Index Investing Becoming a Victim of Its Own Success

Too much of a good thing can end up being bad. That includes using a benchmark index as the basis for an investing apparently.

In the July 2010 paper (download here from SSRN; acknowledgement to Stingy Investor where I found the link) On the Economic Costs of Index-Linked Investing, NYU prof and NBER research associate Jeffrey Wurgler reviews some research results that are disquieting for investors who follow a passive index strategy based on popular indices such as the S&P 500.

Wurgler says: "... the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits ..." The problems:

• the inclusion of stocks in the index pushes up prices, by around 9% around the time of the event, a factor that has been getting worse as indexing has gained popularity; this effect is observed for other indices besides the S&P 500, like the TSX 300 (now the delicately named TSX Composite, which hides the fact the fact that it has been shrinking steadily in number of stocks over the years to 235 today)
  
• active managers who are benchmarked against the index have an incentive to overweight index members, even if they think a non-index stock will appreciate the same percentage, due to lesser tracking error
• stocks that join a leading index such as the S&P 500 suddenly begin to move much in tandem and keep doing so, which Wurgler vividly likens to the movements of a school of fish; he calls this effect "detachment"
• the S&P 500 school of fish members moves on their own and less like the overall market, a net loss of diversification for the investor
• S&P 500 membership has in the past over the long period of 1980 to 2005 conferred an increasing price premium; he cites one study that found the S&P 500 stocks got an 82 basis point annual alpha return premium; while it might seem like a good thing to get a hefty excess return, he says it might be a sign of an "indexing bubble" that will sooner or later deflate
  
• as a consequence, bubbles and crashes are more likely; he discusses the mechanism that may explain both the 1987 crash and the May 2010 flash crash
• the risk and return relationship actually does not hold - low beta(risk) stocks have been found to generate better returns, by a lot, than high beta stocks, a phenomenon he rightly calls a spectacular anomaly; he explains how fund managers benchmarked to an index will favour high beta stocks
• he raises the possibility that the S&P cap-weighted index amounts to a strategy of large-cap growth and momentum ... "Clearly, the line between passive and active investment is blurrier than usually presented."
  

Here's another juicy quote: "the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index—it may actually be contributing to their underperformance."

What does he suggest one do about it?

• instead of the S&P 500, pick a broader index like the Wilshire 5000 - "The S&P 500 Index's detachment means, however, that it is reflecting less and less the performance of the full stock market. Index funds based on the more comprehensive Wilshire 5000 (which has included as many as 7,200 stocks) are now providing more robust diversification and stock market exposure."
• exploit the observed "spectacular anomaly" through strategies that focus on low-beta stocks, e.g. employ maximum Sharpe ratio, minimum volatility and absolute returns, though I'd guess that is probably beyond most individual investors' capability

It's the inverse of the dictum that the market only moves towards efficiency if people exploit and thereby remove the inefficiencies - if too many people assume the market is efficient and therefore invest in passive index funds, then the market becomes more inefficient. A delightful irony indeed!

Book Review: Winning the Loser's Game by Charles D. Ellis

Call this book A Random Talk About Wall Street. That is both a compliment and a criticism.

It is a compliment because comparing this book to Burton Malkiel's famous A Random Walk Down Wall Street puts it in a special category. Indeed much of the message is the same in the two books - valuable and sage advice on how to survive and prosper as an individual investor in a financial world filled with many predators and some good guys. Ellis pushes many familiar themes: diversify, buy index funds, trade seldom, take a portfolio view, re-balance to maintain asset allocation, adopt a long-term perspective and ignore short-term market fluctuations, consider inflation and real return bonds, market timing futility, avoid excessive mutual fund fees, take account of how various risks work.

The "Random" comparison is also a criticism in that I found the book meanders quite a bit. A chapter topic is begun, and part way through, the text diverges onto a peripheral topic. Ellis' method of exposition feels like a fireside chat from wise old uncle Charley as one idea spurs another. Maybe some readers like that style but I found myself muttering "stick to the topic, will you?" The epitome of this is Chapter 20 Endgame, at once the best chapter in the book and the worst. Endgame talks about leaving the world a better place after you are done, through using your money wisely so that it is a positive force and not a negative force, as it can end up being. There is much text that I found to be inspiring e.g. "Investors who have enjoyed substantial financial success should give careful consideration - no matter what their hopes or intentions - to whether the amount of wealth they can transfer to their children might do real harm by distorting their offspring's values and priorities or by taking away their descendants' joy of making their own way in life." Every parent must think of their money actions with kids from a very early age even if they are not rich e.g. giving a child an allowance to spend or save and considering how to guide the child into using it wisely. Ellis quotes another author who suggests people should give younger family members as much responsibility as they can manage as soon as possible. So true, I experienced that myself and wish I had done it more with my own kids. Suddenly Ellis switches gears. On the next page, there begins a series of numbered paragraphs on IRS limits for IRA accounts, tax-free gift limits, compounding rates, personal residence tax exemptions, trust concepts and the like. After four pages of too-general-to-be-useful such info on tax nitty-gritty, he goes back to the original theme and philosophical level of discussion. He could simply have said at the end of the chapter, "once you have decided what you want do, go talk to a good accountant to make it happen."

The informal presentation does have its benefits - short, easily read and digestible chapters. There are lots of good quotes and anecdotes to illustrate his points. I got lots of ideas for blog posts! e.g. on why this statement is wise in the sense he means it, and silly in another sense - "Never risk more than you know you can afford to lose."

Overall, this book does deliver on its sub-title promise to provide "timeless strategies for successful investing". It is definitely worth reading.

