By Tom Bradley

Boyd Erman wrote an article before Christmas titled “Squeeze Is On For Smaller Investment Firms.” When I saw the headline, I shuddered a little. Was he going to talk about firms that don’t have billions of dollars under management? Was he going to burst my bubble?

Well, after a couple of sentences I realized the article was about the “sell” side of the Street in these treacherous markets – the investment dealers that research, sell, trade and underwrite securities. Phew.

But what about the asset managers? How does the size challenge reveal itself on the buy side?

Let me say off the top that it’s not nearly as scary. Certainly, the smaller independent firms would like to have more scale in areas such as sales and marketing, compliance, processing and administration. But there are some significant differences that make the buy side a friendlier place for the small fry.

First and foremost, asset management is not a capital-intensive business. Investment firms that manage money for clients need enough capital to fund operations and satisfy regulatory requirements, but a large capital base is nothing more than a drag on profit margins.

As for what drives money management – investment research – the playing field was leveled in 2000 when Regulation FD came into effect in the U.S. Reg FD prevents the selective disclosure of nonpublic information. In other words, an analyst from a mega-firm can’t (or shouldn’t) hear something from a CFO that hasn’t already been disclosed to the public. Today, when corporations do their quarterly conference calls, small managers can listen in just like the big players.

But more importantly, the buy side is less threatened by large firm domination because it’s an anti-scale business – the bigger a manager gets, the more difficult it is perform. While this adage has generally proven out, each area of the business is affected differently.

In general, our relatively illiquid Canadian market is a challenge for large firms. Equity managers with a few billion dollars to invest are forced to concentrate on the largest 80 to 100 stocks.

Size is less of a constraint outside of Canada. The U.S. and overseas markets offer a broad array of companies to invest in. Indeed, it’s possible to be too small for international investing, as a minimum commitment is necessary to deal with the number of offerings, longer travel distances and different regulatory regimes. It can be done with a small, experienced team, but a global footprint helps overcome these hurdles.

A manager also needs critical mass for bonds. Canada’s corporate market is still relatively illiquid, but if managers are too small, they won’t see bond offerings until all the big guys have been filled (or have passed). Also, the market is getting more complex, which requires a serious research effort. Early in my career, small investment counsellors were stock pickers. If bonds were needed to balance out a client’s portfolio, the admin assistant phoned a broker and bought some Government of Canada bonds. Not so today.

Clearly, in some asset categories, having horsepower is an advantage, but there are tradeoffs. More people in more locations means the decision-making process is prone to slippage and compromise. Bigger engine, but clunkier transmission.

I can’t finish this comparison without mentioning fees. This is an area where the buy side has a greater ability to differentiate. On the sell side, trading commissions and underwriting fees are pretty standard across all dealers, but asset management fees can range from a few basis points for indexing to a 2-and-20 arrangement (2 per cent base plus 20 per cent of the return) for more specialized categories such as hedge funds. Small buy side firms that deliver a unique product can charge more and, as a result, be profitable on fewer assets.

Now don’t get me wrong, it’s no treat operating in the shadows of the big players. The banks and insurers are marketing machines and have plenty of advertising dollars to throw around. The large foreign firms have seemingly unlimited resources. But in the asset management business, their challenges are just as tough as the small firms’ – they have to manage their anti-scale.

By Tom Bradley

A meeting I had with a prospective client a few years ago has always stuck with me. She told me her adviser had done well for her in the previous five years, but had been letting her down more recently. After reviewing the data, we discovered the opposite was true. Her portfolio was actually holding up well in the current year relative to a weak market, but had performed poorly over the longer term – the return didn’t nearly reflect the strength of the post tech-wreck markets.

Most investors know how a few of their individual stocks have done, some may have a sense of whether a mutual fund has been good or bad, but a vast majority have no idea how their overall portfolio has performed. This knowledge gap, which is especially evident at this time of year when clients are opening their year-end statements, is a unique and disappointing element of wealth management.

How has it come to be? There is plenty of blame to go around. Investment companies spend time and money selling products with the promise of better returns, but rarely show returns on their statements. Buy side firms (investment counsellors) do a better job than sell side dealers (brokers and banks), but no one is where they need to be. And neither are the clients. Few investors maintain any kind of discipline around monitoring their portfolio, despite the fact that their financial health depends on it.

In the face of this sad state of affairs, our firm just updated a report that helps clients assess their returns. It covers a wide range of topics, but some key themes permeate throughout.

This is important!

With the decline of the defined benefit pension plan, responsibility for investing is increasingly falling to the individual. To make the necessary decisions about asset mix and security selection, investors need to know how they’re doing and what’s working for them. Without an accurate assessment of the past, making future decisions is challenging to say the least.

Context

As my story at the beginning illustrated, what’s most often lacking when clients assess their results is an understanding of the environment their portfolio is operating in. They don’t know if losing 2 per cent last year or earning 4 per cent over the last five years is good or bad.

Ideally, investors should construct personalized indexes. This default portfolio, or benchmark, would blend the returns from various market indexes in proportion to their particular long-term asset mixes (cash, GICs, bonds, Canadian stocks, foreign stocks). The investors then have something to compare their returns to, and assess how their strategies and hired help have done.

Unchanging criteria

Too often a fund is bought for long-term reasons and then judged by how it’s done for the short time it’s been in the portfolio. It doesn’t make sense. If a fund was selected using the four Ps – philosophy, process, people and performance (long-term) – then it should be consistently measured against those same criteria.

This is particularly important for investments that have been weak performers. After all, not all components of the portfolio do well at the same time (if they do, then the portfolio is not properly diversified). Staying focused on the initial selection criteria will help investors determine how likely it is that the laggards will one day take their turn carrying the load. And importantly, it will give them the confidence to allocate money to these areas of weakness when their plan calls for it.

I should note that it’s hard not to focus on the laggards when reviewing a portfolio, but it’s important to also look critically at the current winners. Short-term glory shouldn’t obscure the need for an ongoing assessment.

Action and inaction

In the end, a thorough portfolio review produces lots of grey. Black and white conclusions, such as consistently poor performance, personnel or philosophy changes, and excessive fees, are the exception, not the rule. Most performance gaps require more study and patience. On that note, I can say unequivocally after 28 years of observation and painful experience, the biggest weakness investors have is impatience. They don’t wait long enough for their strategies to play out and as a result, sell when the assets are most attractive. In my view, a proper performance assessment helps foster that much-needed patience.

By Tom Bradley

My holiday reading included two journal articles that challenge the notion that investing for the long term reduces risk.

The message: It’s all well and good to recommend that an investor take the long view and not worry about short-term market dips, but quite another for that investor to truly maintain the strategy over multiple decades. While it’s easy to be a long-term investor in good times, it’s quite a different matter in times of euphoria or panic. Most investors can’t resist the temptation to become short-term oriented at extreme points in the market cycle.

The researchers have plenty of evidence on their side. Academic studies consistently show that investors achieve poorer returns on average than the funds they invest in. This shortfall, which is called the behavioural gap, primarily results from too much trading and a tendency to buy what’s done well in the recent past.

Many other factors can also take investors off track and expand the gap. Sometimes a change in life circumstance – a new job, a divorce, a mid-life crisis – will lead to an untimely strategy shift. There’s always the promise of the cool new products that are focused on what’s popular at the time – technology, gold, China, food, covered calls and/or dividends. And then there’s the psychological imperative (most common in males) to just do something when markets are moving.

Clearly, it’s hard being a committed, consistent long-term investor, but it can be done. During my time on the buy side, I’ve met thousands of investors who have let the power of compounding work for them and done well as a result.

As we start a new year, it’s worth reviewing a few of the keys to staying on a long-term track. I’ve got five.

First, you need to recognize that investing is like no other product decision you make. It’s perverse. Your best moves will feel terrible when you’re making them. Your well-thought-out plan will appear to not be working for long stretches of time. And, like golf, there will always be someone telling you they’ve figured out a better way (usually someone who posts higher scores and lower returns than you).

Second, you should stop doing the obvious things that are causing the behavioural gap. Contribute less to the profitability of the financial services industry by trading less and avoiding high fees. And don’t screen potential investments based solely on how they’ve done in the last three years. Look forward, not back.

The third key: You need to work from a Strategic Asset Mix. This is a plan, a place you go when you’re confused, disappointed, frightened or over confident. Your SAM should be the basis from which all decisions are made. “How does this new product fit into my portfolio? Should I be buying or selling these lousy foreign stocks?” Your SAM won’t vary much from year to year and should never be changed drastically at extreme times. When markets are going wild, it’s time to lean on your plan, not change it.

Fourth, you need to eliminate the word “if” from your vocabulary and substitute “when.” You’re more likely to be surprised by ifs, as opposed to being prepared for whens. For example, when the stock market goes down 20 per cent, you’ll gradually add to your equity funds. When your foreign stocks smoke the rest of your portfolio, you’ll re-balance back to Canada. And when it seems you’re going against what everyone else is doing, you’ll smile and pour yourself a nice glass of wine.

Finally, to be a successful long-term investor you need someone to lean on. You need a veteran who has a better investing temperament than you and has experienced the end of the world a few times. We all need a touchstone (for years I’ve leaned on Bob Hager, Warren Buffett and Jeremy Grantham), although you shouldn’t expect them to be right all the time. Rather, you’re looking to benefit from their calmness, thought process and most importantly, their longer-term perspective.

It’s easy building a long-term portfolio. It’s tougher sticking to it. But it’s not rocket science. If you’re committed and consistent, the markets will present you with some wonderful opportunities and the process will be very rewarding.

By Tom Bradley

I came out of the “me” generation (have I told you about my latest injury?), so even though this time of year is about giving, I’m mostly into receiving. In our household, my wife Lori goes for quantity at Christmas, while I’m all about quality. When I wrote Santa this year, I asked for both.

Better markets

Dear Santa, I’m running a small, growing investment firm and need better markets. I’m not asking for another 2009. That would be too greedy, even for me. Your help with my U.S. stocks last year was much appreciated and it would be great if you focused on my value plays in Japan and Europe for 2012. I know they aren’t growing very fast and have a few warts, but they won’t break your budget. They’re really cheap.

In the past I’ve asked for lower interest rates, but you can stop now. Indeed, they’re hammering the pension plan I serve on, not to mention our retired clients, and my readers are starting to doubt my view that rates are going back up. Your lovely present has turned into a lump of coal.

Santa, I’d like a book, or some divine insight, that helps explain why the reasons for buying gold don’t change, no matter whether the price is $800, $1,600 or $2,600. Doesn’t valuation factor into my decision somehow?

Boxing Day prices

It’s not all about me Santa. I also want you to help my young friends chill out and become less petrified of stocks. They need to embrace the opportunity they’ve been given by politicians in Washington and Brussels. Investors with a time horizon of more than 10 years, let alone 30, should be trying to scratch together as much money as possible to invest. I know they’re scratching now, but it’s for a down payment to buy an overpriced house. My generation hasn’t been too good at managing the fear/greed thing, but there’s hope for our children.

Strained regulators

I want provincial governments to give more funding to their regulators. (Did I just say that?) There is so much to do and more urgency than ever. Investors desperately need proper performance and fee reporting. They need to know how they’re doing and what they’re paying for advice and investment management. The current state of affairs is beyond ridiculous, but most companies won’t act until they’re forced to. Please Santa, use your charm to halt the perpetual public consultations, and get the regulators to just ram the rules down the industry’s throat. It’s time.

(I’m not usually this blunt Santa, but I feel I can talk to you.)

Stewardship

Investors are screaming for someone they can trust – investment-oriented firms that have clients’ best interests at heart. Santa, can you deliver to these disillusioned investors the stewardship grades that Morningstar has worked so hard to create? Their research is the best measure we have of alignment between client and manager, but nobody is paying any attention to it, including the media and bloggers. It’s been shown that, in general, firms that rate highly on stewardship generate better long-term returns.

Stocking stuffers

Santa, there are a few little things I need. I’d like more stocks, less bonds. More Vanguard, less closed-end funds. More no-load, less load. I desperately need more Wealthy Barbers and fewer economists. More Lang, less O’Leary. And more dividends, less “Premium Enhanced Protected Tax-Efficient Deceptively Expensive Dividend Income” funds.

And finally Santa, if you have any time and energy left, I have one more request, although it’s a toughie. I want you to make “small” cool again. How about working your magic so people remember what it was like when their investment firms were personal and investment driven. Santa, it’s not that much of a stretch. Scale makes it harder for fund managers to do their thing, so when it comes to managing a portfolio, help spread the word: “Small is the new big.”

If you’re not able to deliver on all this stuff, I’ll understand. More than anything, I want Canadian investors to be excited about the opportunities ahead and the options they have. And Santa, when you’ve planted these sugar plums in their heads, make sure you use my strategy, not Lori’s – quality over quantity.

By Tom Bradley

It’s a remarkable time to be an investor and investment professional. After decades of overspending, we’re watching Europe melt down and the American empire decline faster than anyone expected. The debt burden has accelerated the power shift from West to East.

It’s also remarkable because it feels like there are a lot of one-way streets out there. I’m referring to strategies, trades and trends where everyone is headed in the same direction. Being a natural contrarian, I feel uneasy when I see a seemingly unchallenged consensus. “This stock can’t miss!” “You can never go wrong with real estate.” “I can’t see what could possibly take the market higher (lower).”

My points of uneasiness today are not the same as they were a year ago when the list included gold ("sky’s the limit"), U.S. ("don’t touch it") and China ("our salvation"). Gold is up 25 per cent over the last year, but the stampede has slowed and the commentary is more balanced today. There’s still a hate-on for the U.S., but more Canadians are perking up to the real estate and stock bargains there. As for China, the steady stream of positive press has turned. The scale of capital misallocation and use of debt is being brought to light (it looks eerily similar to post-Bush/Greenspan America).

There are other extremes to keep an eye on now.

In my 28 years in the business, I’ve never seen a time when people’s views are so universally negative. Certainly, it’s understandable given the macro events of the day and the extreme market volatility, not to mention the fact that baby boomers are starting to retire with 2008 fresh in their memory. The fear/greed meter is firmly planted on the fear side.

I’ve written a lot about our artificially low interest rates because they’re a remarkable feature of the landscape. It’s a wonderful time to be a creditworthy borrower – everyone is competing for your business – while it’s a lousy time to be a lender (bondholder). Savers are seriously subsidizing spenders.

Finally, large corporations are as well positioned and poorly appreciated as I can ever remember. With their strong balance sheets, steady cash flow, regular dividends and ability to finance cheaply, they’re the antithesis of governments. They’re able to use their scale to cash in on the trends toward globalization and industry consolidation. The strong are getting stronger, and yet their valuations are going lower.

So what should you do about fear, low rates and strong corporations? Well, first of all, you should remember that markets have a propensity to overreact to short-term news, so a strong consensus creates opportunities. Although the fear is understandable and very real, it’s no less valuable for investors. Therefore, it’s important to maintain a balanced perspective. I recommend reading, or rereading, a Warren Buffett book and seeking out all the information you can about what could go right in the next few years (the negative stuff will find you, the positive won’t).

You need to stay in close touch with where valuations are. The big mistake made by investors who missed the 2009-10 rally was focusing exclusively on the bad economic news and losing sight of the compelling valuations on stocks and corporate bonds. You want to hold assets that look to be undervalued, or at least fairly valued, with respect to their long-term fundamentals. Conversely, you want limited exposure to assets that have become overvalued due to short-term factors.

I put equities in the former category. When people ask where they should invest, I tell them what they don’t want to hear – “Stocks.” In my view, equities will generate the best returns over the next three to five years.

On the overvalued side are assets that are dependent on low interest rates – bonds and real estate. Rates may stay near current levels for a few years yet, but it’s not ordained that a weak economy means low rates (ask Europeans about that). The safety premium on U.S. Treasuries will go away one day and Canadians will be faced with lower bond prices and higher borrowing costs. Cheap financing is transitory, but paying too much for an asset stays with you forever.

So my recommendations for 2012 are: Warren Buffett, high quality stocks and corporate bonds, a modest cash reserve and two-way streets.

By Tom Bradley

A year ago, I wrote a column inspired by a holiday in Arizona (my in-laws have that effect on me). The piece attempted to level a rather tilted picture of the United States, one that was firmly focused on dismal economic and political news. I suggested that from an investor’s point of view, the U.S. didn’t look so bad. Canadians were being given the chance to buy cheap assets with a richly valued currency (the loonie).

From the comments I received, I found out how intensely Canadian investors dislike the U.S., and how strongly they disagreed with my view. Well, I’m nothing if not stubborn, so I headed south again this year to continue my research. After 10 days in Florida and the Republican desert, I’ve returned with a higher golf handicap, five years worth of Nordstrom sweaters and a renewed desire to buy southern real estate.

Before revealing my other findings, it’s useful to look at what’s happened since last year’s column. The politics in Washington have gotten more bizarre (I call it entrenched denial), the economy is still hanging on by a thread and the government debt grew by another trillion dollars or so. As for the housing market, prices were down slightly year over year and are 30 per cent below their 2006 peak.

The results were different, however, in the stock and currency markets. The S&P 500 was up 8 per cent for the 12 months to Oct. 31, while the S&P/TSX composite was down 1 per cent. The exchange rate has bounced around, but now shows the greenback a couple of pennies stronger against the loonie.

How did this happen? Well first of all, let’s remember that one-year returns are pretty flaky, even bordering on random. The numbers could reverse with a two-week run of the gold and energy stocks. But beyond that, these results are a reminder of just how big a role sentiment (emotion) plays in short-term returns. A strong consensus often creates an opportunity to go in the opposite direction. The return gap is also a reminder of how important valuation is. Cheap assets priced in an undervalued currency help to offset many ills.

Having taken a fresh look at the U.S. (on foot and at my desk), my investment conclusion remains the same – Canadian investors need to be open to opportunities south of the border. Stocks and real estate are still cheap relative to what’s available in Canada and the American economic outlook has improved relative to ours. The Americans are well along in adjusting to their new reality, while we’ve yet to have our comeuppance. The following factors illustrate what I mean.

The U.S. economy is growing almost as fast Canada, but with zero help from the housing sector, which is flat on its back. In Canada, real estate is contributing mightily to economic activity.

Government deficits in the U.S. are worse and the accumulated debt now exceeds Canada’s (as a percentage of GDP), but we’re running large deficits too (embarrassingly so given the health of our housing and resource sectors), and our consumer debt burden is now heavier.

There’s no question that the U.S., with its cheaper land, labour and currency, is now more competitive than Canada and the gap is widening. Last week it was reported that U.S. productivity gains are running well ahead of ours. This week Chrysler chief Sergio Marchionne opened contract negotiations with Canadian workers by saying, “You cannot have all things. You cannot have a strong currency, you cannot have an uncompetitive wage rate and then expect Chrysler or all the other car makers to keep on making cars in this country and be disadvantaged.”

The point is that investment managers are always looking for changes at the margin. Improvements that are unappreciated by the market. A poor situation that’s turning around. They’re not always looking for good, just better. If the sentiment toward the U.S. improves and concerns about insolvency abate, then the attractiveness of U.S. stocks will become apparent.

As investors, we need to check our emotions at the door and critically assess each opportunity on its fundamentals and valuation, regardless of head office location. Which reminds me, now I’ve got to wangle a golf trip to Europe.

By Tom Bradley 

I recently watched a promotional video that outlined the reasons for owning dividend-paying stocks – tax-efficient income, lower volatility and you get paid to wait for markets to recover. I agreed with all the fund manager’s points, but he failed to mention that investors tend to get sloppy when it comes to income and dividends. The level of analysis and discipline that goes into buying tech or industrial stocks isn’t always evident when higher-yielding stocks (and structured products) are involved. Too many decisions are made for the wrong reasons. Here are a few of them.

Yield

For income investors, one number takes on disproportionate importance – yield. If I invest X dollars, how much regular income will I receive? Is it 4 per cent, 5 per cent, 6 per cent?

It’s perfectly appropriate to build a portfolio from a subset of securities that have a yield above a certain level, but once a stock qualifies on that basis, it’s time to determine what it’s worth. Is the price reflective of the company’s assets and growth prospects? Can the underlying business support the dividend payments over the long run?

The early days of income trusts provide a great example of when current yields unduly influenced purchase decisions. Trusts were a burgeoning area of the market and, as a result, the analysts tended to be less experienced. Too many of them were valuing trusts based on the yield spread above government bonds, instead of determining what the businesses were worth. Incredibly, interest rates were perceived to be a bigger risk factor than revenues and profits.

