Financial Literacy Proposals - You Gotta Be Kidding!

Amongst the less-than-sensible ideas floating around these days is the notion that the general population can be sufficiently trained to successfully manage on their own all their finances, investments, pensions and the like. There's even a national task force doing the rounds of consultation to come up with a strategy.

There are two big reasons that proposals to improve financial literacy don't make sense:

1. It's not knowledge, it's behaviour that is the key problem people have - not saving enough and taking too much debt results more from lack of judgment and self-control not from knowing the difference between simple and compound interest. The large and growing body of research on behavioural finance shows that the main impediment to financial and investing success is the irrational decisions we are all too prone to make. I do believe it is possible to train people to a certain degree - some people being more naturally capable of being trained, just like some people learn to play golf faster than others, even with lessons. However, I seriously doubt that the task force will be going down that path (unless somehow the "skill" they define as being part of financial literacy means the ability to manage their own reactions, impulses, fear, greed, over-confidence, framing errors and all the other quirks, foibles and thinking errors identified in behavioural finance).
2. It is rocket science - whenever people give out simplistic financial advice it reminds me of simple instructions for playing the clarinet "just blow in the top and run your fingers up and down the holes". Modern finance is not simple. Part of the cause of the credit crunch and financial crisis is apparently that the executives of the banks did not themselves understand the models and products concocted by the math and physics PhDs. Look at the random page below from the book The Calculus of Retirement Income by Moshe Milevsky one of the few dozen people on this planet who properly understand how pensions work. I don't know about you but I have an MBA in Finance, I have spent the last three and half years reading and blogging about investments and personal finance and I estimate it would take me about another two years of hard work to relearn math sufficiently to really understand what he has written.
   

Noted author William Bernstein writes in his latest book The Investor's Manifesto: "I have come to the sad conclusion that only a tiny minority will ever succeed in managing their money even tolerably well." By managing their money, he means the ground-up type of DIY investing that is assumed when the leaders of our society foist defined contribution retirement plans and RRSPs upon us and pretend that we will be fine with a little "financial literacy" i.e. technical knowledge of finance. Bernstein does propose some relatively simple methods, imperfect but much better than what happens now, but I doubt they could be adopted as public policy education goals due to their bias in favour of some specific industry products like index funds and against others like actively managed mutual funds that are perfectly legal though harmful to the investor.

So what could and should be done? First, I believe the government should undertake public behaviour modification in favour of saving more and borrowing less. A societal attitude change is necessary - like anti-smoking and anti-drink driving. Second, proper retirement income reform that considers first and foremost the income needs of retirees along with the risks they face in retirement needs to happen. I'll post more about that tomorrow.

Cap-Weight vs Fundamental: Live Realistic Portfolio Showdown

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

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

Here is how these portfolios will operate:

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

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

Canadian TaxPayers' Ombudsman Office

Fellow blogger Michael James' post today about his hassles with the Canada Revenue Agency reminded me that I received an email recently from a relatively new government service for aggrieved Canadian taxpayers - the Office of the Taxpayers' Ombudsman.

Here is a chunk of their email to me:
"Canada’s Taxpayer Bill of Rights was expanded in 2007 to include eight service rights. Mr. J. Paul Dubé was appointed as Canada’s first Taxpayers' Ombudsman in February 2008 to uphold these eight service rights by ensuring that taxpayers get professional service and fair treatment from the CRA.

In that light, the Office of the Taxpayers' Ombudsman plays an important new role by providing independent and impartial reviews of complaints about how the CRA serves and treats taxpayers. The Office also addresses systemic problems that affect large numbers of taxpayers.

Attached is an electronic version of our Interim Report as well as our first Annual Report. As they demonstrate, the activities of the Office of the Taxpayers' Ombudsman have already resulted in a number of disputes between taxpayers and the CRA being resolved. It provides a few examples of the types of cases in which we have made a difference in the lives of taxpayers. As a result of our intervention, the CRA has:

* issued apologies;
* released bank accounts they had seized;
* cancelled penalties and interest they were charging;
* reviewed some of its internal policies and procedures; and
* in some instances, ended collection activities.
...
Additional information is available at: http://www.taxpayersrights.gc.ca/mssg-eng.html." The complaint form can be downloaded here.

