In the latest episode of the Canadian Couch Potato podcast, I speak with Robert J. Shiller, professor of economics and finance at Yale University, and winner of the 2013 Nobel Prize in Economics.

Prof. Shiller was in Toronto recently for the launch of the BMO Shiller Select US Index ETF (ZEUS), a fund that selects US stocks using a methodology based on Shiller’s CAPE ratio. The acronym stands for cyclically adjusted price-to-earnings: unlike traditional P/E ratios, which usually use only the previous 12 months of earnings, CAPE uses the average of the previous 10 years. The idea is to smooth out any short-term aberrations and provide a more useful measure of a company’s value.

The CAPE ratio is widely followed, not just for individual companies, but for the US market as a whole. During the interview I mention that a 2012 study by Vanguard found the CAPE ratio was the one of the most useful tools for estimating long-term stock returns—although even then, it explained less than half of subsequent performance.

Prof. Shiller has also lent his name to the Case-Shiller Home Price Indexes, which track real estate prices in major US cities. During our interview we chat about whether home ownership has historically been a good investment, both in US and here in Canada.

More promises of reward without risk

This episode’s “Bad Investment Advice” segment focuses on a new book called Slash Your Retirement Risk, by Chris Cook, founder of an advisory firm in Dayton, Ohio. The book begins by making a common claim: “Traditional buy-and-hold investment strategies that emphasize return on your investments don’t work anymore.” It goes on to suggest an alternative designed to “maximize the equity portion of your portfolio to capitalize on market upsides, while protecting against dramatic losses on the downside.”

Here’s the basic strategy: you start with a portfolio of 11 ETFs covering all of the economic sectors—healthcare, utilities, real estate, financials, and so on. You stay invested until the S&P 500 declines by 10%: as soon as it hits that threshold, you sell all your equities and move to bonds. Then you wait for the S&P 500 to recover by 15%, at which point you buy back the equities.

The idea is to limit your losses during a major drawdown—like the ones that followed the bursting of the tech bubble in 2000 and the financial crisis of 2008–09—without missing the whole recovery.

We’d all love to capture the returns of the market without having to endure all of that pesky risk, and there’s no shortage of investment gurus who make that promise. They’re inevitably well-armed with backtests showing you how well you would have done if you’d just been able to anticipate the huge drawdowns of the early 2000s. Funny how the strategies are only revealed after the fact.

On the path to becoming an enlightened investor, everyone needs to accept that there is no reliable way to capture equity returns without also accepting the risk of gut-wrenching short-term losses. The only way to reduce those losses is to diversity with high-quality bonds, GICs or cash, all of which will lower your expected return. That’s the trade-off.

Loonie tunes

In the “Ask the Spud” segment, I answer a question from Abe, who wants to understand the pros and cons of currency-hedged ETFs. These are designed to reduce or eliminate the impact of currency exchange rates for investors holding foreign equities. When the loonie soars—as it did between May and September—returns on US an international equities suffer, and currency hedging starts to look attractive.

I’ve written a lot on this topic (most recently here), so regular readers will know I advise against it. First, it’s not very precise. For example, over the three years ending September 30, the iShares S&P 500 Index ETF (IVV) returned 10.76% annually in U.S. dollars. One should expect a currency-hedged Canadian ETF tracking the same index would deliver a very similar return. But both the iShares and Vanguard versions delivered 9.95% annually over that period, for a difference of 81 basis points a year. Roughly half that difference is the result of higher fees and foreign withholding taxes, but even a tracking error of 30 or 40 basis points will erode returns over time.

The second reason to avoid currency hedging is that it can actually increase volatility. That’s why it’s misleading to say hedging “eliminates currency risk,” because this implies that non-hedged ETFs are more risky. In fact, there’s evidence that being exposed to multiple currencies—and especially the U.S. dollar—can actually lower the volatility of an equity portfolio for Canadian investors.