This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

Why are there no DSC Index Funds?  On one hand, pretty much any advisor knows that there is no such thing as a DSC index fund and why that is so.  On the other hand, many retail investors probably never thought about it- and likely wouldn’t be able to accurately explain why this little wrinkle exists even if they did.  There’s likely a pretty severe disconnect on this- a topic that could have applications in the fields of practice management, ethics, client suitability and advisor ‘value propositions’ to name a few.

(Note: there actually are DSC Index funds these days, but they are far from ubiquitous – Preet)

In order to be clear, it needs to be underscored that mutual fund companies “manufacture” products, while financial advisors “distribute” them.  Obviously, no one could be expected to distribute a product if no one is manufacturing that product in the first place.  So, to modify my original question in the interest of specificity, “why don’t mutual fund companies manufacture DSC index funds?”

I’ll try to grapple with the question by confessing my concern right off the bat.  To me, this is a case of undue bias.  I would hope that all readers would agree that in an advisory relationship, the interests of the client should always come first.  Still, advisors are absolutely allowed (indeed, expected) to advocate for whatever products and processes they feel are best and are absolutely allowed to choose their own business model, too.

Many advisors insist that they are “independent”.   When asked by someone who understands the industry, however, one quickly finds that many “independent” advisors have an attitude that is similar to Henry Ford’s early take on car colours: “you can have any colour you want, as long as it is black”.  My take on those advisors who use mutual funds is that they effectively tell their clients that they suggest that they can: “have any mutual fund they want, as long as it pays an embedded compensation”.

This isn’t a topic that is confined to index funds, obviously, since there are dozens of credible actively-managed mutual funds available that never make it on to many advisors’ product shelves, either.  I chose to explore index funds because in the case of actively-managed funds, advisors can always find a similar fund that offers an embedded compensation and skirt the ‘advisor value’ conversation that might otherwise ensue.

The problem, as I see it, is when the business model drives the product recommendations to the potential detriment of the client interest.  The implicit premise of much financial advice is that the advisor is more likely than a layperson to reliably identify outperformers in advance.  Indexing drops all pretense of doing that.  As such, it begs the question of what one might reasonably expect from an advisor.  It has been suggested that the three primary functions of good financial advisors are to:

1. Spot problems and identify solutions.

2. Motivate people to act/change their behaviour.

3. Help people to emotionally detach from investment market events.

Notice that picking stocks and picking people who pick stocks (i.e. picking actively managed funds) is not on the list.  When talking about index funds that offer no embedded compensation, there’s no product alternative available today that has a similar mandate, but with advisor compensation built in.  In essence, advisors that use a commission model simply do not offer index products to their clients.

Obviously, the absence of a DSC index option would be a complete non-issue if actively managed products were demonstrably superior.  But what if substantial evidence suggests otherwise?  What if there are a number of clear and compelling reasons for a rational, self-interested investor to prefer an index product?  That brings us to what I believe is one of the fundamental questions in our industry today.  Where does one reasonably draw the line in regard to required disclosures regarding the risks and limitations for competing products and strategies where the relative efficacy of two or more alternatives is not obvious?

When giving presentations to ten or more members of the public, what if the following disclaimer was used:

The views expressed are those of (advisor name) and are not necessarily shared by (firm name).  Debate regarding market efficiency, the usefulness of fundamental and technical analysis, active vs. passive management and the efficiency of payments is ongoing.  To date, neither side has been able to claim unchallenged victory.

I cannot help but notice that people who favour active products and strategies, but fail to compare the two are not required to use the disclaimer.  The question that it begs is: “if neither side has been able to claim unchallenged victory, then how can an independent advisor recommend only one side to clients with a clear conscience”?  The corollary is: “how can it be acceptable to avoid an important disclaimer by simply avoiding a direct comparison”?  At the very least, shouldn’t all advisors be required to disclose that both alternatives exist, irrespective of the approach they favour- especially if there’s a reasonable possibility that the alternatives they favour is inferior to the one being recommended?  The industry hides the ugly truth by tolerating the non-disclosure of material considerations that could alter the decision-making process.

