Does active management work for institutional investors?

It is increasingly well-understood that low-cost index funds will, on average, beat actively managed mutual funds for average investors. I think that there is still a perception that large institutions like pension funds and endowments, with access to the supposedly best money managers are able to outperform.

Fortunately there are some good sources of information that we can turn to to see if this is true.

It has been well documented that fees can vary substantially depending on who is investing. Retail investors typically pay much higher fees in terms of percentage of their assets than institutions. Institutions are also able to access asset classes, like real estate, private equity, and hedge funds, that might not be readily available to a retail investor. A proponent of active fund management might argue that these factors should be conducive to market beating performance for institutional investors.

A 2017 report from Standard and Poors looked at the net and gross of fee performance for institutional investment accounts with the intention of seeing if fees were the sole cause of underperformance for retail active managers. The data in the report show that the overwhelming majority of actively managed institutional accounts underperformed their benchmark over 10 years, before fees. The underperformance was only exacerbated after fees. Well that answers that. While it may help, the lower fees that institutional investors are able to negotiate do not mean that active management will work for them.

Every year, the National Association of College and University Business Officers (NACUBO) releases their report on the performance of college endowment funds. With people like the legendary David Swensen at the reins of the Yale endowment, endowment funds have often been looked to as thought leaders for the investment world. Taking advantage of their exceptionally long time horizons, endowment asset allocations will often allow for less liquid asset classes like private equity and hedge funds. These asset classes do also tend to be more expensive to invest in and require more staff on hand to manage. It’s all worth it if the returns are great.

The 2017 NACUBO report shows that the 10-year average return for all 809 institutions that they track has been 4.6%. A simple 60% stock and 40% bond index fund portfolio has returned a little more over the same period, for a tiny fraction of the costs and far less complexity. Endowments have not generated the stellar performance that we might expect.

In the great financial crisis, Harvard’s massive endowment was famously left with no cash to cover their margin calls, and had to go into debt to stay afloat. Much of their capital was tied up in illiquid private equity and real estate. They lost nearly 30% in 2009, about the same as a 60/40 index fund portfolio.

Some pension funds have gotten the message. Steve Edmundson, who manages the Nevada State pension fund, a 35 billion dollar fund nearly the same size as Harvard’s endowment, does nothing but invest in low-cost index funds. It’s also worth mentioning that the Nevada State Pension fund has consistently outperformed Harvard’s complex and expensive endowment fund.

In a 2013 report, the Maryland Public Policy Institute wrote that:

“State pension funds, including Maryland, have succumbed for years to a popular Wall Street sales pitch: “active money management beats the market.” as a result, almost all state pension funds use outside managers to select, buy and sell investments for the pension funds for a fee. the actual result — a typical Wall Street manager underperforms relative to passive indexing — is costly to both taxpayers and public sector employees.”

The report continues:

“Getting pension fund administrators to support the policy and to educate legislators about indexing will be an uphill battle. By agreeing to the policy, administrators essentially admit they made mistakes by betting heavily on active managers. Who wants to admit an error? Investment consultants and Wall Street money managers will vigorously oppose such a policy.”

With their ability to negotiate lower fees and gain exposure to more exotic asset classes, it might be expected that large institutional investors could beat the simple low-cost strategy of index investing. That data do not support this assertion. What we do know is that complexity increase costs, and costs decrease average returns. Even the largest and most sophisticated investors cannot escape this truth.

How much risk should you take?

Risk is more than an important part of investing. The whole concept of a financial market exists on the basis that taking risk can result in financial gain. If you do not take risk in financial markets, you expect very low returns. Of course, with risk also comes the potential for loss. Elroy Dimson of the London School of Economics said “Risk means more things can happen than will happen”.

In other words, risk means that there is a distribution of outcomes, and you will not know which outcome you actually get until it happens. As much as we like to think that we can understand risk, the possible distribution of outcomes is beyond our ability to comprehend.

While we are not able to control or predict the distribution of outcomes, we are able to choose the type and amount of risk that we take with our investments.

To start this discussion, I need to introduce two types of risk. The first type of risk is called idiosyncratic risk, which may also be referred to as company specific risk, or diversifiable risk. Idiosyncratic risk is not directly related to the market as a whole. Individual stocks will typically move to some extent with the market, but they may also fluctuate due to their specific circumstances. Think about Volkswagen’s share price plummeting after their emissions scandal.

