Youtube comments of (@BenFelixCSI).
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@Evan relax.
@Voice Guy
Why did Gold jump in 2019 like 20% or something?
Nobody knows why asset classes perform the way that they do over any given short period of time. We can speculate, but there is no way to know for sure. Gold is uncorrelated to financial assets, so it's not like we can say that gold does well when stocks do poorly. It does what it does based on supply and demand.
If Gold is so useless with limited use then why does US federal still hold gold?
The Federal Reserve does not own gold. The US Department of the Treasury owns gold, a small amount of which it custodies at the Federal Reserve Bank of New York. Most of the Treasury's gold is held at Fort Knox.
Why does the US Department of the Treasury own gold?
The Treasury holds gold, at least in part, because it was part of the Treasury's Exchange Stabilization Fund (ESF) which is based on the Gold Reserve Act of 1934. As explained by the Treasury:
The legal basis of the ESF is the Gold Reserve Act of 1934. As amended in the late 1970s, the Act provides in part that "the Department of the Treasury has a stabilization fund …Consistent with the obligations of the Government in the International Monetary Fund (IMF) on orderly exchange arrangements and an orderly system of exchange rates, the Secretary …, with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities.
This is a legacy tool for conducting foreign transactions. In 1974 the Treasury actually moved the US gold stock held by the ESF to the Treasury General Account "in view of the likelihood that the Exchange Stabilization Fund [would] not be engaging in further transactions to stabilize the value of the dollar relative to gold." Keep in mind that prior to 1971 the US currency could be redeemed for gold, so the US needed to have a lot of gold.
It seems irrational for the Treasury to maintain its gold stock if it no longer has practical use. This irrational behavior was identified and examined in a 2012 paper titled Central Banks and Gold Puzzles. The authors questioned why central banks hold gold at all, and conduct analysis to try to answer the question. From the paper:
A central bank’s gold position retains the stature of signaling economic might. The intensity of holding gold is correlated with ‘global power’ – by a history of being a past empire, or by the sheer size of a country, especially by countries that are or were the suppliers of key currencies.
This is consistent with the Treasury continuing to hold gold reserves despite no longer having a practical use for them.
One of the other issues among central banks is that many of them own a lot of gold. This means that if one of them started selling off gold aggressively it could affect the price of gold, which would be detrimental to other central banks. This concern was formalized in the Washington Agreement on Gold in 1999, where a group of central banks agreed to limit their gold sales to stabilize the market. This agreement was renewed in 2004, and 2009, but was allowed to lapse in 2019. This shared concern for destabilizing the price of gold could be a reason that many central banks have maintained their gold positions over time.
Why countries like Russia, China, India etc. have been buying gold Aggressively lately? Surely all that money could be used elsewhere i.e. let the fools buy the gold why should Big sane governments invest in a metal which don't do much?
This exact question was addressed in the above-referenced paper:
Recognizing the growing global might of key emerging markets, we close the empirical discussion by noting the recent sharp increase in the gold positions of the largest emerging countries: China, India, and Russia [Figure 5]. Table 8 shows that as of November 2011, China is the 6th largest gold holder in the world, Russia is the 8th, and India is the 11th largest. Several recent articles indicate that these countries are likely to continue building up their gold reserves.[22] This trend is consistent with the desire of ‘super emerging markets’ to signal their economic might, to diversify their reserves, and to insure themselves during the global turbulence.
When the IMF decided to sell one eighth of its total gold holdings in September 2009, India became a counterparty of the gold sales, and purchased 200 tons from the IMF.b According to the FT.com (November 3, 2009),c India’s finance minister said that the purchase “reflected the power of an economy that laid claim to the fifth largest foreign reserves in the world.”
Again, we see signalling economic might expressed explicitly as a reason for a central bank to own gold.
It is worth noting here, that as described above, the IMF sold off 1/8 of its gold in 2009. It is also worth mentioning that Canada sold off most of its gold by 2016.
Gold has been used as currency for past 5000 years or so while the latest Fiat currency experiment have been in use for less than 100..what makes us think that USD or any other paper currency will hedge better against Gold?
I am not suggesting that currencies should be part of a portfolio. Allocating 5% of your portfolio to USD, CAD, or whatever would be just as baseless as allocating to gold. Currencies, like gold, are not productive assets and they do not have an expected return. If you own assets as opposed to currencies, the issue of currency valuation goes away. If you own stocks and your currency begins to lose value, your stock returns as calculated in your home currency will go up as much as your currency goes down. Stock returns, like gold, are volatile, so stocks are not a hedge. If you need a short-term hedge, then rolling short term debt obligations might be a reasonable option to hedge against inflation.
Why governments across the globe are not able to increase the interest rates (or go to negative interest rates) and what happens when they print ton of money devaluing an average Joe's savings takes a dump?
Who knows. US inflation has continued to be suspiciously low considering their monetary policy. This is why cash is a risky long-term asset. The same is true for long-term bonds. But it is not a reason to own gold.
In a 2014 paper on US monetary policy, University of Chicago economist John Cochrane briefly mentioned why a gold standard is not a simple solution:
The gold standard seems like a pure monetary policy, but it is not. Since no government ever backed 100% of its nominal debt with gold, the gold standard was a way to communicate and commit the government to raise the appropriate surpluses to pay off its nominal debt. If people wanted to redeem notes for gold, the government would raise the gold with current or, via borrowing, future taxation. The gold standard is impractical, of course, since we want to stabilize the CPI not the price of gold. And its history is full of crashes, when the essentially fiscal "commitments" fell flat. Foreign exchange pegs are similar fiscal commitments.
Sources:
https://www.nber.org/papers/w17894.pdf
https://www.federalreserve.gov/faqs/does-the-federal-reserve-own-or-hold-gold.htm
https://www.treasury.gov/resource-center/international/ESF/Pages/history-index.aspx
https://www.gold.org/what-we-do/official-institutions/central-bank-gold-agreements
https://www.theguardian.com/world/2009/sep/19/imf-sells-gold-bullion
https://www.cbc.ca/news/business/gold-canada-reserves-1.3443700
https://faculty.chicagobooth.edu/john.cochrane/research/papers/cochrane_policy.pdf
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Thanks Jonathan! These are all really good points.
First point:
I think the piece about maintenance that gets missed is that it's not just maintenance to keep the house livable, but also the maintenance required to allow the house to maintain its value. Things like updating a kitchen or a bathroom could be included in maintenance costs along with HVAC, furnace, roof, windows etc. Anyway, we could debate this one all day and there is no objective way to determine the right answer.
Second point:
For the analysis I assumed all investments were made in a taxable investment account. Taxes were accounted for on an annual basis and the accrued gains are realized and taxed at the end of 25 years. I make a comment at the end of the video that if the RRSP and TFSA are used it will make the renter look better, but I do not assume that these account types are used in the analysis.
Third point:
It's really hard to make a comparison between a diversified portfolio of stocks and bonds and a house. I agree that a 90/10 portfolio has been more volatile than average house prices, but a house has way more idiosyncratic/ asset specific risk. The house also has leverage. So while I agree the 90/10 portfolio may have been more volatile historically, I do not think that we can say that the house is a less risky investment.
I agree that the discipline is a big issue. I have no rebuttal there, other than that some people (including myself) can do it.
I ran my model with your assumptions (0.75% maintenance cost, 4% real estate growth, 60/40 portfolio = 5.24% return), and home ownership wins by a large margin.
Long-term real estate returns have not been 4% globally. The only country with long-run data that has returns that high is Australia. It would not be reasonable to expect the same return going forward for a given country. Check out page 26 in this report: https://www.credit-suisse.com/media/assets/corporate/docs/about-us/media/media-release/2018/02/giry-summary-2018.pdf
While it is true that many Canadians end up with a lot of their wealth in real estate (on average Canadians have 52% of their wealth in financial assets, presumably real estate makes up most of the remainder), I do not think that is because real estate is an inherently good investment. A lot of it is cultural. For example, most Germans do not own their home, and they are no less affluent than Canadians.
I agree, this banter is fun.
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A nit to your nit, here is Lynch from One Up on Wall Street:
I talk to hundreds of companies a year and spend hour after hour in heady powwows with CEOs, financial analysts, and my colleagues in the mutual-fund business, *but I stumble onto the big winners in extracurricular situations, the same way you could: Taco Bell, I was impressed with the burrito on a trip to California; La Quinta Motor Inns, somebody at the rival Holiday Inn told me about it; Volvo, my family and friends drive this car; Apple Computer, my kids had one at home and then the systems manager bought several for the office; Service Corporation International, a Fidelity electronics analyst (who had nothing to do with funeral homes, so this wasn’t his field) found on a trip to Texas; Dunkin’ Donuts, I loved the coffee; and recently the revamped Pier 1 Imports, recommended by my wife. In fact, Carolyn is one of my best sources.* She’s the one who discovered L’eggs. L’eggs is the perfect example of the power of common knowledge. It turned out to be one of the two most successful consumer products of the seventies. In the early part of that decade, before I took over Fidelity Magellan, I was working as a securities analyst at the firm. I knew the textile business from having traveled the country visiting textile plants, calculating profit margins, price/earnings ratios, and the esoterica of warps and woofs. But none of this information was as valuable as Carolyn’s. I didn’t find L’eggs in my research, she found it by going to the grocery store.
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I guess you are not familiar with the letter A index. This was a very geeky joke in the older video. I'm glad someone noticed!. An index consisting of stocks that start with the letter A has outperformed the market, dividend growth, tech, BRK, and pretty much anything else you can imagine for the last 20+ years. It also has positive loadings to common risk factors and a statistically significant alpha. Of course, there is no theoretical basis to believe that the letter A tells us anything about differences in expected returns, or that we should use it as a proxy for factor exposures going forward. I still think it's a pretty good analogy for dividends.
don't you think the fact that they do pay a dividend could impact their level of reinvestment?
No. This is the whole point of the theorem. Given investment policy, dividend policy is irrelevant, or stated differently, dividend policy is a financing decision (which is irrelevant to valuation). This is a good writeup: https://www.chicagobooth.edu/review/why-merton-miller-remains-misunderstood
The Miller-Modigliani model innovatively identified the factors to hold constant in order to isolate dividend policy: the cash flows coming into the firm and the real investments being made. That left a gap, which is a constant amount once these are fixed. However, the dividend payout could be larger or smaller than this amount because the firm could issue or retire shares. This rendered dividends (given investment policy) irrelevant to the value of the firm except in cases where dividends revealed information or had tax implications (such as the retained earnings tax that the United States had in the 1940s, which made paying out cash a sensible investment policy).
The predictor for future investment that is used in models like the five factor model and in line investment strategies like Dimensional and Avantis funds is growth in the book value of assets (reinvestment). Past asset growth predicts future asset growth.
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Mr. Penetrator, I am not advocating focusing only on capital gains. That would be just as foolish as focusing only on dividends. I am advocating diversifying across the universe of available stocks, whether those companies pay dividends or not.
I agree 100% that reinvesting dividends is an important aspect of total return. If a company pays a dividend its value drops by the amount of the dividend. If we assume that the shareholder reinvests, then their net worth has not changed after receiving the dividend.
My argument is that dividends are not a consistent way to identify a good investment, not that we should take all dividends and throw them in the trash. You are no better or worse off by having received a dividend. It is diversification, not dividends, that increases the reliability of your outcome. Focusing on dividends means that you could be missing lots of great companies just because they have not made the decision to pay dividends. As I mention in the video, those companies could have chosen to return capital to shareholders through buybacks. Why aren't you investing in those companies?
Warren Buffett loses $4.5B of capital each year as it shifts into his bank account in the form of dividends. We can't ignore that side of the equation. If you like Buffett, maybe you read his 2012 letter to shareholders where he explains why he does not like dividends, and also walks through the math that I have been referring to.
Page 19: http://www.berkshirehathaway.com/letters/2012ltr.pdf
If you told Buffett that you only invest in dividend paying stocks, I think that he would tell you to give your head a shake.
Quote:
And that brings us to dividends. Here we have to make a few assumptions and use some math. The numbers will require careful reading, but they are essential to understanding the case for and against dividends. So bear with me.
We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth – $240,000 – and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.
You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the one third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).
After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company’s net worth). And we would live happily ever after – with dividends and the value of our stock continuing to grow at 8% annually.
There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach.
Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.
Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value.
This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.
Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.
Aside from the favorable math, there are two further – and important – arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them – perhaps even most of them – are in a net-savings mode and logically should prefer no payment at all.
The sell-off alternative, on the other hand, lets each shareholder make his own choice between cash receipts and capital build-up. One shareholder can elect to cash out, say, 60% of annual earnings while other shareholders elect 20% or nothing at all. Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)
The second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts
No worries on the tone; your username more than made up for it. Thanks for the discussion! This is my favorite part of YouTube.
Edit: Formatting of the quoted text.
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Statistically, your are far more likely to underperform by picking stocks. The challenge with the approach of testing new ideas over the years is that this is not a game. It is your ability to fund your future liabilities when you have depleted your human capital. Of course, you are free to do this, and the majority of people do, I just do not see the logic.
Always keep in mind that no matter how much research you do to pick a stock, there is someone on the other side of the trade. That someone is most likely an institution with far more resources to dedicate to research than you or I have. What do you know that they don't?
I do agree that many funds end up being closet index funds, as you described, but there has been research done in that space. The term has been defined as Active Share, meaning how much a fund differs from the market. So a closet index fund would have low active share. One paper tried to push the idea that high active share funds were more likely to beat the market. That paper was debunked in a paper from AQR in 2015 with the conclusion being:
Overall, our conclusions do not support an emphasis on Active Share as a tool for selecting managers or as an appropriate guideline for institutional portfolios.
https://www.aqr.com/~/media/files/papers/aqr-deactivating-active-share.pdf
Hedge funds definitely do their best to beat the market, but their returns as an asset class have been embarrassing.
