Archive | June, 2011

The Stock Picker’s Quest for Alpha

Among academics, the active-versus-passive debate often centres on mutual funds. But among DIY investors—who readily concede that mutual funds with high fees are unlikely to outperform an index strategy—the discussion usually focuses on stock picking. Many people who shun mutual funds believe that building their own portfolios of individual stocks offers a high likelihood of market-beating returns.

At a recent symposium in Toronto hosted by Dimensional Fund Advisors, I listened to financial author Larry Swedroe discuss this idea and others in his book The Quest for Alpha. Swedroe also spoke the night before to a group in Ottawa that included several bloggers. Some were put off by Swedroe’s assertion that investors should not be picking individual stocks.

It’s impossible to make sweeping conclusions about the performance of retail investors who pick stocks, because the data are hard to get, at least compared with what’s available in mutual fund databases. Any researcher can look up the performance of funds, but how can we possibly know how successful individuals are?

Here’s what we know

In fact, there have been a number of studies by researchers who had access to account data from brokerage firms,

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Can’t We All Just Get Along?

I’ve never been shy about criticizing actively managed mutual funds, but I’m starting to think this debate is getting old. More than that, I feel like it’s driving a wedge between people who should be allies. So let me be the first to extend an olive branch and say that the active v. passive debate is too often a distraction from what’s really important in personal finance.

I’ve been thinking about this issue since reading Tom Bradley’s It’s Not Rocket Science. Bradley is president and co-founder of Steadyhand, a small firm that offers a family of low-cost mutual funds sold directly to investors.

A fundamental part of Steadyhand’s investment philosophy is that an active manager’s best chance to beat the market is to ignore index benchmarks and build concentrated portfolios. They even call their strategy “undexing.” So you might expect that a committed passive investor would be filling the margins with indignant notes when reading a book by someone with such confidence in active management. But here’s the thing: I agree with about 95% of what Bradley writes.

One of the first pieces in the book—which is a collection of Bradley’s past blog posts and Globe and Mail columns—is called “Three Keys to Investment Success.” He identifies these as the discipline to set financial goals and decide on a strategy to reach them,

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Ask the Spud: Can You Time the Markets?

Q. Have you ever done any calculations into the optimal time to purchase index funds or ETFs based on broad market indicators? I’m essentially talking about buying during market dips and corrections, perhaps based on moving averages. — Joe S.

Canadian and international stocks are now in negative territory for 2011, and even US equities have fallen more than 5% since the beginning of May. If you’re an index investor with a global strategy, does it make sense to wait on the sidelines for opportunities like this? Can you enhance your returns by identifying the right time to buy?

Let’s call a spade a spade here: this is market timing. It is always possible to look in the rear-view mirror and identify what would have been the optimal time to buy into any asset class. But trying to spot buying opportunities ahead of time, based on moving averages or other technical indicators, is likely to be futile and costly.

Besides, the Couch Potato strategy already includes a technique for buying into asset classes when they’re “cheap.” It’s called rebalancing.

About once a year—or when your portfolio’s target allocations are out of whack by a certain amount—it makes sense to trim the best performers and use the proceeds to prop up the winners to get the portfolio back to its targets.

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Claymore Advantaged ETFs: Costs and Risks

Monday’s post took a peek inside Claymore’s family of Advantaged ETFs, which use forward agreements to make them more tax-efficient. Today we’ll look at the costs and risks associated with these ETFs so you can decide whether they’re suitable for your index portfolio.

The ETFs have reasonably low management expense ratios, ranging from 0.32% for the Claymore Advantaged Canadian Bond (CAB) to 0.66% for the Claymore Global Monthly Advantaged Dividend (CYH). However, the forward agreement carries an additional fee of 0.50% that is paid to the counterparty.

This fee is not included in the MER, so the total cost of the Advantaged ETFs is between 0.82% and 1.16%. That’s very high for an ETF, of course, but those fees have to be considered in context. If you hold a traditional bond ETF in a non-registered account and you’re in a 45% tax bracket, then a 4% yield is cut to 2.2% by taxes. If that 4% yield were taxed as a capital gain at just 22.5%—and that is the whole point of the Advantaged ETFs—it would be reduced to 3.1%. Even after deducting another 50 basis points in fees,

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Understanding Claymore’s Advantaged ETFs

In a series of posts earlier this month, I tried to demystify the swap-based ETFs launched by Horizons last year. These funds use a type of derivative called a total return swap to get exposure to the companies in the S&P/TSX 60 or the S&P 500 without actually holding any of the stocks in these indexes.

