Roger Lowenstein’s latest article in The New York Times is a must-read. In Taking Stock, Lowenstein (a financial author and journalist) draws parallels between the investment environment and mindset of individual investors today to that of the 1970s.

The most striking similarity between then and now? A disappearance in the “ethos of confidence in long-term investing.” As was the case in the ‘70s, investors are discouraged and tired today. Gloom is selling well. One needs to look no further than the rise of gold and prophecies of economic doom. As noted in the article, one investment strategist recently drew a crowd of 600 people to elaborate on his call for a “bloody, deep recession ... and a stock market crash of at least 60 percent.”

Investors in the U.S. are withdrawing money from equity funds for the third straight year. In Canada, it is no different. Money has been flowing overwhelmingly into bond and income-oriented funds for quite some time. What makes this trend more troubling is the extremely low yields and limited upside of many fixed income securities – government bonds in particular.

What many people are missing, according to Lowenstein, is an important principle of investing:

“What the herd tends to overlook is that stocks are not – except perhaps in the very short term – a bet on the odds of an apocalypse, nor are investors in securities rewarded for their prowess as macroeconomists. The real challenge of investing is so prosaic it is often forgot. Stocks are simply a claim on future corporate earnings: if you can buy those claims at a discount, you should do well.”

The author notes that Business Week proclaimed “The Death of Equities” in 1979. A remarkable bull market arrived in 1982. Many observers are predicting a similar fate for equities today, despite the fact that businesses are profitable and stock valuations are reasonable (particularly in relation to bonds). Beware of buying into the apocalypse.

I recently finished reading False Economy – A Surprising Economic History of the World. Along with its New York Times Bestseller status and praise from all the usual suspects (The Washington Post, Financial Times, The Economist, etc.), I was intrigued by the book’s accolades from Bono and Mohamed El-Erian (CEO of PIMCO, the largest bond fund manager in the U.S.). If it appealed to a rock star and a bond geek, I figured it must be worth a read.

The book is written by Alan Beattie, the world trade editor for the Financial Times. Beattie examines the different paths that various nations have travelled in their rise to economic success or failure.

False Economy leads off with a comparison of Argentina and the United States. Beattie points out that just a short century ago, both nations were in similar places. Yet, the paths they took were very different. He explains how Argentina backed a small number of wealthy and powerful landowning families while America favoured small homesteads and settlers. American business owners invested in industrializing their country and created a nimble industrial sector, while Argentina developed a fear of the free market and sealed off its manufacturing companies behind a high wall of tariff protection. The American political system absorbed new ideas while Argentine politics were dominated by a small, self-perpetuating elite, which eventually led to a military coup and a nationalist (if not fascist) form of government. And the rest is history.

Beattie then jumps to the middle east to examine the strategic use of water and questions why Egypt doesn’t import more of its staple food. Subsequent topics include oil and diamonds (he suggests they are more trouble than they are worth), the role of religion in economic fate, and corruption (which he opines may be less damaging than it first appears).

Each of the book’s 10 chapters examines a particular nation or region and its economic history, with the author’s take on why the nation succeeded or failed and what lessons were learned along the way. His wish is that “the experience of history should lead us to hope and strive to make the world better, not to despair and resign ourselves to fate.”

While the book can be dense at times, Beattie keeps readers engaged by exploring seemingly random yet provocative topics, such as why Africa doesn’t grow cocaine, why much of America’s asparagus comes from Peru, and why giant pandas are “incompetent, inefficient piebald buffoons, and we should end their public subsidies and let them die out”.

All said, False Economy is an interesting book with good insights and lots of useful information. Yet, it reads like a text book in parts, which is why, like me, you may want to have your iPod on hand if you need a break. I found U2 to be rather appropriate.

The Flip-side of the Foreign Takeover Binge
Originally published in The Globe and Mail on April 20, 2007
By Tom Bradley

Like everyone else, I don’t like seeing corporate Canada get gutted by foreign buyers. I’ve thought for years that we were getting hollowed out, even if study after study claimed otherwise. I say that because I had a front row seat through the 90’s as a pension fund manager at Phillips, Hager & North. Instead of meeting with pension committees in a Canadian city, my partners and I increasingly found ourselves servicing the same Canadian plans in places such as Dallas, New York, Connecticut and New Jersey. The parent companies had taken as many white-collar jobs out of Canada as they could and that included the pension department.

But as we beat ourselves and the Finance minister up about our northern passivity and lack of guts, I think there is a need for some perspective on the foreign takeovers. To date, the commentary has been very emotional and increasingly political.

So, under the heading of perspective, I add three comments to the dialogue.

First, there is an underlying assumption in all the commentary that the foreigners are making wise purchases. Perhaps Canada is grossly undervalued and guys like me are missing it, but there’s plenty of evidence that paying premiums to buy public companies at the end of a business cycle (or somewhere near the end) usually turns out badly. How much value was there in Inco, Dofasco or Four Seasons at the takeout price? Did that price represent an outstanding opportunity to generate an above-average return? Only time will tell.

Right now the hyper-aggressive acquirers and empire builders are the heroes. That’s typical of every cycle. But I think it’s far too early to make that judgment. Certainly as the cycle goes on, the buyers from 2006 or before are looking better and better, but a few tough years might change the jury’s mind. By 2008, shareholders in the acquiring companies may want to reclaim some of the bonuses that were paid to executives in 2005-2007.

As for private equity, we don’t know how well these funds are going to do this cycle. Buying public companies at a premium has played a much bigger role in their strategy. We may find that their returns aren’t so great this time around because of it.

Second, throughout my business career I’ve found that the foreign buyer, in any industry, has been predictably fickle. In the business I’m most familiar with, investments, foreign firms are well known for jumping on and off the bandwagon with great regularity. When the world wants what Canada has to sell, every self respecting brokerage firm must have a top-tier investment banking and M&A operation in the snowy north. When Canada moves back into the ‘forgotten’ category, hidden in the shadow of the U.S., foreigners are quick to downsize or completely pull out. Industry veterans know that Merrill Lynch is famous for buying into the market when things are hot and then bailing out when the executives at the mothership need to refocus or cut costs. They’ve had lots of company.

There was a period in the energy business when the big multinationals were only too happy to offload their Canadian subsidiaries. There were a number of terrific companies that came out of that purging. A sale by Occidental created what is now Nexen, while BP’s sale became Talisman and Sun Oil’s is now Suncor.

Which brings me to my third point. If my first two comments have a speck of truth to them, Canadians will have a great opportunity to buy back many of these assets at reduced prices a few years from now.

I accept the fact that many of the acquired companies are gone for good. Some of the foreign buyers operate like Warren Buffet or Ontario Teachers, meaning they buy companies to hold them. That is so they can benefit from a continuing, and perhaps growing, flow of cash.

The companies bought by “strategic, in-industry” buyers are also less likely to come back to us. But there will still be lots of situations where the new owner will change its mind and deem Canada to be ‘non-strategic’ a few years from now. Those companies will likely come back on the market.

And private equity funds have a much shorter fuse. Eventually they have to liquefy their hard assets so they can return capital to their investors. For every headline we see today about a private equity purchase, there will be an offsetting headline in two to seven years announcing the sale of the same asset. There will be a flip-side to the huge buildup of capital at the private equity firms that’s influencing our market so significantly today.

With every announcement of another Canadian firm being bought, a little of me gets hollowed out. The industries that were solidly Canadian ten years ago now have little or no Canadian ownership today. Steel is in the news right now, but think about beer, hotels, technology and forest products.

We’re not going back to where we were before, but we should be aware that the dialogue about this topic right now is pretty one-sided and focused on the short term. Hopefully, our big pension funds and opportunity-starved equity managers will be ready and waiting to buy back the Canadian assets when they find their way back across the border.

RRSP Nightmare: Too Many Funds in Your Basket
Originally published in The Globe and Mail on February 9, 2007
By Tom Bradley

We were driving to Whistler last weekend and out of the blue my wife Lori said “it's RSP season and you still haven't written that column”. It took me a minute to clue in, but what she was referring to was a piece she wanted me to write about a Financial Facelift column we'd seen last summer in the Globe and Mail (August 12th).

Lori got really worked up about this particular column because she just couldn't believe that someone could get themselves into the situation the Canmore couple found themselves in. The featured couple had registered retirement savings plans totaling $170,000 that were spread across 29 mutual funds. “Twenty-nine funds. How does that happen? What were they thinking? Where was their advisor through all of this? Tom, when are you going to do a column about this?”

Because I didn't have any other brilliant ideas for a column this week and do value my marriage, I thought I'd give it a go.

Holding 29 funds is ridiculous whether you're investing $170,000 or a million dollars. It demonstrates that you don't have a financial plan. There's no focus and certainly no commitment to the funds you own. If you're not willing to add money to a core group of funds (5-10), then why do you own them?

Owning this many funds also makes it difficult to figure out what your asset mix is. It becomes a major project every time you want to figure out whether you're still on plan.

But more than anything, owning 29 mutual funds means you're seriously overdiversified. A little math would be useful here. Let's assume that 20 of the 29 funds are equity funds and on average these funds own 60 stocks. We have to assume that there are lots of stocks that are owned by more than one fund. In the case of Canadian equity funds, the overlap may be as high as 60-70% between some funds. Indeed, it is conceivable that you own Royal Bank or Manulife in 10 to 15 funds.

If we assume that there were 45 unique stocks per fund, that's 900 stocks plus the ones that showed up in multiple funds. Let's say you own 1000 stocks. What you really own is a very expensive index fund.

Through exchange-traded funds (ETFs) you could get the same market exposure for an average fee of 0.25 to 0.30 per cent a year on their management expense ratios. I hazard a guess that the couple in the article were paying in the neighbourhood of 2.5 per cent. It is no wonder they were disappointed with their mutual fund returns.

How does this happen? I don't really know, but I imagine it is a combination of things.

Each RRSP season has its own themes. While foreign funds are the dominant sellers one year, it could be tech funds the next and clone, income trust or lifecycle funds in other years. If you are prone to chasing past performance and your advisor is inclined to take the easy road (that is, give you the current best seller), you could easily add two to five new funds a year.

Where was the advisor through all of this? Clearly, he or she never said, “XYZ fund has been out of favour for a while and I think you should put more money in it this year. Think of it as being on sale.” While the Canmore couple continued to add funds, they weren't willing to sell any on the other side because of the redemption fees they would incur.

