US Value Indexes - If it Ain't Broke, Don't Fix It

A comment was left on my posting The Slippery Meaning of Value in ETFs and Indexes stating that there was a problem in 2000-2002 that revealed the weakness of the simple price/book metric used by S&P for its Value indexes, which led to the inclusion of all sorts of other metrics to better assess 'value' by Russell, MSCI, Morningstar and Dow Jones/Wilshire. The comment concluded that I should compare the Russell with the S&P ETFs to see how the S&P underperformed compared to them and to the index. So here are some comparisons based on charts from Yahoo.

Large Cap
Both IVE, the iShares S&P Large Cap Value fund, based on the p/b metric, and IWD, the iShares Russell 1000 Large Cap Value fund, based on all sorts of other metrics, far outstrip the S&P 500 index, though the Russell is ahead during the period 2000-2002 but pretty well only during that period. see this first chart.







Small Cap
Again, both IJS, the iShares S&P 600 Small Cap Value fund, the one based on the p/b metric and the IWM iShares Russell 2000 Value fund (the small cap fund most comparable to IJS) outstrip the S&P 500 index. IJS outperformed IWM particularly in the 2000-2002 period. It is interesting that IWM tracks the overall market value index IWW, the Russell 3000, much more closely than IJR. see this second chart.







What does all this tell us? First, in the grand scheme of things, the seven years from 2000 to today isn't very long, so any conclusions are rather tentative. Second, both the large and small cap iShares ETFs seem to have return streams significantly enough different from the overall S&P 500 to make them useful diversifiers, as do the Russell funds. Third, the divergence of the large cap version IVE seems to have been temporary and confined to the period 2000-2002. Fourth, the similarity of performance of IWM and IWW seem to make IWM less useful as a diversifier for small caps.

Overall, the iShares value ETFs, using the original value measure of price to book ratio as uncovered in financial research, seems to have done the job, especially for small caps, though less so for large caps. In that light, why develop all these fancy, complicated alternate measures of value, none of which are proven in the long term?

Government Appoints Untested Bank of Canada Governor

Anytime I see the words whiz kid and Bank of Canada Governor in the same sentence I start to worry, especially when the terms refer to the same person. Indeed that is the exact language used on the CBC website news item to describe the Canadian federal government's new appointment to be Governor, a fellow named Mark Carney. He is 42 years old and finished his studies with a doctorate in 1995, which by my arithmetic, gives him about 12 years of work experience. Apparently that qualifies him for the most senior and responsible financial post in the country, one charged with controlling the monetary policy and keeping inflation in check. Where are the accomplishments that have formed his judgement, nurtured his wisdom, taught him when to be cautious or do nothing and when to be firm and bold? Where are the hard times and struggles he has been through that show he knows to persist, that he knows to survive and to keep faith in adversity? Perhaps he will be good or even great but isn't it a kind of big risk? Why does Canada need this now? What was wrong with the bar that it needed raising according to the search committee quoted in the above news item? Carney himself was quoted as saying that the Bank of Canada has one of the best reputations in the world among central banks. Isn't a ''steady-as-she goes'' type of governor what we need, given the satisfactory control of inflation? It's a bit hard to figure what Minister Flaherty was thinking in making the appointment. Huh? ... My investment portfolio is diversified and will remain so.

Individual Investors Can Outperform

All you do-it-yourself stock investors out there, take heart and smile!

''We find that a sizeable fraction of all individuals that are active in the stock market
are able to consistently outperform the market.''

The above surprising and welcome conclusion comes from the recent research paper Performance Persistence of Individual Investors, written by Limei Che, Oyvind Norli and Richard Proestley of the Norwegian School of Management. The paper was presented at the Northern Finance Association Annual Meeting, that took place Sept.28-30, 2007 in Toronto, hosted by the Schulich School of Business of York University. You can download the original paper from the Schulich site for the conference. Click on the program pdf on that page. The link to this and all the other papers is within the pdf. A big thumbs up to Jonathan Chevreau for posting about the conference on his blog.

The image and the conclusion of individual investor incompetence, admittedly documented by impartial studies (which are cited in the paper; also, see references in books like What Kind of Investor Are You? previously reviewed in this blog) and constantly reinforced by the financial industry who want us to use their services, is not necessarily true. Now, it is possible that only individual investors on the Oslo stock exchange (those studied in the paper) are smart enough to outperform the index by a country mile and that Canadian, German, Chinese, US, UK, Japanese etc investors are stupid and rash......

