Friday, July 18, 2014

Short Takes: New Advisor Disclosure Rules, Investment Fee Questions, and more

Here are my posts for this week:

Does the Value Premium Exist?

The Glass Ceiling

Here are some short takes and some weekend reading:

Preet Banerjee explains new disclosure rules for financial advisors that will come into force in 2016 including dollar amounts of fees. He predicts that Canadians will be “shocked” at how much their investment advice costs. I hope so.

Tom Bradley at Steadyhand answers a list of questions about investment fees. Investors would do well to get their own advisors to answer this list of questions.

Gail Vaz-Oxlade says that while economists say we’re in a low interest rate environment, a great many average Canadians pay high interest rates on their debt.

Big Cajun Man reviews William Bernstein’s short but very good book If You Can.

Million Dollar Journey says you should think twice before getting a mortgage with one of the big banks.

My Own Advisor is a fan of staycations. I like to spend some vacation time around home in the summer, but once it gets cold, I like to travel somewhere warm.

Wednesday, July 16, 2014

The Glass Ceiling

“Glass ceiling” refers to the invisible barrier that holds women back from rising in management. I’ve read many opinions on this subject, some sensible and some less so. Recent remarks by Sherry Cooper, outgoing Bank of Montreal chief economist, paint a picture of a corporate environment that differs sharply with my own experience.

Coopers remarks are from an article based on her CBC interview. Here is part of what she had to say:
“No one ever considered I could be in training for a C-suite job in the bank.”

“It’s not that I aspired to be a CEO. It’s just that I was never even considered in that role.”
To me, these remarks paint a picture of many high-level bank employees working hard, doing their best for the bank, and waiting to get noticed. Maybe Cooper didn’t mean them this way, but I know many people who think corporate environments work this way. My experience has been much different.

I’ve spent most of my career in high-tech reporting to high-level management. But I was a technical person and not in management myself. So, I got to observe CEOs interact with their direct reports without getting caught up in the fray very much myself.

I would characterize the climb to the top as a bunch of intelligent psychopaths playing an adult high-stakes version of king-of-the-mountain. I’m not just saying this for effect. Let me explain.

I use the word “psychopath” to mean a personality type I saw frequently. These are people who are indifferent to the happiness or suffering of others. They don’t enjoy hurting people. As a matter of fact, they seem not to notice or understand the feelings of others. They can scream at someone and then be baffled when that person leaves crying. There were others who did seem to understand others’ feelings, but they used this knowledge to manipulate rather than to create a pleasant work environment.

King-of-the-mountain is a child’s game where one child climbs to the top of a mountain of snow and declares loudly that he, usually a boy, is the king of the mountain. Then many other children begin climbing the mountain to first shove the king off and then shove each other off. Hilarity and concussions ensue.

When I hear someone complain about not being considered for promotion, I imagine a child standing beside the mountain of snow waiting to be acclaimed as king while the other children are violently throwing each other down.

Of course, the adult version of king-of-the-mountain is much more subtle than the child’s version. There certainly are frantic periods where executives get fired. But mostly there is relative calm where everyone is lining up their strategies to get each other fired. Some CEOs will fire potential rivals, but mostly they try to keep everyone in line with the promise of excessive bonuses and stock options.

I have some sympathy for low- and middle-level employees who get passed over for promotion for unfair reasons. This can happen due to gender bias, racial bias, or a whole host of reasons that affect both men and women. However, those aspiring to a top-level position need to roll up their sleeves and join the rest of the mostly anti-social executives in their slug-fest.

Monday, July 14, 2014

Does the Value Premium Exist?

Many investors take it as fact that small-cap stocks earn higher long-term returns than large-cap stocks, and that value stocks earn higher long-term returns than growth stocks. This belief originates with work by Fama and French on their 3-factor model of stock returns. The evidence that a small-cap premium exists is compelling, but not so for the value premium. Whether or not these premiums exist affects the choice of ETFs for an indexed portfolio.

John Bogle discusses growth vs. value stocks in the final third of an excellent speech in 2001. In it he observes that the Fama and French conclusions are based on stock market data from 1963 to 1990. It turns out that the size and even the existence of a value premium is period dependent.

Bogle extended the period of study to 1937-2000 and found the average annual compound returns to be 11.8% for growth stocks and 11.9% for value stocks, hardly a significant edge. You may ask what happened from 2001 to 2013. According to Standard and Poors, value stocks won by a little over half a percent per year. So, there was no statistically significant value premium in U.S. stocks from 1937 to 2013.

There certainly were periods where either value or growth stocks had a large advantage. However, unless an investor can predict whether a given future period will favour growth or value stocks, these swings are of no use.

Some might object that investors like Warren Buffett proved that value stocks are superior. This is a different situation altogether. Bogle, Fama, and French are comparing all value stocks to all growth stocks. But Buffett sought to own only those stocks he believed would outperform. Value investing through stock-picking is very different from an index strategy where the investor chooses to own all value stocks.

Implications for index ETF portfolios

In my own portfolio, I’ve chosen not to tilt toward either value stocks or growth stocks. I do have a modest tilt to small-cap stocks over large-cap stocks. I prefer Vanguard Canada’s fund VCN over the iShares fund XIU because VCN contains some small-cap stocks.

