Passive Investing: The Movie

December 10, 2012

There are countless books laying out the case for index investing, but as far as I know there has never been a film—until now. A UK investment firm has just released a 54-minute documentary called Passive Investing: The Evidence, which includes cameos from some of the leading proponents of strategy.

The film was financed by Barnett Ravenscroft Wealth Management, which manages portfolios using products from Dimensional Fund Advisors and Vanguard, so they clearly have a vested interest in promoting the strategy, but it would be unfair to dismiss the film as an hour-long infomercial. BRWM works only with individuals and institutions who have over £1 million in investable assets, yet the company seems eager to get its message out to the UK public, even though the vast majority of the film’s audience will never become clients.

They’ve certainly made a significant investment in the film: the production quality is very high and the interviews include luminaries such as John Bogle, Charles Ellis, Rick Ferri, Kenneth French, William Bernstein, Burton Malkiel and William Sharpe. Not since Toy Story have so many potatoes appeared in one film.

A shaky foundation

The documentary is divided into eight chapters. The first two do a good job of covering ground familiar to Couch Potatoes: the failure of most active funds to outperform and the erosion caused by high costs. Part 3 lays some theoretical groundwork, including the Capital Asset Pricing Model (CAPM) and the Efficient Markets Hypothesis. I appreciate the challenges of bringing these complex ideas to the public, but I found this chapter problematic. CAPM—which predicts the expected return of a security based on its beta—is still widely taught, but it doesn’t do a particularly good job of explaining returns in the real world. (The Fama-French three-factor model is a dramatic improvement.) So I’m surprised the film’s website describes CAPM as “the mathematical foundation of passive investing.”

It’s also going too far to suggest that in an efficient market “shares are always priced correctly because they already reflect everything that is publicly known about the company.” I’m not sure anyone believes stocks are “always priced correctly.” The more subtle argument is that inefficiencies in the market certainly exist, but they are short-lived and extremely difficult to exploit in any systematic way.

Why isn’t passive more popular?

French1Part 6 is an interesting look at why active strategies remain so popular, despite the evidence that most of them fail. Here the film hits all the right notes, explaining that it’s a combination of powerful marketing by investment firms, distractions in the financial media, and behavioral biases such as overconfidence. The best quote comes from Ken French when discussing the constant need for newspapers and magazines to celebrate hot fund managers: “Put me on the cover and you’re not selling anything.”

In Part 7, the film argues that passive strategies are gaining a foothold in the UK, where they currently make up only 7% of retail investor assets, compared with about 30% of institutional assets. (I’d estimate the popularity of indexing is similar in Canada, though it’s about twice as high in the US.) The discussion touches on the arrival of Vanguard in the UK in 2009: “Vanguard believes that passive investing has far greater potential in the UK because the cost of active fund management is higher over here than it is in the US.” Of course, those costs are even higher in Canada, so Vanguard must have seen enormous potential when it landed here in 2011. Unfortunately, a lot of that potential remains untapped.

If you’ve got a friend or relative who’s interested in the Couch Potato strategy but not inclined to read a whole book about it, send them a link to this short film, which is also available via YouTube. It might be the best 54-minute investment they’ll make this year.

{ 50 comments… read them below or add one }

Jungle December 10, 2012 at 10:07 am

I could tell my wife we’re having a movie night..
“What’s the movie about?”
“potatos”
“huh?”
“there’s a lot of old, rich men in this movie. Boring as hell, but they are rich” lol

Canadian Couch Potato December 10, 2012 at 10:10 am

@Jungle: I added a bottle of wine and a nice fire and thought it was really quite romantic. My wife disagreed, so we ended up watching Duck Dynasty.

Kiyoshi Masui December 10, 2012 at 10:34 am

“There are countless books laying out the case for index investing, but as far as I know there has never been a film—until now.”

The film “Taking Stock”, which was produced in Toronto, is about behavioral investing, but it also has very passive message.

Canadian Couch Potato December 10, 2012 at 11:37 am

@Kiyo: I hadn’t heard of that film, but would like to watch it. Any idea if it’s available anywhere? Here’s the trailer on YouTube: http://www.youtube.com/watch?v=lBaUsnU9V-E

Noel December 10, 2012 at 1:06 pm

The video is very well done and I am going to suggest it all those who tell me they don’t want to read the Moneysense book you wrote and are waiting for the movie to come out. ;)

The only criticism I have, other than what you pointed out about CAPM, is when, near the end of the video, Jasmine Birtles, Editor – moneymagpie, says, after saying (in not so many words) that she recommends passive investing to people who don’t have the time or interest to spend a lot of time researching companies that “if you do have that time to really to spend the amount of time that you need to, the kind of time that Warren Buffett spends, then sure”. So, here we have an entire video extolling the virtues of passive investing and at the end of it she suggests that the alternative, ie active investing, is an viable alternative if you have the time and interest. What she should have said is that even if you had the amount of time and interest that Warren Buffett has, you are still better off being a passive investor because the numbers speak for themselves, Warren Buffett is an anomaly, and the chances of us being as successful an active investor like he is are almost nil no matter how much time or interest we have in researching companies.

Canadian Couch Potato December 10, 2012 at 1:28 pm

@Noel: I noticed that, too, and you make a great point. There is a persistent idea that indexing is fine for people who don’t have the brain power or time to pick stocks—like we’re all a bunch of disengaged halfwits who have to settle for mediocrity, while the smart money outperforms.

