Gold titillation

For all the constant chatter about gold, I had never seen the real thing in such vast amounts - the Bank of England's gold vault in a Wimp.com video. The scene is so weirdly banal. The weirdness is only accentuated by the incoherent  explanation of the reason that the BOE keeps gold.

A Tipping Point in the CPP Expansion Debate?

Surprise and initial disbelief was my reaction upon reading the headline "Canadians should be allowed to contribute more to CPP to ‘reignite a culture of savings,’ urges CIBC chief" yesterday in the Financial Post. But it's true - the head of one of Canada's banks has come out in support of an idea that has been portrayed by some as the stupid notion of an ill-advised anti-business left-wing labour movement but which actually makes a lot of sense (as I have blogged about comparing CPP to RRSPs and the like, in relation to retirees' needs, comparing to the proposed PRPPs). It is quite significant when a major bank head publicly expresses support. After all the banks make a lot of profit from RRSPs, mutual funds and would do so from PRPPs that are the private sector alternative to CPP. So kudos to CIBC and CEO Gerry McCaughey for saying something that may not be in their narrow best interest but which is good for Canada and average Canadians.

A fine but critical point of potential disagreement with what McCaughey said is that the voluntary participation in the expanded CPP should be made the default option i.e. people should be automatically included though they could opt out if they deliberately chose to leave it. That way, just about everyone would be in it. To offer participation as a voluntary opt in, where you have to take action to join, would be next to useless as too few people would join. People need a Nudge as Thaler and Sunstein tell us in the eponymous book.

Disclosure: I own bank shares directly and in ETFs (and so does just about every Canadian in their equity mutual funds or ETFs) and I will be getting CPP, though not any expanded benefits if it is expanded on a pre-funded basis as I believe it should be done.

Pure Dead Brilliant!

Though Scots have a wonderful way with expressions and a great sense of humour, I'm pretty sure the one who first came up with "pure dead brilliant" to describe something fabulous were not contemplating death. But the expression fits perfectly to memorial diamonds.

Yes, Virginia, technology has moved forward and lockets of hair of a dear departed are passé. Get your hair or your ashes turned into a diamond. (no joking, it's a real business as the innovative first company to offer this unique product LifeGem has been joined by others) Forget the complications and uncertainty of reincarnation. Since diamonds are forever you can be present forever.

It's convenient for the living too. No messy ashes that could spill. No having to visit a far away grave, the loved one is ever present on your finger. Just give him or her a wee affectionate rub once in a while. And it's very discreet too, unless you want to brag how the person was a cut above the rest. Not only that, but one person can easily be used to make several diamonds - very convenient for each member of the family to get their very own piece of grand-dad.

Since any dead thing made of carbon can be turned into a diamond, consider also the mixing & matching possibilities - gran and grand-dad united forever, mom and her favourite cat etc.

Perhaps the only downside is the obvious one mentioned by lawyer Ian Hull, on whose blog Toronto Estate Law I found this idea. You could lose the diamond! (Sure hope there weren't any amongst the gigantic heist today at Brussels airport).

Fundamental vs Cap-Weight Portfolio: Still Very Close after 2 and a Half Years

Early in 2010 I became convinced that indices based on fundamental accounting numbers made more sense as an ETF investment strategy than the traditional indices based on market capitalization. The research seemed convincing but would real world investing see the same results I asked myself. To try answering the question, in June 2010 I created two parallel portfolios with the same initial pretend capital of $100,000 and the same asset class breakdown to pit ETFs based on each type of index in a head to head battle.

