For those seeking a safe and dependable income source, today’s painfully low interest rates pose a real challenge.  Bank of Canada Governor Mark Carney regularly reminds us that persistent low rates can be dangerous because they incent excessive borrowing.  But low rates also pose some risk to the asset side of investors’ balance sheets.  It looks like low rates will be here for a while so here are a few things to keep in mind when structuring investment portfolios.

Fees are critical

It has always been important to control the fees and expenses incurred to invest in bonds or bond investment funds.  But as yields fall, fees increase in importance because they chew up a larger proportion of the starting yield.  And this is an asset class with limited potential for outperformance by active managers.

Canadian bond mutual funds sport an average management expense ratio (MER) of 1.4% annually.  The yield-to-maturity (YTM) of the Canadian investment grade bond market is an annualized 2.4 percent.  Proportionately, that’s nearly 60% of bonds’ expected gross return.  (Last fall, I explained some of the YTM’s finer points.)

Even five years is long enough to see fees’ powerful impact on net bond returns.  For instance, the top performing bond funds over the past five years sport fees that are a fraction of the category average.  That’s no mere coincidence but irrefutable math.

Don’t reach too far for yield

While the worst of the financial crisis may be behind us, the crisis isn’t gone.  Recall that one of the crisis’ first signs in Canada was the asset backed commercial paper freeze in 2007.  ABCP was held by many investors as a cash-substitute because it offered higher yields than safe treasury bills or other low risk short-term bonds.  But we eventually found out that not only were these baskets of longer-term loans that were ‘rolled over’ or refinanced in the short-term but many also included higher-risk loans.  In other words, reaching for yield was one of the sources of pain in the early days of the financial crisis.

Today, investors are becoming more enamoured with emerging markets bonds and preferred shares, both of which are valid portfolio components.  But it’s important to establish limits on how much to put in riskier or less liquid securities offering higher yields.

REITs & dividend stocks are not bond replacements

While real estate investment trusts (REITs) and other dividend-paying stocks are often used to produce investment income, one must be cautious not to view these as bond replacements.  The investment industry has been promoting stocks based largely on the juicy yields they offer today; often exceeding that available from safer bonds.  But as I detailed in this December 13, 2010 blog post, there are good reasons to be careful of this reasoning.

Stocks are generally riskier than bonds so they should offer greater return potential.  But the greater risk means that from time to time, investing in stocks will be a painful experience.  By all means, look to high yield equities generally in the context of an income-oriented portfolio.  But every portfolio needs at least some bond exposure to soften stock market volatility.

Beware of apparent ‘free lunches’

Investors and advisors are increasingly looking to so-called private placement funds that offer fat yields in this ultra-low-rate environment.  One type, mortgage funds, make shorter-term loans to commercial property developers.  There are more of these funds than I realized.  One that I found claims to have earned 8% in each of the last nine calendar years.  It further claims a 10% return in each of the four prior years – all interest.  And the fund claims that the capital hasn’t risen or fallen – ever.

The fund is in a continuous offering, meaning that it’s open to new money.  And it’s surprisingly liquid, allowing investors to buy and sell regularly.  But think about this for a moment.  These shorter-term loans are basically fixed income instruments – like bonds.  And as interest rates fluctuate, these underlying loans’ market values should fall and rise accordingly.

As a base of comparison, short-term Canada bonds returned 5.1% in calendar 2011 but only about half was from pure yield.  The rest came from capital appreciation from falling yields.  But funds like these have unit prices that barely move, if they do at all – which punishes sellers in this scenario.  So I’m a little skeptical of funds like this that neither rise nor fall in value to reflect changes in interest rates, credit spreads and liquidity.

All might be kosher with this and other similar funds but it’s naive to assume that any investment offering yields in the 8% to 10% range is not without material risk when short Canada bonds yield barely above 1% today.

Bond remain a critical portfolio component for virtually everybody.  Keeping at least half of fixed income exposure in conventional investment-grade debt is a prudent policy.  If you can’t resist reaching out for more yield, keep these tips in mind to help avoid making poor decisions with what should be a portfolio’s conservative foundation.

I was quoted in a recent Globe & Mail article warning that higher yields available in emerging markets bonds (compared to Canada bonds) come with additional risk.  Given that the investment fund industry has launched several emerging markets bond funds and exchange traded funds in recent years, it’s worth putting my comments and this growing class of funds into context.

Canada’s first generation EM bond funds

If memory serves, this latest string of emerging markets bond fund launches is round two for the Canadian investment industry.  When I started in the industry in 1994, emerging markets equities had just finished a year of triple-digit returns.  But unlike today’s focus on China and India, most of the enthusiasm back then zeroed in on Brazil and its Latin American counterparts.  Fidelity and Guardian were two sponsors of first generation emerging markets bond funds.

