What scares me (and 70-year old retirees)

That Japan happens here.

The problem with low interest rates is that once you’ve cut them to zero, you can’t cut them again. Your ammunition, your firepower, your ability to excite the market is gone. Nor can you raise rates — not if the economy doesn’t gain traction.

Years of near-zero interest rates. That was Japan’s  reward for not dealing with their bubble. And it made life very difficult for the country’s retirees and savers, who saw their post-retirement fixed income dwindle to nothing. Nor did it help equity holders, with the stock market today still 70% below its 1989 peak.

Japan’s experience taught Asia (which went through its own  financial crisis in 1997-98) that sometimes the best for cure for a boom is a bust. Investors will never invest when they think there’s more pain to come. Sky-high interest rates in Asia forced bankruptcies and flushed the crap out of the system, paving the way for recovery.

Is the US doing the right thing with zero interest rates? One thing I know for sure right now — there’s got to be something seriously wrong with an economy when at zero interest rates, borrowers don’t want to borrow, and lenders don’t want to lend. Bank lending has continued to contract in the US in recent months.

But it’s not the US that scares me. Canada has been piggybacking off US interest rate policy. An interest rate policy that may have been inappropriately low for us. So our asset prices have not adjusted downwards, just the opposite.

At least when this is all over, and US rates start to rise, the United States will have adjusted. It will be globally more competitive with a markedly lower dollar and property prices some 30-50% below peak levels. But what about Canada? When interest rates start rising, the Canadian economy may be in a world of pain. And it won’t just be the recent home-buyers who get burnt with 30-40 year mortgages, but all the retirees who’ve taken on excessive risk because they could no longer live off their GICs.

Another way to value your home

For most Canadians, their home is by far their largest investment. That said, most new home buyers don’t actually do much in the way of valuation analysis to ascertain whether they should buy this largest investment.  Instead they focus on “affordability” and the ever popular “hardwood floor-to-crown molding” ratio.

Imagine if your broker used affordability as a reason to buy a stock. Imagine this conversation:

Broker:  “Ahhh. I just picked up 100,000 shares of Acme stock for you at five dollars.”

You: “Really?  That’s $500,000! I’ve only got $50,000 in my account. And this stock has risen so much! What’s the valuation look like?”

Broker: “Huh? Valuation? What do you mean by this word “valuation?” I never heard such a question. The stock trades at five dollars. I bought your shares at five dollars. Five dollars is the valuation. Right now. But it’s going higher. The  price has been rising for years and analysts, banks, politicians, property agents & taxi drivers expect it to continue to rise. Particularly if people like you continue to buy. Don’t worry about the price. I arranged a $450,000 loan for you to cover the difference. Don’t worry about the loan either. You and your wife earn good incomes and can afford the loan payments. Especially if we assume that interest rates remain at all-time lows — for the next 30-40 years.”

When an  investor looks at an investment — any investment —  as part of their due diligence, they should value it against its alternatives — both alternatives within the same industry and alternatives in other industries/asset classes. After all, greed knows no boundaries — it’ll eventually chase out the best returns.

When investors evaluate stocks, a popular valuation tool is the Price/Earnings ratio (P/E), which measures share price relative to earnings per share (EPS).  For example,  a stock with a share price of  $40 and an EPS of $1 would have a P/E of 40x. The corollary of P/E is earnings yield (EPS/Price), which in this example works out to be  2.5%.  Is an earnings yield of 2.5% atttractive? It depends on several factors: the growth of the earnings,  the dividend payout, and of course the alternatives.  An earnings yield of 2.5% might be attractive relative to other stocks in the same sector. But if risk-free government bonds were yielding 10%, then 2.5% on a risky company might not look so good.

Which brings us to property valuation.  Professional investors’ favorite valuation metric for commercial property is “cap rate” which (not unlike earnings yield) measures  a property’s net operating earnings relative to the price.*  Property cap rates tend to be correlated to interest rates and vary across sector. For instance. according to Colliers International’s latest report, 1Q10 Cap rates for Toronto Grade A office ranged from 6.75-7.75% while multifamily low rise apartments ranged between 5.75-6.5%.

