Monday, December 20, 2010

ETF Education Part 3 Construction of an ETF


Review: It is hopefully obvious to those following the recent series of blogs, that ETFs are not quite as simple as we might have believed when they first arrived on the scene. They are like a house in that we look at the furnishings and carpeting to see if we like it, but we rarely check the foundation or the attic to see if it is solid.
We have reviewed how indices were created, how that in turn lead to index mutual funds, and then eventually to ETF Index funds. We noted that the names were often misleading (DJIA for example),that there are differences in how various indices were weighted, and we also looked at who the "players" were in the ETF world. We also looked at several of the common characteristics of ETFs and noted they could be positive (low cost) or negative (tracking error) for investors.
 Now we will dissect some ETF structures to see what we actually own when we buy an ETF. We will look at four common structures that can be used to replicate an index.

1- “Basket of Securities” Structure: Let’s start with a plain vanilla ETF Index Fund. This simplest “open ended structure” is what most people believe they are purchasing when they buy an ETF. In this structure the ETF creators duplicate the performance of an index by actually holding a basket of all the underlying securities through a “designated broker”. As an investor you buy a “unit” from another investor or sell a unit to another investor. The underlying stock is transferred in kind which means no capital gains or trading costs need be incurred with respect to the underlying index components. If you attempted the same trade on your own using, for example, a Dow Jones index of stocks, you would make 30 buys on acquisition of the stocks and 30 sells when you sold out; with each transaction generating a tax event (gain or loss)and brokerage fees. A typical simple ETF structure should be able to closely track an index because it directly owns the index components and thus the index performance, minus fees to maintain the ETF.

2- Representative Bundle Structure: If I want to create a Canadian Fixed Income ETF to track the Dex Bond Universe ( 1,100 bonds at last check), I would need to make an extremely large number of bond purchases to capture the whole index. A significant number of the bonds would be difficult to acquire since they may have been a small issue to begin with. Rather than attempt such a ridiculous approach, a creator can do a statistical measure of the characteristics of the DEX Index. The analysis might look at traits such as average term, duration, yield to maturity, and credit rating of the full universe of bonds. They can then select a smaller number of bonds that, on aggregate, match the characteristics of the full Dex Index. Thus with a basket of 30 or so bonds I can reasonably expect to track the Dex Index performance, at a much lower cost for the unit holders. Of course the risk of the ETF not performing exactly as predicted does exist. When you purchase an ETF Index that uses the “representative bundle” approach you should monitor tracking error closely. It is reasonable to assume that this structure can and should reasonably track the index with minimal risk of performance variance and generally lower costs.

3- Future Contracts: Another way to play the market is to buy a futures contract which promises to deliver the value of the underlying securities at a given time. For example, let’s say a one month future contract on the TSX60 can be purchased on a futures exchange. The contract pledges to pay me the value (or actual shares) of the TSX60 at the end of trading on a specified date. If the index goes up I get the higher value and if the index goes down I receive a lower value. An ETF using the future contract structure, is thus not holding the underlying stocks, but is actually exposed to the “contract” which will fluctuate in value. The future value of a share should not be expected to reflect the “current” value of a share. Markets have expectations for price moves that are reflected in the contract values but not necessarily in the stock’s current price. As well the ETF will need to roll over the contracts as they mature and again will pay for “an expected future price”, not the current price. This roll over process is inefficient and as such this type of structure has a greater risk of tracking error. In fact, the ETF is actually exposed to the futures market, not the index itself. With the increased risk comes a few significant benefits as well.
One benefit of this type of structure is that it allows for increased exposure to commodity markets which are not available as a straight stock strategy. Recently oil has been a commodity that many investors are tracking via an ETF, but corn futures or hog futures are also possible to track when you utilize contracts. At the end of a contract the ETF trades out of the contract so that it does not actually take delivery of the underlying asset. The process has some complexity and contract roll over’s can bring significant tracking errors into the picture. This is especially evident in commodity ETFs. For those wanting more information you can look up the impacts of either contango or backwardation on contract rollovers.

4- Exchange Traded Notes: ETN’s are very similar to future contracts in that the “note” is a promise to deliver a value on a given day. Typically a note is an agreement with a large financial firm such as a bank. The agreement requires the note issuer to pay the note holder a given value on a given day. An Investor could for example sign a note with BNS to deliver the value of the TSX60 on Jan1st of 2012. They would agree to a price and the bank would likely hedge the underlying stocks and make money on a price spread built into the cost of the note. Of course, in the event BNS becomes insolvent before 2012, the investor may face a large loss due to the inherent credit risk of the note holder. Default risk may seem obscure but it is a large part of the reason for the current market crash we are working out way through.On the positive side, ETNs offer a great deal of customization since any agreement can be structured as a note as long as two parties agree to the terms and fees.

The above structures are all in common use today. If you buy an ETF Index Fund you will need to know the structure to know what you are holding (stocks or contracts) and whether or not you are taking on counter party credit risk (notes ). Each structure has its benefits and its drawbacks and you need to understand when you should favour one structure over another.

Proliferation: One of the reasons for the wide variety of structures in the ETF market is because institutional investors are often looking to build securities that offer either exposure or protection from price fluctuations in a specific asset class or commodity. As these products get built they are also offered to retail investors as an ETF they can use for similar exposure or protection. While institutional investors have a very specific requirement to fill a strategic goal, investment sales people often just want to offer something new and flashy for retail investors. A classic example is leveraged ETFs which were sold to unwitting investors by supposed advisors who often had no understanding of how they worked or what risks they exposed investors to. Eventually the industry had to back off leveraged ETFs under a barrage of negative media coverage.

ETF Securities: Below is a list of some of the more common types of ETF Index funds that are common in the market place.

1- Broad Market ETF’s: An ETF that encompasses a significant portion of a large market index is considered to be a broad based ETF. These are the indexes that started the whole indexing phenomenon. In fact, many ETF gurus will tell you that these are the only ETFs a retail investor should purchase. Examples are ETFs tracking the TSX 60 or TSX Composite index, the S&P500 or the Russell 3000. The concept is that with one ETF you gain full market exposure.

2- Sector Indexes: A number of indexes are provided to allow investors to focus on stocks within a specific sector of a market. An example would be Energy ETFs, Technology ETFs, or Financial ETFs. Typically these ETFs follow international guidelines for determining which securities fit in which category of the standard “sectors” . All the sectors added together will form the whole of a broad based index. As such these are often called sub-indexes. In effect this becomes a bet on a single sector outperforming the general market and is useful for traders who use a sector rotation strategy.

3- Style Based ETFs: You can purchase an ETF to allow you to take a bet on one style of investing being more profitable than the whole index. The most common examples are Growth and Value style ETFs. During a bull market where stock prices are rising rapidly you would expect growth stocks to outperform the market. In periods of recovery or market fluctuations you might expect stock selection to favour those who can find under- valued stocks reflected in the Value Index. Similarly you can focus on small cap stocks or dividend paying stocks to outperform the general market or to better match your investment needs.

4- Fixed Income ETFs can also track sub-indexes. Typical sub-indexes would include short term, mid term or long term bond sectors. These can be subdivided again by high, medium, or low credit quality. The fixed income options listed can also focus on government bonds or corporate bonds. As well an ETF can track “real bonds” for inflation protection.

In fact, an ETF Index can be created to track anything from world markets, to African Banks, to Companies that sell mouthwash! The positive is that we get access to cheap fees and strong diversification; the negative is that we have to sort between hundreds of different ETF Index funds.  The key point is that JUST BECAUSE THEY CAN TRACK IT DOES NOT MEAN IT IS WORTH BUYING! As such you can expect to see many new indexes come and go on a regular basis to meet the investment whim of the moment.

So, it has been a longer than normal dialogue for this blog, but there is a lot more to ETFs than meets the eye. If you have gotten this far you can have some confidence that you know more about ETFs than many sales people who sell them and certainly far more than your neighbour who is telling you to buy an ETF to track Outer Mongolian Natural Gas Pipeline Companies! Next blog we will look at some ETF investment strategies! See you in the New Year!

Soismike.........with a special thank you to Ken Hawkins at for his suggestions on how to work my way through this topic.

Friday, December 10, 2010

ETF Education: Part 2 Lifting the Hood on ETFs

ETF Characteristics

In part one, we reviewed the history of Index tracking, index weighting, and the transformation from Index Mutual Fund to an ETF Index Fund. We also remind investors of a comment concerning the increasing complexity of ETF’s.
In today's blog we will explore ETF’s to see why they exist. The key learning point we are focusing on here is the need to understand that ETFs are built to deliver specific characteristics. It can be more challenging to compare one ETF structure to another if you do not know why it was built a certain way! When we know what characteristics are important to ETF investors we can see how different structures best capture different characteristics that investors seek. We will also get an introduction to the players who make index investing possible.

