Jonathan Chevreau Report: Index Fund Advisors come to Canada

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

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

UK Tracker Indices not Wholly Representative of UK Economy

Came across this fascinating article titled "Buying British not what it seems" by Sylvia Morris that discusses how the presence of many foreign companies on the London Stock Exchange and the foreign operations of many UK based companies (even the big food retailer Tesco!) means that buying the FTSE 100 or the All Share Index entails a very significant foreign exposure. The All-Share is apparently not quite as foreign as the 100 Index but in either case one is more or less buying an internationally diversified holding. Hmmm, not sure what to do about this so that the UK holding better represents the UK economy as the more purely domestic funds in the UK are high-fee actively managed funds.

The progress of globalisation is no doubt having this growing effect in all markets and on all market indices. Might it be that the diversification benefits of international investing are becoming less and less so? Perhaps diversification on the basis of non-correlation of asset classes/holdings would be better pursued through asset classes based on something like industry sectors?

UK Portfolio - Part 4 - Fund Selection

This step of the creation of the new diversified UK portfolio required translating the asset class selection into an actual fund to purchase. The process turned out to be somewhat iterative as I discovered that my initial intention to obtain diversification by buying US small cap and value funds could not be done since there are no such low-cost funds (there are probably high-cost actively managed OEICs or unit trusts but those have been excluded from the potential purchase list due to the harmful effect of those fees) available on the UK markets. Instead I picked European ETFs from the iShares stable. Since the low correlation behaviour of small cap (e.g. this research paper) and value funds (see this reference at Dimensional Fund Advisors and this research paper titled Global Portfolios with Market, Size and Value Considerations) has been found to hold internationally as well as in the US, this switch seemed reasonable to do.

The result of the search and selection process is shown on the spreadsheet summary with the fund names in the boxes of each asset class. I conducted the fund search through a combination of the iShares UK website, since they are the only company currently offering ETFs on the UK market, the TrustNet website and the SelfTrade broker website (another reason that it won out as my next post explains). It is interesting (to me at least!) that there are a few index-tracking low cost OEIC (i,e, not ETF) funds available to represent the UK FTSE index and a pan-European index. The reason I chose them instead of the comparable iShares ETF, is that the ISF only holds the 100 largest UK FTSE-listed companies, whereas the M&G UK Index Tracker holds the whole market and has a lower expense ratio (0.30% vs 0.40%). Similarly, the M&G European fund is far more representative than the largest 50-company iShares DJ Stoxx 50.

So that's it, with eight holdings, there are around 2000 companies from around the world that will form part of the total portfolio.

UK Portfolio - Part 5 - Broker Selection

The final step in the UK portfolio revamp required selection of an appropriate broker through which mutual funds or ETFs could be purchased.

Since I was not very familiar with the UK scene, initially my search for a broker involved Google searches. It would have been far quicker had I known about the GoodWebGuide of Share Dealing brokerages, which contains a brief synopsis and rating of most if not all the online brokerages available in the UK, though be sure to follow the links to each company website as I discovered several instances of inaccurate or incomplete information in the synopsis. The main criteria I used included:

• low cost - per trade costs, monthly/quarterly/annual account administration costs, account closure or transfer costs. Since the investment strategy will involve few trades (once annually amongst a maximum of eight holdings) slightly higher trading fees may be offset by account inactivity fees or other costs.
  
• PEP, ISA and regular accounts - being able to have all types of accounts at one brokerage simplifies life in many ways, such as doing summaries/portfolio views, transferring money from a regular account into an ISA, as is planned to be done for the next number of years
• customer service - ability to phone and readily get explanations or assistance from a human being, a capability that was tested informally as I collected information from websites; for instance, eTrade quoted the cheapest prices but I got into voice mail wilderness trying to contact them while SelfTrade posts their phone number everywhere on their website and polite knowledgeable staff answered the phone quickly, a very handy thing whenever a less than expert investor is involved, as in this case. Some low trading fee brokerages, such as iDealing don't even offer phone support, only email support.
• direct foreign market access - ability to trade directly on foreign markets, especially the US' NYSE and Amex for ETFs due to the paucity of ETFs in the UK. This was a secondary objective in this case since adequate diversification could be achieved within what is available on the London Stock Exchange (LSE).
  

