Canadian Couch Potato is moving

I’maa pleased to announce that Canadian Couch Potato has been redesigned and moved to a new host. The new format is more flexible and will allow me to better maintain subscriptions, accurately measure traffic, and to carry advertising.

The switchover should be seamless for anyone who has bookmarked the blog, and for anyone using RSS to subscribe to the feeds. However, email subscribers will have to follow a simple step in order to keep receiving new posts in their inboxes. You will soon receive an email from Feedburner, the service that handles subscriptions for the blog. The email will contain a confirmation link that you must click to verify that you want to receive posts from Canadian Couch Potato.

I expect that there will be a few creases to iron out over the next week or so, and I ask for your patience. Please let me know what you think of the new format, and thanks for reading.

Review: Lifecycle Investing

Most investors understand that you should have more exposure to stocks when you’re young and gradually allocate more to bonds and cash as you approach retirement. In their new book, Lifecycle Investing, Ian Ayres and Barry Nalebuff point out there’s a problem with that strategy—and they offer a solution.

Ayres and Nalebuff believe in diversifying across asset classes and agree that index funds are the best way to do this. But they argue that we must also diversify across time, something almost no one does: “Even after accounting for inflation, a typical investor has twenty or even fifty times more invested in stocks in his early sixties than he had invested in his late twenties… It’s as if your twenties and thirties didn’t really exist.”

We do take advantage of “temporal diversification” when we buy a home. When you’re in your twenties, you might save $25,000 and use it as a 10% down payment on a house, which gives you $250,000 exposure to the real estate market using 10-to-1 leverage. As you pay down your mortgage, you gradually “deleverage” as you build up equity. But even if you trade up to a bigger house a couple of times, your lifetime exposure to the real estate market stays relatively stable over three or four decades. “Homeownership is one of the very few ways that people have been willing to diversify across time,” the authors say. “This is a huge, hidden benefit of buying a home.”

Now compare that with the way most people invest for retirement. Someone in her twenties might have just a few thousand dollars invested in stocks. After paying off her mortgage, she’ll have a lot more money to invest, but by that time she may by 50 years old, and the conventional wisdom says she should be in more conservative investments. That’s the crux of the problem Ayres and Nalebuff identify: you either have lots of time and little money to take advantage of the higher returns on stocks, or you have lots of money and little time to ride out the volatility of the equity market.

By now you may have figured out Ayres and Nalebuff’s strategy: borrow to invest in stocks when you’re young. They suggest investing 200% of your savings in stocks throughout your twenties and thirties — in other words, using 2-to-1 leverage. As with a mortgage, you gradually reduce the amount of leverage as you get older, but you keep your lifetime exposure to the stock market much more consistent over time.

The authors provide reams of backtesting to compare their strategy with traditional asset allocation models. (The most common is the rule of thumb that your stocl allocation should be equal to 110 minus your age — for example, you should hold 70% in stocks age 40.) The leveraged strategy delivered much higher lifetime returns in every case, even for people who lived through the Depression or retired right after the market crash of 2008–09. If you’re comfortable with the math, you can download their original research paper to see the detailed results.

I have no doubt their numbers are accurate. But the problem with Ayres and Nalebuff’s strategy is not math, it’s human psychology. The book does discuss cases where the Lifecycle strategy would be inappropriate, and one of these is “if you would worry too much about losing money.” This is stated casually, almost as an afterthought, but it’s a fatal flaw. The strategy would work magnificently if you were in a coma and a computer were managing your portfolio. But it’s hard to imagine that more than a tiny percentage of non-comatose investors would have the stomach to carry it out.

Ayres and Nalebuff must never talk to investment advisors or they would know that just about everyone “worries too much about losing money.” Advisors repeatedly tell me that their biggest challenge is convincing their clients not to panic during market downturns. Even without leverage, most investors earn subpar returns because they can’t stick to a disciplined strategy. How would you have reacted if you’d had 200% of your savings in stocks during the 2008–09 crash? You would have been wiped out, and you probably would have been scared out of the market for a long time, maybe forever.