But a Mexican Peso crisis in late 1994 began a string of mid-late 1990s emerging markets currency crises.  They all put a dent in the market values of and infatuation with emerging markets bond (and equity) funds.

Fidelity Emerging Markets Bond Fund, for instance, was merged into its sibling, Fidelity American High Yield fund in 1999.  Similarly, Fidelity North American Income (sold by many advisors as a foreign money market fund) was merged into Fidelity Canadian Short-Term Bond after its big Peso sent the fund’s unit price southward.

Today’s EM bond funds – the pitch

Fast forward to today and there is a growing list of second-generation emerging markets bond mutual funds and ETFs.  And the sales pitch is striking a more sensitive chord today.  Developed countries the world over are up to their eyeballs in debt and sovereign default fears are abundant.  Emerging markets, on the other hand, sport skinnier debt-to-GDP ratios and are looked at as global economic saviours.  Accordingly, as developed nations are getting credit downgrades, emerging markets are being held out as safer credits.

But these supposedly safer credits are offering yields well in excess of bonds issued by more heavily-indebted developed nations.  Venezuela is an interesting example.  The country boasts a debt-to-GDP ratio of 39% and has seen GDP growth north of 4% year over year (according to www.TradingEconomics.com).

Yet 15-year Venezuelan bonds yield north of 12% annually according to Bloomberg.  Other Latin American government bonds yield 1 to 2 percentage points more than bonds issued by Canada, the U.S. and Germany.

Debt levels alone don’t predict emerging markets defaults

The sales pitch for emerging markets debt – like this one from RBC – might have us think that debt levels alone can be used to assess sovereign default risk.  But judging by the ‘spreads’ of emerging markets bond yields above developed world sovereign debt, the global bond market is saying that other important factors determine default risk.  Otherwise, emerging markets bonds would yield less than developed country debt.

In This Time is Different – Eight Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff examined – among other things – a history of default among developing countries.  While high debt levels were universally linked to default episodes, the authors found that emerging markets defaults have generally occurred at debt levels that are generally considered ‘safe’ for more mature economies.

They found that nearly half of the three-dozen emerging country defaults between 1970 and 2008 occurred at debt-to-GNP ratios below 35 percent.  One recent illustration of this is Ecuador’s 2008 default which occurred at a debt-to-GNP ratio of 20 percent.

While developed countries tend to run a higher risk of default at debt-to-GNP ratios above 60%, history suggests that the danger zone for emerging markets typically starts at 35%.  While emerging markets countries boast lower overall debt levels, they also are less willing and less able to shoulder as much debt as their more developed peers.

Reinhart and Rogoff suggest that pinpointing any one country’s debt intolerance threshold (or where the risk of default rises significantly) may largely be a function of a country’s own history of default and inflation.  In other words, the global bond market and the credit default swap market generally consider emerging markets higher default risks for good reasons.

Including emerging markets debt in portfolios

Our firm has never explicitly included emerging markets debt as part of client portfolios.  Those who can’t resist the lure of this class of global bond should keep a few things in mind.

When determining allocation limits, include emerging markets bonds into the larger bucket of higher yield bonds.  Common guidelines limit high yield (and in this case emerging markets) bonds to between 33% and 50% of total bond exposure.  But for some investors the appropriate exposure might be zero.  Whatever the case, all investment policy guidelines should be driven by individual goals – which can’t be stressed enough.

Too many investors and their advisors will gravitate to emerging markets bonds because of the lure of the sales pitch and the returns in recent years.  Our approach is to build portfolios with ‘core’ and ‘enhancement’ building blocks.  We begin with ‘core’ exposure; and only when that is insufficient to achieve stated goals do we introduce ‘enhancement’ strategies – like higher yield bonds – to juice portfolio return potential.

Those simply chasing returns, however, tend to have unrealistic expectations – which is bound to end in disappointment.

The mutual fund industry seems to be under the microscope on a regular basis.  That’s partly a function of its size.  But, to be fair, it’s also because the industry has earned criticism for its commission structures, high fees and proliferation of gimmicky products.  The issue of fees is the subject of perpetual debate.  A recent letter by FAIR Canada has pushed the hot-button yet again.

A FAIR request

Finance Minister Jim Flaherty has asked the Senate National Finance Committee to examine why prices of many retail goods continue to be higher than in the U.S. while the Canadian dollar has been at (or near) par with the U.S. dollar for a year or more.  Just over a week ago, FAIR Canada called on Flaherty to add mutual fund management expense ratios to that list of retail goods.

I have a great deal of respect for FAIR.  Given that investor advocacy isn’t a high-paying job – it pays nothing, sometimes less – FAIR is a much-needed organization.  But I think their request and fee comparison miss the mark.

