This restriction has come under question lately, a recent manifestation being a paper written by Poonam Puri, an Associate Professor of Law at Osgoode Hall Law School. There are two main complaints:

• pension funds are blocked from becoming active investors and pursuing the maximization of shareholder value
• Canadian pension funds are put at a competitive disadvantage vis-à-vis foreign pension funds (Canada is the only OECD country that imposes such a rule).

Professor Puri argues the rule should be abolished for the above two reasons plus the fact pension funds are increasingly finding ways to get around the rule anyways. He cites three instances by the Ontario Teachers’ Pension Fund to achieve technical compliance with the 30% rule:

• use of convertible debt (e.g. private placement of convertible debentures from Railpower Technologies Corp. in 2007)
• use of convertible non-voting shares (e.g. non-voting shares issued by Maple Leaf Foods Inc. in 2007)
• use of a shell company to own and vote shares as the pension fund directs (e.g. attempt to privatize BCE Inc.)

The professor makes a good case. But what about the original purpose of the rule — which was to prevent pension funds from owning major pieces of the Canadian economy? Pension funds represent the interests of specific social groups such as unionized teachers, auto workers, and civil servants: would companies and sectors controlled by their pension funds be run in a way beneficial to the companies themselves, minority shareholders, and indeed, the whole of society — or more in the interests of these organized groups and their retirees?

The table below contains numbers for the 15- and 20-year periods (ending 2008). As can be seen, the dividend-growth approach beats the S&P 500 by about 1.5 percentage points a year in both periods. The one qualm is uncertainty over Mergent’s choice of S&P 500 Index. It would be appropriate to do the comparison with the total return S&P 500 yet I could not find in the document an explicit reference to using that version.

Regardless, a 9.73% average annual return in dividend growth stocks over 20 years is laudable in itself. So is the 8% average annual return over the past 15 years. And with dividend yields currently still elevated relative to historical norms in the aftermath of the financial crisis of 2008, the return from owning dividend-growth stocks over the next 15 to 20 years could potentially be even better than what is shown below.

The One-Minute Portfolio (OMP) is a passively indexed portfolio, one that runs with a minimum of effort. It has been rebalanced annually and consists of just two exchange-traded funds (ETFs): iShares Canadian Bond Index ETF (XBB) representing bonds, and iShares S&P/TSX 60 Index ETF (XIU) representing equities.

So far the decision to hike the allocation to equities during the rebalancing in December is paying off. But we shall see what ultimately unfolds as 2009 wears on. For more details on the OMP, check out the December 18th article on the last rebalancing.

Yet, as reported on stockchase.com, a good number of money managers appearing on the Business News Network (BNN) channel have voiced bullish views on BCE. Here’s a quick look at their reasons:

• David Baskin of Baskin Financial Services - one of his top picks, says he likes the strong cash flow and pledge to raise the dividend
• Steven Conville of Blackmont Capital - thinks BCE has the best balance sheet of the three major telcos and is nice defensive play
• Laura Wallace of Coleford Investment Management - sees strong management with a well-defined plan to cut costs aggressively
• Bruce Campbell of Campbell and Lee Investment Management – one of his top picks, cites the price currently being depressed by the Ontario Teacher’s Pension fund selling off its stake in BCE
• Ross Healy of Strategic Analysis Corp – a top pick for him because it is cheap, having fallen to an all-time low at its book value of about $22 a share
• Craig MacAdam of Aurion Capital – would buy because balance sheet and new management is quite strong
• Colin Stewart of J.C. Clark Investments Ltd. - trades at a low valuation multiple of about 4.5 to 5 enterprise/EBITDA

The bearish money managers on BNN don’t recommend BCE because it’s a defensive, utility stock and such stocks tend to lag during economic upturns. They also don’t like its growth prospects vis a vis peers: Telus is seen as the better telco for wireless-growth prospects and Rogers Communications is seen as having the better technology over the longer term. 

I’m not bullish on BCE’s long-term prospects either but did buy the stock when it crashed after the privatization bid collapsed, thinking it would be good to hold for a while for the income and buybacks (and a possible sale around $28 to $30). I feel encouraged to continue holding for several of the reasons given by the bullish money mangers.