I bring this up, because even though I have found no reliable data on housing cap rates, all anecdotal evidence suggests that Canadian housing cap rates are far lower than commercial cap rates. In Toronto, based on my own observation, I’d put them at no more than 3-4%. Obviously, there are tax savings and considerable intangible benefits, but do they really justify cap rates lower than apartment buildings, Government bond yields and the dividend yields of property-exposed bank stocks and REITs? Especially if interest rates do indeed go up.

The fact that most home buyers don’t look at cap rate or buy a home with the intention of renting it out is beside the point. Whether  you choose to live in your house or rent it out is irrelevant. You are saving rent by living there, and your property is implicitly earning the rent that you would otherwise have received, were you somewhere else.

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* You might argue that it’s more akin to dividend yield than earnings yield, but that’s a different conversation.

Clickworthy: The active/passive red herring

While it remains to be seen whether the recent weakness in the markets proves to be a turning point, one fact remains constant. Whether you are invested in passive ETFs  or in active mutual funds you will be effected by the direction of the markets. That’s because, mutual fund managers — despite their “active” approach — are typically required to stay fully invested. They can’t short or go to cash even if they believe the market is headed off a cliff. This latest commentary by Arrow Hedge Partners sheds an interesting perspective on the so-called active/passive debate. Key point for me:

… We believe the active/passive debate is asking the wrong question. The question should not be: do active funds outperform passive? The question should be: why aren’t actively-managed mutual funds more active, when it comes to protecting investors from bear markets? …

… The average mutual fund manager knows that there is little they can do to protect you in a falling market. That’s why they harp on about their performance relative to the market. So when the market falls 40% and their portfolio falls 38%, they’ll brag to investors about how they did a good job. To that end, perhaps the active/passive debate should be renamed the passive/slightly-less-passive debate …

An easy way to increase your inheritance

It’s only been two months since I started blogging for Weigh House and I’m already numb to the issues. Every day there’s another blog or newspaper that essentially says the same thing: you’re paying too many fees for your mutual funds, mutual funds underperform, your advisor is not your fiduciary, bleah, bleah, bleah.

Today’s forum in the Globe & Mail is a case in point. The issue of financial advisor regulation is — once again — probed, dissected and blathered about. There’s a lot of smart people making a lot of smart comments — but we know nothing will likely change.

Now why is that? Why does nothing ever seem to change?

Perhaps it’s because the investors who take the trouble to read investment blogs and the personal finance section of the newspaper already deem the system a joke. It’s their friends and idiot cousins who have no clue what’s going on, mostly because they make no effort to educate themselves.

While the greedy capitalist in me loves the idea of strangers losing money — it makes me feel richer — I thought I would put together a simple email template that you could forward to your own relatives. After all, what is left of their retirement savings may one day be yours.

Dear xxx,

Hope all is well. It’s been a while. I heard from Auntie xxx that you’ve been having a bit of a rough time what with your  recent surgery. She also told me that your bladder is acting all funny again. So sorry to hear that.

I’ve also been thinking a bit about your investment portfolio. After all with all your health problems you certainly don’t need to be worrying about your retirement income.  I know that you don’t understand the high-flying world of finance, but here are three easy things you could do right now, that will save you money:

1. Transfer your mutual funds to Questrade. You will still own the mutual funds — nothing will change there. But from that simple transaction, you could receive cash in your pocket of $1,000 for every $100,000 that you transfer. That’s not a one-off payment. That’s $1,000 per year — minus some minor fees.  Click here for details.
2. Switch your money out of mutual funds and into portfolio managers. You could save up to 1% per year in fees by switching. Click here for details.
3. Switch your investments out of  mutual funds and into ETFs. This will be a little more labour-intensive but you could save up to $2,000 in fees per year for every $100,000 you switch. If you don’t know what an ETF is, or how to do this, contact Weigh House Investor Services and they will teach you.