Past updates on the contest:

• June 2010 - initial post with all the portfolio rules
• August 2011 - Cap-weight portfolio ahead by 0.4%; both portfolios up about 10%
• March 2012 - Cap-weight portfolio ahead by 0.07%; both are up 16% in total

Today (see bottom of this blog page for the Google spreadsheet with details of the current portfolio):

• Cap-weight still ahead in total by a slight 0.5% 
• Both have gained over 22% since inception
• Every asset class / ETF holding has made gains
• Asset class gains are unequal as expected but none has yet gone beyond the automatic rebalancing rule of a quarter deviation over/under its initial share (e.g. a 5% holding going above 6.25% or below 3.75% of the total portfolio)
• In some classes the cap-weight ETF is ahead, while in others it is the fundamental index ETF

Recent Substitution trades

• In May 2012, the fundamental ETF PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) replaced the iShares Canadian Fundamental Index Fund (TSX symbol: CRQ) since it tracks the identical Canadian equity index but has a much lower MER (see post discussing the two)
• In January 2013, the commodity ETN UBS Bloomberg Constant Maturity Commodity Index Total Return ETN (UCI) replaced iPath DJ-AIG Commodity Index Total Return (DJP) because of what I found out in this post on my other blog, basically that UCI employs a much superior futures rolling method)

Bottom line

• The jury is still out with such a tiny total cumulative difference, though I am a bit surprised the fundamental side isn't pulling ahead. 
• Having a portfolio with a mix of asset classes really works well - note how the total portfolio is up 22+%. By comparison, the TSX Composite Capped index is up almost the same at 21%, almost the same but the ride has been a lot smoother with both our portfolios

TAIL (Trade and Investment Liberalization) Wags Investment Dog?

A Shrinking Universe by Jordan Brennan on the Canadian Centre for Policy Alternatives website argues that trade and investment liberalization measures such as the 1988 Canada - US Free Trade Agreement and the NAFTA extension in 1994 have warped economic power such that the 60 biggest corporations have grabbed an ever-increasing share of the wealth and income pie. Here is one of the study's charts.

Apart from the huge downward dagger around 2001 - due to the tech bubble and Nortel bust? - there certainly looks to have been an upward trend in earnings share and market cap share. If Brennan is right as to the cause - the TAIL wagging the investment dog - then maybe investors in TSX 60 companies e.g. by holding iShares S&P/TSX 60 Index Fund (XIU), just need to sit back and enjoy their profitable future so long as trade liberalization doesn't end.

Would that life were so simple. I just wonder why the lower end of the TSX Composite stocks, held for example in the iShares S&P/TSX Completion Index Fund (XMD) seems to have performed just as well as XIU over the past ten years, in fact, a little better - XMD's total annual compound return (net of costs including a higher MER) was 9.58% while XIU's was 9.09%.

Perhaps there are other explanations than TAIL, like the amazing rise to dominance of financial services over the last 25 years?

Brennan's study is interesting as well for a few other bits of data: in 1965 there were 153,000 private and public corporations in Canada and by 2009 there were over 1.3 million. A sizeable proportion, more than executives, of the people in the top 1% of earners are health professionals.

Book Review: The Missing Risk Premium by Eric Falkenstein

Not many books can be summed up in one sentence but this one can be and author Falkenstein does it himself in this quote taken from his Falkenblog: "... risk is generally not related to expected return because people are more envious than greedy". This is a radical blockbuster statement with significant implications for both finance theorists and practically minded investors.

The book is a meticulous exposition and expansion of this quote - starting with a description of standard finance theory relating to portfolio management and asset pricing focusing on risk vs return, the "how things are supposed to work" according to the theory, which is basically that there is a expected return premium for taking on risk based on one and only one starting assumption "... that our happiness is solely dependent on our individual wealth and increases at a decreasing rate" i.e. people are greedy. Falkenstein proceeds to document the extensive finance research that shows how the theory simply does not work in the real world - empirically vacuous or bankrupt, as he puts it - and how the attempts to fix it have created a hodge-podge of adjustments devoid of intuitive sense. The basic idea that there should be a higher expected return for taking on more risk he says has been perversely twisted by defenders of the Capital Asset Pricing Model faith - anything that shows a higher actual return, like small cap stocks and value stocks, must be riskier, though no one can actually say how these types of assets are riskier.