Last week, there was a bit of a rally in BCE shares. Also, its bond sale was oversubscribed and raised $1 billion. And a report out during the week from BMO Nesbit Burns predicted BCE Inc. will use its excess cash to renew its stock buyback. The company currently pays out 65% of earnings per share.

In a Globe and Mail interview a few days ago, Bissett Investment Management senior vice-president Juliette John said “BCE has become more shareholder-friendly: It has been buying back stock, raising its dividend and cutting costs.” As for coming wireless competition, she doesn’t think it will be a serious threat to existing providers given the sluggish economy and tight credit conditions.

iShares CDN MSCI World Index Fund (XWD)

• tracks the MSCI World Index, which covers 1,500 stocks from 23 developed markets, including Canada and the United States (but not emerging markets)
• it does this by investing in U.S-based, country-focused iShares ETFs in proportion to the weighting pattern in the MSCI World Index
• MER is 0.45%
• denominated in U.S. dollars (not hedged back to Canadian dollars)
• because invests in a large number of countries, foreign currency exposure will be broadly diversified

iShares CDN MSCI Emerging Markets Index Fund (XEM)

• tracks MSCI Emerging Markets Index, which cover stocks in emerging countries
•  does this by investing in U.S.-based iShares MSCI Emerging Markets ETF (EEM)
• MER is 0.82%
• denominated in U.S. dollars (not hedged back to Canadian dollars)
• because invests in a large number of countries, foreign currency exposure will be broadly diversified

These new ETFs join the three other foreign-equity iShares ETFs: iShares CDN MSCI EAFE Index, iShares CDN S&P 500 Index and iShares CDN Russell 2000 Index Funds. These three existing iShares foreign-equity ETFs are currency hedged (back to Canadian dollars).

Why not invest in U.S.-based ETFs instead?

Are the two new ETFs worth investing in? Why not just invest in U.S.-based ETFs tracking the same markets with lower MERs — like those in the Vanguard group? 

The main reason for investing in the iShares ETFs instead of  U.S.-based ETFs, as given in the iShares news release, is to avoid “… estate tax considerations usually associated with U.S.-listed ETFs.” This is a reference to the fact that Canadians owning U.S. assets face a U.S. estate tax on those assets in the event of their death.

However, if the value of a Canadian’s worldwide gross estate is less than $3.5 million (U.S), they are exempt in 2009. In 2010, there will be no limit.

The threshold will come down to $1.78 million (U.S.) in 2011, which includes $780,000 in credits. Another $780,000 U.S. in credits is available if your assets are willed to your spouse. This would bring the effective ceiling to $2.5 million (U.S), which still leaves most Canadians unaffected. It would appear most Canadians thus need not worry about U.S. estate taxes.

Even if one is over the threshold, there are several strategies for minimizing U.S. estate taxes. For example, one can hold U.S. assets in a corporation (as discussed in tax guides such as Tim Cestnick’s 101 Tax Secrets for Canadians (2008 edition).

Investing directly in the U.S.-based ETFs also avoids extra tax, according to posts by Canadian Capitalist blogger. As he concludes:

“If a Canadian ETF simply holds a U.S.-listed ETF, an additional tax drag is created due to withholding taxes that are not recoverable when the ETF is held within a RRSP account. It may be cheaper, instead, to simply hold the US-listed ETF directly.”

The study, authored by Lily Fang and Joel Peress, is to be published in a forthcoming issue of the Journal of Finance under the title “Media Coverage and the Cross-Section of Stock Returns.” The authors note that the outperformance of stocks not covered by the media is particularly large among i) small caps, ii) stocks with low analyst coverage, iii) stocks primarily owned by individuals, and iv) stocks with high volatility relative to the market. For some of these subclasses, the annual premium ranges from 8% to 12% after risk adjustments.

Highlights from other studies

Another study in the genre is Paul Tetlick’s, “Giving content to investor sentiment: the role of media in the stock market,” which was published in the Journal of Finance in 2007. He did a word-content analysis of one of the most widely read summaries of daily stock market activity, the Wall Street Journal’s Abreast of the Market” column, from 1984 to 1999. He found that a rise in the number of pessimistic words in the column foreshadowed a market downturn the next day.