Here is a chunk of the paper's abstract with more of the good news:
''We find that a substantial number of investors exhibit economically and statistically significant performance persistence. This is robust to how we measure past performance, how often investors trade and whether investors are small or large. Unlike the evidence from mutual and pension funds, the persistence in performance we uncover is not concentrated in investors with poor prior performance. We also show that forming a portfolio that is long in stocks previously favored by top performing investors earns a substantial risk adjusted return in the future.''

The outpermance is persistent too - i.e. it last for several years, unlike results for mutual funds and pension funds, whose outperformance, when it does occur, tends to quickly go back to average or under-performance, which is why chasing last year's hot fund is a formula for disappointment.

Maybe there's a market to be developed here? It's also well-known that stock newsletters and forecasting services don't do well on predictions. However, the missing ingredient might be the ''putting your money where your mouth is'' factor. Someone who publishes their own portfolio has laid their fortunes on the line and those who are proven to be good at it, if this paper's conclusions can be generalized to other markets, have created something of value.

As for me, I'm sticking for now with the cautious average of ETF index investment. No doubt, those individual investors who do outperform must spend considerable time and effort to make their stock choices.

Financial Books & Reviewers Extraordinaire

For those like me who like to read and find out how little they truly know about finance, you might like to know about Gaetan Lion, a fellow who has reviewed no less than 318 books to date on Amazon.com. His tastes are eclectic but many reviews are about financial and investing books. His reviews are sometimes lengthy but well composed, perceptive and exacting in their criticisms and praise. He's worth reading to cull the gold from the dross.

Another source with an extensive listing of vetted investing books is the Canadian Bylo Selhi, whose website is also permanently linked from the sidebar of this blog. Though he doesn't actually review the books, given the sensible and and well-reasoned analysis he provides, I'd expect to find a lot of high-quality books on his recommended list.

Question on Bond ETFs Doing Poorly

A reader asks: ''Interested in any comments you might have on XBB & XSB bond ETF's. Performance has been poor this year even with dividends.''

You are right, the performance of both has not been very good, barely keeping pace with inflation over the past year at around two and a half percent total return (for details see the Fixed Income list at iShares.ca product page). That's the reflection of the usual pattern - when interest rates rise, as they have, bond prices go down and so the market value of XBB and XSB suffer. If interest rates remain stable, the yield of around 4 to 5 % will re-establish itself as the bond return. Though the returns haven't been good, I'd still consider them a good long term investment as part of a diversified portfolio with equities. I don't actually own any myself since I have been buying individual bonds, which have also gone down in market value.

If equities are having their day now, bonds will again have theirs sometime. Compared to bond mutual funds, the iShares XBB and XSB have lower MERs so from that perspective they give you more. And they are passive index trackers, rather than active managers, which most bond mutual funds are. That's another advantage of XBB and XSB.

Meantime, you can keep receiving the cash distributions (not technically dividends but interest income when it comes to tax reporting). If you treat them like I do as part of a portfolio, come rebalancing time if they are still down in value and less than their target percentage of your portfolio, I'd sell some equities and buy more XBB and XSB to get back up to the target. I call it the autopilot ''sell high, buy low'' strategy.

Thanks for the question Patrick. Best of success with your investing.

Credit Card Negligence

Yesterday, I was checking my credit card balance and transactions using Visa's automated telephone system and noticed a charge of $1600 from Air Canada that I had not made. A worried call to the TD Visa security center and a review of recent transactions suggested that it wasn't fraud but negligence, both on Air Canada's part in submitting the charge under my card number and on Visa's part in accepting the charge with - obviously - insufficient validation.

Air Canada does not have my card details on file. The Visa rep could not tell me what actual validation took place, though I know it can have only been to accept the card number presented, i.e. no expiry date, name of cardholder, address or other details was required by Visa. Air Canada could not have had the full details, even using Aeroplan, since the card details that were stored on Aeroplan (not any longer, since they've now been erased ... at least, I think so; who knows whether Aeroplan has kept them anyway) included an old expiry date. So any transaction that would have referred to Aeroplan would have had the wrong expiry date and the transaction would/should have been rejected by Visa. Ironically, yesterday I did try to make a booking on Air Canada through the Internet using Aeroplan's old card details / expiry date and Visa rejected my genuine attempt to book on Air Canada.

