TheUnbiasedPortfolio

INVESTING IN BAD TIMES!

2012-01-24T16:50:00.001-05:00

The current investment climate is about as bad as it gets when you look back over an extended time period. Canadian investors have watched as equities vary between days of terror (huge market drops) and days of despair (slow death via multiple days of small declines). The odd good day or week in the markets seems to just tease us for what might have been had we invested in the 90’s instead of this century! Even the old standby, the Money Market Fund, has proven to be neither safe nor profitable. We lamented the lost decade for equities from 2000 to 2010, and then started the new decade with negative equity markets for 2011.

So what can we do and what should we do!

1- We CAN stop adding to the problems by making poor decisions about our investment strategy. The typical investor in a MF or ETF Index fund will make significantly less than the fund itself over the course of a typical year. That is because investors jump in and out of the equities market based upon the current emotions they are feeling. Studies show that this undisciplined approach will cost investors up to 4% less return than a mutual fund would make on average. Professionals do NOT jump in and out of the markets based upon emotions. They follow an Investment policy Statement (IPS) that outlines the minimum and maximum percentages of equity that MUST be held in the portfolio. For those that wondered about the definition of “rebalancing” a portfolio; that is the term used for bringing a portfolio in line with its IPS guidelines. Without an IPS you CANNOT rebalance your portfolio!

2- We CAN stop pretending that the folks who make a good living managing investments have an ability to predict what stocks will go up or down next week or next year. Professionals can help you select stocks which have good balance sheets and good management in place. They can also help you ensure your portfolio is well diversified. Other than that, professional stock traders are of little use unless they can provide insider information (which in general is illegal). In 2011 the consensus forecast of investment managers in Canada was for stocks to outperform bonds and commodities. It will come as no shock that a) they were wrong, and b) they have made the same forecast for 2012. In fairness.....they eventually will be correct just based on the law of averages!

3- We CAN reduce the fees we pay. With investor returns at historic lows we cannot continue to give a guaranteed 2-2.5% return to investment salespeople. If markets were to provide you with the 4%-5% returns we expect in the near future, a fee of 2.25% would be 45-55% of your total investment return. In years where markets drop, like 2011, the fee just increases your losses. If you negotiated a fee of 1.25% you would be giving up only 25% of the same return forecast! If you used ETF Index funds you could reduce the fee drain to a fee of .25% and have only a 6% fee drain.

While markets are certainly tough it does not mean we cannot do better. A little effort, some simple strategies and a calm demeanour can go a long way to lessening the pain of being an investor today!

If you need an IPS then ask an independent (non-selling) firm to customize one for you!

Soismike

2012-01-23T10:55:00.000-05:00

Well, it was another year of frustration for “real investors”. By “real investor” I mean those of us who trade without access to inside information and who cannot augment our returns through hidden fees or commissions. While we will lick our wounds and carry on, we should also track where the smart “professionals” were focused in 2011 to see where we missed the boat.

Consensus Forecasting for 2011: The “professionals” forecast the market performances every year and then a “consensus report” is tabulated to allow us to peak under the curtain and see what active traders are doing to beat the markets. The asset class forecasts were very clear that security performance in 2011 would see returns ranked as follows:

- Equity stocks would be the best performing asset class

- Commodities would be the second best performing class of assets, and

- Bonds would trail the above classes and provide weak performance

Based upon the forecast, you would overweight equities, diversify with commodities, and minimize your bond holdings.Let’s see how well the smart money did in forecasting 2011.

- Equity returns in Canada ( TSX broad market total return index) -8.71% and if you choose to look just at the blue chip TSX 60 returns were -9.08%

- Commodities as measured by the Auspice Broad Commodity Index was 1.78% to the positive side

- Bonds as measured by the Dex Bond Universe was up 9.7%

Wow, the smartest guys on the street managed to show an amazing dyslexia of returns! They used thousands of analysts to crank out the research math and got everything backwards! In fairness however, the forecasts were great for revenues at the brokerage firms as investors traded heavily into the markets based upon the forecasts. By the end of the investment rich RRSP seasons investors had bid up the equity markets and the research looked great. However, once all the suckers....um, investors were fully invested, the professionals did a quick sprint to the exits, leaving the retail investors holding a smelly mess of equities. The TSX dropped from the lofty mid 12,000’s to the more realistic low 11,000’s. Unfortunately, those who followed the advice in late February and early March can only wish they had lost 8 or 9%! In fact many will see 15-20% drops with their RRSP investment money.

So, how did a conservative indexer do in this type of market? If the pro’s got it wrong we can only assume the indexers got creamed! Our conservative 50/50 balanced model would have received the returns of a typical mix of ETFs somewhat like the following:

ASSET CLASS	WEIGHTING	ETF SYMBOL	RETURN
Cdn Equity	25%	XIU	-9.22
US Equity	12.5%	XSP	1.07
EAFE	12.5%	XIN	-12.7
Bond	50%	XBB	9.38
Total	100%		0.92%

Well, it was definitely a tough year; however staying diversified reduced the damage significantly. Even if investors reduced the risk by splitting the fixed income between short and long duration bonds (50% XBB and 50% XSB), the overall return would be -0.3% for the year 2011.

Obviously the higher the Canadian equity component or the EAFE equity component, the worse the overall portfolio performance. For those active traders that jumped on the gold bandwagon the entry point was a challenge. On the whole XGD (the gold ETF) was down 14% and the much recommended emerging markets saw a decline of 16.4% as measured by the emerging market index. So, if you followed the professionals you were heavy equities, heavy emerging markets, heavy gold and light weight bonds. If you followed your Investment Policy Strategy as a conservative investor you retained your capital! Thank goodness I am a dull investor with a conservative IPS!

soismike

Part Two: Why Mutaul Funds are like Popcorn.....Explaining The Fee Gap

2012-01-09T11:22:00.002-05:00

Mutual Fund Fees: Part Two

In part one we discussed the position put forward by Fund Companies and Advisor/salespeople that the Management Expense Ratios in Canada represent fair value for investors. The logic they use does not hold water when you break down the component parts of the MER between investment management, sales channel expense, and the “advise” component. As we showed in the previous blog, the portion that is reasonably assigned to “advice” seems to be far too high. In an efficient world we have shown that a typical Canadian Mutual Fund with an MER of 2.4% per year would have approximately 1.2% available to cover the advice cost. In fact, the fund companies generally pay a “trailer fee” to sales people to cover the cost of the annual advice component of the fee. That trailer can vary between 0.5% and 1% per year. This would suggest an average advice fee of .75%. This suggests that there is another fee component that we are not accounting for?

Formula: MER = investment management expense + sales channel expense + advice fee + ?

2.4%= .7% + .5% + .75% +?

? = 2.4% -.7% -.5% - .75% = 0.45%

Where does the mysterious 0.45% go? In fact, on the typical mutual fund with a 0.5% trailer the mysterious “?” factor is 0.95%. In effect, we can surmise that Canadians are paying an extra half to one per cent on mutual funds after all reasonable fees have been accounted for. Who gets the extra fee?

Alternative Scenario: Mutual Funds in Canada are priced to reflect what an uninformed investor can be convinced to pay. The mutual fund industry and the “advisor” industry have set up an ideal world for the exploitation of investors. The key components are as follows:

Ø A closed market where prices can be set by a few large companies.

Ø Self regulatory oversight where the same companies can dominate the rule making process

Ø A sales channel that can act to keep the investor unaware of low cost alternatives

Ø An uninformed Government that can be manipulated to support the ongoing deception

For those that think this is about a big “conspiracy theory”, let me assure you it is not. Conspiracies are too complex and the details would eventually leak out. Instead this is about a combination of ignorance, laziness, and business strategy.

Ignorance & Laziness: Most of us slowly and almost unwittingly enter the world of investing. Our first investment need is often an RRSP or TFSA account. Investors are typically directed to their bank or “advisor” to teach them how to manage their investments. Often young adults will learn important skills from their parents; however the financial world has changed so fast that we do not have a pool of knowledgeable parents to educate the young investors. The educational system does not teach money management and, in truth, most investors are unaware of the problems and thus of the need to become educated. Investors are focused on their jobs, family, and day to day life. The path of least resistance is to be a part of the current system and use the bank or fund company sales channel. This is a combination of laziness ( not getting ourselves educated about investing) and ignorance (not knowing the current process is a problem).

Governments are also a part of the ignorance problem. Rather than regulating the investment process the governments have chosen to allow the industries to regulate their selves. These “SRO’s” include the Investment Funds Institute of Canada (IFIC) and the Investment Dealers Association “IDA” whom have morphed the regulatory duties into the Investment Regulatory Organization of Canada (IIROC). In short, those who profit the most from unfair fees are the group the government allows to set their own rules and standards. The result of this has been a government who does not protect investors and who then actually looks to the industry SRO to provide guidance to the government on industry policy. An example of this collusion was the decision by the government of Ontario to exempt fund companies from disclosing the HST paid on mutual funds. The only possible purpose in doing so was to hide any information that could allow investors to determine their monthly fund fees. The government bought into the bizarre suggestion to exclude the information from statements and the industry benefits at the expense of the investor.

Currently we are seeing an even more egregious example of an industry run amok as the various levels of governments defer “investor education” programs to committees dominated by executives of financial firms who sell funds. Most people who understand the industry are left to shake their heads and mutter about the “wolf guarding the henhouse”. As for the government, they appear to be happy to defer to the industry in a way very similar to how the average investor defers to the mutual fund sales status quo. Governments are not being so much duplicitous as they are being ignorant and lazy. Why look for problems and solutions if investors are not making waves.

Business Strategy: The fund executives are in the business to make profits for investment firms who employ them. Period! They are not in the business of providing advice, education, or regulatory oversight. Their business strategy, however, necessitates that they control the advice, education and regulatory processes that impact the fund industry. Their strategy has been to control the process from start to finish and create a closed loop. The industry controls the production of funds, the regulatory oversight, the distribution of funds, investor education, provides guidance on government policy decisions and sets the pricing of all services to the investor. It is a great business model and one that generates massive surplus profits for the fund industry.

On the Street Impact: The impact of the strategy is felt directly by the investor. While most investors are not aware of the strategy they are very aware of the impact it has had on investors.

- Canadians pay the highest fund fees in the world

- Canadians deal with “advisors” who are in fact licensed sales people and have no legal duty to put the client’s interests before their own. In actual practice advisor/salespeople clearly prioritize their own benefits ahead of their clients. For proof look only as far as the next point.

- Over 80% of mutual fund sales people are NOT LICENSED to sell competing products such as low cost index funds that trade on the TSX. These funds are amongst the top performing funds every year and cost as little as a tenth of the cost of equivalent mutual funds.

- Canadians buy a significant portion of their mutual funds with deferred sales charges. These charges are being banned in a number of countries (Britain, Australia) and are rarely sold in the U.S. where investors are much quicker to sue an advisor over improper advice. These fees are designed to lock an investor into a single mutual fund company for up to seven years with little or no corresponding benefit to the investor.

- Canadians have no binding complaint process that allows for arbitration of investor complaints with multi-billion dollar financial firms. If a firm does not pay up the individual investor faces the daunting task of suing a firm that has the top securities lawyers on speed dial.

- Canadian mutual fund statements and disclosures are amongst the worst in the world. Investors are not provided with monthly cost of fund fees, personal rates of investment return, nor proper benchmarking information.

- Risk ranking of various mutual funds has been left to each individual fund company. In fact, the same fund can be rated at a different risk level by two different distributors at the same time. The acceptable risk rankings have no basis in quantitative analysis and thus are at best useless and at worst dangerous.

The above are only a few of the negative impacts we can attribute to the business strategy of Canada’s large fund firms. However, as any fund executive will tell you....it’s not personal, it’s just business!

As Canadians struggle to build their retirement nest eggs it should be clear that at least part of the problem for investors is the significant skimming of retirement funds by mutual fund companies and so-called advisers. In the real world the cost of the additional and excessive fund fee is reflected in delayed retirements, eroding retirement portfolios, improper retirement planning advice, and a general sense that the average Canadian cannot seem to get ahead.

Perhaps this is part of the issues that pushed some people to Occupy Wall Street! Add in the bank strategies on increasing consumer debt, excessive credit card fees, excessive chequing account fees and you begin to see a pattern of skimming that leaves the 99% with little to cover basic living expenses. Of course ignorance and laziness are somewhat self induced so we can solve these issues ourselves. However the solution will have to start at the ballot box because currently the fund firms hold all the trump cards!

Wow, that sounded more political than I intended! This blog does not take political stands but fortunately (or unfortunately in this case) all political parties currently bow to the financial firms with equal deference.

Sois mike

Quick Hit on Index Linked GICs

2011-12-29T15:52:00.001-05:00

I know I said my next blog would be on fund fees however I wanted to acknowledge a great article by John Heinzl in the Globe today. It fits into the investor education debate that is ongoing.

Why the Blue Chip GIC isn’t a blue chip investment

Investor Education: I noted a great article in the G&M today by John Heinzl. For those that do not follow John, he is one of the best writers when it comes to both understanding and explaining investment products and strategies. His topic was a follow-up on one he wrote when BMO introduced its unfortunate “Blue Chip GIC” product. John felt it was a product designed to heavily favour bank profits and was highly unlikely to be a great product for the clients of BMO who were sold this product. Note John made this call a year ago!

John had explained the basics of the product and how the structure was likely to work against clients expecting a reasonable return from a product offering “guarantee of principle” but little in the way of upside returns. Not surprisingly, the GIC paid investors a paltry 0.2% for a one year term. We thank John for the follow up article as it clearly shows not just that the product was a poor performer; but more importantly it shows how predictable the poor results were. John “forecast” the performance as opposed to merely stating it after the fact. Thanks John!

For investor advocates, John’s original comments were no surprise and the performance of the GIC was equally predictable. BMO is not alone in this cynical exploiting of investors through “index linked GICs”. TD bank also pushes staff to maximize the sales of these products and rewards those who do so. So does most every other bank in Canada. The marketing pitch is to play on the fear that markets are unpredictable and that investors should try to keep their money safe. Given the losses generated by mutual funds over the past few years, one would expect that many investors are ripe for this sales pitch. The reason the pitch works is based upon a few key investor attributes:

1- Most investors trust bank employees and do not realize that most bank employees do not understand how the actual investments work.

2- Investors are not educated or trained to understand the full impact of the underlying terms and conditions on these complex products. What the investor hears is “GIC” and “guaranteed”. The belief is that any market gains will increase returns and any losses will be absorbed by the bank. Unfortunately that is not the case! The underlying terms were designed to minimize payouts such that even a positive average return on the underlying stocks would not necessarily generate a bonus. In effect, the game was tilted in favour of the bank.

3- In general, the more complex the product, the larger the profit margin is for the bank. This suggests that the bank benefits from having both the staff and the client uninformed.

With the banks all pretending to support investor education, this is a practical example of why you cannot believe the basic information provided by your trusted local banker. The issue is that the employee does as they are told/trained in the belief their employer would not treat customers unfairly.

The customer in turn trusts that the local bank employee would never do anything that would treat a loyal customer unfairly. In fact, a highly paid bank executive signed off on the product because it generates much higher bank profit than a conventional GIC....period! Client investment returns or “fairness” never enters the picture for the executive. So long as it is possible to market a scenario where the client might have done better with the “linked GIC” the bankers can sleep at night without acknowledging how unlikely a positive outcome is for most clients. If a client complains the banker will simply suggest the GIC was better than if the client had actually bought the stocks and lost much of their investment capital. Of course the problem with that answer is that the client never intended to buy the underlying stock! They went to the bank to buy a simple GIC and were sold this crap instead!

Beware bankers bearing gifts!

Mike

Why Mutual Funds are like Popcorn

2011-12-16T12:24:00.002-05:00

Why Mutual Funds are like Popcorn!

The Canadian mutual fund industry runs on the theory that Canadian investors will voluntarily pay annual fees to mutual fund salespeople in return for selling a mutual fund and providing advice. The main players in this business are a) the investor, b) the mutual fund company, and c) the salesperson.

The key to implementing this strategy has been to ensure that the investor is not provided with either a minimum service standard for the “advice” component nor a summary of the fees being paid for the “advice” service.

If we focus on the retail investor; the investor is paying an annual MER which covers everybody’s expenses and profits. In fact, the investor is the only source of money and the only person who is not guaranteed a profit every year. As such, we can conclude the embedded cost of the “advice” is equal to the fee paid by the investor less all expenses involved in fund manufacturing and sales.

Formula: Investor Cost is defined as: MER= manufacturing cost + sales cost + advice costs

The Advice: When fund companies talk about “advice” being provided they do not attempt to explain why the advice would need to be facilitated through the fund company’s salesman. Since fund companies are not promoted as being in the business of providing advice, it would seem that the advice component would be a distraction from the core business of managing money. Fund companies do have expertise in managing investments and that is where they are most efficient. In many cases the fund company will outsource the “advice” component to an independent salesperson. These salespeople generally call themselves “financial planners” or “advisors”, although these titles mean nothing specific in terms of knowledge. The “advice” component is non-defined in terms of either quality or frequency of the advice investors should receive. As such the salesperson does not need to meet any standard for advice nor confirm any advice has been provided in order to collect the advice fee. In fact, the commission for providing the advice is often paid to the salesperson up front before any follow up advice service would be expected to take place.

COGS: Fund companies are in the manufacturing business. As such the fund companies are fully aware of the accounting term “COGS” or cost of goods sold. The COGS for a fund company is likely in the order of 0.4-0.5% based upon the wholesale pricing that is available. Some would argue the number is more likely between 0.2-0.4% but let’s assume the higher number to be conservative. Adding a margin for strong profits, the manufacturing company can thrive on a price of 0.7%. This is on the high side of the estimated cost range and provides a profit margin of 75%-100%.

Having solved for what appears to be a generous but reasonable manufacturing cost, the formula can be updated as below:

Investor Costs (MER) = manufacturing cost + sales cost + advice cost

= 0.7% + sales costs +advice costs

Sales: Mutual fund manufacturers also need to sell their product. The cost of the sales process varies based upon the sales channel(s) the company uses to distribute their funds. Some companies such as Steadyhand sell manufactured products directly to investors. As such, a large investor can achieve MERs as low as 0.77% for a Canadian equity fund and just below 1% on foreign equity funds. Steadyhand is not a manufacturer, but is a low cost distributor of custom funds they create through investment management firms who provide wholesale services to Steadyhand. Steadyhand does not utilize an “advisor” sales force, but handles sales via phone and internet which is lower cost and quite efficient.

Alternatively, bank mutual funds are sold by a “captive” sales channel. The bank’s employees are most often salaried and the salary cost is spread across multiple product lines. This sales channel is low cost and efficient as the banks’ leverage internet sales, discount brokerage sales and branch staff sales. TD bank offers a balanced mutual fund through its e-series for 1.28%. The e-series does not provide an advice component so the fee is comparable to Steadyhand. The Steadyhand pricing reflects a small focused sales channel approach, while TD represents a large multi-channel sales approach, neither of which is advice focused.

