at 3% real return is 50,000/.03 = $1.7 million). I'd question whether such a person should invest even a penny in fixed income whatever his/her nervousness about volatility (which I'd venture to say is higher that the average private sector worker since the whole ethos of government and its workers is to prevent, minimize and avoid risk - "we never expect praise, we just want to avoid criticism").
  

This second edition adds two sections: a chapter on eight common investment pitfalls (which the book shows how to avoid or fix) and a series of chapters on what he calls "advanced investing", that elaborate some really important topics - the benefits of international investing, the effects of currency changes on international investments, the value of a house over the long term and expected future rates of return.

The complete table of contents can be found at the book website http://www.empoweredinvestor.ca/. The book can be purchased there as well.

Matthews was kind enough to send me gratis a copy of the book and to agree to answer some questions I threw at him. The email interview follows below and readers will be pleased to note that he practices what he preaches by holding a diversified portfolio based on asset classes discussed in the book! If you want to reach him, his website even includes his email address keith@tma-invest.com.

My rating: 4 out of 5 stars.

Q1 - Do you think investors should always have an investment advisor? Do you use one yourself?

To begin, I am a portfolio manager that works at Montreal based firm providing discretionary portfolio management & wealth management services. This is an important disclosure in that it sheds some light on my responses.

I do not think that all investors need to have an investment advisor. If an investor has informed themselves well, have seen enough (or studied enough) economic cycles, and finally has the right mind set to control their emotions, then with the asset class investment vehicles (notably ETFs) available in the market place today;; then and only then would I feel comfortable & confident that they could build, monitor and rebalance their investment portfolios over time. At minimum, there is always a need for objective planning (retirement & estate) that these individuals could follow-up on with a fee-only advanced financial planner.

However, what I have witnessed and seen over the years is that most individual investors (novice or advanced) are not necessarily “wired” to oversee their personal investments. There is still too much performance chasing (asset class, sectors, and companies) which can hamper an investment experience. Not with standing the complexity of trying to plan and oversee a well diversified portfolio. So – I do believe that the majority of investors (large, small, novice and advanced) can benefit from a reasonably priced asset management & wealth management service…if anything simply to keep them on track and away from investment pitfalls, and to ensure that the details in the execution are taken care of.

The good news is that there is a growing group of “unbiased & objective” advisors in Canada. While a decade ago, there was minimal selection, today the list of qualified advisors submitting to principles found in the book in growing rapidly.

Q2 - Do you think investors should make any changes or adjustments in light of the current financial / economic situation?

The asset mix should have been one that was set knowing that equities correct in price every 5 to 7 years. So the short answer is “not really”. It is my view that this current economic situation as difficult as it is (and it is a difficult one) should not require any rethinking on the long-term asset mix. Investors in equities should have a minimum 10 to 20 year horizon, and should think accordingly. Gradual rebalancing from fixed income to equities should however be taking place with the new asset class levels in a diversified portfolio. If anything, I think that many investors may want to rethink the way they have invested up till now. Unfortunately sometimes it takes a crisis for many investors to want to reevaluate their portfolio, portfolio methodology or even portfolio service. I propose that investors unhappy with their portfolios should rethink the way they invest. Here are some of my thoughts on this point:

8 tips to rethink the way you invest:

- Do not build your portfolio on bold forecasts

- Do not chase past returns as they are random

- Do not invest in alternative investments as they are too risky

- Be aware of and stay clear of investment pitfalls

- Invest in asset classes and not “star managers”

- Build a diversified portfolio using asset class investments

- Hire a firm with an investment process and plan for you

- Insist on full transparency and investment reporting

Q3 - What do you hold and in what proportions in your own portfolio? ... I'm more interested in the reasoning behind it than finding out how rich you are!

I am 45 years of age with a long-term investment horizon. My asset allocation would look something like this.

25 % Short-term Canadian bonds

10% S&P/TSX 60 Index (iShare)

21% DFA Canadian core companies

9% IVV (iShare)

7% DFA U.S value companies

6% DFA U.S. small companies

9% VEA (Vanguard Europe & Asia)

7% DFA international value companies

6% DFA international small companies

Q4 - How do you suggest coping with multiple and uncertain time horizons e.g. retirement (people sometimes don't retire when they expect), illness, kids' university, marriage/divorce, death (who knows how long they will live)? Should one have different buckets of money - short-term vs medium vs long-term? Or is it not an investment question at all - insurance the answer?