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This is an excellent question. I looked at VBR and VTV initially when I was putting together the model portfolios. I liked VBR more than I liked IJS, and was leaning in that direction, but the difference-maker in that decision was the extent of small value exposure that each ETF offers.
The SmB regression coefficient for IJS is 0.86, while it's 0.60 for VBR. They are similar for HmL (0.27 for IJS and 0.29 for VBR). IJS has an average market cap less than half the size of VBR (1,554m vs. 3,647m), and a lower P/B (1.53 vs. 1.72). If small cap value exposure is the goal, I think that IJS is delivering more of it than VBR. This decision is not just about cost - based on 50% of the past factor premiums, IJS would beat VBR by about 20 bps per year after fees.
As for VTV, again, it was intuitively my first choice before I started doing analysis to compare the options. The problem with VTV is that it's all large cap. It has an SmB regression coefficient of -0.18. This means that it reduces the overall portfolio's small cap exposure from IJS/VBR. I suppose I could have done less VTV and more IJS to balance it out. I like how IJS and IUSV together give total market value exposure.
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MSCI’s quality factor, if I remember correctly, is measured using return on equity, debt to equity, and earnings variability.
Valuation theory suggests that expected future profitability should be related to expected returns. Return on equity uses net income which can be affected by one-time expenses such as extraordinary items. Research by Robert Novy-Marx (2012) shows that you get a better proxy for expected future profits if you move up the income statement to gross profits.
Once you control for the level of gross profitability, the variability of profitability contains little additional information about future profitability. Academic studies such as Fama & French (1992) also show that once you control for size and book-to-market, leverage contains little additional information about differences in average returns.
In short, the MSCI quality metric combines multiple signals which do not add any explanatory power to the model when size, relative price, and gross profitability are accounted for. Adding multiple signals together instead of using one clean signal may lead to less diversification and higher turnover for no additional benefit.
All that said, quality and profitability should give somewhat similar results. They are arriving at the same place, but profitability is more parsimonious.
I would tend to prefer a fund that is targeting multiple factors as opposed to a single factor like quality/ profitability.
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Hello Zeric E, in future correspondence please feel free to address me by name. My name is Ben.
Thank you for putting so much effort into writing this comment. I will respond only to the portions of your comment that are objectively and unequivocally incorrect. The rest is conjecture.
You are, by all definitions, a clear victim of the mental accounting bias. There is no rational reason to favour dividends. This has been written about extensively by the leading researchers in the world of portfolio theory and financial planning. It is also taught in the CFA curriculum.
Your assertion that a dividend strategy will never touch principal is false. The status of your principal is governed, in full, by the share price of the stock that you own, regardless of its dividend paying status. If you happen to pick a dividend paying stock that ends up having financial trouble you most certainly could lose your principal. I will not buy the argument that you or anyone else has the ability to overcome idiosyncratic risk and select only companies that will do well over the long-term. That is simply not how the world works.
The notion that dividend investing circumvents sequence of returns risk in early retirement in a way that a total return approach does not is objectively incorrect. What a dividend strategy does do is force you to spend only dividends, which can be cut. In the rational world of total return investing we would call this a variable spending strategy. Variable spending to reduce sequence of returns risk is well-researched and does not require an emphasis on dividends. The benefit of variable spending in a total return world is that you are in control, not the board of a company.
Small cap stocks, on their own, are more volatile than large cap stocks. Your comment on small cap stocks is another side effect of the mental accounting bias – failing to consider how assets behave together in a portfolio. Small cap stocks are more volatile than large cap stocks, but they are also imperfectly correlated with the market. Adding in exposure to the size premium and the other well-researched risk premiums such as relative price and profitability can actually improve the overall risk-return characteristics of a portfolio. I suggest reading up on this.
It is true that dividend investing may make some people happy. That is fine. However, they should be coached to understand that there is no quantitative benefit to dividend investing, and by emphasizing dividends they are likely to increase their overall risk due to a lack of diversification. If an investor still wishes to proceed with this strategy based on how it makes them feel I cannot argue against that.
Similar to the US, Canada has very low, in some cases even negative, tax rates on dividends paid by Canadian companies. For investors in those low-income tax brackets Canadian dividends are more attractive. However, the dividend income is still counted toward income tested government benefits, so it is not free from implications. A focus on Canadian dividend paying stocks also leads to risks that are likely to outweigh the tax savings. Your suggestion that these comments could be viewed as a breach of the CFP Board's Code of Ethics and Professional Responsibility is laughable in light of the fact that your comments are advocating an investing strategy that has been repeatedly proven to be sub-optimal in all cases.
I agree in full that there is no one-size-fits-all approach to investing, but an emphasis on dividend paying companies is only suitable if it is being used to satisfy biases that cannot be corrected. Any financial professional should do their best to educate their clients on these biases to hopefully improve their behaviour, ultimately increasing the statistical reliability of their outcomes. Making no effort to do this based on a poor understanding of portfolio management could be viewed as a breach of fiduciary duty.
Here’s some further reading:
https://www.vanguardcanada.ca/documents/dividend-oriented-strategies.pdf
Our analysis finds that absent beneficial tax treatments, dividend-oriented equity strategies are best viewed from a total-return perspective, taking into account returns stemming from both income and capital appreciation.
Swedroe: Irrelevance Of Dividends
https://www.etf.com/sections/index-investor-corner/swedroe-irrelevance-dividends?
Additionally, you have seen how the preference for dividend stocks has driven dividend strategy valuations to levels well above the valuations of value strategies and the overall market. This should raise concerns about future returns.
Should Retirees Use A Total-Return Or Income Portfolio?
https://www.forbes.com/sites/wadepfau/2017/04/18/should-retirees-use-a-total-return-or-income-portfolio/#75f7eb175e96
Total wealth is not affected by a dividend payment. Actually, the dividend may be taxed at a higher income tax rate rather than the capital gains rate, diminishing after-tax returns with dividends.
Total Return vs Income Investing: Same, But Different
https://www.mcleanam.com/total-return-vs-income-investing-same-but-different/
One of the big draws to income investing is that it seems safer because you don’t touch the principle. You always have the same number of shares. But if you think about what a stock is – a tiny sliver of ownership in a company and all future cash flows – you realize how deceptive this thinking is. As dividends are distributed, the share price of the stock declines.
Can You Rely On Dividends For Income?
https://retirementresearcher.com/can-rely-dividends-income/
One of the main reason people find dividends so appealing is that they don’t have to sell their stocks – their “principal” remains untouched. That’s true, but dividends aren’t free money. Just like XYZ’s share price dropped when they paid us $100, a stock’s value will always drop when it transfers cash from itself to its owners.
You should care about meeting your spending goals, not how you get your money out of your portfolio. There’s a lot that you need to manage with your portfolio: the amount of risk in your portfolio, your level of diversification, your asset location, your expenses, and all sorts of other things. The amount of income your portfolio puts out is not one of them.
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Yikes! You're absolutely correct. Not sure how that made it into the video :/ I'll add a note to the description.
The problem with ZEM is that it tracks the MSCI Emerging Markets Index. XEC tracks the MSCI Emerging Markets IMI Index.
Here are the index definitions from MSCI:
The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries*. With 1,138 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI Emerging Markets Investable Market Index (IMI) captures large, mid and small cap representation across 24 Emerging Markets (EM) countries*. With 2,876 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in each country.
The problem that you introduce with ZEM is that you are eliminating all of your small cap exposure. We have data from all over the world showing that, over the long-term, small outperforms large.
Emerging markets small cap stocks returned 12.23% per year on average between 1989 – 2017 while large cap stocks returned 10.47% per year on average. That is an annualized difference of 1.76%.
For the past 10 years, the MSCI Emerging Markets Index has returned 5.36% per year on average, while the MSCI Emerging Markets Small Cap Index has returned 7.69% per year on average. The MSCI Emerging Markets IMI Index is about 15% small cap, so the average performance difference between EM IMI and EM would be about 0.30% per year over that period.
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Gunnar, great question. I have already recorded a video on this exact topic which should be released early 2019.
I am familiar with the paper. On page 42, they explain the following:
Other premia being stronger among small caps may be a rationale to want to overweight small cap stocks even if there is no size premium. For example, the value premium in small stocks may be so large that it justifies being overweight small stocks even though there is no stand-alone size effect. Of course, simply being overweight small is not nearly as profitable as being overweight small value. Hence, absent a pure standalone size effect, an investor is always better off being overweight certain kinds of small stocks (e.g., those with high value, momentum and quality) rather than generic small stocks.
They also had a preliminary and incomplete paper in 2015 titled Size Matters, if You Control Your Junk, where they conclude:
Size matters – and, in a much bigger way than previously thought – but only when controlling for junk. We examine seven empirical challenges that have been hurled at the size effect – that it is weak overall, has not worked out of sample and varies significantly through time, only works for extremes, only works in January, only works for market-price based measures of size, is subsumed by illiquidity, and is weak internationally – and systematically dismantle each one by controlling for a firm’s quality. The previous evidence on the variability of the size effect is largely due to the volatile performance of small, low quality “junky” firms. Controlling for junk, a much stronger and more stable size premium emerges that is robust across time, including those periods where the size effect seems to fail; monotonic in size and not concentrated in the extremes; robust across months of the year; robust across non-market price based measures of size; not subsumed by illiquidity premia; and robust internationally.
Put simply, small caps as a whole are not compelling in the data. Their performance is negatively affected by small cap growth stocks with low profitability (or junk as AQR writes it). Controlling for relative price and profitability (or quality) makes small caps far more compelling.
My view on this is that unless you can get small cap exposure without being bogged down by small growth low profitability, it might not be worth the additional risk and cost.
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@Edric thanks for the thoughtful comment.
1) I used one example from the paper, but they offered 56 cases of historical hyperinflation in major and minor countries, all occurring in fiat regimes. There was no obvious pattern indicating a relationship between the real price of gold and hyperinflation. I believe that there are many better options. Even losing money in negative yielding German bonds would likely be more stable than an asset like gold which has been historically more volatile than stocks. Foreign currencies, real estate, and bonds all seem to be superior to gold in every way if there are concerns about your home currency. I think that it is also important to keep in mind that owning foreign stocks, while not dealing with the volatility problem, does offer protection against a devaluing currency. If CAD plummets, globally diversified Canadian investors will have fantastic returns.
2) If the goal is to hold a store of value I do not see how gold is the best thing to own. Why not global bonds, foreign currency, real estate etc.? It is not sensible to think that you can substitute gold miners for gold. The correlation of the gold spot price and the MSCI ACWI Select Gold Miners IMI Index has been 0.835 going back to 2003 (when the index starts), but the range of returns for miners has been far wider. In other words, even if the correlation is fairly high, the miners index has had much higher highs and lower lows than the gold spot price.
3) Yes, I consider the actions of many central banks to be irrational. The Canadian central bank disposed of most of its remaining gold reserves in 2016. A 2012 paper looked at the question of why central banks hold gold at all. They found that it is used as a means to signal economic might to other countries. I do not think that gold's history means anything. The world is very different now than it has been in the past. Something is not good simply because it has been good, especially when that goodness is derived from how other people feel about it.
I disagree that owning gold is rational. The only argument that I can see is holding it because it feels good.
Central Banks and Gold Puzzles
"A central bank’s gold position retains the stature of signaling economic might. The intensity of holding gold is correlated with ‘global power’ – by a history of being a past empire, or by the sheer size of a country, especially by countries that are or were the suppliers of key currencies."
https://cafin.ucsc.edu/research/sigfirm/pdfs/WPS-2012/WPS%203%20Gold%20Puzzles%20Aizenman%208.2012.pdf
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@igorfeldman7 It is irrational for two main reasons: 1. there is no rational reason to have a preference for dividends and 2. why would you let a company's dividend policy dictate your retirement lifestyle?
I have a video coming out in a few weeks specifically on dividend growth investing. I am not opposed to dividends, but I am opposed (or at least I think it's irrational) to have a preference for dividends.
Here is some of my upcoming video:
Is buying a good solid company, like BMO or Fortis, a good investment? Only if you know something that the market doesn’t. When a company is rock solid, it is no secret that it is rock solid. The whole market knows that, so those expectations are already included in the price.
If the company does what it is expected to do, you might expect to earn something close to the market return, while also taking on the risk of that individual company not delivering on the expectations. It is only if the company exceeds current expectations that you would expect to do better than the market, and there is no good reason to believe that you can anticipate those results, at least not consistently.
I can’t stress enough that picking dividend growers should not be expected to beat the market over the long-term. We can look to the SPIVA Canada Year-End 2017 report for a sample of professional investors who try to do exactly this. For the ten years ending December 2017, the S&P/TSX Canadian Dividend Aristocrats returned 8.01% per year on average.
There were 48 dividend mutual funds in Canada at the start of that period, and exactly 0 of them managed to beat the index return over ten years. The average return of the funds was 4.90% per year on average over the period. Even if we add back an estimated 2.5% fee, the funds were unable to match the index.
Now here is where it gets tricky. I just told you that dividend funds can’t beat the dividend index, but both the Canadian and US Dividend Aristocrats indexes have decimated the broad market in recent history. Don’t worry, there is a sensible explanation. Dividend paying companies, especially dividend growers, do tend to have loading to the known factors that explain the differences in returns of diversified portfolios.
They tend to be value companies with robust profitability and conservative investment. For example, the strong performance of the the S&P 500 Aristocrats Index is well explained by excess exposure, relative to the S&P 500, to the factors that explain returns. Simply put, the difference in returns is explained by the aristocrats index having exposure to more value stocks, more stocks with robust profitability, and more stocks that invest conservatively.