The combined manufacturing and sales channel costs for Steadyhand are assumed to be mid way between the lowest Canadian and foreign equity MERs. Subtracting the 0.7% manufacturing cost leaves a sales channel cost of 0.14% ( 0.84 - 0.7 = 0.14%). TD sales costs using the balanced fund as the average would be 0.58% (1.28-0.7= 0.58%). Let’s assume the sales channel expense of a fund company is on the higher end of the range provided by the two examples, and we can set sales channel expenses at 0.5%. Our formula now looks like this:

Investor Costs = 0.7 + 0.5 + advice costs.

Given the average MER for Canadian equity funds is approximately 2.4%, the formula can be solved as follows:

Investor costs= manufacturing cost + sales cost + advice cost

2.4% = 0.7% + 0.5% +advice cost

Advice cost= 2.4% - 0.7% -0.5% = 1.2%

The advice component is thus valued at 1.2%. That is half the cost of a typical equity fund MER in Canada. In effect, if this is correct, fund companies are in the primary business of selling advice since it accounts for the largest component of their MER fee.

U.S. Comparison: If we were to use an example of typical U.S. mutual fund fees the formula appears to work reasonably well. Based upon an average MER of 1.4% for US equity mutual funds the formula looks like this:

Investor costs= manufacturing cost + sales cost + advice cost

1.4% = 0.7% + 0.5 % + 0.2%

The advice cost is 0.2% and the fund companies are definitely in the primary business of manufacturing and selling investment funds. If we assume U.S. funds have a lower cost environment and economies of scale, the advice component may be as high as 0.3%-0.4%, but it is still the smaller component of the various fees in our formula. Regarding economies of scale, the Canadian fund firms manage hundreds of billions of dollars in mutual funds yet the largest firms such as Investors Group have amongst the highest fees. This suggests economies of scale are not passed down the line by fund companies in Canada.

Popcorn Theory: A similar approach can be used to look at the movie theatre business. This comparison would provide a glimpse of what may be wrong with the conclusion that fund companies are really charging fees for “advice” as opposed to investment skills.

When my wife and I head to the theatre it is for the express purpose of seeing a movie. We understand the evening will cost a set amount of money and we are prepared to spend accordingly. We do not divide the cost of the event into “movie cost” and “snack costs”. We understand we will have popcorn, a soft drink and we will watch the movie and it will cost around $30.00 for the evening.

The theatre owner, however, does care how we spend our money. Movie theatres make extremely large profits from selling popcorn. Expenses in preparing popcorn are very low, popcorn profit margins are very high, and little skill is needed to train staff. The actual movies by contrast are expensive to make and thus expensive for a theatre to purchase. Movies can be big winners or they can be expensive duds for the theatre owner. On the surface, it would appear the theatre owner would be better off if they focused on selling popcorn and not on the low margin movie component of the business. However, here is the catch: in real life nobody would travel to a theatre just to buy popcorn. The movie is the sizzle that creates the opportunity to sell the popcorn! Without the movie there is no opportunity to distribute the extremely profitable popcorn!

Applying the popcorn theory to the investment business; few investors would buy mutual funds without the confidence they were getting valuable investment and planning advice. In essence, investors do not seek mutual funds, they seek advice!

The fund companies know that the "advice" component attracts investors who otherwise would not purchase mutual funds. The "advice" performs the same function as the "movie" does.... it attracts clients who can then be sold a very profitable secondary product. In the case of investors, the very profitable secondary product is the mutual fund.
Further proof that this comparison is correct is found in the high volume of expensive mutual funds sold with an advice commission, versus the much smaller sales volume of lower cost, direct sale mutual funds. Investors overpay for the mutual fund to get the perceived advice they are seeking. The main difference is moviegoers know what the popcorn costs them while investors face a hidden "advice fee" buried in the MER costs.

In the next blog we will delve a little deeper into why the Canadian mutual fund fee model does not make sense and how that contributes to Canada's exorbitant mutual fund fees.

mike

A discussion on Risk

2011-12-04T15:46:00.002-05:00

RISK: Deviation from an Expected Outcome!

The current economic climate is the perfect backdrop to an examination of the “four letter word” most likely to scare an investor today! Risk is the most misunderstood word in investing and yet we all seem to believe we know what the word means in most every other context. “Drink & Drive” and you risk injury, death, increased insurance rates, public condemnation and potential fine and jail time. If you do not wear a hard hat on a construction site you risk injury or death. These seem obvious as well they should. So why is it that investing is different? Well there is one very significant reason for this: in the scenarios listed above you cannot imagine a potential profit that would make the risk worthwhile. Is saving a taxi fare worth a death; is saving the cost of a hard hat worth being paralyzed in a construction accident? Of course not! Attaching the concept to “reward” to “risk” causes emotions to become involved. Add a thousand different opinions on “market risk” from a thousand talking heads and it makes your head hurt to even try to quantify risk.

Investing is one of only a very few areas where “risk” is directly associated with “reward”. In economic theory any investment return greater than that of a “90 day treasury bill” is considered “return on risk”. Investment managers measure “risk adjusted return” on a portfolio or security. Investors often act as if the expression “no risk, no reward” was a balanced equation. In fact, taking risk can enhance returns but taking risk does not ensure enhanced returns. MF Global Holdings is a hedge fund that most recently learnt this tough lesson when it invested in “high risk” Euro bonds and lost billions in a few short weeks. The lesson here is that professional investors quite often ignore risk and the results can be devastating.... not for the investment manager, but for the investors who provided the money! Risk is NOT owned by the “manager” but by those who provide the capital!

Risks are wide and varied when it comes to investments. In fact, there are so many different risks that the mutual fund industry has undertaken a strategy of hiding risk from the investor rather than spend a ton of time explaining the risks. The fund investment industry has lobbied hard to ensure the Point of Sale Disclosure document will report only a singular risk factor to investors. This type of misleading information is based upon the widely held belief by fund executives that investors are too dumb to understand more than one simple thought at a time. Unfortunately the securities administrators who vet the POS document have taken a pro-fund company approach and ignored investor needs. This is not surprising since the securities administrators are a cozy group of insiders who spend significant time with fund executives and next to no time with normal investors.

Risk Factors: The risks listed below are a small sample of what risks lie out there for investors. It is not in any order of importance but is meant to provoke questions when investors are looking to buy securities/funds.

Price volatility: The amount a fund/security varies in price is a measure of the swings you might expect in the value of a fund you invest in. In short, if a fund has a history of values rising or falling by as much as 30% in a given period, then that fund has twice the risk of losses compared to a fund that tends to fluctuate by 15% up or down in the same period. The typical fluctuation for each security or fund is measured by the “standard deviation” of returns and is generally represented by a “bell curve” of probable outcomes. Most of us will remember bell curves being used to standardize test results so that a predetermined average outcome is obtained on test scores. This approach to measuring risk makes a ton of sense if you ignore the warning that comes with every fund prospectus that “past performance is not indicative of future performance”. A simple way to express the short comings of this approach is to look at the past experience of a turkey in the year prior to Thanksgiving. Every morning the farmer feeds and cares for turkey so in the days leading up to Thanksgiving, the turkey would see the farmer as being of no risk to the turkey! For 364 days the performance of the Farmer shows no variance! Like the turkey discovers on day 365, a lot can change in a day even if past history has not prepared us for the change. However, as a general rule it is good to know the volatility of a fund before you invest so long as you do not look at the information in isolation and suddenly become a turkey for the slaughter one day.

a- A subset of this volatility risk is “event risk”. Like Thanksgiving to the turkey, certain events occur which alter the volatility measure for a security/fund. Since a 1 yr, 3 yr, or 5 yr horizon will not likely capture all the possible or even likely “events”, it is a fact that risk will be understated. This chronic understatement is exposed when a black swan or flat tail event occurs. For example, a tsunami wipes out a Japanese nuclear plant and uranium producers see their stock values plummet as nuclear energy is exposed as having more risk than suggested by the standard deviation in price volatility. While advisor/salespeople will shrug and say you cannot foresee such an event, in fact tsunamis in Japan are a well known fact and both Chernobyl and Three Mile Island accidents had the same effect on uranium markets. These events are plausible but hard to predict accurately over the short term but not over the long term. Most time periods used for standard deviation are very short term and in many cases the time period is manipulated to provide a desired outcome.

Market Risk: Market risk is considered a systemic risk and thus cannot be easily avoided. In recent times we have learnt a lesson on the importance of correlations. Prior to 2008 we had forgotten that in a terrible recession all securities can drop together and the past price volatility of securities means little or nothing. While diversification can add value in many instances; when the whole market decides to move in unison even the best past price history or quality business model can get trashed. Contrary to market advisors, sometimes a falling knife is dangerous and not a buying opportunity. Interestingly, a group of wise money managers have created a strategy around bucking the market as ‘contrarian investors”. Equally, a different set of wise money managers have created a strategy of buying into market movements as “momentum investors”. Typically one side will guess right and claim they are truly wise and the other side will fail and bide their time until they eventually guess right and can reclaim the status of “wise investors”. Either way, market movement is a real risk for all investors.

a- “Market risk” is very hard to measure in the short term. A number of managers claim they have the secret formula to understanding market moves and they provide advice based upon “market timing”. This is generally a macro strategy that claims to understand future market moves based upon a series of trends or analytics. In fact, given the number of salespeople who perpetually recommend buying securities in every market it is very likely that market timing is a sales strategy more often than an investment strategy. Guess wrong and the losses can be huge.

Political Risk: Those Canadians that piled money into the expanding income trust markets will know exactly what I mean by political risk. One simple regulatory change can wipe billions in supposed value from the markets. I say “supposed value” because in the case of income trusts, the value being created was not a reflection of a business strategy or performance, but was rather a combination of business value plus a regulatory tax value. Unfortunately investors were sold on the notion that the price was a reflection of simple business value. Something every analyst knew was false. When the tax laws changed many investors claimed the government caused the market losses. In fact the government created the value through poor tax laws and corrected the values by fixing the tax loophole. The decision was clearly political but the risk was financial. Common political risks include countries such as Venezuela nationalizing oil assets or the Congo extorting funds from mining companies. These risks tend to appear suddenly and cause rapid drops in stock/fund prices. Some political events are hard to predict such as the collapse of a government while others are well known risks such as war in the Middle East disrupting oil prices. A more recent political risk was the failure of the U.S. to approve the Keystone XL Pipeline expansion which caused shares in pipeline companies to drop.

a- A subset of political risk is “country risk”. Certain countries are prone to a combination of regulatory risk, government changes, civil wars and trade embargos that affect securities issued in the country. A rash of kidnappings in a country can result in companies closing down foreign operations and losing revenue streams vital to the company. Whole regions can be affected in some areas such as the Middle East, when a single country has a significant political or military event.

Advisor Risk:

The number one risk to your investment success and often your retirement success is “advisor risk”. The vast majority of “advisors” are using a title they have not earned and should not be using. Most people who sell securities are licensed as “sales representatives” but utilize the terms “advisor” or “planner” to self describe their functions. In fact, the vast majority of sales people are licensed ONLY to sell Mutual Funds. As such they can sell you a fund managed by somebody else, and typically can offer very basic financial advice. Obtaining a license to sell Mutual Funds is quite easy and requires very little additional education on either financial planning or portfolio management. The typical “planner” is trained by a fund company on how to “sell” funds. The complexity in the job is around issues such as maximizing commission revenue, sales pitches to convince investors that high MER fees are acceptable and that deferred sales penalties are a good way to purchase funds. The fact is that the business is taught to sales people by the companies who benefit from commissions the most. As such many salespeople actually do not understand the damage they can do by selling high cost funds or complex funds. Investors learned this lesson the hard way when the U.S. asset backed commercial paper market became illiquid in 2008. Sales people had unwittingly sold funds holding ABCP as no-risk money market funds or fixed income products. The fact is, that most salespeople are not qualified to make the decision on what was a safe fund and they just sold what their fund firms told them to! Combine that with the fact most are not licensed to sell alternative products such as exchange traded funds, stocks or bonds, and you can see how the “advisor”/salesperson has no choice but to believe that the funds they sell are a great solution for every client.

Advisor performance is difficult to determine as, unlike investment counselling firms, the salespeople who sell funds or non-discretionary stocks and bonds do not provide audited performance results for their clients. Typically only “investment counsellors” working on a discretionary basis can do so. So basically investors choose an advisor based upon the recommendation of other uninformed investors. While that sounds harsh, the other investors are uninformed because the mutual fund firms refuse to inform them. As an example fund firms generally refuse to provide:

- A clear rate of return for each investor every quarter or year (the return of the fund rarely equals the return received by the investor, which studies show to be consistently lower than the funds stated returns)

- A measure of how the fund performed against the normal benchmarks used by investment managers (ex. how did your Canadian Equity fund perform against the TSX 60 index?)

- A monthly, quarterly or annual summary of fees paid to the fund by the investor

- A similar summary of commissions paid from the MER to the sales person each period

- An accurate asset allocation for the portfolios held by a fund investor ( mutual funds are not an asset class despite what many statements claim)

Interest Rate Risk: The values of many securities are sensitive to changes in interest rates. The classic example is Fixed Income securities such as bonds. Once a bond has a set coupon rate (the percent paid out to investors each year), any increase in current interest rates will cause bond values to drop as new bond purchasers will seek the higher current coupon rates/ payouts that are available. Any decrease in current interest rates will cause bond values to rise as investors are willing to pay a bonus rather than accept the lower coupon rates that are the new norm. This risk is measured by “duration” and typically the longer the term of a bond the higher the duration measure is on a bond. Other securities such as preferred shares will often reflect the same general fluctuations since they trade predominantly on the payout levels fixed to the security. On a more macro level, when interest rates are higher or equity prices are extremely volatile, money may move out of the equity markets and into the generally less volatile fixed income markets. In today’s market we are hearing the terms “risk-on” and “risk-off” to reflect capital flows into and out of equity markets respectively. With current interest rates at historic lows, the risk of a significant interest rate increase makes long term bonds susceptible to greater price risk.

Management Risk: Funds are generally managed by a professional portfolio manager. The manager or management team will make the crucial decisions on when and what to purchase in a fund. The track record of the fund manager is often the major selling feature of a fund. When the key decision maker decides to leave a fund the investment decisions are made by a new fund manager. Given the abilities of the fund managers to attract investors, the fund can often lose a large number of investors if the manager changes. This can require funds to sell securities at a bad time and incur losses. Also, the track record of the fund is used in the marketing material even though the new manager has no ownership of the track record. What often makes this even worse is that sales people lock investors into a deferred sales penalty that can prevent them from following the fund manager that they were told was the reason the original investment was made.

Fraud: the risk of an investor being defrauded is higher than it should be in Canada. The reason is that the Canadian securities regulators are ineffective. Billion dollar frauds such as Bre-X and Nortel occur with no significant action by the regulators. Numerous frauds have occurred in Canada over the past decade and many are by firms who operate with no regulatory oversight right under the noses of our watchdogs. The best an investor can do is to confirm the licensing of the investment firm with a regulatory body such as IIROC or IFIC or the OSC. The most recent issue suggesting fraud is the Sino-Forest debacle which happened while the OSC was napping. Expect more frauds until some regulatory action is taken to curb the profits of the fraudsters.

Foreign Exchange Risk: Investors who buy securities in a currency that is different than the currency they use to fund the investment will have foreign exchange risk. In the case of Europe we can see the high risk currently associated with the value of the Euro versus the Canadian Dollar. If I buy a European security denominated in Euros and the Euro drops 5% against the Canadian dollar, then my investment loss on selling the security at the same price I bought it is 5% plus any sales fees. Investors have seen the Canadian dollar fluctuate strongly against the American dollar. A share bought when the Canadian dollar was worth $0.67 required almost $1.5 CDN dollars to buy one US dollar worth of shares. If it was sold when the Canadian dollar was at par the same share returned only $1 CDN dollar. Foreign exchange risk can be removed with currency hedging strategies but it does have a cost in increased expenses for the hedging.

Many investors take a simple view of risk and thus underestimate the consequences. This tends to show up in portfolios in a number of predictable ways: too much equity, too much low quality fixed income products (high yield), too many complex securities, and fees which are far higher than they should be. Many of these risks should be dealt with by a competent investment sales person. Unfortunately there are very few quality investment sales people in the industry and even fewer who do not have a conflict of interest due to the commission structure used in Canada. The above list of risks is not exhaustive. Issues around liquidity and leveraging risk are two more examples of risks that come to mind when I reflect on portfolios I have reviewed. It is difficult to make a comprehensive list that covers everything. In fact it would be overwhelming to read such a risk. In ending I will just say “risk needs to be understood and managed not totally avoided”. It is never the bus you are waiting for that runs you over, it is the one you did not see coming! Demand your sales person better understand the risks in what they sell and ask questions until you are satisfied you understand the whole picture.

sois mike

p.s. Sorry for the long delay between posts!

NEWSFLASH OBSI In Critical Condition

2011-08-09T14:53:00.000-04:00

Canada: Banks Stomp OBSI to Near Death

“In a shocking news development, we get word that a gang of extremely large, powerful and petulant banks have stomped the current Ombudsman for Investments to near death”!

In investigating the disturbing allegations we, like most Canadians, are confused as to why such large and powerful beasts would suddenly turn on such a small, frail, and youthful position.

For those requiring more background, the OBSI is the “ombudsman for banking services and investments”. This position was formed in the late 1990s when rumours were heard about a rampaging group of banks beating up small business owners and stealing their lunch money. No charges were laid as the surviving small business owners were hesitant to risk future lunch money. In 2002 the OBSI added the investment industry to its mandate; attempting to provide fair resolution to small retail investors who wondered how their current lunch money and future lunch reserves (RRSPs) had seemingly disappeared from their investment accounts. Of course many of these nest eggs were “prudently” invested by the gorillas in the Investment industry including of course the bank gang.

Many speculate that adding the investment bullies to the mandate of the ombudsman was short-sighted. Like a British police constable, the ombudsman carries no weapons when confronting these wild marauding gangs. Apparently the governments of the day felt that moral suasion and a proper upbringing would keep the gangs in line. Unfortunately, it would appear that power and greed have tilted the scale away from any fear of public condemnation. The large powerful bank investment firms appear to actually believe that whatever they do is always correct and any opposition is to be immediately crushed!

In fairness, it appears that the ombudsman did not even get his weapon (public disclosure) out of his holster before he was set upon. Despite clear warnings of the dangers, the ombudsman actually thought he was a respected friend of the gangs and appears to have walked into the back alley willingly and without back-up. One can only wonder at his surprise when the organized criticisms began raining down on his unprotected skull. Early word from investor advocates familiar with the case is that the ombudsman was guilty of having his own opinion on both the veracity of the banks documents and the claims made by the banks commissioned sales forces. Indeed, some have actually charged the ombudsman with talking to investors who lost their savings and in several radical cases, believing the word of a lowly common client over that of the banks commissioned sales person.

Medical staff tells us it will be some time before we know if the ombudsman will survive his injuries. While the powerless neighbourhood watch (investor advocates) keep a vigil at the hospital bedside of the ombudsman; the power, wealth and sheer overpowering influence of the gangs continues to threaten any recovery. Amid rumours that the gangs are looking at appointing their own “gang controlled” ombudsman to fill the void they are attempting to create; government and regulatory officials appear to be keeping a very low profile. Apparently the gang is so powerful even the government is leery of challenging their tantrum.