Tetlick’s view is that professional investors have their own sources of information such that they usually know about the information before it gets published in the media. Readers of the media are thus reacting to “stale” data, causing an overshoot in prices. After they drive the prices of mentioned stocks up or down, sophisticated investors will return prices to their fundamentals by buying the stocks experiencing media-induced dips and/or shorting the stocks with media-induced spikes.

In a 1990 Journal of Business article, “Clearly heard on the Street: The effect of takeover rumors on stock prices,” there is a similar message that new information tends to be discounted in the market before it appears in the media. Authors John Pound and Richard Zeckhauser examine the impact of takeover rumors published in the Wall Street Journal’s “Heard on the Street” and finds “trading strategies based on buying or selling rumored targets’ stocks yield zero excess returns. They also observe that stock prices of rumored takeover targets run up in the month before publication.

In “All that glitters: The effect of attention and news on the buying behavior of individual and institutional investors,” Review of Financial Studies (2007), Brad Barber and Terry Odean confirm the “hypothesis that individual investors are more likely to buy than sell attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one day returns.”

Paul Tetlock, Maytal Saar-Tsechansky, and Sofus Macskassy find in “More than words: Quantifying language to measure firms’ fundamentals,” Journal of Finance (2007) that the fraction of negative words in Wall Street Journal and Dow Jones News Service stories about individual S&P 500 firms from 1980 to 2004 predicts earnings and stock returns.

Felix J. Meschke’s Arizona State University 2004 working paper, “CEO interviews on CNBC,” concludes that stocks of companies whose CEOs were interviewed on CNBC between 1999 and 2001 experienced a strong run-up initially, but in the following days exhibited strong mean reversal so that the “abnormal” cumulative return (i.e. return relative to market) was -2.8%

Q. Can you give readers a bit of a background on yourself?

A. I have approximately 25 years of experience in asset management – all of it in the realm of indexed and quantitative investing, including ETFs. I was with Barclays Global Investors Canada Limited for 14 years, joining them in their very early days to establish the investment side of the business. For the last four and a half years I served as President and CEO….

When BGI decided to move its investment management operations to San Francisco I elected to remain in Canada. I am extremely proud to be with BMO - the only bank that is taking a leadership role in Canada by offering ETFs to Canadian investors.

Q. Why another family of ETFs? 

A. BMO has a long and strong tradition in providing investment solutions for all of the client segments that we serve … we see BMO ETFs as another means of ensuring that our customers have access to an even broader range of solutions that meet their evolving investment and savings needs.

ETFs are consistent and resonate with BMO’s vision to “make money make sense” by providing products that are very transparent and simple to understand for the retail investor. At the same time ETFs can be the building blocks for comprehensive portfolio construction for sophisticated HNW and institutional customers ….

Competition is good for the industry – it will increase awareness and education regarding ETFs among clients and ultimately works to their benefit.

Q. How can BMO succeed in the ETF space in light of TD Bank’s experience a few years ago?

A. We will follow a two pronged strategy to ensure success:

Firstly, we intend to give investors comprehensive and efficient home-grown solutions for their ever evolving investment needs. With our four BMO ETFs that are already launched and the three more that are coming in July we are providing investors with a broad and robust initial offering. And we plan to add to these significantly in the coming months so that as investors need change we are always there for them. (TD only had four before it decided to pull back from market).

Secondly, BMO will put significant educational and sales support in ensuring that the marketplace and investors are fully aware of all the benefits that BMO ETFs bring to their portfolios. In this we will work to support investment advisors and end-clients alike.

Q. Where are the growth areas in the ETF industry?

A. ETFs are experiencing broad based growth – across asset classes and across geographies.

• World wide the growth has been incredible with assets increasing by 65% over the last three years.

• In Canada, the growth was 8% in 2008 to over $19B, which is remarkable given that the majority of market indexes plummeted more than 30% and ETF AUM was up $7.3B compared to net redemptions of $10.5B for mutual funds.

• This is a market that is forecasted to grow to $105B by 2016 in Canada and a product that our clients have expressed a need and desire for.