Some criteria that had no real importance but might for others with different investment strategies include:

• research tools - availability, breadth and quality of such tools as stock or fund screeners and research reports, charting tools, market news and market activity streamers
  
• discounts for frequent trading

Here are comments on some of the main players and the reason that they got disqualified:

• HSBC - no ISA account admin charge, nor any account closure or transfer fees but requires the opening of an HSBC bank account
• Abbey Sharedealing - the GoodWebGuide has more information than the Abbey website itself - pathetic!
• Barclays - charges account inactivity fees
• iDealing - low trading costs but offers only email support and website has very skimpy info
• Royal Bank of Scotland - higher trading, account admin and transfer/closure costs
• Lloyds TSB - higher trading fees and higher account admin costs
• eTrade - low trading fees but trying to talk to them is voice support hell
• Halifax Sharedealing - reasonable trading fees but higher admin costs
• TDWaterhouse - offers direct access to US NYSE, Amex markets, which means access to the wider range of ETFs available there, but I wasn't initially aware of TDWaterhouse and had already begun the process of opening accounts and transferring funds into SelfTrade so decided not to back track; maybe next year it will be worth switching.

In the end, it was SelfTrade that came out on top. The company's fees are in the middle for trading and low for account administration. By happy coincidence, SelfTrade has been offering no trading fees on purchase of LSE-quoted ETFs till May 31st, which is exactly suited to the ETF orientation of this portfolio. Best of all, SelfTrade wins on customer service: the phone gets answered quickly by knowledgeable, polite people both before and after one becomes a customer.

Book Review: Asset Allocation by Roger Gibson

The mere fact that this book is now in its 3rd edition indicates that to some degree it has stood the test of time. It is indeed a very good book, much of it brilliant, but it has some serious flaws and a 4th edition could/should correct those short-comings.

Gibson's primary target audience is financial planners and US investors. There is nevertheless a great deal of value for individual investors everywhere and as a do-it-yourself investor, I found much of personal benefit. Though not for the absolute beginner, this book is at an intermediate level and is understandable to anyone who has been dabbling in mutual funds and knows generally about bonds. He explains terms and builds knowledge carefully from a fairly low level, utilizing the results of finance research without delving into the heavy duty maths that characterize modern finance.

The subject matter of the book is not individual stocks and how to pick winners. It is instead about how to make money investing using a kind of tortoise strategy - moving ahead steadily but not spectacularly, in any given year always being behind the current winner but never worst, with the least chance of actually losing money and over the long term being ahead of every individual investment asset alternative. That approach is termed asset class investing in a portfolio built on observed diversification benefits of asset classes. Asset classes are groupings of investment securities that go up or down out of sync with one another, for example, the US stock market, international stock markets and real estate investments.

Gibson does a great job explaining how this works, with numerous graphs and tables using historical data. Chapter 8, titled the Rewards of Multiple-Asset-Class Investing is superb and worth the price of the book alone. Using a didactic method, he unveils the subject matter progressively to surprise the reader with the wonderful diversification benefit that I described in my previous post 3+1=5. This powerful result tells us to diversify using various asset classes such as international stock markets and real estate securities. It was very interesting and comforting for me to read the next chapter on portfolio optimization in which he shows how small changes in any of the inputs (estimates of future returns, volatility and correlation) among asset classes can have enormous effects on the computed optimal percentage allocation asset classes. This is comforting because a key decision is how much to put in Canadian equities vs US equities vs international vs fixed income/bonds. It doesn't matter enormously. Gibson's result is that there isn't a known correct answer - the most important benefits come from the different asset classes being represented, not the exact proportions, so one should spread out the investments relatively evenly (his answer is no less than 5% nor more than 20% in each).

This book does a very good job presenting the principles of asset class investing but does not get as detailed as Richard Ferri for example, whose book I previously reviewed, in identifying other useful asset classes for a portfolio, such as small cap stocks, value stocks and commodities. These asset classes do show up later in Figure 12-2, the Investment Portfolio Design Format but without any supporting explanation of why they are there. The book also does not get down to the actual securities that one can buy to build the portfolio, such as mutual funds and ETFs.