That’s it. I really hope you get better and I hope to see you soon. Unfortunately, I won’t be able to make your birthday party next Sunday. It sounds like it will be a blast though. Give my best to the nurses, the therapists and all the other residents.

I love you so much!

xxx

The Canadian stock market — it’s not up to us

Most conversations about the markets are a waste of time. They usually go something like this:

Person #1 (lurking in doorway):
“So what do you think about the market?”

Person #2 (making eye contact):
“Oh, I’m bearish.” or “Oh, I’m bullish.”

Person #1 (nodding seriously):
“Ahhhh, why?”

Person #2 (nodding back seriously):

“On the back of a strong commodity market, growth is blah,blah,blah.” or “Economists still expect Canada’s housing market to blah, blah, blah.” or “Canada’s banks are the most blah, blah, blah”

And so on….

This blog does not give investment advice. I am never going to attempt to predict the future. However, what I am going to do is show you a chart which I believe illustrates a crucial point for any Canadian investor. It’s not up to us.

This chart shows the five-year performance of  the Australian All-Ordinaries Index and the Canadian TSX. The blue line is the TSX. Not that it makes a difference — the two indices are virtually indistinguishable.

And why are they so similar? I imagine it’s because both our economies are highly dependent on commodity exports. Roughly 2/3 of the world’s incremental demand for commodities comes from China and India. So perhaps Canada’s housing/economic/stock market resilience is not because we’re particularly talented or more conservative than the US. Perhaps, like Australia, we’ve got stuff in the ground that Asia wants. Which is why I’ll pick the Asian Wall Street Journal over a Canadian newspaper any day of the week.  Because Asia’s bubble boom has been our boom — and so might be their bust.

Not that this makes it any easier to predict the future.

Mailbag: A question I don’t want to answer

An email from a confused client:

As you know an investor can redeem 10% of the units free of redemption fees each year and I was under the impression that if I redeemed my remaining DSC units before the end of the DSC schedule then redemption fees would be applied to the number of units remaining in the DSC version of the fund and would not include the number of units that had been redeemed free under the ’10% free’ allowance. Evidently this is not the case. I spoke with my mutual fund manager today and they confirmed that redemption fees are based on the original amount invested. Here is the relevant section from their simplified prospectus that explains this:

‘We may modify or discontinue your free redemption right at any time in our sole discretion. The free redemption right only applies if your units or shares remain invested for the full deferred sales charge schedule. If you have exercised your free redemption right and then redeem your units or shares before the deferred sales charge schedule has expired, your cost per unit or share will be increased to compensate us for the units or shares redeemed under the free redemption right. In other words, even if you redeemed units or shares under the free redemption right, your deferred sales charge on a full redemption would be the same as if you had not redeemed any units or shares under the free redemption right’

I would appreciate your perspective on this and whether this is normal practice within the fund industry as we were not made aware of this when we purchased our funds under the DSC option.

So is this normal practice within the industry? I’ll answer that shortly. Let me first say that I was not at all surprised by this firm’s particular practice. In fact, from a business point of view, it seems perfectly logical: when you buy a DSC (Deferred Sales Charge) mutual fund, the fund company must pay a commission upfront — typically 5% — to the hard-working advisor who sold you the fund. The fund company then recoups that cost out of the annual MER that you pay over the lock-up period. That’s why they charge you a penalty if you “want out” before they’ve recouped all the fees. Whether you redeem “free” units or not, the fund company still has to recoup the same dollar amount, although it would appear to you to increase on a per unit basis.

Now is this normal practice? The short answer is, I have no idea, because I have no idea what “normal” actually is. To know what normal is, one would need the data to properly compare fund practices. Unfortunately, advisors do not provide sufficient information on associated fees in their monthly statements. Moreover, while Morningstar’s subscriber-only Paltrak database does provide fee information, the information lacks the detail necessary to provide a true apples-to-apples comparison for DSC penalties. Which means the only way to learn the answer for sure is to read the prospectuses themselves.