My rating: 4 out of 5 stars

Thank you to publisher McGraw Hill for providing me with a review copy.

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.

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?

The Benefits and Imperfections of Asset Class Investing

What's Wrong with Judging Investment Performance with an Index
One of my pet peeves is articles about investment performance based on the price variation of indexes such as the TSX, the Dow or the S&P 500. Unfortunately they do not reflect real world individual investor experience. Though it is possible to buy ETFs or mutual funds whose objective is to track an index, such things as trading costs / commissions, tracking error, bid-ask spreads and distributions can cause actual results to vary from the index.

Another thing I find annoying is that people often limit themselves to indexes for only two asset classes - stocks and bonds. We've all seen the classic 40% bonds, 60% stocks. There are a lot more asset classes out there with which to diversify, like real estate (REITs), real return bonds, foreign developed or emerging market equities (which introduce the issue of currency hedging), small and value cap tilts, commodities. Current theory says we should take advantage to maximize diversification and the ETFs are there to allow the average investor to do that, so why not model it?

Another issue of note is whether and when to rebalance a portfolio. Would a policy of reviewing the portfolio every December, and rebalancing if too much out of sync with target allocations, have done better than simply buying and holding?

Finally, the recent (on-going?) financial crisis and market crash provides a real high stress period in which to see how various realistic portfolios fared.

Assumptions: So, I've done some calculations in as realistic a way as possible. I started with $100,000 in May 2007 before the troubles really began and took it to the close last Friday, September 11, 2009. The portfolio is split 70% equity, 30% fixed income, with finer sub-divisions of both for the 4- and 16-asset portfolios. I used passive index ETFs available on US exchanges and the TSX.

The USD-CAD exchange rate I've used is based on the mid-market closing rate, which I've adjusted for the initial purchases by adding 1% to approximate the foreign exchange fee embedded in Canadian broker rates. At the Dec.17, 2008 rebalancing date, I have not adjusted for FX since almost all of the FX fee could be avoided by doing wash trades offered by most brokers and/or keeping the USD distributions in a USD account when received, as all brokers allow for non-registered accounts and some do for registered accounts. Also I have not deducted any US withholding tax from the US ETF distributions, which is ok for ETFs held in registered accounts but not in a TFSA or a non-reg account. So that assumption might slightly overstate returns depending on the account in which a portfolio is held.

As to rebalancing, I modeled none in Decmeber 2007 because the ETFs had not strayed far from their May target percentage allocations. Ths cash distributions were merely accumulated in the account. I ignored interest on the cash since it would have been too little to matter. ... all this stuff about my assumptions shows why so many people don't like taking the trouble to do realistic calculations - it's painstaking!

Results:

• big surprise, the simplest portfolio, consisting of only the iShares S&P/TSX 60 Index (XIU) and the iShares ScotiaCapital DEX Bond Index (XBB) fared best in every way!! It dropped the least to the review point of Dec.17, 2008 and has recovered almost fully (less than 1% below) to the starting value. That's why I've named it the "KISS Me Quick" portfolio - It has treated you well - who doesn't like a kiss!? It's KISS = Keep It Simple Stupid and it sure is quick to implement.
• big surprise again, the more diversified the portfolio, the worse the results! Huh, I though diversification was supposed to help, but whether or not the strategy was buy-and-hold or rebalancing, the fancy 16 asset portfolio did worst: it dropped the most and has receovered the least. That's why it's called the "Diversification Guru" - we all know what gurus are really worth.
• wow, rebalancing really worked well. In the short time since last December, all three rebalanced portfolios have outdone the buy-and-hold approach by anywhere from 7% to 9%.
• no surprise, diversification by holding fixed income is a lot better than just equities; if only XIU had been in the portfolio, there would have been a 31% drop in value, even including distributions. That's much worse than the 22% fall of even the worst portfolio, the 16-asset version. And XIU as of Sept.11th was still 14% below its initial value of May, 2007. The strong recovery of XIU has not made up the ground lost up to December. The reason is that no rebalancing occurred, as it could not with a single asset.

Why More Diversification Didn't Work

• real estate and foreign markets - some of the extra asset classes fell harder than Canada's; the UK's banks made up a bigger chunk of the FTSE index and they had just as much trouble as US banks
  
• currency shifts - up to last December, the CAD's big drop relative to USD as the flight to safety occurred cushioned some of the blow of drastically falling stock markets but since then the strength of CAD (check all the blue appreciation of the last 3 months at RatesFX) has limited the upside.

Further Thoughts:

• the future may not be like the past - this time and in this relatively short period, it was bonds, particularly government bonds, that provided the critical diversification benefit. Safety of principal was the issue. That may not be the case if inflation for instance, is the next big threat. In an uncertain world, different assets for different threats is still my best guess at what will allow me to survive if not thrive quite as much as the strategy which has worked best in retrospect.
  

International Diversification for the Canadian Investor: partial evidence

There is much published material on how international diversification benefits US investors but surprisingly little on the topic from the perspective of a Canadian investor. While one would normally expect that results from one country will be repeated elsewhere, as with so much else in investing (e.g. mutual fund MERs are too high, bonds return less than stocks over the long run), it is always worthwhile to look specifically at the Canadian experience.

In 2007 two graduate students from Simon Fraser University, Lei (Jeff) Wang and Luoxin (Peter) Wang took a look at the period 1996-2006 in their thesis Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test. They wanted to figure out how much benefit could be obtained from international diversification in recent years given the rise in world economic integration and the convergence of stock market returns, which we all observed last autumn as markets crashed together in perfect unison. They took account of currency shifts to estimate real returns for portfolios optimized using equities and/or bonds from the USA, UK, Japan and Hong Kong combined with Canadian stocks, bonds and T-bills/cash.