Good vs. service

While a mutual fund is a financial product, it is a bundle of ‘services’ – i.e. money management, financial advice in many cases and financial administration.  That is why mutual fund fees and expenses were previously GST-taxable.  Many services, including money management, are regulated and provided to a residents of one or more specific jurisdictions.  Mutual funds can’t be ‘shipped’ to another country and sold to its residents.

(Note:  The Securities and Exchange Commission prohibits the sale of Canadian-domiciled mutual funds to U.S. residents.  This is called a closed mutual fund market.  Similarly, Canada is also a closed market.  In Europe, it’s more common for funds domiciled in one country to be sold to residents of a neighbouring country.)

So as much as I’d like to see lower fees in Canada, I don’t understand the reasoning behind tossing mutual funds in a basket with running shoes, computers, books and greeting cards.  Otherwise, we might as well add legal services, will kits and insurance policies to the mix.

Fees

To bolster its case, FAIR cited Morningstar’s global survey of fund fees and added its own comparison for good measure.  This past March, Morningstar’s Chicago headquarters published the 2011 edition of its Global Investor Experience report.  Fees and expenses were just one of the handful of factors on which Morningstar graded 22 countries surveyed in its report.  But Canada’s failing grade on fees drew most of the attention.  However, Morningstar’s fund fee comparison appears to suffer from weaknesses that plagued some others before it.

Morningstar compared fees via a survey format using the firm’s global mutual fund database.  The nature of the survey questions and the vague descriptions in the text point to a superficial comparison.  Here are just a few of the many issues that seemingly muddy its global fee comparison.

• Fund of fund fees are all-inclusive in Canada; not the case in many other countries.
• Trading costs incurred by the fund are excluded from published expense ratios.  This is biased against Canada and the U.S. if our admittedly non-scientific survey is any indication.  (See this article for one example.)
• The range of fees or the proliferation of low-fee product is not addressed.
• The content of what’s included in “equity” and “fixed income” categories is unlikely to be equal across 22 countries.
• There appears to be no attempt to compare the proportion of advice-seekers vs. do-it-yourselfers.

Further skewing this issue is FAIR’s own comparison of a Fidelity U.S. stock fund (sold in the U.S.) with a Canadian stock fund (sold in Canada).  I would instead compare virtually identical funds but let’s go with FAIR’s chosen comparison for a moment.

The Fidelity Blue Chip Growth Fund‘s 0.92% expense ratio includes no trailing fee commissions.  Meanwhile, their choice of Fidelity Canadian Large Cap‘s 2.28% MER includes 1% annually for advisors.  When you control for trailing commissions, most of the difference disappears (1.28% vs. 0.92%).  Pull out Canada’s GST/HST and the difference narrows further to an estimated 0.15% per year.

Fifteen basis points isn’t likely to inspire much action by Minister Flaherty.  But stating that Canadian fees are nearly 150% higher than U.S. fees – as FAIR implies in its comparison – is more eye-catching.  I estimate the true difference, when controlling for fund type and taxes at closer to 40-50 basis points annually.

Compensation structure

What FAIR really seems to want is to unglue advisor compensation from product pricing.  They clearly want more transparency for the investing public – a cause I personally support.  But their focus on superficial cross-border price differences misses the mark.  They’re barking up the wrong tree.

Low-fee advocates should vote with their wallets

As I’ve pointed out before, Canadian investors have easy access to a handful of low-fee mutual fund families in Canada.  They also have direct access, via the Toronto Stock Exchange, to a growing number of exchange-traded funds.  Perhaps more interesting is Canadian investors’ equally easy access to ETFs and actively managed closed end funds trading in the U.S.

What we don’t have – and the U.S. does – is every fund available in no load and load form.  But if Canadians truly want lower fees, then they should stop investing in funds with higher fees.  If more Canadians voted with their wallets, we’d see more price competition in Canada.  For example, if a Canadian DIY investor wanted exposure to domestic stocks, why not invest in something like Mawer Canadian Equity (1.24% MER) instead of Fidelity Canadian Large Cap with its higher fee?

Let Google help you.  Simply typing in the phrase “low fee mutual funds Canada” results in lots of good suggestions.  The founder of one of the higher profile low-fee firms in Canada – Tom Bradley of Steadyhand Investments – writes bi-weekly for Canada’s largest paper.  He’s easy to find – and he’s one of the nicest guys in the business.

The industry has its share of blemishes – from market timing scandals to conflicted trades and poor governance.  But that doesn’t mean we should blame the industry or regulators because Canadians want advice (which costs more) and choose not to put their money into cheaper investments.