We will start by looking at ETF characteristics. Contrary to the beliefs of many retail investors, ETF investing is dominated by the big institutional players in the industry. As such an ETF is most often constructed to meet the needs of the institutional investors first. In general, the plain vanilla low cost ETFs based on popular indices were designed for cost conscious institutional investors – the more expensive ETFs were targeted to smaller investors without sufficient dollars to build comparable investment pools at low cost. As an example the XBB although based on a popular index is too expensive for many institutions. They can buy or create cheaper investment pools on their own. This is an example of a characteristic (low fee) being the motivator to build a fund and the absolute cost determining the target market (retail clients). We need to understand why specific ETFs are created and what characteristics are driving their new found popularity. When we know "why" they are being created, we can better understand the different approaches that can be used to structure an ETF.

It is important for retail investors to understand the logic behind ETF construction, because while the large investment managers are extremely qualified to analyse the various security characteristics of an ETF structure, that knowledge is not always obvious to investors nor to the poorly trained front line sales staff (typically your so called advisor). These complex structures then bleed down to retail products which are sold as “ETF Index Funds” with no explanation with respect to the ETF structure. The ETF disclosure/sales material is vague at best and often the product is sold without investors being informed of the different risks and characteristics associated with different structures.

More ETF Basics

While it is always dangerous to issue blanket statements about securities, it is fairly safe to say that most ETF Index funds do have some similar characteristics.

A. The Players:

1- The “creator” of the fund is the company that establishes the fund concept and acquires rights to use the target index from the index owner. S&P for example owns the rights to the S&P500 Index and will issue a license to allow a fund company to create an ETF based on the S&P500 Index.). The creator will issue any required prospectus and get approvals to issue the new securities. As an example Blackrock who own the iShares brand are the “creators” of iShares ETFs. Creators are motivated by gathering large pools of investment dollars and skimming a small peice of revenue from every dollar every year.

2- Market Maker: A market maker, according to an Investopedia definition, is a broker-dealer firm that assumes the risk of holding a certain number of shares of a security in order to ease the process of trading the security.
Market makers are looking for the fastest way to hedge trades, create units, and maximize ETF trading capabilities. When an ETF launches, the lead market maker will typically create the first units, delivering the  shares of an ETF product’s underlying index in exchange for units of the ETF. i.e. the market maker gets 100 units of a new TSX60 ETF in exchange for delivering 100 shares of each stock in the TSX60 to the creator.

Lead "market makers" must stand ready to both buy and sell their products on a continuous basis. They typically hedge all bets and make money on bid and ask spreads. It is desirable to keep the spreads as narrow as possible to prevent hedge funds from exploiting differences between the unit value of the ETF and the value of the underlying shares. This works, in live market conditions, to improve both the liquidity of the ETF and to minimize tracking error.Market makers make their profit on trade volumes.

3-  Advisor/Salespeople: ETFs are marketed to both institutional investors (pension funds, insurance companies, hedge funds etc) and retail investors. The products sold are often identical, but the resources necessary to understand the product varies greatly between the two investor types. The role of sales people is to ensure the playing field is level by doing two things; learning how the product works before selling it, and clearly disclosing how the ETF works, what it costs, and the risks of owning the ETF to investors. Their track record at doing these basic things is dismal to say the least.

B- Dual Liquidity Characteristics of ETFs:

The liquidity of a normal widely held mutual fund or an individual stock security is based strictly upon trade volumes of the fund or security. With an ETF, because it is easy to create or release units on demand, the liquidity restrictions are not solely based on the “ETF unit” liquidity, but also on the liquidity of the underlying securities. This means a new ETF offering on the TSX60 can have high liquidity regardless of trade volumes in the actual ETF units. This is because the TSX60 has high liquidity in the underlying stocks. If I request 50,000 units of a new ETF, the market leader just puts in a request for the shares through computerized trading and issues the 50,000 newly created units within minutes (actually seconds).
CAUTION: While liquidity may appear better in the ETF structure, in actual practice an ETF with low trading volume will tend to have greater tracking error than an ETF with high trading volume even though the liquidity of the underlying securities might be the same. As an example the new and smaller BMO ETF will likely have greater tracking error than the XIU until volumes help the designated market maker to keep the bid and ask spreads narrower.
The one wild card in the liquidity situation , is if the market maker for the ETF abandons the market. The risk is similar for most securities but may be more relevant for ETFs given what happened in the “May 2010 flash crash”. (a story for another blog)

C- Cost Advantage:

 Although some active managed expensive mutual funds are starting to use the term “ETF” in their name to confuse investors; a general advantage of the ETF structure is low cost. This low cost is a significant advantage and thus ETF index funds with higher MERs (expenses) generally are not desirable. ETF Index funds for major Canadian market indices can cost as little as 0.08% annual MER. Typically you will not see any deferred sales fees or trailing commission expenses with an ETF, unlike many high cost mutual funds.

D- Tax Advantage:

Typical ETFs have a more passive approach to investing and thus generate low trade volumes , which then translates to low tax costs. A broad based index ETF would rarely need to add or subtract securities from the underlying basket of securities comprising a unit, since most indices are quite stable. Exceptions would be where mergers eliminate a security or where a security was added or dropped from an index.

E- Tracking Error:

Index funds, whether ETF or mutual funds, attempt to duplicate an index’s performance. In all cases there is likely to be some level of tracking error since the index fund charges an annual expense ratio to cover the cost of maintaining the fund. Also, various structures may be prone to tracking error due to the fact the index fund lags the index when changes are made. An index fund is not generally allowed to make changes prior to the actual index making a change. This allows large investors to "front run" changes to the index which increases tracking error and reduces performance. Another significant cause of tracking error is the ETF structure, so without further ado let’s look at what makes an ETF tick!

So, in summary, in part two we learn:

- ETFs often start life as a specialized product to meet the needs of institutional investors, and then are sold later to retail investors through generally poorly trained advisors(tip; some advisors are ETF specialists and better trained than a typical salesperson on the intricacies of ETFs)

- we now can recognize who the ETF industry players are and how they make their profit from ETFs

- we understand the common characteristics of ETF Index Funds that investors either seek to aquire (low cost, high liquidity, low taxes) or to avoid (tracking error, high bid/ask spreads)

I confess this blog was an added step to my initial ETF education series plan. In preparing the next section on ETF structure, I realized it is easier to understand the "what" of creating an ETF if we better understood the "why" and "who" of  ETFs. Hopefully with this better understanding of the above ETF common characteristics, it will make the next section a little less confusing.

Our next blog, I promise we will get down to the serious business of how ETFs actually work! Part 3 coming very shortly!


Friday, November 5, 2010

ETF Education : Part 1 ETF Basics and History

The Good, Bad, and Ugly of Understanding an ETF Portfolio

Like many folks, I “get” the underlying premise of ETF Index investments. The basic premise is to replicate the performance of a given “index” of securities, without the need (or expense) to actively research individual securities. For example, if I want to replicate the performance of the TSX 60 index, I only need to buy one common share of each stock that comprises the TSX 60. Seems to be simple enough, right?

Unfortunately, nothing is ever quite as simple as we would like it to be in the financial world. While ETF Index investing is not nearly as frightening as trying to evaluate hundreds of securities accurately in a timely fashion, you still need to do your homework. In the next few blogs we will look inside the world of ETF Indexes, and try to lift the hood on how they work, rather than just kicking the tires. The areas we will look at will include index construction, index history, index proliferation, ETF structures, and the increasing number of ETF strategies available to investors.

Today we will tackle "Indices"; what they are and how they impact your ETF Index Funds.

Let’s start by going back a in time a bit and discussing “indices” and how they came to be. One of the oldest and most commonly followed indices is the Dow Jones Industrial Average. This index was developed by Charles Dow in 1896 to provide investors with a timely overall measure of the performance of the U.S. markets. It was created by measuring the “average stock price” of the 12 biggest industrial firms and has expanded to include the stock of 30 of the largest companies trading on the U.S. exchanges today. The name remains unchanged but the index is not nearly as focused on “industrial stocks” as the name might imply. The lesson we learn here is that you cannot trust the name of an index to be a totally accurate reflection of what is being measured.