From my vantage point, the issue is not whether or not advisors should be allowed to advocate for one product line or business model or another.  Clearly, they can do whatever they feel is best.  The issue is whether or not they should be allowed to deliberately withhold credible and viable alternatives from their clients and still be considered independent professionals.

Thanks Jimbo. So what do you guys think? I realize this is written more towards advisors (as Jim’s articles usually are), but there is certainly food for thought for everyone.

No related posts.

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also sometimes include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world. NOTE: you have to visit the actual website to see the embedded video – it may not appear in your email. Just click on the title of the email to see it…

I made a 24 hour commando-mission to Atlanta last weekend and the result is that I will be co-authoring a new book which we hope to have published in May. I’ll fill you in on details as we near the end of the project, but I think I will have another book in me for 2010 or early 2011 as well which will be focused on sharing some horror stories with the hopes of helping figure out what NOT to do when it comes to managing personal finances – that was inspired by Larry MacDonald – who writes a blog here.

Mentions In The Media

Financial Post Magazine: 2010 RRSP Playbook

National Post: Investors have met ‘the enemy in the mirror’

Toronto Star: Requiem for a Bay Street Titan.

From Around The Blogosphere

Dan Bortolotti has recently launched an entire blog devoted to Couch Potato Portfolios. I see it quickly becoming a very popular website.

Rob Carrick talks about Post-Traumatic Stress Investing.

Jonathan Chevreau discusses a poll which found that 20% of people hope CPP and potentially winning the lottery will be enough to fund retirement. Yikes!

Ellen Roseman says it’s time to stop the madness.

Michael James elaborates on Ellen’s thoughts.

Canadian Capitalist links to an exposé on the Rich Dad, Poor Dad seminars. A must read.

Thicken My Wallet explains why the Latte Factor doesn’t work.

Million Dollar Journey shows us how one could save 70% off their grocery bill.

Four Pillars has an interesting post on bank accounts and dating.

Big Cajun Man wants a financial GPS.

This Week’s Racing Video

Rally drivers are bonkers. This short 22 second clip shows one driver jumping half a football field during an event. Holy moly guacamole!

No related posts.

Designer extraordinaire, and guest author Daniela Garritano returns. If you would like to secure her services, don’t be afraid to email her by clicking here. Take it away D…

Happy New Year everyone!

Today’s class is all about becoming a de-clutter bug! Now, I don’t know about you, but every year after the holidays, I somehow manage to have additional clutter in my home, not knowing where it actually came from. So, this can be a project we take on together!

Clutter is all around us. Nowadays with reality t.v shows zeroing in on compulsive hoarders or shopping addicts, it’s in the limelight more than ever. Whether it exists in our own home, our cars or even our jobs, it can be an overwhelming task that can easily become an emotional burden. It can not only weigh down our home, but it can also weigh down our lives. It can leave us feeling unmotivated, stressed out, helpless or even embarrassed.

However, with these easy tips (along with me cheering you on! Yay!) you’ll be well on your way to a clutter free home. You just have to remind yourself, that in the end – it’s just stuff. And with any luck, it can make you a little extra of the stuff you actually want: the green stuff!

1) One step at a time

If you’re a fan of Oprah, you may have seen superstar de-cluttering coach, Peter Walsh, as a regular fixture on the proverbial yellow couch. The great thing about Peter, is that he really breaks it down into the simplest of terms when it comes to tackling the muddle. Your first task is to simply start with one room at a time. Then, separate your clutter into four major self explanatory categories: The Keep Pile, The Junk Pile, The Sell Pile and The Donation Pile. When sorting through the jumble, try to refrain from just throwing everything back into the keep pile. Take a deep breath, ask yourself if you really need it and if you hesitate for even a second, you can likely live without it!

D’s Tip: If you find yourself getting flustered, take a short break to clear your head, and come back to it. If you find yourself overly frazzled, make a list of what you are doing to clear the chaos and check it off one at a time when each task is complete. i.e. fold clothes and put away, make the bed, clear the nightstand etc.