Their results are positive but less strong than I would have hoped or expected. Despite correlations that did not exceed about 0.7 amongst any of the asset classes and a number of negative correlations (especially bonds vs stocks), the benefits of both return enhancement or risk reduction (aka reduction of volatility / standard deviation) were quite modest. The main benefit came from the addition of international bonds, which provided a hedge against inflation for the Canadian investor. The optimized portfolios they came up with are decidedly unusual - most have a 0% weight in US equities and not a single one has any UK or Hong Kong equity component.

Part of the problem with the weak benefit they found is that, as they note, in this particular period of 1996-2006 the Canadian stock market outperformed everyone else's. That may not, probably will not, be the case forever, especially since the Canadian stock market is so concentrated in only three sectors - financial services, resources and energy. Thus, diversification should work better over a longer period in the future than their results show. A second point worth considering is that they found a fairly significant inflation-hedging benefit during a period when inflation in Canada has been consistently low. That also may not be true forever. It's good to have a supplement to real return bonds as an inflation hedge. The final point, which they do not discuss and which is probably significant, is that their portfolio construction method included no rebalancing. They calculated the single optimal portfolio for the duration. Rebalancing provides the "buy low-sell high" mechanism for enhancing portfolio returns and reducing risk. Perhaps they can do a PhD to do more calculations.

Portfolio Heavyweights Square Off on Commodities

The battle is joined. Should commodities figure in a portfolio? It is to be expected that there be a big division and difference of opinion between investors with an active strategy trying to beat the market and those with a passive, market index allocation strategy. But commodities seem to be controversial even amongst the passive index asset allocation crowd, in which I count myself.

Pro Commodity
Main proponent: Larry Swedroe, best-selling author and principal of Buckingham Asset Management
Arguments: collateralized commodity future funds provide positive return, that is negatively correlated with both stocks and bonds (i.e. a strong diversification benefit), as well as protection for unexpected inflation, which together are excellent portfolio insurance

Anti Commodity
Main proponents: Rick Ferri, author of several "All About ..." books, and head of Portfolio Solutions LLC investment advisors and managers; William Bernstein, author of The Intelligent Asset Allocator and The Four Pillars of Investing amongst others; Kenneth French, renowned finance prof and researcher.
Arguments: commodities have no real expected return net of inflation and the backtested returns on various commodities indexes are essentially trading strategies, not passive market investments in an index, whose future success in uncertain

The Debate:
Rick Ferri and Larry Swedroe go head to head in a discussion hosted by Hard Assets - The Great Commodities Debate part 1 and part 2
Kenneth French video interview on Yahoo Finance Why Investors Shouldn't Own Commodities
William Bernstein writes on his Efficient Frontier website "On Stuff"
Dimensional Fund Advisors quotes paper by Truman Clark on their website

The Research
Hard Assets Investor lists a half dozen seminal papers on the Hard Assets University page - see the Grad School section which links to free downloads from SSRN. Must read: The Tactical and Strategic Value of Commodity Futures by Claude Erb and Campbell, 2006, which everyone seems to quote. It's almost a book at 61 pages but a very worthwhile couple of hours of slow reading. Around pages 39-40 there is a great general explanation of the beneficial effects of negative correlation, variance and number of securities interacting with regular rebalancing in a portfolio. HAI also has useful primers, interviews, current news.

My Take
Despite his being outnumbered, my reading of Erb and Campbell tells me that I believe more Swedroe's conclusion. Commodity ETFs/ETNs do depart from the purist passive asset allocator model, being essentially active portfolio strategies based on futures (i.e. derivatives) but there is good reason to believe that the diversification return of around 3% will continue and the powerful portfolio risk reduction effect from (most of the time) negative correlation makes them worthwhile. I don't believe in the inflation protection benefit. An allocation of about 5% of my portfolio seems reasonable. So I'm sticking with my holding of DJP, the iPath Dow Jones-UBS Commodity Index Total Return ETN (recently renamed, replacing the AIG reference in the name with UBS).

The Truman Clark paper cited by Dimensional, which seems to have no visibility (or credibility?) amongst the other researchers on commodities, being cited by none of them, seems too impossible to believe - how could there be no reduction in portfolio standard deviation, as it concludes, when negatively correlated commodity assets are added? It seems to be a mathematical impossibility the way covariance works.

Benefits of Investment Diversification for Retirees

A few weeks ago I noted in my review of Moshe Milevsky's excellent book Are You a Stock or a Bond? that further diversification beyond the US stock, bond and T-bill portfolio he used could provide more benefit. I've done a bit of research and number crunching and take a look at these benefits!

Diversification can:

1. Raise the possible safe withdrawal rate from the investment portfolio by 1.5% a year, perhaps considerably more. Safe withdrawal rate is the percentage amount that can be taken out and spent every year while minimizing the chance of running out of money before dying - a 4% rate on a $100,000 portfolio means taking out $4,000 per year and raising that 1.5% means being able to spend $5,500 per year.
   
2. Reduce the chances of running out of money by anywhere from 3 to 10%.

Most of the benefit of diversification comes from the potential large reduction in volatility, or swings in the portfolio. Diversification helps enormously to reduce the sequence of returns risk (the chance of having bad markets at the start of retirement) which can send a portfolio on a downward spiral from which it never recovers. Retirees face this damaging risk, which is quite different from investors in the accumulation phase, because they are taking money out.