Much later the merger of financial service companies created the Standard & Poors Index. This index changed the weighting process to  “market capitalization” of the component companies instead of the average stock price weighting utilized by Dow.
 The lesson learned here is that not all indices use the same methodology to measure an index. You need to know both what underlying securities comprise the index AND what methodology is being used to weight the index.
Since the simple start a wide range of indices have become available to track markets big and small. In every case you need to know what is being tracked and how components are being weighted.
While in theory you can use any methodology to weight the value of an index, the common ones tend to be:

1-market capitalization ( pure or capped): market capitalization weights the components of the index by multiplying each stock price by the shares outstanding to get the market value of a firm. It then calculates the firms weighting by dividing that number by the total value of all the firms in the index. A “capped” index will generally restrict any single firm from having a weighting greater than a set value ex. 10% of the total index. This capping is valuable in situations where the index has a small number of companies in it or when a single company such as Nortel gets too big and impacts the index’s ability to provide diversification.

2-stock price average: as stated above, the Dow Jones uses the “price” of the stock to calculate the index weighting relative to the total prices of all the stocks in the index. In reality the math does get a little more complex to account for mergers and other events which disrupt pricing, but the basics hold true.

3- fundamental indexing: the London Stock Exchange and Financial Times created a company known as FTSE, which in turn developed a different weighting system commonly called “RAFI”. (research affiliates fundamental index). This weights each stock on a collection of pre-set fundamentals such as sales, book value, cash flow etc. A number of index fund providers now use their own set of fundamental analysis calculations to weight indices.

4- equal weighting: as it implies, each component of the index is treated equally, regardless of share price or market capitalization. This approach puts more emphasis on smaller companies than you would find in a market capitalized index. In general an equal weighted index would be more volatile than one that was cap weighted.

Indices have been created and tracked for over a century so how is it that ETF Index Funds are such a new phenomenon?

Well, creating, tracking. and valuation of indices has benefited from computing power. To trade effectively on an exchange the index needs to be able to provide valuations every second of every trading day: So computerized programs make index trading possible by providing efficient valuations of the underlying assets in the index.
The second thing that needed to happen was to find an innovator who was willing to break with the status quo in the securities industry. It is obviously more profitable to sell an investor 60 stocks through 60 separate trades than it is to buy one ETF unit and accomplish the same result. Similarly, it is more profitable to sell a mutual fund which pays both upfront fees and trailer fees to a broker. In 1976 Vanguard in the USA created the first index fund to track the S&P 500 Index and that opened the flood gates to the index world for fund investors.
 In 1990 Toronto was the origin of the first Exchange Traded Index Fund when TiPS was traded on the TSX to track the TSX 35 Index. That first ETF Index Fund has transformed several times to become the iShares S&P/TSX 60 of today. Vanguard in turn has become the worlds largest provider of ETF Index Funds for investors. To understand why ETF Index Funds are not more popular than mutual funds re-read the second paragraph above about profitability for advisors/salespeople!

So, we have an evolution that includes creating the concept of indices, expanding the methodology for weighting index components, turning an index into a mutual fund, and then turning the mutual fund concept into an Exchange Traded Index Unit.

Some key learning's for Investors are:
1- You cannot trust the name of the index fund to provide sufficient information to understand the fund components
2- Two ETF Index Funds tracking the same index with identical components can behave very different if the components are weighted with different methodologies.
3- It is rarely beneficial to an advisor/salesperson to recommend an ETF Index Fund over alternatives such as stocks or mutual funds.
4- Canada was home to the world's first ETF Index Fund......TiPS!

Next blog we will look at how ETF Index funds have grown in number and complexity, leading to a variety of structures that are often difficult to understand.

Sois mike

Sunday, October 3, 2010

Bubble Trouble: Will We Ever Learn!

One of the most recognized signs of a bubble is when every person you meet feels they are an expert on investing. We are all good at looking backward and finding “inflection points” where it is obvious in hind sight what was happening. Where we seem to be myopic is in identifying the manure BEFORE we step in it. History is a good teacher; but alas investors are poor students.

I arrived in Toronto in the late 80’s and was involved in mortgaging real estate as the prices skyrocketed. Today it is no big shock to look back and see how the late 80’s real estate collapse was inevitable. Buying real estate in 89 was retrospect. Similarly we can look at the stock bubble of 1999 known as the tech wreck. To those that bought a house in 1989 and then put their RRSP savings into Nortel....well our heart goes out to you!

The incident of back to back bubbles is obviously not unheard of. As money fled real estate it crowded into high tech stocks to create the perfect conditions for the double whammy. So how does this relate to today’s market? Well, money fled the stock markets in 2008 and as stocks crashed large amounts of capital began to flow into fixed income investments. The net result appears to be the creation of a perfect scenario for the second half of the double whammy.... a fixed income crash.

In the case of fixed income, there is even more reason for concern than usual due to both behavioural and macro economic factors. The behavioural concern is the belief by many investors that bonds are inherently low risk. This means investors often choose not to pay close attention to the fixed income markets and price fluctuations. As well, many investors unfortunately have an inflated sense of their knowledge of how securities work (as validated by Zweig ). Fixed income instruments such as bonds are interest rate sensitive (duration) and move inversely to the movement of interest rates. If rates rise then fixed income markets drop in value. Also, if the economy weakens then debt instruments like fixed income face credit defaults which cause values to drop as well.

When you combine those facts with the current macro scenario of historic low interest rates and very low economic growth, you create the conditions for a fixed income disaster! Investor capital will flow to wherever they can find better yield. When that happens, the product vultures kick into gear and create “high yield” products to sell to the retail markets. For those who are kicking the tires on fixed income it may not be apparent that “high yield bonds” are known in the business as “junk bonds”. Once again we see retail investors pouring money into opaque fixed income and yield products, ignoring risk and paying higher fees that often exceed the yield they might gain.

It very much looks like the double bubble process has begun! Every investor seems to be “seeking yield” and new product offering are focused on lowering the bar on bond quality. Junk bonds are now buried in “hybrid fixed income” funds and every fund firm is keying the marketing department to hype higher yield going into the 2011 RRSP season. ETF’s are not excluded as iShares launches its new HYbrid fund, joining the BMO High Yield Corporate (U.S) fund launched in late 2009, the iShares U.S. High Yield Bond index launched in early 2010, and a slew of others. According to IFIC the global and high yield bond funds market sales are up 62% year over year to August 2010.

Hang on tight folks. The bond world can be cruel to those who see it as a sleepy back water investment. With cash flow and capital far exceeding the equity markets, bond markets are dominated by the big players and are far from being a transparent playing field. Just when you think you are finally safe investing your hard earned savings again.....WHAM!

Anecdote: I just spoke with a DIY investor who told me he has purchased a fund of emerging market high yield bonds...... what could go wrong!

Sois mike

Saturday, September 11, 2010

Tuesday, September 7, 2010

Crawling Out From Under An IIROC

IIROC REPORT: New Product Due Diligence Regulatory Review– Common Deficiencies and Requirements for Written Policies, Procedures and Controls

The good folks at IIROC have just released a fresh report designed to hold the investment dealer industry’s feet to the fire! They had their rapid response SWAT team swarming over the latest dealer fiasco's to give investors the heads up on current and relevant deficiencies in the sales of both Principal Protected Notes (PPN) and.... well, basically every new product that comes along!

The fact that these issues were extremely relevant in 2007 and are far less useful or timely now would seem to mean little to our conscientious industry sheepdogs, oops watchdogs, at IIROC. The inspectors at IIROC seem to believe the best time to inspect the barn is after the livestock has gone missing. The good news is that in only 2 short years from 2008-2010, the inspectors were able to confirm the barn door was and still is, wide open!

In effect, IIROC is really disclosing how useless their services are to investors. The reason you inspect is to head off problems not define what went wrong. The regulatory environment in Canada acts as a great coroner..... however what investors need is a good diagnostician! This problem is not new and does not appear to be getting any better!

Barn Door Warnings:

1- Mutual Fund Disclosure Practices are a mess in Canada. This is despite of regulatory reviews that have proposed, reviewed and analyzed the issue since as far back as 2002. According to an article in in 2009, “POS disclosure has been a major issue of contention in the industry for more than a decade. It was a major plank of the work done by former Ontario Securities Commissioner Glorianne Stromberg in the late 1990s.” So, if you cannot work out a simple two page disclosure in a decade, what actual value do you add?

