Wednesday, 22 December 2010

CD Howe and Pension Study - The Proper Choice of Reno Tools

Head of the CD Howe Institute William Robson told us in the Globe and Mail last Friday to Fix pensions with screwdrivers, not sledgehammers based on the results of the Institute's newly-published study Sizing Up the Retirement Challenge: How Well are Canadians Preparing for Retirement?. With all due respect, since the study, of which Robson is an author along with Kevin Moore and Alexandra Laurin, is an interesting and worthwhile piece of work, after reading through it, I think we should be saying "Don't patch pensions with the wrong colour paint, cover the whole wall over ".

Through its reasonable, for the most part at least, assumptions the study projects that the likely pension income shortfalls cover such a broad spectrum and such a large and steadily growing number of future retirees that spot fixes like the proposed PRPPs won't do the job.

The study summarizes the future problems thus (my highlighting):
"The principal finding of this study, however – that is, a projected gradual increase in the proportion of future retirees likely to experience a significant decline in their standard of living upon retirement – persists even with differing assumptions for future real wage growth, inflation, rates of return, RPP coverage, and future saving rates." (page 2)

"... the proportion of newly retired individuals unable to replace at least three-quarters of their average pre-retirement consumption from the sources we model is projected to nearly triple over the next 40 years (see Figure 9). If current trends persist, by the 2046-50 period, about 45 percent of workers currently aged between 25 and 30 years would not meet our 75-percent threshold ... " (page 20)

"This decline in potential consumption replacement would be felt across the entire earnings distribution ... " (page 20)
We are just at the start of a long-term uptrend in inadequate pensions that is little affected by such things as increased saving in RPPs, which is essentially what the new PRPPs would offer to people working for small companies and the self-employed. Look at this chart from the study. Other charts in the study have similar inexorably upwards trends based on "business-as-usual" in pensions savings methods/plans.

All this looks like a pretty substantial problem to me.

Ironically, the following quote suggests an alternative:
"... the public pension system, which is mandatory and has nearly universal coverage, provides high levels of consumption replacement to individuals with low pre-retirement earnings. The higher a person’s earnings, the more voluntary saving by the individual (and/or his or her employer) through RPPs, RRSPs, home equity, or other instruments is needed to replace consumption in retirement." (page 13)
In other words, the combination of OAS/GIS and CPP have been doing a great job. When higher income income earners have to rely on the various other means, they fall short.

There is one problem with the public pension option, however. The beneficial influence of OAS will progressively wane. By being indexed to CPI inflation, it only maintains the standard of living at the moment of retirement. The standard of living slowly rises i.e. real wages increase and real consumption does too, faster than CPI does. Since the pension objective assumed in the study is to maintain a level of consumption, anything that goes up only by CPI will produce less and less consumption relative to new retirees. Here is the relevant study chart.

A couple of assumptions probably understate the future pension challenge.
1) Home equity drawdown - the study assumes as base case that 50% of equity in a home would contribute to retirement income. The methods for accessing home equity, like high-fee reverse mortgages, or downsizing, seem unlikely to happen for most people except under forced circumstances. To the authors' credit they run the model excluding that assumption and the difference is another 5% or so today, rising to about 8% in 2050, of the population with less than the target 75% consumption replacement rate.
2) Consumption replacement at age 70 - this number derives from actual government data based on what is used from various sources, including investment return sensitive limited capital RRSPs and RRPs from defined contribution plans. The study does not, that it says anyhow, model consumption to track adequacy all through the retirement years. What happens to the income at age 75, 80 and 85? Chances are it won't go up. Age 70 is likely the maximum income / consumption. One of my relatives has been using a RRIF to supplement her income but it will run out in a few years so she is facing a significant drop in income/ consumption. The model thus does not seem to attempt to evaluate the effect of longevity risk sharing, or not, (running out of money before you die).

One telling point founded on the actual past statistics is the fact that " ... the net real rate of return received by individuals in the future is roughly 1 percent for RRSPs and 2.5 percent for defined-contribution RPPs." That's a shockingly low return compared to the actual historical asset class returns of 4% averaged for a portfolio. The combination of fees and poor investment decisions by individuals trying to manage on their own really cuts deep. If the real return for investors could magically be 1.5% higher, it looks from figure 13 as though another 5% of Canadian retirees in 2050 would escape the inadequate income threshold of the study.

People need to assess the problem properly before deciding on how to fix it. Like a bad paint job, if you don't do it right the first time, you will soon be doing it again.

Tuesday, 21 December 2010

Green Investing - Returns Performance Evidence Inconclusive

The EDHEC Risk Institute's November 2010 Adoption of Green Investing by Institutional Investors: a European Survey contains the chart below that conveniently summarizes available research on the financial performance of green investing. Some studies say green investing provides worse performance, some say it does better and some say it does the same.

In their survey of European institutional investors, authors Noel Amenc, Felix Goltz and Lin Tang found that almost 90% already pursue Green investing as an investment theme and 90% intend to do more. Not surprisingly to anyone who has looked beyond the mere phrase to try understanding what Green investing entails, the biggest obstacle is the lack of credible standards in the field.

One finding that may surprise those who have an unwavering negative view of the institutions of society: the motive for doing Green investing by these institutional investors in more than 80% of cases is simply a sense of responsibility to the planet and society.

A surprise for me is that equity/ buying stocks is not the only way to go. Bonds are a Green investing option too as the table below shows. At least they are for European investors. Canadian investors do not have such a choice available. Maybe an option for our federal government to consider?

Thursday, 16 December 2010

Flaherty Decides to Build Wading Pool for Pensions

Federal Finance Minister Flaherty's proposal today to set up something called Pooled Registered Pension Plans is a disappointing timid response to calls for improvements to Canada's pension system.

The proposal only suggests a few minor improvements:
  • small companies and self-employed workers would have access to portable group pension savings plans instead of being limited to personal RRSPs.
  • contributions would seem to be locked in for retirement only, unlike RRSPs where people can withdraw funds anytime
PRPPs would have the following deficiencies:
  • attempts to address only the first half of pension construction, the savings process and completely ignores how to turn those savings into a steady, reliable, inflation protected income that lasts as long as you live and pools those risks - that why it's more like a wading pool than a real pool
  • it sounds nice for the proposal document to say low costs are an objective but there is no evident mechanism by which overhead costs will be kept under control
  • the investment mechanism doesn't makes sense - how can the money be "co-mingled for investment purposes" with participants only having "personal accounts for record-keeping" alongside the idea that the plan administrators will offer a "manageable number" of "investment funds that permit a person to create an investment portfolio for his or her own objectives and risk preferences". I think the answer is that there will be a menu of mutual funds, like a DC plan, which, in fact, the draft document says on page 6. So the only real scale efficiency and risk sharing is what already exists in mutual funds. The proposal doesn't answer the critical question of who will be negotiating the lower fees with the portfolio managers and how the incentive scheme will make that happen.
  • no mandatory participation, each province can decide whether to do so or not, thus ignoring the very big issue that too many people simply don't sign up when given the choice
  • "tools" to enable people to make an informed choice. Har, har I can just see it now.... Mr Smith, would you like a Conservative Low-Risk Fund, a Balanced Fund or an Aggressive Growth Fund? On top of that, employers would have to figure out what contribution level to set for employees and themselves. How could employers have the knowledge and expertise to do this at all adequately? For the self-employed, they would have to do it themselves, or will this scheme include provision of expert personal financial advice supplied by advisors, working under fiduciary duty rules?
As the draft document says on page 8, PRPPs "will essentially be a new type of defined contribution RPP" catering to small companies and self-employed people. It's another addition to the already complex and confusing plethora of savings and retirement plans.

