Saturday, December 3, 2011

Pension Breakthrough for the Rest of Us

This is a press release that introduces an approach that could be disruptive to suppliers of the $525 billion invested in target date funds (TDFs) in the U.S.. TDFs are the fastest growing product in the defined contribution market in the U.S., Canada, Australia and elsewhere because they make investing simple. But they all benefit from a fundamental half-truth. They reduce equity exposure on a predetermined fixed glide path or become more conservative as a target date, like retirement, approaches. To the casual observer, it sounds like the fund reduces its exposure to risk over the life of the product. This would be exactly what plan members want and would do if they had the time and investing acumen to monitor and manage the assets themselves. Sadly these funds do not manage risk at all. The paper "What DC Plan Members Really Want" describes why this is the case and offers two ideas to fix and improve outcomes. 

Friday, November 4, 2011

Target Practice

Figure 1: Capital Accumulation Plan

Accumulating enough money to retire with a 60% replacement income is great, unless you were planning for 70%. Last month, we described Personal AlphaTM as achieving a goal beyond a target, like saving money and earning extra years of retirement income. Accountants and financial planners, particularly fee-only planners who consider their client’s interests unbiased by product trailers and incentives, have been doing this successfully for some time. But new products like exchange traded funds (ETFs) and services like discount and online brokerages have ushered in a new reality. As consumers become more knowledgeable, financial advisors (FAs) will have to develop and expand their value proposition beyond trading and research.

ETFs allow investors access to instant diversification and relatively inexpensive exposure to a large and rapidly growing list of asset classes, regions, countries, styles, capitalizations, sectors, and industries. As retail investors discover the flexibility that ETFs offer, their expectations from other financial products will change. One consequence of an informed public is the growing acceptance of the principles of passive or index investing as the efficient way to access market or beta exposure. The debate over active or passive will rage on as investment professionals protect the turf that pays their bills. But most active managers concede a role for passive investing, particularly in a multi-fund, multi-manager environment when overlap yields market returns at full fees. At the very least, more investors understand that adding returns above the market is not easy and that few can do it consistently. FAs may find building a core business around this kind of activity to be frustrating at best.

Managing risk

An investment professional’s definition of risk - volatility - is different than most retail clients who fear absolute losses. An alternative definition, based on the reality of client’s lives, is the risk of not achieving a goal.

Let’s use retirement investing as an example. Defined benefit (DB) pension plans, given to Members of Parliament and civil servants, are tenaciously guarded by unions and some large corporations. They are professionally managed and, in retirement, pay a percentage of final year’s salary depending upon each plan. DB plans are administered by expert committees and employers are obliged to pay or, in the example above, the taxpayers are.

While both employer and employee contribute, investment decisions are left to the committee. Mandatory valuations every three years assess how the fund measured up to the theoretical liability to pay all those folks their pensions currently, if retired, or in the future, if still working. Any shortfall or funding deficit must be made up over time by the employer or taxpayers. In contrast, defined contribution (DC) plans are like registered retirement plans. The employee makes contributions, usually with employer matches, but the responsibility for investment decisions is the employee’s. Importantly, there is no target income in retirement and no triennial valuations assuring that the program is tracking towards success or failure. In fact, no targeted percentage of income like a DB plan is required. Over several decades, many DB plans have switched to DC or stopped admitting new members in an attempt to control corporate liabilities.

Financial advisors have a great opportunity here. By targeting a percentage of salary as retirement income, a DC or RSP portfolio can be managed like a DB plan. Investors benefit by focusing on a stream of income in retirement rather than short-term performance, and improve the chance that they receive what they want from a retirement plan - a reliable income. Here’s how to do it.

If someone wants to replace 70% of annual income in retirement, the FA calculates the capital required to fund an immediate annuity that would pay this amount in today’s dollars at retirement. Using the investor’s contribution rate and assumptions for inflation and something reasonable for returns, the FA establishes a capital accumulation path towards the target retirement capital. (See Figure 1, “Capital accumulation path.”)

Actual performance will be above or below this path as indicated by A, B and C in Figure 1. By matching the risk of a portfolio to the capital accumulation path, the FA makes decisions based upon progress towards the goal. The target may change modestly over time as interest rates change or dramatically as the investor’s circumstances change, such as a big promotion, more children than expected, family illness, inheritances or a lottery win.

