Steadyhand Blog

The Case for Dividend Stocks

Sat, 04 Sep 2010 13:15:00 PDT

The Globe and Mail, Report on Business
Published September 4, 2010

One of the joys of my day job is talking with smart, turned-on people from all aspects and levels of the investment business. My good fortune comes from having a long and diverse career (as Woody Allen put it, 90 per cent of life is just showing up), running a company that’s still too small to threaten anyone and, on most days, just being a nice guy.

Over the past few weeks, I’ve been camped out in Toronto meetings with a broad range of analysts, portfolio managers and executives. At some point in each conversation, I’ve asked the question: “What is the elephant in the room? What do you see out there that’s being overlooked or underappreciated?”

There have been an array of answers, but the consensus hit on two themes, neither of which could be described as under the radar. First, why would anyone buy a 10-year government bond yielding less than 3 per cent? And the second, which is related to the first, is that a portfolio of dividend-paying stocks is now a better way to generate a stream of income and higher return.

Few of my confreres are calling government bonds the next bubble, as Warren Buffett and Jeremy Siegel are, but they’re all struggling to make the math work and are dumbfounded by the massive flows going into bond mutual funds, particularly in the U.S. It would appear that individual investors are chasing past returns that are not achievable given the current level of interest rates.

Bond yields are low because of the economic outlook (can you say double dip?) and the possibility of deflation. In a deflationary environment, even low-yielding bonds look attractive. But in the more likely scenario where there is some inflation, 2.5- to 3-per-cent yields provide little cushion.

Of course, these investment professionals do still own government bonds in their clients’ portfolios for liquidity and diversification reasons, but it’s a matter of degree. Their point is that buying bonds or GICs in isolation, which was the safe strategy of the past, will lead to disappointment.

The other half of the consensus is that dividend-paying stocks are the way to go. By being an owner instead of a lender, the income stream is higher (none of us have gone through a period when dividend yields were above bond yields), more tax-efficient, and likely to grow over time as corporations increase their dividends.

Of course it’s easy for these (mostly wealthy) professional risk-takers to have this view, but what does it mean for investors who are living off of their portfolios. Certainly being an owner comes with its risks – dividends are paid only after all other obligations have been met and lenders (including bondholders) have been paid in full. If a company hits a rough patch, the first thing to go is the dividend. Manulife Financial Corp. was a core holding in most income-oriented portfolios and it cut its dividend in 2009, as did Manitoba Telecom Services Inc. recently (not to mention the many income and royalty trusts that reduced their distributions).

Being an owner also means the portfolio’s market value will bounce around with changes in interest rates, news on the companies’ business prospects and the stock market in general. Nobody expects another 2008, but a dip of 20 per cent or more is possible at any time, even for a conservative stock portfolio. Indeed, it’s assured of happening some time in the next 10 years.

It’s important to be prepared for this because the dividend strategy only works if you stick with it. If you bail out when prices are down or dividends are being cut, you will end up worse off than owning a low-yielding bond.

Even though I hate running with the herd on anything, I have to agree with my informal consensus. The reward/risk for bonds doesn’t look great, while the case for high-quality stocks is quite compelling.

Having said that, I go into this strategy with my rose-coloured glasses buried deep in the drawer. That’s because valuations are attractive for a reason. Corporate profit margins are already levitating at record levels, economic growth is expected to be slower and the business environment will be more competitive than ever. In other words, dividend growth will be harder to come by and there will be more Manulifes and MTSs ahead.

I want to diversify across industries and types of stocks as much as I can. While the financial sector dominates the dividend stock universe, there are other companies that pay reasonable dividends and have a record of increasing them – we own Rogers Communications Inc., Corus Entertainment Inc., and Enbridge Inc., to name a few. And for registered accounts, there are many high-quality foreign stocks yielding well in excess of 3 per cent.

As always, I want to be sensitive to valuation. Buying a big, fat quarterly dividend to maximize income in the short term can lead to disappointment (i.e. cuts) or mean less growth in the future.

We are in a unique circumstance where reaching to equities for income makes sense, but make no mistake: This approach requires discipline, fortitude and careful cash management. And it should be done in the context of a diversified portfolio, one that even has a few bonds in it.

Taking Stock

Tue, 31 Aug 2010 09:36:04 PDT

By Scott Ronalds

Roger Lowenstein’s latest article in The New York Times is a must-read. In Taking Stock, Lowenstein (a financial author and journalist) draws parallels between the investment environment and mindset of individual investors today to that of the 1970s.

The most striking similarity between then and now? A disappearance in the “ethos of confidence in long-term investing.” As was the case in the ‘70s, investors are discouraged and tired today. Gloom is selling well. One needs to look no further than the rise of gold and prophecies of economic doom. As noted in the article, one investment strategist recently drew a crowd of 600 people to elaborate on his call for a “bloody, deep recession ... and a stock market crash of at least 60 percent.”

Investors in the U.S. are withdrawing money from equity funds for the third straight year. In Canada, it is no different. Money has been flowing overwhelmingly into bond and income-oriented funds for quite some time. What makes this trend more troubling is the extremely low yields and limited upside of many fixed income securities – government bonds in particular.

What many people are missing, according to Lowenstein, is an important principle of investing:

“What the herd tends to overlook is that stocks are not – except perhaps in the very short term – a bet on the odds of an apocalypse, nor are investors in securities rewarded for their prowess as macroeconomists. The real challenge of investing is so prosaic it is often forgot. Stocks are simply a claim on future corporate earnings: if you can buy those claims at a discount, you should do well.”

The author notes that Business Week proclaimed “The Death of Equities” in 1979. A remarkable bull market arrived in 1982. Many observers are predicting a similar fate for equities today, despite the fact that businesses are profitable and stock valuations are reasonable (particularly in relation to bonds). Beware of buying into the apocalypse.

Book Review: False Economy

Mon, 30 Aug 2010 16:36:49 PDT

By Scott Ronalds

I recently finished reading False Economy – A Surprising Economic History of the World. Along with its New York Times Bestseller status and praise from all the usual suspects (The Washington Post, Financial Times, The Economist, etc.), I was intrigued by the book’s accolades from Bono and Mohamed El-Erian (CEO of PIMCO, the largest bond fund manager in the U.S.). If it appealed to a rock star and a bond geek, I figured it must be worth a read.

The book is written by Alan Beattie, the world trade editor for the Financial Times. Beattie examines the different paths that various nations have travelled in their rise to economic success or failure.

False Economy leads off with a comparison of Argentina and the United States. Beattie points out that just a short century ago, both nations were in similar places. Yet, the paths they took were very different. He explains how Argentina backed a small number of wealthy and powerful landowning families while America favoured small homesteads and settlers. American business owners invested in industrializing their country and created a nimble industrial sector, while Argentina developed a fear of the free market and sealed off its manufacturing companies behind a high wall of tariff protection. The American political system absorbed new ideas while Argentine politics were dominated by a small, self-perpetuating elite, which eventually led to a military coup and a nationalist (if not fascist) form of government. And the rest is history.

Beattie then jumps to the middle east to examine the strategic use of water and questions why Egypt doesn’t import more of its staple food. Subsequent topics include oil and diamonds (he suggests they are more trouble than they are worth), the role of religion in economic fate, and corruption (which he opines may be less damaging than it first appears).

Each of the book’s 10 chapters examines a particular nation or region and its economic history, with the author’s take on why the nation succeeded or failed and what lessons were learned along the way. His wish is that “the experience of history should lead us to hope and strive to make the world better, not to despair and resign ourselves to fate.”

While the book can be dense at times, Beattie keeps readers engaged by exploring seemingly random yet provocative topics, such as why Africa doesn’t grow cocaine, why much of America’s asparagus comes from Peru, and why giant pandas are “incompetent, inefficient piebald buffoons, and we should end their public subsidies and let them die out”.

All said, False Economy is an interesting book with good insights and lots of useful information. Yet, it reads like a text book in parts, which is why, like me, you may want to have your iPod on hand if you need a break. I found U2 to be rather appropriate.

Bearish Millionaires - Bring it on

Mon, 30 Aug 2010 08:48:07 PDT

By Tom Bradley

It was reported this week that millionaires are feeling more bearish. The Spectrem Millionaire Investor Confidence Index fell to -18, which represents “mildly bearish territory”. Prior to the August score, the index had been in neutral range (-10 to +10) for 12 straight months. In response to the number, Spectrem president George Walper said the “decline is particularly troubling since it suggests millionaires, typically more sophisticated than the broader affluent population, are reverting to a bearish frame of mind.”

As readers of this blog know, I learned from Art Phillips to watch market sentiment very carefully. When everyone is bullish, it’s generally a time to be careful. And when everyone is running for the hills, it’s time to pull out the buy tickets. Sentiment is not an exact timing tool, but rather a check against what the fundamentals and valuations are indicating.

I’m not familiar with the Millionaire Index, but it confirms what I’m hearing from clients and people I’ve been meeting with in Toronto over the last few weeks. The sentiment among investors is generally cautious, and at times downright gloomy. One senior portfolio manager went so far as to say that he thought the investor mood is worse now than it was after the market declines of 2008.

I’m not reading too much into the Millionaire Index or individual comments from the street, but I certainly differ from Mr. Walper in my interpretation. When investors – rich, poor, professional or amateur – are wary of the market, it’s a good thing for future returns. The more bearish the better.

Summer Reruns VIII - Foreign Takeovers

Thu, 26 Aug 2010 09:19:31 PDT

This week’s rerun comes from April 2007. Foreign buyers were on the hunt for Canadian assets, which was stirring emotions and politics at home. Tom weighed in with some unique perspective on the issue. With Potash Corp. now in play, it’s timely to revisit the topic.

The Flip-side of the Foreign Takeover Binge
Originally published in The Globe and Mail on April 20, 2007
By Tom Bradley

Like everyone else, I don’t like seeing corporate Canada get gutted by foreign buyers. I’ve thought for years that we were getting hollowed out, even if study after study claimed otherwise. I say that because I had a front row seat through the 90’s as a pension fund manager at Phillips, Hager & North. Instead of meeting with pension committees in a Canadian city, my partners and I increasingly found ourselves servicing the same Canadian plans in places such as Dallas, New York, Connecticut and New Jersey. The parent companies had taken as many white-collar jobs out of Canada as they could and that included the pension department.

But as we beat ourselves and the Finance minister up about our northern passivity and lack of guts, I think there is a need for some perspective on the foreign takeovers. To date, the commentary has been very emotional and increasingly political.

So, under the heading of perspective, I add three comments to the dialogue.

First, there is an underlying assumption in all the commentary that the foreigners are making wise purchases. Perhaps Canada is grossly undervalued and guys like me are missing it, but there’s plenty of evidence that paying premiums to buy public companies at the end of a business cycle (or somewhere near the end) usually turns out badly. How much value was there in Inco, Dofasco or Four Seasons at the takeout price? Did that price represent an outstanding opportunity to generate an above-average return? Only time will tell.

Right now the hyper-aggressive acquirers and empire builders are the heroes. That’s typical of every cycle. But I think it’s far too early to make that judgment. Certainly as the cycle goes on, the buyers from 2006 or before are looking better and better, but a few tough years might change the jury’s mind. By 2008, shareholders in the acquiring companies may want to reclaim some of the bonuses that were paid to executives in 2005-2007.

As for private equity, we don’t know how well these funds are going to do this cycle. Buying public companies at a premium has played a much bigger role in their strategy. We may find that their returns aren’t so great this time around because of it.

Second, throughout my business career I’ve found that the foreign buyer, in any industry, has been predictably fickle. In the business I’m most familiar with, investments, foreign firms are well known for jumping on and off the bandwagon with great regularity. When the world wants what Canada has to sell, every self respecting brokerage firm must have a top-tier investment banking and M&A operation in the snowy north. When Canada moves back into the ‘forgotten’ category, hidden in the shadow of the U.S., foreigners are quick to downsize or completely pull out. Industry veterans know that Merrill Lynch is famous for buying into the market when things are hot and then bailing out when the executives at the mothership need to refocus or cut costs. They’ve had lots of company.

There was a period in the energy business when the big multinationals were only too happy to offload their Canadian subsidiaries. There were a number of terrific companies that came out of that purging. A sale by Occidental created what is now Nexen, while BP’s sale became Talisman and Sun Oil’s is now Suncor.

Which brings me to my third point. If my first two comments have a speck of truth to them, Canadians will have a great opportunity to buy back many of these assets at reduced prices a few years from now.

I accept the fact that many of the acquired companies are gone for good. Some of the foreign buyers operate like Warren Buffet or Ontario Teachers, meaning they buy companies to hold them. That is so they can benefit from a continuing, and perhaps growing, flow of cash.

The companies bought by “strategic, in-industry” buyers are also less likely to come back to us. But there will still be lots of situations where the new owner will change its mind and deem Canada to be ‘non-strategic’ a few years from now. Those companies will likely come back on the market.

And private equity funds have a much shorter fuse. Eventually they have to liquefy their hard assets so they can return capital to their investors. For every headline we see today about a private equity purchase, there will be an offsetting headline in two to seven years announcing the sale of the same asset. There will be a flip-side to the huge buildup of capital at the private equity firms that’s influencing our market so significantly today.

With every announcement of another Canadian firm being bought, a little of me gets hollowed out. The industries that were solidly Canadian ten years ago now have little or no Canadian ownership today. Steel is in the news right now, but think about beer, hotels, technology and forest products.

We’re not going back to where we were before, but we should be aware that the dialogue about this topic right now is pretty one-sided and focused on the short term. Hopefully, our big pension funds and opportunity-starved equity managers will be ready and waiting to buy back the Canadian assets when they find their way back across the border.

The Fine Art of Making the Right Investment Call

Sat, 21 Aug 2010 10:38:43 PDT

The Globe and Mail, Report on Business
Published August 21, 2010

Portfolio management is both a science and an art. The science can be learned from finance professors and investment books. The art part, however, comes from years at the school of hard knocks.

Like every grizzled money manager who’s attended that particular school, I’ve developed rules to protect me from myself. Some of them have a fundamental basis, some work for inexplicable reasons, and some are just plain superstition. All are hard to quantify and yet can often be more important than the data that’s provided each quarter – revenue, profit, market share and management guidance.

Here are a few of my hard-earned lessons.

When a company makes a major acquisition in an unrelated business, it’s time to reassess. Numerous studies have shown that such deals lead to lower profitability. And even when a newly diversified company executes successfully, the market often struggles with how to value it. Ultimately, the stock gets weighed down by the dreaded “holding company discount.”

I think back 20 years to Imasco, which was considered to be a successful conglomerate. If it had stuck to its original business, Imperial Tobacco, it would have made a pile more money for shareholders. And if only Molson had stuck to beer.

When a retailer announces that it’s expanding into the U.S., or has just made an acquisition south of the border, I start to squirm. One of the highest-profile debacles was Canadian Tire buying White Stores in the 1980s, but there have been many disappointments since, including Jean Coutu’s disastrous purchase of Rite Aid.

Retailers that are building a state-of-the-art distribution centre or installing a new inventory management system also warrant caution. Getting products to the shelf is a complicated process and one that requires years of refinement to get right. Loblaw, which suffered from stocking issues for a number of quarters, is the most recent addition to a list of companies that stumbled badly during conversion.

