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.

Are too many people investing in index funds?

The idea of index funds was conceived in the 1970s, and received immediate support from some of the smartest academics and economists in the world at the time. Industry practitioners on the other hand, laughed at the idea. Index funds were even called un-American. Who wants to be average?

The first index fund that could be accessed by retail investors was launched by Vanguard in 1975. Despite the long-term existence of index funds, actively managed funds have completely dominated the investment fund market until recently. In the U.S., passive funds have doubled their market share since 2006 – increasing from 17% to 34% of the investment fund universe at the end of 2016. A similar trend has been present in Canada, with the market share of passive funds increasing from 6% in 2007 to 11% at the end of 2016.

People in general are becoming increasingly aware of fees and performance, and there is ever-mounting evidence that favors index investing as the most sensible approach. So what happens if everyone invests in index funds?

The failure of actively managed funds has played a significant role in the growth of index funds. Most active managers underperform their benchmark index. One of the explanations for their underperformance is that markets are efficient, a term that was coined by Nobel Laureate Eugene Fama. It means that security prices reflect all available information. In an efficient market, an active manager does not have an information edge because anything that they can know about a stock is already included in the price. The only way to beat an efficient market is to accurately predict the future, which is very hard to do consistently.

Most people that believe in market efficiency do not believe that markets are perfectly efficient. They believe that markets are efficient enough to make it extremely difficult to know when someone who profits from a trade was skilled, or just lucky.

The way that markets get efficient is by having a lot of people buying and selling stocks based on the information that they have. All of the active managers who are spending resources to research stocks in an effort to make a profit are injecting the information that they have into the price. These aren’t mom and pop operations either. The largest and most sophisticated investors in the world are the ones placing most of these trades.

If markets are efficient, you can’t beat the market consistently, and indexing is the smartest way to invest. But markets can only be efficient if there are enough people trying to beat the market. That’s a paradox, and it has a name. It is called the Grossman-Stiglitz paradox. It was introduced in a 1980 paper titled On the Impossibility of Informationally Efficient Markets.

Let’s think about this practically. If everyone really did switch to index investing, markets would lose some of their ability to accurately set prices. If that happened, there would be inefficiencies in the market and active managers would be able to swoop in and make big profits on mispriced securities. That action of them swooping in and profiting would attract other active managers to do the same.

It’s like an equilibrium. If too many people index, some active managers may profit, but by doing so they will push the market back toward being efficient. Markets are probably not perfectly informationally efficient all of the time, but they are efficient enough that it is very difficult to beat them consistently.

There is no way to know exactly when markets would cease to be efficient in a way that could be exploited consistently, but Eugene Fama, the guy that introduced the idea of market efficiency, explain in a 2005 paper Disagreement, Tastes, and Asset Prices that it depends on who turns to passive investing.

If the misinformed and uninformed active managers turn passive, then market efficiency will actually improve. If the well-informed active managers turn passive, then markets could become less efficient. But even if an active manager with good information turns passive, the effect might be very small if there is still sufficient competition among the remaining active managers. The paper also explains that costs are an important factor. If the costs to uncovering and evaluating relevant information are low, then it doesn’t take much active investing to get markets to be efficient.

In a 2014 paper, Pastor, Stambaugh, and Taylor explained that skill and competition have both been increasing in the world of active fund management.

Index investing is growing, but it’s still small in comparison to the long-entrenched world of active management. Even if index funds continue their current growth trajectory, there will always be investors who are motivated enough to absorb the additional risks and costs of active investing in an attempt at achieving higher returns. With the decreasing costs of information and increasing skill and competition among active managers, it is likely that markets will remain mostly efficient for a long time.

The TFSA Is a Give-away, But It’s Not a Toy

How often does anyone, especially the government, give you something for nothing? Canada’s Tax-Free Savings Account, or TFSA, is the rare exception. Introduced in 2009, your TFSA lets you save and invest after-tax assets that then grow tax-free. Both the principal and earnings also remain tax-free upon withdrawal. The government even throws in more “room” each year for you to add more – currently up to $5,500/year.  