Back to you in the mainstream media for our next follow up on this troubling story......

soismike

Why Canadian Fund Investors are Confused

2011-07-29T12:19:00.000-04:00

Canadian fund owners have every reason to be confused.....and it is likely to be getting worse not better! The average investor often makes the assumption that they just don’t have the time to sort things out, when in fact the industry is ensuring the investor does NOT sort things out. The basic information required by investors is either completely lacking or is provided in a format that cannot or will not be understood by investors.

- Ask why we pay higher fees on Mutual Funds than other countries and you get a resigned shrug of the shoulders. Ask the fund companies and they will assure you 1% and 3% are the same fee really! (Canada ranks last in fund fees on virtually every international study)

- Ask why salespeople who sell funds are called “advisors” and not “salespeople” and you get a shrug. (Industry lobbyists pushed for changes to use other terms in regulatory requirements and the salespeople call themselves "advisors" which means nothing)

- Ask why so many Canadian investors purchase funds on a deferred sales charge basis and you get a funny look, like “what is that?” from the investor who has bought the punitive DSC option of a fund. (check your statement for initials such as DSC, or BEL beside your fund name; some countries just regulate there can be no DSC fees, which solves the problem)

- Ask how much an investor is paying each month, quarter, or year to have their funds managed and the investor shrugs. Even the GST/HST fees are hidden for some reason? (government complicity allows fund firms to hide HST fees so investors cannot calculate their MER fees)

- Ask how a fund can lose money and yet still issue tax slips for dividends, capital gains, and interest supposedly received by the investor, and you get a shrug.

- Ask what the annual rate of return on an investor’s portfolio is and you get a shrug. (funds advertise their performance when it suits them but will not tell you your fund performance....can you guess why?)

- Ask how you’re fund has performed against the relative benchmark for the last month, quarter, year etc, and you will get a shrug. (SPIVA reports consistently show funds perform very poorly against passive index strategies)

- Ask how a balanced fund can be called “balanced” when it rarely is a 50%/50% split between equity and fixed income and almost always holds more equity holdings. Many investors actually believe balanced means “equally balanced”! (International rules define the amount of allowable asset mix in a fund that is balanced)

....as you can see the list of reasons to be confused can be quite high for a typical Canadian trying to invest their RRSP and/or TFSA into something paying more than 0.10% annual interest. Most Canadian investors wrongly blame themselves. Their thought process is that “they must be too busy to understand all the information they get”, or perhaps “they just do not have the interest or aptitude for investing”. In fact, the real reason investors do not comprehend answers to the above concerns is because the information is being withheld by the manufacturers and sales people. That’s right; information is not unknown to the fund firms and sales people. It is simply withheld from the paying client! Apparently we are too “simple” to understand the information or explanations.

In fact the fund industry has a policy of ensuring the language in fund information documents does not exceed the comprehension level of a child in grade six! No, I could not make that up folks! This is official policy! (National Instrument 81-101; Section 4.1 (3) (f) requires the document not to exceed a grade 6 reading level on ...).

So, why do I say it is getting worse? While foreign securities regulators continue to advance the requirements for transparency, Canadian regulators continue to lose ground with newer and dumber approaches to fund disclosures! The next blog will discuss the new “risk” disclosure approach recommended for Canadian funds. It is misguided, misleading, and another fund industry sham supported by what appears to be a totally out of touch and disinterested regulatory body! Here is a clue to how bad this new risk disclosure is.....the same fund manager managing two identical versions of the same fund can have the identical funds ranked at two different risk levels depending on who is sponsoring the fund. Apparently, risk is just a state of mind!

Sois mike

TRUST BUT VERIFY

2011-07-09T13:29:00.000-04:00

Is the Truth Good Enough? I think not!

One of the great challenges for all investors (and especially DIY investors) is determining what information you should accept as truthful and valid. All information is provided from a specific perspective by the source of the information. This blog is no exception!

The easiest part of the process may be determining if information is factually true. If I say “the ETF symbol XIU is a broad based Canadian Equity fund with a MER of 0.17%”, you can determine if that is true quite easily by checking the iShares site or better yet, by reading the prospectus for XIU. Of course, other information can be more challenging to validate. If I stated “the XIU was the most liquid Canadian Equity ETF” or “the lowest cost EFT”, that would require you to do a little more research (it is not the lowest cost but is arguably the most liquid Canadian Equity ETF based upon the liquidity of the underlying securities and daily trade volumes).

OK, if we assume you accept my comments on XIU as being accurate; you then need to ask yourself “why would I believe this blog or any argument it may present with respect to the information provided?” It may be that you have validated the accuracy of previous blogs or it may be that you have checked for confirmation from another source you trust. The important thing is that you do not just assume the information is correct or the correct information is being presented in a proper context. For example, if I stated “you should always buy XIU for your portfolio because it is the most liquid Canadian Equity ETF” then I am using accurate liquidity information to support an improper suggestion. Strong liquidity is not a compelling argument on its own for you to select an ETF for your portfolio.

Ask yourself some critical questions: what association or affiliation does the blogger (Mike) have with iShares? Does he sell the security for profit? Does he own shares in iShares parent company? Is he trying to induce you to pay for advice by providing some basic facts to build trust with you? Is he an amateur “wannabe” advisor playing on the internet from his basement apartment? (In the interests of full disclosure: I do not sell or recommend any securities and carry no license to do so, I do not own shares of iShares parent company {I do own some units of XIU in my portfolio}, I do not solicit clients via my blog, I have a BA from UWO with a major in economics, hold a FMA designation from the Canadian Securities Institute and have 27 years experience working with major Canadian financial institutions.)

Assuming we can accept that I have no obvious conflict of interest in making the above comments about XIU and that I have sufficient experience to suggest the data is likely correct; the challenge becomes determining why I shared the comments and whether I am might be unknowingly passing along inaccurate assumptions. Given the above disclosures, my motives are likely somewhat more pure than an industry originated blog. Given my experience I should know what is accurate and what data is not trustworthy.....right?

The investment world, more so than most others, is filled with people who write with conviction about investments that they do not understand. Most advisors do not read a prospectus before selling a fund or stock offering. Information that is passed along is second, third, and often fourth hand by the time it reaches an investor. An analyst might work for a major bank and recommend stock “ABC.com” for a portfolio. The analyst then shares the report with the senior executives who decide to pass the recommendation to the company’s advisors. The advisors then receive a “hot sheet” with a number of analyst recommendations, including ABC.com. In order to support the recommendation a small sales blurb is included with the hot sheet and this is what the advisor reads. The advisor is looking to make a sale so they approach clients with the recommendation, often pretending to have researched the stock and determined that it is the most suitable for the investor. The challenge for the investor is that the motives and skill of the analyst, bank brokerage executives and the advisor are all built into the risk of the investment. If we lift the hood on the whole process and peer inside we might see the following:

The bank is trying to win business from ABC.com as a securities advisor, commercial lender, or corporate banker. They approach the analyst and suggest a strong recommendation might help our sales pitch. The analyst reviews the company, and not finding any major problems and knowing the banks business plans; the analyst uses some extra positive adjectives to ramp up excitement about ABC stock as an investment. The bank executives love the report and strongly suggest the advisors jump on this opportunity as supported by the analyst report. The advisor, looking for a security to sell, reads the sales blurb from the tip sheet and feels comfortable selling the securities of ABC because a top analyst has recommended the firm and the tip sheet sounds very positive on the future of ABC. The investor is overwhelmed by the opportunity as described by the advisor, recommended by the bank, and supported by a respected analyst. The analyst has a CFA designation and plenty of experience. The bank executives see no obvious problems with ABC and benefit from accepting the analyst report and adding their full support to the recommendation. The advisor trusts the firm he works for and feels the analyst must have done the hard research before making such a positive recommendation. The analyst gains positive stature and a reputation for being dependable from his companies senior executives. The executives get a positive reception from the management of ABC when they suggest their services to ABC at a significant revenue gain for the bank. The advisor gets a positive story they can sell to investors about a stock the investor will likely buy thus generating commissions for the advisor. Nobody lied to anybody. No factually incorrect statements will be made to anybody. Everybody feels good and has benefited..... With one exception. The investor has bought a mediocre stock based upon marketing hype that is not supported by ABC’s relative strength as an investment. While nothing is “wrong” with ABC, it is just not the best option the investor could have bought. There is no way for the investor to know what motives were behind the recommendation and it is difficult to point to other securities you might have bought a year or two after the fact when ABC has lagged the market by a few per cent. It might even have gained in value versus the book value.

Solution: So, “buyers beware” is the key when investors receive advice from ANYBODY! Check multiple sources. How many analysts are following ABC and how many of those rate ABC as a strong buying opportunity? Ask the advisor the right questions: have you read the full analysis yourself, what are the key risks outlined, is your bank soliciting business or doing business with ABC and how did you confirm that, what other securities did you consider and why is ABC a better choice, why do I need another stock in my portfolio and why this sector of the market at this point in the business cycle?

As my good friend Joe always says.....”It is good to trust but safer to not trust”! That translates to “trust but always verify” when you are an investor!

soismike

2011-06-04T14:05:00.001-04:00

Part 3b) ETF Strategies

Following up on the passive/passive discussion in the previous blog, the focus of this blog will be on the DIY investor and the passive approach. Keeping with proper investment protocols we first look at the Investment Policy Statement or , as it is commonly known, the IPS.

Investment Policy Statement: As a general rule, if you do not have a written investment policy statement, you do not have an investment strategy. If you do not have an investment strategy you are not an investor. So what are you? If you are managing your own investments, likely you are either 1- a gambler who unknowingly takes risk in the markets; or 2- you are frustrated and often find yourself frozen and not knowing what to do next. The vast majority of investors without an IPS are “customers”! They trusted an advisor/planner and thought that they had a strategy. They are caught in the overlapping active/active or active/no strategy categories and are seeing modest market returns eaten up by excessive active management fees (well, not actually seeing that happen as most fees are hidden, but you know what I mean).

Developing an IPS is a blog for the future so for now suffice to say, you need to know your asset allocation targets and ranges. Specifically, what percentage of cash, fixed income, equities and any other asset classes you wish to use in constructing your portfolio. In our basic passive/passive strategy we will fill the asset requirements with broad based ETF Index funds.

Example only.

ASSET	STRATEGIC TARGET	RANGE	SECURITY
Cash	5%	2.5-15%	Money market account, high interest savings acct
Fixed Income	25%	15-35%	1-5 year bond ladder or GIC ladder, Dex Universal Bond Index, Corporate bond index, government bond index
Canadian Equity	35%	25-45%	TSX 60, TSX Composite Index
U.S. Equity	17.5%	7.5%-27.5%	Dow Jones Industrial Average, S&P 500, Russell 2000
International Equity	17.5%	7.5%-27.5%	EAFE, World Index (ex North America)
	100%

The above is an example of a "basic broad based passive strategy" that would be fairly easy to build with common broad based and low cost ETF Index funds. The characteristics of this strategy are very positive: low management expense costs, very low trading cost, low tax impact (due mainly to the low trade characteristics of Index funds), broad diversification, and high liquidity. In fact this basic approach will meet the needs of the vast majority of investors and very likely out- performs an existing mutual fund portfolio over time.

While the broad based strategy is highly recommended, it does also have its weak points.

1- The risk level in a broad based strategy has a beta of one. That level of risk is too high for some investors. As a general rule, if the risk is too high you can lower the equity components (which reduces return and risk), or you can reduce diversification by adding lower beta securities such as replacing part of a broad based index with a lower risk sector fund having a beta of less than one. ( a utilities sector fund might have a beta of approximately 0.5%)

2- Broad based strategies generally will have less income potential than a dividend focused equity fund. Again, the solutions seem obvious (add a dividend fund) but the consequence is reduced diversification and overweight holdings as the dividend fund replicates a portion of the broader index fund.

3- While the strategy is low tax, it is not the lowest possible tax strategy. For those willing to sacrifice some of the benefits of the broad based portfolio, you can pay for securities that offer greater tax relief, such as "corporate class funds".

A Word On Tax Strategies:

ETPs have a very useful tax profile for higher income earners. In fact, after fees and performance benefits, the tax benefits are the next best feature of exchange traded products (ETPs). Most investors in active Mutual Funds do not understand how tax inefficient mutual funds often are. Funds are legally established as trusts and as such are required to flow through income to the unit holders (you). Each active trade has the spin off outcome of generating a) trade costs charged to the fund, b) a capital gain or loss recorded on the fund tax slips. As well, stocks held in the funds spin off dividends that are also recorded on your annual tax slip. With active funds often trading 50-100% of the securities they hold each year, these tax events are very common regardless of whether the fund is making any market gains or not. When funds face high redemption levels securities are sold and again generate capital gains and losses to all fund holders. As you can see, structurally active mutual funds are not able to remain very tax efficient.

ETNs are even more tax efficient as they entail use of contracts that reflect dividend payouts but do not actually receive nor distribute dividends to unit holders. The dividend value is reflected in the "contract" maturity value of the fund. The value of dividends are treated as a distributed capital gain only upon the sale of the units or contract maturity date. For high income investors looking to defer taxes and earn income as tax favoured capital gains, the ETN is a great security. Obviously if you are seeking income via dividend distributions, these notes are not for you. ETNs also carry default risk not generally associated with typical ETFs.

Cautions: Tax strategies are often a means of disguising poor investments as a “strategy”. Who has not been burned by “labour sponsored funds” sold strictly as a tax strategy!

ETPs As Portfolio Insurance

When discussing ETPs it is good to remember that many of the strategies are used by professional traders and portfolio managers. As “exchange traded” securities, you can trade ETPs on the stock exchange. That means you can “short” the securities or you can buy inverse versions of many ETFs. For professionals that may result in long/short strategies where, as an example, a trader buys a stock long (say RBC) and then shorts the financial sector. This attempts to select the winners (RBC) and discount the less attractive sector players (the other major banks), thus removing market risk from the final trade outcome.

Portfolio Insurance: If an investor has a large net gain in a Canadian stock portfolio, they want to protect the gains but may not want to sell the securities and face a capital gain tax. In this scenario the investor might short the Canadian market ETF to insure their capital gains against a market drop. If the market, including the investor's securities, drops 10% then they make up for the stock losses with the gains on the short position. Rather than buying a short position against every stock held, the investor could simply short the broad based stock index using an ETF Index fund.

Interest Rate Anticipation Strategies: A number of investors are concerned about interest rates rising and hurting returns on fixed income portfolios. Within the ETP product scope, investors can customize interest rate sensitivity (measured by duration) by mixing fixed income ETFs with a variety of durations. Purchasing a Dex Universal ETF Index is the broadest based Canadian bond index fund. By mixing in a ladder strategy (Claymore has popular laddered ETFs) or using the BMO Index funds, an investor can mix long, short and medium term Fixed Income ETFs. By doing so you can shorten the duration and thus lower the interest rate sensitivity of the fixed income holdings.

ETF Passive/Passive: The "broad based strategy" outlined in the chart provided, is the preferred approach for most DIY investors. It is a simple approach with few securities and few moving parts for an investor to monitor. While variations exist, an ETF Index portfolio utilizing 5 funds remains the most basic strategy with the greatest diversification and the most bang for your buck.

Some investors use this as a core strategy within a "Core & Explore" portfolio. With the bulk of the portfolio in the well diversified broad ETF strategy, the "explore" portion of the portfolio (10-20% as an example) can pursue other strategies without tilting risk too far off the intended levels. This approach works well for those that want to mix a little personal stock picking or additional diversification (say gold bullion) into the portfolio, without letting the riskier components distort the overall strategy.

That wraps up the basic ETF review discussed in the last four blogs. Hope it helps you better understand the ETP world!

Mike

Passive vs Active Portfolio Strategies: Which do you use?

2011-05-17T12:52:00.000-04:00

How do you know if a "passive" strategy is what you want or need?.....and what exactly is a passive strategy?.....and how do Exchange Traded Products (ETP), such as ETF Index funds fit into a strategy?

Exchange traded products, for our purposes, will include exchange traded funds (ETF) and exchange traded notes (ETN). Both of these products are an effort to reflect the performance of a chosen index as a general rule. Notes will typically use debt instruments (forward contracts) to obtain the index returns while funds generally hold the underlying securities (stocks or bonds) from the index to accomplish the same results. The blog will talk about ETFs, however in most instances you can use ETNs to accomplish the same goals.

ETF’s have changed the game when it comes to investing regardless of whether you are a professional or an individual investor. The goal of serious investors is to: diversify risk, make a positive return, and to keep as much of the return as possible. Professionals generally try to “beat” an index while most individuals aim for a reasonable after tax “total return” relative to the market indexes.

One of the challenges of being an individual investor is the difficulty in understanding which strategies are for “professional investors” and which ones are for “retail or DIY” investors. I want to start with a couple of broad statements to set the stage for how this blog will approach the strategies:

1- Individuals who “think” they are experts will often take on high risk strategies and often confuse luck with skill. If you “play” the markets, use your “instinct” to tell you when to buy or sell, or feel you have the ability to determine the “sector rotation” timing or market momentum at any given time, then please feel free to skip this section (and perhaps this whole blog) as you won’t accept what I have to say. If you believe a well balanced broadly diversified portfolio can help you share in market gains then please read on.

2- The terms “passive” and “active” are often utilized when discussing ETF Index Funds and Mutual Funds. The term “passive” can be used to reflect both a type of “security” and an investment “strategy”. Thus an index fund that has a strategy of mirroring a chosen index will be called a “passive” security. An investor who, in turn, tries to hold a diversified strategic allocation of passive funds will be said to have a “passive” strategy. Conversely, an investor who attempts to buy and sell securities in an effort to outperform markets will be considered to have an “active” strategy. If the investor holds funds that also attempt to beat the benchmark indices, the funds will be deemed an “active” security. As you will have rightly assumed, "passive" means a hands-off approach while "active" means on-going trading of investments.

So, what does that mean? Well, it suggests we can have 4 different scenarios:

1- Passive Security and Passive Strategy

2- Passive Security and Active Strategy

3- Active Security and No Strategy

4- Active Security and Active Strategy

Passive/Passive:This is what I will call the “true” indexing strategy and is the only strategy this blog site recommends for Do-it-Yourself investors. This approach requires an investor to determine the strategic asset allocation model they wish to maintain, and then to fill that allocation with passive index funds. As an example, a 3 asset class model with 3 equity sub-classes can be utilized to create a great allocation model using 5 passive index funds.

The 3 asset classes are:

A-Cash – short term low risk debt securities maturing in less than one year, bank account

B- Fixed Income- Interest bearing debt securities maturing in one year or more (1-30 years typically)

C- Equities – individual funds or securities in “stocks” whether common or preferred

Equities sub-classes: Within the equity class we might further break down the holdings into three geographic sectors: Domestic, U.S., and International

In this scenario a simple “passive/passive” portfolio might include 5 securities:

1- a money market fund

2- An ETF reflecting the Dex Canadian Bond Universe

3- Three equity ETF Indexes reflecting – the TSX 500, the S&P 500, and the EAFE index

The joy of this type of investing is that it is easy to understand, easy to implement, and easy to monitor. Investors have some research to do as they need to decide which broad based index they wish to follow i.e. the S&P 500 versus the Russell 3000 or the Dow Jones Industrial Average, but the basic concept is the same.