I watch out for companies that report a pattern of earnings that is steadier than their underlying business. The longer that management smoothes the bottom line to meet Street expectations (yes, it still happens), the greater the risk of explosion. That’s because when the news turns bad, the chief financial officer’s hidden reserves are tapped out. The closet is full of skeletons, but the cupboard is bare.

Bombardier is a good company with a wonderful legacy, but when it was riding high in the eighties and nineties, its business, which is lumpy and erratic, didn’t match up with its smooth earnings. Bomber’s fall from grace in 2001 was harsh. Loewen Group, Laidlaw and Enron, all masters of managing their earnings, were also tough lessons.

When the commodity cycle is roaring and profitability is high, it’s a good idea to avoid the empire builders. I’m referring to companies that use their bulging coffers to make large acquisitions. Nobody knows when a cycle will end, but we know for sure the buyers are paying fancy prices and will be carrying too much debt when the downturn hits.

I also steer clear of resource companies that are in that awkward stage between discovery and startup. When the focus shifts from proving up reserves to bringing the mine into production, the only news is bad news – delays, cost overruns and technical difficulties.

I’m also wary of companies in industries that are deregulating (a wide open field brings with it increased competition and lower margins), that are selling to low-quality customers that are losing money, or whose leader has recently been named “CEO of the Year.” And I shouldn’t forget to mention companies that put their name on sports arenas.

There are certain management behaviours that warrant close attention.

When the CEO of a company gets into a fight with an analyst or short seller, I get uneasy. During my analyst days, I had a mixed record on “sell” recommendations, but when management protested too much, I knew I was on the right track. If the C-suite is overly sensitive (think Biovail, Enron and Timminco), then there’s probably something to be worried about.

I follow management departures very carefully. Over the years I’ve covered Extendicare from both sides of the Street and made good money on it. But when the CEO and CFO, for whom I had a high regard, retired within a few months of each other, I should have sold. The company subsequently went through a rough patch due to challenges in its U.S. operation.

In revealing my list, I have to acknowledge that it’s hard to act on these warning signs. That’s because art is less concrete than the science of formulas and spreadsheets. And in the back of our minds we know there have been exceptions to every rule.

But the older and more sensitive I get, the more weight I put on the soft stuff, because as the old proverb says, “Fool me once, shame on you; fool me twice, shame on me.”

Summer Reruns VII - Too Many Funds

Wed, 18 Aug 2010 15:58:45 PDT

Flashback to February 2007. It was the middle of RRSP season and Tom Bradley penned a Globe and Mail article that would, in turn, prompt numerous investors and advisers to share stories of their RRSP nightmares...How many funds do you have in your basket?

RRSP Nightmare: Too Many Funds in Your Basket
Originally published in The Globe and Mail on February 9, 2007
By Tom Bradley

We were driving to Whistler last weekend and out of the blue my wife Lori said “it's RSP season and you still haven't written that column”. It took me a minute to clue in, but what she was referring to was a piece she wanted me to write about a Financial Facelift column we'd seen last summer in the Globe and Mail (August 12th).

Lori got really worked up about this particular column because she just couldn't believe that someone could get themselves into the situation the Canmore couple found themselves in. The featured couple had registered retirement savings plans totaling $170,000 that were spread across 29 mutual funds. “Twenty-nine funds. How does that happen? What were they thinking? Where was their advisor through all of this? Tom, when are you going to do a column about this?”

Because I didn't have any other brilliant ideas for a column this week and do value my marriage, I thought I'd give it a go.

Holding 29 funds is ridiculous whether you're investing $170,000 or a million dollars. It demonstrates that you don't have a financial plan. There's no focus and certainly no commitment to the funds you own. If you're not willing to add money to a core group of funds (5-10), then why do you own them?

Owning this many funds also makes it difficult to figure out what your asset mix is. It becomes a major project every time you want to figure out whether you're still on plan.

But more than anything, owning 29 mutual funds means you're seriously overdiversified. A little math would be useful here. Let's assume that 20 of the 29 funds are equity funds and on average these funds own 60 stocks. We have to assume that there are lots of stocks that are owned by more than one fund. In the case of Canadian equity funds, the overlap may be as high as 60-70% between some funds. Indeed, it is conceivable that you own Royal Bank or Manulife in 10 to 15 funds.

If we assume that there were 45 unique stocks per fund, that's 900 stocks plus the ones that showed up in multiple funds. Let's say you own 1000 stocks. What you really own is a very expensive index fund.

Through exchange-traded funds (ETFs) you could get the same market exposure for an average fee of 0.25 to 0.30 per cent a year on their management expense ratios. I hazard a guess that the couple in the article were paying in the neighbourhood of 2.5 per cent. It is no wonder they were disappointed with their mutual fund returns.

How does this happen? I don't really know, but I imagine it is a combination of things.

Each RRSP season has its own themes. While foreign funds are the dominant sellers one year, it could be tech funds the next and clone, income trust or lifecycle funds in other years. If you are prone to chasing past performance and your advisor is inclined to take the easy road (that is, give you the current best seller), you could easily add two to five new funds a year.

Where was the advisor through all of this? Clearly, he or she never said, “XYZ fund has been out of favour for a while and I think you should put more money in it this year. Think of it as being on sale.” While the Canmore couple continued to add funds, they weren't willing to sell any on the other side because of the redemption fees they would incur.

In general, I believe that patient, long-term investors don't need a lot of advice. It is more important that you keep your costs down. Occasional advice and low fees is a great combination. Having said that, I recognize that some people are in need of more help and that costs money. Unfortunately, this couple was getting the worst of both worlds. They were paying for advice they desperately needed, but they weren't getting it.

The Financial Facelift article that got Lori so worked up is obviously an extreme case, but overdiversification is definitely an issue for many mutual fund investors. In actual fact, holding even half the number of funds this couple owned could still result in an overdiversified portfolio, depending on what kind of funds they were.

If you haven't made a contribution to your RRSP for 2006, or even better, are contemplating what to do for 2007, I'd look first at the funds listed on your quarterly statement. If there was a good reason to buy a fund in the first place and those reasons haven't changed, then you might ignore the “flavours of the month” and show commitment to what you already hold.

And if the one you choose hasn't been doing well in the last year or two, all the better.

Summer Reruns VI - 'It Will Sell'

Thu, 12 Aug 2010 16:02:55 PDT

This week’s rerun comes from April 2009. The stock market had recently bottomed and investors were particularly fearful of risk. Not surprisingly, investment products with special features that promised certainty or limited downside were gaining popularity. Yet, there’s always a tradeoff to be paid for fancy features.

‘It Will Sell’: A Tipoff for Bad Investment Products
Originally published in The Globe and Mail on April 4, 2009
By Tom Bradley

As the wealth management industry works through this bear market, investment products that promise certainty and limited downside risk are going to be popular. With guaranteed investment certificates (GICs) offering minuscule yields, stock-market-related products with “guaranteed income” and “principal-protection” will be big sellers.

I think that's unfortunate for two reasons. First, we're now in a favourable environment to take more risk, not less. And second, investors give up a lot of return for the fancy features they're buying. Such things as downside protection, tax deferral or arbitrage and convenience come with a price.

My purpose here is to illuminate some of the tradeoffs investors make when they go beyond plain vanilla.

But first some background. I developed an aversion to complex investment products and packaging about 10 years ago. I was at Phillips, Hager & North at the time and we had a number of investment bankers come through our offices pitching us on their newest creations. They wanted to work with us because we had a good brand name that would lend credibility to the products. At the sessions I attended, I always asked the same question: “Is this good for the client?” I never once was told that it was. There was some diverting of eye contact, hemming and hawing, and on a couple of occasions, the answer was simply: “It will sell.”

We once committed to working with one of the banks on a product that saved high-tech executives taxes when they exercised their stock options. We thought it looked like a reasonable idea, but as we got further into it, we became increasingly uncomfortable. We calculated that the executives could achieve higher after-tax returns without a complicated structure. Fortunately, we were able to escape our commitment honourably when the high-tech bubble burst.

From that point on, I've done research (sometimes vicariously through much smarter colleagues) on many new packaged products and rarely have I come up with a different answer to my question. What I got was a notebook full of issues.

Lack of transparency: We should always understand the basics of what they're investing in, even when an adviser is involved. But products like principal-protected notes (PPNs) and guaranteed income funds are complicated and hard to figure out. Too often investors don't know how they work, what the underlying assets are and how much they're paying.

Misalignment of objectives: A lack of understanding often leads to investors buying products that are ill-suited to their needs. For example, a 40-year-old with a 30-year investment horizon shouldn't be buying short-term stability or principal protection, no matter how appealing it sounds. A bumpy 8 per cent return is what she/he needs, not a smooth 4 per cent.

The marketing imperative: My undergrad degree was in marketing, but when it comes to product design, that area of business should play a secondary role. Sales and marketing departments want things that will sell, which means looking in the rear-view mirror. The easiest sale is whatever worked last year (I recently saw an ad for a “bear-resistant” fund). In general, marketing-driven products encourage investors to “buy high.”

Overdiversification: “One-solution” products, including some wrap funds, are convenient, but tend to be too diversified. By having multiple managers in each asset category, the product (I'm reticent to call it a portfolio) owns hundreds or thousands of stocks. Effectively, it's an index fund with an annual fee that's two percentage points higher than it should be.

Complexity risk: In many packaged products, there are so many moving parts that it's difficult to determine what risks are being taken. That complexity sometimes results in outcomes that were unforeseen by bankers and advisers (liquidity drying up; the worst bear market in 80 years; global bank failures). Other times, however, the risks have been identified, but not communicated. The creators of PPNs (the type known as Constant Proportion Participation Insurance) have always known that their notes were path dependent (i.e. if the underlying asset goes too far down in value before it goes up, eliminating any chance of a positive return). That potential outcome is never openly discussed with potential buyers, even though it reduces the value of the note.

Degrees of separation: It's best if money managers live and die with the performance of their funds. Managers should be invested alongside clients. With packaged products, that accountability gets diluted with every person that gets between the client and the portfolio of stocks and bonds.

Cost: And with every degree of separation comes more fees. When investment bankers, lawyers, traders, money managers, insurers, marketers and salespeople get involved, they need to be paid. As a result, structured products are expensive.

Who's insuring who?: There is a common misconception about fancy investment products. Too often buyers believe that someone else is paying for the insurance and guarantees. Wrong. There is no new source of return being invented. Additional costs come directly out of what is earned by the underlying stocks and bonds.

There are other issues scribbled down in my notebook – poor liquidity, misunderstood by advisers, bad names – but I'll stop there.

I liken structured products to Viagra. The industry is hooked on them because they stimulate sales. They're a specialty product that should be used by few, but are sold to many. And the buyers get instant gratification, but pay for it in the long run.

When Investors and Their Advisers Don’t See Eye-to-Eye

Thu, 12 Aug 2010 14:36:15 PDT

The Globe and Mail, Report on Business
Published August 7, 2010

In my last column I talked about fear and investors who wanted to get out of the market. My advice (don’t do it) was based on valuation, investor sentiment and the difficulty of timing the market. It was aimed at helping the investor make the best decision.

But what about the investment professional? What is the best reward-versus-risk tradeoff for the adviser in a situation like this when he doesn’t agree with a client’s strong view? Indeed, he might even believe the strategy could do some real harm. These are the times when advisers and investment managers earn their keep.

In an ideal world, the recommendation to stay the course would be based on an assessment of potential returns and risks. The client would know that the advice could be wrong, but if the two of them are disciplined about always putting the odds in their favour, then the long-term results will be good.

Unfortunately, investors don’t always get what they pay for. In a challenging situation like this, advisers too often provide little resistance, making it easy for clients to go with their emotions. (Note: I’m not implying clients are always wrong, but am assuming that if they have an adviser they need help.)

While I’m often quick to criticize our industry for not having enough of a backbone in such cases, I recognize that the professional has a different reward/risk equation than the client. And the disparity makes it more difficult to provide the appropriate advice.

Let me explain by using the example of when I disagreed with my worried client. We’ll assume I talked her out of selling all her stocks. She may be right at the end of the day, but I didn’t think it was in her best interests to make such an extreme shift. So we trimmed back on her equity holdings, but basically stuck close to her long-term asset mix.

Now that we’ve tried to maximize her odds, what does my situation look like?

Well, if the markets hold steady or go up over the next six to 12 months, I have a happy client. She’s made some money and our relationship has moved up a notch on the trust and confidence scale.

If, on the other hand, markets go down and the portfolio valuation drops, then my client is upset. She felt strongly about selling, but I talked her out of it and it cost her money. If the market takes a big dip, then she may be dissatisfied enough to take her account elsewhere.

While I truly believe I’m giving her the best chance of succeeding, my reward/risk balance is not so favourable. I have potential upside for sure (better returns and a stronger relationship), but the downside is far greater. I risk losing a client for good.

To improve my prospects, I could take a different tack. I could voice my concern about the “bail out” strategy, but then get out of her way. Call it the “Olé approach.” If markets go up, my client misses out on the gains, but I’m on record as having advised otherwise (albeit feebly). If markets go down, she’s happy, and while she may not give me much credit, our relationship lives on. In the short term at least, I’ve enhanced my business.

This is an extreme case obviously, but there are many situations where the best intentioned advisers or managers have the incentive to water down their expertise. It’s just too risky, from a business point of view, to push back at clients when they feel strongly about something.

When this happens, neither side is getting what they need. Clients aren’t receiving the steady, thoughtful advice they’re paying for. And advisers are weakening their businesses in the long run, especially now when investors have plenty of low-cost, advice-lite options to go to.

What can clients and advisers do about this reward/risk imbalance?

Clients can ask questions with the intent of listening to the answer. They can ask what the adviser is doing in his own account. And, ultimately, they can take responsibility for their actions.

The paid professionals can focus on keeping their interests aligned with that of their clients. That means matching up their recommendations with what they’re doing in their own portfolios. They can use the good times to prepare clients for the inevitable situation when there is a fundamental disagreement on strategy. And they can remind their clients that those disagreements are what they’re paying for.

The Back Hand – Relief from the Macro Gloom

Thu, 12 Aug 2010 14:36:51 PDT

Everything we read about the economy these days is depressing – too much debt, scary demographics (with regard to social security and healthcare), weak political leadership and a warming planet. As an antidote to this macro gloom, there were lots of positives in the news this week.

Billionaires in gear – It was announced that 40 billionaires have accepted Warren Buffett and Bill and Melinda Gate’s challenge to give away at least half of their wealth to charity. Ted Turner, Larry Ellison and Michael Bloomberg are among the names that went public with their pledge. In face of government cutbacks, it’s encouraging to see the mega-rich taking on some important global issues. Even if our governments had the money, they probably couldn’t achieve the cross-border coordination that organizations like the Gates Foundation can.

It feels good when you stop – BP got the well sealed and 75% of the spill has evaporated, broken down or been collected. Yahoo!

Writing them off – Speaking of BP, I always find it interesting how quickly we write off the ‘down and outs’. Whether it be countries (Korea, Sweden and Canada a decade ago), companies (Apple, IBM, Teck … the latter by me), politicians (Bill Clinton, Joe Who), athletes (Tommy John, Jim Plunkett, Grant Hill) or entertainers (Britney Spears, Tina Turner, Robert Downey Jr.), bad press and short-term outlooks make us jump to premature conclusions. Besides BP, we’re doing that now with Toyota (it will never be a power again) and RIM.