That this inconsequential and ineffectual proposal has been put forward tells us that Minister Flaherty has been convinced that there is no real widespread pension problem looming in Canada. Simple and straightforward CPP enhancement appears to have lost and if so, it will be business as usual for the financial services industry, which will continue to profit. Time to buy those shares again!

Wednesday, 15 December 2010

Book Review: What Investors Really Want by Meir Statman

Thought-provoking but at times a dull read. Full of insights but ultimately confusing. That's what my emotion and my logic give me after reading this excellent book.

Thought-Provoking and Full of Insights: When I read finance books I take notes of interesting points and I highlight ideas that can serve me for my own life or for my blogging. This book gave me about twice the usual number of notes and a large number of potential blog post subjects. For example, on page 95 Statman tells us that people typically spend more than the amount of the gift card they have received but less than the cash when they receive cash as a gift ... ergo, suggestion to promote frugality in these frugal times - for Christmas, give cash, not a gift card ... but, people who receive gift cards also tend to buy luxury products they really enjoy that they would not otherwise buy, whereas a cash gift gets spent on mundane items, which means that you might want to give a gift card after all depending on your motives! (oh well, there goes one blog post). The book was also the source for my recent Holiday Financial Tip: Eat Turkey Dinner post. Believe it or not, I also found in the book the simple but true root cause explanation ;-) of the whole credit crunch mess and will be posting soon on that.

There is much serious and substantial topic matter, covering the gamut from the conflict between the hope for riches to the fear of poverty, to the desire to avoid taxes, to the effects of status-seeking. The book is dense with ideas. Indeed, in pure factual terms, it is essentially an extended popularized annotated bibliography of behavioral finance research compiled by an authority in the field (Statman is Professor of Finance at Santa Clara University and has produced many well-regarded papers). As a well-organized - by chapter subject theme (table of contents here on the book's blog site) - comprehensive and documented - 31 pages of fine print footnotes - collection of the state of the art knowledge in this subject area, Statman's book is well worth the price on that basis alone.

Apart from the multitude of small insights that the book recounts and relays from other sources, the book's main insight is that people invest for more than the utilitarian or profit-making value. They also seek a payoff in emotional terms to make themselves feel better, and for expressive benefits to exhibit their own values, tastes and status to themselves and to society. Instead of portraying behavioural finance as a negative series of biases and errors contrary to rational behaviour, Statman says that much, though not all of it, actually is a positive feature of investing. There isn't always only one answer or one best outcome - maximum profit - for all investors. However, I suspect that his suggestion that it is good to invest for fun and status - "we should enjoy all the benefits of investments - utilitarian, expressive, and emotional" (p.241) - would quickly take a back seat to utilitarian money if losses began to accumulate.

Dull: I believe it's mostly due to the nature of the book as a collection of very disparate ideas, since the writing style is simple, direct, informal and understandable, but I needed to force myself along through the pages. The book is not a gripping tale with flow that pulls the reader through. However, the frequent nuggets of gold make the effort worthwhile. It reminded me of my experience in a former business life of attending business conferences - most talks are a waste of time but one or two good ideas or contacts - make the cost and effort of attending worth it. This book has more than one or two good ideas.

Confusing: The deluge of motives and forces that Statman describes chapter after chapter eventually becomes overwhelming. Two or more interpretations may be possible for any action or situation. What makes it worse is Statman's admission in the final chapter: "It is often hard to distinguish facts from from cognitive errors and even harder to distinguish cognitive errors from wants or expressive and emotional benefits." (p.237) On the next page, I believe Statman is right when he says "I see no benefit in cognitive errors that mislead us into sacrificing utilitarian benefits for no benefits at all." How do we differentiate the errors from the expressive and emotional benefits and what should we do?

The answer to this last question is not be found in the book. His effort is a descriptive tome. To be fair, Statman evidently did not aim to answer the question so he cannot really be faulted for the missing piece.

Maybe we are meant to read it all, digest it and fabricate our own answers. I believe, however, that what many, if not most, investors really want and need is a prescriptive book that incorporates all the lessons and observations to tell people what to do. Hopefully, someone will write it soon. Statman would have the perfect follow-on title - What Investors Really Need, subtitled Apply (instead of the present book's "Want" and "Learn") the Lessons of Behavioral Finance.

Nevertheless, this is a fine and useful book for the individual investor to spur self-analysis and self-knowledge of his/her own personal finance and investment emotional and expressive drivers.

My rating: 4 out of 5 stars.

Tuesday, 14 December 2010

CPP Adequacy "Myth" in Greg Hurst's Financial Post Pension Article

In Pension Myths published Dec.2, 2010 on the Financial Post website private pension consultant Greg Hurst rails against what he says are myths about CPP.

Myth 1 according to Mr. Hurst is "Canada's pension system is insufficient for the delivery of adequate pension income." He then cites the Mercer Melbourne 2010 Global Pension Index as a source to assert that Canada is well positioned compared to the rest of the world with a number two rank on the pension adequacy sub-index. Fortunately, the Mercer study is available on the web here, so your faithful blogger, ever the nit-picking detail guy, happily dove into the Mercer documents to do a reality check.

The reality:
  • Mercer doesn't say that Canada's system is sufficient, it merely says that Canada's system is better than most of the other insufficient systems around the world. No country attains an A grade from Mercer as a "first-class and robust" pension system on an overall level and though Mercer does not actually assign grades on its three sub-indices, Canada's 75 score on the Adequacy sub-index would put into the B grade of "a sound structure with many good features ... but has some areas for improvement"
  • Canada's score fell from 2009 to 2010 in Total and across every sub-index (p.19). Is that cause for complacency and doing nothing?
  • Mercer's Adequacy entails a miserly low level of income. The Adequacy sub-index doesn't just use the CPP, it uses ten questions to arrive at a rating. Canada does comparatively well because of its score on the two heaviest weight questions (attachment 1, p.64). Question 1 assesses the ability to provide a pension to the aged poor. Thus, in Canada OAS/GIS enables people to receive 32% of the average single person's wage (0.32 x $40,600 = $13,000), which is, according to the OECD, where Mercer got its data on this question, enough to keep someone above the poverty line set at 30%. Whooppee, happy days, huh? It is ironic that Hurst should cite Mercer whose conclusion on Adequacy relies on OAS and GIS when his myth 3 says that those two programs are at risk because they are funded from general tax revenue. Would an increase in tangible funding to CPP through higher rates not then make sense? Q2 deals with a target income replacement rate. Mercer says the net (considering taxes and deductions) replacement rate of lifetime average earnings for a median income single earner should be in the range 70-100% and Canada is reasonably close at 63.6%. Lest these numbers seem to be a high target, Mercer reminds us that the lifetimes earnings model from OECD (found in Pensions at a Glance 2009 - gotta love the sly humour in that name for a 283 page document) on which the scores are based assume no real (though it does keep abreast of inflation) pay increase throughout a working career and should thus be targeted much higher than a replacement rate based on final salary. A median Canadian worker thus would get 0.636 x 40,600 = $25,820 to live on. Would that support an active fulfilling retirement or one that entails working to supplement income? Mercer themselves comment that "A net replacement rate below 70% of lifetime earnings suggests a significant reliance on voluntary savings" (p.24).
This last point is the nub of the current problem and debate, one which Hurst himself acknowledges, and Mercer confirms (see its recommendations for Canada on page 57). The reliance on voluntary savings in defined contribution plans and RRSPs isn't working too well, it needs improvement. People are not saving enough and the trend towards types of plans where they have to manage their own investments with all the exposure to their own mistakes and high fees makes the future quite problematic.