To be fair, it’s clear Jasmine Birtles didn’t mean to imply that, but that line of argument is common. I would respond by asking why 7% of retail investors use passive strategies, compared with 30% of institutional investors. Is it because institutional investors aren’t smart enough, or don’t have the time to be active? Or do you think they’ve figured out active rarely adds value?

Noel December 10, 2012 at 1:36 pm

I agree that she really wasn’t trying to imply that, given what she said before, but I can see people who are new passive investing watching this video and then hearing that statement at the end of the video and then thinking ‘Whoa, I must have missed something. I thought everyone on this video just said there is really no way for most people to beat the market even if they researched stocks’. I just wish that comment was left out so as to leave absolutely no doubt about the message of the video.

Michel December 10, 2012 at 2:08 pm

Good presentation. Quite often, when I try to explain passive investing, I find it difficult to convince people that it works, although they’ve rarely heard of it, compared to the glamour of active star managers! This movie explains it quite well.

Jon Evan December 11, 2012 at 3:50 am

Vanguard in Canada obviously believes in indexing choosing to offer very low cost passive etfs, but in the USA where active funds enjoy lower costs Vanguard is confusing! They suggest that active and passive strategies can exist in a portfolio: “We believe both active and index funds can play a role in a balanced and diversified portfolio. They’re not oil and water, but more like peanut butter and jelly.” While in the longer term passive strategies have done better but in the shorter term of ten year rolling periods due to the fact that markets are not perfectly efficient Vanguard obviously believes that active strategies can add alpha. Now isn’t that confusing!
https://personal.vanguard.com/us/insights/article/active-index-funds-05042011

Big Cajun Man December 11, 2012 at 8:10 am

I think a video explanation is a great idea, since a lot of folks get really scared by financial documentation, or brochures about Indexing as a way of investing (namely me for one, I just don’t feel like I have time to read all that stuff, whereas watching a video gives me more confidence (yes, that doesn’t make sense to most folks, I suspect I have an aversion to reading)).

Canadian Couch Potato December 11, 2012 at 10:30 am

@Jon Evan: I think you’ll find virtually every investment company holds out the possibility of active adding value. Certainly BlackRock, BMO and other ETF providers in Canada do—it’s just business. I’m not swayed by the “passive core, active explore” idea: I think it is more likely to subtract value. But I’ll acknowledge that with Vanguard, where active management often costs 20 to 40 basis points, you at least have a fighting chance. Here in Canada, where active regularly costs 200 to 250 basis points, you do not.

Noel December 11, 2012 at 11:15 am

I am surprised that Vanguard offers actively managed funds, albeit at a lower MER than others. But, from this article that compares Vanguards managed funds with its indexed funds, it turns out not even John Bogle, the founder, is 100% indexed. He’s 80% indexed if the article is accurate. Also, it looks like Vanguard has gotten into managed funds due to demand from investors. So, why not get a piece of that pie too? (even if it does muddy the waters for investors). http://www.indexuniverse.com/publications/journalofindexes/joi-articles/3864-do-vanguards-managed-funds.html

@ Big Cajun Man – I do find I usually get pushback from friends who I try to encourage to explore index investing by reading a book on it (I always recommend Dan’s). The reason is usually that they don’t have the time to read a book. I find that reaction frustrating, especially when they are in the same breadth complaining about poor performance from their money manager, financial advisor or stockbroker, since they always seem to have the time for leisure pursuits. So, I do think that in the end it is more fear of the whole finance/investing world rather than not having the time.

Sensible Investing December 11, 2012 at 11:34 am

Thanks for the comments about our film – we’re delighted with the reaction it’s provoking around the world. We’ll take your comments on board and bear them in mind for future films (there are many, many more on our website http://www.sensibleinvesting.tv – take a look!)

Passive investing is rarely discussed in the UK and we wanted to make the film to address this issue. It was not primarily aimed at building business for BRWM and we’re happy for other companies to embed the film(s) on their own websites, as long as sensibleinvesting.tv is credited.

You’re right, Noel, Warren Buffett is an anomaly (he admits as much himself). Jasmine Birtles was commenting that virtually no-one else has the time or magic touch of Buffett and that very few people should even try to emulate him. The trouble is, some think they can. Jasmine is well known in the UK for common-sense financial advice to ‘ordinary people’ (ie not professional investors) and it was no doubt to this audience that she was directing her comments.

Canadian Couch Potato December 11, 2012 at 11:42 am

@Sensible: Thanks for stopping by and adding your comments. It’s interesting to hear that passive investing is rarely discussed in the UK. I think it is gaining popularity in Canada, though we are still well behind the UK in regulating advisor compensation the way you have. Keep up the good work.

Sensible Investing December 11, 2012 at 11:48 am

Talking about regulating advisor compensation, we have a new video series about that – http://www.sensibleinvesting.tv/ViewAll.aspx?id=BDD630A6-B7A6-4C16-AFD2-83685915F859 (apologies for the shameless plug – part two and three coming up in the next couple of days.)

Andrew December 11, 2012 at 3:06 pm

Perhaps the reason why passive investing, the superiority of which must be very well known to professional investment advisors, is not more widely recommended is advisor compensation.

Active investing implies action which somehow justifies the 1-2% or more in fees despite rampant closet indexing.

I still have trouble with advisors charging 1% to recommend a passive portfolio when their role may be no more than establishing initial asset allocation through some algorithmic process, rebalancing annually and recommending to stay the course during volatility through a phone call or two. These activities take no more than 10 hours a year in total (if that) but an advisor to a passive portfolio of 1 million will charge $10,000 for it.