This gets a little nuanced, but there is an extremely important distinction between a company with exposure to the factors, and a company with a long track record of increasing its dividend. The distinction is that not all stable dividend payers have exposure to the factors, and many stocks that do have exposure to the factors are not dividend payers.
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Good point regarding cash, but not for the reason that you described. I would say this video is about asset allocation for long-term portfolios. In aggregate, an individual would also have an allocation to cash for their emergency liquidity bucket. I typically say between 3 and 6 months of living expenses depending on the overall situation. I do not typically include that bucket in an investment policy statement, so I excluded it from the asset allocation discussion in the video. But you are correct. An allocation to cash is prudent.
Regarding mean-variance analysis (MPT/Sharpe Ratio optimization), it has to be taken with a grain of salt, or more likely many grains of salt. Sharpe ratios are based on historical returns and relationships between asset classes. This means that an optimal portfolio based on past data may well be sub-optimal going forward. This makes the idea that we can find a perfect combination of securities and then adjust for risk tolerance by borrowing or lending at the risk-free rate wishful thinking.
Further to that, mean-variance optimal is not necessarily optimal for a human investor. MPT assumes that investors are perfectly rational, but in reality they are not. For example, a MPT investor who has found the perfect portfolio and has a high tolerance for risk would borrow lots of money at the risk-free rate to invest. Most humans do not do this. MPT also assumes that stock returns are normally distributed when in reality they have fat tails and skewness.
With all of that in mind, I am not clear on your last sentence:
It turns our that using bonds does not improve the sharp-ratio of your portfolio. Instead if you want to decrease the risk of your overall portfolio in an optimal way you better add saving to your stocks portfolio, instead of bonds.
Sharpe ratio lies on a line tangent to the steepest part of the efficient frontier. The mix of assets used to create the efficient frontier may include stocks and bonds. It depends on the type of bonds, the time period examined, and the other assets in the portfolio. To maintain that optimal Sharpe ratio you would combine cash and the optimal portfolio to meet your risk tolerance.
In real life portfolios it is not possible to capture the optimal Sharpe ratio because the magnitude, volatility, and covariance of live returns are not constant, nor are they predictable. As opposed to hoping that we can find the perfect portfolio and combining it with cash, which has no expected return, most investors will combine stocks and bonds (which both have a positive expected return) to match their comfort with risk.
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I have never argued that markets are fully efficient. https://youtu.be/yco0sC7AJ2U
It's a little strange to cherry pick a list of names with ex post strong track records while accusing me of cherry picking data. Beyond that, some of these names have not, in fact, done anything special.
Lynch managed his fund for 13 years and the fund was only available to the public for the last 9. Most of the returns happened when the fund was not available to the public. Either way, this is not a 20-30 year track record. Icahn, as measured by IEP has trailed the US market by an annualized 61 bps from August 1987 - December 2020. 100% of Greenblatt's publicly available funds have trailed the market, in most cases by a huge margin, since inception. It seems a little disingenuous to point to results from Gotham's 1985-1995 early days with huge returns as proving anything. Not taking away from those early results, but investors can't buy past returns. Similar to the points in this video, investors chasing past returns tend to get burned.
Edit to add BRK (Buffett/Munger) has trailed the index for the past ~20 years. So, again, looking at magazine article about great investors from the past does not tell us much about what will do well in the future.
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I have taken the following from a post in my podcast community by user bquant https://community.rationalreminder.ca/t/lionizing-lynch/3764?
After watching a few Youtube videos of Peter Lynch (the famous mutual fund manager), I said: wait a second… why should I care what this guy thinks about picking stocks? :thinking:
The financial media lionizes him for his index-beating returns as a Fidelity fund manager from 1977-1990, calling him a “star” and “wizard”. Apparently, he’s a stock-picking guru.
But I think his brilliance is over-stated. I’m not impressed.
Criticism #1: he only managed this fund for 13 years. That’s not a very long track record, and he retired in 1990 while his track record was strong. His Magellan fund was an aggressive small-cap fund, and those kinds of stocks are very volatile. It’s not particularly amazing to see highly volatile (high beta) small cap stock picks outperform the S&P 500 index, even over 13 years.
Criticism #2: extremely lucky timing both on entry and exit. He started in May 1977 and ended in May 1990. As can be seen at Portfolio Visualizer 3, 1977-1990 was right in the middle of an incredible bull market in the US Small Cap asset class. Lynch (purely by luck) skipped the bad years, and May 1990 was even a lucky exit as shown in this chart 1, before the selloff later that year.
To emphasize just how lucky that timing is, take a look at the Berkshire Hathaway annual track record, shown on page 1 of Buffett’s letter 1. You can see how badly Buffett underperforms the index from 1972-1975. Those were turbulent times in markets and very difficult for investors.
While Buffett and others had to navigate those tough years, Lynch did not. He waltzed into his new job in 1977. That’s dumb luck.
Criticism #3: his fund wasn’t even open to the public for several years, and it was only possible to invest with him for the last 9 years.
I doubt that Lynch could have sustained these results for a longer period, and through a bull/bear market cycle. I suspect that he just got lucky, and maybe he thought the same thing… he retired at age 46, after just 13 years of managing this fund!
He never had to manage the portfolio through a declining market.
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Great questions, Quinton!
I agree that with a 58% success rate in the model there appears to be a positive expected outcome, but that could easily change if the realized returns end up being different from those used in my example. I arbitrarily tested the model using two sets of assumptions, but those assumptions do not come close to capturing reality. The point is not so much that value is added in 58% of trials. It is more that when we change the assumptions, the probability of value being added changes substantially.
Further to that point, when the magnitude (0.07% in the example) and frequency (58% in the example) of positive outcomes are weighed against the potential drawbacks of an optimized location strategy (cost, complexity, regulatory risk, model risk) I do not think that this is an obvious value-add. In fact, I think that it introduces a new risk which, unlike the dimensions of returns, does not have a positive expected outcome. Taking on the risk that future returns and tax rates will be what you expect them to be is not a priced risk. It is very different from taking the priced risks of small cap and value stocks.
Asset location ends up being a bet on your ability to predict the future. As the differences are likely to be small, I see no problem with professionals implementing asset location strategies for their clients if it makes the client happy. I similarly take no issue with any DIY or professional who chooses to have the same allocation across all accounts.
As far as I know there is zero evidence that current tax rates are predictive of future tax rates. On a macro level tax rates change with governments. At the individual level tax rates change based their individual circumstances. I would be very hesitant to bet on future tax rates, or the magnitude of future returns, which are both requirements of asset location optimization.
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Thank you, Patrick, for furthering my point. Alright, I watched Joseph's video. Who is he exactly? I'd never heard of him.
I would love to have the data point on how many of the people disagreeing with this theory (including Joseph) have actually read the paper that initiated it and the empirical work that has followed as opposed to a Wikipedia article summarizing it. Have you read it, Patrick? We have to keep in mind that this is a theory, which is explicit in the paper. Any theory is not expected to be a perfect description of reality, but it can still offer insight into how something (the market in this case) functions.
Joseph is conflating the theory of dividend policy irrelevance in valuation with the importance of dividend policy in general. Those are two extremely different things. Many companies should pay dividends because they do not have sufficient use for their cash. However, looking at two companies that are otherwise identical, but one pays a dividend and the other does not, there is no reason to believe that the market will value them differently. This is true theoretically, but it is also true empirically.
The theoretical aspect of valuation is crucial to understanding how capital markets work. In order to make an informed decision it is important not only to consider past results ("look, this dividend paying stock has done well") but also the theoretical basis for those results. Without a theoretical basis there is no reason to expect a past outcome to be repeated.
Here is an excerpt from the original paper:
In the hope that it may help to overcome these obstacles to effective empirical testing, this paper will attempt to fill the existing gap in the theoretical literature on valuation. We shall begin, in Section I, by examining the effects of differences in dividend policy on the current price of shares in an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty. Still within this convenient analytical framework we shall go on in Sections II and III to consider certain closely related issues that appear to have been responsible for considerable misunderstanding of the role of dividend policy. In particular, Section II will focus on the long-standing debate about what investors "really" capitalize when they buy shares; and Section III on the much mooted relations between price, the rate of growth of profits, and the rate of growth of dividends per share. Once these fundamentals have been established, we shall proceed in Section IV to drop the assumption of certainty and to see the extent to which the earlier conclusions about dividend policy must be modified. Finally, in Section V, we shall briefly examine the implications for the dividend policy problem of certain kinds of market imperfections.
[...]
Like many other propositions in economics, the irrelevance of dividend policy, given investment policy, is "obvious once you think of it." It is, after all, merely one more instance of the general principle that there are no "financial illusions" in a rational and perfect economic environment. Values there are determined solely by "real" considerations- in this case the earning power of the firm's assets and its investment policy - and not by how the fruits of the earning power are "packaged" for distribution.
Obvious as the proposition may be, however, one finds few references to it in the extensive literature on the problem. It is true that the literature abounds with statements that in some "theoretical" sense, dividend policy ought not to count; but either that sense is not clearly specified or, more frequently and especially among economists, it is (wrongly) identified with a situation in which the firm's internal rate of return is the same as the external or market rate of return.
A major source of these and related misunderstandings of the role of the dividend policy has been the fruitless concern and controversy over what investors "really" capitalize when they buy shares. We say fruitless because as we shall now proceed to show, it is actually possible to derive from the basic principle of valuation (1) not merely one, but several valuation formulas each starting from one of the "classical" views of what is being capitalized by investors. Though differing somewhat in outward appearance, the various formulas can be shown to be equivalent in all- essential respects including, of course, their implication that dividend policy is irrelevant. While the controversy itself thus turns out to be an empty one, the different expressions do have some intrinsic interest since, by highlighting different combinations of variables they provide additional insights into the process of valuation and they open alternative lines of attack on some of the problems of empirical testing.
The rebuttal that I keep hearing to this theoretical framework for understanding valuation is that it has been "proven wrong". An empirical instance of a theory not perfectly describing reality does not prove the theory wrong. The classic line from Alfred Korzybski, "the map is not the territory," applies here as it does anywhere. A model is an abstraction that helps us view the world, but it is not itself the world. That does not preclude us from using models, and avoiding models because of this would be foolish.
The line in the Miller and Modigliani paper about overcoming empirical obstacles is extremely important. In 2006, Eugene Fama and Ken French came out with a paper titled Profitability, investment and average returns in which they showed empirically that the variables theoretically suggested by the valuation equation to explain differences in stock returns do, in fact, explain differences in stock returns. The theoretical valuation equation hinges on dividend irrelevance.
Later in 2015, Fama and French came out with their five factor asset pricing model which, again, relies on the theory of dividend policy irrelevance. The five factor asset pricing model can be used to empirically test the valuation equation; the model explains well over 90% of differences in returns between diversified portfolios. This is very clear evidence that the theory is an excellent descriptor of reality.
Sources (please read them)
https://www2.bc.edu/thomas-chemmanur/phdfincorp/MF891%20papers/MM%20dividend.pdf
http://finpko.faculty.ku.edu/myssi/FIN938/Fama%20French_Profitability%20Investment%20%26%20Avg%20Returns_JFE_2006.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2287202
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There are different ways to think about this. I think that the best way to think about it is that it is not a liquidity issue, but a price discovery issue. The ETF price can drop below the NAV due to liquidity issues - too many people wanting to sell the liquid ETFs while the illiquid bonds can't trade with the same volume. Is this a problem with the ETF, or a problem with the underlying bond prices? Dave Nadig explained this in detail with an example on my podcast https://rationalreminder.ca/podcast/ep-71
The reason people get hung up about ETF’s is because you can end up in a situation where you have a very liquid, very well-known ETF that owns a lot of very illiquid, very unknown securities and junk bonds are the sort of poster child for this, the two big ones there, HYG and JNK and you know, both of those individual funds have vastly more liquidity on a daily basis than most of the underlying bonds, they hold trade in in gear, so there is this paradox of liquidity.
Now, people see that and they think that, “Oh well, that means that when everybody decides they want to get in on junk bonds, there’s going to be this huge disconnect between what you can do in the underlying market and what you could do with the ETF,” and they’re not wrong about that, there will be and there has been a disconnect.
But that doesn’t mean that you’ve somehow broken the market. What you’ve actually done is add a vector for price discovery into a market that would otherwise lock up. For example, when Orange County was going bankrupt, the muni bond market locked up. You could not get a bid on high yield munis anywhere in the country. Nobody wanted to touch the darn things.
The ETFs that help those bonds traded like water, all the way through that hiccup and you know, did they trade down? Of course they traded down. I don’t remember off the top of my head but imagine they trade down 20%, right? Blood bath of a day. And then supposedly, that’s not a ‘fair’ price because the last price those bonds traded at might have been 20% higher because those bonds haven’t traded it since, say, last Thursday.
So you end up with this huge timing disconnect between when you can trade the ETF and when you can get a good price on the underlying. That timing disconnect appears as a pricing disconnect so everybody assumes that the world is broken. What actually happens is, when everybody comes back to their desk after lunch and they look and see that the world is not over, the muni bond market opened up and lo and behold, it traded to precisely where the ETF was trading.
So yeah, you can get huge disconnects during market events, there’s nothing magical about the ETF that removes the beta risk of whatever thing you’re holding. But the ETF is much more likely to give you a price discovery mechanism in a crisis than the underlying bonds. We’ve seen that over and over again whether it was Egypt in the Arab spring or junk bonds in 2010.
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I think I need to do a video on what a financial advisor should do. Like you point out, it should not be trying to do fancy stuff in the portfolio. I'd probably summarize it as follows:
Understanding the evidence (portfolio theory, financial planning research etc. as basis to give any advice)
Portfolio advice (which index funds and in what allocation)
Tax minimization (where to hold assets, tax loss selling, when to use which accounts)
Financial advice (planning, debt, insurance, saving, spending etc.)
