Ignore Market 'Experts'

People want certainly. David Freedman, in his 2010 book “Wrong” offers the example of a person suffering from back pain. He visits two doctors to review their MRI. One doctor says that he has seen many similar cases and that it’s hard to say exactly what’s wrong. He suggests trying out a treatment and going from there. The other doctor says that he knows exactly what is wrong and knows what to do. Which doctor do you choose?

Most people will choose the doctor who seems certain about his diagnosis, but that doctor may very well be wrong. As much as we crave certainty, it rarely exists, and it definitely does not exist in the world of financial markets where returns are driven by events that cannot be consistently forecasted. Market experts want you to believe that their insight can help you make better investment decisions. Sell this, buy that [point side to side for animations of stocks to buy].

It may be interesting to listen to market experts, but should you actually believe anything that they say?

Let’s start off by remembering that there is a tremendous amount of evidence that actively managed funds, on average, consistently fail to outperform their benchmark index. Actively managed funds are groups of market experts working together to outsmart the market, and, on average, they are not able to make the right calls based on their own predictions. So why would some person claiming to be a market expert online, on the radio, or on TV be any different? Well, guess what? They are not any different.

There have been two comprehensive efforts to aggregate and analyze the predictions of stock market gurus. One data set from CXO Advisory Group looked at the forecasts of 68 stock market experts spanning 2005 through 2012. They collected a total of 6,582 forecasts for the U.S. stocks market. Some of the forecasts had been made as far back as 1998, ending by 2012. The forecasts were then compared to the S&P 500 over the future intervals relevant to the forecast. The analysis found that the aggregate accuracy of all forecasts was less than 50%.

The other study of predictions is called the Gurudex. It looks at the 12 month period ending in December 2015. Rather than focusing on individual market gurus, the Gurudex looks at the stock predictions of large institutions. Not only does the Gurudex assess the accuracy of the forecasts, but it also compares the return of an investor who had acted on all of the predictions to the return of the S&P 500 over the same period.

For the twelve months ending December 2015, the Gurudex shows an average stock prediction accuracy of 43% for the 16 institutions that they tracked. It’s not like these are no-name institutions, either. RBC Capital Markets, BMO Capital Markets, Goldman Sachs, and UBS were all included. Only 4 of the 16 institutions had greater than 50% accuracy over the 12 month time period. One of those four, a Japanese institution, batted 60%, while the other 3 were right 53% of the time, barely better than a coin flip. The accuracy numbers drop sharply from there.

If an investor had acted on each of the stock predictions that these large institutions made in 2015, they would have earned a -4.79% return while the S&P 500 was relatively flat at -0.69%.

In an attempt to explain such low accuracy for these supposed experts, the author of the CXO Advisory analysis points out an important perspective on forecasts. The market expert making a forecast may have motives other than accuracy. For example, some market gurus may be making extreme forecasts to attract attention to their institution or publication. This is an important thing to keep in mind when you read or listen to market experts - they don’t care about you. Their motivation might be driving traffic to their publication, or bringing attention to their product or service, but their focus is almost certainly not on giving you financial advice that is in your best interest.

One notable market expert, Andrew Roberts, the Royal Bank of Scotland’s research chief for European economics and rates, made headlines in early 2016 by advising investors to ‘sell everything’ in preparation for a ‘cataclysmic year’. This was sensational enough to be picked up and written about by the Telegraph, CNN, the Wall Street Journal, and the Financial Post, among many other publications. Of course 2016 went on to be an excellent year for investors. So did 2017. Woops.

Warren Buffett famously said “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

While it may be tempting to listen to those who prognosticate the best stocks to buy or the future direction of the market, it is important to remember that the data refutes their ability to improve your investment decisions. Market experts are not regulated. There is no licensing body or minimum level of education to call yourself a market expert and start making predictions. Even if there was, the evidence shows that no level of education or intelligence makes it possibles to beat the market consistently. Market experts should be viewed as nothing more than they are: a source of entertainment.

Should you buy Bitcoin?

In my last video I told you about Bitcoin. What is it? Bitcoin is a relatively new thing called a cryptocurrency. Some people think that you can compare it to a traditional currency, or gold, while others describe it as a new asset class. Whatever it is, excitement about its potential for future adoption has lead to a rapid increase in price, which has a lot of people wondering if they should be buying in.