This is an important function missing in DC and RSP management today. FAs can help investors work on a solution that is useful and valuable. For more details, go to to find a link to our article, “What DC Plan Members Really Want” in the upcoming fall edition of the Rotman International Journal of Pension Management.

Thursday, October 13, 2011

ETFs Reach Adolescence

The Canadian exchange-traded fund (ETF) market has reached adolescence, and hair is starting to grow in funny their chins.

What’s that smell?

The Canadian ETF market has matured with sufficient size ($45 billion) and momentum (30% annual growth) to get the attention of the major banks. According to BNY Mellon, the U.S. ETF market will double through 2015 - and Canada’s could match it. Banks and investment companies smell profit potential, and a chance to protect and grow their retail base despite massive books of profitable mutual funds.

They may also fear others will crowd them out of a lucrative market that is, apparently, here to stay. Heavy hitters RBC and Vanguard have declared their intention to enjoin iShares, Bank of Montreal, Horizon Beta/AlphaPro, Claymore, a newcomer to Canada, Invesco, and rookie XTF Capital Corp. in the battle of sponsoring ETFs here. A major Korean fund manager’s interest in BetaPro Management confirms the stakes are changing. Deep pockets and sophisticated distribution are changing the landscape.

Where did those come from?

Unlike early plain-vanilla indexes that got simple ETF wrappers, competing sponsors now race to represent different asset classes, occasionally using derivatives to replicate them. Regulators are concerned these structures may lead to another subprime crisis, or a “flash crash” like in May 2010. The Financial Services Authority (FSA) in the UK is considering banning swap-based ETFs from retail use altogether. The FSA is the UK’s version of Canada’s cluster of securities commissions. These products offer an exciting array of tools to enhance and enable new methods of portfolio construction, but registered representatives need to understand the underlying composition of all ETFs not only to use them effectively, but to manage the liability if a structure goes bad.

Why voices need to deepen

Blindsided by collateralized mortgage products, regulators are determined to prevent similar problems with ETFs. Although prospectus disclosure has been the regulatory focus for retail products, veteran fund executive Paul McKenna of One Financial reminded me that ETFs trade in the secondary market where prospectuses are available but issuance to buyers is not mandatory. Most registered reps know that prospectuses are a legal crutch few people read. Regulators need to rethink the principles and practicality of disclosure in a digital age and speak to consumers with a new voice. Perhaps making all advisors fiduciaries is part of the answer.

Will the ETF market grow up to look like the mutual fund market?

Duplication is costly and confusing, yet every mutual fund family feels it needs at least an equity, fixed income, and money market fund. ETFs compete for market share based upon a different and more useful set of metrics. Sponsors market ETFs based upon index construction, liquidity, diversification and other risk characteristics rather than how a manager happened to outperform his or her benchmark last year. While the conversation has been elevated to issues that really impact portfolios, it’s not as much fun as talking about whether RIM’s quarter will beat analyst expectations. However, getting money into investors’ pockets through lower costs is a powerfully persuasive pitch.

Each bank may want a complete stable of asset classes for their clients, but there may not be enough room for a seventh or eighth ETF based on the S&P/TSX 60. Watching RBC and Vanguard position their Canadian equity offerings will be interesting.

BMO’s ETF launch in 2009 signaled the return of banks to a space vacated by TD in 2006. Critically, taken with RBC’s filing of eight target maturity fixed-income ETFs this summer, the product category has been validated. Vanguard, the dominant index fund player in the U.S., will launch a series of funds in Canada by year-end. This is important and intriguing because Vanguard’s reputation for delivering straightforward passive products at low cost will challenge everyone. Will there be a refocusing on passive low-cost ETFs, or will active strategies finally gain traction?

Waiting for the swelling to go down

ETFs represent only 6% of Canadian mutual fund assets - a rounding error. Unquestionably, ETFs offer investors more effective, low-cost delivery of capital market exposure than mutual funds. Only two things stand between the consumer and a superior product: smarter investors and the entrenched investment advisor. Because information is ubiquitous, investors are getting smarter. Savvy RRs are already using ETFs and as clients get better informed, other advisors will follow. Peer pressure works in trading rooms as well as high school lunchrooms. Advisors sitting at the end of the bed waiting for the ETF swelling to go down are being left behind.