In general, I believe that patient, long-term investors don't need a lot of advice. It is more important that you keep your costs down. Occasional advice and low fees is a great combination. Having said that, I recognize that some people are in need of more help and that costs money. Unfortunately, this couple was getting the worst of both worlds. They were paying for advice they desperately needed, but they weren't getting it.

The Financial Facelift article that got Lori so worked up is obviously an extreme case, but overdiversification is definitely an issue for many mutual fund investors. In actual fact, holding even half the number of funds this couple owned could still result in an overdiversified portfolio, depending on what kind of funds they were.

If you haven't made a contribution to your RRSP for 2006, or even better, are contemplating what to do for 2007, I'd look first at the funds listed on your quarterly statement. If there was a good reason to buy a fund in the first place and those reasons haven't changed, then you might ignore the “flavours of the month” and show commitment to what you already hold.

And if the one you choose hasn't been doing well in the last year or two, all the better.

‘It Will Sell’: A Tipoff for Bad Investment Products
Originally published in The Globe and Mail on April 4, 2009
By Tom Bradley

As the wealth management industry works through this bear market, investment products that promise certainty and limited downside risk are going to be popular. With guaranteed investment certificates (GICs) offering minuscule yields, stock-market-related products with “guaranteed income” and “principal-protection” will be big sellers.

I think that's unfortunate for two reasons. First, we're now in a favourable environment to take more risk, not less. And second, investors give up a lot of return for the fancy features they're buying. Such things as downside protection, tax deferral or arbitrage and convenience come with a price.

My purpose here is to illuminate some of the tradeoffs investors make when they go beyond plain vanilla.

But first some background. I developed an aversion to complex investment products and packaging about 10 years ago. I was at Phillips, Hager & North at the time and we had a number of investment bankers come through our offices pitching us on their newest creations. They wanted to work with us because we had a good brand name that would lend credibility to the products. At the sessions I attended, I always asked the same question: “Is this good for the client?” I never once was told that it was. There was some diverting of eye contact, hemming and hawing, and on a couple of occasions, the answer was simply: “It will sell.”

We once committed to working with one of the banks on a product that saved high-tech executives taxes when they exercised their stock options. We thought it looked like a reasonable idea, but as we got further into it, we became increasingly uncomfortable. We calculated that the executives could achieve higher after-tax returns without a complicated structure. Fortunately, we were able to escape our commitment honourably when the high-tech bubble burst.

From that point on, I've done research (sometimes vicariously through much smarter colleagues) on many new packaged products and rarely have I come up with a different answer to my question. What I got was a notebook full of issues.

Lack of transparency: We should always understand the basics of what they're investing in, even when an adviser is involved. But products like principal-protected notes (PPNs) and guaranteed income funds are complicated and hard to figure out. Too often investors don't know how they work, what the underlying assets are and how much they're paying.

Misalignment of objectives: A lack of understanding often leads to investors buying products that are ill-suited to their needs. For example, a 40-year-old with a 30-year investment horizon shouldn't be buying short-term stability or principal protection, no matter how appealing it sounds. A bumpy 8 per cent return is what she/he needs, not a smooth 4 per cent.

The marketing imperative: My undergrad degree was in marketing, but when it comes to product design, that area of business should play a secondary role. Sales and marketing departments want things that will sell, which means looking in the rear-view mirror. The easiest sale is whatever worked last year (I recently saw an ad for a “bear-resistant” fund). In general, marketing-driven products encourage investors to “buy high.”

Overdiversification: “One-solution” products, including some wrap funds, are convenient, but tend to be too diversified. By having multiple managers in each asset category, the product (I'm reticent to call it a portfolio) owns hundreds or thousands of stocks. Effectively, it's an index fund with an annual fee that's two percentage points higher than it should be.

Complexity risk: In many packaged products, there are so many moving parts that it's difficult to determine what risks are being taken. That complexity sometimes results in outcomes that were unforeseen by bankers and advisers (liquidity drying up; the worst bear market in 80 years; global bank failures). Other times, however, the risks have been identified, but not communicated. The creators of PPNs (the type known as Constant Proportion Participation Insurance) have always known that their notes were path dependent (i.e. if the underlying asset goes too far down in value before it goes up, eliminating any chance of a positive return). That potential outcome is never openly discussed with potential buyers, even though it reduces the value of the note.

Degrees of separation: It's best if money managers live and die with the performance of their funds. Managers should be invested alongside clients. With packaged products, that accountability gets diluted with every person that gets between the client and the portfolio of stocks and bonds.

Cost: And with every degree of separation comes more fees. When investment bankers, lawyers, traders, money managers, insurers, marketers and salespeople get involved, they need to be paid. As a result, structured products are expensive.

Who's insuring who?: There is a common misconception about fancy investment products. Too often buyers believe that someone else is paying for the insurance and guarantees. Wrong. There is no new source of return being invented. Additional costs come directly out of what is earned by the underlying stocks and bonds.

There are other issues scribbled down in my notebook – poor liquidity, misunderstood by advisers, bad names – but I'll stop there.

I liken structured products to Viagra. The industry is hooked on them because they stimulate sales. They're a specialty product that should be used by few, but are sold to many. And the buyers get instant gratification, but pay for it in the long run.

Interestingly enough, the Canadian dollar today is worth almost the same value against the U.S. dollar and the euro as it was at the time of our posting (see graph).

Looney Predictions
Originally posted on September 21, 2007
By Scott Ronalds

With the loonie hitting parity with the U.S. dollar for the first time in over 30 years, the forecasters are once again coming out of the woodwork with predictions on the future direction of the currency. Some are patting themselves on the back for correctly calling the loonie’s rapid ascent, while others are back-peddling on prior forecasts and coming out with fresh revisions.

The bullish camp points to strong fundamentals driving the currency higher over the short-term: high oil prices (the loonie is viewed by many as a petro-currency, with its fortunes tied closely to the price of oil), continued demand for commodities, low unemployment, etc. While the bearish camp points to an oversold U.S. dollar, a slowdown in global growth, and a probable cut in interest rates by the Bank of Canada as key reasons why the loonie is likely to lose steam.

So which camp are we supposed to believe? How about neither. Short-term currency movements are really anyone’s guess and are next to impossible to predict. If the loonie is closely tied to the price of oil, where is oil going? Who’s to say that it won’t fall to $50/barrel? Or rise to $100/barrel? If its path depends on the strength of the domestic economy and the interest rate environment, will Canada steam ahead or pull back? You get the picture. There’s too many variables at play. Not to mention that movement in the loonie isn’t entirely correlated to these variables anyways.

If you can’t sleep at night because the loonie’s rise is killing your foreign equity returns, you can consider hedging away some or all of your foreign currency exposure (although it may not be the best time to do so, given the substantial short-term appreciation that you’ve already absorbed). A better solution is to ignore the headlines and accept that currency movements are too unpredictable to gamble on, and tend to balance themselves out over the long term. And while it certainly hasn’t benefited Canadian investors lately, foreign currency exposure actually provides a layer of diversification to your portfolio and can boost your returns. Remember the 1990s?

We all like to have fun with predictions (don’t kid yourself, even the big addresses on Bay Street have 'friendly' pools on where the loonie will close at the end of the year), but it’s not so fun when you jeopardize your portfolio by acting on them and making the wrong call on something that’s entirely out of your control (read currency movements).

That said, I couldn’t end this posting without a prediction of my own, all in good fun of course. So here goes: Seahawks 27 – Bengals 21. Now you can take that to the bank.

By Scott Ronalds

Investors have learned to deal with a lot of anxiety over the last couple of years, what with a severe credit crisis, major bank failures, derivatives gone bad and gyrating stock markets. Indeed, stress is becoming the new buzz word.

Below are some stress-related observations and musings on the week that was.

Stress tests: European banks were recently subject to a health check in the form of stress tests that were designed to determine how well they would cope with another recession or financial shock. While only 7 of 91 banks failed, analysts were still stressed this week over the credibility and level of difficulty of the tests.

Stressed leadership: BP (British Petroleum) was so stressed about their heavily-criticized CEO’s (Tony Hayward) inability to effectively deal with the Gulf of Mexico oil spill that they replaced him with Robert Dudley, the company’s first non-British head.

De-stressing: Tom Bradley was on holiday in Ontario’s cottage country for two weeks of R&R. His de-stressing technique: twice daily short-line slalom sessions (waterskiing) at 34 mph. Whatever works for you, boss. I think I’ll stick to something less strenuous, fishing and Heineken.

STRESS nations: With a new acronym hitting the investment dictionary, STINC (Singapore, Thailand, Turkey, Indonesia and Chile), we’ve come up with our own group of high risk, strained economies that may represent attractive investment opportunities for the gamblers out there. We call them the STRESS nations – Syria, Turkmenistan, Rwanda, El Salvador and Somalia. Look for an offering on the ETF product shelf soon.

Stressed wireless: Discount wireless carriers are stressing over Rogers Communications’ launch this week of chatr, its new low-cost brand that targets the unlimited talk and text market.

Salary stress: Canucks forward Mason Raymond and Oilers forward Gilbert Brule were so stressed out about their salary arbitration hearings that they both accepted offers from their clubs before proceedings were set to start.

We could all use a little less stress this summer. Serenity now.

This week we look back to the summer of 2006. The U.S. housing market was at a turning point. The consensus view was that it would be a soft landing. Tom disagreed. Four years later, prices are still down 40-50% from their peaks in some markets. Indisputably, the consensus was wrong on this one.

An Orderly Decline of the Housing Market? Not.
Originally posted on June 22, 2006
By Tom Bradley

It is pretty much conventional wisdom that the housing cycle in the U.S. is going to turn down. The fundamentals point that way and there are now signs of a slowdown. The consensus amongst the analysts, however, it that it will be a soft landing, with only a modest impact on the U.S. economy. That consensus points to a scenario whereby prices will stabilize or decline modestly from current levels and sales and building activity will also pull back. The Chairman of the Federal Reserve, Ben Bernanke, summed it up recently when he was quoted as saying that "it looks to be a very orderly and moderate kind of cooling at this point."