A ‘minimalist’ lifestyle usually refers to living only with the basics.  The less ‘stuff’ you have, the less you have to worry about day-to-day and the happier you will be, say proponents.  Perhaps you can’t part with your new smart phone, your second car or the notion of home ownership.  But I am convinced that adopting minimalist-like investing style would set most investors on the path of greater happiness and prosperity.

Balanced funds are under-rated

There was a time when I poo-pooed the use of balanced funds.  As I grew more interested in investor behaviour – and saw anecdotal and broad-based quantitative behavioural evidence – I embraced the idea that balanced funds are good for most people.  Even though balanced funds have not been terrific performers, my research on long-term investor returns showed that investors using balanced funds saw better performance compared to using a mix of individual stock and bond funds.

While balanced funds are considered best for novice investors with modest portfolios, they are hugely under-rated for larger portfolios.  There is no good reason to invest $100,000 much differently than $10,000 – with one exception.  Investors with significantly more money should generally expect to pay lower percentage fees.  Since most investors – novice or expert, wealthy or not – are guilty of investor misbehaviour, a reasonably-priced diversified balanced fund can be an investor’s only holding well into six-figure dollar amounts with pleasing results.

Those that doubt this ultra-simple approach should revisit a related post:  The ironic comfort of balanced funds.

Avoid niche & gimmicky products

Funds and ETFs providing exposure to high-growth BRIC countries; the popular agriculture theme; or perhaps to higher-yielding infrastructure plays are exciting.  I get it.  When stock markets are falling and bond yields are extra-lean, these can be exciting alternatives.  But these themes and strategies usually hit main street long after big institutional investors have made the easy money.  I’d rather see investors go into more broadly-based funds so I have a compromise to propose.

Do you want to invest outside of Canada but avoid emphasizing more developed but debt-laden U.S. and Europe and more of the more financially-fit emerging countries?  Instead of picking a BRIC or China fund consider a fund like Dynamic Global Value or Manulife Global Focused.  The idea isn’t so much to run out and buy those specific funds but rather that the decision of which countries or themes to invest in should be taken out of the individual investors’ hands.

This approach keeps the portfolio more compact, makes it lower-maintenance and reduces the likelihood of disappointing performance.

Pay attention to costs

Many financial advisors think I’m too tough when it comes to investment fees and expenses.  By contrast, many investors and their advocates think I’m not tough enough.  Sometimes I can’t win.  What’s not debatable is the importance of costs.  All investors should keep an eye on fees and expenses (those that are visible and those that are not).

Nearly two years ago, I gave Globe & Mail readers a few tips on how to pay attention to costs and keep them in proper perspective.

Less is more

Portfolios should be built to match an investor’s assets with future spending plans.  My partners at HighView and I use this goals-based approach to construct portfolios.  Accordingly, each portfolio holding has a well-defined role to play in helping clients achieve stated goals.

When asked whether this theme or that strategy should be added to a portfolio we ask how it will help the portfolio move the client closer to his/her goals.  If it doesn’t fit, we don’t consider it.  If it does, then it may have a place.

Too many portfolios are product-driven, where products are added based on their availability.  Rather, individual goals should define what is needed and whether the next new product or theme fits.  I have no doubt that a simpler portfolio is the right structure for most investors.  And if my research is any indication it won’t just make you happier – but wealthier too.

(Postscript, 19-Sep-2011:  Coincidentally, the Globe & Mail today posted a video interview I did with Rob Carrick a couple of months ago.  Toward the end, I re-iterate the advice of concentrating mutual fund portfolios.)

Neither I nor our firm makes high level calls on the economy.  We refrain from peering into our crystal ball in part because the best time to invest is often when the economic news and data are seemingly at their worst.  But that doesn’t mean we ignore economic sign-posts.  I found data for one such indicator – the steepness of the U.S. yield curve – courtesy of my friend and value investor Dr. Norman Rothery of www.StingyInvestor.com.

10-3 Treasury Spread

Five years ago, The Federal Reserve Bank of New York (aka New York Fed) published a paper examining how effective the bond market had been at predicting recessions in the U.S.    Specifically, the authors – Arturo Estrella and Frederic S Mishkin – focused on the yield spread between 10-year and 3-month U.S. Treasuries.  (The industry has long followed variations of this indicator.)

They reasoned that this spread is very useful to study for the direct information that can be observed from it – i.e. short rates are used as a policy tool to spur or slow growth – and for the information (beyond monetary policy) and expectations embedded in bond prices.

In short, Estrella and Mishkin found that when the 10-3 yield spread is wide, good economic times are more likely a year from now.  When the spread is very thin or negative, we’re more likely to be in a recession twelve months from today they said.

The New York Fed updates this data monthly.  As of the end of July, the model suggests that we’re unlikely to be in a recession by July 2012.  While yields have dropped this month, this model’s output is no different.  But there are reasons not to take this model too seriously, at least right now.

