The Little Book of Safe Money
Jason Zweig

“The keys to investing are simple: diversify, keep costs low, buy and hold.”

“Like dieting, investing is simple but not easy.”

“It is absolutely mandatory for you to keep a reservoir of liquidity in your portfolio at all times.”

“No matter how valuable an investment may be or appear to be, it’s of no practical value to you unless it’s liquid when you need to cash out.”

“The biggest single holding in your portfolio is you: the income that your career will generate over the rest of your life.”

“Anyone whose human capital is vulnerable to the escalating cost of living should consider investing heavily in TIPS.”

“Wall Street is forever inventing another newfangled way to promise higher yield at low risk.”

“In Japan at the end of 1989, the leading Nikkei 225 stock index was at 38,915.87; two decades later, it languishes below 10,000.”

“Invest as if stocks are likely-but not certain-to beat all other assets. Keep some money in bonds, cash, and real estate just in case they do better.”

“Stocks are not certain to outperform bonds and cash no matter how long you hold on.”

“Men should make a special point of having their wives review any choices the husbands regard as a sure thing.”

“It is irresponsible for a husband to keep such tight control of the family’s investments that his wife will find them completely unfamiliar after he is gone.”

“In the stock market, much of what seems to be patterns is, in fact, just random noise.”

“You should never act on an investing idea the same day you get it.”

“Never invest in anything on the recommendation of a friend or family member alone.”

“Commit to a dollar-cost averaging or automatic investment plan that require you to add a little bit of money every month.”

“If you are investing for retirement 30 years away, buy a total stock-market index fund and hold it continuously for the next three decades.”

The Millionaire in You
Michael LeBoeuf

“Money should be invested passively. Passive investing means buying and holding no-load, low-cost index mutual fund with performances reflecting that of entire markets.”

“Don’t waste your time playing the market. Own the Market, live your life and enjoy the journey.”

“Taylor Larimore–summarized the index advantage best: “Index funds offer much more than superior returns. They also provide maximum diversification, no overlap, no style drift, no manager changes, lower turnover, lower expenses, lower taxes, greater simplicity and peace of mind.”

“The master key to wealth can be summed up in just one word: Simplicity.”

“The main reason index investing is so successful is because fewer people have their hands in your pocket.”

“Timing the market is for losers. Time IN the market will get you to the winner’s circle, and you’ll sleep a lot better at night.”

The Only Guide to Alternative Investments
Larry Swedroe and Jared Kizer

“Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred.”

“When considering an asset class for inclusion in a portfolio, — investors need to consider the diversification benefit of the investment.”

“Recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence.”

“The evidence from academic studies demonstrates that equity REITs, both domestic and international, offer an attractive risk/return trade-off” and provide meaningful diversification benefits to portfolios.”

 ”The bottom line is that investors should consider devoting at least some significant portion of their fixed-income allocation to inflation-protected securities.”

” “Only informed and disciplined investors should consider including commodities in their portfolio.” 

“Unless they are highly risk-averse, investors should probably not buy an immediate fixed annuity until approaching age eighty.”

“Despite its low correlation with other portfolio assets, high-yield debt provides almost no unique benefit in terms of portfolio diversification.”

“In times of crisis, the markets for illiquid assets can virtually dry up.”

“For most investors the only way to obtain sufficient diversification of the risks of investing in speculative securities is through a mutual fund.”

“After ten years the survival rate of private firms was only about 34%.” (2002 study)

“Private equity investors forgo the benefits of liquidity, transparency, broad diversification, and the access to daily pricing that mutual fund investors enjoy.”

“Understanding the difficulty of identifying superior hedge-fund, venture-capital, and leveraged-buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high.”

“While preferred stocks offer relatively high yields, in general, they possess enough negative attributes to make them inappropriate choices for individual investors.” 

“One of the rules of prudent investing is to avoid complex securities because the complexity is likely to favor the issuer.”

“The bottom line on hedge funds is this: They are ’sinkholes’ for investors.”

“Variable annuities are products that are sold, not bought.”

“Variable annuities (VA) convert what would otherwise be long-term capital gains into ordinary income.”

“Education, or a good fee-only advisor who is not influenced by commission-based compensation, can be the armor that protects investors.”

To be continued …

You can calculate how much HST you’ll be paying with this calculator on the National Citizens Coalition website

On Nov. 12, the Ontario Government announced exemptions for prepared food and beverages sold for $4.00 or less and print newspapers

The Premier says the exemptions granted Nov. 12 will be the last.