Passive/Active:

A number of professional investment managers are utilizing passive securities to implement an active strategy. The primary reason is that index funds allow an investment manager, using a single trade, to enter or exit from an asset class or sub-class. As an example, if the previously shown model was utilized by an active manager, trading the ETF Index fund representing the TSX 500 allows the manager to completely enter (buy) or exit (sell) the primary Canadian stock market. This easy approach to making significant portfolio changes appeals to managers who follow a “macro” approach to their investment strategies. This would not appeal to an investment manager who has a “bottom-up” approach which entails looking at each and every company that you invest in, however for “top-down” strategies” it is quick, effective, and cheap. Similarly, a strategy of “sector rotation” can be implemented by buying or selling a variety of “sector ETFs”. The proliferation of ETF funds has created a large base of index funds representing a wide variety of slices or sub-sets of each broad based index.

Caution: A number of DIY investors have been caught in the trap of holding ectors such as a Canadian Dividend fund or a Canadian Financial sector fund alongside the TSX 500 Index ETF . This causes a loss in diversification as a result of both the sector funds and the broad based index ETFs holding large positions in the same stock. Most true passive/passive investors do not require subsets of the large broad based ETF funds they hold.

Active/Active:

One of the challenges of “active” investing is doing it in a way that prevents one strategy from counteracting a second active strategy. As an example we often see investors with equities split between a “value” fund and a “growth” fund. The net result is similar to holding the full index as whichever style does well is being off-set by the opposite style which is likely underperforming the market. It is rare for the two styles combined to both enjoy a strong year simultaneously unless the whole index also did well. A true active strategy works best when the strategy has a singular favoured approach (pick value or pick growth as an example) at any given time. Some claim they can rotate from one to another effectively and that would seem to be a valid active/active strategy; however if you own a bit of everything in your funds then you are going to reflect a passive strategy at a substantially higher cost.

Active/No Strategy: A large number of folks that sell mutual funds have an approach that utilizes active managed mutual funds alongside a non-existant strategy. That is, they buy and hold active funds with no strategy to make tactical changes to reflect market conditions. While I believe this approach likely does less damage than a poorly implemented active/active approach; this strategy is not really a strategy but rather an abdication of the advisor/planner role as an investment strategist. Investors are sold funds, often with seven year DSC penalties, and the advisor/planner never look at the portfolio again until there is more deposit money to invest (think your annual RRSP phone call). This non-strategy was very evident in 2008 when markets crashed and advisor/planners told clients to “do nothing”. Doing nothing generally reflects a lack of tactical decision making in a strategy. While the active security managers (fund managers) maintain their strategy throughout the market cycle, the advisor driven portfolio strategy is frozen in place and no course corrections are made.

Summary: Within each category there will be room for more than one approach. A proper Passive investment strategy will include tactical rebalancing, strategic rebalancing, and of course adjustments made to the index components by the index committees of the various exchanges. The passive/passive investor may also favour a market capitalization approach, average price, equal weighting or a fundamental analysis approach. Passive does not mean abandoned or ignored and does not imply zero decision making by the investor.

As a rule you can typically classify yourself in one of the four categories above. If you are passive/passive or passive/active then ETPs are worth considering. The next installment of the blog will deal with strictly passive/passive investing strategies.

ETF Education Part 3 Construction of an ETF

2010-12-20T14:24:00.004-05:00

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 Ohow.ca for his suggestions on how to work my way through this topic.

ETF Education: Part 2 Lifting the Hood on ETFs

2010-12-10T13:29:00.005-05:00

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!

Soismike

ETF Education : Part 1 ETF Basics and History

2010-11-05T17:18:00.002-04:00

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

Bubble Trouble: Will We Ever Learn!

2010-10-03T12:13:00.002-04:00

BUBBLE TROUBLE!

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 dumb....in 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

National Post article Jonathan Chevreau re: DIY Follies

2010-09-11T11:22:00.000-04:00

We thank Jonathan for his coverage. "A Little Advice A Dangerous Thing" adds to the discussion started with our DIY Follies blog. Follow Jonathan at the National Post.

http://www.financialpost.com/news/Wealthy+Boomer+little+advice+dangerous+thing/3507590/story.html

Crawling Out From Under An IIROC

2010-09-07T17:01:00.001-04:00

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 Advisor.ca 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! Hello.....watch 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:

COMMON DEFICIENCIES:

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

DIY Follies

2010-08-27T15:11:00.000-04:00

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!

POS DEBATE RAGES ON

2010-07-08T13:21:00.002-04:00

Jonathan Chevreau fires a broadside at the Point of Sale proponents. You to need to do more and do it quicker!

Directions to the article. http://www.financialpost.com/opinion/columnists/case+little+late+mutual+fund+warnings/3244193/story.html

INVESTOR RISK: SKIM NOT SCAM!

2010-06-28T16:18:00.007-04:00

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.

WHY JOIN ORGANIZED CRIME WHEN YOU CAN GET RICH USING LEGAL SKIMMING TECHNIQUES?

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

WHO GIVES A FIDU?

2010-04-11T11:13:00.007-04:00

FIDUCIARY 101..... OR WHO GIVES A FIDU?

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.

PART 2:
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.

STEP ONE IN SALESPERSON RELATIONSHIP:
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

STEP TWO:
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.

WHAT WOULD THE FIDUCIARY DIFFERENCE BE?
Step 1:
- THE ADVISORS FIRM WOULD ENSURE THE ADVISOR HAD PROPER SKILLS AND ACCREDITATION SO THEY WERE NOT EXPOSED TO A LAW SUIT FOR VIOLATING THE FIDUCIARY OBLIGATION TO THE INVESTOR
- THE ADVISOR WOULD REVIEW THE PLANNING NEEDS AND INVESTMENT REQUIREMENTS OF THE CLIENTS SO INVESTMENT DECISIONS WERE BASED SOLELY ON ESTABLISHED CLIENT NEEDS
- THE ADVISOR WOULD STAY UP TO DATE ON PRODUCTS, FEES, COMMISSION STRUCTURES, PERFORMANCE OF SECURITIES AND REGULATORY REQUIREMENTS
- LESS TIME WOULD BE SPENT ON THE ADVISOR STORY AND MORE ON THE INVESTOR STORY

Step 2:
- THE ADVISOR WILL COMPLETE A THOROUGH ASSESSMENT OF THE CLIENT NEEDS, RISK TOLERANCE, AND KNOWLEDGE
- THE ADVISOR WILL EXPLAIN THE K.Y.C. FORMS AND ENSURE EVERY BOX TICKED IS APPROPRIATE
- THE ADVISOR WILL REVIEW THE UNIVERSE OF SECURITY OPTIONS AVAILABLE, DISCLOSE WHETHER THEY ARE RESTRICTED FROM SELLING CERTAIN TYPES OF SECURITIES, AND SELECT SUITABLE SECURITIES FOR THE CLIENTS NEEDS
- THE ADVISOR WILL EXPLAIN THE SECURITIES CONSIDERED, EXPLAIN WHY SOME WERE SELECTED OVER OTHERS, EXPLAIN THE COSTS OF ALL OPTIONS CONSIDERED AND EXPLAIN HOW MUCH THEY PERSONALLY WILL MAKE FROM THE PURCHASE OF THE SECURITIES IMMEDIATELY AND OVER TIME

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!

PART 1: THE CONFERENCE

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!

Follow Up on F.A.I.R.

2010-02-28T11:28:00.003-05:00

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!

MUTUAL FUNDS: GETTING IN THE WEEDS ON INVESTOR ISSUES

2010-02-23T13:13:00.005-05:00

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

Risk: What my salesperson forgot to mention!

2010-02-07T15:52:00.009-05:00

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

2009 A YEAR WELL WASTED.....

2010-01-16T11:39:00.002-05:00

A YEAR WELL WASTED FOR INVESTOR RIGHTS!

As 2009 arrived it seemed like the only silver lining to the economic and investment mess was the fact that true change would come to the investment industry on the investor rights front. It seemed inconceivable that the media, politicians and regulators could ignore the disastrous consequences of the unfettered sales approach of the securities and mutual fund salespeople. Similarly it seemed a certainty that investors would not allow the status quo to continue; either voting with their feet or demanding redress from the security sales forces that had miserably failed in their duty of due diligence.

The financial crisis exposed irresponsible sales activity by all levels in the security industry. Indeed the only common denominator seemed to be the absolute lack of due diligence by all participants. The bond rating agencies were on the defensive arguing that their triple-A ratings did not mean the securities were safe; just that they existed, in some form, somewhere, and contained some stuff that smarter security firms seemed to somewhat understand. Clearly they had no intention of supporting the investors who counted upon their ratings nor acknowledging the fact that ratings were deficient if not fraudulent. Integrity is a very rare commodity in the securities field....only found in amateurs such as retail investors.

So against that tumultuous backdrop, how did investor rights do in 2009? Well, the answer is clearly a split decision! International investors, supported by strong regulatory bodies and engaged politicians, have made strong progress. Australia and Britain have taken aim at hidden trailer fees that distort the honesty of the sales forces selling mutual funds. I suspect that within 5 years trailer fees will be limited to only Canadian sold mutual funds. In the U.S. the government has taken dead aim at the sales person conflict of interest and is looking to enforce a fiduciary obligation on all financial sales people. The surprise for most people is discovering that sales people, hidden behind advisor titles, actually have no duty to protect their investor clients.

So, in the glass is half full view, the international rights of investors have prompted action worldwide. Investor rights have been supported by numerous regulatory driven legal actions, including large fines and settlements levied against Canadian banks in the United States. Worldwide there is a consequence for the firms who lead the retail investors down a greed filled path.
Now, let’s talk about Canada. At the start of the year we hoped that Canadian complacency would finally be overcome by the need to act to protect our financial futures. As with Britain, Australia and the U.S., our democratic, free market approach would allow the will of the people to manifest itself in corrective action. The time was now and the need was great! So let’s reflect on what has occurred in Canada.

Federal Politics & Media: Alas, the political class continued to play politics in Ottawa and self preservation and power games (think our coalition farce of a year ago) were the focus of our political parties as well as our myopic media. Between the Toronto Star, The Globe & Mail, and CBC, the media heavy weights did what they do best: they focused on their own agenda and had little time for the plight of Canadians. In a midyear blog I espoused the belief that action required an engaged media and politicians who could use the media focus to drive legislation through parliament. Again, I note that by media I do not point at the financial media, but rather the editorial pages that are the key to broad awareness of complex issues. Clearly I was far too optimistic that issues driving worldwide change might be noticed in Canada.

Provincial Governments: With securities regulation being well within the provincial mandates, and with Ontario in particular having a nanny state approach; it seemed to be a natural fit for the Provincial Government of Ontario to take up the plight of the Ontario investor. The ability to influence regulatory bodies meant that Daddy McGuinty had a great opportunity to improve on his primary focuses (banning pit bulls, banning cell phone use, mandating helmets for all activities involving movement). Again, the plight of investors fell to the wayside as the provincial focus was on helping auto workers maintain massive incomes, benefits, and pensions not available to investors. Indeed, if investors had the pension plans of either McGuinty or an auto worker this focus on investor rights might well not be a major issues for investors.

Regulators: With regulators worldwide lighting the path it would seem that investors in Canada might benefit by even some simple "copy cat" legislation. In short, we did not need to create the better way, just follow the better regulators. Alas, in a bizarre way, Canadian regulators have used the mess of 2008 as an excuse to assist dealers at the expense of investors. How so you ask?
Dealer Representatives: One of the few points of clarity for investors in this bizarre regulatory mess was the fact that security salespeople were licensed as salespeople. The primary focus of regulators should be to add clarity to the security industry. Instead our regulatory folks thought this would be a good time to blur titles so that investors have no idea whether they are dealing with a sales person striving for a fee or commission, or a fiduciary advisor focused on investor needs. Now you will deal with a “dealer representative”, which is Latin for “huh?” Apparently the solution to the concern about selling securities nobody can understand is to create titles that nobody can understand! Clear only to IIROC ,we can presume.

Point of Sales Disclosure Documents: The regulators had a great idea when they surmised that investors would benefit from a clear Point of Sale (POS) document explaining the features, benefits and risks of the security you are about to buy. They also correctly determined no normal investor could read or understand the legal prospectus. This great idea, however, was quickly attacked by the investment industry. My father often said that “a camel is a horse designed by a committee”. By the time the self serving SRO’s had flooded the process with objections, the document was missing a few rather vital components. Small questions like “how much does my sales person get for selling me this”, “what other purchase options exist for this security and what would those options pay my sales person”. As well the document was not sullied by "performance against relevant benchmarks" or information on the risk ratios that might assist an investor. Clearly investors were not sharp enough to understand a Sharpe Ratio!

Similarly, the regulators are either not sharp enough to know when the industry is playing them or are more focused on dealer relationships than investor protection!

Product Complexity: Well, the P.O.S. is at least a partial victory. It speaks to the need to make disclosure more transparent and thus protect investors from complex products with risk profiles they cannot easily quantify. On the heels of this success (?) the regulators then opened the markets to higher risk and higher complexity products. Counter-intuitive to me, but clearly a quid quo pro for security dealers. Rather than be chastised for the abuses occurring with leveraged ETFs that were sold by sales people with little understanding of the risks, now sales people could sell complex derivative products with even higher risk potential. After all, what could possibly go wrong?...... Welcome to CFD’s and the joys of combining gambling with investing. Throw in “blind pool” investing and mix well until your portfolio melts! My forecast is that abuse of these products will result in significant losses for many unwhitting investors over the next 5 years.

Pet Peeves:
Well, as you can see, 2009 was not what investor advocates in Canada hoped for! Will it get better? I am afraid the answer is not likely. I wanted to end this dismal year with a message to two groups who can potentialy make a difference.

FAIR: The advocate community has been further splintered with the addition of FAIR, a foundation who appear well positioned to bring advocates together . As the only advocate group with a source of funding (tainted as it may be), FAIR needs to rally investor advocates. Arrogance toward those who have long fought the advocacy battles is both unwarranted and unhelpful. Focus more of your efforts toward changing the industry and a little less towards chastising the approach of other advocates.

Ombudsman Offices in the Banks: An ombudsman is supposed to investigate impartially on investor concerns in dealing with the banks. The office of the ombudsman was not intended to be a “tactic” used to shield the bank. The offices however appear to be fulfilling little more than the role of a speed bump. They slow, frustrate, and deflect investors with little apparent desire to resolve conflicts. Again I offer a little unsolicited advice; if you have completed the report on an investor complaint without ever speaking to the investor, you are probably not an ombudsman and should change your title.

Investor advocates and investors should mourn a year lost…….and then get back at it! I just received a notice today from TD Waterhouse raising the fees on a registered account so I can help them attain a new profit record in 2010! Obviously the timing is meant to show the empathy they have for the many investors who they exploited in their "advisor" services guidance in 2008 and who have yet to get back to where their retirement accounts need to be.

Soismike

The Birth of a new Fund

2009-12-06T11:18:00.006-05:00

Birth of a New Fund

Even the cynics in the mutual fund industry had to scratch their collective heads when the latest fund “solution” was unveiled by Invesco Trimark. It might be useful to stop a minute and walk through how the newest mutual fund came to be. New funds do not just appear without a thought to what the market either needs or will bear. It costs money to launch a fund and it costs money and time to wind down an unsuccessful fund. The industry is quite efficient at burying the dead within the living by merging the failed funds with other more successful funds to make them disappear. However, every new fund is somebody’s best idea and the fund industry needs to breed many more successes than failures if they are to continue to thrive.

The Winning Conditions: To be successful and receive support within a fund factory, a new idea has to hit two primary thresholds:
1- Can we market it successfully? Funds are “sold” not bought. As such, the fund must have sex appeal within the investing marketplace. A great example is creating a fund focused on Gold when the market is hysterical about either a crash or hyper inflation. The gold market has its moments, as all markets do, but buying a fund after the hysteria has occurred means getting in high and likely selling off shortly thereafter at a market low. Having said that, it is as easy as falling off a log to market a fund during the hysteria.

2- Can we incent Advisors/Salespeople to push our new fund off the shelf and into portfolios? Because funds are a “sold” product, you need to excite the sellers to be successful. If funds were “bought” and not sold products then you would need to excite the investor. Fortunately, while investors can be fickle, salespeople are not. The way to an advisor/salespersons heart is through their wallet. Salespeople sell to make commission.

The Birth: The latest fund to enter the investing world is PowerShares Fund which combines the efficiency of ETF investing with the (?) of Mutual Fund investing.

The Challenge: This is the point at which the marketing folks start to earn their dollars. We know that ETF Index funds are efficient, low cost, and highly diversified. We also know that investors are becoming keenly aware of the popularity of ETFs. Combine that with the knowledge that ETFs are the enemy of the high cost, inefficient salesperson sold funds and you understand the challenge. How do we meet the demand for “bought” ETFs with a “sold” mutual fund? An equal marketing hurdle is how do we get salespeople to even have a discussion about the feared and hated ETFs with a potential investor?

The Solution(s): The challenge requires two solutions. The first is to make the investor feel they are getting the latest hottest craze, these new fangled ETFs, without needing to actually investigate what makes then so efficient. For that we need a name that screams ETF and avoids any in-depth detail on what makes then work. The focus needs to be “look you can get ETFs without leaving your salesperson”! Knowing most investors are totally reliant on the salesperson to select the funds, this approach meets the criteria for a successful marketing campaign.

The second part of the solution is to position the new fund as lucrative and beneficial to the salesperson. First we commit to the old standby; a fat commission via lucrative trailer fees. When the trailer fee is sufficient the salesperson/advisor will be more than happy to ignore the investment paradox of a high fee, non-managed fund. The second part is to play on the advisor/salesperson fear of the growth in ETF investing worldwide. The salesperson/advisor is well aware the ETF trend is a threat. What better way to handle the challenge then by jumping on board with a fund product wrapped in the disguise of an ETF.

Advisor/Salesperson Pitch: The product sales pitch is a great one and easy to understand.....what, sorry? Oh, let me be clear, the sales pitch is to the salesperson not the investing client. Why would we pitch an investor who has no clue what the salesperson is about to sell them? It would be a counterproductive extra step, as well as a potential death blow to the fund launch. No, let’s stay focused on who really matters, the salesperson/advisor who butters the fund company’s bread!

Now, as I was saying, the sales pitch is easy. Say you have clients upset that the funds they own massively tanked during 2008/2009 and they are thinking of starting a couch potato low cost ETF approach. Rather than slandering the ETF approach you can now say “no problem, I can take care of that for you with no need for a messy discount broker account and all that reading and research you need for a couch potato portfolio”! A further side benefit for the salesperson/advisor is that the ETF, with a huge 500% or so increase in MER costs, may very well underperform some of the mutual funds the investor owns! You get to rake in the trailer and if the fund underperforms due to high fees, you just tell the client “that’s why I recommend the high fee active managed funds; you should have listened to me!”. Clearly a win-win for advisors.

