Sunday, May 31, 2009

A Mutual Fund Too Successful to Succeed?

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Suppose that you have found a mutual fund called XYZ with a good track record of strong returns and an honest manager who has not closed and renamed losing funds and has not incubated funds. Hurray!

XYZ fund manages $50 million making it small by mutual fund standards. The fund manager is very skilled at investing in small companies that are about to grow big. So, you switch out of your current mutual fund and switch into XYZ. This is going to be good!

The herd is with you.

It turns out that you weren’t the only person with this idea. Literally thousands of other people pile into XYZ chasing those high returns. Assets under management at XYZ swell to $2 billion, a 40-fold increase.

This is great for the fund’s managers; they will collect 40 times the management fees. But, what are they going to do with all that investor money? XYZ fund was successful at finding a handful of small companies that give big returns. These companies aren’t big enough to buy 40 times as much stock in each one. The fund managers worked hard to find 20 good investments, and suddenly they need at least 100 more investments, fast!

Something has to give.

XYZ’s managers quickly find several more small companies along with some larger ones and invest the whole $2 billion. However, these hasty investments turn out to be nowhere near the quality of their picks back when XYZ was small, and a year later, the returns are very disappointing. XYZ has turned into just another mediocre fund. You got into this fund too late to make any money.

This illustrates the danger of chasing high-returning funds – you get mediocre returns and keep paying fees and possibly loads for switching in and out of funds frequently.

Friday, May 29, 2009

Short Takes: Shorting 2X ETFs and Mortgage Penalties

1. Preet takes a detailed look at strategies for shorting bull and bear double-exposure ETFs simultaneously.

2. Ellen Roseman addresses interest rate differential (IRD) penalties for paying off a fixed-rate mortgage early. Based on the comments on this article, it seems that people often get caught when they sell homes before the end of the terms of their mortgages. The penalty amounts can be quite large.

3. Big Cajun Man thinks the new rules for credit card companies should have gone further. In particular, he’d like to see lower interest rates on credit cards.

Thursday, May 28, 2009

Nortel Pensions and Paying in Advance

I was recently offered a 10% discount by a contractor for paying in advance. Of course, this raised warning flags for me. Believe it or not, this has a connection to the current trouble with Nortel’s pension plan.

Ordinarily, I wouldn’t consider paying a contractor in advance for fear that he would just skip off with the money. In this case, it was a contractor I’ve used and trusted for about a decade now. I went for the deal with only mild misgivings.

In the end, my contractor didn’t skip out on me, but he also didn’t give me quite the same service as he had in the past. The work was done a little later than usual, and I had to place a couple of extra phone calls to be the squeaky wheel that gets the grease. In the end, I’d say that the 10% discount wasn’t quite worth the extra trouble.

This is often the way things go with an agreement between two parties where one side fulfills their obligations first. The other side may renege entirely, but much more often they just change the deal slightly. The delivered goods or service may not be quite up to the promised standard or may be delivered late.

This is what is happening to current and former Nortel employees now. A percentage of the work done by Nortel employees was paid for with a promise of a pension when they retire. Nortel has already benefited from this work, and now they are changing the deal by reducing the promised pensions for at least some of the employees.

Laid off Nortel workers who choose to withdraw the current value of their pensions are now being told that they will only get 69% of the originally promised amount.

There isn’t much that can be done about this. If there are only 20 cookies on a plate and ten people are owed three cookies each, something has to give. The battles over Nortel’s pension and assets will continue until nothing is left. When all the assets are gone, there will be plenty of people left still owed money.

Wednesday, May 27, 2009

Canada Pension Plan Fire Sale

Many people are hurting financially in this recession, and the government has decided to help out with changes to the Canada Pension Plan (CPP). This is the same kind of help you might get from a stranger who sees you need money badly and offers you ten bucks for your iPod.

The two big proposed changes are as follows.

1. You will be able to draw CPP at age 60 while still working without taking two months off. This is welcome news for older workers who have been laid off and are having a hard time getting by on half as much pay at a new job. (Thanks to Preet for pointing out the poor wording of this point in the original version of this post.)

2. If you take CPP at age 60, it will be reduced by 36% instead of 30%. Payments used to be reduced by 0.5% for each month they start before age 65. This will be increased to 0.6%.

This second point is not well understood by some. If you take your CPP early, the reduction in pension amount is permanent. The pension will not go back up to the “normal” level at age 65. So, the extra 6% reduction will apply for the rest of your life.

The combination of allowing people still working to draw early CPP along with being in a recession will cause many people to make the short-term decision to draw CPP early. And the government is right there to help them out with a lowball offer of 36%-reduced CPP payments.

From an actuarial point of view, this increased early penalty makes little sense because people are living longer. The longer you live, the less enticing a reduced early pension becomes.

From the point of view of taxpayers, this is a good move by the government. CPP payouts will increase somewhat in the short term, but over the long run, the total benefits paid out will be lower.