Over time, the HST on mutual fund annual MERs can add up to a large sum. “… if you invest $10,000 every year for 25 years, assuming a management expense ratio of 2.6% and an annual rate of return of 6%, you will end up paying a total of $9,100 more in [HST] …”

Mutual-fund companies fear investors will switch to ETFs because the HST burden will be much lighter on their substantially lower MERs.

Mutual fund companies not headquartered in a province charging the HST (e.g. Investors Group in Winnipeg and Mawer in Calgary) will escape the HST and thus have a competitive advantage because of the HST.

HST a disincentive to saving for retirement.

A recent report by Jack Mintz projects the HST and other tax cuts in the 2009 provincial budget would create $47 billion in new investment in Ontario and 591,000 jobs over 10 years (the bill will “introduce sweeping corporate tax cuts that will reduce taxes on new investment to 23.7% in 2010 from 33.6% one year earlier. That rate will fall even further, to 18.5 %, by 2018).”

Summing up:

1. Many groups and academics laud the HST as good for the economy. The PST is a bad tax, they say, because it falls on business inputs and cuts into capital investment and jobs. But hasn’t anyone thought of eliminating the PST on business inputs by instead cutting out some of the wasteful and unnecessary spending in the government? According to an international study, 25% of government spending falls into the wasteful category. Wow – lower taxes without a material reduction in public services – wouldn’t that be much more of a boost to the economy?

2. Opposition leaders and various citizen groups have condemned the HST. But where were they before? The HST just makes visible the provincial sales tax that was hidden in the inputs purchased by businesses (and passed onto consumers). Shouldn’t they have been hammering away at the tax before (when it was, to a large extent, hidden)? Yes, but it appears Canadians are so dumb  that they’ll gladly pay taxes as long as they don’t see them (like the goose whose feathers are getting plucked).

3. The HST on mutual funds and ETFs doesn’t seem to make sense given the administrative and compliance problems: i) funds have an inventive to shift headquarters to provinces not charging HST, and ii) charging HST on mutual-fund investors living in non-HST provinces is a challenge.

Appendix:

The Investment Funds Institute of Canada raises more problems with applying the HST to mutual funds.

“Ontario and B.C. will be the first provinces to levy a sales tax on mutual and other types of funds (8% and 7% respectively) as all Canada’s currently harmonized provinces provide rebates or equivalents to funds.”

“Canada is an outlier compared to other jurisdictions: European countries, as well as Australia and New Zealand, treat management and advisory services much more favourably than in Canada, whether through sales tax exemption or credits.”

“Discriminatory level of tax levied on funds: Under the GST and HST, the issue is not that mutual fund services are taxed; it’s that they are taxed at effectively four to five times the rate that guaranteed investment certificates (GICs), equities, bonds, term deposits and other non-fund financial vehicles are.”

“Some pension plans pay no sales tax at all and Canadians who have access to private-sector defined benefit plans also pay less tax than Canadians who save in an individual retirement savings plan. At the end of 2007, Canadians had $739 billion invested in individual retirement savings plans, such as RRSPs and RRIFs, which means that holders of at least 41% of all retirement savings in Canada were at a relative disadvantage to holders of other Canadians saving for and in retirement.”

There are two interesting aspects to this debate. The first is the cross-party battles taking place across the country. In Ontario you have provincial Liberals walking hand in hand with federal Conservatives, while the provincial Conservatives are fighting back. In B.C., where the HST is also expected to pass, a former right wing premier has teamed up with the NDP leader to plan protests against the tax. It’s a little weird, and while some of this is just plain politics, the unusual alliances also show just how divisive this tax is. I wrote more about this in a Canadian Business story — you can read it here.

I’ve written about this other issue in the past, but MoneySense magazine does a great job covering what the HST will mean to investors. There’s been some talk that the Liberals will make investments HST exempt, but so far that hasn’t happened. Read more about this here.

There are a number of other interesting HST-related issues — hopefully I can get through some of them in the weeks ahead.

The Intelligent Investor (Rev Ed)
Benjamin Graham and Jason Zweig

“It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.”

“Allocating at least 10% of your retirement assets to TIPS is intelligent.”

“The worse the future looks, the better it usually turns out to be.”

“The primary cause of failure is that investors pay too much attention to what the stock market is doing currently.”

“The key to rebalancing is having a predictable schedule”

“For most investors, intermediate bonds are the simplest choice, since they enable you to get out of the game of guessing what interest rates will do.”

“For most investors, bond funds beat individual bonds hands down.”

“If you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your portfolio would have been worth $16,797.” (Stock indexes do not include dividends.)

“It is essential that (the intelligent investor) entrust himself only to firms of the highest reputation.”

If you find yourself trading more than twice a year–or spending more than an hour or two per month on your investments–then something has gone badly wrong.”