The table below uses Milevsky's formulas, which incorporate the risk of dying along the way, for calculating the risk of running out of money before death. It shows a few hypothetical (but based on realistic numbers) calculations and a couple of results using historical data.

Hypothetical Calculations:

• Weak vs Strong Diversification, keeping the same 4% withdrawal rate - the slight increase in return combined with the large reduction in portfolio volatility (standard deviation from year to year) means that there is a 10% better chance that the money will last till death - which would you rather have an 87% chance of not running out or a 98% chance?
• Weak vs Strong Diversification but boosting the withdrawal rate - for the same risk of 87% chance of successfully having the money last, an extra 2.7% could be withdrawn. That's $2,700 extra for every $100,000 in the portfolio.
• both these scenarios assume a 50% chance of living 19 or more years e.g. a 65 year old getting to 84, which is about the current number according to Milevsky

Historical Data

• TSX from 1958 to 2008 (i.e. including the highly "volatile" 2008!) produced a 2% higher return than the hypothetical scenarios but the volatility is about the same. The comparison portfolio is from the conservative 50 portfolio (50% fixed income) from IFA Canada, which is quite broadly diversified with Canadian, US and international equity holdings, fixed income and real estate, though it does not include other potential asset classes such as commodities and real return bonds. There is still a huge reduction in volatility in the IFA portfolio to 8% from the 15% of the TSX alone. This would have allowed the withdrawal rate to be 1.8% higher with the exact same 97% assurance of not running out.

By playing with the numbers in the spreadsheet, it becomes evident that the longer the expected time in retirement, the stronger the effects.

Bob Clyatt's interesting book on how to semi-retire, Work Less, Live More, shows similar results using the approach of reconstructing actual data for a US investor from 1927 to 2004. He estimates that an internationally-diversified, value- and small-tilted portfolio would allow investors to increase their safe withdrawal rate by 1.5% or more per year. His analysis addresses the needs of much younger people (the semi-retirees) who essentially need their portfolio to last indefinitely, 40 years or more.

PS: Those who want to try Milevsky's formula with their own numbers should read a A Gentle Introduction to the Calculus of Sustainable Income. If you use OpenOffice instead of Excel, be aware that the GAMMADIST function parameters are in the same order as for Excel, not as the OpenOffice help documentation says (that caused me some head scratching till I "reverse-engineered" the correct way to do it).

The moral of the story - in retirement, diversification is a huge opportunity to both boost income and/or reduce the risk of running out.

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.

The TSX in 2009: fewer, bigger companies = less diversification and more concentration risk

Canada's prime public equity market the Toronto Stock Exchange has been progessively shrinking and concentrating over the last few years. It isn't just the credit crisis at fault. Look at the figures below on additions and deletions to the headline index called the TSX Composite (source is the Standard and Poor's download table of adds and deletes, which seems to be somewhat incomplete since my backwards calculation doesn't quite jive with official figures I found for a couple of points in time, but the trend is nevertheless clear).


The Composite includes or excludes companies based on several criteria, notably liquidity and market weight (i.e. if the shares don't trade often enough and the market cap is too small compared to the overall market then they are out). The shrinking Composite reflects fewer companies taking up more market space.

Though I have not traced the numbers back further than 2007, there is even some evidence that the overall equity market in Canada is shrinking. The total of TSX-listed issuers dropped from 1613 from the end of 2007 to 1570 on December 31st 2008 and 1555 on January 31st, 2009 (from the TSX 2008 Yearly and January 2009 Monthly Trading Summaries). The same downward trend is evident for the number of issues (securities) listed on the TSX.

Causes:

• fewer IPOs (none in the last half of 2008, according to this PriceWaterhouseCoopers press release)
• a continuing slow stream of buyouts causing delistings (11 in 2008 by my count of the S&P deletes), a few of which seem to be due to income trusts selling out

No doubt the credit crunch exacerbated the situation in 2008, which PWC says will not change much for the first half of 2009, but the longer term trend suggests something else must be at work. What that reason is I don't know (possibly partly the influence of huge pension funds deciding to go progressively more overseas to invest?) but it isn't good for the average individual Canadian equity investor. Why?

Insufficient Diversification - Popular ETFs that track the TSX are more concentrated than ever. The iShares TSX Composite (symbol XIC) has about 20% of its value in the top five holdings alone and 73% in only three dominant sectors - energy, financials and materials. For investors who work in those sectors and whose job security goes along with prospects for their industry and company, their financial fortunes are distinctly concentrated and less diversified than they should be.

Potential Actions for the Investor

• complement XIC with iShares Small Cap Index Fund (symbol XCS), which has only 9% in its top five holdings amongst a broad base of 207 companies, about 130 of which do not appear in the Composite index; the negative is that there is still over 60% in the same top three sectors as well as the doubling up of the 70 or so overlapping companies
• diversify internationally in the US or elsewhere, where other sectors like manufacturing, health care and consumer products are better represented

Update March 14: The trend continues. GlobeInvestor reports that S&P will add 6 and drop 12 companies from the TSX Index as of March 23, a net loss of 6 companies in the index.

It Ain't Just Sports China is Good At

As we watch the Chinese pile up the medals in the Olympics, possibly displacing the USA as the top dog in the sports world, we might also note China's rise in capital markets.

This past January, the McKinsey Global Institute published its 4th annual report on Global Capital Markets and the results are amazing. (The report shows 2006 figures, so things are no doubt different today but it's the best available data.)

Maybe China isn't so democratic but it sure is becoming a capitalist country. In 2006 it ranked second, on a par with all of the Eurozone, in equity issuance and was not too far behind the USA - see this chart.