Return of capital

Today, the wealth management industry has embraced an exciting not-so-new tax deferral strategy. It’s called “return of capital” and it works like this. A product has an advertised yield of 6 per cent, but is earning only 3 per cent from interest, dividends and capital gains (after fees). The investors’ capital is used to cover the rest of the distribution. It’s a marketer’s dream. The client makes up the shortfall and it’s positioned as a selling feature. “Buy now and you’ll receive a tax-efficient 6 per cent yield.”

There are investment products where return of capital is part of the design and is communicated as such. There are too many others, however, that aren’t quite so forthcoming.

Diversification

I have a friend whose parents live in Ireland. For years they invested most of their savings in Irish banks and insurers. When the financial crisis hit in 2008, they lost virtually everything. I tell this story because Canadian investors love their banks too. Layered throughout their portfolios are bonds, preferreds and common shares issued by the Big Five.

Now, I’m not here to bash the banks. They’re some of the best in the world and play a significant role in my portfolio. But that doesn’t get around the fact that they’re highly leveraged businesses and are all driven by the same economic factors. Income investing isn’t an excuse to not be diversified across different types of companies and asset classes.

Opportunity cost

In poor markets, it’s easier to hold on to a stock that’s paying an attractive dividend. As long as the income stream is secure, it’s a good thing. Conversely, that same dividend can cause an investor to hold onto a stock when it gets expensive. “I don’t care if it goes down … I’ll get my dividend.”

But consider the following example. You hold 100 shares of Company A priced at $10. It’s yielding 4 per cent, but your adviser thinks it’s getting overpriced. You decide to sell A and buy 100 shares of Company B, which is also $10, but looks considerably cheaper. Over the next year, A goes down to $8, while B rises to $12. At that point, you reverse the trade and find yourself with 50 per cent more shares in A and 50 per cent more income.

This trade is a favourable example for sure (and transaction costs and taxes have not been accounted for), but it’s meant to reinforce the point that there’s a cost to holding an overpriced stock, dividend or no dividend.

When it comes to income investing, yield and tax efficiency are important, but they have to take a back seat to diversification and valuation. Sometimes the best strategy is to accept a lower current yield and own a broader range of securities.

By Tom Bradley 

“Creep.” The dictionary defines it as a “slow and stealthy movement.” To me, it’s something you don’t notice while it’s happening, but later when you do, you go “Wow!”

If you think about our lifestyle, we’ve slowly moved to a place where jeans are appropriate everywhere (almost), we drink a milkshake every day (otherwise known as a latte), we’ve allowed BlackBerrys and ball caps to erode our manners, and we’ve radically altered our definition of a small apartment and large home.

As for investing, there’s been plenty of creep, some of it due to poor stock returns in recent years, and the rest related to the market’s extreme volatility. Investors are slowly and stealthily moving away from their strategy of holding a diversified portfolio of long-term securities.

Caution creep

Today every investment discussion and sales pitch is laden with words like caution, capital preservation and downside protection. In the context of recent markets, this is understandable for retirees, but it’s also part of the conversation for investors who have 10, 20 or more years until retirement. As a result, investors own fewer assets with the potential to generate a return in excess of the risk-free rate.

Caution creep has taken many forms. Sometimes it’s purposeful – new money goes into a GIC instead of an investment portfolio. Other times, it’s oblivious – money is moved slowly from one account to another, or cash is left to accumulate in a bank account over a number of months. In either case, the result is the same – the overall portfolio has a lower equity weighting than the long-term plan calls for.

When changes are made, they’re often toward a more-conservative investment. Instead of an equity fund or broadly diversified Balanced Fund, it’s a Monthly Income Fund that’s focused on dividend-oriented stocks or a structured product with capital guarantees.

In a recent column, I projected stock returns of 7 to 10 per cent per annum over the next five to 10 years. I can be accused of being too optimistic, but I have a lot of room to be wrong when compared to investors who are protecting themselves all the way down to a return of 2 to 4 per cent.

Parochial prudence

Foreign stocks are a big reason Canadian investors are unhappy with their returns. Over the last 10 years, the MSCI World Index had a return of minus 0.5 per cent (in Canadian dollars). There are explanations for this lost decade – the loonie going from 70 cents (U.S.) to par; the U.S. going from glory to despair and Europe just going – but they don’t matter. Investors, who were maxing out on U.S. and international stocks a decade ago when leading companies were trading at 30 times earnings, now have minimal holdings outside of Canada when multiples are 8 to 12 times.

It’s worth noting that the most popular balanced products, the above-mentioned Monthly Income Funds, have little or no foreign content.

Hedged to the hilt

Increasingly, the foreign investments that remain in portfolios are currency-hedged. A number of fund companies offer hedged versions of their U.S. and international equity funds and virtually all foreign-equity ETFs are hedged. A volatile dollar and love for everything Canadian has moved investors away from currency diversification, just when the loonie has achieved par with the greenback.

Economists everywhere

With today’s volatility, the consequences of buying a stock or equity fund at the wrong time have been magnified. A new purchase can be down (or up) 5 to 10 per cent in a heartbeat. As a result, investors are becoming more short-term-oriented. Even fund managers who are good at analyzing companies and doing valuation work are being sucked into the macro game. I’ve talked to a number of them who’ve deferred purchase of well-priced stocks (according to their models) because they need more clarity on central bank and government policy. Yikes, stock managers are becoming economists along with the rest of us.

As investors, it’s important that our portfolios are the result of a calm, objective, valuation-based analysis, not creep. In my view, we’ve crept to a place that reflects what happened in the last 10 years, not the next 10. Market volatility has obscured the attractiveness of common stocks and past performance has put Canada on too high a pedestal.

By Tom Bradley

I’ve written in the past about the tension between the investment profession and the investment business. As asset managers, we need to find a balance between managing portfolios to achieve the best return for our clients, and making a profit for our firms’ shareholders. In a recent paper published in the Financial Analysts Journal, Charley Ellis says the industry has failed to find that balance. “We are losing the struggle to put our professional values and responsibilities first and our business objectives second.”

Mr. Ellis is a thoughtful, well-connected industry observer. He’s consulted to investment firms for decades and written a number of books, including an industry standard, Winning the Loser’s Game: Timeless Strategies for Successful Investing. In his article, entitled “The Winners Game,” he outlines three errors that are leading to this inappropriate balance between values and business objectives.

First, we’re defining our mission incorrectly. It’s no longer reasonable to tell clients that our focus is on beating the market. Evidence shows that it’s hard for active managers to outperform the indexes because there are so many skilled, well-informed people competing against each other. As Mr. Ellis said to me recently, “The more smart people there are trying to beat the market, the less likely it is to happen.”

The second error cuts to the heart of the profession-business balance. Mr. Ellis says we have our priorities wrong. “As investment management organizations have been getting larger, it is not surprising that business managers have increasingly displaced investment professionals in the senior leadership positions or that business disciplines have increasingly dominated the old professional disciplines.” He goes on to say, “When business dominates, it is not the friend of the investment profession.”

I could write at length about these two errors of commission, but it’s the third error, one of omission, where Mr. Ellis’s perspective is the freshest. He calls it, “the largest problem and the best opportunity for our profession going forward.” While we’ve been trying to beat the market, outsmart each other with innovative products and feverishly gather assets, we’ve given short shrift to something that will help our clients more than anything else – effective investment counselling.

In conversation with Mr. Ellis, it becomes clear that he doesn’t consider investment advice to be rocket science, but rather basic blocking and tackling. From my perspective, it involves putting a plan in place with a prescribed long-term asset mix. It means executing the plan in a simple and consistent way. It means looking ahead and preparing for the down periods as being inevitable as opposed to being a surprise. And most assuredly, sound counsel means spending more time with clients when markets and emotions are at extremes, not less.

The industry’s biggest failure is not its products and services per se, but how clients use them. It’s been well documented that, in aggregate, investors suffer from a behavioural gap – their portfolios don’t do as well as the funds and products they invest in. That’s because they trade too much, chase past performance and generally stray from their plan. Don’t get me wrong, there are plenty of bad investment products out there, but the gap comes largely from misuse.

Unfortunately, the industry is doing more to widen the gap than narrow it by advertising last year’s best performers and introducing a constant stream of new products. Pumping a hot fund through multiple distribution channels is hugely profitable, but ensuring that it’s used correctly by the appropriate clients is not. Investment counselling is bad for business in the short term – it takes time, costs money and is not very scalable.

Mr. Ellis’s article may serve as an indictment of the industry, but as the title implies, there is plenty to be positive about. If we recalibrate our priorities a little, be more ruthless about eliminating products and business practices that hurt clients, and think more about client returns as opposed to fund returns, we’d be taking a big step in the right direction. All of this might hurt profitability (and I’m not even sure about that), but as Mr. Ellis points out, it’s certain to be successful. That’s the kind of risk/reward tradeoff all investment professionals are looking for – possible short-term pain, certain long-term gain.

By Tom Bradley

“In calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions: They act as though uncertainty has vanished and the outcome is beyond doubt.”

These words are from the late Peter Bernstein – analyst, strategist and author of Against the Gods: The Remarkable Story of Risk.

When we look at today’s investing landscape, there’s a lot we shouldn’t be certain about in the political, economic and business arenas. But at the risk of ignoring Mr. Bernstein’s counsel, the current market fray does make me more confident about some things.

Bond returns will be poor

With a further decline in yields, the math for bondholders is even more dismal than it was just a few months ago. If yields stay at these low levels, investors are going to earn 2 per cent before commissions, fees and taxes. If rates rise, they’ll eventually achieve better returns, but not before experiencing capital losses on their existing bond holdings.

Expect more from stocks

Stock prices always take a more winding path than do the company fundamentals that underpin them. With a recession looming, the outlook for corporate profits in the short (and perhaps medium) term has worsened. But true to form, stocks have more than reflected that and price-to-earnings multiples are now down to attractive levels. This has occurred despite the fact that only a small part of any stock’s value is derived from near-term earnings.

At client presentations in January, I suggested that stock returns over the next five-plus years would be between 5 and 8 per cent. I arrived at that intentionally wide range (I’m uncertain) by adding dividends (2 to 3 per cent) to corporate profit growth (3 to 4 per cent) and assuming no change in valuation multiples. (Note: The growth number is well below the historical pace of 6 per cent). Today, however, my range is 7 to 10 per cent. To get there, I’ve left the first two variables unchanged (although dividend yields are higher now) and built in an improvement for future valuations, which will produce higher returns.

Relax, everyone is bearish

An investor was recently heard to say, “The market may not have bottomed yet, but I have.” I’ll resist quoting Warren Buffett, but suffice to say that when everyone is beaten up, discouraged and fearful, risk in the market is substantially reduced and opportunity is greater. That’s because when people are negative, most of the selling has been done and the bad news is largely factored into security prices. A bearish consensus is a prerequisite for a market bottom and sets the stage for above-average returns on the way back up.

Moving from market generalities to portfolio specifics, there are a few other things I’m more certain about. First, investors in the accumulation phase who have a long time to invest are being given a gift. At current prices, they can buy more shares with the same amount of money.

Second, investors who haven’t yet rebalanced their portfolios have a lower percentage in stocks than they did when the market started its decline six months ago. If they want to ride the market back up with as much as they went down with, then it’s a mathematical certainty they’ll need to do some buying.

And finally, this is a time when investors should lean on their long-term plan, not rewrite it. It’s tempting to make changes that match the magnitude of the market declines, but what’s called for are small, incremental moves (that is, rebalancing). With emotions running high, the chance of a major overhaul going seriously wrong is also high.

Mr. Bernstein says market bottoms are defined by a “switch from doubt to certainty.” On that measure, I don’t know if we’ve seen the lows yet. Certainly, I’m guilty of being more confident about some things, but be assured my list doesn’t include what’s going to happen to Spain, interest rates, gold, Swiss francs, credit spreads, correlations, GDP growth, copper, volatility, the U.S. dollar, profit margins, China’s real estate market, natural gas or where the market will be next month.

By Tom Bradley 

“Isn’t it funny when you walk into an investment firm and see the financial advisers watching CNBC. It gives me the same feeling of confidence I would have if I walked into the Mayo Clinic and the doctors were watching General Hospital.”

This little jab at the investment industry is doing the e-mail rounds right now. Unfortunately, it’s not such a rare scene and is a reminder of just how short-term-oriented professional investors have become. You can’t have a conversation today without hearing the phrases “risk on” (the market is going up and risk is being rewarded) and “risk off” (market down, risk punished).

By tuning into all kinds of indicators, including the news flow on the business networks (CNBC and Bloomberg in the U.S. and BNN here), the pros are trying to determine whether their portfolios should be “on” or “off.” If we’re in a “risk on” environment, they want to be fully invested in stocks and higher-risk bonds, with perhaps some leverage thrown in. If it’s “risk off,” cash is king and shorting is the order of the day.

I don’t like this trend, but I understand why it’s happening. Markets have been volatile and traditional methods of holding stocks for the long term have been less rewarding. Investors want more, and are looking for managers who can get them in and out of the market at the appropriate time.

Of course, the implication of “on/off” is that the direction of the market is predictably linked to short-term news (it isn’t) and there are people who have it figured out (there aren’t). Are we to believe that someone can consistently get the on/off switch right? If asked at gunpoint, the economists, strategists and fund managers who appear on television would answer, “Of course not.” It doesn’t stop them, however, from making short-term pronouncements (it’s an occupational hazard).

But it goes beyond entertainment and sound bites. The on/off phenomenon is having a huge impact on markets. Today there are hundreds of billions of dollars with hair triggers attached. Aggressive market timing and quantitative strategies (algorithmic trading) are no longer exclusive to little hedge funds in Connecticut. The amounts being moved around by large institutions are having a meaningful impact on trading flows and have increased the market’s volatility.

There are products specifically designed to help investors time the market. Leveraged ETFs are the most extreme example – the warning labels say they’re not suitable for holding periods longer than a day – but the proliferation of ETFs in general is feeding the frenzy. Broad market and sector-specific ETFs provide a perfect on/off switch for market timers.

The combination of trigger fingers and ETFs has meant that in recent months correlations between individual stocks and the overall market have risen. In other words, more of a stock’s price movement can be explained by the overall market as opposed to the company’s fundamentals. When a fund manager flicks the “off” switch on his Canadian stocks, he might put in an order to sell iShares “XIUs” [the ticker of S&P/TSX 60 Index Fund], which means that 60 stocks are sold, regardless of size, industry, earnings growth, balance sheet strength or valuation. So in the short term, security selection is being overwhelmed by what’s happening to the overall market. Mining and technology stocks move in tandem, as if their business fundamentals are closely aligned.

As an industry executive, I’m bemused and somewhat discouraged by the preoccupation with on/off. As a fund manager, however, I’m jumping-out-of-my-skin excited. That’s because the more investors who are making decisions for non-economic reasons, the better. The more dollars going into price-insensitive products, the better. The more investors making judgments based on flaky and quickly changeable factors (correlations are the flakiest of all), the better. And most importantly, the more investors and commentators who think they know what the market is going to do next week, the better.

Why better? Because the increasing focus on the short term has improved the chances that fundamental-based managers, who take a longer view and consistently invest for economic reasons (i.e. attractive valuations), will generate above-market returns in the long term. And that’s what really matters to clients.

By Tom Bradley

I got turned on to finance while stumbling through my MBA at the University of Western Ontario. I suddenly found myself reading Report on Business right after the Sports section (go figure). When it came to finding a job, I got lucky. There weren’t many openings, but Richardson Greenshields was looking for a stock analyst and I fit the bill. The director of research at the time, Chuck Winograd, was a Western alumnus (tick), sports fanatic (tick), and the position was in my hometown of Winnipeg (tick). I got the job without combing my hair.

Needless to say, it’s not that easy for aspiring analysts and portfolio managers today. The jobs still aren’t plentiful and the competition is stiffer. This year about 4,000 candidates wrote the Level I exam for the Chartered Financial Analyst designation in Canada.

When I talk to young people about getting into the business, I tell them there’s no silver bullet. As opposed to me, they’ll need to work at it and bring some discipline to the search process. What limited advice I have for them goes something like this.

Analyze yourself

Graduating from a good school helps, but your degree is a qualifier, not a differentiator. Financial modelling skills and accounting knowledge are expected of every candidate. So your first research assignment should be determining what your strengths, weaknesses and competitive advantages are. If an employer was to do a discounted cash flow analysis of you, what would they put in the calculation? You need to give them concrete examples of how determined, creative and personable you are, or better yet, how you have an innate ability to make money.

You shouldn’t be afraid to play up your “non-biz school” background – music, sports, travel, languages, hobbies and YouTube credits. Leo de Bever, CEO of Alberta Investment Management Corp., told me he’s always looking for what else is in the toolkit. “I’ve had good luck with people from different backgrounds.”

Show your personality

If you think personality isn’t important, then you’re pursuing the wrong profession (perhaps law or accounting is a better choice). Every executive I talk to puts personal traits at the top of their list. Tony Hamblin, who hired, trained and promoted more great portfolio managers than anyone while he was chief investment officer at Confederation Life, looked for drive, energy, curiosity and decisiveness. “That’s the important stuff. I can teach them the technical skills.”

Kim Shannon, president of Sionna Investment Managers, asks, “Would I like to sit beside this person on a plane?”

Act like a fund manager

I can tell right away when someone is trying to get into the business for the wrong reason – money. Being an analyst or portfolio manager can be financially rewarding, but you’ve got to have a passion for it. And that means doing it.

If you don’t have money to invest, then you might start by running a simulated portfolio on Globe Investor (you can monitor your investments by setting up a Watchlist). If you have enough knowledge, try writing up a research report on something you own. A thoughtful, thorough paper can be a door opener.

Working on the buy side involves a lot of reading, so I recommend putting a book list on your resume. If you haven’t read anything yet, get started. The list has to include some Warren Buffett and David Swensen, but doesn’t need to be limited to investing. But don’t pad the list, because you will get asked about it.

Network like crazy

Whatever role you end up in, you’ll always be selling. Getting in the door is just the first of many sales jobs. So you have to do what sales people do – talk to everyone you can, whether you think they can help you or not. From that you’ll develop connections and job leads, and importantly, you’ll learn. The more you know about the industry, the more confident you’ll be.

It’s great if you can connect with senior managers, but don’t get greedy. Talk to people at all levels. A recent grad, perhaps someone you drank beer or danced with two years ago, will gladly tell you how and what they’re doing. Marketing presentations by banks and fund companies are also good opportunities to meet people and see money managers in action.

Your job search may turn out to be toughest thing you do in the industry. To succeed you need to read a lot, talk to everyone you can and analyze everything including yourself, the people you meet and the stocks you own. And you need behave like a stock investor – eternally optimistic.

By Tom Bradley

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett

“My best trades turned out to be the ones when my hand was shaking as I gave my trader the blue ticket.” – Bob Hager, co-founder of Phillips, Hager & North

In light of the recent weakness and volatility in the stock market, both statements are particularly poignant. It’s easy to agree with the logic and simplicity of Warren Buffett, but not so easy to behave like him. My former partner’s shaking hand reinforces just how hard it is to buy at uncertain times, and how rewarding it can be.

With markets in serious fear mode, investors with a time horizon of five years or more need to ask themselves, “Am I hiding under my desk or excited about the opportunities? Am I giving up on stocks or getting prepared to buy like Messrs. Buffett and Hager?”

I’ve talked before in this space about being "approximately right," which is what my firm calls our approach to asset allocation. Approximately right means keeping your portfolio stuck on its long-term asset mix (strategic plan) most of the time. This part of the process is dead flat boring, even when rebalancing is required. But approximately right also means taking advantage of extremes in the markets – extremes in terms of valuation (cheap or expensive) and investor sentiment (fear or greed). This is the more interesting, and dare I say, challenging part of the process.

Eight months ago was one of those times when we recommended that long-term investors move away from their strategic mix and build a cash reserve. We didn’t think stock valuations were fully compensating for the economic risks, and had concerns about the distortions caused by artificially low interest rates. In this column I wrote, “It’s a sellers’ market now, but as the extremes come back to earth, as they invariably do, suppliers of capital (buyers) will regain the upper hand.”

Well, we’ve gone a long way to redressing the imbalance. Even though the outlook for economic activity and profit growth has deteriorated (and is getting worse with every month of political dithering), stocks have adjusted, or over-adjusted, to the new reality. They’re factoring in bad news. With prices down and fear running wild, however, expected returns for stocks have gone up. As Tony Arrell, chairman of value manager Burgundy Asset Management, said to me on one of the particularly gloomy days, “these are opportunity-laden times.”