Product allocation (mortgage, annuities, insurance)
Maintaining context (understanding the situation and goals to advise on the above)
Ability to communicate (poorly communicated advice will never be actionable)
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I have an upcoming video on asset allocation where I answer this question. Here is a preview:
The optimal mix between Canadian, US, International developed, and emerging markets stocks in a portfolio is an unknown. This makes the geographic asset allocation choice mostly arbitrary, as long as global exposure is achieved.
Most model portfolios, including PWL Capital’s, Wealthsimple’s, Vanguard’s asset allocation ETFs, and the Canadian Couch Potato portfolios have a heavy bias toward Canadian stocks, at about ⅓ of the equity allocation. This might be surprising when it is considered that Canadian stocks make up about 3% of the global market cap. Why so much in Canada? It comes down to tax treatment.
I have talked in the past about unrecoverable foreign withholding tax on foreign dividends in registered accounts, which is an issue that you will never have with Canadian stocks. Further to that, in a taxable account Canadian dividends receive preferential tax treatment. With asset allocation being a somewhat arbitrary exercise, assuming some level of global diversification, favoring a tax efficient asset class is sensible.
We have established that it is sensible to diversify globally to attain exposure to the stock market, and it might make sense to be overweight Canadian stocks relative to the market to reduce the impact of both foreign and domestic taxes.
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Hello Julien! These questions sound like something that a financial advisor would say :)
Anything is possible, but in this case there is no good argument in the data for certain fund companies performing better bank-run funds.
Here is a small sample of data for three equity asset classes for bank funds and Fidelity/Mackenzie funds. Many of the bank and non-bank fund companies do not have funds with 10-year track records in every asst class. In many cases this is due to fund closures which have happened due to poor performance.
Canadian Equity
-TD Canadian Index Fund: 4.35%
-RBC Canadian Equity Sr A: 2.93%
-BMO Canadian Equity A: 3.85%
-Fidelity Canadian Disciplined Eq Cl A: 3.89%
-Fidelity True North Cl A: 3.94%
-No Mackenzie Canadian equity funds that I can find have a 10-year track record
US Equity
-TD US Index Fund: 12.59%
-RBC US Equity Sr A: 7.64%
-TD US Equity Portfolio A Series: 12.37%
-Scotia US Blue Chip: 5.85%
-Fidelity American Disciplined Eq Cl A: 8.89%
-Fidelity American Equity Fund Series A: 9.15%
-Mackenzie Cundill US Class – A: 9.17%
International Equity
TD International Index Fund: 5.55%
-RBC International Equity Sr A: 4.30%
-TD International Growth Fund A Series: 2.34%
-Fidelity International Disciplined Eq A: 2.71%
-Mackenzie Ivy International Class A: 2.17%
There is no evidence that SRI funds perform better or worse than other funds due to being SRI alone. They may suffer from being less diversified than the index, but any actively managed fund has the same issue.
There is no evidence that 'star' funds perform better in the future. This is true whether 'star' is defined by past performance or Morningstar star ratings. Here is an article about how useless star ratings are https://www.thebalance.com/the-risks-of-buying-only-5-star-funds-4038866
Common sense investors invest in index funds :) If it were as easy as picking 'good' funds to beat the market, then everyone would be doing this, including me. It is not this easy, even though it may sound that easy in a sales pitch.
There is certainly no evidence that a financial advisor is able to select funds that will do well in the future.
>They move the money pretty soon after funds begin to shrink.
This is the definition of selling low and buying high, or performance chasing, which is one of the most harmful things that an investor or their advisor can do.
>Is it possible that a decent investment strategy, looking at indicators like the growth of investment in such and such company could be valid?
This would be great! Unfortunately there is no evidence at all whatsoever that a strategy like this adds any value.
>Is this possible that in the mean time, the investors could beat the indices?
If investors (no expertise) and their advisors (limited if any expertise) could beat the index by switching between funds, then why can't fund managers (lots of expertise) beat the index? That does not add up. Markets react very quickly to new information. This shows up in the data discussed in this video, and also in academic studies.
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Hello Zeric E, this is a good discussion. Thank you for the engagement. I think this second round of comments is much more balanced, offering context to the first round which did not come across that way. I will do my best to respond.
I agree I mis-read your statement regarding a balanced portfolio. I took it to be more weighted toward an income generating portfolio. We are in agreement that if left to sit untouched a diversified portfolio will appreciate over time. However, a portfolio more heavily weighted toward income securities should not be expected to allow more spending than a total market portfolio assuming that their total returns are similar. I do not think you are disagreeing with that point here, but it is somewhat implied based on the conversation. An income focused portfolio creates a built-in spending rule, but offers few other benefits other than potentially preferential tax treatment at low levels of income.
Point taken on dividends being a spending strategy that fits into an overall portfolio. My view on that is that it is irrational and unnecessary, but point taken nonetheless.
Point taken on the small caps message. I can see how I could have made that information more clear such as "small caps have higher expected returns and other characteristics that may play a beneficial role a long-term investment strategy".
There is a substantial amount of nuance in investing as you clearly understand. I do my best to cover all bases, but some digressions, while important, simply do not make it into the videos.
You are correct that I took from your comments that you were advocating a more income heavy approach as opposed to a balanced approach with an income slant (how's that for nuance). Of course, any total market index fund portfolio will pay dividends. In the video and in our discussion I am suggesting that it is a focus on dividends that is sub optimal. Based on this second round of discussion it seems that we are mostly in agreement.
To answer your final question, the answer is yes. For clients who are drawing an income we will typically reinvest all distributions and raise cash for income from a regular (monthly etc.) redemption. We determine sustainable spending using Monte Carlo analysis as opposed to relying on cash flows.
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Thanks for sharing, Sylvain.
Excuse my skepticism, but I have to ask if comparing your Fidelity funds to the TSX was really appropriate. There are two primary reasons for this: many Canadian equity funds have meaningful exposures to foreign equities, and many Canadian equity funds have different risk factor exposures than the TSX. This matters to you because if your Fidelity fund with high fees beat the TSX due to foreign equity and risk factor exposure, you could have recreated the same performance for lower fees by building an index fund portfolio with foreign equities and comparable risk factor exposure.
Let's take a look at the geographic exposure of some (randomly selected) Fidelity Canadian equity funds:
Fidelity Greater Canada Fund: 22% foreign equities
Fidelity True North® Fund: 7.1% foreign equities
Fidelity Canadian Opportunities Fund: 8.5% foreign equities
Clearly, some performance difference relative to the TSX would be explained by foreign equity exposure.
I am not going to take the time to run regression for these funds, but a regression is how you would determine how much of a fund's performance was explained by risk factor exposure. Comparing a fund to an index with different risk factor exposure would give you misleading results. For example, Canadian value stocks have handily beaten the TSX over the past 10 and 20 year periods. If you Fidelity fund has a value tilt, that may explain the performance difference. A better option than paying Fidelity 2.3% for value exposure? Add a value index to your index portfolio.
Finally, even if your fund has done better than you would have done by tracking the appropriate indexes, using your own anecdotal experience as a means to ignore the weight of evidence against high fees and active management is... an interesting decision. Yours to make, of course, but interesting nonetheless.
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Hi Max,
Each risk factor is independent. Based on this, adding additional independent risks should make your portfolio overall safer due to the diversification effect. In your case, I would not touch any equity risk factors for a 3-5 year goal. Over a 3 year period this is about a 30% chance of losing money in stocks, and a 20-30% chance of a negative factor premium for size and value. There is no way to conclusively settle the debate on what drives the value premium, but this paper made a compelling case for the risk story https://www.robeco.com/docm/docu-20141016-what-drives-the-value-premium.pdf
Source for my comments on the probability of losing money over shorter time periods https://poseidon01.ssrn.com/delivery.php?ID=391084087124087006070101110116073119041027020035083029074065019002113115093005014101106062010057062109039082004000004097081080025060001076032092087118065094010005065062055004120115077009009087109029125002010072118030002091115031024093113000066113123&EXT=pdf
Larry Swedroe explained my point about factor diversification in this episode of our podcast https://rationalreminder.ca/podcast/2019/2/14/episode-30-the-authority-speaks-a-complete-guide-to-investing-and-retirement-with-larry-swedroe
[BF]: "Is there any merit to avoiding factors because you can’t wait for them to deliver?"
[0:26:53.9] LS: No, it’s exactly backwards here. What people fail to understand because they are unaware of the evidence is that any one factor can go through very long periods of underperformance and that’s the point we make in my book, Your Complete Guide to Factor Based Investing. We have a table that shows the odds of each factor having negative performance.
Even the US, we estimate there is a 3% probability that it could underperform totally risk less treasury bills over 20 year periods. And as I mentioned, we’ve had three 13 year periods where US stocks have underperformed T Bills so that can happen to one factor [including the market]. If that’s true, why would you want to run the risk that your portfolio is totally concentrated? Virtually all of your eggs are in that one basket. That makes absolutely no sense to me at all. In fact the shorter your horizon the more likely it is you can underperform by very large amounts and I’ll give you one great example.
From 2000 to 2002, the S&P 500 lost about 40%. Our equity portfolio, which is much more tilted to small and value and international did lose money during that period but our model portfolio that you see in my books only lost about 6%. So what if you retired and you were sitting with that period, you didn’t have the ability to wait out and get the better returns in the long term, your portfolio crashes because you retire in 2000 you are now withdrawing from that portfolio and you can’t recover from those loses with money that is already spent.
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I do not have a video, but I can walk you through it here. Let's take a $500,000 property and assume real estate prices increase at 3% per year.
Pay cash: You invest $500,000 (plus some other costs but we will ignore that for simplicity). One year later your $500,000 investment is worth $515,000 based on a 3% return. Your return is calculated as (current value - carrying costs - initial value)/initial investment. In this case: ($515,000 - $500,000)/500,000 = .03 = 3%.
Put 20% down, finance the rest with a 2.5% mortgage: You invest $100,000 to buy a 500,000 asset. One year later your $100,000 investment is worth $515,000 based on a 3% return, and you have paid $10,000 in interest based on 2.5% on a $400,000 mortgage. Your return is calculated as (current value - carrying costs - initial value)/initial investment. In this case: ($515,000 - $10,000 - $500,000)/$100,000 = .05 = 5%.
You can see that you get a greater return by investing less of your own money. You also take more risk by doing this.
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Willem that's a perfect explanation. It's worth paying attention to the precision in the language used by Fama and French.
In A Five Factor Asset Pricing Model, they write:
The average HML return is captured by the exposures of HML to other factors. Thus, in the five-factor model, HML is redundant for describing average returns, at least in U.S. data for 1963-2013.
They followed up on this statement in their later paper International Tests of a Five-Factor Asset Pricing Model:
In U.S. data for 1963-2013, FF (2015a) find that the intercept in the regression of HML on the other four factors of the five-factor model is close to zero. This implies that HML is redundant for describing U.S. average returns during this period; its average return is spanned (fully explained) by the average returns on the other four factors. It is interesting to examine whether this result holds for the shorter period used here, for other markets, or other factors.
...
In short, all five factors are important for describing NA average returns for 1990-2015. The heavy lifting in Europe and AP is left to Mkt, HML, and RMW, with perhaps a marginal assist from CMA in Asia Pacific.
...
We caution that factor spanning inferences can be sample specific. Given the different results for HML here and in FF (2015a), we would not be surprised to find that factors that are redundant for describing average returns in one period are important in another.
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It's a model. If people confuse it with reality it becomes dangerous. If they understand that it's a model it is extremely useful. I asked Robert Merton about this on my podcast. Merton was integral to developing this model - it's often called the Black Scholes Merton options pricing model. Here was part of his answer:
That said, it's really important to understand that these are models. They're not reality. Models have error. Every model is incomplete. Therefore, every model has errors in it. To say, well, we have a big machine that gives you all these answers and churns out all the data is not good enough. You need to be able to trust what's in there. That is a major challenge. That has always been a major challenge. The fact that it's mathematical is very powerful because we can solve problems we couldn't. It also creates a discipline and a common language for measuring risks. You all are familiar with benchmarks and so forth. We've developed an enormous amount of technology for trying to monitor performance and test performance and so forth.
At the end of the day, they're models. They're only as good as the abstractions that are into the models. I'm going to get on my soapbox for just a second as a scientist. I don't care whether in economics, or physics, or life sciences, all right. Everything is a model. The most important thing you do as a scientist is to make the right abstractions. All models are abstractions from complex reality, right? If you pick the right abstractions, you create a great model.
https://rationalreminder.ca/podcast/234
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Excellent question. If I had to pick one from iShares I would probably go value, but I would be hesitant across the board.
MSCI’s value factor uses forward P/E, enterprise value/operating cash flow, and P/B. Forward P/E uses analyst forecasts of EPS. However, Fama/French 2006 show that analyst forecasts do not add to the overall power of profitability forecasts after controlling for size and other accounting variables including the level of lagged profitability. Other research has found that combining P/B with additional valuation ratios such as P/CF does little to improve average returns but does tend to increase portfolio turnover.
MSCI’s quality factor is measured using ROE, leverage (Debt/BE), and earnings variability. Valuation theory suggests that variables that help predict expected future profitability should be related to expected returns. ROE, which uses net income, can be affected by one-time expense variables such as extraordinary items. Research by Novy-Marx shows that you get a better proxy for expected future profits if you move up the income statement to avoid volatility from things like extraordinary items and taxes. Once you control for the level of profitability, the variability of profitability contains little additional information about future profitability. Academic studies such as Fama/French 1992 also show that once you control for size and book-to-market, leverage contains little additional information about differences in average returns.