Well, that brings us to the end of the process. For clear proof that funds are “sold” and not “bought”, keep a watchful eye on the volume of the new fund sold by advisors who, up to now, have railed against ETFs as an extremely poor investment choice for their clients.

If the advisor/salesperson truly believed the ETFs were a poor product, then the ETF fund should be a total flop! If the advisor/salesperson is motivated primarily by trailer fees, the fund should be a raving success. I know which way I am betting!

For a great article on this new fund launch visit Jonathon Chevreau’s blog, Wealthy Boomer . He raises all the relevant points and leaves no room for waffling! The follow up industry responses seem to be a hodge podge of whining and denial.

Your “still looking for the meat” blogger, SOISMIKE

HST & Fund Folks

2009-10-10T14:58:00.003-04:00

HOW CAN YOU TELL WHEN A MUTUAL FUND SPOKESPERSON IS LYING.....?

It is of course the oldest joke in the book when it comes to politicians (their lips are moving), however you can make a case for the fact that the fund industry is a much bigger source of disinformation than the local politician!

As for how blatant the lie can be....well we only need to look to recent events to see how little the industry respects the intelligence of the average investor. Failure to disclose all relevant information allows the industry to “stand up for the average investor” publicly while continuing to shaft the public by carrying on just like the folks the industry attempts to vilify!

THE LIE:
How about this from a recent Globe & mail article....

” At the heart of the fund industry's lobbying effort is one of the simplest concepts in personal finance: the magic of compound interest. Take the example of a 45-year-old investor who puts $20,000 into a mutual fund in an RRSP. This hypothetical fund comes with very high fees (2.75 per cent) but nevertheless churns out some excellent gains; by the time the investor is 85, he has a nifty nest egg of about $835,500.
Here's the punch line: If not for the provincial government imposing its dastardly HST, that number would be $70,000 higher. “We would hope that the government would not want to take 350 per cent of your initial investment if they truly understood the consequence of this tax,” writes Patrick Farmer, chief executive officer of EdgePoint Wealth Management and the author of this example.”

So why is this less than complete disclosure….well part of dishonesty is telling only a sliver of the truth. You know the old saw about when I point my finger at you, 3 fingers point back at me! Well, the industry complaint is that the government can only get away with this because the fee is hidden from consumers. The point being if consumers saw this egregious fee they would surely storm parliament and have the Harmonized tax reversed.

In fact I absolutely agree with the Fund Folks on that point. And truth be known, the Fund Folks (FFs) know this because they have been charging the most ridiculous fund fees on the planet using exactly that same deceptive approach. All fund fees are hidden in the investment returns where an investor cannot see them….EVER! What the uninformed investor does NOT know WILL hurt the investor, but not the FF’s (nor the politicians of course).

So to summarize, when the government hides a fee of say 12% HST on the MER fee charged to a fund it is equivalent to theft from an unsuspecting investor…. but when a fund company hides a fee approximately 8.5 times larger from the same investor it is good business practice.

THE TRUTH: The truth is that the industry has used considerable pressure on the government to gain an exemption from disclosing its GST charges. Check other receipts and you will see the GST number and amount for virtually every purchase you make! Why not the MF MER’s that you currently pay GST on?

Well the FFs realize that the average investor may well discover that a $100.00 GST receipt means the fund fees were $2,000.00 last year. At this point the investor becomes “informed”, the advisor likely becomes “fired” and the FFs become “unemployed”! In fact, it only takes about $80,000.00 in MFs to generate those types of fees! A $100,000 fund portfolio at 2.5% MER generates $2,500.00 in MER, which taxed at the current 5% GST would be $125.00….etc,etc.

So back to another old parable….. The guy crapping on you (politician) is not always your worst enemy, and the guy helping to wash the manure off (the Fund Folks) is not always your friend. The only certainty is that it is always the investor who comes out smelling bad!
Raising a stink on HST…….sois mike!

Who Is Fighting Against Modern Commission Theory

2009-09-04T12:29:00.003-04:00

It is encouraging to see the number of organizations and ex-industry veterans who continue to lead the charge against what we view as the greedy and unethical majority in the investment industry. More advocates seem to jumping on board every day. In fact the advocacy boat is getting so full it might well sink under its own weight. So who are these advocates and what should they do? Lets first frame the issue as viewed by SOIS Mike, and then look at the players in the world of advocacy.

THE ISSUE:
The Modern Commission Theory holds that the actions of sales persons are directly driven by the ability to derive maximum revenue. Any suggestion that salespeople work in the interests of clients to mitigate risk and ensure suitability to naive at best and most likely is deceitful.

THE PLAYERS:

In an effort to sort out the playing field I have categorized some of the key players on the advocacy front (my opinion only of course) below

.
Infiltrators (Infil-traitors?): Groups that on the surface are there to help!

The Ombudsman Office of each of the major banks: The banks are not the nicest people to deal with at the best of times! But they are amongst the cleverest of the investment folks. Outwardly they have convinced many clients that they have an army of compliance folks just waiting to jump on any trade that is not a perfect match to the client’s needs and risk profile. In fact the compliance folks serve a much more important role in the banks. They are the canary in the coal mine. Complaints come in and are regularly assessed to see what damage they might do to the bank profits and bank reputation. If your claim is deemed to pose little risk you should not be surprised to get a quick note back to you saying your case has been reviewed and you signed and acknowledged the actions of your advisor/manager and thus have no claim. In fact, the compliance folks do a great job of training bank staff to ensure you signed the forms in such a fashion as to minimize bank risk. The problem is the forms are supposed to minimize your risk not the banks! Your complaint provides the bank with all the details they need to build a case against your claim. They have many experts and you are pretty much on your own.

Self Regulatory Bodies: The folks at the IDA and MFDA attempt to provide consumer education and basically a friendly face to anybody looking for information on investing. Enough said about self regulatory bodies in the past; suffice to say beware strangers offering candy. In the world of investments you need to ALWAYS follow the money trail. Who is paying for whom to do what to whom? SRO’s are member paid and industry funded to ensure the most egregious issues are dealt with before the industry gets a black eye. The day to day slashing and high sticking do not get any attention from these referees.

Nice Guys Finish Last: This group represents the folks with good ideas and a good heart, but they are entering a gun battle with only a dull knife to defend themselves.

F.A.I.R.: This group is relatively new and as stated in the past, I do not like their chances of making meaningful change without a regulatory cannon to threaten the powerbrokers in the industry. The approach of keeping a watchful eye on the industry can only drive change if FAIR can harness the media. The ability to harm reputations can get the attention of the industry; however, again we must follow the money. The media will support the ideals of FAIR but only up to the point it causes stress in the advertising budget when a big bank/investment dealer threatens to pull an advertising.

Media: Within the media, there are folks who know right from wrong (well, within the business section anyway). The journalists who challenge fund fees and hidden costs and lack of disclosure are brave souls indeed. They depend on the investment industry for the revenue that keeps the paper/TV going and keeps them employed. The net result has not been that they sell their souls for ad revenue (at least some of them do not), but their ability to criticize is limited to the generic issues. It is hard to point to a single firm like Investors Group and say “hey, your MERs are way too high”, but they can point to the industry as a whole and do in fact do so on occasion. Unfortunately many are cheerleaders for the industry and a consensus approach will never happen as long as the media battle for ad revenue.

The Ombudsman for Banking Services and Investments (OBSI): The bank is a powerful master in the Canadian investment scene. With their own Ombudsman offices being ineffective (even the politicians did not fall for that one), a Bank Ombudsman was set up to handle the investors not completely overwhelmed by the Bank’s in-house Ombudsman. Unfortunately you need to go through the bank sham to get a hearing with a truly impartial arbitrator for your complaint. How good are these guys......well RBC has stopped dealing with the Ombudsman for Banking because they found the Ombudsman was actually listening to complaints and making sound recommendations that cost the bank real money! Clearly that cannot be allowed to continue! So RBC took their ball and bat and set up their own cosy game. Good luck with those RBC complaints! The issue here is clear to see. The Ombudsman simply cannot force investment dealers to toe the line. As to why the bank would have an option to back out of this government driven approach is a question for another day. The OBSI clearly states they do not act as an advocate for investors....the scary thing is they might be as close as we get to a true impartial advocate. Of course, follow the money and they again are funded by participating firms.....does this conflict never end!

The Don Quixote’s: In this category I include all of us who knish our teeth at the investment shenanigans but who have neither media clout not enforcement powers. While we are too many to name, you only need go to a bank board meeting to see somebody stand up and challenge the status quo. Below is a short list of people who continue to tilt. I exclude myself from the list, not because I do not tilt at windmills, but compared to the folks below, I have accomplished nothing worthy of being included.

The folks below continue the battle with long odds against them. They rile the giants and annoy the heck out of the pretenders in the industry. They just do not give up no matter the odds, the lack of power, and the lack of clout!....and of course, lack of money!

Larry Elford: http://www.investoradvocate.blogspot.com/

Joe Killoran: http://www.investorism.com/

Stan Buell: http://www.sipa.ca/

Ken Kivenko: http://www.canadianfundwatch.com/

If you look at the sites noted, you will understand that the power of the collective efforts is leveraged by the exposure provided by the internet. The internet however is unfocused and hard to motivate for a single cause. (Unless United Broke Your Guitar of course). So what are advocates to do?

FIGHT MONEY WITH MONEY: The Political Solution is "Money=Power=Money"

The key, if not yet obvious, is to follow the money! Politicians get elected by fanning the flames of issues to motivate voters, who in term vote for the politician and thus give them access to the money! Most voters are totally disillusioned by the investment world and how it operates.GREAT! That makes it a top of mind issue for politicians!

Our only hope of making meaningful change is to have a political solution.....why? Because politicians trade power for money! And the only way to deal with the powerbrokers is to have more power.... and the only one with more power than the investment world is the political world. And they will only use the power in return for THE MONEY!

In short, the message to all advocates is focus on the politics (as disgusting as it may be to many) because the regulatory approach just does not work! Instead of bringing our dull knife to the gun fight, we need to borrow a tank from the government and resolve this issue for good!

You’re “not likely in my lifetime” author....SOIS MIKE

Investor Hopes: Canadian Security Institute or Investor Advocates

2009-07-05T13:20:00.005-04:00

Grey Knights and Mixed Messages: The Canadian Securities Institute or Investor Advocates

As I look through the massive reams of media commentary on Investor Education and the flurry of activity from so-called SRO’s and other industry shills, two questions come to mind?

1- How did Canada, a well educated, conservative, rational nation of mostly honest people end up with such poor consumer protection and awareness in the area of investing?

2- Who is going to be the white knight that will expose the flaws in a multi-billion dollar industry that does not want to change?

The questions are quite simple; the answers a lot more vague than I would have thought. To set the scene lets first acknowledge that much of what is wrong is the result of entrenched financial interests. Things do not just happen....people have agendas and set out to make things the way they are.

Having said that; it also appears that some people with great intentions have added to the problems they were trying to fix. A primary reason seems to be that the white hats always focus on changing the consumer behaviour while remaining either helpless to deal with the industry or unable to find a strong regulatory body to act for the consumer against the industry.

So, on to question number one; How did we get here?

Since investor education is considered a current buzz word, let’s focus on the body that claims to educate both the advisors/brokers/salespeople as well as the public. The Canadian Securities Institute is a company that sells courses required for people to enter the financial securities industry. They also provide courses on securities and investing for the average investor as well as financial planning courses. There is a very good chance your investment advisor and insurance agent have taken a CSI course to get licensed. Thus we have the source of much of the training that has given us the advisors of today in one spot, managed by one firm with a pure education mandate! So that appears to be strength, right. But when you scratch the surface things are more grey than black and white.

The Canadian Securities Institute makes more money by attracting more people to the industry and thus providing more courses. They also make more money if the mutual fund firms are happy with the process and send all the new recruits to the courses. Thus the courses are “mutual fund friendly”.
Sample from a wealth management course: “An investor is looking to invest money for two years and is offered a 10% return by a mutual fund....” . Let’s stop right there! This is a course for wealth managers (Wealth Management Techniques) and it uses an example of a 10% mutual fund return over a 2 year investment horizon! That might seem like a moderate return to a hedge fund like the one that financed the privatization of the CSI, but a couple planning on using the money in 2 years should never be in a hedge fund. The assumptions are clear; mutual funds offer options such as guaranteed 10% returns and clients with a 2 year time horizon before a major purchase should look at mutual funds. The course does not clarify what type of fund offers such a deal of course! It is little wonder new advisors think funds are a bullet proof way to get rich when the advanced planning courses they take teach them just that!
As stated, nothing in the industry is ever all bad or all good. .The CSI does teach ethics and does a good job of teaching the benefits of diversification and of explaining the workings of many securities The main challenge is that the educational industry is intricately tied to the fund industry and is not in an independent position to expose the issues and challenges that come with funds. In many subtle ways (as in the above example) the institute has given in to the fund industry and abdicated the educational independence required to provide critical comparisons of competing strategies. That's why our education system has public funding and not corporate ownership; otherwise Coca Cola would be taught to be health food!

Question 2: Who will be the white knight!
Independent consumer advocates are our only current hope! Amazingly, it is refugees from the fund companies who are its biggest critics and who are opening the doors on the industry’s activities. Warren MacKenzie, an ex-insider, wrote the Unbiased Advisor which is an expose on how advisors exploit investors. (Disclaimer; I work with Warren)

As the likes of hardline investor advocates Joe Killoran and Ken Kivenko rattle the chains of politicians and the regulators; small parts of the industry are being exposed to light. The media plays a big, if somewhat conflicted, role as well. Consumer advocates like Ellen Roseman, Rob Carrick and Jonathon Chevreau tread the line of exposing the bad parts of the industry while realizing fund companies advertise a lot in their papers. William Hanley from the National Post has written very direct articles on the industry shortcomings as well.

Unfortunately, I suspect the above advocates will never be in the same room together due to some strong personalities and significant differences of opinion. Nonetheless, they will continue to push the envelope (Ken and Joe) and build on the small gains (the media folks) and collectively they will move investor advocacy forward. As for Warren, he is trying to change the industry from the inside with a radical new advice model that may or may not gain traction.

Where will F.A.I.R. land in this mix? Too early to say as they have not really shown their true colours yet, just the tangle of connections to the industry money that makes me so nervous.

Are we winning? No.

Will we win? I do not know.

Will the above folks quit the battle and surrender? I hope not!
Tilting at windmills.....sois mike

WHY I FEAR FAIR!

2009-06-11T13:01:00.006-04:00

F.A.I.R. OR NOT FAIR? I WOULD GRADE THEM FAIR AT BEST!

The Canadian Foundation for the Advancement of Investor Rights was launched in September of 2008. Undoubtedly you have been as overwhelmed with their good work as I have!

Mr Pascutto, the Executive Director, has raised the funds necessary to launch the Foundation from IIROC ; and of course IIROC is a merged entity created by Investment Dealers Association (IDA) and the Market Regulatory Services organization (MRS). We are delighted to see that such distinguished investor advocates are willing to back this venture!

For those of you without a sarcasm detector, the Investment Dealer Association and MRS are two of the very good reasons we need an advocate for the investing public. Both are “self regulatory bodies”, which in the investment industry seems to mean they help ensure the big players run the industry without having to worry about real regulatory bodies constantly demanding they do what is right for investors!

The goals of an organization often provide some insight into how they will carry themselves in the process of assisting you and me. As an investor advocacy group I would expect that the foundation would “provide clear policies for immediate implementation”, “demand action on outstanding issues”, “fight to ensure investors are treated fairly”! In fact the primary goals include such hard hitting items as “making reports”, “proactively identifying trends”, and when bad stuff happens to investors they will “encourage action”!

So, you just lost your pension money in the market, discovered the advice you received was suitable for either an 18 year old with $40.00 to invest or a gazillionnaire looking for losses! You are mad, frustrated and most importantly broke! Your Advisor referred you to his boss, the Investment Dealer , who said tough luck buddy. You complain to the ombudsman for the dealer (if they even have one) but again, tough luck! ! You can go to the Ombudsman for Banking Services and Investment (OBSI) , again good luck! The IIROC folks appear to have no interest in the matter and the local paper agrees you got shafted but it is so common it’s not even news. So you head to the FAIR folks and say THIS IS NOT RIGHT!

So what can we expect? Based upon the goals of the foundation it may look like this:

Yes, we have identified that a trend that appears to be emerging is that you and your fellow investors are getting shafted on suitability. As a matter of fact we are preparing a report as we speak outlining this trend and also encouraging the IIROC to review their files and see if they are seeing a similar trend. If so we can assure you we will suggest they take some action at an appropriate time to make things somehow better. We want to be careful of course not to do anything drastic that might imply our “one time “funding (nudge, nudge, wink, wink) was being utilized to serve the one sided needs of the powerless investor at the expense of the well funded industry big boys!

What do we need? A great response to an investor would be something like this: You are right, you have been shafted along with hundreds of others who have called and emailed us with their concerns. We are preparing a press release naming the major offending firms and demanding a meeting with the Presidents within the week. If it does not happen we are launching a media blitz and a letter/email campaign to all MPP’s and MP’s. We are also going to be sending registered letters to the independent members of the board of the firms who are the greatest offenders based upon our data. We have begun to raise funds to support a class action suit against the major brokerage firms and mutual fund firms for return of hidden fees and lack of disclosure of fees in plain English/French. The advisors have been knowingly selling funds without ensuring the investor is aware of and understands all the fees and risks and alternative investments they should be aware of! In short we are going to be the worst nightmare for the IIROC and every other SRO who has let the investor down!

Okay, maybe I am looking for more than any foundation sponsored by the industry can offer. My point is that no group who accepts funds from an industry SRO can truly reflect the average investor. We need an Eliot Spitzer (the lawyer not the politician) who can hold large dollar penalties over the heads of these firms. Money talks and no investment firm is going to voluntarily give up easy money just to do what is right!

MY POINT: The situation is a crisis for small investors and a bump in the profit trail for major investment firms. Until the issues of the average investor can threaten the bonus of the big bosses NOTHING will EVER change!

Let me by very clear, FAIR are great people and I do not in any way doubt the integrity of the directors of the foundation. However, they set a dangerous precedent because they are toothless watchdogs; but they give politicians and the investment firms the ability to point and say “ the interests of small investors are being met” by this august body of advocates.

Simply put; the best intentions of the FAIR foundation is no match for the fire power of the investment firms. In real life David gets pounded to a pulp by Goliath!
Reality sucks, eh!

Sois mike

The Truth About Canada's Banks & Their Success

2009-04-27T22:02:00.006-04:00

A lot has been made about the relative strengths of the Canadian banking system. The newspapers are filled with stories about how the focus on "retail" has lead to lower risk profile for the Canadian banks. You have also been reading recently about the superior risk management focus of the Canadian banks and the superior compliance regime of both the banks and the Canadian regulators.

That's pretty neat stuff for us Canadians; hey we're number one! It was all pretty reasonable to the average bloke who has not worked inside the machinery of a big Canadian financial institution.....but I have and I can assure you it is all CRAP!