The other obstacle with the Lifecycle strategy is that it’s too complicated for most investors to implement on practical level. I won’t get into the details, but it involves buying on margin or using index futures, which are derivatives that allow you get market exposure without actually buying shares in an index fund. Recommending that retail investors manage their life savings this way is like suggesting that homeowners should do their own electrical work. Some will be able to do it successfully, but most will eventually get a nasty shock and give up. And a few will burn their houses down.

More ETFs Now Paying Monthly

Both iShares and Claymore have announced that several of the their ETFs will start paying distributions monthly instead of quarterly. The announcements came within five days of each other earlier this month. It’s good to see the two biggest players in the ETF market pushing each other into improving their products.

Here are the ETFs that will begin paying monthly distributions starting in July:

Claymore Equal Weight Banc & Lifeco (CEW)
Claymore 1-5 Yr Laddered Government Bond (CLF)
Claymore 1-5 Yr Laddered Corporate Bond (CBO)
Claymore Advantaged Canadian Bond (CAB)
Claymore S&P/TSX CDN Preferred Share (CPD)
Claymore Balanced Income CorePortfolio (CBD)
Claymore Balanced Growth CorePortfolio (CBN)

iShares DEX All Corporate Bond (XCB)
iShares DEX Short Term Bond (XSB)
iShares DEX Universe Bond (XBB)
iShares DEX All Government Bond (XGB)
iShares DEX Long Term Bond (XLB)
iShares U.S. IG Corporate Bond (CAD-Hedged) (XIG)
iShares U.S. High Yield Bond (CAD-Hedged) (XHY)
iShares Dow Jones Canada Select Dividend (XDV)
iShares S&P/TSX Capped REIT (XRE)
iShares S&P/TSX Capped Financials (XFN)
iShares S&P/TSX Income Trust (XTR)

The press releases from both Claymore and iShares say they made this change because investment income is becoming more important to Canadians. It’s true that the new monthly schedule will improve cash flow for people who are drawing down their nest egg.

However, the new schedule may be a disadvantage for small investors who are trying to grow their portfolios with dividend reinvestment plans, DRIPs. (Many discount brokers offer this service with Canadian ETFs.) Because only full shares can be purchased with a DRIP, small investors may find that monthly distributions are smaller than the cost of a single share.

For example, suppose an ETF trading at $30 currently pays a quarterly distribution of about 1%. That would mean you’d need 100 shares in the fund — about $3,000 — to receive enough to purchase a single share with a DRIP. When the fund switches to a monthly distributions, each payout will fall to 0.33%. That means investors will need to hold about $9,000 in the fund to receive a distribution large enough to buy one share. Anyone holding less than that will receive all of their distributions in cash.

Should You Use Index Funds or ETFs?

This week I got an email from a reader who is in the process of firing her advisor and becoming a Couch Potato. “I have decided it’s time to take matters into my own hands,” wrote Sarah. “I have $25,000 in mutual funds in my RRSP with my current adviser. I want to create a Couch Potato portfolio with ETFs, but I’m a little intimidated. I don’t even know how to set up a brokerage account.”

I surprised Sarah with my response: I suggested that she not open a discount brokerage account, and that she forget about ETFs for now. That’s because $25,000 is not enough to make ETFs efficient—index mutual funds are a much better option. The trading commissions Sarah would pay to buy and sell ETFs would outweigh the benefit of the lower annual fees. In fact, index mutual funds beat ETFs for most small portfolios.

I recently wrote an article in MoneySense about this issue, but I wasn’t able to go into detail about the math. Doing the calculations is important, though: choosing the wrong option can cost you a lot of money. If you’re considering your first Couch Potato portfolio and you’re not sure whether to use index funds or ETFs, here’s how to figure it out:

1. Determine the total MER of each portfolio option.

In general, ETFs have lower annual fees than index mutual funds, but the gap isn’t necessarily large, especially if you’re comparing ETFs to TD’s e-Series mutual funds. To determine the total MER of a portfolio, multiply the annual fee of each individual fund by the percentage you’ve allocated to that fund, then add them all up. For example, here are the calculations for two versions of the Global Couch Potato portfolio:

