This week the 2011 sales numbers came out for Canadian ETFs (exchange traded funds). For the year, $7.6 billion flowed into ETFs (net of outflows) and total assets in the 200 plus funds finished at $43 billion.

While the number of funds exploded in 2011, the ten largest still accounted for 87% of net sales. Seven of the top ten best sellers had an income orientation, including bonds, preferred shares and covered call strategies. Under that theme, the BMO Covered Call Canadian Bank ETF, which was new in 2011, garnered the second most dollars overall ($708 million).

To put these numbers in context, net sales of mutual funds in 2011 totaled about $20 billion. There would have also been money flowing into individual securities and investment counseling firms.

To me, the EFT sales numbers are both underwhelming and disappointing.

They’re underwhelming because ETFs have been the rage over the last few years. There has been a constant flow of new products and the media and bloggers have written about ETFs extensively and positively. In the context of a wealth management industry with over $1 trillion in client assets, $7 billion doesn’t represent much of a market share swing.

There are some reasons why ETFs are gaining ground more slowly than I expected. First of all, it was generally a tough year for new flows. Weak stock markets caused investors to park more of their assets in GICs and high-interest savings accounts.

The second reason is structural. In Canada, the bank branches don’t sell ETFs directly. This leaves the ETF firms on the outside looking in at a large and growing part of the market. As a result of this, the sales numbers understate the rate of ETF growth in the distribution channels where they are available.

I’m also disappointed because when I strip out the flows (and assets) related to professional investors – institutional managers using ETFs for asset mix shifts and liquidity; hedge funds and market timers actively trading them – I have to wonder what portion is being used by individual investors to implement low-cost, long-term strategies. I don’t know the number, but suspect it pales in comparison to the money that’s going into high-cost, index-like structured products.

I also find the numbers disappointing because it appears there was some serious performance chasing going on. I recognize that fixed income ETFs are an improvement over most other pooled products, but the assets in this category increased 44% in 2011, a year when the bond market was up 10%.

At Steadyhand, we compete actively against ETFs (we recently published a report comparing Steadyhand clients to ETF investors), but I still want these simple, low-cost products to have a bigger impact on the industry landscape. The wealth management industry is making too much money off the backs of Canadian investors. I expect and hope that better equity markets, along with Vanguard’s entry into the market, will amp up these numbers in the years to come.

I just finished listening to Chris talk with a client about her RRSP transfer. He told her that the paperwork had been sent to the relinquishing institution and we would be monitoring its progress. Chris tried to set reasonable expectations, “Given our experience with this bank, you should expect it to take about 3 or 4 weeks. It may be sooner, but I don’t want to set any false expectations.”

This conversation follows one I heard last week. Sher was following up on a different transfer from one of the bank-owned discount brokers. By the end of the call, she was pulling her hair out. The forms had been faxed on December 2nd. The broker didn’t acknowledge receipt of the transfer until the 13th. Sher called on the 23rd and the transfer was still in process. She left messages on December 30th and January 5th (she couldn’t wait on hold any longer). When she got through, she was told they wouldn’t begin processing it until four weeks after receipt of the forms (the 13th). Who knows when the client will get their money invested in the Steadyhand funds?

Why is it that big, sophisticated institutions can put money into your RRSP in a millisecond, but take weeks to transfer it out? Taking money in is actually more complicated than sending it out. A new account may need to be set up, the ‘Know Your Client’ information has to be completed (or updated) and the money needs to be allocated across specific investments. The transfer out, on the other hand, is dead simple. The bank receives a transfer form from Steadyhand, the requested trade/withdrawal is processed, a cheque is cut and sent to 1747 West 3rd Avenue, Vancouver.

Canadian dealers are all over the map on RRSP transfers. Ironically, some of the highest fee firms are the slowest. For sure, the smaller independent firms are the best. At Steadyhand, we treat transfers ‘out’ the same way we treat transfers ‘in’. We process them in one day, just as a number of other investment counselors do, including my former firm, PH&N. Interestingly, if you ask any of these firms why they do it that way, they’ll tell you two things: it’s not hard to do and it’s in the best interests of the client.

These calls make me regret not putting timely RRSP transfers on my list for Santa. These industry practices are completely unacceptable.

Michael Nairne, president of Tacita Capital, wrote a good piece in the Financial Post last weekend, titled A Gift From Risky Markets, which looks at historical stock market returns and valuations (dating back to 1825) and provides some perspective on the level of long-term returns investors can expect going forward.

If you got stiffed this holiday season or are looking for a little cheer as the bills come rolling in, this short article may be just the elixir you need.

It’s bureaucracy like this that prevents smaller firms (like Steadyhand) from offering their funds nationwide. Canada is one of few countries that doesn’t have a national securities body, which has been cited as a weakness in our system by many observers. Instead, investment firms have to deal with 13 different regulators (one for each province and territory).

The cost of filing a prospectus, and the associated regulatory expenses of dealing with each province individually, is extremely expensive. It’s the key reason why we only offer our funds in five provinces. As we grow, we hope to make our offering available in every province, but at this stage in our development, the costs are too prohibitive.

As a young business, it’s disheartening to turn down interested investors in Quebec, the Maritimes and the Territories (where the inquiries have been growing steadily). Unfortunately, the news today suggests we’re not going to see a national regulator anytime soon. Bah, humbug.

“Tom, I agree with your view on stocks, and boy, you’re so right about how negative people are, but ... I can’t help but wonder if it’s different this time.”

It’s different this time. I’ve been trained to never utter these words. They’re the most dangerous four words in investing.

So when I hear my friends, clients, readers, competitors and, in some cases, idols, telling me they don’t like what they see, I’m torn. I know how bad the global economic/debt situation is. I know there will be dislocation, shocks, volatility, perpetually gloomy headlines and earnings misses. And I know we’re navigating all of this without a (government) net. But it’s not that simple because:

• Mr. Market knows all this. He figured it out in April and has been worried ever since.
  
• The corporations we’re investing in have never been in a better position to take advantage of economic and competitive dislocations. They’re the antithesis of weak, overstretched, running-out-of-options governments.
  
• Recessions are all about cleansing and adjustments. The gloomy outlook does not take into account the fact that consumers, companies, cities and countries are adjusting to the new reality. The U.S. is learning to live without a real estate market. The resource industries are adjusting to shortages by spending record amounts on developing additional supply. Huge investments are also being made on more efficient power grids, solar panels, networks, air conditioners, cars, buses, aircraft, billing systems, medical procedures and the list goes on. The pace of progress on many fronts is accelerating, which means when the turn comes, it will be faster than expected.
  
• When negative sentiment is so firmly planted on the fear side of the fear/greed meter, the downside risk is significantly reduced. Stocks could still go down, but it’s less likely and the magnitude of decline is likely less.

It feels like we’ve entered the ‘it’s different this time’ zone again. Certainly there’s a lot that will be different over the next 5, 10 and 25 years, but I’m not convinced stock market behavior is one of them. The market will continue to over-react to short-term news, trade well below (and above) the intrinsic value of underlying companies and it won’t wait for complete resolution or perfect information to turn around. If the market doesn’t do these things, it will indeed be different this time.

With the holidays around the corner, shopping is in the spotlight. It got me thinking …

We’re used to high price tags on the wet coast. We’ve got the most expensive housing market in Canada (if not the world, based on some measures). A bottle of wine typically costs more than in any other province (Tom insists, the world). Gas prices often rival the highest in the country. And high-priced yoga wear and lavish lattes fly off the shelf.

Yet, Vancouver is home to some of the lowest cost mutual funds in the country. Steadyhand, PH&N and Leith Wheeler are commonly recognized as low-fee leaders for active management (while also providing advice). Sky high real estate and low cost mutual funds makes for an interesting dichotomy. Must be something in the water.

By Scott Ronalds

A dirty little secret in this business: when a fund has an ugly performance record, it can be buried by merging it into another fund.

Fund mergers occur all the time (see Fund Company Calls the Cleaner). The latest track records to be swept under the rug belong to a handful of under-performing Investors Group funds (see below).

Given Investors Group’s dizzying array of over 500 products (in numerous classes and series), these mergers will largely go unnoticed by investors.

Morningstar Canada published its updated Stewardship Grades for 26 fund companies yesterday. The grades are designed to help investors further research, identify, and compare fund companies that do a good job – or a poor job – of aligning their interests with those of fund shareholders.