Different buckets of assets matched to different liabilities or obligations is an interesting wealth management concept. Where it is applicable – it can be used. It is an investor friendly concept that is easy-to-understand by investors. Short and medium term liabilities should be matched off with short-to-mid term secure bonds. Longer-term obligations such as legacy goals can be positioned in diversified equities.

Uncertain time horizons is the most challenging concept in this questions. This is an element of “human, life and work related risk” that is often completely out of our control. I do not think that there is an easy way around this one. However, I do think that you always have to plan for the longest period but also have to ideally have a short term contingency plan in place (ie available secure funds) – so that if something was to happen, long-term assets would not need to be used. For any individual who finds themselves in the unfortunate position of having to retire earlier than expected – I think that there are some tough choices to make. If a person is able to still work – then they must pursue new work opportunities (even if it is less interesting and less pay than the previous job). If this cannot materialize then they must prepare themselves to reduce lifestyle or stay in the work force (perhaps even on a part time basis) for many additional years. Unfortunately there is no magic or easy way out.

Health and disability risks should be managed by insurance.

Q5 - In chapter 18, you mention expected future real returns for US and Canadian equities of 3.5% to 4.5% over t-bills in the coming decades. What would be the numbers for the international equities that you suggest a portfolio should have for proper diversification?

On page 148 International equities are also mentioned with U.S. and Canadian as having t-bills + 3.5% to 4.5%.

For a Canadian investor, having 50 to 70% of their total equity weighting in non-Canadian equities makes sense. This percentage removes bonds from this calculation. However, many Canadians however have a “home bias” and have higher Canadian equity concentration levels. So there is an opportunity for Canadians to shift away from Canadian centric and commodity weighted portfolios to a more diversified global portfolio.

Q6 - You say in the intro that writing the book has been an amazing experience? How? Did any of your thoughts or philosophies of investing change in the course of preparing the book?

Jean,

It had been an amazing opportunity for many reasons. Firstly, the book writing experience has made me a better communicator of investment concepts. Writing a book forces the writer to cut through the noise and the blur and get to a point of clarity and consistency – and this is good. I feel that I experienced this. The investment business is often complex and cloudy for investors. Writing a book and/or providing a clear investment message (in a world of complex marketing) was a challenge that I enjoyed and wanted to undertake.

Secondly, my clients provided much input into the language used in the 10 Principles to Successful Investing and obtaining this feedback was an absolutely terrific personal experience. This feedback was so much appreciated and in essence validated the concepts that would be further expanded upon in the book. If it was important to my clients and had an impact on them, then I knew that the book would connect with – real people.

Lastly, I knew that while I was writing the second edition, that the content (and the style of the content) would have a positive impact on investors. The feedback from many readers of the first version surpassed my expectations and I received many email notes of thanks from readers across Canada – and so I had this in the back of my head while I was writing the New & Expanded version. This was a very motivating thought and I enjoyed that.

Asset Allocation Fallacies: on Average ≠ All, Is ≠ Should

Wander through a few web sites or read a few books on personal investing and you are sure to come across references to the 1986 study Gary P.Brinson, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986 (henceforth BHB) or to its later update Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Determinants of Portfolio Performance II: An Update, The Financial Analysts Journal, 47, 3 (1991) (which I have unfortunately been unable to find posted online ... perhaps its lack of wide availability itself contributes to the misuse?).

The studies are typically summarized something like this: "asset allocation accounts for 90% of a portfolio's return" or "asset allocation decisions are the most important factor affecting portfolio returns". This is then used to justify things like the need to develop an asset allocation plan, to invest based on passive index investing, to buy ETFs and not mutual funds, to not worry about which mutual fund to buy as long as it fits into the right asset class. Wrong!! Much as I subscribe to many of these ideas, the study provides no such support as subsequent follow-up studies have pointed out.

