Canada Falling Back in World University Rankings

The Times World University Rankings for 2010 are out and it is not good news for Canada.

Last year 11 Canadian universities were amongst the top 200 ranked universities in the world. This year only 9 made the list, which uses a supposedly improved methodology that puts less weight on reputation and more on more measurable harder facts. A bunch got dropped and a couple of new names entered the top 200 from Canada. The list:

• U of Toronto - 17th place in the world - up from 29th!
  
• UBC - 30th - up ten spots too from 40th!
  
• McGill - 35th - down from 18th ;-(
• McMaster - 93rd up fifty spots from 143rd!!
• U of Alberta - 127th, down from 59th, ouch!
• U of Victoria - 130th, from nowhere last year!!!
• U of Montreal - 138th vs 107th
• Dalhousie - 193rd, another new entrant
• SFU - 199th, still hanging on after 196th placing last year

Those who fell right off the list into oblivion: Waterloo (2009 - 113th); Queen's (118th), Calgary (149th), Western (151st).

Those who are fond of knocking the USA or predicting its imminent fall may wish to consider that the new rankings indicate an overwhelming dominance by that country in higher education. It dominates in every way: owning the top 5 spots, 7 of the top 10, 27 of the top 50 and 72 of the top 200. That's 18 more in the top 200 than last year! One negative mentioned in this analysis article is that public universities like the U. of California system are suffering from government cutbacks as a result of the debt crisis. Rich private universities like world no.1 Harvard are merely less rich.

The UK has held its own with 29 spots in the top 200, the same as last year and it has the other three in the top ten.

Though Canada's position has fallen back relative to the best, I would not want to be a citizen of much larger countries than Canada that have fared very poorly in these rankings such as Japan with only 5 spots, France with 4, and Italy with not a single university among the top 200. In the national "medals table" (see here) Canada is 5th after the USA, the UK, Germany and the Netherlands.

Amongst countries of the emerging world, China is already in the top class - including Hong Kong and Mainland China together, it would be tied at 10 spots with the Netherlands. The other members of the BRIC - Brazil, Russia and India - do not have a single top 200 university, though the Times editors feel India is on track to muscle into it soon, while Russia is in decline. It is an interesting thought relative to investment prospects for these countries given the key role universities play in economic development.

There is competition not just amongst universities, but between rankings too. After a combined effort in 2009 (the one which is used above to compare), QS and Times have split. The QS 2010 Rankings paint a slightly different overall picture, though Canada has also fallen back in this set of rankings. There is one less top 200 spot - SFU has slipped down to 216th and all but one (U of T) have slipped lower. In QS' results, the number one spot is held by Cambridge, the UK has 4 of the top ten, the US has fewer overall in the top 200, only 53 total, which is down one from last year.

The QS rankings are interesting in that they go right down to the top 500. Being down there is not so shabby, even for bottom-feeders like Carleton, Concordia and U du Québec considering that there are said to be more than 17,000 universities around the world.

TD Waterhouse Offers International Trading - Partly Good, Partly Bad

The news that TD Waterhouse (hat tip to Wealthy Boomer Jonathan Chevreau's post today) is offering the ability to trade directly on major international stock exchanges is mostly good - international diversification becomes a little easier. Canada is catching up to the UK, where TDW has offered such a service for years now.

I guess the small matter of the financial crash of 2008 somewhat delayed the implementation of TDW's intention announced by the Globe and Mails's Rob Carrick as I posted about two years ago, almost to the day.

But TDW is charging too much. Why is TDW charging Canadians £29 commission per trade (see TDW Canada Online Commissions and Fees) for buying shares in the UK when TDW UK's commission is less than half at £12.50 (rate table here)? The same higher cost applies to the other foreign markets too. Give us a break TDW!

Update Sept.16: TDW says blandly in an email reply to my enquiry that the higher commission fees in Canada are "...reflective of the greater underlying costs..." and that they are "competitive". I guess the Canadian operation of TDW isn't as efficient as it is in the UK. TDW also says the online Global Trading capability cannot be used in registered accounts, another difference with the UK where it is possible to trade on international exchanges in the similar ISA account.

Investment Banks and Hedge Funds: the Bubble of the Past Quarter Century?

The Credit Bubble leading to the Crash of 2008. Who profited and where did all the money go? That's a question I have been asking myself since 2007 and the start of the credit / financial crisis. The answer I now believe is a) employees of investment banking; b) managers / employees of hedge funds; c) shareholders with stakes (i.e. whether as separate entities or whose profits flow up to a parent entity) in investment banking and hedge funds.

The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."