I'm inclined to think the consensus will be wrong on this one. It almost always is wrong at major turning points when a trend has been going on for a long time. I think this cycle is going to end badly and take a long time to find a bottom. I can support my view with lots of charts and statistics, but it is the 30,000 foot view that is most important here. The view is this. (1) The housing industry has been pushed upwards by one of the biggest tailwinds of all time - declining interest rates, unprecedented availability and use of credit, reasonable building costs, robust job growth, positive demographics/ immigration...the list goes on. The problem is, many of these positives are turning into headwinds now. (2) Any chart you look at is at an extreme. This up-cycle has gone beyond where we've ever been before. (3) Long cycles that have gone to extremes always require a long recovery period and never end in an orderly manner. The longer the cycle, the longer the retrenchment. The more extreme the cycle, the more bad stuff that comes out of the wood work during that retrenchment. In the case of this cycle, the bad stuff could be the amount of speculation and financial leverage in the system and/or the amount of inventory that needs to be chewed through.

I thought the U.S. housing boom would have ended a couple of years ago. I've been wrong on that. But by going on longer and climbing to greater heights than many of us expected, it has made a long and ugly retrenchment all the more likely.

The latest acronym in the investment world smells a little funny. The STINC countries (Singapore, Thailand, Turkey, Indonesia and Chile) are meant to represent export-oriented nations that have shown good fiscal restraint and infrastructure investment over the last several years. Financial writer Jon Markman recently coined the term as a group of countries that represent promising investment opportunities, in contrast to the debt troubled PIIGS (Portugal, Italy, Ireland, Greece and Spain).

While the industry’s marketing machines love a good acronym, I’m not sure they’ll be able to do much with this new geographic hodgepodge. Although I certainly wouldn’t be surprised if a STINC-based ETF hits the market in the coming weeks. There’s a clever play on words in there somewhere.

The Increasing Complexity – and Masked Risks – of Wealth Management
Originally published in the Globe and Mail on April 19, 2008
By Tom Bradley

Purdy, what were you thinking? Didn't you know how complex and convoluted investment products have become? Didn't you know this would become a hornet's nest with many different interests at play and the big financial institutions playing multiple roles?

If only you'd extended your summer in Nova Scotia a week longer and missed the call. Or better yet, listened to your wife.

When Mr. Crawford's committee to sort out the asset-backed commercial paper mess stopped in Vancouver a couple of weeks ago, I went to watch the proceedings. I am lucky enough to not own any of the combustible paper, but was curious to see how the process was playing out.

Very early in the proceedings, Mr. Crawford revealed that he wouldn't have taken the assignment had he known what he was getting into. What it involves is a classic example of how the investment industry has gone overboard inventing new and often inferior ways to sell the same thing - stocks and bonds. We have become intoxicated with our own genius and the marketing hooks that go along with it.

ABCPs are a symbol of how complicated investment products have become. At the Vancouver meeting, we learned that these short-term notes were backed by securitized loans (ranging from autos to immigrant loans), leveraged super senior structures, unleveraged synthetic CDOs, and U.S. residential mortgages. And the restructuring plan adds a few new elements to the mix - master asset vehicles, senior and junior notes, a margin funding facility and, well, don't ask.

Very few people at the meeting could have understood what was said. I've been around a while and I was hard pressed to keep up. This despite the fact that the presenters did their best to methodically take us through what the products are, how they blew up and what the restructuring plan is.

Over the course of Mr. Crawford's esteemed legal and business career, the wealth management industry has come a long way, most of it good. A few decades ago, it was pretty simple. The investor paid a broker to purchase a long-term security for his portfolio - a stock or bond. Commissions were high, but the investor got access to the interest, dividends and capital appreciation without incurring continuing fees.

As we move away from that basic model, each new feature or level of complexity increases trading, legal and administration costs. Investment banking, money management and trailer fees come into the mix. And in some cases there are performance bonuses and additional costs related to currency hedging and principal protection.

That's a lot to put into a package like an ABCP, particularly with low single-digit yields on government T-bills. By the time everyone has been paid, there isn't enough extra return in the product to justify the additional risks that are being taken.

For longer-term products with greater return potential, some of these costs are totally justified. If you want to hire someone who can beat the market, you have to pay a higher management fee, and perhaps a performance fee. Certainly increased trading is done in the hope of adding value.

But the other complexity costs (structural and marketing) erode the attractiveness of a product. They result in investors getting a smaller portion of the additional return, even though they are taking all the extra risk. The investment professionals involved receive the lion's share of the premium (as was the case with ABCPs), but shoulder none of the risk.

Consider a fictitious example. The hot new product for spring - Super Secure Dividend Enhanced XYZP - holds securities that will generate a yield 1 per cent higher than a GIC issued by one of the big banks. This is done by backing the XYZP with a package of higher risk investments (including loans to Third World fish farmers). The cost of bringing this product to market, however, is 0.75 per cent, so the investor is receiving an extra 0.25 per cent return for incurring 1 per cent worth of additional risk.

If the fishing is good and the XYZP doesn't run into difficulty, there is a modestly higher return for the investor. Everyone is happy. If it's good for a long time, the sellers and buyers forget that there is any risk being taken at all.

Despite what you might think, I'm not a troglodyte. I'm not adverse to using advanced methods or hiring someone to do them for me. And I like a marketing hook as much as the next executive, maybe even more.

But in any investment structure, the majority of the extra return, if there is any, belongs to the buyer who is taking the risk.

In too many products today, this is not the case. The current generation of structured products have little or no transparency and, as a result, they mask the risks being taken and how the potential rewards are being apportioned.

As Mr. Crawford's lapse in judgment reminds us, if you don't understand what you're getting into, don't buy it.

By Scott Ronalds

The second quarter of 2010 was a challenging period for equity markets, as investors focused on the European debt problems and the sustainability of the global economic recovery. In this podcast, we review these issues and highlight some of the key messages from our Quarterly Report.

Download, subscribe via iTunes or RSS, or listen now:

In our discussions with investors, we’ve found there are a few misconceptions surrounding the deductibility of investment management fees. The most common misunderstanding is that mutual fund investors are at a disadvantage (from a tax standpoint) to investors who hire an investment counselor, as the latter receive an invoice for their fees directly which can be used as a deduction on their tax return.

The fact is, there is no advantage to investors whether the management fee is charged within a fund or billed outside of a private investment account, except in rare circumstances.

The structure of most mutual funds is such that they allocate all realized capital gains, dividends and interest income to unitholders in the form of distributions. This income represents a taxable liability and is reported to investors each year on the tax slips (T3’s) they receive from their fund company. Importantly, however, the management fees and other expenses that the fund company charges are deducted from this income prior to the distributions being paid out. In other words, the fees are used to offset any taxable income, thereby reducing the amount of the distributions. Consider the following example:

• XYZ Fund has $50 million in assets under management and charges a management expense ratio (MER) of 1.5%.
  
• There are 5 million units of the fund outstanding ($10/unit).
  
• The fund earns $1 million in interest income and $1 million in realized capital gains. It therefore has $2 million that it needs to distribute to unitholders.
  
• The fund company collects a fee of $750,000 (1.5% of $50 million).
  
• This amount is deducted from the $2 million in income generated within the fund, resulting in a net amount to be distributed of $1.25 million, or $0.25/unit, as opposed to $0.40/unit before the deduction. The deduction is first applied against the interest income, as this is the least tax favourable form of income.
  
• While they cannot “see” the mechanics of the deduction, unitholders receive a lower distribution and their net taxable liability would be the same as if they collected the gross income from the portfolio, paid the fees directly, and claimed a deduction on their tax return.

To expand on this last point, assume a large investor held the same assets in a private account and paid an investment counselor the same fee for managing the portfolio. The investor would receive a fee invoice of $750,000, which she could use as a direct deduction against the income generated by her portfolio ($2 million), but she would still have to pay tax on the balance of $1.25 million. In the end, she would be no better off from a tax standpoint than investors in the mutual fund.

Where a benefit may arise for the private account scenario is when the management fees exceed the income generated by the portfolio. In such a circumstance, the individual could deduct the fees against the full amount of the investment income and apply any excess amount (loss) against other sources of income. Under the mutual fund structure, the loss cannot be distributed to investors to offset other forms of income, but is instead carried forward by the fund to be applied to investment income generated in a future year(s). As long as the individual continues to hold the fund, they will eventually receive the benefit of the carried forward loss.

The second misconception that we’ve run into is the belief that fees incurred with respect to the management of registered accounts (e.g., RRSPs, RRIFs, TFSAs) can be deducted for income tax purposes. This is not the case. Canada Revenue Agency (CRA) does not permit the deduction of fees related to registered accounts. So while individuals who use investment counselors may receive a fee invoice for these accounts, it is of no use to them from a tax perspective, although it is certainly beneficial from a fee transparency standpoint. But that’s another topic.

Who doesn’t love summer? Sunshine, BBQs, lounging, water sports...it’s all good. And then of course, there’s the other summer ritual – reruns. We thought we’d build on the tradition by re-publishing a blog each week from the Steadyhand archives.

For our first posting, we’re digging up a classic from the spring of 2009 where Tom suggests that we have to be careful going too far in declaring that ‘the world has changed’.

The World Has Changed
April 15, 2009

More and more commentators and experts are acknowledging that the world has changed. The framework for the future that Pimco’s Bill Gross laid out recently – namely de-levering, de-globalization and re-regulation – encapsulates what I’m reading every day, as does his resulting caution.

I guess it’s my contrarian blood, but I do think we have to be careful going too far in declaring that the world has changed. As the pronouncements get bigger, more confident and extend further into the future, it is more likely they will be wrong.

No doubt, this downturn is a biggie. It’s the most severe one any of us have seen and will cause serious dislocation. And de-levering will take time. Steps have been taken to address the problems in the capital markets (margin calls made, hedge fund lending reduced, equity capital raised), but consumers have a long way to go to get their affairs in order and governments of course are going the wrong way.

But as the list of concerns expands and the conviction builds (which is a trend I’ve definitely noticed), it feels like we’re piling on. It’s easy to come up with more doom and gloom, but difficult and less topical to seek out the balancing items.

So here are my bold, confident predictions of what’s on the other side of the ‘world has changed’ ledger.

First, I can say without hesitation that not all of the grand pronouncements are going to come true.

Second, in the new world, we will be surprised at how big the gains will be for the strong, prudent players. Well-positioned countries, companies and individuals are going to move up the ladder, maybe a few rungs this time. We’ve focused on the weak so far, which is natural, but the strong will also prove to be a noteworthy feature of this cycle.

This recession will accelerate the shift of economic power to the developing world. Many emerging market countries are sporting a current account surplus and are better financed than in previous crises. I’m not suggesting that they’re ‘decoupled’ from the worldwide recession, but they may weather the storm better and come roaring out the other side. It could be a seminal moment for some of the Asian countries in particular. Canada has a chance to be in that category, although the determination of the Federal government to subsidize the past as opposed to invest in the future weakens our case.