Let's do a myth vs reality rundown to disentangle truth from lore or illogic.

Myth: BHB says asset allocation, aka the choice amongst asset classes of stocks, bonds or cash in the portfolios they looked at, determined the level or amount of return achieved e.g. 8% vs 10% return in a year

Reality: BHB looked only at the variability over time, in crude terms the amount of up and down, of individual portfolios relative to the benchmark for the type of asset;

Researchers Ronald Surz, Dale Stevens and Mark Wimer in Investment Policy Explains All also examined investment policy or asset allocation at mutual and pension funds and came to this conclusion: "... investment policy, on average, accounted for 104% of the total return for mutual funds and 99% of the pension fund results." Then there was Roger Ibbotson and Paul Kaplan's (IK) Does Asset Allocation Policy Explain 40, 90, or 100% of Performance? in which they conclude yes to all three depending on the precise question being asked.

As Surz et all show with a brilliant simple example, if a portfolio moves in perfect lockstep with its index year after year consistently returning either 2% above or 2% below the index, it would have the exact same performance in BHB terms; BHB says nothing about the absolute level of returns; as Surz et al put it, "... their study tells us only that the average plan in the sample adhered very closely to its policy targets and used broad diversification within asset classes."

Myth: for every fund (or the bulk of, or the typical fund) asset allocation determined variability of returns

Reality: BHB took an average of many funds; to understand the logical fallacy, think of the old joke, if your feet are in the oven and your head is in the freezer, on average you will be comfortable; IK found a wide dispersion amongst balanced mutual funds - only 40% of the variability of their results arose from differences in asset allocation policy: "... the remaining 60 percent is explained by other factors, such as asset-class timing, style within asset classes, security selection, and fees.", in other words "... the relatively low R2 of 40 percent must be the result of a large degree of active management". If a fund chooses to be aggressive and deviate from the index it can easily do so and its results will vary much more. A big deviation isn't necessarily good or bad - results can be way above or below the index.

Myth: the results of these studies say that no one can beat the market and therefore index, passive investing is the only way to go and
Myth: the asset allocation decision is the only one that matters

Reality: though I subscribe heartily to passive index investing based on an asset allocation policy, such studies imply nothing of the sort; the leap from description of what actually happens to saying that is what one should do, or that it is inevitable, doesn't make sense - if most countries of the world have corrupt, despotic governments does that imply we should aim for the same or that it is not or cannot be otherwise?

The various studies conclude that as a whole (i.e. on average) mutual funds detract from the total return compared to an index - when it is said that policy accounted for 104% of total returns, it means the mutual fund managers detracted 4% due to market timing, security selection and costs. That doesn't say no one can beat the market, it says not everyone has, few have and most have not.

It is very dangerous to take a sentence such as this in Surz et al out of context: "Manager selection matters, but not to any great extent." The proper expansion of the sentence would be: "Manager selection has not mattered to any great extent over the average of the many funds we looked at, so do not be surprised if it proves not to be so for any specific fund you choose, and considering that the sum of investors as whole ARE the market, it should be no surprise either that such is the case; however, manager selection has mattered greatly in certain cases." The authors are somewhat culpable in leading us down the slippery slope from description to prescription by the use of the present tense 'matters' as if to say it cannot be otherwise and by omitting the word 'average' as if to imply that statement is true in every case.

Here is what I think the prescriptive statement should be: If you are picking amongst actively managed mutual funds, then manager selection is your critical task. You should not just pick a fund at random in an asset class since you probably will get a fund that does worse than the index of that asset class.

IK say it this way: "An investor who has the ability to select superior managers before committing funds can earn above-average returns." Going with an actively-managed fund means you are swapping the challenge of picking the best stocks or bonds with that of picking the best manager.