The Visa ''I only deal with fraud'' rep then blithely told me it was my ''dispute with the merchant'' and I had to get in touch with Air Canada to get my money back. There was no question of simply cancelling the charge, even despite the fact that the charge is so recent that it hasn't appeared on my current balance due statement.

Huh? How does this happen? Any merchant with an account with Visa can simply supply your card number and Visa will stick any charge up to your credit limit on your bill? And on top of that, the error which you had no part in creating is one where you must chase after the merchant to get a reimbursement? Apparently so.

TD Visa's published security advice on this matter is vacuous and insultingly misleading:
''Check your monthly statement carefully and report billing errors to your credit card issuer as soon as possible and always within 30 days of the statement date.'' They neglect to add, ''so we can tell you to go fix them yourself.''

Incidentally, the incorrect charge by Air Canada was apparently a telephone transaction, not one via the Internet, so it isn't a question of online security. I learned this by contacting TD Travel Rewards, the travel agency connected to the TD Visa card, which I had phoned in trying to figure out what was going with the charge.

There, fortunately, the rep did help by contacting Air Canada and finding someone there who admitted that the charge was an error and who promised to reimburse my account within 48 hours (fingers crossed that it actually happens). Kudos to Sheng at TD Travel Rewards for outstanding customer service since she didn't have to fix it since the error had nothing to do with TD Travel but knew where to go and extracted the promise to reimburse me from Air Canada. A raspberry to TD Visa for its unfair policy and to rep Jomo for crappy customer service in refusing to do anything about TD Visa's negligence.

The big question is how to prevent this from happening again in future and short of cancelling all credit cards, I am a bit at a loss. Peripherally, it may help a bit to never leave any credit card details on any website or with any vendor. Having as low a credit limit as possible probably would help too but then, with too low a limit, what good is having a card?

Maybe some folks out there have some suggestions? Are some cards better than others or is this endemic to the way all credit cards run their operations? This website describes a system used for large scale fraud that appears to have similar holes to that which caused my problem. It's very scary, especially since the information on the website dates back to 2002 and one wonders if the banks and credit card companies have essentially made any improvements since. Has anyone else had this problem with Air Canada? Are some vendors better or worse than others and is there some list or website that tracks this?

Update September 30 .... Well, haven't I been surprised at the further developments! It turns out the original error was committed by TD Travel who used my credit card by mistake to pay for another family's travel booking. The error was compounded and abetted by both Air Canada and Visa, neither of whom bothered to verify anything beyond the correct card number and expiry date. All that rigamarole we go through as individuals for web bookings to authenticate ourselves apparently doesn't apply to travel agencies. TD Travel say they are very concerned about the slip-up and are investigating their internal processes. They agreed to give me some compensation (in the form of more of their travel points) for all my trouble. The compensation has now been provided, though my Visa account has not yet been credited for the actual ticket reimbursement.

It also turns out that Visa will look into a charge that a customer like me officially reports as not being their own. During several initial contacts, neither customer service nor security at TD Visa
mentioned this facility. Meantime, despite explicit recognition that it was a case of error not fraud, TD Visa still blocked my card for a few days till I phoned them back to ask the block to be lifted.

All in all, none of Air Canada, TD Visa or TD Travel comes out looking very pretty in this incident. We'll see if TD Travel chooses to make a public statement on this blog since I told them I would be writing about the outcome and offered to print their comments, should they have any.

Update Oct. 2 - My Visa has finally been reimbursed so I am ''whole'' again. Whew!

Tax-Free Saving for Children in the UK

What is the best way to save for the future for a child in the UK? Recently, that question was put to me by a family member who had seen a TV program in which Martin Lewis of the MoneySavingExpert has said something to the effect that an ordinary child savings account at a bank or building society could give a higher tax-free return / rate of interest than specialized products such as Child Trust Funds. I decided to take a very broad approach to comparing the options, including using a parent's ISA or other investments like National Savings and Investments various tax-free bonds. It turns out that there are a number of excellent alternatives all offering tax-free saving but which differ considerably according to flexibility, control of the funds, types of risk, likely after-inflation returns, ease of investing or topping up and amount of effort to manage.