With regard to companies we invest in, think about the opportunity that the Canadian banks now have in front of them. The environment for their basic banking services, both for retail and corporate customers (yes, they still do that), is fabulous. And with a few exceptions, their global competitors are reliant on government funding and unable to do acquisitions. Unless our big five experience further unexpected blowups, their world standing is on the rise.

Individuals with confidence, discipline and a job (importantly) stand to gain as well. Goods and services will be marked down in price and investment opportunities (stocks, real estate, and businesses) will be plentiful. It is a buyers’ market.

And finally, I remain confident that this will be a cycle like all others. The downside will be bad and may last a while, but the excesses will be purged and the next up cycle will occur. The longer and deeper we go, the more powerful the other side will be.

Stocks have halved in price and corporate bonds are trading at depression-like valuations. The markets are telling us the world has changed. But not everyone will be impacted the same way and not all of it will be bad. Indeed, good news and opportunity will become a bigger part of our changing world as we move forward from this point.

Below are some observations and musings on the week that was – a new feature that we’ve aptly coined The Back Hand.

The world’s eyes are on Toronto this week as the G20 Summit nears. While the thought of a weekend of politics and bureaucracy was enough to make the city’s belly rumble, T.O. wasn’t the only thing shaking this week.

The Investment Funds Institute of Canada (IFIC) was shaking its finger at Morningstar after the mutual fund research firm released a study on stewardship that didn’t sit well with them. Can’t we all just get along?

Bay Street was shaking with excitement with the IPO of Smart Technologies, a Calgary-based world leader in producing interactive (electronic) whiteboards. It’s nice to see a public offering of a Canadian success story as opposed to IPOs of mutual funds disguised as closed-end funds.

The French were collectively shaking their heads at their national soccer team after one of their players staged a mutiny against the coach, resulting in an early exit from the World Cup. There may be no “I” in team, but there’s a pronounced one in equipe.

Taxpayers in B.C. and Ontario were shaking their fists at their provincial governments for introducing the Harmonized Sales Tax (HST), which comes into play next week.

American lawmakers were shaking from too much caffeine following a 20-hour conference session (which culminated this morning) that laid out the terms for several new financial reforms on a wide range of issues, ranging from derivatives to mortgages to credit cards.

And finally, Henrik Sedin was shaking at the knees when he heard his name called as the winner of the Hart Trophy (MVP) at the NHL Awards. Don’t be so humble, Hank, you deserve it.

In his latest interview with Independent Investor (a U.K. publication), Sandy Nairn, the CEO of Edinburgh Partners (the manager of our Global Equity Fund), provided his views on the global economy and capital markets. After being cautious in late 2007 and bullish in early 2009, Sandy sits more in neutral territory today. He sums up his outlook for investors as follows:

“I’m not massively depressed about the outlook. But nor am I massively excited either... Returns from equities are likely to be lower and volatility greater than in the past, but the long-term outcome for equities remains a positive one, both absolutely and relative to other asset classes. In other words: get rich slowly!”

As for how Edinburgh Partners is positioning the Global Equity Fund:

• “We expect to retain substantial holdings in the U.S., but as with other developed economies, unless valuations fall meaningfully from here, it is unlikely we will have much exposure to those sectors of the economy which are exposed to falls in Government expenditure and direct consumer purchases.”
  
• “We are still finding European stocks worth buying. Europe is very much a region of contrasts. The largest economies are not in bad shape, even though both Italy and Spain do need fiscal retrenchment. It is in the periphery that the issues reside and it is important to keep in context the relative sizes of each.”
  
• “The one area where we’ve made a significant increase recently is in Japan, where we’ve gone from having 4% of our global portfolio to more than 15%. The percentage could easily go up further.”

The piece expands on Edinburgh Partners’ rationale for Japan, and touches on a number of issues that are top of mind for global equity investors today – namely, the Greece/euro situation, the outlook for China, the recovery in the U.S., opportunities and obstacles in Europe, and banking reform.

If a ‘staycation’ is in the cards this summer, click here to download the full article. Sandy will take you around the world.

Financial Post journalist Jonathan Chevreau wrote an interesting piece yesterday on Morningstar Canada’s new Stewardship Grades. The article highlights an attempt by the Investment Funds Institute of Canada (IFIC) to discourage Morningstar from releasing the report.

Chevreau notes that IFIC has serious concerns with the report, and in a two-page letter their president attacks Morningstar for its belief that fund companies should disclose information concerning fund manager compensation and co-investment, among other issues. Interestingly, Chevreau goes on to note that not all IFIC members agreed with the letter.

While these are understandably touchy issues, we side heavily with Morningstar in that they deserve more attention and transparency.

When fund managers look at a potential investment, one of the things they focus on is management. They want to know how much of the company the management team owns, how much the key executives make in compensation, and what they hold in terms of stock options and other benefits. Put simply, they want to know how “shareholder-friendly” the management team is to determine whether their interests are well aligned.

Shouldn’t mutual fund investors consider similar measures for those that are managing their money? Wouldn’t you want your manager to have her money invested alongside yours?

We certainly think this information is important, as do several other companies who scored favourably in the Morningstar report. Presumably, these companies didn’t agree with the IFIC letter either. It looks like there’s some drama brewing in fundland.

Morningstar Canada, a mutual fund research firm, recently introduced Stewardship Grades for over 25 fund companies. In their words, the Stewardship Grade “goes beyond the usual analysis of strategy, risk and return. It is intended to assess the manner in which fund companies are run as well as the degree to which their managers’ interests are aligned with those of fund unitholders. While the grades are not intended to serve as buy/sell signals in isolation, they can help determine the difference between a great investment and one to avoid.”

We’ve written often about the attributes that investors should look for when hiring an investment manager. In other words, the intangibles that go beyond past performance – features like a manager’s investment process, experience, transparency, and whether or not they eat their own cooking (invest alongside their clients).

These features have long been hard for investors to assess and incorporate into their investment decision making process. Until now. Morningstar has done a comprehensive analysis of these qualities. It was a large undertaking that drew on a thoughtful methodology, thorough research, and the experience of their U.S. parent (Morningstar USA has had a similar rating system in place for a few years now).

The grading system is based on four components: Corporate Culture, Manager Incentives, Fees and Regulatory History. Fund companies receive a score out of 8 points and a corresponding Stewardship Grade ranging from A to F. A company must receive 7.5 points to receive an “A”.

We’re proud to announce that we received the top grade. And we’re beaming at the fact that we received the highest score (8 out of 8) of all the fund companies rated.

We’ve ridiculed industry awards that focus on short-term performance and other futile measures, but the Stewardship Grades address what we believe to be invaluable characteristics of an investment manager.

The Globe and Mail recently reported on an issue that all investors who own a Tax-Free Savings Account (TFSA) should be aware of – over-contribution penalties. Canada Revenue Agency (CRA) has informed 70,000 investors that they may have to pay a penalty, of up to several hundred dollars, for over-contributing to their plans. The surprise tax bills have left many investors confused and angry.

As a reminder, you can contribute up to $5,000/year to a TFSA. You can also redeem the money at any time without any tax consequences. And as a nice bonus, you can re-contribute any money that you withdraw without impacting your contribution room. This feature, however, is the source of the confusion and penalties. If you withdraw funds from your plan, you have to wait until the start of the NEXT calendar year to deposit the money back in the account (if you already contributed the maximum amount in the year of the withdrawal).

Let’s clarify. Say you contributed $5,000 in March 2009. Two months later (May), you decided to withdraw half of the account ($2,500). You are permitted to add back the amount you withdrew ($2,500), BUT you would have had to wait until January 2010 to do so. At such time, you could contribute $7,500 to your account (the amount you withdrew plus your allowable contribution for 2010). If you added $2,500 back to your account in June 2009, you would be on the hook for an over-contribution penalty tax of 1% a month. In this case, the penalty would be $175 ($2,500 x 1% x 7 months).

Investors transferring TFSA accounts from one institution to another must be careful to complete the proper paperwork in order to avoid potentially nasty penalties. If you redeem your account and subsequently use the proceeds to open a plan with another institution in the same year, the transaction will be viewed as a ‘double contribution’ by CRA. To avoid this, you must complete a Transfer Form for Registered Investments (along with an application form) issued by the firm that you are transferring the money to. This is the same process that must be followed when transferring RRSPs and other registered accounts.

TFSAs are great investment vehicles. Just make sure you know how to drive them.

Small funds produce better returns. This is the conclusion of a recent study, titled Pension Fund Performance and Costs: Small is Beautiful, which looked at the performance of U.S. pension funds from 1990-2006. Published by a trio of professors from Yale and two Dutch universities, the report found that the smaller funds generated the best risk-adjusted performance. Small in this context refers to both the amount of assets in the fund, and the type of securities held (i.e., small-cap).

The study included 711 pension funds, which invested exclusively in domestic equities (U.S. stocks). The size of the funds ranged from $1 million to $94 billion, with the median defined benefit fund holding $1.2 billion in assets (the median defined contribution fund was roughly half this size).

Among the findings were that U.S. pension funds on average tend to generate returns (after expenses and trading costs) that match or slightly exceed their benchmarks. Small cap mandates, on the other hand, outperformed their benchmarks by a sizeable margin – roughly 3% a year.

The researchers present an explanation as to why size plays a critical role in performance – liquidity. They observe that “liquidity limitations seem to allow only smaller funds, and especially small cap mandates, to outperform their benchmarks.” As a reminder, liquidity refers to the ease of converting an asset into cash swiftly and without a notable price discount. Illiquid investments are those that trade with much lower frequency and volume, and significantly higher bid/ask spreads, than their larger counterparts.

The professors point out that there is considerable literature which has established that illiquid investments generate higher returns. They opine that “since pension funds often have liabilities with a long duration, they naturally have longer-term investment horizons and may consequently invest in illiquid equity investments, thereby gaining the liquidity premium associated with these investments.”

It is easier for smaller funds to invest in illiquid securities because there are fewer shares of such companies outstanding and only a limited number of attractive investment opportunities. It can be very difficult for large, multi-billion dollar funds to accumulate meaningful positions in smaller companies without excessively bidding up share prices or exceeding maximum ownership limitations. In short, smaller funds are much more agile.

The paper points to other studies which show a negative association between fund size and performance, and suggests that the sheer size of the largest funds makes active management more difficult, and therefore outperformance less likely. Indeed, larger funds tend to look more like the index, as one of the authors points out.