As I have blogged before here and here, the CPP seems to offer a better solution to meet retirees' needs. Probably, changing the CPP by both raising the contribution rate and increasing the earnings limit on which CPP is deducted will both help. So what if "Expanding CPP benefits is a very complex undertaking that would likely have widespread repercussions for Canada's pension system overall"? Perhaps one of those repercussions might be a reduction in Hurst's pension consulting business as no-longer-so-necessary private pension savings declined. But is that a reason not to make changes?

His conclusion that Canada merely needs to deploy targeted solutions (harkening back to the notion that there is only a pension problem for a limited few, which I doubt, as expressed in this blog post) and leave aside CPP-enhancement, while somehow boosting employer-sponsored workplace pensions or individual retirement savings, ignores the failures and deficiencies of such options.

CPP enhancement certainly doesn't solve all pension problems. It only pays off gradually over many years as people work and earn a higher pension. Present-day retirees without sufficient savings won't get anything - we'll just have to keep working or buying lottery tickets and/or reduce our standard of living down towards that OAS/GIS level.

I'd like to see arguments more convincing and practical regarding CPP than what looks too much like self-interest or guilt by association from the fact that major labour unions are backing such proposals. Though the labour movement too often itself proposes stupid things merely for ideological reasons, we shouldn't make the same mistake should we?

Thursday, 9 December 2010

Waterfurnace Renewable Energy - Insiders Buying Post Q3 Report

When I did my first post on Waterfurnace Renewable Energy (TSX: WFI) assessing it as a stock to buy, insider trading had been quiet. Now we are getting the encouraging signal from a couple of insiders who have been actively buying shares themselves in the last month or so since the release of the company's 3rd quarter report, which I reviewed in this post. Both Board Member Thomas Dawson and the CFO Fred Andriano have been tangibly demonstrating their faith in the company's future according to this list of recent WFI insider trades from - all purchases and fairly large amounts too, given the size of company. It looks like they took advantage of the recent price dip too, paying pretty much the bottom price.

Wednesday, 8 December 2010

Canada Savings Bonds Needs to Change Motto

Yesterday, blogger Michael James on Money left a good comment on my post about taxes and inflation - how people with Canada Savings Bonds are irrationally wistful for the old days of high interest rates. However, even at today's low interest rates, the CSBs are awful - paying only 0.65% this year (see this rate chart for ordinary anytime cashable CSBs and this chart for the once-a-year cashable premium bonds), they don't come close to compensating for the current 2.4% CPI inflation even before taxes. The stealth tax of inflation is quietly, and probably mostly invisibly to most CSB holders, giving the government almost a 2% real return.

What can one do with cash? In his post on this year's CSB issue, Canadian Capitalist and his commenters discussed some higher interest alternatives for liquid and secure cash. Rob Carrick of the Globe and Mail posted a list of investment savings accounts in his October 29th column How to get some bang for your safe bucks, though one should check the current interest rates as they may have changed.

The CSB motto is "the way to save, guaranteed" (see top of page here). More accurate would be "the way to lose, guaranteed".

Tuesday, 7 December 2010

How Taxes Increase Inflation's Effect as a Return Killer

Income tax reduces investment returns. Inflation does too. Together they enhance each other's effect in quite dramatic fashion that surprised me when I did some simple example tables.

First, to be a little technical but more precise, whereas the rule of thumb to figure real returns net of inflation is to take a nominal return and subtract inflation, the more accurate formula divides (1 + nominal return) by (1 + inflation) as Wikipedia explains in the article on Inflation Tax. Our calculations below use the precise formula. When inflation is low the difference between the approximation and the precise formula is very small but at higher returns and inflation rates, the difference can be substantial, which comes out in the tables below.

Here is the first table (click to see it large). Observe that:

  1. Taxes make the investor a net loser even when nominal returns equal inflation. The yellow highlighted cells on the diagonal show nominal return equal to the inflation rate. In every cell except where both are zero, taxes on the nominal return eat up part of the inflation compensation. The higher the inflation, the worse it gets and the more taxes reduce returns. As we see sliding down towards the right e.g. when both nominal returns and inflation are 8%, someone at the 40% tax rate of this table actually loses 3.4%!
  2. Taxes can result in negative real after-tax returns even when nominal returns exceed inflation and again it gets worse the higher the inflation rate e.g. a 13% nominal return would not be enough to make a net gain when inflation is 8% in the bottom right corner. Another of looking at this is to note case A) (the cells highlighted with a blue border), where a combination of nominal pre-tax 4.47% return and 0% inflation equals the net return of the much wider 6% spread combo of 8% nominal and 2% inflation.
  3. Note how the GIC-zone of 1 to 3% current rates (per Canoe Money) within Bank of Canada target 1% to 3% inflation is pretty well entirely in negative red returns for a 40% tax rate. And it's true for more or less the whole gamut of tax rates as our other tables for 46% (posted below) and 25% (not posted here but I did the numbers) tax rates show.
  4. Net returns are higher in low inflation even when pre-tax real (after inflation) returns are the same e.g. in case B) the real pre-tax return of 5.88% equals the 8%-2% combo but the 5.88% - 0% combo would produce 3.53% real after-tax versus only 2.68%.
The second table shows the effects at the highest Ontario marginal tax rates of 46.21%.

  1. Net returns are even worse at the higher tax rate, not a surprise, as there is more red / negative returns and lower numbers throughout the table.
  2. The spreads necessary to make money are even more accentuated at the higher tax rate - it takes more difference between nominal returns and inflation to compensate when the tax rate is higher e.g. whereas at 40% tax, the 6%-0% combo could be equalled by the 9.58%-2% combo, at 46% it takes 10% nominal to be equal at 2% inflation (case E) the green framed cells).
What defences and counters are there? Apart from praying and maybe doing a little political lobbying to have government set even lower inflation targets (noting however, that when the investor loses from taxes and inflation, the government is a big beneficiary), the basic strategy is to defer taxes as long as possible:
  • Though one cannot escape the effects entirely with registered accounts since taxes must eventually paid upon withdrawal, using registered accounts for tax deferral becomes even more important the more inflation rises;
  • In taxable accounts, trade less to avoid realizing capital gains, buy and hold with index funds (on page 71 of Jeremy Siegel's Stocks for the Long Run that shows how the inflation tax effect on capital gains lessens progressively with longer and longer holding periods; hat tip to Siegel as well since that is where the idea for this post came from).
  • Pick funds or ETFs for taxable accounts like the new Horizons BetaPro S&P/TSX 60 Index ETF (symbol: HXT) (reviewed here) that produces no immediate taxable distributions.
  • In taxable accounts, seek returns from lower tax rate types of income - the lowest being dividends, then capital gains, with interest the last choice (Canadian real return bonds have the unpleasant feature that the inflation adjustment component is just as taxable as the real return portion, as Bylo Selhi notes here)
It used to be that only death and taxes were inevitable. Unfortunately, inflation is too nowadays, so we need to be aware of its toxic effects.

