October 23, 2005

The Naked Investor
Good book proves everyone biased

John Lawrence Reynolds' book, The Naked Investor, received a lot of positive press earlier this year. Its subtitle - Why almost everybody but you gets rich on your RRSP - pretty much sums up its tone. Understandably, the industry is divided over this book. While I generally liked it for its warning of ethically-challenged advisors, The Naked Investor is a prime example of how no one is free from bias.

I don't mean to suggest that the author, Mr. Reynolds, is making any consciously biased statements. Rather, in reading through this book, I realized that information used to support the book's central thesis is diluted by errors that would have been caught if such information had been scrutinized as heavily as other data.

Market timing vs. late trading

In tackling the hot and sensitive issue of the mutual fund market timing scandal, the book confuses the terms 'late trading' and 'market timing'. This is a big deal since the former is blatantly illegal while the latter is not (though it clearly compromised the interests of unitholders). The book discusses the U.S. and Canadian scandals as if they were identical. In fact, the specific activities that transpired in the U.S. were far more scandalous (i.e. late trading, market timing and direct significant insider participation) than what transpired here (i.e. market timing with some insider participation).

Some may call this splitting hairs, but suggesting that late trading may have happened here, when the OSC found no such evidence, is a fairly serious oversight. What is described in the book is actually "market timing" (i.e. taking advantage of stale prices created by time zone differences). The term the book used in describing this activity is "late trading" - which is allowing trades to be placed in domestic funds after markets closed and prices were already determined. The two are very different.

Phantom wrap

I acknowledge that 'packaged portfolios' like wrap accounts have some benefits. Even so, I don't much care for them - as I summarized in this November 2003 article. But using erroneous information to prove a point isn't effective. Reynolds writes of a hypothetical wrap account that charges 2.5% per year on top of funds already charging 2.5% per year - for a total annual fee of 5% annually. The problem is, no such program is formally offered by any institution or sponsor.

In fairness to Mr. Reynolds, he obtained this illustration from what most people would consider to be a reliable third party source. This perfectly illustrates my earlier point about bias and scrutiny, however. When data support one's general opinion, less scrutiny is applied to such information. But a couple of phone calls to people in the industry would have confirmed that such a product does not exist - at least not that I know of and I've done a bit of research in this area.

Unclear advice

At one point the book takes aim - and justifiably so - at the many unlicensed 'gurus' providing advice to the masses in various forms. In part, Reynolds writes, "The unlicensed gurus are accountable to no one until they cross a legal line.". Yet, in a chapter aimed at helping investors protect themselves, the book offers (of all things) investment tips and guidelines. Not backed by a license of any kind with a securities commission (journalists are generally exempt from needing a license), the book offers what is rather confusing advice to consumers.

For instance, its age-related asset mix guidelines are based on the "age = fixed income allocation" rule. The guidelines, however, have an inconsistent fixed income (i.e. bond and cash) allocation. Plus, a separate category - called Growth and Income - is earmarked for balanced funds, thereby boosting the bond component above the book's own allocation guideline. The same chapter also suggests setting realistic return expectations in the 10% range. In my opinion, basing plans on such lofty expectations is bound to disappoint.

I confess that part of my motivation for writing this article is in response to the combination of overwhelming positive coverage of the book's content and the extent of what I consider to be either significant errors or unrealistic assumptions. That said, I find the book's intent - telling readers not to place blind trust in people too quickly when big money is at stake - to be genuine.

And I applaud Reynolds for highlighting the segmented, and sometimes ineffective, nature of the investment industry's regulatory framework. But there is a wider message here. Even when a set of information supports your opinion, scrutinizing it will ensure that your opinion is backed by a solid data from a reliable source. Failing to do so runs the risk of diluting what may otherwise be a worthwhile message.