I don’t blame people who choose to take early CPP despite the extra reduction. It’s possible that a person’s unique circumstances make this a wise choice. More likely, though, people will make choices based on their immediate needs. It’s good to know that when people are hurting, the government is right there to say “I’ll give you a hundred bucks for your car.”

Tuesday, May 26, 2009

Bell Makes Another Offer

In the past Bell has made me numerous offers for internet service that doesn’t work at my house. Their latest offer of a long distance plan is equally enticing.

Apparently, the Canada Block of Time Long Distance Plan is only $17.95 per month. Just before this price is the word “from” written sideways in small letters. There is also a tiny “1” indicating the footnote on the back of the letter that informs me in ultra-small font that taxes and a $5.95 per month network charge are extra.

The letter says that this “long distance plan matches your unique calling habits and saves you money.” It’s hard to see how this could be true given that in a typical month my family uses about $4 in long distance.

This reminds me of the time when a life insurance salesman promised to save me money, but then proceeded to offer me plans that all cost more than double what I was already paying. I guess the target market is people who look at two numbers and can’t figure out which is bigger.

Monday, May 25, 2009

Update of Market Timer Breakeven Date

With the TSX index continuing to rise in recent weeks, only a select few market timers who remain out of the market are in positive territory. Looking at past prices, we can find the day during the stock market downswing that had the same price level as today. I call this the “market timer breakeven date.”

The following chart shows what I mean:

As prices continue to rise, this date travels further back in time. Apart from a few bumps in the TSX chart, the breakeven date is now back to October 6. Not too many market timers who jumped out of stocks during the downturn managed to do it before this date.

Curiously, a few people I know who jumped out of stocks seem quite unconcerned by all this. They are content to wait until “things calm down,” but fail to see the fact that they sold low and are waiting to buy high.

Sunday, May 24, 2009

Mutual Fund Mantra: Focus on Long-Term Returns

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Mutual fund managers often close, rename, and merge funds with a history of low returns to hide their poor record. To counter this, investors are advised to choose funds with a long history of good returns. Typical advice is to focus on 10-year returns.

Investors do tend to choose funds with a history of high returns. However, they often focus on just the past 1 or 3 years of returns, rather than looking at longer periods. Not surprisingly, mutual fund managers are aware of this.

Because mutual fund managers are paid a percentage of their fund’s assets each year, they are motivated to attract as many investors as possible to the fund to drive up its total assets under management. This has led to an interesting practice among some mutual fund companies to drive up reported returns.


Some companies start up several mutual funds with small amounts of private money and run them aggressively. After a while, the poor performers are closed and the strong performers are ready to be advertised to the public. This process is called incubation.

The returns on these incubated funds look great initially, and they attract a lot of investor money. Of course, once the managers have to invest a big pot of new money without the benefit of quietly closing losing investments, the returns tend to be just mediocre.

Incubating funds to get high reported returns is a bit like holding a lit match under a thermometer to warm a room. The thermometer will report a nice high temperature, but the room will be just as cold.

If the management company keeps an incubated fund open to the public after the first year or so, the returns during the incubation period can be dramatic enough to unrealistically influence even the fund’s 5 and 10-year returns.

I have no idea how to find out if a particular fund has inflated its reported returns with incubation. This makes it hard to put much faith in any mutual fund tables full of investment returns.

Friday, May 22, 2009

Short Takes: Credit Card Rules and Inflation for Retirees

1. New credit card rules are on the way in the U.S. My Dollar Plan outlined the expected changes. The most interesting new rule to me is the one requiring cardholders under 21 to have a co-signer unless they can prove that they can make payments on their own. This is an attack on the practice of extending credit to young people with the expectation that they will get themselves into debt trouble and get bailed out by their parents.

2. Canadian Financial DIY reports on a study showing that inflation is higher for retired people than it is for the general population due to rising health care costs.

3. The Big Cajun Man reports that while inflation overall hasn’t begun rising significantly, the price of food has been rising.

4. Preet observes that when markets are volatile and flat, leveraged ETFs tend to perform poorly making them attractive to short. Of course, the trick is to anticipate whether markets will remain flat and volatile.

5. Frugal Trader designs an income portfolio for a 60-year-old with $1 million in retirement savings. Unfortunately, I know a lot more retirees with less than $100,000 saved than those with $1 million or more.

Thursday, May 21, 2009

Are Leveraged ETFs Leaky?

The basic idea behind leveraged ETFs seems appealing. These ETFs seek to go up or down double or triple the amount of a given index. Since stocks tend to go up over time, you’d think that doubling or tripling this gain would be a good idea. Unfortunately, volatility punishes leveraged ETFs and some of these ETFs seem to have unexplained leaks.

Many investors believe that if an index rises 10% one year, then a double-leveraged ETF will rise 20%, and a triple-leveraged ETF will rise 30%. If you think this is true, you need to slow down and understand where this reasoning goes wrong. These ETFs get rebalanced daily and this changes everything.