Myth: the 90% figure matters or suggests that an investor should pay attention to asset allocation

Reality: though an investor should pay attention and implement an asset allocation, it is for other reasons, not because of these studies; the 90% figure means nothing more than the fact that a portfolio was invested in the markets. Meir Statman's The 93.6% Question of Financial Advisors (Spring 2000, Journal of Investing) models a hypothetical US portfolio which assumes perfect foresight and uses extreme asset switching going 100% from stocks to bonds or to cash each year with perfect predictive ability of the highest yielding asset class; this portfolio still has 89.4% of its returns accounted for by a balanced portfolio with a constant asset proportion policy, i.e. asset allocation could be thought to be the determining factor but the high correlation is deceiving. IK noted the same thing and concluded: "Hence, the high R2 in the time-series regressions result primarily from the funds’ participation in the capital markets in general, not from the specific asset allocation policies of each fund". Statman's artificial portfolio did achieve hugely greater total or absolute returns - 9% per year more compounded, indicating the value of perfect foresight!

Why I Have Reduced my Allocation in US Investments

Last Friday October 17th, I made some major changes to my portfolio allocations:

• total US investments reduced from 19% to 4%
• European equities, much of it in fact consisting of the UK, also reduced from 19% to 17%.
• Canada upped from 44% to 55%
• Far East raised from 5% to 6%
• Developing countries raised from 4% to 5%
• Global increased from 9% to 13% through addition of the Vanguard Global Index Fund VEU

The reason in a nutshell - the aftermath of the debt crisis, which raises the risk of US investments, both for market results and for currency.

How so? Starting with the anecdotal but startling nevertheless - the clock tracking the US national debt in New York city has run out of digits the debt has ballooned so much. All the various bailout measures to shore up banks may have stabilized the system but the debt has not gone away and is now on the books of the US government/taxpayer. The negative consequences are likely to be severe and long term.

More substantial evidence:

• Contrary Investor details the US Federal government's rising debt, its dependence on foreign sources of funding in Fun with Funding and shows that they are losing confidence and pulling out in The 'Other' Consumer Confidence Survey.
• Sudden Debt posts on the level of personal debt in the US and how far it has to go to drop to a reasonable level with other posts on how consumer spending is already dropping.
• Cause for Depression has an informative graph of the deteriorating balance sheet of the US Federal reserve as well as a series of posts describing the financial crisis from its origins to the present; the blogger is a a US economics prof
• Market Ticker in Fiscal Cat 5 Hurricane Warning describes how US debt markets could totally collapse unless the government imposes some very harsh medicine
• Market Oracle discusses the impact on US government debt of the Fannie & Freddie bailout.
• Financial Times reports possible weak interest / few buyers for US debt in upcoming auctions.
  

Contrary mainstream views do exist:

• National Bank's Oct.17 Economic Weekly newsletter says the impact of the $700 billion rescue package on US government debt is inconsequential.
  

Of course, there's a song to go with the theme, Crash Dance by Versus (I recommend all their brilliant satirical parody songs). The same group has another great song The Dollar and Its Diving that express my fears that the USD while strong now, may not be so for long.

On the other hand, the increasing allocation to Canada, despite the consequent lessening of diversification, is to reduce the extreme USD currency risk and market risk. In contrast, Canada's debt levels are low enough and stable. No banks are going under. Times may be tough during the worldwide recession but survival is sure and Canada's eventual prosperity I feel confident in.

European countries and the UK in particular, may warrant a further reduction. Generally I have read that debt levels are high in the UK and the government's borrowing is at record levels - see BBC's UK Borrowing Hits a 60-year High - so there is increased risk there too. The big question is whether it has become unsustainable as in the case of the USA, a conclusion I have not reached yet.

Update October 25th ... A GlobeAdvisor article says the USD may suffer a crisis. It's nice to find supporting opinion but am I deluding myself? Need to find contrary views...

Adding Infrastructure as a Separate Holding in a Portfolio?

Back in June, when I posted about the Canada Pension Plan Investment Board's investing approach, I discovered that it has significant holdings of infrastructure investments to provide inflation protection and portfolio diversification. Infrastructure consists of physical structures that support society - airports, seaports, water systems, electricity grids, toll roads, gas distribution, telecommunications networks, schools, hospitals, prisons.

So I asked myself why and how I as an individual investor should add infrastructure as another component of my portfolio.

