Book Review: The Art of Asset Allocation

Here's the one word review: yucchh!

This book is to asset allocation and finance as metaphysics is to philosophy. Much complicated ado that ultimately is of little use.

I was really looking forward to reading this book by David Darst, which I had bought at the same time as Richard Ferri's All About Asset Allocation. The contrast between the two could not be greater. Ferri is excellent, as I have written in another review. Darst displays the worst of financial writing - dense, boring sentences, superfluous numbers and tables, chart junk illustrations, endless checklists, non-actionable general recommendations and worst of all, radical departures from financial theory that will get an investor into trouble - I refer to tactical asset allocation, which is nothing more than market timing in disguise. A little less "art" and a little more "science" in asset allocation is what we need.

Consider that the book has no footnotes, no references or reading lists - as if Darst's exposition is self-sufficient. Even Newton found it beneficial to stand on the shoulders of others. On the other hand, Darst does take time to say, "Of particular value have been the advice and counsel provided by: ...", followed by four and half pages of names, which I guesstimate is over 600 people. Really?! 600 people?

The hilarious epitome of useless complication is the chart on page xiii, a series of circles within circles with overlapping wheels, which shows an alternative sequence of reading the chapters. I would suggest an author's task is to simplify for the reader and present the material in one logical sequence of chapters, not complicate matters as he has.

I almost get the impression Darst wrote this book to show how smart and knowledgeable he is, a career move to impress his boss and others in the industry. But it doesn't help Mr. Average Investor. The net effect of trying to read this book for an average investor would be to feel that asset allocation is such an esoteric and arcane subject that only someone like Darst or Morgan Stanley (Darst's employer) could possibly do it.

Is Currency Hedging on Foreign Equity Too Expensive?

Someone named George$ wrote a very pertinent post on the Financial Webring asking what people think of the Globe and Mail article by Allan Robinson in which several major fund managers like Franklin Templeton and Fidelity Investments say they do not do currency hedging on their international equity funds to eliminate the effects of foreign exchange shifts because it is not worth it. I've replied to George$ on the site, where hopefully others will comment too, but here is my reply. This is an important question for anyone who wants to use international investments, whether equities or fixed income, to diversify and reduce risk.

I'd sure like to see those studies done by Templeton because there can be very long term trends between currencies, for example the Canadian vs the US dollar. In the ten years from January 1997 to April 2007, the CDN$ went from 0.73 to 0.87 a 20% increase and from 0.62 to 0.88 in the five years between November 2001 and November 2006, a 42% increase. That would be enough to wipe out a substantial chunk of the US market gains for a Canadian investor. How long does the investor have to wait for currency fluctuations to even out and what is to be done in the meantime if the investor needs to cash in? Is Templeton referring to the situation of a large number of currencies with a very broad portfolio such as the MSCI EAFE index? But then, iShares Canada sells the XIN fund that mirrors the MSCI EAFE index and is 100% hedged to CDN$. Its MER is 0.15% - quite reasonable. The similarly hedged XSP mirroring the S&P 500 also has a 0.15% MER. In the end I ask myself, why do I want to bet on the currency as well as the foreign stock/index if I can avoid doing so at a reasonable cost.

One possibility I cannot admit to having modeled or seen done by someone else is the effect of re-balancing under an asset allocation policy. That would have one pushing more funds into markets when the exchange rate changes, a kind of dollar cost averaging. Not sure if that would reduce or completely eliminate the currency effect over time. Anyone have a view?

I've previously posted other comments on this question on my blog.

I wish Allan Robinson had gone to see the iShares folks but it was good to read anyway.

Book Review: All About Asset Allocation by Richard Ferri

Author Richard Ferri delivers what the subtitle of this compact (300 pages fairly large typeface) book promises: "the easy way to get started". It's a fine introduction that explains what asset allocation is and why it is so important to investment success for the average individual investor. It then shows in straightforward, practical terms exactly what to do, right down to listing the funds that one can choose to form a portfolio according to the asset allocation principles. The words I use to describe this book - "simple, practical and introductory" do not mean this is a dumbed down version or lacking in the theoretical grounding of modern finance.