In fact (the factual-ness of which he takes many pages to demonstrate - there are lots of footnotes to studies done by many researchers) - Falkenstein finds that the highest risk (in an intuitive sense) end of many asset classes displays markedly lower, not higher, returns. Examples in penny stocks, equity options, IPOs, currencies, corporate bonds, futures, real estate are cited. This is the empirical part of the explanation of why low volatility investing works - it eliminates the significant chronic return drag at the highest risk end of the spectrum.

Falkenstein then moves on to his theory, the "because" part of the quote at the top of this review. He proposes that instead of the standard utility function of absolute ever-increasing happiness with wealth that underpins present finance theory, we should instead use a relative utility function to understand asset pricing. Adopting relative utility means that it is assumed people primarily behave in a greedy fashion, in other words that they are happy or satisfied if they are doing well in reference to others. In investment terms, people use benchmarks to judge success. They want to outperform relative to some standard such as the TSX Composite. Under such an assumption, Falkenstein shows, with the same straightforward math as for the CAPM, that the risk premium is zero. A zero risk investment is no longer something like a no-volatility T-bill but a security that tracks the benchmark. He says this viewpoint explains asset pricing and indeed many other human behaviours (such as why 21st century humans are not happier than people of a century ago despite being a lot richer in absolute terms).

Falkenstein goes on to examine how and why people take too much financial risk and why he thinks his theory has been ignored for so long (his own PhD dissertation was on the subject in 1994 and he traces key ideas to others going back to the 1970s). The final chapter outlines how to benefit in a practical way from his findings and theory. That is the low volatility strategy. The proof is in the pudding he says and he cites studies and his own out-of-sample investing success as evidence.

This book is important to every investor. If he's right, it points to a better investing strategy through minimum variance or low beta portfolios. There are low volatility/ low beta ETFs available to ordinary investors. Falkenstein's theory implies that passive index ETF investing will do poorly (lower returns and higher volatility) in comparison to low volatility ETF investing (assuming, of course, that fees remain within certain limits). Unlike passing anomalies that have disappeared or for which there is no theory to support why outperformance should continue (we note the irony of referring to outperformance as a test of whether it's good or not but that's the way the world works!), this book offers such support. If he's right, the ideas of this book will be viewed as foundational to finance.

Even if you think he's wrong, the book will surely make you think hard. If you think you understand the what and why of finance theory, try to say why's he's wrong.

Much of it is not easy to read, as he slides into and out of highly technical statistical or economic issues. On the other hand, much of it is also highly intuitive and appeals to common sense using plain language.

Falkenstein is very aware of his rebel status in finance. "A crank is simply someone with a minority opinion among his peers, and the key to whether that person is considered a genius or stupid is whether he was correct, which is often known only with hindsight." Those who would dismiss him merely because he thinks the CAPM is fatally broken, in opposition to the mainstream of finance academics, are doing so too blithely. He is extremly conversant with the finance literature (208 footnotes in this brief book and reams of citations in his bibliography) and it sure looks like he understands the stats and math (here, I must express my own limitation in being able to judge this properly). Read his blog and his home page here to judge for yourself whether he knows what he's talking about. These sites contain links to many of his papers where much of the book's ideas are also found. There's even a hilareous video with toy people called Asset Pricing Theory Explained and a 5 minute summary of this book on this page.

Falkenstein writes like a man in a hurry. Though generally very eloquent and quotable, sometimes his sentences are dense and must be re-read to detect implicit commas and awkward phrasing, sometimes words even seem to be missing or he assumes the reader knows technical stuff as well as he does. There's also no index - that would help for the paper version (search works fine in the Kindle on a laptop). These are quibbles.

Is he right? Time will certainly tell - about 2050 is the date he says the data will have gone on long enough for the doubters to conclude with statistical tests that he is right. Meantime, we can check his blog for evidence coming in as he reviews new articles on the topic, such as this post last May. The discussion of some EDHEC findings in that post and many accounts within the book of findings in finance research subsequently being negated when data errors and sampling problems, certainly induce caution in reaching a conclusion.

Nevertheless, the arguments and evidence is credible and convincing enough that, as a matter of disclosure, I will say that I have bought a significant position in a low volatility equity ETF.