In the U.S., I prefer Vanguard’s VTI, which represents the entire U.S. stock market, over funds that hold just the S&P 500. In addition, I own some of Vanguard’s VB fund, which holds U.S. small caps, to add an extra small-cap tilt.

As always, I don’t think anyone should follow my choices blindly; think for yourself. That said, hopefully this discussion of how I bet my own money carries more weight than some pundit’s “investing ideas.” Comments and constructive criticism are most welcome. There is too much at stake when investing to ignore useful ideas.

Friday, July 11, 2014

Short Takes: Unsustainable Income Funds, Bonds – Ontario vs. Italy, and more

Here is my only post for this week:

Target-Benefit Pension Plans: Pros and Cons

Here are some short takes and some weekend reading:

The Wealth Steward names monthly income funds that have unsustainable payouts. Many such funds have already cut their payouts. Some retirees want high monthly income so badly that they look past obvious signs that not only will their income not rise with inflation but will get cut even in nominal terms.

Tom Bradley at Steadyhand compares bonds from Ontario and Italy. Unfortunately, Ontario doesn’t come out too well.

Sandy Martin takes Advocis to task for implausible claims about what will happen if advisor compensation is banned. “You know what banning embedded commissions will do? It’ll end the illusion that advisors on the commission system are anything more than salespeople.

Rob Carrick explains the necessary evil of repeatedly negotiating package costs for television, internet, home phone, and wireless.

Canadian Couch Potato profiles Vanguard’s new All-World ex Canada ETF (VXC). It looks a little expensive for RRSPs and TFSAs. The MER is about 0.3%, but there are also some added withholding taxes that amount to about 0.45%. He also explains that he will be making some changes to his blog’s look as well as using a new subscription service to replace Feedburner. This makes me nervous because it seems that I will likely have to do something similar myself (shudder).

Big Cajun Man got caught by a subtle difference between insurance companies about how they apply the rule that they only pay for one pair of glasses every two years.

My Own Advisor reviews a very short but excellent book by William Bernstein called If You Can: How Millennials Can Get Rich Slowly.

Tesla Motors announced that they hit the 1 GWh supercharging milestone. I wasn’t even aware that this supercharging network existed. They seem to be pressing close to the point where electric cars are practical for typical consumers.

Thursday, July 10, 2014

Target-Benefit Pension Plans: Pros and Cons

The C.D. Howe Institute published a well-written report on Target-Benefit Pension Plans that explains how they differ from traditional Defined-Benefit (DB) and Defined-Contribution (DC) plans. Target-benefit plans solve a number of the problems with DB and DC plans, but they have some serious challenges as well.

Defined-Benefit (DB) pension plans push all of the risk onto employers who have to provide predictable benefits. Employers must shoulder the risk that investments may perform poorly, forcing them to make large contributions.

One problem with some DB plans is that they use unrealistic assumptions about future returns to reduce today’s contributions. This can lead to chronic under-funding. Another problem with some DB plans is they use unrealistic actuarial information. Effectively, they assume people will die younger than they actually will. This leads more under-funding problems.

Defined-Contribution (DC) pension plans push the risk from employers to employees. The employers know exactly how much they will have to contribute each year, but employees cannot predict how their savings will grow, and certainly cannot predict their future pension payments.

Even worse, DC plans create a risk that wasn’t present with DB plans: longevity risk. A given employee cannot predict how long he or she will live and must either underspend or take a chance on not living past the average lifespan. With DB plans, this risk gets diversified away, but with DC plans, employees must choose between frugality early in retirement or potentially running out of money late in retirement.

Target-Benefit Plans eliminate many of the disadvantages of DB and DC plans. Employer contributions are predictable within certain ranges. Whether benefits rise by more or less than inflation is determined by how well investments perform. So, employees take on some risk, but longevity risk is eliminated.

A big concern for Target-Benefit Plans is potential influence by employers or employees on how plans are run. If competent, well-meaning people choose investments and choose actuarial tables, then Target-Benefit Plans look like a great solution to difficult problems.

However, employers and employees would have strong motivations to influence how these new pension plans are run. If an employer can get the pension plan to use unrealistically high investment return assumptions, the pension plan will be chronically underfunded. This saves the employer a lot of money, and employee benefits will fail to keep up with inflation. Similarly, employees could get benefits rising faster than inflation if investment return assumptions are too low.

Another way employers and employees could influence the pension plan is through actuarial assumptions. Employers would prefer to assume we all die as young as possible to reduce the size of their contributions, and leave employees with benefits trailing inflation. Employees would prefer to use actuarial tables that assume long lives to increase required employers contributions and increase employee benefits.

Another risk is the growth of expensive administration for the pension plan. With DB plans, expensive administration leads directly to employers having to make larger contributions. With Target-Benefit Plans, the cost of bloated administration comes out of employee benefits. Usually, employers are in a better position to control administrative costs than employees are.

I don’t think it is overly difficult for competent independent people to handle investment return assumptions and actuarial tables fairly. The problem is that there are billions of dollars at stake, and employers and employees will be very strongly motivated to influence how Target-Benefit Plans are run.