While we don’t want to overplay the significance of one academic study, size is a crucial aspect of investing that often gets overlooked. Maybe now that ‘too big to fail’ has been thrown out the window, small may become the new beautiful.

Preet Banerjee is an industry insider who runs a blog titled 'Where Does All My Money Go?' (his blog was ranked Canada’s #1 investing blog by the Globe and Mail last month).

Preet recently developed a resource for investors called the Know Your Advisor Tool (KYA). In his words, ‘the tool is designed for investors to help them figure out who the good financial advisors are out there.’

An integral part of the KYA is a questionnaire that probes issues such as an advisor’s candour, competency, and services offered. In order to make the tool as useful as possible, Preet is looking for input from investors, financial advisors and other interested parties. We sent him the following feedback on the tool:

You are to be congratulated for taking on this project. Picking an investment professional to work with is one of the most important aspects of investing for individuals - arguably the most important thing for investors who are totally reliant on their advisor.

I know a lot of thought has gone in to the KYA questionnaire, but we have a few thoughts that you might consider.

First, a general comment. This questionnaire is for someone who is looking for soup-to-nuts financial planning and advice. This is in contrast to someone who is strictly looking for ‘investment advice’. It’s an important distinction because the point system embedded in the questionnaire rewards the breadth of offering and expertise more than it does the depth. That makes sense in the context of a client who needs the full service, but may lead to an inappropriate result for a client looking for investment advice. In other words, an advisor focused on investments, and the product and market knowledge related to that, is likely to have more to offer to that type of client.

In addition, there are a couple of areas where you might consider adding to the questionnaire.

Philosophy

When it comes to investing, there are thousands of ways to skin a cat and each advisor has a different approach. It’s important, first of all, to determine whether the advisor has a well-grounded, consistent philosophy. While this sounds obvious, it’s often the case that an advisor doesn’t, and is subject to the changing trends, and dare I say fads, in the industry. Without a stable foundation, it’s unlikely the advisor will keep the client on a steady, long-term path.

With regard to investment philosophy, it’s important that the client understand how the advisor is going to do it. Are they a value investor? Or is it Growth? Do they use funds and/or ETFs? How did they work with their clients in the fall of 2008?

The advisor’s approach to asset mix is important to understand. Are the active in shifting their clients’ asset mix? How big are the shifts? Do they get their clients right out of the market at certain times?

Reporting

A key part of an advisor’s service is the on-going reporting - regular statements and quarterly updates. In hiring an advisor, it’s essential that the reporting package be part of the assessment. Will the client know (1) what they own (i.e. overall asset mix by asset class and geography); (2) what they are paying (including commissions, MERs and administrative fees); and (3) what their returns are?

We recognize that advisors don’t have control over the reporting protocol of their firms, but it’s nonetheless a required piece of the service offering. Not knowing any or all of those three things doesn’t allow the client to monitor the advisor’s work. Why would a client hire an advisor that isn’t going to give them the tools to assess their performance? To us, inadequate reporting is a deal breaker and should be given a heavy weighing in the questionnaire.

If you have any comments on the tool, you can post them below, or on Preet’s blog (hyperlinked above).

I was having dinner with my dad the other night and we got on the topic of credit cards. We both have cards that reward us with air miles (in one form or another) for all our purchases. And importantly, we both pay our cards off each month.

Somewhat proudly, he stated that one of his oldest cards is his gas card. I asked him what kind of rewards he got with the card. “None”, he replied. I then asked, “So why do you use it when you could be getting air miles if you use your credit card?” No response. After thinking about it for a while, he replied, “Bad habit, I guess; I’m just so used to it.” He felt shame, I topped up his wine and we got onto another topic.

Bad habits are hard to break, especially when they’ve become engrained in our behavior. Some companies have done a masterful job of developing products/services that change our behavior and deliver a superior experience. Think of Apple. The iPod has changed the way we purchase, store, transport and listen to music. Creating change isn’t easy, however, as we’re creatures of habit and tend to stick to what we’re familiar with.

At Steadyhand, we’re out to change behavior by breaking bad industry habits. The habit of paying a middleman to sell our funds. The habit of communicating in a manner that nobody can understand. The habit of wasting paper, money and time by mailing (rather than e-mailing) reporting materials. The habit of index-hugging. And the habit of poor transparency.

It’s a tough battle, but it’s a worthy one. I was reminded of this when I was leaving dinner and saw an iPod on my dad’s kitchen counter and a Steadyhand ball cap on the coat rack. This from a guy who not long ago was buying Kenny Rogers Live on cassette and whose favorite head gear had an RBC logo on it. Nothing wrong with that, of course. Kenny can rock a crowd.

By Scott Ronalds

Tom met with Edinburgh Partners Limited (EPL) on their home turf last week for an annual update on their firm and global equity portfolio. It was also an opportune time to discuss some of the issues currently impacting Europe and get the CEO’s (Sandy Nairn) thoughts on the debt crisis that is overhanging Greece.

A little jet-lagged and with a hint of an accent, Tom highlights some takeaways from his visit in this podcast, which is a supplementary posting to a blog on the same topic.

Download, subscribe via iTunes or RSS, or listen now.

I recently attended a luncheon hosted by Connor, Clark & Lunn, the manager of our Savings Fund and Income Fund. The session focused on the economy. Larry Lunn, the firm’s chairman and co-founder, was the keynote speaker. Larry is an experienced industry veteran who has navigated through a number of economic and market cycles and always has a thoughtful and well researched view – and he doesn’t sugar-coat it.

Prior to introducing Larry, the presentation started with a quip by Phil Cotterill (Head of the Client Solutions Team at CC&L) that the session had been moved to a lower floor of the building at the last minute (read: to prevent any ‘jumpers’). After the presentation, I wished I hadn’t turned down the Heineken at lunch.

Larry and the team at CC&L didn’t exactly paint a rosy picture of the secular forces that will shape the next decade. They focused on the debt hangover that the global economy is facing and the unfavourable demographic scenario that is emerging as the boomer generation moves past its peak equity accumulation period and into a ‘dissavings’ phase. In a follow-up report, CC&L summarized their take on the next ten years as follows:

• The structural imbalance between a savings-short, leveraged American consumer and the Chinese mercantile economic model, with an emphasis on too much savings, fixed investment and exports, will be disruptive.
  
• We will face a period of anemic sub-par economic growth because of changing demographics and debt formation, which will lead to shorter and more volatile business cycles.
  
• Bigger government, more regulation and higher taxes are in store.
  
• Higher risk premiums (because of the aforementioned imbalances) will lead to lower P/E (price-to-earnings) multiples on stocks.

Larry concluded the presentation by suggesting that investors should expect low single-digit stock and bond returns over the next decade. As I said, no sugar-coating.

I was hoping to leave the session with some positive insights and messages to report back to our clients, but I was stumped.

After reflecting on CC&L’s message for a few days and reviewing their outlook, however, I’ve changed my stance. There were some useful takeaways worth sharing. First, the economic situation is not entirely discouraging, as they note in their report. Corporate profits have improved (substantially in some cases), growth has picked up, government spending is creating stimulus and interest rates remain very accommodative for growth. While government spending and low interest rates will eventually have to be unwound, the immediate future appears reasonably bright (notwithstanding the debt hiccup in Europe). There are certainly longer-term issues that need to be addressed, but that is not to say they can’t be resolved.

Second, economic forecasts are just that, forecasts. They are meant to paint a rough picture, not a detailed map.

Third, greater short-term volatility can play into the hands of opportunistic investors and agile managers.

Fourth, it’s motherhood stuff, but investors are well advised to make sure they have an asset mix that they’re comfortable with – one that reflects their risk tolerance and time horizon. Those who take on too much risk and/or can’t handle short-term volatility will have the most sleepless nights.

Fifth, Larry and his team are preparing their clients for low single-digit returns over the next decade, not negative returns. Given the economic headwinds they foresee, they still believe the capital markets will provide positive, albeit volatile, returns.

And finally, Europe and the U.S. are on sale for Canadian investors. Our dollar goes a long way these days in buying foreign assets. In fact, if the Vancouver real estate market holds up and southern Europe goes bankrupt, I’m thinking of selling my place and buying Greece as a ‘fixer-upper’.

The Task Force on Financial Literacy is a federal government initiative aimed at strengthening the financial literacy of Canadians. The Task Force, which is comprised of 13 members, was appointed in June 2009 (as part of the federal budget), and will provide advice and recommendations to the Minister of Finance on a national strategy to strengthen and promote financial literacy.

The Task Force is encouraging Canadians to communicate their thoughts and suggestions through a series of online and public forums. Their public consultation process recently ended, and the group will submit a report by the end of the year to the Minister of Finance that recommends a national strategy and course of action.

Steadyhand submitted a brief proposal with two simple recommendations:

• Require all statements provided by investment providers to include information on how much the client has paid the provider – in dollar terms and as a percentage of their total invested assets – over the reporting period.
  
• Require all statements to also include relevant information on how the client’s investments have performed. All investment providers should be required to show rates of return at the account and consolidated portfolio level. Performance figures should be provided for the same time periods that mutual funds are required to publish their returns (e.g., 3 months, 1 year, 3 years, 5 years, 10 years, and since inception).

We believe strongly that transparency is a critical element of financial literacy. Specifically, individuals need to clearly understand their costs associated with investing and how their accounts have performed. To be blunt, our industry’s reporting practices and standards with respect to these measures are awful. Greater transparency would go far in improving financial literacy.

You can read our full submission here.

First it was swine flu. Now it’s fragile economies. Seems like pigs can’t catch a break these days. The southern European nations of Portugal, Italy, Greece and Spain (PIGS) are garnering plenty of attention in the media, as investors fear these countries may default on their debt obligations, with Greece at the forefront.

Reminiscent of the global credit crisis of 2008/09, emergency bailout measures have been proposed to curb another financial fallout. Not surprisingly, we’ve seen an increase in stock market volatility and overall nervousness about the events transpiring across the pond.

As our name suggests, we are encouraging investors to maintain a steady hand on their portfolios. Knee-jerk reactions to negative short-term news and uncertainty are often ill-timed and later regretted. That said, it would be irresponsible to simply turn a blind eye to the state of affairs in Europe.

So, what exactly is happening? Best to turn to the source, Edinburgh Partners (the manager of our Global Equity Fund). Tom is making a trip to Scotland next week, coincidentally, to visit the team in Edinburgh and will report back with an update on the portfolio and EP’s views on the economic situation and investment conditions in Europe. In the meantime, investors interested in details on the recent bailout package may find Bank of America’s latest report useful.