There is no reason to expect a positive outcome for taking on idiosyncratic risk. It may work out in your favour, but it may result in substantial and unrecoverable losses. Idiosyncratic risk can be diversified away. Owning all of the stocks in the market eliminates the specific risks of each company. What is left is market risk.

Market risk is the risk of the market as a whole. It cannot be diversified away. For taking on the risk of the market, investors do expect a positive long-term return. When you invest in one stock, or one sector, you are getting exposure to both market risk and idiosyncratic risk, but the idiosyncratic risk can easily dominate the outcome. The most reliable long-term outcome would be expected when idiosyncratic is diversified away. Practically, this simply means owning a globally diversified portfolio of index funds, an idea that is not new to anyone who has been watching my videos.

Most investors do not own a 100% equity portfolio. Portfolios will typically consist of some mix between equity index funds and bond index funds. Long-term outcomes are uncertain, but we know that over the past 116 years stocks have outperformed bonds globally, while bonds have been less volatile. A portfolio becomes less risky and has a lower expected return as the allocation to bonds increases.

The decision about how much risk to take is driven by the ability, willingness, and need to take risk.

Equity market risk has tended to pay off over long periods of time, and the distribution of outcomes also tends to narrow. For example, over the 877 overlapping 15 year periods from 1928 to 2015, the US market outperformed risk-free t-bills 96% of the time. The ability to take risk is primarily driven by time horizon and human capital. We have been talking about risk as an unpredictable distribution of outcomes. A more tangible definition might be the probability of not meeting your goals.

For a young person with lots of remaining earning capacity, the market underperforming t-bills hardly affects their ability to meet their goals - in fact, it would be a good opportunity for them to buy cheap stocks. On the other hand, a near-retiree taking substantial losses in the years leading up to retirement would be devastating to their ability to meet their spending goals. In general, it is sensible to take less risk for goals with short time horizons and more risk for goals with longer time horizons.

Even with an unlimited ability to take risk, most investors are constrained by their own willingness to take risk. An investor may look at the history of market risk and decide that it is too volatile for their preferences. The MSCI All Country World Index was down 33% in Canadian dollars between March 2008 and February 2009.  That’s a pretty big drop. In his book Antifragile, Nassim Taleb introduced what he calls the Lucretius Problem: we tend to view the worst historical outcome as the worst possible outcome, but that is nowhere near the truth. If a 33% drop scares you, you would need to be comfortable with the potential for a far deeper decline to be confident investing in a 100% equity portfolio.

The need to take risk brings us back to goals. If someone wants to spend $5,000 per month adjusted for 2% average inflation for a 30-year retirement, they would need about $2.5 million dollars to be able to afford to take no risk. They could hold cash in savings deposits and deplete their assets over time without any volatility. Most people do not accumulate enough to fund a risk-free retirement, so they must introduce some level of risk to increase their expected returns..

The right amount of market risk in a portfolio is sufficient to hopefully meet the goal for the assets without introducing the potential for catastrophic failure due to large declines at the wrong time. There are rules of thumb out there, like having 100 minus your age in stocks, but they have little basis. Truly there is no optimal answer, but there is little debate that expected returns and expected volatility are highest with a 100% equity portfolio, and investors might add in bonds to match their ability, willingness, and need to take risk.

Do most financial advisors know what they're talking about?

Napoleon Bonaparte famously said "Never ascribe malice to that which is adequately explained by incompetence". This is a way of thinking known as Hanlon’s Razor, and it can help us interact with the world more favourably.

There is an established body of evidence that high fees and active management are not in the best interest of investors. Commissions are often blamed for influencing the questionable advice that many financial advisors give, but there may be a much more innocent explanation.

As of December 2017, 89% of Canadian investment fund assets were invested in mutual funds, with the remaining 11% invested in ETFs. A 2017 Morningstar study of the Canadian mutual fund landscape showed that the majority of mutual fund assets in Canada are in commission-based products. These are typically actively managed mutual funds that pay a trailing commission to the financial advisor that sold them. It’s probably safe to conclude that many Canadians are still relying on the advice of financial advisors selling commission based products.

The lack of a fiduciary duty for most financial advisors is often blamed for the generally poor financial advice that many retail investors receive. A 2015 study commissioned by the Canadian Securities Administrators showed that Canadian financial advisors are likely influenced by commissions. Similar studies in other countries have concluded the same thing, leading some countries to ban mutual fund commissions altogether.