Suppose that a stock index alternates between rising 2% one day and dropping 1.9% the next day for 250 trading days in a year. Superficially, you might think that you are gaining 0.1% every two days repeated 125 times giving a 12.5% gain over the year. Sadly, it doesn’t work this way. Over 2 days, a $1000 investment would be affected as follows:

$1000 x 1.02 x 0.981 = $1000.62

Note that the gain is only 0.062% rather than 0.1%. For the double- and triple-leveraged ETFs, we have

2X: $1000 x 1.04 x 0.962 = $1000.48
3X: $1000 x 1.06 x 0.943 = $999.58

Multiplying this out 125 times for the whole year gives the following results:

1X: +8%
2X: +6%
3X: -5%

The leveraged ETFs magnify volatility, and this compounded volatility punishes returns.

All this analysis has been based on the “bull” ETFs. There are also “bear” ETFs that seek to get the opposite return of the index. So, if the index goes down 1% one day, a double-leveraged bear ETF would go up about 2%.

A natural question is “would a triple-bear ETF go up 5% in the example above?” Sadly, the answer is no. The volatility penalty makes both the bull and bear ETFs go down. Here are the bear returns for this example:

2X bear: -36%
3X bear: -55%

These returns have excluded all trading fees, MERs, and any other expenses.

An Experiment

Is this volatility problem the only drain on leveraged ETF returns? I decided to try an experiment where a pot of money is invested 50/50 between the bull and bear versions of the same ETF. With daily rebalancing, this should eliminate the volatility problem. The gain in one ETF should cancel the loss in the other each day leaving just expenses.

Of course, it makes no sense for an investor to actually do this. The goal of this experiment is to eliminate volatility losses and see what happens. My analysis ignores the trading fees that would result from the daily rebalancing because I want to examine the nature of these ETFs.

The first ETFs that I tried this on were the Direxion US Large Cap triple bull and bear. The following chart shows what would have happened to $10,000 split between these ETFs since their inception.

If we ignore the initial big drop, these ETFs seem to be leaking money at a consistent rate of about 9% per year. This far exceeds the advertised expenses of about 1%. The bull ETF also paid out a couple of small dividends, but this falls far short of explaining the leak. Perhaps, the trend in the chart is only short-term and will change. In the end, I have no explanation for this drop.

The results for Canadian Horizon BetaPro TSX 60 double-exposure bull and bear ETFs were stranger:

It’s hard to see any particular trend in this data. The overall drop of about 3.5% in 20 months exceeds the advertised yearly MER of 1.15%. The inconsistency of results seems to indicate that the ETFs do not track the index exactly as intended, but it’s hard to tell.

Between the volatility penalty and the unexplained leaking of money when volatility is factored out, these ETFs won’t be part of my portfolio.

Wednesday, May 20, 2009

Conrad Black’s Supreme Court Free Roll

Conrad Black has won a U.S. Supreme Court review of his fraud conviction for taking money from hapless investors. He has been serving his sentence for a little over a year now and hopes to be released by the Supreme Court. Black has nothing to lose and much to gain from this appeal.

Black and others were convicted of giving themselves illegal bonuses of $6.1 million. This money is just a small slice of the total amount in question during the investigation into Black’s actions. The cost of employing lawyers to continue his defense up to the Supreme Court is not a concern.

In poker parlance, Black is on a free roll. At worst if he loses the appeal his situation remains the same and he is forced to serve the remaining 5 years of his sentence. At best he will be released soon. It would be much more entertaining if there was some downside risk attached to this appeal.

In most cases, I see appeals to higher courts as an effective means of keeping lower courts in line. But this case doesn’t have that feel for me. One gets the feeling that if Black is released, it won’t have much to do with guilt or innocence. The evidence against Black seems very clear, and something is needed to add interest.

What if this was a double-or-nothing opportunity? If Black wins, he gets out, but if he loses, his remaining sentence increases to 10 years. That would be entertaining.

Tuesday, May 19, 2009

Maintaining Your Asset Allocation

In a very unscientific poll of a few acquaintances who claim to have a fixed percentage asset allocation between stocks and bonds, I asked whether they did any trading to maintain their percentages through the recent stock market turmoil. It turns out that none did.

The idea behind asset allocation is that when bonds are cheap, you sell some stocks to buy more bonds, and when stocks are cheap (as they were a couple of months ago), you sell bonds to buy stocks. If done properly, you are buying low and selling high.

However, if the few people I spoke to about this are any indication, even investors with a fixed plan often aren’t managing to follow their asset allocations at the very time when it would be most beneficial.

It takes courage to buy when the world seems to be crashing down around you. However, a financial plan isn’t worth much if you don’t follow it.

Monday, May 18, 2009

Why did My Mutual Fund Change its Name?