If you have a specific question you’d like answered by the manager, email us and we’ll send it along with Tom (and his golf clubs) to Edinburgh.

There’s an old saying that mutual funds are sold, not bought. Canada’s mutual fund industry is a perfect example.

The majority of financial advisors are paid commissions by fund companies for selling their funds and keeping clients invested in them. Up-front commissions can run as high as 5% or more, while trailing commissions (paid each year) typically range from 0.5% for bond funds to 1.0% for equity funds. In other words, an advisor who sells a client $100,000 worth of XYZ Fund may receive $5,000 up-front and $1,000 each year (give or take, based on market fluctuations) from the fund company for keeping the client invested in the fund. The commissions are paid to the advisor for advice they provide to the investor.

Critics of this structure argue that it has two big flaws. First, advisors may be enticed or biased toward selling products that pay the highest commissions, thereby ignoring the best interests of their clients. Second, the transparency is awful. Investors are often unaware of the fees they pay and how much their advisor is compensated for selling them a fund and providing ongoing advice.

The U.K., which has a similar compensation structure for advisors, recently took the bold step of banning commissions on financial products. The country’s Financial Services Authority (FSA) recently announced that by the end of 2012 advisors will no longer be allowed to receive commissions on products they sell to investors. Instead, investors will be charged separately for advice.

The FSA noted: “Firms will have to be upfront about how much they charge for their services, and no longer hide the cost of their advice behind the cost of a product…consumers will know what they are buying up-front, how much it will cost them and also have the peace of mind that it was recommended to suit their needs.”

Regulators in Australia are considering a similar course of action, where it is being recommended that up-front commissions and trailing commissions should not be permitted in relation to personal advice.

Such moves would go far in improving transparency. Investors would be equipped with a better idea of the all-in cost of buying and holding a financial product. What a concept. Maybe it will make its way to Canada. Or is that just crazy talk?

Rob Carrick’s column in today’s Globe and Mail looks at big, expensive mutual funds. He identifies the funds with the most assets under management and the highest management expense ratios (MERs). The 23 funds on his list all have more than $1 billion in assets with MERs ranging from 2.52% to 2.84%. Evidently, these funds aren’t passing any economies of scale on to unitholders (with respect to management fees and operating expenses).

An interesting observation, however, is the number of balanced funds on the list. Over 30% of the funds have some combination of stocks and bonds (or cash), with MERs as high as 2.68%. Let’s do some quick math. Assuming a fund charges an MER of 2.6% and has a traditional balanced asset mix of 60% stocks and 40% bonds, investors would be paying about 3% for management of the fund’s equities and 2% for fixed income management. Or, if a lower fee were assigned to the fixed income portion of the fund, say 1.5%, investors would be paying nearly 3.5% for the equity component. Either way you look at it, that’s just bad math.

Michael Lewis has a talent for writing about financial issues in a provocative and colorful manner. Having worked as a bond salesman for Salomon Brothers in the 1980s, he leans on his experiences and lessons learned on Wall Street to bring his readers ‘inside the tent’.

His latest work, The Big Short, is a narrative on the U.S. housing market crash. Unlike many books and articles on the topic, however, Lewis focuses his novel on a small group of investors who were on the ‘other side of the trade’ (i.e., betting that the rapidly escalating housing market would implode).

He tells the story of three groups of investors who were unwavering and obsessive in their bets against subprime mortgage bonds. And who made a whack of money because of it. He explains the birth and role of credit default swaps (CDS) and collateralized debt obligations (CDO) – those much talked about but little understood financial instruments that helped serve to bring down the likes of AIG, Bear Stearns, Citigroup and Lehman Brothers, among others. And he illustrates the colossal failure of risk management departments and rating agencies to identify and curb the risks that were growing in the system.

While the outcome is known in advance, Lewis’ take on the recent financial and housing market collapse provides many fresh and humorous (albeit dark) insights and observations. Aside from gaining a greater understanding of what was, and wasn’t, happening behind the scenes, a key takeaway is that investors who do their homework and who have a great deal of conviction in their strategies shouldn’t be afraid to run against the herd. Indeed, simply being one of the sheep can lead you to slaughter, as was the case of virtually every major Wall Street investment bank in 2008/09.

The Big Short is receiving some great reviews. One of my favorites is, “Michael Lewis doing what he does best, illuminating the idiocy, madness and greed of modern finance…Lewis achieves what I previously imagined impossible: He makes subprime sexy all over again.” (Andrew Leonard - Salon.com ). Canadian Capitalist also reviewed the book in a positive light in a recent blog. And who knows, we may even see it on the big screen in the future, given Lewis’ recent success with The Blind Side. It’s a fairly quick read, and last I checked it was on sale at Costco for about 40% off. So grab a 24-pack of popcorn and tuck in.

Related reading:
Book Review: Panic
Recommended Reading (The End)

George Morgan joined Mackenzie Financial in January 2009 as a Senior Vice-President and Portfolio Manager for the Mackenzie Cundill American Class Fund. Mackenzie issued a public announcement at the time. Here are a few excerpts:

• “George is an extremely tenured and talented investor; his leadership is a tremendous addition to the team,” says Peter Cundill, founder of the Cundill organization.
  
• “We are always looking for opportunities to add to the strength of our investment management teams…George is an experienced global value investor who brings many years of investment success to the Cundill team and who has had a relationship with the team, having been a member of the Cundill Investment Advisory Committee for the last two years,” says Charles R. Sims, President and CEO of Mackenzie Financial Corporation.

Mr. Morgan left Mackenzie at the end of 2009 to pursue other interests. Here are a few excerpts from the announcement at the time:

• "                                                               "
  

(No public announcement was made).

The media has recently brought the issue to light, and there are reports that investors in the fund are upset due to the “undisclosed departure”. Mackenzie’s stance, as noted by Advisor.ca, is that the decision to not make his departure public was based on the conclusion “that there was sufficient continuity of portfolio management on the fund and the change did not warrant a general public release.”

Silence – 1; Transparency – 0.

By Scott Ronalds

In this podcast, Tom and I highlight some of the key messages from our Quarterly Report. We also discuss our three-year performance (Steadyhand marked its third anniversary in the quarter) and provide an overview on the advice we are currently providing to clients.

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By Scott Ronalds

Wil Wutherich, the manager of our Small-Cap Fund, was in town last week on a research trip. We snagged a morning of his time to review the fund and get some further insights on some of the stocks in the portfolio.

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By Scott Ronalds

Toward the end of every quarter, we get on the phone with each of our fund managers and review their portfolios (our funds). This is a formal process that we go through with CC&L (the manager of our Savings Fund and Income Fund), CGOV (Equity Fund), Edinburgh Partners (Global Equity Fund) and Wutherich & Company (Small-Cap Equity Fund).

In this podcast, we take you 'behind the scenes' by highlighting some of the issues and topics that we discuss in these sessions, using our recent call with CGOV as an example.

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The Steadyhand Equity Fund consists of no more than 25 stocks. This is one of the manager’s (CGOV Asset Management) disciplines that we love. It ensures that we’re only getting their best ideas. Nalco is one of these ideas.

The Nalco story is a little different than most of the fund’s other holdings. As we emphasize in our reporting, CGOV favours companies with strong cash flows, proven management teams, clear competitive advantages and little debt. Nalco scores top marks in all of these, except the last one.

First a little background. Nalco (NYSE: NLC) is an Illinois-based water treatment giant. The company also owns a majority stake in a leading emissions control business (Nalco Mobotec). Nalco’s applications are used by mining, paper and petroleum companies, as well as hospitals, schools, and hotels, among others. Its products and services help prevent contamination, increase efficiency, and reduce pollutants. The company is also active in developing new environmentally-friendly technologies that improve efficiencies while reducing pollutants.

There is a lot to like about the company, as illustrated by CGOV’s investment thesis:

• Water is becoming an increasingly scarce resource and Nalco is twice the size of its nearest competitor in the water treatment and water related services market.
  
• The company operates on a service based model where 80% of revenue is recurring, providing better than average predictability in the business.
  
• There are high switching costs, resulting in a very loyal customer base.
  
• The company generates a lot of cash.
  
• With 70,000 customers and a diverse client base, they can offer new services easier than a new entrant.
• The business model is “green” yet also sustainable, as opposed to many solar and wind companies that depend on subsidies and do not have the same competitive advantage as Nalco enjoys.

Yet, Nalco has had a mixed record of delivering strong and consistent earnings and has been saddled with debt – a notable strike against the stock that kept CGOV on the sidelines until recently. In 2008, a new CEO took the reins (J. Erik Frywald) and implemented an aggressive strategy that focused on reducing costs, increasing productivity and trimming debt. His efforts have paid off. Over the past year, cash flows have improved, costs have been reduced, expensive debt has either been paid off or restructured (the balance sheet has been de-levered) and more energy has been focused on higher-growth areas such as advanced technologies and projects in the emerging markets.

Nalco has long been an attractive business, but its improving balance sheet finally made it an attractive investment idea to CGOV. Given there is still more risk associated with the company relative to some of the manager’s holdings with rock solid balance sheets (e.g., Rogers Communications, Cisco Systems, TD Bank), CGOV accumulated the stock in tranches. They initiated a small position last July and purchased additional shares in November and last month, as they became more comfortable with the new management team’s ability to execute.

Investments like Nalco come with higher return expectations. Yet, they also come with greater risk. To compensate for this, the manager typically maintains a smaller position size (e.g., 3%) and purchases the stock at what they believe to be a much greater discount to its true value.

Given the fund’s low turnover (11% in 2009) and the manager’s high level of conviction in their investments, a new holding often generates some discussion and buzz around the proverbial water cooler here at Steadyhand. In Nalco’s case, this seemed particularly fitting.

The notion of “active share” is in the news again. Coined by a pair of Yale professors in 2007, active share is a measure that indicates just how actively managed a fund really is. In other words, it is a gauge of how much a fund looks like, or overlaps, a certain index or benchmark. A fund with an active share of 100% would have no replication of the index, whereas a fund with an active share of 0% would look exactly like the index.

Dan Richards, a faculty member at the University of Toronto’s Rotman School of Management and president of Clientinsights, expanded on the concept in an article in Monday’s Globe and Mail titled Only the Truly Active Fund Managers Lead the Pack.

