In her latest Globe & Mail Number Cruncher, Shirley Won ranked the largest Canadian stock funds (including those with significant foreign stock holdings) by 5-year annualized return as of June 30, 2010.  The column also featured each of the funds’ 10-year annualized return and the last few calendar year returns.  The iShares S&P/TSX 60 Index Fund (XIU) topped the 5-year list with a 6.3% per year rise.  But it’s a cellar-dweller on the 10-year list with a 2.9% per year ascent.  What caught my attention were the reasons iShares gave for the big ETF’s bi-polar performance.

Won correctly pointed out that XIU’s hefty commodities exposure was a huge driver behind its 5-year outperformance.  The iShares representative quoted explained that its low 0.17% management expense ratio was also a factor.  Fees are always a factor but in XIU’s case its low MER has been trumped by other factors in explaining its performance – even over the past decade.

XIU’s underperformance for the ten years ending June 30, 2010 was dominated by the massive decline of technology stocks from their euphoric ascent.  Some will recall that Nortel Networks – now in restructuring mode – accounted for 45% of XIU’s market value at its peak.  That this ten-year period starts just a couple of months prior to Nortel’s peak explains the bulk of XIU’s poor performance.  The Nortel effect is so strong, XIU even underperformed most Canadian-Focused Equity funds, which were held back by a soaring loonie.

Be careful about reading too much into 10-year return figures, however.  End-date bias will skew comparisons for several months until the Nortel and tech stock effects fade away.  Once that effect is dropped from compound return numbers, XIU may well be more competitive – that is unless its 45% stake in commodity stocks knocks it back down to the basement.

I was quoted in today’s National Post regarding the launch of the Horizons AlphaPro Balanced ETF (HAA/TSX).  As is common practice in the ETF world, the firm only quotes the management fee on its website.  This fund, like most other AlphaPro offerings, charges a base management fee of 0.70% annually.  There was a time when an ETF’s management expense ratio was the same or just a few basis points above the base management fee.  It wasn’t unusual to see a sponsor eat the GST and operating expenses.  (See this Rob Carrick article for more on this.)  With a new tax and stiffer competition – making it tougher to grow assets – this is no longer the case.

We estimated that this new ETF’s fees might clock in at 1.09% annually (0.70% x 1.13 + 0.30%).  The firm countered that it expects the MER to slide in under the 1% barrier.  But this is not rocket science.

Most new funds have so little in assets that the fund sponsor routinely absorbs many of its costs for a few years.  Since AlphaPro is new and small it’s no surprise that the firm subsidizes costs for all of its ETFs.  The net amount of operating costs incurred, after the company’s subsidies, come in around 40 basis points annually (before the HST regime).  So, our estimate of 30 basis points of operating expenses is conservative.  Then again, the extent of subsidies is completely at AlphaPro’s discretion.  In other words, they can make the fees whatever they want for a year or two (maybe longer).  But this is not sustainable long-term.  The firm will have to attract enough new money into this and its other ETFs to bring fees down a sustainably low level.

But as Mark Barnicutt and I noted in a prior posting, they may do just that if they launch quality funds sub-advised by high calibre money managers.

Morningstar Canada recently introduced its Stewardship Grades for 27 Canadian fund companies.  Media coverage began slowly but picked up momentum.  The Toronto Star’s Jim Daw had some valid critique of the scoring scale.  Then, Tom Bradley devoted his Globe and Mail column to the topic.  (Note:  Bradley’s Steadyhand Investment Funds ranked 8 out of 8 on Morningstar’s stewardship scale – the only perfect score of the more than two dozen surveyed firms.)

This story took an interesting twist when the Financial Post’s Jonathan Chevreau reported on his blog that the Investment Funds Institute of Canada (IFIC) attempted to block Morningstar from publishing their findings (which drew a response from Morningstar Canada CEO Scott Mackenzie).  Chevreau later wrote a related article for the paper.  There is a lot to this issue but I’ll zero in on a few items.

Industry lobbying

I have no illusions about IFIC’s raison d’être.  While they provide some helpful information for consumers, IFIC is an industry trade group that lobbies on behalf of its members – sponsors of mutual fund firms and the dealers that sell mutual funds.  Sometimes the interests of its members align with those of retail investors and sometimes they don’t.  Two decades ago they lobbied to classify trailer fees as commissions so that they would not be subject to GST.