There has been a massive shift from bank deposits to equity investments in China. In 2004, equity made up only 15% of total capital in China while bank deposits were 72%. A mere two years later, equity had gone up to 30% of the total - see this chart.

And its total financial assets had climbed from a tenth that of the USA to a seventh. That's a huge shift in such a short time.

Last but not least, with their new found wealth, the Chinese are going global shopping, investing their capital in other countries and becoming the world's largest net exporter of capital in 2006. Who knows, they might get a liking for sports teams and buy the Oilers soon, though it's more likely they'll buy the oil sands. Oops, they tried that, didn't like Canada's response and have already pulled out, heading instead for Venezuela.

My investment take-aways:
1) It seems that the action and the growth for investors is coming mainly from places beyond our traditional comfort zone of North America and Europe.

2) However, the report is also interesting as confirmation of the degree of the increasing integration of world capital markets. I believe that means we can expect continuing high correlation of stock market returns across international, making international diversification less viable for an investor.

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.

Some Views of Expected Future Returns

Ever wonder what to enter for the rate of return in those calculators that tell you what you will have accumulated after 40 years of saving and investing? It doesn't take a genius to understand that you can't just will a certain number to happen. Even extrapolating the past returns can be chancy - who says the future will be like the past and how many years of the past do you take?

Here are some forecasts whose credibility you can judge for yourself.

The US Social Security Administration's Chief Actuary Stephen Goss
Presented at the 2005 National Academy of Social Insurance Conference


Portfolio Solutions LLC (Richard Ferri) 30 Year Market Forecast


Canada Pension Plan Chief Actuary Jean Claude Menard
Presentation on Projecting Diversified Investments at the same Social Security Conference


I find it interesting that the forecasted returns on Canadian equity are lower than both US and other foreign countries. Is that Canadian reticence or a reflection of a country in the wrong economic sectors, like commodities, or just bad economic management? Whatever the reason, if accurate, it reinforces the need for Canadian investors to diversify internationally.

Investing Surprises and Ideas from the CPP Investment Board

Have you ever wondered how that monthly Canada Pension Plan payment you will receive in retirement is generated? It doesn't come from government tax revenue, it comes partly from investments (and mostly from CPP inflows) made by the government-mandated but independently-operated (except for the influence arising from the fact that the federal government appoints the board members) CPP Investment Board.

The CPPIB has a conservative mandate: " ... to maximize returns without undue risk of loss." This sounds similar to my objectives, so I was curious to see what they do at CPPIB and whether there are any worthwhile investing ideas for the individual DIY investor. After all, the CPPIB is just a gigantic RRSP with no end date. It cannot afford to ever run out of money nor can I in my retirement. What does the CPPIB invest in and in what proportions? How much foreign content does it have and does it do any hedging to manage currency fluctuations? Does it just do passive index tracking or does it engage in active management?

What I found was very interesting and surprising.

Separation of Portfolio Structure from Cash Flows
The very existence of the CPPIB as a separate body whose only job is to generate investment return, not a retirement income cash flow, illustrates what I feel is a fundamental mistake in the way financial planners advise people to structure their portfolios in retirement. Planners often say to put lots of fixed income or high dividend stocks into the portfolio to directly generate cash to spend. But the CPPIB approach says the portfolio function is to generate returns, most of which is actually a capital gain of sorts, that can then be turned into cash as required by selling an investment and then shipping the net amount over to the CPP, the government body that mails the cheques to pensioners.

Right now, the CPP is still receiving massive net inflows ($6.5 billion in 2007-08) from the difference between CPP contributions and CPP payments - projected to last till 2019, another 11 years from today. That means it is in the pre-retirement phase, the equivalent of a person in his/her mid 50s. Will the CPPIB's portfolio shift dramatically to fixed income in 2019? There is nothing explicit I could find on the website that says what changes they will make at that point. I take hints from the use of words like sustainable in reference to their strategies, in other words not likely to change.

One caveat that applies to the individual but not the CPPIB and does justify somewhat a different investment allocation is taxes. The CPPIB doesn't pay any, at least in Canada (it does overseas) but you and I do. Therefore dividends, which have a much lower tax rate, do make sense for individuals in taxable accounts. But in a taxable account bonds, which are taxed at the highest rate, do not make sense, if the sole purpose is to generate cash. Investments that generate capital gains are also taxed at a lower rate than bonds.

Foreign Content and Lots of It
Surprise #1 - As of the end of March 2008, about half the portfolio (47%) of the CPPIB is invested outside Canada! Every penny of the returns goes to fund Canadian pensions in Canadian dollars yet the CPPIB invests abroad and intends to do that even more. Partly this is because the enormous amounts of money it has to invest mean that it must go elsewhere (already it owns 2% of all Canadian public equities). But it is also because of investment reasons, namely to further diversify risk and to achieve attractive returns in other sectors and countries (see CPPIB FAQ question 8). This is a good idea for the DIY investor too.

Currency is Not a Risk It's a Diversifier ... in the long term
Surprise #2 - The CPPIB does only partial hedging to remove the effects of currency fluctuations, which are negative when the CAD increases in value and the value of foreign holdings decrease as a result. One would have thought that huge foreign exposure ($57.7 billion in foreign assets and $47.6 billion in net currency exposure per page 69 of the annual report) would lead this organization with a conservative mandate and an obligation to pay out in CAD to remove all of the currency risk. It is not so - the CPPIB seems to hedge only about 20% of its foreign exposure.

The CPPIB hedges the amount arising from its investments in real estate and infrastructure. I cannot see why. Is it related to the fact that these investments are classed as inflation-fighters?