Happy Victoria Day! This is a special edition of the Sunday feature that looks back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

I used to hold mutual funds in an employee savings plan. The first time that one of the funds I held changed its name, I was puzzled. Was I switched to a different fund? Why was this done?

I asked the representative of the firm that managed our savings plan about this. He said I shouldn’t worry because the name change was inconsequential, and this seemed to be true. The number of units I held and their approximate value didn’t change. What was the point of all this?

After comparing my last two statements, I did find one seemingly small difference. The part of my most recent statement with the 1-year and 5-year performance of my fund was blank. The previous statement listed these returns for the old fund name, and the returns weren’t very good compared to other mutual funds.

Erasing History

The purpose of the name change was to erase an unpleasant history and start over. Because of this little trick, mutual fund lists are purged of their poorest performers. There are definitely funds that do badly, but their records go away after a while.

This leads to what is called survivorship bias. If you calculate the average 5-year return of all mutual funds, you will get a percentage that is higher than the real returns seen by investors, because the bad returns are missing from the average. I guess my investing performance would look a lot better too if I could eliminate all my bad investments.

So, if your mutual fund changes its name, odds are that you’ve lost some money. Erasing the history of this loss will help you forget about it, but the money will still be gone.

Sunday, May 17, 2009

Common Investment Trap: Borrowing to Invest

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

The second financial advisor I actually invested money with was a pleasant woman who used to work at my bank branch handling my mortgage and had moved out on her own. I won’t use her real name; let’s call her Gina.

Initially, my wife and I each invested a small sum with Gina in some mutual funds. We were contemplating moving the rest of our investments over from our first financial advisor, but Gina had an idea for something even bigger.

The Pitch

Based on our income and lack of debt, Gina said that we should be borrowing a large sum of money and investing it. Interest rates were low, and when it came to taxes the interest could be deducted from the big gains we were sure to make on our investments. At the end of 5 years, we would have big profits with “no money down”.

Gina worked on us for quite a while with this pitch. Fortunately, the borrowing made us nervous, and we decided not to go for it. This all took place just before the high-tech bubble burst. We would have lost a lot of money and would have been left paying off a large debt for some time.

Although Gina was surely aware that she was recommending something that would make her a lot of money, I think she believed she was helping us. The training Gina received as a financial advisor with her firm told her that borrowing was the right thing for a couple in our situation. I don’t think she knew any better.

Common Tactic

My wife and I are not alone in getting this pitch. Members of my extended family as well as friends have been hit with higher pressure versions of this “borrow big to invest” strategy from financial advisors. This appears to be a common tactic that financial advisors (or the firms who train them) use to increase mutual fund sales.

Borrowing large amounts of money to invest is called using leverage and is an advanced and risky investing strategy. This does not mean that it is always the wrong thing to do, but if you need a financial advisor to show you how to invest, then it is likely that borrowing to invest is not for you.

Friday, May 15, 2009

Short Takes: Rating Canada’s Mutual Funds, Female Investors, and the Glut of Retirees

1. Morningstar conducted a study of mutual funds in 16 countries. Preet gives us Canada’s overall scorecard and Larry MacDonald questions Canada’s grade of A on investor protection and transparency.

2. Jason Zweig explains how women get better investing results than men.

3. Canadian Financial DIY is a little concerned about his retirement finances and has an amusing modest proposal for dealing with the swelling numbers of retired people.

4. Big Cajun Man finds that the recession has made it easier to give things away.

5. Million Dollar Journey addresses the question of what a young guy with an extra $5000 should do with it. The extensive reader comments are the most interesting part. It’s not hard to see why some people are chronically short of money.

Thursday, May 14, 2009

Tax Avoidance on New Homes

The Ontario budget announced plans to change the sales tax structure on new homes. The way the harmonized sales tax will be applied starting in mid-2010 will create some perverse incentives that are likely to result in a cycle of tax avoidance and modified regulations.

Under the new plan, all new homes will be taxed at the HST rate of 13%, but those selling for less than $400,000 will get a 6% rebate. New homes selling for more than $500,000 will get no rebate. The rebate gradually fades away between these two prices.

A common reaction to all this “good – let the rich people who can afford big houses pay.” Even if you think this way, consider that if these thresholds remain the same in the future, inflation will eventually push the price of even modest new homes past these thresholds. Inflation will create a hidden tax increase each year.

The sales tax on a $400,000 home will be $28,000, and the sales tax on a $500,000 home will be $65,000. This means that the marginal tax rate will be 7% up to $400,000, but on the next $100,000 it will be 37%! After $500,000 the marginal rate drops to 13%.

The huge tax rate of 37% from $400,000 to $500,000 will create a strong incentive to avoid taxes. We’ve already heard of strategies of builders selling homes before they are finished and leaving it to the home owner to complete the job.

Another possible strategy might be to sell a house on a minimal piece of land and sell the rest of the land in a separate transaction. No doubt the housing industry will find many more creative ways than this to avoid the ultra-high sales tax rate. This isn’t intended as an indictment of the housing industry. Almost all of us try to avoid high taxes.