Commissions do seem like a sensible explanation for the bad financial advice that so many Canadians receive, but what if there is a bigger issue? We know that the barriers to entry for becoming a financial advisor are quite low. If financial advisors don’t necessarily have a great understanding of investing and portfolio management, it is feasible that their bad attempts at giving good advice are simply misguided.

A 2016 study titled The Misguided Beliefs of Financial Advisors looked at this exact issue. The study looked at more than 4,000 Canadian financial advisors, and almost 500,000 clients, between 1993 and 2013. By comparing the accounts of the advisors to the accounts of their clients, the study authors were able to test whether advisors were also acting on the advice given to their clients in their own personal accounts.

If, for example, financial advisors were selling expensive actively managed mutual funds to their clients while investing in low-cost index funds in their personal accounts, we would suspect a conflict of interest. If advisors were buying expensive actively managed funds in their own accounts, we would suspect that they really believed that to be a wise investment.

The data show that both advisors and their clients tend to exhibit performance chasing behaviour and an overwhelming preference for actively managed mutual funds. They also both had poorly diversified portfolios and owned funds with high fees, but the advisors own portfolios actually had worse diversification and higher fees than the clients. All of these tendencies are well documented as being detrimental to long-term returns. The study also shows that financial advisors typically continue with these behaviours once they have retired, ruling out the possibility that they hold expensive actively managed portfolios only to convince clients to do the same.

This evidence makes a strong case that the many financial advisors selling expensive actively managed investment products may be doing their best to give good advice based on their own misguided beliefs. None of this should come as a surprise. A license to sell mutual funds is not terribly difficult to obtain, and fund companies pour resources into convincing financial advisors that they should be selling actively managed products to their clients.

The possibility that many financial advisors are misguided in their beliefs has important implications for investors. A 2017 white paper from Vanguard titled Trust and financial advice shows that one of the most important factors that investors consider in assessing the trustworthiness of their financial advisor is the expectation that the advisor will act in their best interest at all times.

Of course having someone looking out for your best interests should be valued, but well-meaning advice from a misguided financial advisor is just as damaging as malicious advice. If you need financial advice, seeking out a financial advisor with advanced financial education and an understanding of the evidence supporting the use of index funds could be a sensible solution.

It is always a good idea to ask your financial advisor what they think about index funds. The right answer, and there is a right answer, is that index funds are the most sensible approach to investing for most people.

Do You Need Alternative Investments? Part III: Hedge Funds

I’ve talked before about the tendency of investors to feel like they deserve more than the plain old market return. This seems to be especially true as people build more wealth. Anybody can buy index funds. More sophisticated investments have high minimums, or require you to be an accredited investor. The pinnacle of what I am describing is investing in hedge funds. Hedge funds are exclusive, elite, expensive, and lightly regulated financial products.

There are about 3.3 trillion dollars invested in hedge funds globally, and they continue to grow as an asset class, despite suffering from continued performance that lags a portfolio of low-cost index funds.

The first hedge fund was set up by Alfred W. Jones in 1949. His fund, A.W. Jones & Co, was the first fund to invest in stocks with leverage while using short selling to remove market risk. He structured the fund as a limited partnership to avoid regulation. None of this innovation would have mattered except for one important detail: the fund did really really well. We know that funds that have done well in the past are no more likely to do well in the future, but Jones’ success was publicized in Fortune magazine, and hedge funds were born.

Today there are a lot of different hedge fund strategies. They are typically designed to have performance that is uncorrelated with the market. The Credit Suisse hedge fund index shows that hedge funds have done an okay job at accomplishing this goal. While relatively low correlation with other asset classes can be seen as a good thing in an overall portfolio, the high costs, low returns, and additional risks of owning hedge funds must be considered.

Hedge funds command high fees due to the supposed skill of their managers. They will typically charge 1-2% of the assets under management, plus 20% of any excess performance. In a 2001 study Hedge Fund Performance 1990 - 2000: Do the ‘Money Machines’ Really Add Value Harry M. Kat and Gaurav S. Amin found that the weak relationship between stock returns and hedge fund returns is not attributable to manager skill, but to the general type of strategy that hedge funds follow. Any fund manager following a typical long/short type strategy can be expected to show low systemic exposure to the market, whether he has special skills or not. This leads to the question of why investors would pay such high fees.

The exclusive nature of hedge funds would lead most people to believe that they must also have high returns. This is refuted by the data. The Credit Suisse Hedge Fund Index shows an annualized return of 7.71% from January 1994 through November 2017, while a globally diversified equity index fund portfolio returned 9.19% over the same period. Even a much more conservative index fund portfolio consisting of 60% stocks and 40% bonds outperformed the hedge fund index, returning an average of 7.75%.