How Bitcoin is going to perform in the long-term is anyone’s guess. Without long-term data on Bitcoin, or any other cryptocurrency, it is not possible to make an evidence-based decision about investing in it.

Let’s look at Bitcoin from the perspective of it being a currency. Are currencies good investments? Traditional currencies do not have a positive expected return. In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that over the last 115 years, currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another.

Bitcoin has also drawn comparisons to gold. Unfortunately, that does not mean that you should buy bitcoin. The evidence for gold as an investment is not very good. Some people argue that gold is an inflation hedge, and that bitcoin could be the same. In a 2012 paper, Claude Erb and Campbell Harvey found that while gold has been an inflation hedge over the very, very long-term, “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

So if Bitcoin is a currency, it probably isn’t something that you want to invest in. The price volatility of currencies, and gold, does mean that while they do not have a positive expected return as a long-term asset, you may still be able to profit by trading them - buying low and selling high as the price fluctuates. Of course, the problem with trading currencies is that they are random and volatile, leading to extremely unreliable outcomes.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. Much like stocks and bonds currently serve public companies, Ludwin writes that cryptocurrencies are assets that serve decentralized applications. A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party.

While decentralization sounds like a good thing, there is a catch. By nature of being decentralized, decentralized applications are slower, more expensive, and less scalable. They also have worse user experience, and volatile and uncertain governance. When a service is completely decentralized, there is no customer service center. There is no help line. There is no way to get your bitcoin back if you lose it. In contrast, if you damage your US dollars in a fire, you can bring the scraps to the US government and they will try to identify the bills and reimburse you. That type of centralized service is lost with decentralization.

Ludwin explains that bitcoin isn’t best described as “Decentralized PayPal.” It does not compare to PayPal in terms of user experience or efficiency. It’s more honest to say it’s an extremely inefficient electronic payments network, but in exchange we get decentralization. The obvious question follows: who cares about decentralization enough to put up with a slow, inefficient, and inconvenient method of payments? The most obvious answer is people who want their transactions to remain anonymous and who do not want to be censored by, say, a government.

Based on Ludwin’s arguments for bitcoin as a separate asset class that serves a decentralized payments application, its value will be derived from the adoption of Bitcoin as a means of exchange. Buying bitcoin in hopes of benefitting from its widespread adoption, keeping in mind the very specific type of person that would value bitcoin enough to put up with its shortfalls, would be very speculative.

In an interview with Coin Telegraph, Eugene Fama, the father of modern finance, explained he believes that bitcoin only has value to the extent that people will accept it to settle payments. He explains that if people decide they don’t want to take it in transactions, it’s value is gone. When Fama’s interviewer tells him that bitcoin also derives value from its censorship resistance component, Fama says “I guess that for a drug dealer that has a lot more value. But otherwise, I don’t see the big value about that.” While Fama’s answer may seem flippant, it touches on the same point that both that Ludwin made - Bitcoin’s price depends on its adoption.

So why has bitcoin’s price seen such a sharp increase? It's safe to say that the future supply and demand of bitcoin are highly uncertain, but the expectations of future supply and demand are factored into the current price. Each time someone pays a little more to own a bitcoin, they are injecting their future expectations into the price. The recent rapid price increase is due to people’s expectations that bitcoin will be widely adopted in the future. The fact that the number of bitcoins can reach an upper limit is an often-used argument that bitcoin will retain its value over the long-term. That may be true in isolation, but the future supply of cryptocurrencies is a big unknown. New cryptocurrencies have emerged that attempt to improve on bitcoin's design, potentially reducing the demand for bitcoin as a payment system.

Bitcoin is either an inefficient currency in the early stages of adoption with plenty of disadvantages and one big advantage over traditional currencies, or its a new type of asset that serves a decentralized payments application. In either case, the long-term value of bitcoin will mainly be derived from from its adoption as a mainstream currency by the people who value decentralization enough to put up with all of the downsides.

There is no doubt that bitcoin is based on an exciting new technology with potentially widespread applications. Investing in bitcoin is a bet that this technology will meet or exceed the expectations that current market participants have for it. Just like I would be wary about investing in gold, an individual stock, or a specific currency, I would be very hesitant about buying bitcoin. And I’m not the only one thinking that way. Warren Buffett, one of the greatest investors in history, recently said "In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending,"

If you must buy bitcoin, keep in mind that its market capitalization is still less than 1/3rd of 1% of the global market capitalization of stocks. You might consider allocating bitcoin to your portfolio accordingly.

