Friday, September 28, 2012

Short Takes: Paying Tax Snitches, Aligning Interests in Mutual Funds, and more

The Blunt Bean Counter makes the case for CRA adopting an IRS-like whistleblower program that pays tax snitches a fraction of recoverd tax money.

Steadyhand employees show that their interests are closely-aligned with their clients by having 81% of their collective personal assets invested in their funds. Incentives matter and this says more about their commitment to achieving good long-term results than any marketing message could.

Canadian Capitalist asks whether we should care that ING Direct is now owned by Scotiabank. I doubt it will make much difference in the short term, but over the long term it seems certain that the reduced competition will be bad for consumers.

Money Smarts says that the new rules for disclosing advisor trailer fees to mutual fund investors aren’t likely to make much difference. I agree that it is always possible to hide information in confusing account statements, but I’m happy to have this disclosure anyway because it will be relatively easy for honest advisor firms to comply and will complicate life for firms that choose to try to hide this information from investors.

My Own Advisor gave some highlights from the 2012 Canadian Personal Finance Conference (CPFC) held recently in Toronto.

Million Dollar Journey reports on a credit card that offers more cash back for online purchases.

Big Cajun Man has a list of the worst 4-digit bank card PINs and connects it to a funny clip from the movie Spaceballs.

Wednesday, September 26, 2012

Efficient Market Hypothesis

In simple terms, the efficient market hypothesis says that there is no better measure of the value of a stock than its market price. In his 1988 letter to shareholders, Warren Buffett ridiculed academics who cling to efficient market theory in the face of decades of market beating returns by Buffett and his mentors, saying “apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.” This debate rages on with one side insisting markets are efficient or nearly so, and the other side dismissing efficient market theory. However, this debate is mostly pointless. On its own, it makes little sense for the stock market to be efficient or not. It can only be efficient with respect to some observer. This means that the market can appear to be efficient to one investor, but not another.

To explain what I mean by market efficiency being dependent on the observer, consider a simple example of a coin toss. To most observers, when the coin reaches its maximum height, the probability that it will come up heads is 50%. However, an observer with a high-speed camera connected to a computer running an algorithm that analyzes the coin’s velocity and spin might be able to determine at the coin’s maximum height that the probability of the coin coming up heads is 55%. So, who is right? Is the probability 50% or 55%? The correct answer is that the probability is different for each observer.

Buffett talks of a stock’s intrinsic value. This is essentially an investor’s estimate of the value of a share. When an investor, such as Buffett, is able to calculate a better estimate of a stock’s value than the market price, he is able to use this information to get market-beating returns. He doesn’t have to do this for all stocks; he just has to be able to do this for a few stocks and to know for which stocks he has a good estimate of intrinsic value.

The vast majority of investors, including me, are not able to produce estimates of a stock’s intrinsic value that are better than the stock’s market price. In a sense, this is saying that we’re not smarter than the collective market of investors. Share prices are a worldwide dollar-weighted consensus of the intrinsic value of stocks. Viewed this way, it isn’t surprising that few investors can calculate a stock’s intrinsic value better than the market can. This doesn’t mean that no investor can have an expectation of beating the market; it only means that this ability must be rare.

So, the market looks efficient to most investors, even if their overconfidence makes them think otherwise. Buffett has proven in the past that the market looked quite inefficient to him. With his huge portfolio and shrinking universe of businesses large enough for him to invest in, my guess is that the market looks more efficient to him with each passing year.

Tuesday, September 25, 2012

ETFs Offer a Wide Range of Investing Approaches

With the ETF industry producing new products at a furious pace, investors can implement a wide range of investing and trading strategies using ETFs. Unfortunately, most of these strategies are a bad idea.

It used to be that investing in ETFs was synonymous with widely-diversified passive investing. Investors could buy XIU for Canadian stocks, VTI for U.S. stocks, and maybe a couple of others for bonds and foreign stocks, and then go to sleep for a decade. However, new ETFs are nothing like these older products.

Investors who have been unhappy with their mutual fund returns can now bring their faulty investing strategies into ETFs. Many mutual fund investors used to chase the previous year’s hot fund with disastrous results. Now they can bring new hope to the ETF domain and chase the latest hot ETFs.

Investors who used to try to guess the next hot sector using mutual funds can now do the same with ETFs. Unfortunately, most of them will just buy the sector hottest in the recent past (and now expensive) regardless of whether they trade mutual funds or ETFs.