Between high fees, lacking evidence of manager skill, and low average returns, hedge funds aren’t sounding so good. Wait until I tell you about the risks.

Hedge funds do not have the same kind of liquidity that an ETF or mutual fund has. Investing in a hedge fund will typically involve a lock-up period during which your funds are not accessible. After the lock-up, hedge funds can suspend investors’ ability to withdraw from the fund at their discretion. That would typically happen at the worst possible time, like if the fund is crashing.

One of the pitches of hedge funds is that they are less risky than stocks, as shown by their relatively low standard deviation of returns. Standard deviation does not tell the whole story. Hedge fund returns exhibit negative skewness and high kurtosis. In plain english, that means that most investors lose while a few winners win big, and the funds exhibit exceptionally high and low returns with greater frequency than would be expected in a normal distribution.

One of the reasons that they seem exotic is that hedge funds can invest in anything. It might be cool to tell people about over dinner, but in reality it means that the riskiness of the underlying assets can be more extreme than you might expect. A 2000 study by AQR Capital Management found that many hedge funds were taking on significantly greater risk than their benchmarks by investing in illiquid assets.

Illiquid assets could result in outperformance due to the illiquidity premium, but investors may have been taking on far more risk than they realized. Hedge funds also employ leverage. The combination of illiquid assets and leverage can be disastrous for hedge funds during bad markets, especially if investors ask for their money back. A worst case scenario would see the hedge fund having to unwind illiquid positions at a significant discount, resulting in losses for investors.

Despite the hype about low correlation, hedge funds are a poor combination with equities. While we know that hedge funds have a somewhat low correlation with the stock market, that correlation can become high at the worst possible times. This is exactly what happened in both the 1998 and 2007 financial crises. So while the correlation data may look good on paper, it may not be very useful in practice.

Even if there are hedge funds out there with great returns, remember that past performance is a terrible predictor of future results. One prolific example of this is the Tiger Fund. It was formed in 1980 with ten million dollars and went on to average returns over 30% for the next 18 years. Wow. By 1998, it had over 22 billion under management, most of that coming from new investments wanting to get in on the performance. Tiger then stumbled badly, losing ten billion dollars, before closing in 2000. The funny thing is that while the fund still shows a 25% average annual return, it is estimated that most investors lost money because they invested after all of the great returns had been earned.

High profile hedge fund failures have not stopped many investors from allocating capital to hedge funds. One of the largest failures, Long Term Capital Management, cost billions of dollars and almost resulted in a global financial crisis. That was in the ‘90s, and hedge funds have continued to grow.

In 2014, CalPERS, a massive California pension fund and one of the leaders in the institutional investment space, made the decision to exit hedge funds as an asset class in their portfolio. They made the decision to shut down their hedge fund program primarily due to the program's cost, complexity, and risk. Other large pension funds have since followed suit.

Eugene Fama, Nobel Prize winner and the father of modern finance, said “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question. Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds.”

Warren Buffett famously won a 10-year million dollar bet against a hedge fund manager who was allowed to select five hedge funds to beat the S&P 500 index. The index won out easily. Buffet can’t predict the future, but the odds were certainly in his favour.

The Case For Renting A Home Part 2

In my last post, I told you that renting is not throwing your money away, and home ownership may not be all that it’s cracked up to be. Renters take less risk, have predictable costs, and have no illusion that their housing is an investment. The cost of home ownership is high, and long-term real estate returns have not been as good as many people like to think.

Let’s crunch some numbers to further the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth.

Let’s look at an example. Imagine someone who decides to purchase a $500,000 home with a $100,000 down payment. Between legal fees, land transfer tax, and other purchase costs they might have to come up with another $6,000, for a total cash cost at purchase of $106,000.

We can assume that the rest of the purchase is financed with a 25 year mortgage at a 3% interest rate, resulting in a monthly mortgage payment of $1,893. The buyer will also budget for property taxes at 0.75% of the value of the home per year, maintenance costs at an annual average of 1.5%, and home insurance at $200 per month. All things considered, the annual cash cost of owning this $500,000 home is around $37,000. We can assume that real estate grows at 3%, beating inflation by 1%.

Alternatively, this person could take the $106,000 cash cost of buying a home and invest it in an aggressive portfolio of index funds. They could rent a comparable home for $1,875 per month, and pay a less expensive $100 per month for renter’s insurance. Their total annual cost of housing would be about 24,000.

