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The Next Smart Beta Revolution

{Note: This post was an April Fool’s joke!]

As the ETF industry in Canada matures, more and more providers are moving away from traditional cap-weighted index funds in favour of more exotic strategies, which have been lumped together under the label smart beta. The goal is to build indexes that will deliver excess returns by adding more exposure to stocks with specific characteristics, known as factors.

For example, small cap stocks in the U.S. beat the S&P 500 by almost 2% a year from 1926 through 2012  (the size factor), while stocks with a low price-to-book ratio outperformed by a similar amount (the value factor). More recent evidence has revealed other factors, such as momentum and profitability. Now a group of academics has discovered a way to combine all of these factors into a single strategy that will revolutionize the way we invest.

The researchers have not yet published their findings, but I recently had a chance to interview the group’s leader, Dr. Molti Fattore, professor of financial engineering at the University of Milan. “It’s really very simple,” he explains. “We’ve known for a long time that the various factors can boost returns by a percentage point or two compared with the broad markets.

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What (Returns) to Expect When You’re Expecting

Investing decisions should always be made in the context of your overall financial plan. And although we know short-term forecasts are futile, a retirement plan needs to include some assumptions about returns and risk over the long term. To help with this important task, my colleague Raymond Kerzérho, PWL Capital’s director of research, has just updated our white paper, Great Expectations: How to estimate future stock and bond returns when creating a financial plan.

As we explain in the paper, there are two main approaches to estimating future stock returns. The first is to rely on a historical premium: over the last 50 years, stocks have delivered returns of about 5% above inflation, so one could simply expect that to continue. The second approach raises or lowers that expected premium depending on whether stocks are currently undervalued or overvalued. You can apply similar methods to expected bond returns, using either the long-term premium (about 2.7% over inflation) or the current yield on a benchmark index.

Both methods are flawed, but an average of the two is likely to be a useful estimate.

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How Long Will You Wait for Smart Beta to Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense, which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies.

“Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term.

Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing—low-cost, broad diversification, and a rules-based process—with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA),

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It’s Better With Beta

The title of Larry Swedroe’s latest book, The Incredible Shrinking Alpha, raises a question: what happened to the idea that skilled managers can consistently beat the market? In a recent interview with Swedroe, we discussed the idea that this ability hasn’t really disappeared: it’s just that “alpha has become beta.”

What exactly does that mean? In investing jargon, alpha is the name given to the excess return a fund manager achieves through skill. Beta, on the other hand, refers to the returns available to anyone who is willing to accept a known risk. When Swedroe says “alpha has become beta,” he simply means that anyone who understands how to structure a portfolio can increase their expected returns by simply changing their exposure to specific types of risk, known as “factors.”

A factor is a characteristic of a stock that affects its expected return and risk. Factor investing (sometimes marketed as “smart beta”) means identifying which of these characteristics might predict higher returns in the future—even if it also brings more risk—and then building a diversified portfolio that captures those returns in a systematic way,

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Is Beating the Market Harder Than Ever?

Is beating the market harder than it’s ever been? Larry Swedroe thinks so, and he lays out his case in his newest book, The Incredible Shrinking Alpha.

PWL Capital has just published a custom edition of the book, with a foreword I co-wrote with my colleague Ben Felix. In our introduction, Ben and I note that Swedroe likes to use sports analogies when he discusses investing. I recently chatted with Swedroe about the book, and he looked to baseball and tennis to explain why active investors face more difficult obstacles than ever.

Outliers in the outfield

Swedroe begins with an argument that others have invoked before: the disappearance of the .400 hitter in baseball. Since 1903, seven different players have batted .400 or better a total of 12 times. However, that feat has not been accomplished since 1941, when Ted Williams hit .406 for the Boston Red Sox. “Of course, the skill of the pitchers today is much higher, and the fielders are much better,” he notes, so that might explain why batting .400 is considered almost impossible today. However, over the last 50 years,

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How Contributions Affect Your Rate of Return

Whenever I update the returns of my model portfolios, readers ask how the performance would have been different had they added money to the portfolios money each month. This question gets to the heart of the difference between time-weighted and money-weighted returns, which I introduced in my previous post.