Stewardship Grades were first introduced in 2004 in the U.S., and a study published earlier this year found that funds with top grades were more likely to survive and deliver competitive risk-adjusted returns.

Morningstar introduced their Stewardship Grades in Canada last spring (see our blog on the topic), and Steadyhand scored favourably. In fact, we were the only company to receive a perfect score (8 out of 8) along with an “A” grade.

We’re proud to announce that we received an overall A grade once again. Of the 26 companies graded, four received the top mark (click here for the full list).

There are four components considered in the grading process: Corporate Culture, Manager Incentives, Fees, and Regulatory History. Morningstar made some slight changes to their process this year, motivated in part to better align the Canadian methodology with the approach employed by their U.S. fund analysts. The firm now assigns more weight to the Corporate Culture and Manager Incentives components. Steadyhand scored A’s on Culture and Incentives.

We’re unhappy that we scored a B on Fees this year, although we do understand that some other 'direct’ companies have lower fees before our fee rebate program kicks in.

Morningstar notes, “The Stewardship Grade goes beyond the usual analysis of strategy, risk, and return. It helps investors to assess a fund based on the degree to which the fund's parent – the management company offering the fund – has its interests aligned with those of fund shareholders. The methodology also examines whether shareholders can expect their interests to be protected from potentially conflicting interests of the management company.”

We pay little heed to industry ratings and awards that focus on short-term performance, but the Stewardship Grades address important intangibles that are not captured in a review of past performance alone.

I feel for the twentysomething generation. Good jobs are tough to come by, home ownership is out of reach for many (in Vancouver and Toronto, at least), skinny jeans are deemed fashionable for men, and a weekend camping now means pitching a tent downtown.

What’s more, young investors are avoiding risk at an alarming rate. A recent article in the Wall Street Journal (The Young and the Riskless) highlights a survey which showed that 52% of investors in their 20s agreed with the statement: “I will never feel comfortable investing in the stock market.” (only 29% of investors of all ages agreed with the statement)

The piece suggests: “Investors who eschew risk at such a young age might be setting themselves up for disappointment. Without the compounding effects that come with investing in equities for a long time, stock-less investors might find it nearly impossible to accumulate a big enough nest egg to retire at all, let alone in their 60s.”

We’re all aware that the stock market has been turbulent over the past several years, and that the economic headlines aren’t exactly rosy. But investors in their 20s who intend to avoid stocks altogether are making a mistake. A big one. Over a 30-40 year investment horizon, stocks will almost certainly outperform cash and bonds. This is especially true using today as a starting point – stock valuations are attractive on many measures and bond yields are close to historically low levels. Big short-term swings in the market are hard to stomach and can be particularly damaging for older investors, but the twentysomethings should use volatility to their benefit.

Young investors, no doubt traumatized by the events of the past few years, need to step up and take some risk (i.e., invest in stocks) if they want a phat portfolio down the road.

Special to the Globe and Mail
by Tom Bradley and Lori Lothian

His Market Savvy and Concern for Clients Helped Build a West Coast Powerhouse

Few icons of the investment industry are celebrated outside the confines of Bay Street, but Bob Hager is one.

Bob, who died on Oct. 7, was a driving force in building one of Canada’s most successful asset managers. In 1965, he (centre of picture) and partners Art Phillips (left) and Rudy North (right), started a fledgling firm called Phillips, Hager & North. By the time he retired in 2001, PH&N’s family of mutual funds had given thousands of Canadian investors access to direct, low-cost investing and the firm had become the largest independent manager in Canada. When it was sold to Royal Bank in 2008, assets under management were $69 billion.

There were many people who contributed to the firm’s success, but it was built in Bob’s image and on his personal values. Like Bob, the company was quiet and understated, growing without advertising, acquisitions or sales commissions. The values of the firm were grounded in the best interest of the clients.

Robert Stewart Hager was West Coast to the core, born in Vancouver in 1937 and raised in the Kerrisdale area. He went to high school at Magee, and received a commerce degree from nearby UBC. After marrying Judy, his long time sweetheart, he ventured south to earn his MBA at the University of California at Berkley, then returned to begin working with Phillips and North.

PH&N was unique in the early years. The young partners, along with Dick Bradshaw (who just missed getting his name on the door), used to brag that the company was the largest investment counselor in Western Canada. Truth told, it was essentially the only investment counselor in Western Canada.

In the early days, it relied heavily on Art’s financial resources and track record. He was the oldest of the four and had already tasted success while running the All-Canadian Fund.

PH&N didn’t truly catch fire until it won an important pension client in Eastern Canada in 1972. By then, it had established an outstanding record and was in position to benefit from an emerging trend that saw pension plans shift their assets away from the traditional providers – trust and insurance companies – to independent asset managers.

Bob didn’t have a sales bone in his body, but his values and sensibility were the best marketing tools a firm could have. Clients took to PH&N because it was humble about its successes, and brutally honest about its mistakes. No matter how good the results were, Bob often led off client presentations with what went wrong. There were meetings where the client had to remind him that the returns were actually very good.

Clients and consultants also liked that the company’s ownership was spread widely amongst employees. Bob and the other senior shareholders were generous in this regard. He always said that he didn’t mind selling shares to a new partner, as long as he or she helped build the business. He was happy to own a smaller piece of a more successful firm.

While PH&N was primarily a pension manager in the early days, Bob and his partners had the foresight to create a family of mutual funds, partly in response to pension trustees and executives who wanted to put their personal money with the company. It was telling that Bob never viewed the funds’ low fees as a marketing ploy or missed profit opportunity. To him, they just seemed appropriate.

Not only did his gentle nature appeal to clients, it also set the tone inside the firm. Executive rank or shareholding meant nothing to him. He bonded with people at all levels of the organization.

Whether he was President and CEO (1973-87) or Chairman (1987-2001), he was subject to the same ridicule as everyone else when his picks in the basketball pool went bad. After stepping back in 1987 to focus on his clients, he subsequently worked for three CEOs: Bradshaw, Tony Gage and me. He grumbled from time to time, but his support was unwavering.

Bob’s warm personality hid an intense, competitive fire. He couldn’t stand mediocrity and took it hard when the firm wasn’t performing well. As Dick says, “Bob worried so much that the rest of us didn’t have to.”

As the firm grew, Bob’s dedication to clients, common sense approach to investing and decisiveness in troubled times, continued to influence the analysts, portfolio managers and support staff he worked with. He never mailed in a client meeting, even though his experience and stature would have allowed it. He prepared extensively, to the point where he was no fun traveling to a meeting.

Flights home, on the other hand, were enjoyable. Bob was an engaging and interesting seatmate. He always had stories to tell of the early days and was a wealth of knowledge on sports, golf courses, Four Seasons Hotels and Air Canada’s fleet.

At his core, he was an investor, and his simple approach helped ground more than a few young analysts. He reminded them that bottom-line profits drove stock prices, not the more fashionable EBITDA numbers (earnings before interest, taxes, depreciation and amortization). He was not seduced by fancy wrapping on investment products.

Bob’s most lasting lessons came in weak markets. While he worried incessantly about his clients, it never prevented him from acting. Indeed, that’s when he was at his best.

Some words of wisdom:

• “With every bear market, there are always unknowable concerns, and every time we’re told that this bear market is different.”
  
• “Make sure you go up with more than you went down with.”
  
• “My best trades turned out to be the ones when my hand was shaking as I gave [the equity trader] the blue ticket.”

One particularly memorable moment came in September of 1998. The S&P/TSX Composite Index had dropped more than 20 per cent in August and the research team was shaken. Bob’s not-so-gentle nudge moved them to start buying stocks.

“We will be buying into these companies as the market declines,” he said.

Bob and his wife lived in the same home for 38 years, but traveled extensively throughout their 57 years together. Their philanthropic interests were many and varied, but they took a special interest in helping young people achieve their potential.

Bob’s retirement passions were rugby, fishing, gardening, travel, his daughters Leslie and Shelley and their families, including six grandchildren.

His family and friends will miss his stories, his laugh, his irreverence, his grumpiness, his kindness and his wise counsel.

Canada lost a great investment executive at a time when he’s needed the most. “Bob was our keel,” Bradshaw says. “He kept us focused on our goal of achieving the best possible results for our clients.” He was the conscience of a firm that was known for its conscience.