It’s a sweet deal, for sure. But too often, I see people using their TFSA like it’s a toy instead of as the incredibly powerful financial tool it can be.

The wishful thinking goes something like this: “If I use my TFSA to ‘play the market’ and I happen to win big, it’ll all be tax-free. Yippee!” But as I explain in today’s video, there are important reasons you are far more likely to lose out on important tax savings than you are to hit pay dirt by turning your TFSA into a fanciful playground.

Bottom line, the essential laws of Common Sense Investing still apply in your TFSA, just as they do in any other financial account you may hold. Would you like to keep those essentials coming your way? Be sure to subscribe here and click on the bell.

Original post at pwlcapital.com.

Bond Index Funds in Rising-Rate Environments

In past videos, I’ve been covering the benefits of using passively managed index funds for your stock/equity investing. But what about bonds/fixed income? Since interest rates essentially have nowhere to go but up, could an active manager protect you from eventually falling prices?

Here’s the short answer: For stocks and bonds alike, we recommend a low-cost index approach over active attempts to react to an unknowable future. As a Common Sense Investing fan, though, you might want to know more about why this is so.

Think of it this way: If the markets were a three-ring circus (which they sometimes are!), stocks are your high wire acts of daring. Bonds are more like your wise old elephants. When you hear scare-stories about rising rates leading to plummeting yields, first, remember, a sturdy bond portfolio shouldn’t have that far to move to begin with. Second, despite the label “passive,” bond index funds don’t just sit there when rates change. They’ve got a balancing act of their own, but it’s based on patient persistence instead of a bunch of clowning around.

Want to keep your Common Sense Investing act in the center ring? Subscribe here, click on the bell, and the show will go on.

Original post at pwlcapital.com.

Why Your Financial Advisor Doesn’t Like Index Funds

As reported in a 1988 New York Times exposé, in the 1950s, “independent researchers began publishing major studies on the health hazards of smoking.” How did the cigarette companies, respond? To their credit, they substantiated the same findings, and tried to create safer smokes. Unfortunately, as The New York Times revealed, they did this work in secrecy, while “publicly denying that any hazards had been established.” So much for offering them a Good Citizen Award for their efforts.

What does this have to do with today’s Common Sense Investing video, “Why Your Financial Advisor Doesn’t Like Index Funds”? It’s an out-of-sample example of how we humans (including financial advisors) are often unable to make changes for the better. Even when the evidence tells us it’s high time. Even if – in fact especially if – our livelihoods depend on it.

The challenges of facing up to common-sense reality are as real for today’s advisors who refuse to switch to index funds as it is for cigarette manufacturers who still haven’t given up the ghost. Today’s video offers four compelling reasons why this is so. While these reasons may not be enough to change your advisor’s mind, I hope it will convince you that active investing is hazardous to your wealth. Stop doing it today.

Instead, keep watching my Common Sense Investing videos by subscribing here. I expect you’ll find them good-habit-forming.

Original post at pwlcapital.com.

Is Now a Good Time To Invest?

“Tactical” is a great word, isn’t it? It sounds smart. It sounds hands-on. It sounds like you’ve got everything under control, come what may.

Too bad, it’s such a bogus idea when it comes to investing.

The truth is, “tactical” is a fancy way of saying you’re going to try to come out ahead of the game by consistently nailing the best times to get in and out of the market. It’s another name for market-timing and, call it what you will, it’s still a bad idea.

So when should you actually invest in the market? Common sense tells us: Invest whenever you’ve got the money to do so. But what about dollar-cost averaging? Are you better off diving in all at once with your investments, or periodically dipping in your toe? That’s a great question to cover in today’s Common Sense Investing video, “Is Now a Good Time to Invest?”

Now that we’ve sorted out when to invest, don’t forget to subscribe here for more Common Sense ideas on how to do it. That’s one tactic worth taking.

Original post at pwlcapital.com.