Some observers have speculated that this trend represents a shift to do-it-yourself investing. Disenchanted with the losses they were incurring, investors are “firing” their advisors and venturing out on their own. Or they are dumping mutual funds with their high fees for exchange-traded funds and stocks. But a survey of 65,000 investors earlier this year by J.D. Power & Associates (for its Full Service Investor study to be released June 24) found a different explanation.

In a mini-whitepaper released today, J.D. Power says the trend is driven more by the desire of investors to diversify over investment channels. That is, investors at full-service brokers are increasingly opening up accounts with online discount brokers: in last year’s survey, 25% of full-service investors reported using an online brokerage firm whereas in this years’ survey, the percentage using an online brokerage had jumped to 36%.

Why so? The mini-paper postulates that the bear market has spawned a new frugality, “a situation in which an investor might call their advisor to get recommendations on portfolio mix and stock selection, but then turn around and place their order online for $9 or $7 per trade rather than spending $250—or 2% of total transaction value—by trading through an advisor.” In a bull market, investors might not mind full-service commissions but when they are losing money, that extra trading charge could become painful enough motivate opening up an account with an online broker.

Below follows an interesting chart from the mini-white paper: “Investment Advisory Services Used By Investors in Canada.” The 41% “None’ category includes investors i) who do not have investable assets other than employer pensions and stock plans or ii) do not use investment advisory firms.

I would have liked to have seen on the chart a separate number for those not using an advisor – i.e. exclusively a discount online broker. But elsewhere in the document, it says the percentage who fall into this category (if I understand right) is 16% — which the document says was still on the low side (I guess they mean in relation to other countries).

Many investors are now buying gas stocks and exchange traded funds (ETF), thinking they are cheap. Of note, trading volumes are soaring for the United States Natural Gas (UNG) and the Claymore Natural Gas Commodity ETF (GAS), the ETF tracking Canadian gas prices.

But new sources of supply are emerging in areas such as shale gas and LNG due to technological advancements. In the U.S. alone, the Potential Gas Committee reports that there are now about 2,000-trillion cubic feet of recoverable natural gas still in the ground, a nearly 60% increase from estimates four years ago.

Given this upward structural shift in gas supply, wouldn’t it be possible that a great deal of the narrowing in the spread between gas and oil prices will come about from lower oil prices instead? The oversupply situation in gas could be like an anchor that weighs down oil prices, as energy users increasingly switch from oil to much cheaper gas (and speculators catch on to the dynamics). The substitution effect may also get a boost from governments favoring natural gas as a cleaner-burning fuel with less dependence on foreign suppliers.

Who knows, maybe we are entering a period of inexpensive energy prices again? The Peak Oil thesis had us going for awhile. However, other fuels such as natural gas could perhaps step up to the plate and keep prices reasonably sane.

In fact, I found it well written and easily understood. It doesn’t get bogged down in a lot technical minutia but explains in an intuitive way the central ideas such as the Black-Scholes method for valuing options and implied volatility (all in the first third of the book). As long as we understand the ideas behind the formulae, we can let the online calculators do the actual crunching of the numbers.

Still, I have to admit when I first picked up the book, I was a bit wary. The leverage in options is seen by many people as the route to a big score, but statistics show that the vast majority of option users with such aggressive orientations end up loosing their money. Then they swear off options for good, denying themselves a tool that could improve the performance of their portfolio in other ways.

But the author won me over with his sensible approach. Throughout the book he cautions readers to avoid swinging for the fences and instead focus on using options to reduce risk and/or implement conservative strategies that belt out singles and doubles. Small, but consistent, gains are a more sustainable strategy that trying to hit home runs.

Even if you want to use options to speculate aggressively, you should begin with conservative strategies, recommends the author. There is no better way to learn about options and see how they are affected by volatility, time decay, etc. than actually trading them — so do it in a manner where loses aren’t going to be overwhelming. I thought that bit of advice was worth the price of admission itself. It takes away some of the fear for the neophyte to know they can ease into options in a relatively safe way.