Friday, August 19, 2011

To women: Is your boss evolved?

The CFA candidates gathered in the vaulted Great Hall of Hart House, once the exclusively men’s athletic facility at the University of Toronto. In two weeks these students would sit an exam with a Level 1 pass rate of 37%. Despite dismal odds, these particular students bristled with confidence because all were enrolled in Michael Hlinka’s (CBC Radio Business commentator) preparation course that boasts a 76% pass rate. They had a statistical edge and they knew it. Mr.Hlinka is known for frank observations of business and economics delivered daily on CBC Radio Toronto. Leveraging Michael’s energy, the students seemed completely self-assured.

They had come to hear Margaret Franklin, current Chair of the CFA Institute, the organization that oversees the exams and sets international standards of education, conduct and professionalism for the investment industry, a remarkable accomplishment for a Canadian. Ms. Franklin had presided over the annual CFA conference in Edinburgh earlier in the week and had flown back the night before to attend this reception.

Ms. Franklin, one of the 22% women of her graduating class fifteen years ago remarked that women constitute only 20% of the current roster of CFAs. Statistics confirm that women have made little progress in the investment business or in the boardroom. In my experience as a manager of investment professionals I applaud this lack of progress. It has made my job easier. As a young U.S. equity portfolio manager, the best coverage from Wall Street came from women. In retrospect, Canada was considered a third world market so many women would be relegated to cover institutional accounts north of the border because lucrative U.S. accounts were covered by men. What I quickly learned was that any woman in the investment business had to be better, more tenacious, more insightful, and more aggressive to survive. There weren’t many of them and the environment was never accommodating. My job was made easier by just hiring the women. They usually held an edge over the men.

Don’t get me wrong. I was never interested in equality or diversity, big themes with big companies these days, I just knew that for both good and bad reasons, women in the industry had to be better than their XY chromosome cohorts.

Speaking informally with a group of women CFA candidates afterwards, and in bewilderment over the apparent lack of progress over the years, I offered my observations about management in the investment business and how to identify “evolved” managers from those less gender neutral. Others encouraged me to list my albeit-unscientific observations as a guide to others.

If you are a manager, how evolved are you?

How to identify evolved managers

If your boss’s wife works, he is possibly evolved. If your boss’s mother worked and he was secure enough not to resent being left alone occasionally, he has a higher chance of being evolved. If your boss has daughters, he has the potential to be evolved.

Danger signs

If your boss’s wife is a stay-at-home “soccer” mom, danger; you are in trouble! Corollary rule; someone observed that 90% of investment bankers’ wives do not work; seek employment with bosses from the other 10%. If your boss’s mother did not work – he has a serious impediment to evolution. If your boss has a son in medical school and daughter in modelling, you are in for serious trouble!

Franklin made an interesting observation that women of an earlier generation were not always helpful to other women. So if your boss is a woman there are no guarantees. In fact some of the same dangers exist. If your boss has a house husband, beware, she is likely to be less empathetic.

Source: Catalyst 2011

Canadian public corporations have only 10.3% women board members according to a Global Survey released by Catalyst in May 2011. Canada is just behind Turkey’s 10.8%! Even the unenlightened U.S. has 15.7%. Why should investment professionals care? As Chief Investment Officer for several large institutional investment companies I have had the responsibility to vote proxies. In my experience, corporate governance in Canada is poor. Nortel is a good example of management failure and lack of board governance yet nobody has gone to jail. Is there any guarantee that adding women to boards would make a positive difference? No. But I know that women in my specialized slice of the world had to be better so why not give them a try? They could certainly not be any worse. In fact, true equality will only occur if women are given a chance to be as mediocre as the boys.

For those of you looking to hire graduates from that CFA class of 2011 and beyond, here is a tip that could give you the statistical confidence of Hlinka’s CFA candidates. Pick the woman. She is likely to be better than the average guy because, unfortunately, she has to be.

Tuesday, April 19, 2011

Final Score: ETFs 1: Leafs 0

Too much success can be a bad thing.

The Toronto Maple Leafs don’t need to put a competitive team on the ice. Season ticket holders already compete for 90% of all seats, broadcasting revenues are maxed and virtually every game is sold out.

