Archive | November, 2012

Inside the BMO and PowerShares Low-Vol ETFs

In the last 14 months or so, Canada’s ETF providers have launched several funds based on low-volatility strategies. As we saw in my last post, the research suggests it may be possible to build a portfolio of stocks with lower volatility than the broad market without sacrificing expected returns. But exactly how do you select those stocks?

There are several ways to implement a low-volatility strategy, so before you consider any of the new ETFs, make sure you understand how they differ. Today we’ll take a look at the methodologies used by BMO and PowerShares. Next week we’ll look at the iShares strategy.

BMO looks at beta

Rather than tracking an index, the BMO Low Volatility Canadian Equity (ZLB) simply uses a transparent set of rules. You start with the 100 largest stocks in Canada and rank them according to their beta over the previous 12 months. You then select the 40 with the lowest beta: the lower the beta, the greater the company’s weight in the fund. No stock can make up more than 10%, sectors are capped at 35%, and the fund is rebalanced just once a year.

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The Promise of Low Volatility

The relationship between risk and reward is one of the most fundamental in finance: to get higher returns, say the traditional models, you must accept more risk. There’s just one problem with that idea: it’s not borne out by history. Over long periods, in most markets around the world, stocks with the highest volatility have not been the best performers—and during some periods, the least volatile companies have done significantly better. This low-volatility anomaly has been known since the 1970s, and has gained renewed popularity with the appearance of a number of ETFs designed to capitalize on it.

In the last year or so, BMO,  iShares and PowerShares have all launched low-volatitly ETFs in Canada, and each them uses a quite different strategy. I’ll review these later in the week, but first, I’d like to share an excerpt from my recent interview with Jean Masson, managing director at TD Asset Management and an expert on low-vol strategies. Dr. Masson is the portfolio manager for the  TD Canadian Low Volatility Class and the TD Global Low Volatility Fund,

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Virtual Brokers Becomes the ETF Leader

The Globe and Mail announced its annual discount brokerage rankings yesterday and crowned a new winner. Virtual Brokers took top spot for 2012, ending a six-year run by Qtrade. In his article about the rankings, Rob Carrick commended the winner for its low costs and innovation, noting that “new for this year, commissions to buy any and all ETFs have been waived.” I have to admit that was news to me.

Following Scotia iTrade and Qtrade, Virtual Brokers became the third in Canada to offer a menu of commission-free ETFs last fall. (I’ve summarized the offerings of all three brokerages here.) VB’s current list of eligible ETFs has 100 names, including many from iShares and BMO, as well a few dozen US-listed funds, most of them very narrowly focused. All these ETFs can be bought and sold with no commission, as long as the two trades do not occur on the same day. However, what I had not realized—it’s not clearly explained on the site—is that Virtual Brokers now allows its clients to buy any ETF with no commission.

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Four New ETFs and an Invitation

BMO has announced it’s launching four new ETFs, which will start trading on Tuesday, November 20:

BMO S&P 500 (ZSP/ZSP.U)
BMO S&P/TSX Laddered Preferred Share (ZPR)
BMO S&P/TSX Equal Weight Industrials (ZIN)
BMO S&P/TSX Equal Weight Global Gold (ZGD)

Let’s look at the two most interesting ETFs in this lineup. Investors seem to be falling out of love with currency hedging, which causes a long-term drag on returns for Canadians who invest in US equities, and ETF providers are responding. Less than three weeks after the launch of the unhedged Vanguard S&P 500 (VFV), BMO has a competitor. Back in September, BMO changed the benchmark for its US equity ETF from a Dow Jones index to the better-known S&P 500, but that fund retained its currency hedging. The new BMO S&P 500 (ZSP), however, is unhedged and its management fee is identical to Vanguard’s at just 0.15%.

What’s interesting is that BMO has also created a version that trades in US dollars (ZSP.U). If you want a USD-denominated ETF that tracks the S&P 500 it generally makes more sense to go with one of the New York-listed funds from iShares,

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Blog for Financial Literacy: A Simple Plan

Today’s post is part of the Blog for Financial Literacy campaign spearheaded by Glenn Cooke of Life Insurance Canada.com. Glenn encouraged dozens of bloggers to devote their November 15 post to sharing their “single best financial tip,” in recognition of Financial Literacy Month.

Long-time readers of Canadian Couch Potato know I occasionally explore some pretty arcane facets of index investing. I hope this advanced information has helped serious index investors make better decisions, but I recognize it may have left some readers scratching their heads. With that in mind, here’s the single best financial tip I can offer: keep your investing strategy simple.