In our new white paper, Understanding Your Portfolio’s Rate of Return, Justin Bender and I explain the differences between these two methods using two hypothetical investors with a $250,000 portfolio: the first makes a single $25,000 contribution while the other makes a $25,000 withdrawal. Now let’s look at a different example that includes monthly cash flows.

A tale of two accounts

Meet Buster, an investor with an RRSP and a TFSA that both hold an index fund of Canadian stocks (I’ve used the MSCI Canada Investable Market Index for the calculations). At the beginning of 2014, Buster’s RRSP had a balance of $200,000 and he made $500 monthly contributions throughout the year. Buster’s TFSA has valued at $30,000 at the beginning of the year and he made a single lump-sum contribution of $10,000 in September.

At the end of the year,

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Raining on the All Seasons Portfolio

Investors are hungry for success stories, especially tales that include high returns with low risk. And the investment industry is always happy to stoke that appetite.

One of the most popular stories today is the so-called All Seasons portfolio, whose virtues are trumpeted in the massive bestseller Money: Master the Game, by motivational speaker Tony Robbins. The book has been out since last November and I thought the hype would blow over quickly, but I’m still getting inquiries about it, so I thought I’d take a closer look.

The All Seasons portfolio was created by Ray Dalio of Bridgewater Associates, one of the largest hedge fund managers in the world. It’s based on Dalio’s similarly named All Weather fund, which reportedly has more than $80 billion USD in assets. The portfolio has the following asset mix:

30%      Stocks
40%      Long-term bonds
15%      Intermediate bonds
7.5%     Gold
7.5%     Commodities

In a backtest covering the 30 years from 1984 through 2013, the All Seasons portfolio had an annualized return of 9.7% (net of fees) and only four years with a loss.

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How Bad Data Leads to Poor Investment Decisions

Making smart investment decisions is difficult enough when you have reliable information. If you’re working with inaccurate or misleading data, good decisions become almost impossible.

The most popular source of confusion and misinformation has to be Google Finance. I don’t want to be too hard on Google: the company offers a suite of extraordinarily useful tools for free. But for Canadian investors, Google Finance provides information about ETFs and mutual funds that is highly misleading, and often flat-out wrong. Let’s look at some examples.

The price is right—but it’s only half the story

Google Finance (and other services offering online stock quotes) is useful for charting the changes in an ETF’s price over time. But it does not measure the effect of reinvested dividends and interest. That means you’re only getting half the story: the total return of an investment fund should always be measured assuming all distributions are reinvested.

This can make a dramatic difference when you’re looking at the performance of a fund that pays large distributions. For example, type ZRE into Google Finance and you’ll see the price change in the BMO Equal Weight REITs Index ETF during the 12 months ending April 30 was just over 5%:

The chart above shows the monthly distributions of $0.08 each,

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Ask the Spud: Do Aggressive Portfolios Pay Off?

Q: I noticed that over the long term (10 to 20 years) the average returns of your model portfolios are quite similar regardless of the asset allocation, but the maximum losses vary dramatically. Would you say that people saving for retirement may as well be less aggressive, since their goal can still be reached with less risk? – L.V.

One of the first principles of investing is that more risk should lead to higher returns, while playing it safe comes at the cost of slower growth. That’s why I was surprised when we compiled the historical returns of my model ETF portfolios. Over the 10- and 20-year periods ending in 2014, you were barely rewarded for taking more risk:

As you can see, a portfolio of 30% equities and 70% bonds enjoyed an annualized return of 7.48% over 20 years, while portfolios with 60% and 90% equities returned only slightly more. Yet equity-heavy portfolios would have endured a much rockier ride: the investor with 30% stocks never suffered a loss of even 8%, while the poor sap with 90% equities lost almost a third of his portfolio during the worst 12 months (which was February 2008 through March 2009).

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