The Leafs represent a clear distortion in the marketplace. There is little incentive to win because fans act irrationally.

The popularity and institutional success of passive investing in general (replicating the performance of an index), and exchange-traded funds (ETFs) in particular, have led some to believe that distortions result because investors act rationally.

“ETFs are radically changing the markets to the point where they, and not the trading of underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” write Harold Bradley and Robert R. Litan in a 2010 paper for the Kauffman Foundation.

The authors are concerned about ETFs and other influences they feel discourage new issues and impede the efficiency of capital markets. They believe the popularity of ETFs has led to trading volumes that overwhelm the liquidity of underlying securities, thus distorting valuations.

Fundamental to the authors’ argument is the dominance of passive over active investing. Dominance that overrides the arbitrage of individual stocks gives their argument credibility.

The case for indexing

In an analysis for Vanguard research, “The Case for Indexing in Canada,” authors Philips, Walker and Kinniry restate in a Canadian context what others have observed elsewhere: that costs are difficult for active managers to overcome. The asset-weighted expense ratio for actively managed Canadian equities funds was 2.29% (May 31, 2010) versus 0.87% for Index funds, a difference of 1.42%. Cap-weighted Canadian equity ETFs have expense ratios between 0.07% (HXT) and 0.25% (XIC) for a difference of 2.04-2.22%.

Active management can occasionally overcome this disadvantage in the short term but has difficulty over the long term. The sidebar (see “Relative performance of Canadian actively managed funds”) from the Vanguard study shows the consistency with which actively managed funds underperform their benchmarks, and somewhat alarming median annual return shortfalls.

The (weak) case for active management

1. The most popular argument for active management is a desire to beat the market. Advisors say the only way to guarantee you won’t beat the market is to index. It is possible to pick an outperforming stock but difficult to do so consistently, and really difficult to pick a portfolio of winners. If investors selected only a few stocks, watched them closely and kept trading costs low, they would have more success because high turnover costs kill returns. Picking active, outperforming mutual funds is a low-probability activity. Nevertheless, investors try to pick winners because they think it is possible.

2. Fun. Indexing isn’t. There is no question that passive investing is the intelligent choice. Lower costs boost returns, but talking about stock picks is more fun. People do it even if they aren’t quite sure what they are doing. There is higher entertainment value to active management.

3. Special knowledge. In most professional endeavours, specialized education is a barrier to entry. With no apology to my portfolio manager colleagues, picking stocks is not neurosurgery. Anybody can do it. Results may not be consistent and the methodology may at times resemble picking horses at the track, but anybody can open an online account and get some kind of return. In bull markets they are likely to be successful. Less so in bear markets. Investing is egalitarian.

Current SEC investigations aside, material non-public information is difficult to obtain and illegal to use, so potential access to inside information is no longer an advantage for Street veterans. Twenty-four-hour business news media has given the public access to the same information as the professionals, on as timely a basis. The poor record of investment professionals—reflected in the mutual fund numbers—suggests that educated and experienced pros find outperforming difficult. Despite what should be a discouraging record, mutual funds have 20 times the assets of ETFs in Canada. This is hardly the overwhelming dominance to which the Kauffman paper alludes.

4. The superstar. Western society has a fascination with the superior individual. The U.S. Naval Academy graduate with a Harvard MBA and PhD in Quantitative Finance from Wharton must be a superior human being and should be able to build portfolios that outperform on any basis. If such a person exists, she is working at a hedge fund and couldn’t care less about your money or mine!

5. Not-so-smart people do it. Hubris is a huge motivator. The annoying neighbour, the chatty dentist, and Uncle Fred the blowhard all talk about how they picked the stock of the decade. Maybe they did, but you will also notice that only lottery winners are interviewed, not the hundreds of thousands of losers. Ask Uncle Fred about his portfolio’s total return over five years for a reality check.

There’s not much of a case for active management. In Canada, however, a $12 billion-a-year gorilla of an investment industry stands between the retail investor and the door containing common sense. Greed will always create the motivation to arbitrage the valuation of underlying securities in an index. This may not happen as instantly as the Kauffman authors would like, but if there is an opportunity to squeeze a penny from the market, it will be done.