And what did I learn? What I learned is that I don’t want to read any more prospectuses. Unless I’m having trouble sleeping. What I can tell you from the two 200+ page prospectuses that I “perused” is that the fund companies appeared to have penalty structures that were  both similar and different.

• I say, “appeared” because I can not tell you with clear conscience that I fully understood everything that I read.
• I say, “different” because the penalty schedule of one fund company appeared to be based on the invested amount while the other was based on the market value at the time of the redemption. This would have an enormous impact on the investors’ charges depending on whether the funds had increased or decreased in value.
• I say “similar” because in both cases, the penalties struck me as being outrageously high.

The big question for me is not, “Is this normal practice?” Nor is it even, “Why isn’t this information more transparent?” The big question for me is, “Why on earth would any informed investor lock himself up in a DSC fund as opposed to a Front-End fund, which has no penalties to redeem, or even a No-Load fund?”

The only answer I can come up with, is that poor, unsophisticated investors need to be protected from themselves. After all, studies have shown that investors underperform the mutual funds they invest with, given their tendency to buy/sell said funds at the wrong time. By dissuading investors from selling at the “wrong time” through large DSC penalties, advisors are actually doing those silly investors a huge favor. Not to mention themselves. It’s too bad that not all advisors feel the need to mention those other studies that show that actively-managed mutual funds underperform ETFs. But then they might be out of a job.

Weigh House certified for fiduciary excellence

Weigh House Investor Services  yesterday announced that its investment support services have been certified by the Centre for Fiduciary Excellence (CEFEX) as adhering to the fiduciary standard of excellence. Weigh House is the first organization in Canada to achieve this independent certification. Click here for press release.

I wrote about fiduciary duty last month and I’m amazed by the obfuscation in the industry. It’s not surprising that Weigh House should be first to get this certification. It’s a new player in the Canadian market place and helping to reshape the industry. It sells no investments and receives no hidden fees. Unlike  advisors who in a perfect world would be called salesmen, Weigh House only gets paid upfront from its customers. Clients demand a high level of fiduciary duty from Weigh House because they have to reach into their own pockets to pay them.

Except investors who don’t reach into their pockets also pay — at least indirectly — through the high fees that go toward advisors’ commissions. Not to mention opportunity cost. Perhaps these investors are paying a lot more than they think when it comes to “free” advice.

Clickworthy: ETFs not so passive after all

Those who think that ETF investing is a passive activity have obviously never done their own taxes. Calculating ACB (Adjusted Cost Base) for your capital gains & losses is no easy matter. With ETFs and mutual funds you need to pay very close attention to the nature of your distributions, as it could affect the ACB. Moreover, if you engage in any foreign investing, you might also have a forex gain or loss — even if there was no forex transaction at the time of the investment transaction.

There are many more details to consider: superficial losses, foreign exchange exclusions, and so on. I spent the better part of this weekend working on my own taxes. The problem for me was not so much the calculations, as it was trying to remember how my home-made spreadsheet works. That and the fact that my house guests ate all my cereal.

Below are some links that you might find useful in your own preparations. I’m not a tax expert and can’t pledge for their accuracy, so use at your own risk:

The CRA on calculating capital gains/losses. Click:

• here for T4037, Capital Gains 2009
• here for IT95R  Foreign exchange gains and losses
• here for RC4169, 2009 -Tax Treatment of Mutual Funds.

Some web resources:

Taxtips.ca on calculating income from ETFs

Canadian Tax Resource blog on exchange rates and capital gains/losses

ACB Tracking Inc. provides ACB calculation services

Canadian Money Saver on calculating ACBs

Canadian Business article on maximizing ETF tax efficiency

Financial Webring forum on capital gains & ACB

Feel free to add more links in the comments section.

Passive is as passive does

The greatest risk to passive investing is being too active.

Passive investing is an investment strategy in which a portfolio is managed with as few trades as possible to minimize costs and taxes. Index funds are the most popular form of passive investing. Active investing seeks to outperform an index through the strategic buying and selling of securities.