What is Bitcoin?

It is next to impossible to avoid hearing or reading about bitcoin. Within the past decade, it has gone from being a fringe idea proposed in a paper written by a mysterious author, to being a mainstream technology that some people are treating as a new asset class. Bitcoin is now getting attention from the media, individual investors, and even large financial institutions.

As bitcoin continues to surge in both popularity and price, investors will naturally wonder if they should own some. This is an important question to ask, but to frame the decision about owning bitcoin, we first need to know what Bitcoin is.

Bitcoin is a cryptocurrency. Cryptocurrencies are a relatively new technology that has emerged within the past decade. Unlike traditional currencies, cryptocurrencies do not rely on a central issuing body or sovereign government. Instead they rely on blockchain technology. The blockchain is an open, distributed ledger that records transactions in a way that is public, verifiable, and permanent. While there are now countless different cryptocoins available, Bitcoin was the first, and it continues to be, by far, the largest cryptocurrency by market capitalization.

You can buy bitcoins using traditional currencies, or you can mine them. Mining means receiving newly created bitcoins in return for using your computer power to compile recent transactions into new blocks of the blockchain by solving a complex mathematical puzzle. There is a finite supply of bitcoin, with a total of 21,000,000 that can be mined. More than 16,000,000 of those are currently in existence.

For a long time, cryptocurrencies were pretty obscure, and mostly popular within a very niche crowd. More recently,  the sharp increase in the market value of bitcoin and other cryptocurrencies like Ripple, Litecoin, and Ethereum has contributed to intense attention from the media and investors.

Being such a new technology, it is challenging to draw evidence-based conclusions about what bitcoin is. We can try to work around this issue by finding things with longer histories that bitcoin might share characteristics with. On his blog, Aswath Damodaran, a professor of finance at NYU, explains that things can fall into one of four groups: a cash flow generating asset, a commodity, a currency, or a collectible.

Damodaran goes on to explain that Bitcoin is not an asset, since it does not generate cash flows. It is not a commodity, because, at least for now, it is not raw material that can be used in the production of something useful. This leaves currency or collectible, and of the two it is most likely that bitcoin could be classified as a currency.

A successful currency needs to be three things: a unit of account, a medium of exchange, and a store of value. As a unit of account, bitcoin is as good as anything. As a medium of exchange, bitcoin is still far being accepted as mainstream for transactions, and where it is accepted transaction costs are high. Bitcoin has struggled as a store of value due to its significant price volatility. While bitcoin has room to improve as a currency, we might be able to look at it through this lens.

There is one other currency in particular that draws comparisons to Bitcoin: gold. Gold would be considered a currency, not a commodity, because its value comes from its currency-like functions, not its use as a raw material to produce something useful. Like Bitcoin, the amount of gold that can exist is finite. As a currency, gold also has high transaction costs, and a volatile price. It seems like Bitcoin could be a digital substitute for gold.

But not everyone agrees.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. He does not think that cryptocurrencies should draw comparisons to traditional currencies because their use case is so much different. Ludwin explains that in much the same way that that stocks and bonds serve public companies, cryptocurrencies serve decentralized applications.

A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party. The growth and acceptance of decentralized applications could mean enormous growth in the value of the cryptocurrencies that serve them.

Damodaran believes that Bitcoin could take one of three paths in the future. It could become the global digital currency, in which case its high price could be justified. It could become like gold for Millennials. A seemingly safe place for those who have lost faith in centralized authority. In this case, the price would fluctuate much like gold does. Lastly, it could prove to be the 21st century tulip bulb, a comparison to a speculative asset that soared in the sixteen hundreds before collapsing.

I have just told you that bitcoin can draw comparisons to traditional currencies like gold, but it could also end up being a whole new asset class if decentralized applications take off. Or it could fizzle out. Interesting, right? I know I haven’t answered what you’re really wondering. Should you invest? I will be talking about that in my next video.



Do active managers really protect your downside?

Active money managers want you to believe that they can act defensively to mitigate the downside of stocks during a market downturn. This is one of the ways that active managers may try convince you that index funds are too risky. No investor likes the idea of passively sitting by while their portfolio falls with the market.