They have spoken out on the recent HST implementation on the grounds that it unfairly taxes mutual funds compared to other investment and deposit products.  Their members have launched many products that appear aimed more at gathering assets than to further investors’ wealth accumulation.  I know all of this.  Yet, I was a bit surprised to learn of IFIC’s letter to Morningstar’s Chicago-based director of research in an effort to fight the release of Canadian stewardship grades.

Perhaps the argument I found most puzzling was the part where IFIC charges that Morningstar is “attempting to impose a new regulatory standard in place of the existing robust regulatory set of standards currently active in Canada” – and concluding that the new Stewardship Grades have no predictive value in an attempt to persuade Morningstar to sit on the study.  While Morningstar may be considered a competitor to HighView on some level, I fully support their efforts at making stewardship information available to the public temporarily and, later, to their paying clients.

You have to admire the irony in this story, however.  Fearing a media parade would follow the release of the stewardship grades, IFIC attempted to block their release.  In fact, the media was very quiet about the whole thing at first.  And a key factor fueling the story is IFIC’s surprising tactic.

The meaning and importance of stewardship

Stewardship is often confused with compliance.  As some of my partners have explained, compliance is about doing things right whereas stewardship is about doing the right thing.  The concept of stewardship is woven into everything HighView does, which is why our CEO, Mark Barnicutt, authored a paper entitled Return of the Investment Steward at the height of the credit crisis in late 2008.  A year later, in December 2009, it drove the spirit of our Chairman’s letter on our homepage.  It’s also the name of this blog, The Wealth Steward.  And we use fiduciary (the word and the concept) when describing who we are and what we do.

Stewardship is a simple concept – put clients’ interests ahead of our own – and it’s the obligation of fiduciaries.  All fund companies are fiduciaries because they have discretion over their end clients’ assets.  So, if those firms are legally held to be fiduciaries, there’s nothing extraordinary about holding them to that standard as part of the research process.

For more than a decade, I’ve been asking money managers about how they invest their personal net worth and how their bonus is calculated.  My partners at HighView have done the same – and this is a standard line of questioning that we continue to ask.  We’ve always asked several questions and monitored business decisions and marketing materials aimed at evaluating company culture.

Any worthwhile analyst asks these as part of his/her basic due diligence process.  And no serious money management firm worth talking to will refuse to answer these questions.  Inquiring about competing interests and company policies is not akin to setting a new regulatory standard – as IFIC suggests – but prudent due diligence that our clients (and, in turn, our clients’ clients) appreciate and perhaps expect.

Critiquing the work of others is much easier than actually doing the work or coming up with solutions.  There are weaknesses to any method (which I touch on below) but attempting to discredit the entire effort on that basis is misguided in my view.  If IFIC really wants a better solution for the industry, they’ll make suggestions on how to improve the stewardship grading methodology.

Limitations of stewardship grades

Overall, I think Morningstar has done a good job on the method and execution of their stewardship grades.  I note, also, that Morningstar Canada was a client of mine many years ago and I have a lot of respect for the people at 1 Toronto Street.  In that context, I have thought of a couple of questions or limitations that are worth highlighting.

One issue that stood out for me was the regulatory component of the grades.  A fund company can lose as many as two points (on their eight-point scale) due to the existence of any regulatory problems over the previous seven years.  I highlight the time frame because Morningstar’s stewardship grades seemingly missed the regulatory issue of the decade for mutual funds.  Remember the market timing scandal?

While the market timing activity ended around mid-2003 (just seven years ago), settlement payments for this activity were agreed to in December 2004.  Fund companies that settled were AGF, AIC (now part of Manulife), CI, Investors Group and Franklin Templeton.  Broker/dealers that settled were subsidiaries of BMO, RBC, TD and Investors Group.  And in one or two of those brokerage settlements the related fund company involved was not one of the five settling fund companies.  And it’s clear that at least a couple of fund companies and/or dealers (in addition to this list) were involved in market timing.

In the course of our research we’ve uncovered a fund company – one that received a good culture grade and had no regulatory deductions – that purchased shares in a related company in one of its funds.  Since the firm has followed all of the rules, technically, it’s not considered a regulatory issue.  Accordingly, the trade was not reviewed by the IRC.  But when we discovered all of the facts, we have zero doubt that a conflict of interest existed, whether or not the law defines it as such.

(Only our paying clients will learn the identity of this organization later this summer as we decide how this impacts our opinion of the firm.)

Yet this is an issue, understandably, that the stewardship grades missed because it required a fair bit of digging to uncover and pursue the issue.  To be fair, we won’t uncover every issue and there will be things that we miss.  But these are two significant instances that should illustrate that every method has its limitations.

