So what can we do and what should we do!

1-      We CAN stop adding to the problems by making poor decisions about our investment strategy. The typical investor in a MF or ETF Index fund will make significantly less than the fund itself over the course of a typical year. That is because investors jump in and out of the equities market based upon the current emotions they are feeling. Studies show that this undisciplined approach will cost investors up to 4% less return than a mutual fund would make on average. Professionals do NOT jump in and out of the markets based upon emotions. They follow an Investment policy Statement (IPS) that outlines the minimum and maximum percentages of equity that MUST be held in the portfolio. For those that wondered about the definition of “re-balancing” a portfolio; that is the term used for bringing a portfolio in line with its IPS guidelines. Without an IPS you CANNOT re-balance your portfolio!

2-      We CAN stop pretending that the folks who make a good living managing investments have an ability to predict what stocks will go up or down next week or next year. Professionals can help you select stocks which have good balance sheets and good management in place. They can also help you ensure your portfolio is well diversified. Other than that, professional stock traders are of little use unless they can provide insider information (which in general is illegal). In 2011 the consensus forecast of investment managers in Canada was for stocks to outperform bonds and commodities. It will come as no shock that a) they were wrong, and b) they have made the same forecast for 2012. In fairness…..they eventually will be correct just based on the law of averages!

3-      We CAN reduce the fees we pay. With investor returns at historic lows we cannot continue to give a guaranteed 2-2.5% return to investment salespeople. If markets were to provide you with the 4%-5% returns we expect in the near future, a fee of 2.25% would be 45-55% of your total investment return. In years where markets drop, like 2011, the fee just increases your losses. If you negotiated a fee of 1.25% you would be giving up only 25% of the same return forecast! If you used ETF Index funds you could reduce the fee drain to a fee of .25% and have only a 6% fee drain.

While markets are certainly tough it does not mean we cannot do better. A little effort, some simple strategies and a calm demeanour can go a long way to lessening the pain of being an investor today!

If you need an IPS then ask an independent (non-selling) firm to customize one for you!

Soismike

Consensus Forecasting for 2011: The “professionals” forecast the market performances every year and then a “consensus report” is tabulated to allow us to peak under the curtain and see what active traders are doing to beat the markets. The asset class forecasts were very clear that security performance in 2011 would see returns ranked as follows:

-          Equity stocks would be the best performing asset class

-          Commodities would be the second best performing class of assets, and

-          Bonds would trail the above classes and provide weak performance

Based upon the forecast, you would overweight equities, diversify with commodities, and minimize your bond holdings.

Let’s see how well the smart money did in forecasting 2011.

-          Equity returns in Canada ( TSX broad market total return index) -8.71% and if you choose to look just at the blue chip TSX 60 returns were -9.08%

-          Commodities as measured by the Auspice Broad Commodity Index was 1.78% to the positive side

-          Bonds as measured by the Dex Bond Universe was up 9.7%

Wow, the smartest guys on the street managed to show an amazing dyslexia of returns! They used thousands of analysts to crank out the research math and got everything backwards! In fairness however, the forecasts were great for revenues at the brokerage firms as investors traded heavily into the markets based upon the forecasts. By the end of the investment rich RRSP seasons investors had bid up the equity markets and the research looked great. However, once all the suckers….um, investors were fully invested, the professionals did a quick sprint to the exits, leaving the retail investors holding a smelly mess of equities. The TSX dropped from the lofty mid 12,000’s to the more realistic low 11,000’s. Unfortunately, those who followed the advice in late February and early March can only wish they had lost 8 or 9%! In fact many will see 15-20% drops with their RRSP investment money.

So, how did a conservative indexer do in this type of market? If the pro’s got it wrong we can only assume the indexers got creamed! Our conservative 50/50 balanced model would have received the returns of a typical mix of ETFs somewhat like the following:

Well, it was definitely a tough year; however staying diversified reduced the damage significantly. Even if investors reduced the risk by splitting the fixed income between short and long duration bonds (50% XBB and 50% XSB), the overall return would be -0.3% for the year 2011.

Obviously the higher the Canadian equity component or the EAFE equity component, the worse the overall portfolio performance. For those active traders that jumped on the gold bandwagon the entry point was a challenge. On the whole XGD (the gold ETF) was down 14% and the much recommended emerging markets saw a decline of 16.4% as measured by the emerging market index. So, if you followed the professionals you were heavy equities, heavy emerging markets, heavy gold and light weight bonds. If you followed your Investment Policy Strategy as a conservative investor you retained your capital! Thank goodness I am a dull investor with a conservative IPS!

soismike

Our new blogs will be authored, for the most part, by myself, Mike Macdonald, and will reflect the content released simultaneously on the blog “unbiasedadvisor.blogspot.com” which is written under the name “soismike” ( a throwback to our corporate roots as Second Opinion Investor Services”).  While our posts will be less frequent than we previously published, we hope each posting will help engage our readers in the investment world, financial planning, and our current markets.

mike macdonald

We live in strange times. Where retirees are forced to chase yield (and risk) to supplement their pensions. Where governments punish savers with low rates to the benefit of debtors. My only consolation to lower rates is that the government will get lower tax from my lower interest income.

I was fortunate to have escaped the financial crisis unscathed. Moreover, I knew with low interest rates that it made sense to buy dividend stocks. Still, I get no pleasure now from watching my dividend portfolio rise in value. That’s because with interest rates down to all-time lows, and escalating fears of a Japan-style future, I’m wishing I had bought more.

But chasing yield is not without its risks. Stocks have risen a lot since the crisis bottom. The catchphrase on CNBC is to keep buying dividend stocks because their yields are higher than government bonds. That’s a red herring in my view. The only reason bond rates are at emergency lows is because of the dire state of the patient. If that patient gets better, rates go up, which could have an adverse effect on share prices, particularly for leveraged dividend plays. If the patient stays the same, rates might stay low and dividend stocks might still be a good buy. And if the patient gets worse — can we be certain that dividends won’t be cut or that share prices will hold up on the back of yield alone?

It’s a tough call.

In March, I wrote: Don’t shoot for the stars. The main message being: investors should avoid targeting returns that are too high, otherwise they risk taking more risk than they can handle. It’s why I won’t sell my dividend portfolio even as prices rise exponentially. It’s also how I resist from buying (too much) more — (I’m not perfect).

For retirees who live off their investment income, it can be hard to resist chasing yield. These individuals would do well to carefully consider all the risks and ask themselves if they can better afford to tighten their belts now, or risk being forced to tighten them later.

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.

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.

… 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 …

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

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.

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.