The renter could take that $13,000 annual cost difference between renting and owning and add it to their portfolio of index funds each year. We can assume that the portfolio is held in a taxable investment account, and consists of 90% stocks and 10% bonds with an expected annual pre-tax return of 6.6%. After fees on the index funds and taxes, the annual return might be closer to 5.3% assuming fees at 0.20% and tax at the rate for income between $75,000 and $85,000.

Fast forward 25 years. Owning the home would result in a real estate asset worth $1,046,889, which would be reduced to $994,545 after 5% selling costs. Selling the principal residence would not result in any taxes owing. Renting and maintaining a disciplined investment schedule would result in an investment portfolio worth $1,016,977, but selling the portfolio would trigger some taxable capital gains.

After-tax, the portfolio would be worth $987,579. The difference in ending wealth between the renter and owner is a negligible $6,966 in favour of the owner. If instead of investing in a taxable investment account the renter invested in the RRSP and TFSA, the scale tilts heavily in favour of the renter.

We just used reasonable assumptions to show that renting and owning can both result in substantial wealth accumulation over time. It is possible that reality will differ from our assumptions, tilting the advantage toward either renting or owning over some time periods. Many of the variables we cannot control: asset returns, inflation, and interest rates will be what they will be. Other variables are within our control. If a renter keeps their investment fees low, invests in an aggressive portfolio, and maintains strict discipline, they are putting themselves in the best possible position to build wealth that meets or exceeds the wealth of a homeowner.

I have shown you quantitatively that there is nothing wrong with renting from a financial perspective. I have nothing against home ownership, but I do believe that renting a place to live deserves equal consideration as a sensible financial decision.

For more on this see my PWL Capital white paper The Case for Renting.

The Case for Renting a Home Part I

Canadians really like real estate. It’s hard not to be excited when prices in hot markets like Toronto and Vancouver have been making global headlines. Around two-thirds of Canadians own their home, and the perception is generally held that owning your home is a smart investment.

Many Canadians feel that they need to buy a home as soon as possible because they are throwing their money away by renting. I’m sure you have heard the line that renting is “paying someone else’s mortgage.” On the surface this seems to make sense, but there are some important factors that need to be considered.

Let’s think about the benefits that renting has over owning. If there is a possibility that you could move within ten years of purchasing a home, you are taking on enormous risk. It is true that over the long-term real estate tends to go up in value, but in the short-term, its value can go up or down unexpectedly. Combine this price risk with the fact that most people borrow a significant portion of the money needed to buy their home, and ownership gets pretty risky for anyone with a short or uncertain time horizon.

A renter is paying a set cost in exchange for a place to live. Explicitly knowing the cost of your housing has its advantages, and the predictable monthly expense is useful in planning your finances. A homeowner can easily plan for their mortgage payment and property tax, but they may also have expensive maintenance costs that appear unexpectedly. These unexpected costs may result in the need to borrow money, or the need to carry a large cash reserve - both inefficient uses of capital.

Owners get sucked into the idea that their home is an investment. Based on this thinking, they will often spend heavily on renovation or maintenance projects on the premise that they are increasing the value of their home. Unfortunately, there is no guarantee that expensive home improvement projects will actually pay off. In his book The Wealthy Renter, real estate analyst Alex Avery explains that his “Golden Rule of Investing in Real Estate is that buildings never go up in value. Ever. Period. Only land can go up in value”.

Those were three benefits of renting that are important to keep in mind: Less risk, predictable cost, and no investment illusion. Of course you’re still wondering, isn’t renting throwing money away?

When you’re renting you’re just exchanging money for the use of something without any expectation of a residual value. Paying rent for a place to live is obvious. You give money to the landlord. They give you the keys. You get nothing back. What many people fail to consider is that homeowners are also paying forms of rent. They are renting services from the city in the form of property taxes, they are paying unrecoverable maintenance costs just to keep their house inhabitable, and they are renting money from the bank while they have a mortgage. But surely when the mortgage is paid off a homeowner’s cost of living is much lower than a renter’s. Not so fast.

Let’s think about someone with a paid off house worth $500,000. They could sell that house, keep around $475,000 after costs, and invest the money. Let’s say that they could expect to earn a 6% annual average long-term return on their investments, while the long-term expected return on real estate is closer to 3%. That 3% difference in expected returns is an opportunity cost. The opportunity cost of owning this home is around $14,000 per year. You don’t actually see the opportunity cost in any of your accounts, but it’s there. Add to that property tax and maintenance costs, and we can easily arrive at a total monthly cost of ownership of over $2,000. That’s $2,000 of unrecoverable costs with no residual value. Renting doesn’t look so bad anymore.

