Archive | April, 2012

The Models Are Broken—But Indexing Still Works

If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.

In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”

The background

Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution.

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Closing the Behavior Gap

I once went to an investment seminar at my local library. It was attended by a handful of folks who had little or no experience with investing and were looking for someone to put them on the right track. The guy leading the session held up a copy of the Globe and Mail business section and encouraged us all to read it every day so we could learn what was happening in the economy and apply it to our investments.

That is some of the worst financial advice I’ve ever heard, and if Carl Richards had been there I imagine he would have thrown a few rotten eggs and tomatoes. Richards’ new book, The Behaviour Gap: Simple Ways to Stop Doing Dumb Things With Your Money, spends most of its 178 pages encouraging investors to ignore the headlines and focus on the real determinant of financial success or failure: ourselves.

“Forget about what’s going on in China or global demand for the dollar or the price of gold,” Richards writes. “While we’re worrying about those things, we could be doing things that actually make a difference in our financial lives—like working or trying to figure out how to save or earn a little more.”

Richards is a financial planner and a New York Times blogger who has a remarkable talent for distilling his insights into napkin sketches.

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Apple and the Dividend Puzzle

As loyal readers will know, I’ve been critical of the zeal with which some investors approach dividends. Based on countless blog posts, emails and conversations, I feel that many investors’ preference for dividends is often irrational. And that’s not simply my opinion—the dividend puzzle has been a popular topic in financial theory for decades.

There are some situations where dividends are clearly preferable to price appreciation. The most clear-cut is the tax advantage enjoyed by investors (especially those in a low tax bracket) who hold Canadian dividend stocks in a non-registered account. But there are other situations where investors should actively avoid dividends—and yet they flock to them anyway. The latest example of misplaced enthusiasm comes from Apple.

As everyone knows, Apple announced in March that it will pay a quarterly dividend starting later this year. Predictably, the news was met with widespread approval—the dividend was called “payback,” and a “reward.” As The Globe and Mail reported, “It will raise demand for the stock, since dividend-focused investors, mutual funds and exchange-traded funds will now put Apple on their radar screens.”

Therein lies the puzzle.

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Claymore’s Final Report Card

Tracking error—the difference between the performance of a fund and that of its benchmark—is the best way to measure an index fund’s true cost. While many investors focus on MERs, a low fee means little if an ETF lags its index by an additional 30 or 40 basis points.

A couple of weeks ago, I reported on the tracking errors of iShares ETFs in 2011, which were mostly very low. Today let’s look at the 2011 performance of the most popular ETFs that formerly bore the Claymore name, all of which were recently rebranded as iShares.

Canadaian equity
Ticker
Fund
Index
Diff

Canadian Fundamental
CRQ
-8.3%
-7.9%
-0.4%

S&P/TSX Canadian Dividend
CDZ
6.3%
7.4%
-1.1%

US and international equity
Ticker
Fund
Index
Diff

US Fundamental (hedged)
CLU
-1.5%
-0.4%
-1.1%

US Fundamental
CLU.C
1.8%
2.3%
-0.5%

International Fundamental
CIE
-13.1%
-12.2%
-0.9%

BRIC
CBQ
-22.5%
-22.0%
-0.5%

Global Real Estate
CGR
-3.1%
-2.0%
-1.1%

Global Monthly Advantaged Dividend
CYH
-5.5%
-5.7%
0.2%

Fixed income
Ticker
Fund
Index
Diff

1–5 Yr Laddered Corp Bond
CBO
4.7%
5.0%
-0.3%

1–5 Yr Laddered Gov’t Bond
CLF
5.4%
5.5%
-0.1%

Advantaged Canadian Bond
CAB
6.8%
8.9%
-2.1%

Advantaged High Yield Bond
CHB
4.6%
6.4%
-1.8%

Let’s start with the positive results: the three core equity funds tracking the RAFI fundamental indexes had very low tracking errors.

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Why Daily Market Commentary Is a Joke

I haven’t watched Saturday Night Live for a long time, but I’ve been thinking about a classic line from the show’s Weekend Update sketch. Back in 1988, during the Winter Olympics, Dennis Miller opened his sportscast like this: “In Calgary tonight, Katarina Witt won the gold medal in figure skating, prompting Yankees owner George Steinbrenner to fire manager Billy Martin.”