Asset allocation is a very sure method for an average investor to ensure unspectacular but steady investment results with risk that is well managed through effective diversification. And it requires a minimum of time to maintain once the initial set up is done. As Ferri says: "Asset allocation eliminates the need to predict the future direction of the markets and eliminates the risk of being in the wrong market at the wrong time." (think technology stocks in 2001/2002) The fundamental concept of asset allocation is that different sorts of investment assets do not go up or down in sync. That property, and that property alone, allows one to combine those unconnected types of investments into a portfolio that both raises investment returns and reduces risk. That is true diversification, as opposed to the common misconception that merely having many stocks accomplishes diversification. The holdings required for real diversification and asset allocation, as it turns out according to Ferri, should include European stocks, Far East and Asian stocks, Canadian stocks (for natural resources), Emerging market stocks, US small company stocks, US total stock market, US value stocks, real estate and fixed income. Within the fixed income part of the portfolio, he recommends diversification as well, noting that this is often overlooked by financial advisers. Accordingly, he advises holding a combination of a total US bond market fund, US Treasury inflation-protected, US high-yield corporate bonds, Emerging market bonds and US municipal bonds. All of these stock and bond holdings he says are best obtained through low-cost index funds or ETFs, because of their market representativeness of the asset class, their savings on fees and their ease of re-balancing. What is reassuring is that in each case, he establishes through a review of the correlation of returns that there is indeed worthwhile non-correlation with other classes which creates a diversification benefit.

The book is structured into thirds. The first part lays the foundations and the principles that serve throughout - how risk works, how asset classes are determined, how diversification results from non- or negative-correlation, the importance of re-balancing. The second part examines each asset class mentioned above in turn, analyzes the correlation characteristics of each, including the possibility of alternative investments such as fine art, wine, collectibles. I very much like the fact that he addresses home ownership and finds it to be a worthwhile investment though he concludes that it cannot practically be part of an asset allocation investment strategy since one cannot re-balance when necessary by selling a part of one's house. The final third is devoted to discussing historical rates of return and variability/risk, building a portfolio adapted to one's real risk tolerance (as opposed to the over-estimate of risk tolerance most people apparently display when encountering a market downturn), dealing effectively with taxes, investment fees and financial advisers.

This is quite a complete book ... for US investors, for that is his audience. Canadian and UK or other non-US investors have to take the principles in hand and assume that the same kind of asset class relationships exist elsewhere. If I were to adopt his actual recommendations and invest mostly in US holdings, I would be incurring significant exchange rate risk of the Canadian dollar versus the US dollar. Mr Ferri only briefly notes the existence of such risk but does not recommend doing anything about it. Will re-balancing fix that problem? It would be better to see an explicit discussion and recommendation within the book.

Another recommendation that Mr Ferri does justify in a bit more detail but it could still do with more in my opinion is that re-balancing of the portfolio be done annually, as opposed to more or less often, or according to thresholds of departure from the target allocation percentages.

The presentation of the book is excellent. There are lots of helpful tables and charts, there are chapter summaries and key points, there are references and extra readings and a glossary of terms. The writing is clear, grammatical and engaging. Most useful of all and a great time saver, is a list of potential funds (from among the thousands available), at the end of each chapter.

Overall, this book could do the job perfectly well for a US investor. For Canadians and others, we need a "foreign" version, Mr Ferri but I still recommend it to everyone.

You can find another review of this book at the Chartered Financial Analysts Institute.

Buy this book at
chapters.indigo.ca

For Once I Agree with Jack Layton of the NDP

I didn't think it would happen but if what Jonathan Chevreau says is true in his April 3 blogpost about comments made by Jack Layton leader of the federal NDP party then I have to say I agree wholeheartedly. The comments in question are that the Canada Revenue Agency should provide tax calculation software for download or as a web application for free to every citizen / taxpayer. After all, the CRA provides the paper forms for free. All we taxpayers are doing by using the commercial tax packages is data entry for the CRA and paying for the privilege!

The CRA is partly along that path that would be necessary to develop free software for taxpayers since it has developed comprehensive test suites for certifying the commercial packages. Since the CRA seems to be stuck on saying no to going the rest of the way, perhaps the next best alternative is for people to develop their own. There is one free package out there that is Netfile certified called StudioTax but it has a few situations it won't handle (see this CRA webpage for details). Is it time for a true public, permanently free version under open source licensing to be created? Any views out there? Are there software developers and accountants willing to work on creating such software?