Meanwhile, uncertainty has driven interest rates down to unsustainable levels, such that bonds are less appealing. Safety is even more expensive than it was, while risk is back on sale.

This divergence in value between stocks and bonds reveals itself in the gap between the stock market’s earnings yield (the flipside of a price-to-earnings ratio) and bond yields. With the S&P 500’s earnings yield at 8 to 9 per cent and bonds at 2 per cent, the gap is as wide as it’s ever been (there was little or no gap throughout the 1990s). For it to narrow, I suspect that both numbers will move toward each other – bond yields will rise over time and earnings yields will move down to more normal levels.

Nobody knows where the market is headed in the months to come (and if you hear someone talking as if they do, politely excuse yourself so you can do something more useful). But we can be confident that buying securities at below-average valuations when investor sentiment is flashing FEAR will be profitable in the medium term. We can be almost certain that buying bonds with yields between 1 and 3 per cent will provide a negligible return. And we know absolutely that in this context any adjustments to a portfolio should be made within the constraints of a long-term plan.

To be clear, investors shouldn’t expect their stock purchases to go straight up in price like they did in March, 2009. Indeed, they may get a chance to buy more at even lower prices. Mr. Buffett’s investing tenet is not a precise timing tool, nor is my valuation work. They’re both simply a way to get it approximately right as opposed to exactly wrong.

By Tom Bradley

“Hey Tom, how was your holiday? The weather’s been great – skiing conditions must have been calm?”

“Oh Ralphie, it was amazing. Two weeks of Crystal Lake at its best. I’m totally decompressed. But what about you man? You’re looking pretty ragged.”

“Yeah, I’m ready for a vacation. Work has been tough and the markets have got me spooked. You’re a market guy. What do you think about all this doom and gloom?”

“Well, Ralphie, I’ve been reading this book, The Rational Optimist [by Matt Ridley], so most of what I’m seeing is pretty positive. Our business has been better with me away. I’m skiing well. My Blue Bombers are 4 and 1. That Canadian kid made a great run at winning the Canadian Open. What else? The Ontario corn has been great. And …”

“No, no, I’m talking about the debt crisis in Washington and what’s going on, or not going on, in Europe. The U.S. is such a screw-up. They’re going to bring us all down.”

“Oh, that. Well, we talked about it last summer, and I think the one before that. The debt crisis is a rolling tour and will go for years. It will rotate from country to country to state to county to city to company. Someone will be selling T-shirts at every stop. Fortunately each mini-crisis stimulates much-needed political action. You might as well get used to it, Ralphie, because the Western world has too much debt and is still spending beyond its means. We need to look at each situation differently, though. The media is quick to lump each one into the same category, which is wrong. Greece’s ability to dig itself out is far different than that of Spain or Ireland, or the U.S. for that matter. Personally, I’m not crying any tears for poor penniless California.”

“That Rosenberg guy that writes in your paper, he’s a beauty. He’s really worried about the economy. Aren’t you?”

“David looks like he’s going to be right and certainly has lots of company now. So yes, I’m worried. But I’m not sure we agree on how his scenario will impact client portfolios. For sure, profit growth will be slower going forward, but the companies we own are the antithesis of government. They’ve got strong cash flows, little or no debt and are growing their dividends. They’ll be able to take advantage of a sluggish economy. And for most of them, modest forecasts are baked into the valuations. This isn’t a euphoric market that’s out of touch with reality like 1999 or 2007.”

“Tom, are you out of touch? Haven’t you noticed that the TSX is down double digits since April? Did you see how ugly it was this week? I really wonder whether I should be in the market at all.”

“Not out of touch, Ralphie, just steady. It would’ve been nice to own no stocks over the last few months, but you can’t get that cute. You were really concerned last summer too, and the fund you have with us is up over 10 per cent since then, even after a tsunami, revolutions in northern Africa, a Gong Show in Washington and the latest market drop. If you want to tilt the portfolio away from your long-term strategy, that’s fine, but don’t be trying to get in and out of the market. Especially at extremes like now. I can’t tell you how many people I’ve talked to who missed the whole recovery because they were spooked by the headlines.”

“I don’t know Tom. I find the market declines hard to take.”

“Ralphie, listen to me. You’re 20 years younger than I am, or so you keep reminding me, and you’re going to be adding to your portfolio for a long time. When prices on good assets go down, as they are now, it’s a good thing. You should be pumped. You can spend less money and get more shares today than you could in April. I know you have some cash on the sidelines. It’s time to start thinking about what you’re going to buy with it. Let’s talk about it after you’ve been off-line for a couple of weeks. In the meantime, do you want to borrow my book for your holiday?”

By Tom Bradley

I recently spoke at a conference about the future of the wealth management industry. It was a good audience, but a bad gig. No matter what I said, I was sure to be wrong about some things. As Yogi Berra said, "It's tough to make predictions, especially about the future." So I took a defensive tack, and used my allotted time to focus on the factors that I believe will shape the industry.

I picked five, starting with the most important one – investment returns. With interest rates where they are, we're bound to have lower portfolio returns in the coming years. At most we're looking at 3-per-cent per year from government bonds, the foundation of a balanced portfolio. If interest rates start rising, that number could be closer to zero in the medium term. And as I've pointed out in this space numerous times, artificially low rates inflate all asset prices, including stocks and real estate.

Out of returns flows factor two – asset allocation and portfolio construction. Rock-bottom yields will eventually translate into clients holding fewer bonds and guaranteed investment certificates (GICs), which means income will increasingly come from equities and structured products. On the equity front, investors will hold fewer Canadian stocks and more foreign. (This was the easiest non-prediction I made, because after a decade of world-beating returns, our home-market bias can't go much higher).

On the topic of building portfolios, I did find myself proffering some forecasts. The trend toward indexing and exchanged-traded funds (ETFs) will continue. Despite the recent attention from the industry and news media, the penetration of passive investing is still low in Canada. I also suggested (somewhat hopefully) that there would be a clearer separation between market-related returns (beta), which should be cheap to acquire, and added-value from active managers (alpha), which is more expensive. Closet index funds, which are the worst of both worlds (expensive beta), will become extinct.

Real estate has to be factored into any forecast about money. If house prices go stagnant or decline owing to interest-rate sensitivity, mortgage payments may compete more vigorously for investment dollars.

The third factor to shape the wealth management industry will be the need to lower the cost of distribution. Progress has been made on bringing down fees, with investors now able to trade cheaply and take advantage of low-cost mutual funds and ETFs. But the progress has been uneven. Overall, Canadians' total cost of investing has gone up with the growth of structured products, hedge funds and the re-emergence of closed-end funds.

What gains we've had so far have come from the buy side (money managers), who are being pressured to reduce their fees. The distribution channels (advisers, agents, investment bankers, bank branches) have not yet taken a hit, but their time is coming. Lower returns and legislated transparency around commissions and advisory charges will change the game. The good players may not be affected much, but the "one-call-a-year" asset gatherers will increasingly be shaken out. Fewer Canadians will pay advisory fees for no advice.

I called factor four the "shadow pension crisis." There’s been much said about the sorry state of pension plans in Canada, but also troubling are the 60 per cent of Canadians who don't have workplace pensions at all. They're underfunded, too. Soon-to-retire baby boomers have been buffeted by the same perfect storm that hit defined-benefit workplace pension plans, namely low interest rates and poor foreign-equity returns.

This means Canadians will be saving more, paying increasing attention to their investments, and likely using some kind of government-sponsored supplementary plan for part of their portfolio.

The last factor I highlighted was the state of the customer. I wasn't around in the 1930s, or even mid-1970s, but I would suggest that investors' faith in the investment industry is as low as it's ever been. The professionals have been wrong too many times (client returns reflect it), have proven untrustworthy on occasion, and are too rich (where are the clients' yachts?).

This lack of trust will increasingly define how clients invest. Baby boomers will take more interest in their portfolio and push their providers harder. Gen X and Yers will do it online with the help of bloggers and peer networks.

Where do these five factors point? Oh darn, I've run out of space. No for room for predictions today. I'll leave that up to you.

By Tom Bradley

Are you confused? I certainly am. It’s not clear whether investors are on a risk-taking binge, or are battening down the hatches for another market decline.

There is plenty of evidence in support of the risk binge. Technology IPOs are coming out at exotic multiples and moving to huge premiums on opening day. Commodity-based funds and exchange-traded funds are now a staple in many portfolios. And there’s been an enormous thirst for high-yield bonds and aggressive fixed-income products.

On the other side of the divide, there are investors who are totally focused on capital preservation. They want and need balanced returns, but aren’t willing to take on the short-term volatility that goes with it. Indeed, some are frozen by the memory of 2008 and are sitting with bulging savings accounts. Most, however, are either soldiering on with their usual asset mix, but are uncomfortable with it, or are pursuing safety through guaranteed and income-oriented products.

As different as they are, both investor types are prominent features of the current landscape. And importantly, both are taking more risk in hopes of achieving their return objectives, whether they know it or not. That’s because low-risk strategies are yielding next to nothing and valuations on higher-potential assets have moved up.

For the bingers, the increased risk comes from paying a larger-than-normal premium for growth. According to the manager of our Global Equity Fund, Edinburgh Partners Ltd., the growth component of the MSCI World index is trading at a 40-per-cent premium to the value part (a price/earnings multiple of 18.4 versus 13.2). To get back to a more sustainable spread, either growth companies have to grow faster than their long-term average, or value companies slower.

Wild About Growth

I should add that some of my favourite thinkers, including Howard Marks (Oaktree Capital Management), Jeremy Grantham (GMO) and Tim Price (PFP Wealth Management), think the risk-takers have gone wild in pursuit of growth.

For the batten-down-the-hatches types, truly low-risk assets won’t deliver adequate long-term returns – government bonds and GICs provide little income – so they now own more corporate bonds than usual, perhaps even some in the high-yield or junk category. They’re also getting more of their income from preferred shares and dividend-paying common stocks. These strategies are fine, but they will come with more volatility. It’s not a matter of “if” junk bonds and banks stocks will go through a rough patch, but “when.”

In this higher-risk/low-return environment, there are no easy answers for either type of investor. In a recent letter, Howard Marks outlined five unappetizing solutions. Investors can (1) go to cash; (2) ignore low absolute returns and pursue the best relative returns; (3) forget about high valuations and buy for the long term; (4) move up the risk curve and reach for returns that used to be available with greater safety; or (5) concentrate on special niches where value still exists.

Our recommendation to clients is a combination of (1), (4) and (5). We’ve been advising that they hold a cash cushion (5 to 10 per cent or more, depending on the objective), go light on bonds where valuations are poor, and focus on high-quality stocks of all sizes and geographies.

Margin of Safety

Why the cash and quality? Because there are not enough cushions elsewhere, especially if we run into serious economic or credit difficulties. Our most effective crisis-fighting tools – interest rates and government spending – are no longer available to us. There’s no room for rates to go lower and the spender of last resort is close to being tapped out. Similarly, the indebted consumer is running close to the line.

The world economy has leaned heavily on China for growth, but there too the cushion is getting thinner. The government can keep spending for years to come, but the stresses of past stimulus are starting to appear – housing excesses, weak banks and rising inflation.

In a situation like this where we’re working without a net, we’d typically expect some concessions in the form of cheaper valuations. But as noted above, even that “margin of safety” isn’t there.

So without adequate cushions in the system, we need to build some of our own. That will take a different form for each type of investor, but should be done, as always, in the context of a long-term strategy.

By Tom Bradley

We’ve had low interest rates for years, and really low rates for almost three. We’re used to them, and may even be getting complacent. I had more questions and concerns from clients about rising interest rates a year or two ago than I do now.

Well, I’m here to tell you that it’s not a time to be complacent. Quite the opposite. Low rates are causing enormous distortions in the economy and financial markets, and it’s important to understand them, and try to be on the right side of the divide.

Before explaining, I want to be clear that I’m not calling for interest rates to rise next week. I have no idea where they’re going short term, nor is our bond manager calling for a big change.

But taking a slightly longer view, investors and borrowers need to recognize that interest rates are artificially low. By that I mean, the normal mechanism for setting prices has been tampered with.

The U.S. Federal Reserve is holding short-term rates near zero in hopes of stimulating the economy. As a result, the U.S. government, and other more creditworthy institutions, are able to issue bonds at rates that don’t even offset expected inflation (i.e. the real or after-inflation yield is negative). A five-year U.S. Treasury bond is yielding 1.5 per cent.

This Fed subsidy serves to transfer wealth from the lender to the borrower.

Bill Gross of Pimco describes it well. “The artificial yields, in effect, act as a tax on savings, undercompensating asset holders and transferring the haircut benefits to the debtor nation.”

Who Benefits

Unfortunately, Fed chairman Ben Bernanke can’t control who he subsidizes. So while helping out indebted home owners and the government, he’s also giving a boost to borrowers who don’t need any assistance, including profitable corporations, hedge fund managers and Canadian home buyers. Here come the distortions.

For starters, people saving for retirement, or already living off their investments, are being stolen from. Returns from their bond portfolios won’t be adequate to live off of going forward, let alone keep up with inflation. To attain a reasonable amount of income, they’re forced to take more risk.

By encouraging more risk-taking across a broad range of assets, too-low interest rates push prices up. Corporate bonds are the most visible example, but stocks, real estate and other long-term assets are also affected.

Real estate is a great example. Prices are driven by a number of factors (the economy, jobs, location and, in the current context, Chinese buyers), but they’re always linked tightly to interest rates. With rates where they are, prices on both commercial and residential properties have risen steadily in Canada, with some income properties now being transacted at “cap rates,” or yields, under 4 per cent. A property manager I know describes the availability of cheap credit as “rocket fuel.” Real estate is all about location, location, location, but these days rates, rates, rates aren’t far behind.

Neither a Borrower Nor a Lender Be

So it’s not a great time to be a lender. Yields are low and the assets being financed may be on the pricey side.

Is it a good time to be borrower? Certainly, if you’re refinancing existing obligations, it’s the best. Your cost of borrowing goes down while the value of your asset is going up.

But what about borrowing to buy an asset? Would you rather buy an expensive house with a cheap mortgage, or buy a cheap house with an expensive mortgage?

Of course, there’s only one answer to that question. As an owner, you live with the price forever. Buying low always make the economics work better. Favourable financing terms, on the other hand, are transient. There is a risk that the mortgage has to be renewed at a much higher rate. Unless you’re a government or corporation that can raise 25-year money, you can’t match your liability – your mortgage, in the case of home buyers – to the life of the asset.

Low-cost financing is intoxicating, and it’s nice to be subsidized, but we need to keep our intake in check. And we need to make sure that the valuations on our assets make sense, not just today, but in non-artificial times as well. It’s not a time to be complacent about too-low interest rates and the impact they’re having on the economy and our investment portfolios.

We heard this week that Vanguard, the giant U.S. asset manager, is coming to Canada. As a permanent student of the business, I’ve been fascinated by Vanguard for many years. It’s an example of a company that grew through word of mouth. It went viral before the Internet was mature and long before Facebook and Twitter existed. Without a big advertising budget or a commission-based sales force, it now manages mutual and exchange-traded funds totalling $1.85-trillion (U.S.).

To go viral, a company needs to be unique, fill a customer need and be entrepreneurially managed. Vanguard fits the bill. On the uniqueness measure, it’s off the scale.

The company was founded by the father of indexing, John Bogle, and is headquartered in Valley Forge, Penn. It’s not owned by a family or bank, nor is it a public company. Vanguard is a co-operative. It’s owned by the unitholders and the mutual funds are run at cost. As a result, they have the lowest management expense ratios (MERs) in the business by far.

I have visited the Vanguard campus a number of times over the years, and what’s always jumped out at me is the esprit de corps. In an industry that has a tarnished image, this crew (nautical terms are used to name everyone and everything) is passionate about what it’s doing. Staffers work hard to improve client returns by providing lots of educational material while pounding away at the principles of long-term investing.

Vanguard was built on the back of the indexing trend, even though its roots were in active management (now 30 per cent of equity assets). When Mr. Bogle started the S&P 500 Index Fund in 1976 (now holding $112-billion), it took a while to get traction. When indexing eventually caught on, however, the company owned the market for a number of years.

As it enters Canada, Vanguard will be up against established players who offer a broad range of ETFs, but the market is still under-penetrated. Indexing has been much slower to catch on here due to the dominance of commission-based advisers and bank-branch sales. Indeed, until ETFs emerged in the last decade, Canadian investors had few low-cost index funds to choose from.

Set Benchmark for Fees

I expect Vanguard to lead on fees, and there will be some categories where it establishes a significant advantage. For example, one of its big sellers in the U.S., Vanguard MSCI Emerging Markets ETF, has an MER of 0.22, which is considerably cheaper than the competition.

Vanguard will also tout its strong record in tracking the indexes, where it’s rated best among the majors (i.e. smallest tracking error).

Will Vanguard have an impact on our investment landscape? I’d be surprised if it didn’t. Fees will come down. It will take away meaningful market share from existing ETF and mutual-fund players (there is already substantial pent-up demand for Vanguard funds among investors and advisers). And it will bring more of a long-term focus to the wealth-management scene through its educational efforts. In the U.S., Vanguard was late to the ETF party, but was the sales leader last year and is now No. 3, behind BlackRock (iShares) and State Street.

Skip the Advisers

If Vanguard chooses to focus on selling ETFs to advisers, as most people expect, its entry into Canada will be more evolutionary than revolutionary. In my opinion, it would have a far greater impact if it developed the other side of its U.S. model – a direct-to-client fund company that doesn’t rely on the adviser network. Without the middleman, the cost for clients would be substantially lower and Vanguard would have a bigger impact on investor behaviour.

Direct distribution makes up 20 per cent of the fund market in the U.S., with Vanguard, Fidelity, T. Rowe Price and a few others having substantial assets under management. In Canada, however, the direct market is still a niche, with only RBC Phillips, Hager & North and a few other small firms (including Steadyhand) taking it seriously.

Whichever way Vanguard chooses to approach the Canadian market, it will be a positive influence. Its culture and ownership structure put it solidly on the side of the investor and it has the heft to shake up our market’s dominant players.

By Tom Bradley

“What I find of particular interest is the speed at which changes in communication technology are happening. It’s causing a great intergenerational knowledge gap, which is rather worrisome because many decision makers are still part of my old-fart generation.”

This comment by my friend John Rogers, a lawyer and technology entrepreneur, got me to thinking about my industry. Is there a similar gap in asset management? And if so, who does it favour?

Given that I’ve been burdened with grey hair at a ridiculously young age (I think of it as premature wisdom), I’m desperately hoping there is a gap that favours the seasoned over the newly brilliant. It seems to me that the buy side is one industry where tenure should be an asset.

To test my thesis, I sought out seasoned portfolios managers who’ve successfully guided their funds and firms through many market and performance cycles. I asked this esteemed and highly biased group one question: What advantage do you have over the young bucks?

I started with Bob Hager, co-founder of Phillips Hager & North. Unfortunately, Bob is extremely humble and spent more time rhyming off reasons why the youth have the upper hand. Their technical skills are more current and they’re quicker to embrace “the new stuff,” which means they gain the early spoils.

I tried to cut Bob off because that wasn’t what I wanted to hear. I know all about the disadvantages. A veteran’s energy level isn’t as consistently high. They have more distractions including management duties and other activities that success brings (speeches, media appearances, art collections, season tickets, southern homes). And they have a tendency to lose the edge that made them successful – i.e. stock pickers become big picture thinkers – and focus too much on protecting their legacy.

Despite a rocky start, I continued my survey and quickly found consensus – experience really shows through at market extremes. Tony Arrell (chairman and CEO of Burgundy Asset Management) felt strongly that a veteran has the most value at the “critical moments.” There is no substitute for having gone through the intensity, confusion and hysteria of a market event. Bob Krembil (co-founder of Trimark) added, “You can’t learn it from books. You have to experience it.”

Catastrophe and Euphoria

In extreme circumstances, veterans can provide a steady hand. They’re less likely to conclude that it’s different this time. Larry Lunn (Connor Clark & Lunn), whose firm managed through the 1987 crash as well as anyone, told me, “I’ve been through the end of the world a number of times.”

Having talked a lot about bear market moments, I asked Bob K. about the other extreme. Interestingly, he felt that experience, and the strength to apply it, was even more important in euphoric times. It’s then that a patch of poor performance puts the most pressure on a manager to change strategies. Clients are quicker to leave at peaks because, in Bob’s view, “greed is more powerful than fear.”

Some of the grizzled felt that experience was essential in sorting through the flood of information that hits them each day. Differentiating between what’s urgent and what’s important is an acquired skill.