2) Pack it up!

An easy step I often take with client’s who have real difficulty in letting go of the clutter is the cardboard box trick. To start, pick a room that is filled with confusion. Grab all of the things you do not use or need on a regular basis, shove them in a box and store it away. Come back to the box a week later, and see how you react when you open it. Are you excited to see it? Did you forget what was even in there? Or does it just look like junk in a box? Also, think about what your living space has been like without it. I am thrilled to report that very few clients ever revert back to their messy ways. When you enjoy a clutter free room, it becomes increasingly harder to fill it up with junk again.

3) Re-gift without the guilt!

So simple, so entertaining and oh so much fun!

Gather up your bestie’s and hold a swap party for all of the gifts you have ever received but have never used (I have plenty of those. Singing trout anyone?) This includes everything from birthdays, Christmas’, anniversaries and even wedding favours that are just sitting in your home collecting dust. You may not want it, but it may be an absolute treasure to someone else. Plus, it may give you the chance to get rid of something you don’t need and get something you do need. And, if you’re all looking to make a little extra cash, have a swap for a toonie party. Same rules apply, but everything costs a toonie!

D’s tip: Make a pact with your guests in that whatever doesn’t get picked up, does not go back home with the owner! Toss all of the leftovers or donate them to the charity of your choice.

4) Fun & Games

If getting your kids to clean up is like finding the Holy Grail, try finding a way to make it fun! In our family, we made it a habit that after every special gift giving occasion, a trip to the local shelter was made the following week. It not only taught us to live without the need of excess, but it also reinforced the notion that the clean up was not only benefitting our home, but other’s as well.

D’s Tip: Kids giving you a hard time? Check out these kid friendly clean up games that will get the whole family involved! http://www2.scholastic.com/browse/article.jsp?id=11690

5) Seasonal Spring Cleaning!

A great habit to get in to, is to clean out your closet at the beginning of each season. Try keeping a special hamper solely for the purpose of tossing in clothes that you never wear. Rule of thumb: if you have not worn it through an entire cycle of the seasons (that’s one full year folks!) you will never wear it again.

Each time you come across something you have never worn or no longer want, toss it in the hamper immediately before you have a chance to justify why you haven’t worn it. Before you know it, the hamper will be full, and it will be time to donate it to a shelter. Then, start all over again when the hamper is empty. Try getting the whole family involved in this process too!

D’s Tip: Most people are always looking for a bargain on the latest and greatest. Try posting your unwanted hubbub on sites like Kijiji or Craigslist for a little extra green. Where else do you think all of those unwanted bridesmaid dress go? 

Next time from Daniela: The suggestion box!

No related posts.

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

So I hopped on to my computer one morning and typed in the phrase “scientific method” into my search engine to see what came up. Click here for the  definition that our friends at Wikipedia use. Then read the following:

As far as I can tell, the preponderance of evidence supports the notion that the majority of active products and strategies fail to outperform and that the ones that do cannot be reliably identified in advance. It’s sort of like lottery tickets. The majority of tickets sold are losing tickets and the ones that are actually winners cannot be reliably identified until the winning numbers are called. The obvious rhetorical question that begs asking is: “Should advisors actively encourage their clients to buy lottery tickets?”

To be absolutely clear, everyone (advisors and investors alike) is entirely entitled to do what they personally feel is best. My concern is when people make decisions (and recommendations) without a reliable basis of factual evidence and fail to disclose that lack of reliable evidence. Is the question of appropriateness of approach one of fact or opinion? If it is a question of fact, there is considerable empirical evidence in support of passive products and strategies. If it is a question of opinion, then surely it ought to be disclaimed as such. What I find particularly telling is the notion of full disclosure. Irrespective of how you might personally feel about this conundrum, do you fairly disclose this fact/opinion and bring both alternatives to your clients?

Thanks Jimbo – ’till next time! -Preet

No related posts.

Last post on this topic (at least for a while). Click on the following links for Part I, Part II, and Part III.