Andrew F December 11, 2012 at 3:41 pm

“We believe both active and index funds can play a role in a balanced and diversified portfolio.”

Kind of like how ‘Nutella’ can be part of a balanced breakfast.

Andrew F December 11, 2012 at 3:54 pm

Andrew:

That’s why I think there is potential in a business model with highly automated portfolio management. Essentially some asset allocation consultation to start off with, some automated rebalancing/contribution management, and perhaps a help line where panicky investors can call in and be calmed down. The cost of doing this should be on the order of hundreds of dollars a year, not thousands or tens of thousands. And savers get the advantage of having some of these activities taken out of their hands and automated, removing the temptation to deviate from the pre-agreed plan.

Canadian Couch Potato December 11, 2012 at 3:55 pm

@Andrew: Clearly not everyone needs an advisor, but think about what you’re saying here. We agree an advisor can’t add value with active management, but you’re saying he/she cannot add value with passive management, either. In other words, an advisor adds no value, period.

Remember that many advisors do a lot more than simply choose investments. Indeed, that’s probably the easiest part of the process. The planning, tax management and behavioral aspects are often far more important. What do you feel is a fair fee for these benefits, assuming they are done well?

Jon Evan December 11, 2012 at 6:43 pm

@CCP “I think you’ll find virtually every investment company holds out the possibility of active adding value…. it’s just business”
Dan, you are too kind to these companies.
Frankly, it has become a sinister business and sadly no longer professional (a few exceptions and here I’m thinking of Steadyhand)! It’s only about business profit for the shareholders of BMO for example and the value of their active funds is not for the investor but for the profit of the company at the expense of confused investors! That’s wrong! Look at their investorline brokerage! They don’t even mention their index etfs in their model portfolios! Only the expensive active mutual funds! Why? It’s unprofessional and I’ve written and told them that.
The passive/active discussion needs to end and I’m glad people like yourself are setting the record straight. Even John Bogle has admitted that debate will eventually end!
“A reporter once asked me if I was optimistic about whether the trend toward indexing will triumph. I said I was not optimistic; I was absolutely certain.” That was in 2007.
A most recent excellent Bogle interview is very clear:
http://pragcap.com/deep-thoughts-from-john-bogle

Noel December 11, 2012 at 9:14 pm

@Andrew – I think your 10 hours a year is very unrealistic. And it would take a bit more than that initially to meet with a client and develop and implement a plan but not too much more. However, I think you are underestimating the on-going work that may be required. Clients phone in to ask questions, want to have meetings, call when the market goes down, call when it goes up, want hand-hodling and inevitably start wanting to get advice on tax planning, estate planning, and other aspects of their financial lives and while these are probably not services which you provide you have to spend time arranging meetings to take care of them, etc. Even if you are a bare-bones operation doing only passive investing for clients and nothing else there is office space to pay for, other overhead, staff salaries, etc. Certainly I don’t think this is all worth 1% of ones investment portfolio value per year, but it’s worth more than a few hundred dollars a year.

I looked up one of the people interviewed in the Sensible passive investing video, Rick Ferri (http://www.portfoliosolutions.com/). He is based in the US. His firm charges 0.25% of assets with a minimum portfolio size of $500,000 and a minimum fee of $2,500 per year for portfolios under $1M. There are no start-up fees, no annual administration fees and no hidden costs. This seems entirely reasonable to me. He has over $1B under management. At $1B he would generate $2.5M in fees/year. With 17 staff and office overhead he’s not cleaning up like he could be if he was an active manager. Any less and it probably just wouldn’t be worth it (certainly not compared to active management).

Andrew December 12, 2012 at 10:33 am

Andrew F, Noel, Jon Evan Dan:

I agree with your points, however I used to work for an investment advisor company, one of the first in Canada to offer global mutual funds and believe me, its all about the fees. I was frankly surprised at the level of compensation at first, being one of the lowest level employees there. This was before there was transparency in fees but the situation has not changed that much and most RSPs today are in 2% average or more MER mutual funds.

Today wealth management is THE growth area of finance. There have been many articles written about this recently with lots of mergers and consolidations. The reason is that returns from traditional banking activities are so low because of the current structure of the credit markets. The fees in excess of about 50 basis points or 0.5% for most portfolios are “leveraged” (to use financial services jargon) out of the general level of financial literacy, behavioural biases and a lack of transparency and a lack of competition. We need more work like what is being done in Britain in advisor compensation.

The example provided by Noel of the portfoliosolutions.com company is fair compensation. I think to run a large portfolio it takes about the same number of basis points it takes to run a bond fund 0.25% and $2500 a year minimum for less than 1000K. 0.5% max. It gets tricky with small account sizes where low MER mutual funds and more traditional access may be more appropriate.

Another way of looking at it:
A 1000 k portfolio managed by say RBC or TD wealth could cost 1.65% all in (rates have recently started to climb up from 1.5% which is still possible to obtain, even 1.2-1.4% in some cases if you negotiate). This $16,500 a year. If the manager works for 40 hours on the portfolio a year they are making $412 an hour! It could be more if mutual funds are used. Usually you have to hire an outside accountant for the tax side in addition and at any rate tax planning by the primary advisor could still be just basic.
Plus if the real return from a balanced portfolio is 3% a year wouldn’t 1.5% fees use up half the return?

To really open up the debate I would like to see an itemized list of hours worked and tasks performed by any advisor, as lawyers do for their schedules. If there really is at least 40 hours of work and if paying $400 an hour adds a return in excess of what could be provided by a semi automated-passive-rebalanced-appropriate asset allocation portfolio plus 0.25% or $2500 and 5 hours a year of tax work by an accountant then I guess there is value for money.