The reason Canadian Banks are so successful is quite simple. They have an oligopoly structure that lends itself to high margins through low competition strategies. In short, they make tons of profit by over-charging for virtually all domestic services! Need convincing? The evidence has been sitting staring at us for years so lets point out a couple of obvious situations to get us started!

High Interest Savings Accounts: For years the Canadian Banks have made a fortune by offering little or no interest on your savings account. In fact the situation got so ridiculous that a foreign bank figured out that they could pay for their whole expansion into Canada by exploiting the fat margins that existed on savings accounts. Thus that annoying ING guy made his appearance and told Canadians the ugly truth! Your banks are not paying you interest you dummies! Of course the banks were not about to fight back over one measely foreign bank offering fair interest rates.

Think about it.....if Royal has ten billion in savings accounts earning 0.25%, they are not about to start paying 2.25% and give up $200 million in profits. They( and all the other banks) just sacrificed a few hundred million in deposits each, that would drift to ING, counting on Canadian apathy to keep most of the money in their accounts! The Canadian banks did not react at all until the credit unions followed ING's lead; at which time they created a high interest saving option that was not as high as ING and the credit unions, but was enough to stem the flow of apathetic money from the big banks!

Credit Cards: Foreign credit card companies also noticed that Canadian rates were very high, even though losses were quite low. In the hyper competitive card market south of the border, aggressive credit granting and extreme marketing competition pushed card companies into high risk credit granting, expensive rewards programs, and aggressive direct marketing campaigns. No wonder the card interest rates were 19% to cover the losses and expenses. In Canada that was not quite the case. Rates were 19%, but marketing was through the branches to existing customers. Credit standards were still very reasonable and losses were consistently below the U.S. experience. Even better, the banks owned the card processing firms and could screw both the customers (think 19% rates) and the merchants who had to pay outragious fees for the privelege of accepting the cards! Again, the Canadian banks took it to the extreme and again foreign banks eventually stepped in. Check your mail box and see how often a U.S. monoline (sells only one product) firm has sent you a pre-approved card at a low teaser rate. Again, the banks are not about to match low rates and sacrifice the profits from tens of billions in outstanding card balances at 19%, or 24%, or 27%. Let Capital One or some other company steal the crumbs from the table, but never give in to the temptation to be competitive!

Need further proof? Canadian banks are paying huge class action fines for illegal foreign exchange fees on the credit cards! Canadian banks are the leading broker and mutual fund firms in Canada.....and Canadians pay the highest mutual fund fees in the world! Ask the small business guy about the cost of banking services in Canada!

So how does that make our banks the best in the world? How do you explain the lower risk profiles and the lack of idiotic leveraging? Simple actually; Canadian banks just were not willing to pull their capital out of Canada and forego the huge domestic profits to chase U.S. sub prime assets, or expand aggressively into the U.S. capital markets. While foreign banks greedily schemed and took risks to gain any slight advantage in terms of profit, it was a totally foriegn concept to the Big Five! Compete for profits? Surely you jest! Stay home; stay fat and happy!

So now you know! The success of the Canadian Banking System rests with us! If we were not suckers who overpay for all our banking services, then the big banks could not have been nearly so clever! Lets give ourselves a hand! Of course don't forget to thank the government, who through the weakest banking regulations in the free world, continue to let the oligopolies thrive!

Keeping with this fine Canadian tradition; you can apply the same logic to some of the worlds wealthiest civil servants, dairy farmers, and financial planners! Low competition, poor regulations and consumer apathy! I am Canadian!

sois mike

IS YOUR ADVISOR A FIDUCIARY?

2009-04-04T22:51:00.003-04:00

ADVISOR DILEMMA: FIDUCIARY OR EMPLOYED?

I have poked a sharp stick at some Advisor behavior in past blogs. But it may be time to show my more mellow side; after all, most Advisors are just good folks following the direction of their employers! They do not often intentionally destroy portfolio and kill retirement dreams, it is just an almost unavoidable result of how they make a living.

Fiduciary: What is a fiduciary and who is a fiduciary?

Definition from Investopedia is as follows: “The fiduciary manages the assets for the benefit of the other person rather than for his or her own profit.”

Fiduciary 360 defines a fiduciary as “Someone who stands in a special relation of trust, confidence and/or legal responsibility”

Since fiduciary comes from the latin fiducia which means “trust”, one would think an Advisor would naturally be a fiduciary but, alas it appears they are not all up to the task. In fact for most, being a fiduciary would make life much more difficult. Simply put, if an Advisor puts the clients interest in front of their own interest they will find that their real employer is not very happy!

Compensation: Advisors, in general, need a firm where they can hang their cap, gather research, find admin support, and benefit from the marketing packages of large securities firms. The advisor works on an income split with the parent company for the most part. The quality of office, support, income split, and even job title is dependent on the Advisor making the firm happy by bringing in big revenue!.

Double Dilemma: Advisors face a double dilemma; doing what is best for the client will often mean doing what is NOT best for the company that employs the Advisor and it will also reduce the income the Advisor makes from both the investor and the company. So what is an Advisor to do?

The 10% Who Are Fiduciaries: Okay, I made up the number! I am optimistic that perhaps 10% have got it figured out! They actually just do not care all that much about titles, internal recognition, or the fast buck approach to wealth. Any Advisor can act as a fiduciary by just putting the customer first!

How do I know if I have a fiduciary:

I am blessed to have an Advisor Fiduciary who handles my security selection. G.G. and his team came from the pension and investment counseling side of the world where a fiduciary, discretionary approach is much more the norm. In short, he was trained as a fiduciary, hired his team as fiduciaries, and has enough clients to be able to dictate his approach to his bosses without repercussion.

The Fiduciary Difference: Here are some of the clues that an Advisor takes the fiduciary duty seriously!

When income trusts were all the rage and paying fantastic fees my Advisor watched his peers earn fat pay days selling every new issue they could get their hands on. His stature (think total revenue to the company) took a hit but GG felt over exposure to income trusts was a bad move in what was really a tax dependent strategy. We all know how that ended!
The next Fiduciary difference came with Index Linked Notes (PPN’s) that were sold at the top of the market and earned huge fees for Advisors. GG’s approach was that people too nervous to invest in equities should just not invest as much in equities! Wow, what a novel approach! Getting your own money back in 10 years with no inflation protection just did not seem to be worth a huge fee, never mind the “protection event” clauses that most Advisors forgot to read!

An ongoing sign that my Advisor acts as a fiduciary is the fact he has never sold me a fund with a back-end load ( DSC). The DSC hinders your ability to manage your investments on a going forward basis. Any penalty that restricts your ability to move in and out of investments will eventually cause you to face a choice between the right strategy and the cheapest strategy.

Why so few fiduciary Advisors: The security firms that employ Advisors pay big money to Advisors who can attract large amounts of money and keep it invested in expensive securities. They run the industry and that includes the Self Regulatory Organizations (SRO’s) that provide oversight to the industry. They have a lot of political clout and can ensure the Advisors who play ball will have an easy ride from the legal and regulatory side of the business.

HOW CAN THEY DO THAT?

The industry has created an environment where just about anything goes. The fox is not only in the hen house, they are running the joint.

1- Advisors are not likely, nor encouraged, to disclose the commission they receive from selling a security. They also will not disclose the various sales options available on the same product with investor costs directly linked to which option is chosen.

2- Advisors are not to provide alternative investment options and the comparative prices and fees on the comparative security. For example if you are sold a Canadian Equity Mutual Fund you are not to be told the relative price or performance of the equivalent Index Fund.

3- Ever notice that you never receive the cost of your investments each year on a statement? My apology to the 1% of you who do! Fees should be tax deductible on your non-registered accounts but it is not if you own mutual funds. Of course if you could deduct the fund fee you would actually know what you paid in fees and that is not the way to make big commissions going forward. Best to let dormant clients remain dormant.

4- Point of Sale disclosure: After significant lobbying, the industry had two small parts removed from the document: Fees earned by your Advisor and the benchmarks to measure performance. Sound like the fox just swallowed a couple of more hens? (P.O.S. Profits Over Service)

5- Ever buy something and not have the vendor disclose the GST ? Funny thing about investments in Mutual Funds; you never see any tax info that might provide a hint to the total fees being charged. Hmmmmmmm

Solution: Ask the tough questions! The best of breed Advisors will love the questions and the average Advisor will have a snit about how you can ask such harsh questions after all you have been through together! You might remind the Advisor that what you have been “through together” is about 30% of your total savings!!!

There are good Advisors out there but you need to ask the tough questions if you are going to find one!

Thankful for GG, but still a skeptic,
SOIS Mike

Ignorant Money

2009-02-21T21:12:00.005-05:00

WHERE THE IGNORANT MONEY GOES?

We hear a constant stream of discussion about what the “smart money” is doing? So I ask myself, given the mess the MBA’s and PHD’s have got us into, who exactly is ‘the smart money”?

According to the mainstream media and the talking heads on T.V., the smart money folks are exactly the same people who are currently wrecking our retirement and destroying our banking institutions.

Amazingly enough, these same folks are now suggesting the way to a renewed investment strategy and healthy retirement is to ask these same investment guru’s for a “second opinion”. (Anyone who knows the firm I work for will understand how much the “second opinion” ads grate on my nerves.)

The concept seems to be that retail investors bought our crap once so why not stick with it and screw the retail investor one more time! Unfortunately....it will work because confused investors are blindly seeking somebody, anybody, they can trust! Thus the “smart money” folks will lead the “ignorant money” into a grab bag of garbage products.

Ignorant Money: I use the term “ignorant in its truest sense to reflect “lack of knowledge”, not in the pejorative sense of ill mannered! Investors have been lead into high risk, over-priced, and in many cases totally unsuitable investments. The reason that happened was because Canadian investors are trusting when they should be dubious. Most lack the understanding of how advisors make money, and are exposed to the shifty investment industry. Without the quality regulatory oversight they mistakenly believe is provided by the self regulatory ‘boys club’ investors are unaware the regulator hides a corrupt/lazy/incompetent investment community from the light of day!

I pilfered the term “ignorant money” from a university professor who was speaking on BNN. He used it to explain the mass movement of money to poor quality investments. In short (my interpretation) he was talking about the money that blindly follows the marketing advice from the big banks and investment firms.

“Come and get a free retirement assessment from BIG Bank and you can rest easy!”, “Come and get a second opinion for free! From BIGGER Bank”, and my absolute favourite “It's time to look forward not backward and take advantage of the low market prices”.

I actually have a fantasy about honest ads from the big banks: “ Come and get a free assessment that will do you as much good as the last one you got from a bank for free!”, “You were stupid enough to trust us before, how about double or nothing on whatever money you have left”, “Don’t look back, we can’t afford to have you learn from your past mistakes!”.

THE FORECAST: In the next 6-12 months you will be overwhelmed with ads for the following products or products very similar to them.

Product: Segregated Mutual Funds: You will be told that getting your original investment back with no gain in 10 years is the best way to protect your money. For this privilege you will pay about 3% per year.

Ignorant Feature: With markets down 30-40% the guarantee is virtually worthless now. This makes some sense at the top of the market and absolutely no sense after a major market correction. Also most investors don’t have the 10 years to wait for the return of capital.

Product: High Yield Bonds: With government bonds paying next to nothing and investors too nervous to buy equities, advisors will focus on the corporate high yield bond market. You can get much higher yields and the protection of security with the bonds versus the common stock.

Ignorant Feature: People need to ask the big question, why is this bond paying such a high return? The answer is because the underlying firm is likely to go bankrupt, renege on its bond payments, or be unable to pay you back when the bond matures. High Yield means JUNK. A small amount in the portfolio might be acceptable for some, but look for major whacks of this stuff to find its way into portfolios of vulnerable seniors.

Product: Leveraged Loans: With stocks “on sale” it will be an absolutely amazing opportunity for investors to make a quick killing on the recovery by utilizing the brilliant strategy of leveraged investment loans.

Ignorant Feature: What could go wrong? I don’t know.....maybe we should ask Lehman Brothers or AIG, they are the most recent experts on leveraging. The key point to remember is that your advisor will make roughly 5% up front on your leveraged investments and have no monthly payments. The only way to make this work for the average investor is to write your CSC exam and become an advisor. Now the strategy is brilliant!

Product: Market Linked GIC’s (PPN’s): While these products have been a real mess, the banks just make too much money selling them. Confused seniors are still available and untrained bank staff can sell them with great sincerity since they do not actually understand the risks.

Ignorant Feature: Similar to seg funds, the guarantee is somewhat useless at the bottom of the market and the fees are ridiculously high. Most investors got killed on the “protection event” but in the next round it will be a straight fee grab.

Product: Lifecycle Funds: OK, your advisor was asleep at the switch and forgot that you might want to reduce your equity exposure as you approached 80 years of age and had only a small RIF to help sustain your meagre lifestyle. No problem, your advisor can buy a fund that will pay somebody to automatically rebalance and adjust the asset allocation as you get older. Phew, that’s a relief!

Ignorant Feature: About that lazy advisor you had? What is it you are paying them for again? In short, you are paying a premium to have your advisor fir e somebody to do the work you hired them to do, and you pay both parties.

Well, there you have it, my forecast of what you can expect to see on the shelf at your local investment market. The two things required to keep the markets alive are fees and uninformed investors to pay the fees. Inspite of the painful lessons of 2008, I predict 2009 will be a great year for advisors. They make money on greed, fear, and ignorance and all three are in abundant supply.

Your jaded blogger, SOIS MIKE

2008-12-23T13:42:00.004-05:00

THE ANTI-RANT: HOW TO HANDLE THE MARKETS AND YOUR SO-CALLED ADVISOR

OK, having enjoyed my rant on what to stop doing, now I will share my thoughts on what you should do!

Let me preface this by saying my beliefs carry into the work I choose to do but do not require an investor to engage my services or, anybody's, to take charge of your investments. Consider it a free consult!

Point: ONLY YOU CARE ABOUT YOU!

You both "earn" your money and "own" your money. It seems that many people spend more time cleaning their golf clubs than they do managing their money. Sorry, I do not believe the common drivel that “I am so busy I have no time”. You spend 8-10 hours each working day to earn money and then you hand it to an advisor you met an hour ago because they are your friend’s cousin’s brother and thus can be trusted.

ACTION:

Understand that Advisors and Financial Planners are simply sales people. Would you hand your chequing account to a car salesman and say hold my money until you find me a good car? Not likely yet it is almost a certainty the car dealer cares more about your follow up business than your advisor. If your car breaks down you are immediately inconvenienced; if your portfolio breaks down you pay a price at a future date. Trust your advisor like you would any 100% commission sales person.

Point: GET AN EDUCATION!

The investment industry fills the airwaves and newspapers with financial pornography designed to excite you and thus lower your defenses as they pick your wallet. The blogosphere cannot be trusted, after all who is behind the blog and how do they make money? Ya, that includes me if you have not done your homework.

ACTION:

Go to unbiased or low biased sources. An unbiased source would be “investopedia.com” which provides definitions and articles to help explain investing(ignore the ads). A "near unbiased" source would be the Canadian Securities Institute, which is supposed to be unbiased but seems to think mutual funds are heaven sent. Take the Canadian Securities Course, it will cost you a few hundred bucks and a few hours work but it will provide some good definitions and explanations. You do not need to do the exam to learn.

Point: You need to explore your personal needs before you go hunting for a sales person to sell you securities.

You can’t explain what you need if you do not know what you need. The sales person knows what they need; your money and a securities company that will pay them to deliver your money. What do you need?

ACTION:

Go and get a “real” financial plan.

DO NOT accept a two page plan that says you need to put $235mo into our mutual funds. Get a plan with at least two scenarios so you can compare options, and by the way you should choose the options not the planner. If you are good with a spreadsheet then do your own forecasts but you will need to get the tax piece right so be careful. The plan should link to your investment strategy by pointing out what rate of return will meet your future needs.

Point: You need to direct your advisor on what you need to do.

You can take advice, but never hand the wheel to the advisor. If you have less than $150,000.00 you should probably just do it yourself as you will not likely find a good advisor anyway!

ACTION:

If you want to hire an advisor, interview at least three. You should set the parameters upfront with the advisor to weed out the obvious greedy bastards.
- I will not pay total costs in excess of 2% ever
- I will not buy deferred sales charge funds EVER
- My target rate of returns net of fees is x%, what is the lowest risk portfolio you can structure to achieve that goal over the next 5-10 years
- I will not hold any individual security that represents more than 10% of my portfolio
- I do not want any product where I do not understand how it works or how everybody involved gets paid

You need to get the advisor to sign the above documented objectives for your records.

Point: We are back to the key point “ONLY YOU CARE ABOUT YOU”.

You need to have independent monitoring of the investment accounts. It is best if you do this yourself. You need to have a composite or blended benchmark and you need to know your rate of return (not the rate of the fund you’re in as it will differ)

ACTION:

There are a variety of ways to monitor your accounts. The best way is to use two free websites to determine both your true rate of return and how your benchmark returns performed.

showmethereturn.ca
showmethebenchmark.ca

Point: The on-going management of your account is made either hard or easy based upon whether you think you have super powers or whether you think you are normal. If you have super powers and can tell really good B.S. from the truth and can explain why the smart folks with sure fire winning strategies are giving away the information for free, then you should actively manage your money and make lots of really smart trades every day!

Action: Nobody consistently beats the markets. Nobody consistently beats the market. Yes I did repeat that for a reason. It is very expensive to buy into the delusional view that some people know what random market move will happen tomorrow.

It is quite cheap to “participate” in the markets with a good diversified low risk portfolio of index funds and ETF’s. Similarly some well monitored, well diversified “buy and monitor” portfolios will be successful over time. Pick a strategy to participate at low cost. Avoid any strategy that is designed to beat the market.

THE SECRET TO SUCCESS: SEPARATE WHO GIVES YOU ADVICE FROM WHO SELLS YOU SECURITIES.

Every advisor needs to have a secret solution that others seek. I gave my secret away (since I am not a securities advisor).

ONLY YOU CARE ABOUT YOU…..and based upon your actions, EVEN YOU MAY NOT CARE ENOUGH TO DO IT RIGHT! For years I was guilty of this....very busy and very important!

To those who do care and think your money is important for what it can provide your family for years to come; put in the effort or hire somebody to do it for you.

Find somebody who is very tightly bound to your goals (by contract in writing preferably) and monitor their performance and more importantly also their strategy ,to ensure they always put your family first.

When their need comes first you will see a change in strategy. That change should be viewed as the canary in the coal mine. Look for the signs: more calls and recommendations for purchases, a shift to "managed", "structured" or "guaranteed" products, and the biggest warning sign; when they utter the killer phrase "it's different this time". When that strategy shift happens, get out quickly!

Your skeptically focused blogger,

sois mike

Financial Pornography

2008-12-10T20:32:00.009-05:00

Most people find pornography offensive! That has been true for the past few thousand years of course. That is why it is so confusing as to how so much of it survives, even though nobody buys it or watches it.

Financial pornography is the same, but with charts instead of pictures! In both cases the reality is not nearly as stimulating as the "doctored" graphics try to portray.