These tax avoidance efforts will force the government to close loopholes, and the cycle will go back and forth. All this effort will be driven by bad tax policy.

A curious side effect of the tax rules amounts to social policy. House builders are now discouraged from building homes that would sell for more than $400,000. If they must go over this threshold, they might as well go way over and go after the high end of the market. We can expect the $400,000 to $600,000 range to be a little thin.

One potential fix is to give all new home buyers a 6% rebate up to $400,000. This would give a fixed rebate of $24,000 on high end homes, and the marginal tax rate would not exceed 13%.

Another possibility is to reduce the rebate over a wider range of prices, say from $400,000 to $800,000 (instead of only $500,000). In this case, the marginal sales tax rate never goes over 19%.

Punitive marginal tax rates are bad tax policy that create strange incentives and foster tax avoidance. Governments need to make tax rate structures smooth.

Wednesday, May 13, 2009

Profiting from Your Confidence

If you ever watch come-ons for trading systems you’ll find that they are a lot alike. “It’s possible to make money in any type of market, whether stocks are going up, down, or staying the same.” They promise to teach you how to make money, but there is a catch.

It’s true that you can make money in any type of market. If a stock is going up, you can profit by buying a call option. If the stock is going down, you can profit by buying a put option. If the stock is going to stay steady, you can profit by selling both call and put options.

The unstated catch in all this is what if you are wrong? The answer is that you’ll lose money. If the companies behind these come-ons really could predict stock price movements, they would use their systems to make money rather than waste time teaching you how to do it.

These companies profit from your activity. You pay fees to them for their software and platforms and for teaching you, and they may get part of the trading fees you pay. They make money even if you lose money. They are exploiting your sense of confidence in predicting the future of stock prices.

Scott Adams of Dilbert fame said it well in his blog entry yesterday: “What the world really needs is a product that will prevent people from using their own dumbass ideas to invest.”

Tuesday, May 12, 2009

Financial Incentives Drive Advisor Behaviour

Financial incentives are a big factor in driving behaviour. Understanding how mutual fund salespeople are paid helps in predicting how they will do their jobs. Investors who understand this are better able to protect themselves from conflicts of interest.

A friend of mine, who I’ll call Tim, was caught between careers and tried selling mutual funds for a few years. His pay was commission-based. When he signed up a new client, he got 5% of the invested money immediately, and each year he got 0.5% of the invested money as a “trailer” commission. Some of this money had to be shared with other salespeople in his firm.

The up-front 5% commission is sometimes paid for with a front-end load that the mutual fund charges the investor. In other cases the up-front commission is paid for with either the yearly MER fees that investors pay, or if investors pull their money out of mutual funds within about 5 years, they are charged a back-end load to help cover this up-front commission.

Tim dreamed of working hard signing up clients to build up to $10 million worth of client investments so that he could semi-retire collecting $50,000 per year in trailer commissions. This dream evaporated quickly as he found how difficult it is to sign up clients, particularly those with 6-figure portfolios.

Many of Tim’s clients didn’t stay invested with him for decades as he had hoped, and the trailer commissions never amounted to very much. For the most part, he lived on the up-front commissions as he signed up new clients.

This incentive structure explains why mutual fund salespeople work so hard to get new clients (and why so many try to get clients to borrow large sums of money to invest). Unfortunately, the incentive to work hard at keeping clients is weak, and advisors often ignore clients after signing them up. Not all advisors ignore clients after the initial sign-up, but the financial incentives push them hard in that direction.

Less scrupulous advisors may even try to get clients to switch to new mutual funds so that the advisor can collect a new up-front commission. We’d like to think that people are basically honest and wouldn’t do things like this, but mounting bills can make some people desperate for income.

These realities of what life is like for most mutual fund salespeople drove Tim to a career outside the financial industry.

So, if you feel ignored by your financial advisor, or he keeps trying to get you to borrow money or switch to new mutual funds, you can blame both him and the way he is paid.

Monday, May 11, 2009

Stock Indexes Outpace the Economy

Historical data show that stock market indexes grow faster than the economy as measured by Gross Domestic Product (GDP). On the surface this seems impossible. The stock market is part of the economy, and while it may grow faster than the economy for short periods, it makes no sense that it could outperform GDP over the long term, but this is what seems to happen.

According to data from Angus Maddison, from 1926 to 2000, Canadian GDP per person grew by a factor of 5 above inflation. Because the population grew as well, overall GDP rose by a factor of 16 above inflation. The U.S. had a similar experience with per person GDP rising 4.3 times, and overall GDP rising just 10.3 times.

However, according to Ibbotson and Associates, over this same period of time (1926 to 2000), large stocks with reinvested dividends rose by about a factor of 300 above inflation, and small stocks rose by a factor of 700 above inflation! This means that large stocks outgrew U.S. GDP by about 4.7% per year, and small stocks outgrew GDP by about 5.9% per year.