A quote from passive investing guru William Bernstein:

“The prudent investor treats almost the entirety of the financial industrial landscape as an urban combat zone. This means any stock broker or full service brokerage fir, any newsletter, any advisor who purchases individual securities, any hedge fund.”

Jimmy December 12, 2012 at 10:34 am

@ Noel
Thank you for that link. Your comments are directly related to something I’m struggling through right now.

I’ve met an advisor that has the same philosophy as me (passive approach using index/ETF vehicles). I’m willing to take a more hands-off approach now; however, her 1% fee would mean me writing a cheque for $X every quarter. Of course, she needs to be compensated; however, my assets have grown enough that the 1% seems high (in absolute terms) due to economies of scale.

In other words, there would not be a lot of work setting up the portfolio. In fact, the passive portfolio would be similar to what I have now. And most of the advice I need is more tax-related than investing anyway – which is provided by my accountant.

I don’t want to come off as being cheap, however, my preferred approach would be to pay her by the hour; but agree on a minimum amount, so she knows she is not wasting her valuable time.

However, if the fees were consistent with the link you provided, I would probably be fine with that. I would be satisfied that I’m getting value and they are getting adequately compensated.

Noel December 12, 2012 at 11:30 am

@Jimmy – I think 1% is ridiculous for a passive indexed portfolio. Dan here has given us the tools to do this ourselves. His Moneysense book and this website gives you all you need to know. You can likely do it too.

Look at what I did. I spent 2 days (16 hours) setting up an indexed portfolio for a friend of mine. But, I read every post in this entire blog, Dan’s Moneysense book and another book. We used the Complete Couch Potato portfolio, determined the appropriate equity/bond split, allocated each portion to various ETFs (there were 7 total since my friend wanted to split the REIT into a Canada & Global component for slightly more diversification), and then allocated the ETF’s to my friend’s RRSP, TSFA and taxable accounts in a tax-advantaged manner. This also included researching the brokers (he was with TD already so that made it easier) and allocating some of his ETF’s to Qtrade to save on commissions (he’ll be adding multiple times a year to his portfolio). We also executed a couple of Norbit’s Gambits to convert CDN$ to USD$ and then made the purchases. It will now take less than an hour a year for him to manage the portfolio. We will rebalance yearly (unless a ‘black-swan’ event like happens again like in 2009) and review the equity/bond split every 5 years and adjust as necessary.

I don’t think it would take someone much longer than it did me starting from scratch. You don’t have to read his entire blog. Just Dan’s Moneysense book is enough. Certainly if I was doing it again it would take me no more than a day. I suggest you contact some of the firms Dan has listed under the link above ‘Find an Advisor’ and maybe you can find someone more reasonable than 1%. Or just do it yourself! It’s not as daunting as it seems. But, as another friend of mine that is thinking of moving from active to passive said at dinner the other day to me “I’d easily pay someone 0.25% just to not stop me from investing as the market does it’s gyrations”.

Onkar December 12, 2012 at 4:31 pm

I was “recruited” as a client by RBC about 8 months ago and was recommended RBC funds by the adviser(also RBC). MER fund 1: 1.2% and MER fund 2: 1.95%, both of these were fund of funds, there were no additional fees, the average MER would be around 1.55%. We had one meeting: 2 hrs and the adviser said he likes to meet with clients at least once per quarter(I would presume 2 hr meeting each time), Total time: 12 hrs + lets say that that it takes him 1-2 hrs to prepare each time, that would total time per year: around 20 hrs, on $1M portfolio, MER fee: $15500, around $775/hr. Thank goodness I found this blog, I have read through all of the articles and articles on vanguard.com site , it has taken me good 6 months to implement. I have implemented modified complete couch potato with MER of 0.17%, this sure beats 1.55%.
Dan’s blog was quite an eye opener. Thank you Dan. Keep doing excellent work you are doing.

Jimmy December 12, 2012 at 6:20 pm

Although it has been a couple years since I have looked, I didn’t find any advisors in Canada that charged 0.25% of assets. In fact, the lowest was 1%, and that was only available for large accounts ($500K or $1 million portfolios). And many of the well-recommended advisors (i.e., that use passive philosophies and DFA funds) still charge 1%.

That’s why I was pleased to see that link that noted 1% per year fee is “much too high” in their FAQ section. I’ve thought that 1% is too high for a large/passive portfolio; and I would question whether there really is $10,000 worth of work to do for a million dollar passive portfolio (for example). To be 100% clear, I understand that there are many advisor – investor relationships in which a 1% fee is perfectly reasonable (for complete wealth planning). I guess I have come to the conclusion that 0.25% fee would probably be reasonable for me. And if that is not available, I’ll do it by myself.

Oldie December 12, 2012 at 7:06 pm

@Andrew F; re: advisor’s recommendation of a balanced mix of passive and active investments “Kind of like how ‘Nutella’ can be part of a balanced breakfast” lol!