Statistically, there can be little doubt that passive investing beats active investing. This is supported on an ongoing basis by SPIVA as well as numerous other academic studies. In my view, the biggest problem with passive investing is that many investors are emotionally unable to stay the course. In other words, there are certain investors who are not passive enough to be successful with passive investing.

For instance, many passive investors bailed out of equities during the 2008 decline, most right near the bottom. Many were still out of the markets in 2009 during the massive recovery, afraid to get back in. They locked in their losses and missed the rebound. This was not what they were supposed to do according to the passive mantra, but emotionally they could not stick with the plan.

My clients are constantly being swayed by the news and wondering if they should make changes to their portfolio. I spend time talking them out of making moves because of Greece or oil price movements — not to mention interest rates, China and maybe even rumours of the cancellation of 30 Rock.

A study entitled “Investor Timing and Fund Distribution Channels” shows that investors will often underperform the actively-managed mutual funds in which they find themselves. They make bad market timing decisions that have a negative impact on their portfolios. This is disconcerting, since the performance of actively-managed funds is already impaired by the higher fees.

It is easy to state that a simply constructed passive portfolio will outperform an active, higher cost portfolio. Without the help of investment professionals however, certain individual investors will most likely undermine the ideal that is passive investing and be worse off than if they had a good and honest investment counsellor. What kind of investors? My experience suggests both the novice investor and those with too much confidence in themselves will have difficulties with passive investing.

Finding a manager

One of the more popular services that Weigh House offers is ManagerSEARCH, which introduces frustrated investors to portfolio managers that are aligned with their interests. I sat in on a ManagerSEARCH last week and was impressed by the process. Aside from the fact that Weigh House pre-screened the managers who came calling and provides a detailed summary report of their unique distinctions, there are other benefits: A Weigh House consultant chairs the meeting, asks relevant questions, and aims to keep the managers focused on what’s important to the investor. Moreover, having Weigh House in the room means investors are not going to be pressured into buying something they do not want. After all, Weigh House receives no remuneration from any of the managers.

But what exactly is a portfolio manager (often referred to as investment counsel)? If all you’ve ever used are mutual funds, you may not be familiar with their services. Historically for the wealthy, portfolio managers manage your money on a discretionary basis. This can be done either in your own segregated account or in a pooled fund. Pooled funds are similar to mutual funds, with the major differences being a minimum investment of $150,000 and disclosure in the form of an information circular as opposed to a prospectus. The Investment Counsel Association of Canada has a good summary* of the differences between investment counsel/portfolio manager firms and all the other types of advisers, including those who in a perfect world would be coined salesmen.

To me, the biggest difference is lower fees. Portfolio managers charge you a fee which typically runs around 1.25-1.5% of assets per year. Balanced mutual funds typically charge you north of 2.25%. You’ll recognize many of the firms that offer investment counselling services since they also offer mutual funds.

Another thing that I like about portfolio managers is greater versatility in investment approach. No disrespect to mutual fund providers (and — errr — those in the transportation industry) but I’ve often viewed mutual fund managers as little more than glorified bus drivers. That’s because mutual funds are typically required to stay fully invested. That works great in a bull market but when market conditions change do you really want to have your money with somebody who must always keep their foot on the gas pedal?

With discretionary portfolio managers there’s greater breadth of strategies. Like mutual funds, some will stay fully invested at all times. Others may be more tactical in their investment philosophy and even go to cash if they feel conditions warrant.

Given that Weigh House represents many clients — and the managers know they’re competing one-after-another — they’ll typically offer fee rebates directly to the customer. In the ManagerSEARCH I witnessed, two cut their per annum fee by a meaningful amount, while one offered a one-time discount. Moreover,  while many portfolio managers rarely accept less than $1 million under management, some will reduce this requirement to $500,000 for Weigh House clients.

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*As if all the ambiguous job titles in this industry were not confusing enough, since September 2009, the legal registration for discretionary managers has changed. Previously (as per the report) it was “investment counsel/portfolio manager.” Now it is “portfolio manager.”