In his letter this month, Bill Gross of Pimco talks about the cure to all our ills – growth. As he says, “No country has enough of it.”

In discussing the prospects for economic growth, Mr. Gross does a good job of capturing the challenges we face.

“The lack of growth ... is structural as opposed to cyclical, and therefore relatively immune to interest rate or consumption stimulative fiscal policies. 1) Globalization, 2) technological innovation, and 3) an aging global demographic have all combined to dampen policy adjustment post Lehman and will inexorably continue to work their black magic going forward.”

He goes on to point out that another structural impediment, high debt levels, is also a barrier to growth.

Our managers (and I) aren’t spending a minute trying to figure out whether we’re heading into another recession or not, but we are factoring into our forecasts a slower, bumpier economy.

Oracle, which is a holding in the Equity Fund, announced a takeover bid for RightNow Technologies this week. In the past, Oracle has proven to be an effective and disciplined acquirer, but there is talk on this one that they paid too much – over 5 times sales and 50 times 2012 earnings according to the Financial Times.

I don’t think anybody would doubt Oracle, however, if they read the description of RightNow in the regulatory filings. The company sells a "comprehensive customer experience solution for consumer-centric organizations to enable interactions across web, social and contact centre touch points." It’s easy to see what Larry Ellison saw in RightNow.

I came across a talk by China-based professor Michael Pettis on Paul Kedrosky’s ‘Infectious Greed’ blog. For those who are interested in China and where it’s headed, I highly recommend these 38 minutes. It’s heavy duty economics, but the points are made clearly and methodically.

Mr. Pettis’ comments are a cautionary tale. China’s growth has been impressive, but has created distortions in the economy. The country is highly dependent on investment spending for its growth (factories, mills, roads, bridges, airports, trains). In turn, it has increasingly become dependent on available credit. Debt levels overall are still manageable, but Mr. Pettis points out that the pace of loan growth is unsustainable. He also talks about the impediments getting in the way of the Chinese consumer becoming a bigger factor in the economy, something that the country desperately needs.

In the economic discourse of today, the camp that says we’re going into the tank has lots of ammunition. You don’t have to go past the front page of the newspaper to know we’ve got issues. For those arguing that we’ll be OK, or at least not have a severe recession, it’s tougher sledding. They have some good points to make (emerging economies will carry us, inventories are down, Japan is bouncing back, the U.S. housing market has nowhere to go but up, corporate balance sheets are strong, etc.), but these points are being overwhelmed by the negative headlines.

I like to cheer for the underdog, but I don’t like the fact that the ‘we’ll be OK’ camp is regularly justifying its position by referencing what’s going on now. We’re not going into recession because:

“Demand is good right now. Order books are still solid.”

“Corporate profits are outstanding this quarter. They’re coming in ahead of expectations.”

“With rates so low, real estate is still moving.”

As consumers of financial information, we have to be careful to not get caught up in the ‘right now’ arguments. Right now doesn’t matter when it comes to capital markets. Mr. Market is always looking ahead. He could care less about conditions today.

I’m more in the ‘we’ll be OK’ camp than that other one, but I take no comfort from the fact that right now car sales are good, iPads are flying off the shelf and restaurants are busy.

China, India and the other emerging economies will grow considerably faster than the developed world over the next ten years. That statement appears to be as close to an economic certainty as anything we can say today.

Does it follow then that any reasonable investment strategy should be heavily stacked towards securities from these countries? Presumably, they will grow faster and deliver better returns to their shareholders over the long run.

The answer is yes, portfolios should have meaningful exposure to emerging markets. Should they be heavily stacked? Read on.

Emerging market stocks are a great example of where the price paid has to match up with the potential. In the past couple of decades, there’s been money to be made, but investors’ timing and skittishness has resulted in disappointing returns.

In his latest letter, Howard Marks, the Chairman of Oaktree Capital Management, addresses this point.

“I don’t mean in the least to suggest that the outlook for China, India and the rest of the emerging markets is less than bright. In fact, I’m sure they’ll out-grow the developed world over the remainder of the century. The problem, however, is that simplistic, mania-following investors elevated emerging markets to the pedestal of the “sure thing” where nothing can go wrong. And when prices incorporate unlimited virtue, the eventual result is bound to be disappointment, disillusionment and depreciation. Even favourable developments can lead to losses when they fail to measure up to expectations. That’s been the case in the emerging markets.”

Staying with Mr. Marks for a moment, it seems appropriate to bring out one of his well-traveled quotes.

“No asset can be considered a good idea (or a bad idea) without reference to its price.”

In the Steadyhand equity funds, we’ve been gradually increasing our exposure to emerging markets over the last year. It’s come in two forms – directly in companies located in the emerging market countries and indirectly through western-based firms that have meaningful and growing emerging market revenues. Stocks we’ve bought or added to include Unilever (Netherlands), Asia Pacific Breweries (Singapore), China Mobile (China), Dongfeng Motor Corp. (China), HSBC (UK), Samsung Electronics (Korea), Mead Johnson (U.S.), Dairy Farm International (Hong Kong), Bridgestone (Japan), SK Telecom (Korea) and Singapore Telecommunications (Singapore).

All of our managers are aware of the potential that emerging markets offer. They are looking for the best vehicles to tap into that potential and are carefully considering the price.

In preparing our Quarterly Report, I compiled some numbers that speak for themselves:

• Global stock markets had their worst quarter since Q4 2008
  
• Greece was down 42%. Italy, France and Germany were all down 25%. Canada was down 12%. Japan was down 11% (all in local currency terms)
  
• Almost every major European market has a P/E below 10 and dividend yields are commonly north of 4%
  
• The loonie hit $1.06 US in July and ended the quarter at $0.95
  
• Oil fell 17%
  
• Base metals fell by more than 20%
  
• The Government of Canada 10-year bond yield dropped from 3.1% to 2.1%
  
• The US Treasury 10-year bond yield dropped from 3.2% to 1.9%
  
• The DEX Universe Bond Index was up 5.1% - its highest quarterly return since 1996
  
• North American sovereign bond yields are at levels not seen since the 1940s

For stock investors, it was an ugly quarter. Bond investors, on the other hand, had a heyday. Looking ahead, it seems pretty evident where the opportunities lie. Hint: it’s not government bonds.

We write a lot in this space about investor sentiment. Art Phillips, the founder of Phillips, Hager & North, taught me to pay attention to the mood of other investors. Like every tool, sentiment is not a failsafe indicator, nor is it a precise timing tool. It is, however, a good check against getting too carried away in one direction or another. If everyone is bullish, it’s time to get more cautious. Everyone else knows the good news too. If the consensus is firmly in the bearish camp, it’s time to focus the research efforts (and trading tickets) on the buy side.

The Canadian Couch Potato posted a good piece this week on where investor sentiment is today. He referred to a survey of 200 institutional money managers carried out by Morgan Stanley. The managers were asked, “What best describes your attitude to global stocks right now?” The results showed that they were pretty evenly divided across four distinct categories:

• “I’m buying stocks now” (20%)
• “I’m waiting for an entry point after the policymakers get their act together” (30%)
• “I’m continuing to sell” (25%)
• “I’m confused” (25%)

I don’t know where this mishmash would come out on Art’s sentiment indicators, but it’s cautious and confused enough to tell me that it’s a better time to buy than sell.

Dan Hallett published an article today about mutual fund fees and how they compare to the U.S. It puts some meat on a topic that so far has been laden with hyperbole. Management expense ratios (MERs) are a lot higher in Canada, but as Dan points out, the comparison isn’t apples-to-apples. Generally, Canadian MERs include a charge for financial advice, whereas U.S. MERs don’t. He refines the comparison by adjusting for advice and taxes.

The bottom line is that Canadians pay too much for wealth management. Higher management fees contribute to the difference, but there are other issues at work. Poor transparency has led to a situation whereby most people don’t know what they're paying, who it’s going to and what it’s for. That is turn means too many investors are paying for advice but not getting it.

As Dan says, the mutual fund industry “has its share of blemishes”, but the distributors, who keep almost half of those high Canadian MERs, also need to be held up to scrutiny.

Below is an internal email from Chris Stephenson today. It wasn’t meant for public consumption (it’s an email, not a blog), but Chris is OK with me doing this.