“If you started investing $100/month in September 1929, your money would have grown to $15,571 by August 1939. That’s the power of disciplined buying–even in the worst bear market of all time.”

“The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is an investor’s most powerful weapon.”

“Alan Greenspan said on January 7, 1973: “It’s very rare that you can be as unqualifiedly bullish as you can now.” (1973 and 1974 turned out to be the worst years for the stock market since the Great Depression.)”

“A great company is not a great investment if you pay too much for the stock.”

The Intelligent Portfolio
Christopher Jones

“Sadly, our educational system has been woefully behind the curve in preparing people for the heavy new financial responsibilities of a self-directed investment world.”

“Be careful of how your advisor gets paid. Conflicts of interest can yield advice that is not in your best interest.”

“There are many ways to measure risk other than looking at just the volatility of returns.”

“A study of investor behavior by the research firm DALBAR found that market timers in stock mutual funds lost -3.29% per year on average relative to investors who pursued a consistent strategy.”

“Unlike a mutual fund, it is quite possible for a single stock to lose all its value by going bankrupt.”

“Never make the critical mistake of being too concentrated in your employer’s stock.”

“Fund expenses are like termites. They can quietly eat away at the returns of your investment without you even realizing there is a problem.”

“From the analysis of 22,472 mutual funds–only about one quarter of mutual funds were able to demonstrate performance that exceeded what you could achieve with a low-cost index fund.”

“Evaluate diversification at the household level, not at the individual account level.”

“If you own a home already, you probably have enough real estate in your household portfolio.”

“Asset allocation explains more than 90% of the variation in returns for most mutual funds.”

“You are virtually guaranteed to outperform more than two-thirds of the actively managed funds with low-cost index funds.”

“It is very expensive to guarantee that you will have a certain amount of money in the future, but if you can tolerate some uncertainty, you can likely fund your future goal with significantly less savings.”

“The only way to be more confident of reaching a financial goal is to invest more conservatively and save more.”

“All other things held equal, it will cost a woman more to fund her retirement than a man of the same age due to her longer expected lifespan.”

“As an investor, you want to be cautious about investing in a fund just prior to it making a distribution to shareholders.”

The Individual Guide to the Top Mutual Funds
American Association of Individual Investors

“The most important factor when diversifying a portfolio is selecting investments whose returns are not highly correlated.”

“Bond mutual funds are attractive to investors because they provide diversification and liquidity, which is not as readily attainable in direct bond investments.”

“The higher the turnover, the greater the brokerage costs incurred by the fund.”

“The market risk measure used for common stocks is beta; for bond funds, average maturity is used.”

“Dollar-cost averaging works especially well with more volatile portfolios.”

“Top Performance lists are dangerous.”

“The classic response of funds that focus on small stocks is to migrate investments to mid-cap and large stocks when they start to achieve a large asset base.”

“Don’t forget that almost all fund performance data is reported without adjusting for front-end or back-end loads.”

“One reason beyond low expense ratios that make index funds are tough to beat is that they are always 100% invested in the market.”

To be continued …. here.

Commissions have been one of the few drawbacks to ETFs because they can chew up accounts of investors who prefer to invest through dollar-cost averaging. This was once an area where mutual funds had an edge, but no more at Schwab and other brokerages who may follow suit (Preet wonders if this is what the Bank of Montreal — BMO — has in mind with its ETFs). So mutual-fund executives could be on the Maalox now. And so too might executives at ETF companies with no brokerage arms.

But how is it possible for Schwab to charge no commissions and MERs as low as 0.08%? In a previous post, I thought it would be possible for ETFs to get their MER costs down lower, even all the way to 0%, by using fees earned from lending out securities to cover operating costs. This seemed less fanciful a speculation when a few months later, as Preet noted in a blog post, some ETFs had emerged in Europe with 0% MERs.

So that would be my guess in this case. Schwab is diverting the revenues from its securities lending operations to cover off its operating costs. With sufficient volumes of business, they could still turn a profit while giving investors big breaks on fees.  This is what Tom Lydons of ETF Trends thinks it might be too.

Indeed, it’s conceivable, as competition heats up, for MERs on ETFs such as Schwab’s to move to the 0% mark. It may not happen overnight or not at all, but there is a potential. Also, one wonders if established ETF families like Barclays Global, which currently pocket 50% or more of the securities-lending fees for themselves, might now feel pressured to switch their cut toward lowering MERs. Could they even possibly pay investors to buy their ETFs — or otherwise reimburse their trading commissions?

His name, by the way, is Ed Rempel (CMA, CFP, C.H.F.S.), with Ed Rempel & Associates. Here is his response:

“I don’t believe those numbers [in the survey]. It is like the “dirty little secret” of financial planners — that everyone wants to CLAIM they do planning.