Related to that, a few talked about how experience gave them the ability to pull back and get away from the day-to-day noise. Tony Hamblin (retired from Hamblin Watsa) likened it to being an army general whose job is to command from a distance. This perspective is necessary to help pick up on inflection points in the market and understand the nature and durability of trends – how they take off and how they inevitably unwind.

Perhaps what the years bring more than anything else is the ability to make simple, “tried and true” fundamentals a usable part of the investment process. I’m talking about the real basics. Patience is key. Leverage is a double-edged sword. Don’t invest in anything you don’t understand. And don’t let a good story, positive investor sentiment or lack of alternatives be substitutes for value.

Dennis Starritt (a principal at Bluewater Investment Management) summed up my research as only a portfolio manager could. “Experience is hard to value. It’s like an intangible on the balance sheet.” Certainly it’s no substitute for brains and discipline, but for my money (and my clients), I’ll take the old farts every time.

By Tom Bradley

Personal disclosure: I’m a dyed-in-the-wool active manager, but admit to having used exchange-traded funds in my portfolio. I’ve tread on the dark side for tax planning purposes and, occasionally, to hedge certain long-term positions. I also must confess that I’ve taken no issue with our clients using ETFs, despite the fact that our company offers a simple, low-cost mutual fund alternative.

With that out of the way, I must also say that I get pretty steamed about the lack of scrutiny ETFs get. They seem to have an impenetrable halo over their heads, which emanates from their noble roots – cheap, simple and diversified. I grumble because the ETF landscape has been changing at breakneck speed and is now far from halo perfect. Fees are edging up (there are even performance bonuses in a few cases), complexity is emerging as a real risk, and performance often lags behind the target indexes.

I recently read a report on ETFs published by the Financial Stability Board, which is an international body set up to “assess vulnerabilities affecting the financial system.” The report points out that “the speed and breadth of financial innovation in the ETF market has been remarkable in some large financial systems [countries] over the past five years, and has brought new elements of complexity and opacity into this standardized market.”

The authors focus on the structural issues around ETFs and some of the new risks. For example, in Europe, 45 per cent of ETFs are “synthetic,” which means they obtain the desired return by entering into an asset swap with a counterparty, usually a bank. This derivative strategy is in contrast to “plain-vanilla ETFs” that own the actual securities of the index they aim to replicate. The report is balanced in its commentary and sounds an early warning to regulators and market participants about potential areas of concern – illiquidity, counterparty risk, poor disclosure and misaligned incentives.

If the Canadian regulators or industry were to commission such a report, it might raise some of the same issues. Uncertain liquidity and lack of transparency are obvious ones. Fortunately, the structural risks are less of a worry in Canada because, thus far, most of the ETFs are of the plain-vanilla variety.

But where a Canadian report should focus its attention is on the behavioural aspects of the ETF market. While providers pay lip service to the importance of long-term investing, they are enthusiastically encouraging widespread speculation. The reality is that a small portion of the $40-billion in ETFs in Canada are used to form a low-cost foundation for long-term portfolios.

We’re now approaching 200 ETFs in Canada after having just a handful 10 years ago. The flood of new offerings (reminiscent of mutual funds in the 80’s, 90’s and ... er ... well, today) has steadily carved the bond and stock markets into smaller and smaller pieces. The race is on to achieve first-mover advantage, whereby firms try to get their ETFs established as the standard, or benchmark, in as many sectors as possible. As a result of this proliferation, many of our ETFs are highly illiquid – they trade like micro-cap stocks – and need to be bought and sold with great care and patience.

The ETF firms are playing to the active traders and speculators, whether they be individuals in their basement or professionals in office towers. Trading volume and assets under management are focused on the hot and, dare I say, more speculative areas of the market. All of this is fine for the purposeful trader, but the Financial Stability Board isn’t worried about them, and neither am I. It’s the investors who are unknowingly investing less, and speculating more, that is the concern.

I came across a quote a few years ago that reinforces this point. John Bogle, the father of indexing, was credited with saying: “As the splinters get thinner, they grow sharper, and the odds of folks hurting themselves with these pointed objects now approach 100 per cent.”

Right off the top, I could tell the team was worried about my loose-cannon tendencies. They want me to stay away from town hall meetings and only answer questions in writing, with editors at hand. They want nothing to do with my agenda for lower fees, better transparency and more foreign exposure. Counter to my mavericky nature, they want me to run a conventional campaign. I’m not allowed to say what I’d really do.

Something for every man, woman and child

I’m told I have to offer something that everyone wants, so I must liberally use words like “yield” and “dividends.” Recommending Canadian investments in general is a safe way to get applause, but I’ve also been directed to link our resource sectors to the growth opportunity in China.

In my policy document, the Gold Book (what colour did you expect?), I’ll bash the U.S. every chance I get and recommend currency hedging on foreign holdings.

Exchange-traded funds have a halo over their heads. There’s a new one every week and the media love them unreservedly. So even though I’m an active manager, I’m told to sing their praises.

Obscure the truth

My people tell me that there are areas where it’s alright to play fast and loose with the facts. I think they’re referring to guaranteed products and Principal Protected Notes (PPNs), where investors rarely question, and the industry never says, how much they cost or what the unintended risks are. Hedge funds are also fertile ground. The regulators haven’t got there yet.

I’m advised to talk as much as I can about tax-efficient yield and return of capital. Again, it seems nobody has figured out that giving investors their own money back is not a particularly innovative tax strategy.

Don’t go there

When I bring up some of my pet topics, the strategists go ballistic. I am told they’re to be avoided at all costs. In that vein, all numbers have been removed from the Gold Book, as have my views on complexity risk, overdiversification and lack of co-investment.

I’m to avoid talking about future returns. Investors don’t want to be told they need to save more. Real estate is also a no-no. The impact of rising interest rates could be dramatic, but my handlers were quick to remind me that Jeff Rubin almost got lynched for predicting significant house price declines in the late ’80s.

The single regulator debate is also no-man’s land. It’s of no interest to voters, even though 13 regulators make no sense in this hyper-competitive world. And besides, even with czarist powers, my chances of overcoming the politics of the issue are virtually nil.

Ahead of the curve

There are changes coming to the industry that no leader will be able to affect, so I’ve been given the okay to endorse them and even take ownership. Australia and the U.K. are embracing transparency around adviser compensation, and the U.S. is moving that direction, so it’s only a matter of time before Canada falls in line. Therefore, I’m happy to state that I’m in favour of eliminating hidden fees – i.e. trailers and deferred sales commissions.

In general, the industry is abysmal at reporting investment returns and fees, but my contacts in the regulatory world tell me that’s also going to change. My people are hopeful that I can get Peter Mansbridge to point out that our client statement already meets the new standard.

After just a few sessions with my strategists, I realize just how tough politics can be. Dealing with the irrational Mr. Market on a day-to-day basis is starting to look pretty good. But oh, how I’d like just once to wield some power over the industry and see whether we could make it more investor-centric and less self-interested.

By Tom Bradley

Value managers make a habit of scanning the 'new lows' list on the stock page. They’re hoping to find good companies that have stumbled and are oversold.

Buyers of the funds run by those same managers, however, rarely do that. They most often go for the 'new highs.' Typically, money flows into funds, and fund categories (technology, precious metals, energy), that have done well in recent years. While other factors come into play – such as the manager and firm’s reputation, marketing efforts and long-term returns – good recent results are buyers’ prerequisites.

This bias is unfortunate because it narrows the field unnecessarily. If the best managers are going through a tough patch, which they invariably do, then their funds may not be considered. It’s particularly unfortunate because those are often the times when managers are feeling the best about their portfolios.

The performance requisite can also suck investors into what I call the Cycle of Hope. By consistently rotating to funds or sectors that have done well in the recent past, they can get caught in a downward spiral. They’re positioning themselves for what’s already happened instead of what might be. As a result, their returns suffer.

Can a fund that’s led the way in your portfolio continue to do well? Absolutely. It may stay at the top of the rankings for years and deliver excellent long-term returns. But be assured that it too will experience some down times.

There are a number of reasons for this. First and foremost, it’s impossible to be right all the time. Even top managers have periods when they’re out of sync with the market.

Also, when stocks go up, so do valuation multiples. Funds that have done well aren’t as cheap as they previously were. Managers make adjustments – sell expensive stocks and buy cheaper ones – but it’s difficult to do completely. And it isn’t easy to part with companies that fit perfectly with the manager’s philosophy, particularly in Canada where there are so few alternatives.

It’s important to remember that what works in one environment may be totally unsuitable in another. For instance, a manager with strengths in resource stocks will thrive in an inflation-driven market, but will likely struggle in an economic slowdown.

And we shouldn’t forget about luck. It definitely has an impact in the short term, but the last I checked, it evens out over time.

Can investors fight this tendency to chase performance? I think so. A number of years ago, I had an experience where a client did just that. My partner and I were given the opportunity to present to a pension committee that was looking for both Canadian and U.S. equity managers. We thought the only chance we had was on the U.S. side, where our numbers were smoking hot. Our Canadian returns were just okay.

When the decisions were made, they hired us for ... wait for it ... Canadian equities. The committee liked the firm, people and approach. As the CFO said to me, “We’re pleased to be hiring a good manager when they’re down.”

Now jump ahead a number of years to when I was doing a semi-annual review with the committee. It went well and they were pleased with the returns. But later that day I met with a newer client who had hired us after our returns had improved. Their choice was more influenced by short-term returns and as a result, the session had an entirely different feel. The relationship was fine, but it never attained the same level of confidence and the returns (since inception) weren’t as good. Same portfolio. Same personable manager. Different result.

I’ve always had a high regard for the first committee, because they did something that few investors do. They ignored the short-term results and chose us for the right reasons. And they were rewarded.

So it’s not a bad thing when the short-term data are misaligned with the long-term factors. There’s a lot to be said for going against the grain and hiring a proven manager whose strategies have yet to play out. Your cycle has more chance of being a virtuous circle than an “always hoping” death spiral.

By Tom Bradley

In Toronto last week, I was waiting for a friend at my Starbucks office. As I browsed the Sports section, I couldn’t help but overhear a nearby conversation between two investment types. The checked shirt was leading the discussion.

“My overweight in energy is really working. I’m 300 beeps ahead, even though my TE is sub 4. If this holds until quarter-end, my one-year number will be first quartile. I don’t know if it’s enough to get on any short lists though. My moving fours still suck.”

I was getting bored reading about the Leafs’ momentary playoff run, so I tried to descramble the jargon. What I think he said was: So far this quarter, his portfolio has achieved a return that is 3 per cent (300 basis points) better than the index he’s trying to beat. This has occurred because a larger percentage of his fund is invested in oil and gas stocks, which have done well, compared to the index.

Tracking error (TE) is a statistic that predicts how much the portfolio’s return is expected to deviate from the index – the lower the number, the more closely the portfolio will mirror the index.

I also picked up that if the shirt does okay in the remaining days of the quarter, his one-year return will look good and be in the top 25 per cent of funds he’s competing against. Unfortunately, one good year won’t be enough to make his longer-term results look attractive; specifically the four-year periods ending March 31, 2011, 2010, 2009 and possibly further back. The manager hasn’t been getting invited to compete for any new institutional accounts recently.

Unfortunately, the other geeky-looking guy was a bond manager. “It doesn’t make any sense to own Canada’s when I’m getting 75-80 beeps in Ontario’s. More of our risk budget is in provies than I can ever remember. Where I’m struggling is with the credit bucket. I want to sell some Trucks and Boats, but can’t find anything to replace them. I need something in the belly of the curve that’s better than bank paper.”

Bond talk is more challenging to translate, but I take it that Mr. Corduroys has a large position in provincial bonds in lieu of Government of Canada bonds. By holding Ontario, B.C. and other provincials, the fund is getting an extra yield of three-quarters of 1 per cent. In the corporate bond portion of the portfolio, he’s planning to sell specialized income securities issued by Royal Bank (“Trucks”) and BMO (“Boats”), but hasn’t figured out what to replace them with. In his opinion, the extra yield he gets by owning six- to 10-year bank bonds isn’t attractive enough to justify the risk.

As the lattes were disappearing, it became evident that I was the only one doing any listening. The shirt motored on.

“This focus on cheap beta is killing me. It’s all the consultants and media can talk about. That hottie from AON Mercer Towers keeps reminding me that index-like returns are free. She doesn’t seem to get that my fund doesn’t go down as much as her beloved XIUs. But I might have got through to her this time. The propeller heads did a chart for me that shows my bear capture at 73 per cent.”

Whoa, maybe bonds aren’t so bad after all.

Beta is an industry term used to describe the return of the overall market. For pension funds, and other large institutions, index investing (beta) can be done at an extremely low fee (a few hundredths of 1 per cent). On the other hand, active managers, who are out to beat the index funds, charge considerably more and are under pressure to justify their fees to clients and consultants (male and female).

Most active managers beat the indexes in weak markets, which can be shown by a ratio that statisticians call Bear Market Capture. In this example, the shirt’s portfolio had a bear capture of 73 – in down markets, it declined only 73 per cent as much as the index (as represented by the iShares exchange-traded fund – symbol XIU).

Thank goodness my friend arrived so we could relax and talk about the Canucks’ PK, Stevie’s triple double and where the Wildcats were seeded in the West regional. No translation required.

By Tom Bradley

Over the last two years, I’ve spent most of my time encouraging people to get invested. As a result of the 2008-09 market meltdown, there were, and still are, too many investors who have strayed significantly from their long-term asset mix and are out of the stock market. I’m speaking of those who have a longer time horizon and want to build their financial wealth.

More recently, I’ve altered my view and been forced to do something that’s very hard for me. I’m preaching the joys of cash. Yes, the stuff that earns 1 per cent. Investors who are on their long-term plan (and are therefore fully invested) should be carrying a modest amount of cash (5 to 10 per cent).

It’s hard because I’m trained to be fully invested and feel uncomfortable when I’m not. In my early days at Phillips, Hager & North, my more worldly and wise partners (read: older) pounded into me that in the long run, bonds beat cash and stocks beat bonds. It went something like this, “Tom, you can’t call the market in the next month or two, so why do you have that much cash in the portfolio? Don’t you know that … .” To which I’d invariably respond, “I know, I know – lower returns, no inflation protection and how do I know when to get back in?”

Certainly that is one school of thought. Over time, stocks rise and cash returns will lag. A portfolio manager has to really be struggling to find well-priced securities before he or she should carry a significant cash reserve.

The fully invested approach particularly comes into play with specialty assignments for institutional clients. What matters to a manager of the Canadian equity portion of a pension plan is not whether returns are positive or negative, but how they compare to the S&P/TSX composite index. And because the index has no cash in it, anything above a token amount represents a bet against the market.

As I work almost exclusively with private clients now, I find myself moving away from the relative approach of asset allocation and toward the other school, which is grounded on absolute valuations. I want to own bonds and stocks because they’re cheap, not just cheaper than something else. If I can’t find enough undervalued securities to fill out a portfolio, I’m happy to hold low-yielding cash.

To be clear, I’m not any better at timing the market than I used to be (so I don’t try) and I still want to beat the cashless indexes over the long term, but I’m more valuation driven today. I hate holding cash, it’s true, but I hate holding overpriced assets more.

In a recent report, James Montier of U.S.-based GMO LLC brings the differences between the two approaches into the current context. “One of the ‘arguments’ for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I’ve described this as the ugly stepsisters’ problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I’d rather wait for Cinderella to come along,” he writes.

Despite the decidedly non-current analogy (couldn’t he have used frogs and princes?), Mr. Montier’s point is a good one. Methods that allocate capital based on relative valuations have a major flaw – they fail to predict long-term returns for either asset class.

The current market environment is very revealing of money managers’ fundamental approach to investing. I say that because many that I talk to seem to have less and less enthusiasm for what they own. They can rhyme off the merits of resources, dividend-paying stocks and/or corporate bonds, but are quick to point out that bargains are harder to come by. Conversations are punctuated with phrases like “it’s not as cheap as last year” and “we’re being selective.” For managers using a relative value approach, this means reallocating from expensive assets into something cheaper. For the more absolute oriented, sale proceeds go into a growing cash reserve, while the search goes on for frogs with prince potential.

By Tom Bradley

In addition to my day job, I sit on investment committees for two institutional funds, so every quarter there is a pile of manager reports to read and many different perspectives to assimilate. Unfortunately, if I try to do too much in a short time, as I did this week, my head starts to spin (wine is only partially responsible) and I develop a deep yearning to get back to basics. Just let me buy cheap stocks.

It’s the big-picture stuff that does me in. I’ve written in the past about my skepticism for top-down, economics-driven investing. Given the complexity of the world, and capital markets, it’s hard to consistently add value when there are so many conflicting factors feeding into every decision.

But despite my yearning, I recognize the need to find a balance between stock-picking and the big picture. Renowned value investor, Seth Klarman, described his approach to the conundrum as, “Worry top down. Invest bottom up.” At Steadyhand, we think similarly, although we describe it as trying to be “Approximately Right.”

Approximately Right means that most of the heavy lifting is done from the bottom up by our fund managers. In the context of a diversified portfolio, they do their best to buy securities that are worth considerably more than they’re trading for. As for the top down, most of the time we advise our clients to stick closely to their strategic asset mix, which is a guess (an educated guess, mind you) as to what combination of security types will work best in the long run.

This approach is boring, and has the appearance of doing nothing, but in the absence of compelling reasons to do otherwise, it’s also effective. As Warren Buffett says, “Wall Street makes its money on activity. You make your money on inactivity.”

Straying from the Long-Term Mix

But Approximately Right doesn’t mean standing idly by when there are extreme dislocations in the markets. To call on another of Mr. Buffett’s analogies, if there is a fat pitch over the middle of the plate, we will take the bat off our shoulder and swing. To be clear, I’m not suggesting that clients try to time the market based on headlines, but rather react to extremes in valuation and divergences from long-term trends. We want them to follow a steady course and get the market extremes approximately right as opposed to exactly wrong.

Are there reasons to stray from our long-term mix today? The answer is yes. Too many indicators are at extremes and most of them are either presaging slow economic growth or reflecting high valuations.

We have artificially low interest rates. Bonds prices are assuming a perfect scenario – an extended period of slow economic growth, benign inflation and some semblance of sound fiscal management by governments.

In the meantime, low rates are inflating asset prices. As one property manager said to me recently, it’s like adding rocket fuel to the real estate market. But it goes beyond buildings. Across a number of asset classes, we’re seeing too many bidding wars at a time when the economy is employment-challenged and in need of restraint.

The restraint part is the result of another biggie – government and consumer debt. Many countries, states, provinces and households have reached, or gone beyond, their credit limit. For the overextended, there is now little room for error.

There are other measures that are off trend. Corporate profit margins are running at all-time highs, which will make growth harder to come by. The world economy is more influenced than ever by countries lacking in stability, transparency and/or democracy. And the euphoria for gold and hostility for anything American (except Apple and Natalie Portman) are near all-time highs.

There’s always a reason for any one chart or statistic to be outside of its normal range, but when many of them need an explanation, it’s time to be wary. To me, that means lightening up on bonds, carrying extra cash and making sure my stock valuations are reasonable. It’s a sellers’ market now, but as the extremes come back to earth, as they invariably do, suppliers of capital (buyers) will regain the upper hand. It’s time to start getting the bat cocked.

By Tom Bradley

“Risk-free investing. Yes, it does exist.”

These words are featured prominently in a financial institution’s ads we’re seeing this season. And every time I see them, it sets me off. Why? Because investing is all about taking risk. Without it, we get risk-free returns (currently 1-2 per cent). François Sicart, chairman of Tocqueville Asset Management in New York, captured it best when he said, “I never invest in a situation in which I cannot lose money.”

Investors should go on full alert whenever they hear the words risk-free and safe. Our industry throws them around too freely, or at least, allows them to be misinterpreted too easily.

Bill Gross of Pimco recently coined the phrase “safe spread” to describe his firm’s use of corporate bonds, U.S. agency mortgages and emerging market bonds to enhance yield. Certainly Pimco has been astute at navigating the credit markets, but putting “safe” and “spread” in the same sentence is a dangerous precedent. The reason their clients receive a higher yield is because they own bonds with a greater chance of default. They’re taking more risk.

In some quarters, investing in gold is presented as a safe strategy. The shiny metal is perceived to be a store of value at a time when governments are doing their darnedest to devalue their currencies. Owning gold has merit in terms of diversification, and may indeed produce positive returns, but it should be recognized for what it is – pure speculation.

Gold generates no income, so it’s difficult (or should I say impossible) to value. And with 80 per cent of it locked up in vaults, the price is driven by how investors are feeling, rather than supply and demand. It’s the ultimate sentiment-driven asset.