This sustained outperformance by stock indexes over GDP growth seems impossible. So, how could it be? The short answer is that GDP is real and stock indexes are not. Extremely little money was placed in stocks indexes in 1926 and left there until 2000. Every dollar invested in large stocks in 1926 would have grown to about $3000 in 2000 (but only worth about one-tenth as much due to inflation), but very little money actually sat in the index untouched that long.  On average, all dividends get spent.

How do stock indexes outperform the average investor? Typical investors fail at market timing efforts and put large portions of their money into inferior investments like bonds and cash.
Another interesting part of this paradox is that if a significant number of investors suddenly bought into the index and left their money there for an extended period of time, and companies stopped paying dividends, stock indexes would cease to outperform the general economy because stock index returns would become real for a large proportion of wealth. It is the very fact that few people take advantage of the power of the index that makes it such a good investment.

In his 2007 letter to shareholders, Warren Buffett ridiculed those who project the Dow Jones Industrial Average (DJIA) to increase by 5.3% to 8% per year because this means that the DJIA will reach 2,000,000 to 24,000,000 by 2100. The implication is that these large figures are clearly impossible.

But, unless investor patterns change, the DJIA will continue to be just theoretical and not represent real money because few people will buy the DJIA and forget the money for 100 years. If investors continue to underperform the DJIA, it would easily reach crazy-looking heights.

I should note that Buffett was using his argument to criticize two groups:

1. Companies who make overly-rosy predictions of returns on pension funds to justify underfunding pension plans.

2. Financial advisors who sell potential clients with overly-rosy predictions.

These two groups deserve criticism. The rosy predictions are impossible because they are based on growing real money. While the DJIA could reach into the millions by 2100, the bulk of real investment dollars cannot.

We tend to think of index investors as those who are satisfied with being average. But, buy-and-hold index investors are a small minority who, on average, have outperformed the average investor by a wide margin.

Sunday, May 10, 2009

Common Investment Trap: Back-End Loads

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

A mistake that some mutual fund investors make is repeatedly getting hit with back-end loads on their mutual funds. This can be a very costly for the investor, but lucrative for financial advisors.

What is a back-end load?

A back-end load is a percentage of your investment that you pay when selling out of a mutual fund. Other names for this are “contingent deferred sales charge”, “redemption fee”, and “exit fee”. A common arrangement is for the mutual fund to charge a 5% load if you sell within the first year, 4% if you sell in the second year, and so on until the back-end load drops to zero after 5 years. In such cases, the fund typically does not charge a front-end load.

You may wonder how the fund could afford to eliminate the back-end load after 5 years if they had to pay the financial advisor at the beginning without collecting a front-end load. The answer is that the management expense ratio (MER) collected each year is high enough to cover the advisor’s up front commission if the money stays in the fund long enough. So, the mutual fund pays commissions out of either the MER or the back-end load depending on how long you stay in the fund.

How do investors get into trouble?

Many people feel vaguely uneasy about their investments, and some of them act on this feeling by periodically firing one financial advisor and jumping to another one who puts them into new mutual funds. Investors often do this without understanding back-end loads.

Suppose that impatient Ian switches financial advisors three times in 5 years paying a 4% back-end load each time in addition to a 2% MER each year. If he had an average of $200,000 invested over the 5 years, Ian would pay $20,000 for the MER, and another $24,000 in back-end loads. Ouch!

Sometimes getting out of a bad situation and paying the back-end load may be the right thing to do, but doing it repeatedly out of ignorance and impatience can be costly.

Friday, May 8, 2009

Short Takes: Breaking a Mortgage and more

1. Million Dollar Journey looks at what factors to consider when deciding whether to break a mortgage to get a better interest rate.

2. Larry Swedroe looks at the positives and negatives of using Monte Carlo simulations of your portfolio. One of the negatives is that these simulations usually use a normal distribution of returns, which understates the chances of extreme returns. I’ve never understood why this has to be the case. Why not just use a more accurate distribution in the simulation?

3. Where Does All My Money Go gives us an insider’s understanding of what a financial advisor’s “turn on assets” means.

4. The Big Cajun Man debates what to do with found money. I’d say to pay off debt, or if you have no debt, invest it. If you feel strongly about blowing some of it, maybe you could blow the interest savings or investment returns instead.

Thursday, May 7, 2009

Option Collar as Portfolio Insurance

Yesterday, I looked at how to protect a portfolio from a big drop in stock prices using put options, but the result was unsatisfactory. Mark Wolfinger left a comment suggesting selling a call option as well to create what is called a “collar.”

This may sound complex, but the effect of a collar is simple enough. Your stock market returns are limited to a range. If stock losses are too deep, the purchased put options compensate you to limit your losses. If stock market returns are very high, the call options you sell limit your gains.