Insider Trading and Securities Regulation in Canada

The posts by Larry MacDonald on a number of studies which found highly suspicious statistical evidence that insider trading is rampant in Canada are sickening (the insider trading, not the posts!) to say the least. A big thank you to Larry for bringing this up. A few years ago I sent a complaint to the Ontario Securities Commission about what seemed to me to be very suspicious price changes shortly before surprising and important news on a small company called CSI Wireless. I only ever got an acknowledgement back, months later, from the OSC that they would "look into it" and never saw or heard anything more. Maybe there was or there was not information leakage and insider trading but without confidence in the fairness of trading in that stock, it's one reason I eventually sold out and will not consider buying again.

The lack of control over insider trading is another confirmation that a properly funded national securities regulator is badly needed in Canada; I'm with Canadian Money Blogs Reviewer on this one.

UK Stakeholder Child Trust Funds

Every child living in the UK (with some exclusions) has the right to a Child Trust Fund (CTF) and the Stakeholder is the standard type of CTF that every financial services provider must offer to the public if it wants to offer any CTF. The list of approved providers has no less than 44 companies. The providers includes a wide range of institutions from banks to building societies to credit unions to stockbrokers to fund companies. In addition, there is a list of 73 distributors who work with providers and pass along applicants, no doubt garnering a share of the fees in the process. That list is even more varied from banks again to retailers like Boots and Asda.

One might think that there would be a bewildering variety of Stakeholder plans with so many options, tweaks and special conditions that it would be impossible to compare. Not so! In fact, as it turns out, for a Stakeholder type of account, there is little need to compare. One is pretty safe to simply go to whatever institution or store one finds most convenient. That's due to several reasons:

• first, the government has imposed certain terms and conditions that every Stakeholder plan must respect, like a cap on annual fees of 1.5%, no upfront charges or commissions, no charges/commissions on additional investments, no exit fees, no switching fees, acceptance of additional lump-sum or monthly investments as low as £10; this eliminates almost all of the nit-picky but often important detail differences between providers and their products that drives one crazy trying to compare - hooray!
• second, it seems that the majority of providers have opted to offer (only) a UK FTSE index tracking fund for their Stakeholder accounts; some use Legal and General's FTSE All-Share Tracker, some the Insight Investment or the Homeowners versions thereof while F&C use their own; the providers that differ provide a balanced fund of about half equities vs fixed income/gilts; though I prefer the all equities option due to the 18-year long investment time horizon (the child only receives the funds at their 18th birthday, so there is time to even out the highs and lows of stock markets and gain the historically greater returns of stocks over fixed income), either type of plan is ok; the nature of the underlying investment, whether equity index tracker or balanced fund is probably the only question that needs to be asked I believe.
• third, the cap on fees at 1.5% means that all the providers, are you ready, have exactly 1.5% annual fee - no shopping around required! While this may seem like cartel pricing, if one puts oneself in the shoes of the financial provider, there will likely be a lot of small accounts (the government contributes only £250 at birth and another £250 at age 7) and a lot of ordinary folk who need much handholding at extra cost, so there likely isn't a huge profit being made. I'm guessing this is also the reason those cheaper-to-administer index tracking funds are the standard investment vehicle ... but that's a good thing compared to actively-managed funds, which as we all know will, on average, under-perform the index. The only exception I found to the 1.5% annual fee, out of about ten funds I checked into, was the F&C offering of their own FTSE All-Share Tracker at 1.22% annually - go for it!

So there you are, stick your child's money and anything else you can spare - best, just set up an automatic debit from an account into the CTF (another capability that is mandatory for all Stakeholder accounts) - then forget about it for 18 years while you get on with life.

Actually, that's not quite the best approach. When the account balance gets to about £1100, it is worth looking to switch to a non-Stakeholder Share dealing account. These types of accounts allow any sorts of fees, conditions and investments, which one chooses oneself, so a lot of shopping around and nit-picky comparison is required. Though I did not check out all the 13 approved providers (listed here) of this type of account, an interesting one I came across is offered by The Share Centre, which allows one to buy the Legal & General UK Index Tracker at no upfront charge at a mere £10 or more per contribution and the annual fee amounts to about 1.03% (0.125% quarterly admin fee plus 0.53% Legal and General annual management fee). That's an assured risk-free increase in annual return of almost half a percent - £4.70 per year per £1000. It more or less pays for the Share Centre admin fee.

