Archive | May, 2011

A Portfolio Makeover

Last September, I wrote a piece for Canadian MoneySaver called An ETF Portfolio With Added Dimension. The article looked at the strategies used by Dimensional Fund Advisors, “the best money management firm that most people have never heard of.” The portfolio I put together for that article became the Über-Tuber — as in “the ultimate Couch Potato” — which you’ll find on my page of Model Portfolios.

If you’re not familiar with Dimensional Fund Advisors, that’s not surprising: the firm keeps a low profile, and its funds are offered only through a select group of advisors who must first undergo extensive training. DFA’s investing strategies are based on the academic work of Eugene Fama and Kenneth French, whose research demonstrated that value stocks and small-cap stocks have historically delivered higher returns than the overall market. (For more details, see the DFA website and my own post, Where Do Returns Come From?) The point of my article was to suggest a way for do-it-yourself investors to use Dimensional’s passive strategies with ETFs.

I later learned that the article made the rounds among DFA advisors,

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Fundamental Indexing for Corporate Bonds

On Monday, I took issue with the argument that cap-weighted bond indexes are fatally flawed. Rob Arnott, the creator of fundamental indexing, has argued that the classic model is “patently ridiculous.” The Research Affiliates website frames the problem like this: “Traditional bond indices give their greatest weights to the biggest debtors. Should investors buy more of a company or nation’s debt solely because it increases its issuance?”

My previous post looked at this idea as it applies to government bonds. However, there are currently five RAFI fixed-income indexes, and all of them cover corporate debt—three for investment-grade bonds, and two for high-yield bonds. And right now there’s just a single ETF tracking one of these indexes: the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). This fund has been around since 2007, though it didn’t start tracking the RAFI High Yield Bond Index until last August.

The other side of the argument

In a recent conversation with Steven Leong and Oliver McMahon, who handle product management for iShares, I brought up the idea that traditional bond indexes overweight companies with the most debt.

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Are Bond Index Funds Stupid?

When Rob Arnott, the creator of fundamental indexing, spoke in Toronto last week, his presentation focused exclusively on equities. When he took questions at the end of his presentation, I asked him a question about the lesser-known RAFI fundamental bond indexes.

Recall that the goal of fundamental indexing is to address the flaws in capitalization-weighted indexes, which give the most influence to stocks that may be overpriced. Traditional bond indexes are cap-weighted, too: the more bonds a country or corporation issues, the greater their weight in the index. Arnott and others have criticized this methodology, so I asked him to comment. Here’s what he said:

“If you’re bond investor, you’re a lender. If you’re cap-weighted, then you’re lending the most to whomever has the most debt. What is the rationale behind that? If you’re investing in a global sovereign bond fund and Greece decides it wants to double its debt, as an index investor you would have to own twice as much. What’s the sense of that?

“Cap-weighting in bonds is patently ridiculous. Cap-weighting in stocks has a lot of theoretical justification,

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Fundamental Indexing in the Real World

Earlier this week I discussed the promise of fundamental indexing. This strategy takes aim at the shortcomings of traditional cap-weighted indexes, which overweight growth stocks and are prone to bubbles. In 2005, Rob Arnott and his colleagues unveiled the Research Affiliates Fundamental Indexes (RAFI) and produced data showing that they would have outperformed cap-weighted indexes by about 2% to 3% per year over the long term in almost every market.

Any strategy that can outperform by a couple of percentage points is certainly worth a look. However, the proof is in real-world performance, not in backtested computer models. The question for investors, then, is whether the ETFs and mutual funds based on RAFI indexes have lived up to their billing.

One crucial point before we look at the data. I wasn’t interested in whether the fundamental ETFs have outperformed their cap-weighted counterparts: over a period of five years, this is virtually meaningless. Lots of actively managed funds can make the same claim, but over longer periods, that outperformance generally disappears. So I was more interested in whether the RAFI funds are tracking their own indexes closely.

Cap-weighted index funds are not perfect,

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The Promise of Fundamental Indexing

Last Friday, I had the pleasure of attending a talk by Rob Arnott, the creator of the Research Affiliates Fundamental Indexes (RAFI). The Toronto event was hosted by Claymore Investments, who use the RAFI indexes for their flagship equity ETFs.

If you’re not familiar with fundamental indexing, here’s a primer. Most traditional indexes are weighted by market capitalization, which means that a company’s influence is determined by its size (as measured by the number of shares outstanding, multiplied by the price per share). If a stock doubles in price, its influence in a cap-weighted index will also double. Similarly, if a company’s stock price declines, so does its weight in the index.

This methodology makes perfect sense if the goal of an index is to be a barometer of the market. Indeed, the cap-weighted S&P 500 was created in 1957 to measure the performance of the U.S. stock market, and other traditional indexes (including the S&P/TSX Composite in Canada) perform the same role.

However, proponents of fundamental indexing point out that these benchmarks were never designed to be the basis of an investment strategy.

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Could You Have Picked the Winning Funds?

Last month I put together the Global Couch Potato’s 10-year report card. I calculated the returns of this simple index portfolio using data from TD’s e-Series index funds, including annual rebalancing. The annualized return of the portfolio from 2001 through 2010 was 4.03%.

In a subsequent post I looked at how the Couch Potato stacked up against other globally balanced mutual funds. But at that time, the only 10-year performance data I could get was what I looked up myself in annual reports. So even though it appeared that the Couch Potato did well during a turbulent decade, it was hard to say much more than that.

While researching my column for the June issue of MoneySense, however, I collected much more complete data. I called Morningstar and asked them to provide me with the 10-year returns for all Canadian mutual funds in two categories: Global Equity Balanced and Global Neutral Equity. These categories most closely resemble the Global Couch Potato, with its 40% bond allocation and its equity holdings spread across Canada, the US and international markets.

How many of these outperformed a portfolio of humble index funds?

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Why You Don’t Need a Financial Realtor

On Monday, I asked readers to consider whether even index investors would benefit from the services of a financial advisor. Most of those who left a comment seemed to agree that the right advisor could add value, although committed DIY investors expressed their doubts.

The most interesting response I received came from a financial advisor with a major financial institution. While he has to remain anonymous—compliance departments don’t like their advisors spouting off on blogs—he gave me permission to publish his thoughts.

This advisor advocates using passively managed funds, but feels that his role is about much more than building portfolios:

Dear Dan,

I thought I would poke my head up and enter into this emotionally charged debate about whether an advisor’s fee is worth it. As with all the big questions in finance, there is no black or white answer: it comes down to what colour of grey you can stomach.

Let’s start with the facts, since they pack less of an emotional charge. At first glance, the data do not look good for advisors. In their paper What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?

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Do Indexers Need an Advisor?

Whenever I write about indexing with an advisor, I get questions from readers who wonder why passive investors would work with a professional. After all, in most cases, you’ll pay an advisor about 1% assets under management—and that’s on top of the MERs on the ETFs or mutual funds. Index investors, who are especially keen to avoid fees, wonder aloud if that’s worth it.

Here are a few ways passive investors can benefit from the help of an advisor:

Emotional control. The theory of index investing is simple: build a low-cost, well diversified portfolio and stick to the plan through all the ups and downs of the market. But in practice, this is incredibly difficult for most people. Rebalancing is particularly hard, because it invariably means adding money to asset classes that are out of favour. When everyone is screaming at you to get out of bonds or international equities, can you plug your ears and stay the course? An experienced advisor—and an Investment Policy Statement—can remove the emotional obstacles that impede even seasoned indexers.

Risk management. If you need a 4% return to meet all of your financial goals, how much of your portfolio should be in equities?

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