CPPIB's explanation of its hedging policy on page 17 of the 2008 Annual Report is worth reading, especially since it figures it could hedge at a cost of only 5 basis points or 0.05% (which raises the question why does it cost those hedged ETFs and mutual funds so much more?). Among the reasons cited for not hedging:

• when Canadian equities do worse than foreign equities, the CAD tends to fall, so the foreign equities go up even more in CAD terms - a performance boost
• a falling CAD results in higher inflation (which gets reflected in higher CPP payments) from imported foreign goods so the higher returns from foreign equities helps offset this source of inflation; they note it works both ways - as the CAD rises and foreign import inflation is reduced, as has been the case recently, the foreign holdings fall in value

An individual investor faces the same problem with inflation that the CPPIB does - the need for higher payments aka spending. Not hedging is thus a good idea from the inflation perspective.

The last reason cited by the CPPIB I do not believe applies to me as an individual:
"Investment theory, historical results and our research indicate that hedged and unhedged portfolios over the very long term have the same expected returns, except for the costs and fees of maintaining the hedge."
The key is the phrase "very long term". Is that 10, 20 or 40 years? I do not have an indefinite time horizon like the CPPIB. A 20 year upwards movement of the CAD that results in constantly lower or even negative returns from foreign holdings would not be good.

My own foreign holdings are only about 15% hedged. That's probably too little but hedging costs in the available hedged ETFs (like iShares S&P500: XSP and iShares Russell 2000: XSU) are much higher than for the CPPIB. Higher costs directly lower returns so the amount of hedging to do is a dilemma for me or any individual investor.

Equities are the Majority of the Portfolio
Surprise # 3 One would think they'd stick most of their money into "safe" fixed income, right? Nope, only 28% is in fixed income! The chart says only 25.6% but there is another 3% in inflation-linked bonds classified under inflation-sensitive assets. The rest is in equities. If the CPPIB is really adhering to its low-risk mandate, as it keeps repeating through the 90 pages of the annual report, then it must have mechanisms to control risk. While some means like the use of derivatives are difficult or impossible for the average investor to implement, the most important one - diversification - is available. Diversification for the CPPIB happens two ways:

• lots of investments - 2600 companies around the world, including 700 Canadian companies (the TSX only comprises 300 odd companies so the CPPIB has more than twice as many) - and
  
• investments whose risk-return characteristics fit together to reduce the overall portfolio risk.
  

Moral of the story for the DIY investor - diversify.

Inflation-protection is a Key Objective
Investing Idea: The CPPIB has a special category in its portfolio that it terms inflation sensitive assets to protect against inflation and help meet its obligation to fund CPP payments that are adjusted to rise with inflation. That objective is exactly what any individual investor would want to do as well. There is a hefty 11.7% of the portfolio devoted to such assets. There has been a significant increase in this type of asset since 2005.

What is interesting and worth looking at to do in any individual investor portfolio are the investments: real return bonds, real estate (commercial and office, not residential and most of it foreign) and infrastructure. There are ETFs and funds focused on those areas so it's quite possible for the individual investor to implement. There are attractive returns to be gained. In 2008, infrastructure was one big source of outperformance for the CPPIB. Infrastructure includes electricity transmission and distribution, gas transmission and distribution, water and sewage companies, toll roads, bridges, tunnels, airports and ports. CPPIB excludes hospitals and schools because the projects are too small - and it has big money to invest!

Costs are Low, VERY Low
Surprise #4: Considering that it is a government agency, the CPPIB's operating costs of 15 basis points, a measly 0.15%, are pretty darn good. Consider this statement in the annual report: "... every dollar saved in transaction costs is equivalent one dollar of additional income, or alpha, with no increase in risk." Low costs go straight to the bottom line and increase returns. Perhaps the CPPIB has the advantage of scale and doesn't have the marketing costs of mutual funds to pay for, but such low costs make one wonder again about the 2+% MERs charged by the average Canadian equity mutual fund.

Fixed Income contains Only Government Bonds and NO Cash
Maybe I missed the explanation but it was another surprise to find no corporate bonds in the CPPIB's portfolio. It is all federal and provincial debt (for some strange reason it has more PEI bonds than Quebec bonds). Global corporate bonds and private debt are on CPPIB's 2009 expansion list. I do not think the CPPIB's fixed income structure is one I or other DIY investors should emulate - corporate bonds have been shown to be an effective diversifier.

There seemed to be no, that is, zero cash on the books. That's right, the favourite ultimate "safe" asset isn't something the CPPIB holds at all in its investment portfolio. Obviously, the net CPP contribution inflow of $6.5 billion in 2008 didn't sit around long before it got invested. The only cash holdings of the CPPIB are a special fund (not considered part of the investment portfolio) it calls Cash for Benefits which it administers on behalf of the CPP to ensure cash is always available to meet CPP payment obligations. This is like an individual's current account cash for daily expenses.

The CPPIB doesn't explain anywhere why it holds no investments in cash. Cash is an asset un-correlated with other assets so can provide diversification to a portfolio. Probably, the reason is that the CPPIB is embarked upon the chase for higher returns. Which brings us to the next surprise.

The CPPIB is a Gung-ho Active Manager
Passive indexing as an investment strategy for pension funds is passé. The new best practice (or is it group-think?) is active management. That entails a whole raft of techniques and tactics, all of which the CPPIB is pursuing already or wants to expand: stock picking, hedge funds aka absolute return strategies, opportunistic buying (like ABCP last autumn), private equity and debt, tactical asset allocation aka market timing in stocks, bonds and currencies, country picking, buyouts and company management as principals. Holy moly, I'm having an attack of cognitive dissonance! This is cautious investing?