A few years ago, in response to the 2007-09 financial crisis, the Federal Reserve lowered short-term rates about as much as they could.  Today, the 3-month Treasury yield is effectively zero.  Since it’s been between zero and 25 basis points for nearly three years, this is one policy tool that has been unavailable.  Arguably, that neutralizes one of the arguments for assigning significance to this indicator.

Economy ≠ Investment Environment

In a recent conference call, portfolio manager David Taylor – one of our favourite money managers – nicely captured the state of the economy.  He opined that the economy is at a tipping point; where it might be equally likely to tip into recovery mode or to fall into a recession.  But virtually all of those that are in the recovery camp agree that economic growth will remain sluggish.

If the economy is indeed at this tipping point, the shape of the yield curve may not be a good economic indicator today.  However, there is a strong argument for not even trying to figure out the economy with too much precision.  In his Q2 2011 commentary, portfolio manager Geoff MacDonald wrote about his view that the economy will be slower for longer.  More importantly he doesn’t try to figure out whether we’ll be in a recession or not in 2011.  But he does acknowledge that the economy faces significant headwinds – which aren’t going away quickly.

It’s certainly possible that the current decline will tip over into official bear market territory.  But that shouldn’t be surprising since bear markets have historically been clustered.  More importantly, a bad economic environment does not equate to a bad investment environment.  An economy that looks to be in its darkest days often gives birth to terrific investment opportunities.  While we haven’t seen widespread indiscriminate selling of stocks – as in 2008 – many great opportunities have emerged.

When hunting for investment opportunities, MacDonald is happy to invest in businesses even if their growth prospects are low or moderate.  The key, he says, is not paying for the growth.  And there are many quality businesses today that are growing – and should continue to grow – but are priced for zero or negative growth.

If the markets continue heading south, the bargains will keep getting better – which will simply set the stage for more attractive subsequent returns.  While stocks aren’t dirt cheap on a broad asset class level like they were a few years ago.  Then, you could throw your money at virtually any stock or any stock fund or ETF and do extremely well.  It’s not that easy today.  But the individual opportunities that have emerged imply that today is a good time to buy stocks selectively.

The Globe & Mail’s Rob Carrick recently wrote about the lessons learned from those investments that lost the most in calendar 2008.  One of his most important points is in the very first sentence where he wrote,  “Never buy an investment product without first checking how it performed in 2008“.  There are a couple of items related to this sound advice that are worthy of a more detailed discussion.

Isolating bear markets

To keep things simple so that readers can replicate the analysis, Carrick focused on calendar 2008 returns – an easy period for which to screen.  Since bear markets almost never fall neatly into any calendar year, it is more insightful to calculate bear market during isolated bear market periods.

To help in this exercise, the table below lists a handful of asset classes, their respective bear market losses, total return during the subsequent recoveries, associated time frames and total returns on the ’round trip’ for each.

Financial advisors and investors can use the above table when doing homework on a particular fund or other product.  Since it was listed in Rob Carrick’s table, I’ll use the Dynamic Power Canadian Growth fund to illustrate how to use the dates in the above table.  When digging into the fund, you can look up its profile on Globeinvestor and use the chart function.

The smaller the time increment, the larger the loss you’re likely to find.  This fund’s 50% loss in calendar 2008 is steep but its actual top-to-bottom loss is quite a bit larger.  Globeinvestor’s mutual fund charting tool – or something similar – can be used to calculate the loss using monthly returns.  Set the start date at May 2008 (the market peak based on month-end data), set the end date as February 2009 (the month-end market bottom) and select the S&P/TSX Total Return as the benchmark.  Click “Draw Chart” to update it and you’ll find that the index lost more than 43% (as noted above) but this fund actually lost 59% based on month-end data.  Daily data reveal an even worse loss, exceeding 63%, for this popular fund.

So even though the fund has soared 87% from the market bottom, the fund’s steep loss means that it still must gain more than 45% to touch its previous peak on a total return basis.  This is but one illustration of one of Carrick’s other points – the mathematics of loss recovery.

The bear market test

Once comfortable with this analysis, the tables below detail start and end dates and other selected data for U.S. and Canadian equity bear markets post-WWII.  Realistically, it may be relevant to replicate the above analysis for only the last two bear markets but it’s useful to look further back in time to get a better feel for overall risk for the asset class.

You’ll find that many funds sailed through the previous bear market that began in 2000.  This gave many investors too much confidence in the bear market saviours of that time.  Investors weren’t so lucky a few years ago since there was nowhere to hide within equity markets from the 2007-09 bear.  But starting with a simple screen (for calendar 2008 returns) and doing a bit of extra work to isolate bear market losses will help provide greater context of a fund’s historical risk.