Financial pornography is represented by the distortions, misrepresentations, phony fund commercials, stupid bank claims, and all the other obviously bogus claims being delivered by phony senior citizens claiming to be retiring to France when they are actually working into their late 70's because they bought the stupid mutual funds they are flogging.

Nobody would ever listen to "Mad Money" nor follow the crazy advice, yet I keep hearing people talk about what they heard from a "friend" who watched the show. Stop watching that stuff, its morally and financially corrupt.

The financial markets have always had a way with words and graphs. In the past, it was all rather innocent since "good" people were not exposed to the financial smut. Then along came the Internet, cable T.V., thousands of financial planners and ,yes , blogs! Now the financial world has gone nuts and products that were once in the restricted world of professionals are now discussed by Joe Trader as if he actually understood them!

Since when did:

- retirees read 80 page legalese on a split-share issue and understand the leveraging (hint: the answer is never),

-when did your local lawn care guy start trading in options because a "covered call" is free money.

-I heard a caller on Business News Network today who claimed he never lost money on a single option trade and could not understand why everyone was not writing puts and calls.

Well enough of this smut! Here is the truth you need to listen to and learn from!

Day traders live in their mothers basement and are really just degenerate gamblers.

Active trading by an investor works only when the average investor is Warren Buffett and has billions to cover his mistakes....and yes, he does make mistakes. Active trading without a billion dollar corporate team behind you is just stupid....yes, I mean you!

Managed or structured products are a fee looking for someone to pay it. The only way to win is to be the salesperson skimming the investments! Yes, mutual funds are a managed product so figure it out.

Wraps are the way small time investors get exposure to fully diversified fees. You pay everybody in good times and bad. You make benchmark returns almost never. Duh!

Financial Planners do not often do financial planning. They get the qualification because the title "Mutual Fund Fee Skimmer" was too difficult to fit on their cards. They are paid to collect your money and deliver it to big corporations. They do not manage your money, they collect "vig" on the deposits.

Bankers are like a stealthy thief sneaking into your house and stealing the silverware one piece at a time. Before you know it your eating with your fingers and the bank is offering you a cutlery loan at 18% interest. Service charges on proprietary funds are obnoxiously high and the people selling the funds are proof that the bottom of the class can still find work somewhere.

Stop feeding the beast and thinking the teller is your friend. friends don't refer friends to bank planners.

There, now I feel better.

I hope that I have offended a few bankers, advisors, and planners because that way I feel like there is a purpose to life. If you are ready to handle the ugly truth, wait for 2009 when the real stuff starts to fly and markets test 7,000 and lower!

Then the real smut will come to the fore!

See you in 2009!

Tired of 2008.....sois mike

2008-11-18T15:16:00.004-05:00

PPN SALES STRATEGY: OBFUSCATION VERSUS DIRECT LIES?

A friend was lamenting the other day, about why all politicians lie. I had to clarify that they do not lie, they obfuscate! She responded, what the heck is that supposed to mean? I said, “ah ha, it works!

OBFUSCATION: to make something obscure, to confuse

Politicians obviously are the masters of obfuscatory practices, however those in the investment business can take their place of pride alongside, some might even say “under”, politicians. The business of advising investors has long been a very fertile ground for the obfuscators.

At first, in honing their practice, advisors sought confusion via simply creating a “lingo” that excluded those investors not on the inside, or in the know as it were.
Terms were designed to make investors feel small. Who knew whether a 60% margin meant you had to put in 60% or your loan was 60%?, who knows a “put” from a "call", what's an option or a warrant? Yup, this is tough stuff, I better pay a small fortune to hire a translator who we will call a “broker”.

The broker quickly left investors broker so a new obfuscation was required; let’s call them advisors! But, you cry, aren’t they just sales people? Most don’t go within a mile of a prospectus, they just read the “hot sheets” from head office and sell whatever crap is on the sheet. How can they be called advisors…..ah, obfuscation!

The next stage was more devious, as you would expect from an industry with no oversight to speak of. Instead of picking off investors one at a time, they needed an obtuse process that could channel investor lemmings to the advisory cliffs! But they couldn’t just say, hey suckers come see what we are selling now. The old “pump and dump” was well known and not nearly as lucrative as it had been. Thus we entered the new age of the “mutual fund”! This gathered lemmings by the thousands and told them all about sharing risk. What wasn’t explained, was a thousand people taking too much risk is a thousand people losing too much money!

Obfuscation (I like the word obviously) was not limited to explaining the underlying risk. With mutual funds came:

hidden fees to obfuscate the costs,

misleading fund descriptions ,( think “balanced fund, Canadian Focused funds, Opportunity funds”),

false reporting ( a mutual fund is not an asset class folks)

Having learned that you can make more money by suckering the masses on a large scale, the industry started to look at how they could pry cautious GIC investors from their money. Low and behold, along comes the Principal Protected Note (PPN)! If ever a name was going to obfuscate, this was it. Investors thought they were the “protected “ party.

If markets took a big dip, they were protected and when it skyrocketed they got to “share” in the gains. Note the obfuscation around the word “share”. The advisor got paid BIG commissions up front, the manager got fat annual management fees and a totally unwarranted share of profits through capping market gains. And if the markets had a bad spell in the middle of the 5-7 year terms, hell management cashes out and moves on to the next sucker game. The investor, well your locked in with all "market participation" cancelled for years to come!

Don’t worry, we will be back in a few years to hand you your inflation ravaged principal! What, you didn’t read the 89 page small font section on “protection events”, oh, you thought you were the protected party? Sorry, I thought you knew what obfuscation was? Look, don’t worry. When you get that piddly principal back we have a great new product for you….guaranteed to make up for any losses! What, details…..don’t you worry about the details, you have an advisor! He can clearly spread the obfuscatory fertilizer well enough to separate you from your money…..and we have some great news for you!
You will (snicker, snicker) be fully informed (giggle, giggle) according to the “principle based” (how can I keep a straight face) "Point of Sale" documents coming into effect!

Oh, you’re skeptical? Who designed the POS document? Why it was designed by a committee of the same folks who oversaw the PPN’s. Wait, come back,.... I’m warning you... those GIC’s are bad. They're too simple, they have no hidden fees….you’ll be sorry!

I trust the above was not too clear....after all, I am a professional!
sois mike

P.O.S. = Profits Over Service

2008-11-02T19:59:00.004-05:00

81-406 POINT OF SALE DOCUMENT:

To quote U.S. politics; You can put lipstick on a pig, but it is still a pig!

I recently reviewed the POS document from the Joint Forum of Financial Market Regulators. Given the makeup of the group I will admit I was worried they would gloss over the key points and produce a lame document. I could NOT have been more wrong!

They did not gloss over the key points when they produced the LAME document. They flaunted the fact they knew what should have been in the document, and told you why they don’t really care! It was a bold and clear statement that investor’s rights are well back of industry rights!

It looks like Joe Killoran, the over-energized investor advocate, is proved correct. His POS alternative may provide way too much information, but at least he starts from the viewpoint that investors often can read above a grade 6 level! (I can’t make this crap up; it is a requirement of the Joint Forum that the POS be written for no higher than a grade 6 level of reading. Thanks for protecting us dumb investors from all those big words like “capital loss” and “hidden-commission ”.

I began to copy sections that concerned me but quickly realized I was copying most of the document. I was reminded of a statement by Warren Mackenzie, of Second Opinion who stated “the industry is always pleased to move the investor slightly forward so long as it does not impact commissions”. But you get the point; investors get a story instead of facts and any concrete practical requirement gets so watered down it becomes irrelevant by the time you read it.

But a poor blogger like I can’t do this justice, so let’s let the Joint Forum speak for themselves. (to those who are sarcasm challenged, no such interview took place, but the quotes do belong to the Joint Forum. The witty dialogue is all mine).

Fundsellor: What's the secret to remaining so vague that this document does not give any real information to those masses of mutual fund investors?

J.F.: “It does not outline specific requirements for the new regime. Rather it sets out concepts and principles agreed upon by members of the CSA and CCIR. The framework will form the basis for implementation.”

Fundsellor: Huh?.... anything I can actually understand?

J.F. “In response to comments, we have also revised the framework to include less frequent updating and filing of the Fund Facts…. Other aspects, including the specific content under some items, will be left to fund managers and insurers to determine.”

Fundsellor: Is there any way we could make it easier to just pretend investors have the incriminating….er, necessary information to evaluate the fund?

J.F. “Electronic delivery could include, for example, sending directly to the investor an e-mail with an electronic copy of, or link to, the Fund Facts, or directing the investor to the relevant Fund Facts on the fund manager’s or insurer’s website.”

Fundsellor: So they do not actually have to give and explain the document to the investor…..slick! How did you come up with this neat dodge…er, option?

J.F.: “Many commenters were opposed to the requirement to deliver the Fund Facts before or at the point of sale for subsequent purchases because of the potential disruption to the purchase process. “

Fundsellor: Obviously we can’t have lack of vital information slowing down the sales commissions or the industry will really have a crisis to deal with!

Fundsellor: With all this asset backed paper making people nervous how are you going to deal with short-term investments?

J.F. “We have therefore excluded money market funds from the point of sale delivery requirement because they are generally of low risk..... In these circumstances, the adviser may go back to the client after the initial recommendation of a money market fund and resume the e discussion of what fund or funds may be more suitable as a longer-term investment. “

Fundsellor: I get it; no big commission equals no disclosure. That will teach investors to buy low fee products! But seriously, if I really want to sell a juicy commission product is there any way I can set it up to avoid all this?

J. F. “. If the investor initiates the purchase” (bolding by the writer not the J.Fer’s)

Fundsellor: That’s easy enough to arrange. It’s not like anybody else was in the room with us. How do we sell this gigantic loophole?

J.F. “We agree that investors who initiate the initial purchase of a fund through an adviser should be able to decide whether they want to receive the Fund Facts before or after the point of sale. “

Fundsellor: How about the prospectus. A few clients read that and then give me some flack when I maybe glossed over a few fees or risk factors. Can I escape that problem too?

J.F. “ Dealers will have to deliver the simplified prospectus to investors only on request. “

Fundsellor: Have we been able to hide any other fees?

J.F.: “A few commenters suggested adding the trading expense ratio (TER). We considered these comments, but for simplicity, we have kept the reference to the MER only.”

Fundsellor: How about the real basic stuff? I assume there is no way to get around providing meaningful benchmarks now?

J.F. “A few commenters wanted to see benchmarks added to the performance information. We considered these comments, but based on our principle of simplicity, we have not included benchmarks. “

Fundsellor: You can do that?.....I mean, well done! I don’t suppose you got rid of the risk disclosure as well?

J.F. “The framework contemplates use of the IFIC risk scale at least until an acceptable alternative is developed. “

Fundsellor: Wow, we get to use the risk ranking designed by the companies selling the funds. You guys are amazing! Next you will tell me we can still hide my fees from the investors! Sorry, that might be expecting a little too much. You folks can’t work miracles…..can you?

J.F.: We have removed the adviser compensation section and changed references from “adviser” to “firm”.

Fundsellor: so you mean I can hide behind the firm and not disclose my skim on the fees, great! Hang on. Are you sure the investors won’t figure out that they are paying all the costs for everybody? How did you word that section?

J.F.: “MER: YOU DO NOT PAY THESE EXPENSES DIRECTLY….”

Fundsellor: Wow, you guys couldn’t do better if you had all worked directly for the fund companies and advisors. Just kidding!
I noticed that the asset allocation does not show the split between fixed income, cash, and equities. How can that even be considered asset allocation?

J.F.: “Flexibility will be permitted in certain areas to allow fund managers and insurers to describe their funds accurately. These include:
-the description of the fund’s investments
-providing up to two pie charts for investment mix
-the type of allocation used for pie charts "

Fundseller: Well, thank you to the J.F.er’s on the committee for the great job. I haven’t seen so thorough a review since the Warren Commission looked into the grassy knoll! I only wish I could have smoked the “joint” your committee was named after!

Soismike: Well folks you heard it straight from at least one end of the horse! No full fee disclosure by advisors, no benchmarking, no clear asset allocation, and no proper risk ranking! Thank goodness the industry has regulatory oversight to protect us……Say it ain’t so Joe, say it ain’t so!

soismike

2008-10-18T12:20:00.007-04:00

BUY AND FOLD STRATEGY

While Advisors hide under their desks (OK not all, just most) a huge number of investors will make the panicked decisions necessary to complete the most common of investor strategies “The Buy & Fold”.
The B&F strategy is what I call a “naked cover strategy”! By the time the investor has lost their shirt (the naked part), their Advisor is taking cover ...hiding under a desk mumbling some insane non-sense about waiting out the storm, ( or yo-yo’s walking up a hill, or fund managers are on top of this, or my personal favourite – stocks are on sale)….basically covering their Advisor butts (the cover part) and hoping that you do not call the compliance area to report their idiotic investment strategy . That strategy of course is driven by the Modern Commission Theory (MCT ) and explains how we find a senior citizen with 80% of assets in equities at the top of the bubble!

How Do You Recognize If You Are In A Buy & Fold Investor Strategy ?
First, let me explain clearly, there are no B&F investors, only B&F strategies. Anybody with a bad portfolio can be involved in a B&F strategy. The key is to understand how it starts and how you can recognize the symptoms.

STEP 1: You choose an advisor based upon a recommendation from your buddy/bank/relative who actually know as little as, or less, about investing than you do.

STEP 2: The advisor uses a useless “risk questionnaire” to determine how much high risk equities they can legally push on you without you throwing up in a good market. This is also part of the cover strategy for the advisor and the related brokerage or fund house they are shilling for. You will note the advisor directing you to go up at least one level of risk from your initial thought so you do not get hampered by compliance issues later.

STEP 3: Utilize the MCT to sell you expensive and high risk options that include deferred sales charges (DSC) to ensure a change of strategy does not put future commissions at risk for the advisor. This is important later as you begin to get skittish about your losses.

STEP 4: The next step takes some time. It is the moderate drift in asset weightings to even more equities. In a good market it can be done by being too lazy to rebalance the portfolio. In a slow market it may be by directing new deposits to equities only. This step is vital to moving for example, a 55% equity balanced allocation to a 70%+ equity weighting. The longer you stay with the advisor the more the equity weighting increases and the less the investor asks questions.

STEP 5: The markets begin to drop and become erratic. You see fluctuations that start to erode your gains and come close to threatening your principal. You contact your advisor to see about reducing risk. Your advisor, with a big warm smile assures you now is the time to get aggressive! Yes, equities are on sale!
Chagrined that you had shown weakness, you jump in further and climb on the equity express. Each “dead cat bounce” in the market is another buying opportunity. Now we can often get our equity position up to 80% +.

STEP 6: You’re done. Your money is disappearing daily, you are afraid to open your investment statement, and you have not heard from your advisor in 2 months or more. The “fold” stage unfortunately is where you un-cover the mess you’re in. Your savings are nearly gone, firing your advisor is moot since you can’t find him/her and they do not return calls or emails. The advisor covers their butt, you cover your losses and hope you still have a roof to cover your head!

THE GOOD NEWS: You can bail out at any step. Just because you are in the B&F game does not mean you need to stay with the program until the bitter end. The fastest and least painful way out is as follows:

- Get an independent review of your investment process by a consultant that does not sell securities or work on commission.
- Use a professional service to find a proper advisor
- Get an independent professional to help draw up or review your Investment Policy Statement
- Either you or another independent body need to monitor the performance of your advisor.

One last piece of advice......Tell your advisor that equities are not on sale….new advisors are!

sois mike.....no need to buy and fold now that you've been told!

The Pension Problem: Retiring on Kraft Dinner

2008-10-03T21:38:00.002-04:00

ADVISORS JOIN CORPORATIONS IN KILLING RETIREMENT FOR WORKERS

As manufacturing jobs go slowly down the bowl, a large number of factory workers are being dumped into the investment world with zero support and a larger amount of money to invest than they have ever imagined possible. For most it is the rolling over of the pension plans and for a lucky few it includes a severance package. On the surface this is a positive as in days of old workers were left with little to invest or live on. So what’s the problem you ask?

Many of these workers are doing the equivalent of walking out with a pork chop around their neck to feed the starving jackals. The pork chop is their pension money and the jackals are of course the many advisors chasing the employment ambulance! Let’s back this up a bit though.

EMPLOYERS DUMP THE MARKET RISK ON EMPLOYEES: The workers first began to lose their retirement nest egg when employers switched the onus onto uninformed employees to manage their own Defined Contribution pension plans. Knowing the difficulty the top pension managers have in keeping pensions fully funded, one can assume everybody knew that the workers had little or no chance of having their pension fully funded on retirement. However, not leaving failure to chance, the insurance companies managing the funds ensured employees had a miserable selection of high cost mutual funds or low return money market funds to invest in. In fact I could not imagine a respectable pension fund manager EVER choosing from the selection offered to the employees. To further show the care and concern for employees, millions of dollars in DC pensions sit in money market funds for years with no effort to contact employees and discuss better options.

EMPLOYEES LEFT HOLDING THE MONEY BAG: While a few employees might think they can handle the job of investing their pension over a 30-50 year period, very few actually can. The vast majority are left to wander the streets hoping to stumble onto an honest advisor to help them out. Sadly, many advisors adhere to the Modern Commission Theory and, unlike a true pension manager, they quickly ascertain maximum risk they can get away with and the employee ends up in an equity dominant, high fee managed product. While you might say, why not go heavy on equities when they have a long term investment horizon(?) that would ignore the fact they are nearing retirement, unemployed, and often have debt and cashflow challenges. For many capital preservation and emergency funds are the immediate need. Regardless, the fact is that all of these employees need a good financial plan before anything gets done.

SOLUTION: The solution is obvious and easy to implement. The challenge is that the people who need to help make it work are not focused on the people who are leaving the job.

The employers need to provide training to EVERY employee who is in a capital accumulation plan (CAP Plan) to ensure they have the ability to assess the plan and understand the role they now play in managing money for retirement.

The insurance companies running the plan should offer education in how the plans work, the options available, and most of all the fees. Every pension plan should have an index fund solution with diversified asset classes and auto re- balancing. Insurance companies should be providing options for successful investing, not herding the uninformed employees into fee heavy lucrative fund options.

Last of all, and the most perplexing to me, is the role of the big unions. First you allow the Defined Benefit pension to be bargained away, then you ignore the basic safeguards that YOUR membership needs to protect there interests. Wake up fellows, your membership needs help.

Overriding this whole issue is a regulatory system that truly seems to worry more about the advisors and insurance companies and a lot less about the employee being asked to become an investment manager. So who is going to step up? Self Regulatory Bodies….. OSC, IDA, IIROC, advocis,CSA? I suspect that will happen when pork is airborne.

Okay, this article will no doubt end my hopes for the Leacock award for humour, but remember even funny guys can get peeved when an injustice is in front of you. The economy is squeezing the worker and this is a forewarning that retirees in the next two decades are going to be impoverished if politicians (good luck) do not bring the key parties to the table to balance the risk that is now borne by those who can least afford the impact of that risk.

Retiring on kraft dinner.....SOISMIKE

History Rewritten!