Monday, 29 November 2010

Waterfurnace Renewable Energy Q3 Report Good and Bad

Back in September when I rated Waterfurnace (TSX: WFI) a Buy at the then price around $25.50 it looked as though the near future would see no growth due primarily to the poor state of the US housing market. The 3rd Quarter report came out November 10th and things look even a little worse than merely flat results as Earnings Per Share dropped a fair bit from the same quarter last year. Profitability has been squeezed by a shift from residential to the more active but lower margin commercial market and due to the rising cost of inputs like copper.

The somewhat good news is that WFI continues to take back market share lost in 2009 to its main competitor LSB Industries (NYSE: LXU), as evidenced by WFI's 15% rise in sales while those of LXU (in the Climate Control business) fell in its 3rd quarter report. The company management in its Q3 earnings webcast and in an email in response to my questions state that things like a 3% price increase and bulk buying will improve margins.

We investors (yes, I still own the shares I bought in September) need to be patient. Maybe I'm just one of those "refuse to sell a loser stock" that all those behavioural finance books make fun of, but I'm not selling. I still think the payoff is two years away. The key US housing market is still looking very weak in recent data. The post Q3 report drop in price to around $22 makes WFI an even more attractive Buy in my opinion though two professional analysts have dropped their recommendation to Hold according to

The folks at Waterfurnace looked into why the US dollar version of the stock is not trading (and has not done so for a long while) on the TSX. This is their reply:
"WFI.U, WaterFurnace stock traded in U.S. dollars on the TSX, is still a valid symbol. When WaterFurnace set up WFI.U, there was expectation that there would be significant interest in trading in U.S. dollars. At first, the market maker made some attempt to get things going, but trading in U.S. dollars didn’t take off. The market maker has now posted its bid and ask orders so far apart that trading via WFI.U is not a feasible option. I think investors who want to trade in U.S. dollars simply use WFIFF.PK."
The Yahoo Finance chart for WFIFF.PK shows it is about as active in volume as it is in Canada.

Monday, 22 November 2010

Holiday Financial Tip: Eat Turkey Dinner

No, I'm not kidding, this is completely serious. It works like this.

Self-control and the ability to resist impulsive choices are key to financial and investing success. Whether it involves saving instead of spending or reacting too fast to market moves, such qualities are associated with success or conversely, where they lack, with failure.

Here's how the traditional turkey dinner comes in: foods that enhance levels of a body chemical called serotonin, such as the combination of turkey, containing tryptophan, with the carbohydrates of mashed potatoes, improve self-control and reduce impulsive choice. These effects were apparently confirmed amongst post-Thanksgiving US holiday shoppers in a paper on SSRN We Are What We Consume: The Influence of Food Consumption on Impulsive Choice by Arul Mishra and Himanshu Mishra, which I found in a new book by Meir Statman called What Investors Really Want (a book I will be reviewing soon).

So as US readers get ready for Thanksgiving this Thursday and everyone for Christmas, just remember to say, "Another helping please, I'm in training!"

Friday, 19 November 2010

Testing Purchasing Power Parity with Golf Equipment

The idea of purchasing power parity says one should be able to buy the same thing for the same price in different countries. I've previously compared prices of personal computers to see where the cheapest prices are to be found, with exchange rates factored in. From the 2007 comparison where the USA was the cheapest and Canada the most expensive, to the March 2010 comparison there was a big shift, as the UK became the cheapest, Canada fell in the middle and the USA went from least to most expensive. PPP wasn't much in evidence. There was huge spread in the price of Dell PCs - 16% in 2010 and 33% in 2007.

Golf is another passing interest of mine (ok, it's really become more of an obsession) and I have recently been in the market for a new set of irons so I've done more international online comparison shopping. This time it seems the pricing of individual equipment makers and online stores may be more important than exchange rates. My mini survey (using exchange rates found on Google Finance):

TaylorMade R9 (steel, 8 clubs, with delivery and taxes)
Mizuno JPX800 Pro (steel, 8 clubs, with delivery and taxes)
Golf Balls - Srixon AD333 (1 doz)
Canada is cheapest for one set and most expensive for the other, while the balls are all within tiny fractions of the same price. The price spread between lowest and highest for the golf equipment is under 10%, much less than what I found for the Dell PCs. The golf business may be managing foreign exchange better in equalizing prices than the computer industry, or than Dell does at least. Or maybe it's just that the movement of CAD versus USD has tightened considerably during all of 2010 and for CAD vs GBP, since March.

Moral of the story - right now, special deals, services and promotions make more of a difference. For instance, in the UK Mizuno has free custom-fitting test centres in various locations (with no obligation or pressure to buy and as it turned out, lots of friendly golf chat) and a number of linked vendors that will order at no extra cost the spec clubs from the factory.

However, if exchange rates go volatile again, or more likely when they do, and CAD has a big upswing against the USD that could well present cross-border buying opportunities.

Wednesday, 17 November 2010

Et tu Beta? A downside risk betrayal

A central tenet of modern finance theory is that Beta is the appropriate measure of the systematic risk of stocks. The idea is that the higher the Beta, the more a stock price varies when the overall market rises or falls and thus the higher the risk.

Nothing is sacred or safe. Researchers Victor Bahhouth and Ramin Cooper Maysami in Risk Prediction Capabilities of P/E During Market Downturns, on AllBusiness' Academy of Accounting and Financial Studies Journal, tested how well Beta and P/E (the Price/Earnings ratio) predicted downside risk of all NYSE and NASDAQ stocks during the year of the latest big crash up to the end of October 31, 2008. Their conclusion: " ... beta's power was insignificant in predicting stock price movements ... On the other hand, the price-earnings ratio exhibited significant power in predicting stock price movements and accordingly was a more reliable measure of risk." An unkind cut it is indeed.

I wonder how many people actually have tried to use Beta to assess individual stock risk. I suspect most who look at individual stocks fall into the fundamental value assessment camp and so have been using P/E all along. When I looked at Waterfurnace recently, I came across some finance website or other that showed a Beta of 0.5 or so for the stock, presumably because WFI has been ultra-stable, trading around $25 for about the last four years. It made no sense to me to consider that figure of any use in judging its upside or downside risk.

Tuesday, 16 November 2010

My Search for a Travel Rewards Credit Card

Recently my credit card came due for its bi-annual replacement so I wanted to check that I am still getting the best deal. Travel rewards credit cards give you points for what you spend that can be redeemed for travel or possibly merchandise. Not surprisingly, offerings vary quite a lot between card companies and there is lots of devilish detail and fine print that can turn a seemingly good deal into a disappointing choice.

Two web sites that I found to be extremely useful with lots of detailed comparative info and unbiased advice:
  • Rewards Canada - almost one-stop shopping for the features and costs of available cards, saves a huge amount of work flitting around vendor sites with its large spreadsheet-like comparative table. It seems to be quite up-to-date with the latest temporary bonus offers and specials. There is even a top 5 credit cards for 2010 article. The same web owner runs sister sites for the UK FrequentFlyerBonuses, and for worldwide
  • Financial Consumer Agency of Canada - yes, that's right a federal government agency actually can manage to supply useful information at its section on credit cards. The unique info, not found on the Rewards Canada site, is the table of extra fees and charges, and particularly for the traveller, the Cash advance fee outside Canada and the Converting transactions made outside Canada into Canadian currency (which, frustratingly, is 2.5% in the vast majority of cases)
The tables are invaluable for quickly eliminating cards that do not meet basic criteria e.g. for me, I absolutely want a card with Auto Rental Loss/Damage Insurance (which avoids needing to pay the usurious daily fees charged by rental companies to cover any damage, whether it's your fault or not; funny that if you decline the rental company coverage, they do not ask for proof that you have other cover, which of course means the rental company has its own insurance for damage and you are only lining their pocket ... but since you must sign on the rental agreement that you will pay for damage, you still are wise to get some insurance from somewhere). That meant, for example, eliminating the American Express Blue Sky card.