Momentum appears to be persistent in the data and the historical premiums have been sizable, but it doesn’t have a sensible explanation which raises the question of whether it is likely to persist. It is also questionable if the momentum premium can be captured cost-effectively in diversified portfolios. Some studies have shown that, once price friction is accounted for, portfolios tracking momentum fail to generate abnormal returns (Lesmond, Schill and Zhou 2004). Differences in how the factors behave should also be considered in portfolio construction and implementation. For example, the momentum premium decays rapidly and therefore requires high levels of turnover to maintain consistent exposure to past winners. MSCI rebalances their indexes twice a year, which may not mesh well with something like momentum.
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Thanks for sharing, Sylvain.
Excuse my skepticism, but I have to ask if comparing your Fidelity funds to the TSX was really appropriate. There are two primary reasons for this: many Canadian equity funds have meaningful exposures to foreign equities, and many Canadian equity funds have different risk factor exposures than the TSX. This matters to you because if your Fidelity fund with high fees beat the TSX due to foreign equity and risk factor exposure, you could have recreated the same performance for lower fees by building an index fund portfolio with foreign equities and comparable risk factor exposure.
Let's take a look at the geographic exposure of some (randomly selected) Fidelity Canadian equity funds:
Fidelity Greater Canada Fund: 22% foreign equities
Fidelity True North® Fund: 7.1% foreign equities
Fidelity Canadian Opportunities Fund: 8.5% foreign equities
Clearly, some performance difference relative to the TSX would be explained by foreign equity exposure.
I am not going to take the time to run regression for these funds, but a regression is how you would determine how much of a fund's performance was explained by risk factor exposure. Comparing a fund to an index with different risk factor exposure would give you misleading results. For example, Canadian value stocks have handily beaten the TSX over the past 10 and 20 year periods. If you Fidelity fund has a value tilt, that may explain the performance difference. A better option than paying Fidelity 2.3% for value exposure? Add a value index to your index portfolio.
Finally, even if your fund has done better than you would have done by tracking the appropriate indexes, using your own anecdotal experience as a means to ignore the weight of evidence against high fees and active management is... an interesting decision. Yours to make, of course, but interesting nonetheless.
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No he didn't. People use Bogle as an argument to allocate to gold. Bogle does not advocate investing in gold. He put 5% of his scholarship fund at Blair Academy in gold, but for individual investors he has been much more critical of it. Starting At 2:05 in this video [1] he explains:
Gold is not an investment at all! Gold, to go back to where we started, is a speculation. It has absolutely no underlying intrinsic value. You know, bonds are ultimately supported by interest coupons. Stocks are supported by dividend yields and earnings growth. And gold is supported by …. Well ? The ability to think that somebody is going to take it off your hands for more than you paid for it! It doesn’t have an internal rate of return. So it’s a speculation.
In another interview [2] he explains that if you must allocate to gold, 5% would be the limit in his opinion, but it is still a losers game.
Gold is the best diversifier of all. In the short run, it can help you if there is rampant or hyper-inflation. In the long run, it's a loser's game. It has no internal rate of return. Bonds have interest rates. Stocks have a dividend yield or earnings growth. Gold has nothing like that. It's complete speculation. If you are enamored with gold, 5% of your portfolio is okay.
Even in the above comment, Bogle is wrong. Gold has been a poor hedge against hyperinflation.
[1] https://youtu.be/KlhT07G8zGs
[2] https://www.theglobeandmail.com/report-on-business/rob-magazine/invest-like-a-legend-john-bogle/article33731856/
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Glad it's helpful! Welcome to Canada.
Your understanding of the RRSP is not correct.
You put in $14,285 - this is pre-income-tax money, say your tax rate is 30%
If you had paid taxes on this money you would have only had $10,000
You now have $14,285 in your RRSP (pre-tax contribution)
The $14,285 turns into $100,000 over 10 years (21% per year on average, nice)
When you withdraw, the full $100,000 is taxable at your tax rate at that time
Say your tax rate is 30% still. You have $70,000 after-tax
Alternative: Use the TFSA
You put in $10,000 of after-tax money
You earn 21% per year for 10 years
It turns into $70,000, free of tax
RRSP = TFSA if beginning tax rate = ending tax rate
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Aged poorly? Let's see.
Since this video was published in September 2020 the equal weighted portfolio of FB, AMZN, AAPL, GOOGL, MSFT, and TSLA has underperformed AVUV, a small cap value fund, by an annualized 19% and the Russell Top 200 Growth index has trailed AVUV by an annualized 30%.
YTD 2021 the equal weighted portfolio of FB, AMZN, AAPL, GOOGL, MSFT, and TSLA has underperformed AVUV by 4.1% and the Russell Top 200 Growth index has trailed AVUV by 11.2%.
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There's always a point of indifference. For example, you might be indifferent (financially) between buying a $1M home vs renting for $2,800 per month. In other words, as long as you rent for less than $2,800 per month you are better off financially renting compared to owning. The challenge is that the point of indifference moves based on a lot of variables. My initial example of indifference assumed investments taxed at the highest marginal tax rate. If instead you are using RRSP and TFSA accounts, the point of indifference on a $1M home is closer to $3,500 in rent. In other words, renting will put you ahead of buying financially as long as you stay under $3,500 per month.
My conclusion is that most people, including in Toronto, should max out their RRSP and TFSA accounts with long-term low-cost investments before considering buying a home. You can play with the calculator here (excel file) http://www.pwlcapital.com/pwl/media/pwl-media/PDF-files/White-Papers/Rent-vs-Buy-Calculator.xlsx
It is possible that Toronto and Vancouver are different now due to foreign flows, but there are other cities that have had similar situations in the past so I don't think we are in uncharted territory.
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Good question Barwin. The Smith manoeuvre assumes that you have a mortgage that you have not yet paid off, and a portfolio that could be used to pay off some or all of the mortgage. Doing so and then borrowing the money back on a secured line of credit to invest makes the interest tax deductible. Pretty sweet deal. Everything nets out to being the same, but your interest is now deductible. The downside is that HELOC interest is usually higher than mortgage interest, so for the spread between your after-tax interest cost on the HELOC and the interest cost on the mortgage to be interesting, you have to be in a high tax bracket.
On Ratehub I can find a 5-year variable mortgage for 2.65% while the lowest HELOC is 4.45%. If you're at the 53.53% bracket, then your after-tax interest cost is 2.07%; better than 2.65%, but not that much better. If you're lower than the highest bracket on marginal income, then this can flip quickly. If you tax rate was instead 37.91% (the marginal rate for an Ontario resident with income over $91,101 up to $95,259, then your after-tax interest cost is 2.76%.
HELOC debt is also callable. Sure, that might never happen in Canada, but you can be sure that if it does happen it will be in a terrible economic scenario, and your portfolio is not going to be in any condition to cover the loan.
Some of my above comments apply to both the Smith manoeuvre and your question. I have some additional comments on your question which is assuming you have equity in a property, and you are considering borrowing against it to invest.
I think that for real estate to be an attractive investment you have to be leveraged. The unlevered expected return is not worth the risk or hassle. If you use that leverage to invest in the market, it becomes a question of your willingness and ability to handle the risk. Could you handle it financially if the loan were called? Could you handle it emotionally if you knew the portfolio was 50% of the loan, and it might be called?
If we ran a computer model to maximize wealth it would suggest as much leverage as possible to invest in risky assets. You would end up borrowing against the property to invest in stocks, and then borrowing on margin to buy more stocks! Of course very few people do that because it is terrifying.
Does that sufficiently answer the question?
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Thanks Toni!
I think that multi factor investing is the best way to approach portfolio construction, but most multi factor products, especially ETFs, probably aren't worth their fee. Managing the way that the factors interact is one of the hardest parts of implementing a multi factor strategy. In the MSCI Multifactor ETFs it seems like there is more emphasis on quality (which shows up in a fama/french regression as profitability), and less on size and value. Profitability alone would tend to push the portfolio more toward large cap and growth which have lower expected returns. I single out ETFs specifically because ETFs are usually rebalanced semi-annually, which may not be often enough to capture factors well.
You also have to ask how the index provider is defining their factors and whether or not it aligns with the research.
I am copying and pasting from a previous reply:
MSCI’s value factor uses forward P/E, enterprise value/operating cash flow, and P/B. Forward P/E uses analyst forecasts of EPS. However, Fama/French 2006 show that analyst forecasts do not add to the overall power of profitability forecasts after controlling for size and other accounting variables including the level of lagged profitability. Other research has found that combining P/B with additional valuation ratios such as P/CF does little to improve average returns but does tend to increase portfolio turnover.
MSCI’s quality factor is measured using ROE, leverage (Debt/BE), and earnings variability. Valuation theory suggests that variables that help predict expected future profitability should be related to expected returns. ROE, which uses net income, can be affected by one-time expense variables such as extraordinary items. Research by Novy-Marx shows that you get a better proxy for expected future profits if you move up the income statement to avoid volatility from things like extraordinary items and taxes. Once you control for the level of profitability, the variability of profitability contains little additional information about future profitability. Academic studies such as Fama/French 1992 also show that once you control for size and book-to-market, leverage contains little additional information about differences in average returns.
Momentum appears to be persistent in the data and the historical premiums have been sizable, but it doesn’t have a sensible explanation which raises the question of whether it is likely to persist. It is also questionable if the momentum premium can be captured cost-effectively in diversified portfolios. Some studies have shown that, once price friction is accounted for, portfolios tracking momentum fail to generate abnormal returns (Lesmond, Schill and Zhou 2004). Differences in how the factors behave should also be considered in portfolio construction and implementation. For example, the momentum premium decays rapidly and therefore requires high levels of turnover to maintain consistent exposure to past winners. MSCI rebalances their indexes twice a year, which may not mesh well with something like momentum.
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Agree on the first bit. I said starting at 12:16:
In summary, leveraged ETFs will deliver the daily leveraged returns of an underlying asset, but their long-term buy and hold outcome can be materially affected by volatility, and some evidence suggests that the embedded leverage is priced in, reducing expected returns relative to a directly leveraged investment in the underlying asset.
The leveraged ETF would still have an implicit cost of borrowing built into the derivatives it is using to get exposure to the underlying asset. I am not sure exactly how to price that cost, but that would be additive to the pricing effect of embedded leverage, which I'm also not sure how to price. I agree that decay could go either way but I'm not sure if it makes sense to ignore it. The best way to deal with decay would be to periodically rebalance the position to maintain the desired amount of leverage in the portfolio, but that could become impractical. One of the papers that I mentioned looked at this:
The study also shows that leveraged funds can be used to replicate the returns of the underlying index, provided we use a dynamic rebalancing strategy. Empirically, we find that rebalancing frequencies required to achieve this goal are moderate—on the order of one week between rebalancings. Nevertheless, this need for dynamic rebalancing leads to the conclusion that LETFs as currently designed may be unsuitable for buy-and-hold investors.
Source: https://www.math.nyu.edu/faculty/avellane/SIAMLETFS.pdf.pdf
If I were to employ leverage myself I think that I would either use margin or use futures. The challenge with futures is that, despite their low implicit cost of leverage, they are not available for all securities. If I wanted to maintain my current portfolio with leverage I'd need to use margin. A discussion on the details of implementing a leveraged strategy could be a good video topic.
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Hi Jennyy07, I agree that owning has its set of benefits and renting has some disadvantages. The main point here is that in certain cases renting can be better than owning, and from a financial perspective the decision is pretty neutral between the two options. As a renter, I'm not sure that I agree with all of your points.
-It is not any more difficult to find a detached home for rent. Also, many owners (where I live anyway) will own a condo, town home, or one side of a duplex. I don't think that shared space is a disadvantage for renters. Most owners will also have neighbors. One disadvantage of owning is that if you end up with bad neighbors, it is harder to move.
-I agree rental vacancies in many cities are low making it harder to find a place to rent. However, those cities with high demand for housing will also have higher real estate prices. There is no guarantee that an appropriate home will be for sale *at a reasonable price*. If you genuinely cannot find a place to rent then of course there is no choice to be made.
-The rental market in both Victoria and Vancouver is scarce (<1% vacancy in Victoria), but the rents are not so high that owning would be an inherently better option. Average rent in 2017 for a 3 bedroom in Victoria was $1,568, Vancouver was $1,801. Compared to average home prices those rents leave plenty of room for additional savings.
-I agree that there is a risk of being given notice when you are not in a lease. That deserves real consideration for a renter. One solution is pushing for a longer lease. For someone with a relatively short time horizon for their housing (maybe they expect to move to a new city eventually, need a bigger house for a growing family etc.), the costs of moving are much lower for a renter than an owner.
Thanks very much for your thoughtful comments! Great perspective.
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It’s probably a little deeper than that. I asked Professor Lubos Pastor when he was a guest on my podcast.
Why do you think the active fund industry remains so big, given all this information?
You can tell a rational story or an irrational story. The typical stories are the ones based on investor mistakes. So perhaps investors don't understand how to interpret performance data, or perhaps they get confused by slick salespeople or by marketing campaigns, or perhaps everybody thinks they will be better than the average. That's the irrational story. I think some of that is going on. In the paper, you've mentioned though, we tell a rational story where even without anybody making any mistakes, active management industry is large. And that story is based on these industry level, decreasing returns to scale. Because people understand that if they move money out of that, if they move too much money out of the active management industry, they will be leaving money on the table. Because alpha of active managers is going to go up as soon as I move money out.