In the face of all this illogical behaviour, investors can still efficiently participate in the long-term growth of an economy, sector or industry using ETFs at low cost and with full transparency. Unlike the long-suffering, irrational Maple Leafs fan, an ETF investor may appear to perform in mediocre fashion throughout the season but in the long run will beat 90% of the competition.

Stanley Cup? Who cares, because someone other than the owners will be laughing their way to the bank: you.

Tuesday, April 5, 2011

Evolving Revolution in ETFs

Free at last!

Once an opaque pastime for the rich, investing has been hidden behind obscure terminology, highly paid advisors, and arcane documents, like the mutual fund prospectus. The digital age is changing all that. ETFs are weapons in the movement to emancipate individual investors.

The explosive growth of exchange traded funds (ETFs) has been both exciting and bewildering. Retail investors, excited by broad access to timely, low-cost, tax efficient and diversified exposure to capital markets are also bewildered by the scope, breadth and number of products – 224 in Canada, 3,500 globally and 500 ETFs in registration with the Securities and Exchange Commission (March 2011). Sorting, selecting and constructing portfolios are new and growing challenges for investors. Nevertheless, ETFs have provided only the second significant advance for individual investors since the popularization of the mutual fund in the 1990s (the first being the introduction of the index mutual fund).

Mutual fund companies must also be excited and bewildered. Traditionally marketers and distributors of investment products, banks and fund companies are reassessing their business models. Scale has always been important but it is critical today with compliance expanding and margins contracting. Although the mutual fund continues to dominate retail investing, better-informed investors recognize that costs matter and that in an interconnected world, transparency and access to pricing more than once a day should be fundamental.

ETFs, because they are listed directly on stock exchanges without having to be “approved” by a sales entity, provide a distribution “end run” around the established axis of bank and fund company control, and give buying choice directly to individual investors. Furthermore, the hype around “star” managers and persistent marketing of past performance has worn thin. It is not exactly breaking news that past performance is no indication of future performance.

Sophisticated investors have been using ETFs for over a decade, but the broad public is catching on, albeit slowly. Early adopters of ETFs have been CEOs, senior executives, sophisticated high net worth investors, and investment professional themselves. However, innovation is still driven by professional money managers motivated by increasingly knowledgeable institutional clients. Individual investors can exploit these trends and ETFs enable them.

Democratizing diversification

The principle of diversification is not new. Natural selection and evolution itself may have been the first practical implementation of diversification as a means for the species to survive. Harry Markowitz put form around the substance of portfolio diversification in (Modern) Portfolio Theory (1952). Retail and institutional investors already knew not to put all their eggs in one basket but it wasn’t until the 1970’s that index or passive investing became pervasive among large institutional portfolios about ten years after the introduction of the Capital Asset Pricing Model (CAPM) suggested a distinction between systematic non-diversifiable or market risk, β, and unsystematic diversifiable idiosyncratic or asset specific risk, α. The idea of combining a low cost passive core portfolio using index strategies to capture broad market (β) returns and using satellite portfolios to generate excess (α) returns has been accepted institutional practice for 30 years. Importantly, passive investing, once the domain of the largest institutions and pension funds is becoming “mainstream”.

Investment professionals were the first to embrace exchange traded funds (ETFs) when the Toronto Stock Exchange introduced Toronto Index Participation Shares (TIPS) in 1990. Replicating the TSE 35 Index (predecessor of the S&P/TSX 60 Index), institutional managers found they could rapidly deploy cash in a diversified manner using TIPS. Individual investors gained their first access to instant transparent diversification through an exchange as a result.

Diversified Canadian Equity – ranked by diversification and cost



iShares S&P/TSX Capped Composite



BMO Dow Jones Canada Titans



Horizon BetaPro S&P/TSX 60



iShares S&P/TSX 60 Index



International diversification

Thirty years ago, international equities were considered “alternative” asset classes. Access to markets and diversification within them were barriers. Not so today. ETFs offer access to a growing array of international markets. The emerging markets are an area of particular interest to professional investors. As a consequence, more granular choices are available to all.