Many good ETFs help investors by having lower MERs than mutual funds. However, investor behaviour can easily eliminate this advantage. Frequent trading drives up commission costs as well as the less visible bid-ask spread losses.

Better investing comes from better strategies. Moving the same failed investing strategy from mutual funds to ETFs will lead to disappointment. The cost difference between mutual funds and ETFs is significant, but the difference between good and bad investing strategies is much bigger.

Friday, September 21, 2012

Short Takes: Mortgage-Breaking Costs, New Mutual Fund Disclosure Rules, and more

Lenders can really stick it to you if you have to break your mortgage. Take a look at this list of some of the exciting ways that lenders pump up mortgage-breaking penalties. If you think you’re safe because you have a variable mortgage, you’d better take a look. The bottom line is that you should really understand your mortgage contract before signing.

Steadyhand is one fund company with a positive view of the new disclosure rules for mutual funds coming from the Canadian Securities Administrators (CSA).

Larry MacDonald makes a strong case that a lasting solution to the battle between teachers’ unions and governments is a voucher system that allows parents to bring their share of school funding to the school of their choice. I would love to see a system that subjects teacher pay to market forces. Any system that brings higher pay for good teachers and lower pay (or no pay) for poor teachers would be a big benefit.

Canadian Couch Potato explains foreign withholding taxes. This subject is likely more complex than you realize.

The Blunt Bean Counter explains why your net worth statement may look a lot better than it really is.

Big Cajun Man takes a run at defining what it means to be debt-free. It’s not quite as simple as it seems.

Million Dollar Journey explains housing co-ops.

My Own Advisor explains his approach to saving money on car insurance.

Wednesday, September 19, 2012

Just Close Your Eyes and Swing

“Taking investing advice from a Wall Street firm is like getting hitting tips from the opposing team’s pitcher.” Michael James
Years ago I thought I understood the mechanics of investing. You had a broker at some big financial firm who took your trades and gave you advice on trading stocks and bonds. The first time I found out that these same firms also have people who do trades with company money, I couldn’t understand how this could be anything but a huge conflict of interest. But, I assumed that I just didn’t understand some critical aspect of this relationship.

Enough time has passed that I now realize that I wasn’t really missing anything; there is a conflict of interest. There may be rules or laws intended to prevent abuse, but there remains an incentive for financial firms to advise their clients to trade the opposite sides taken by their internal traders. For example, if the company is trying desperately to unload a pile of XYZ stock they believe is about to tank, one way to find enough buyers is to advise their clients to buy XYZ stock.

Given this misalignment of interests, why do so many people take investing advice from financial firms that trade on their own accounts? How do they tell whether they’re getting the investment equivalent of “just close your eyes and swing”?

Tuesday, September 18, 2012

Bodie and Taqqu Collar Chokes Investment Returns

Recently, Drs. Zvi Bodie and Rachelle Taqqu wrote an article in the Wall Street Journal calling on investors to avoid stock market risks. In one example of a way to limit risk, they describe a method using stock options to create a “collar” to limit stock losses. I decided to back-test this idea to see how it would affect investor returns.

In Bodie and Taqqu’s example, they assume an investment in the exchanged-traded fund SPY which tracks the S&P 500 (stocks of the biggest companies in the U.S.). At the time of their writing, a share of SPY was trading at $136.41. You could buy a put option at $116 to limit losses to about 15% over 4 months. To avoid being out the cost of this put option, you could also sell a call option at $143. These strike prices were chosen so that the call and put had the same cost and you weren’t out any cash. The result is that if you use this collar, over the next 4 months you can’t lose more than 15% on your SPY investment and can’t make more than 4.8%.

If these caps on your upside and downside seem a little unbalanced to you, I agree. I decided to dig up some historical S&P 500 stock returns and see what a collar like this would do to returns. In a first experiment, I used 42 years of S&P 500 data starting in 1970. I ran one portfolio without a collar and another with a collar from -15% to +4.8% on the capital appreciation (or depreciation) every 4 months. Both portfolios received dividends. The results for the collar were dismal. Without the collar you end up with $572,000, and with the collar you end up with only $14,400. That’s nearly 40 times less money!

However, this is likely not a fair test because in times of higher inflation the collar was likely shifted a little toward positive returns. In another experiment, I assumed that the collar shifted up when inflation was higher. Essentially, this places the collar at a fixed position in real terms (after inflation). The following chart shows the growth of $10,000 with and without this collar.