With David’s experience with the [un-named fund company] rip-off, the Globe article about $1,305 in transfer fees and a couple experiences I had yesterday, it occurred to me that the industry’s transfer process is seriously letting down clients.

Not only the hefty fees, but the time it takes and the concurrent market risk. Because it’s paper based, forms are prone to hang out on an advisor’s desk or get caught up in bureaucracy. And don’t get me started on the lack of transparency / status updates.

The OSC’s discussions about implementing Fiduciary standards are nice and everything but how can the industry ever consider itself fiduciaries without addressing this giant black hole rip-off zone?

The CBC woke me up this morning with rain warnings (Is summer really over?), big stock market declines and the voice of Finance Minister Jim Flaherty. The rain and markets didn’t get me too worked up, but I found the minister’s attempt at optimism to be disconcerting. Even in my semi-conscious state, his statements were too sanguine for my liking.

In the commentary below, I’ve paraphrased what Mr. Flaherty said and then added some perspective. I’m not doom and gloom on Canada, but I do think his comments need a counterpoint.

Canada’s economy is in much better shape than the rest of the Western world.

This is true, but he’s talking about present day. Reassurances about the future based on what’s happening today are … well … useless at best and irresponsible at worst. One of Federal Reserve Chairman Ben Bernanke’s most infamous lines came in the spring of 2006 when he tried to provide reassurance about the U.S. housing market. He said, "it looks to be a very orderly and moderate kind of cooling at this point." (An Orderly Decline of the Housing Market? Not.) With finance ministers, central bankers and economists, always be careful when they justify predictions about the future with facts from the present.

Canada has more room to move if things slow down.

I suppose that compared to Europe and the U.S., Canada has a little more firepower to fight a recession, but he glossed over two important points. First, we may have more in the cupboard, but it’s mostly crumbs. We’ve been running a $40 billion deficit while the economy has been strong and our resource and housing industries have been humming. Mr. Flaherty’s government has already used up most of its fiscal stimulant.

And as for interest rates, I don’t think we can say that a 1% bank rate (vs. 0.25% in the U.S.) is a huge advantage. From these levels, lower interest rates won’t do anything. It’s only crumbs here too.

In summary, we’ve got almost no ability to soften the impact of a global recession. To think otherwise is misguided.

From conversations with business people, the thing that’s holding back the economy is the uncertainty. Businesses need to recognize that Canada is in good shape and get on with it.

Certainly, we’d all like to see the business community forge ahead and take advantage of the current dislocations in the world. Their reticence, however, is understandable for a couple of reasons. Canadian businesses are highly dependent on exports and yet, they’re not feeling very competitive these days. As one portfolio manager said to me recently, “Canada isn’t low cost at anything it does and is high cost at a lot of things it does.” The second reason is that their two big customers – the U.S. and China – aren’t what they used to be. The U.S. outlook is uncertain and there are cracks starting to show in the China machine. So while our world-beating stock market hasn’t necessarily reflected it, our economy is what industry professionals describe as ‘high beta’. In other words, it will be more volatile than the global economy overall.

Maybe I just got up on the wrong side of bed, or the rain and markets have me in a foul mood, but I don’t think Minister Flaherty’s hollow pep talk is what we need right now.

The passive (indexing) vs. active management question is a polarizing debate, but it shouldn’t be. The bottom line is that both strategies have merit when they’re done right.

As Morningstar USA’s President of Fund Research (Don Phillips) notes, credible voices within the index community are being drowned out by a vocal fringe – the indexing extremists. In an article first published earlier this year, Phillips suggests these individuals grossly overstate the indexing case, and that “many of the fund world’s recent stumbles – the misguided expectations surrounding leveraged and inverse ETFs and the poor performance of many commodity products – have come under the indexing banner.” This coming from someone who admits that indexing is a good way to invest and acknowledges to holding much of his personal assets in index funds.

There’s a paragraph in the middle of the article that’s particularly telling as to the state of the debate (in the US, at least):

“At some point, however, many index fans went from making the honest and helpful argument that indexing is good to making the hyperbolic and divisive case that anything other than indexing was not only bad, but also morally suspect. Extreme index supporters went from asserting that indexing beats the average fund to implying that it beats all funds. Ironically, they've advanced this claim during a decade when indexing has experienced unusually weak results. For the 10 years through the end of 2010, the Vanguard 500 Index fund placed in the 49th percentile of the large-blend category--hardly in keeping with its perceived dominance. The dichotomy between the facts and their assertions hasn't humbled the true believers, however. Their words have grown more extreme, as seen in a recent statement from an ETF provider that likened active fund managers to big tobacco companies, claiming that active management was as dangerous to investor wealth as tobacco is to our health.”

As a proponent of active management (undexing), I found Phillips’ article refreshing, although I’m sure it will raise the hackles of many indexers. If nothing else, the ongoing discussion is sure to be entertaining.

One of the richest men in the world wishes he was taxed more. Warren Buffett paid $7 million in federal taxes last year, which equated to 17% of his taxable income. Surprisingly, this was the lowest rate of any of the 20 employees in his office.

In a rare plea in the New York Times, Buffett is asking Congress to stop pampering the super rich. “My friends and I have been coddled long enough by a billionaire-friendly Congress”, he notes. His advice to Washington is to leave rates unchanged for 99.7% of taxpayers and raise taxes on Americans making more than $1 million, with an additional increase in rates for those making $10 million or more.

As for the potential backlash, he believes the super-rich will take it in stride:

“I know well many of the mega-rich and, by and large, they are very decent people. They love America and appreciate the opportunity this country has given them … Most wouldn’t mind being told to pay more in taxes as well, particularly when so many of their fellow citizens are truly suffering.”

America needs to reduce its deficit, urgently. Its second richest citizen is willing to do his part, and feels that his bridge and poker buddies wouldn’t mind sharing in the sacrifice either. If nothing else, it’s an interesting message to Congress.

I came across a commentary in the Financial Times this week on the downgrade of U.S. government debt by the rating agency Standard and Poor’s. I highlight it because there’s a hate-on for the U.S. and we know all its warts. In arguing that S&P got it wrong, Bill Miller, Legg Mason’s legendary equity manager, provides some balance to the discussion.

"First, it is incredible that S&P should think the US is less creditworthy now than two weeks ago, when an agreement to raise the debt ceiling had not been reached, both parties appeared intransigent and contingency plans were being considered that included prioritising payments or even declaring the debt ceiling null and void. In any event, an agreement was reached that assures the ability of the US to fund its operations through the next election and initiated a process to tackle the nation’s long-standing fiscal imbalances."

"Second, S&P apparently gave little or no weight to the unique role the US plays in the global economy. The US is the world’s largest, most productive economy and the dollar remains the global reserve currency. The only possible alternative, the euro, is structurally flawed and is in what may turn out to be an existential crisis. Issuing its own currency means the US can settle its debts by printing more money if need be, so there is absolutely no question of its ability to pay."

"Third, the market says S&P is wrong. The US enjoys among the lowest interest rates in its history coincident with the highest deficits and a daunting long-term fiscal outlook. Yet when investors are looking for safe assets, they buy Treasuries. The US is borrowing at lower long-term rates than it did when it was running a budget surplus. In the 2008 crisis, investors flocked to Treasuries and the dollar because they sought the safest, most creditworthy assets in the world. S&P seems not to have noticed this."

I was reviewing a new client’s portfolio last week and I stumbled across the Manulife Simplicity Balanced Portfolio. It’s a fund-of-funds product, meaning it holds a basket of mutual funds. In this case, the Portfolio holds 18 funds (as of December 31, 2010), which are managed by 13 different firms (manager in parentheses):

• Manulife Canadian Large Cap Value Equity Fund (MFC Global)
  
• Manulife Canadian Bond Fund (MFC Global)
  
• Manulife Canadian Universe Bond Fund (CIBC Global)
  
• Manulife Canadian Fixed Income Fund (Addenda Capital)
  
• Manulife International Equity Fund (Templeton)
  
• Manulife Mawer World Investment Class (Mawer Investment Mgmt.)
  