What leads the CPPIB to think it can do better than the market? Page 18 onwards of the annual report lays out the comparative structural and operational advantages that it feels will allow it to consistently outperform:

• a long investment horizon (they can be patient ... does that mean it believes other big investors like mutual funds suffer from short-termism?)
  
• a stable asset base and cash flows (CPP is predictable)
• scale (it can get deals, especially in private markets, and terms that others cannot)
• ability to acquire expertise (it says it will be smarter than the average)
• portfolio approach aka non-traditional view of asset classes where it is the risk-return characteristics they use to construct the portfolio (e.g. an infrastructure investment can behave like a bond)
• investment only mandate and transparent investment processes (government keeps its nose out so it has been able to avoid doing politically-correct screening out, or in, of poor investments)

Some of these qualities individuals can duplicate and should apply, like patience, unbiased choices, regular savings for investment and taking a portfolio approach. Other qualities are harder, like scale and outsmarting everyone. Perhaps the scale advantage can be turned around, for instance, the smaller companies that the CPPIB or other big investors have no interest in, can possibly be fertile investing ground.

The CPPIB has two strategies for pursuing outperformance relative to its benchmark:

1. "better beta" which consist of investing in new non-traditional asset classes whose risk-return characteristics lower overall portfolio risk and enhance return; it mentions specifically real estate, infrastructure and private equity, the first two of which we individuals can also invest in
2. "alpha" or above market returns obtained through skill and or smarts applied to temporary market mis-pricing
   

Aside: sometimes I wonder if the pursuit of alpha has something to do with the other meaning of alpha as signifying the dominant male in a pack of animals. Is part of the subliminal investment motivation to pursue alpha related to the macho alpha motivation to be top dog? Why don't those behavioural finance researchers who are so fond of revealing how individuals make stupid irrational decisions look at institutional behaviour?

In terms of risks of the active investing activities of the CPPIB, there are some interesting comments in a paper Upgrading the Investment Policy Framework of Public Pension Funds by Dimitri Vittas, Gregorio Impavido and Ronan O'Connor of the World Bank:
"Nevertheless, some aspects of the new approach should raise policy concerns. First is the risk (identified by Warren Buffett, the well-known investor) that ‘mark-to-model’ valuations may over time mutate to ‘mark-to-myth’ valuations. The recent experience with CDOs based on sub-prime mortgages lends support to this concern. Second, the more extreme forms of alternative investments, such as management of infrastructure projects, engaging in principal investing, and participation in hostile takeovers, expose public pension funds to risks for which they are unlikely to be well prepared and for which they are unlikely to have the requisite skills. It would be more consistent with the long-term objective of public pension funds to seek to maximize returns with a prudent level of risk if they limited their involvement in alternative asset classes to those that avoid ‘principal investor’ risks and rely on robust valuation models."

In its discussion of risks on page 44 of the annual report, the CPPIB does not address what I would describe as Fatal Flaw Wrong Assumption risk. With the intended increasing complexity of investments, will the board and top management really understand what the real under-lying risks are? That seems to have been a major cause of the sub-prime mess - institutions had no idea that the supposedly triple A mortgage CDOs were actually crap. Things can go fine for years, then the roof falls in. Oh well, we're in the same boat as Ireland, Norway and New Zealand since they have also gone modern and agressive. The actively managed part of the portfolio is still only a few percent so the total risk isn't that great ... yet.

One must admit that the results so far of the active management approach have been more than satisfactory. Compared to the passive Benchmark Portfolio, the CPPIB outperformed by about 2.4% last year, about the same as the year before. Hmm, is this proof that active management can work and the poor results of actively managed mutual funds merely shows that something is wrong with that model? This study posted on the U. of Toronto Rotman School International Centre for Pension Management shows US pension funds have also outperformed. The CPPIB's ongoing goal for outperformance is a modest 0.4%.

In 2007-08, about one quarter of the outperformance came from infrastructure and the rest from private equity, something not really available to the individual investor.

Maybe if they made executive compensation susceptible to actual losses instead of only rewarding upside performance, real "skin in the game", I'd be more convinced about active management.

I think I'll stick with going after "enhanced beta" in my portfolio for now.

The Reference Portfolio is a Good Guide
Investing Idea: the Reference Portfolio (see page 16 of the annual report) is the base against which the CPPIB measures itself. It is an investable portfolio composed of:

• 25% Canadian Equities
• 40% Foreign Equities
• 25% Fixed Income (all domestic government bonds)
• 10% Real Return (inflation-indexed) Bonds

That portfolio is designed to produce the 4.2% annual real (after-inflation) return that the Chief Actuary of Canada says is required to sustain the CPP for the next 75 years. In short, the Reference Portfolio offers a low-risk ultra-simple model portfolio that anyone can adopt and a target rate of return as well.

Where the CPPIB is Looking for Growth and Higher Returns
In case you might want to follow their lead:

• China, Hong Kong, South Korea, Taiwan, Mexico and some Eastern Europe
• infrastructure
• global corporate bonds
• real estate, especially Latin America

A "Modest Proposal" - investing in the CPP
>The thought crossed my mind that if the CPPIB were a mutual fund I might want to buy in; it would be one of the best with low cost, diversification, ability to participate in things I cannot do as an individual investor, outperformance of the market. Funny that the guru of pension management Keith Ambachtsheer, one of the drivers of the active management trend in pensions, was written up in a May 30 post on Jonathan Chevreau's blog Supplementary CPP for those without Workplace Pensions. He proposes that very idea plus a lot more, a beginning-to-end solution to the reason most people invest in the first place - to maintain a post-retirement standard of living.