Child Trust Fund
Every child born in the UK after September 1, 2002 gets a CTF, courtesy of the government which provides a £250 voucher (plus £250 extra for low-income families) that parents can use to open a CTF account. If you don't bother opening one yourself, after a year the government will open one for your child with the voucher and pick a provider at random, so you'd be just as well do it and choose yourself. The government adds another £250 (plus £250 again if eligible) when the child reaches age 7. You have a choice of one of three types of CTF available - 1) a savings account with a bank or building society, 2) a stakeholder equity account and 3) a self-select equity account. You can change from one type of CTF to another later on without penalty.

The CTF ''wrapper'' imposes certain common rules that should be considered when deciding how much of the savings for the child should be deposited in it. The first is that the funds are locked in till the child is 18 and cannot be withdrawn, not by parent nor child. The second is that the funds belong to the child, not the parent (or the government). At 18, the child can do absolutely whatever he/she wishes with the money. If you have doubts about whether the child will spend the money wisely at 18 and blow it all on frivolities, then you may want another type of vehicle. On the other hand, isn't part of your job as a parent to teach your kids how to handle money properly? They can't be children forever.

One additional good thing about the CTF is that the child can choose at age 18, when the account must be closed and the funds paid out, to transfer the whole amount into an ISA, which allows it to continue to grow tax-free. Given that the balance in the CTF may have grown far above the annual contribution allowed of £7000 for an ISA, that provides a way to avoid feeling that the money must be spent immediately. Perhaps the 18-year old will want to save further for a house purchase.

In other words, the CTF is meant to be a long-term savings vehicle. If you think you might need the funds before then, you should use another tax-free savings method. To my mind, the CTF should not be invested in a savings account, whose chief merit is to be safe from loss / decline in value in the short term, but whose long-term return is minimal after inflation. Instead the CTF should be in equities of some sort, either the Stakeholder account or the Self-Select. As I described in a previous post on Stakeholder CTFs, all such CTFs are invested in some form of UK Index Tracker Fund. F&C's is the best of the lot since it has slightly lower fees (1.22% per annum vs the usual 1.5%, which is the legal cap on this type of CTF). You don't have to watch the stock market and worry what to do since you are just getting the UK market average, a very good thing for busy parents who don't have the time or inclination to be an investment expert. In fact, it's best to ''file and forget'', ignore the market ups and downs, just let it grow on average over a long period as equities show their long-term superiority over savings. The Stakeholder CTF is the ideal way to have a no maintenance investment in equities for amounts up to perhaps £2000. Above that, a Self-Select Share Dealing CTF offers the opportunity for lower overhead costs and better diversification. My preferred choice there is Self-Trade due to its zero annual account admin fee, though The Share Centre is a close second because of its low trading fees. Why diversification? The UK is not the only market in the world and good investment practice is to include holdings from around the world and in other types of assets such as real estate. The Self-Select CTF accounts offer the ability to invest in any type of equity, or bonds available on the UK market, though I am partial to ETFs ( and not OEICs or other types of actively managed funds). There is apparently now even a shari'a compliant CTF for Muslim parents. I would put all the CTF money into equities and not any into bonds or cash-type fixed income since the other types of tax-free vehicles below can meet those needs and provide total portfolio balance of equities and fixed income. The chart below shows the detail of the terms and conditions.



Individual Savings Account (ISA)
An ISA is another tax-free account wrapper that enables various types of savings and investments free of income or capital gains tax. It is really a product for adults - you must be at least 16 to have one in your own name - but parents can use their own annual allowance of up to £7000 to save for the future needs of their children or themselves. The funds within the account are under the complete control of the parent/adult and can be withdrawn at any time. The money of and for the child is mixed in with the adults' own money.

Normally, this shouldn't be a problem, unless the parents themselves are spendthrifts and cannot save or unless a situation like a marital break-up complicates matters. Grandparents, other relatives or friends who may wish to contribute may feel more comfortable giving money to a child when it is clearly in his/her name. Better, I believe, to establish a formal and psychological barrier between what belongs to the child and what is the parents', i.e. not use ISAs at all for children. Anything invested for the children reduces the amount that parents can save tax-free for themselves. In any case, the £250 government voucher cannot be put into an ISA, only into a CTF.