In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of WhereDoesAllMyMoneyGo.com for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the Advisor.ca website - N.B. I have added to Research Affiliate's chart the red Bubble line)

The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.

When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.

I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.

What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:

• USA - in Vanguard's Market Cap VTI, Financial Services = 16.4% as of 31 July 2010 vs Powershares RAFI PRF = 20.9% as of 31 Aug 2010
• Canada - iShares TSX Composite XIC = 29.6% vs Claymore Canadian Fundamental Index CRQ = 45% as of 3 Sep 2010
• World - Vanguard All-World ex-US VEU = 25.8% as of 30 April vs PowerShares Developed RAFI ex-US PXF = 28.9% as of 3 Sep 2010
  

Regulators will impose new regulation to control and to deliberately reduce the size of Financial Services (as the Paper of the Year post reports, regulation is the only thing that effectively controls the size of the sector, not market forces). But the authorities don't know how much to reduce -
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".

And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at FT.com, others at FT.com, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).

It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.

Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.

Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.

Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.

iShares XTR Changes from Passive to Active

The steady disappearance of the income trust sector as a result of the looming 2011 federal tax change has forced iShares' hand in an interesting way regarding the now formerly-named iShares Income Trust Index Fund (symbol: XTR). Following a shareholder vote (press release here), the fund's name, strategy and investment objective have changed fairly radically - from passive index tracking of income trusts to active management of any and all income bearing investments under the new title iShares Diversified Monthly Income Fund.

As significant as the change is a non-change - the management fee will remain at 0.55% including, as the press release takes pains to point out, any embedded fees arising from XTR owning other ETFs. Though there probably will be higher costs for XTR shareholders (which we will be able to find out only later when annual reports are issued) from more frequent trading due to active management, I find it refreshing that active management will in this case be associated with low fees, a situation found all-too seldom in Canada. I hope that the modified presence of XTR as a reasonable size fund ($200 million in assets) within the leading ETF provider puts some pressure for change to lower fees in the Canadian fund industry. Maybe the low fee will in itself be good to control excessive trading by XTR portfolio managers - they won't get paid much so why would they bother spending a lot of time on it and as we all know, excessive trading lowers returns.

It looks as though XTR is changing into a fund of funds since it will "... invest primarily in income-bearing Canadian iShares Funds". There may be duplication or overlap with its own iShares Conservative Core Portfolio Builder Fund (symbol XCR, MER 0.60%). As of September 2nd, the XTR fund holdings have not changed away from income trusts so I'll have to check back in a month when Blackrock says it will have completed the changeover to see how alike XTR and XCR may be. XCR is so small, with only $8 million in assets, that maybe they should just fold XCR into XTR.

The S&P TSX 60 Index vs Claymore Canadian Fundamental ETF and Active Stock Picking

Take a look at the holdings of the supposedly passive iShares S&P TSX 60 Index ETF (symbol: XIU) and you will not find a number of companies that I would expect to see based on the philosophy of not actively selecting stocks but simply mimicking the overall stock market according to relative market value or capitalisation. The description of XIU on the iShares website says "The Index is comprised of 60 of the largest (by market capitalization) and most liquid securities listed on the TSX ...". Go into GlobeInvestor, do a stock search of all common stocks, then sort by the handy Market Cap column heading, compare the top 60 there with the XIU holdings and you are in for a surprise.

Missing from XIU are no less than eight stocks listed on the TSX amongst the 60 largest by market cap according to GlobeInvestor as of close of business September 1st:

• Newmont Mining (symbol: NMC) in 13th spot by market cap
• Great West Lifeco (GWO) 18th,
• Power Financial (PWF) 28th
• Boliden AB (BLS) 29th
• Domtar Canada Paper (UFX - that's what GlobeInvestor says, though maybe it should be UFS) 32nd
• IGM Financial (IGM) 45th
• Ivanhoe Mines (IVN) 51st
• Fairfax Financial (FFH) 52nd

Why is this so? The main reason is found not on the iShares website but in the index provider Standard and Poors' Canadian Indices Index Methodology document which states this about the TSX 60 Index: "It has 60 constituents and represents Canadian large cap securities with a view to matching the sector balance of the S&P/TSX Composite Index." If S&P merely followed market cap for the top 60, there would be much heavier weight in the financial services sector stocks. The Composite Index is only 30% financial services so the 60 Index is artificially made to look like it.

That's why such small companies as Inmet Mining and Yellow Pages Income Fund, neither in even in the top 100 by market cap, show up in the 60 Index.

In contrast, another ETF which weights its stocks by size according to fundamental economic factors, the Claymore Canadian Fundamental Index ETF (symbol CRQ), has a substantially larger allocation to financial services - about 45% lately.