Investing in index funds means accepting the market through good times and bad, but active managers claim that there is a better way. Should you listen to them?

An index fund will continue to own all of the stocks in the index regardless of the external environment, meaning that when stocks are falling in value, you will continue to own them, and your portfolio will fall in value. An active manager will claim that they can reduce your losses by making changes to the portfolio.

Remember that investing is a zero sum game. If one active manager is able to beat the market during a downturn, it means that another active manager is underperforming. This simple rule invalidates the claim that active managers will always be able to protect you when the market is falling.

Most actively managed funds underperform the market over the long-term, but active managers claim that in anticipation of a downturn they might sell some of the stocks in your portfolio to insulate you from the expected losses. You can always find active managers prognosticating the next market crash, and explaining what they are doing to prepare for it. Maybe they are holding cash, or only buying certain types of stocks.

If you can find an active manager that can offer protection in bad markets, that would truly be an advantage. The problem is that there is no evidence of the ability of active managers accomplish this consistently. During the 2008 US market downturn, 60% of actively managed US equity funds in the US outperformed the market. In the 1994 European bear market, 66% of funds were able to beat their benchmark. That seems promising. Better than a coin flip, anyway.

As promising as that may seem, a 2008 white paper from Vanguard looked at active manager performance during bear markets between 1973 and 2003. Of the 11 bear markets examined, there were only 5 instances where more than 50% of active managers outperformed. There is no evidence that active managers, on average, have been able to produce better performance than index funds in down markets.

Vanguard’s research did not stop there. The paper goes on to examine what happened to the funds that were able to outperform during bear markets in subsequent bear markets. The results showed that outperformance in one bear market had no statistical relationship to outperformance in other bear markets. This is an indication that the funds that did outperform were merely lucky as opposed to skilled. This result was corroborated in a 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns. They found that, on average, U.S. equity mutual funds do not demonstrate evidence of manager skill.

More recent research, again from Vanguard, examined the performance of flexible allocation funds in bull and bear markets between 1997 and 2016. Flexible allocation funds are able to change their allocations at will to try and time the market. During that period there were three bull markets and two bear markets. During bull markets, only between 31 and 36 percent of the funds were able to beat their benchmarks. The numbers were better in bear markets, with 65% of funds beating their benchmark in the 2000 to 2003 downturn, and 45% of funds beating their benchmark in the 2007 to 2008 downturn.

While active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets in this sample. The cost of active management is a heavy cost to carry for what might be a slightly greater chance at outperformance during bear markets. In the 10 years ending June 2017, only 8.89% of Canadian mutual funds investing in Canadian stocks were able to beat their benchmark index, and only 2.54% of Canadian mutual funds that invest in US stocks were able to beat their benchmark index.

Does income investing really increase your income?

In my last two videos I talked about high yield bonds and preferred shares. These are two alternative asset classes that investors venture into when they are seeking higher income yields. I told you why you might want to avoid those asset classes. Today I want to tell you why focusing on investing to generate income is a flawed strategy altogether, and why a total return approach to investing will lead to a more reliable outcome.

Investors often desire cash flow from their investments. There are blogs, books, newsletters, and YouTube channels dedicated to income investing. Income investing means building a portfolio of dividend paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain a desired lifestyle. The idea is that if you have enough income-paying securities in your portfolio, you will be insulated from market turbulence and can comfortably spend your dividends and coupon payments regardless of the changing value of your portfolio.

There is a perception that if you never touch your principal, you won’t run out of money. It seems like a fool-proof retirement plan. But is it, really?

Let me start off by saying that there is no evidence that dividend paying stocks are inherently better investments than non-dividend paying stocks. There are five factors that explain the majority of stock returns. Dividends are not one of these factors. For example, we know that if you gather up all of the small cap stocks in the market, they will have had higher long-term returns than all of the large cap stocks. Based on this, company size is one of the factors that explains stock returns. The same evidence does not exist for dividend paying stocks.

If they aren’t better investments, why do people like them so much? In a 1984 paper, Meir Statman and Hersh Shefrin offered some potential explanations for investors’ preference for dividends. If they have poor self control, and are unable to control spending, then a cash flow approach creates a spending limit - they will only spend income and not touch capital. Another explanation offered in the paper is that people suffer from loss aversion. If their stocks have gone down in value they will feel uncomfortable selling to generate income. On the other hand, they will happily spend a dividend regardless of the value of their shares.