Richards highlights some of the professors’ key findings on the topic, including:

• only half of actively managed funds are truly active, defined by the professors as those funds with an active share of 80% or higher (based on 2003 U.S.-based data);
  
• there has been significant growth in “closet indexers” – funds that closely track the index;
  
• there is a direct correlation between true active management and performance (i.e., funds with the highest active share outperformed their index);
  
• size matters (smaller funds outperformed larger funds); and
  
• high active share doesn’t mean greater volatility.

He closes his piece by suggesting that Canadians need to be diligent when selecting actively managed funds to ensure they are getting what they are paying for.

We’ve written on the topic in a past blog and article and, not surprisingly, we’re in the same camp as Richards and the Yale researchers. To beat the index, you have to look different than it and focus on your best ideas. Yet, it’s not always easy to determine how closely a fund mirrors its benchmark. To assist investors in this respect, we calculated the active share of our equity funds. Based on year-end data, the ratios were as follows:

• Equity Fund – 77%
  
• Global Equity Fund – 91%
  
• Small-Cap Equity Fund – 97%

Now that’s undexing.

By Scott Ronalds

It’s Day 5 of the Games. As we’re lucky enough to be in the heart of the action here in Vancouver (or unlucky enough depending on your viewpoint), it’s time for a few observations:

• Canadians are bursting with pride and patriotism. Which is a good thing, no matter how you look at it.
  
• There have been a few early disappointments for the home team (Manny Osborne-Paradis, Jeremy Wotherspoon) and some pleasant surprises (Alexandre Bilodeau, Mike Robertson). Like any well diversified portfolio, this is bound to happen. The results will come; it’s important to think long term (i.e. 17 days).
  
• Fans are snapping up Olympic gear at a record pace. The line-up to get into The Bay’s downtown store at 10:30 PM last night was still 50 people deep. Their red sweatshirts, scarves and mittens are as hot as income funds.
  
• Spandex isn’t a good look on men.
  
• The weather has been a distraction (this is Vancouver, after all). Just like short-term market noise, best to ignore it.

We’ll report back in a few days, as there’s sure to be plenty more excitement (and easy analogies) to come.

Seth Godin is a renowned author, marketer and blogger. He has great insights and observations on human behavior and the business world. In a recent blog, Hunters and Farmers, he examines the differences between the two types of individuals.

In Seth’s words, “Farmers [are those who] spend time sweating the details, worrying about the weather, making smart choices about seeds and breeding and working hard to avoid a bad crop. Hunters, on the other hand, have long periods of distracted noticing interrupted by brief moments of frenzied panic.”

He goes on to suggest that both groups have strengths and weaknesses, but they are very different from each other and they should be marketed to (and taught) in different ways. Hunters are impulsive and can change gears instantly; farmers are methodical and absorbed. Mark Cuban is a hunter. Warren Buffett is a farmer.

Godin’s key observation is that marketers often confuse the two groups. Some companies sell products designed for farmers but hope that hunters will buy them.

This is becoming very evident in our business. The key attributes of successful investors, as motherhood as they may be, are patience, discipline and long-term thinking. Investing is a practice that is not designed for hunters. A mutual fund, ETF, or any other investment product should not be an impulse buy. Investors need to do some research and hard thinking to become comfortable with a product and make sure it’s a good fit. And they should be prepared to stick with it for a while before ‘rotating the crop’.

Yet, the industry markets to hunters. Companies sell flashy short-term returns and products that are focused on the hottest trend or fad. Little heed is paid to the investment philosophy or process that is designed to produce the bumper crop over time.

The industry knows that it’s easier to sell to hunters than it is to farmers. And because marketing efforts are targeted towards the former, more farmers are putting down their hoes and taking up spears. The mentality and behavior of investors is changing. We’ve seen this in the average holding period of mutual funds, which has fallen noticeably over the past few decades; and in the increased number of products that investors own in their portfolios (which often include lots of last year’s winners, or perhaps next year’s carcasses).

But investors who take a hunting mentality will often be disappointed with their longer-term returns. There are times to act swiftly on opportunities, but those who jump from product to product and constantly change gears will do their portfolio more harm than good. Investment firms that market to hunters will also see much more volatility in their sales and redemptions, which hurts all their clients at the end of the day.

Marketing to farmers is difficult. It’s a much longer sales cycle and the rewards aren’t as instantaneous. We’re happy, nonetheless, to keep planting the seeds.

Tom was on BNN this morning (Feb 8) with Marty Cej and Frances Horodelski. Topics of discussion included:

• What to do at this stage in the market
  
• How to reflect caution in your portfolio
  
• ETFs

The seven minute piece brings together some key messages from Tom’s recent Globe and Mail articles. And as an added bonus, he’s wearing a cool new Olympic tie.

You can watch the segment on BNN’s website by clicking here.

In his latest Wealthy Boomer video segment, National Post columnist Jonathan Chevreau sat down with Tom Bradley to discuss the concept of “undexing”. The term, creatively coined by our brash marketing team, refers to an investment philosophy that is based on beating the index by looking nothing like it.

Rather than constructing a portfolio that has a lot of the same constituents as the index (or benchmark), undexing involves running non-benchmark oriented portfolios that are concentrated in the manager’s best ideas.

Readers who know Steadyhand will be familiar with the concept. The video, nevertheless, is a great refresher. You can watch it here.

By Scott Ronalds

Don Cranston, one of the founding partners of CGOV Asset Management (the manager of our Equity Fund) was in town last week enjoying some of our rain. We put Don in front of the microphone and asked him a few of the questions that are at the top of investors’ minds these days:

• How and why does CGOV incorporate foreign holdings into the fund?
  
• What were some of the disappointments in the portfolio last year?
  
• How is the fund currently positioned?

And, as is customary with a visit from one of our managers, we closed with some rapid fire questions to get to know the real Don Cranston. Evidently, he’s not a fan of synchronized swimming.

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By Scott Ronalds

If you’re an income investor, T-Bills and GICs aren’t helping you much these days. And the prospects for government bonds are nothing to get excited about. In order to achieve a more desirable return, you may find yourself reaching for yield, or moving up the risk scale.

While this isn’t necessarily a bad thing, it should be done in a conscious and appropriate way. In this podcast, Tom expands on some of the advice he proposed in his latest Globe and Mail article. He also discusses the outlook and opportunities in our Income Fund.

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Morningstar’s Manager of Fund Analysis, David O’Leary, recently published an article titled Six Changes We Would Like to See in the Canadian Mutual Fund Industry. O’Leary acknowledges that by and large, Canada has an investor-friendly fund industry. Yet, there is still room for improvement in a number of areas. His laundry list includes:

• Fees
  
• Manager co-investment (a call for some form of disclosure)
  
• Management team changes (a call for greater transparency)
  
• Disclosure of regulatory findings
  
• Currency hedging (a call for greater clarity)
  
• Share class naming conventions (a call for standardized terminology)
  

David’s list is pretty complete and we agree with most of his suggestions, but we would add one thing to the list:

• Client statements (few firms/dealers show fees and account performance)

It’s been a busy year at Steadyhand, and in the capital markets. In this year’s Holiday Letter, we reflect back on some of the accomplishments, highlights and lowlights that the team endured over the course of the year.

Happy Festivus!
The Steadyhand Team

A quick reminder that with the exception of the Savings Fund, the year-end distributions of all our funds will be calculated on December 15th and paid on December 16th. The distribution for the Savings Fund will be calculated on December 31st.

Distributions represent the mechanism whereby mutual funds transfer to unitholders any interest and dividend income, along with any return of capital (ROC) and realized capital gains they have accrued over the course of the year.

Remember that immediately following a distribution, the price of a fund drops by an amount equivalent to the payment. However, you will receive additional units in the fund which are equivalent in value to the amount of the distribution. The end result is that the value of your investment doesn’t change, but you own more units in the fund at a lower unit price.

For example, assume you own 100 units in a fund that is valued at $10.00/unit (your investment is worth $1,000). If the fund pays a distribution of $0.10/unit, its price will drop to $9.90 following the distribution. However, you will receive an additional 1.01 units in the fund ($0.10/$9.90), so the value of your investment remains unchanged (101.01 units x $9.90/unit = $1,000).

The estimated distributions for our funds are as follows:

• Income Fund: $0.12/unit
  
• Equity Fund: $0.05/unit
  
• Global Equity Fund: $0.04/unit
  
• Small-Cap Equity Fund: $0.08/unit

Please note that these are only estimates and are subject to change.

If you have any questions about distributions, feel free to give us a call at 1-888-888-3147.

Tom will be on Business News Network (BNN) tomorrow morning (November 27th) from 9-10 AM eastern time. He’ll be sitting in with Marty Cej and Frances Horodelski on Market Morning.

Black Friday just got a whole lot brighter.

Update (November 27): For those who missed the show, click here to watch the rerun.

By Scott Ronalds

Recent data out of the U.S. suggests that American retail (individual) investors have been watching the stock market rally from the sidelines. According to an article by Morningstar USA, investors have pulled an estimated $4.4 billion out of U.S. equity funds so far this year (as of October 31st). While the bleeding pales in comparison to 2008, when nearly $100 billion was redeemed from these funds, investors appear to remain very cautious of equities. International stock funds have fared better, with $16 billion in net sales ($70 billion was redeemed from the category last year). By and large, however, asset flows into equity funds have been anemic, and very little of the retail money that was pulled out in haste last year has returned to stocks.

It’s the opposite story for bond funds, where net sales have reached nearly $300 billion this year (2008 sales totaled $34 billion). All this in an environment where short-term interest rates are at their lowest levels ever, and 10-year U.S. Treasuries are yielding less than 3.5%. Where has the money come from to fund these purchases? Money market funds. As the Morningstar article points out, roughly $400 billion has been redeemed from these funds this year. After reaching a peak in January at $3.6 trillion, the mountain of cash sitting in money market funds has shrunk somewhat. Yet, there is still a significant amount of idle cash that could be re-deployed in the equity markets at some point.

Clearly, retail investors have not shed much of their aversion to risk. The numbers suggest that rather than taking advantage of a beaten up stock market, Americans have been ‘riding the pine’ in 2009, preferring the safety of bonds over the volatility of stocks.

It’s a similar story in Canada. Retail investors at home have pulled $4.8 billion out of equity funds year-to-date, with $9.8 billion flowing into bond funds, according to the Investment Funds Institute of Canada (IFIC).