So it's just a matter of how much should I move out of active management in order to achieve a respectable alpha going forward. And what we discuss in the paper is that it's been very difficult to learn about the right amount. We take all data going back about 40, 50 years to the sale of the data back to the 1960s and we try to estimate to this, essentially the extent of returns to scale, we try to estimate how much alpha is going to shift when I move one dollar out. And it's very difficult. There's so much uncertainty about that estimate that it turns out it's possible to rationalize the current size of the active management industry, even with data we have. So it's not even clear that we are in the wrong spot right now.
https://rationalreminder.ca/podcast/124
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You're right. I did say that, and those 6 stocks did beat ACWI and, by a smaller margin (10% annualized), US total market since September 2020. I generally wouldn't compare US equities to ACWI; US total market is a better benchmark for US stocks. NASDAQ 100, measured by QQQ, only beat the US market measured by VTI by an annualized 0.12% over the same period.
QQQ has returned 10% annualized since inception in March 1999. DFA US Small Cap Value (which is similar to AVUV, but goes back to 1993 vs. 2019 for AVUV) has returned 11.01% annualized.
What makes me nervous about QQQ is that the last time valuations looked like they do today, in fact not even as high as today, QQQ went on to have a full decade + of meaningfully negative returns. You lost 8.02% per year on average for the decade ending February 2010 in QQQ while small value returned 8.54% per year over the same period. Even recently when large growth has been on a tear and small value has struggled, the returns for small value have been positive in absolute terms and they have not trailed large growth by as much as large growth trailed small value previously.
I also said:
With no way to predict what will do well in the short run, either at the individual stock level or the asset class level, the best thing that we can do is consistently own the entire market, value and growth, large and small, and everything in between, which we can easily do using low-cost total market index funds. If you need more excitement than that, starting with the market and then adding some extra weight to value stocks, or better yet small cap value stocks, is a much more statistically reliable bet than following the crowd into large cap growth stocks.
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Hi Gunnar, thanks for an excellent question.
DES targets dividend-paying small cap companies. We need to be careful with naive factor exposure and data mining. Dividends do not explain the differences in returns between diversified portfolios, while RMW, HML, and SMB do. Dividends are not a factor because they do not consistently explain differences in returns. Due to this, dividends are not always going to be a proxy for RMW and HML, even though it sometimes appears that they are. Focusing on dividends also massively decreases the opportunity set without any expected benefit. Based on this we would expect the factor clone analysis using DES and IWC to vary over time, which is exactly what we see.
DFA only began using RMW in 2014, so we would expect stronger RMW looking at 2014 through 2018. We also have to keep in mind that RMW is not a standalone factor that is targeted in DFA portfolios. They use profitability as a secondary filter once they have sorted by value and size. If they used profitability as a standalone factor then we would see much less exposure to HML - HML and RMW are sort of opposites. Profitability alone ends up looking like a large cap growth strategy. Anyway, bit of a digression there.
If we look at the 4-year period starting in 2014, the weights of DES and IWC required to match DFSVX vary significantly from the 12-year period and even with those clone weights we do not see similar factor exposure.
2014 - 2018: 53% IWC, 47% DES; DFASVX has RMW 0.12 with 1.801 tstat while the clone has RMW 0.00 with 0.062 tstat. Notably the weights are substantially different from the weights in your 12-year period. It is also interesting that this time around the clone has no RMW. As you correctly point out, consistent RMW exposure is important. As mentioned, we would not necessarily expect consistent RMW exposure from dividend-paying stocks.
I get a much better RMW for the clone using 76% IJR and 24% DES, but the problem (which we would expect) is that we lose HML. DFASVX has HML 0.43 with a tstat of 8.512 while the clone has HML 0.16 with a tstat of 2.890. The clone does have more RMW, but using RMW before HML results in less HML which is not necessarily what we want.
Here's a point from Larry Swedroe's summary of Robert Novy-Marx's 2013 paper on profitability:
Controlling for profitability dramatically raises the performance of value strategies, especially among the largest, most liquid stocks. Controlling for book-to-market ratio improves the performance of profitability strategies.
It does not look like IJR is controlling for value before applying the profitability screen.
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Generally mean variance optimization (MPT-based portfolio optimization) is of limited value. The inputs are based on historical returns and correlations neither of which are great predictors about the future; it can even make you worse-off.
You are correct that the risk-return characteristics for a 60/40 portfolio have been historically more favorable than for a 100% equity portfolio. Other than the previously mentioned concerns about MVO, levering a 60/40 portfolio is not practical for most investors. One of the biggest practical challenges is the cost of borrowing relative to fixed income expected returns, but there are other constraints like the limitations of callable debt (margin, HELOC), principal payment requirements, and opportunity costs (traditional mortgage). If people want to increase expected returns in practice I think that concentration makes a lot more sense than leverage until equity concentration has reached 100%. If more expected return is desired, then leverage is a consideration.
I did reference MPT in the leverage video:
The definition of well-diversified is debatable. Lots of literature suggests that even a total stock market index fund is not well diversified because it is concentrated in a single risk, market risk. Adding in independent risks, like those of small stocks, value stocks, profitable stocks, and other alternative risk premiums might lead to a more reliable result. For our purposes today, *let’s assume that you have a portfolio which you have deemed to have optimal risk-adjusted expected returns*.
Follow up materials:
https://www.advisor.ca/investments/market-insights/stop-playing-with-your-optimizer/
aqr.com/Insights/Research/Alternative-Thinking/Why-Do-Most-Investors-Choose-Concentration-Over-Leverage
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There's a lot to unpack here. Nick and anothercrappypianist you both raise good points. Thanks for starting a good discussion.
Canadian eligible dividends are taxed more favorably at lower levels of taxable income. For taxable income above $95,259 in Ontario in 2019, eligible dividends are taxed at a higher rate than capital gains. That piece is situation-dependent, so there's no way to make a blanket statement.
The other important point that Nick mentioned is tax drag. Even if we are talking about a situation where eligible dividends are taxed more favorably than capital gains, the important difference is that we are comparing tax on dividends received every single year to capital gains which may be deferred for many years. It becomes a present value problem. The longer we can defer the capital gains, the lower the effective annualized tax rate becomes. I'd rather earn deferred capital gains than any kind of taxable dividends, assuming that I have a long time horizon.
The only exception might be low income situations (sub $47,630 taxable income) where eligible dividends have a negative tax rate due to the dividend tax credit. However, in that case I would expect that there is ample RRSP and TFSA room available, making this a non-issue.
Lastly, we have to keep dividend yield in mind. Canadian stocks tend to pay a higher yield than US stocks. I ran the numbers on this a while ago, and found that the higher yield of Canadian stocks negates the more favorable tax treatment (at the highest tax bracket at least), making Canadian stocks no more tax-efficient than US stocks. You're paying a lower % of tax on a higher % of dividend, and I observed it to be pretty close to a wash.
I dig into a lot of this in an upcoming video on swap-based ETFs which convert all returns (including dividends and interest) into capital gains.
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Keep in mind though that from a cash flow perspective, by the time the owner pays off their mortgage, the renter (assuming they were disciplined) will have enough cash flow from their portfolio to cover their rent.
In Ontario, Canada, a landlord can kick you out after a lease, but I believe they have to give 60-90 days notice depending on the circumstances, and they can only kick you out to do a major renovation, or to allow a family member to move into the unit.
My answer to that has always been that if you push for longer leases, and know your landlord's situation, then you are less likely to run into issues. I would never rent from a "real estate investor" who owns one or two properties. I would rent from an established property manager with purpose-built rentals, or I would know in detail the situation of the owner to minimize the chances of an unexpected eviction.
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Thanks!
Good question Charles.
You will run into some issues with Norbert's Gambit in your situation. The issues are:
1. XAW does not have a US listed counterpart. You would instead need to break up your portfolio into the three US listed ETFs that replicate XAW (ITOT, IEFA, IEMG). This increases the mental overhead to manage the portfolio, and depending on your brokerage it may also increase the costs of implementation due to having to place multiple trades.
2. Norbert's Gambit is a relatively cheap way to convert money, but it still has costs. The trading commission on small amounts will eat away at the tax savings very quickly. For example, ITOT has a 1.8% trailing yield. Holding ITOT as opposed to a Canadian listed US equity fund in an RRSP eliminates the 15% withholding tax that the US government imposes on dividends leaving the country. So your savings are approximately 0.27% per year, or $2.70 per year on $1,000. It would take a few years for the tax savings to outweigh the costs if you convert each $1,000 contribution.
You could wait until you have a larger sum in cash before converting, but then you would be missing out on expected returns while you wait. You could also invest in XAW in your RRSP for now, and then break it out into the US listed components when you have accumulated a large sum in XAW.
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Hi Lynn, here is the same preview from my upcoming video on asset allocation that I shared in response to your other comment:
The optimal mix between Canadian, US, International developed, and emerging markets stocks in a portfolio is an unknown. This makes the geographic asset allocation choice mostly arbitrary, as long as global exposure is achieved.
Most model portfolios, including PWL Capital’s, Wealthsimple’s, Vanguard’s asset allocation ETFs, and the Canadian Couch Potato portfolios have a heavy bias toward Canadian stocks, at about ⅓ of the equity allocation. This might be surprising when it is considered that Canadian stocks make up about 3% of the global market cap. Why so much in Canada? It comes down to tax treatment.
I have talked in the past about unrecoverable foreign withholding tax on foreign dividends in registered accounts, which is an issue that you will never have with Canadian stocks. Further to that, in a taxable account Canadian dividends receive preferential tax treatment. With asset allocation being a somewhat arbitrary exercise, assuming some level of global diversification, favouring a tax efficient asset class is sensible.
We have established that it is sensible to diversify globally to attain exposure to the stock market, and it might make sense to be overweight Canadian stocks relative to the market to reduce the impact of both foreign and domestic taxes.
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@razorockIB I would call this blatant misinformation. First of all, your comment on great business doing well while the economy does not do well is true. However, the other side of that coin is that while capitalism as a whole continues to function, many individual business, no matter how great someone thinks they are, will fail. The probability of a business doing better than the market while capitalism fails is small. The probability of capitalism continuing to deliver a positive risk premium while many individual businesses fail is very high.
Analysis of an individual business does not offer any improvement in your expected outcome. At best, it gives you a psychological crutch to lean on when markets drop. It does not give you an objective advantage over the market. Even Warren Buffett's returns can be explained by exposure to known risk factors, not by his stock picking ability.
Index funds are my niche, sure, but I am doing everything that I can to provide truth based on evidence. Spreading the idea that you can have a better outcome by picking stocks is irresponsible, in my opinion.
The evidence of the ability of anyone to have skill in securities markets is questionable at best.
Stock picking works for you and that's great. I could never get behind the idea that it is a sensible approach to investing, and I would certainly never agree that picking stocks allows you to reach your goals faster. It might work out that way. But more likely will have the opposite effect.
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@anothercrappypianist VVL/VMO/VLQ are straight up actively managed in the sense that they are selecting individual stocks. Using factor models, sure, but still selecting stock.
The portfolio management team selects stocks and constructs the portfolio using quantitative models that are designed to achieve targeted exposure to the value factor. In contrast to indexing’s fixed rebalancing schedule, the team adjusts the portfolio as needed to maintain exposure to the factor while considering transaction costs.
XCV and XFC are more in line with an index strategy as they are tracking indexes as opposed to selecting stocks, but they're still not ideal.
XCV tracks an index with 57 constituents that rebalances annually. 57 securities is arguably not diversified enough to offer factor exposure, and even if it is, annual rebalancing is probably not enough to capture the value factor.
XFC claims to offer multiple factor exposure. There are a handful of issues with implementing a factor product. It is not always clear which factors you want exposure to and why. Once you know the factors that you want exposure to, you are unlikely to get consistent exposure through an ETF due to the way that ETFs are implemented.
For example, XFC tracks the MSCI Canada IMI Select Diversified Multiple-Factor (CAD) Index which targets Value, Momentum, Quality and Low Size.
MSCI’s value factor uses forward P/E, enterprise value/operating cash flow, and P/B. Forward P/E uses analyst forecasts of EPS. However, Fama/French 2006 show that analyst forecasts do not add to the overall power of profitability forecasts after controlling for size and other accounting variables including the level of lagged profitability.
Momentum appears to be persistent in the data and the historical premiums have been sizable, but it doesn’t have a sensible explanation which raises the question of whether it is likely to persist. Even if we assume that it will persist, the momentum premium decays rapidly and therefore requires high levels of portfolio turnover to maintain consistent exposure to past winners. The index reconstitutes semi-annually which makes it challenging to capture the momentum factor.
MSCI’s quality factor is measured using ROE, leverage (Debt/BE), and earnings variability. Valuation theory suggests that variables that help predict expected future profitability should be related to expected returns. ROE, which uses net income, can be affected by one-time expense variables such as extraordinary items. Research by Robert Novy-Marx shows that you get a better proxy for expected future profits if you move up the income statement to avoid volatility from things like extraordinary items and taxes. Once you control for the level of profitability, the variability of profitability contains little additional information about future profitability. Academic studies such as Fama/French 1992 also show that once you control for size and book-to-market, leverage contains little additional information about differences in average returns.
As mentioned above, the index reconstitutes semi-annually. Stocks migrate across factor exposures over time. Consistent factor exposure requires more frequent maintenance. It's like buying a bunch of small caps today and hoping they stay small for the next six months. In reality, half of them may have become mid caps after six months.
The size premium basically goes away when you include small cap growth stocks with low profitability in the small cap return. Those stocks are included in any small cap index, so capturing the factor exposure is hard to do, especially considering that small cap products will usually have higher MER, higher turnover, and may need to be purchased in USD due to the lack of Canadian products. Using a small cap value ETF is probably the best approach. VSS (not small value) has about 15% overall is in small cap growth according to Morningstar. VBR is a little better with only 4% in small cap growth.
I have a video coming out on small caps specifically, but I agree that a video on retail factor exposure in general would be good.
Sorry, that was a long response.
It's great to know that you're listening to the podcast!