The final thoughts I wanted to share with you about this refer to the assumptions under which market cap-weighting an index suffers a drag when linking portfolio weight to price. We have already shown that overpriced stocks will be overweighted and underpriced stocks will be underweighted. These mispricings happen in every sector, and in every size of stock (small-, mid- and large-caps). How do we know which are overpriced and which are underpriced? We never know. No one knows what “fair value” is for any stock. But because the market has so many participants we assume that prices tend to revert towards fair-value more often than not. This does not preclude the market from getting prices drastically wrong at times, but with so many participants these mispricings are eventually identified and this is acted upon by the market and the result is the reversion to fairer prices.

So let me throw this out there to you: If the market is efficient enough that you can’t reliably outperform it, then is it fair to say that the market will tend to revert to fair prices on average? If it is fair to say that, then is accepting the drag of the price-weight link a necessary evil?

No related posts.

A hedge fund can decide to suspend the redemption rights of investors, usually whenever it feels it is necessary, which means you won’t be able to get your money out until a later date. The hedge fund would be considered to be “gated” at this point.

Why would they do this? It is a provision in the offering memorandum that investors agree to (although let’s face it, not everyone reads the whole offering memorandum so it comes as a surprise if enacted). It is actually designed to protect the fund. If a hedge fund invests in illiquid securities and investors suddenly want their money back en masse, the fund may not be able to sell the assets it holds to fund the redemption requests. If the fund is the major holder of certain investments then there may also not be a ready buyer at the given moment, which would lead to an unfavourable sale price – which would hurt the investors making redemptions and the other investors as well. This could lead a manager to gate the fund for a certain period of time in order to protect the NAV of the fund as best as possible.

Hedge funds get a lot of bad press, but just as with any investment – you need to understand where you put your money. I am not against hedge funds – I’m against people/advisors who use hedge funds when they don’t know what they are doing. There is a whole spectrum of hedge funds from conservative to super aggressive.  Remember to do your homework.

No related posts.

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also sometimes include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world. NOTE: you have to visit the actual website to see the embedded video – it may not appear in your email. Just click on the title of the email to see it…

I’m heading to Atlanta this weekend, but just for Saturday. While it was 17 degrees there today, it will only be 4 degrees while I’m there – bah! Oh well, if anyone has any suggestions on what to do while I’m there let me know – otherwise I’ll just take a tour of the CNN studios and grab a slaw-dog. (I worked in Atlanta for a few weeks back in my racing days, but there was no time to do anything except work and eat slaw-dogs.)

From Around The Blogosphere

“Why are we so clueless about the stock market?” is a book reviewed by Thicken My Wallet.

Big Crotchety Man regales us of his misadventures in buying a new (to him) van.

Jonathan Chevreau writes a piece in which the TFSA account is shown to be a superior investment vehicle over the RRSP in some cases.

Rob Carrick discusses your mortgage options: fixed or variable? Yes.

Michael James on Money asks if people WANT to be fooled by car ads.

Four Pillars explains personal finance at Ridgemont High.

Million Dollar Journey explains that we don’t have to give up lattes to save money: there are other ways less painful (to some).

Canadian Capitalist highlights a recent documentary that looks into the world of credit card companies from the inside. Great video.

This Week’s Racing Video

Have you ever thought about strapping a jet engine onto a truck? Neither have I. Enjoy! (Email Subscriber: click here to view)

No related posts.

Continuing from Part I and Part II…

Actually, tonight I`m going to share some thoughts that struck me in the shower this morning when I was thinking about inverse cap-weighting a slice of the market (as reader Jordan had suggested to avoid market capacity constraints). Another reason this won`t work in practice is that you are foregoing the participation in the growth of companies since your exposure to companies declines as they become more highly valued by the market.

Again, I`m going to reiterate that we are operating with the assumption that over the long term, market prices are efficient enough that taken en masse, a rising total market capitalization indicates long term growth in an economy. I don`t think that is a stretch by any means. If you were to inverse cap-weight the stocks in an index the long term winners would be less and less represented in your index. This long term drag would counter much, all, or more than the gains produced by the goal of overweighting underpriced stocks and underweighting the overpriced stocks.