'Buy Canada'

Another prevailing sentiment these days is that having all your investments in Canadian securities is safer. Canada has a stable government, sound banking system, healthy housing market, strong currency and abundance of natural resources. Why would an investor go anywhere else?

Well, there is a flip side to the all-Canada, all-the-time story. At a fundamental level, Canada is now running chronic trade deficits, despite the commodities boom, and the quality of exports is deteriorating – we’re now shipping logs from British Columbia instead of wood furniture from Quebec. We have failed to penetrate the emerging markets or develop industrial leadership in anything other than energy and raw materials. And it’s not clear if Canada is going to participate in the manufacturing renaissance that’s beginning in the U.S.

As the Canadian economy becomes more resource dependent, so too have Canadian investors. Owning an index-like portfolio of Canadian stocks means having a large exposure to the highly cyclical industries, specifically energy (24 per cent of the S&P/TSX composite index), materials (17 per cent) and industrials (5 per cent). A bulk of our economy – health care, consumer products, technology and utilities – accounts for just 10 per cent of the index’s capitalization.

So while we take comfort from Canada’s strong economy and world-beating market returns, our portfolios have become more speculative, higher priced and increasingly focused on a few industries. And going forward, returns will be constrained by some of these same comfort factors, namely a less competitive currency and dearly priced real estate market.

What To Do

What can you take away from all this?

First, a prudent investment strategy involves owning a combination of risks, including Canada, Europe, Asia, emerging markets, dividends, growth, resources, large caps, small caps, bonds, real estate and cash. Canada alone does not represent a well-diversified portfolio.

Second, it is possible to have a safer Canadian portfolio by owning stocks that more closely reflect the Canadian economy and less closely the S&P/TSX’s industry weightings.

Third, nobody knows when the resource boom will end, but it’s important to remember that it’s a cycle, not a secular trend. For all commodities, high prices lead to more supply (higher production, innovation) and less demand (delayed purchases, substitution), which ultimately translates into lower prices and sales volumes.

And finally, in pursuit of safety, you should be careful what you wish for. You may end up with risk-free returns.

By Tom Bradley

Bay Street, we have a problem. A PR problem. Our clients think we can do more than we’re capable of. Some think we know which stocks are going up and when to get in and out of the market. We’re setting them up for disappointment and as a consequence, hindering the growth and stability of our business.

The gulf between client expectations and the realities of the wealth management industry covers a lot of ground. Investment returns are at its core – what’s hoped for versus what’s achievable – but there are other factors that serve to widen it.

Overselling

We all want to win new clients, so naturally we put our best foot forward. We trot out all the great things we’ve done in the past. Savvy stock picks and prescient interest rate calls are duly highlighted. We advertise the funds that are performing the best right now.

We do it because it works. Managers and advisers with the most appealing “recent past” look the smartest and win most of the business. Industry statistics consistently show that money flows into funds and firms with good short- and medium-term returns.

But what makes it worse is that we continue overselling, even after the client has been won. We take credit for too much. Way too much. If a stock does well, it was a great call. If it goes down, it was a problem with the market. Our clients are led to believe that we have a higher batting average than we actually do.

Predicting the unpredictable

In overselling our abilities, we imply there’s a level of precision in investing that just isn’t there. When we confidently predict the market will be “up 8 to 10 per cent this year” or “the dollar has little downside from here,” we weaken our client relationships. Too many factors come into play in a stock, currency or asset mix decision to project anything more precise than a range of potential outcomes. Sorting out the visible, quantifiable variables is hard enough; let alone factoring in the lesser-known triggers that lurk in the shadows. (How many prognosticators had Greece or Egypt in their forecasting models?)

Charlie Munger, Warren Buffett’s trusty sidekick, refers to it as physics envy, or the tendency for economists (in this case, investment professionals) to put false precision into a complex system. “[The profession’s] search for precision in physics-like formulas is almost always wrong.”

It’s a perverse world

But the gulf is not all our fault. The nature of investing makes it extremely hard to communicate clearly with clients. Capital markets are volatile, unreasonable at times and most often counterintuitive. Think about it. If everyone you know is recommending an appliance or car, then it’s likely to be a good buy. If, on the other hand, they all like a stock, it’s time to run for the hills.

In the perverse world of investing, it’s hard to remain credible with clients when we’re telling them their best moves will be the ones that make them feel the most uncomfortable. Or poor short-term results will translate into higher returns going forward. Or they should ignore a heavily advertised fund and buy more of the boring one in their portfolio.

In spite of these challenges, there are things we can do to solve our PR problem.

Narrowing the gap

When returns are really good, we can do a better job of talking them down. My former partner, Bob Hager, was a master of this. When he had great numbers to report, he went out of his way to point out the missteps he’d made. He primed his pension clients for a time when the numbers wouldn’t be so good.

We can talk with certainty about uncertainty. It’s not a matter of “if” an equity fund goes down 20 per cent, but rather “when.” By framing it in these terms, expectations are more realistic and clients better prepared.

We can cast risk in a more positive light. After all, it’s the fuel that drives returns and we’re the risk managers. So rather than advertising our risk-free approach to investing, we should illuminate the risks our clients are taking.

And finally, we can represent the markets for what they are – totally and utterly perverse.

By Tom Bradley

On the buy side, we have a love/hate relationship with our stars. We’re happy when they put big return numbers up on the board, bring recognition to our firms and attract new assets. We don’t like it, however, when we become too dependent on them. Then we have to dutifully answer to their pay demands, carefully manage their egos (or should I say massage), and above all else, make sure they don’t leave.

Over the years, mutual fund companies have been more than happy to showcase their star managers. Just about the time the NBA went from promoting the Lakers and Celtics to showcasing Magic and Bird, fund companies started putting their portfolio managers on billboards. They did it for the same reason the NBA did – it sells.

And despite the managerial challenges, it’s an asymmetric bet for the fund company – more assets are gathered because of the star than are redeemed when said star leaves or retires. The risk is one of lost opportunity, not lost assets. (I’m always amazed that the fallout isn’t worse when a highly regarded manager leaves. Some clients sell the fund, but it’s never as bad as first predicted.)

I have a particular interest in the dependency dilemma because it’s a natural consequence of my investment approach. And being a relatively small and young firm, we get asked about it a lot. What happens if one of your fund managers leaves? How dependent is the firm on Tom’s leadership? What if he goes skiing and never comes back?

Whether I am running a big or small firm, my philosophy is always to look for the “three smart people in a room.” I’d rather have the best person or small group I can get than a large team spread around the world. I want the full benefit of their intellect, experience and temperament, unencumbered by size and organizational constraints. And when I find a talented money maker, who may or may not be well known, I’m happy to get on their back and ride them for all they’re worth.

Beyond investment returns, this approach has the advantage of being transparent. It’s clear who’s managing the portfolio, or at least, losing sleep over it. And it’s equally clear when they’re gone. With the team approach, you don’t always know who the key player(s) are or how decisions are made.

That’s not to say that the organization a portfolio manager is working for isn’t an important factor, because it is. She needs to be in an environment that has appropriate resources and minimal distractions, and importantly, provides support when it’s most needed, when the returns are less than star-like. Having said that, I do think our industry focuses too much money and attention on putting horsepower under the hood (teams of analysts) and forgets about the transmission that delivers the power to the wheels (crisp decision-making). I recently heard of a global asset manager that had four analysts in different parts of the company doing research on the same stock. Is that depth or dilution?

In the institutional arena, the three-smart-people approach doesn’t work as well. Pension and foundation committees are generally leery about hiring a firm that’s dependent on a star. Instead, they’re looking for depth on the investment team and want to be assured that if someone leaves, the philosophy and process, and presumably performance, will live on. For an institutional investor, changing managers is costly and time-consuming.

For individual investors, however, the three-smart-people approach makes more sense. They don’t want to be changing managers either, or following them around the Street, but it’s easy and cheap to do if necessary. So I don’t avoid star dependency, but rather embrace it. It’s a nice problem to have a portfolio of high-performing, ego-centric managers that I’m worried about losing.

By Tom Bradley

“Finding the right answers is easy. Asking the right questions is the hard part.”

As we open our calendars on 2011, this old adage has never been more apt. We’re being buffeted with crosswinds and it’s not obvious which ones will affect investment returns the most. I have no special insight on what will dominate in 2011, but do have a few questions to help guide investors’ thought processes.

Can profitable, cash-rich countries thrive while debt-ridden governments and consumers are cutting back?

There is no doubt that a slow or no-growth economy will restrain profits. Economic growth is the number one driver of corporate earnings.

In a subdued environment, however, opportunities will emerge for well-funded companies. Increasingly, public infrastructure will be privatized, and innovative companies can be part of the solution in areas such as power generation and delivery, energy efficiency, health-care management and transportation. Corporations are better capital allocators than governments and can take advantage of low interest rates and labour availability.

There are also parts of the world that aren’t debt and growth challenged. If you’re sitting in Beijing, Bangalore or Sao Paulo, you’re not worrying about lack of opportunity.

Where do I want to be when interest rates are two percentage points higher?

Low interest rates are the economy’s Red Bull. They encourage consumption and risk-taking now, at the cost of lethargy later. The rate tap is flowing because, on balance, there are more segments of the economy that need life support than don’t.

While low rates keep the weak alive, they’re overfeeding the strong. Risk-taking is being encouraged and asset prices are inflating. Investors are buying corporate bonds (credit risk) with the expectation of a 3- to 5-per-cent return. Income-producing real estate is being scooped up based on similar rates. And valuations in some sectors of the stock market are getting stretched.

When the Western world’s economy picks up enough to shift the focus from supporting the needy to discouraging the greedy, and/or a little more inflation creeps into the system, rates will rise. At that point, we don’t want to be only holding rate-sensitive securities like bonds and income-oriented stocks, or trying to sell a condo.

I have strong views on [hot-button issue here], but am I getting the valuation right?

We’re living in a time of extreme views. People either believe passionately in gold or think it’s a bubble. They want to avoid the U.S. and Europe at all costs, or see these recession-ravaged economies as great places to invest. They’re worried about inflation, or deflation.

As investors, however, we’re not here to be proven right on our theories, but rather to generate attractive returns. We therefore need to understand how much of our view is already factored into the price. It’s important to make the right fundamental call, but it’s more important to profit from it by getting the valuation right.

As Howard Marks of Oaktree Capital Management often says, “No asset can be considered a good idea (or a bad idea) without reference to its price.”

Are there compelling reasons to diverge from my long-term asset mix?

An investor’s strategic asset mix is the blend of securities that has the best chance of achieving his/her long-term goals. It’s an educated guess, designed to find a balance between return, volatility and income. Given how unpredictable markets are in the short term, investors need compelling reasons to stray too far from their mix.

Currently, I’m running close to my targets, although I’m holding more cash than usual at the expense of government bonds. To my mind, the reward-versus-risk equation for bonds is tilted the wrong way.

Through my Steadyhand funds, I own a broad range of stocks, including domestic and foreign, and dividend and non-dividend paying. And I’m keeping my speculation on currencies and commodities in check. Some of the cash is in U.S. dollars to fuel my southern property dream, but I don’t own gold, silver or copper.

In a nutshell, I think corporations will do just fine in this economic environment, I can live with higher rates when they come and am not confident enough at this point to make a big bet against my long-term plan.

By Tom Bradley

Hindsight bias: The inclination to see events that have occurred as being more predictable than they were before they took place.

That’s Wikipedia’s definition of a behavioural weakness we all have. We take credit for having seen something coming when we really didn’t (or at least our actions give no indication that we did). Investors are particularly susceptible to hindsight bias. So much so in fact, that a friend of mine suggested we start up a helpline to assist deluded portfolio managers who have convinced themselves they saw the tech wreck coming. She’s heard it too many times.

So in looking back at 2010, I’m going to focus on things that few people saw coming. I’m not talking about the obvious – the Leafs being bad or the Alouettes winning the Eastern Conference – but rather stuff that wasn’t even contemplated a year ago: LeBron James going from revered to despised, or curling emerging as a viewing highlight of the Vancouver Olympics. The stuff that prompts us to say, “Who knew?”

For instance, who knew Canada would continue to cruise along, seemingly immune to the troubles of its largest customer, the United States. And our residential and commercial real estate would be downright hot, while the market to the south was a sinkhole.

As for the U.S., who knew the government would go another year without showing any spending discipline, let alone austerity. Or that investors would continue to spend so much time listening to an institution that was discredited years ago, namely the U.S. Federal Reserve.

Who knew another year would go by without a plan to utilize one of Canada’s greatest resources – natural gas. I guess declining exports to the U.S. (they now have lots of gas, too) and environmental concerns about the oil sands weren’t enough of an incentive.

Who knew a major takeover (Potash Corp.) would get turned down after foreigners had effortlessly bought Alcan, Algoma, Anderson, ATI, Canadian Hunter, Cognos, Creo, Dofasco, Duvernay, Fairmont, Falconbridge, Four Seasons, Hudson’s Bay, Ipsco, Inco, Labatt, MacMillan Bloedel, Masonite and Newbridge, to name a few.

While most investors started the year worrying about rising interest rates, who knew bond yields would drop further (David Rosenberg, that’s who). In the face of the crises in Greece and Ireland, and a U.S. economy that was weak enough to require more quantitative easing, stock markets went up. And despite all the talk about the loonie’s strong fundamentals against the U.S. dollar, it remains where it was last January.

Who knew that after two excellent years in the markets, so many people would still hate stocks? Over the course of my career, I’ve never come across as many investors who are sitting on cash, making a huge bet again the market (and their own investment plan).

In the investment industry, who knew that Ned Goodman would sell out – to a bank, no less. Or that we’d have so many new exotic exchange-traded funds, including ones that play the spread between oil and gas, the volatility of the S&P 500 and the odds of “The Biebs” winning a Grammy.

Who knew the U.S. government would make money on its Citigroup investment, or that Government Motors (GM) would be one of the year’s hottest IPOs.

Who knew that Manulife would let another year pass without rebuilding the confidence of the investment community? Or that making women’s bums look good would be worth 55 times earnings to Lululemon shareholders.

And speaking of multiples, who knew RIM would be down 16.8 per cent on the year, and trading at well under 10 times earnings, after revenue grew by 35 per cent, earnings by 45 per cent and the company bought back $2-billion worth of stock?

The year once again demonstrated how perverse and unpredictable financial markets are, and how lucky we are to be living where we do.

By Tom Bradley

We’re going through another wave of consolidation in the asset management industry. Last summer, Sceptre Investment Counsel merged into Fiera Capital. More recently, CI Financial bought Hartford’s mutual funds, Bank of Nova Scotia made an offer for DundeeWealth and AGF bought Acuity.

Will there be even more consolidation on the horizon? Before addressing the question, it’s useful to first look back. When I started in the business in the early 80s, most professionally managed money was in the hands of big institutions, namely trust and insurance companies.

Fortunately for me, a shift was in progress toward independent firms owned by their employees. Investment counsellors, run by people who had built their records and reputations at the institutions, were winning all the pension mandates and were wooing wealthy individuals away from brokerage firms. With mutual funds going mainstream, independents like Mackenzie, AGF, Trimark, CI and Templeton jumped to the fore.

In recent years, we’ve seen the other side of the equation. The big institutions have been keen to grow their asset management businesses at a time when the founding shareholders of independent firms were looking for an exit strategy. This happy circumstance led to a decade of deals in which bigger firms swallowed smaller ones.

Banks were major players in this consolidation. It wasn’t too long ago that the Big Five were considered to be second-tier investment managers. Indeed, when I was at Phillips Hager & North, I made a few of my partners angry when I was quoted in the paper as saying the banks were our competitors. It was an insult.

But the comment proved to be prophetic. Banks are now big players in mutual funds, private counsel for wealthy individuals, structured products and brokerage. Acquisitions accounted for some of the growth, but it came primarily from banks improving their investment capabilities and using their brute distribution force to sell products through branches and brokers.

This industry transformation has been so complete that it’s become downright scary to be an independent. To compete with banks that have the massive budgets required to advertise on Hockey Night in Canada, firms need to have bank-like scale or something else going for them in terms of performance or product innovation.

Will the acquisition trend continue? At the risk of again being called crazy, I think the tone of the next decade will be quite different. We’re heading into a new phase of the industry life cycle, which I’ll call “The 80s – Part 2.” It will be a time when many new investment managers start up, and some small and mid-sized firms emerge from the pack.

Some of the factors driving the growth spurt will be the same as in the 1980s – available talent, entrepreneurial juices and the desire to escape slow-moving institutions. Are Dundee’s stars, like David Goodman, Rohit Sehgal and David Taylor, going to be bank employees a few years from now? Not likely. Out of the great consolidation comes a band of rich, capable investment managers who still want a say in running the business, and will increasingly cherish the freedom that bank bureaucracy and tens of billions of dollars in assets doesn’t permit.

Institutional investors will welcome these new, smaller money management firms because pension plans and consultants increasingly view the established players as being too big to take on more domestic assets.

Changed compensation structures will also encourage entrepreneurial managers to head out on their own. With the emergence of hedge funds, clients are used to paying performance bonuses in addition to a base fee. This compensation arrangement makes it enticing for portfolio managers to go out on their own because they don’t need a large asset base to make a living.

So will there be more deals? Yes. Will the banks be the giants? No question. And will there be a renaissance in the asset management industry? Only if you believe that things go in cycles, size is an investor’s enemy, and client returns are more important than shareholder returns.

By Tom Bradley

In investing, it’s easy to mistake a transient trend for an eternal verity.

Right now, for instance, many investors are tacitly assuming that China will grow at 10 per cent forever. Same goes for the notion that we’re running out of oil, that gold is the best store of value, that Japan will never grow again, and that the U.S. dollar has nowhere to go but down.

But are these facts to be counted on, or risks to be continuously assessed?

The latter, I think. Persistent trends are not investment truths, although the longer they go on, the more likely people are to treat them as truths, at least temporarily. With every year that goes by, current trends get more entrenched in our minds as evidence accumulates in their favour, and alternative outcomes move beyond the limits of our memory.

In today’s market, all of the trends mentioned above are moving toward what I call “truthdom” – a situation in which people accept recent market movements as enduring truths. Last week, for instance, during a trip to Arizona, I encountered firsthand the overwhelming pessimism surrounding the outlook for the U.S. dollar – it’s now a generally accepted truth that the greenback must weaken.

That is part of the wider pessimism regarding the United States. I won’t pretend to have garnered any profound insights on the golf course or in the basketball arena, but a few things did scream out at me. I learned that, at 36, Steve Nash is still amazing (a new son, a divorce and two wins while I was there). I also learned firsthand that the U.S. economy is as bad as we hear it is. Our neighbours have got a long way to go to get back on the growth track.

But most striking of all was the in-your-face proof that the U.S. is unbelievably cheap, and it’s not just real estate. Wine, food, clothing, green fees – and did I mention wine? – are bargains from a Canadian perspective. I’m not much of a shopper, but I had to buy a few things at Safeway just to satisfy the value investor in me.

It was a huge contrast from just a few years ago. In my usual winter hangout, Whistler, the economic force back then was the Microsoft millionaires. Our U.S. friends from Seattle and beyond were using their strong dollars to buy condos and build palatial lodges. Even the most expensive spot in Canada was a bargain for them. Now, the situation is reversed.

My southern experience confirms what the economic numbers are already saying. After a significant decline, the U.S. dollar has moved into undervalued territory. The standard measure for valuing currencies is purchasing power parity or PPP, which measures the point at which different currencies have the same buying power in each country. PPP is now suggesting the loonie should be trading in the range of 81 to 84 cents (U.S.).

In the context of truths and trends, what can we take away from this?

In the short term, not much. The U.S. dollar could continue weakening for a while longer. Currencies can trade significantly above or below PPP for many years. Certainly the greenback’s valuation reflects a lot of the bad economic news, but it is by no means extreme.

In the long run, however, the risk of making a bet against the U.S. dollar has gone up. If the PPP figures are right, the U.S. dollar has more upside than the negative sentiment around it would indicate. If the greenback were to decline further, it would have to do so from an already undervalued situation.

The U.S. is still the world’s safe haven and therefore a good diversifier in times of crisis. Those who say the dollar has nowhere to go but down need to be reminded of what happened in 2008 when the banking crisis hit – the greenback shot up, pushing the loonie below 80 cents.

Investors should treat the noise around the currency wars and quantitative easing as a sideshow, and instead start thinking about what the loonie will buy. Opportunities to purchase hard assets in the recession-ravaged U.S. are at hand. As a result, I recommend you follow my lead and do a little southern sleuthing this winter.