If you’re not a baseball fan, the joke needs an explanation. Billy Martin was the manager of the New York Yankees during five separate stints beginning in 1975. The mercurial Steinbrenner fired Martin in 1978, rehired him in 1979, fired him again after 95 games, then hired and fired him three more times in 1983, 1985 and 1988. No one knows exactly what reasons Steinbrenner used to justify all those firings, but Katarina Witt’s gold medal performance in Calgary seems as good as any.

I remembered the joke this morning when I read the Financial Post’s daily market commentary: “The S&P 500 added more than 2% in the two previous sessions as immediate concerns over rising yields in Spain and Italy ebbed and on bets the Chinese GDP data would surprise on the upside.”

This commentary can sound so knowledgeable and wise.

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Is the Market Overvalued? Depends Who You Ask

Critics of index investing often argue that the strategy is not sensitive to valuation. They feel that a simple strategy of buy, hold and rebalance is folly: there are times when the market is cheap or overvalued, and it makes sense to shift toward or away from equities accordingly.

It’s hard to argue with that principle. There are certainly periods when markets appear frothy and others that look like excellent buying opportunities. The problem is, whose valuation should you believe?

On April 2, Vanguard’s chief economist Joseph Davis went on BNN and said that valuations are right around their historical averages, so expected stock returns over the next several years should also be near their historical averages, which in the US is about 9% a year.

Three days later, The Globe and Mail ran an article about Prof. Robert Shiller’s method for valuing the market. According to Shiller, the earnings yield of the S&P 500 is currently 4.5%, compared with the historical median of 6.3%, which means the market is significantly overvalued. This translates to expected returns of 2.6% annually over the next 10 years.

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ING’s Streetwise Fund v. TD e-Series

The humble Global Couch Potato portfolio, first recommended by MoneySense eight years ago, is an excellent way to get started with indexing. So when ING Direct launched its Streetwise Balanced Fund in 2008, I thought it would be perfect for new investors, since it’s a single fund with the same target allocation: 40% Canadian bonds and 60% equities, divided equally between Canadian, US and international.

The one problem with the Streetwise Funds was cost: with an original MER of 1% (now 1.07% with HST added) they were more expensive than I would have liked. After all, banks already offered index mutual funds with fees in that neighbourhood, and the TD e-Series Funds are dramatically cheaper: you can build the Global Couch Potato for a total cost of just 0.37%.

But four years after the launch of the Streetwise Balanced Fund, it’s worth taking a closer look at how it fared in comparison with the with TD e-Series. Here are the returns:

TD e-Series
Streetwise

2008
-14.22%
-14.13%

2009
12.00%
10.72%

2010
8.02%
6.52%

2011
0.68%
0.30%

Annual
1.10%
0.40%

As you can see,

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What’s Next for iShares — Part 2

Here is part two of my interview with Mary Anne Wiley, Head of iShares, who explains what to expect in the wake of BlackRock’s acquisition of Claymore. You can read the first part of the interview here.

Claymore pioneered some innovative programs, such as preauthorized cash contributions (PACCs) and dividend reinvestment plans (DRIPs), as well as the Scotia iTrade partnership that brought commission-free ETFs to Canada. Will those programs continue?

MAW: Let me take each one of those individually. Claymore did have a program with PACCs, DRIPs and SWPs, and by far the DRIPs were the most popular. There are other ways to do DRIPs with the brokerages directly, but not every brokerage has every ETF set up for it, and we want it to be as easy as possible for all types of investors. So we are going to keep all of the programs on the existing funds, and we are looking to expand the DRIPs, in particular, to a wider set of iShares.

As for the commission-free partnerships, we think these are fabulous programs. Anything that encourages investors to try ETFs and get to know them,

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What’s Next for iShares?

Back in January, BlackRock—the parent company of iShares—announced that it had acquired Claymore Investments, the second-largest ETF provider in Canada. Since then, BlackRock has been gradually integrating the former Claymore funds into its family. The ETFs were officially rebranded last week and all of them now trade under the iShares name.

Many readers have wondered about what this acquisition will mean for individual ETF investors. On Monday, I had an opportunity to sit down with Mary Anne Wiley, the newly named Head of iShares for BlackRock Canada. Here’s part of our interview—more to come later in the week.

I was surprised when I first heard about the acquisition, but after a bit of reflection, it was clear that the two ETF families actually had very little overlap.

MAW: I think that was the reaction of most people: “I never saw that coming.” But then they took a step back and realized that it made a huge amount of good sense for us, and for the market at large. We have one of the most trusted brands in ETFs, and Claymore had done a really nice job of building a platform that was where iShares was not.

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