So far we have established that renting has some advantages, and owners also have substantial expenses with no residual value, so why does home ownership have such a good reputation?

The real estate and home improvement industries have obvious self-serving motivations to make home ownership look good. The Canadian government has programs in place to encourage home ownership, making it seem like a good idea. Most importantly, there are a lot of people in Canada who genuinely believe that their home has been their best investment. It is common for well-meaning friends or relatives to encourage home ownership based on their perception of their own experience.

It’s no wonder why many people think that their home has been a great investment. The numbers are big, and investment returns are not always easy to understand. The average Canadian home purchased in 1980 for $62,000 would be worth $496.500 in 2017. That seems like a great return. Over 38 years it works out to 5.63% per year on average before costs. When a homeowner is standing back after 38 years and admiring the appreciation in the value of their home, they aren’t usually accounting for the costs incurred along the way, but the costs were definitely there.

Property taxes and maintenance could be reasonably estimated at a combined 2% per year reducing the annual return to 3.63% after costs and before inflation. Canadian inflation over this time period was 3%. So that seemingly massive gain from $62,000 to $496,500 was really only equivalent to a 0.63% average annual return after costs and inflation. For context, the S&P/TSX composite index returned an annual average of around 5.9% after inflation over the same time period. The long-term after-inflation returns to US and UK real estate are similarly low, barely beating inflation over the past 115 years, while stocks in those countries have far exceeded inflation.

Hmmm so real estate returns aren’t actually so great. Home ownership does have one big benefit that really does build wealth. A mortgage forces discipline. It is much easier to stop the monthly contribution into your RRSP than it is to miss a mortgage payment. That discipline does pay off over the long-term, but it does not actually make home ownership an inherently great investment. People can be disciplined renters and investors, too.

I have started to make the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth. In my next post, I will lay out the numbers that prove my case.

For more see my PWL Capital white paper on renting.

Debunking Canadian Dividends for Taxable Investors

Canadian eligible dividends are tax efficient for taxable Canadian investors. This is one of the reasons that the mystical dividend investing strategy continues to have a cult-like following. As attractive as the tax rates on dividends are, dividends do still produce taxable income. A dividend-focused strategy will likely have most of its return coming from dividends. This means that even if the portfolio is producing more income than you can spend, you are still paying tax on the excess. There are also structural issues with a dividend-focused portfolio: a portfolio constrained to Canadian dividend paying stocks cannot possibly be sufficiently diversified. Structural issues aside, in this paper we will look at the capacity of a Canadian dividend focused portfolio to build wealth and fund retirement expenses on an after-tax basis.

Making some assumptions

We will assume that a taxable portfolio worth $1,500,000 is the only asset of a 65-year-old individual with the goal of funding a $4,500 monthly after-tax living expense for the next 31 years. We will assume that their expenses are funded from a combination of their portfolio and Old Age Security.

Setting up the analysis

For the first part of the analysis, we will compare the ending wealth, assuming straight line returns, of a Canadian dividend focused portfolio to a globally diversified and rebalanced total market portfolio. In applying the expected returns to the analysis, we assume unrealized capital gains remain unrealized unless a sale in the portfolio triggers a gain. Realized capital gains are assumed to be triggered annually regardless of any specified withdrawals to simulate the tax costs of rebalancing. The dividend focused portfolio is assumed to only earn Canadian dividends and unrealized gains.

Table 1 - Expected Returns (Equities)

Foreign Dividends Canadian Dividends Unrealized Capital Gains Realized Capital Gains
Canadian Dividend Focused 0.00% 4.04% 2.00% 0.00%
Globally Diversified Rebalanced 1.31% 0.80% 1.97% 1.96%

Data Source: PWL Capital

Looking into the future

Running this scenario for 31 years results in an ending net worth of $3.18M for the dividend focused portfolio, and $3.35M for the globally diversified and rebalanced index fund portfolio. This result is primarily driven by the relative tax efficiency of the globally diversified portfolio. While this may seem counterintuitive, the taxation of each scenario can be seen in Table 2. The dividend gross up results in an adverse interaction with both the age credit and OAS clawback.