The results for the collar are still dismal. Instead of $572,000, you end up with only $67,800. This is a huge price to pay for the comfort of limiting your downside to 15% every 4 months. The collared portfolio only beat inflation by an average of 0.3% per year. In contrast, the S&P 500 beat inflation by an average of 5.5% per year.

The collar that Bodie and Taqqu propose may sound like a good way to protect your portfolio, but you’ll pay a very high price for it over the long run.

Friday, September 14, 2012

Short Takes: ETF Liquidity, Protecting Canadians from TFSA Mistakes, and more

Canadian Couch Potato explains that investors concerned about ETF liquidity should focus less on daily trading volume and more on bid-ask spreads.

The Blunt Bean Counter says Canadians are still running afoul of TFSA rules, and he has some suggestions for CRA and financial institutions to help Canadians avoid penalties.

Rob Carrick says that if you’re in debt, your biggest risk is unemployment rather than rising interest rates.

Mr. Money Mustache does a good breakdown of the cost of owning and operating an electric car.

Big Cajun Man defines what he wants out of retirement. I guess the next step is to make a plan to get there.

Money Smarts answers a reader’s RESP questions.

Wednesday, September 12, 2012

Are You Smart Enough to Work at Google?

Today’s tough job market allows companies to put prospective employees through the wringer in interviews with little fear that they’ll leave in disgust. Imagine a company asking you back for 5 interviews and then rejecting you. Or imagine being asked how you would go about weighing your own head. These are a couple of the things that William Poundstone describes in his excellent book Are You Smart Enough to Work at Google?

On one level, this book is a collection of questions that interviewers ask during interviews. Some questions are difficult puzzles with an objectively correct answer. For example, suppose that eggs thrown out of a 100-story building always break when thrown from a particular floor or higher and never break when thrown from lower floors. You are given 2 eggs and may retrieve an unbroken egg after a throw, but a broken egg can no longer be used. Yo are to devise a strategy that determines the highest floor from which eggs don’t break. Your goal is to minimize the maximum number of egg tosses required. In the calm of my own home I was able to solve this one after a while, but I could easily see most candidates flailing around during an interview unable to think straight.

Other puzzles are designed to see whether you tend toward technical solutions or pragmatic solutions. For example, suppose you want to know if Bob has your correct phone number. You can send a note to Bob through an intermediary Eve. Eve will take your note to Bob and return Bob’s response without changing either note, but she will read them. If you don’t want Eve to know your phone number, what message do you send to Bob? One answer is to use public-key cryptography and to send Bob a public key, and ask him to send back an encrypted copy of your phone number. A more pragmatic solution is to tell Bob to phone you with the number he has for you. Which answer impresses an interviewer the most depends on the interviewer and the culture of the employer.

This book isn’t just a list of puzzles, though. Poundstone gives a lot of insight into the kinds of employees different companies want. For example, Google values pragmatic solutions to problems and likes solutions that make use of their massive databases built from user search data.

The book includes an answer section for the puzzles, but the answers given aren’t always the best available. For example, Poundstone’s cryptography-based solution to the phone number puzzle above is insecure. Another puzzle asks how you would use a fair 5-sided die to decide which of 7 people gets a prize assuming that the choice must be random and fair. There is a more efficient solution than the one given in the book.

Overall, I enjoyed this book and recommend it to anyone who likes puzzles, is interested in the corporate culture of various large companies, or who expects to be interviewing and would like to be prepared for some tricky questions.

Monday, September 10, 2012

Light-Speed Traders Compete for Your Pennies

Wired Magazine had an interesting article recently: Raging Bulls: How Wall Street Got Addicted to Light-Speed Trading. It tells the story of how quant firms compete over fractions of a penny per share in computer algorithm trading. They go to great lengths to shave milliseconds off computer communication time to get an edge on their competitors. This article gives some insight into where your trading spread losses go.

To get their trades executed as quickly as possible, high-frequency trading firms go to great expense including buying up land allowing them to install shorter fiber-optic cables, and in the future “A fleet of unmanned, solar-powered drones carrying microwave relay stations could hover at intervals across the Atlantic.” They do all this to grab fractions of pennies faster than their competitors.