2- LEVERAGED ETF’s were a significant addition to the product line-up for advisors heading into the current mess. These are high risk leveraged products which can drain an account faster than you can imagine. So what training and skills did advisors require before pushing them on investors in the stock crash of 2008.... apparently only the skill to calculate a large up front commission fee. And who was there to protect investors? Well, not IIROC since the issue was driven primarily by FAIR Canada, an investor advocacy group that issued a warning report on leveraged ETF’s in May of 2009 after IIROC had watched over $2 billion in these funds get traded over a period of over two years! dogs are supposed to sound the alarm before I get robbed not after!

3- Money Market Funds were actually being sold at a time when the return was less than the fee to own them. One would think this would jump off the page as an opportunity for a regulator to regulate the actions of dealers managing and selling the products. But, again the outcry was from others but not from our watchdogs!

Without getting too sidetracked, I think you get the issue! Investors in Canada are not being proactively protected when a self regulatory body such as the IIROC only appears willing to pull its thinking appendage out of its output channel well after the damage is done. It appears equally obvious that reviews such as this one are only being organized after others have blown the whistle on abusive practices. It cannot be coincidence that these reports are general and never seem to provide concrete examples of who benefited from the problem at hand and what were the consequences to those who benefited.

Report Highlights: I think the report truly does speak for the industry practices, or lack their of, so let’s look at the conclusions from the report itself:


1- Absence of a clear definition of “new product” : This conclusion is simply that dealers do not even know what a new product is. They can sell it no problem and they understand the commissions with no problems.... but knowing if a product was available before last week is a little tougher!

2- Absence of an adequate analytical framework for the consideration of whether the “new product” should be offered :I guess we should not be surprised if the dealers do not check on suitability of the new product given the point above that they do not even recognize a new product when they start selling it. I guess the dealers are not as professional and diligent as new car sales people who can tell you the features on a new car model within 30 seconds of the car arriving on the lot! I would bet however, every advisor knew within 30 seconds what commissions and trailer fees were available.

3- Absence of consideration of proficiency, training and marketing issues: Again, it is a wonder that new complex financial products can get on the shelf at major brokerage firms with no consideration whatsoever to the ability of the advisor to understand and properly explain the product. A great example was the variable annuities which were so popular that Manulife is choking on the sale of the product. An advisor told me straight up that they called in the product rep from Manulife and after the presentation the advisor had no clue how the product worked but was fine to begin selling it!

4- Absence of Product Due Diligence Committees: This last point helps explain the term “reasonable deniability”. The dealers do not create committees to review new products because then they would be aware of the risks and training needed before the product could be sold. It would also increase the risk of a lawsuit since written minutes acknowledging the concerns raised above would create liability for the firm. No, the decisions are made with open eyes and with malicious intent; never create a committee that exposes risk which must then be disclosed and dealt with.

“So, what now our hardy and tardy regulators? Another few years of study, another memo on best practices?”

“You have published findings that by your own report are atrocious! Investors have lost and are continuing to lose millions due to these deceptive and incompetent practices.”

“ What is the call to arms? How do we use this information to better improve our industry? How do we ensure investor rights and interests come first?”

“ What..... do I have a quarter......and I should call somebody who what?”

Oh, I get it. Thanks for your report on what we should have done in 2006 but still are not doing in 2010; and will not be required to do now that you have filed your report! "We couldn't have not done it without you!"

sois mike

Friday, August 27, 2010

DIY Follies

DIY Follies and The Danger Of Web Experts!

First let me start by saying I am a big supporter of DIY investing, both professionally and personally. I believe investing is too important for people to completely trust their money to a third party advisor, regardless of how qualified the advisor might appear to be. I also think that fees in Canada are so egregious that many investors can make a better return on any DIY portfolio than they will on a “fat fee” fund strategy.

So what frustrates me about DIY? It is the smug self assured certainty of many DIY investors I hear from or read comments from. The web has been a great source of information on DIY investing, and much of it is good stuff. Unfortunately a lot of it is also total crap. It seems that reading a single book and wasting a few hours an evening on web blogs is actually deemed sufficient training to become an unlicensed expert advisor to the masses. To make matters even worse, the advice is most often anonymously shared by somebody hiding behind an ego driven pseudonym. Who would not want to follow the advice of “dividendman” or “investpert”! (my made-up examples in case these pretentious pseudonyms are really being used by somebody out there)

So let’s take a look at some of the idiotic recommendations that appear regularly on investment blogs from DIY advisor wannabee’s:

1- Only Idiots invest in Fixed Income: This one is an idiotic comment that even some mediocre professional advisors spout! With the professional advisor it is understandable because they make more money selling stocks than bonds. With the DIY guys it is because they are navel gazers! They often have no concept of risk or downside protection, little understanding of investment horizons, and believe anybody who disagrees with them is a moron. Not surprising many also claim to be young and thus have little money and plenty of time! By the same theory you should invest in lottery tickets since you have years to invest which greatly increase your odds of success.....right?

1a- Contra the DIY: Equity investing is high risk. The returns on equities are typically higher over the long term but with no certainty that the returns will be superior on any given day, month or year. The larger market corrections can take over three years to recover and equity markets can move sideways for decades at a time. In fact some money managers believe we are in a seventeen year sideways market as I write. In looking at a top investment firm’s numbers for the past 5 years, I see a fixed income fund with average 5 year returns of 6% and with no negative returns in the 5 year period. The same firm’s equity portfolio was a top performer over the past 5 years and has a return of 6.3%. Net of fees (2% on equity and 0.9% on fixed income) and the fixed income portfolio has higher returns, lower volatility and lower fees. So what if the person was indexing their DIY portfolio? The benchmark returns were 3.7% for the equity fund and 4.9% for the fixed income fund.

2- Dividend Funds are the perfect strategy for everybody: The blog world is filled with folks who push the concept of 100% dividend stocks. They suggest that only the bright geniuses like themselves are aware that “dividends pay you to hold the stock in good markets or bad” and that historically, the “consistent dividend growth is the secret to better investment returns”. In fact dividends can pay more than GICs so sell your low interest GICs and buy dividend stocks and you will grow rich!

2a – Contra the DIY: Dividends are indeed a good thing! They are not however the primary investment goal of all clients. Most dividend companies are in older mature and thus lower growth industries. If you are in equities for growth then you may find non-dividend paying energy or tech stocks more appropriate than the dividend approach. The blue chip dividend stocks are often very highly priced with similarly high price earnings ratios. When dividends outstrip GICs it should come as no surprise that the additional return is compensation for increased risk. The other nasty part of a dividend strategy is when a firm suddenly decreases the dividend and the stock drops like a rock. It can take a lot of years of 3.2% dividends to make up for a 35% price drop! (think Manulife for a recent real life lesson)

3- Don’t Invest in Foreign Markets Because of a- currency risk, b- currency conversion fees, c- Canadian markets will outperform! : The Canadian market is a top performing market. European markets are weak sisters that never make a good return and Japan is a wasteland! The smart money invests in Canada because we have natural resources that can only become more valuable over time. We also have gold that will save us when the world ends as we know it. The stock markets all move together so it does not pay to diversify by geography. The loonie is king and foreign holdings increase currency risk too much.

3a –Contra the DIY: In fact diversification has very little to do with long term currency risk and long term investors do not suffer a lot of losses on currency fees (which are still annoying and to be minimized). The diversification into foreign countries is done for two reasons. Foreign countries often have less than perfect market correlation which means if we drop 30% and Europe drops 25% in a bad market, we would benefit by holding some Europe equities on average. Historically the major markets do not hold the top spot for more than a few years before a nation drops back and is replaced by a new market that is heating up. You cannot reasonably predict the world wide shifts so benefit from holding a little of many markets. You do not expect peak performance from every market every year.
The second reason to diversify geographically is to diversify across sectors. Canada is a small market with little health or high tech companies to be had. Foreign firms often provide better exposure to business sectors the Canadian market cannot offer.

4- Follow My Lead Because I Made 30% Returns For Every Year in The Last 7 Years!

I buy only a- dividend, b- small cap, c-gold and diamonds, d- options, e- outer Mongolia futures, and I have beaten the pros for years. Everybody else is stupid and I am a genius and am willing to share my brilliant approach with you! Honest! Check my blog! Honest! Ask my brother-in-law! Honest!

4a Contra the DIY: Unfortunately, I am only exaggerating a little bit! There are several thousand very bright and well educated investment experts with almost unlimited support from top analysts. They did not miss your magic formula for success! You are not a genius unless you do it, have it audited by professionals, and can repeat it over and over. You may be lucky, you may have incorrectly measured results or you may be full of crap! It’s hard to tell from this side of the screen, but I am very confident you are not a genius! Honest! Really! Seriously!

The DIY world is a great place with a lot of bright folks who are interested in investing! But be aware, not every comment is created equal and a little assumed knowledge can indeed be very dangerous. The key to success in the DIY world is very simple: Do Your Own Research! Blogs can be fun and informative but they are not tested or validated. The top forums or blogs will most often make it very clear they are expressing “opinions”, not expert opinions, and just somebody’s opinions. They also make it clear they are not licensed security advisors and you should not buy or sell on their opinions, but rather may want to research what they are commenting on.

Your sceptical of advice friend.....SOIS Mike!

Monday, June 28, 2010


SKIM: Skimmed milk refers to milk which has had the rich cream taken off the top, leaving a less rich milk product. For our purposes skimming refers to removing a hidden fee from a mutual fund portfolio prior to valuing the portfolio for an investor. It also leaves a less rich portfolio for investors.

The media and casual investors intently follow the stories of investment scams and how they devastate the lives of investors and their families. It is understandable of course: a good human interest angle will definitely get the attention of readers!
In fact, the damage done by investment scams and frauds is very minor compared to the damage done within the standard “rules of engagement” between investors and investment firms. F.A.I.R. Canada has reported that as little as 2% of the dollars lost in major frauds over the past decade in Canada involved a regulated investment firm. In short the odds of being “scammed” in a recognized mutual fund are near zero. The odds on having your investments “skimmed” however are close to 100%!

THE SKIM: As an investor you put money into a fund to gain diversification and professional management. Those are worthy goals and the fund industry is fully capable of delivering on both fronts. The issue that leads to the skim is putting a value on the services you want. In effect the industry has clouded the process on two key fronts by:

- Adding mandatory “advice charges” to many mutual funds, most often through hidden and excessive sales fees being mislabelled as an advice fee.

- Portraying licensed fund sales persons as “Financial Planners”, “Advisors” or some form of Vice President/Director. These titles imply an advice or planning offering often not available.

The net effect, for most investors, is a steady skimming of your investment portfolio in return for little or no advice or planning services. In fact, there is no requirement for a fund salesperson (your planner or advisor based upon their job title) to even talk with an investor in order to justify the skimmed fees for “advice”.
You can, in effect, be charged fees for an unlimited number of years without even knowing who your current advisor/salesperson is! Your salesperson could sell their clients to other salespeople and the advice fee continues to be skimmed annually and forwarded to the new “advisor” you have often never even met.

WHAT IS MISSING: At its most basic level, what is missing is the quality professional advice and planning most clients need but cannot identify or articulate without having experienced it. Basics such as a detailed financial plan, an annual review of the Investment Policy Statement, disclosure of material information on changes made in fund management, an assessment of client need versus risk etc.
All of these would require a salesperson to spend time before a client meeting doing preparation, time in a meeting reviewing client requirements and current finances, and post meeting time to implement any required changes. If a salesperson spent 3 hours per client per year doing a proper review then the fee likely could be earned.
Does it happen? No it does not. How do I know? I worked for a major bank with a large financial planning team. The bank would never allow sufficient time to do even a basic annual review. We always had literally thousands of uncompleted reviews and no prospect of ever getting caught up.
Why? Take even 250 clients times three hours and you have 750 hours of review work. That is roughly 100 days of work per year. So, the salesperson gets the fee if they do not do the work and they get the same fee if they do complete the work. How many salespeople do you think will opt to do the work? What if you have 300 or 400 clients? The system clearly cannot work as it is structured.


As an ex-banker I was always amazed that bank robbers would risk up to ten years in jail to rob a bank for $300 (average take from a bank robbery these days is quite low) when instead passing bad cheques/cheque fraud could earn you thousands with virtually no risk of jail time. Only a dummy robs a bank using a mask and a gun these days.

Similarly, I cannot understand why fraudsters would go through the hard work and stress of scamming investors (false documents, false statements, a risky paper trail, high risk of being exposed and charged with a crime), when you can legally “skim” investment accounts with fees that add no apparent value and are not required to be disclosed to investors.

What Does Add Up:
Investors pay a number of innocuous sounding fees either directly or indirectly from their investment accounts. Most investors work on a basis of trust and have no clue what dollar amount they are paying nor what they should be receiving for those fees. This is the environment that makes the skim possible and lucrative.
The average planner/salesperson may have a portfolio under administration of $20 million dollars. At a mere 0.5% skim the portfolio is diminished by $100,000.00 per year. Many trailer fees are as high as 1% which translates to $200,000.00 being taken every year from client accounts. There is no accountability that would require any work to be done by the salesperson. The money is skimmed by the fund firms and forwarded directly to the salesperson's firm.
Many salespeople lock clients into the fund via a deferred sales penalty program for up to seven years. In the simple example given, with a 0.5% trailer fee, the total money skimmed by the average salesperson over that sales cycle will be $700,000.00. Now picture a firm with 1,000 salespeople on staff. I think it becomes clear why fund sales are such a lucrative business and why your salesperson can drive a nicer car than you can.

For those who say, well the salespeople have to eat too I will remind you of two things:

1- Front end loaded fees: Salespeople often receive 5% of the invested funds up front from the fund firm. On a $20,000,000 portfolio that is $1 million dollars. The commission is split amongst the 600 or so client accounts of the salesperson and is again a hidden charge. (Investor Economics data suggests the average portfolio for a salesperson in the advice business is just over $20 million)

2- With the skimmed fees we are talking about a forced, concealed payment for a service that is often neither articulated nor delivered to the client.

BEATING THE SKIM: We do not have to be skimmed as fund investors. You have several options to help fix the problem.

1- Set clear expectations with your salesperson for what you expect for the fees you pay.

a. Communication should include monthly updates, and semi-annual conversations as well as at least one face to face meeting every year.

b. Investment information should include an estimate and explanation of all fees paid from your account , performance results versus a set benchmark, and current versus targeted asset allocations.

c. Planning information should include a review of your financial situation, income, expenses, and liquidity needs going forward.

2- Ensure that your salesperson has the capacity to handle your account effectively. A salesperson with 100 clients is more likely to have the capacity for a review than a salesperson with 600 accounts. Ask about support staff but remember support staff is to aid with internal paperwork not to handle client reviews.

3- Purchase low cost mutual funds and you will not have as many worries about skimming. You can purchase funds without embedded advice fees from a number of fund firms and can purchase ETF funds without embedded advice fees as well. Ditching your advisor/salesperson does not ensure you avoid the skim as discount brokers often take the skimmed fees that normally went to the salesperson. That is of course the height of skimming as discount firms are not even licensed to provide any advice to investors.

It is not easy to be a wise investor when the market is such a deceptive place. It truly is a “buyer beware” experience and not a safe place for those who tend to trust without verifying.

sois mike

Sunday, April 11, 2010



In keeping with industry tradition of backward processes and thinking, I will start with part 2 and then move on to part 1. This is important to reinforce the understanding that the sales discussion is most important and is always front and center. The information component required to make an informed choice will be provided at the end ....for those few who get all the way to the end! Think of it being just like a mutual fund sales conversation where key information is delivered well after the sale is closed.

So let’s get to my main topic: Fiduciary 101:

An advisor is a salesperson. A trusted advisor should be a "fiduciary". What is the difference and why should an investor care?
Fiduciary Duty would require an advisor to be legally and morally bound to put a client’s interest before their own interest.

Maybe I am just too simple a person but I cannot help but ask “why is this such a big deal for an advisor”? Why would any investor not want to be assured their advisor was acting in their best interests? We all understand that salespeople work to maximize commission, so it is always a case of "buyer beware"! But what if you did not know your salesperson was a salesperson? What if they created a false and misleading title to fool you? In that case a salesperson might deceptively call themselves an "advisor", "financial planner", or "investment manager", "retirement specialist", "estate planner" or any number of misleading titles! But underneath the sheepskin lies the cunning wolf we call a salesperson! A word of caution to all investors, whether experienced or a novice: If approached by a salesperson using one of the above deceptive titles, immediately put your left hand over your wallet and back away slowly! Place your right hand in your pocket and make a fist so that a pen cannot mysteriously appear in your hand to sign any seemingly harmless document!They are cunning so try to avoid direct conversation or answering any leading questions
But common sense and integrity aside...... let’s just look at real life for an example.
Starting Premise: For a fiduciary obligation to exist we would need to have a situation where one party has far more expertise, knowledge, access to information, and skill than the second party to a transaction. Now let’s look at the advisor/salesperson relationship with a new prospective investor.

The salesperson will:
- proclaim their accreditation and designation from an educational institute (typically Canadian Security Institute ) signifying both knowledge and skill
- explain their experience in the industry and with their current employer to show expertise as an advisor and money manager
- sell their access to current privileged information from company analysts and direct access to mutual fund managers and portfolio experts

The client will:
- Complain they do not understand what happened to their money with the last guy they trusted
- Profess a greater knowledge than they have for fear of looking like a pigeon to be plucked
- Sign whatever they are told to get the process started, regardless of any true understanding of the jargon
- Write a cheque or sign a transfer document
- Abdicate most or all decisions to the new saviour/advisor/salesperson

The salesperson will:
- Prepare a Know Your Client questionnaire to say whatever the salesperson pleases, exactly as they are trained to by their compliance department (department of obfuscation)
- Explain vague terms like “risk” in such a manner as to suggest only morons would claim to be low risk and only vegetables look for conservative returns
- Have the client sign forms to purchase securities being careful to:
o Avoid showing any alternatives that are lower cost
o Maximize the commissions to the salesperson without disclosing amounts or options
o Keep the salespersons employer happy by pushing proprietary securities
o Do everything they can for the client up to the point where an action might infringe on the advisor commissions or the parent company’s profitability

The client will:
- Nod when requested
- Sign where told
- Ignore the poor performance for years before getting frustrated and returning to step one.

Step 1:

Step 2:

Conclusion: Oh yeah, I get it now! Being a fiduciary would be a real pain in the butt for a sales person trying to maximize revenue with a quick deal! And yeah, if a client had the full range of product options, profits from hidden fees would be tough to maintain. And of course it costs money to actually train advisors on all the options they need to consider and the licensing they require to sell those other options. In fact, many of the sales persons disguised as advisors would have to spend months and thousands of dollars being trained to meet the new standards.
The compliance people would need to learn why a KYC questionnaire is filled out instead of how it should be filled out to protect an employee!
Of course all you salespeople hiding behind advisor titles can relax. We will not see fiduciary duty extend to the advisor industry in the near future! Whew, that was scary for a moment.... it was like a weird dream where investors have rights and advisors work for clients not security and fund companies!


I recently attended a conference on FIDUCIARY requirements in the investment industry. Most advisors did not attend as they are not fiduciaries; and I suspect they also do not know what the big multi syllabic word means. In fairness, almost all investors also ignore discussions on “fiduciary duties” since they only tend to learn about advisor/salesperson obligations after they have been fleeced.

Based upon the conference discussions, it was clear to me that the usual entrenched positions are still in place. As always, the fiduciary question excites the lawyers who make a living from investor disputes and it excites the investment manufacturers (fund and insurance companies mostly) who make a killing by avoiding fiduciary obligations. The third excited group are the investor advocates and regulators who know fiduciary obligations should be in place but cannot seem to get attention or focus on the issue.
And again based upon the conference dialog, the third group will remain easily distracted by sidebar issues that prevent them from really working towards the end goal of investor protection.

A last comment on the conference would be to lament that the Ombudsman for Banking & Investment is very much an under-funded, under-focused, and under-performing group. The first two “unders” contributing to the third “under”! If an investor was willing to slog through the investment broker/mutual fund advisor complaint process, stick handle through the idiotic Bank employed Ombudsman, and then finally reach the end game Ombudsman for B & I: they would find themselves tired and frustrated from what has been a 3-6 month battle just to get to the starting line.
At this point they would be assured that a small over-worked group will look at their situation sometime in the next six months or so. They would also find a group that does not consider the battle to be one of giant company versus little investor, but rather a battle of equals. Taking a cautious non controversial approach they will likely try to saw off some workable agreement and get everybody to go away with a small piece of the loaf. Based upon the example situation presented to the conference, the small guy will get no break when confronting the big company lawyers and liars with paperwork to back them. The O for B&I has no big stick to make change, cannot order restitution and may well, at some point, be looking for work again from one of the big bank/insurance/law firms that oppose the little investor.

On the legal front, it was almost embarrassing to listen to the lawyers who work for the big firms. No duty or obligation is so small that it cannot seem far too onerous to enforce on the poor hard working advisor!
Hell, the Canadian contingent at the conference was still debating what name to call a salesperson as if that minor detail was an insurmountable hill to be climbed! While Europe and Australia lead the charge on big issues, Canada has no momentum and no process for change!
It seems the Canadian establishment is going to obstruct the regulatory changes on every front for fear a small win for investors will turn the tide of the battle. We should expect no concrete ideas or solutions from the industry or any willingness to listen. They will jam every panel, write a sea of position papers, demand second, third and fourth reviews and basically ensure no progress occurs!It is as close as we can get in Canada to having a Republican Party mentality of "obstruct at all costs!" Think I am exaggerating, then consider the recent Point of Sale document debates! It's been years of haggling and infighting to get a watered down thin gruel of a document.

Of the distinguished panellists present, Allan Hutchinson of Osgoode Hall was one of the few who seemed to get it! Peter Smith from the U.K. FSA also clearly got it and actually was able to do something about it for U.K. investors. I thank FAIR and the Hennick Centre for making the conference possible. Maybe next time they will find a way to have an independent investor voice on a panel as well as all the official institutions, but overall, a job well done in laying out the size of the opposition faced by investors in Canada!
Your "I give a fidu!" advocate.....soismike
p.s. The firm I work with has just passed an international fiduciary certification audit so fiduciary duty is real and we "walk the walk" while most firms just "talk the talk"! Check out Weigh House Investor Services at CEFEX for details on the certification process available for all firms who act as fiduciaries for clients.....including the one you deal with!

Sunday, February 28, 2010

Follow Up on F.A.I.R.

A while back I expressed some concern about having F.A.I.R. act as the primary spokesperson for investor rights.( Why I Fear FAIR) I will confess that I still have a number of concerns about how FAIR set their priorities and the lack of a transparent approach to gathering feedback from the small investor. Having said that, I did want to give credit where credit is due!

FAIR had some good ideas backed by some sound research on issues involving investor scams. In short, why do so many frauds seem to involve registered salespeople who work for companies who DO NOT belong to an SRO (Self Regulatory Organization). They also had some insights into the difficulty for a wronged investor to actually get their money back after being victimized. Both of these issues are worthy of advocacy and, however they got on FAIR's radar, they are garnering some attention and discussion.

A recent article in Investment Executive highlights key issues that FAIR is championing. As discussed in last years review on investor advocacy groups , I felt that one of the tools required to make FAIR successful was the ability to engage the media. While Investment Executive is far from mainstream media, it is a significant voice in the industry.

So while I remain cautiously skeptical I did want to acknowledge good work by FAIR. I may not share similar ideas of how the research should be interpreted (mainly the concept that SRO's are effective at protecting investors versus better at avoiding the most obvious scams), but I could not even have expressed my opinion if FAIR had not completed the research and shared the outcomes. Kudos on this one go to FAIR!

Tuesday, February 23, 2010



A lot is being written about Mutual Funds being the investment of choice by Canadians. The fund industry has done a great job of sales and marketing, and since the bankers joined the fund party there are really very few competing products to turn to. In fact many Canadians would have no idea what alternatives they should consider if they did chose not to invest in Mutual Funds. So that begs the question; why are so many bloggers and DIY investors so upset about funds and how they are sold? Can funds be all bad if almost every Canadian adult seems to own at least one fund?

Let’s start by acknowledging that few things in life are all bad. Mutual funds began life as a low cost, highly diversified product that allowed average investors to participate in the equity and bond markets. In the 70’s and mid 80’s you could well have made an argument that freeing investors from falling GIC rates allowed investors to break free from the bank GIC’s and share in the rising stock markets. So let’s concede that mutual Funds began their life as a very good concept to bring investment options to the masses. Having conceded that point, what is so different today?
Lets review some of the old strengths of funds and why they might no longer be strengths in todays world!

Old : When funds first gained popularity investors generally could not invest in equity markets unless they utilized a brokerage house that charged what we now call “full service” brokerage fees. In short you might pay $300.00/trade and constructing a diversified portfolio could cost $8,000-10-000 in broker fees. That generally meant most investors were shut out of the equity markets unless you were wealthy.

New : Today investors can utilize a discount broker (DB) to access the equity markets at fees ranging from $10-29/trade. The DB web sites offer research that is less likely to have a bias and that allows investors to utilize security screens and other investment tools to assist them in choosing securities.

Old: Fund fees in the booming 80’s were often in the range of 3% MER on funds that were earning 12-15% in annual returns. Investors looked at the net return (often over 10%) and felt the returns in excess of GIC rates warranted the fund fees... and they were probably right.

New: New products such as ETF index funds have been created. The new ETF index funds offer low cost diversified portfolios at MERs that are often less than a tenth the cost of current mutual funds. Now you can build a whole diversified portfolio for less than a half of one percent in fees. On top of that, the past decade has seen extremely low returns on equity markets. With MERs refusing to decline as economy of scales grow, investors are now finding themselves paying over 2% in MERs for funds that have lost them money for years. While a 3% MER once allowed for a 10% net return on funds, investors are now paying 2.5% to earn less than they would make by buying a GIC.

Old: When funds first arrived on the scene they were often small and nimble. A high quality manager could make a difference and truly add value through smart trading decisions. As well, a well connected manager could gain advantage by having better knowledge of a specific firm or market sector. Indeed, if you check some of the largest and most successful long lasting funds you will see many examples of funds having a great first few years in the market.

New: We now have over 2,000 mutual funds in Canada holding over $600 billion in assets. Fund managers also manage pension plans in many cases. Every one of the 2,000 funds has a team of highly trained analysts and portfolio managers with MBA’s and CFA’s. It is now virtually impossible for a fund manager to outperform the markets because everybody has similar skills. As well, the fund industry is so large that they “are” the market! Trading between fund managers nets out over the year but the fees continue to increase with every trade. New laws on disclosure of financial data mean that the well connected broker/trader can no longer get information before the market. Despite what you see on TV, every fund manager knows where Russia is located and that they buy winter tires!

THE FEE FACTOR: I was reading a popular finance blog by a Canadian journalist and I am sure one of the comments must have come from a fund salesperson (unattributed of course). He expressed the view “fees do not matter, its the net return on investment that counts”. Only a fund salesperson could believe the two issues are not connected to one another. I agree wholeheartedly that fees are irrelevant if a fund can consistently earn better than the benchmark return after fees! The problem of course is that fund returns very rarely manage that feat. In fact the frequency of mutual funds beating the benchmark seems to be about what you would randomly expect with 2,000 managers trading securities with each other. Typically, less than 1 in 5 can match the standard benchmark indexes for any length of time. For those looking for empirical evidence, you can review the Standard & Poor’s SPIVA scorecards.
I would suggest the question is not “can a mutual fund with a 2.4% MER beat the index”, but rather can anybody tell me which one will manage the feat in any given year? If not, why would I not just buy the index for one fifth the cost?

SOLD NOT BOUGHT: THE ADVISOR FACTOR: The evidence clearly shows that Canadians have a greater willingness to pay fund fees (MER) than international investors. With MERs averaging near 2.4%, and with Canadians having $600 Billion in funds, the industry stands to pull in billions of dollars a year in fees. In the U.S. market fund fees are considerably lower than in Canada (even allowing for different rules on what is contained in the MER) and American investors are making ETFs the fastest growing securities product in the marketplace. So why are Canadians different?
Funds are sold not bought! Investors place their trust in salespeople who are licensed as a “salesperson” but who prefer to give themselves the title of “ADVISOR” on their business cards.
There is no licensing available in Canada for a mutual fund “ADVISOR” or “FINANCIAL PLANNER”, but there are licenses for mutual fund sales person and registered dealing representatives. Canadians place their faith in their banks and their advisors and choose to believe they will be rewarded by unbiased advice from those they trust their hard earned money to. What Canadian investors seem to be unaware of is that the trusted advice is coming from people trapped in a commission system. It truly is a case of “don’t hate the players, hate the game”.

WHY YOUR SALESPERSON HAS NO CHOICE: A salesperson is either self employed (rarely) or works for a larger firm. The large firm will both manufacture and sell funds (think Investors Group) or will just sell funds. Fund sales people tend to wrap themselves in the “financial planner” title, although they rarely provide comprehensive planning. Planning is a labour intensive task for which salespeople do not receive a fee or commission. It is similar to the free toaster when you open a bank account. Salespeople receive fees ONLY when they convince you to invest your money into a fund. At that point the industry forces the behaviour of the salesperson to mirror the fund’s objective. The funds objective is to maximize commissions. Only behaviour that maximizes commissions will generate payments to the salesperson.

SKIMMING YOUR MONEY: Mutual Funds take their revenue from YOUR account. Most investors understand the fact that fund companies and salespeople get paid, but few realize how or more importantly how much they get paid.
The primary reason investors are unaware is that the industry intentionally hides the fees and commissions from the investor. Imagine if fund companies ran a credit card business the same way they manage your funds. You would never get a statement of interest charges, would rarely be aware what the current interest rates are, would never know how much they took from your bank as a payment and your sign up documents would be written as a 50 page legal contract. Your statement would show a balance but no way for you to confirm how they arrived at the balance. In short, you would not allowthis type of reporting to happen with a $500.00 credit card. So why is it acceptable for your life savings?

MANY WAYS TO SKIN A CAT: The fees are hidden as discussed above; however a further issue is that the commission splitting between the fund and the salesperson is also hidden. Salespeople often argue that "how" or "how much" they get paid is not relevant to investors. Nothing should be or could be further from the truth

Hidden Gems: One reason why it matters is that different fund companies can pay your salesperson different commissions to sell Fund A instead of Fund B. Now consider the last recommendation from your salesperson to buy ABC Canadian Equity. Did you know that XYZ had a lower cost to you and a similar performance history but paid lower salesperson commissions? Did your salesperson recommend ABC because their firm wants more high commissioned funds sold and they pressured your salesperson? Was it because your salesperson was having a rough spell financially and needed the commission? The key point is I do not know, and neither do you.

A second hidden gem is the fact the very same fund can be sold to you in a variety of ways, all with different costs to the investor. So if you believe ABC fund was the best choice, was that based upon a seven year lock-in requirement known as “deferred sales charge” that pays a hefty up-front fee to salespeople; or was it based upon a “front end load” that paid a smaller up-front fee to the salesperson? Did you know your salesperson could sell the fund with a 0% front end load and still receive the annual trailer fees from the fund company as compensation? Did you know the salesperson could sell you an “F Class” or advisor class fund with very low expenses and no commissions? In this case the salesperson negotiates a fee with the investor for their services in an open agreement that sheds light on your costs.

The third broken leg of the commission process is hidden trailer fees. Trailer fees are a hidden commission paid to your salesperson every year by the fund company. The fee is only paid if you stay with the fund company. Now ask yourself why your salesperson insisted you “stay the course” in the recent market meltdown? Was it because going to cash would end their trailer fee revenue and cost them income? Did you know that the salesperson benefited by keeping you exposed to a falling market? To compound things further, the annual trailer fee varies by how you were sold the fund. This means your salesperson has a very direct conflict of interest. The higher your fees the more commission your salesperson likly makes from behind your back trailer fees. Do you still feel confident your salesperson is a trusted “advisor”?

As I stated earlier, the salespeople are caught in the system. The fund companies outline the commission rules and the salespeople have a difficult time avoiding the conflicts inherent in the system. A few truly good ones manage to balance investor needs with their own income requirements, but most slowly give in to the system and begin to feel they are “entitled” to the fees. When asked about the practice of accepting hidden commissions the most common refrain is a combination of “investors do not care” or “I work hard for my money”. The first is hard to assess since the investor is unaware of what is happening for the most part. The second is an irrelevant comment, since we all work hard for our money but few of us feel we need hidden commissions to make our business model work.

If we put aside the issues of excessive cost, manipulative sales practices and poor performance; is there an argument for mutual funds as an investment vehicle?
The answer is “yes”. The cost or MERs make mutual funds expensive as a core holding in a portfolio versus a low cost index fund, however mutual funds offer diversification and professional management. If an investor wants to hold some small cap or emerging market assets, a good fund manager can likely add value. The cost is high but so are the risks in investing in small cap or emerging markets without knowledge of the markets. As an example, I hold an Asian focused mutual fund as a very small weighting in my portfolio. I could not do the research required to build a high quality diversified Asian portfolio and I did not want to own the whole Asian market via an ETF index fund. I felt the professional management was worth the cost, not to make greater gains but to reduce the risk of large losses in a higher risk market.

CONCLUSION: Mutual Funds are a niche product being used to build core portfolios by salespeople who generally know better. The rationale for this volume of fund sales, from my perspective, can only be based upon the desire by the industry for the billions of dollars in hidden revenue streams.
In the light of full disclosure of fees, commissions, performance numbers and knowledge of available options, I believe investors would make different choices. Where more of disclosure is provided (the U.S. for example) investors have selected ETFs for their core holdings in many cases. In Canada we may never know what an informed investor might do because our current system does not generate sufficient numbers of informed investors to determine how we might choose to invest.