Table 2 - Income Tax Projection

Dividend-Focused Portfolio Globally Diversified Rebalanced
Investment
Foreign Dividends $0 $19,650
Taxable Canadian Dividends $83,628 $16,560
Taxable Capital Gains $0 $14,700
OAS Income $6,453 $6,453
Total Income $90,081 $57,363
OAS Clawback $2,126 $0
Taxable Income $87,956 $57,363
Federal Tax on Taxable Income $15,468 $9,169
Tax Credits (Non-Refundable)
Personal Credit $1,771 $1,771
Age Credit $0 $641
Dividend Credit $12,561 $2,487
Total $14,332 $4,900
Regular Federal Tax $1,135 $4,296
Ontario Income Tax
Basic Ontario Tax $7,392 $4,087
Ontario Tax Credits $8,886 $2,285
Ontario Surtax $1,619 $0
Total $2,369 $1,803
Total Tax (Including OAS Clawback) $6,462 $6,099

Data Source: NaviPlan

Sequence of returns

We have now seen that a dividend focus is not a sure-fire way to build after-tax wealth. One of the other risks that dividend investors are exposed to is a false sense of safety. The notion that you will be paid to wait by collecting dividends when stocks are down can make dividend paying stocks seem safer than they are. Dividend stocks are still stocks. Based on the history of the DJ Canada Select Dividend Index we can estimate an annual standard deviation of 11.80%. That’s a lot of volatility for a retiree, but volatility is only one measure of risk. A more tangible measure of risk might be the risk of running out of money. From this perspective we can use Monte Carlo analysis to compare the outcome of an investor using an all-equity dividend focused strategy to an investor using a globally diversified 60% equity 40% fixed income portfolio.

It is clear that, on average, an all-equity dividend-focused strategy can be expected to outperform a 60/40 portfolio on an after-tax basis in terms of building wealth. This is simply due to the higher expected returns of stocks more so than the tax attributes of dividends.

Table 3 - Expected Returns (60/40)

Foreign Dividends Canadian Dividends Unrealized Capital Gains Realized Capital Gains
Canadian Dividend Focused 0.00% 4.04% 2.00% 0.00%
60/40 Portfolio 1.70% 0.48% 1.33% 1.33%

Data Source: PWL Capital

Based on these expected return assumptions we would expect an ending net worth of $3.17M for the dividend investor, and $1.95M for a globally diversified 60/40 investor.

The story gets much more interesting when we also consider the impact of the expected volatility on the long-term outcome. The Dividend-focused portfolio has an expected return of 6.04% with a standard deviation of 11.80%. The 60/40 portfolio has an expected return of 4.84% with a standard deviation of 7.09%. Based on a $4,500 per month draw, we can compare the results of relying on each of these portfolios using Monte Carlo analysis.

Table 4 - Probability Analysis

Goal Success Rate 90th Percentile Ending Wealth 50th Percentile Ending Wealth 10th Percentile Ending Wealth Earliest Age Assets Depleted
Canadian Dividend Focused 94.40% $6,198,188 $2,182,697 $312,337 83
60/40 Portfolio 98.40% $3,063,997 $1,544,148 $458,468 91

Data Source: NaviPlan

Despite a lower average return and therefore lower average ending wealth, the 60/40 portfolio offers a higher probability of achieving the ultimate goal of funding retirement expenses until death. The 60/40 portfolio also offers a higher average ending wealth in the 10th percentile of outcomes. Most importantly, in a worst-case scenario, the 60/40 portfolio lasts 8 years longer than the dividend-focused portfolio. If the primary goal is to build wealth, then it is true that an all stock portfolio is likely to provide the best result. However, the volatility of equities may be sub-optimal for funding retirement income.

Idiosyncratic risk

So far, we have shown that a dividend-focused Canadian equity strategy is suboptimal in terms of building wealth (compared to other equity portfolios) and funding retirement goals (compared to a 60/40 portfolio). The other risk that needs to be considered is idiosyncratic risk. It is not possible to sufficiently diversify using only Canadian stocks that pay dividends. Idiosyncratic risk cannot be planned for or modelled, but it can quickly wipe out a portfolio.

Conclusion

As we have seen from the preceding analysis, a Canadian-dividend-focused investment strategy does not necessarily result in superior tax efficiency. We have also seen that the statistical reliability of an all-equity portfolio may be suboptimal for a retiree. Finally, the idiosyncratic risk of a dividend portfolio is a substantial risk that is easily mitigated through proper diversification.