Despite the top 5 article mentioned above, my eventual choice did not settle on their top-rated RBC Visa Avion Card. Instead the separate Travel Anywhere Credit Comparison showing rewards redemption values versus spending required focused my choice initially on the Capital One Aspire World MasterCard. It seems to offer the best spending to reward ratio. Note the word "seems".

The fine print on the card reward scheme, found only by drilling down into the Capital One website, has some tricky conditions that ensure almost no one will be able to get full value from their points and achieve the seemingly best-in-class rewards. The tricky bit is buried in the Important Disclosures document you see only after starting the application process under the heading Reward Miles Redemption, where it says: "... The reward mileage requirement is as follows: 15,000 reward miles are required for tickets up to $150.00; 35,000 reward miles are required for tickets from $150.01 up to $350.00; 60,000 reward miles are required for tickets from $350.01 up to $600.00. For tickets over $600.00 in value, the required number of reward miles will be determined by multiplying the cost of the ticket by 100 (ex. $741 ticket requires 74,100 reward miles). You need to have the minimum reward miles required in order to redeem - partial redemptions will not be processed." In other words, you cannot buy a $500 ticket and top up the missing $100 you need. You must always use more points than the cost of the ticket. Unless you spend big amounts every year on the card - like $25,000 - you won't get to the 60,000 level of points where the no top-up point loss penalty gets less onerous. For me at least, it would be far too long before enough points for trans-Atlantic flights ($1000+) could be useful. Lesson, read the fine print.

After hours of reading the fine print, I literally came back to the place I started - my existing TD Travel Visa Infinite card. Not that TD Visa is the most wonderful outfit ever (see my own less than wonderful experience with them here and here). But their rewards accumulation and their redemption methods (especially where one gets triple the points when booking travel through their own travel agency, which I have found to be responsive and easy to reach) fit my current lifestyle. The devil is in the details and it is the devil I know.

Wednesday, 10 November 2010

Alzheimer's: NOT a Reason to Become Bilingual

Any news about Alzheimer's attracts my attention these days since it will become the major health issue for Canada as the population age profile gets older and it will have many financial consequences for retired people.

It is thus that a press release from the Baycrest health institute affiliated with the University of Toronto announcing with breathless seriousness that "A Canadian science team has found more dramatic evidence that speaking two languages can help delay the onset of Alzheimer's symptoms by as much as five years." Wow! Here comes the government with programs for teaching French, English or other second languages (any two will do, apparently). As a bilingual person I would love to believe the conclusion but skeptical me wonders if these professionals have made a very fundamental mistake in confusing association or correlation with causation.

Do a Google search with the words spurious correlation and causation and read the dangers of confusing the two ideas. One of my favorites is the video Everything is Dangerous: A Controversy from the American Scientist in which many spurious claims in medical research are dissected by Stanley Young Director of Bioinformatics at the US National Institute of Statistical Sciences for their faulty science and application of statistics. The most basic smell test - does this sound too incredible to be true? - when as they say themselves "There are currently no drug treatments that show comparable effects for delaying Alzheimer's symptoms", should make everyone highly suspicious. The lack of any reference to a physical causal (chemical, biological etc) process to link language-speaking with slowing down the brain gunk (to use a term that shows the depth of my medical knowledge on the subject) present in Alzheimer's undermines my confidence in the announced results even more.

The researchers say they are "dazzled by the results" in the original 2007 study announcement from Baycrest. Too ironically true.

Monday, 8 November 2010

Alzheimer's: Another Reason for an Expanded CPP

Retirement Action's Peter Benedek included a link in the Nov.8 ediction of his excellent weekly summary to the scary article The Financial Toll of Alzheimer's Disease, in which is explained the vulnerability of people with Alzheimer's to financial mistakes or fraud. The article mentions a number of useful protections.

Another defence not mentioned is simply to have a steady, reliable, lifetime, non-tradable/non-withdrawable/non-stealable source of income about which no decisions have to be made ... like the CPP.

Alzheimer's (and other forms of dementia) is a significant issue now and it will grow much worse. Increasing longevity will mean an increasing number of people getting Alzheimer's as pointed out in the appropriately-named report Rising Tide: The Impact of Dementia in Canada from the Alzheimer's Society of Canada.

CPP simplifies retirement finances. As such, it can help avoid financial problems by requiring fewer complex, people- and time-intensive legal and family protections.

Book Review: Behavioural Technical Analysis by Paul Azzopardi

This book is a rationalist's attempt to make sense and investing use, through technical analysis, of the often irrational behaviour documented in the field of behavioural finance. Two-thirds of this book is brilliant and the other third is disappointing.

The brilliant part: Azzopardi provides the best explanation and summary of behavioural finance concepts that I have come across to date. Not only does he explain simply and clearly with entertaining examples each individual idea like framing, representativeness, anchoring etc, he classifies and organizes it all and turns a bunch of seemingly random and contradictory ideas into a cohesive, sensible structured whole. His two groupings – the first is Complexity, Perception and Aversion and the second is Self, Society and Gender – really succeed in fitting together the disparate concepts. I found this material to be very helpful in reflecting on my own money and investing actions, to figure out what I'm doing wrong and right, which will allow me to make improvements.

In this regard, the book is a better and more satisfying read than more famous books in the behavioural finance pop charts like Dan Ariely's Predictably Irrational, Jason Zweig's Your Money and Your Brain and Terry Burnham's Mean Markets and Lizard Brains (my review here).

The disappointing part: The case for being able to successfully apply the undoubted truths of behavioural finance and the assumed efficacy of technical analysis isn't convincing. While there is no doubt that emotions and faulty thinking affect stock markets, the problem is the difference between ex post prediction and ex ante explanation. After the fact, everything is clear and periods when the crowd of investors has been irrational can be pinned down, as Azzopardi does do, to the stock price charts and technical indicators. But how do we know today what optimistic or pessimistic behavioural finance impulse is driving the market? As he writes on page 158, “It is always hard to tell what the reaction will be and the market often reacts to the same kind of news in a different manner.

A surprise for me in this book was to find a reference to a research paper by William Brock, Josef Lakonishok and Blake LeBaron that supports a conclusion that at least some technical analysis trading rules – all of which are entirely mechanical and have no behavioural finance shaping - were successful in generating true excess trading profit. I looked the paper up and indeed their research does state the technical analysis methods tested (moving average and trading range break) did “... provide strong support for the technical strategies”. It will be interesting to look into this stuff for a future blog post!

Another feature I like is the fact that the book provides the detailed reference to this paper and many other research papers and books cited in the book. Its website at also has online links, within a password-protected area (the password is in the book), to the actual documents.

Rating: This book is worth buying for the excellent first part alone but my rating for it suffers due to the second part – (5/5 x 2/3) + (2/5 x 1/3) = 3.5 out of 5 total.

Friday, 5 November 2010

British Airways Delivers Baggage Delay Compensation

On a recent holiday trip on British Airways to the lovely city of Barcelona, my wife and I got that sinking feeling on arrival when our bag did not show up. A day later, after we had gone shopping for essential bits of clothing and toiletries, BA did deliver the bag and everything was fine after that, including the bag's trip home, simultaneously with us.