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@deanoudhini7292 Let's work through this one. Say you have a $2m taxable portfolio. You can choose between investing in a portfolio that pays only dividends, or a portfolio that only accrues capital gains. In both cases the total annual return is 4%, and we receive one lump-sum income payment at the end of the year.
If we invest in the dividend-only portfolio we earn $80,000 in eligible dividends, and our capital does not increase. We pay about $3,400 in tax.
If we invest in the capital gains only portfolio, our $2m portfolio increases in value to $2.08m by the end of the year, and we create our own dividend by selling $80,000 of the portfolio. With a market value of $2.08m and a cost basis of $2m, this self-made dividend triggers a capital gain of $3,100, half of which is taxable.
The tax owing? $0.
For the dividend investor it gets even worse. Not only do they pay tax, but they have to gross up their dividends by 38% for tax purposes. OAS clawback is calculated on grossed up dividends, so our dividend investor ends up losing nearly all of their OAS, over $5,000.
For the capital gains investor to pay more tax than the dividend investor, their capital gain on $80,000 of self-made dividend would need to be about $55,000 of gross capital gain. That takes some serious returns to achieve - it's not realistic in most cases.
Dollar for dollar at low tax rates I agree eligible dividends are the most tax efficient. In real life, capital gains are more tax efficient especially in the $ range that we are talking about (75-80k) due to OAS clawback.
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Aged poorly? Let's see.
Since this video was published in September 2020 the equal weighted portfolio of FB, AMZN, AAPL, GOOGL, MSFT, and TSLA has underperformed AVUV, a small cap value fund, by an annualized 19% and the Russell Top 200 Growth index has trailed AVUV by an annualized 30%.
YTD 2021 the equal weighted portfolio of FB, AMZN, AAPL, GOOGL, MSFT, and TSLA has underperformed AVUV by 4.1% and the Russell Top 200 Growth index has trailed AVUV by 11.2%.
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I think you would be financially independent if dividends were supplying all of your income.
Unemployment: Given the concept of unemployment as the unutilized supply of labour, the operational definition of unemployment is based primarily on the activity of job search and the availability to take a job. In addition to being conceptually appropriate, job search activities can, in a household survey, be objectively and consistently measured over time. The definition of unemployment is therefore the following.
Unemployed persons are those who, during reference week:
were on temporary layoff during the reference week with an expectation of recall and were available for work, or were without work, had looked for work in the past four weeks, and were available for work, or had a new job to start within four weeks from reference week, and were available for work.
https://www150.statcan.gc.ca/n1/pub/71-543-g/2010001/part-partie2-eng.htm
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The answer is that it depends on how much excess factor exposure you are targeting. For example, the Dimensional US Adjusted Market 1 Index is a US total market index that slightly increases the weight of securities with factor exposure relative to the market.
10/1/1969 - 9/30/2019 (50 years)
Annualized Return
CRSP 1-10 (Market): 10.36%
Dimensional US Adjusted Market 1 Index: 11.46%
Standard Deviation
CRSP 1-10 (Market): 15.50%
Dimensional US Adjusted Market 1 Index: 15.73%
Lowest 1-Year Return
CRSP 1-10 (Market): 42.48%
Dimensional US Adjusted Market 1 Index: 43.19%
Data source: Dimensional Returns Web
Index description:
June 1927 - December 1974: Dimensional US Adjusted Market 1 Index Composition: Targets all the securities in the Eligible Market with an emphasis on companies with smaller capitalization and lower relative price. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and Investment Companies Source: CRSP and Compustat
January 1975 - Present: Dimensional US Adjusted Market 1 Index Composition: Targets all the securities in the Eligible Market with an emphasis on companies with smaller capitalization, lower relative price, and higher profitability. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and Investment Companies Source: CRSP and Compustat
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Seth Klarman had similar commentary in his 1991 book Margin of Safety:
I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron’s has pointed out, “A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing.” When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.
I disagree on both accounts. Index funds are responsible for a tiny fraction of trading; Vanguard and Blackrock have both estimated roughly 5% of trading is done by index strategies. Trading sets prices. Even beyond that, indexing is still a relatively small part of the market in terms of asset ownership. Of total assets index strategies, including non-fund index mandates run by institutions, own somewhere around 20% of assets.
My next video addresses the concept of indexing setting prices.
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Thanks! From the paper:
Out of the 1,021 rolling 12-month investment periods we analyzed for the U.S. markets, LSI investors would have seen their portfolios decline in value during 229 periods (22.4%), while DCA investors would have seen such declines during only 180 periods (17.6%). Furthermore, the average loss during those 229 LSI periods was $84,001, versus only $56,947 in the 180 DCA periods. The allocation to cash during the DCA investment period decreases the risk level of the portfolio, helping to insulate it from a declining market.
It is essential to point out, however, that this temporarily cash-heavy asset allocation is much more conservative than the investor’s true target allocation (the one that will exist after the DCA period) and that, while this short-term deviation from the target provides some relative protection from market downturns, it does so by sacrificing some potential for greater portfolio gains. As with any asset allocation decision, investors must determine for themselves whether or not reducing their portfolio risk in an attempt to avoid losses and regrets is worth reducing the potential for higher returns.
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There is little question that the value of a firm drops when a dividend is paid - you are questioning (with no basis other than your own statements so far, I might add) whether the price reflects the value.
In an efficient market prices should be reflections of values, but market efficiency is a flawed model (like every model is). Markets are not perfectly efficient, and were never proposed to be. Dividend irrelevance is similarly a model, and like any model it is inherently flawed. A model being flawed does not mean that its usefulness in decision making is reduced. The theory of dividend irrelevance is at the core of the Fama French five factor asset pricing model which is able to explain well over 90% of the differences in returns between diversified portfolios.
Whether the market is perfectly efficient or not, if an asset pricing model based on market efficiency (and dividend irrelevance) is able to consistently explain differences in returns, including explaining anomalies like low beta, and the higher average returns of dividend stocks, is the model still useful? I would say that it is.
So, in short, market efficiency and dividend irrelevance do not need to be perfect descriptions of the real world (which they are certainly not) in order for them to be useful in understanding where expected returns come from.
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I get the argument, but how did this couple accumulate the $2.86m in their taxable account? Why were they not using their RRSP and TFSA?
I used this example in another reply, but it applies here too:
Example: Let’s say you have an income of $100,000 and assume your marginal tax rate on income is 40% and on eligible dividends its 30% while you’re working. At the end of the year you could choose to max out your RRSP with $18,000, or you could invest $10,800 ($18,000 minus 40% tax) in a taxable investment account and buy dividend stocks. Say the RRSP and the taxable account both earn a 4% dividend and 2% capital gain each year, but in the taxable account we lose 30% of the dividend to taxes. By year 20, the RRSP is worth $58k while the taxable account is worth $28k. Now, the RRSP still has to pay tax, but rather than the 40% we were deferring when we made the contribution, we are only paying 20% based on a taxable income of $59k (which after 20% tax = the $47k of dividends that could be earned tax-free in a taxable account). Even if we take off the 20% in taxes, the RRSP is worth $46k vs the $28k in the taxable account – and I didn’t even take off capital gains tax from the taxable account. So, if our investor used their taxable accounts to accumulate in lieu of the RRSP with the intention of living off of dividends, they shot themselves in the foot.
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That is correct. Doomsday predictors are excited about an inverted yield curve. I would not allocate to gold, especially tactically. Gold has not been a great hedge against anything.
From this blog post https://www.etf.com/sections/index-investor-corner/swedroe-dont-be-distracted-golds-glitter
In terms of being a currency hedge, they found the change in the real price of gold seems to be largely independent of the change in currency values. In other words, gold is not a good hedge of currency risk.
As for gold serving as a safe haven, meaning that it is stable during bear markets in stocks, Erb and Harvey found gold wasn’t quite the excellent hedge some might think. It turns out 17% of monthly stock returns fall into the category where gold is dropping at the same time stocks post negative returns. If gold acts as a true safe haven, then we would expect very few, if any, such observations. Still, 83% of the time on the right side isn’t a bad record.
In terms of gold’s value as an inflation hedge, the following example should help provide an answer. On Jan. 21, 1980, the price of gold reached a then-record high of $850. On March 19, 2002, gold was trading at $293, well below where it was 20 years earlier. Note that the inflation rate for the period 1980 through 2001 was 3.9%. Thus, gold’s loss in real purchasing power was about 85%. How can gold be an inflation hedge when, over the course of 22 years, it loses 85% in real terms?
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Getting the specific factor exposure that dividend aristocrats has had is tough to do with a value fund because you would only expect value exposure. Aristocrats has historically had exposure to the value and profitability factors. VIVAX is giving you value but no profitability. Until there are some better products out there to target value and profitability I think that just going for value is probably the best bet.
Your comment about luck is insightful. Yes, you are correct. The way that we can measure "luck" (or skill) is through alpha, or the amount of return that is not explained by exposure to factors. In the case of NOBL, the annualized alpha has been +1.19% with a low t Stat, indicating statistical insignificance. In other words, those excess returns were likely due to luck.
The greater systematic risks with the aristocrats index are exposure to value stocks and profitable stocks. Value stocks are priced by the market as being risky. Profitability is a bit less intuitive, but once we control for relative price (price relative to book value), a more profitable stock must have an additional risk baked into the price. So two stocks side by side, one has more robust profitably, but they have the same relative price, the more profitable stocks must be viewed as riskier by the market.
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We discussed that in detail here https://rationalreminder.ca/podcast/84, including why their track record doesn't matter to an investor evaluating their funds today. Excerpt:
Why is [explaining Mawer's returns with factor exposure] relevant now? Because now the academic research has caught up. The theory has caught up. The empirical evidence has caught up. If you're an investor today looking at Mawer’s track record, it's like, for international equity, you could have come pretty close with a good mix of factor exposure that we are now are totally aware of. For Canadian market, you could have done better in perfect hindsight, but now we have this information. For US equity, they underperformed anyway and value did better over that time
period.
It's tricky, right? Because you're looking at Mawer’s past performance. Yes, they've beaten the market, the market cap weighted index. Value tilted index with a bit of a profitability filter, not so much. It's not as obvious. Forward-looking, it's like, are you better off with a relatively concentrated portfolio, because these are; Mawer’s much more concentrated, which of course that's one of their benefits. That's what they're doing well. They've got high active share. Can we reliably say that they're going to continue to deliver the type of returns that they have? Well, have they even generated alpha? Not statistically. Then what should we expect going forward, it's a huge question mark.
Anyway, I think this is an important discussion, because there are other funds like Mawer. I mean, this is a mini – not as sophisticated version of the Buffett's alpha paper, where you look at okay, this active fund has done really well. Can we explain that performance with what we now know to be true about how markets work?
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@RazoRock ///"So basically, you are trying to outsmart the idea of just buying an index fund that tracks the growth of the global economy?
You see the flaw here? How do we know that your weighting system and profitability screen is more effective than just buying the MSCI World Index?"///
I like your quote formatting.
You are putting your lack of a fundamental understanding of the theoretical backbone of finance on display. In an efficient market investors are compensated for taking risk. There are multiple independent risk premiums that explain nearly 100% of the differences in returns between diversified portfolios. In other words, if we take two portfolios with different returns, about 98% of the return difference will be explained by exposure to risk factors not by security selection or market timing.
The most widely accepted risk factors are market beta, company size, relative price, gross profitability, and investment. Exposure to the market, small cap stocks, value stocks, stocks with robust profitability, and companies that invest conservatively, each offers an independent risk premium. A market cap weighted index fund only offers exposure to market beta. Increasing the weights of certain stocks within an index offers exposure to the other risk factors.
There is no flaw. This is all evidence based to its core. Nothing arbitrary or wishful. No intuition. No assumption of skill or outsmarting the market.
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That is incorrect.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2553889
The size premium has been challenged along any fronts: it has a weak historical record, varies
significantly over time, in particular weakening after its discovery in the early 1980s, is concentrated among microcap stocks, predominantly resides in January, is not present for measures of size that do not rely on market prices, is weak internationally, and is subsumed by proxies for illiquidity. We find, however, that these challenges are dismantled when controlling for the quality, or the inverse “junk”, of a firm. A significant size premium emerges, which is stable through time, robust to the specification, more consistent across seasons and markets, not concentrated in microcaps, robust to
non-price based measures of size, and not captured by an illiquidity premium
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Thanks. I try to keep a balance between getting the point across and digging into every detail. You are right, there are many variables that go into these rent vs. buy examples.
I currently think about this in terms of 5%. If I can rent for 5% or less of the value of a home, then renting is the better deal. 5% is my estimate for the total unrecoverable costs of owning: 1% property tax, 1% maintenance costs, 3% cost of capital (interest on debt, opportunity cost on equity).
So for a $700,000 home, the total unrecoverable costs would be $35,000, or $2,916 per month. If I can rent for less, I would expect to be better off (strictly from a financial perspective), renting.
It goes the other way, too. If I find a place that I love for rent for $4,000 per month, then $4,000 X 12 / 5% is the equivalent cost of a home that I would be paying for. This helps to contextualize rent as a lifestyle choice. Am I comfortable with the housing costs equivalent to a $960,000 home? You're paying it whether you rent or own. Rent is just easier to see.
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You do not need to apologize to me.
You do realize that in this short discussion you have drawn on Taleb, and then offered an example of an individual outcome as basis for an argument, right? Do you not see the problem there? Are you sure that you have read Taleb? I am now skeptical. I am all for a good discussion; this one is lacking substance.
You sir, have been fooled by randomness. It may be time to rethink your view of the world. Or, at the very least, read the books that you say you are basing your thinking on :)
Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).
...