Not all index funds are created equal

I talk a lot about index funds in this video series. I have told you that low-cost index funds are the most sensible way to invest, and that you should do everything that you can to avoid the typical high-fee mutual funds that most Canadians invest in. Great, well that’s easy then. Buy index funds. Where do I sign up? Unfortunately the financial industry does not like making things easy for investors.

With the increasing popularity of index funds, index creation has become big business. There are sector index funds, smart beta index funds, equal weighted index funds, and many others, making it that much more challenging for investors to make sensible investment decisions.

Let’s start with the basics. An index is a grouping of stocks that has been designed to represent some part of the stock market. Most of the indexes that you hear about day to day are market capitalization weighted. Standard and The S&P 500, an index representing the US market is a cap weighted index. This just means that the weights of the stocks included in the index reflect their relative size. A larger company, like Apple, holds more weight in the S&P 500 than smaller companies, like Under Armour.

You can buy a fund that just buys the stocks in the index. When the index changes, the holdings in the fund change. This all sounds great so far. Low-cost index investing is what it’s all about. One problem for investors is that the big name indexes like the S&P 500 only track large cap stocks. Historically, large cap stocks have had lower returns than small and mid cap stocks, so excluding them from your portfolio could be detrimental.

The Center for Research in Security Prices, or CRSP, is another index provider. The CRSP 1 - 10 index is a market cap weighted index covering the total US market. While the S&P 500 offers exposure to 500 stocks covering 80% of the value of the US market, the CRSP 1 - 10 offers exposure to over 3,500 stocks, covering the vast majority of the value of the US market, including the smaller stocks missed by the S&P 500.

An index fund tracking the CRSP 1-10 is what you would call a cap weighted total market index fund. This is the building block for an excellent portfolio. There are total market indexes, and index funds that track them, available for Canadian, US, International, and Emerging markets stocks. The MSCI All Country World Index is.. What it sounds like. A total market index covering the whole world. An ETF tracking this index can be found in the Canadian Couch Potato ETF model portfolios. Total market index funds are well-diversified and extremely low-cost to own. That is exactly what you want as an investor. The Canadian Couch Potato ETF model portfolios, which are globally diversified total market index fund portfolios, have a weighted average MER of around 0.15%.

That is exactly why fund companies have had to come up with other index products to try and sell you. They need a reason to make you pay higher fees. One way that fund companies have been able to increase the fees on their index funds is by focusing on indexes that track specific sectors. The Horizons MARIJUANA LIFE SCIENCES INDEX ETF captures a sector that many people are interested in right now. It has an MER of 0.75%. There is no rational reason to buy this ETF other than to speculate on a hot sector, but Horizons is cashing in.

Another buzz word that fund companies have been using to charge higher fees on index funds is smart beta. Smart beta funds attempt to find characteristics of stocks that seem to have explained higher returns in the past. Some of these factors are extremely well-researched.

A 1992 paper by Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” pulled together past research to present the idea that a large portion of stock returns could be explained by company size and relative price. In 1997, Mark Carhart, in his study “On Persistence in Mutual Fund Performance,” added to the Fama/French research to show that momentum further explains stock returns. Finally, in 2012, Robert Novy-Marx’s paper, “The Other Side of Value: The Gross Profitability Premium,” showed that profitability further explains stocks returns.

Together, those characteristics are responsible for the majority of stock returns, so owning more stocks with those characteristics in your portfolio might be a good idea. Fund companies have tried to build products around this research, but the execution has not always been great.

In a 2016 blog post, my PWL colleague Justin Bender analyzed the iShares Mutifactor ETFs, ETFs tracking indexes that target some of the well-researched factors. Justin found that they did not deliver on their promise of factor exposure - disappointing considering their relatively high cost compared to a total market ETF. There are other fund companies, like Dimensional Fund Advisors, with a long history of capturing the well-researched factors. recommend products from Dimensional Fund Advisors in the portfolios that I oversee.

I keep saying well-researched factors because there are companies building indexes based on factors that are not as well-researched. They may be based on bad research, bad data, or data mining. In their 2014 paper, “Long Term Capital Budgeting,” authors Yaron Levi and Ivo Welch examined 600 factors from both the academic and practitioner literature. Not all of these factors would be expected to give you a better investment outcome, but they do give fund companies a reason to charge you a higher fee.

For most investors, a portfolio of market cap weighted total market index funds is all that you need. Many of the other index fund products out there claiming to track some special index are gimmicks designed to convince you to pay extra.