– Sources of raw data:  Dr. Robert Schiller, S&P/Citigroup, BlackRock Inc.

– Data for U.S. stocks are in U.S. dollars.  Averages are for all U.S. stock bear markets starting in 1871

See also:  Five things you should know about bear markets (Dec 2008)

In this morning’s Globe & Mail, Shirley Won has an article on portfolio manager Noah Blackstein.  While yours truly is quoted in this piece, I mention it here because the article touches on a topic that I’ve been mulling for some time.

Historical value-added

In the article I commended Blackstein for his excess returns (above his benchmarks) over his tenure, which includes two bear markets.  I also made note of Blackstein’s high turnover.  But I’d like to add some context to both items and propose that there may be a link.

Blackstein began managing money for Dynamic funds in 1998.  (Side-note:  I met him more than a year earlier when he was an analyst at BPI Funds.  But now I’m aging myself.)  He began managing Dynamic Power American Growth in 1998.  Three years later he became lead manager of Dynamic Power Global Growth Class.

In both cases he has posted returns just north of 6% annually since each fund’s respective inception date.  Since Blackstein’s 1998 start in Power American Growth, U.S. stocks (in Canadian dollars) have been flat.  Global stocks, also in Canadian dollars, have also been about flat (-0.2% per year) since the fund’s 2001 birth.  So he has generated excess returns of about 6% annually on his Dynamic funds.

The magnitude of his outperformance is more impressive when you consider that his funds’ returns (as with all mutual funds) are reported net of each fund’s management expense ratio (MER) and brokerage costs incurred on stock trades.  The funds’ MERs, which range from 2.35% to 2.45%, were higher in previous years.

And given Blackstein’s heavy-trading style – turnover has averaged north of 300% annually in recent years – the funds have racked up a significant amount of trading costs (not included in the MER).  Blackstein has posted excess returns exceeding 600 basis points annually net of fees, expenses and trading costs totalling more than 3% annually.  (And his turnover is lower than it used to be.  I first began studying his American Growth fund in 2001 and I was struck by its 2,100% turnover rate for calendar 2000.  That’s no typo.)

The number of bets and confidence levels

Given that our firm advises wealthy families, our clients tend to have most of their wealth outside of tax-deferred and tax-free accounts.  Accordingly, we tend to favour money managers that don’t trade a lot to minimize taxes and fees.  (We also prefer managers with a longer-term view.)  But for the purposes of this discussion I propose that in the case of managers like Blackstein, the combination of high turnover and portfolio concentration may give a higher level of confidence in past excess returns.

Let me use the opposite extreme to illustrate.  Suppose a manager bought a bunch of stocks a dozen years ago and didn’t trade at all over the subsequent 12 years.  Assuming this low-turnover manager generated excess returns of 6% annually over the subsequent 12 years, one might be inclined to attribute success to luck.  All this hypothetical manager needed was to make good picks at the outset with no decisions thereafter.  I note that this is a big assumption since this manager may have been very active ‘behind-the-scenes’ and simply chose not to trade – which is sometimes harder.  But bear with me for a moment.

In Blackstein’s case, he has generated a similar amount of excess returns but he’s done so having made many more decisions or ‘bets’ as implied by his more than 300% annual turnover.  Extending this argument, Blackstein has always held a very concentrated portfolio of 20-25 stocks.  That level of concentration is another form of ‘bet’.  Portfolio managers can play it safe by holding a long list of stocks so that they don’t stand far apart from the index.  In Blackstein’s case, he not only is very concentrated but by trading a lot he’s giving himself many opportunities to make bad, money-losing decisions.  Overall, his trading appears to have enhanced returns.

This doesn’t mean that heavy-traders tend to generate more value added.  But where a money manager has generated returns in excess of his benchmark, it may be reasonable to assign a greater degree of confidence in managers that have achieved success while making a larger number of bets.  I’m not yet convinced of this but it strikes me as a reasonable thought to put forward.  That said, I’d love to hear others’ thoughts on this so don’t be shy to write a comment below.

Last week, I wrote about not reading too much into distributions paid by bond mutual fund and bond exchange-traded funds.  I admit to being surprised by the sensitive chord this struck with many investors.  In the spirit of brevity and focus, I glossed over some finer details pertaining to bond yields.  So, this week, I delve a bit deeper into a few issues that emerged from the many public and private messages I have received over the past week.

Clarifying YTM

The main thrust of last week’s post was to prompt investors to focus more on YTM than on current yield or distribution rates.  But even YTM is a theoretical figure.

Technically, a bond’s YTM is the rate of return that equates the purchase price of a bond with the present value of all future coupon payments and the repayment of the maturity (or par) value.  I gave the impression that a bond’s YTM is a definitive measure of a bond’s future return when held to maturity.  While it’s the best forward-looking estimate available, it’s not precise.