• Manulife Mortgage Backed Fund (MFC Global)
  
• Manulife Canadian Large Cap Equity Growth Fund (McLean Budden)
  
• Manulife Fixed Income Plus Fund (Alliance Bernstein)
  
• Manulife U.S. Equity Fund (Alliance Bernstein)
  
• Manulife Small Cap Value Fund (Foyston, Gordon & Payne)
  
• Manulife Global Equity Fund (Capital Guardian)
  
• Manulife Growth Opportunities Fund (MFC Global)
  
• Manulife U.S. Small Mid-Cap Equity Fund (Goldman Sachs)
  
• Manulife U.S. Diversified Growth Fund (Wellington)
  
• Manulife Canadian Equity Value Fund (Scheer Rowlett & Assoc.)
  
• Manulife Canadian Equity Fund (MFC Global)
  
• Manulife Canadian Large Cap Growth Fund (Greystone)

The fee on the product is 2.59% (3.13% for the segregated version). While the managers are reputable and experienced, there are nonetheless 13 cooks in the kitchen. I haven’t done the math, but I’m guessing there are well over a thousand stocks in the Portfolio, likely with a fair degree of overlap between managers. Over-diversification is a real danger here. No matter how much statistical analysis is done, with seven Canadian equity funds, six foreign equity funds and five fixed income funds, it’s difficult for products like this to not just be very expensive index funds.

This doesn’t look like a simple dish to me. Maybe that’s why it comes at a premium price.

My last Globe column (Of Cash and Quality Stocks) prompted a reader to ask, “Do you believe Canadian Banks will be able to grow their dividends at a healthy clip going forward? Is the growth of the Canadian Banks over?”

In the past, I've underestimated the banks' ability to grow, so I'm reluctant to say it will be any different going forward. And indeed, I suggested in my answer that they will continue to grow their profits and dividends. But I also pointed out that there are some trends that fueled the banks’ past growth that won't be as favourable in the medium term.

• The banks are big and are running out of room to grow. They already dominate most of the businesses they're in ... in Canada. So growth in these areas will come more from population/economic growth and market share gains (versus each other) than a favourable secular trend. That makes it tougher. As for growth outside of Canada, I love what TD is doing on the U.S. east coast and what BNS is doing in the Caribbean, but in general the competition will be tougher and profit margins lower.
  
• There also doesn't appear to be any new business areas that will be meaningful sources of growth. In the past, the banks have moved effortlessly into credit cards, brokerage (full-service and discount), investment banking, wealth management and almost every other area of our lives. It’s not obvious what the next vehicle will be. Perhaps insurance, but it doesn't appear to be developing as favourably.
  
• The customers are considerably more leveraged than they were 10 or 20 years ago. Clearly the banks have benefited from this secular trend (and are largely responsible for it), but again, it’s a trend that at best will be neutral going forward, and indeed could be a headwind if Canadians start to deleverage.
  
• Canada is one of the few Western countries that hasn't experienced a housing collapse. We aren't heading the way of the U.S. (I hope), but if our market cools off, or indeed drops 10% or more, the banks will feel it. Much of Canada’s economic activity is linked to real estate and another cyclical industry, namely resources.
  
• The regulatory environment will be more restrictive going forward. The banks will be required to set aside more capital than they did in the past and will have less freedom in some business areas. This will likely lead to lower ROE's (return on equity).

As I said at the beginning, I never want to sell the banks short. They are well managed and importantly, well regulated. They have a diversified mix of business and know how to use scale to their advantage (ask me about it!). And they are an oligopoly, so the competitive environment is friendly. In other words, they’re in a great position to grow their dividends, but perhaps at a slower pace than they have over the last few decades.

By Tom Bradley

In a post last week, Larry Swedroe wrote about one of our favourite topics – the behavioral gap. I’m referring of course to investor behavior, not child rearing or post-Stanley Cup rioting. In an investment context, the term refers to the gap in returns between mutual funds and the investors that buy them. In study after study, it’s been shown that investors don’t do as well as the funds they invest in.

The reasons for this are many, but generally come down to two main ones. First, investors hurt themselves by buying what did well in the recent past (buy high) and selling what’s underperformed (sell low). These actions lead to the second reason, which is that investors trade too much and incur extra costs.

What prompted Larry’s article was new data (U.S.) from Morningstar that shows that gaps persisted over the last 3 years. In the U.S., international and bond fund categories, it varied from 0.5% to 2.0% per year. Only in the balanced fund category was the gap negligible.

In the piece, there is a quote from Warren Buffett who says, “We continue to make more money when snoring than when active.”

I started by saying it’s our favourite topic because Steadyhand is all about eliminating the gap, whether it be our philosophy, communications, fund managers or company name. And we track both fund returns (time-weighted returns) and client returns (dollar-weighted) to see how we’re doing. While the data is impressive, we aren’t able to release it yet because the record is too short. Four years of rapid growth is not a meaningful enough sample.

In the meantime, we’ll encourage our clients and readers to mind the gap – trade infrequently and re-balance when needed.

Canadian Couch Potato posted an interesting blog yesterday. Dan Bortolotti, the author of this highly-rated blog (in a recent Globe and Mail contest, it was voted the best investing blog in Canada), thinks we need to stop fighting about which is better – active management or indexing – and move on to more important matters. He starts by saying that, “the active v. passive debate is too often a distraction from what’s really important in personal finance.”

In this context, Dan discusses my book (It’s not Rocket Science – Plain-English Advice for Managing Your Investments) in some depth. He admits to being surprised that he found himself agreeing with 95% of what is in the book, despite the fact that he is strongly in favour of indexing and I’m an active manager. I presume that the 5% relates mostly to our different investment philosophies.

I couldn’t agree more with Dan on his main point. Investors, managers and commentators get too entrenched on active versus passive and lose sight of the bigger investing issues (Note: the same could be said for the scuffles around mutual funds versus ETFs). Dan sums it up by saying, “The fact is, if Canadian investors are suffering from chronic underperformance, it isn’t because their portfolios are actively managed per se. The problem is that most investors pay too much for active management, largely because the fund industry is driven by commissioned salespeople. Disciplined, patient and courageous investors can do just fine if they stick to low-cost, prudently run active funds ...”

Fund (as in mutual) has become a dirty word. I was reminded of this the other day when Tom was lamenting over all the negative connotations associated with mutual funds.

What was once a beautiful concept – investors pooling their money in a shared vision of investing in stocks, bonds or other assets through the expertise and guidance of an experienced professional – has been tainted by high fees, over-diversification, poor performance, index hugging and questionable client-manager alignment. Not to mention a lack of sex appeal.

But the mutual fund is still the most effective vehicle for most individuals to achieve their investment objectives. It just has to be structured right.

In an environment of record low bond yields, high-flying (and free-falling) IPOs, volatile commodity prices, and exotic ETFs, investors may soon be longing once again for experienced, professional management at a reasonable cost. As dull as it may be.

I for one can think of a few other four-letter words that may prove to be much more offensive in coming years. Bond, debt, and gold come to mind.

In his June 6th letter, Tim Price of PFP Wealth Management in the UK provides a thoughtful take on our debt burden.

“From a narrowly financial perspective, government debt is an asset class, albeit an asset class now offering vast potential for capital losses for the unwary. From a broader social perspective, government debt is taxation deferred, a burdensome claim on all our individual futures, a reflection of wealth to come being diverted from the private sector to the state and its putative political leaders.”

Later in the piece he reviews potential solutions.

“When the problem is too much debt, there can only be three solutions. One is austerity, and as the UK (and Greece, and Ireland) is finding to its cost, it is difficult to cut your way back to growth. One is outright default, which is politically unpalatable (though may still be inevitable) given the extent of debt in today’s world. The third option is inflation – default by stealth, in other words. Even now, given the deflationary headwinds, it is by no means clear whether the west resolves its debt mountain by Options 1, 2 or 3. Perhaps we get all three. What is clear is that in protecting the interest of narrow financial elite, our politicians are lying to us about the reality.”

Given the severity of the debt problem, I have to think it will be some combination of all three, although the austerity may not come until we have another crisis.

By Scott Ronalds

We’ve all dealt with it and it drives us insane. Calling a toll-free number and following an automated voice prompt. Just give me a damn human voice!

Pretty much every big business uses them. Yet, I don’t know of a single person who likes responding to synthetic voice instructions or let alone finds the process helpful and efficient. A website now exists that lets you enter a company’s name to find tips and shortcuts to speak directly with a human. Check it out, www.gethuman.com. If you enter United Airlines, for example, you’re told to “ignore the talking voice and press 0 at each prompt – three times”. The search results also tell you that the average wait time to get through to a human at United is 6 minutes.