All this raises the question: whose pennies are these quants fighting over? To some degree they are stealing from each other, but they are also taking pennies from couch potato investors like me. If you use your 2012 maximum RRSP contribution of $22,970 to buy the exchange-traded fund XIU, you could buy 1300 shares (at the current price as I write this article). The bid-ask spread is one penny. This makes the total spread $13. With each trade you lose roughly half the spread, which makes 650 pennies for the quants to tear apart and gobble up.

Looking over my trades for the past year, I donated about $96 in spreads to the quants’ cause, and I expect this to be less in future years now that I’ve almost completely sold off individual stocks. My guess is that light-speed traders would starve if they had to survive on contributions from investors like me. Fortunately for the quants, there are plenty of individuals who try to make money with frequent trading and contribute much more in spreads than I do.

Whenever you’re tempted to trade in an out of stocks because you think you’ve found the secret formula for success, it’s useful to imagine thousands of computer algorithms ready to take away a slice of your money.

Friday, September 7, 2012

Short Takes: Big Bank Fees, Low-Volatility ETFs, and more

Rob Carrick looks at how the strength and market control of the 5 big banks isn’t much help for their customers.

Larry MacDonald asks why investors need to pay higher fees for low-volatility ETFs when there are other ways to reduce portfolio volatility.

Canadian Capitalist and Canadian Couch Potato reported on Vanguard Canada’s 5 new ETFs. Finally we have a non-currency-hedged U.S. stock ETF.

The Blunt Bean Counter did three short video interviews about inheritances and wills. Have a look.

Big Cajun Man says you need “a pay day loan like a penguin needs a George Foreman grill.” I can just see a payday loan storefront with a picture of a penguin happily grilling dinner on a George Foreman grill.

Million Dollar Journey gives another detailed net worth update. He’s over $650,000 now, but I wonder how close he would be to the magic million dollar mark if he were less conservative with the accounting values of his house and pensions.

Thursday, September 6, 2012

Vanguard Canada Introduces 5 New ETFs

Vanguard Investments Canada announced that they are introducing the following 5 new ETFs:

1. Vanguard FTSE Canadian High Dividend Yield Index ETF
2. Vanguard FTSE Canadian Capped REIT Index ETF (based on the FTSE Canada All Cap Real Estate Capped 25% Index)
3. Vanguard Canadian Short-Term Corporate Bond Index ETF (based on Barclays Global Aggregate Canadian Credit 1-5yr Float Adjusted Bond Index)
4. Vanguard S&P 500 Index ETF
5. Vanguard S&P 500 Index ETF (CAD-hedged)

The most interesting of these ETFs to me is number 4, the un-hedged S&P 500 index. My only question is whether there would be a 15% U.S. withholding tax on dividends when it is held in an RRSP or RRIF. Ordinarily a tax treaty between the U.S. and Canada allows RRSP and RRIF accounts to avoid U.S. dividend withholding taxes, but I’m not sure what happens when the dividends are generated within a Canadian ETF. Canadian Capitalist says that this ETF would be subject to a withholding tax.  If any ETF company would be motivated to reduce investor costs, it is Vanguard, but I can't see any easy way for them to prevent this 15% drag on dividends.

Wednesday, September 5, 2012

Lessons from Facebook’s IPO

Facebook investors aren’t happy. The company’s shares were priced at $38 for the initial public offering (IPO) but now trade around $18. One writer, Andrew Ross Sorkin, blames this “debacle” on Facebook’s chief financial officer, David Ebersman. Sorkin seems to treat IPOs as a cooperative venture among investors, offering banks, and the company going public where the goal is to set a fair price. In reality, there are competing interests.

Sorkin says “it is remarkable that nobody — no bankers, no one at Nasdaq, no one at Facebook — has been fired for botching the offering.” I can’t see why Facebook would see the offering as a failure. If the offering had been at a lower price, Facebook would have received billions less in investor money.

At its core, an IPO is a transaction where a company sells its shares to investors. Why is it surprising that the company would want the highest price it could get? No doubt Facebook will face some problems due to its falling share price. But these problems seem small compared to having an extra few billion dollars in its coffers.

Facebook is unlikely to have to make a secondary offering any time soon. This gives them plenty of time to weather the current storm of investor unhappiness and execute their business plan. I have no idea of how successful Facebook will be over the next 5 or 10 years, but I doubt that current short-term investor unhappiness will matter much in the long run. However, having an extra few billion dollars may help a lot in driving future Facebook business success.

I don’t recommend participating in an IPO, but if you are considering doing so, remember that it is not a love-in; it is a transaction where the company going public is on one side and you are on the other.