Hot Off the Web- October 3, 2011

Personal Finance and Investments

In WSJ’s “Why buying on dips isn’t all it’s cracked up to be” Jason Zweig explains that even though it might seem counterintuitive “Buying on the dips might make you feel better, just as it feels good to go shopping when a department store tacks up the sale signs. But don’t kid yourself into thinking that buying on the dips is a sure way to raise your investment returns.” Furthermore, “buying low doesn’t do you much good unless you also can sell high.” However, “Rebalancing—selling one asset that has gone up in price to buy another that has gone down—does tend to raise returns over time.” (Sounds like setting your asset allocation to a level consistent with your risk tolerance and rebalancing periodically is the only “system” that works consistently.)

Jeffrey Horvitz in the CFA Institute Wealth Management conference presentation entitled

“Myths, folklore, and misunderstandings about taxable investment management” explains how, done right, “tax management can yield a “tax alpha” that adds value with no downside risk”. Some of the techniques mentioned applicable to both US and Canada include: must be personalized to each investor’s circumstances, tax deferral (to get really substantive value you need long time, 20-30 years) and the simple formulas which explain how deferral works), “all after-tax (performance) reporting be done on an as-if-liquidated basis”, tax-deferred accounts whether tax-prepaid (IRA or TFSA) or tax-postpaid (401(k) or RRSP/RRIF) are “mathematically identical except when tax rate of contributions is different from tax rate on withdrawals”, “tax-loss harvesting is usually discussed as if there is no potential recapture” (i.e. when repurchased, an investment will have a lower cost basis, and thus typically result in a higher future tax liability) so often it can turn out not to be beneficial (except in US estate situations).

In CFA Magazine’s “Emerging Threat Funds” John Rubino looks at how under the “ETF”’s high quality brand name, where assets have grown worldwide to $1.3T, some questionable products lurk which might sully the good name of ETFs. Types of products and risks mentioned, which may have opaque risks themselves or may pose even systemic risks, include: inverse and leveraged funds implemented with derivatives or swaps, synthetic ETFs (very popular in Europe) implemented with swaps which may or may not have adequate/suitable collateral or the ETF sponsor may have inherent conflict of interest  by also acting as swap counterparty, synthetic ETFs could even lead to confused investors who can’t distinguish between plain old vanilla (asset based broad index ETF) and potentially much lower cost synthetic ones, commodity ETFs which buy up physical commodities (less so in case of gold, than industrially used copper, aluminum or agricultural products like wheat, corn etc or energy) which then effectively become unavailable for industrial use and thus drive commodity prices up, and finally there is the systemic risk which may result from leverage and ultra concentrated ETFs and situations where an investment bank (ETF sponsor) also acts as counterparty and becomes unable to handle as unusually large redemptions. (I wouldn’t be surprised if regulators would actually initiate some restrictions to restrict the use of certain types of ETFs in the future. Sticking with plain vanilla broad index, low-cost and high liquidity ETFs for long-term investing should continue to be a successful portfolio implementation.)

Reading Wade Pfau’s recent blog on Huxley and Burns’ book “Asset Dedication” which advocates that instead of annuities investors for retirement should “lock in future spending needs with specific bonds”, reminded me of Charles Ellis’s must read book “Winning the Loser’s Game” one of the core concepts and basic themes is that funds available for long-term investment will do best for the investor if they are invested in stocks and kept in stock over time. (Ellis defines long-term as 10 years. This in turn leads me to consider another measure of risk tolerance and thus minimum allocation to risk-free (or at least high quality fixed-income) assets which might be [(NPV of next ten years of spending)/Total Assets]%

In the Globe and Mail’s “Let’s stop hiding the cost of mutual fund fees”Rob Carrick writes that “The cost of owning a fund is measured through the management expense ratio, where almost all costs of running the fund are expressed as a percentage of assets. Included among those costs are trailing commissions, which are kind of like a salary that fund companies pay directly to advisers who sell their products and their firms… Here’s a better idea: Get the mutual fund industry to address costs by stopping the longstanding practice of including compensation for investment advisers in fund fees. Leave it up to advisers and their clients to set the price of advice.” (This is long overdue, but of course it will just accelerate the demise of mutual funds, accelerate the move to passive investing, and explicit visibility of cost and corresponding value or lack thereof. Great idea, but will continue more than likely to be fought tooth and nail by both the fund industry and advisers.)