Accordingly, advisors and investors should make use of the stewardship grades since they contain useful information – and they’re free for the summer.  But use them as a screen and in conjunction with your own due diligence and knowledge of the various fund companies.  If nothing else, getting you to think like a fiduciary and holding the firms with which you entrust client money to a fiduciary standard can only benefit your practice.

Financial advisor compensation is one of those topics that is hotly debated but never fully resolved.  A recent article by the National Post’s Jon Chevreau sparked a private exchange between me and another person quoted in that article.  The exchange raised a number of issues, some of which I consider misunderstandings pertaining to advisor compensation.

Is fee-only superior to commission?

Fee-only refers to advisor remuneration that is paid entirely by the client – and nobody else.  Commissions on the other hand see product sponsors paying advisors for placing client money in their products.  If the introduction of the GST in 1990 is any indication, Canadians may prefer bundled and hidden fees.  There are arguments in favour of both forms of paying advisors for their work.

Fee-only advisors, who usually charge some percentage of client assets, don’t usually offer lower fees for clients.  Fee-only advisors’ advantage lies in the transparency and the resulting accountability.  But this is not the exclusive domain of fee-only advisors.  Forward-thinking advisors who are paid by commissions can create the same level of transparency.  When I was a dedicated research support for a MFDA dealer I created investment policy statements for advisors’ clients with portfolios valued at $250,000 or more.

I wrote the IPSs and detailed portfolio recommendations on one condition – the advisor had to include my plain language explanation of various fees and commissions and a dollars-and-cents disclosure of the weighted average MER on the current and recommended fund portfolios.  In every case, our advisor was the first to provide that kind of disclosure.  Presto – clear transparency on fees and a professionally-written IPS.  It’s not rocket science; any advisor can effect the same transparency in a commission model (if they can get their compliance department onside).

Neither model is categorically superior in my opinion.  With good disclosure, the choice comes down to suitability, which is based on client-specific factors including portfolio size, range of services required, client personality and preferences.

Do load funds create an equity bias?

Some charge that because trailing commissions are higher on equity funds (1% annually) than on bond funds (0.5%/yr) that the advisor can make more money if s/he can justify a higher equity weighting.  Indeed, there are consultants like Nick Murray who espouse an all-stocks-all-the-time strategy that, in my view, is disconnected from investor behavioural realities – but that’s another topic.  The argument is that by charging the same fee for all asset classes, the advisor’s conflict disappears.  But this structure is not conflict-free.

Fee-only advisors typically charge an amount starting from 1% per year of the value of their client’s portfolio.  By charging 1% on stocks and bonds, the fee-only advisor may well find himself with the same equity bias as his commission-based counterpart, albeit for different reasons.

Consider that the Canadian bond market sports a weighted yield to maturity of about 3% annually at the time of writing.  An advisory fee of 1%, in addition to the underlying cost of the bonds (let’s assume 0.3% for an ETF) and taxes on both brings total costs somewhere around 1.37% per annum (1.47% after HST is implemented).  That’s almost half of available bond yield.

A forward thinking advisor could easily do that calculation and figure that his clients with balanced portfolios will not be happy after a few years when they find they’ve made next to nothing on their bonds net of fees, in a best case scenario.  This advisor might just as well want to find a reason to recommend a heavier stock allocation simply to avoid the risk of disappointing clients and losing their business.  Such business risk is also tightly linked to compensation because fewer clients = fewer assets on which to charge fees = lower revenue for the practice.

So the answer to the above question is ‘yes’ but it’s ‘yes’ for both fee-only and commission models.

Which method pays advisors/costs clients more?

This cannot fairly be generalized.  In theory, commission-based advisors have just as much flexibility on pricing as their fee-only peers.  In my days with the MFDA dealer, I introduced many of our advisors – and their clients – to funds from solid low-fee boutique money management firms.  Even though the trailing commissions were a skinny 0.2% to 0.4% annually, advisors were happy to include these quality products.  Sure such low-fee funds paid them less but were used for part (not all) of the portfolio.

And the advisor was the only one of her peers presenting a professionally-written IPS containing unique solutions blending traditional load funds with cheaper products from institutional boutique firms.  I still get calls today from those advisors thanking me for designing such solutions for their clients.  My point isn’t to give myself a pat but to demonstrate that forward-thinking advisors can compete head-to-head with their fee-only competitors on fees and quality when they choose to do so.