We need to get rid of the idea that successful investing has to be complicated. If you’re naturally curious like me, you’ll genuinely enjoy spending time and effort to learn the subtleties. Gaining a deep knowledge can be empowering, but it’s not essential. What’s more, it comes with the risk of analysis paralysis and the tendency to second-guess your decisions.

Do you disagree with one of the ETF choices in my model portfolios and want to substitute another?

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Profitability: Entering a New Dimension?

Investors should always be skeptical about new strategies that promise abnormal returns. As I explained in last week’s post, some of those strategies are dubious to begin with, and even legitimate ones don’t always last.

But that’s not to say academic research can’t shed light on how markets work. Indeed, the Fama-French three factor model, described in a landmark 1992 paper, reveals how small-cap and value stocks offer additional risk premiums that have become the specialty of Dimensional Fund Advisors.

Now there’s new research that may prove equally influential. In The Other Side of Value: The Gross Profitability Premium, Robert Novy-Marx of the University of Rochester argues that “profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns.”

As you can tell, the paper is rather technical, but here’s the basic idea. It’s rational to expect higher returns from cheap value stocks, since they are inherently riskier. It is harder to explain why profitable companies would reward investors when they trade at higher multiples and are less prone to distress. Yet Novy-Marx found that profitable companies actually performed about as well as value companies.

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Why Market-Beating Strategies Don’t Last

This past spring I asked why everyone isn’t beating the market when countless strategies have been shown to deliver outsized returns—at least in theory. I put it down to self-destructive behaviour, but now two US researchers have a different explanation: they’ve demonstrated that market-beating strategies tend to lose their mojo after they’ve been published.

In their paper, Does Academic Research Destroy Stock Return Predictability?, David McLean and Jeffrey Pontiff examine 82 characteristics that have been offered up in peer-reviewed journals to explain variations in stock returns. These include things like market cap, value measures, liquidity, dividend policy, momentum, credit downgrades, and many others. If an investor could use of any of these characteristics to pick market-beating stocks they would be called market anomalies.

Anomalies can come and go for various reasons, the researchers tell us. They may be the result of statistical biases: in other words, if you were to look at a different data sample the anomaly would probably disappear. For example, if stocks with a given characteristic delivered higher returns in the US but not in other countries, or only during a specific period,

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Don’t Invest in the Rear-View Mirror

Investors face many behavioral biases—that’s just part of being human. Perhaps the most difficult to overcome is recency bias: the tendency to believe what has happened in the immediate past is likely to continue in the future.

Although experienced investors understand short-term market movements are random, once patterns develop over three to five years the gurus start calling them new paradigms. Then they urge us to change that stodgy old strategy that isn’t appropriate anymore and encourage us to adapt to the new normal.

Problem is, while this sounds wise, it’s little more than performance chasing. What happened over the last five years cannot help you during the next five years—in fact, investing in the rear-view mirror is almost certain to produce disappointing results. To see why, let’s turn back the clock five years to the autumn of 2007, when investors were enjoying a full-on bull market following the tech wreck of the early 2000s. Imagine sitting down for a meeting with your advisor who shows you the following performance numbers:

Annualized returns: Five years ending October 2007

S&P/TSX Composite
20.99%

Russell 3000 (in USD)
14.83%

Russell 3000 (in CAD)
3.91%

MSCI EAFE (in CAD)
11.95%

MSCI Emerging Markets (in CAD)
26.97%

US dollar versus Canadian dollar
-9.51%

Source: Dimensional Returns 2.0

These results are pretty dramatic: Canada absolutely pummeled the US even when performance is measured in local currency.

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Should You Buy Stocks For Your Kids?

If you’re a parent, how can you set your child on the road to investing success?

One popular way is to buy young kids shares in companies familiar to them—maybe Disney, Apple, or McDonald’s. The idea is to get them excited about owning businesses that make their favourite products and services, with the hope that will turn them on to investing. I’m sympathetic to this idea, and it may work for some families—I’m certainly not trying to be a judgmental parent here. But I do wonder whether the best way to teach young people about investing is to turn them into stock pickers. I’ll offer three arguments against it:

It’s the wrong priority. On the list of key ingredients in an investment plan, picking the right stocks (or funds) isn’t even in the top five. At the top of the list is a commitment to regular saving. After that comes choosing the appropriate risk level for your goal, diversification, low cost, and minimizing taxes. Focusing on the stocks themselves is emphasizing the wrong part of the process. It’s like teaching your child to play hockey by buying him a cool stick rather than showing him how to pass,

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