In the Financial Post’s “How to figure donation benefits”Jamie Golombek writes that “In provinces and territories without a high-income surtax, the value of your donation credit is independent of your tax bracket and level of income since donations give rise to a credit rather than a deduction from taxable income.” For example in Ontario on a $500 charitable donation you get a 2011 tax credit of $160; $117 federal (15% on the first $200 and 29% on the rest, and $43 Ontario (5% of first 200 and 11% on balance). (i.e. in Ontario 20% on first $200 and 40% on the rest)

In the Financial Post’s “Regulators considering fiduciary duty standard for advisers and dealers”Jonathan Chevreau reports that “The Ontario Securities Commission says it “considering whether an explicit legislative fiduciary duty standard” should apply to dealers and advisers in Ontario.”

In the Journal of Financial Planning’s “Getting on track for sustainable retirement: A reality check on savings and work”Wade Pfau has a very interesting table (Table 1), based on historical data, which provides a measure of the usefulness (or lack thereof) of progress reports toward achieving one’s retirement goal (as measured by wealth at retirement date) as a function of stock allocation and number of years before retirement. The table (implicitly) illustrates the risk of not reducing equity allocation within ten years of retirement and therefore why target-date funds’ glide-paths show decreasing equity allocation as one approaches target retirement date.

Tom Bradley in the Globe and Mail’s “Investing certainties in times of economic doubt”opines that looking ahead: “bond return will be poor”, but he expects 7-10% from stocks (dividends 2-3%, earnings growth 3-4%, the rest from valuation (P/E) improvement).

Paul Sullivan in the NYT’s “Challenging dollar-cost averaging and other bad ideas” writes that “big risk for average investors now is confusing volatility with opportunity” and lists a number of bad ideas for action: looking for ten-baggers (risky stocks which will increase tenfold), dollar-cost averaging (new research shows that between 1926-2010 “investing your money on one day yielded better results over a 20-year period than investing the same amount of money in equal chunks over 12 months”), rushing out of Treasury bonds (“while inflation would still be bad for bond returns, there is enough bleak news coming from the United States and Europe to make a rush out of Treasury bonds premature”)

Jason Zweig in WSJ’s “Shareholders, don’t buy into buybacks”questions the motives and value of shareholder buybacks at a time when Warren Buffett just committed to the act. He suggests that that you consider the following: “Here is a red flag: If cash is dwindling as buybacks are growing, the firm may be starving future growth to pay off present shareholders. That is fine if you sell into the buyback. But it is bad if you hang onto your shares. Owning a bigger piece of a corporate cannibal may leave you hungry in the long run.”

In WSJ’s “Beat the market with less risk” Ben Levisohn writes that “academic research has shown that a relatively simple strategy of buying the least-volatile stocks and holding them for the long term has matched the overall market’s returns—without the violent swings.” Some reasons mentioned why this strategy might work include: the nature of compounding (takes 25% gain to make up for 20% loss), and glamour stocks tend to get to be overpriced, and low-volatility stocks tend to have higher yields. The most popular fund mentioned in the article is PowerShares S&P 500 Low Volatility (SLV). The article suggests that this low-volatility strategy may have more staying power than other strategies which tend to lose effectiveness as more assets pile into them. (I haven’t considered this strategy seriously since I am primarily invested in broad index ETFs, but it may have merit for the decumulation phase, since volatility is particularly damaging when one is making portfolio withdrawals. You might also consider the whether you are comfortable with high concentration in utilities/consumer-goods (30%/24% for this strategy), and likely higher turnover than the S&P 500)