By Tom Bradley

It’s only been 18 months since the nadir of our once-in-a-lifetime financial crisis, but it feels like we’re already forgetting some of the lessons learned. I’m referring to the fact that, in this market full of cross currents, we have another major asset class getting frothy and investors making bigger bets in their portfolios than ever.

Inflating the gold bubble

We’re still talking about how ridiculous it was that so few people saw the housing bubble coming, or the tech wreck for that matter. But are we doing it again with gold?

Certainly we can tick off a number of boxes on the bubble checklist. The shiny metal has been on a 10-year rocket ride and there are authoritative voices predicting even higher prices ahead (check). Nobody is calling for a pullback, at least not publicly (check). It’s not like 1979-80 when people were lining up on the street to buy bullion. Now they’re queuing at their investment dealers and Bay and Wall Street firms are responding with a rash of new gold-related products to meet the demand (check). Precious metals funds will end up being some of the largest IPOs of 2010 (check).

But the scariest feature of this cycle, in my view, is that investor purchases now make up approximately 40 per cent of the demand for physical gold (check, check, check). This percentage is up from a token amount 10 years ago when gold started its move from $250 (U.S.). If the speculators stop buying, let alone start selling, there’s a lot of downside in the price. As Sir John Templeton once noted: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Like the tech stocks that traded at huge valuations at their euphoric peak, gold and gold stocks will have a lot of air under them when the cycle ends.

Market timing gone mad

I don’t have hard evidence, but it appears that investors are making bigger market timing bets than ever before. There are two aspects to this that are noteworthy, but not totally consistent. The first is that many investors are keeping large amounts of cash on the sidelines due to concerns about the economic outlook. They’ve sold stocks, or delayed making new purchases, such that their portfolios are nowhere near their long-term asset mix. In other words, they are making a big bet against the stock market.

The emergence of specialized exchange-traded funds has also encouraged more market timing and sector rotation. ETFs were once billed as a low-cost way to invest for the long term, but the reality is they’ve become market timing machines. The advertisements tell us that we can click a button and make a bet on the oil sands one day, shift over to natural gas the next, and finish the week owning gold.

These quite different bets – the cash build-up and active sector rotation – both imply that investors are more confident in their ability to time the market, but that’s not the case. It’s more likely that a decade of poor returns, a lack of trust in the old way of doing things and some effective marketing are what’s causing it.

Risk control 2.0

In face of these issues, I have a risk management tool for investors to consider. I suggest it with great trepidation because the risk management industry has fallen into disrepute in the last few years. It turns out that the statistical models, despite their brainy elegance, didn’t work when we needed them. Mine, on the other hand, is simple, reliable and easy to remember.

You just need to calculate what percentage of your purchases are going into securities that have done well in the recent past. You should also assess your overall portfolio on this basis. If all the money is flowing into the high fliers of last year – in today’s terms that means gold, high yield bonds, Canadian resource stocks and emerging markets – then an alarm will sound. It’s signalling that you’re investing while looking solely through the rear view mirror.

To keep the model’s alarm from going off, there needs to be a better balance between what’s been working and what’s most likely to work in the years ahead. As David Swensen, the chief investment officer of Yale University so eloquently put it, “Overweighting assets that produced strong past performance and underweighting assets that produced weak past performance provides a poor recipe for pleasing prospective results.”

Whenever one investment theme, strategy or person is in the spotlight, it’s important to look in the shadows for a different perspective. That’s because as voices get louder and more confident, a consensus emerges that makes it harder to find the counterpoint.

Right now, the economists have the stage (“It’s all about the macro”) and the most bearish ones are hogging the podium. As much as anyone in the world, my fellow Globe columnist David Rosenberg, chief economist and strategist at Gluskin Sheff, has been responsible for forging the current consensus. He believes we’re heading into a sustained economic slump and perhaps another recession. His 2011 earnings estimate for the S&P 500 is $75 (U.S.), well below Street estimates of $95.

As a result, Mr. Rosenberg is bearish on stocks. In a column earlier this month he multiplied his $75 estimate by a price-earnings multiple of 10 to arrive at a 750 target for the index, far below its current level around 1,184. He picked a 10 multiple because it’s “consistent with the prevailing economic uncertainty.”

In search of market perspective, I started by pulling out my trusty Morningstar chart that shows returns for one-, three-, five-, 10-, 20- and 30-year periods going back to 1950. As you’d expect, the range of one-year returns for the S&P 500 (in Canadian dollar terms) is wide, stretching from minus 40 per cent (for the period ended September, 1974) to plus 56 per cent (July, 1983).

As the time frame is extended, however, the ranges narrow considerably. For the 10-year period ended June 30 of this year, Canadian stocks, U.S. stocks and Morningstar’s hypothetical balanced portfolio (10 per cent cash, 30 per cent bonds, 60 per cent stocks) are all right at the bottom of their historical ranges at plus 3 per cent, minus 5 per cent and plus 2 per cent respectively (compounded annually).

The chart tells us that stock markets have just gone through one of the worst 10-year periods in history and prices are already reflecting some bad economic news.

The next stop on my search for perspective was the valuation tables. This critical element of investing is always tricky. When looking at price to earnings multiples (P/Es) for instance, we know the numerator to the penny (stock prices), but the denominator (earnings) is an estimate that moves around.

Nonetheless, it strikes me that Mr. Rosenberg and others in his camp are doubling up on the pessimism. They’re multiplying a conservative earnings estimate by a rock bottom P/E multiple – a 10 multiple is near the bottom of the historical range. My research suggests that P/Es are at worst in normal territory and at best significantly below where they should be. I’ve had portfolio managers tell me that valuations are just “okay,” but also had enthusiastic endorsements peppered with words like “screamingly cheap” and “getting paid to take risk again.”

Certainly valuations are dramatically different compared to the start of the last lost decade. If we flip P/Es over to create what is called earnings yield, the comparisons are stark. In 2000, earnings yields were 3 to 5 per cent at a time when bond yields were 5 to 6 per cent. Today, earnings yields are 7 to 9 per cent while bonds are yielding just 2 to 3 per cent.

The other area where it’s important to maintain a balanced perspective is investor sentiment. In this regard, it’s clear that the consensus view is a gloomy one. Mr. Rosenberg isn’t one to run with the herd, but whether he likes it or not, the herd is running with him.

The bears may prove to be right on the economy, but we have to remember that it’s tough to make money by betting with the consensus. If everyone is looking one way, the opportunity to generate over-sized returns often lies in another direction.

As I’ve said before, I’m not optimistic about what lies ahead for jobs, housing prices, GDP growth and corporate profits (yes, I’m in the middle of the herd in this regard). But I’m not so quick to translate that view into another lost decade for stocks. We’re starting from a very different place. Valuations are dramatically better and the average investor is underinvested.

I have no idea where the bond and stock markets are going in the next few months, or even the next year or two. But from my position in the backstage shadows, it looks like stocks are going to beat bonds by a substantial amount over the next decade.

When investors open their quarterly statements this month, they’ll be pleasantly surprised. Despite all the doom and gloom, the last three months have brought a year’s worth of returns.

But despite the fact that the most recent quarter will bring the fifth good news statement out of the last six, it won’t change the fact that investors are worn out and discouraged.

I’m generalizing grossly of course, but there are strong indications that many people are losing faith in stocks and investing in general. Balanced portfolios have earned 3 to 4 per cent annually over the last 10 years, which feels like nothing compared with the previous 10 (and may literally be nothing if a few mistakes were made along the way). In hindsight, a similar return could have been achieved by rolling five-year GICs.

Disappointing returns are at the core of investor disillusionment, but I think an equally important factor is the volatility that has gone along with it. In 10 years, investors have had two hair-raising bear markets and two equally impressive recoveries. The swings between quarterly statements have been nothing short of remarkable and have spooked investors. Now they’re saying, “I want some growth, but I can’t take any more losses.”

For those who are drawing on their portfolio for income and have a shorter time horizon, volatility is certainly something to beware. These investors can’t afford to have markets dip just when they need money.

But for investors who have the luxury of time, volatility doesn’t equal risk, not in theory anyway. These investors can hold assets with a higher potential return knowing that short-term price swings are inconsequential. Long-term returns are what matter. Risk is holding overpriced assets, being too concentrated on one type of investment, and having no protection against inflation. Risk is having a portfolio that doesn’t fit with their objectives.

John Thiessen, manager of the Vertex Fund, captured this issue well in a recent note to unitholders. “Every day we start our day trying to reduce risk in our portfolio but not necessarily volatility. Volatility in the short term is hard on stomachs and nerves but in the long term will deliver better investment returns. Investment policies suffer from a tendency to equate volatility with risk and an indifference to whether assets are cheap or expensive.”

While John is able to put theory into practice, the same can’t be said for most amateur investors, and more professionals than I’d like to admit. The reality is, volatility brings with it so-called execution risk – the risk that investors won’t be able to hold on when prices are down and sentiment is negative (or control their enthusiasm when times are good). It’s great to say you’ll buy when stocks are at their lows, but it’s quite another to consistently do it. Indeed, in the face of peer pressure and marketing hype, it’s easier to do the wrong thing. Even a simple strategy of regular contributions and re-balancing can get off track in highly volatile markets.

A high-potential, high-volatility portfolio should generate better returns over time, but it has to match up with the investor’s psychology. As investment professionals, we run the risk of doing what trainers at the gym do. Too often they develop textbook programs with all the required exercises, but fail to take into account their clients’ time, willpower and exercise history. Routines that are shorter, less perfect and more fun would have more staying power and get better results.

In the investment context, Dan Hallett of Highview Financial Group has done research that suggests investors in less volatile balanced funds have a longer holding period and achieve better returns than those in all-equity portfolios.

For long-term investors, volatility shouldn’t be a risk factor, but it clearly is. Today it’s showing itself in client portfolios that have strayed far from their long-term asset mix. Investors are holding too much cash and are slow to invest new money. They are likely to delay doing any re-balancing. In general, they’re frozen.

Investment professionals must make sure that our recommendations are realistic for our clients, but we’ve also got to help them absorb more volatility. I don’t know what the markets are going to do over the next year, but I do know that portfolios that are trying to avoid downside volatility will not meet their goals in the long term.

“Maybe you might have, some advice to give, on how to be insensitive.”

The chorus from this great Jann Arden song speaks to where the investment industry has gone over the last 20 years. I’m not referring to touchy-feely, relationship stuff, but rather a hard-core investment issue – valuation.

Today, investors are much more “price insensitive” than we’ve ever been. Many portfolios are set on auto pilot – they’re managed by fixed rules as opposed to being shaped by how attractive stocks and bonds are relative to each other.

In the area of asset allocation, a majority of portfolios are now built around a strategic asset mix. They may shift a little between asset classes, but basically they hold the same proportion of stocks, regardless of whether stocks are cheap or expensive.

As for security selection, the indexing trend has moved us a long way toward being valuation insensitive. The holdings in a traditional index fund are based on company size, not the price tag on the stocks. This showed itself in an extreme way in the late 1990s when Nortel, which was trading at an unprecedented multiple of earnings, accounted for a third of the S&P/TSX composite index based on its market capitalization.

Today, investors are subjected to an array of structured products, many of which are index based or hold a set basket of securities (that is, blue-chip or dividend-paying stocks). These products, including some principal-protected notes and other “guaranteed” products, take insensitivity a step further. They are designed to do “dynamic” hedging, rebalancing or leveraging, which means they actively increase or decrease market exposure at exactly the wrong time – they buy more when prices are up and sell when they’re down. They’re dynamic alright, but in a way that runs counter to common sense investing.

Now, being the new-age sensitive guy that I am, I have mixed feelings about this trend.

On the surface, I don’t get it. Why would anyone buy a security without evaluating its price? We don’t do that in any other aspect of our life.

On another level, I’m excited about it. The more insensitive investors become, the more opportunity there is to pick up bargains. Purchases and sales done for non-economic reasons provide fertile ground for portfolio managers.

For example, when a company splits itself up, or spins off a division, the new entity often doesn’t qualify for the index and isn’t large enough to be held in billion-dollar portfolios. It automatically has to be sold, no matter how attractively priced it is.

Now I’m not saying that insensitivity is always a bad thing. In fact, on the individual investor level, it’s smart to be insensitive, particularly when it comes to asset allocation. Regular rebalancing is the best strategy for all but the most sophisticated investors. It’s a discipline that encourages buying low and selling high. Yes, the weighting for each asset class is set no matter where valuations are, but it means portfolios don’t get loaded up with the most expensive assets at the wrong time.

And even though index funds ignore price, for investors who don’t have the knowledge or confidence in an adviser to pursue active management, they’re an effective way to execute an investment plan.

The question is, can we do better than succumb to this heartless trend?

I think so. At our firm, our preferred approach is to be hypersensitive at the security selection level. Our fund managers spend their days looking for bonds and stocks that are cheaper than the overall market. But when it comes to asset allocation, we dial down the meter to “numb,” in recognition of how difficult it is to time the market or shift between asset classes. We encourage our clients to stay close to their strategic asset mix and make significant shifts only when there are severe dislocations in the market.

The tech bubble and Wall Street’s mortgage meltdown are reminders that the trend toward valuation insensitivity can go too far. At times of extreme valuation, cheap or expensive, investors need to be sensitive to the price they’re paying.

As always, the columns will be posted on the Blog later the same the day.  

Every summer Lori and I make a pilgrimage to the famous Highland Cinema in Kinmount, Ont. This summer’s movie was Inception. While I had mixed feelings about the film (movie – 2 stars; conversation after – 4 stars), I found the premise of being able to implant ideas in people’s brains to be intriguing. So in subsequent weeks, I’ve been asking the investment pros I meet with to play Leonardo DiCaprio’s role. If they could implant one idea, concept or skill to help investors generate higher returns, what would it be?

The mind altering suggestions I got fit into three general themes.

Implant No. 1: Make judgments based on longer-term information.

There’s a real frustration with how short term investors’ focus has become. Investing is an endeavour we do to offset long-term liabilities (i.e. provide a paycheque in retirement). And yet we’re wired for instant feedback. The dialogue, strategies and reporting are all focused on what’s happening now. In a world where patience is defined by the 24 hours it takes to get the results for Dancing with the Stars, waiting a few years to see whether a fund is going to perform or a strategy will play out seems out of the question.

The frustration comes from the fact that, in the world of investing, short-term price moves are totally random, and judgments based on it have little impact on long-term value creation. Rather, returns come from letting the power of compounding do its magic over time.

I must admit that I didn’t expect to hear professionals who are managing billions of dollars saying: “Get started early, have a long-term plan and stick to it.” It’s hard to believe we need to implant something so basic in our brains.

Implant No. 2: The stock market does not equal the economy.

People tend to expect the market indexes to reflect what’s going on in the economy, but the fact is that when this alignment occurs, it’s a total fluke. That’s because the market is continually looking forward, having long since absorbed the current situation. It doesn’t always predict the future correctly – I remember Paul Samuelson, the Nobel laureate economist, saying that the stock market predicted nine of the last four recessions – but it’s always trying.

This disconnect constantly confuses investors, amateur and professional alike. Shouldn’t the market ultimately reflect what’s going on in the economy? Yes, ultimately. But it’s a sloppy, unpredictable relationship.

Along with the time frame issue, there is the volatile linkage between the economy and the market, namely valuation. What the market is willing to pay for corporate profits will vary with interest rates, investor sentiment and a variety of other factors.

So even if we get the economy right, we can be totally wrong on our market call. For instance, those who predicted in the fall of 2008 that there was a recession ahead were absolutely right, but if they weren’t fully invested in 2009, they left a lot of money on the table.

As one of the portfolio managers said to me, “People have to stop trying to figure what the economy and market are going to do and start buying good companies.” We’ve made investing as complicated as Inception, but unfortunately we don’t have whiz kid Ellen Page (woefully miscast) to save us.

Implant No. 3: Stop running with the herd

It’s important for investors to realize that if they’re applying the investment basics correctly, they’ll sometimes be out of sync with a majority of the people around them. That’s because the crowd is chasing past performance, buying flavour-of-the-month products and/or trading too much. And because of that, their results are poor. We might take comfort from being with the crowd, but we don’t want their returns.

A consultant I spoke to had a simple strategy for fighting the herd mentality – find a good manager and hire them when they’re at the bottom of the industry rankings, when everyone else is ignoring them.

Similarly, at market extremes when investors are wallowing in negativity, it’s important to realize that poor “past” returns lead to better “future” returns (and vice versa). At such times when markets are fertile, planting seeds for the next cycle makes sense, but it’s guaranteed to be a solitary pastime.

One executive gave me a line (which he credited to Hall of Fame oil man Jim Gray) that sums up what I heard from a number of people: “If you’re getting a warm feeling about what you’re doing, it’s probably because you’re in the middle of the herd.”

Do we need Leonardo dodging bullets and dealing with his inner demons to help us lengthen our time frame, look beyond what’s going on in the economy and prepare to be lonely? Well yes, we all need a little rewiring.

One of the joys of my day job is talking with smart, turned-on people from all aspects and levels of the investment business. My good fortune comes from having a long and diverse career (as Woody Allen put it, 90 per cent of life is just showing up), running a company that’s still too small to threaten anyone and, on most days, just being a nice guy.

Over the past few weeks, I’ve been camped out in Toronto meetings with a broad range of analysts, portfolio managers and executives. At some point in each conversation, I’ve asked the question: “What is the elephant in the room? What do you see out there that’s being overlooked or underappreciated?”

There have been an array of answers, but the consensus hit on two themes, neither of which could be described as under the radar. First, why would anyone buy a 10-year government bond yielding less than 3 per cent? And the second, which is related to the first, is that a portfolio of dividend-paying stocks is now a better way to generate a stream of income and higher return.

Few of my confreres are calling government bonds the next bubble, as Warren Buffett and Jeremy Siegel are, but they’re all struggling to make the math work and are dumbfounded by the massive flows going into bond mutual funds, particularly in the U.S. It would appear that individual investors are chasing past returns that are not achievable given the current level of interest rates.

Bond yields are low because of the economic outlook (can you say double dip?) and the possibility of deflation. In a deflationary environment, even low-yielding bonds look attractive. But in the more likely scenario where there is some inflation, 2.5- to 3-per-cent yields provide little cushion.

Of course, these investment professionals do still own government bonds in their clients’ portfolios for liquidity and diversification reasons, but it’s a matter of degree. Their point is that buying bonds or GICs in isolation, which was the safe strategy of the past, will lead to disappointment.

The other half of the consensus is that dividend-paying stocks are the way to go. By being an owner instead of a lender, the income stream is higher (none of us have gone through a period when dividend yields were above bond yields), more tax-efficient, and likely to grow over time as corporations increase their dividends.

Of course it’s easy for these (mostly wealthy) professional risk-takers to have this view, but what does it mean for investors who are living off of their portfolios. Certainly being an owner comes with its risks – dividends are paid only after all other obligations have been met and lenders (including bondholders) have been paid in full. If a company hits a rough patch, the first thing to go is the dividend. Manulife Financial Corp. was a core holding in most income-oriented portfolios and it cut its dividend in 2009, as did Manitoba Telecom Services Inc. recently (not to mention the many income and royalty trusts that reduced their distributions).

Being an owner also means the portfolio’s market value will bounce around with changes in interest rates, news on the companies’ business prospects and the stock market in general. Nobody expects another 2008, but a dip of 20 per cent or more is possible at any time, even for a conservative stock portfolio. Indeed, it’s assured of happening some time in the next 10 years.

It’s important to be prepared for this because the dividend strategy only works if you stick with it. If you bail out when prices are down or dividends are being cut, you will end up worse off than owning a low-yielding bond.

Even though I hate running with the herd on anything, I have to agree with my informal consensus. The reward/risk for bonds doesn’t look great, while the case for high-quality stocks is quite compelling.

Having said that, I go into this strategy with my rose-coloured glasses buried deep in the drawer. That’s because valuations are attractive for a reason. Corporate profit margins are already levitating at record levels, economic growth is expected to be slower and the business environment will be more competitive than ever. In other words, dividend growth will be harder to come by and there will be more Manulifes and MTSs ahead.

I want to diversify across industries and types of stocks as much as I can. While the financial sector dominates the dividend stock universe, there are other companies that pay reasonable dividends and have a record of increasing them – we own Rogers Communications Inc., Corus Entertainment Inc., and Enbridge Inc., to name a few. And for registered accounts, there are many high-quality foreign stocks yielding well in excess of 3 per cent.

As always, I want to be sensitive to valuation. Buying a big, fat quarterly dividend to maximize income in the short term can lead to disappointment (i.e. cuts) or mean less growth in the future.