@ Noel: I agree the more responsibility you take on yourself, the more outrageous the fee extracted by active managers seems. But this assumes you have done your homework. For myself, starting from zero in June this year it’s been a long determined slog, reading this whole blog and the discussions, and following a lot of leads and references, but I think I’m eventually getting it. I am contemplating the mechanics of Norbert’s Gambit and am preparing to convert a large sum of US$ into CAD. My advisor (he’s ok with the Passive Investing) was initially ignorant of Norbert’s Gambit, but to his credit, researched it and is on board with me. However, I have 2 problems with using DLR/DLR.U @ the TSX — firstly, my advisor says that with the account I am invested in, the sell can’t take place till the trade has settled, ie 3 days, and the exchange rate may have drifted off by then — but that actually may not be as bad as it sounds — after all the US$/CAD disparity or worth would still come to the same effect after I had bought ETF’s priced in CAD. My other problem is the bid-ask spread of DLR which eats into the conversion ratio, which would be significant for a large amount converted. I understand other vehicles (such as POT) that trade more heavily may have a smaller bid-ask spread measured as a percentage. What were the mechanics of your Norbert’s Gambit?

Noel December 12, 2012 at 7:46 pm

@Oldie – I too did not like using DLR/DRL.U because the price drift in 3 days could conceivable wipe out any exchange fees saved (and since I was advising a friend I wanted no risk). We used TD stock which is heavily traded both on the TSE and the NYSE. The Canadian funds were already with TD Waterhouse. In the RRSP we did it all online. Bought TD on the TSE, it cleared in a second and then we sold it on the NYSE immediately. The proceeds of the NYSE sale were later auto-washed into a US money market fund in the RRSP (TD allows you to set the RRSP to do it automatically this way as you cannot hold US funds outright in TD’s SDRSP’s yet although it’s allowed by law. The ability to do so is coming later in 2013 apparently for TD but is available now with other brokerages). In the taxable account we did both trades online too but had to call TD to have the stock journalled over to the US side in order to clear what essentially is a short sale. TD then wanted a full commission to do the journalling. Best to call TD or whatever brokerage firm you are using first before you do this so you know what fees have to be paid. Also, at least with TD, some CSRs are not familiar with this procedure. If you get one that knows about it then just execute the purchase and sale while you have them on the line so they can immediately set up the journalling of the stock. Also, there was a glitch as 6 days later TD had still not journalled the stock over so my friend was sitting with TD stock long on the Canadian side and short on the US side and then it took multiple phone calls to clean that up. I know when I did it myself about a year ago I had no problem at all and it journalled over as I expected. The money saved is worth the hassle, in any event.

If you google there’s lots of info on how to do this.

Canadian Couch Potato December 12, 2012 at 11:53 pm

@Oldie and Noel: The concern over DLR is misunderstood. If you think about it carefully, you’ll realize that your currency exposure is the same regardless of how long it takes the DLR trade to settle.

Scenario 1: You buy DLR on Monday and have to wait until Thursday for it to settle before you sell DLR.U. You are exposed to US dollar risk immediately after you purchase on Monday. If the USD plummets over the next three days, you will lose money.

Scenario 2: You buy DLR on Monday, journal it over immediately, and sell DLR.U a few minutes later. (You can do this at RBC Direct Investing, for example.) Then you buy a US-listed ETF immediately after that, so once again you are exposed to currency risk beginning on Monday. If the US dollar plummets over the next three days, you lose the same amount of money as in Scenario 1.

You might be concerned that the ETF you want to buy could move dramatically in price during the time it takes the DLR trade to settle. (In Scenario 2 you get Monday’s price for the ETF, while in Scenario 1 you get Thursday’s price.) But your currency exposure is the same either way.

Hops Leviathan December 13, 2012 at 12:30 am

If I was to pay the advisor fees at the percentages mentioned in these posts I would be writing a cheque every year for over $20,000. I just can’t imagine any scenario whatsoever in which I get a proportionate return on that money.

Conversely, I can easily imagine that sitting with a clever accountant for half a day every year to have him maximize all the avoidance measures possible would easily return that money. I think the cost of that little get-together would be a tenth of the manager’s bill.

What am I missing?

Andrew F December 13, 2012 at 12:34 am

I’m wondering what magical incantations an accountant can perform to save huge amounts in taxes. Is it anything you can’t find out by doing a bit of your own learning, online?

Looking for an example. I don’t know what I don’t know.

Noel December 13, 2012 at 1:08 am

You are correct with those scenarios and you probably know this but for anyone reading who doesn’t, I wanted to make a distinction for the situation where Norbit’s Gambit is used to convert funds into $USD for a combination of portfolio use and personal use or entirely for personal use. By personal use I mean for the consumption of goods, services or real estate in US dollars. In this case, waiting until the settlement day to execute the sell portion of the equity on the US exchange can work against you.

Consider the situation of a friend of mine. She wanted to buy a house in Florida and needed to convert $CDN to $USD. I told her about Norbit’s Gambit and helped her execute it using a TSE buy and an immediate NYSE sell of TD stock. Had she waited until the settlement day to do the sale and the CDN $ moved to her detriment in the meantime then she would not have had enough $USD to purchase the house as the price of TD would have fallen on the NYSE to account for the exchange rate change. However, the value of the $USD proceeds in $CDN would have still been the same. But, that wouldn’t have helped her. She would have berated me for not doing the stock sale right after the buy (and she’s not even my wife!).

Although this is an extreme example, I can see someone converting money to $USD using Norbit’s Gambit in their taxable account and then taking some money out for personal consumption in the US and then being surprised they converted too little. I myself have converted money to $USD this way in my taxable account for personal use and usually piggyback such a conversion on a portfolio Norbit’s Gambit that I was doing anyway.

I didn’t know that RBC Direct Investing would allow an immediate sell of DLR.U so that’s good to know.

Canadian Couch Potato December 13, 2012 at 1:20 am

@Noel: If I understand your situation correctly, any loss you experienced with your transaction had to do with a decline in the value of TD stock, not in the value of US dollars. For that reason, using DLR is actually safer, since there is no equity risk involved in the transaction.