Normally, this would not be worth noting. The big, and pleasant, surprise, which is worth a pat on the back to British Airways, is that the airline reimbursed all our expenses due to the wayward bag! Far different from the - how shall we say this politely - typical nasty treatment of passengers by such as Ryanair, who have to be coerced by the authorities to redress nasty behaviour e.g. here, BA dealt with our case quickly, politely and efficiently. Within five days of our return home, we had entered a claim online, sent in our invoices as requested by email and been reimbursed through an electronic deposit to our bank account. Well done British Airways.

What is all the more remarkable is that BA could have been a lot stickier with compensation. According to the AirTransport Users Council, the UK's consumer council for air travellers,
"There are no set rules for how airlines must assess baggage claims. For delayed baggage, some airlines offer immediate one-off payments at a set amount to cover emergency purchases (such as toiletries or underwear). Some will pay a set amount per day up to a maximum of days. Others will not make cash payments at the time, but prefer to reimburse expenditure on essential items on seeing the receipts. But the general principle is to cover essential expenditure resulting from the delay to delivery of the baggage."
The airline liability limit for lost or delayed luggage is 1000 Special Drawing Rights (IMF conversion table here) per passenger per the Montreal Convention. Or maybe not. There seems to be confusion about the amount, since BA itself says its liability is actually 1131 SDRs, or about £1000, as does Delta and the AUC, but the European Commission's Ireland section says it is 1000 SDRs, equivalent to about 1134 euros. has informative articles here and here on the differences between what airlines may wish to offer as compensation and what are the legal liabilities of baggage delay and claim.

The European Commission has passed laws that put additional responsibilities on air carriers for passenger treatment in cases of cancelled or delayed flights, denied boarding and the like in Regulation EC No. 261/2004. The rules apply to international flights into or out of the EC.

Mishandled baggage still accounts for the 3rd highest number of complaints received by the AUC according to its 2009/10 annual report published in July, though the number was down slightly from the previous year (maybe just in keeping with faltering air travel from the recession?). The AUC's special 2009 report on luggage problems showed that many airlines are much more tight-fisted and mean than BA, with Ryanair apparently a leader in that department as it drew particular mention from the AUC: "Some airlines set their own limits on how much passengers can spend while their bag is delayed. For example, complaints to the AUC show that Ryanair often limits passengers to £15 whatever the length of the delay."

Now if BA would only be as good at delivering baggage in the first place as it is at providing compensation for delay, it would be top class.

Friday, 29 October 2010

Pension Income Shortfall a Problem for Only a Few - Is That So?

Some pundits and politicians like Alberta's Finance Minister Ted Morton oppose the expansion of CPP to give a bigger assured retirement income to Canadians on the basis that it isn't a big problem because it is "... limited to a small sector of the Canadian workforce ..." (as quoted in this News 95.7 report from June this year).

Perhaps he was looking at data such as that in the Retirement Income Adequacy Research Report of December 2009 which was commissioned by the federal and provincial finance ministers. Tables 2 and 3 cite research showing that retired 70-72 year old men and women in 2006 had average income replacement levels from about 70% on up across every single income level. Looks good doesn't it since 70% replacement is the common rule of thumb for maintaining a standard of living. Furthermore, that result holds whether or not the retiree had been a member of a Registered Pension Plan or not and to complete the picture, in all but the highest income quintile, the non-RPP retirees had higher incomes than the RPPs. That's true even when the employment earnings of the non-RPPs (since non-RPPs, unsurprisingly, still are working and have much higher employment earnings) are subtracted. Got that? Retirees without a pension plan had higher incomes. Shocker! What retirement income problem?

As report author Jack Mintz writes, "The results are thus quite striking but need to be interpreted with care." Enter the nit picking detail. Note the word average in the above paragraph. Consider this dumb statement - if you have one foot in the freezer and the other in the oven, then on average your feet are a comfortable temperature. The Stats Can researchers Yuri Ostrovsky and Grant Schellenberg who put together the original data in Pension Coverage, Retirement Status, and Earnings Replacement Rates Among a Cohort of Canadian Seniors realized the hidden danger of using an average and have since done a revealing follow-up in A Note on Pension Coverage and Earnings Replacement Rates of Retired Men: A Closer Look at Distributions (no, they did not look at the detail for women) of July 2010. By looking at the breakdown of replacement income percentage, they found that the non-RRPs had a much higher concentration of men at the low end of the income replacement scale. The RPPs are clumped in the middle of the replacement spectrum. The average came out the same because of an offsetting bunch of non-RPPs at the highest end of the scale. A few rich people counterbalance a bunch of poor people and the average looks the same. The graph below from the study shows this for the middle income group ($45,700 to $58,200 / quintile 3).

If one cares to look, the phenomenon is the same in all three middle income quintiles, covering income of $32,800 to $76,100. In every income group except the very lowest (where OAS and GIS ensure that the bulk of men have pretty close to or more than their pre-retirement income) about half fall below 50% replacement rate of income. 50% replacement must be about the minimum for anyone to maintain a standard of living no matter how modest and probably it isn't near enough at lower income levels. Conclusion: pretty darn close to half the Canadian retired population of men must be unable to maintain their standard of living in retirement. A small sector of the workforce indeed, Minister Morton!

Tuesday, 26 October 2010

Senate Weighs in With Some Useful Retirement Savings Suggestions but ...

Canada's Senate committee on Banking, Trade and Commerce announced a half-dozen recommendations on how the government could enhance retirement savings in its Oct.19 report Canadians Saving for Their Future: A Secure Retirement.

The recommendation that would likely have the most beneficial effect is the suggestion to establish a Canada-wide plan for retirement saving and investing. The new plan would entail setting up five or so professionally-managed, competitively-sourced investment funds into which savings deductions/contributions of Canadians 18 and over would go. It's a pretty good but incomplete plan. Why?