In the Financial Post’s “RBC’s new ETFs a hybrid product” Jonathan Chevreau reports that RBC’s initial entry into the ETF business was with “target-maturity” corporate bond funds. “Corporate bonds seem a happy compromise between equities and government bonds, typically yielding 1% or 1.5% more than the latter, although with more credit risk… The RBC ETFs combine the diversification of a mutual fund with the cash distribution of a bond when it matures, says B.C. based fee-only financial planner Fred Kirby. RBC’s first eight ETFs all mature late in the year they target: between 2013 and 2020.” For more info on new RBC funds see the Prospectus.

Real Estate

In the US the just released July 2011 S&P Case-Shiller Home Price Indicesshowed a fourth consecutive month of increases for the 10- and 20-City Composites, with both up 0.9% in July over June”. On an annual basis only Washington and Detroit showed an increase among the 20 cities; 10- and 20-City indices were down -3.7% and -4.1%. On a seasonally adjusted basis July was unchanged over June.

In Canada the just released July 2011 Teranet-National Bank House Price Indexthe just released index shows a 1.3% increase over previous month and a 5.3% increase over the past year. Calgary and Toronto had the highest MoM increases, while Halifax and Montreal the lowest. Toronto and Vancouver had the highest YoY increases and Calgary and Halifax the lowest. With the exception of Calgary the other five indices were at all-time highs.

In WSJ’s “New home sales drop” Zibel and Bater report that “Sales fell by 2.3% on a monthly basis to a seasonally adjusted annual rate of 295,000, the Commerce Department said Monday. It was the weakest pace in six months.” (This perhaps shouldn’t be such a surprise given that existing home prices may have fallen well below replacement cost?)


In the Financial Times’ “Time to bring on the super trusts”  Pauline Skypala presents a persuasive case for large-scale non-commercially run (i.e. non-profit) super-fund focused on investors’ interests only (e.g. a Vanguard-like model). She figures that these would deliver an incremental 1% return, with 0.5% generated by lower costs and 0.5% by improved governance. Some even argue that the last 25 years of trying to provide more choice and more engagement for investors was a mistake, when in fact it would be better if the system would “allow choice but not require it”! (How refreshing, but it sure doesn’t sound like the path Canada’s pension reform is on with the PRPP which is based on a highly fragmented private sector for profit implementation! So much for pension reform in Canada, when all we need is large scale, non-profit management/administration allowing but not requiring choice, and if they added a pure longevity insurance option under the same framework, it could just about be perfect.)

Dimson, Marsh and Staunton in a 2003 paper entitled “Irrational optimism” take a century long look at world equity markets. They suggest that past equity risk premiums (ERP) might have been lower than commonly believed and forecast even lower ERP going forward. Furthermore they discuss how companies with DB plans have systematically made even more aggressive and ridiculous assumptions. The authors also suggest that “Maybe plan sponsors’ high projected returns represent not the average expectation for stock market performance but accounting manipulations that reduce pension contributions and hence enhance reported earnings.” The authors also allow that perhaps it is not all about “wilful earnings management” but it might just be plain old management stupidity. (Many readers would be surprised to hear that?!?J) And while stocks historically beat inflation and provided a risk premium over government bonds, that risk premium was because equities are in fact risky! The authors present data for the US and 15 other countries (real geometric and arithmetic means, standard deviations and autocorrelations) between 1900-2003. U.S. and Canada are some of the top performing countries. They conclude that: equities will remain risky and will continue to pay a risk premium, but stocks cannot provide a guaranteed superior performance one the investment performance”. (Thanks to Wade Pfau for recommending the paper.)