You may wonder why anyone would bother with the call option part if they limit your gains. The answer is that you get cash from selling the call options that you can use to buy the put options. So, in trade for the guarantee that you won’t lose too much, your gains are limited as well.

The particular strike prices of the options are what determine the limits on gains and losses. Of course, we prefer a tight limit on losses and a generous limit on gains, but we’d also like the cash generated from selling the call options to cover the purchase of the put options. This forces a balance between the upper and lower limits on returns.

An Example

Let’s continue with yesterday’s example of investing in large U.S. companies through the S&P 500 (which is now sitting at 907.00 as I write this). This time we’ll focus on limiting losses between now and December 2009.

If the S&P 500 were to drop to 800, this would be an 11.8% loss. If we don’t want to lose any more than this, we need to buy December 2009 put options on the S&P 500 struck at 800. The current ask price of these options is $55.60. So, we need to sell call options at the same price.

Unfortunately, options don’t come in enough choices to exactly match this price. However, we can sell two types of call options to get the right blended price. The bid price on calls struck at 950 is $64.30, and for calls struck at 1000 the bid price is $44.90. With the right blend, the average price is $55.60, and the blended strike price is 972.4.

Unfortunately, this blend of call options means a cap on stock returns of only 7.2%. So, the returns over this 7.5-month period are limited to between a loss of 11.8% and a gain of 7.2%. This doesn’t seem like a very good deal. In fact, assuming that the average yearly stock return is 12% and the yearly standard deviation is 20%, the expected return from our collar works out to 1.3% over those 7.5 months.

That didn’t work out very well, but it was based on just one choice of option strike prices. The following chart gives a range of possible collars and the expected return from investing with that collar. To understand the chart, imagine any vertical line cutting through the chart. The blue line is the top of the collar, the red line is the bottom, and the green line is the expected return over 7.5 months.

To decide if any of these collars are worthwhile, we need something to compare them to. Suppose that the alternative to a collar is just using a 70/30 asset allocation between stocks and a fixed income investment returning 2%. If we expect 12% from stocks, we expect 9% yearly from this allocation, or about 5.5% over 7.5 months.

To get an expected return of 5.5%, the collar ranges from a loss of 34% to a gain of 24%. This is definitely not very useful. If an investor is looking for protection, capping losses as 34% over only 7.5 months isn’t much protection. But, limiting losses further cuts into expected gains and makes this approach less desirable than simply buying some fixed-income investments.

Note that this discussion has ignored the commissions and taxes resulting from trading options.

Overall, I’ve still failed to find an option-based strategy for portfolio protection that competes with asset allocation. Perhaps the problem is that recent stock market volatility has changed option prices in an unfavourable way for collars. In any case, I’m not going to be trying any option strategies for portfolio protection until the numbers make sense.

Wednesday, May 6, 2009

Stock Options as Portfolio Insurance

For investors who can’t stomach the volatility of investing 100% of their long-term savings in stocks, the usual advice is to put some fraction of savings into fixed income investments. Another approach is to use stock options to protect against large losses.

Suppose that an investor Irene has $100,000 that she wishes to invest mostly in large U.S. stocks, but is nervous about losing money. One approach for Irene is to just put all of her savings into the S&P 500 (which is sitting at 900.80 as I write this) and live with the volatility.

The following chart shows the returns for Irene across a range of possible outcomes in the S&P 500. We’ll focus on her results as of June 2010, a little over a year from now.

It’s the lower left hand corner of this chart that worries Irene. The thought of losing that much money is scary. One solution is for Irene to put some money (say 30%) into fixed-income investments. The following chart compares the all-stock approach to the 70/30 approach assuming that the fixed income return will be 2% over the next year and a bit.

Now Irene’s potential losses are blunted and she can sleep a little better at night. The down side is that her potential gains are reduced as well. But, this is the price that nervous investors pay for some peace of mind.

A different approach to limiting losses is to use stock options. Irene could buy put options on the S&P 500 that would allow her to sell her stocks at a specified price if they happen to drop in value. For example, Irene could buy put options struck at 675. For a June 2010 expiry, the current price of these put options is $45.20 each.

The following chart compares the all-stock approach to the stock plus put options approach.

By giving up about 5% of her returns, Irene can cap her losses at about 30%. If this doesn’t seem like a good idea to you, I agree. The 5% she is giving up represents about half of her expected returns (if we believe that expected stock returns are 10%), and a 30% loss is not particularly likely.

A 30% loss would still sting badly, and Irene might prefer to cap her losses at some lesser percentage. Unfortunately, the cost of the put options to cap losses at less than 30% is even higher than 5% of her portfolio. This put option approach to insuring against losses looks less attractive than the 70/30 fixed income approach.

It could be that recent market volatility has driven up the price of stock options. In current conditions, put options as portfolio insurance look like a poor choice. Nervous investors will have to stick with fixed income investments or search for some other stock option strategy for portfolio insurance.