As much as a dividend may seem like free money, the reality is that the payment of a dividend decreases the value of your stock. If a company pays twenty million dollars to its shareholders as a dividend, the remaining value of the company has to decrease by twenty millions dollars. The investor is no better or worse off whether the company that they invest in pays a dividend or not. This is known as the dividend irrelevance theory, which originated in a 1961 paper by Merton Miller and Frank Modigliani.

I have just told you that whether returns come from dividends or growth does not make a difference to the investor, but there is an important detail for taxable investors. There is no difference whether returns come from dividends or growth on a pre-tax basis. On an after-tax basis, the investor without the dividend is in a better position because they could choose to defer their tax liability by not selling any shares if they don’t need to cover any spending. The dividend investor is paying tax whether they spend their dividend or not. This is a big problem for an investor who does not need any income at that time.

About 60% of US stocks and 40% of international stocks don’t pay dividends. Investing only in the stocks that do pay dividends automatically results in significantly reduced diversification. Dividend investing can also lead to ignoring important parts of the market. There are plenty of great companies that do not pay dividends. Ignoring them because they do not pay a dividend, which we now understand is irrelevant to returns, is not logical. A good example of this is small cap stocks. An income-focused investment strategy will almost certainly exclude small cap stocks, few of which pay dividends.

Now, don’t get me wrong, dividends are an extremely important part of investing. One dollar invested the S&P/TSX Composite Price Only Index, excluding dividends, in 1969 would be worth $14.37 today. The same dollar invested in the S&P/TSX Composite Index, including dividends, would be worth $64.59. If you are investing in Canadian dividend paying companies, you also receive favorable tax treatment on your dividend income. You should want dividends - they are an important part of stock returns. But you should not want to focus on buying only stocks that pay dividends.

Dividend paying common stocks are an important part of a portfolio, but a dividend-focused portfolio leads to tax-inefficiency for taxable investors, poor diversification, and missed opportunities. A total-return approach, accomplished by investing in a globally diversified portfolio of total market index funds, results in greater tax efficiency, better diversification, and the ability to capture the returns that the market has to offer.

Why I prefer to avoid preferred shares (Alternative Investments, Part 2)

This is the second video in a multi-part series about alternative investments. In the first video in this series, I told you why high-yield bonds fall short on a risk adjusted basis, and should only be included in your portfolio in small amounts through a well-diversified low-cost ETF, if at all. If you haven’t watched it yet, click here. And BTW, I do not recommend high yield bonds in the portfolios that I oversee.

Alternative investments are generally sold on the basis of exclusivity to wealthy individuals. Warren Buffett said it best in his 2016 letter to shareholders: “Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice.”

In addition to high yield bonds, income-seeking investors may turn to preferred shares.

Preferred shares typically offer higher yields than bonds. They also have some tax benefits for Canadians who own Canadian preferred shares. While these benefits are attractive, preferred shares also come with additional risks and complexity that bonds do not have. Remember, risk and return are always related.

Preferred shares are equity investments in the sense that they stand behind bond holders in the event of bankruptcy. In a bankruptcy, debt holders would be paid first, followed by preferred shareholders, and then finally common stockholders. Typically, preferred and common shareholders will receive nothing in a bankruptcy. Where preferred stocks differ from common stocks is that they do not participate in the growth in value of the company. The return on preferred stocks is mostly based on their fixed dividend.

Unlike a bond, preferred shares do not generally have a maturity date. This makes them effectively like really long-term bonds. Unfortunately, fixed income with long maturities tends to have poor risk-adjusted returns. Long-term fixed income also exposes you to a significant amount of credit risk. Can the issuing company pay you a dividend for the next 50 plus years?

Like a bond, if interest rates fall, the price of perpetual preferred shares can increase. While this sounds good, the problem is that perpetual preferred shares typically have a call feature. If interest rates fall too much, the issuer will redeem the preferred shares at their issue price. The same thing can happen of the credit rating of the issuing company improves, allowing it to issue new preferred share or bonds at a lower interest rate. This creates asymmetric risk for the investor. They get the risks of an extremely long-term bond, but have their upside capped.