We are in a unique circumstance where reaching to equities for income makes sense, but make no mistake: This approach requires discipline, fortitude and careful cash management. And it should be done in the context of a diversified portfolio, one that even has a few bonds in it.

Portfolio management is both a science and an art. The science can be learned from finance professors and investment books. The art part, however, comes from years at the school of hard knocks.

Like every grizzled money manager who’s attended that particular school, I’ve developed rules to protect me from myself. Some of them have a fundamental basis, some work for inexplicable reasons, and some are just plain superstition. All are hard to quantify and yet can often be more important than the data that’s provided each quarter – revenue, profit, market share and management guidance.

Here are a few of my hard-earned lessons.

When a company makes a major acquisition in an unrelated business, it’s time to reassess. Numerous studies have shown that such deals lead to lower profitability. And even when a newly diversified company executes successfully, the market often struggles with how to value it. Ultimately, the stock gets weighed down by the dreaded “holding company discount.”

I think back 20 years to Imasco, which was considered to be a successful conglomerate. If it had stuck to its original business, Imperial Tobacco, it would have made a pile more money for shareholders. And if only Molson had stuck to beer.

When a retailer announces that it’s expanding into the U.S., or has just made an acquisition south of the border, I start to squirm. One of the highest-profile debacles was Canadian Tire buying White Stores in the 1980s, but there have been many disappointments since, including Jean Coutu’s disastrous purchase of Rite Aid.

Retailers that are building a state-of-the-art distribution centre or installing a new inventory management system also warrant caution. Getting products to the shelf is a complicated process and one that requires years of refinement to get right. Loblaw, which suffered from stocking issues for a number of quarters, is the most recent addition to a list of companies that stumbled badly during conversion.

I watch out for companies that report a pattern of earnings that is steadier than their underlying business. The longer that management smoothes the bottom line to meet Street expectations (yes, it still happens), the greater the risk of explosion. That’s because when the news turns bad, the chief financial officer’s hidden reserves are tapped out. The closet is full of skeletons, but the cupboard is bare.

Bombardier is a good company with a wonderful legacy, but when it was riding high in the eighties and nineties, its business, which is lumpy and erratic, didn’t match up with its smooth earnings. Bomber’s fall from grace in 2001 was harsh. Loewen Group, Laidlaw and Enron, all masters of managing their earnings, were also tough lessons.

When the commodity cycle is roaring and profitability is high, it’s a good idea to avoid the empire builders. I’m referring to companies that use their bulging coffers to make large acquisitions. Nobody knows when a cycle will end, but we know for sure the buyers are paying fancy prices and will be carrying too much debt when the downturn hits.

I also steer clear of resource companies that are in that awkward stage between discovery and startup. When the focus shifts from proving up reserves to bringing the mine into production, the only news is bad news – delays, cost overruns and technical difficulties.

I’m also wary of companies in industries that are deregulating (a wide open field brings with it increased competition and lower margins), that are selling to low-quality customers that are losing money, or whose leader has recently been named “CEO of the Year.” And I shouldn’t forget to mention companies that put their name on sports arenas.

There are certain management behaviours that warrant close attention.

When the CEO of a company gets into a fight with an analyst or short seller, I get uneasy. During my analyst days, I had a mixed record on “sell” recommendations, but when management protested too much, I knew I was on the right track. If the C-suite is overly sensitive (think Biovail, Enron and Timminco), then there’s probably something to be worried about.

I follow management departures very carefully. Over the years I’ve covered Extendicare from both sides of the Street and made good money on it. But when the CEO and CFO, for whom I had a high regard, retired within a few months of each other, I should have sold. The company subsequently went through a rough patch due to challenges in its U.S. operation.

In revealing my list, I have to acknowledge that it’s hard to act on these warning signs. That’s because art is less concrete than the science of formulas and spreadsheets. And in the back of our minds we know there have been exceptions to every rule.

But the older and more sensitive I get, the more weight I put on the soft stuff, because as the old proverb says, “Fool me once, shame on you; fool me twice, shame on me.”

In my last column I talked about fear and investors who wanted to get out of the market. My advice (don’t do it) was based on valuation, investor sentiment and the difficulty of timing the market. It was aimed at helping the investor make the best decision.

But what about the investment professional? What is the best reward-versus-risk tradeoff for the adviser in a situation like this when he doesn’t agree with a client’s strong view? Indeed, he might even believe the strategy could do some real harm. These are the times when advisers and investment managers earn their keep.

In an ideal world, the recommendation to stay the course would be based on an assessment of potential returns and risks. The client would know that the advice could be wrong, but if the two of them are disciplined about always putting the odds in their favour, then the long-term results will be good.

Unfortunately, investors don’t always get what they pay for. In a challenging situation like this, advisers too often provide little resistance, making it easy for clients to go with their emotions. (Note: I’m not implying clients are always wrong, but am assuming that if they have an adviser they need help.)

While I’m often quick to criticize our industry for not having enough of a backbone in such cases, I recognize that the professional has a different reward/risk equation than the client. And the disparity makes it more difficult to provide the appropriate advice.

Let me explain by using the example of when I disagreed with my worried client. We’ll assume I talked her out of selling all her stocks. She may be right at the end of the day, but I didn’t think it was in her best interests to make such an extreme shift. So we trimmed back on her equity holdings, but basically stuck close to her long-term asset mix.

Now that we’ve tried to maximize her odds, what does my situation look like?

Well, if the markets hold steady or go up over the next six to 12 months, I have a happy client. She’s made some money and our relationship has moved up a notch on the trust and confidence scale.

If, on the other hand, markets go down and the portfolio valuation drops, then my client is upset. She felt strongly about selling, but I talked her out of it and it cost her money. If the market takes a big dip, then she may be dissatisfied enough to take her account elsewhere.

While I truly believe I’m giving her the best chance of succeeding, my reward/risk balance is not so favourable. I have potential upside for sure (better returns and a stronger relationship), but the downside is far greater. I risk losing a client for good.

To improve my prospects, I could take a different tack. I could voice my concern about the “bail out” strategy, but then get out of her way. Call it the “Olé approach.” If markets go up, my client misses out on the gains, but I’m on record as having advised otherwise (albeit feebly). If markets go down, she’s happy, and while she may not give me much credit, our relationship lives on. In the short term at least, I’ve enhanced my business.

This is an extreme case obviously, but there are many situations where the best intentioned advisers or managers have the incentive to water down their expertise. It’s just too risky, from a business point of view, to push back at clients when they feel strongly about something.

When this happens, neither side is getting what they need. Clients aren’t receiving the steady, thoughtful advice they’re paying for. And advisers are weakening their businesses in the long run, especially now when investors have plenty of low-cost, advice-lite options to go to.

What can clients and advisers do about this reward/risk imbalance?

Clients can ask questions with the intent of listening to the answer. They can ask what the adviser is doing in his own account. And, ultimately, they can take responsibility for their actions.

The paid professionals can focus on keeping their interests aligned with that of their clients. That means matching up their recommendations with what they’re doing in their own portfolios. They can use the good times to prepare clients for the inevitable situation when there is a fundamental disagreement on strategy. And they can remind their clients that those disagreements are what they’re paying for.

In my quarterly letter to clients I used the word “discouraged” to describe investor sentiment. In the few days since we published it, however, I’m starting to think a better word is “despair.” Too regularly I’m being asked whether it’s time to get out of the market.

The worry isn’t coming from portfolio returns in the first half of the year – balanced portfolios are down from zero to 3 per cent – but rather a deep concern about what’s going to happen in the second half and beyond. Investors don’t want to go through another 2008.

The despair seems to have common roots. It’s a news article about the world’s debt burden and its ramifications – higher taxes, unemployment and more “Greece-like” events. It’s the realization that growth is going to be tough to sustain after the government stimulation tap is turned off. Or it’s a gloomy economist pontificating on how we can’t get out of this mess without another debacle, or at least a very slow period of growth.

This stuff is hard to refute and I don’t try. I’ve been in the “bumpy road ahead” camp for a long time and have been counselling caution since last fall. But that doesn’t mean my nervous clients, friends and family will hear what they want to hear from me. That’s because my strategy doesn’t call for getting right out of the market. Far from it.

If I’m given time to respond to the question (and questioners don’t always want an answer), I start by reviewing a few basics. It goes something like this:

Remember, Susan, Mr. Market is well aware of the issues out there. Security prices are always trying to anticipate future events. Your fears are shared by many investors and may already be fully factored into market prices.

Whatever you do, don’t make radical changes at a time of maximum stress, or excitement for that matter. That’s when the biggest mistakes happen, mainly because the shifts are made to conform to the consensus.

Yes I know, the consensus can be right for a time, but believe me, it’s always wrong at the peaks and troughs. If investors are dead certain, then they’re certain to be dead wrong. Yes, I did just make that up.

I think you know that getting out of the market involves two decisions, not one. After you sell, you have to get back in at some point. Any expectation of precision on either of those moves would be misguided. There will be no alarms going off telling you the way is clear.

Scott, I remind you that the “all-GIC strategy” that your dentist was bragging about always looks good when the stock market is down, just as an all-equity strategy does in the good times. If you only need a 3-per-cent return before taxes and inflation to live comfortably in retirement, then a “sleep well” strategy like that is an option. For investors who need more return, however, the potential of missing an up market poses just as big a risk as catching the down.

Jake, I want you to think about your portfolio in terms of ranges around a long-term asset mix, one that reflects your long-term goals and the odds of you winning at the market-timing game. For example, if your strategy is to have 60 per cent in stocks (or other higher-volatility investments) over the long run, then you might give yourself room to move the weighting between 50 and 70 per cent. The less experience and time you have for investing, the narrower the range should be.

Then you need to look at three things to determine where you should be in the range. The first is your outlook, which in this case is negative. But don’t stop there. Next you look at valuation (pricing), because dire headlines don’t preclude investors from making a pot full of money. Indeed, if all the bad news is factored into the market already, then it might be time to buy, not bail.

And then you need to take a reading of market sentiment. Are other investors positive or negative? The market’s mood provides a good reality check, sometimes advising caution (when everyone is bullish) and other times pointing to areas of opportunity (bearish). It’s that consensus thing I was talking about. Are you alone, or running with the crowd?

Now the crescendo: Brad, I want you to make an informed decision based on those three factors, not just that article you read. Right now I would make sure your higher-risk holdings (stocks, commodities, high-yield bonds) are in the bottom half of your range. With you running between 50 and 70 per cent, that means 50 to 55 per cent of your portfolio in stocks. I say that because I agree with you that the big picture isn’t very pretty. But having said that, you should be getting prepared to do some buying because weaker markets have improved valuations and market sentiment is getting better (i.e. more despair).

If you have a specific need for money in the next year, set it aside in a high-interest savings account now. Cash management is always important, especially in a higher-volatility environment.

And Brad, be careful not to confuse economic forecasts or political ineptitude with the risks and opportunities for you in the market.

I’ve had a bias to owning higher quality companies since 2007. In a challenging economy with unpredictable credit markets, it seemed reasonable to pay a premium for stable profits, excess cash flow and strong balance sheets. I knew the companies would survive, and possibly thrive, in a tough business environment.

Buying the best sounds like a good strategy, but it can lead to poor returns if you’re not attentive to industry dynamics and stock valuations. We learned that in the 1970s when investors paid fancy prices for leading U.S. stocks known as the “Nifty Fifty” and were disappointed.

Most of my quality favourites continue to deliver profits and are in a better competitive position today than they were three years ago, but a number of them have seen their stock prices lag behind the market. Instead of being stars, stocks like Research In Motion, Ritchie Bros. Auctioneers, Shoppers Drug Mart and Rogers Communications just keep getting cheaper.

The question is, am I holding great companies at bargain prices, or getting caught in a value trap?

If it’s the former and the stocks are screaming “buys,” then it will be because of a double whammy. Earnings will turn out to be better than forecast and sentiment toward the companies will get less negative. The result is nirvana – a better valuation on better-than-expected earnings.

If, on the other hand, they’re value traps, we’ll keep waiting for good stuff to happen, but it never will. Growth will be slower than expected, or negative, and repeated efforts to turn things around will fail to pan out. Meanwhile, the stocks’ valuation metrics – price to book value, earnings and cash flow – will keep getting cheaper.

With the benefit of hindsight, it’s possible to identify some general themes that run through every value trap. There is usually a major trend that turns against the company. The product is being made or delivered in a different way, or customers are looking for something new. The change is secular in nature, as opposed to cyclical, and may bring new competition with it.

Established firms are unable to adapt to the new paradigm because their assets and competitive strengths lie in other areas. In some cases, management is unwilling to adapt. They’ve been successful with their old model and are reluctant to give it up. They don’t want to absorb the profit hit that a major shift will cause.

Of the names mentioned above, RIM is the one being most vigorously debated in Canada’s money management circles today. Only a few months ago it would have been inconceivable to mention RIM and “value trap” in the same sentence, but at a conference I attended recently, a panel of fund managers discussed just that topic.

This is the RIM that’s a world leader in the fastest-growing segment of mobile communications – smart phones. The maker of the iconic BlackBerry, which has a clear advantage in e-mail and texting, and is the most efficient user of bandwidth. The firm that’s done a masterful job of working with wireless carriers and corporate IT departments to dominate the business market. And yes, the same RIM that saw revenue grow 24 per cent last quarter, profit increase 41 per cent and cash on the balance sheet tick above $3-billion (net of debt).

So why is the stock down 40 per cent from its 12-month high and trading at less than 10 times earnings?

There are many reasons of course. The stock market has been skittish and hyper-sensitive to any hint of bad news. RIM is facing off against two of the most powerful forces in the world, namely Apple and Google. But the main issue is that the competitive landscape has changed. After being the technological leader throughout the smart phone revolution, RIM now finds itself playing catch-up. E-mail got the company to where it is today, but the new battlefield is Web access. The iPhone, and various devices based on Google’s Android software, have better browsers and a more appealing array of applications.

In high-tech, where a company’s assets are people and patents, it’s hard to catch up after there’s been a severe change of direction. Redesigning operating systems and rewriting major software takes time. Meanwhile, the competition keeps moving forward. Technology is a sector that value investors usually steer clear of, even if valuations look compelling.

If RIM’s next generation Web-browser is as good as management says it is, and proves to be less of a bandwidth hog than the Apple products, then the stock will make up a lot of ground. If the new version doesn’t get the BlackBerry back in the race, then the bears will be justified in using the words “value trap.”

The smart phone market is going through a jolting change, but I’m not willing to give up on RIM yet. Management has its head up and their team has the right skill set. And importantly, I’m not paying much to wait and see if they’re up to the task. But ah, that’s how we get sucked into value traps.

There has never been more investment information available to investors, so it’s frustrating to see the release of the Morningstar Stewardship Grades, the most useful piece of research to come out in decades, slide by with little or no coverage from the major media outlets and investment bloggers.

I’m frustrated for a couple of reasons. Selfishly, I’d like to see it get more attention because I run a fund company that ranked well. But more importantly, the report opens a window into the inner workings of the asset management industry and investors should look through it. Morningstar has used its clout and research depth to reveal what insiders know, but which until now has been invisible to the outside world.

Most of the information coming at investors is data that’s readily available, easily measurable, but unfortunately, of little value. They’re barraged by economic forecasts and market projections, all of which have little impact on portfolio returns. They’re shown fund comparisons based on year-to-date and one-year performance, which are totally random and of no use to anyone.

The Morningstar research is at the opposite end of the spectrum. Stewardship, which is the degree to which mutual fund companies’ interests are aligned with their unitholders, is subjective and tough to measure, but it plays an important role in selecting an investment manager.

There are four components to the grading system – corporate culture, manager incentives, fees and regulatory history. The first two make up 75 per cent of the score (6 out of 8 points) and are the hard-to-measure stuff. With respect to culture, they attempt to answer the following questions. Does the company have a thoughtful, repeatable investment process? Does it offer clear, pertinent disclosure? Is it a responsible marketer? And the biggie, do talented managers spend much or all of their careers at the firm?

In the manager incentives category, they assess whether fund managers are invested alongside the clients and the degree to which they are rewarded for long-term returns (as opposed to asset growth and short-term numbers).

These are the same criteria that consultants and institutional investors (pension plans, endowments and corporations) consider when they’re selecting managers. Long-term performance is a necessary qualification for entering the race, but people, process, incentives and ownership structure weigh heavily in the decision.

Stewardship is important because investors are prone to making long-term decisions based on short-term inputs. Morningstar provides individual investors with much needed data that is likely to be stable over time. By bringing investment process and personnel into the equation, investors are encouraged to move away from making decisions based strictly on recent performance.

It’s also important because what we’ve been doing over the past twenty years hasn’t worked. Selling yesterday’s disappointment to buy yesterday’s glory has led to poor results. The “Cycle of Hope,” as I call it, has to be broken. To do that, investors need information that allows them to be patient and gives them some comfort that past returns can be repeated in the future.

The stewardship grades are not without their critics. For an industry that is constantly measured quantitatively (returns), this research is uncomfortably qualitative. Joanne De Laurentis, president and CEO of IFIC (Investment Funds Institute of Canada) sent a letter to Morningstar voicing “serious concerns” and asking them to not release the study. She found it to be “qualitative and subjective” and pointed out that there are different views on whether fund managers should invest in the funds they manage.

The Toronto Star’s James Daw found the eight-point scale “rough at best” and felt it exaggerated the differences between companies.

In the business of investing, no research report is perfect or guaranteed to be correct. Assessing the subjective factors that constitute stewardship is a difficult process. But this doesn’t negate its importance.

Despite the simplicity of Morningstar’s grades, the study does what it’s supposed to do. It reveals significant differences between how ‘A’ rated firms (Mawer, Beutel Goodman, Chou Funds, Capital International and Steadyhand) relate to their clients compared with the firms with ‘C’ and ‘D’ grades. The ‘A’s fees are generally lower. Their products are investment driven as opposed to being sales and marketing vehicles. They have a process and team that have been in place for a long time. And they eat their own cooking.

Ultimately, it’s up to the investor to decide how important the information is and where it fits into their decision-making process. In the meantime, I hope the Stewardship Grades get the industry and media stirred up because we need to make changes. Frequent manager turnover, high fees, and poor disclosure are not a road to mutual fund prosperity.

We’re starting to see stories about a softening real estate market in Canada. Listings are up, sales are down, and even the always bullish industry executives are predicting lower prices in the coming year.

It reminded me of a quote I saw recently: “Real estate is the drunk driver on the economic highway.” This statement, attributed to Tom Barrack, the CEO of real estate investor Colony Capital, speaks to the fact that residential real estate can be volatile. Yet that same volatility highlights why it can be fertile ground for a disciplined, patient investor. There are a number of reasons for this.

First off, it’s cyclical in the best way – the cycles are generally long while memories are always short. The most recent trend, up or down, is assumed to be sustainable. For an investor willing to take a longer view, this is a good thing.

Second, real estate is a topic that produces lots of “armchair” experts. Despite a lack of rigorous analysis, views are strongly held and overconfidence is rampant. Again, this is good for someone who is less entrenched and has a broader perspective.

The third reason is that buying decisions are often steeped in emotion (“It’s perfect. I have to have it!”), and based on non-economic factors (“The baby will be here soon.”). Music to an investor’s ears.

And finally, houses are easy to borrow against. Thus, the potential for overindulgence.

Despite these attractive investment features, there are reasons why I don’t invest in real estate beyond my personal needs. For one, I have a day job, and this type of investing is time intensive. It also doesn’t help that transaction costs are extremely high (commissions, legal fees and taxes), and there are significant carrying costs (maintenance and more taxes). Both have to be factored into the investment return.

But if I did have time and could find the equivalent of a discount broker, many of the rules I use for investing in stocks would apply.

Because leverage is involved, real estate prices are sensitive to changes in interest rates. Purchases are often financed up to 90 per cent with debt, so mortgage payments are a key factor in determining prices.

For almost 30 years, we’ve been in a bull market for interest rates and with every tick down, property values have gone up. Given that we are somewhere near the end of the rate declines, investors have to recognize that a huge tail wind is swinging around.

After such a long up trend, it’s easy to forget that residential real estate is cyclical. And as with all cycles, there is only one thing that’s easy to predict – the farther prices stray from their fundamental value, the bigger the downturn will be. If you think back to periods when prices were rising at a mind-blowing rate, there was always an equally astonishing decline to follow. Torontonians, for example, didn’t see the high prices of the late 1980s again until well after they’d rung in the new millennium.