One can illustrate the strange concept of alternative histories as follows. Imagine an eccentric (and bored) tycoon offering you $ 10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realization would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death. The problem is that only one of the histories is observed in reality; and the winner of $ 10 million would elicit the admiration and praise of some fatuous journalist (the very same ones who unconditionally admire the Forbes 500 billionaires). Like almost every executive I have encountered during an eighteen-year career on Wall Street (the role of such executives in my view being no more than a judge of results delivered in a random manner), the public observes the external signs of wealth without even having a glimpse at the source (we call such source the generator.) Consider the possibility that the Russian roulette winner would be used as a role model by his family, friends, and neighbors.
Edit:
I figure it's worth adding here that Warren Buffett does not care about dividends. Please go and read his 2012 letter to shareholders starting on page 19 https://www.berkshirehathaway.com/letters/2012ltr.pdf
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Makes sense on the surface, but the piece that you need to keep in mind is the cost of capital. It is not your mortgage payment that you need to compare to rent, but your cost of capital. That is mortgage interest + opportunity cost of equity.
For example, a $1m home with 20% down and 80% financed with a 3% mortgage: The opportunity cost on the $200,000 down payment might be 3% (6% expected return on stocks minus 3% expected return on real estate); that's $6,000 per year. The interest cost on $800,000 at 3% is $24,000 per year. Add on another 2% total for estimated property tax and maintenance and you have $50,000 in total annual unrecoverable costs. Subtract from that the rental income (before tax), and you have $23,600 of unrecoverable costs, or about $2,000 per month. Once you take taxes off of the rental income you might be back closer to the $2,400 that you were paying in rent. Now I don't know if the house you bought was $1m, so my example may be way off.
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We can still have inflation. Major bouts of inflation have not historically been caused by QE, so there is no reason to believe that inflation is gone because QE (which is relatively new) is not necessarily inflationary. We discussed this in a few podcast episodes with guests who know more about economics than I do.
https://rationalreminder.ca/podcast/110
But anybody that suffered through first year economics was told if you increase the money supply, you eventually end up with an inflation problem. Well, in secondary economics, they tell you that's actually not quite true.
And the way it works is, if you inject additional money in the economy, as that money circulates through the hands of businesses and investors and consumers, it will be used to buy products. And if that happens and you don't increase the supply of the products, you will bid up prices and that's what we call inflation.
https://rationalreminder.ca/podcast/106
The amount of total money in society can be a factor, there's no doubt about it. So this is why you watch credit creation indicators as a sign of what's happening, both in the real economy and with inflation. Remember, the quantitative easing that we're seeing from the Central Bank and the money that's created with it is not even offsetting the money that's being destroyed through the contraction of private credit, because of the downturn and the loss in incomes and the canceled investment plans, and so on.
On the net basis, the total amount of credit in the economy is not going anywhere. There's huge excess capacity in industries, and that combined with competition, is going to keep a lid on prices. You have seen very weak indicators from consumer prices from wages and other things. So the idea that this will inevitably lead to inflation is wrong, both by looking at the current macroeconomic conditions, and looking at the experience of other countries that have been doing this for decades, and still haven't ended up like Zimbabwe.
It's not to say that you can't end up like Zimbabwe, you can, but what the central bank is doing now has nothing to do with that.
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Very true, and I would never suggest that it is worth a 100 bp fee solely for access to Dimensional. However, a 100 bp fee (or, hopefully, less), should be paid for many other non-portfolio services, like a combination of financial planning, financial advice, tax minimization etc. regardless of what the portfolio is invested in. For anyone who values what they are getting for that fee, regardless of the portfolio, I would not call it a 100 bp cost for access to Dimensional.
Based on Dimensional's factor exposure in the products that we use, and based on 50% of the historical premiums (maybe a good conservative estimate for the future?), Dimensional would be expected to deliver about 20 bps of excess return over the market. That's over the market, so compared to an ETF with a 10 bp fee, that's 30 bps excess return.
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So the argument goes. The problem that you run into is that the tax liability is not only a function of the tax treatment of the asset, but the returns of the asset. Comparing VTI in a TFSA to VTI in an RRSP misses this point. We should be comparing VTI in an RRSP to IEFA in an RRSP. All else equal VTI looks better, but this ignores the fact that all else is not equal - the relative tax savings are not guaranteed because the relative returns are not guaranteed.
This would be a non-issue if attempts to optimize asset location did not add complexity and risk. The added complexity comes mostly from the need to take after-tax asset allocation into account in the portfolio management process (video on that is forthcoming). The risks come from the potential for tax changes and the uncertainty of future returns. Trump decides to take away the RRSP withholding tax exemption, and instead adds an additional tax. That optimal asset location is no longer so attractive. US underperforms for 10 years, same story.
Favoring bonds in the RRSP is also generally flawed. It is a requirement to take the initial tax savings into account when comparing the RRSP to a taxable investment account. For example, at a 20% tax rate investing $10,000 in the RRSP must be compared to investing $8,000 in a TFSA. When this is accounted for properly it becomes clear that there is really no difference between holding bonds in the RRSP vs. TFSA. There are other issues, like premium bonds, which make bonds relatively tax inefficient in taxable accounts, but that should not last forever.
In any case, I think most DIY investors will find some happy medium that works for them, or at least feel "good enough". I don't think there is an optimal solution. I do agree that once the registered accounts are full, it's a good problem to have!
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I disagree that there is an imputed income (rent) that needs to be considered in addition to the cost of capital. That is accounted for by the cost of capital, whether through leverage or through the opportunity cost of equity. A homeowner does not have any implied income through not having to pay rent. A renter pays to borrow a residence. An owner pays to borrow money (interest) /use their own money (opportunity cost).
I did take leverage into account. My example used a 20% down payment. I did not assume equity stripping to buy more properties, but an investor in stocks could do the same thing so that's not an advantage.
On market efficiency, funny, I made the same points in the paper on which this video is based:
Public equity and fixed income capital markets are generally accepted as being mostly efficient, most of the time (Fama, 1970). They are at least efficient enough to make exploiting inefficiencies consistently extremely unlikely (Carhart, 1997). This characteristic of public capital markets is driven by liquidity, the low cost of information, low transaction costs, a high volume of transactions, and numerous market participants. The private real estate market shares few of these characteristics. Knowledge specific to each property and location may impact the price, and that information may not be readily available to both parties in a transaction. This may create opportunities for a skilled investor with low-cost access to quality information. The question that any investor has to ask is whether or not they are skilled and well-informed party.
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I appreciate the discussion on the topic, but this one is not a point of opinion. It is mathematics. The only thing that matters to your after-tax net worth is your after-tax asset allocation. What you see in your accounts (pre-tax) means nothing to your ultimate result. The 60/40 will only act differently than the 75/25 *pre-tax*, which is a meaningless comparison because you cannot access your pre-tax dollars.
Let's say that you have $1m 60/40 pre-tax allocation like my example in the podcast. You put $400k in the RRSP and $600k in taxable. Assume a 50% tax rate, which means that your after-tax allocation is 75/25. Say we have a 50% stock decline while bonds stay flat. Your portfolio could fund a $500,000 liability at that moment ($300k from stocks in the taxable account + $200k in after-tax bonds from the RRSP). Let's instead say we had a 75/25 mix in both the RRSP and taxable accounts: $300k in stocks + $100k in bonds in the RRSP, and $450k in stocks and $150k in bonds in the taxable account. Both the pre and after-tax allocations are 75/25. Stocks drop by 50%, now you have $150k in stocks + $100k in bonds in the RRSP, and $225k in stocks and $150k in bonds in the taxable account. If you liquidate, you again have $500k after-tax. $75k in stocks + $50k in bonds from the RRSP, and $225k in stocks and $150k in bonds from the taxable account. So, in a 2008 scenario, you are indifferent between the two portfolios with the same after-tax allocation. Your ability to fund your liabilities is impacted in exactly the same way. Do you agree now, after seeing the math?
The point on basing location decisions on what is most tax efficient at a point in time ignores the (potentially substantial) tax cost of reshuffling the locations when circumstances change. Interestingly, bonds are not the most efficient asset class to hold in the RRSP at this time - Internationals stocks are. If we control for the higher after-tax allocation to stocks, there is no advantage to bonds in the RRSP. In fact, there is a disadvantage. That was one of my last points in episode 36 if I remember correctly. An accidental 75/25 is less efficient than an intentional 75/25 with all International stocks in the RRSP.
Thank you for listening to the podcast, watching the videos, and especially for commenting!
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@razorockIB Thanks for the ongoing discussion!
I agree with you regarding the windfall examples. Keep in mind, though, that if the person receiving the windfall already had a maxed out their RRSP, they will no longer be able to take advantage of the zero tax rate on dividend-only income. They will have CPP and RRIF minimums to deal with, eroding the benefits of a dividend-only portfolio. I think the idea of having an investor with a magical $2m taxable investment account with no other income or assets is unrealistic.
Even if this is a realistic case for some people, the relative tax efficiency of a dividend-only portfolio is only marginally better than earning a mix of dividends, and unrealized and realized capital gains.
There is no question that Canadian dividends are tax efficient, but not by that much compared to a mix of capital gains and dividends. The question is whether or not the marginal gains in tax efficiency outweigh the lack of diversification inherent in owning dividend paying stocks.
On the flaws that you pointed out:
a) I assumed that the gain was never realized, so it's a non-issue for the example.
b) We are not discussing most people, we are discussing someone who needs $47k of after-tax income which they can either get from tax-free eligible dividends, or from
$59k of regular income from an RRSP/CPP/OAS. The tax rate on $59k of income is less than 20%, so I was being generous.
c) If you pass away with a big RRSP you pay tax on it (unless you have a living spouse). If you pass away with a large taxable investment account you pay tax on the as-yet unrealized capital gains (unless you have a living spouse). We cannot ignore the unrealized capital gains. The RRSP will pay tax at a higher rate on death, but that is only because the taxable dividend investor paid more tax tax earlier.
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Agreed. It was not a good example. Sorry, everyone.
https://www.project-syndicate.org/commentary/how-covid19-pandemic-affects-financial-market-narratives-by-robert-j-shiller-2020-03
To see this, consider that the stock market in the United States did not crater when, in September-October 1918, the news media first started covering the Spanish flu pandemic that eventually claimed 675,000 US lives (and over fifty million worldwide). Instead, monthly prices in the US market were on an uptrend from September 1918 to July 1919.
Why didn’t the market crash? One likely explanation is that World War I, which was approaching its end after the last major battle, the Second Battle of the Marne, in July-August 1918, crowded out the influenza story, especially after the armistice in November of that year. The war story was likely more contagious than the flu story.
Another reason is that epidemiology was only in its infancy then. Outbreaks were not as forecastable, and the public did not fully believe experts’ advice, with people’s adherence to social-distancing measures “sloppy.” Moreover, it was generally believed that economic crises were banking crises, and there was no banking crisis in the US, where the Federal Reserve System, established just a few years earlier, in 1913, was widely heralded as eliminating that risk.
https://www.tandfonline.com/doi/full/10.1080/21645515.2019.1607711
https://royalsocietypublishing.org/doi/pdf/10.1098/rstb.2001.1012
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Good point on the hassle factor of GICs, Grant.
ZDB has paid off so far. Despite lower pre-tax performance since inception, it has beaten ZAG by about 30 bps per year after-tax on average. One thing to keep in mind, though, is that as interest rates rise, we will start seeing more discount bonds across the board, leading to capital gains in bond funds. ZDB will be distributing these gains. ZAG will have losses to carry forward to offset gains.
I am not convinced that GICs are comparable to bonds in terms of expected returns. Forget about the past 30 years. Even the past 5-years, which have not been the greatest for bonds, ZAG has averaged 3.32% pre tax vs. somewhere around 2.5% for a 5-year GIC ladder. After tax, ZAG is 1.80% vs. 1.20% for a GIC ladder. I used the average GIC rates available through National Bank for the comparison, so you could squeeze out more going direct to EQ bank etc which might make GICs look better.
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Correct DFA is not available to retail investors which is unfortunate.
I am always skeptical of ETFs that attempt to capture factor returns. Most factor products, including this one, use factors that may not be robust.
For example, DEUS uses quality as a factor defined as a composite of profitability, efficiency, earnings quality and leverage. Valuation theory suggests that variables that help predict expected future profitability should be related to expected returns. ROA, which uses net income, can be affected by one-time expense variables such as extraordinary items. Research by Robert Novy-Marx show that you get a better proxy for expected future profits if you move up the income statement to avoid volatility from things like extraordinary items and taxes. Once you control for the level of profitability, the variability of profitability contains little additional information about future profitability. Academic studies such as Fama/French 1992 also show that once you control for size and book-to-market, leverage contains little additional information about differences in average returns.
The other concern is implementation. Russell rebalances their indexes annually. By restricting rebalancing to once a year the portfolio is exposed to substantial style drift. For example, a value stocks may not stay a value stock, and small may become large, reducing exposure to the factors until the next reconstitution. Furthermore, the risk controls on security/sector/country weights are only applied at reconstitution, which means the portfolio can deviate substantially from market cap weights between reconstitution dates.
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Oh I did factor that in.
Property tax is relative to value so it will not stay the same over time. Maintenance will at least rise with inflation. The mortgage will be gone. The biggest cost for the owner is the opportunity cost of capital. This is an implicit cost which increases with rising equity in the home. If the renter has a $1,000,000 portfolio and the owner has a $1,000,000 home, then the owner's costs include property tax, maintenance costs, and the difference in expected returns between real estate and stocks/bonds on $1,000,000. The combination of those unrecoverable costs will in many cases exceed the cost of renting. The comparison that I do in the video factors all of that in, including rent increases.
I agree that discipline is the biggest issue here. I bet the majority of renters will not actually save the required amount to make renting a good decision.
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