One of the most common types of preferred shares in the Canadian market are fixed reset preferred shares. These have a fixed dividend for 5-years, which is then reset based on the 5-year government of Canada bond yield plus a spread. Investors are able to accept the new fixed rate, or convert to the floating rate. This process continues every 5-years. In 2015, rate reset preferred shares dropped in value significantly, causing the S&P/TSX Preferred Shares index to fall 20% between January and September 2015. Hardly a safe asset class.

Preferred shares have some other characteristics that make them risky. A company is usually issuing preferred shares because they want to raise capital but are not able to issue more bonds. This could be because they can’t pile any more debt onto their balance sheet without getting a credit downgrade. Companies also have a much easier time suspending dividend payments on preferred shares, which they can do at their discretion, than they do halting bond payments, which would mean bankruptcy. These characteristics might cause an investor looking for a safe asset to think twice.

Enough negativity. Why does anyone invest in preferred shares? I’ve already mentioned the higher yields that preferred shares offer compared to corporate bonds, making them attractive to an income-oriented investor. Canadian preferred shares also pay dividends that are taxed as eligible dividends in the hands of Canadian investors. This might make preferred shares a good candidate for the taxable account of an investor that pays tax at a high rate. Preferred shares do also have returns that are imperfectly correlated with other asset classes, meaning that there can be a diversification benefit to including them in portfolios.

So, should you invest in preferred shares? For their few benefits, preferred shares have substantial risks. In Larry Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes that “The risks incurred when investing in preferred stocks make them inappropriate investments for individual investors.”

I do not recommend preferred shares in the portfolios that I oversee. In a 2015 white paper my PWL colleagues Dan Bortolotti and Raymond Kerzerho recommend that if you are going to invest in preferred shares, you should only use them in taxable accounts, limit them to between five and fifteen percent of your portfolio, and diversify broadly. They also emphasize that you should avoid purchasing individual preferred shares due to the complexity of each individual issue.

Do You Need Alternative Investments? Part I: High Yield Bonds

At a certain point, good old stocks and bonds might start to seem a little bit boring. There has to be more out there, especially when you start to build up substantial wealth. These other types of investments are often referred to as alternatives. They sound much more exciting and exclusive than stocks and bonds, and are typically sold as having higher potential returns or diversification benefits that plain old stocks and bonds can’t offer. As Warren Buffett explained in his 2016 letter to Berkshire Hathaway shareholders:

“In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”

Alternative investments are a broad category, so I have split this topic up into multiple parts. In Part One, I will tell you why high yield bonds don’t quite yield enough to justify their risks.

In our low-interest rate world, investors tend to seek out the opportunity to earn higher income yields from their investments. Two of the most common ways to do this are through high-yield bonds and preferred shares.

High yield bonds are riskier bonds with lower credit ratings and higher yields than their safer counterparts. Standard and Poors rates all bonds between AAA, the highest rating, and DD, the lowest rating, based on the bond issuer’s ability to pay back their bond holders. High yield bonds have a rating of BB or lower, defined by Standard and Poors as “less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial, and economic conditions.”

Remember that you typically hold bonds in your portfolio for stability. High yield bonds are too risky to serve this purpose. In fact, a 2001 study by Elton, Gruber, and Agrawal found that the expected returns of high yield bonds can mostly be explained by equity returns. In other words, high yield bonds contain much of the same risk as stocks. Only 3.4% of high yield bond issuers have historically been unable to pay back their bond holders, but when they are unable to pay, bond holders have typically recovered a little less than half of their investment.

It is true that, in isolation, high yield bonds have had high average returns in the past. However, including high yield bonds in portfolios has been less exciting. In a 2015 blog post, Larry Swedroe compared four portfolios, one with all of its fixed income invested only in safe 5-year treasury bonds, the other three with each an increasing allocation to high yield corporate bonds. He found that while the portfolios with high yield bonds did outperform by a narrow margin, between 0.2 and 0.5 percent per year over the long-term, they did so with significantly higher volatility than the portfolio containing only treasury bonds. On a risk adjusted basis, the high yield bonds did not add value to the portfolio.

In Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes “Investing in high-yield bonds offers the appeal of higher yields and the potential for higher returns. Unfortunately, the historical evidence is that investors have not been able to realize greater risk-adjusted returns with this type of security.” In his book Unconventional Success, David Swensen, the chief investment officer of the Yale Endowment, similarly denounces the characteristics of high yield bonds, writing that "Well-informed investors avoid the no-win consequences of high-yield fixed-income investing."