Noel December 13, 2012 at 1:41 am

@Andrew F – I am no expert, but save making sure you have your portfolio positions in the right buckets (RRSP, TSFA, Taxable) so as to minimize the taxes on dividends, income and capital gains, maybe doing some tax loss selling before the end of the year if there are any remnants of failed stock picks still in your taxable portfolio from your active stock picking days, or the extreme example of not having earned income (ie quit your job) and only having Canadian eligible dividend income so that you can take advantage of the $47K+ you can earn in such income (in Ontario – other provinces vary) without paying any tax (except for the $600 Ontario Health Premium) I don’t know of anything else you can do to minimize tax on your portfolio.

Passive index investing in itself has the side benefit of being a tax minimization approach as it minimizes the sell activity which triggers taxation, which is all too prevalent in active investing where portfolio churn can be over 100% in a year.

Any tax savings magic, especially major feats, is almost always later exposed to be smoke and mirrors by the CCRA and inevitably results in reassessment, interest and penalties. The only winners appear to be those who receive a commission to flog such schemes. No wonder they always protect themselves from any liability at the time of sale.

Noel December 13, 2012 at 2:32 am

@Canadian Couch Potato – There was no loss experienced in the transaction I described as we bought and immediately sold TD and the value of the TD stock did not decline in the interim. However, if we had waited until the settlement date to sell, and the exchange rate happened to move to our detriment (ie it cost more Canadian dollars to buy a US dollar) then there would not have been enough US dollars resulting from the Norbit’s Gambit to purchase the real estate even if the price of TD had remained constant until the sale. I don’t see how this would not be the case if DLR/DLR.U had been purchased and sold in the same manner as the value of DLR in $CDN would have remained constant until settlement, but the value of those units in $USD would have fallen. The fact that the price of the US real estate when converted to $CDN at the new exchange rate results in the same value in $CDN does not change the fact that there is simply not enough $USD to purchase the property now.

If DLR is bought and DLR.U sold immediately afterwards as you described using a broker that allows this, such as RBC Direct Investing, then this scenario cannot happen (except if there was an instant horrendous freefall in the CDN $ while you were executing the gambit). So, I think that your statement above that ‘your currency exposure is the same regardless of how long it takes the DLR trade to settle’ is true but the corollary is that your trade may result in less foreign currency than you originally expected and therefore less than you needs. In the situation I described, if the CDN $ had fallen it would not have resulted in enough $USD to buy the house even though there was no currency exposure.

Using a stock like TD to execute a Norbit’s Gambit where the stock is not sold on the US exchange until the settlement date actually introduces two risks: 1) that the exchange rate will go against you and 2) that the price of the stock will decline due to company-specific reasons. Using DLR/DLR.U removes the second risk only, but the first risk will not affect you when using DLR/DLR.U unless you are consuming the proceeds of the trade for non-portfolio purposes.

Oldie December 13, 2012 at 7:01 pm

@Noel and @CCP: I think I figured out that the change in foreign exchange rate during the execution of the gambit using DLR/DLR.U has no overall bearing on the outcome; it is reassuring to find that my reasoning, derived from basic principles is actually correct. However, my second point was the fact that as the amount of currency exchanged grows towards infinity, the loss on the transaction tends towards the sum of 2 factors: 1) the bid-ask spread and 2) the annualized MER for the 3 days of holding DLR/DLR.U. (The commission on 2 trades, being a fixed cost, tends towards zero as the amount traded rises). The MER is 0.4% per annum, so 3 days MER is about 0.004% which is trivial, but the bid-ask spread seemed not to run below about $0.02, which works out to be 0.2% of the cost of the fund. So it seems to me that 0.2% is the cost of my trade; this is still much better than the 0.5% that was the prior “best offer” by my advisor, but I wonder, is this the lowest percentage cost that I can reasonably expect on my own (i.e. is there any other strategy or any other stock swap that is likely to have a lower bid-ask spread)? I ask because I am trying to prepare the best strategy to convert a large amount of US$ to Canadian$.

Noel December 13, 2012 at 8:46 pm

@Oldie – The only way to avoid the effect of a miniscule 3-day MER ‘drag’ is to sell DLR.U right after you buy DLR, which is possible with RBC. The only way to attempt to reduce the bid/ask spread of using DLR/DLR.U is to an equity like TD, since a difference of even 1 cent in the $81+/- current price of a TD share is 0.012%, which is much less than the 0.2% you quote, assuming the price of TD stock on the NYSE vs TSE has no arbitrage opportunity for professional traders (ie it is priced to take into account the exchange rate perfectly). But, I say ‘attempt’ as the equity could go the wrong way on you in a few seconds, as well as rise to benefit you.

As Dan said, even if both securities are bought and sold at the same time DLR/DLR.U is safer than using something with an equity-specific risk like TD.

Oldie December 14, 2012 at 10:55 am

@Noel: TD looks promising: I just checked and at this moment the bid ask spread is $81.08-$81.09, i.e. 1 cent in $81 which is 0.012% like you said. Yesterday’s total range high-low was 15 cents, so the worst possible Norbert’s Gambit yesterday would only have come out to 0.18%. Of course, that’s history and the future is unpredictable, but this is hopeful. How did your Non RRSP TD Norton’s gambit described above work out for you price-wise? You had to involve the staff on the phone to do the journalling, so they charged full commission — was this $29.95 or some formula involving a percentage of the amount traded? If the former, that would be small compared to the amount traded — hundreds of thousands for a house, I suppose. So what was the bid-ask spread on that day at the time of the Gambit, and was there any drift during the brief delay of the 2 trades? How much was the extra charge because it was a short sale on the US side?