Wolfinger allots about a third of the book to explaining three strategies for conservative and/or beginning investors: i) covered call writing (selling options against stock holdings to earn extra income, ii) collars (adding a put option to a covered call position to protect against a large loss), and iii) cash-secured, or naked, put writing (sell a put option to earn income and buy a stock at a lower price).

After the section on conservative strategies, Wolfinger devotes the last third of the book to more advanced topics such Greek terminology, European-style options, credit spreads, iron condors, etc.

Rookie’s Guide to Options: The Beginner’s Handbook of Trading Equity Options, Mark Wolfinger, W.A. Publishing (2008)

A reader asked: “Is this just a case of CREA trying to shine things up so agents might see a pick up in business?” I wondered the same thing as I wrote the piece. I can’t really say for sure, but I can see how dramatic increases in prices might play to the interests of the real estate industry. Namely, those persons who were holding off buying have a flashing green light to now venture out and do the rounds with real estate agents. Indeed, the magnitude of the reported price increases could potentially generate a buying panic of sorts as prospective buyers feel the pressure to buy before prices go up too much more and/or they miss out on the price gains from owning a home.

In December, we had the opposite situation. CREA indexes appeared to be substantially overstating the decline in prices. The appearance of steep declines could also dovetail with industry interests. As I conjectured back then, it could erode the optimism of owners with houses listed for sale, leading them to cut their asking prices rather than let their properties sit longer on the market in hopes of getting the offer they had hoped for. The end result would be a pick-up in sales.

Flat to moderately trending markets lull buyers and sellers into inaction. Extreme price changes arouse emotions get people off their duffs. Could this be a reason why CREA continues to headline a flawed indicator? Its tendency to overstate price change at turning points can be a tool for altering the buying and selling psychology of the housing market.

Regulation does have a role to play in achieving that objective but we must not lose sight of other factors and measures that go more directly to the heart of the matter. That is to say, at ground zero in this whole mess is a huge set of imbalances in the world economy; to get out of the bubble-and-bust pattern that has settled in during the past decade, these disequilibria must be corrected.

And so far, there aren’t any good indications of such. That is not a good omen. One can have the best regulatory system in place but it will be like a sieve if the structural imbalances in the economy are not turned down.

The chief imbalance manifests most directly as a chronic deficit in the U.S. balance of trade, which has in recent years stood at about 6% of GDP. That means, as a nation, the U.S. is consuming and investing 6% more than it’s producing. Ordinarily, such an imbalance does not persist for very long – market forces would drive consumption lower in the deficit country and drive it higher in the surplus country.

But those market forces are not being allowed to operate. Many countries in the world, notably Asian countries such as China, are pursuing industrialization strategies based on export-led growth and are suppressing the value of their currencies against the U.S. dollar. They need to de-emphasize such export-led growth in favor of domestic-led growth. As well, they need to allow their currencies to appreciate against the U.S. dollar (or, on the flip side, let the U.S. dollar fall against their currency).

As for the U.S., its spendthrift ways need to be dialed down to get national spending more in line with production. By some combination of measures, the rate of internal savings needs to be raised. This starts with, as former Fed chairman Paul Volker says, “a strong sense of monetary and fiscal discipline.”

There are no signs of such discipline at present. Indeed, U.S. monetary and fiscal policies are set to accommodative extremes not seen since World War II. Now that the risk of financial collapse has subsided, they should be reined back. This may trigger stagnation for a time but that is not to be feared. The U.S. is not Japan; it is a deficit country whereas Japan is a surplus country. Japan needs to stimulate its economy more, the U.S. less.

Living within its means is what the U.S. has to do to bring about a sustainable solution to the imbalances that are generating grave disequilibria. Just as good, it will put pressure on trading partners to abandon their export-led industrializations in favor of domestic-led industrializations — because if the U.S. is living within its means, it won’t be buying as many exports from other countries. For more thoughts on this theme, see the article, Averting Armageddon.

“Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks — call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot … I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”

Volker recently gave a speech in China on U.S. economic prospects, which a few media outlets covered. “A long slog, with continuing high levels of unemployment, seems to be in store,” Volker said. He went on to say the anemic pace of the upturn was likely to forestall the surge in inflation that some expect to be triggered by the huge policy stimulus. “This is not an environment in which inflationary pressures are at all likely for some time to come,” he said.