The commission-based advisors who don’t operate in this fashion may have a harder time competing for larger clients.  Some will use fee-based offerings from various fund companies to satisfy their high net worth client needs but that product segment is seriously lacking in quality.  (Sales pitch alert:  this is where our Guided Portfolio Package, Managed Funds Program and Managed Investments Program can add real value for advisors, dealers and clients.)

Which model is free from conflicts of interest?

No method of paying an advisor is free from potential conflicts.  Commission-based advisors and fee-only advisors have a bias toward advice that leaves more money invested so that they can continue generating revenue off of a larger asset base.  Some consider paying an hourly fee for an advisor’s time, or a flat fee-for-service, is the solution.  It’s not.  First of all, the increased costs of new regulation make this model unfeasible for a firm that is actually licensed to give individualized investment advice.

Second, these structures have unique conflicts.  Paying an hourly fee could motivate ethically challenged advisors to recommend unnecessary work or pad the time sheet to maximize revenue.  Flat dollar fees for specific services will have the reverse effect.  Since the fee is fixed, it could motivate advisors to minimize the amount of time spent on client files in order to maximize the effective hourly rate.

Good advisors know that their revenue comes from clients, whether it’s direct or indirect.  And good advisors feel that it is their responsibility to provide great value for the fees or commissions they receive.  In other words, good wealth stewards are not defined by their method of compensation but rather by their character and conduct.

I have been a happy ING DIRECT banking and insurance client for more than a dozen years.  A little more than two years ago, they sent me (and presumably all of their clients) a brochure on their then-new Streetwise Funds® which extolled the virtues of indexing and minimizing costs.  In very broad terms, I won’t argue against an approach aimed at delivering broad diversification with low fees.  But that initial promotion placed ING DIRECT among the industry’s most impressive spin-doctors.  The table below summarizes my observations from the original brochure I received promoting these funds.

So why bother talking about two-year-old information?  Between its recent press release and the Streetwise Funds® website, ING DIRECT continues to use nearly all of these arguments.  For instance, two years after I received my first brochure, the June 2010 release states in part, “And because The Streetwise Funds use an index-based approach, they keep costs down with a low 1% MER compared to an average 2.6% MER that Canadians pay for the average balanced fund“.  This figure is, in fact, eight years old and a full 30% above what Canadians actually pay, on average, for all balanced funds (i.e. equity balanced, fixed income balanced, neutral balanced, Canadian, foreign, fund of funds, target date, etc).

I admit to holding ING DIRECT to a somewhat higher standard than your garden variety mutual fund company for two reasons.

First, the Streetwise campaign is squarely focused on fees and putting more jingle in its clients’ jeans.  And yet they’re offering a rather expensive product by index fund/ETF standards.  Second, ING DIRECT gives the impression that it is unlike most other institutions – i.e. “the unmortgage” – by being more customer-friendly and transparent.  And its advertising seemingly targets a large contingent of generally unsophisticated investors.  And it appears, from my perspective as a client and industry analyst, that they are being less than forthcoming in this mutual fund promotion.

Having said all of that, I concede that these funds could be a decent starting point for unsophisticated investors that already deal with ING DIRECT.  The irony is that as those same investors become more knowledgeable and confident, they may soon realize just how much they can save by trading in their Streetwise Funds® for cheaper unbundled options.

In a recent blog post, I warned that advisors may face investment, competitive and/or compliance challenges when using ETFs in a fee-based account for clients.  In the May 2010 issue of Investment Executive, I took the opposite side of the issue by detailing how diligent advisors can add value to fee-based ETF portfolios.  Advisors aren’t the only segment of the industry making greater use of ETFs.

Actively managing ETFs

Money managers also appear to be making more use of these popular products.  In a recent Globe & Mail article, I noted that this is partly because the number of ETFs has exploded in recent years.  My earliest recollection of mutual fund managers using ETFs dates back to BPI Global Asset Management of Boca Raton, Florida in the mid-to-late 1990s.  They routinely used ETFs to mop up excess cash while they searched for stocks to buy – a practice still in use today by many firms.  Then, in 2001, Spectrum Investments (later acquired by CI) launched Spectrum Tactonics– which used technical analysis to trade in and out of North American ETFs.

With a wider array of new ETFs came broader uses of ETFs by money managers.  The likes of Christine Hughes (formerly of AGF), Frank Mersch and Eric Sprotthave used some of the short ETFs available on the U.S. market as part of their permitted short exposure.  And a few funds, like BMO Guardian Global Absolute Return, have long included the SPDR Gold ETF (or something similar) among its top holdings – as a more efficient way of holding bullion.