It’s also evident that professional money managers have been acting in an opposite fashion. Internally, our fund managers have been putting funds to work since last fall and have brought down their cash positions (quite substantially in some cases) from pre-meltdown levels. Anecdotally, we’ve heard and seen much the same from other managers.

At Steadyhand, our clients have benefited from being in the game, as most sat tight through the volatility and many added to equities when the markets were bottoming. We’ve opined that we may be ‘stuck in the middle’ right now in terms of valuations, sentiment and the direction of the economy. Tom also suggested some acts of caution in his last Globe article. If there is more fuel for the rally, however, it may well come from all those investors who are still sitting on the bench.

Related Reading:
A Mountain of Cash in the Waiting
The Risk Today is Not Buying Cheap Equities
Tackling Uncertainty This RRSP Season
Stuck in the Middle

From: jsmith@mega-bank.com
To: NewProductCommittee@mega-bank.com
Date: Mon 11/16/2009 1:08 AM
Subject: This Year’s Meal Ticket

Just woke up with a brilliant idea!! I’m putting it in an email while the juices are flowing. Still working on the name, but I’m thinking something along the lines of the H1N1 Fundamental Vaccine Equity Plus Fund. We could even throw the word ‘yield’ in there somewhere to capitalize on the current demand for income products.

Hear me out. H1N1 is all over the news. An investment product attached to the vaccine would be hot. Real hot. It would simply hold shares of the major vaccine makers – GlaxoSmithKline, Sanofi, Novartis, and AstraZeneca. We could either hold the stocks in equal proportion, or throw a quant overlay over the portfolio to make it sound more sophisticated and intriguing!

If we go with an open-end fund, I figure we could charge a fee of at least 2.5% (in line with other specialty funds). Or, we could add a few features to really get this thing off the ground. I’m talking principal protection. We could call our friends at the derivatives desk and slap a guarantee on this baby. We’ll make the minimum holding period 10 years to make sure the odds of the guarantee kicking in are next to nothing. We should be able to get an extra 0.5% in fees out of this each year.

We’ll offer it in multiple series so that no advisor will be left behind. A healthy trailer fee on the A-Series will get this thing moving.

If the idea doesn’t fly with the mutual fund brass (although I can’t see how it wouldn’t), we’ll take it to the investment bankers. Make it a closed-end fund. They’ll be all over it as long as they can take their usual 7% off the top. And they shouldn’t have any problems raising millions on the Street, given how hot this thing is sure to be!!

Or, if we want to give the bank’s ETF division something to build on, what better product than this?! With only four stocks, the trading costs will be next to nothing, but I figure we could still charge a fee of around 0.7 – 0.8%. Or better yet, we could leverage it up. Leverage, baby!!! Give investors 2X the daily return of the portfolio. Average Joe still can’t figure out how these things work, but the word ‘leverage’ alone would be sure to pique some interest.

Bottom line, we can’t lose on this idea. If we get it to market right away, we can capitalize BIG TIME on this flu thing. What happens when the craze cools down, you may ask? We’ll just merge it with one of our health care funds. Brilliant!!

Let’s set up a meeting first thing in the AM.

Cha-ching!
JS

By Scott Ronalds

Housing stocks make me squeamish. It was painful to watch them fall like a rock over the last couple of years as the U.S. real estate market imploded. A number of companies faced bankruptcy or saw their share prices slashed due to stretched balance sheets, huge unsold inventories and weak consumer demand.

Our global equity manager, Edinburgh Partners Limited (EPL), took their lumps on Pulte Homes, a Florida-based builder, which they sold last year after their worst-case-scenario estimates on the company’s book value and earnings were realized. Although the position was fairly small, Pulte was a clear loser for unitholders of the fund (including yours truly; the fund represents 25% of my portfolio). EPL made some strategic moves when the markets were bottoming and has since regained much lost ground, but Pulte sticks with me for whatever reason.

The U.S. housing market is still a pretty ugly place. Especially in places like Arizona, California and Nevada, where speculative activity was the highest during the days of mad flipping. Yet, as the economy pulls itself out of recession, opportunities are emerging. While there are still plenty of foreclosures, there are signs of a floor being reached in many markets, and unsold inventories are winding down. For those with a very high tolerance for risk, an investment property in Scottsdale, San Diego or Vegas may turn out to be a big winner a few years from now.

For more conservative investors, taking a longer term view on homebuilders could prove to be a good bet. As the economic storm passes, the best of the group will return to profitability in a world with fewer competitors and more end-users (i.e., those looking to buy a home to live in, rather than trying to sell it for a quick buck). Edinburgh Partners feels the risk/reward tradeoff is enticing enough to revisit the sector, and they’ve found what they believe to be a good opportunity in DR Horton, a Texas-based homebuilder. They like Horton because the stock satisfies all of their requirements from a valuation perspective (e.g., it’s cheap on a number of measures). The company is also one of the largest homebuilders in the U.S. and their focus is on the lower end of the market with respect to price point. In other words, their homes are affordable and appealing to first-time buyers.

Pulling the trigger on a housing stock right now may not feel overly comforting. Yet, the best investments are often made when you feel the least comfortable. Tom referenced this notion in a recent Globe column where he quoted the late Peter Bernstein, “If you are comfortable with everything you own, you’re not properly diversified.”

I felt pretty uncomfortable eight to twelve months ago when EPL was buying bank stocks, Chinese internet companies and Hong Kong land developers, but those investments have since proven to be very wise. This is what we pay them for. They take emotion out of the game as best they can and buy undervalued stocks, wherever they may be found. And their experience and longer-term track record speaks for itself.

So go ahead, make me squeam.

We could’ve had some fun with a list of the scariest Halloween costumes this year. Bernie Madoff, Allen Stanford and Jon & Kate come to mind. But we thought it would be more educational, and just as fun, to highlight some of this year’s scariest investments. Queue the Monster Mash.

Leveraged ETFs
These products, which double-up your exposure to the daily performance of an underlying investment (often a commodity, currency or market index), have scared the #*&! out of investors who bought them without doing their homework. This is because they track the daily performance of the underlying investment, not the annual performance. They are designed for short-term speculators and professional money managers, not the average investor. Take the Horizons Beta-Pro NYMEX Crude Oil Bull Plus ETF, and its sister, the Bear Plus ETF. The former is a bet on the price of oil (futures contracts) rising; the latter on oil falling. As of the end of September, the underlying investment that the ETF tracks (the NYMEX Light Sweet Crude Oil Futures Contract) was down roughly 5% on the year. Yet, the Bull Plus ETF was down 36%, and the Bear Plus product was down 42%. Yikes!

Money Market Funds
The Bank of Canada’s key lending rate sits at 0.25%. The good news is that it’s extremely cheap to borrow money if you’ve got a sparkling credit record. The bad news is that you’re looking at earning very little on lending your money to those with sparkling credit records (i.e., the big banks and corporations). After fees, investors can expect next to nothing on money market funds until the central banks raise short-term rates. Spooky prospects indeed.

Maple Leafs Seasons Tickets
1-7-2. Need we say more.

Guaranteed Target Date Funds
Marketing-driven, fee-laden, and deceptively complex is how the boss referred to these products in an earlier blog. Target date funds (also known as life-cycle funds) are managed for a particular demographic (i.e., investors retiring in the year 2010, 2020, or 2030) and the manager adjusts the asset mix as the retirement date approaches. Not a bad idea in concept. But it’s the guarantee that comes with these products that really throws them off the rails (not all target date funds come with guarantees). When the markets turned sour last year, the asset mix on several of these funds was ‘shifted’ to ensure the guarantee could be paid out and the issuer wouldn’t lose any money. The problem is that many of these funds are now invested 100% in bonds but the target end-date is 10 or more years into the future. Investors are thus faced with minimal future growth prospects and may have to hold on to the product for 10 or more years for the guarantee to kick in. Simply terrifying.

The U.S. Dollar
The greenback has had a rough year so far against most major currencies. It’s fallen roughly 15% against the loonie and is down significantly on the euro as well. With parity closer by, however, it may be an opportune time to revisit your asset mix. If it’s off balance, you may want to creep up your U.S. exposure. Or at the least, your dollar should go farther in your cross-border fireworks shopping this year.

In a recent article written about Steadyhand titled Mischievous Strangers and a Steadyhand, Karin Mizgala draws a connection between Tom Bradley and Charles Dickens. Very flattering. Especially when compared to some of the other comparisons thrown around the shop.

Karin, a fee-only financial planner and co-founder of the Women’s Financial Learning Centre, is referring to Tom’s frequent writing on the problem of relying on “mischievous strangers” (i.e., economists and financial analysts) to do our thinking and investing for us. In Dickens’ novel Hard Times, he similarly comes down hard on the bankers and other financial experts of the day and “rages against their dubious use of statistics to confound and befuddle the common man.”

Karin mentions Steadyhand’s commitment to educating the public about the investment industry from an “insiders” perspective and how we (Tom) are not afraid to express controversial views. She also has some kind words about Steadyhand’s investment philosophy and transparency in her article, which of course makes it a must-read.

We couldn’t have said it better ourselves – that’s what this blog is all about. And for those of you ladies who are interested in quality financial education programs which speak to women, check out the WFLC’s website (a little back-scratching, in the interest of transparency).

By Scott Ronalds

Tom recently sat down with Larry Lunn, the Chairman and founder of Connor, Clark & Lunn (CC&L), to talk shop.

At the front end of the podcast, Larry discusses where we are in the economic recovery and his view on [the hot topic of] inflation. He then addresses some of the strategies that CC&L is pursuing in the Income Fund, and where they are seeing the best value in the bond market.

And we’d be remiss if we didn’t close the podcast by asking the veteran money manager where he sees returns headed over the next 5 or so years, given the extraordinary circumstances we’ve been through over the past 12 months.

If you’ve got 20 minutes to spare, there’s a lot of wisdom to take away. If you’d rather tune in by topic, here’s a breakdown of the conversation:

0 – 2:40.  Introduction.
2:40 – 5:12.  Where we are in the economic recovery.
5:12 – 8:35.  Inflation.
8:35 – 11:35.  Strategies in the Income Fund that have paid off recently.
11:35 – 13:10.  Bank bonds and other areas of opportunity.
13:10 – 14:12.  Corporate bond exposure going forward.
14:12 – 15:15.  The U.S. high yield market.
15:15 – 17:25.  Strategy with respect to income-equities.
17:25 – 19:02.  Medium-term outlook for the markets and the Income Fund.

Download (the file may take a minute or two to download), subscribe via iTunes or RSS, or listen now: