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

MUTUAL FUNDS: GETTING IN THE WEEDS ON INVESTOR ISSUES


WHY MUTUAL FUNDS ARE ABUSED AND MISUSED

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.

MONEY MAKES THE WORLD GO AROUND!
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 "Investopedia.com" 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 annually....how 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.


RISK MEASURES:

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.......


soismike