Tuesday, May 5, 2009

Shorting Stocks: Big Challenge with Little Reward

Most investors who are stock pickers have had the feeling at one time or another that a particular stock would go down. The usual response to this is to sell any shares they have or not buy shares. Some are tempted to short the stock, but this is a difficult game.

Shorting a stock means to sell shares that you don’t own. You are essentially borrowing shares from someone else and selling them with the promise that you’ll buy the shares back later and return them to the original owner. This is done with the hope that the shares will drop in value between selling them and re-buying them so that you’ll make a profit.

Unfortunately for short sellers, stocks tend to go up. Suppose that the stock market tends to go up 10% each year. So, investors in low-cost stock index ETFs make 10% per year, on average, without doing anything. To beat the index as a short seller, you have to find a stock that will go down by about 10% or more.

If a short seller just throws darts at a stock listing, he can expect to lose about 10% each year, on average. If he is so clever that he is able to pick stocks that perform 20% worse than average (so that they drop by 10%), his reward is that his investment returns will roughly match those of the know-nothing index investor.

Short sellers are like runners in a downhill race who choose to run uphill from finish back to start. Taking on added challenges is sometimes admirable, but don’t expect to win any races.

Monday, May 4, 2009

Advice for Lottery Winners

The book Luck of the Draw: True-Life Tales of Lottery Winners & Losers by Chris Gudgeon and Barbara Stewart is a fun read, but it contains some very bad financial advice.

This book is packed with funny and strange stories about lottery winners, but it may not be very good for the financial health of people inclined to buy lottery tickets. One unavoidable problem with a book like this is that reading about a new lottery winner on each page creates the impression that winning the lottery is common. It is exceedingly rare. You won’t win the lottery.

Many of the stories discussed whether or not the winners would quit their jobs, even with modest-sized wins like a few hundred thousand dollars. This is not enough to retire on. Perhaps $2 million would be enough if the winner invests wisely and lives a middle class lifestyle without excessive spending. But how likely is that? Winners tend to splurge with plenty of help from family and friends.

Page 60 contains advice supposedly from an actual financial planner. Here are some spectacularly bad tips for a lottery winner:

1. Move somewhere like the Bahamas where taxes are lower. So, now that you have a lot of money, you should leave family and friends to save money? I’d rather stick with doing things that make me happy. If you’ve always wanted to move, go for it, but moving just for tax reasons is crazy.

2. Divide your win among family and friends so that investment returns will be taxed in lower tax brackets. So, if you win money, you should give it all away so that you won’t be rich and won’t have to pay so much tax. I can see where your family and friends might like this one.

3. Go crazy and spend all the money fast to avoid paying tax on investment returns. Great idea. You should lick metal poles in the winter, too.

I have my own idea. Take the money you were planning to spend on lottery tickets and put it in a savings account. Each year put the money into a low cost index fund. After 25 years, look at the account balance in the fund. You’ll find that it looks like a modest-sized lottery win.

Sunday, May 3, 2009

Financial Advisors

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many people have investments in the form of retirement savings. For Americans, this might be a 401(K) or IRA, and for Canadians, an RRSP. Often these investments have been set up by a financial advisor. I have dealt with many financial advisors over the years and have learned a few things.

1. Competence. Most financial advisors seem to be well-meaning people who don’t know as much as you might hope about investing. I’m sure that there are exceptions to both the well-meaning part and the competence part.

2. Main focus of the job. Their job is more of a mutual fund salesperson than what most people would think of as a financial advisor.

3. Individual Customer Attention. The comprehensive personal financial assessment that they perform with each client seems mostly geared toward figuring out how much they can get you to invest in mutual funds.

4. Conflict of Interest. The amount that financial advisors get paid varies from one mutual fund to the next. The funds they choose should be based on what is best for you, but some advisors choose the funds that pay them the most.

These comments do not apply to fee-based financial advisors who are paid for their time and do not receive commissions from selling mutual funds.

Are Financial Advisors Helping or Hurting People?

The short answer is some of each. Suppose that your financial advisor, Fiona, convinced you to set aside money for mutual funds each month. If you would have spent the money on shoes and over-priced coffee, then Fiona is helping you even though you may be paying high fees on your investments. However, in most cases, you could be invested in essentially the same investments for much lower fees. In this sense, Fiona is hurting you financially.

If you have managed to find a financial advisor who is knowledgeable about investing and serves your interests well, then you are fortunate because this is not the norm.

Friday, May 1, 2009

Short Takes: Stable-Value Funds and more

1. Larry Swedroe looks at stable-value funds. The word “stable” is great marketing, but it doesn’t line up well with reality.

2. Million Dollar Journey debates the value of a Costco membership.

3. The saga of the dealership that messed up the contract on a Lexus continues at Where Does All My Money Go?

4. Big Cajun Man gives us the best financial advice he ever received in the form of a parable.