Quotes:

• "The idea that to get rich you need to take risk seems to imply that risk begets higher returns, but this is just a logical fallacy, like using successful gamblers as role models for investing."
• "Although broad asset indexes contain the wisdom of crowds, they also necessarily contain a lot of foolishness that make them distinctly suboptimal portfolios. ... By ridding your asset classes of these objectively bad assets, you can improve your returns rather simply, and this has been demonstrated in real time via the dominance of low-volatility investing."
• "...like the latest miracle diet, the latest anomaly is treated skeptically by your average expert for good reason—because most have been dead ends based on selection biases or bad data."
• "when you measure distress directly, as opposed to merely inferring it from the size and value dimensions, such stocks deliver abnormally low returns, patently inconsistent with value and size effects as compensation for the risk of financial distress."
• "R-rated movies are the high volatility stocks of the movie industry."
• "Simon Lack notes that over the 1998-2010 period, a whopping 97% of the dollar profits generated by the hedge fund industry went to the fund managers, not the investors."
• "Risk takers dominate our lives via their disproportionate effect on our genes and their influence on our technology and culture. They did not become successful, however, merely by taking some abstract risk that is the same for everyone and then enjoy the higher rewards that came with it. They instead took the right risks, those consistent with their unique strengths, and reaped rewards consistent with a mastery of something important."
• "... children not only lie, but lie more the higher their IQ."
• "A major problem is that as most of the active and esteemed researchers have built their careers extending or modifying the current framework, it would be very costly to classify work built on bad assumptions as irrelevant, and so there is this strong desire to work within the paradigm and salvage all those mentor’s reputations."

Rating: 5 out of 5 stars, original and important, a must read

Readings on the History of the Financial Crisis 2007-2009

Worth reading:  summary of the "how it happened" of the financial crisis 2007-2009 - Getting up to Speed on the Financial Crisis: A One‐Weekend‐Reader’s Guide by Gary Gorton and Andrew Metrick

Quotes:

• "... changes  in  credit  supply  (bank  loans)  are  a  strong  predictor  of  financial  crises, particularly  when  these  changes  are  accelerating... "
• "Credit booms seem to often coincide with house price increases."
• "House  price  run‐ups  prior  to  crises  are  common."
• "... the financial crisis of 2007‐2009 was not special, but follows a pattern of build‐ups of fragility that is typical."
• "... banks cut back on credit supply, although the demand for credit also
  fell" and the availability of credit is how the real economy was harmed - companies reduced expenditures and cut employees
• "The  financial  crisis  of  2007‐2009  was  perhaps  the  most  important  economic  event  since  the  Great Depression."
• "The  crisis  was  exacerbated  by  panics  in  the  banking  system,  where various  types  of  short‐term  debt suddenly became subject to runs.  This, also, was a typical part of historical crises.  The novelty here was in the location  of  runs,  which  took  place  mostly  in  the  newly  evolving “shadow  banking”  system, including  money‐market  mutual  funds, commercial  paper,  securitized  bonds,  and  repurchase agreements.  This  new  source  of  systemic  vulnerability  came  as  a  surprise  to policymakers and economists ..."

The report summarizes the mechanisms through which the relatively tiny (in global financial system terms) rising defaults in sub-prime mortgages set off a chain of contagion that almost brought down the global financial system and the dire real economy consequences we are still living with. The good and the faultless get side-swiped along with the bad and the guilty.

This kind of report is a salutary dispassionate counterpoint to ones like The Big Banks' Big Secret from the Canadian Centre for Policy Alternatives, which paints the Canadian government's intervention in providing liquidity, primarily through CMHC buying bank-owned mortgages, as a reprehensible and un-necessary bank bailout. Canada's actions were so minor in a global scale that it does not even figure as one of the 13 key countries in the IMF's Chapter III. Market Interventions during the Financial Crisis: How Effective and How to Disengage? referenced in the Gorton paper. Canada's actions were exactly in line with those of all the other countries, however. Canada, and Canadian banks, didn't cause the crisis but everyone has suffered, and could have suffered a lot more without intervention.