Valuations no longer a prop for the rally

Valuation played a role in boosting stocks over the past three months. In early March, stock prices had become quite cheap, inviting bargain hunters to go shopping. Now, that reason for buying has ebbed with stocks rising to either fully valued or over-valued levels, depending on the valuation yardstick used.

Paul Lim writes in a June 14 New York Times piece, This Rally May Need a New Source of Fuel, that the price-earnings ratio of the S&P 500 based on GAAP earnings currently stands greater than 100. Based on operating earnings, the ratio is near 22, compared to the average of 19 over the past two decades.

But get this: Lim cites a Ned Davis Research study of bear markets since 1929 that found the market’s P/E ratio tends to climb by about 10% in the first three months after bear markets. In the three-month rally from March 9 of 2009, the P/E ratio for the S&P 500 has soared almost 40%.

Chinese stocks for the long run?

Maybe buy-and-hold investing will work if one picks the right country to invest in. The U.S. has two centuries of stocks averaging 9% a year but its brand of capitalism now seems sclerotic, leaving one to wonder if the youthful capitalism of emerging countries is the place to be for the long run. Even noted bear David Rosenberg of Gluskin Sheff + Associates Inc. seems bullish on China, at least in the near term. In his June 15, 2009 commentary, he notes:

“While exports seemed to have suffered a bit of a setback in May (-36.4% YoY versus -22.6% in April), it does look as though the government stimulus is percolating through the Chinese economy much more quickly than it is the case in the industrialized world. Retail sales are up more than 15.0% YoY; turnover in the commercial and residential real estate market has expanded 45.3% and investment spending has accelerated at a 33% YoY pace. No wonder commodity prices are booming again.”

The pullback the buy-the-dippers were waiting for?

Stocks sold off sharply on Monday, June 15 but will any weakness in stocks at this point be seen as a pullback for sidelined investors to jump in? A MarketWatch piece, Funds looking to pullback to get in stocks, thinks the answer to this question is yes. Funds that have been sitting on cash and looking to do a bit of window dressing for the end of the quarter are likely to be buyers, says author Nick Godt. But after June 30, what will the market do without the buy-the-dippers and window dressers?

• two-year Fixed-Rate Bond: 1.25%
• three-year Fixed-Rate Bond: 2.00%
• five-year Fixed-Rate Bond: 3.00%
• seven-year Variable-Rate Bond: 1.00% for the first year
• five-year Step-Up Bond: 0.75% in first year, 1.50% in the second year,  2.50% in the third year, 3.50% in the fourth year, 4.50% in the final year

The two-year and five-year Fixed-Rate Bonds are new offerings this year. Plus, starting this June, Variable-Rate bonds will be redeemable annually and have their interest rates reset once a year (earlier series had their interest rates reset every six months).

Rates are generally better on GICs. According to the Fiscal Agents website, you can get the following annual interest rates on GICs:

• Two-year GIC: 2.5%
• Three-year GIC: 2.9%
• Five-year GIC: 4.0%
• Escalator GIC: 1.25% in first year, 1.75% in second year, 3.0% in third year, 4.0% in fourth year, 7.0% in fifth year.

GICs longer than 5 years are not covered by Canada Deposit Insurance Corp. The seven-year Variable-Rate Bond, backed by the Ontario Government, would be one way to earn a government-insured, GIC-like return beyond five years. And its rate will rise if market rates rise.

Yet, high-interest bank accounts may offer a better deal. They are guaranteed by the federal government on an indefinite basis, offer higher interest rates that will similarly go up if market rates rise, and are easy to withdraw cash from. ING Direct’s investment savings account, for example, pays 1.35% currently.

Ontario Savings Bond website

Mortgage rates may be climbing but they are still near historic lows. Moreover, Kasriel notes, there is another factor besides mortgage rates that affects housing affordability: house prices. They have fallen to such an extent against income that measures of housing affordability are at historical highs (see chart below). In short, even with the uptick in mortgage rates, housing affordability is still very high.