ISAs from different institutions offer the same range of investment alternatives as CTFs - everything from bank and building society savings accounts, to investment funds, to self-select investment accounts. An additional player is National Savings and Investments, which offers two types of mini cash ISAs (whose annual contribution limit is £3000). The one in the table below on the best ISAs, shows the higher-yielding alternative, the Direct ISA, which can only be managed by phone or on-line. The other one, the Cash Mini ISA, currently pays about a percent less at 5.35% but it can accept additional contributions of as little as £10 at a time (vs £100 or £250 for the Direct ISA), better for those of more modest ability to save.



Child Bonus Bonds and Index-Linked Savings Certificates
These two investments are available only from National Savings and Investments, a government agency that started out as the Post Office bank (which explains why Post Offices in the UK display racks of NS and I brochures). Both types of investment are automatically tax-free. Both belong legally to the child and in-trust forms are available for non-parents to buy the bonds for children under 7. It is interesting that the Index-Linked certificates can be controlled by a child 7 or over ... hmmm, imagine a 7 year-old with £15,000 under his/her own control.

Both are better considered for medium-term three to five year investments. Though the funds are not locked-in and can be withdrawn on demand, interest is not earned at all or is considerably reduced if the funds are withdrawn early. A week ago, it might have been said that the direct backing of the government provided extra protection from loss than other bank accounts, but now that the Northern Rock debacle seems to confirm that no bank depositors will be allowed to lose their money, that seems to be a moot point.

The interest rate offered is almost identical - 5.1% vs 5.15% - but the index-linked certificates offer a guarantee that they will beat UK inflation by 1.35%, not a lot, but that eliminates the major risk of fixed rate investments, that inflation will reduce their value in real terms. I think I'd rather have the Index-linked Certificates. The table below gives the details of these two savings alternatives.


Child Savings Account at Bank or Building Society
Yet another alternative is to open an account in the name of the child at a bank or building society. Very many, if not all, such institutions offer them. The advantage is that most often a higher rate is offered. In the quick search for the best rate from the MoneySavingExpert's website, the Chelsea BS had the highest the day I did it, but it can and does change almost constantly and that's the problem. Unless you are prepared to be checking the website and changing banks frequently, a hassle in itself, you wouldn't be getting the absolute best rate for long. On top of that, at some point down the road, the bank/BS might just drop the rate without notice, a point that MoneySavingExpert warns about. There's also a limit of £100 interest per year that the child can earn from a parent's gift (the idea being to quash parents hiding their own savings in children's accounts), which equates to about £1600 max in the account. In order to avoid tax being deducted automatically (at a tax rate of 20%) from the interest earned on the account, you must fill in form R85 (said to be normally available at the bank branch) and send it on to HMRC, which is a bit of extra work, though only needs to be done once. Despite the complications, such an account may still be a valuable tool for a child to learn how to save and spend money under his or her own control. The table below gives details of a Child Savings Account.


Bare Trust
Not to leave out any, another option is the bare trust which is, in the definition of HMRC:
''A bare trust, also known as a 'simple trust', is one in which each beneficiary has an immediate and absolute right to both capital and income. The beneficiaries of a bare trust have the right to take actual possession of trust property.

The property is held in the name of a trustee. But that trustee has no discretion over what income to pay the beneficiary. In effect, the trustee is a nominee in whose name the property is held. The trustee has no active duties to perform.''

The child is the beneficiary and gets taxed at his or her rate on dividends and capital gains, which is usually lower than the parents'. The £100 limit on interest income from funds donated by each parent applies to a bare trust as well so the maximum benefit accrues when non-parents donate funds for the trust. Bare trusts are used to reduce inheritance taxes and are most appropriate when many thousands of pounds sterling are involved given that professional legal and accounting advice to set things up correctly is highly recommended e.g. see this UK DirectGov website on trusts.

Since the alternatives are not mutually exclusive, I tend to feel that the best course of action is to spread things around and utilize several simultaneously.

Other Websites with Useful Info
BBC.co.uk - see Savings and Investments in Your Money section
SavingforChildren.co.uk
Child Trust Fund Official website