Somewhere along the way, something went wrong with customer interaction. The fact that gethuman.com even exists proves just how far we’ve fallen. According to the financial decision makers, it’s all about costs and scale. But are costs and scale more important than human interface and an efficient client experience? The banks, airlines, cable companies, utilities, etc., sure think so.

Here’s a tip if you’re trying to get through to a human at Steadyhand. Call 1-888-888-3147. Press nothing else. Average wait time: 2-5 seconds. Chris, Sher, myself, or if need be, Tom will pick up.

Get human.

When I was an analyst on the brokerage side of the business (1980’s ... I was a teenager), there were a few iconic people that we all looked up to. Hugh Brown, who was with Burns Fry (now part of BMO), was one such person. He was the guy on the bank stocks. Everyone else was playing for second.

The Report on Business magazine (April issue) did an ‘Exit Interview’ with Hugh upon his retirement. In it he was asked to comment on his most traumatic time during his 42 year career.

"In 1982, Third World debt collapsed. The Big Five Canadian banks had 2½ times their equity invested in Third World loans, and those loans plunged to 50 cents on the dollar. On a mark-to-market basis, the banks were insolvent. Canada was also in the worst recession in 40 years. But it was another testimony to the banks’ core franchise – give them time and they can earn their way out of trouble. It took seven years to absorb the Third World writedowns."

It would be interesting (not fun, but interesting) to think about what would have happened in the 1980’s if the banks had been forced to mark their assets to market value (mark-to-market) as they do now. Can you say bailout?

Today, our banks are more diversified and don’t have any exposures that comes close to the Third World loans. And post-crisis, regulators have increased capital requirements. But Hugh’s story reminds us that we should have little sympathy for bankers who grumble about more restrictions. We should be hard on them in the good times (i.e. capital requirements, conflict rules, regulatory scrutiny, consumer protection), because as history has proven, we’ll need to be there for them in the bad times.

In the meantime, when my wife Lori grumbles about bank charges and billion dollar profits (Hugh calls it a franchise, I prefer oligopoly.), I remind her that it beats the alternative.

By Scott Ronalds

I learned last week that the HealthShares Dermatology and Wound Care ETF has been shut down. A shame, really. Seemed like a solid backbone for a portfolio. Investors who like their ETFs sharp and narrow need not fret, however, as the Direxion Daily Agribusiness Bear 3X Shares ETF is still around (for the time being).

Forbes magazine recently came up with a list of the 15 most outrageous ETFs. Along with the aforementioned, the iShares S&P North American Technology-Multimedia Networking Index Fund, the PowerShares Autonomic Allocation Research Affiliates Portfolio and my personal favorite, the soon-to-be-launched Market Vectors Mongolia ETF, also made the list. Without a doubt, there are some cracks in the ETF halo.

Not only are these products obscure, they can be dangerous for investors not knowing what they’re getting into. As Forbes notes, “Such is the way of things in the byzantine world of ETFs, where offerings have exploded in recent years. Nearly 900 ETFs have been launched over the past five years, leading to a preponderance of funds that straddle the line from obscure to downright bizarre…”

Clearly, bizarre sells well these days. How else do you explain Lady Gaga, The Sister Wives and Charlie Sheen? We’re all a little intrigued by the ludicrous; the last place it belongs, however, is in your portfolio.

“If I’m curt, then I apologize. But as I understand it, we have a situation here and time is of the essence.” - Newman

I’m a Seinfeld junkie. One of my favorite episodes was “The Muffin Tops”, in which Elaine’s former boss (Mr. Lippman) decides to open a business that sells muffin tops. He runs into a problem, however – he can’t get rid of the undesirable bottoms. Cue Newman, a.k.a. The Cleaner, who is hired to make the problem go away (by eating the muffin stumps).

It looks like Newman has paid a visit to AGF. The fund company purchased competitor Acuity in February and is acting fast to get rid of the unwanted offerings in its lineup. This involves merging 9 Acuity funds, pending approval by unitholders and regulators – 8 are being merged into AGF funds and 1 is being merged into another Acuity fund.

We don’t view fund mergers in a positive light for a number of reasons. For one, the fund being merged is often repositioned or assigned a different mandate, meaning that an investor’s original reason for buying it may no longer be applicable. Second, the common practice is to merge an underperforming fund into one that has a better record or falls into a more popular category. In other words, the fund company may simply be chasing performance. Further, a fund merger can remove a weak performing fund from a company’s lineup and thereby mask a history of poor money management. (For more on the topic, see our article Patience in Investing – The Exception)

We don’t have an axe to grind with AGF, but their latest round of mergers does illustrate our point. A few observations:

• 6 of the 9 Acuity funds are being merged into a fund that falls into a different fund category (based on Morningstar data).
  
• 8 of the 9 funds being culled have a worse 3-year performance record than the fund they’re being merged into (we looked at 3-year performance, as most of the funds do not yet have 5-year numbers).
  
• 6 of the 9 Acuity funds have been in existence for less than 5 years (were the managers given a suitable time horizon to achieve their objectives?).

With the purchase of Acuity, AGF acquired an additional 50+ funds to incorporate under its umbrella of close to 200 products. One positive of the mergers is that AGF is removing some of the clutter from the investment landscape. In our view, companies offer far too many funds, many of which have extensive overlap and/or mandates based on the latest trend. Our industry would be well served to grab a few more quarts of milk for Newman and set him loose on all the muffin bottoms.

There was news today that two private equity firms, Berkshire Partners LLC and OMERS Private Equity, are buying Husky International from Onex, another private equity company. This secondary buyout (defined as one private equity firm buying a company from another) is part of a growing trend. Late last year, I saw some numbers from Standard & Poor’s that showed that 68% of European private equity deals in 2010 (year-to-date) were secondary buyouts, while 49% of U.S. deals fit this category.

It’s understandable why this is happening. In aggregate, private equity firms are awash with capital and need to deploy it on behalf of their clients. And yet, some of the older funds they manage are in liquidation mode and need buyers for their assets. The public markets have been robust, but a little flaky when it comes to initial public offerings (IPOs). In some cases, a secondary buyout is cleaner, quicker and/or the only option.

I note this trend because I find it hard to see how it contributes positively to client returns in the long term. One of the advantages private equity firms have over other investors is people. They’re reputed to have the best and the brightest. I tend to think this edge has been diluted by the exponential growth of the industry (Private Equity II - Jeremy Grantham's Buyer's Guide), but that’s not relevant here. In secondary buyouts, the ‘best and brightest’ are on both sides of the table.

Given the high fees and time constraints on private equity funds, the managers need everything going for them. It’s hard to see how they’re going to consistently add value for their clients by buying already-optimized assets from equally smart and plugged-in people.

I wrote about private equity funds when they started paying premiums to buy public companies, sometimes even getting into bidding wars (An Evolving Asset Class - "Not-so-private" Equity). To me, that was a big step towards mediocrity. This trend is another. There may be a deal or two where a secondary buyout makes sense, but you tell me, does buying from Gerry Schwartz, who has already squeezed all the inefficiencies out of the company, sound like a good way to make money? Not on your life.

There are lots of terrific people and firms in the private equity space (I have been an admirer and shareholder of Onex for many years), but to me, the raft of secondary buyouts is another sign that this asset class has become too big too fast.

On the plane yesterday I was scanning the list of Canadian exchange-traded funds (ETFs). There were 145 funds on the list from four providers (BMO, Claymore, BlackRock and Horizons BetaPro). I know the numbers are higher now because I know of a few new ones that weren’t on the list and BlackRock just announced it was adding 6 sector funds to its iShares lineup.

A few things came to mind as I looked down the list:

• The ETF providers have ceded the simplicity label back to mutual funds and wrap products. ETF-land is now a busy and complicated landscape.
  
• With BMO’s 40 funds, investors can get exposure to almost anything, including short, mid or long-term government bonds, junior natural gas stocks and a bank portfolio with covered-calls written against it. The only exposure BMO investors have trouble finding is foreign currencies. All but a few of the foreign funds are hedged back to the Canadian dollar.
  
• In general, it’s difficult to find foreign equity funds that aren’t hedged. In most cases, this has worked for clients, but with the Canadian dollar now at $1.04, this design feature will likely be less advantageous going forward.
  
• Claymore continues to be the only player who pays a trailer to advisors. The extra fee ranges from 0.5% to 1.0% per year.
  