Two of the New BMO ETFs Worth a Look

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

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

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

Guest Post: Money Advice by a Six Year Old

Grandson Jack has been over visiting lately and we got to discussing my blogging. He offered to help me write up some financial advice and here is what he came up with:

"Put lots of pounds [Jack lives in Scotland] in the bank to have money for holidays, for a car, for a big castle house, for a laptop, for a football, for a caravan. If you have money you can buy a telly.

If you do not have money, you can't buy anything. You need money to get a radio.

You can't get a house if you don't have any money. If you don't have any money you will have a tough life, my mom says. You can't get a book like this popular book if you don't have any money.

If you don't have any money you would be poor. If you are poor you could ask somebody to help you in your life. A job would be a good way to earn money.

If you would like money you would have to stick in at school.

Chapter 6 if you would like money and you would like to earn money.

You would have to get a very good job. If your job was very good you would have loads and loads of hundreds of pounds. If you would like hundreds of pounds you would have to work very very very very very very hard at school."

This eminently sensible advice leaves me with these thoughts:

• if a six year old knows the basic realities of money, probably most people do too - the basic problem is motivation and getting yourself to do the right thing
• keep your ears and mind open when kids are around - they can come up with good ideas too
  

Cap-Weighting Problem - the Market Overpays for Growth (and by a lot)

Two recent fascinating papers in the Journal of Portfolio Management - Clairvoyant Value and the Value Effect and Clairvoyant Value II: The Growth/Value Cycle written by Robert Arnott, Feifei Li and Katrina Sherrerd at Research Affiliates - effectively knock the "wisdom of the market" in pricing stocks. The papers take a time-traveling investor back to 1956 and give him perfect powers of foresight (thus the word clairvoyance in the title) to know exactly what actual cash flows, mainly dividends but also buyout premiums upon takeovers, the companies of the S&P 500 would have distributed from 1956 to the present day (1956 was chosen because that is when the S&P data starts). The reasoning is that a company is ultimately only worth what it gives back to an investor. A 1956 investor with perfect knowledge of the future (at least up the present) would only have been willing to pay the discounted net present value of the cash flows, which includes the price today as the best available terminal value. The second paper examines whether the 1956 start date somehow was unique. It was not - in the long term of 20 or more years the market is always shown to have overpaid in terms of realized value.

Note that the authors all work at Research Affiliates which sells its fundamental indexing methodology for weighting stocks in a portfolio, claiming this this does better than cap-weighting (and which, to give full disclosure, I too am convinced is a better method, to the extent of switching from cap-weighting to such investments myself). Unless they have fudged the numbers, which I doubt, and unless their reasoning of using discounted actual cash flows to establish realized value is wrong, the results must be accepted.

Some of the results (using JPM page numbers in the pdf):

• the market consistently picks out which companies will grow faster, better even than a strategy based on weighting on company size fundamentals, but the market really overpays for that growth - by about 50%! (p.24, paper 1)
• this conclusion holds for the vast majority of starting years from 1956 forward - for 20-year forward views of future cash flows, only in the three years 1964-66 did the market underpay for growth stocks (those defined as having multiples of metrics like Price/Earnings, P/Sales, P/Dividends, P/Book value)
• but, "It takes a long, long time for the market to correct pricing errors relative to Clairvoyant Value, because Clairvoyant Value cannot be known for a long, long time." (Clairvoyant Value is the value the prescient investor would have been willing to pay) (p.148, paper 2)
• the over-payment for growth stocks is the same whether the company is large or small (p.149, paper 2)
• the spread for over-payment is getting worse in recent years, not better (p.149, paper 2)
• a portfolio based on the economic size / fundamental weighting of companies doesn't do nearly as well as the portfolio based on clairvoyance, not a surprise given that the clairvoyance value is based on perfect foresight of future cash flows, but it does substantially better than a portfolio based on cap-weighting (p.151, paper 2); the annual return difference of company size weight vs cap-weight is 1.3% according to exhibit 4, paper 2
• "... a Cap Weighted portfolio puts the majority of money in stocks that subsequently prove to have been overvalued." (p.155, paper 2)
• the amount of overpayment for growth stocks and underpayment for value stocks has varied considerably through time i.e. there have been bubbles! When the gap between growth and value is the highest, that's the time to invest in value stocks since their returns will be much better in the subsequent time. The converse is true too - when there is a very small gap between value and growth, it is time to buy growth stocks since they are destined to do much better in the for some time following. (pp.155 and 156, paper 2)
  

To me, it all adds up to more evidence against cap-weighted indexing as an investment strategy. Put your money in a cap-weighted index and you will suffer long-term under-performance compared to RAFI or other non price-biased portfolio selection methods. It is a shock for those who believe that the market is on the whole right to learn that the market for the past 50+ years has been over-paying for growth stocks in a chronic, virtually continuous, general, excessive and non-accidental manner. And, it seems to be getting worse, not better. Caveat emptor.

Beware the M2 Credit Card

I got caught out! Here is what I learned the hard way about credit cards and interest charges on late payments.

Mea culpa, through simply not paying attention, I was a day late paying the full balance. Of course, that means interest is charged and not just for the one or two days that payment was late but for the whole time since the purchase date up to the payment date. That hurts, especially considering the usurious interest rates (mine is 19.5%) charged by the card companies, but hey it was my fault. Note to lawmakers and regulators - why is it impossible to set up a pre-authorized chequing payment for the full card balance on the due date so that late payment charges cannot happen at all?

What really aggravates is the gratuitous punishment applied by M2 type credit cards. Read this excerpt from a typical cardholder agreement (in this case a TD Visa card):

"You will lose your interest-free status on all Purchases and fees if we do not receive payment in full of your Balance by the Payment Due Date shown on your current statement. We will then charge interest on all Purchases and fees that appear on that month’s statement as well as all new Purchases and fees. Interest will be charged on the amount owing to us from the transaction date until that amount has been paid in full."

In other words, those words I highlighted in red mean that not only do you get dinged for the purchases on which you missed the payment, but also for purchases afterwards during the next billing period and until you pay the next full statement amount by the due date. Nasty! It's akin to being stopped for a speeding ticket and then being given another ticket for stopping in the wrong place on the roadway.

It does not help, once you know you have missed the payment date, to pay extra to cover the interest on the late payment. That does not stop new interest being applied. If you have paid late, the only fix is to stop using the credit card for the next billing period, or perhaps to make one tiny purchase on the card so that you have something to pay off in full, on which you will be charged a small amount of interest for sure but that will get you through the punitive cycle at minimal cost.

Which cards apply this crafty (if it took an hour on the phone for the Visa customer service rep to herself find out how this works and to explain it to me, what hopes does a consumer have to understand what they are getting into?) and nasty method, you ask? Pretty well all of them is the answer. The Financial and Consumer Agency of Canada publishes detailed comparison tables of all the credit cards here. In the table, look for the code M2 in the column Grace Period on New Purchases. All the major banks - TD, Royal, BMO, Scotia, CIBC - apply M2 across the board, except for National which uses the much fairer M1 method. The M1 method, as another excellent FCAC publication Getting the Most from Your Credit Card explains here, only applies interest on the late payment purchases and not on subsequent new purchases. M1 cards are also available from some other smaller banks and credit unions so check the tables and shop around. Another note to lawmakers and regulators - when next you think of ways to reform credit card practices I'd like to see the M2 method banned.

Interestingly, when I called to ask about the second set of interest charges on the new purchases (the M2 stuff), the TD Visa customer service rep very quickly cancelled the second interest charges citing the fact that I normally pay off the card balance in full. So, if you are in the same situation give them a call and ask.

Update Nov.1, 2010 - Good news. Apparently M2 has gone away - according to the Financial Consumer Agency of Canada website, footnote 5, M1 applies to all cards across Canada as of Sept.1, 2010.