Panic over Greece

Gold bullion is becoming increasingly popular.  But gold’s price ascent is not the result of booming industrial or commercial demand.  It’s because of soaring investment demand fueled by fears that high government debt will devalue paper currencies across the globe.  Indeed, the situation in Greece (and the EU) recently caused markets to go haywire – which tends to give investors a nudge.

When markets hit a euphoric high, investors become disenchanted with bonds and feel that their bonds and cash can be more productive in soaring stock markets.  When we get days like May 6, 2010 investors start to wonder if they should dial back their stock allocation and stuff the proceeds into safer bonds and cash.  And so it goes.  Accordingly, my advice in this recent National Post article was essentially to sit tight in light of the panic over Greece.  Some might question such advice but selling into a panic has rarely proven to be a good move.  With elevated valuations, risk is higher than it was a year ago.

But this is not reason to panic unless investment strategy doesn’t line up with an investor’s short-, medium- and long-term goals.  Rocky stock markets simply lend more merit to the goals-based approach to investment strategy design that HighView espouses, which matches assets to future spending liabilities in the context of a client’s respective time horizons.  And when funding of future liabilities is on track, it becomes easier to navigate the market’s wild swings.

Advisor.ca reported on my talk at the Strategy Institute Mutual Fund Point-of-Sale (POS) Summit.  The panel in which I participated focused on Product Arbitrage – the situation that results when similar products are not treated the same by prevailing rules and regulations.  Where regulations result in a lower barrier to selling for some products (compared to others), arbitrage will result.  Indeed, I’ve heard of many advisors dropping their mutual fund sales licenses to focus on less regulated segregated funds.  While the POS initiative applies to both mutual and seg funds, arbitrage still exists between these two products (not to mention many others).

As for the panel discussion, I tried to stay on topic.  But nearly three years ago, I laid out two key reasons why I thought the Joint Forum‘s POS initiative, as proposed, will fail.  See my article in the mid-November 2007 issue of Investment Executive.

In the April 2010 Investment Executive, I touch on some of the challenges that advisors face in transitioning to an index-oriented fee-based business model.  Keep an eye out for my follow-up in the May issue, in which I will outline where advisors can really add value to ETF or index-fund portfolios.

On the other end of the investing spectrum, in this Globe & Mail article, I commented on market neutral (MN) funds and the difficulty of putting the theory into practice.  There is some explanation that couldn’t fit into the article.  In theory, adding MN funds can enhance a portfolio’s risk-return profile.

Investment theory holds that any performance in excess of risk-free alternatives like Treasury Bills comes only from taking stock market risk.  If you have zero exposure to market risk, you should expect the same return as T-Bills.  To generate performance above that, some market risk exposure is required.

Beta is a measure of exposure to market risk.  MN funds, then, target a beta of zero (i.e. no market risk) while shooting for annualized returns of T-Bills plus, for example, 5 percentage points.  To the extent they can achieve this target, they’ve done their job and, in this case, will enhance a portfolio’s risk-return profile.  In poor markets, like 2008 and 2002, a market neutral fund should be flat or generate modestly positive returns.  In soaring markets, market neutral funds should post respectable returns that lag sharply recovering stock markets.

So, the first difficulty in finding a good market-neutral manager is tied to the fact that many managers can’t successfully execute on their stated goal (of zero beta + hitting return targets).  Second, successfully choosing such a fund is fraught with difficulty thanks to opaque structures, secrecy of managers and the wide gap between returns of good and bad managers.  One of the funds mentioned in the above article, Picton Mahoney Market Neutral Equity, outperformed the index in 2006 and 2007 – both strong years for Canadian stocks.  So, some of its strong overall performance likely came from being net long, not from being neutral.  Clearly Picton Mahoney made the right call but this is not strictly a market neutral fund but more of an actively managed hedge fund.

None of this debunks the notion that market neutral funds – or hedge funds in general – have potential portfolio benefits.  But venturing down this path involves challenges and limitations of putting this alluring theory to work in real time.

In a recent Globe & Mail article, I recommended two mutual funds focused on generating regular income.

In the March issue of Investment Executive, I opine that the ETF industry is following in the footsteps of the larger and older mutual fund industry.

This CBC Windsor Radio One panel discussion, in which I participated, tackles the Loonie’s recent ascent.