• The Horizons BetaPro lineup is a marvel of modern financial engineering. There are leveraged Bull and Bear funds on everything you can imagine. I only detected one Bull/Bear pairing where returns looked out of whack. For one year, the Crude Oil Bear Fund was down 31.7%, while the Bull Fund was down 0.5%. This is an improvement from a few years ago when volatile markets caused a number of pairings to have negative returns in both funds.
  
• As the fund offerings continue to proliferate, I expect we’ll also start to see more fund mergers. In pursuit of first mover advantage, all four providers have brought funds to market that only have appeal to a few investors at a specific point in time. When it isn’t that time, the funds are uneconomic.

As I said in a posting this time last year (ETF Providers Have Cluttered a Pristine Landscape), “when investors are looking for simple and transparent, ETFs are no longer the default. There are still many clean, easy-to-understand ETFs, but they're harder to find among the proliferation of new products.”

Irony n. incongruity between what might be expected and what actually occurs

My brother-in-law and I have an on-going banter going over the usage, or should I say incorrect usage, of the word irony (I lose regularly). Waking up this morning to an election story on CBC Radio, I heard something that struck me as ironic.

In Federal elections, Canada’s youth have a much lower turnout rate than the general population. I find this ironic because while they struggle to find issues they care about, the older generation is gladly mortgaging their children’s future by living beyond their means.

Ironic Jeff? I think so.

Please encourage the youth around you to vote on May 2nd.

As managing director of a firm that manages US$1.2 trillion, Bill Gross’ words carry a lot of weight. Indeed, we blog on his writings often.

In his April letter, he closes with a tight and powerful summary:

“I am confident that this country [U.S.] will default on its debt; not in conventional ways, but by picking the pocket of savers via a combination of less observable, yet historically verifiable policies – inflation, currency devaluation and low to negative real interest rates.”

Mr. Gross and his team have put their money where their mouth is. Pimco owns virtually no U.S. Treasury bonds on behalf of its clients, which is remarkable given the size of the Treasury market and the size of Pimco.

There was an article in yesterday’s Globe on closed-end bullion funds that are trading at a premium to their underlying value (Why Pay a Premium for a Commodity). Unlike mutual funds, closed-end funds have a fixed number of units available (in the short term at least) and trade on the market like a stock. The fund price is subject to supply and demand. As a general rule, closed-end funds trade at a discount, but premiums do occur when a particular asset type, or investment manager, is in the spotlight, or when a fund is new and has been marketed heavily.

As the article explains, some of the premium may be the result of American buying. Apparently, there are tax advantages for U.S. investors who buy Canadian-domiciled bullion funds.

In any case, the premium amps up the volatility of an already speculative investment. And unfortunately, the increased volatility is all on the downside. To demonstrate what I mean, let’s assume that Jake is holding units in a gold fund that’s trading at an 18% premium (the highest of the ones mentioned in the article). Here are his possible outcomes:

1. Gold stays popular and rises in price. If the premium holds (18%), Jake will participate fully in the price increase.
2. Gold rises in price, but the premium shrinks due to new funds being offered or alternative vehicles being developed. Jake will benefit from the price rise, but only to the extent that it isn’t offset by the premium shrinkage. If the fund went back to trading at net asset value, gold would need to rise 18% (to $1,700) just for him to stay even.
3. If enthusiasm wanes and the gold price drops, it’s likely that the premium will disappear and instead turn into a discount. If gold went down 10% and the fund traded at net asset value, which would be a good result in a weak environment, Jake would be down 28%.

It’s possible that Jake could buy at a lower premium and see it rise (who would’ve anticipated 18%), but I’ve tried to cover the most likely scenarios.

There may be valid reasons why other investors are willing to buy an asset for more than it’s worth, but if those reasons are not relevant to you, don’t do it.

In general, there is money to be made in closed-end funds, but only by the most savvy of investors. It is an inefficient part of the capital markets where those who know benefit from those who don’t. It brings me back to an old analogy: If you’re playing poker and don’t know who the patsy is, it’s you.

When I was a stock analyst at Richardson Greenshields in the 1980’s, I was forced to spend more time analyzing the Federal Budget than I ever wanted to. Everyone in the research team had to determine how the Finance Minister’s words would affect the industries they covered. In my sectors (conglomerates and transportation), there was never any material impact, but I dutifully reviewed the budget items just in case there was a need to change my earnings estimates or recommendations.

Since that time, I’ve steered clear of reporting on budgets. They’re important to a lot of people, but rarely do they have an impact on the stock market. But as I read the articles leading up to this week’s statement, I can’t help but provide a little perspective.

Canada is running a significant deficit at a time when two of its most important industries are experiencing boom times. For natural resources and housing, two highly cyclical drivers of economic activity (and tax revenues), it’s about as good as it gets, and yet, the country is struggling to get its budget under control.

At a time when we should be taking advantage of our good fortune to prepare for the inevitable demographic challenge ahead (increased demand for healthcare) and less favourable economic trends, we’re being provided with a recession-like budget. So when we hear the politicians and media debating about the trees (program spending, election goodies), let’s not lose sight of the forest.

As we watch the horrific destruction in Japan, we are well aware that our Global Equity Fund owns a number of businesses in that country. Roughly 20% of the fund is invested in Japanese stocks.

At this time, we don’t have any information or insight to pass along beyond what is available in the public media. It goes without saying that the loss of lives and property is tragic. It’s worth noting, however, that the market’s short-term reaction to natural disasters frequently assumes a more dire impact than is often the case. As we consult with Edinburgh Partners (the manager of the fund) in the coming days, we’ll be sure to provide an update on the situation.

Subsequent to posting my last blog (Hocus Pocus but no Magic), I came across some weighty comments that relate to the topic of fancy, highly-marketed investment products.

In his latest piece, James Montier of U.S.-based GMO says, “If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself!”

He also quotes John Galbraith: “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

I just read an article by Jade Hemeon in the February issue of Investment Executive, a trade magazine aimed at financial advisors. The piece was on a new product called BMO Lifetime Cash Flow. My experience with the article went something like this.

Investment Executive: BMO Lifetime Cash Flow allows clients to create what the bank calls a “personal pension” that provides steady monthly income. The initial deposit is invested in a portfolio of BMO mutual funds that is rebalanced annually and gradually moved toward a more conservative asset allocation over time. However, the cash flow is guaranteed at 6% annually for the client’s lifetime ...

Sounds pretty good. Certainly with the investors I talk to, especially the ones who are retired or close to it, security of income is a big concern.

IE: For the first 10 years, the money is invested on a tax-deferred basis, and no withdrawals are permitted. For the subsequent 15 years, the client receives guaranteed cash payments equal to 6% of the initial deposit. The payments are categorized as return of capital, and so are tax-deferred.

Looks like I’ve got to look ahead. No income for the first 10 years, but also no tax slips. That’s good. And when I do start to get paid, the distributions will be deemed a return of capital. I like that too.

IE: In Year 26 and beyond, the client continues to receive 6% a year, but the income is now classified as interest and thus fully taxable.

Well, I’ve got to pay the tax man sometime. Interest income is the highest taxed form of investment income, but maybe I’ll be in a lower tax bracket by then.

IE: The performance of the underlying funds will be net of a 2.75% annual management fee.

Ouch, that’s pretty steep for a conservative portfolio. In fact, in a few years when the portfolio is primarily fixed income, it will be ridiculous.

IE: One of the downsides of the new BMO product, says [Dan] Hallett, is that there is no inflation protection for clients – the 6% rate of income remains fixed and based on the original deposit … [and] there is no feature to lock in any portfolio gains along the way to increase the level of income.

Ah, my friend Dan has looked at this product. Now we’re getting a little more balance here. I guess the reality is that by the time I start to receive some income (year 11), it will be of considerably less value. Let’s hope this food and energy inflation thing doesn’t take hold.

IE: Another downside: the BMO Lifetime Cash Flow product is completely illiquid for the first 25 years.

Wow, that’s a long time. I’m a strong advocate of long-term investing, but … wow. Not only is the retirement income guaranteed, but it’s guaranteed that I’m going to be a BMO client for a long time.

IE: As with other guaranteed investment products, such as principal-protected notes, the new product’s portfolio could be tilted toward a conservative asset allocation in the event of any dramatic declines in the equities component to ensure preservation of capital at maturity.