International or Global Equity – ranked by diversification and cost



iShares MSCI World Index






BMO International Equity Hedged to CAD



Claymore International Fundamental Index (hedged and non-hedged)



Emerging Markets Equity – ranked by diversification and cost

iShares MSCI Emerging Markets Equity Index



BMO International Equity Hedged to CAD



Claymore Broad Emerging Markets



Specific Emerging Markets Equity - ranked by diversification and cost

Claymore China



Claymore BRIC



BMO China Equity Hedged to CAD



iShares MSCI Brazil Index



iShares China Index Index



iShares CNX Nifty India Index



iShares MSCI Latin America 40 Index



BMO India Equity Hedged to CAD



The three factor model and the style box

Institutional managers have found CAPM a useful but imprecise tool. The Fama-French three factor model added style (value/growth) and size (small cap/large cap) to market risk finding that, for U.S. equity markets over time, value outperformed growth and small capitalization stocks outperformed large capitalization stocks. These simple ideas provided the basis for the Morningstar Style Box of money management categorization (1992) and contributed to the popularization of mutual funds over the past two decades. ETFs are available that address all three factor approaches.

Value Canadian Equity – ranked by diversification and cost



Claymore Canadian Fundamental Index



iShares Dow Jones Canada Select Value



Horizon AlphaPro North American Value



Growth Canadian Equity – ranked by diversification and cost



iShares Dow Jones Canada Select Growth



Small Cap Canadian Equity – ranked by diversification and cost



iShares S&P/TSX SmallCap



iShares S&P/TSX Completion Index



Sectors and countries

If three factors are good, more must be better. Breaking market risk into more component factors can be a comprehensive way to control components of risk. The simplest example is the aready-pervasive practice of isolating sectors and industries domestically and globally. Canadian sector ETFs are available for energy, financials, information technology, materials and REITs from iShares with choice in most offered collectively by Bank of Montreal (BMO), Claymore and Horizon BetaPro. Global sectors include agriculture, real estate, and water offered by Claymore with choice in metals and infrastructure offered by BMO.

For U.S. markets, BMO offers banks, healthcare and NASDAQ ETFs. Investors with access to U.S. markets get an even broader palette of ETFs in every sector imaginable. On the fixed income side, there is a growing list of sector, quality, and term choices with international and inflation protection included. Commodities and income choices are also pervasive.

What’s next and why

Investors who experienced the financial crisis and market meltdown in 2009 know that there were few places to hide from the twin forces of volatility and a liquidity vacuum. At one end of the spectrum, broad diversification did not save portfolios nor did stock picking at the other.

Expect more creative approaches towards diversification. Income generation is a popular one at the moment.

Income – ranked by diversification and cost



iShares Diversified Monthly Income



BMO Monthly Income



Claymore Canadian Financial Monthly Income



Claymore S&P/TSX CDN Preferred Share



iShares S&P/TSX Preferred Stock Index Hedged to CAD



Alternative approaches will also start to appear in Canada that replicate hedge fund strategies. BMO’s Covered Call Canadian Banks (ZWB 0.65%) and Horizons AlphaPro S&P/TSX 60 130/30 Index (HAH 0.95%) are examples. In the U.S. merger arbitrage and managed futures ETFs are several active global macro choices are also available.

Most intriguing are ETFs that reflect what professionals are trying to accomplish using risk and leverage. There is a clear relationship between volatility, as measured by the standard deviation of a market like the S&P 500, and market direction. Stable or falling volatility appears to accompany rising markets while increasing volatility accompanies falling markets. The reason is that volatility is persistent over the short term (autocorrelation = 0.75) and return is not (0.05). This has led to the tracking of VIX, a measure of volatility based upon option premiums. These strategies are not for the retail investor ...yet.

Volatility Indices



HBP S&P 500 VIX Short-Term Futures™



HBP S&P 500 VIX Short-Term Futures™ Bull Plus



As other professionals study the relationship between groups of securities we expect that their experience will be the same as PŮR’s. There are relationships that have always existed but have not yet been exploited. The application of various statistical techniques will lead to new ways to bend and shape risk and ETFs will be the testing ground for these new ideas. The retail investor will benefit in the end because the vehicles will be transparent and available on public exchanges.

The educated consumer is the ETF’s best customer today and the product stream of the future will affirm this. In a single digit return environment with pension plans shifting liability to individual and social welfare programmes under challenge, investors must take more responsibility for their financial futures. Advisors need to improve their skills and mutual funds will have to find a new value proposition.