The YTM formula assumes that all interest payments are fully reinvested (without cost) into the same bond at the YTM.  This just isn’t possible because yields and YTM levels aren’t constant; and full reinvestment at no cost isn’t possible.

Relevance of YTM

Many sharp readers pointed out that most bond funds and ETFs don’t just hold bond to maturity, which would make the YTM figure less relevant.  This is a good point.  In fact, I was surprised by the amount of turnover in what is supposed to be a ‘passive’ bond fund.  Yet the iShares CDN Short-Term Bond Index ETF (XSB) has turned over its portfolio more than 60% annually over the past five years.  (See page 9 of XSB’s 2010 Management Report on Fund Performance for year-by-year turnover data.)

Despite the above points on the imprecision of YTM and the fact that bond yields can and do change, an investor’s ultimate return can’t be known with certainty in advance at any point in time.  But the YTM remains an excellent indicator of future total return over the term of the bond (or average term of a bond fund).  To that point, I would urge investors in bonds and bond funds/ETFs to focus on YTM when looking at return potential at the time of purchase.

Impact of rising rates

Many are leery of bonds today because of the prospect of rising interest rates (and the downward price pressure that would result).  And some argue that YTM isn’t such a good indicator of future fund or ETF return in a rising rate environment.  In this context, there are two important noteworthy points.

First, in all of my seventeen years in this industry there has been a near-constant sentiment that historically-low interest rates are poised to rise.  It’s true that the farther rates fall, the less room they have to fall.  However, as I wrote last year bonds remain one of the key portfolio building blocks.  While some might de-emphasize bonds a bit based on an expectation of rising rates, you don’t want to be out of them altogether.

Second, while many have been calling for the end of the bond bull market and the damage that awaits bond-heavy investors, I have rarely seen any quantification of the potential losses that bond investors could suffer.  So, I ran some simple calculations.

Bond bear market scenarios

Since XSB is the focus of last week’s post and the topic of many other articles, I start this illustration with a bond portfolio with a YTM of 2.11%, an average coupon of 3.62%, a term of 2.91 years and a duration of 2.72 years (all stats from the XSB profile page as of June 30, 2011).  Let’s assume that rates shoot up by 400 basis points in year one, kind of like they did in 1994.

Even 1994, the worst bond market since 1981, was followed by what turned out to be one of the best years on record for bonds.  In other words, bond yields don’t usually shoot up sharply and stay there.  They fluctuate.  So, if that initial 400 basis point rise is followed by two years of falling rates – e.g. each year falling by 100 basis points – the total return would be around 5% over the 2.91 year holding period.  That’s a loss of 7.45% in year one, followed by two years of about 6.5% gains, as shown in the table below.  That’s not bad considering the steep loss in year one.

What about the fear of rates rising and staying there?  The second scenario assumes the same 400 basis point rise in bond yield in year one.  But instead of subsequently rates falling, I assume that they stay flat after year one.  The result for year one is the same – i.e. a 7.45% loss.  With no rate changes, prices would remain stable thereafter.  But coupon interest would continue to be paid.  So, if you hold XSB for a time period equal to its average term to maturity – 2.91 years as of June 30 – you’ll basically be flat (technically a loss of 0.2% over the 2.91 years).  So even in a very negative scenario, capital remains largely intact over the average term of the fund.  The table below summarizes these two scenarios, showing selected data.

Even though the bonds in an ETF aren’t left to mature and assuming a fairly bearish scenario, simply holding a bond fund or ETF for a time period equal to its term upon purchase should minimize the chances of loss.  And if yields bounce around in both directions, as has been the case in the past, the chances of losing money are even slimmer.  Applying a similar analysis to mid-to-long-term bond funds would show similar results.

As I was finishing this post, I found two other related articles.  Read John Heinzl’s answers to reader questions about bonds vs. bond ETFs in the Globe and Mail.  Also, blogger Canadian Couch Potato does an excellent job of exploring the prospect of rising rates and how that might impact different parts of the bond market.

Some of my partners and I recently met with investors that have some commonalities pertaining to how they built their significant wealth.  Each of these investors, through a combination of hard work and good fortune, amassed significant wealth by making concentrated bets in relatively few stocks.  No doubt we’ve all heard stories about how somebody’s father or grandmother stock-piled shares of a company like Royal Bank, Coca-Cola decades ago.  Such stories all end happily with a pot of gold at the end of the rainbow.

These are real stories and there are many of them – and there will be more in future decades despite today’s gloomy mood.  From these many anecdotes and our recent client meetings, I’d like to highlight a couple of important points.