Things to Ponder

In IndexUniverse’s interview with John Bogle entitled “Bogle: ETF trading has no social value” he continues his campaign for better outcomes for investors and an environment stacked against them. Here some comments on ETFs: “And if I were trying to capture the market return over a lifetime, I’m going to do fine. But investors that are trading them (index funds) all day, every day, they are making a terrible mistake. It will be suicidal to their investment capital.” He figures that typical shareholders (trading) in ETFs will have 200 bp lower returns that the ETFs themselves. He’d “love to have some people mutualize, or some people coming into this industry with an idea of forming a “mutual” fund group. At Vanguard, as one can easily observe, nearly all the profits go to the investors and the funds. And our average expense ratio is now around 20 basis points. No one is anywhere near that.” “I’m certainly an optimist in that I think stocks will do considerably better than bonds. And I consider them to be in essence the only, or nearly the only, investment alternative that most people should deal with.” He believes that a lot of the speculative activity in the market is “essentially because we’ve taken the frictional cost out of investing. I therefore have no trouble with some kind of a transaction tax, or a capital-gains tax on short-term capital gains—a very high tax. And even a capital-gains tax generally on gambling—that is to say trading—as compared to providing capital for new ventures. I don’t see any social value in all this trading.” For more Bogle wisdom see Bloomberg’s “Five questions for Vanguard’s Jack Bogle”where Ben Steverman reports on some more of Bogle’s insights such as ““Nobody knows nothing.” And of course that’s true. It’s not given to us to know. The future is not ours to see. You try to make intelligent decisions, have an intelligent plan that balances risk and reward, balances stocks and bonds, and ignore the noise in the market… This is not a particularly cheap market to invest in. But, the problem is that we must invest. We can’t stand back. If you don’t save anything, I guarantee you will end up with absolutely nothing. There’s no such thing as a bad market. If the market goes way down, that’s good for buyers and bad for sellers.”

In C.D. Howe Institute’s “Core, what is it good for? Why Bank of Canada should focus on headline inflation” Bergevin and Busby write that “Core CPI can prove an unreliable guidepost for future headline CPI. Although our evidence suggests core is one among a group of helpful indicators of future inflation, the Bank would be better off to concentrate its messaging and actions on its ultimate goal: total CPI.”

In WSJ’s “Where are the bond vigilantes?”Ronald McKinnon writes that the Fed’s “ultra-low interest rates” not only “undermine political discipline and creating bubbles” but: “the counter-cyclical effect of reducing interest rates in recessions is dampened”, “financial intermediation within the banking system is disrupted… almost all going into excess bank reserves” and “a prolonged period of very low interest rates will decapitalize defined-benefit pension funds”.

In the Globe and Mail’s “Eight countries with the highest taxes” Tim Begany presents an interesting picture of tax rates with some explanations as to what the highest rates pay for. (Canada at 31% of GDP looks like a tax haven.)

A couple of articles this past week discuss the different perspectives on regulation of banks to prevent another systemic failure. The Globe and Mail’s “Carney vs. Dimon a clash of world views” describes Mr. Dimon as a ‘fatalist” while Mr. Carney believes that like in any human endeavour there is opportunity to learn and improve (including in the financial world and the Financial Post’s “Dimon too flawed to shine on reform”suggests that “If the banks are being criticized for whining about having to adjust to new rules after being accustomed to getting their own way for so long, regulators must shoulder some of the blame for their complicity. It’s not that simple, which is why financial reform requires a measured approach that doesn’t shoot the messenger but still aims to secure its goal of ensuring the calamity that necessitated the changes won’t be repeated.”

And finally, in “Ruling curtails recovery of funds in Madoff fraud”Rothfeld and Bray report that “Judge Rakoff’s ruling shortened the period during which Mr. Picard can attempt to recover investors’ withdrawal of false profits or principal from six years prior to the bankruptcy of Mr. Madoff’s firm—the limit under New York law—to a two-year window allowed under federal law.” (This reduced dramatically the claw-backs from investors who have taken out or received more from Madoff funds than their investment.)


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