Did Jade have to bring up PPNs? Now she’s got my attention. I’ve never found a PPN that I liked, or any rational investment professional liked for that matter.

So I guess the 2.75% fee and 10 years without income and no protection against inflation and the 25-year lockup isn’t enough to protect the bank. They also have the ability to cripple my long-term return potential if it looks like there is any risk that their profitability will be compromised.

Darn, I thought they were on to something here. I guess Bob Hager was right when he always told me that nobody has come up with a magical new source of return. The performance of any portfolio, or investment product, ultimately comes down to how stocks and bonds do, minus the costs. Well, there certainly is lots of hocus pocus here, and some serious costs, but as Bob says, no magic.

Tom discussed Longleaf Partners’ annual letter to shareholders in a blog posting yesterday. Today, the grand-daddy of all shareholder letters is in the news – Warren Buffett’s. I’m beating Tom to the punch for a synopsis, as his posts in previous years have been a little ‘drawn-out’ (The Buffett Letter #1, The Buffett Letter #2, The Buffett Letter #3, The Buffett Letter #4). I promise to keep it tight.

This year’s letter to the shareholders of Berkshire Hathaway was released on the weekend. As usual, it’s getting plenty of attention in financial circles. Some of the noteworthy items being highlighted include Buffett’s:

• Bullish view on America (“The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective ... America’s best days lie ahead.”)
  
• Desire to make a big acquisition (“Our elephant gun has been reloaded, and my trigger finger is itchy.”)
  
• Confidence in a housing recovery (“A housing recovery will probably begin within a year or so. In any event, it is certain to occur at some point.”)

There are a few reminders of Buffett’s investment style that stand out:

“Fund consultants like to require style boxes such as “long-short,” “macro,” “international equities.” At Berkshire our only style box is ‘smart.’”

“At Berkshire we face no institutional restraints when we deploy capital. Charlie and I are limited only by our ability to understand the likely future of a possible acquisition.”

Buffett’s success in beating the market over the past 45 years has come from a long-term perspective (“At Berkshire, our time horizon is forever”), an independent viewpoint and an unconstrained approach.

While plowing through my research pile, I had the pleasure of reading the year-end report of the U.S.-based Longleaf Partners Funds. I’ve followed Longleaf, which is an extension of Southeastern Asset Management, for more than a decade and long admired them. They have a good record managing U.S. and international equities, and have something I always look for - a defined investment philosophy and a set of business practices that are closely aligned with their clients’ best interests.

Here are a few morsels from the report.

They were a more active trader than usual in 2010 due to the extreme volatility in the stock market. They are unapologetic about it.

Volatility is a friend of long-term investors who know the value of the underlying cash flows and assets of a business.

The letter talks about high quality stocks. It makes the point that quality is too often equated to dividend yield, to the exclusion of other important factors.

“Cheap” is not enough to protect capital and earn adequate returns. Broadly used quality categories and metrics, however, do not adequately capture the strengths of many businesses.

In their search for quality, Longleaf goes beyond yield. They look for distinct and sustainable competitive advantage, high return on capital, a sound balance sheet and management that has demonstrated operating skill, capital allocation prowess and is properly aligned with shareholders through ownership-based incentives.

They strongly disagree with those who equate stock price volatility with low quality and high risk.

… in 2010, our best performers were some of the highest quality companies we own. None were among the most heavily levered (by any metric). The high returns generated involved little or no risk. (We define risk as the chance of permanent capital loss) Price movements have no bearing on capital loss unless one is forced to sell at a low point. Long-term investors who know the value of their businesses and intelligently take advantage of price volatility increase their return and lower their risk of loss.

In concluding, Longleaf points out that their clients are one of their competitive advantages.

Our clients’ stability and long-term investment time horizon have allowed us to be patient and successfully execute our disciplines.

A recent Angus Reid poll confirms what we have believed for a long time - many investors don’t know what they’re paying for their investment services (Steadyhand clients notwithstanding). The December 2010 poll revealed that 45% of respondents were unsure about what fees they were paying on their mutual funds. 28% weren’t able to suggest what a fair fee might be.

In light of these stats, it’s remarkable that the report from the Task Force on Financial Literacy failed to take any concrete steps towards encouraging, coercing or regulating the wealth management industry to report fees and investment returns in a clear and transparent way. Because of its importance, our submission to the Task Force focused strictly on this element of enhancing literacy.

No matter how knowledgeable clients are, if they don’t know how they’re doing and what they’re paying, they won’t be in a position to make effective decisions.

A reporter called yesterday wanting to talk about the S&P/TSX Composite Index breaking through 14,000. He wanted to know my thoughts on the market’s rapid rise from the low of March, 2009 – what had taken 5 years to accomplish in the prior run-up, took just 2 years this time.

I responded by saying that we shouldn’t get too hung up on the previous high or low, especially the ones established in 2008 and 2009. In hindsight, 15,155 was fueled by a debt-induced bubble and didn’t represent anything close to fair value. On the other hand, 7,480 was an equally false bottom. With the collapse of the financial system a definite possibility, valuations on all types of stocks got to ridiculously cheap levels. Indeed, the first 4 months and 2,000 points of the subsequent market recovery could be attributed solely to valuations moving back into a more normal range.

So what about 14,000? As usual, I don’t know where we’re going from here. As I map out all the factors that will influence markets going forward, it’s confusing ... but then again, it always is. We should never pretend to know where the market will be going in the medium term.

Having said that, I find myself sitting in neutral position on equities for the following reasons:

• The outlook for profit growth is just OK - profit margins are already high, input inflation is becoming a factor, and consumers and governments continue to be burdened with debt. But corporations are in a strong position to take advantage of any uncertainty. They’re sitting on plenty of cash with which they can grow their businesses, increase dividends and/or buy back stock.
  
• Valuations in some areas of the market are getting stretched, but there are still lots of cheap stocks to be found. A theme in our funds is slow growing, high-quality companies (Canadian and foreign), with a specific focus on Japan and Europe.
  
• Investor sentiment is heating up (which is negative for stocks), but is not at an extreme. There are still plenty of skeptics out there.

Given the big surge we’ve had in the markets, we shouldn’t be surprised if we see serious price declines, particularly in the hot areas of the market – i.e. resource stocks and gold. But I don’t think we’re heading for a replay of the 2008 meltdown.

If we do get a market pullback, I believe it will look more like 2000-2002 than 2008. The earlier bear market had a particular theme to it (technology), which led to huge declines in the TSX and S&P 500. But there was money to be made throughout that period. I watched my former partners Art Phillips and Rudy North do well, as did my current partner, Wil Wutherich. They found cheap stocks in the shadows of the technology and large-cap boom. Today there are equally attractive situations in the shadows of the commodity boom.

Tom Bradley was recently a guest on the Women’s Financial Learning Centre’s “Let’s Talk Money Podcast” with Karin Mizgala, a co-founder of WFLC. The topic of the show was transparency in the investment industry (or lack thereof). Tom and Karin discussed the four most important questions to ask your advisor or investment provider:

• What do I own?
  
• How am I doing?
  
• How much am I paying?
  
• What are you investing in?

Click here to listen to the episode.

As Dan says, “the industry has created numerous products that kick out generous amounts of cash each month.” But many of these funds can’t sustain their distributions without being forced to return capital to the unitholders (their own capital).

Dan calculates the return that’s required for the BMO Monthly Income Fund to sustain its 6 cent per month distribution.

• After factoring in costs (the MER is 1.51%), the fund needs to generate a pre-fee return of 10.5% per year.
• He assumes that the bond portion of the fund (50%) will earn 3.7%, therefore contributing 1.9% to the total return (3.7% x 50%).
• Dan then works backwards to determine what stock returns need to be. That number is 17%.

Needless to say, in a 3% interest rate world, 17% is a pretty high expectation. In any world for that matter.

With the low-risk portion of these funds earning so little today, I’m sure many or most of them will be forced to do one of two things: continue to have the investors take back their money to support the distributions (which means the fund price will decline over time), or reduce the payouts.

The lesson here is that we shouldn’t treat these funds as if they’re a GIC or other fixed income security. They’re perfectly good balanced funds (assuming the fee is reasonable) that will generate returns of 4-7% over the long term. They’re different from traditional balanced funds, however, in that they’re paying out the earnings in advance. It’s kind of how the western world is running its economy – spend now and pay later.