On top of all of this, high yield bonds are tax-inefficient. They pay relatively high coupons, which are fully taxable as income when they are received. As an asset that behaves similar to stocks, high yield bonds are a very tax-inefficient way to get equity-like exposure.

High yield bonds do have some proponents. Rick Ferri, a well-respected evidence-based author and portfolio manager, does include high yield bonds in his portfolios.

I do not recommend high yield bonds in the portfolios that I oversee. If you do choose to include high yield bonds in your portfolio, they should only make up a small portion of your fixed income holdings. Due to the risk of default and relatively low recovery rate, it is also extremely important to diversify broadly with a low-cost high-yield bond ETF. I would never suggest purchasing individual high yield bonds.

Should You Currency Hedge Your Portfolio?

There is no question that investing globally is beneficial. Diversification is the best way to increase your expected returns while decreasing your expected volatility. Diversification is, after all,  known as the only free lunch in investing. When you decide to own assets all over the world, you are not just getting exposure to foreign companies, but also to foreign currencies.

If you own an investment in a country other than Canada you are exposed to both the fluctuations of the price of the asset in its home currency, and the fluctuations in the currency that the asset is priced in. For example, if a Canadian investor owns an S&P 500 index fund giving them exposure to 500 US stocks, and the S&P 500 is up 10%, but the US dollar is down 10% relative to the Canadian dollar, then the Canadian investor will have a return of 0%.

To avoid the impact of currency fluctuations, some investors choose to hedge their currency exposure. If our Canadian investor had purchased a hedged index fund, eliminating their currency exposure, they would have captured the full 10% return of the S&P 500 index without being dragged down by the falling US dollar. Of course, the same thing could happen in the other direction, increasing returns instead of decreasing them.

Before I continue, I want to be clear that I am talking about adding a long-term hedge to your portfolio. Trying to hedge tactically, by predicting currency movements, is a form of active management which you would expect to increase your risks, costs, and taxes. Now, on with the discussion.

Multiple research papers have concluded that the effects of currency hedging on portfolio returns are ambiguous. In other words, with hedging sometimes you will win, sometimes you will lose, but there is no evidence of a right answer, unless you can predict future currency fluctuations. With no clear evidence, and an inability to predict the future, the currency hedging decision stumps many investors.

The demand for hedging tends to rise and fall with the volatility of the investor's home currency. If the Canadian dollar strengthens, investment returns for Canadian investors who own foreign equities will fall, which might make the investors wish they had hedged their currency exposure. While it may seem obvious that a hedge would have made sense after the fact, hedging at the right time is impossible to do consistently.

In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that between 1900 and 2015 real exchange rates globally were quite volatile, but did not appear to exhibit a long-term upward or downward trend. In other words, over the last 115 years currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another. This was demonstrated in Meir Statman’s 2004 study of US hedged and unhedged portfolios over the 16 year period from 1988 to 2003. The study concluded that the realized risk and return of the hedged and unhedged portfolios were nearly identical. One study

If there is no expected benefit to hedging your foreign equities in terms of higher returns or lower risk, why would you hedge at all?

It is always important to remember why we are investing. Most people are investing to fund future consumption, and most Canadians will consume in mostly Canadian dollars. Hedging against a portion of currency fluctuations might help investors capture the equity premium globally while limiting the risks to consumption in their home currency. It is typically not a good idea to hedge all of your currency exposure because because currency does offer a diversification benefit.

Well, it seems like we’re back to square one, trying to decide whether we should hedge or not. There is no evidence either way. You would not expect a difference in long-term risk or return from hedging. Currency hedging at least a portion of your equity exposure has the benefit of keeping some of your returns in the same currency as your consumption, but too much hedging removes the diversification benefit of currency exposure.

In the absence of an obvious answer, I think it makes sense to take a common sense approach. If you’re going to hedge, don’t hedge all of your currency exposure - I wouldn’t hedge more than half of the equity portion of your portfolio. If you don’t want to hedge, that is okay too. Remember that there is no evidence in either direction.

Whatever you choose to do, understand that there will be times when you wish that you had done something different. If the Canadian dollar rises, you might wish that you had hedged. If it falls, you might wish you were not hedged. At those times, the worst thing that you can do is change what you are doing. The best thing that you can do is pick a hedging strategy and stick with it through good times and bad.