So, by trying to correct a small drag in returns that occurs when stocks are mis-priced and then revert to their fair value in a cap-weighted index, you may suffer a larger drag by systematically decreasing your exposure to the long term winners in the index. With respect to this drag of cap-weighting, note that this occurs in small and large cap stocks (and everything in between), remember – just because a stock is large cap doesn`t mean it is overpriced and similarly just because a stock is small cap does not mean it is underpriced. This is important to understand for the previous parts in this series and the next ones too… stay tuned!

No related posts.

In the first part of this series we discussed the impracticality of inverse cap weighting (also note Michael James’ comments at the bottom of that post.) In this part we will look at what needs to be done to sever the link between price and weight so as to avoid overweighting overvalued stocks and underweighting undervalued stocks.

Not intending to be patronizing: to sever the link between price and weight you must weight stocks based on something not directly related to price. The question then, is to figure out what metric to use. Many people use stock market indices as long term proxies for measuring the growth of an economy. If that is a loose assumption we can make, then any metric which accomplishes this can be used. We could look at the number of employees in a company versus all employees in all companies. We could look at the number of telephone lines in a company versus all the telephone lines in all companies. I’ll see if I can dig up the actual research, but these two methodologies both outperformed cap-weighting over long periods of time.

Whether one uses these metrics (they don’t in practice) or metrics found in the audited financial statements (like gross sales), they all accomplish the goal of randomizing pricing errors instead of magnifying the overpriced weightings and decreasing the weights to underpriced companies. This is the important concept in all of this and it is spelled out in detail in this post.

Disclosure: I work for a company which manufactures index funds which seek to break the link between portfolio weight and stock price, so take all of this with the grain of salt that I have a bias.

Part III click here.

No related posts.

In a recent post about market-cap weighted fixed income indices, it was noted by reader Xenko that one way to overcome overweighting overvalued companies and underweighting undervalued companies (counter to what a rational investor would desire) could be to inversely weight constituents of an index. While the original post was about fixed income indices, I’m assuming the thought was directed at equity indices so I will speak directly to that (there is an extra step with respect to fixed income indices that we’ll go over some other time).

Here is the problem with that suggestion: if you assigned more weight to a company based on its inverse cap-weighted rank then you run into the problem of running up the price of smaller cap stocks. A large market-cap stock might be worth $50 billion and is highly liquid. If it is the largest stock by market cap in an index it will have the most weight. But if the smallest company in an index (say with a market cap of $100 million) had the highest weight then if there were a lot of people trying to track that index their might be additional pressure on that stock’s price because it might be illiquid.

Let’s explain with an example. Let us say that the total market capitalization of all companies is $1 trillion. The $50 billion company would have a 5% weight in this index by market-cap and the $100 million company would have  a 0.01% weight in this index. If we created another index which reversed these weightings so that the $100 million company represented a 5% weight in this new index (let’s called it the ‘inverse index’ for now) and the $50 billion company had only a 0.01% weight in this index, this wouldn’t be a problem for the $50 billion company. But what if this index had $4 billion worth of investors’ money pouring into it on day one because they liked the concept. The index fund traders would have to allocate 5% of $4 billion into the $100 million company. 5% of $4 billion is $200 million. This would send the $100 million company’s stock soaring artificially. This is a problem of “index capacity”.

So in practice, this would not work.

This is essentially the same line of thinking which explains why an equal weighted index will not work as well in practice as it does in theory. An equal weighted S&P500 index would allocate a 0.2% weighting to each stock in the S&P500 index. Now, your exposure to pricing errors is randomized instead of the tendency to overweight overpriced stocks and underweight underpriced stocks. Maintaining a 0.2% weighting to each stock would have higher turnover than a regular cap-weighted index, but the same problem of capacity concerns on the smaller stocks exist as with the above example.

In the next part of this series we will look at how else we can randomize the exposure to pricing errors without these ancillary problems cropping up. (We can never eliminate pricing errors.)

No related posts.