Index mutual fund	%	MER	Weighted MER
TD Canadian Index – e	20%	0.31%	0.2 × 0.31 = 0.06%
TD US Index – e	20%	0.48%	0.2 × 0.48 = 0.10%
TD International Index – e	20%	0.50%	0.2 × 0.50 = 0.10%
TD Canadian Bond Index – e	40%	0.48%	0.4 × 0.48 = 0.19%
Total MER for portfolio			0.45%
Exchange-traded fund	%	MER	Weighted MER
iShares S&P/TSX Composite (XIC)	20%	0.25%	0.2 × 0.25 = 0.05%
iShares S&P 500 (XSP)	20%	0.24%	0.2 × 0.24 = 0.05%
iShares MSCI EAFE (XIN)	20%	0.49%	0.2 × 0.49 + 0.05%
iShares DEX Universe Bond (XBB)	40%	0.30%	0.4 × 0.30 = 0.12%
Total MER for portfolio			0.32%

If you’re investing in only these four asset classes, the MERs are not dramatically different. The iShares version has an edge of just 0.13%.

2. Multiply the total MER by the value of your portfolio.

This step will determine your annual cost in dollar terms. We’ll use Sarah’s $25,000 portfolio value to make the comparison:

$25,000 × 0.45% with TD e-Series Funds = $112.50
$25,000 × 0.32% with iShares ETFs = $80

Turns out the difference in MERs works out to only $32.50 a year on Sarah’s portfolio. Fractions of a percent don’t add up to much in small portfolios. Had Sarah been investing $200,000, the difference between the two options would have been $260 a year and more of a concern.

3. Determine how many ETF trades you’d make annually.

At a minimum, count on making one trade per ETF each year. (If you make an annual lump-sum contribution and rebalance the portfolio at the same time, that’s as efficient as you can get.) Multiply the number of trades by the commission charged by your brokerage. For example:

4 trades with big-bank brokerage at $28.95 = $115.80
4 trades with low-cost brokerage at $9.95 = $39.80

4. Add the cost of the MER and the cost of the trades.

You need to consider both the annual MER and the trading commissions to determine the overall cost of your portfolio. Let’s compare the different versions of the Global Couch Potato portfolio at $25,000:

		MER in	Trades	Cost of
	MER	dollars	per year	trading	Total
TD e-Series Funds	0.45%	$112.50	0	$0	$112.50
iShares ETFs @ $28.95	0.32%	$80	4	$115.80	$195.80
iShares ETFs @ $9.95	0.32%	$80	4	$39.80	$119.80

You’ll notice that for a $25,000 account, the total cost of maintaining the portfolio is less with the TD e-Series funds, despite the lower management fees of the ETFs. It’s a lot lower compared with the $28.95 trades, and even a few bucks less with super-cheap $9.95 trades.

5. Find the break-even point for the two options.

As your portfolio grows in size, the dollar cost of the MER goes up, but the cost of trades remains the same. That’s why ETFs are more cost-efficient in large portfolios. The trick is to find the break-even point. If your portfolio is more the break-even point, use the ETFs. If it’s lower, use the index mutual funds.

Here’s an illustration that assumes you’re comparing an ETF portfolio with a total MER that  is half that of comparable mutual funds, and that you’re making eight trades per year. In this case, let’s use a portfolio value of $75,000:

		MER in	Trades	Cost of
	MER	dollars	per year	trading	Total
Index mutual funds	0.60%	$450	0	$0	$450
ETFs @ $28.95/trade	0.30%	$225	8	$231.60	$456.60
ETFs @ $9.95 trade	0.30%	$225	8	$79.60	$304.60

When comparing index funds with ETFs at a big-bank brokerage, $75,000 turns out to be the break-even point: the price difference between the two options is less than $7. (With the low-cost brokerage option, the break-even point is about $27,000, at which point the annual cost of the ETFs and index funds in this example is about $161.)

Keep the cost differences in perspective: in the above example, the low-cost brokerage would save you about $145 over the mutual funds, or 0.19% of a $75,000 portfolio. Those small savings come at the cost of flexibility: you can’t make monthly contributions with ETFs (unless you use Claymore’s PACC plan), and your dividends sit in cash until your annual rebalancing date.

While ETFs dominate almost every discussion of index investing (I’m guilty here, too), the fact is they are not cost-efficient for small portfolios. In Sarah’s case, at $28.95 per trade, her portfolio would have to be $86,000 before iShares ETFs were less expensive than TD e-Series Funds (assuming four trades per year). At $9.95 per trade, she would need only $35,000 to make ETFs cheaper. However, she would also be unable to make monthly contributions to each fund, something she does with her current RRSP.

There’s another factor to consider here: Sarah was nervous about even opening a discount brokerage account. With an ETF portfolio, she would need to be comfortable making her own trades, which is intimidating for many inexperienced investors. A couple of errors when entering orders would instantly wipe out any potential cost advantage of ETFs. And when investing makes you nervous, you’re liable to abandon your strategy, which is just about the worst thing you can do as a Couch Potato.

Not All Indexes Are Created Equal

In yesterday’s post I looked at the recently launched BMO Equal Weight REITs Index ETF (ZRE), which invests in Canadian real estate investment trusts. The new ETF is going head-to-head with the  iShares S&P/TSX Capped REIT Index Fund (XRE), which until now had no competition in this space. The big difference between the two funds is that ZRE is equal-weighted, while XRE uses traditional cap-weighting. So, which strategy is superior?

There’s no question that cap-weighted indexes have a flaw: because they are heavily influenced by each stock’s current share price, they give greater weight to overvalued companies and less to undervalued ones. That makes them prone to bubbles: for example, when the price of Internet stocks rose to absurd heights in the 1990s, technology companies dominated the S&P 500, even though some of these had never actually made any money. Meanwhile, fundamentally sound but undervalued companies made up a smaller and smaller portion of the index. We all know what happened next.

In recent years, a number of index providers have looked for ways to avoid this Achilles heel of cap-weighting. Perhaps the best-known “price-neutral” strategy is fundamental weighting, which is based on a company’s dividends, free cash flow, total sales and book value. This is the strategy Claymore uses in its most popular equity ETFs.

Another alternative strategy is equal weighting, or assigning the same fixed allocation to every stock in the index. A number of BMO’s new ETFs use this strategy, including ZRE, which includes 17 real estate investment trusts, each of which makes up about 6% of the fund’s holdings. In contrast, the cap-weighted iShares fund assigns 25% to its largest holding (RioCan) and less than 4% to its smallest.

Many commentators seem to take it for granted that XRE’s top-heavy index is a problem. But my first reaction is that we don’t apply that logic to other indexes. If you buy a cap-weighted Canadian equity index fund, you’re investing 30% of your money in the financial sector and just 3% in consumer staples. A European index fund has about 32% of its holdings in the United Kingdom and 2% in Finland. That simply reflects the economic reality, and few people would argue that we should weight sectors or countries equally.

By the same logic, if RioCan represents 25% of the REIT economy in Canada, why should it not represent a similar amount of the index? RioCan’s market cap is almost $4.8 billion, compared with Artis REIT’s $480 million. Why is it a sound strategy to invest equal amounts in both companies (as BMO’s REIT fund does) when one is ten times larger?

In some ways, criticizing an index for overweighting large companies is like suggesting that Canadian democracy is problematic because Ontario’s voters have more influence than Prince Edward Island’s. In fact, I’d make the opposite argument: by giving all the premiers an “equal weighted” position at First Ministers’ conferences, the 140,000 residents of PEI have a representation that is way out of proportion. This kind of distortion occurs in the Rydex S&P Equal Weight ETF (RSP), which holds all the companies in the S&P 500 and assigns each one a weight of 0.2%. In this index, Exxon Mobil has the same influence as Office Depot, even though the former is a hundred times larger.

If traditional indexes give too much weight to large or overvalued companies, equal-weight indexes are biased toward small-cap stocks, sometimes dramatically. They also overweight sectors that are made up of many small companies (like consumer discretionary) and underweight those dominated by a few large players (like utilities and energy). If you believe in efficient markets — and if you don’t, you’re not an index investor — then equal weighting is hard to justify as an investment strategy.

There are practical considerations that work against equal weighting, too, at least in theory. Daily price changes constantly cause the stocks in the index to deviate from their target weights. That can mean either large tracking errors or frequent rebalancing, leading to higher expenses and capital gains taxes.

OK, time for a deep breath. Despite its flaws, I don’t think the equal weighting strategy is nearly as problematic in ZRE as it is in more broadly based funds. First, an index fund dominated by one or two sectors, or by one or two countries, is not as vulnerable as a fund dominated by a single company. Barring Armageddon, an entire sector or country can’t go to zero. But a company sure can. Nortel once made up more than 30% of the S&P/TSX Composite and is now a penny stock—that’s the reason the iShares S&P/TSX Capped Composite Index Fund (XIC) no longer allows any stock to make up more than 10% of the index. If RioCan were to implode, holders of XRE would be dramatically affected, while investors in ZRE would have much more protection.

Second, there’s a big difference between a fund with 11 stocks (like XRE) and one with 500. The academic literature suggests that a portfolio needs to contain at least 30 names or so before company-specific risk is minimized. I don’t think equal weighting makes sense for the S&P 500, where no single company represents more than 3% by cap weight. But when an index has fewer than a dozen stocks and one of them is hugely dominant, that’s a different story.

The potentially higher cost of equal weighting isn’t likely to be a problem for BMO’s REIT fund either. According to its prospectus, ZRE will be rebalanced just twice a year, and with 17 stocks, that’s not going to be expensive. Its management fee (0.55%) is also the same as its iShares competitor. By contrast, Rydex charges 0.40% for RSP, about four times more than cap-weighted S&P 500 ETFs.

So, what’s my verdict on ZRE? I’m warming up to it. While I am always suspicious of new products that claim to improve on cap-weighting (most have more to do with marketing than sound investment principles), I think equal weighting may well be a superior way to invest in a sector with a small number of companies. I haven’t switched from XRE yet, but I may do so the next time I rebalance my portfolio.

[Congratulations to reader Len, who won the draw for a copy of Keith Matthews’ book, The Empowered Investor. Thanks to everyone who commented on last week’s series of posts, and to Keith for donating the book.]

New Kid on the Real Estate Block

It looks like BMO has finally made a splash in the ETF market. Most of the bank’s family of exchange-traded funds, launched about a year ago, either duplicated existing products from iShares or focused on exotic asset classes. But they’ve changed that with the launch of BMO Equal Weight REITs Index ETF (ZRE) last month. This new fund tracks an important asset class — real estate — and does so with a strategy that may be superior to its competition.

Until the launch of BMO’s fund last month, the iShares S&P/TSX Capped REIT Index Fund (XRE) was the only exchange-traded fund tracking the Canadian real estate sector. With almost a billion dollars in assets, it’s a category killer. But perhaps not for long.

Let’s compare the two funds to get a better understanding of how they differ. First we’ll take a closer look at the index that XRE tracks. The S&P/TSX Capped REIT Index is a subset of the S&P/TSX Composite. That means that if a REIT is not part of the S&P/TSX Composite, it can’t be included in XRE. That explains why there are only 11 REITs in the iShares ETF, even though there are more than 11 publicly traded real estate investment trusts in Canada.

The S&P/TSX Capped REIT Index is capitalization-weighted, meaning that  companies occupy a share of the index proportional to their size (as measured by the current price of a share multiplied by the number or shares outstanding). As a result, RioCan, the largest REIT in the country, makes up a whopping 25% of XRE, which is the maximum allowable. (The word “Capped” in the index’s name refers to the rule that no single security can represent more than 25%.) Indeed, the index is extremely top-heavy: the largest three holdings comprise half the ETF’s holdings.

Now let’s look at BMO’s new fund. This ETF tracks the Dow Jones Canada Select Equal Weight REIT Index. The companies in this index do not need to be part of the S&P/TSX Composite Index. As result, BMO’s fund includes 17 securities, six more than XRE. More importantly, however, the Dow Jones index is not capitalization-weighted. It’s equal weighted, meaning that every REIT is given the same weight in the index (100% / 17 = 5.9%) regardless of market cap.

Many commentators on this blog and others have argued that the equal weighting strategy is inherently superior, because it doesn’t concentrate the fund’s holdings on a small number of securities. That assessment may be valid, but as with any investment decision, it needs to be considered carefully. Capitalization-weighted indexes are not perfect, but they have endured for decades because they are based on fundamentally sound principles. In tomorrow’s post I’ll look at the pros and cons of equal weighted indexes and consider whether they truly are a better way to invest.

Disclosure: I currently own XRE in my own portfolio.

Build Your Own Pension-Fund Portfolio

It’s always interesting to know what the smart money is doing. And I’m not talking about the investment managers who appear on BNN to “talk their book” — like the guy who runs the precious metals fund and suggests you by precious metals. The smart money are the managers of pension and endowment funds worth billions. They earn their salaries by  producing excellent investment results, not by charging high fees while delivering mediocre returns.

Steve from the Think Dividends blog recently suggested I look at creating a portfolio aligned with the asset allocation used by the Ontario Teacher’s Pension Plan, the biggest and one of the most successful pension funds in the country. However, the OTTP’s portfolio is impossible to shadow with ETFs: much of it is private equity and hedge funds. Besides, anyone who invests in the Toronto Maple Leafs can’t be taken seriously. Instead, I looked to the Pension Investment Association of Canada, which compiles data on 130 pension funds.

Before considering how you can use this information to help you design your own portfolio, remember that pension funds are not like individual investors in some important ways. First, they have an infinite investment horizon. The rest of us will eventually retire and die, hopefully in that order. Pension fund managers also have access to investment opportunities that are unavailable to individuals: private  equity, hedge funds and risk-management tools such as derivatives. While most institutional funds employ passive strategies — that is, they invest in entire asset classes rather than picking individual securities — they also use active management to try to exceed their benchmarks.

That said, the composite asset allocation of 130 pension funds represents the collected wisdom of managers who handle over $905 billion. Here’s how they invested that staggering sum, as of December 31, 2009:

Canadian equities	15.9%
US equities	6.4%
EAFE equities	6.3%
Emerging markets equities	2.3%
Global equities	13.0%
Total equity	43.8%
Canadian nominal bonds	25.6%
Real return bonds	4.7%
Mortgages	0.7%
Foreign fixed income	1.9%
Cash and equivalents	0.1%
Total fixed-income	32.9%
Real estate	9.0%
Infrastructure	3.9%
Venture capital/private equity	6.0%
Hedge funds	2.0%
Other assets	2.4%
Total other	23.3%

Turns out that only about 10% of these assets fall into exotic categories: the 6% allocated to venture capital and private equity, the 2% to hedge funds, and the 2% lumped together as “other.” The small allocations to mortgages and foreign fixed income are too small to worry about in a small portfolio, so we’ll just include them with other nominal bonds. It’s impossible to know what countries have the most weight in the “global equities” category, but we’ll divide up that 13% among the US, international developed and emerging markets. When we round off some numbers for simplicity, we can boil down our model pension-plan portfolio and simulate it with these ETFs:

Asset class			Exchange-traded fund
Canadian equities	15%		iShares S&P/TSX Capped Composite (XIC)
US equities	15%		Vanguard Total Stock Market (VTI)
EAFE equities	15%		Vanguard Europe Pacific (VEA)
Emerging markets equities	5%		Vanguard Emerging Markets (VWO)
Real estate	10%		iShares S&P/TSX Capped REIT Sector (XRE)
Infrastructure	5%		BMO Global Infrastructure Index ETF (ZGI)
Canadian nominal bonds	30%		iShares DEX Universe Bond (XBB)
Real return bonds	5%		iShares DEX Real Return Bond (XRB)

The first thing you’ll notice is that this is a very conventional portfolio — if you consider the infrastructure component just a specific type of global equity (which it is), it’s almost identical to Canadian Capitalist’s Sleepy Portfolio. Maybe CC should send his resume to some pension funds and offer his services as an investment manager.

Of course, pension funds are a lot more sophisticated than your average Couch Potato — I’m pretty sure they don’t buy ETFs through BMO InvestorLine. But overall, their strategy comes down to investing in a diversified mix of Canadian and foreign stocks, real estate and bonds. If you’re doing the same with your indexed portfolio, count yourself among the smart money.

9 Secrets of the Empowered Investor, Part 3

This post is the third of three that outline nine critical factors in investment success, as identified by Keith Matthews, a portfolio manager with Tulett, Matthews & Associates in Montreal.

Leave a comment on any of three posts to be automatically entered in a draw to win a copy of Keith’s book, The Empowered Investor, which explores these concepts in more detail.

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7. Most investment strategies don’t survive for long.

Every year sees an explosion of new investment offerings, innovative strategies and brilliant managers promising big returns. During your investment lifetime, however, the vast majority of them will not survive. Most funds will be merged or liquidated, leaving unitholders to look for the next winning strategy. Often investors will find themselves jumping from one loser to the next.

Source: Standard & Poor’s Indices Versus Active (SPIVA) scorecard

Even if specific index funds and ETFs occasionally shut down, the asset classes they track will always survive. Using a passive investing strategy benchmarked to the major indices can significantly reduce “survivorship risk” in your portfolio and produce a more consistent long-term investment experience.

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8. The industry has conflicts of interest.

Successful investors face many roadblocks on the road to financial freedom. One of the biggest is the conflict of interest that exists in the financial services industry.

Advisors who are paid commissions based on the products they sell may have a disincentive to act in the best interest of their clients. Many advisors are also limited to offering only their firm’s in-house family of funds. Fees are often hidden so investors may have no idea how much they are paying.

If you use an investment advisor, look for one with a fiduciary responsibility, which legally requires the advisor to act in your best interest. Use an advisor who is  compensated by fees (whether billed hourly, or as a percentage of assets under management) rather than by commissions.

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9. Humans are not hard-wired to be good investors.

Emotions and cognitive biases are often an investor’s worst enemy. Fear, greed, loss aversion, overconfidence and hindsight bias can often lead smart people to make costly investment mistakes.

We can’t switch off our emotions, but we can make an effort to understand how the mind can play tricks on us, and how our personal hang-ups about money can lead us to make irrational investing decisions.

The structured portfolio approach used by index investors makes many decisions automatic, reducing the chances of falling prey to your emotions. Using an Investment Policy Statement can also help you maintain the discipline you need to reach your financial goals.

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See also:

9 Secrets of the Empowered Investor, Part 1

9 Secrets of the Empowered Investor, Part 2

9 Secrets of the Empowered Investor, Part 2

This post is the second of three that outline nine critical factors in investment success, as identified by Keith Matthews, a portfolio manager with Tulett, Matthews & Associates in Montreal.

Leave a comment on any of three posts to be automatically entered in a draw to win a copy of Keith’s book, The Empowered Investor, which explores these concepts in more detail.

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4. Value and small stocks outperform over time.

Many investors look for opportunities in growth companies. But long-term data show that investments in value companies (which have low price-to-book ratios, and are often out of favor) have produced higher returns than growth companies. Small companies have also produced higher returns than larger, more well-known companies.  These premiums appear to exist in all parts of the world.

Source: Dimensional Fund Advisors

These observations were reported by finance professors Eugene Fama and Kenneth French in the early 1990s. They explained that investors perceive higher risk in value and small companies and, accordingly, their stocks should provide higher expected returns. This is consistent with the notion that markets are efficient.

Portfolios that are “tilted” toward value and small-cap stocks add more risk, and therefore should have higher expected returns than the broad-market indices over the long term.

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5. Markets move randomly and unpredictably.

The chart below ranks the best and worst performing asset classes each year from 2000 through 2008. Can you spot the pattern and use this information to predict which asset class will lead the pack in the years to come?

Of course, that was a trick question: there is no pattern. Markets and asset classes move randomly and unpredictably, and investors often regret bold portfolio moves based on forecasts and predictions. There is no evidence that tactical asset allocation — that is, moving in and out of asset classes in an attempt to enhance returns — is an effective strategy over the long term.

Index investors use a “set and rebalance” approach to asset allocation that is not based on crystal balls. Rather than trying to predict the next hot asset class, they get exposure to all of them at all times.

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6. Passive outperforms active over the long term.

Few actively managed strategies have matched index or asset-class returns over any period longer than a few years. Only a very small percentage of actively managed Canadian, US and international equity funds beat their benchmarks over the last five years, according to Standard & Poor’s. There is nothing new here: similar results have been seen since the first studies of manager performance in the 1960s.

What’s more, there is no way to identify the winning funds in advance with any real confidence.