Saving for Children in the UK Compared to Canada

It has been an eye-opener the last few days doing research for some of my Scottish relatives into the Child Trust Fund program (CTF) that exists here in the UK and comparing it to the closest Canadian equivalent, the Registered Education Savings Plan (RESP). The UK government created the CTF only in 2005 - one wonders whether the policy makers took a look at the RESP and decided to simplify and improve it.

The key common point is that both the CTF and the RESP are tax-protected savings accounts for the future of children. Both also enable savings into various types of equity holdings (stocks, funds, ETFs) and fixed income (bonds, bond funds, guaranteed savings). And both receive some direct contribution of funds from the government.

But the differences between the programs abound:

• RESP is intended to be used only for higher education (and tax-exempted accordingly) while the CTF can be used for anything; score one point for the CTF
  
• CTF receives from the UK government only £250 at birth of the child and another £250 at age seven, while the CESG from the Canadian government to the RESP can be up to $400 per year, soon to be $500 according to the March 19 budget (though the lifetime limit remains at $7200); score one for the RESP
• CTF annual contribution limit is £1200 (about $2700 at today's exchange rate) while the RESP's is $4000, a cap that the budget also eliminates; score one for the RESP
• CTF ends at age 18 but RESP can exist gaining tax-exempt income till age 25; score one for the RESP
• CTF assigns ownership to the child from the beginning and the money is locked into the account (except for terminal illness, in which case funds can be used early) till 18, but the RESP doesn't prevent early withdrawal, a flexibility advantage, though the effect of CESG needs to be considered (see HRDC website); debatable which is better, score it even.
  
• CTF on maturity passes directly to the child to do whatever he/she wants while the RESP is still controlled by the Plan holder (most likely a parent); here's a good debating point! should an 18 year-old be put in full control of a potentially large sum to do whatever with, no accountability to anyone required? my view, with my limited experience of my own kids is, they learn to do it, just like they learn to pick up after themselves when they move into their own place; score one for the CTF
• CTF withdrawal is simple and straightforward while RESP is complex and time-consuming with bad consequences if done the wrong way (all that keeping track of CESG vs capital contributions vs income and the proper withdrawal sequence ... ouch it's a bureaucratic nightmare); score one for the CTF
  
• CTF has three sorts of mandated account types (see the first CTF link above for details) that allow easy choice amongst them according to risk preferences and easy comparison within an account type while the RESP multiplicity of investment vehicles is complex and time-consuming to figure out (to see what I mean check out this discussion on MillionDollarJourney's blog); the UK government has succeeded in establishing a level playing field for the CTF that seems to meet general approval, including mine, which counts the most of course ;-) score one for the CTF
• CTF's account-fee cap of 1.5% on the Stakeholder account type, which minimizes profit prospects for providers, has oriented them to offer index-tracking equity funds rather than actively managed funds, which are more likely to under-perform the index; score one for CTF
• CTF and and Human Resources Development Canada (HRDC) both provide listings of approved providers of the respective plans but CTF shows the types of plans of each provider and gives some guidance on how to choose; score one for CTF
• CTF lowest cost self-directed provider of an index tracker fund that I found at the Share Centre comes at about 1.03% total annual fees while for an RESP there is TD CanadaTrust's eSeries which vary from 0.33% for the Canadian Index to 0.48% for the US currency hedged (S&P500) Index or the International MSCI EAFE Index; too bad a CTF holding has to be traded on a UK exchange!; on top of that, there's only fund as cheap here in the UK so one cannot diversify beyond the UK FTSE index; score two for the RESP
  
• UK telephone helplines of both regulators and providers of CTFs are answered quickly
  (within seconds generally) by knowledgeable personnel without going through menu trees and such, while in Canada one can easily wait for minutes (it was about 10 minutes for TD CanadaTrust) or reach only an answering machine; score one for the UK
  

Overall, the RESP seems better for people like me (because my kids have gone on to university) than the UK's CTF, but what a hassle compared to the UK!