True, mortgage refinancing activity has tumbled. But mortgage applications to buy a house are still edging up and they are more important in terms of stimulating the economy.

Refinancings (not involving the cashing out of equity) may lower monthly interest payments for the home owner and free up money for the purchases of goods and services but they also lower interest income received by lenders. So the net effect is “simply a redistribution of spendable income from ultimate lenders to ultimate borrowers.”

However, mortgage financing to buy a house is more than “a wash in terms of aggregate demand for goods and services.” In the case of the purchase of a newly created house, the construction industry is a major beneficiary. In the case of the purchase of an existing house, the renovation, furniture, and other housing-related industries often get a boost.

As for the notion that rising interest rates on U.S. government bonds are crowding out private-sector borrowing, Kasriel doesn’t buy it. As Kasriel’s chart below shows, yields on private sector debt are declining. That’s because risk appetite is recovering. The rise in government bond yields is part of the normalization in risk appetite — and is a good sign for the recovery.

Down the road, there may be some competition between the public and private sectors in debt markets but for the foreseeable future there is none. “Nonfederal domestic borrowing … has gone from an average $2.1 trillion annualized in the four quarters ended Q1:2008 down to only $291 billion in the four quarters ended Q1:2009,” writes Kasriel.

Getting back to the low “would be consistent with over $5.0 trillion of debt elimination,” says Rosenberg. This is too much for even the U.S. government to absorb, he declares: “A goodly chunk of this excess debt — bringing credit into realignment with the permanently new and lower level of household net worth — is going to have to be paid down (or defaulted on).” Hence, Rosenberg’s bullish stance on government bonds and bearish stance on stocks.

No doubt some of the debt will be extinguished, as it should be. But there is also a denominator in the debt-to-asset ratio. It can move up and take the ratio lower too. Indeed, the previous declines and cyclical lows in the series may mostly reflect, it seems to me, periods of asset inflation brought on by Fed monetary expansion. Something similar could happen again this time around.

Just as I’m not sold on the view we are heading for a raging inflation problem, neither am I personally sold on the debt-deflation thesis. Never underestimate the power of policymakers to pull rabbits out of the air or do whatever it takes to save the system. The bears are right about the system being in need of a great purge but the government is the “house” in this great casino.

A lot of smart persons spend their working days conceptualizing and strategizing about lending out the securities that investment funds hold for their unit holders. How to do it better, how to do more, how to increase yield ….

To get an idea of who is involved and what they are talking about these days, check out the agenda of the security-lending conference to be held on June 15-16 in New York City.

There are also blogs on securities lending. Stock Lending Today is written by one of the consultants vying for a piece of the business. It’s a good reference for learning more about the industry and staying abreast with developments.

The industry is becoming increasingly organized. In April, a group of Canadian organizations with interests in securities lending announced the formation of “the Canadian Securities Lending Association (CASLA) to advocate on behalf of all securities-lending market participants in Canada.” And, as they say:

“CASLA seeks to enhance the public’s understanding of securities lending, encourage the adoption of best practices and work with regulators and other industry associations to ensure an efficient and secure marketplace.”

If industry members are the only ones making their voices heard in the public realm, then fund holders will likely continue to get what appears to be the short end of the stick.

1. BMO Dow Jones Canada Titans 60 Index ETF tracks the float-adjusted, market-cap-weighted Dow Jones Canada Titans 60 Index. The top ten stocks are the same as those in the iShares CDN Large-Cap 60 ETF, with slight variations in relative weights.

2. BMO Canadian Government Bond Index ETF tracks the Citigroup Canadian Government Bond Index. It has 28 holdings of Government of Canada bonds whereas the iShares CDN Government Bond Index ETF has 86 holdings of federal, provincial, municipal government bonds.

3. BMO Dow Jones Diamonds Index ETF tracks the Dow Jones Industrial Average, a “price-weighted” index. It has 30 holdings, representing the largest U.S. companies in a range of industries except transport and utilities. It hedged back into Canadian dollars. Barclays has the iShares CDN S&P 500 Index ETF.