Oldie December 14, 2012 at 11:05 am

@Noel: I should have said that I take your point that there is no currency drift risk in my context with DLR/LDR.U and in that sense a Gambit with DLR would be safer and cost about 0.2%, but in the TD example, it seems to me that the equity specific drift risk is in a lower range (i.e 0.012% to 0.18% to quote all of yesterday as an example, which is history, granted, and not reproducible, but still suggests an acceptable risk with a reasonable chance of a much better deal)

Noel December 14, 2012 at 12:00 pm

@Oldie: I assume you were looking at the bid/ask spread on one exchange only, but you have to look at it on the two exchanges, ie bid TD-TSE/ask TSE-NYSE converted into the same currency. Likely there wouldn’t much difference compared to looking at it on one exchange. As I mentioned, currency arbitrage opportunities with equities could result in this spread being slightly different than it otherwise would without an exchange rate involved, but only for seconds.

I cannot remember what the buy/sell spread was when converted to $CDN on the money converted to US for the house transaction I described above but I am sure it was much less than $0.15 when converted into one currency. The amount converted was about $1M CDN. The savings on the Gambit vs paying the bank exchange rates on that sum of money was about 75% so my friend was very happy. I didn’t know about DLR/DLR.U then or even know if it was available then (it was 2-1/2 years ago).

The difference between the TD and DLR/DLR.U bid/ask spread you quoted is about 0.2%-0.012% or 0.188%. I don’t know how much you are converting but on $1M this is $1,880, a not-insignificant sum of money. But, in the scheme of things you are saving way more than you would by having the bank’s foreign exchange department convert it. Your savings using TD over DLR/DLR.U will vary according to the spread of course, and trend to zero if your spread is as high as $0.15 as you indicated.

On the transaction a few weeks ago when calling for the journalling we had to pay full commission for the sell side and it was the $29.95 + an amount per share (I think it’s 3c now? – I don’t know as my friend did the transaction). It was $120 total for the sell. They halved it when we called to complain 6 business days later about the journalling that still had not been done. I don’t think you can get out of paying this commission outside of a taxable account, but then, again, consider the cost of having the bank convert the money.

I wouldn’t mind knowing how and what you did and what the spread and costs were after you do the Gambit (given our back and forth on here – Sorry Dan!)

Que December 14, 2012 at 11:41 pm

Here’s something to think about. What if the precentages were reversed, and passive index investing took over and made up 80+% of assests? How would the markets move then?

Andrew F December 15, 2012 at 12:23 am

We’re a long way away from that. And that is still probably a high enough percentage of active investment to give efficient pricing. Since passive investing is generally low-turnover, active investing accounts for a disproportionately large portion of the liquidity in the market.

Oldie December 15, 2012 at 1:09 am

@Noel: OK, but I may put off doing this a while till I get more info; also, it is possible that I may use some of this US funds to purchase US ETF’s for my RRSP which I intend to take over and manage myself using CCP style Passive Index Investing, if I can somehow manage to get US dollars into the fund and Canadian dollars out without triggering net movement of funds into and out of the RRSP. No point converting balance to Canadian $ until I am sure how much US$ total I actually need.

Oldie February 13, 2013 at 8:33 pm

@Noel: Sorry to be stuck on this topic for so long, but I am converting $1.4M from USD to CAD and I wanted to be sure I made no errors in executing Norbert’s Gambit. From the long exchanges above, I had finally decided that TD offered the best combination of having low bid-ask spread, (often 1 or 2 cents in the middle of the trading day), high stock price ($83), adequate volumes (typically 1-3 million shares a day on TSE and 300k-500k on NYSE) and of course being traded in both exchanges. In fact I had arranged a meeting tomorrow with my financial advisor to walk me through the trades, while he was in phone contact with the brokerage.

Now I have encountered yet another potential previously unseen obstacle that I fear could trip me up. I have been warned by a financial advisor to be wary of using stocks such POT or TD for a large denomination Norbert’s Gambit because, despite having adequate trading volumes, these stocks trade in small amounts when examined in the context of bid and ask lot sizes. For example, yesterday at the time of the given advice, trading in TD was exhibiting a bid lot size of 300 shares, and an ask lot size of only 100 shares. Needless to say, I find this highly disconcerting, i.e. that I seem to be in a never ending search for adequate information (mostly due to my own inexperience).

In your experience, is the size of the bid and ask lots at all relevant? I know you converted $1M described above; was there any hold-up in completing the buy and sells, and did you feel any need to raise the buy limit or lower the sell limit to make sure the transactions were not delayed?
I think it would be prudent for me to split the $1.4M into 3 groups of 400k, 500k and 500k to minimize delays in converting each chunk; the relatively small trading cost would be well spent. What do you think?

@CCP: in the context of an anticipated large NG conversion, above, could you advise if the smallness of the bid and ask lots of TD (despite adequate daily trade volumes) is at all a concern, or am I just being a worrywort?

Oldie February 14, 2013 at 12:25 am

@Noel, @CCP: Sorry, a clarification: the bid lot of 300 shares and ask lot of 100 shares described above was on the NYSE. The TSE lot sizes were considerably larger.

Canadian Couch Potato February 14, 2013 at 8:12 am

@Oldie: Those numbers are board lots, which are typically 100 shares. So 300 actually means 30,000 shares.