  1. Auto Enrollment - the report calls the plan "voluntary" but that means an optional opt-out, which few people will do. As the famous book Nudge explains (and as the use of the word in the report slyly suggest that the Senate committee is aware of the idea), the difference between voluntary opt-in and opt-out is huge and participation rates will be as good as universal, up in the 90+% range. Goodbye to the costly sales and marketing overhead cost of retail funds because it's a captive market.
  2. Fiduciary Duty Governance and Management and Competitive Sourcing - they call it a commitment to avoid "real and perceived conflicts of interest". Professional managers can add diversification, discipline and net value when the fees they charge are restrained - i.e. the gross investment return isn't sucked dry by the fees. Hello to much lower fees from the powerful negotiating position that such a massive plan will have and hello to a resulting much higher net return to investors with much higher end value retirement savings.
  3. Optional RRSP or TFSA - it is valuable to have the flexibility of being able to contribute to the right account for one's tax situation / income level (the familiar question about whether your tax rate will be lower in retirement - RRSP better, or whether your absolute income is low - TFSA better) and retirement goal (if legacy desired, TFSA better).
The report does not address a few key issues related to this idea:
  • Savings Deduction Rate? - how much should it be? Maybe 9% would do, the same as for CPP, which aims to replace about 25% of pre-retirement income, so such a contribution rate in this plan would provide another 25%. A less desirable method would be to allow the contribution rate to be chosen by the contributor but then the new plan should have a default rate with option to change it (another nudge).
  • Sequence of Returns Risk - the danger of a market plunge, such as happened in 2008, at the intended time of retirement is that the total available to purchase an annuity is vastly reduced and permanently low retirement income would result. The alternative of withdrawals from a RRIF would see much lower sustainable withdrawals. Of course, nobody would retire after a market crash if they possibly could and they would deal with the market returns risk by continuing to work however long it took for market and retirement savings recovery. That's not the only way to deal with this risk though. The method of the CPP is to have a defined benefit payment coming no matter what the state of the market - did the CPP announce a reduction of payments in 2008 even though its investment portfolio dropped about 20%? The reason the CPP can maintain payments is that it can, as a fund with a very long term investment horizon, smooth out market humps and bumps, knowing that savers continue to provide cash inflow. There is time risk sharing going on within CPP that the Senate's proposal lacks, which to my mind is a very important feature of making retirement saving feel secure and actually be so.
  • Conversion to Retirement Income, Inflation Risk, Longevity Risk and Annuities - a retirement savings plan, such as the one proposed, must be converted into an income stream and the report does not consider how this will be done, except for brief off-hand references to buying an annuity. Yet the income conversion vehicle, its cost and its effectiveness in countering inflation and longevity risks determine the success of the whole retirement income exercise. This cannot be considered apart from the savings phase method with the assumption that all will be well. Choose an annuity and even low, normal 2% inflation eats away a huge portion of the value of a fixed payment annuity over the longer and longer retirement periods of today. Real constant-value CPI-adjusted annuities are almost absent from the Canadian marketplace. Most annuities on the market in effect provide income for life at a fast (high inflation) or slow declining standard of living. I bet that's not what people want or need. There is also the problem that the market is lop-sided - the people who want to buy annuities are those who figure they will live longer and not those who will die off sooner and whose cash helps maintain a higher standard of living for the survivors. (Those who believe this is unfair could be reminded that sharing the risk means everyone gets higher payments than if no one shares) The annuity-selling insurance companies know about likely-to-live longer annuity buyers of course, and so annuity payouts are even lower. Contrast that with CPP where everyone, early and late deceased, automatically and without choice to opt out, gets into the annuity payment stream. Choose the other option to generate income, a RRIF from which withdrawals are taken, people have the very hard job to figure out how much to withdraw given their uncertainty how long they will live and need income. Live too long and you run out of money. There is no longevity risk sharing. People can either be very cautious, withdrawing slowly, and perhaps live a much more restrained lifestyle than they might have liked, or they can live high, perhaps to discover that they must drastically reduce their spending later on. Pooled assets with no opt out (i.e. with longevity risk sharing) during withdrawal means higher payments for everyone and much less worry along the way. The prime example of a successful end-to-end solution is the CPP - you pay in a certain amount per year and you are guaranteed (by the most stable provider around, the Federal government) a certain inflation-adjusted amount for however long you live.
The report includes several other worthwhile but less significant suggestions:
  • Set a TFSA lifetime contribution limit of $100,000, which could be used immediately in full any time e.g. for an inheritance; helps present-day retirees with taxable accounts
  • Remove the effect of RRSP withdrawals on means-tested benefits; makes things less complicated and less punitive
  • Defer RRSP conversion age to 75; helps those who work longer
  • Have the Financial and Consumer Agency of Canada do financial education and monitor investment advisors (I think they mean financial advisors, which is much broader than investment advisors) - pretty wimpy, they could and should have recommended that fiduciary duty for financial advisors be put into law with some body given policing powers

Friday, 22 October 2010

Cap-Weight vs Fundamental Portfolios: Q3 Update after DRIP

The live updated spreadsheet at the bottom of this blog, which shows the on-going contest between a cap-weight portfolio and its fundamental weight counterpart, has now been updated to include the automatic reinvestment of dividends where the ETFs offer that feature.

The DRIP purchases included the following:

Fundamental Portfolio
  • CRQ - Claymore Canadian Fundamental Index Equity large cap - 6 extra shares
  • ZRE - BMO Equal Weight REIT - 2 shares
  • ZRR - BMO Real Return Bond - 6 shares
Cap-Weight Portfolio
  • ZRR - BMO Real Return Bond - 6 shares
The leftover cash is now sitting in each account. The Cap-Weight portfolio is starting to pile up the extra idle cash while the Fundamental Weight portfolio is putting it to good use by reinvesting.

I'm going to substitute the new Horizons BetaPro TSX 60 tracker ETF (symbol HXT) in the cap-weight portfolio since its total return swap construction reflects implicit automatic DRIPing and I want to find out about the difference in weighting strategy not the effects of DRIP, which will always be beneficial to the ETFs that do it in rising market.

The net difference between the two strategies is pretty slim, with each one ahead in 3 holdings (I ignore the RWX since they both hold it and the Cap-weight is ahead merely and always because it holds one more share) and the Fundamental Weight portfolio is in the lead overall by only 0.1% or so ($171 on a $111,000 portfolio). It's a tie so far.

Saturday, 9 October 2010

Crown Currency Exchange Collapse a Reminder of Need for Segregated Accounts

The plight of clients who stand to lose large amounts of money given over to the collapsed Crown Currency Exchange provides a harsh reminder that a key baseline requirement for considering any foreign exchange transfer company must be that customer funds be held in segregated accounts that are separate from the funds of the FX company itself. That way, client funds are protected from creditors of the FX company, which means you the client can get your money back instead of suffering the fate of some of the people in the BBC news account, who seem to be destined to lose an amount large enough to buy a house.

A perusal of the websites of various FX dealers reviewed in my initial post on the subject shows that many do claim they segregate client funds but some seem to make no mention of the subject, which probably means they do not. Here is what I found:
If you are transferring large amounts of money, don't take my word for it. Check that they actually do it e.g. by verifying with the regulatory body the FSA in the UK, or asking for a contact at the bank where the funds go.

Friday, 8 October 2010

Stein & DeMuth's Market Signals Go Green Across the Board

Almost a year ago when I reviewed (here) Ben Stein and Phil DeMuth's book Yes, You Can Time the Market, only a couple of indicators / buy signals were green, indicating a good time to buy the S&P 500. Now all four indicators for which they can still get data - Price, P/E Ratio, Dividend Yield and Earnings Yield vs AAA Bonds - are Green. Thought you'd like to know. Let's note that the S&P 500 as I write this is at 1165.47.

Thursday, 7 October 2010

TD Bank Introduces Clever and Beneficial Savings Tool

When a bank launches a good product, it's worth noting and patting them on the back. Part of TD Bank's Get Saving campaign is a clever new tool to help people save. The 1-minute video Tools to help you save explains: each time you make a purchase using your debit card or take money from a cash machine, a pre-set amount (which you set between $0.50 to $5.00 per transaction and can change) is transferred to a savings account. It's the psychological aspect I find most intriguing and promising. First, it's automatic so it's easy. Second, you make the decision to save in advance - people have a much easier time deciding to save more in the future than now. It could actually work!

There is a third aspect, whose effect I could see being good or bad. There is a feedback link to spending - as you spend more, you save more. Will that reduce people's spending by making the money run out sooner or making them think it will, or raise their awareness of how often they are spending? Or will it cause people to think that spending more matters less since they are simultaneously saving more, (with the possible result that they end up being over-drawn - "borrowing to save" would not be good!)?

As an enhancement, TD could offer a pre-set percentage transfer e.g. 1 up to 10% (the latter is an often-recommended amount one should be saving out of income for retirement). That way, people would especially think about bigger purchases and they would save a lot more.