Update June 25
When Net Inflows turn to Outflows
I was wondering what plans the CPPIB has for the moment about 12 years from today when net CPP contribution inflows turn to outflows, how that will affect investment policy and allocations among asset classes. Am still waiting for a response to my email enquiry but in the meantime I found a 2005 presentation given by the Chief Actuary of Canada, whose job it is to monitor the CPPIB and check that it will have enough to pay out CPP. Here is a copy of page 8 of the presentation, where it shows equities going down 10% and fixed income up by that much from 35% to 45% of the total. It's a classic retirement shift in allocation.

Update July 4th - When Net Inflows Turn to Outflows
The CPIB has now provided an answer to my questions!

Q - How will the composition of the portfolio and the investing policy change in 2019 when the CPP net inflow becomes an outflow?

CPPIB Answer - "This will be decided very much closer to 2019 and will be determined by the economic, demographic and investment environment at the time. Because the Canada Pension Plan (CPP) is primarily pay-as-you-go financed, only about one-third of its investment earnings will be needed to pay current benefits when the plan has “matured”. The 70% balance will be reinvested in the fund to provide a cushion against adverse future experience. By contrast, mature fully-funded pension plans use about 70% of their investment earnings to help pay benefits. As a point of interest, the most recent actuarial report assumes the CPP equity/debt asset mix will decline from the current 65/35 to 60/40 in 2010, to 55/45 in 2020 and 50/50 in 2025."


Q - Will you shift to a heavier proportion of investments that provide a stream of income, or those with a shorter expected payoff?

A - "Again, the composition of the portfolio will be determined by the circumstances at the time and the nature of the investment opportunities available. However, many of our most illiquid and longest horizon investments – private real estate and infrastructure – provide us with very large cash-flows. As well, dividends and interest payments are generated from all parts of the portfolio, and even private equity investments provide a steady stream of cash realizations."

It looks as though the CPPIB feels it will not need to shift its allocation to generate enough cash to pay for CPP benefits though it may move to more fixed income / debt investments if the actuary has his way. One can imagine a debate going on between a confident, aggressive CPPIB and the cautious, conservative actuary.

Update August 27 - Was browsing the Financial Webring and found some interesting comments on this thread page from a certain Bruce Cohen who says he has helped write the CPPIB annual report in recent years. He gives some additional info on how and why the CPPIB invests as it does - how much of the CPPIB money will be used for CPP, why no corporate bonds or cash and then unfortunately repeats the "management is too smart and professional to ever screw up" mantra.

Benefits of a Diversified Portfolio in Retirement

Whew! I was pretty sure that holding a portfolio of uncorrelated assets would be just as worthwhile in retirement when withdrawals are being made as it is in the build-up phase before retirement but now I've found someone has crunched the numbers to demonstrate the fact. And the results are impressive.

Retirees are much more concerned to avoid downside risk, the risk of loss that cannot be recovered when poor returns occur, especially several years in a row of negative returns, such as happened in stock markets from 2001 to 2003. The opportunity to make up for losses by working harder or longer is not available to retirees. Capital preservation comes before everything. That fear is the reason many retirees stick to safe bonds, GICs, money-market funds. Unfortunately, such investments have low rates of return too.

In The Benefits of Low Correlation, Craig Isralesen shows that a balanced diversified portfolio is an attractive alternative. He calculates the results from the point of view of a US retiree withdrawing 5% a year (and adjusted upwards by 3% a year for inflation) from a hypothetical portfolio consisting of equal weights in seven different asset classes: large cap US equity, small cap US equity, non-US equity, intermediate term US bonds, cash (T-bills), REIT and commodities. He uses actual return data from 1970 to 2006. He works out the portfolio return and volatility but also shows - and this is the key part for a retiree - how much and how often the portfolio would go down, considering that the withdrawals were also taking place. What is particularly interesting and instructive (after all, he is a university prof) is that he starts with a portfolio of only two assets (the US equities) does all the calculations and then adds another one till the full seven are included. The progressive benefit of downside risk reduction, portfolio stability and return enhancement (or reduction, when a lower return asset like cash is added) comes out very clearly.

It is not the actual numbers he calculates that are important - a real portfolio would have transaction costs and tracking error and the future will not be exactly like the past. Plus a 4% withdrawal rate would reduce even further the risk of a reduction in the portfolio's value in any year, enhancing its sustainability. It is the effect and the magnitude of the effect of diversification through uncorrelated assets that is worth noting.

Here is part of Israelsen's conclusion:
"There are several quantifiable benefits of lowering the correlation of a retirement-withdrawal-mode portfolio's component assets. First, there is a dramatic reduction in the volatility of the portfolio's performance (i.e., lower standard deviation of return). Second, there is a significant reduction in the worst-case portfolio loss, or maximum drawdown. Third, the likelihood (or frequency) of loss is minimized. Fourth, performance does not suffer if sufficient diversification is achieved."

As a mini example of the benefits touted by this study, in my own portfolio, shown at the bottom of the blog, the huge rise in commodities and emerging markets has partially offset the fall in US and European equities, providing stability in the past year.

The lesson I draw is that a diversified portfolio is a viable alternative for a retiree, close to the safety of cash but with much higher returns. Happily, passive index mutual funds or ETFs provide a practical way of implementing such a portfolio. Finding new uncorrelated assets to put into the portfolio, such as inflation-indexed bonds (RRBs in Canada TIPS in the US), which Israelsen did not consider, will have similar benefits of further risk reduction or return enhancement, or both.