Living in a hedge fund

House owners deploy a strategy that is at the core of hedge fund investing – buy long-term assets with short-term financing. The strategy dials up the investment’s return potential, both on the upside and downside. In the case of a house, if rates stay low and prices rise, it’s a beautiful thing. If financing costs rise and cause prices to fall, however, it’s not so good.

When people tell you that their house has been their best investment, they are undoubtedly telling you the truth. But it’s not because prices have gone up more than the stock market over long periods of time, it’s because a house investment is highly levered. And the math is powerful. When a $400,000 house bought with $100,000 of equity goes up 25 per cent, the value of the equity doubles. As Americans found out in recent years, however, high gearing works both ways.

Ultimately it comes back to valuation. Prices have to make sense in the context of the local economy. Do income levels support the price levels? Do people want to live there, and are more coming? Are the demographics going to help or hurt in the future? And what are apartment rents and vacancies doing?

If the continuing income from a real estate investment is barely covering expenses, and the long-term supply and demand outlook doesn’t justify current prices, then I am flat out speculating. When I’m ready to sell, I’m betting a greater fool will pay me an even more uneconomic price.

When I apply my investing skills and experience to the Canadian real estate market, I see a super cycle coming to an end. By plugging low interest rates into mortgage calculators, prices have been driven higher. But rents are coming down. After-tax incomes are likely to be under pressure in the post-stimulation era. And it doesn’t feel like the right time to be adding leverage to a portfolio.

Regardless of what happens, when it comes to real estate, I always want to be the designated driver. That means being be opportunistic, patient, well-financed and stone cold sober.

Related reading:
Become Your Own Hedge Fund Manager. Buy a Home.
When a Trend Reverses, the Slide Won't be Painless or Short
U.S. Housing: Long, Extreme Up Cycle...Quick, Painless Down Cycle?
An Orderly Decline of the Housing Market? Not.

I’m just back from a few days in Scotland. Sightseeing, golf and a meeting with one of our equity managers was the order of the day.

For the golf, I stuck to convention and kept track of my pars, bogies and, unfortunately, the “others.” For my meeting with Edinburgh Partners Ltd., however, I threw out the industry scorecard. We had quite a different conversation from what normally occurs between manager and client.

What I mean is that we spent no time on short-term performance. None. We didn’t analyze where the fund is deviating from the global index with respect to returns or sector weightings. And we spent minimal time on the company’s economic outlook because that’s not what drives the makeup of our fund.

Instead, we discussed personnel changes and employee ownership. I wanted to determine how supportive and ethical the firm’s environment was for the investment team. We reviewed their investment philosophy and process, and the refinements they’ve been making. We touched on some stocks, but only to reinforce their approach and reveal what they do when things go wrong. I wanted to make sure the stiff backbone I hired three years ago was still there.

More than anything, I was watching to make sure EPL hadn’t slipped into being a benchmark-oriented manager. If Steadyhand is going to deliver better returns than other firms, we need to look different than the indexes. As David Swensen, chief investment officer at Yale University, puts it: “Market-beating managers express their insights in concentrated portfolios that differ dramatically from the character of the broad market.”

A 2006 study by two Yale academics (Martijn Cremers and Antti Petajisto) confirmed that view. It concluded that funds which deviated most from the index outperformed their benchmarks (on average) while funds that ran closer to it did not. Interestingly, the study also pointed out that in the United States the proportion of passive funds claiming to be active (closet index funds) increased from zero in 1990 to 30 per cent in 2003.

Despite evidence pointing in the other direction, managers are sucked into the benchmark world by three irresistible forces – risk management systems, clients and success.

It’s a relative world

Risk management systems can be a useful tool. They confirm the types of risk being taken and make sure the portfolio properly reflects the managers’ views. But the problem with all the fancy numbers is that they’re short-term oriented and strictly based on comparisons to the market indexes, however flawed they may be. And instead of providing a reality check, they often take on a life of their own and start to shape the portfolio.

So with the industry scorecard based on how funds look compared to the index, it’s not surprising the managers know the makeup of that index by heart, to the decimal point. Or that they begin managing to a “tracking error” number (a statistic that estimates how much the portfolio’s return will deviate from the index, based on historical data). Or that they start speaking unintelligibly in a secret language – “I’m overweighted consumer staples and underweighted materials.” All signs that the index is near.

Clients and their concerns

Managers are hired to beat the benchmark. Unfortunately, the quarterly comparisons they go through with clients make it more difficult to do. The performance analysis on stock and sector weightings is all done relative to the index. And it’s always for periods of one year or less.

It’s clear where the portfolio did well and where it fell short. If the manager is pursuing a long-term strategy that hasn’t played out yet, a few quarters can feel like a lifetime. There are only so many ways you can say, “The fund has underperformed because it owns a ton of technology stocks and no oil.” So every tough client meeting pulls the manager closer to the closet.

Bonus pools and redemptions

In light of the risk management and client pressures, a fund manager is forced to find a balance between where their research and conviction is pointing them and what the index looks like. How much can they deviate and for how long.

The stakes can be high for the manager (a big bonus versus no job) and the firm (more clients versus redemptions). The higher the compensation and larger the firm, the more there is to protect. Managers find themselves owning “filler” stocks – ones they don’t like much, but keep the fund from straying too far from the index.

Fortunately, I left Scotland knowing that our fund will continue to look different. The EPL team runs concentrated portfolios (30 to 40 stocks), designs their risk management around factors that don’t strictly relate to the index, and is careful to sell themselves as the “undexers” that they are.

I also left knowing that my golf game needs serious work. It’s overweighted sand, underweighted one-putts and subject to extreme tracking error.

As we ride the market volatility caused by Europe’s economic turmoil, I can’t help but think back to Oct. 19, 1987, a date that will forever be imprinted in my memory.

Black Monday saw the Dow drop 23 per cent, while the TSX was down 11 per cent. As an aspiring analyst at Richardson Greenshields, I had just published two ‘Buy’ reports – Laidlaw and Investors Group if I remember correctly – in which I wrote glowingly about the companies’ long-term fundamentals, competitive position and attractive valuations.

All of that good stuff went out the window, however, when the market went into free fall. Everything was going down including my shiny new recommendations.

Fortunately, I was smart enough, or devastated enough, to abandon my desk and go hang around the traders for the rest of the day. I just sat there stunned and watched the insanity.

Black Monday was my first experience with a serious market decline – a crisis that garnered coverage in the front page of the newspaper. Looking back, it didn’t matter that I froze up. I wasn’t managing money at the time and the sales team and clients had more important things to do than listen to me.

But the day didn’t go to waste because I learned some lessons that have served me well in subsequent crises.

More information, less knowledge
When a crisis hits the front page and information is flowing fast and furiously, you have to know two things. First, the markets have already absorbed most, all, or more than all of the bad news. When people are talking about it at the water cooler, the markets have already moved on.

And second, the quality of information is poor. Very poor. It’s heavily tilted toward the negative. And because it’s often something we’ve not gone through before (crises tend to be that way), it doesn’t fit into anybody’s model. We look to the experts to make sense of it, but without the necessary time and data, they are winging it just like the rest of us.

Under-react
When the experts are guessing and emotions are running high, it’s not a time to take a strong view. Big shifts in strategy at times of crisis lead to bad decisions. The potential for blowing up a portfolio, or asset management firm, is very high. Investors who sold all their stocks at or near the bottom last year have devastated their retirement savings, just as many did 10 years earlier when they got carried away with technology.

When things are coming apart, we all desperately want to take action. But trust me, under reacting is good.

Back to fundamentals
That’s not to suggest that there aren’t things to do. Even if no radical shifts are planned, it’s important to know where you stand with regard to your long-term asset mix and what your next steps might be.

While everyone else is looking at the big picture, it’s important to get back to what matters – fundamentals and valuation. Even if earnings and multiples don’t seem to matter at the moment, they ultimately will. So, watching for securities that have been unduly penalized by the crisis is time well spent.

Baby steps
When there are large dislocations in the market, it is likely some portfolio rebalancing will be required. Last month’s asset mix will no longer be in place. I’m a big proponent of taking incremental steps to get where you need to be. Market extremes are not a time for perfection, but rather approximation. Investors who aim to make a bold move at just the right time, usually end up doing nothing because the stakes are too high. They can’t afford to be wrong. It’s better for investors to take small steps that in aggregate are approximately right, as opposed to not doing what they think might be brilliant.

I’m so excited
The Pointer Sisters had it right. Certainly for investors in the accumulation phase, market crises are a time to get excited. It’s a gift. New investment dollars buy more in depressed markets and the value of existing holdings are never impaired to the degree that short-term prices imply. When securities are being dumped for uneconomic reasons – automatic sell programs, fund redemptions, and good old panic – you want to be buying.

Europe has serious economic and political issues. The crisis will have an impact on economic growth and capital markets. Indeed, the world’s debt overhang is a major reason why I’ve been cautious in recent months. But as the support programs, spending cuts and tax increases play out, I’m prepared to do some rebalancing. I have my buy list ready if markets experience a sustained decline (which they haven’t so far). And while I’m not planning on freezing up like I did in 1987, I’m also not expecting to do much. I’m afraid my under-reactivitis condition is chronic.

Burgundy Asset Management sent a letter to its clients this week announcing changes to its management structure. Two years from now CEO Tony Arrell will step down and hand the reins over to the current Chief Investment Officer, Richard Rooney.

In terms of succession planning in our business, this is a biggie. Mr. Arrell is a large shareholder in a firm that manages almost $9-billion in assets. He is a commanding and thoughtful presence both inside and outside of Burgundy’s Bay Street office. And his vision and drive to build a top tier Global firm have shaped who the firm has hired and how it’s grown. While other investment managers concentrate on Canadian stocks and Canadian clients, two-thirds of Burgundy’s research staff is focused on foreign markets and the firm has had success winning institutional clients in the U.S. and elsewhere.

Planning for succession is a bit like picking stocks. You can do the preparation and make all the right moves, but at the end of the day, there are a slew of uncontrollable variables that will determine how well it plays out with clients and business partners. When a new management team is establishing its credentials, there is no doubt that it helps to have a little luck in terms of industry trends and short-term performance.

My former partner Bob Hager always said the time to make a change is when the performance numbers are turning up after being poor. The clients are more open to change, having been through a tough period, and the odds are better that the new team will be shown in a positive light (i.e. improving returns). It gives the firm the best chance of selling the changes internally and externally.

Bob’s strategy speaks to the fact that new CEOs, in any industry, are often given undue credit, or subjected to unfair criticism, based on what happens in the near term. Hockey coaches and finance ministers suffer from a similar fate. The reality is, near-term results are determined by random market forces and strategies put in place by the previous team. The new boss may become a hero by doing nothing more than giving the predecessor’s ‘failed’ strategy a little more time.

For clients of a larger firm, movement at the top is important, but it doesn’t require action the same way changes to the investment team do. When a long-standing portfolio manager steps aside, there is a direct and immediate impact on the portfolio. Holdings change and the investment approach will be different going forward, sometimes quite significantly. The client has to take a close look when there is a new person pulling the trigger.

Changes in the corner office will also have an impact, but they take longer to play out. The incoming team will influence new product directions, the ability to hire top people, the ownership structure and the overall investing culture of the firm, all of which translate into client returns over time.

Some transitions can be categorized as ‘more of the same’, while others portend radical change. In the latter category, AIC’s change of leadership (and ownership) will mean a total overhaul of its investment platform and the new masters at Saxon Financial (Mackenzie Financial) and Phillips, Hager & North (Royal Bank) are moving in new directions. In the pension arena, some public funds are going through profound shifts as a result of changes at the top. The Caisse de Depot (with new CEO Michael Sabia) and AIMCo in Edmonton (Leo de Bever) are examples of this.

I’ve been on both sides of the succession process and have known success and failure. From what I can tell, Burgundy has covered all the bases. The changes are deliberate, transparent and evolutionary. And they’re being made for the right reasons. Even though the “plan is to work for a very long time,” Mr. Arrell is 65 years old and has recognized the need to provide visibility to his partners and the firm’s clients.

Mr. Rooney isn’t a conventional CEO in terms of his overt marketing and people skills, but he has the most important attribute for a firm like Burgundy – he is a respected investment person.

For counselling firms that are all about investing first and marketing second, this is a requirement. It’s part of the DNA and it helps distinguish them from the mega firms that are increasingly being run by marketing and sales executives. In this regard, Mr. Rooney’s credentials were reinforced by how he and his investment team handled the downturn – the Burgundy portfolios held up better than most and they didn’t blink when the uncomfortable buying opportunities presented themselves.

Taking over for a successful, iconic leader is always a tough row to hoe. Fortunately, the post-Arrell team has the benefit of a stable client base, established research team and employee ownership. As for luck, perhaps it will come in the form of better returns from foreign markets, which plays to the firm’s research strength.

Four years ago my business partner Neil Jensen and I were sitting on Kits Beach contemplating a new mutual fund company. As we looked out at the competitive horizon, we could see a wave coming at us. It was called ETFs (exchange-traded funds), and we knew it would be a tough, low-cost competitor to Steadyhand.

What we didn't anticipate was that the wave would turn into a tsunami. In no time, Canadian investors were flooded with new ETF offerings. By our count, there are now 145 funds traded on the stock exchange and a steady flow of new ones coming out from Blackrock (iShares), Claymore, Horizons BetaPro, Bank of Montreal and PowerShares. During the past year in particular, the marketing machines have kicked into high gear.

As a consequence of the swelling numbers, the ETF sector has profoundly changed how it's positioning itself with investors, and how it competes against other investment firms like ours.

Not So Simple. For starters, when investors are looking for “simple and transparent”, ETFs are no longer the default. There still are many clean, easy-to-understand ETFs to be had, but they're harder to find among the proliferation of new products.

Indeed, ETFs no longer take a back seat to closed-end funds or mutual funds when it comes to complexity, opaqueness and fine print. Investors need to ask the same questions they would of any packaged investment product. Will I own stocks, commodities or derivatives? Is there any leverage? What index is the fund replicating? Is it currency hedged? How well does it trade? Are there other fees or costs?

In the rush to catch the wave, the ETF providers have cluttered what was a pristine landscape just a few years ago.

Not so Predictable. It used to be that investors knew what to expect from an ETF. If the market went up X per cent, that would be the fund return, minus a small fee. The emergence of BetaPro's leveraged ETFs blew that notion out of the water. If an investor held their ‘Plus’ funds (two times market exposure) for more than one day (yes, one day), the returns were totally unpredictable relative to the index or commodity they were tracking.

But the unreliability of returns is not limited to the high-octane funds. The returns from some currency-hedged equity funds diverged widely from their expected targets in 2008 and 2009. And in general, the tracking error of ETFs (the amount a fund's return diverges from that of the target index) have widened over the past few years. According to the Wall Street Journal, U.S. ETFs on average missed their targets by 1.25 per cent in 2009, more than double the 2008 gap.

The Fee Halo Over all, ETF fees are lower, but the scene has changed here too. From a rock-bottom start with the original iShares funds, fees have steadily crept up. If an investor uses some specialty funds and trades a few times a year, the cost of an ETF portfolio can easily push into the range of low-priced mutual funds.

In another disturbing innovation, some ETFs are being launched as closed-end funds and then converting to open-end at a later date. These funds are prohibitively expensive for the initial buyer.

Despite the trend to higher fees, there is still a halo around ETFs. This was particularly noticeable recently when some actively managed ETF's were rolled out and the 20-per-cent performance fee was hardly mentioned in the commentaries.

Trading at a Price. One of the advantages of ETFs is that investors can buy or sell at any time. For day traders and institutional investors, including hedge fund managers, this is what makes them so attractive.

However, many of the new funds are extremely illiquid and require trading experience to ensure that the price paid is at or near the value of the fund. For long-term investors who are looking for cheap, broad-based market exposure, negotiating a trade in the open market and paying a brokerage commission is not always so great a deal. For some, buying a mutual fund after the market closes at net asset value (calculated to four decimal points) may be more appealing and practical.

The 90/10 Rule. The marketing of ETFs has gone from being all about cheap, broad-based and passive to being focused on specialization and active trading. Most new products are designed to allow investors who “have a view” to implement their strategy with surgical precision. An investor can now get exposure to virtually any commodity, country or industry sub-sector, and as of this week, can speculate on spread trades between like commodities (i.e. long oil and short gas).

It's all about market timing, sector rotation and trading. In other words, we have arrived at a point when 90 per cent of new offerings are suitable for only 10 per cent of investors.

Stop Generalizing. When we drew up our business plan, we made lots of mistakes, including underestimating how big a competitor ETFs would be. Going forward, the biggest error we could make would be to oversimplify the differences between ETFs and mutual funds. Other than the way they are transacted, the lines between them have almost disappeared.

We can no longer naively say that ETFs are simple, low cost, index-based, tax efficient and have a trading advantage. Or conversely, that mutual funds are none of those things. It's time to stop generalizing and go back to the beach in search of the next wave.

“Tom, is now a good time to invest?”

When I get that question at a party or reception, I freeze up. It's weird because I'm reasonably competent at social banter, especially when I have a cocktail in my hand, and I certainly have views on these kind of things. But I find myself quickly shifting to another topic. “How about those Canucks?”

The reason I hesitate is because the question runs against how I think about investing, so answering it seems inappropriate in a social setting, to say nothing of it being a conversation-killer.

The question investors should be asking is not whether it's time to invest, but rather, are there any reasons not to? The starting point for any decision should be a fully invested position as represented by their long-term asset mix.

Now I know this is pretty basic stuff, but unfortunately, many people are not wired this way. They are savers at heart, not investors. Their default position is the safety of a bank account or mattress, both of which put them at a disadvantage when it comes to achieving their financial goals.

For an investor, a long-term or strategic asset mix is the key element of their strategy and the one that has the most impact on future returns. It's an educated guess at what the best combination of cash, bonds, stocks and other investments (including real estate) is for their situation. It takes into account their objectives, time horizon and tolerance for short-term volatility.

Near-term predictions about which asset types are going to provide the best returns are at best unreliable. But when making projections over longer time frames, the crystal ball gets less cloudy. We know, for instance, that stocks will beat bonds, and bonds will beat cash (SBC). And the range of possible outcomes gets narrower the further we look out.

For example, bond returns are difficult to call in the next year or two due to swings in yields and credit spreads. But looking out 10 years or more, we have a reliable indicator of what returns will be, namely current interest rates (3 to 4 per cent). For stocks, the range is wider, but it's more like 5 to 9 per cent as opposed to plus- or minus-20 per cent.

Investors have the math working for them.

I give investors a further advantage over savers because they can base their decisions on more reliable data, including long-term projections.

Investors first need to set an asset mix. For those with a long time horizon, this is not rocket science (see SBC above). And then they need to determine how they want to manage the portfolio around that mix.

Some investors try to time the market and actively shift the mix. Others, like me, could best be described as tilters, leaners or shaders. Our allocations are adjusted to reflect our views on valuation and market sentiment, but we only move away from our baseline when there's a compelling reason to do so, and always within a set range.

For investors who don't have the wherewithal or inclination to outguess their long-term targets, it's best to set the portfolio mix and keep it there.

What does it mean to make all your investment decisions in the context of a strategic asset mix?

It means you agree with the long-range projections (SBC) and accept the fact that it's impossible to know when to get in and out of the market.

It means that you'll always be diversified, which in turn means that you're not trying to get everything right all the time. This will make you boring at parties (take it from me) because you won't be the one bragging about how you made a killing on oil, high-yield bonds or emerging markets. But you'll be comfortable knowing that you too benefited from those trends, just not in a ‘go big or go home’ way.

It also means there won't be all that much to do. New ‘flavour of the month’ product offerings won't hold much appeal. And the mind-numbing decision of what to do at the RRSP deadline will be an easy one — allocate your contribution in line with your long-term mix.

These days I'm doing three things in my portfolio and emphasizing the same with Steadyhand clients.

First, I'm being careful not to get carried away with the great returns of the last year. Indeed, I've moved my equity allocation towards the cautious side of the range. That has required some rebalancing towards bonds and cash.

My reasons for caution have been outlined in previous columns, but suffice to say it's based on valuations (reasonable), market sentiment (are investors living dangerously again?) and the economy's inevitable transition from The Great Debt Transfer to The Great Debt Reckoning.

Second, as part of the rebalancing, I've used the strong loonie to opportunistically increase my weighting in foreign stocks. They have lagged behind my domestic holdings, mostly because of currency.

Finally, I'm paying special attention to cash flow management. It's easy to get lazy about setting money aside, but now is not a time to be lazy.

Now to get back where we started... Can you believe Steve Nash is having another MVP-like season?