Some of the principles of asset class investing may surprise, e.g. tax minimization and income stream generation must be secondary to the proper asset allocation in a portfolio, which means among other things, do NOT design your portfolio with too much fixed income just to have interest income to live off in retirement. If you need money to spend, sell some of whatever asset class is currently above its allocation.

Where the book falls down in a significant way is the last quarter of the book from chapter 12 on, in which Gibson gives financial planners advice on how to deal with clients. In this section he seems to abandon substantiation and give arbitrary advice, or even worse, present as viable, options that are contradicted by material in the first part of the book. For example, on page 251 and elsewhere he seems to accept that "frame-of-reference" risk (the feeling by his client investors that they want to not be different than their peers), is puzzling to say to say the least. Isn't is desirable to do better and thus perhaps inevitably different, than one's peers? And isn't it the financial planner's professional duty to guide the investor to better and probably different approaches to investing? The advocacy of dollar cost averaging as an investment approach on page 265 is simply wrong, as Moshe Milevsky shows in his book Money Logic (maybe Gibson succumbed to frame-of-reference risk too as no less a luminary than Sir John Templeton, founder of the Templeton Funds, repeats the same mistake in the forward on page xii). The worst sin of all is Gibson's acceptance of an active management approach by trying to pick asset class winners and timing the market on pages 260-261. The rest of the book says that is not necessary or desirable but Gibson blesses it here because some financial advisors do it. He should be stomping all over the idea. Similarly, on page 272-273, Gibson discusses mutual fund fees and manager's compensation as justified - "Similarly, at the level of individual security selection, the money management specialist should be paid for work well done." I ask, what work, what security selection? Doesn't one just buy the index/market of the asset class? Let's see, for the Canadian stock market amongst low cost alternatives of funds or ETFs, there are maybe half a dozen and a good advisor should know them by heart, have one already determined by previous research (mine is XIU). How much is that worth - 1% fee on assets per annum? There's no on-going work. Perhaps a flat one-time fee?

There is one great quote cited in the book. Asset class investing, despite being superior, cannot ensure that one makes money investing. Paul Volcker, former US Federal Reserve Chairman: "You cannot hedge the world." (p.304) At times of world crises, all asset classes become one and move together. There is no escape. And if the crisis were something like nuclear Armageddon or global environmental collapse, it wouldn't matter anyways.

Despite the flaws, this is a book worth buying. It gives one the knowledge and the confidence to go ahead to select the actual investment securities for a diversified portfolio. My rating, 3.5 out of 5.

Buy this book at
chapters.indigo.ca

Portfolio Magic ... 3+1 = 5!

If someone told you that you should buy for your investment portfolio a holding with low annual returns and high volatility of returns (wide swings from year to year, i.e. the "sleep at night" factor) would you not think that this is against common sense, that this would lower your overall returns and make the swings even worse? For example, why add an investment that increased on average 10.3% annually and with volatility of 24.3% (this is the standard deviation, the usual measure of volatility) to a portfolio that has a higher return of 13.7% annually with lower volatility of only 14.7%? Well, contrary to common sense, the marvels of diversification can make this worthwhile. Certain precise, though quite simple and understandable, circumstances that go to the heart of diversification, make this seemingly odd result come about. How does it work you ask?

The key is to combine investment assets that move, in the best case, in contrary directions – when one is going up the other is going down and vice versa. Beneficial, but less so, is the case where the assets move randomly or independently – sometimes together, sometimes in opposite directions. There is still benefit when the assets tend to move together, but not all the time, in a weak positive relationship. Most of the investment assets that can easily be bought by the average investor tend to fall into the last category so it isn't possible to build a high return portfolio with zero volatility but the improvement can be considerable.

Let's continue with the example, which comes from Roger Gibson's fine book, Asset Allocation. The mystery low return/high volatility asset is the Goldman Sachs Commodity Index and the portfolio is a combination of the S&P 500, the MSCI Europe, Australia and Far East Index and the (US) National Association of Real Estate Investment Trusts Equity Index. Gibson shows in chapter 8 that over the period 1972 to 1998, the combination of the four holdings would have increased returns a little, from 13.7% to 13.8%, and reduced volatility a lot, from 14.7% to 10.6%. The reason again for this remarkable result is again, that when commodities go up the others go down and vice versa, even though over the long term, all of them go up. To cap it all, each asset on its own, underperformed the combination of all four. That's the power of diversification.

