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.

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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.

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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.

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How does a financial advisor decide what to invest your money in?

As I described in my last video, not all financial advisors have the range of credentials and experience you might expect from someone telling other people how to invest. So it’s no surprise that the investments they recommend may also be less advisable than common sense would prescribe.

The culprit here isn’t necessarily the advisors themselves. They’re often simply pretty good people with pretty good intent. But they’re also often caught up in an industry that permits if not encourages “suitable” advice to supersede “best interest” advice.

To the untrained ear, “suitable” versus “best interest” advice may sound about the same. But, believe me, there’s a wide moat between them in which everyday investors are too often left to sink or swim. How do you ensure an investment recommendation is in your best interests? Check out today’s video and subscribe here to keep building your bridge of understanding.

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What does it take to become a financial advisor?

Have you ever wondered what qualifies someone to use the title Financial Advisor? The short answer is nothing - Financial Advisor is not a regulated title. Anyone is free to use it.

Most of the people that do use the financial advisor title are licensed by a provincial regulator to sell certain products. They might be licensed to sell insurance, mutual funds, or stocks and bonds. The licensing process differs depending on the products that the advisor is able to give advice on. Some licenses are easier to obtain than others, and it’s not always easy to tell who is licensed to sell what.

Many so-called financial advisors are only licensed to sell insurance products. For the unwitting investor, this will not always be immediately clear. An insurance agent is usually able to sell life and health insurance, segregated funds, and annuities. Some of these products can be sold as investments, but they come with hefty fees, and will often result in penalties if you want your money back.

An insurance agent gets paid when you buy an insurance product, so they are motivated to sell insurance products. Getting an insurance license requires completing a training course, passing a closed book exam, and obtaining sponsorship from an insurance company.

There is nothing wrong with being licensed to sell insurance. But when you are seeking financial advice, you might want to know that your advisor has more qualifications than a license to sell you insurance.

Another common license that a so-called financial advisor might have is a license to sell mutual funds. Similar to an insurance license, a mutual funds license limits the advisor’s tool box. Mutual funds can be great in some cases, but the vast majority of the mutual funds sold in Canada have high fees and, on average, returns that trail the market.

Getting a mutual funds license involves one exam, and a period of supervised activity. The licensing process for mutual fund salespeople is fine, but it is important to understand that the license is for selling mutual funds, and that’s it. If you are seeking out financial advice, a license to sell mutual funds may not be a sufficient qualification.

The most challenging form of financial licensing to obtain is the securities license. This license permits giving advice on mutual funds, stocks, bonds, and ETFs. Obtaining this license requires passing three exams, undergoing a period of supervised training, and completing a 30 month proficiency course on wealth management. This is a little bit more robust, but it is still just a license to sell securities.

Someone who is licensed to sell securities can take their registration a level higher by becoming a Portfolio Manager. Unlike financial advisor, Portfolio Manager is a regulated title - it can’t be used by just anyone. A Portfolio Manager has to meet a 5-year experience requirement, and have earned either the Chartered Investment Manager or Chartered Financial Analyst designation. Both of these designations require hundreds of hours of study in order to pass multiple exams.

Between the experience and education requirements, the Portfolio Manager is actually in a position to offer financial advice, rather than just sell products. They are also legally required to act in the best interest of their clients, which is not the case for the other licensing categories that I have mentioned.

Separate from a license to sell or recommend any type of product, a Certified Financial Planner is someone who has passed multiple exams and met a professional experience requirement. Many Certified Financial Planners may also be licensed to sell some type of financial products, but it is not a requirement.

So, what does it take to be a financial advisor? Technically, nothing. But if you are a person seeking financial advice, it’s a good idea to look for a Portfolio Manager, or someone who has earned the Chartered Investment Manager, Chartered Financial Analyst, or Certified Financial Planner designation.

But my advisor has shown me lots of funds that outperform.

Are you seeing your investment returns through rose-colored glasses? Most investors are … and it’s often because their advisor has provided them with a skewed view.

Besides, colorful past performance doesn’t tell you much about your future prospects anyway. Let’s bring in a little common sense, and put investment performance in proper perspective.

Since at least 1962, a growing body of evidence has informed us that most incidents of investment outperformance are probably luck, not skill. Still, advisors pursuing active investing continue to trot out exceptional past performance as a reason to pile into past winners (especially when there’s a nice commission in it for them).

