Archive | July, 2013

Putting the Portfolio Odds in Your Favour

It’s well known that the majority of actively managed mutual funds underperform comparable index funds over any period longer than a few years. In fact, that statement has become so uncontroversial that even mutual fund salespeople freely acknowledge it. But a recent white paper co-authored by Rick Ferri, A Case for Index Fund Portfolios, takes this idea a step further.

Academic studies of mutual funds go back to the 1960s, and the well-known SPIVA scorecards are updated twice a year. So there’s no shortage of data on individual funds. But investors don’t use mutual funds in isolation: they build portfolios of funds in several asset classes. And there has been surprisingly little research on the performance of actively managed portfolios compared with passive alternatives.

Ferri introduced this idea in The Power of Passive Investing in 2011, and I wrote about his findings when that book came out. Now Ferri and his co-author Alex C. Benke have improved the analysis using more robust data. “The probability of outperformance using the simplest index fund portfolio started in the 80th percentile and increased over time,” the authors write in their summary.

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Seeing Diversification in Action

Why should you add multiple asset classes to your portfolio? That seems like a simple question, but it’s one many investors would answer with only a vague comment about “more diversification.” It’s more precise to say you do so to increase expected returns or to decrease volatility. Sometimes these are mutually exclusive, but Harry Markowitz won a Nobel Prize for explaining that you can sometimes accomplish both at the same time. That insight is the basis for Modern Portfolio Theory.

One of the clearest illustrations of this idea can be found in Larry Swedroe’s book Think, Act, and Invest Like Warren Buffett, which I reviewed late last year. Swedroe shows how the return and risk characteristics of a 60/40 portfolio change as you slice and dice the equity allocations.

A portfolio made up of just the S&P 500 and five-year Treasuries returned 10.6% annually from 1975 through 2011, with a standard deviation of 10.8%. By gradually splitting that equity allocation into multiple asset classes (international stocks, value stocks, small caps, and commodities) the portfolio’s annual return increased 150 basis points to 12.1%,

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Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

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Does “Smart Beta” Really Beat Cap-Weighting?

“Smart beta” has become a buzzword in investing circles, especially among pension funds and other institutional investors. The term may be new, but the idea isn’t: it’s about looking for ways to capture the returns of an asset class with a strategy other than traditional cap-weighting. These alternatives include fundamental indexing, equal-weighted indexes, low-volatility strategies and a few more exotic techniques.

A growing body of evidence has highlighted the inherent flaws in cap-weighted indexes, which are undeniable. By their nature, cap-weighted indexes give the most influence to the largest companies, as well as any that happen to be overvalued. That’s a potential problem because these are companies that are most likely to underperform the broad market over long periods.

A second potential problem with cap-weighted indexes is concentration. This isn’t an issue in huge markets like the US, or in a multi-country index like the MSCI EAFE. But it’s a concern in small countries like Canada (where Nortel once represented about a third of our entire stock market) and in individual sector funds.

Dunce caps?

These flaws are real, but if you listen to the chatter of investment firms these days you’d think cap-weighting is a strategy for dunces.

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Norbert’s Gambit at CIBC: A Case Study

Norbert’s gambit is an excellent way to reduce the cost of converting Canadian and US dollars, but not every brokerage makes it easy. Recently Justin Bender helped a client of our DIY Investor Service with a large currency conversion inside an RRSP at CIBC Investor’s Edge. It saved the client hundreds of dollars, but it was a complicated transaction and we thought other CIBC investors would benefit from learning the steps.

The difficulty stems from the fact that CIBC does not allow you hold US dollars in registered accounts. Whenever you buy or sell US-denominated securities, the brokerage forces you to convert the currency with the usual spread.

In the example below, the goal was to convert approximately $100,000 CAD to the equivalent in USD, and then use the proceeds to purchase a US-listed ETF. The prices and exchange rates were current at the time Justin made the transactions. For simplicity, we’ve rounded some numbers and ignored the $6.95 trading commission that applied to each trade.

Step 1

When doing Norbert’s gambit, we use the two versions of the Horizons U.S.

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Why Diversification is a Piece of Cake

After almost four years of false alarms, the bond bears are finally able to act smug. Broad-based Canadian bond index funds have fallen in price about 4% or so in since the beginning of May. Meanwhile, real-return bonds have taken it on the chin: they’ve plummeted about 13% and are headed for their worst calendar year since first being issued by the federal government in 1992.

In times like these investors question the whole idea of including these asset classes in a balanced portfolio. So it’s time for a reminder about how diversification is supposed to work.

It’s helpful to think about a portfolio like a cake recipe. You probably wouldn’t eat flour, baking powder or raw eggs on their own, but when you mix them with sugar, butter, vanilla and other ingredients the results are delicious. A baker doesn’t view ingredients in isolation: she considers how each interacts with the others to produce the final result.

In the same way, it’s important not to view individual asset classes in isolation. Real-return bonds are a perfect example. It would be hard to make a compelling argument for holding nothing but RRBs: their yields are low,

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