Wednesday, 6 October 2010

Credit Suisse on Inflation - How It Happens, What to Do

Credit Suisse's Global Investor 1.10 report has a lot of worthwhile content on inflation:
  • How Inflation Comes About, a one-page Sim City like picture that shows how the financial system and key bits of the economy interact to create the beast we abhor - from Central banks, through commercial banks, the labour market, the capital market, the goods market. Brilliant communication! There's even a helicopter hovering over the stylized city - a sly reference to Helicopter Ben?
  • an assessment of Inflation as the escape route for high-debt countries - they say it is "unlikely" because many countries have "... experienced the painful consequences and destabilizing effects of runaway inflation," and won't want to experience it again; but it's much more likely in emerging market countries and commodity exporters and those least affected by the real estate crisis ... hmmm, sounds a fair bit like Canada
  • a sidebar on who is best at inflation forecasting - surprise, it is not that implied by subtracting the yield on real return bonds from the nominal return of government bonds - they were the least reliable! Best at the one-year ahead inflation forecasts were ... drum roll ... the central banks. Note how they all slightly under-estimate actual inflation. Based on the expectations on this Bank of Canada page, which does NOT seem to include a forecast by the Bank itself, 2011 looks like it will be in the 2.5-3% range in Canada.
  • an inflation history graph going back to 1500 - inflation was a lot lower and more stable between 1800 and 1900!
  • people almost always feel inflation is worse than the official CPI numbers say. Most people are not inflation-conspiracy believers, they simply notice and feel the pain a lot more on the purchases they rely on most. It's a new area of behavioural finance, an extension of the "you feel losses twice as much as gains" idea. Hmmm, maybe that's why I think life is cheap here in the UK compared to Canada because wine is definitely a lot less expensive (lots of good table wine at the equivalent of $6.50 per bottle)
  • asset inflation caused by lax monetary policy and boosted by leveraging is very dangerous - no kidding - but take away the leveraging, as in the tech bubble, and the lasting real economy effects are not nearly as bad
  • an Adjusting to Inflation article shows different asset classes performed differently in different high-inflation periods . In the 1970s, gold, oil and commodities did best, but between 1986 and 1990 commodities did really well, oil was ok but very up and down and gold did very poorly, much worse than CPI. They then go on with the table below to identify which kinds of assets they think will do well in different economic environments. Their conclusion is one with which I cannot but agree - since you cannot know exactly when and in what form inflation will arise, the best investment strategy is to maintain a balanced diversified portfolio but to be sure to include things like gold, commodities, real return bonds and other hard assets.
  • there are personal accounts from three individuals who have lived through either hyper-inflation (Zimbabwe and Argentina), or deflation (Japan) - a strong reminder that we do not want to go there, diversified portfolio or not.

Friday, 1 October 2010

Cap-Weight vs Fundamental Portfolios: Q3 Update, Guess Who Leads

Regular readers may recall that a few months ago I started a contest to see whether a portfolio based on Fundamentally-weighted ETFs would do better than the traditional standard Cap-weighted index ETFs. This contest is meant to be as realistic as possible using actual funds, including trading commissions, currency effects, distributions, DRIPs etc.

The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).

However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.

Other observations:
  • Strong portfolio gains: both portfolios up almost 10% since June!
  • Correlated asset classes can be good: every single ETF / asset class in both portfolios has gone up since June. That's highly unusual and sure not to continue for very long. The value of having a diversified portfolio is still evident in the large disparity between the gains amongst the ETFs. If one had only been invested in Canadian large cap equity with a 4% gain and bonds with a 2% gain, the overall portfolio gain would have been somewhere in that low range. Emerging markets, Developed markets ex-US, international real estate, commodities and Canadian small cap and REITs all contributed percentage advances of triple or more Canadian large cap's. Another way to look at it is that not having a diversified portfolio means having to pick which asset class will go on a tear next in order to get good gains. Diversification = not as good as the best but better than the worst.
  • Fundamental winning in most asset classes vs Cap-weight - leading by 5 to 2. It is still early days in our contest but this is going in the direction I would expect. ... However, where Cap-weight is winning (Canada large equity and Emerging markets equity), it is by enough to more or less balance things at the portfolio total. As I wrote about here, in the Canada equity case, I believe the difference is due to the ongoing Potash Corp takeover bid.
  • No re-balancing required: in neither portfolio is the actual value of any asset class anywhere near to going beyond the 1/4 away from target that we said would be our rule for re-balancing; the Cap-weight percentages are slightly more out of whack compared to target, which is what we would expect from indices that rely on market prices - fundamental accounting weights should evolve more slowly. That will be interesting to watch as we go along. (in the updated spreadsheet that appears live at the bottom of this blog, I've inserted a new column in the individual portfolio spreadsheets that shows the ratio of each asset class' actual to target)
  • Currency has reduced returns: the Canadian dollar has risen about 1.4% vs the USD since our launch, reducing our net returns on US denominated holdings and that is the same for both portfolios.

The contest continues ...

Wednesday, 29 September 2010

EDHEC Papers Burst Balloons on Cap-Weighted Indexing and SRI Funds

The EDHEC-Risk Institute, an academic institute with a practical orientation, has put out a couple of papers that knock down some investment wishful thinking.

In Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?, authors Felix Goltz and Véronique Le Sourd, after reviewing the academic literature, answer that question quite categorically - "No, it does not". A cap-weighted index does not represent the market portfolio of finance theory and even if it could, it would not be efficient in a risk-return sense without making highly unrealistic assumptions. As they say, "... from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage". It then becomes a practical problem to construct indices that offer higher return to risk trade-off (as expressed in higher Sharpe ratios). They offer their own Efficient Indices here and when they assess alternatives (Improved Beta? A Comparison of Index Weighting Schemes) like fundamental indexing, equal weight indexing, efficient indexing and minimum volatility indexing, the alternatives all beat Cap-Weighting (e.g. their US Efficient Index has outperformed the FTSE US Cap-weighted index by 2% annually since 2002 while lowering volatility). Of course, not all these better indices are investable for the average retail investor - so far only fundamental and equal-weight funds are available - and the costs of running the index fund could obviate the benefits (witness the sorry story of mutual funds in Canada) if too high (my assessment of US ETFs suggests they do preserve the benefit in real life and I've started a realistic portfolio experiment for a Canadian investor that includes Canadian ETFs).

The other foray into clarifying reality vs wishful thinking is
The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis by Noël Amenc and Véronique Le Sourd (again! does she like setting people straight or what?). Comparing the performance of SRI funds in France, they cannot really find any significant difference with ordinary funds in terms of risk-return efficiency. During the period of the financial crisis, SRI funds provided no better protection against the downturn. A subset of SRI, Green (environmental) funds, compared to best-in-class ordinary funds "... reveals, over the long term, higher alpha for green funds, with higher risks, including higher extreme risks." The paper's findings will give some comfort to the SRI-minded investor with its evidence that the investor need not lose out by going SRI. However, it does also remind us that SRI is no investing philosophy panacea either. I am currently reading Confessions of a Radical Industrialist by Ray Anderson and he leaves an over-the-top impression that going green is a sure-fire route to greater profitability. That may be so if you do it right but I daresay there are well run and badly run SRI and green companies, just as in any human activity (as an illustration of the principle for those with a reflective bent, I highly recommend the book Albert Speer: His Battle With Truth by Gita Sereny; it tells the story of a highly intelligent but amoral organizational genius who put his talents in the service of evil as the mastermind of Hitler's war production machine)

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