Even if we ignore the random nature of most outperformance, there’s another reason to be wary of past results. There’s a sneaky little thing called “survivorship bias,” causing the funds that “make it” to appear larger than life.

Check out today’s CSI and subscribe here if you want to get wise to these and other tricks of the trades.

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Do I need downside protection?

There’s no doubt about it: Losing money hurts. Even the fear of losing money is unpleasant. The financial industry is well aware of this, and sends out its sales force to peddle a comforting idea. It’s called “downside protection.” It’s supposed to allow you to continue enjoying the market’s expected returns while simultaneously dodging its correlated risks.

Or so the story goes. But when it comes to principal protected notes and other forms of downside protection, it’s usually not your interests being protected. Common sense tells us why.

The truth is, market risks and expected future returns are related. If you don’t take any risk, you should expect very low returns. This is why long-term investors are better off minimizing their costs, capturing the returns of the global markets using low-cost index funds, and controlling their level of risk through their mix between stocks and bonds.

The rest of any other sales pitch is costly smoke and mirrors. Want to see behind the subterfuge? Watch today’s CSI, and I’ll walk you through the numbers. And subscribe here if you’d like to remain in the clear moving forward.

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Why Is It So Hard To Beat the Market? part II

In my last video, I talked about some of the challenges that active managers face in outperforming the market. It boils down to their relatively high fees, and intense competition from other managers.

There is another, less obvious reason that active managers have so much trouble beating the market. We know empirically that a small number of stocks in an index tend to drive the performance of that index. So trying to select stocks in an index dramatically increases the probability of underperforming. When trying to pick stocks in an index in an effort to beat the index, the likelihood of underperforming is much greater than the likelihood of outperforming.


If we look at data on market returns, the basis of this research is clear. Most of the market’s returns come from a small number of stocks. Let’s look at an example using data from global stock markets between 1994 and 2016.

Over that time period, global stocks returned an average of 7.3% per year. Not bad at all. If we remove the top 10% of stocks in that global market portfolio, the average annual return drops to 2.9%. Excluding the top 25% results in the average annual return dropping to a much less exciting -5.2%. Of course it would be great if active managers could identify only the top performing stocks, but we have seen the data around their ability to do so - it doesn’t look good.

We know that, in most cases, active managers’ performance can be attributed to luck rather than skill. A lucky manager has been fortunate to randomly select stocks that have done well. In their paper, Heaton, Polson, and Witte lay out a very simple example explaining the challenge that active managers face based on what we know about market returns.

If we have an index consisting of five stocks, and assume that four of them will return 10% and one will return 50% over a given time period, and we suppose that active managers will create portfolios using an equally weighted subset of either one or two of those stocks, there will be a set of fifteen possible actively managed portfolios. Ten of the fifteen portfolios will earn a 10% return due to omitting the 50% stock, and five of the fifteen portfolios will earn either a 30% return or a 50% return due to holding the 50% stock, depending on whether it is a one or two stock portfolio. In this example, the average return of the stocks in the index, and all active fund managers, will be 18% (before fees).

Just like we would expect, all active managers together get the return of the market. But when we look at each portfolio individually, two-thirds of the actively managed portfolios will underperform the index due to their not holding the 50% returning stock, which is always included in the index.

Closet indexing is the result of active managers owning the market like an index fund, but charging active management level fees. Some active managers will pitch themselves as having high conviction, or high active share, meaning that they are very different from the index. The implications of this research are that even if you are able to find an active manager that is truly active and has low fees, there is a relatively low probability that they will be able to deliver market beating performance. With this high probability of underperformance, finding a skilled manager, which we already know to be beyond challenging, becomes increasingly important.

Fees typically take the blame for the systematic underperformance of active managers, but this research demonstrates another big hurdle that needs to be overcome to beat the market. If active managers miss out on the relatively small proportion of top performing stocks, they are at significant risk of trailing the market.

In my next video, I will be talking about downside protection, one of the most prolific sales pitches in the investment management industry. Do index funds protect your downside? Join me to find out.

My name is Ben Felix of PWL Capital and this is Common Sense Investing. I’ll be talking about this and many other common sense investing topics in this series, so subscribe and click the bell for updates. I’d also love to hear from you as to what topics you’d like me to cover.

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