Oldie February 14, 2013 at 11:34 am

@CCP: Again, sorry for my loose terminology — I had done the conversion in my head to number of shares to help my figuring — at the time in question, the bid and ask lot sizes on NYSE were actually 3 and 1. Now, I don’t know what this implies for rapidity of liquidation of shares, but it would seem to me to impede the sale of large amounts of shares.

Canadian Couch Potato February 14, 2013 at 1:33 pm

@Oldie: I’m not comfortable offering advice on a proposed trade of $1.4 million. My suggestion is to contact your brokerage and make sure you have answers to all your questions before you proceed. You may also want to ask their rate for converting the currency with Norbert’s gambit, since it’s not uncommon for them to offer a genuinely competitive rate on large amounts.

Oldie February 14, 2013 at 4:52 pm

@CCP,@Noel, re: Norbert’s Gambit — I have just returned from my financial advisor’s office and am still shaking with excitement at what transpired there. My advisor had done a lot of homework at my request, with many phone calls and 30 e-mails to the head office and had finally determined that what I was asking for technically could not be done, but there was a workaround involving a lot of work and a real-time 3 way conference call to the brokerage office. He and the company were willing to do just that for “a valued client” with the understanding that this was likely to be a “one-off” occurrence, and that I don’t spread the word that this company would do this. True, I had told him, from what I understood, all I needed to do was to open an account at RBC Direct Investing and I could do it myself, no phone calls needed. But, as he had put in so much effort, I felt it was only reasonable to take him up on his offer. To make things less confusing, I actually went to his office so I could watch everything unfold on his screen and to eliminate misunderstanding due to 3-way telephone conversations.

I was really glad I did; the education was profound. After some preliminary getting up to speed with the trader (on speakerphone), and exposure to some real-time transaction data of TD on the NYSE, I decided on dividing up the US$1.4M into 4 tranches of about 4100 shares each; at that moment TD was trading at US$82.88 -$82.89. The actual trading was almost anticlimactic. The purchase transaction was fully completed within 30 – 60 seconds of being requested at market price in NY. So whatever fears I may have had about small bid and ask lots never amounted to any glitch. The trader had tried to get access to a look at the depth of the market, i.e. the 2nd and 3rd tier asks lined up behind the ask lot listed on the screen that I could see, but he reported that for some reason he could not get that data from the NYSE at the time. But the mere fact that there were multiple layers of bids and asks beyond that which was listed had never occurred to me, and could explain why the small numbers in the quoted bid/ask lots may not tell the whole picture.

Once the purchase was almost completed I gave approval for a sell at market price on the TSE, and again, this was completed within 30-60 seconds. We repeated the whole process 3 more times over the next 10-20 minutes, and during this time period the TD share price on the NYSE ranged from $82.88-$82.89, down to $82.84-$82.86 then all the way up to $82.96-$82.97. But most of the price drifting took place between the buy-sell sequences of the 4 separate gambits, not during.

When the dust had settled, my advisor calculated how much I would have received in CAD if I had used the brokerage best deal (which he said was a really good rate) for my US$1.4M, and it was $8,400 less than what I actually received doing the 4 Norbert’s Gambits. So it was well worth the effort. I should also mention that in addition to saving this amount (due to my own research and legwork), there was a huge “incidental” benefit ($>30k!!) of getting C$1.00+ compared to last month, where I would have only got 97.5 Canadian cents per USD; I did have some control over this — the rates had shifted, in fact I had missed the sweet spot by a few days, and I wanted to rush to get this deal done today before the Loonie strengthened again. But then again, you never know, the Loonie might keep on dropping.

So, the lesson seems to be, if you have a good relationship with your broker, and if the company technically can’t do what you’re asking, keep asking for imaginative solutions, and he/she might come through for you; and then ,of course, one should reciprocate correspondingly with loyalty. And secondly, get all your ducks in a row; every bit of certainty helps, especially with a large amount, then execute smoothly and rapidly, preferably in the middle of the day.

So thanks to all in the CCP community for the advice from all sides, and sorry if I have been a PITA for a long time; the uncertainty at the time was really unsettling, and I’m glad it’s done.

Noel February 14, 2013 at 8:12 pm

@Oldie – I tried to reply yesterday (while on vacation laying on a beach in South Australia) using my iPhone but it wouldn’t work so had to wait until I got to my laptop.

Bid/ask lot is irrelevant. You just needed to enter a limit price, press the key to buy and then to sell. Simple. The only difference between using RBC and TD is a phone call for the latter to journal the entry over. No mess, no spill, no involvement from any other human being.

There are many bid/ask lots lined up behind the one you see. If not then it would be impossible for hundreds of thousands to millions of shares of TD to trade a day. I usually have done $300-$400K worth of shares at a time and have entered both the ask price and 1 cent above and have always gotten my entire order filled right away.

Too bad I couldn’t reply to your initial post. After reading your posts I am quite shocked your ‘financial advisor’ (perhaps more of a mutual fund salesperson?) turned this into some huge wild goose chase with emails flying back and forth, conference calls and the like. This is not something that ‘technically’ can’t be done. And, no legwork is required. It’s a simple procedure and I do it all the time without the rigmarole this guy put you through. He obviously has no clue how the market works. Furthermore, I am surprised he claims he is doing you a favour as a valued client and that this is a one-off occurence and not to spread the word. He did you no favours, it was nothing special, he didn’t need to be involved and whatever he did was totally unnecessary. Sheesh!

Also, I always check the spot rate on large money conversions right before I do the gambit and the savings are often a bit higher than what your advisor has claimed

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