2008-09-22T17:39:00.006-04:00

Watching Wall Street Re Write History
We are fortunate to have a front row seat at one of the greatest historical re-writes in ….. well history I guess! In reality (because reality is so rare when reading about financial issues today) we are an integral part of the re write because without a complacent sheep like investing public it could never happen! Puff out that chest folks, you are a part of smoothing over the biggest fraud in history!

First lets review the key players in the fraud; then we can look at the cameo role we all will play!

The fraud of course starts with the three key ingredients of all good cons: a large dose of greed, a little street smarts, and a whole whack of arrogance!
The initial level of greed is a shared role involving real estate agents, appraisers, and bankers on the street level. Their greed combined with a little street smarts allowed then to con a massive number of homeowners into thinking they could have free money on run down shacks. They however, can only be complicit in the scheme if somebody can get them real cheap money to prime the pump on the scam.

That of course required a higher level of greed and arrogance than we generally find on the street. For that we needed a team approach. Thus we have the lobbyists and politicians to manipulate rates to set up the free flow of mortgage money. The politicians, being of a lower intelligence level, are influenced for minor amounts of campaign donations. In fact the key role they will play is as a fallback position for when the scheme eventually and inevitably must explode.

The arrogance that was so key to the overall success was supplied, for the most part, by the international bankers and investment experts who refused to admit they had no clue what they were buying for their clients. Thus the scheme takes on an unprecedented scope and size because arrogance is an international trait and thus common to all high paid, lazy analysts and rating agencies. In fact, one can hardly assume the scam was ever meant to get so large because it is ridiculous to think anybody could have predicted how arrogant and lazy the world’s investment experts were to become.

Thus a national scam gained speed and became a large scale fraud that now threatens the free world as we know it! (sorry, I have been listening to politicians too much lately). Anyhow now comes our part!
With the crap having been flung from the blades of the fan, the politicians swing into the distraction mode blaming everybody in site but themselves. While they do this the smart guys bail out and cash in their profits and start shorting the companies they financially raped and pillaged to make even more money.

Then when hysteria hits its highest point the cover-up swings into the whitewash mode. Does this sound familiar, “Let’s not worry about who caused this mess, let’s start focusing on what we need to do to fix it!” That is soon followed by the “Big Lie” approach of “this is all caused by a market correction and will soon be OK”. Note this lie must be repeated ever five minutes on BNN and CNN to ensure the sheep (that’s us) understand that the guys who stole all the profits are not responsible.

And finally the finishing touch on the cover up. Let's try this one on for size ;"In fact this whole thing was caused by a social experiment as the government tried to increase social housing to the lower income folks." In fact some hedge fund folks will tell you this whole thing is really a failed government program and all we really need is “less regulations”. So tell you what, since this is all a government problem, really, the tax payer needs to rightfully make sure all the shareholders are protected from the bad investments their companies made. In fact lets let the government buy up all the poison crap we sold and put it in the treasury.

Surely it’s the least the little people (that’s us again) can do to make it up to the wealthy investment bankers who have been so severely impacted by our actions.

For those that faithfully read this blog, you should know that this is a combination of the Modern Commission Theory and the “One is Born Every Day” theory with a hefty dose of steroids thrown in for good measure!
Your wise historian,
SOIS Mike

THE DEATH OF THE MODERN PORTFOLIO THEORY (MPT) AND THE RISE OF A NEW PHOENIX: MCT !

2008-09-13T13:25:00.006-04:00

All theories have a shelf life in the quickly evolving world of investing. The constant dialectic process ensures new theories challenge the old and the better theory survives until a new challenger comes along. Our analysis shows that the Modern Portfolio Theory may well have been trumped by a new challenger!

The Modern Portfolio Theory (MPT) has been a mainstay of the investment management business for some time. It provides a theoretical underpinning for how an investment portfolio should be constructed. It has been considered a “core” investment principle and is part of the curriculum for investment courses taught in our business schools, the CFA program and also in the Canadian Securities Course. While not everybody agrees wholeheartedly with all aspects of the theory, most acknowledge the relevance of the thought process. In short it is mainstream.

Investopedia offers a nice short definition of MPT.
"According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.

In an analysis of the investment portfolios of individual or “retail” investors, you would expect to find significant evidence of MPT in a review of the portfolio construction. However, inexplicably many portfolio show little evidence of the application of MPT, with portfolios lying well off the efficient frontier.

No theory is “static” in the fast changing world of investing. I believe that a new theory needs to be develop that can adequately explain this phenomenon in portfolio construction at the retail level. Hence, I unveil the “Modern Commission Theory” or MCT.

MCT, while not taught in the CSC courses or found in any investment textbooks, appears to be the chief operating theory guiding many of the financial advisors in the retail investment industry. It is a concept learned strictly through mentorship and on the job experience, with no text books available. The fact that the theory has been adopted by so many sales advisors is due to the enlightened self interest that is so inherent in the theory and rampant in the industry.
The definition of MCT is as follows:
“According to the theory it is possible as an advisor, for each client , to construct an optimized portfolio of securities such that commissions can be maximized for any given set of investment objectives, account size and investment knowledge”

While it requires a strict discipline and a great deal of research and knowledge, a maximum commission opportunity is available for every security type and asset class. Portfolios utilizing the MCT strive to attain the efficient commission frontier; where no further fees can be derived without increasing the time spent with a client!
In its highest and purest form of application the fees and commissions are opaque and can only be determined and measured with the highest level of investigation and analysis. Fees and commissions at the top level should be buried in complex terminology and where possible inserted deeply into the most complex prospectus.
Under the broad theory of MCT, there appear to be a number of principles uncovered that are used with great effectiveness by advisors as they strive for the optimal MCT portfolios.

1.The most complex products with the most confusing and opaque fee and commission structures should be sold by advisors to the least knowledgeable investors. As such investors with limited knowledge should be sold Principal Protected Notes (PPN), Guaranteed Minimum Withdrawal Benefits (GMWB) variable annuities, and other financially engineered products, wherever possible. Let’s face it stocks, bonds, and preferred shares are getting to be too well understood.

2 Wherever possible the wealth should be shared through the use of managed products. Rather than manage a portfolio directly as old world stock brokers and advisors did, you should sub-contract the portfolio wherever possible. Managed solutions such as funds of funds and wrap accounts do a nice job of layering fees. We call it the “team approach”.

3.Intergenerational investing is important. Where possible DSC accounts should have 10% a year removed from the initial fund and reinvested in another DSC fund (the son). The following year you repeat the process and create the third layer or grandson of the original DSC. Who says diversification can’t be profitable for all.

4. Structured products should be the mainstay of an optimized MCT strategy. By their very nature they are sexy, confusing, and best of all they provide great opportunity to increase fees and hide costs and risks.

A word of caution however is worth noting. As with all new theories, some of the dinosaurs are not on side (did I say’ buy and hold’, value, GAARP) and more seriously a few rogue advisors are promoting a counter theory.

Beware the “indexers”! Clearly unaware of the personal satisfaction built into the MCT, they preach low fees and greater diversification. I caution you because opening the door even slightly to index funds will knock you off the maximum commission frontier line. In fact a whole portfolio of index funds may actually cause the portfolio to spontaneously combust and burn up all the fee gains driven through diligent application of the MCT.

Similarly beware the fee based and fee only advisors for they can also erode the key principals of MCT unless corrective commission tactics are embedded in the processes.

Fortunately the indexers are few and the commissions are many. I am convinced the MCT will prevail,after all, haven’t we been able to maintain the worlds highest MER’s inspite of all those annoying investor advocates! Stay the course and MCT shall emerge as the accepted theory by all self aware advisors!

As with all new theories, the idea has not been fully explored to date. But we are just at the start of a great new world of structured commissions…er products that promise to take advisors and their companies to a new revenue high.

Like the original works of MPT by Markowitz,was expanded on by William Sharpe and Merton Miller who all eventually shared a Nobel Prize: I believe that the theory of MCT will be expanded on in years to come and if nominated for the Nobel Prize, I would honorably accept it. I would also be remiss if I did not acknowledge the efforts of my predecessors for their pioneer work on the theory. Special acknowledgement to P.T. Barnum and his work on the “One is born every day” theory!

Note* The above article may contain traces of sarcasm and a heavy dose of reality.

SOIS Mike

BUILDING A HOUSE OR A HOUSE OF CARDS?

2008-08-08T14:05:00.002-04:00

BUILDING A HOUSE OR A HOUSE OF CARDS?

In reviewing portfolios I have noticed that client issues are most often concerned with the performance of an individual security….or several individual securities. It obviously makes sense that a security that you own will catch your eye when it is dropping in value! The main challenge with this approach to portfolio management is that the damage is most often done long before the security caught your eye!

You are not an insider and neither am I. If we were we would be filthy rich and not overly concerned with our daily or quarterly portfolio movements. The investment professionals are the first ones in on a good thing and the first ones out when things go wrong. That’s where the expression “buy on rumour and sell on news” comes from. In fact, unless you are a full time and well networked analyst, you are unlikely to ever get a truly worthy stock tip. The way we small investors can make money in the market, is through two key rules: never chase last year’s winners and always look at the big picture.

The first is obvious. If you never listen to the "Mad Money" or read the business section of the paper and if you ensure that on pain of death you never attend an investment seminar, you should be well on your way to success. Money is made by working hard, saving your spare cash, and investing over long periods of time in quality investments. The secret is to understand that the quality investments are only the building blocks in the big scheme of investing.

Your portfolio needs a good architect if it is to survive in tough times as well as thriving in good times.
Building on the architect theme, your house is designed to look great and meet all of your functional needs with windows, a furnace, plumbing and all the services and rooms you require. But the builder did not just drop by the hardware store and see what was on sale or what paint is the latest hottest colour (hopefully). They filed a plan of subdivision and the building design had to be approved to ensure the house was safe. Then they hired skilled trades to ensure the plans were followed and everything was within the building codes. Your portfolio is built exactly the same way, or at least it should be.
Unfortunately, many portfolios are built from a series of security purchases based upon what is hot today. If kitchens are not big winners with buyers lets not put a kitchen in the house, ditto for bathrooms that just need to be cleaned regularly. Sounds crazy but look in some portfolios and you see huge gaps in the basic asset classes because they were not in favour, were not sexy enough, or simply did not pay the advisor enough commission.

To get specific:
-think of cash as being the furnace and electrical components of the house. Flexible in that they are not always needed, but important because when you do need them you need them at the flip of a switch.
- lets look at fixed income as the foundation and basement of the house; a solid foundation that assures no matter how bad the weather, the house is not going to blow away or float away!
- equities are the siding, the landscaping, the paved drive, the Jacuzzi tub, the chandelier. They are the portion that gives the place curb appeal and provide pride of ownership. Quality equities are often the difference between successful portfolios and drab portfolios. They give your portfolio the lift that allows you to hold inflation in check and build that new addition on the house.
- alternative investments are the four car garage with a Porsche and a BMW. You do not really need them but if you can afford the cost then live a little and spend your mad money! Who know they may become classics and go up in value!

Okay, that’s a bit of a stretch, but you definitely need to have a portfolio that is built with sound planning and that includes the five basic asset classes: cash, fixed income, Canadian equities, U.S. equities and Global equities. You need them in the correct proportion and you need to understand the purpose they serve.

When you are buying a new investment you need to ask yourself, which asset class should I be looking at and what purpose is the investment going to fulfill. There is no sense buying a door when you need a window! Similarly there is no sense buying an equity when you need a bond! Do not get carried away worrying about what security to buy until you know what asset class you should be shopping for!

SOIS MIKE

BUY OR SELL SOMEBODY WINS AND LOSES

2008-07-24T21:25:00.000-04:00

YOUR BUY IS MY SELL!

I had an interesting discussion with my broker today about a stock that was underperforming the expectations we had when we bought it. Coincidentaly at the same time I was reading an analyst review of the same security in the newspaper. It got me to thinking about how the industry handles analysis and recommendations on securities.

Let’s say you work with a portfolio manager who has every initial after his name. Your portfolio is a diversified mix of 30 securities. Your portfolio manager/advisor has 120 clients; all unique just like you! Allowing for overlap, your advisor needs to track and analyze say about 125 securities. If each security is given 5 hours of review quarterly that means approximately 2500 hours of work! Of course, you want your advisor looking at new securities and opportunities too, as well as meeting with you quarterly and of course she needs to prospect for new clients to stay in business. It becomes clear that analysis is truly a full time job for the research team not the advisor!

That is why they have specialists who utilize their CFA degrees and statistical skills to probe deeply into each security in a given sector. Far from your advisor being a one person show, they have the benefit of the brilliant minds and skills of all the top analysts. That obviously explains why we never lose money on a recommended stock selection! Just kidding folks.
With all the geniuses burning through the data and a skilled advisor reviewing the data it’s just like having a guarantee of performance! So why doesn’t it work that way? Well we all can make a mistake so maybe it’s not so much a guarantee as an extremely likely outcome that we will not lose money! Okay, that’s not really how it seems to work either…..what gives?

Well to get back to my discussion with the advisor; after a lot of discussion over several months we finally decided to unload a phone stock that was not adding value. The advisor had done their homework and provided the research results from the in-house sector expert who after following the stock for years had finally put up the sell sign. We were getting out with a small loss and a couple of years wasted.

What was interesting is that the newspaper I was reading was quoting a telecom analyst of some renown who had just reviewed the stock in depth and switched from a “hold” (industry code for a sell recommendation) to a vigorous “buy”. Hang on folks; they reviewed the same material, used the same math, and likely have the same accreditation. So how does it end up that they both come to the decision they had previously been wrong and it was time for a change in recommendation? And then, they both come to the exact opposite decision from the same data!

Just think; one of them will be considered brilliant and one will be considered a moron! Which one am I listening to? Well the obvious answer to those who know the industry is that they are both wrong! The data is obviously not clear and both are making bets on how things will end up. The thing is they are betting with my money and your money! The investor is the pawn in the game; the sucker with the money in many cases.

So who wins? Well the security industry wins of course. I sold and thus generated a commission and somebody bought my security based upon the opposite analysis and paid a commission. So are the analysts and brokers in cahoots to get our money? Not really. They all think they are right and they all think they are helping us get rich!

In six months I will let you know how it comes out! Until then I will keep reminding myself that my advisor has guessed right more often than not. How do I know that? Look up composite benchmark and then start tracking the performance of your advisor. Hopefully my advisor is doing the same with her researcher! As my friend John Home says, “You get what you inspect; not what you expect”!
Tracking results, SOIS MIKE

GAFFLEGAB COSTS MONEY

2008-07-04T16:32:00.000-04:00

Today we are going to talk about how the challenges of today will inspire the financial wizkids of tomorrow! Most recently we have felt the impact of the "skill" or perhaps more appropriately, the "cunning" of financial engineering. The increase in "structured" solutions has come at a tremendous cost as we have all seen with the Sub Prime situation and ABCP fiasco.

While rationale minds might think that would lead to the sale of more "vanilla" securities like stocks and bonds and Index funds, that is not likely to happen any time soon. Financial engineering is "industry speak" for hiding the fees behind the concept. So whats coming next.....

What will actually happen is that the financial "engineers" will construct more of the same structured stuff that got us into trouble today! If real engineers and construction firms worked the same way as financial engineers, houses would be falling down all around us as I write. But one needs to assume we are not crazy enough to buy the same risky securities as the ABCP and bad mortgage products we bought; so this time around the engineers will have a whole new approach to the products. Look for the word "GUARANTEED" to become prevalent in the sale of the "new" structured products! Having just been burned they know we are all looking for a "sure thing" before we dip our investing toe back into the shark tank.

How will they manage this engineering feat? Think of a rundown dilapidated house, but with a new coat of paint and new vinyl siding! The risks and future repairs are hidden by the cheap covering to provide a sense of quality that is not there.

Securities are actually quite basic. They are investments upon which you earn a rate of return determined by rent and risk.
Rent is the return you could get from a zero risk investment such as a short term government guaranteed treasury bill. That is known as the "risk free rate of return".
The "risk" portion is the additional return you get for accepting volatility and some amount of uncertainty in your return. As an example with bonds that risk portion would be the credit risk of the issuer and the impact of interest rate changes on the bond value.

So, if somebody is offering you returns above the risk free rate, and suggesting you have a guarantee, then where did the risk end up? The return over and above the T-Bill rate means there is risk, but the guarantee means somebody else is taking the risk for you! Sounds great! So, just one question(?) what are they getting in return?

Well, for the most part they are getting a significant chunk of the return you might think you will be getting! The neat thing, for the engineers, is you are the only one putting money into the proposition! They are taking a per cent of your positive returns and none of the negative returns because the guarantee is paid for from your deposit. Perhaps now you can see where the cunning comes into the equation!Perhaps these products need to come with a warning on the label:

CAUTION: Guarantees may significantly reduce the value of your investment while drastically increasing your costs!

While that is never likely to happen, the real disgrace is that these products will be sold to those seeking the least risk and who can often least afford the costs.

So what should you be watching for:

Guarantees: Unless you are buying a bank GIC with CDIC coverage or a short term Government Bond, do NOT ever trust a guarantee.

GaffleGab: If you do not understand a product, do NOT think it is because you are stupid. There is a great chance the confusion is intentional and a pretty good chance your advisor does not really understand it either.

Fees: Structured products are often designed to hide fees. Ask for a clear description of all fees in writing from your advisor along with comparable fees without the guarantee. In fact ask your advisor why they can not create the same product for you from standard easy to understand securities.

The attached leads to a great Ken Hawkins article on structured products for those wanting to learn more!

sois mike

http://www.investopedia.com/articles/financial-theory/08/structured-products.asp

If the article does not open when you click the address, paste the address in your browser

Its Not A Lie If My Fingers Are Crossed

2008-06-28T14:51:00.000-04:00

I can remember playing around as kids with my brother and sisters. Our general rule was "it's not a lie if your fingers were crossed when you said it". Of course, as kids our little white lies did not have the power to destroy wealth or mislead strangers. It was more likely to involve who took the last cookie or who left the milk out.

As we read through the tangle of information and dis-information from those selling securities, the little errors of ommission or implied information becomes a much bigger risk to investors.

A great example was exposed in the recent article by Rudy Luuko in the Toronto Star this week. For those that follow Mutual Funds, Mawer has been a great company that delivers on its promise of quality investing at a reasonable price. While many firms have partnership agreements, one of the Mawer partners sells what is basically the same fund as Mawer sells, but at a much higher MER. That higher management expense ratio funds a bigger trail of commissions back to the advisor. So once more the advisor has a choice: I can sell you the Mawer funds directly from Mawer at a low investor cost, or I can make a big commission by having my client buy the same fund through a partner firm. Hmmmm, I wonder how the disclosure works on this sale.

My guess is that the advisor crosses her fingers and says this is a great company with a great track record and maybe just forgets to mention the investor can buy the fund a lot cheaper if the agent looked past self interest and focused on wealth building for clients. For those who think maybe this is an isolated situation, please refer back to the sale of DSC style funds. The concept is the same. WHAT THE INVESTOR DOESN"T KNOW DOES HURT THEM!

Sois Mike