For an investor seeking to mirror the sector weighting of the overall Canadian economy, XIU comes closer than CRQ, since Financial services (including two other sectors - Real Estate and Management) make up only 20% of Canadian GDP (2008 figures - see Industry Canada data here).

The fact that CRQ's weighting scheme is based on actual historical accounting data, i.e. hard numbers, shows to what extent publicly-traded stocks in Canada are comprised of the financial industry. Private companies must thus make up a disproportionate share of other economic sectors. The Canadian public market is lop-sided.

For an investor seeking to go where the money is, or has been in the recent past, in terms of dividends, cash flow, sales and book equity, then CRQ comes closer than XIU since that is the basis on which CRQ picks stocks.

But to say that XIU is a totally passive fund, which therefore conforms best to an ideal, is not really true. XIU is not inherently superior to CRQ. Choosing XIU or CRQ comes down to which alternative investment strategy works best - XIU's strategy being based loosely on market cap (which in turn is based on the market's opinion of relative future value) and CRQ's based on past results being maintained in future. Which strategy works best is a matter of practical investigation.

Addendum
Just finished a chat with a very pleasant gentleman at S&P Canada who said that the financial companies in the above list were indeed excluded to keep the financial sector weight in line with the TSX Composite Index. Three others - Newmont, Boliden and Domtar - are not Canadian companies, a criteria which also forms part of the index composition. The last, Ivanhoe, has too small a float. iShares needs to improve its inaccurate summary description to include the fact that aligning to Composite sector weights is a criteria and that only Canadian registered companies, not merely TSX-listed companies, are included in the S&P TSX 60 / XIU.

Star Investment Analysts Lose Their Brilliance When Changing Jobs

The publisher's blurb for the new book Chasing Stars: The Myth of Talent and the Portability of Performance by Harvard prof Boris Groysberg says:
"Groysberg comes to a striking conclusion: star analysts who change firms suffer an immediate and lasting decline in performance." Why does this happen? "Their earlier excellence appears to have depended heavily on their former firms' general and proprietary resources, organizational cultures, networks, and colleagues." I wonder if that also applies to mutual fund and portfolio managers. It could form a handy way to filter out future losers.

Kudos to Simoleon Sense where I found the link.

Weakness of Fundamental vs Cap-Weight Indexing - The Potash Corp Takeover Bid

Those of us convinced of the superiority of an investment strategy using fundamental index (RAFI) funds over traditional cap-weight funds need to avoid the error of merely assuming that all is well and merely look for positive evidence that it works. We need to be on guard for things that might go wrong. My little one-vs-the-other tracking table at the bottom of this blog recently turned from net fundamental advantage red to cap-weight green and it is almost all due to the effect of the Canadian equity component of the portfolio where the cap-weight iShares TSX 60 (XIU) stands against its RAFI competitor Claymore's Canadian Fundamental Index ETF (CRQ). Why, I asked myself?

Potash Corp Takeover Bid
The buyout battle initiated by BHP Billiton for Potash Corp of Saskatchewan (POT) on August 17th caused a typical leap in the share price of POT (see Google Finance chart below). Guess which fund, XIU or CRQ, did better. Yup, XIU did, because of its much greater holding of POT before the formal takeover bid.


Note how the orange line of XIU jumps above the blue of CRQ the day of the bid. POT's weight in XIU has bounced up and down in the past year but the iShares document store shows weights varying around 3.5% through the past year while the fundamental weight has been much lower. On August 19th, after the takeover announcement CRQ still had only a 1.8% weighting in POT, up from 1.4% at the end of March, while POT jumped to 4.6% of XIU.

The media rumour about a possible takeover has apparently been around a long time, judging by this March 2009 article in the Telegraph and this Andrew Willis article in GlobeInvestor from last October, which may account at least in part for the fact that POT has occupied for over a year in XIU a weight far above what is justified by its profitability and other accounting valuation data, which is what CRQ reflects. (Though one wonders what those smart professional investors were doing bailing out of POT just before the takeover bid - note the big price dip through from March to early July this year.)

The moral of the story is that RAFI will underweight stocks subject to takeover speculation and in a restricted market like Canada's where a fairly small number of stocks occupy much of the index, any takeover will have a much more pronounced effect.

However, not all takeover speculation comes to action and not all takeover bids succeed and this one isn't a fait accompli either. (Hmm, slip of the tongue there folks, didn't mean to say that passive index investing involved being part of the market's indulgence in a stock speculation ... or did I? ;-) Maybe POT's price will fall back down. It remains to be seen whether such takeovers are a factor significant enough to invalidate the RAFI strategy but for now, I'm holding steady.