Source: Standard & Poor’s Indices Versus Active (SPIVA) scorecard

Index funds and ETFs will never rank number one in any given year, but they are the best choice for long-term investors. By doing nothing more than tracking the major indices, the iShares S&P/TSX Composite (XIC), the iShares DEX Universe Bond Index (XBB) and the Vanguard Total Stock Market (VTI) have all ranked in the top quartile over the last five years, according to Morningstar. (In other words, they beat at least three out of every four funds in the same asset class.) The longer the time period under review, the wider the gap between index funds and their active counterparts.

In addition to superior performance, index funds and ETFs also offer excellent transparency, pure asset allocation, low fees and greater tax efficiency.

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See also:

9 Secrets of the Empowered Investor, Part 1

9 Secrets of the Empowered Investor, Part 3

9 Secrets of the Empowered Investor, Part 1

I recently interviewed Keith Matthews for a forthcoming column in MoneySense. Keith is a partner and portfolio manager at Tulett, Matthews & Associates (TMA), an investment counsel firm in Montreal. Index investing is at the heart of TMA’s philosophy: the firm builds widely diversified, passively managed portfolios for its clients using mutual funds from Dimensional Fund Advisors and iShares ETFs.

During our discussion, Keith explained that he recently boiled down his 15 years of investment management experience into a concise framework that he shares with his clients. He’s identified nine factors that contribute to an investor’s long-term success, and he’s agreed to share them with readers of Canadian Couch Potato. I’ll present them this week in a series of three posts. (The material was originally written for TMA clients only, so I have made a few modifications to give them broader appeal.)

What’s more, Keith provided me with a copy of his excellent book, The Empowered Investor, which explores these ideas in greater detail and eloquently makes the case for index investing. By adding a comment to any post in this series, you’ll be automatically entered in a draw to win a copy of the book.

“A structured portfolio is not just about diversification,” Keith explains. “It is about bringing together a series of concepts or principles to match each investor’s unique situation. What follows are nine critical factors you must consider when thinking about your long-term investments. Each is essentially a pillar in a structured investment planning process. Ignoring them can lead to costly outcomes. Implementing all of them together will help you reach your personal financial goals and increase your odds of creating a successful long-term investment experience.”

Disclosure: I am not a client of Tulett, Matthews & Associates (their minimum portfolio size is a wee bit out of my league) and this is not a sponsored post. I asked Keith if he would be willing to share his insights simply because I think they will be an enormous help to readers. He generously agreed to do so.

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1. Investors with a financial plan will have a better outcome.

The lack of a financial plan is at the root of many challenges that investors experience. If you want to achieve financial independence, you need to start by reviewing your goals and life targets, saving rates, and your consumption and  lifestyle habits.

An investment plan comes next. This will map out your long-term investment objectives, time horizons, target asset allocation, tax consequences, risk tolerance and investment strategy. Seeking advice from a financial planning professional can be an important part of this process.

Successful investors keep their long-term goals in mind at all times. This helps them avoid being swayed by market movements and other distractions.

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2. Asset allocation is the dominant factor in a portfolio.

Choosing an asset allocation — the relative mix of stocks, bonds and other asset classes in your portfolio — is one of the most important decisions an investor can make. While market timing and stock picking may be exciting, the academic literature has shown that asset allocation decisions have a far greater impact on portfolio performance.

Source: Determinants of Portfolio Performance II, Brinson, Singer and Beebower, Financial Analysts Journal, May-June 1991

As a result, asset class investing is the most prudent and successful long-term strategy. It’s the one that has been used for decades by the smart money, such as pension fund managers. The best way for retail investors to adopt an asset class strategy is to use index funds or ETFs that track broad-based stock and bond indexes.

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3. There’s a difference between good and bad diversification.

Many investors believe that they are diversified because they own 15 stocks or 10 mutual funds. But often their holdings overlap: a portfolio of five bank stocks, five mining stocks and five income trusts is not well diversified. Similarly, if you hold four Canadian equity funds, chances are that they hold many of the same companies. That’s bad diversification, and it can be costly in the long run.

Good diversification means having exposure to all of the major asset classes with little or no overlap. These asset classes include government bonds, corporate bonds, real return bonds, Canadian stocks, US stocks, international stocks, and emerging market stocks. The equity components can be subdivided further into large- and small-cap stocks, and value and growth stocks.

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See also: 9 Secrets of the Empowered Investor, Part 2

9 Secrets of the Empowered Investor, Part 3