An investment category that moves differently from others is termed an asset class. So what are the asset classes that can/should be combined in a portfolio that maximizes returns while minimizing volatility? The main ones identified by finance researchers are:

• cash / Treasury bills

• bonds, with further useful (i.e. with diversification benefits) subdivisions into corporate, government and international

• equities, with useful subdivisions into large cap, small cap, value, international Europe, EAFE and emerging markets

• real estate, purchasable primarily in the form of REITs, though one's home can be considered an investment to a degree

• commodities - energy, minerals, foodstuffs, gold, basic materials (steel, aluminium)

For examples of how these can be turned into actual portfolios with the purchase of specific ETFs or low-cost mutual funds (the latter being primarily available in the US alas), check out the Index Fund Advisors portfolios. The excellent book All About Asset Allocation by Richard Ferri that I previously reviewed also has example portfolios. The Efficient Frontier shows basic international equity portfolios with ETFs. Bylo Selhi has a handy list of the various low-cost funds available in Canada, some of which represent the above asset classes. For Canadians, since US mutual funds cannot be purchased, US-traded ETFs are the only route. Most (if not all) can be listed and searched for at Index Universe or Morningstar. In the UK, the iShares ETFs are the only low cost option for anything other than UK stocks or bond indices, or European stock indices, which are available from any number of fund companies.

A word of caution is that, as Ferri shows with numerous graphs on every asset class, the advantageous correlation relationships can be absent or reversed from year to year or for periods of many years at a time. The relationships work over long periods when the variations smooth out. While 3+1 is no longer always equal to 4, patience is still a virtue in investing.

UK Portfolio – Part 3 – Equity Asset Allocation

This part of the process in revamping my UK friend's investment portfolio consisted of deciding which asset classes to include in the equity portion of the portfolio and which percentage each asset class should have. I must admit upfront that the assignment of target percentages in this step required some kludging and a bit of hocus-pocus. I feel it's the least defensible and any comments or suggestions on how to improve would be most welcome. Rather than search for a perfect answer, I think/hope that what I've done is good enough. After all, as Scotland's immortal poet Robert Burns (or Rabbie but definitely never Robbie!!, if you don't want to be considered an eejit by any Scot you may encounter) wrote in Tam O Shanter, “nae man can tether time or tide” and one must get on with it.

The table extract from my spreadsheet shows what I ended up with in terms of asset classes. One axis has the geographical breakdown and the other various types of holdings within them. All these are based on the wealth of accumulated finance research that shows these various groupings tend to move differently and so provide the benefit of diversification, namely increasing returns and lowering volatility. In the end there are only eight separate holdings, adhering to the objective of keeping to ten or less. I had wanted to include some international and US small cap and value holdings but they are not available to a UK investor and so ended up with European only. On the property (real estate) column I debated whether to include UK and/or US and ended up with only the global holding, partly to keep the number of holdings low and partly not to duplicate assets because the friend owns a house here and thus already has a large UK property investment.

My biggest uncertainty lies with the appropriateness of the percentages allocated to each asset class. Finance theory indicates that one should hold assets in the proportions that they occupy within the total global market. That would lead one to the proportions shown in Efficient Market Canada's article on Building a Globally Efficient ETF Portfolio or in see this presentation by Alejandro Echegorri citing Brinson Partners data. However, when I looked at sources of top professionals like the Index Fund Advisors, no one seems to keep to the market percentages in constructing portfolios. The IFA portfolio most comparable to the one of this UK friend (that's one with a 55% equity allocation) has a 39% US equity allocation compared to the 22% that US equity occupies in the total investable world capital market. In his book All About Asset Allocation, Richard Ferri recommends anywhere from 25 to 40% US equity allocation. There always seems to be a home market over-weighting. Most people seem to do that, including me in my own Canadian equity over-weight portfolio, but is that actually logical?

In the end, I just took round numbers, no less than 5% in each category, keeping the core total market asset classes large and the others small on the general pattern of the portfolios I have seen, like those mentioned above (imitation is the sincerest form of flattery, no?). Part of the reason for rounding up to 5% is also to make a reasonable size investment so that future re-balancing doesn't end up dealing with tiny amounts that would get chewed up by trading costs.