The Why's?
Potential Portfolio Diversification
The possibility that infrastructure could reduce my overall portfolio volatility and/or improve returns through having its returns uncorrelated with other holdings seems to have some merit. In the April 2008 presentation Global Infrastructure - A "New" Alternative Asset Class by Edward Keating of Lazard Asset Management LLC, chart 20 shows the up and down 3-year rolling correlation of infrastructure with global equities and with global bonds. The low correlations (say 0.3 or less) from around 2000 to 2003 would have been quite worthwhile. Since 2004, the correlations have been climbing to 0.4 or higher, meaning much less portfolio diversification benefit.

In the May/June 2007 issue of the Journal of Indexes, Tony Rochte's Infrastructure article shows on page 3 the correlations from 2002-06 for infrastructure against a number of asset classes like US equities, non-US equities, commodities, US bonds and US T-bills. The equities correlations are high while the rest are low. The time series isn't very long so the strength of the conclusion is weak.

Rochte goes on to show that a portfolio with infrastructure as a separate asset would have done better than one without in his study period, especially during the time of market decline in 2000-02. Maybe now would be a good time to do the numbers again to see if the relationship repeats itself.

Overall, there seems to be a fair diversification benefit.

Potential Higher Risk-Adjusted Returns
This aspect is a puzzle since both the above materials (Lazard chart 19 and Rochte page 2) show that the risk-adjusted returns for infrastructure, as calculated in a higher Sharpe ratio, are significantly higher than other equities. One would expect that market forces would bring the return-risk ratio into line with other types of investments.

Ways to Invest - ETFs, Funds and Companies
There appears to be about 70 to 100 major infrastructure companies around the world, many of whose shares can be bought in North America, whether they are based here or abroad. The easiest way to find them is to look at the composition of various infrastructure indices (and these indices seem to be proliferating as the infrastructure fad is growing):
- FTSE Macquarie Global Infrastructure Indices (MGII) (heaviest weighting in utilities)
- S&P Global Infrastructure
- Dow Jones Brookfield Global Infrastructure Indices (new since July 2008)
- NMX Infrastructure Indices (focus on companies with a perceived monopoly)

There are already a number of mutual funds, most as usual actively managed, and we can be sure the bandwagon will get more and more crowded as the investment industry looks for the "next big thing" after the sub-prime meltdown following the tech meltdown (I think of this as bubble rotation). A few examples: Renaissance Investments Global Infrastructure Fund (Canada), First American Global Infrastructure Fund (USA), Caninfrastructure Mutual Fund (India). One company, the Macquarie Infrastructure Company (NYSE: MIC), is a large diversified conglomerate that operates in several different infrastructure businesses and almost looks like a fund itself.

There are two main passively-managed ETFs aligned to one of the above indices available through US markets:
IGF - iShares S&P Global Infrastructure Fund (guess which index it tracks) - MER of 0.48%
GII - SPDR FTSE/Macquarie Global Infrastructure 100 - MER 0.6% and 80% weighting in utilities

An actively-managed closed-end fund has popped up in Canada - the Macquarie NexGen Infrastructure Corporation (class A shares are traded on the TSX under symbol MNF). It's performance has so far (since March 2007 inception) been disappointing - down 21% vs the benchmark minus 3.4%.

Last October, Roger Nusbaum wrote about MIC, GII and a number of infrastructure companies in Infrastructure Funds Flub Stress Test on TheStreet.com. His Correlating Infrastructure on Seeking Alpha is also worth reading.

The Criticism
A sobering and well-argued counter-argument to treating infrastructure as the next must-have part of a portfolio is The Skilled Investor's post The Birth of Yet Another Darn Asset Class - Infrastructure.

Bottom line for me:
- I do own, at lower MER cost ranging from 0.07% to 0.17% (in VIT, VGK, VPL and XIU) vs the higher MERs of the index ETfs, all or virtually all of the main publicly traded infrastructure companies;
- thus I get the diversifying effect of those companies, only it is hidden within my existing holdings
- I already have enough headaches balancing my overall portfolio across my various accounts - regular, RRSP/RRIF, LIRA - without adding another holding

Some people may wish to play the greater fool game of musical chairs and ride the likely infrastructure fad in hopes it becomes the next bubble and try to sell out in time but for now I'll look at other things to improve my portfolio.