What Can You Do: In a world of busy people trying to make a living, raise families, and manage day to day cash flows there is precious little time to ride shot gun on your salesperson.
The average person has two viable options:
a) manage your own investments with a low cost “couch potato” ETF based portfolio or
b) separate who gives you advice from who sells you your investments.
The second option can be attained by hiring a financial planner or investment consultant who gives advice but does not sell securities, and then take that advice to a salesperson for the execution of your security purchases and sales. In both situations mentioned the conflict of interest between advice and security sales has been reduced or eliminated. That is a vital first step in taking control of your investments.

Sois mike

Sunday, February 7, 2010

Risk: What my salesperson forgot to mention!

It may seem to many investors that the word "risk" is used in many different contexts without the author identifying what they specifically mean by risk? That is because "risk" is a term used to quantify many different investment issues that can lead to potential losses. So lets look at risk, its uses in the investment industry, and how the term is twisted to leave investors at a loss to understand what risk they are being asked to measure.

Risk is defined in "" as: The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

Perhaps the first thing an investor might note is that "risk" is a statistical measurement, not a "feeling in my gut". The second point is that "standard deviation" measures risk of both higher and lower returns than were expected. I think its fair to say most investors personally define risk as only that part of the unexpected results that are negative. Few investors seek to avoid returns that were higher than expected. In short investors need to focus on "downside risk", understanding that upside risk (positive risk if you will) is generally proportional to the downside risk.

Risk Questionnaires: So I am filling out a "risk assessment" and need to identify the risk I am willing to take in my investment portfolio. Not surprisingly the the form does not define risk as a mathematical concept. In fact many of the questions talk about "feelings" and more specifically "hypothetical feelings". So, hypothetically, how would I feel if my investments dropped in value by 10% in a given year? This question is generally a "loaded question" as I am betting most investors would be embarrassed to say a 10% decline would scare them away from investing (especially the alpha male investors who equate risk taking with bravery!). So I would state unequivocally that this low level of risk does not worry me. Now the questionnaire has me thinking in terms of how brave I can "hypothetically be. If 10% doesn't worry me then how about 20%? Well I think to myself..... 20% is something to think about, but hey "no guts no glory" and what are the odds of actually losing 20%? In the end I saw off at 25% as my hypothetical maximum. Having said that we are talking about 25% as being a bizarre one time event which is hardly ever going to happen, right?

CONCEPT #1: Market drops of 30% or more have occurred 13 times since 1900 or, on average a little more than once every 10 years. Drops of 40% or more have occurred 9 times or approximately every 12 years. Losing 20% is likely to happen every 5 years! If you invest for 20-30 years you can bet you will see losses over and above your target several times.

Concept #2: Your losses will not be hypothetical! Your advisor will forget to mention an interesting concept she learned when entering the business: losses cause twice as much suffering as an equal gain would cause joy ( Prospect Theory). In short if you are told there is an equal chance of 20% gains and losses, the gain will feel good but the loss will absolutely devastate you emotionally. Think in terms of dollars and losses. If you saved your hard earned cash over the years and could lose $20,000.00 from a $100,000.00 portfolio in the next few weeks would you still want to stay invested? If you invest $5000/yr into your RRSP would you be okay if the last 4 years of returns were lost by a falling market? How about the last 6 years of deposits?

Risk and Time in the Market: If you have an advisor you have been told "we can take more risk because you are a long term investor. I can be assured of that because advisors want to tick the "long term investor" box on your application. If is basically a "get out of jail free card" for your advisor if you take too much risk and lose your shirt. Your wise advisor, having watched your money evaporate will tell you, with a great sense of false bravado, just hold the course and stay with me because the market will bounce back.... it always does! Should you decide to sell and sue your advisor the advisor will point to the "long term investor" box and say you caused your own losses by not staying invested for the long term! "Sorry Mr Investor but you said you could take risk and said you would not bail out of the market so don't look at me! It's all your own fault!"

Concept: Time in the market increases the likelihood of having large market declines occur. Your risk of catastrophic losses is not spread over 10 or 20 years, but rather it exists each and every year for the 10 to 20 years you might be invested. Since advisors cannot avoid the huge market drops (I think 2008 confirmed that for everybody) then you are at risk of the big drop occurring in every year you have money invested in the market. In short, keeping your gains fully invested is very similar to letting your bet ride at the craps table in Vegas. Look at every year in the market as another separate bet and make sure every year that you are only betting the amount you can afford to lose. Rebalancing a portfolio reduces risk as over time you can take profits out of the equity market and lower the percentage of a portfolio you have at risk.

Types of Risk: There are many types of risk so I will discuss only the two risks I think are most important to me.

Salesperson Risk: While I have lapsed into using the term advisor, your advisor or financial planner is actually a licensed salesperson. They typically earn money through collecting commissions which are often not disclosed to you even though you will pay the commission either directly (broker commission, flat fee) or indirectly (fund trailer fees, hidden fixed income fees, new issue fees). Most salespeople are paid to gather clients and are rewarded for getting your money into a mutual fund or generating fees off that money. Very few (think basically none) are paid a fee to manage your investments effectively. Whether you make or lose money has very little impact on the income of your salesperson so long as you do not leave the company he works for. Trusting your salesperson to effectively manage your money is a huge risk. Why do you think your salesperson buys mutual funds? It is because they do not know how to properly manage investments themselves.

Individual Security Risk: This risk is commonly called "un-systemic risk" and it refers to the concept of having too much risk in any one security, sector or industry. If you buy individual stocks you take unsystemic risk which can typically be minimized by holding 30+ securities. The catch is the 30+ securities also need to be diversified by geography, sector, and industry. Holding 30 small cap companies is less risky than holding 1 small cap stock, but it is much riskier than holding a mix of small cap , mid cap, and large cap stocks. Similarly you should diversify by asset class (holding bonds as well as stock and cash is a good start). If you have an individual holding that is more than 5% of your portfolio you should look at the security risk and decide whether cutting back on the security might be prudent. (I make an exception if it is a government bond).

Measuring Risk: The simple measure is a personal measure you should make much of my hard saved investment portfolio will I put into the equity or high risk security markets this year knowing I can lose most of it if the market tanks.

Once that measure is clear, you might get a little more technical since we started this blog by discussing the fact that investment risk is a mathematical concept.


SHARPE RATIO: A common method of measuring investment risk is to measure the investment returns on a specific security or fund, relative to the risk of owning the security/fund.( risk here is defined as the standard deviation of returns). In short; how much did I gain relative to the risk I have taken? This is generally expressed as a ratio known as the "Sharpe Ratio". Many securities firms show a "sharpe ratio" when you check the portfolio performance of a fund or portfolio.

Concept: You should not compare returns of Fund A versus Fund B unless you know the risk each fund carries. Comparing the Sharpe Ratio allows you to determine if the actual returns on a fund or portfolio are likely due to better portfolio management or just bigger risk taking that happen to paid off in the period you are looking at. In short, when it comes to the Sharpe Ratio, bigger is better as you are measuring returns for a common measure of risk.

Sortino Ratio: The Sortino ratio is a modification on the Sharpe ratio. It correctly presumes investors are worried about downside risk not upside risk. As such it measures the return of a security against the standard of deviation of negative price moves only. If a security tends to have sharp upward price moves and fewer large negative moves, then investors are likely to benefit from the positive volatility. Similar to Sharpe, bigger is better.

The purpose of this blog is to have investors take ownership of their personal "risk" tolerance. To do so you need to understand what your advisor/salesperson is talking about when they mention risk. Many supposedly qualified advisor/salespersons have talked about their clients reassessing the risk tolerance they have. The suggestion is that "clients overestimated their risk tolerance". Nothing could be further from the truth. Your risk tolerance does not change based upon portfolio performance because it is hard wired into your personality. If I had told you the amount of money you were going to lose before the market dropped you would likely have said "no way" because your salesperson/advisor would not leave you exposed to that size of a loss. You likely never understood the risk profile of your portfolio and your salesperson knew that. They understated the market risk you were exposed to and now they are pointing the finger of blame on you for not realizing you should never have trusted their rosy forecast to begin with. They knew that losses were emotionally devastating because they studied the Prospect Theory. Unfortunately they were motivated by the Modern Commission Theory and you were the ticket to their big commission.

Fool us once, shame on the salesperson.....fool us twice.......