The primary benefit of using the swap structure is that the investor does not get an annual tax bill for the dividends. Instead, all the growth compounds until the investor sells her units of the ETF, at which point it is taxed as a capital gain.

While the Horizons ETFs are the only ones in Canada using total return swaps, Claymore also offers a family of ETFs that use a rather complicated structure designed to make them more tax-efficient:

Claymore Global Monthly Advantaged Dividend (CYH)
Claymore Advantaged Canadian Bond (CAB)
Claymore Advantaged High Yield Bond (CHB)
Claymore Advantaged Short Duration High Income (CSD)
Claymore Advantaged Convertible Bond (CVD)

One step forward

Like swap-based ETFs, these Claymore funds give you exposure to a market index without actually holding the assets in that index.

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Review: The House That Bogle Built

In 1951, a Princeton University student wrote a thesis about the mutual fund industry. “Funds can make no claim to superiority over the investment averages,” wrote the scholar, who would go on to create the first index mutual fund some 25 years later. That young man, of course, was John Bogle, founder of The Vanguard Group and the subject of The House that Bogle Built (McGraw-Hill Ryerson, 2011), a new biography by journalist Lewis Braham.

With the news that Vanguard has arrived in Canada, this book seems like timely summer reading. Not only does it paint a vivid portrait of one of the most important investor advocates of all time, but it also peers inside the unique organization he founded—a company that has been steadily drifting away from the vision of its first chairman.

“A long-term loser”

In a chapter called “The Devil’s Invention,” Braham explains what Bogle endured in 1976 when he launched the First Index Investment Trust, which would later become the Vanguard 500 Index Fund. The idea was so slow to catch on that it could not even afford to buy all the stocks in the S&P 500.

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Will Vanguard Really Change Anything?

I’ve been holding back on making comments about Vanguard’s arrival in Canada, because I wanted some time to collect my thoughts. Now I’m ready to go public with my cautious enthusiasm.

Make no mistake, I’m thrilled to see Vanguard in Canada. The company’s ultra-cheap, well managed  index funds and ETFs have played a huge role in pushing fund fees lower in the US, and it’s easy to see why many expect the same thing to happen in Canada, where costs have always been much too high. A MarketWatch article suggested that “a new line of Canada-domiciled Vanguard funds would have a huge impact on Canada’s mutual-fund industry.”

I hope I’m wrong, but I would be shocked if that turned out to be true.

The problem isn’t a lack of products

Canadian retail investors face some significant obstacles, but a lack of excellent investment products is not an important one. Using the TD e-Series index funds or ETFs (including those from Vanguard), Canadians can already build excellent, low-cost portfolios. My Complete Couch Potato is available to anyone with a discount brokerage account for 29 basis points,

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More Swap Talk With Horizons

Here’s part two of my interview with Jaime Purvis, Executive Vice-President, National Accounts, for Horizons ETFs. (See part one here.) In this conversation, we talked about some of the reasons why investors might consider swap-based ETFs such as Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 ETF (HXS).

When you launched HXT last September, you went head-to-head with the iShares S&P/TSX 60 Index Fund (XIU), which has almost $11 billion in assets. Why would an investor switch from the largest ETF in Canada to a new product to save nine basis points?

JP: It’s true, XIU has been a landmark product in Canada for more than a decade. So when we looked to launch our product we asked, how can we compete? We didn’t just want to compete on cost, because that is a difficult strategy—although we did say that we would go as low as we could possibly afford to. And with about $300 million in assets, we are comfortable with our profit and loss on this product.

This company has always been about innovation. Whether it was leveraged and inverse ETFs, or actively managed ETFs,

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Swap-Based ETFs: What Are the Risks?

Monday’s post discussed the inner workings of the two swap-based ETFs launched by Horizons in late 2010. Many investors are understandably concerned about the risks involved in these rather complicated funds, which get exposure to equity indexes without actually holding the underlying stocks.

I recently sat down with Jaime Purvis, Executive Vice-President, National Accounts, for Horizons ETFs, and asked him to explain more about how these products work.

Many investors get nervous when they hear the word “derivative.” Are we going to be reading in the next Michael Lewis book about how total return swaps blew up the ETF market?

JP: People think derivative is a dirty word. But a derivative is simply something that derives its price from an underlying asset. Your Michael Lewis reference is fascinating, because The Big Short describes how they parceled up all of these mortgages that people couldn’t afford, and they lumped together the good stuff and the bad stuff in all of these tranches and tiers. But the underlying assets were not very liquid. If you have a bad house in a bad neighborhood, it’s not like you can sell off a couple of rooms.

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