Survivorship Bias

Survivorship bias is a term often mentioned in the context of past performance comparisons.  Whether we’re talking about hedge funds, mutual funds or other similar products, simply looking at today’s funds with 10 or 20 year histories omits the funds that existed during those periods but didn’t survive through today.  The same concept can be extended to individual investors.

There are many investors who roll the dice on just a one or two stocks.  Some people choose well and hit the jackpot – again through varying proportions of luck and skill.  These are the investors that often visit firms like ours for advice.  We just don’t see the other investors that saw their concentrated bets work against them.  In other words, while hearing many of the strike-it-rich stories can give the impression that this is the path to prosperity, believe me when I tell you that far greater numbers of investors have permanently destroyed wealth using this approach.  This is not a high probability way of building wealth.

Sustainable wealth

Once investors have built significant wealth, however, there is another common thread that quickly appears.  Regardless of the source of investors’ monetary wealth every investor we’ve met with does not want to make their money twice.  In other words, by the time they visit HighView or other similar firms, wealthy investors are looking to keep what they’ve built.

Extending our example of the concentrated investors above, most investors in this situation understand that the way to sustain and responsibly grow wealth over time is to strike a more even balance between concentration and diversification.

So, the next time you hear the story of the widow who accumulated millions in a single telecom stock or the grandchild who inherited millions in one bank stock, stop and think.  Remember that for every such widow or young heir, there are many others whose stories don’t work their way through the grapevine – because they ended badly.

And remember that while the payoff from such concentrated bets can be huge, the odds are stacked against you winning with this approach.  Successful investing often comes down to tilting the odds in your favour as much as possible.  And to the extent that you can do that, you will be further along the path to building sustainable wealth.

(For more on the concept of sustainable wealth management, see our co-founder Mark Barnicutt’s April blog post:  A sustainable approach to the management of wealth)

Real estate has long formed the core of investors’ hard asset exposure.  Individuals and institutions invest in real estate for many reasons – i.e. diversification, cash flow and/or inflation protection.  As with asset classes beyond the basic (stocks, bonds and cash), investors are challenged to implement what is a sound theory.

Current landscape of real estate funds

At one time, there was no shortage of real estate mutual funds.  These funds invested directly in a portfolio of investment properties.  But the structural risks of real property funds became apparent during one of Canada’s worst real estate crises – pushing virtually all of these funds to either shut down or convert to real estate investment trusts (REITs).

As a result, most real estate mutual funds today either invest in REITs or shares of real estate management companies.  This ‘newer’ crop of real estate funds began in the mid-to-late 1990s but have seen a resurgence thanks to rock bottom government bond yields and the popularity of infrastructure investments – of which real estate is a significant component.  GlobeInvestor.com lists more than 70 real estate mutual and segregated funds covering about 25 mandates, the oldest of which was launched in 1995.

(Note that there exist many other funds that invest in properties and are sold under private placement rules that only accept new money as sufficient opportunities are identified by the managers.  These are much harder to find and require much more due diligence.  But they can be a better alternative for those with enough money to meet these funds’ much higher minimums and enough patience to give up mutual funds’ daily liquidity feature.)

Recently, I was asked by the Globe & Mail’s Shirley Won to comment on the CIBC Real Estate Equity fund – one of the older products.  As is often the case, there was not sufficient space to fit all of my comments into the article so I’ll offer them here for those interested.

There is no doubt that the fund has performed well, given its outperformance over the benchmark.  This is more impressive when you consider that the fund’s returns are after paying its hefty 2.9% annual management expense ratio and its beefy 0.32% annual trading expense ratio (the fund’s average TER over the past five years).  This relatively high TER resulted from an average turnover rate of nearly 80% per year over the past five years.

Muddied performance comparisons

The fund’s returns, however impressive, are a little more difficult to compare to the two-dozen or so mandates against which it competes.  Most real estate funds are global in nature.  As the name suggests, this CIBC fund is heavily tilted toward Canada.  CIBC Canadian Real Estate fund is one of just seven funds in the category with at least 70% of its assets in Canadian securities.  With a Canadian dollar that has soared compared to virtually every major currency over the past nine years, this gave the fund a distinct advantage that has nothing to do with the manager’s skill.

It’s also worth noting that the iShares S&P/TSX Capped REIT Index ETF has handily outperformed the CIBC fund (itself a top performer) even after neutralizing fee differences.  BMO launched a similar product – BMO Equal Weight REITs Index ETF – about a year ago.

There are other categories of funds that featured a wide variety of investment policies.  So, when comparing funds in categories like Real Estate Equity, High Yield Fixed Income or Canadian Dividend & Income Equity don’t spend too much time comparing performance within the group.  Focus instead on the type of exposure desired (to ensure the fund’s exposure matches your needs) and the specifics of the fund’s investment objective, strategy and portfolio manager.