De-accumulators delight – We’re quick in these pages to remind readers that weak markets are a great opportunity for investors who are in the accumulation phase (i.e. putting money in as opposed to taking it out). Well it’s been hard to hold the stock market down this summer and de-accumulators are being given an opportunity to re-balance and top up their cash reserves.

A housing breather – I may be the only homeowner in the country that feels this way, but I actually think the news of a slower housing market (sales volumes down significantly and prices weakening) is a good thing. It was getting silly six months ago and I hated to see young friends and family getting started in that type of environment.

Now if only I can avoid reading any big picture stuff over the weekend, all will be good.

Summer Reruns V – Currency Fluctuations

Thu, 12 Aug 2010 14:37:23 PDT

In this week’s rerun we flip the calendar back to September 2007. The loonie had recently hit parity with the U.S. dollar for the first time in over 30 years. Predictions were widespread on which direction it was headed next. As for our forecast? (see the last paragraph) We were almost bang on; the Seahawks won 24-21.

Interestingly enough, the Canadian dollar today is worth almost the same value against the U.S. dollar and the euro as it was at the time of our posting (see graph).

Looney Predictions
Originally posted on September 21, 2007
By Scott Ronalds

With the loonie hitting parity with the U.S. dollar for the first time in over 30 years, the forecasters are once again coming out of the woodwork with predictions on the future direction of the currency. Some are patting themselves on the back for correctly calling the loonie’s rapid ascent, while others are back-peddling on prior forecasts and coming out with fresh revisions.

The bullish camp points to strong fundamentals driving the currency higher over the short-term: high oil prices (the loonie is viewed by many as a petro-currency, with its fortunes tied closely to the price of oil), continued demand for commodities, low unemployment, etc. While the bearish camp points to an oversold U.S. dollar, a slowdown in global growth, and a probable cut in interest rates by the Bank of Canada as key reasons why the loonie is likely to lose steam.

So which camp are we supposed to believe? How about neither. Short-term currency movements are really anyone’s guess and are next to impossible to predict. If the loonie is closely tied to the price of oil, where is oil going? Who’s to say that it won’t fall to $50/barrel? Or rise to $100/barrel? If its path depends on the strength of the domestic economy and the interest rate environment, will Canada steam ahead or pull back? You get the picture. There’s too many variables at play. Not to mention that movement in the loonie isn’t entirely correlated to these variables anyways.

If you can’t sleep at night because the loonie’s rise is killing your foreign equity returns, you can consider hedging away some or all of your foreign currency exposure (although it may not be the best time to do so, given the substantial short-term appreciation that you’ve already absorbed). A better solution is to ignore the headlines and accept that currency movements are too unpredictable to gamble on, and tend to balance themselves out over the long term. And while it certainly hasn’t benefited Canadian investors lately, foreign currency exposure actually provides a layer of diversification to your portfolio and can boost your returns. Remember the 1990s?

We all like to have fun with predictions (don’t kid yourself, even the big addresses on Bay Street have 'friendly' pools on where the loonie will close at the end of the year), but it’s not so fun when you jeopardize your portfolio by acting on them and making the wrong call on something that’s entirely out of your control (read currency movements).

That said, I couldn’t end this posting without a prediction of my own, all in good fun of course. So here goes: Seahawks 27 – Bengals 21. Now you can take that to the bank.

The Back Hand - Stress

Fri, 30 Jul 2010 09:56:45 PDT

By Scott Ronalds

Investors have learned to deal with a lot of anxiety over the last couple of years, what with a severe credit crisis, major bank failures, derivatives gone bad and gyrating stock markets. Indeed, stress is becoming the new buzz word.

Below are some stress-related observations and musings on the week that was.

Stress tests: European banks were recently subject to a health check in the form of stress tests that were designed to determine how well they would cope with another recession or financial shock. While only 7 of 91 banks failed, analysts were still stressed this week over the credibility and level of difficulty of the tests.

Stressed leadership: BP (British Petroleum) was so stressed about their heavily-criticized CEO’s (Tony Hayward) inability to effectively deal with the Gulf of Mexico oil spill that they replaced him with Robert Dudley, the company’s first non-British head.

De-stressing: Tom Bradley was on holiday in Ontario’s cottage country for two weeks of R&R. His de-stressing technique: twice daily short-line slalom sessions (waterskiing) at 34 mph. Whatever works for you, boss. I think I’ll stick to something less strenuous, fishing and Heineken.

STRESS nations: With a new acronym hitting the investment dictionary, STINC (Singapore, Thailand, Turkey, Indonesia and Chile), we’ve come up with our own group of high risk, strained economies that may represent attractive investment opportunities for the gamblers out there. We call them the STRESS nations – Syria, Turkmenistan, Rwanda, El Salvador and Somalia. Look for an offering on the ETF product shelf soon.

Stressed wireless: Discount wireless carriers are stressing over Rogers Communications’ launch this week of chatr, its new low-cost brand that targets the unlimited talk and text market.

Salary stress: Canucks forward Mason Raymond and Oilers forward Gilbert Brule were so stressed out about their salary arbitration hearings that they both accepted offers from their clubs before proceedings were set to start.

We could all use a little less stress this summer. Serenity now.

Summer Reruns IV - The U.S. Housing Market

Tue, 27 Jul 2010 09:10:28 PDT

By Scott Ronalds

This week we look back to the summer of 2006. The U.S. housing market was at a turning point. The consensus view was that it would be a soft landing. Tom disagreed. Four years later, prices are still down 40-50% from their peaks in some markets. Indisputably, the consensus was wrong on this one.

An Orderly Decline of the Housing Market? Not.
Originally posted on June 22, 2006
By Tom Bradley

It is pretty much conventional wisdom that the housing cycle in the U.S. is going to turn down. The fundamentals point that way and there are now signs of a slowdown. The consensus amongst the analysts, however, it that it will be a soft landing, with only a modest impact on the U.S. economy. That consensus points to a scenario whereby prices will stabilize or decline modestly from current levels and sales and building activity will also pull back. The Chairman of the Federal Reserve, Ben Bernanke, summed it up recently when he was quoted as saying that "it looks to be a very orderly and moderate kind of cooling at this point."

I'm inclined to think the consensus will be wrong on this one. It almost always is wrong at major turning points when a trend has been going on for a long time. I think this cycle is going to end badly and take a long time to find a bottom. I can support my view with lots of charts and statistics, but it is the 30,000 foot view that is most important here. The view is this. (1) The housing industry has been pushed upwards by one of the biggest tailwinds of all time - declining interest rates, unprecedented availability and use of credit, reasonable building costs, robust job growth, positive demographics/ immigration...the list goes on. The problem is, many of these positives are turning into headwinds now. (2) Any chart you look at is at an extreme. This up-cycle has gone beyond where we've ever been before. (3) Long cycles that have gone to extremes always require a long recovery period and never end in an orderly manner. The longer the cycle, the longer the retrenchment. The more extreme the cycle, the more bad stuff that comes out of the wood work during that retrenchment. In the case of this cycle, the bad stuff could be the amount of speculation and financial leverage in the system and/or the amount of inventory that needs to be chewed through.

I thought the U.S. housing boom would have ended a couple of years ago. I've been wrong on that. But by going on longer and climbing to greater heights than many of us expected, it has made a long and ugly retrenchment all the more likely.

Something Stincs

Mon, 26 Jul 2010 16:38:09 PDT

By Scott Ronalds

The latest acronym in the investment world smells a little funny. The STINC countries (Singapore, Thailand, Turkey, Indonesia and Chile) are meant to represent export-oriented nations that have shown good fiscal restraint and infrastructure investment over the last several years. Financial writer Jon Markman recently coined the term as a group of countries that represent promising investment opportunities, in contrast to the debt troubled PIIGS (Portugal, Italy, Ireland, Greece and Spain).

While the industry’s marketing machines love a good acronym, I’m not sure they’ll be able to do much with this new geographic hodgepodge. Although I certainly wouldn’t be surprised if a STINC-based ETF hits the market in the coming weeks. There’s a clever play on words in there somewhere.

Making a Go of it, Despite the Doom and Gloom

Sat, 24 Jul 2010 11:46:53 PDT

The Globe and Mail, Report on Business
Published July 24, 2010

In my quarterly letter to clients I used the word “discouraged” to describe investor sentiment. In the few days since we published it, however, I’m starting to think a better word is “despair.” Too regularly I’m being asked whether it’s time to get out of the market.

The worry isn’t coming from portfolio returns in the first half of the year – balanced portfolios are down from zero to 3 per cent – but rather a deep concern about what’s going to happen in the second half and beyond. Investors don’t want to go through another 2008.

The despair seems to have common roots. It’s a news article about the world’s debt burden and its ramifications – higher taxes, unemployment and more “Greece-like” events. It’s the realization that growth is going to be tough to sustain after the government stimulation tap is turned off. Or it’s a gloomy economist pontificating on how we can’t get out of this mess without another debacle, or at least a very slow period of growth.

This stuff is hard to refute and I don’t try. I’ve been in the “bumpy road ahead” camp for a long time and have been counselling caution since last fall. But that doesn’t mean my nervous clients, friends and family will hear what they want to hear from me. That’s because my strategy doesn’t call for getting right out of the market. Far from it.

If I’m given time to respond to the question (and questioners don’t always want an answer), I start by reviewing a few basics. It goes something like this:

Remember, Susan, Mr. Market is well aware of the issues out there. Security prices are always trying to anticipate future events. Your fears are shared by many investors and may already be fully factored into market prices.

Whatever you do, don’t make radical changes at a time of maximum stress, or excitement for that matter. That’s when the biggest mistakes happen, mainly because the shifts are made to conform to the consensus.

Yes I know, the consensus can be right for a time, but believe me, it’s always wrong at the peaks and troughs. If investors are dead certain, then they’re certain to be dead wrong. Yes, I did just make that up.

I think you know that getting out of the market involves two decisions, not one. After you sell, you have to get back in at some point. Any expectation of precision on either of those moves would be misguided. There will be no alarms going off telling you the way is clear.

Scott, I remind you that the “all-GIC strategy” that your dentist was bragging about always looks good when the stock market is down, just as an all-equity strategy does in the good times. If you only need a 3-per-cent return before taxes and inflation to live comfortably in retirement, then a “sleep well” strategy like that is an option. For investors who need more return, however, the potential of missing an up market poses just as big a risk as catching the down.

Jake, I want you to think about your portfolio in terms of ranges around a long-term asset mix, one that reflects your long-term goals and the odds of you winning at the market-timing game. For example, if your strategy is to have 60 per cent in stocks (or other higher-volatility investments) over the long run, then you might give yourself room to move the weighting between 50 and 70 per cent. The less experience and time you have for investing, the narrower the range should be.

Then you need to look at three things to determine where you should be in the range. The first is your outlook, which in this case is negative. But don’t stop there. Next you look at valuation (pricing), because dire headlines don’t preclude investors from making a pot full of money. Indeed, if all the bad news is factored into the market already, then it might be time to buy, not bail.

And then you need to take a reading of market sentiment. Are other investors positive or negative? The market’s mood provides a good reality check, sometimes advising caution (when everyone is bullish) and other times pointing to areas of opportunity (bearish). It’s that consensus thing I was talking about. Are you alone, or running with the crowd?

Now the crescendo: Brad, I want you to make an informed decision based on those three factors, not just that article you read. Right now I would make sure your higher-risk holdings (stocks, commodities, high-yield bonds) are in the bottom half of your range. With you running between 50 and 70 per cent, that means 50 to 55 per cent of your portfolio in stocks. I say that because I agree with you that the big picture isn’t very pretty. But having said that, you should be getting prepared to do some buying because weaker markets have improved valuations and market sentiment is getting better (i.e. more despair).

If you have a specific need for money in the next year, set it aside in a high-interest savings account now. Cash management is always important, especially in a higher-volatility environment.

And Brad, be careful not to confuse economic forecasts or political ineptitude with the risks and opportunities for you in the market.

Summer Reruns - Part III

Tue, 20 Jul 2010 09:17:40 PDT

In this week’s rerun, we revisit the asset backed commercial paper (ABCP) debacle as a reminder of a key lesson in investing – if you don’t understand what you’re getting into, don’t buy it.

The Increasing Complexity – and Masked Risks – of Wealth Management
Originally published in the Globe and Mail on April 19, 2008
By Tom Bradley

Purdy, what were you thinking? Didn't you know how complex and convoluted investment products have become? Didn't you know this would become a hornet's nest with many different interests at play and the big financial institutions playing multiple roles?

If only you'd extended your summer in Nova Scotia a week longer and missed the call. Or better yet, listened to your wife.

When Mr. Crawford's committee to sort out the asset-backed commercial paper mess stopped in Vancouver a couple of weeks ago, I went to watch the proceedings. I am lucky enough to not own any of the combustible paper, but was curious to see how the process was playing out.

Very early in the proceedings, Mr. Crawford revealed that he wouldn't have taken the assignment had he known what he was getting into. What it involves is a classic example of how the investment industry has gone overboard inventing new and often inferior ways to sell the same thing - stocks and bonds. We have become intoxicated with our own genius and the marketing hooks that go along with it.

ABCPs are a symbol of how complicated investment products have become. At the Vancouver meeting, we learned that these short-term notes were backed by securitized loans (ranging from autos to immigrant loans), leveraged super senior structures, unleveraged synthetic CDOs, and U.S. residential mortgages. And the restructuring plan adds a few new elements to the mix - master asset vehicles, senior and junior notes, a margin funding facility and, well, don't ask.

Very few people at the meeting could have understood what was said. I've been around a while and I was hard pressed to keep up. This despite the fact that the presenters did their best to methodically take us through what the products are, how they blew up and what the restructuring plan is.

Over the course of Mr. Crawford's esteemed legal and business career, the wealth management industry has come a long way, most of it good. A few decades ago, it was pretty simple. The investor paid a broker to purchase a long-term security for his portfolio - a stock or bond. Commissions were high, but the investor got access to the interest, dividends and capital appreciation without incurring continuing fees.

As we move away from that basic model, each new feature or level of complexity increases trading, legal and administration costs. Investment banking, money management and trailer fees come into the mix. And in some cases there are performance bonuses and additional costs related to currency hedging and principal protection.

That's a lot to put into a package like an ABCP, particularly with low single-digit yields on government T-bills. By the time everyone has been paid, there isn't enough extra return in the product to justify the additional risks that are being taken.

For longer-term products with greater return potential, some of these costs are totally justified. If you want to hire someone who can beat the market, you have to pay a higher management fee, and perhaps a performance fee. Certainly increased trading is done in the hope of adding value.

But the other complexity costs (structural and marketing) erode the attractiveness of a product. They result in investors getting a smaller portion of the additional return, even though they are taking all the extra risk. The investment professionals involved receive the lion's share of the premium (as was the case with ABCPs), but shoulder none of the risk.

Consider a fictitious example. The hot new product for spring - Super Secure Dividend Enhanced XYZP - holds securities that will generate a yield 1 per cent higher than a GIC issued by one of the big banks. This is done by backing the XYZP with a package of higher risk investments (including loans to Third World fish farmers). The cost of bringing this product to market, however, is 0.75 per cent, so the investor is receiving an extra 0.25 per cent return for incurring 1 per cent worth of additional risk.