4. BMO U.S. Equity Index ETF tracks the float-adjusted, market-cap-weighted Dow Jones U.S. Large-Cap Index hedged back into Canadian dollars. It has 251 holdings, representing the largest and most liquid of public companies in the United States. Barclays’ other ETF for U.S. stocks is the iShares CDN Russell 2000 Index.

In short, the main difference from Barclays’ ETFs appears to be: the BMO government-bond ETF is more conservative and the two U.S. equity ETFs provide exposure to different stocks (with one having a different weighting scheme that gives greater weight to higher priced stocks). Another observation: it’s possible that BMO’s two U.S. equity ETFs may have tracking errors of 1% to 1.5% annually on top of the MERs, similar to iShares U.S.-equity ETFs.

Rudy Luukko of Morningstar Canada notes: “Because of its large trading volume, however, the iShares ETF will enjoy the advantage of tighter bid-ask spreads than its upstart BMO competitor.”

Three other BMO ETFs are to be listed at a later date: BMO International Equity Index (ex-North America), BMO Emerging Markets Index, and BMO Global Infrastructure Index Dow. 

This is already the case, apparently. As reader FinanceProf mentions in the comments section of the June 2 post, Barclays takes 50% of the lending fees flowing from iShares portfolios, but the 50% left over for fund holders is still larger than the revenues Vanguard generates (after covering just its costs from securities lending).

In Vanguard’s case, the incentive of wanting to be the lowest cost supplier seems to be sufficient. Maybe fund holders should be happy with that scenario even though it may not generate as much revenue from securities lending. When lending agents are allowed to take a sizable cut of generated revenues, there is a risk they may push the envelope too far and lower lending standards (like mortgage lenders did in the run-up to the financial crisis of 2008). A few years ago, for example, borrowers of securities had to put up government bonds as collateral, but these days, riskier assets such as stocks and corporate bonds are also accepted.

Even if a fund were to take a large cut like Barclays does, there still is the question of how much of an incentive is enough to maximize revenues. Is 50% the “commission” that yields the optimal amount for fund holders? Couldn’t an unaffiliated agent, operating at arm’s length from iShares, generate the same amount of business with a smaller incentive?

In the first quarter of 2009, the chart shows that the majority of mutual funds beat their indexes, except for two categories: Canadian Equity and Canadian Dividend & Income Equity. But that outperformance doesn’t hold up over the longer run: less than 15% of mutual funds beat their index over the past five years — with the exception being the Canadian Focused Equity category (54% funds ahead).

I have always wondered how mutual funds seem to be able to thrive in the face of mounting evidence that investors would be better off owning index funds and exchange-traded funds simply tracking the market at much lower cost. Are adherents of passive investing missing something or is it just a matter of time until mutual funds become a small rump of the investment-fund space?

This topic has indeed come up at monthly meetings with local finance bloggers (beside myself, attendees include Michael James on Money, Canadian Capitalist, and Canadian Personal Finance). As I recall, one conclusion was that mutual fund companies are very good at marketing.

Of note, one tactic they use is to hire people with a lot of friends, acquaintances, and relatives (preferably wealthy) and get them to make pitches to them. Of course, when a friend or relative asks you to buy something, you are more likely to agree.

Another possibility, which I raised last year in a column (Are mutual funds a rip-off?) and blog post  is that mutual funds often come with a bundle of ancillary financial services.

“The financial advisors who sell mutual funds typically package them with financial advice on taxes, estate planning, RRSPs, RESPs, portfolio diversification, and a host of other aspects related to personal finances. Ostensibly, this advice is offered for free but payment occurs indirectly through mutual-fund fees rebated back to the advisor (i.e. sales commissions and/or trailer fees),” I wrote. So, in short, mutual fund investors may get value added in other ways other than the net investment return.

One other consideration may be the impression generated by comparisons such as the SPIVA scorecard. What might be more accurate is if the mutual funds are compared not to costless indexes but their real-world alternative, i.e. index funds and ETFs — which come with their own costs such as commissions to buy/sell and annual management fees. Norm Rothery of the Stingy Investor website would also include the fees of advisors who assist investors with constructing passive portfolios (to make an apples-t0-apples comparison since mutual fund investors are also getting advice on constructing balanced portfolios).