If the fishing is good and the XYZP doesn't run into difficulty, there is a modestly higher return for the investor. Everyone is happy. If it's good for a long time, the sellers and buyers forget that there is any risk being taken at all.

Despite what you might think, I'm not a troglodyte. I'm not adverse to using advanced methods or hiring someone to do them for me. And I like a marketing hook as much as the next executive, maybe even more.

But in any investment structure, the majority of the extra return, if there is any, belongs to the buyer who is taking the risk.

In too many products today, this is not the case. The current generation of structured products have little or no transparency and, as a result, they mask the risks being taken and how the potential rewards are being apportioned.

As Mr. Crawford's lapse in judgment reminds us, if you don't understand what you're getting into, don't buy it.

Podcast: Second Quarter Review

Thu, 15 Jul 2010 11:36:49 PDT

By Scott Ronalds

The second quarter of 2010 was a challenging period for equity markets, as investors focused on the European debt problems and the sustainability of the global economic recovery. In this podcast, we review these issues and highlight some of the key messages from our Quarterly Report.

Download, subscribe via iTunes or RSS, or listen now:

Summer Reruns – Part II

Wed, 14 Jul 2010 18:48:07 PDT

In this week’s rerun, we travel back to May 2008 for a brief look at the negative sentiment and opportunities in the corporate bond market at the time. As it turns out, the soil was fertile indeed.

Irrational Nervousness = Fertile Soil
Published May 1, 2008

The managers of our funds report to us formally once every quarter. In the Income Fund report from Connor, Clark & Lunn, there was a chart that is a great indication of what the capital markets are going through.

It shows the extra yield an investor receives from owning a Canadian agency bond (i.e. Farm Credit Corp) compared to a conventional Government of Canada bond. While these bonds are explicitly guaranteed by the Federal Government, they typically trade at a higher yield – approximately 10 basis points (bps) or a tenth of 1% - because they are not as liquid as Canada bonds. Big investment managers who are moving a lot of money around prefer to use the more tradable Canada’s.

But as you can see, the nervousness in the markets has led to the spread widening to over 50 bps. This to me is a huge indication of how nervous investors are. I may not think it’s rational that TD Bank bonds trade at 150-200 bps above Canada’s (I don’t), but without knowing what’s going to happen in the banking sector, a spread of that size may be warranted. With agency bonds, however, there is no credit risk. No credit analysis can justify the current spread. It’s just plain irrational nervousness.

Our Income Fund is more than 50% invested in corporate bonds at this stage. CC&L feels very strongly that we’ve been given a once in 10 or 20 year opportunity to buy good quality corporates. Undoubtedly not all of their selections will work out as they hope, but the agency spread chart tells me they are planting seeds in very fertile ground.

When Browsing for Bargains, Beware the Value Trap

Thu, 15 Jul 2010 08:14:38 PDT

The Globe and Mail, Report on Business
Published July 10, 2010

I’ve had a bias to owning higher quality companies since 2007. In a challenging economy with unpredictable credit markets, it seemed reasonable to pay a premium for stable profits, excess cash flow and strong balance sheets. I knew the companies would survive, and possibly thrive, in a tough business environment.

Buying the best sounds like a good strategy, but it can lead to poor returns if you’re not attentive to industry dynamics and stock valuations. We learned that in the 1970s when investors paid fancy prices for leading U.S. stocks known as the “Nifty Fifty” and were disappointed.

Most of my quality favourites continue to deliver profits and are in a better competitive position today than they were three years ago, but a number of them have seen their stock prices lag behind the market. Instead of being stars, stocks like Research In Motion, Ritchie Bros. Auctioneers, Shoppers Drug Mart and Rogers Communications just keep getting cheaper.

The question is, am I holding great companies at bargain prices, or getting caught in a value trap?

If it’s the former and the stocks are screaming “buys,” then it will be because of a double whammy. Earnings will turn out to be better than forecast and sentiment toward the companies will get less negative. The result is nirvana – a better valuation on better-than-expected earnings.

If, on the other hand, they’re value traps, we’ll keep waiting for good stuff to happen, but it never will. Growth will be slower than expected, or negative, and repeated efforts to turn things around will fail to pan out. Meanwhile, the stocks’ valuation metrics – price to book value, earnings and cash flow – will keep getting cheaper.

With the benefit of hindsight, it’s possible to identify some general themes that run through every value trap. There is usually a major trend that turns against the company. The product is being made or delivered in a different way, or customers are looking for something new. The change is secular in nature, as opposed to cyclical, and may bring new competition with it.

Established firms are unable to adapt to the new paradigm because their assets and competitive strengths lie in other areas. In some cases, management is unwilling to adapt. They’ve been successful with their old model and are reluctant to give it up. They don’t want to absorb the profit hit that a major shift will cause.

Of the names mentioned above, RIM is the one being most vigorously debated in Canada’s money management circles today. Only a few months ago it would have been inconceivable to mention RIM and “value trap” in the same sentence, but at a conference I attended recently, a panel of fund managers discussed just that topic.

This is the RIM that’s a world leader in the fastest-growing segment of mobile communications – smart phones. The maker of the iconic BlackBerry, which has a clear advantage in e-mail and texting, and is the most efficient user of bandwidth. The firm that’s done a masterful job of working with wireless carriers and corporate IT departments to dominate the business market. And yes, the same RIM that saw revenue grow 24 per cent last quarter, profit increase 41 per cent and cash on the balance sheet tick above $3-billion (net of debt).

So why is the stock down 40 per cent from its 12-month high and trading at less than 10 times earnings?

There are many reasons of course. The stock market has been skittish and hyper-sensitive to any hint of bad news. RIM is facing off against two of the most powerful forces in the world, namely Apple and Google. But the main issue is that the competitive landscape has changed. After being the technological leader throughout the smart phone revolution, RIM now finds itself playing catch-up. E-mail got the company to where it is today, but the new battlefield is Web access. The iPhone, and various devices based on Google’s Android software, have better browsers and a more appealing array of applications.

In high-tech, where a company’s assets are people and patents, it’s hard to catch up after there’s been a severe change of direction. Redesigning operating systems and rewriting major software takes time. Meanwhile, the competition keeps moving forward. Technology is a sector that value investors usually steer clear of, even if valuations look compelling.

If RIM’s next generation Web-browser is as good as management says it is, and proves to be less of a bandwidth hog than the Apple products, then the stock will make up a lot of ground. If the new version doesn’t get the BlackBerry back in the race, then the bears will be justified in using the words “value trap.”

The smart phone market is going through a jolting change, but I’m not willing to give up on RIM yet. Management has its head up and their team has the right skill set. And importantly, I’m not paying much to wait and see if they’re up to the task. But ah, that’s how we get sucked into value traps.

The Back Hand – The Heat Is On

Thu, 15 Jul 2010 08:34:14 PDT

By Tom Bradley

Below are some observations and musings on the week that was.

The Next Wall Street? – I’m desperately trying to come up with an investing analogy for the LeBron James signing with the Miami Heat, but I’m just too mad to think straight. Three of the best players in the NBA go to one team so they have the highest chance of winning championships “for multiple years”. If we’re looking for the next area of unabashed excess to be shaken out (after Wall Street), perhaps we need look no further than pro sports.

Complexity gone wild – PricewaterhouseCoopers did a report on the risk management problems at Quebec’s Caisse du depot. In the ROB today came the following quote: “...the investment vehicles became so complex that the fund’s risk management group couldn’t (keep up with) them.” We often talk about the four types of risk that fuel investment returns – interest rate, credit, liquidity and equity risk. Unfortunately, a fifth type has emerged that adds cost, not return, to a portfolio – COMPLEXITY.

Bad Math –The Canada Revenue Agency (CRA) is going to review 70,000 TFSAs (Tax-Free Savings Accounts) on a ‘case by case’ basis if there has been over-contribution penalties assessed. Think about the economics of that. It will cost more to crack open the file than the government could ever hope to collect in penalties. Why don’t the Feds admit they screwed up, clarify the rules and wipe the slate clean...and then put the savings in a TFSA of their own.

A Snowflake in Hell – For the first time I can ever remember, real estate companies are actually predicting lower house prices for the year ahead. In its latest survey, Royal LePage is calling for a softening in some areas and is warning that there will be fewer situations with multiple offers. If they are predicting weakness, does this mean the outlook for real estate is REALLY scary?

Procrastination is good...sometimes – As I head off to enjoy the summer heat, Neil gave me a book to look at – ‘The Upside of Irrationality’ by Dan Ariely. I had asked him about it (he’s the source on these types of books) because I saw the following quote from the author, “If you are doing something you hate, like working on your tax return, then it’s better to work straight through without taking breaks, and the opposite for something you like doing. We found that anticipation, savouring the experience and the joy from memory are as strong as the experience itself.” Why is it that we always do it the wrong way?

It's all good – It looks like the summer heat has arrived in most parts of the country, we got a cool new Governor General this week and I only have to mis-pronounce the word vuvuzela for two more days. Enjoy.

Management Fee Deductibility - Clearing the Air

Thu, 08 Jul 2010 13:13:48 PDT

By Scott Ronalds

In our discussions with investors, we’ve found there are a few misconceptions surrounding the deductibility of investment management fees. The most common misunderstanding is that mutual fund investors are at a disadvantage (from a tax standpoint) to investors who hire an investment counselor, as the latter receive an invoice for their fees directly which can be used as a deduction on their tax return.

The fact is, there is no advantage to investors whether the management fee is charged within a fund or billed outside of a private investment account, except in rare circumstances.

The structure of most mutual funds is such that they allocate all realized capital gains, dividends and interest income to unitholders in the form of distributions. This income represents a taxable liability and is reported to investors each year on the tax slips (T3’s) they receive from their fund company. Importantly, however, the management fees and other expenses that the fund company charges are deducted from this income prior to the distributions being paid out. In other words, the fees are used to offset any taxable income, thereby reducing the amount of the distributions. Consider the following example:

XYZ Fund has $50 million in assets under management and charges a management expense ratio (MER) of 1.5%.
There are 5 million units of the fund outstanding ($10/unit).
The fund earns $1 million in interest income and $1 million in realized capital gains. It therefore has $2 million that it needs to distribute to unitholders.
The fund company collects a fee of $750,000 (1.5% of $50 million).
This amount is deducted from the $2 million in income generated within the fund, resulting in a net amount to be distributed of $1.25 million, or $0.25/unit, as opposed to $0.40/unit before the deduction. The deduction is first applied against the interest income, as this is the least tax favourable form of income.
While they cannot “see” the mechanics of the deduction, unitholders receive a lower distribution and their net taxable liability would be the same as if they collected the gross income from the portfolio, paid the fees directly, and claimed a deduction on their tax return.

To expand on this last point, assume a large investor held the same assets in a private account and paid an investment counselor the same fee for managing the portfolio. The investor would receive a fee invoice of $750,000, which she could use as a direct deduction against the income generated by her portfolio ($2 million), but she would still have to pay tax on the balance of $1.25 million. In the end, she would be no better off from a tax standpoint than investors in the mutual fund.

Where a benefit may arise for the private account scenario is when the management fees exceed the income generated by the portfolio. In such a circumstance, the individual could deduct the fees against the full amount of the investment income and apply any excess amount (loss) against other sources of income. Under the mutual fund structure, the loss cannot be distributed to investors to offset other forms of income, but is instead carried forward by the fund to be applied to investment income generated in a future year(s). As long as the individual continues to hold the fund, they will eventually receive the benefit of the carried forward loss.

The second misconception that we’ve run into is the belief that fees incurred with respect to the management of registered accounts (e.g., RRSPs, RRIFs, TFSAs) can be deducted for income tax purposes. This is not the case. Canada Revenue Agency (CRA) does not permit the deduction of fees related to registered accounts. So while individuals who use investment counselors may receive a fee invoice for these accounts, it is of no use to them from a tax perspective, although it is certainly beneficial from a fee transparency standpoint. But that’s another topic.

Summer Reruns - Part I

Tue, 06 Jul 2010 14:37:23 PDT

By Scott Ronalds

Who doesn’t love summer? Sunshine, BBQs, lounging, water sports...it’s all good. And then of course, there’s the other summer ritual – reruns. We thought we’d build on the tradition by re-publishing a blog each week from the Steadyhand archives.

For our first posting, we’re digging up a classic from the spring of 2009 where Tom suggests that we have to be careful going too far in declaring that ‘the world has changed’.

The World Has Changed
April 15, 2009

More and more commentators and experts are acknowledging that the world has changed. The framework for the future that Pimco’s Bill Gross laid out recently – namely de-levering, de-globalization and re-regulation – encapsulates what I’m reading every day, as does his resulting caution.

I guess it’s my contrarian blood, but I do think we have to be careful going too far in declaring that the world has changed. As the pronouncements get bigger, more confident and extend further into the future, it is more likely they will be wrong.

No doubt, this downturn is a biggie. It’s the most severe one any of us have seen and will cause serious dislocation. And de-levering will take time. Steps have been taken to address the problems in the capital markets (margin calls made, hedge fund lending reduced, equity capital raised), but consumers have a long way to go to get their affairs in order and governments of course are going the wrong way.

But as the list of concerns expands and the conviction builds (which is a trend I’ve definitely noticed), it feels like we’re piling on. It’s easy to come up with more doom and gloom, but difficult and less topical to seek out the balancing items.

So here are my bold, confident predictions of what’s on the other side of the ‘world has changed’ ledger.

First, I can say without hesitation that not all of the grand pronouncements are going to come true.

Second, in the new world, we will be surprised at how big the gains will be for the strong, prudent players. Well-positioned countries, companies and individuals are going to move up the ladder, maybe a few rungs this time. We’ve focused on the weak so far, which is natural, but the strong will also prove to be a noteworthy feature of this cycle.

This recession will accelerate the shift of economic power to the developing world. Many emerging market countries are sporting a current account surplus and are better financed than in previous crises. I’m not suggesting that they’re ‘decoupled’ from the worldwide recession, but they may weather the storm better and come roaring out the other side. It could be a seminal moment for some of the Asian countries in particular. Canada has a chance to be in that category, although the determination of the Federal government to subsidize the past as opposed to invest in the future weakens our case.

With regard to companies we invest in, think about the opportunity that the Canadian banks now have in front of them. The environment for their basic banking services, both for retail and corporate customers (yes, they still do that), is fabulous. And with a few exceptions, their global competitors are reliant on government funding and unable to do acquisitions. Unless our big five experience further unexpected blowups, their world standing is on the rise.

Individuals with confidence, discipline and a job (importantly) stand to gain as well. Goods and services will be marked down in price and investment opportunities (stocks, real estate, and businesses) will be plentiful. It is a buyers’ market.

And finally, I remain confident that this will be a cycle like all others. The downside will be bad and may last a while, but the excesses will be purged and the next up cycle will occur. The longer and deeper we go, the more powerful the other side will be.

Stocks have halved in price and corporate bonds are trading at depression-like valuations. The markets are telling us the world has changed. But not everyone will be impacted the same way and not all of it will be bad. Indeed, good news and opportunity will become a bigger part of our changing world as we move forward from this point.

Morningstar Research Doesn't Get Respect it Deserves

Sun, 27 Jun 2010 16:44:01 PDT

The Globe and Mail, Report on Business
Published June 26, 2010

There has never been more investment information available to investors, so it’s frustrating to see the release of the Morningstar Stewardship Grades, the most useful piece of research to come out in decades, slide by with little or no coverage from the major media outlets and investment bloggers.

I’m frustrated for a couple of reasons. Selfishly, I’d like to see it get more attention because I run a fund company that ranked well. But more importantly, the report opens a window into the inner workings of the asset management industry and investors should look through it. Morningstar has used its clout and research depth to reveal what insiders know, but which until now has been invisible to the outside world.

Most of the information coming at investors is data that’s readily available, easily measurable, but unfortunately, of little value. They’re barraged by economic forecasts and market projections, all of which have little impact on portfolio returns. They’re shown fund comparisons based on year-to-date and one-year performance, which are totally random and of no use to anyone.

The Morningstar research is at the opposite end of the spectrum. Stewardship, which is the degree to which mutual fund companies’ interests are aligned with their unitholders, is subjective and tough to measure, but it plays an important role in selecting an investment manager.

There are four components to the grading system – corporate culture, manager incentives, fees and regulatory history. The first two make up 75 per cent of the score (6 out of 8 points) and are the hard-to-measure stuff. With respect to culture, they attempt to answer the following questions. Does the company have a thoughtful, repeatable investment process? Does it offer clear, pertinent disclosure? Is it a responsible marketer? And the biggie, do talented managers spend much or all of their careers at the firm?

In the manager incentives category, they assess whether fund managers are invested alongside the clients and the degree to which they are rewarded for long-term returns (as opposed to asset growth and short-term numbers).

These are the same criteria that consultants and institutional investors (pension plans, endowments and corporations) consider when they’re selecting managers. Long-term performance is a necessary qualification for entering the race, but people, process, incentives and ownership structure weigh heavily in the decision.

Stewardship is important because investors are prone to making long-term decisions based on short-term inputs. Morningstar provides individual investors with much needed data that is likely to be stable over time. By bringing investment process and personnel into the equation, investors are encouraged to move away from making decisions based strictly on recent performance.

It’s also important because what we’ve been doing over the past twenty years hasn’t worked. Selling yesterday’s disappointment to buy yesterday’s glory has led to poor results. The “Cycle of Hope,” as I call it, has to be broken. To do that, investors need information that allows them to be patient and gives them some comfort that past returns can be repeated in the future.

The stewardship grades are not without their critics. For an industry that is constantly measured quantitatively (returns), this research is uncomfortably qualitative. Joanne De Laurentis, president and CEO of IFIC (Investment Funds Institute of Canada) sent a letter to Morningstar voicing “serious concerns” and asking them to not release the study. She found it to be “qualitative and subjective” and pointed out that there are different views on whether fund managers should invest in the funds they manage.

The Toronto Star’s James Daw found the eight-point scale “rough at best” and felt it exaggerated the differences between companies.

In the business of investing, no research report is perfect or guaranteed to be correct. Assessing the subjective factors that constitute stewardship is a difficult process. But this doesn’t negate its importance.

Despite the simplicity of Morningstar’s grades, the study does what it’s supposed to do. It reveals significant differences between how ‘A’ rated firms (Mawer, Beutel Goodman, Chou Funds, Capital International and Steadyhand) relate to their clients compared with the firms with ‘C’ and ‘D’ grades. The ‘A’s fees are generally lower. Their products are investment driven as opposed to being sales and marketing vehicles. They have a process and team that have been in place for a long time. And they eat their own cooking.

Ultimately, it’s up to the investor to decide how important the information is and where it fits into their decision-making process. In the meantime, I hope the Stewardship Grades get the industry and media stirred up because we need to make changes. Frequent manager turnover, high fees, and poor disclosure are not a road to mutual fund prosperity.

The Back Hand - Shaking it Up

Fri, 25 Jun 2010 13:12:03 PDT

By Scott Ronalds

Below are some observations and musings on the week that was – a new feature that we’ve aptly coined The Back Hand.

The world’s eyes are on Toronto this week as the G20 Summit nears. While the thought of a weekend of politics and bureaucracy was enough to make the city’s belly rumble, T.O. wasn’t the only thing shaking this week.

The Investment Funds Institute of Canada (IFIC) was shaking its finger at Morningstar after the mutual fund research firm released a study on stewardship that didn’t sit well with them. Can’t we all just get along?

Bay Street was shaking with excitement with the IPO of Smart Technologies, a Calgary-based world leader in producing interactive (electronic) whiteboards. It’s nice to see a public offering of a Canadian success story as opposed to IPOs of mutual funds disguised as closed-end funds.

The French were collectively shaking their heads at their national soccer team after one of their players staged a mutiny against the coach, resulting in an early exit from the World Cup. There may be no “I” in team, but there’s a pronounced one in equipe.

Taxpayers in B.C. and Ontario were shaking their fists at their provincial governments for introducing the Harmonized Sales Tax (HST), which comes into play next week.

American lawmakers were shaking from too much caffeine following a 20-hour conference session (which culminated this morning) that laid out the terms for several new financial reforms on a wide range of issues, ranging from derivatives to mortgages to credit cards.

And finally, Henrik Sedin was shaking at the knees when he heard his name called as the winner of the Hart Trophy (MVP) at the NHL Awards. Don’t be so humble, Hank, you deserve it.

Massively in the Middle

Thu, 24 Jun 2010 11:42:26 PDT

By Scott Ronalds

In his latest interview with Independent Investor (a U.K. publication), Sandy Nairn, the CEO of Edinburgh Partners (the manager of our Global Equity Fund), provided his views on the global economy and capital markets. After being cautious in late 2007 and bullish in early 2009, Sandy sits more in neutral territory today. He sums up his outlook for investors as follows:

“I’m not massively depressed about the outlook. But nor am I massively excited either... Returns from equities are likely to be lower and volatility greater than in the past, but the long-term outcome for equities remains a positive one, both absolutely and relative to other asset classes. In other words: get rich slowly!”

As for how Edinburgh Partners is positioning the Global Equity Fund:

“We expect to retain substantial holdings in the U.S., but as with other developed economies, unless valuations fall meaningfully from here, it is unlikely we will have much exposure to those sectors of the economy which are exposed to falls in Government expenditure and direct consumer purchases.”
“We are still finding European stocks worth buying. Europe is very much a region of contrasts. The largest economies are not in bad shape, even though both Italy and Spain do need fiscal retrenchment. It is in the periphery that the issues reside and it is important to keep in context the relative sizes of each.”
“The one area where we’ve made a significant increase recently is in Japan, where we’ve gone from having 4% of our global portfolio to more than 15%. The percentage could easily go up further.”

The piece expands on Edinburgh Partners’ rationale for Japan, and touches on a number of issues that are top of mind for global equity investors today – namely, the Greece/euro situation, the outlook for China, the recovery in the U.S., opportunities and obstacles in Europe, and banking reform.

If a ‘staycation’ is in the cards this summer, click here to download the full article. Sandy will take you around the world.

Our Clients Refer us the Old Fashioned Way - Because they Want to

Wed, 23 Jun 2010 14:11:23 PDT

By Neil Jensen

Last week I published our deliberations on whether to launch a client referral program.

We had good response via the blog’s comments, email, and in person. In part this was because we asked for feedback, and in part it was because our clients were passionate about the issue.

While there were a few who favoured the idea of being directly rewarded for referring new clients, the majority felt that it tarnished our reputation of integrity, and made us look too much like the banks. Most of our clients have indicated that they are already referring us to others because they’re happy with our offering.

We’ve decided that the reputational risk isn’t worth any potential upside, so we won’t be proceeding with the referral program.

As an aside, we found the exercise of sharing an interesting business issue with our readers to be very helpful, and will be doing more in the future.

Stewardship Soap Opera?

Tue, 22 Jun 2010 15:04:34 PDT

By Scott Ronalds

Financial Post journalist Jonathan Chevreau wrote an interesting piece yesterday on Morningstar Canada’s new Stewardship Grades. The article highlights an attempt by the Investment Funds Institute of Canada (IFIC) to discourage Morningstar from releasing the report.

Chevreau notes that IFIC has serious concerns with the report, and in a two-page letter their president attacks Morningstar for its belief that fund companies should disclose information concerning fund manager compensation and co-investment, among other issues. Interestingly, Chevreau goes on to note that not all IFIC members agreed with the letter.

While these are understandably touchy issues, we side heavily with Morningstar in that they deserve more attention and transparency.

When fund managers look at a potential investment, one of the things they focus on is management. They want to know how much of the company the management team owns, how much the key executives make in compensation, and what they hold in terms of stock options and other benefits. Put simply, they want to know how “shareholder-friendly” the management team is to determine whether their interests are well aligned.

Shouldn’t mutual fund investors consider similar measures for those that are managing their money? Wouldn’t you want your manager to have her money invested alongside yours?

We certainly think this information is important, as do several other companies who scored favourably in the Morningstar report. Presumably, these companies didn’t agree with the IFIC letter either. It looks like there’s some drama brewing in fundland.

Morningstar Stewardship Grades

Thu, 17 Jun 2010 09:15:12 PDT

By Scott Ronalds

Morningstar Canada, a mutual fund research firm, recently introduced Stewardship Grades for over 25 fund companies. In their words, the Stewardship Grade “goes beyond the usual analysis of strategy, risk and return. It is intended to assess the manner in which fund companies are run as well as the degree to which their managers’ interests are aligned with those of fund unitholders. While the grades are not intended to serve as buy/sell signals in isolation, they can help determine the difference between a great investment and one to avoid.”

We’ve written often about the attributes that investors should look for when hiring an investment manager. In other words, the intangibles that go beyond past performance – features like a manager’s investment process, experience, transparency, and whether or not they eat their own cooking (invest alongside their clients).

These features have long been hard for investors to assess and incorporate into their investment decision making process. Until now. Morningstar has done a comprehensive analysis of these qualities. It was a large undertaking that drew on a thoughtful methodology, thorough research, and the experience of their U.S. parent (Morningstar USA has had a similar rating system in place for a few years now).

The grading system is based on four components: Corporate Culture, Manager Incentives, Fees and Regulatory History. Fund companies receive a score out of 8 points and a corresponding Stewardship Grade ranging from A to F. A company must receive 7.5 points to receive an “A”.

We’re proud to announce that we received the top grade. And we’re beaming at the fact that we received the highest score (8 out of 8) of all the fund companies rated.

We’ve ridiculed industry awards that focus on short-term performance and other futile measures, but the Stewardship Grades address what we believe to be invaluable characteristics of an investment manager.

TFSA Over-contribution Nightmares

Wed, 16 Jun 2010 15:46:29 PDT

By Scott Ronalds

The Globe and Mail recently reported on an issue that all investors who own a Tax-Free Savings Account (TFSA) should be aware of – over-contribution penalties. Canada Revenue Agency (CRA) has informed 70,000 investors that they may have to pay a penalty, of up to several hundred dollars, for over-contributing to their plans. The surprise tax bills have left many investors confused and angry.

As a reminder, you can contribute up to $5,000/year to a TFSA. You can also redeem the money at any time without any tax consequences. And as a nice bonus, you can re-contribute any money that you withdraw without impacting your contribution room. This feature, however, is the source of the confusion and penalties. If you withdraw funds from your plan, you have to wait until the start of the NEXT calendar year to deposit the money back in the account (if you already contributed the maximum amount in the year of the withdrawal).

Let’s clarify. Say you contributed $5,000 in March 2009. Two months later (May), you decided to withdraw half of the account ($2,500). You are permitted to add back the amount you withdrew ($2,500), BUT you would have had to wait until January 2010 to do so. At such time, you could contribute $7,500 to your account (the amount you withdrew plus your allowable contribution for 2010). If you added $2,500 back to your account in June 2009, you would be on the hook for an over-contribution penalty tax of 1% a month. In this case, the penalty would be $175 ($2,500 x 1% x 7 months).

Investors transferring TFSA accounts from one institution to another must be careful to complete the proper paperwork in order to avoid potentially nasty penalties. If you redeem your account and subsequently use the proceeds to open a plan with another institution in the same year, the transaction will be viewed as a ‘double contribution’ by CRA. To avoid this, you must complete a Transfer Form for Registered Investments (along with an application form) issued by the firm that you are transferring the money to. This is the same process that must be followed when transferring RRSPs and other registered accounts.

TFSAs are great investment vehicles. Just make sure you know how to drive them.

Musings on a Possible Customer Referral Program

Tue, 15 Jun 2010 10:30:22 PDT

By Neil Jensen

Everyone in the investment industry knows that summer is a slow time for opening new accounts. It's a given that we should accept that investors go on holiday and the last thing they want to think about is retirement planning, let alone the perceived headache of transferring accounts to another firm.

I don't think we should accept that line of thinking.

I think that summer is when many of our clients have more time to reflect on their future, and that we should make a push to be part of that future.

One of the marketing ideas that we've had since the beginning of the firm, yet never acted on, is a client referral program. The idea is certainly not a new one, yet it is not commonly used in the mutual fund industry (at least in Canada).

I'm proposing that we pilot a two-month project this summer to see if a customer referral program would work at Steadyhand. The hope is that by rewarding clients to open new accounts or refer new clients to Steadyhand, we can turn the summer into a busier period than it generally is.

Here's how it would work:

The program would run July 1 - Aug 31st.
We create a referral code or "key" for each client, and email the key along with an announcement of the program to clients.
The client can use the key when they open new accounts, or provide the key to others to use when they open new accounts.
Each new account that is opened with the referral key will result in a "reward" to the client that referred the new client/account.

Some of the issues that we are are grappling with are:

Does this cheapen the Steadyhand brand? There is the perception that spending $25 or $50 for a client referral is different than spending $25/50 per new client on advertising. I think we can get around this by being clear and transparent in our communications around the program - and let's be honest, we are trying to build a business and are willing to experiment with different means of acquiring customers. There is also some concern that we will look too much like the banks ("open an account and receive a free toaster").
Will it actually work? Is a reward enough to change client behaviour? It wouldn't be a lot of money for our clients, but I'm OK with that. The intention isn't to give a large reward for referrals, but just to nudge people to take some action. We have a number of ideas for rewarding clients:
- a $25 or $50 management fee rebate
- waive fees for a quarter (3 months) or longer
- donate to a charity on the client's behalf
- entry into a draw for one year's fee rebate
- 10 tickets to the third round of the Toronto Maple Leafs 2010-11 playoffs run!
At the moment we make a point of sending a note of thanks to clients who refer new business - perhaps that is sufficient.
Do we alienate clients who open up accounts outside of the program window? Will existing clients feel like they were somehow ripped off because they didn't get the fee reduction? I think our answer to this simply has to be that we are experimenting with all avenues to continue to grow our business.
Are there any privacy or regulatory issues? Securities regulations would seem to require us to notify both the prospect and the client of the reward. We currently don't tell anyone, including the referror, when a new client signs up. We would have to obtain permission from both parties to allow this exchange of information.

As you can tell, this has generated a lot of internal debate, and I'm not sure that we will actually ever try it out; however, I thought the discussion would make for an interesting blog post.

We'd love to hear your feedback on whether we should proceed with this pilot program (post your comments below).

Small is the New Beautiful

Mon, 14 Jun 2010 11:18:31 PDT

By Scott Ronalds

Small funds produce better returns. This is the conclusion of a recent study, titled Pension Fund Performance and Costs: Small is Beautiful, which looked at the performance of U.S. pension funds from 1990-2006. Published by a trio of professors from Yale and two Dutch universities, the report found that the smaller funds generated the best risk-adjusted performance. Small in this context refers to both the amount of assets in the fund, and the type of securities held (i.e., small-cap).

The study included 711 pension funds, which invested exclusively in domestic equities (U.S. stocks). The size of the funds ranged from $1 million to $94 billion, with the median defined benefit fund holding $1.2 billion in assets (the median defined contribution fund was roughly half this size).

Among the findings were that U.S. pension funds on average tend to generate returns (after expenses and trading costs) that match or slightly exceed their benchmarks. Small cap mandates, on the other hand, outperformed their benchmarks by a sizeable margin – roughly 3% a year.

The researchers present an explanation as to why size plays a critical role in performance – liquidity. They observe that “liquidity limitations seem to allow only smaller funds, and especially small cap mandates, to outperform their benchmarks.” As a reminder, liquidity refers to the ease of converting an asset into cash swiftly and without a notable price discount. Illiquid investments are those that trade with much lower frequency and volume, and significantly higher bid/ask spreads, than their larger counterparts.

The professors point out that there is considerable literature which has established that illiquid investments generate higher returns. They opine that “since pension funds often have liabilities with a long duration, they naturally have longer-term investment horizons and may consequently invest in illiquid equity investments, thereby gaining the liquidity premium associated with these investments.”

It is easier for smaller funds to invest in illiquid securities because there are fewer shares of such companies outstanding and only a limited number of attractive investment opportunities. It can be very difficult for large, multi-billion dollar funds to accumulate meaningful positions in smaller companies without excessively bidding up share prices or exceeding maximum ownership limitations. In short, smaller funds are much more agile.

The paper points to other studies which show a negative association between fund size and performance, and suggests that the sheer size of the largest funds makes active management more difficult, and therefore outperformance less likely. Indeed, larger funds tend to look more like the index, as one of the authors points out.

While we don’t want to overplay the significance of one academic study, size is a crucial aspect of investing that often gets overlooked. Maybe now that ‘too big to fail’ has been thrown out the window, small may become the new beautiful.

The Long and Short of Real Estate Investing

Tue, 15 Jun 2010 10:29:11 PDT

The Globe and Mail, Report on Business
Published June 12, 2010

We’re starting to see stories about a softening real estate market in Canada. Listings are up, sales are down, and even the always bullish industry executives are predicting lower prices in the coming year.

It reminded me of a quote I saw recently: “Real estate is the drunk driver on the economic highway.” This statement, attributed to Tom Barrack, the CEO of real estate investor Colony Capital, speaks to the fact that residential real estate can be volatile. Yet that same volatility highlights why it can be fertile ground for a disciplined, patient investor. There are a number of reasons for this.

First off, it’s cyclical in the best way – the cycles are generally long while memories are always short. The most recent trend, up or down, is assumed to be sustainable. For an investor willing to take a longer view, this is a good thing.

Second, real estate is a topic that produces lots of “armchair” experts. Despite a lack of rigorous analysis, views are strongly held and overconfidence is rampant. Again, this is good for someone who is less entrenched and has a broader perspective.

The third reason is that buying decisions are often steeped in emotion (“It’s perfect. I have to have it!”), and based on non-economic factors (“The baby will be here soon.”). Music to an investor’s ears.

And finally, houses are easy to borrow against. Thus, the potential for overindulgence.

Despite these attractive investment features, there are reasons why I don’t invest in real estate beyond my personal needs. For one, I have a day job, and this type of investing is time intensive. It also doesn’t help that transaction costs are extremely high (commissions, legal fees and taxes), and there are significant carrying costs (maintenance and more taxes). Both have to be factored into the investment return.

But if I did have time and could find the equivalent of a discount broker, many of the rules I use for investing in stocks would apply.

Because leverage is involved, real estate prices are sensitive to changes in interest rates. Purchases are often financed up to 90 per cent with debt, so mortgage payments are a key factor in determining prices.

For almost 30 years, we’ve been in a bull market for interest rates and with every tick down, property values have gone up. Given that we are somewhere near the end of the rate declines, investors have to recognize that a huge tail wind is swinging around.

After such a long up trend, it’s easy to forget that residential real estate is cyclical. And as with all cycles, there is only one thing that’s easy to predict – the farther prices stray from their fundamental value, the bigger the downturn will be. If you think back to periods when prices were rising at a mind-blowing rate, there was always an equally astonishing decline to follow. Torontonians, for example, didn’t see the high prices of the late 1980s again until well after they’d rung in the new millennium.

Living in a hedge fund

House owners deploy a strategy that is at the core of hedge fund investing – buy long-term assets with short-term financing. The strategy dials up the investment’s return potential, both on the upside and downside. In the case of a house, if rates stay low and prices rise, it’s a beautiful thing. If financing costs rise and cause prices to fall, however, it’s not so good.

When people tell you that their house has been their best investment, they are undoubtedly telling you the truth. But it’s not because prices have gone up more than the stock market over long periods of time, it’s because a house investment is highly levered. And the math is powerful. When a $400,000 house bought with $100,000 of equity goes up 25 per cent, the value of the equity doubles. As Americans found out in recent years, however, high gearing works both ways.

Ultimately it comes back to valuation. Prices have to make sense in the context of the local economy. Do income levels support the price levels? Do people want to live there, and are more coming? Are the demographics going to help or hurt in the future? And what are apartment rents and vacancies doing?

If the continuing income from a real estate investment is barely covering expenses, and the long-term supply and demand outlook doesn’t justify current prices, then I am flat out speculating. When I’m ready to sell, I’m betting a greater fool will pay me an even more uneconomic price.

When I apply my investing skills and experience to the Canadian real estate market, I see a super cycle coming to an end. By plugging low interest rates into mortgage calculators, prices have been driven higher. But rents are coming down. After-tax incomes are likely to be under pressure in the post-stimulation era. And it doesn’t feel like the right time to be adding leverage to a portfolio.

Regardless of what happens, when it comes to real estate, I always want to be the designated driver. That means being be opportunistic, patient, well-financed and stone cold sober.

Know Your Advisor

Fri, 11 Jun 2010 15:12:00 PDT

By Scott Ronalds

Preet Banerjee is an industry insider who runs a blog titled 'Where Does All My Money Go?' (his blog was ranked Canada’s #1 investing blog by the Globe and Mail last month).

Preet recently developed a resource for investors called the Know Your Advisor Tool (KYA). In his words, ‘the tool is designed for investors to help them figure out who the good financial advisors are out there.’

An integral part of the KYA is a questionnaire that probes issues such as an advisor’s candour, competency, and services offered. In order to make the tool as useful as possible, Preet is looking for input from investors, financial advisors and other interested parties. We sent him the following feedback on the tool:

You are to be congratulated for taking on this project. Picking an investment professional to work with is one of the most important aspects of investing for individuals - arguably the most important thing for investors who are totally reliant on their advisor.

I know a lot of thought has gone in to the KYA questionnaire, but we have a few thoughts that you might consider.

First, a general comment. This questionnaire is for someone who is looking for soup-to-nuts financial planning and advice. This is in contrast to someone who is strictly looking for ‘investment advice’. It’s an important distinction because the point system embedded in the questionnaire rewards the breadth of offering and expertise more than it does the depth. That makes sense in the context of a client who needs the full service, but may lead to an inappropriate result for a client looking for investment advice. In other words, an advisor focused on investments, and the product and market knowledge related to that, is likely to have more to offer to that type of client.

In addition, there are a couple of areas where you might consider adding to the questionnaire.

Philosophy

When it comes to investing, there are thousands of ways to skin a cat and each advisor has a different approach. It’s important, first of all, to determine whether the advisor has a well-grounded, consistent philosophy. While this sounds obvious, it’s often the case that an advisor doesn’t, and is subject to the changing trends, and dare I say fads, in the industry. Without a stable foundation, it’s unlikely the advisor will keep the client on a steady, long-term path.

With regard to investment philosophy, it’s important that the client understand how the advisor is going to do it. Are they a value investor? Or is it Growth? Do they use funds and/or ETFs? How did they work with their clients in the fall of 2008?

The advisor’s approach to asset mix is important to understand. Are the active in shifting their clients’ asset mix? How big are the shifts? Do they get their clients right out of the market at certain times?

Reporting

A key part of an advisor’s service is the on-going reporting - regular statements and quarterly updates. In hiring an advisor, it’s essential that the reporting package be part of the assessment. Will the client know (1) what they own (i.e. overall asset mix by asset class and geography); (2) what they are paying (including commissions, MERs and administrative fees); and (3) what their returns are?

We recognize that advisors don’t have control over the reporting protocol of their firms, but it’s nonetheless a required piece of the service offering. Not knowing any or all of those three things doesn’t allow the client to monitor the advisor’s work. Why would a client hire an advisor that isn’t going to give them the tools to assess their performance? To us, inadequate reporting is a deal breaker and should be given a heavy weighing in the questionnaire.

If you have any comments on the tool, you can post them below, or on Preet’s blog (hyperlinked above).

Bad Habits

Tue, 01 Jun 2010 08:58:12 PDT

By Scott Ronalds

I was having dinner with my dad the other night and we got on the topic of credit cards. We both have cards that reward us with air miles (in one form or another) for all our purchases. And importantly, we both pay our cards off each month.

Somewhat proudly, he stated that one of his oldest cards is his gas card. I asked him what kind of rewards he got with the card. “None”, he replied. I then asked, “So why do you use it when you could be getting air miles if you use your credit card?” No response. After thinking about it for a while, he replied, “Bad habit, I guess; I’m just so used to it.” He felt shame, I topped up his wine and we got onto another topic.

Bad habits are hard to break, especially when they’ve become engrained in our behavior. Some companies have done a masterful job of developing products/services that change our behavior and deliver a superior experience. Think of Apple. The iPod has changed the way we purchase, store, transport and listen to music. Creating change isn’t easy, however, as we’re creatures of habit and tend to stick to what we’re familiar with.

At Steadyhand, we’re out to change behavior by breaking bad industry habits. The habit of paying a middleman to sell our funds. The habit of communicating in a manner that nobody can understand. The habit of wasting paper, money and time by mailing (rather than e-mailing) reporting materials. The habit of index-hugging. And the habit of poor transparency.

It’s a tough battle, but it’s a worthy one. I was reminded of this when I was leaving dinner and saw an iPod on my dad’s kitchen counter and a Steadyhand ball cap on the coat rack. This from a guy who not long ago was buying Kenny Rogers Live on cassette and whose favorite head gear had an RBC logo on it. Nothing wrong with that, of course. Kenny can rock a crowd.

ETFs Gone Wild

Mon, 31 May 2010 14:40:50 PDT

By Tom Bradley

It was announced last week that BMO is adding 8 new ETFs to its lineup. It now offers 30 ETFs, up from zero a year ago. With every new offering, BMO is getting narrower in its focus. The current batch gives the investor specific exposure to junior oil stocks, junior gas, U.S. banks and many more.

It reminds me of a quote I heard a few years ago, which I think was credited to John Bogle (the founder of U.S. mutual fund giant Vanguard and the founding father of indexing).

“As the splinters get thinner, they grow sharper, and the odds of folks hurting themselves with these pointed objects now approach one hundred percent.”

Avoiding Benchmark-oriented Mediocrity

Sat, 29 May 2010 10:24:34 PDT

The Globe and Mail, Report on Business
Published May 29, 2010

I’m just back from a few days in Scotland. Sightseeing, golf and a meeting with one of our equity managers was the order of the day.

For the golf, I stuck to convention and kept track of my pars, bogies and, unfortunately, the “others.” For my meeting with Edinburgh Partners Ltd., however, I threw out the industry scorecard. We had quite a different conversation from what normally occurs between manager and client.

What I mean is that we spent no time on short-term performance. None. We didn’t analyze where the fund is deviating from the global index with respect to returns or sector weightings. And we spent minimal time on the company’s economic outlook because that’s not what drives the makeup of our fund.

Instead, we discussed personnel changes and employee ownership. I wanted to determine how supportive and ethical the firm’s environment was for the investment team. We reviewed their investment philosophy and process, and the refinements they’ve been making. We touched on some stocks, but only to reinforce their approach and reveal what they do when things go wrong. I wanted to make sure the stiff backbone I hired three years ago was still there.

More than anything, I was watching to make sure EPL hadn’t slipped into being a benchmark-oriented manager. If Steadyhand is going to deliver better returns than other firms, we need to look different than the indexes. As David Swensen, chief investment officer at Yale University, puts it: “Market-beating managers express their insights in concentrated portfolios that differ dramatically from the character of the broad market.”

A 2006 study by two Yale academics (Martijn Cremers and Antti Petajisto) confirmed that view. It concluded that funds which deviated most from the index outperformed their benchmarks (on average) while funds that ran closer to it did not. Interestingly, the study also pointed out that in the United States the proportion of passive funds claiming to be active (closet index funds) increased from zero in 1990 to 30 per cent in 2003.

Despite evidence pointing in the other direction, managers are sucked into the benchmark world by three irresistible forces – risk management systems, clients and success.

It’s a relative world

Risk management systems can be a useful tool. They confirm the types of risk being taken and make sure the portfolio properly reflects the managers’ views. But the problem with all the fancy numbers is that they’re short-term oriented and strictly based on comparisons to the market indexes, however flawed they may be. And instead of providing a reality check, they often take on a life of their own and start to shape the portfolio.

So with the industry scorecard based on how funds look compared to the index, it’s not surprising the managers know the makeup of that index by heart, to the decimal point. Or that they begin managing to a “tracking error” number (a statistic that estimates how much the portfolio’s return will deviate from the index, based on historical data). Or that they start speaking unintelligibly in a secret language – “I’m overweighted consumer staples and underweighted materials.” All signs that the index is near.

Clients and their concerns

Managers are hired to beat the benchmark. Unfortunately, the quarterly comparisons they go through with clients make it more difficult to do. The performance analysis on stock and sector weightings is all done relative to the index. And it’s always for periods of one year or less.

It’s clear where the portfolio did well and where it fell short. If the manager is pursuing a long-term strategy that hasn’t played out yet, a few quarters can feel like a lifetime. There are only so many ways you can say, “The fund has underperformed because it owns a ton of technology stocks and no oil.” So every tough client meeting pulls the manager closer to the closet.

Bonus pools and redemptions

In light of the risk management and client pressures, a fund manager is forced to find a balance between where their research and conviction is pointing them and what the index looks like. How much can they deviate and for how long.

The stakes can be high for the manager (a big bonus versus no job) and the firm (more clients versus redemptions). The higher the compensation and larger the firm, the more there is to protect. Managers find themselves owning “filler” stocks – ones they don’t like much, but keep the fund from straying too far from the index.

Fortunately, I left Scotland knowing that our fund will continue to look different. The EPL team runs concentrated portfolios (30 to 40 stocks), designs their risk management around factors that don’t strictly relate to the index, and is careful to sell themselves as the “undexers” that they are.

I also left knowing that my golf game needs serious work. It’s overweighted sand, underweighted one-putts and subject to extreme tracking error.

Podcast: Visit to Edinburgh

Thu, 27 May 2010 09:34:28 PDT

By Scott Ronalds

Tom met with Edinburgh Partners Limited (EPL) on their home turf last week for an annual update on their firm and global equity portfolio. It was also an opportune time to discuss some of the issues currently impacting Europe and get the CEO’s (Sandy Nairn) thoughts on the debt crisis that is overhanging Greece.

A little jet-lagged and with a hint of an accent, Tom highlights some takeaways from his visit in this podcast, which is a supplementary posting to a blog on the same topic.

Download, subscribe via iTunes or RSS, or listen now.

Catching up with Edinburgh Partners

Thu, 27 May 2010 09:14:17 PDT

By Tom Bradley

Last week I met with Edinburgh Partners Ltd (EPL), the manager of our Global Equity Fund, on their home turf. Here are the highlights.

The Firm

EPL has been in existence for almost 7 years and has been very successful. They manage C$11.4 billion for corporate, government and mutual fund clients. It’s a credit to their team and long-term record that they’ve been able to attract many blue chip clients, including a number of pension plans in Canada. To control their growth and ensure a proper transition for new clients, however, EPL recently closed for new business. They aren’t near maximum capacity, so I would anticipate they’ll reopen later this year or in 2011.

In step with their success, they’ve continued to invest in the business by adding experienced people (I met two of the new hires) and enhancing their risk management and IT systems.

Big Picture

Sandy Nairn, the founder and CEO, said that it’s not useful to have one economic theme right now. The world is out of sync. Developed countries are burdened with debt, have challenging demographics (in some cases) and are focused on stimulating economic growth. Their monetary aggregates have not expanded because the banks haven’t been lending. The less developed / emerging economies on the other hand, are well financed and in a position to continue growing at above-average rates. They are more concerned about inflation and have been trying to dial down the expansion.

As a result of this dichotomy, the EPL team is cognizant of where a company’s revenues come from. For example, Carlsberg, a fairly new holding, is based in Europe, but its growth and profitability is tilted toward the emerging markets.

European crisis

Without coming across as unconcerned or cavalier, my sense is that Sandy and the team feel that the crisis is overblown. Certainly the debt problems are serious, but Sandy does not see Spain being in jeopardy and the issue around Greece is its “competitiveness” more than its debt. For Greece to become more competitive, such that it can support its debt load and a reasonable standard of living, it may need to find a way to devalue its currency – i.e. bring back the drachma. How else can they make a 25% pay cut palatable?

The Fund

So far, the crisis hasn’t triggered any changes to the fund’s holdings. EPL felt at the outset that the global economic recovery would be slow and bumpy, and the portfolio is structured with this in mind. While the team wishes they owned “one less European bank”, they don’t want to sell any at current levels. As for buying, the team has been more focused on Japan and the U.S. than Europe, although that may change with the weakness of the last few days. EPL is always quick to jump on opportunities when they arise. There are no committee meetings or world-wide conference calls to schedule.

Despite all the turmoil, EPL is still projecting attractive returns for the portfolio (which obviously improve with every down day) and are maintaining a balanced approach, which means the fund isn’t tilted towards any one theme or economic factor. This is in contrast to their cautious stance in 2008 (when the portfolio was heavily weighted in health care, telecoms and cash) and more aggressive positioning in 2009 (when they acted on opportunities in the emerging markets and within the technology sector).

Sugar-Free Economic Lunch

Tue, 25 May 2010 09:38:58 PDT

By Scott Ronalds

I recently attended a luncheon hosted by Connor, Clark & Lunn, the manager of our Savings Fund and Income Fund. The session focused on the economy. Larry Lunn, the firm’s chairman and co-founder, was the keynote speaker. Larry is an experienced industry veteran who has navigated through a number of economic and market cycles and always has a thoughtful and well researched view – and he doesn’t sugar-coat it.

Prior to introducing Larry, the presentation started with a quip by Phil Cotterill (Head of the Client Solutions Team at CC&L) that the session had been moved to a lower floor of the building at the last minute (read: to prevent any ‘jumpers’). After the presentation, I wished I hadn’t turned down the Heineken at lunch.

Larry and the team at CC&L didn’t exactly paint a rosy picture of the secular forces that will shape the next decade. They focused on the debt hangover that the global economy is facing and the unfavourable demographic scenario that is emerging as the boomer generation moves past its peak equity accumulation period and into a ‘dissavings’ phase. In a follow-up report, CC&L summarized their take on the next ten years as follows:

The structural imbalance between a savings-short, leveraged American consumer and the Chinese mercantile economic model, with an emphasis on too much savings, fixed investment and exports, will be disruptive.
We will face a period of anemic sub-par economic growth because of changing demographics and debt formation, which will lead to shorter and more volatile business cycles.
Bigger government, more regulation and higher taxes are in store.
Higher risk premiums (because of the aforementioned imbalances) will lead to lower P/E (price-to-earnings) multiples on stocks.

Larry concluded the presentation by suggesting that investors should expect low single-digit stock and bond returns over the next decade. As I said, no sugar-coating.

I was hoping to leave the session with some positive insights and messages to report back to our clients, but I was stumped.

After reflecting on CC&L’s message for a few days and reviewing their outlook, however, I’ve changed my stance. There were some useful takeaways worth sharing. First, the economic situation is not entirely discouraging, as they note in their report. Corporate profits have improved (substantially in some cases), growth has picked up, government spending is creating stimulus and interest rates remain very accommodative for growth. While government spending and low interest rates will eventually have to be unwound, the immediate future appears reasonably bright (notwithstanding the debt hiccup in Europe). There are certainly longer-term issues that need to be addressed, but that is not to say they can’t be resolved.

Second, economic forecasts are just that, forecasts. They are meant to paint a rough picture, not a detailed map.

Third, greater short-term volatility can play into the hands of opportunistic investors and agile managers.

Fourth, it’s motherhood stuff, but investors are well advised to make sure they have an asset mix that they’re comfortable with – one that reflects their risk tolerance and time horizon. Those who take on too much risk and/or can’t handle short-term volatility will have the most sleepless nights.

Fifth, Larry and his team are preparing their clients for low single-digit returns over the next decade, not negative returns. Given the economic headwinds they foresee, they still believe the capital markets will provide positive, albeit volatile, returns.

And finally, Europe and the U.S. are on sale for Canadian investors. Our dollar goes a long way these days in buying foreign assets. In fact, if the Vancouver real estate market holds up and southern Europe goes bankrupt, I’m thinking of selling my place and buying Greece as a ‘fixer-upper’.

Submission to the Task Force on Financial Literacy

Tue, 18 May 2010 08:21:14 PDT

By Scott Ronalds

The Task Force on Financial Literacy is a federal government initiative aimed at strengthening the financial literacy of Canadians. The Task Force, which is comprised of 13 members, was appointed in June 2009 (as part of the federal budget), and will provide advice and recommendations to the Minister of Finance on a national strategy to strengthen and promote financial literacy.

The Task Force is encouraging Canadians to communicate their thoughts and suggestions through a series of online and public forums. Their public consultation process recently ended, and the group will submit a report by the end of the year to the Minister of Finance that recommends a national strategy and course of action.

Steadyhand submitted a brief proposal with two simple recommendations:

Require all statements provided by investment providers to include information on how much the client has paid the provider – in dollar terms and as a percentage of their total invested assets – over the reporting period.
Require all statements to also include relevant information on how the client’s investments have performed. All investment providers should be required to show rates of return at the account and consolidated portfolio level. Performance figures should be provided for the same time periods that mutual funds are required to publish their returns (e.g., 3 months, 1 year, 3 years, 5 years, 10 years, and since inception).

We believe strongly that transparency is a critical element of financial literacy. Specifically, individuals need to clearly understand their costs associated with investing and how their accounts have performed. To be blunt, our industry’s reporting practices and standards with respect to these measures are awful. Greater transparency would go far in improving financial literacy.

You can read our full submission here.

In Times of Crisis, Approximation Beats Perfection

Sun, 16 May 2010 10:42:15 PDT

The Globe and Mail, Report on Business
Published May 15, 2010

As we ride the market volatility caused by Europe’s economic turmoil, I can’t help but think back to Oct. 19, 1987, a date that will forever be imprinted in my memory.

Black Monday saw the Dow drop 23 per cent, while the TSX was down 11 per cent. As an aspiring analyst at Richardson Greenshields, I had just published two ‘Buy’ reports – Laidlaw and Investors Group if I remember correctly – in which I wrote glowingly about the companies’ long-term fundamentals, competitive position and attractive valuations.

All of that good stuff went out the window, however, when the market went into free fall. Everything was going down including my shiny new recommendations.

Fortunately, I was smart enough, or devastated enough, to abandon my desk and go hang around the traders for the rest of the day. I just sat there stunned and watched the insanity.

Black Monday was my first experience with a serious market decline – a crisis that garnered coverage in the front page of the newspaper. Looking back, it didn’t matter that I froze up. I wasn’t managing money at the time and the sales team and clients had more important things to do than listen to me.

But the day didn’t go to waste because I learned some lessons that have served me well in subsequent crises.

More information, less knowledge
When a crisis hits the front page and information is flowing fast and furiously, you have to know two things. First, the markets have already absorbed most, all, or more than all of the bad news. When people are talking about it at the water cooler, the markets have already moved on.

And second, the quality of information is poor. Very poor. It’s heavily tilted toward the negative. And because it’s often something we’ve not gone through before (crises tend to be that way), it doesn’t fit into anybody’s model. We look to the experts to make sense of it, but without the necessary time and data, they are winging it just like the rest of us.

Under-react
When the experts are guessing and emotions are running high, it’s not a time to take a strong view. Big shifts in strategy at times of crisis lead to bad decisions. The potential for blowing up a portfolio, or asset management firm, is very high. Investors who sold all their stocks at or near the bottom last year have devastated their retirement savings, just as many did 10 years earlier when they got carried away with technology.

When things are coming apart, we all desperately want to take action. But trust me, under reacting is good.

Back to fundamentals
That’s not to suggest that there aren’t things to do. Even if no radical shifts are planned, it’s important to know where you stand with regard to your long-term asset mix and what your next steps might be.

While everyone else is looking at the big picture, it’s important to get back to what matters – fundamentals and valuation. Even if earnings and multiples don’t seem to matter at the moment, they ultimately will. So, watching for securities that have been unduly penalized by the crisis is time well spent.

Baby steps
When there are large dislocations in the market, it is likely some portfolio rebalancing will be required. Last month’s asset mix will no longer be in place. I’m a big proponent of taking incremental steps to get where you need to be. Market extremes are not a time for perfection, but rather approximation. Investors who aim to make a bold move at just the right time, usually end up doing nothing because the stakes are too high. They can’t afford to be wrong. It’s better for investors to take small steps that in aggregate are approximately right, as opposed to not doing what they think might be brilliant.

I’m so excited
The Pointer Sisters had it right. Certainly for investors in the accumulation phase, market crises are a time to get excited. It’s a gift. New investment dollars buy more in depressed markets and the value of existing holdings are never impaired to the degree that short-term prices imply. When securities are being dumped for uneconomic reasons – automatic sell programs, fund redemptions, and good old panic – you want to be buying.

Europe has serious economic and political issues. The crisis will have an impact on economic growth and capital markets. Indeed, the world’s debt overhang is a major reason why I’ve been cautious in recent months. But as the support programs, spending cuts and tax increases play out, I’m prepared to do some rebalancing. I have my buy list ready if markets experience a sustained decline (which they haven’t so far). And while I’m not planning on freezing up like I did in 1987, I’m also not expecting to do much. I’m afraid my under-reactivitis condition is chronic.

Questions about Europe?

Wed, 12 May 2010 10:09:09 PDT

By Scott Ronalds

First it was swine flu. Now it’s fragile economies. Seems like pigs can’t catch a break these days. The southern European nations of Portugal, Italy, Greece and Spain (PIGS) are garnering plenty of attention in the media, as investors fear these countries may default on their debt obligations, with Greece at the forefront.

Reminiscent of the global credit crisis of 2008/09, emergency bailout measures have been proposed to curb another financial fallout. Not surprisingly, we’ve seen an increase in stock market volatility and overall nervousness about the events transpiring across the pond.

As our name suggests, we are encouraging investors to maintain a steady hand on their portfolios. Knee-jerk reactions to negative short-term news and uncertainty are often ill-timed and later regretted. That said, it would be irresponsible to simply turn a blind eye to the state of affairs in Europe.

So, what exactly is happening? Best to turn to the source, Edinburgh Partners (the manager of our Global Equity Fund). Tom is making a trip to Scotland next week, coincidentally, to visit the team in Edinburgh and will report back with an update on the portfolio and EP’s views on the economic situation and investment conditions in Europe. In the meantime, investors interested in details on the recent bailout package may find Bank of America’s latest report useful.

If you have a specific question you’d like answered by the manager, email us and we’ll send it along with Tom (and his golf clubs) to Edinburgh.

All Quiet on the PPN Front?

Tue, 11 May 2010 13:42:00 PDT

By Tom Bradley

In the media and this blog, it’s been pretty quiet when it comes to principal protected notes (PPNs). Regular readers will know that we have been critical of these bank-issued products and have written about them often.

I don’t have a sense of how well they are selling these days, but they are still around. We saw some statistics from Investor Economics last week showing that there are over 1,700 notes outstanding worth nearly $15 billion.

For those who are tempted to go down the PPN path, or are getting a sales pitch from their friendly banker or broker, I would encourage them to read Fabrice Taylor’s piece in the Report on Business today. It reinforces the points I’ve been making about PPNs. Fabrice’s opening line says it all, “In the great annals of rip-offs to come tumbling off the Bay Street assembly line, few if any rank higher than principal protected notes.”

The Secret Behind Succession Plans and Stock Picks

Tue, 11 May 2010 13:42:00 PDT

The Globe and Mail, Report on Business
Published May 1, 2010

Burgundy Asset Management sent a letter to its clients this week announcing changes to its management structure. Two years from now CEO Tony Arrell will step down and hand the reins over to the current Chief Investment Officer, Richard Rooney.

In terms of succession planning in our business, this is a biggie. Mr. Arrell is a large shareholder in a firm that manages almost $9-billion in assets. He is a commanding and thoughtful presence both inside and outside of Burgundy’s Bay Street office. And his vision and drive to build a top tier Global firm have shaped who the firm has hired and how it’s grown. While other investment managers concentrate on Canadian stocks and Canadian clients, two-thirds of Burgundy’s research staff is focused on foreign markets and the firm has had success winning institutional clients in the U.S. and elsewhere.

Planning for succession is a bit like picking stocks. You can do the preparation and make all the right moves, but at the end of the day, there are a slew of uncontrollable variables that will determine how well it plays out with clients and business partners. When a new management team is establishing its credentials, there is no doubt that it helps to have a little luck in terms of industry trends and short-term performance.

My former partner Bob Hager always said the time to make a change is when the performance numbers are turning up after being poor. The clients are more open to change, having been through a tough period, and the odds are better that the new team will be shown in a positive light (i.e. improving returns). It gives the firm the best chance of selling the changes internally and externally.

Bob’s strategy speaks to the fact that new CEOs, in any industry, are often given undue credit, or subjected to unfair criticism, based on what happens in the near term. Hockey coaches and finance ministers suffer from a similar fate. The reality is, near-term results are determined by random market forces and strategies put in place by the previous team. The new boss may become a hero by doing nothing more than giving the predecessor’s ‘failed’ strategy a little more time.

For clients of a larger firm, movement at the top is important, but it doesn’t require action the same way changes to the investment team do. When a long-standing portfolio manager steps aside, there is a direct and immediate impact on the portfolio. Holdings change and the investment approach will be different going forward, sometimes quite significantly. The client has to take a close look when there is a new person pulling the trigger.

Changes in the corner office will also have an impact, but they take longer to play out. The incoming team will influence new product directions, the ability to hire top people, the ownership structure and the overall investing culture of the firm, all of which translate into client returns over time.

Some transitions can be categorized as ‘more of the same’, while others portend radical change. In the latter category, AIC’s change of leadership (and ownership) will mean a total overhaul of its investment platform and the new masters at Saxon Financial (Mackenzie Financial) and Phillips, Hager & North (Royal Bank) are moving in new directions. In the pension arena, some public funds are going through profound shifts as a result of changes at the top. The Caisse de Depot (with new CEO Michael Sabia) and AIMCo in Edmonton (Leo de Bever) are examples of this.

I’ve been on both sides of the succession process and have known success and failure. From what I can tell, Burgundy has covered all the bases. The changes are deliberate, transparent and evolutionary. And they’re being made for the right reasons. Even though the “plan is to work for a very long time,” Mr. Arrell is 65 years old and has recognized the need to provide visibility to his partners and the firm’s clients.

Mr. Rooney isn’t a conventional CEO in terms of his overt marketing and people skills, but he has the most important attribute for a firm like Burgundy – he is a respected investment person.

For counselling firms that are all about investing first and marketing second, this is a requirement. It’s part of the DNA and it helps distinguish them from the mega firms that are increasingly being run by marketing and sales executives. In this regard, Mr. Rooney’s credentials were reinforced by how he and his investment team handled the downturn – the Burgundy portfolios held up better than most and they didn’t blink when the uncomfortable buying opportunities presented themselves.

Taking over for a successful, iconic leader is always a tough row to hoe. Fortunately, the post-Arrell team has the benefit of a stable client base, established research team and employee ownership. As for luck, perhaps it will come in the form of better returns from foreign markets, which plays to the firm’s research strength.

A Step in the Right Direction

Thu, 29 Apr 2010 09:16:45 PDT

By Scott Ronalds

There’s an old saying that mutual funds are sold, not bought. Canada’s mutual fund industry is a perfect example.

The majority of financial advisors are paid commissions by fund companies for selling their funds and keeping clients invested in them. Up-front commissions can run as high as 5% or more, while trailing commissions (paid each year) typically range from 0.5% for bond funds to 1.0% for equity funds. In other words, an advisor who sells a client $100,000 worth of XYZ Fund may receive $5,000 up-front and $1,000 each year (give or take, based on market fluctuations) from the fund company for keeping the client invested in the fund. The commissions are paid to the advisor for advice they provide to the investor.

Critics of this structure argue that it has two big flaws. First, advisors may be enticed or biased toward selling products that pay the highest commissions, thereby ignoring the best interests of their clients. Second, the transparency is awful. Investors are often unaware of the fees they pay and how much their advisor is compensated for selling them a fund and providing ongoing advice.

The U.K., which has a similar compensation structure for advisors, recently took the bold step of banning commissions on financial products. The country’s Financial Services Authority (FSA) recently announced that by the end of 2012 advisors will no longer be allowed to receive commissions on products they sell to investors. Instead, investors will be charged separately for advice.

The FSA noted: “Firms will have to be upfront about how much they charge for their services, and no longer hide the cost of their advice behind the cost of a product…consumers will know what they are buying up-front, how much it will cost them and also have the peace of mind that it was recommended to suit their needs.”

Regulators in Australia are considering a similar course of action, where it is being recommended that up-front commissions and trailing commissions should not be permitted in relation to personal advice.

Such moves would go far in improving transparency. Investors would be equipped with a better idea of the all-in cost of buying and holding a financial product. What a concept. Maybe it will make its way to Canada. Or is that just crazy talk?

Bad Math

Fri, 07 May 2010 15:12:08 PDT

By Scott Ronalds

Rob Carrick’s column in today’s Globe and Mail looks at big, expensive mutual funds. He identifies the funds with the most assets under management and the highest management expense ratios (MERs). The 23 funds on his list all have more than $1 billion in assets with MERs ranging from 2.52% to 2.84%. Evidently, these funds aren’t passing any economies of scale on to unitholders (with respect to management fees and operating expenses).

An interesting observation, however, is the number of balanced funds on the list. Over 30% of the funds have some combination of stocks and bonds (or cash), with MERs as high as 2.68%. Let’s do some quick math. Assuming a fund charges an MER of 2.6% and has a traditional balanced asset mix of 60% stocks and 40% bonds, investors would be paying about 3% for management of the fund’s equities and 2% for fixed income management. Or, if a lower fee were assigned to the fixed income portion of the fund, say 1.5%, investors would be paying nearly 3.5% for the equity component. Either way you look at it, that’s just bad math.

Book Review: The Big Short

Tue, 27 Apr 2010 09:01:23 PDT

By Scott Ronalds

Michael Lewis has a talent for writing about financial issues in a provocative and colorful manner. Having worked as a bond salesman for Salomon Brothers in the 1980s, he leans on his experiences and lessons learned on Wall Street to bring his readers ‘inside the tent’.

His latest work, The Big Short, is a narrative on the U.S. housing market crash. Unlike many books and articles on the topic, however, Lewis focuses his novel on a small group of investors who were on the ‘other side of the trade’ (i.e., betting that the rapidly escalating housing market would implode).

He tells the story of three groups of investors who were unwavering and obsessive in their bets against subprime mortgage bonds. And who made a whack of money because of it. He explains the birth and role of credit default swaps (CDS) and collateralized debt obligations (CDO) – those much talked about but little understood financial instruments that helped serve to bring down the likes of AIG, Bear Stearns, Citigroup and Lehman Brothers, among others. And he illustrates the colossal failure of risk management departments and rating agencies to identify and curb the risks that were growing in the system.

While the outcome is known in advance, Lewis’ take on the recent financial and housing market collapse provides many fresh and humorous (albeit dark) insights and observations. Aside from gaining a greater understanding of what was, and wasn’t, happening behind the scenes, a key takeaway is that investors who do their homework and who have a great deal of conviction in their strategies shouldn’t be afraid to run against the herd. Indeed, simply being one of the sheep can lead you to slaughter, as was the case of virtually every major Wall Street investment bank in 2008/09.

The Big Short is receiving some great reviews. One of my favorites is, “Michael Lewis doing what he does best, illuminating the idiocy, madness and greed of modern finance…Lewis achieves what I previously imagined impossible: He makes subprime sexy all over again.” (Andrew Leonard - Salon.com ). Canadian Capitalist also reviewed the book in a positive light in a recent blog. And who knows, we may even see it on the big screen in the future, given Lewis’ recent success with The Blind Side. It’s a fairly quick read, and last I checked it was on sale at Costco for about 40% off. So grab a 24-pack of popcorn and tuck in.

Slipping out the Door

Thu, 22 Apr 2010 11:45:35 PDT

By Scott Ronalds

George Morgan joined Mackenzie Financial in January 2009 as a Senior Vice-President and Portfolio Manager for the Mackenzie Cundill American Class Fund. Mackenzie issued a public announcement at the time. Here are a few excerpts:

“George is an extremely tenured and talented investor; his leadership is a tremendous addition to the team,” says Peter Cundill, founder of the Cundill organization.
“We are always looking for opportunities to add to the strength of our investment management teams…George is an experienced global value investor who brings many years of investment success to the Cundill team and who has had a relationship with the team, having been a member of the Cundill Investment Advisory Committee for the last two years,” says Charles R. Sims, President and CEO of Mackenzie Financial Corporation.

Mr. Morgan left Mackenzie at the end of 2009 to pursue other interests. Here are a few excerpts from the announcement at the time:

(No public announcement was made).

The media has recently brought the issue to light, and there are reports that investors in the fund are upset due to the “undisclosed departure”. Mackenzie’s stance, as noted by Advisor.ca, is that the decision to not make his departure public was based on the conclusion “that there was sufficient continuity of portfolio management on the fund and the change did not warrant a general public release.”

Silence – 1; Transparency – 0.

China Interrupted

Thu, 22 Apr 2010 08:43:00 PDT

By Tom Bradley

I am not an economist and have never been to China.

But I am an investor and a student of market cycles, and as such, I’m always wary when something that is far from certain starts being assumed as part of the foundation of the capital markets. Today China is one of those ‘uncertain assumptions’. While investors worry about Greece, the housing market and corruption on Wall Street, they are counting on China being immune to an economic downturn – 8-10% growth will continue uninterrupted. This is a particularly important assumption for Canadian investors because our market has so much pinned on the China miracle.

I bring this up again now because I came across a couple of excellent pieces over the last week. While flopped on the couch at the cabin, I watched a Charlie Rose interview with James Chanos, who is a famous and controversial short seller. In the course of making his clients gobs of money on Enron, he built his reputation as a thoughtful and savvy investor. Mr. Chanos is shorting China.

His argument focuses on China’s dependence on construction (56% of GDP) and investment spending. He provides some color on how the property markets work and the degree to which speculators are involved. If you watch it, remember that he is talking his book (i.e. he has a vested interest in viewers turning against China.)

I also read a White Paper by Edward Chancellor from GMO (you have to register on their website to read the article). Mr. Chancellor is a more learned student of cycles and bubbles than I am, and GMO, under the leadership of Jeremy Grantham, has proven in the past to be astute at flagging market extremes.

For those who are keen on China, the GMO piece will provide a dose of reality. It methodically goes through ten aspects of the bubbles of the last three centuries and then discusses how China measures up. Needless to say, Mr. Chancellor scores it high on all ten measures.

The Chanos interview and GMO paper include and add to the concerns that I have about the China assumption. In no particular order they are:

Abnormally high rates of capital spending are good at fueling economic booms and setting up subsequent busts. The GMO piece refers to an IMF World Economic Outlook which points out that countries with a high investment share of GDP (China is off the scale on this measure, as was Japan in the 80’s) tend to suffer the steepest and most prolonged economic downturns.
Governments are poor capital allocators and China’s central authority is calling all the shots. Both Chanos and Chancellor have some sobering tales about how uneconomic much of the stimulative spending has been.
Cheap money and undervalued currencies also lead to poor capital allocation.
Aggressive growth targets and poor transparency are a bad combination. I liken China to a company that shows a rapid and consistent rate of growth, even though the underlying business is far from steady and predictable. As Mr. Chancellor points out, “whenever an economic indicator is made a target for conducting policy, then it loses the information content that would qualify it to play such a role.” When non-transparent companies finally miss their target, they always ‘blow up real good’. That’s because we find out that they were stretching and straining to keep up appearances such that by the end the cupboard is bare. In the case of China, we already know what we’ll be reading about when the downturn hits – empty factories, apartment buildings and highways; an over-levered and overbuilt housing market; insolvent banks and a poor demographic profile.

China is going to grow rapidly. It will become an ever increasing force in the world economy. That we can assume. But we have to be less definitive about the path the country will take to get there and how much of that success is factored into asset prices around the world.

ETF Providers Have Cluttered a Pristine Landscape

Thu, 08 Jul 2010 22:07:10 PDT

The Globe and Mail, Report on Business
Published April 17, 2010

Four years ago my business partner Neil Jensen and I were sitting on Kits Beach contemplating a new mutual fund company. As we looked out at the competitive horizon, we could see a wave coming at us. It was called ETFs (exchange-traded funds), and we knew it would be a tough, low-cost competitor to Steadyhand.

What we didn't anticipate was that the wave would turn into a tsunami. In no time, Canadian investors were flooded with new ETF offerings. By our count, there are now 145 funds traded on the stock exchange and a steady flow of new ones coming out from Blackrock (iShares), Claymore, Horizons BetaPro, Bank of Montreal and PowerShares. During the past year in particular, the marketing machines have kicked into high gear.

As a consequence of the swelling numbers, the ETF sector has profoundly changed how it's positioning itself with investors, and how it competes against other investment firms like ours.

Not So Simple. For starters, when investors are looking for “simple and transparent”, ETFs are no longer the default. There still are many clean, easy-to-understand ETFs to be had, but they're harder to find among the proliferation of new products.

Indeed, ETFs no longer take a back seat to closed-end funds or mutual funds when it comes to complexity, opaqueness and fine print. Investors need to ask the same questions they would of any packaged investment product. Will I own stocks, commodities or derivatives? Is there any leverage? What index is the fund replicating? Is it currency hedged? How well does it trade? Are there other fees or costs?

In the rush to catch the wave, the ETF providers have cluttered what was a pristine landscape just a few years ago.

Not so Predictable. It used to be that investors knew what to expect from an ETF. If the market went up X per cent, that would be the fund return, minus a small fee. The emergence of BetaPro's leveraged ETFs blew that notion out of the water. If an investor held their ‘Plus’ funds (two times market exposure) for more than one day (yes, one day), the returns were totally unpredictable relative to the index or commodity they were tracking.

But the unreliability of returns is not limited to the high-octane funds. The returns from some currency-hedged equity funds diverged widely from their expected targets in 2008 and 2009. And in general, the tracking error of ETFs (the amount a fund's return diverges from that of the target index) have widened over the past few years. According to the Wall Street Journal, U.S. ETFs on average missed their targets by 1.25 per cent in 2009, more than double the 2008 gap.

The Fee Halo Over all, ETF fees are lower, but the scene has changed here too. From a rock-bottom start with the original iShares funds, fees have steadily crept up. If an investor uses some specialty funds and trades a few times a year, the cost of an ETF portfolio can easily push into the range of low-priced mutual funds.

In another disturbing innovation, some ETFs are being launched as closed-end funds and then converting to open-end at a later date. These funds are prohibitively expensive for the initial buyer.

Despite the trend to higher fees, there is still a halo around ETFs. This was particularly noticeable recently when some actively managed ETF's were rolled out and the 20-per-cent performance fee was hardly mentioned in the commentaries.

Trading at a Price. One of the advantages of ETFs is that investors can buy or sell at any time. For day traders and institutional investors, including hedge fund managers, this is what makes them so attractive.

However, many of the new funds are extremely illiquid and require trading experience to ensure that the price paid is at or near the value of the fund. For long-term investors who are looking for cheap, broad-based market exposure, negotiating a trade in the open market and paying a brokerage commission is not always so great a deal. For some, buying a mutual fund after the market closes at net asset value (calculated to four decimal points) may be more appealing and practical.

The 90/10 Rule. The marketing of ETFs has gone from being all about cheap, broad-based and passive to being focused on specialization and active trading. Most new products are designed to allow investors who “have a view” to implement their strategy with surgical precision. An investor can now get exposure to virtually any commodity, country or industry sub-sector, and as of this week, can speculate on spread trades between like commodities (i.e. long oil and short gas).

It's all about market timing, sector rotation and trading. In other words, we have arrived at a point when 90 per cent of new offerings are suitable for only 10 per cent of investors.

Stop Generalizing. When we drew up our business plan, we made lots of mistakes, including underestimating how big a competitor ETFs would be. Going forward, the biggest error we could make would be to oversimplify the differences between ETFs and mutual funds. Other than the way they are transacted, the lines between them have almost disappeared.

We can no longer naively say that ETFs are simple, low cost, index-based, tax efficient and have a trading advantage. Or conversely, that mutual funds are none of those things. It's time to stop generalizing and go back to the beach in search of the next wave.