When we talk with advisors we meet at the CFP [Chartered Financial Planners] Conference and ask them about their practice, nearly all claim to do holistic advice and planning. However, if I ask them any details about it, they look at me like I’m speaking Greek.

I often ask: “What nest egg are you finding that your clients typically need at retirement to have the retirement they want?” I usually get dumb-founded responses or they change the topic. If they actually had done any planning, they would be able to recall a detail from some recent plan.

[A participant said] they often see what he calls “fake plans”. Often they are just a questionnaire to determine a need so they can sell a product, an investment projection, or a quick plan based on a rule of thumb.

In our opinion, most of the financial planning software is designed for a quick plan. You can enter a few facts, put in that the client wants to retire on 75% of today’s income, and hit a button. You get a nice plan, with pretty graphs, sometimes complete with generic commentary.

I’ve had people tell me they got a nice, printed financial plan after a 15 minute meeting at the bank, which included time to sell investments.

The same [survey says that 70% of people have worked with a financial advisor, but “fewer than 10% claimed to have actually used these other services” (services other than investments). If so many advisors do planning, then why would less than 10% of the public claim to have used any other advice from a financial planner?

We’ve also found the same tendency among the public, where many people want to CLAIM they have a financial plan. However, after I ask them about it, they don’t know where it is, don’t know what it says, and don’t know what the goals in the plan are.

It takes work to make a plan real for clients, which is what a REAL plan needs. Early in my career, I used to do plans that I thought were thorough, but the client did not understand them or believe them.

In the end, a plan is only a REAL plan if the client understands it, believes it, and accepts that the goals are what they want to achieve.”

I pointed out that several academic studies had found mutual-fund advisers added no value to the selection of funds (indeed, likely subtracted it). So why did ETFs need to be adjusted for trailer fees when doing comparisons with mutual funds? Reader John De Goey (a fee-only financial advisor) took this a little further. He noted:

“Call virtually any discount brokerage in Canada … you will find that they all require their investor clients to use A-Class funds. In other words, investors are obligated to pay the trailing commission on a product for advice that is neither received nor requested. This is scandalous! Imagine if Canadian Tire charged people for a muffler and installation if they simply bought a muffler! The Competition Bureau would step in.”

This arrangement further raises questions concerning the view that trailer fees are the cost of financial advice. In this context, it appears to be more part of the cost structure of the mutual fund company. No financial advice or service is provided to the buyer.

In the discussion of trailer fees in Part I, attention had also been drawn attention to a survey that found a minority of financial planners did financial plans for their clients – again raising questions about the value of services obtained through trailer fees. Since then I have come across a post by a financial advisor who paints an even bleaker picture. To quote:

“While many financial planners claim to do financial planning and provide holistic advice, very few actually provide comprehensive planning with written financial plans, as taught in the CFP courses.”

Product integrity

The ETF vs. mutual-fund debate often overlooks important side issues, notably the stability of the products. After an investor purchases a mutual fund or ETF, it may change in various ways. But the changes for ETFs appear to be on a much smaller scale compared to mutual funds. Examples of the changes affecting mutual funds  include:

• turnover in portfolio managers – many investors may buy into a fund because of a well-regarded manager only to see the star later jump ship for another fund, leaving unitholders faced with the decision to stay with a less skilled manager or redeem and pay a rear-end load fee as high as 5%

• changes in the manager’s investing style (style drift) – portfolio managers may stay put but then start trying investment approaches different from what unitholders expected, increasing, for example, the proportion of risky securities in an attempt to juice returns

• termination or merging of a fund with another fund – which again presents unitholders with a disruption in their investing plans

Tax efficiency

While some ETFs may distribute taxable capital gains to unitholders, the incidences are more the exception to rule. Mutual funds, on the other hand, tend to distribute capital gains as a rule rather than the exception. At least that is what the averages would seem to indicate: for example, David Swensen’s book Unconventional Success shows that the average annual distribution of S&P 500 index mutual funds was 1.8% of assets from 1993 to 2002, compared to 0.01% for the SPDR S&P 500 (SPY)

Flexibility

The more one can tailor an investment vehicle to their needs, the more one can maximize their utility; having extra options is a valuable trait to many investors. Some examples:

• ETFs can be bought and sold at a known price throughout the trading day while mutual funds are bought and sold at the price prevailing at the end of the day.

• ETFs can be purchased on margin, sold short, and combined with ETF options to create covered trades and other hedging strategies

Diversification

Mutual-fund defenders say Canadian equity ETFs i) expose investors to the risk of stocks growing to a large weighting in the index, (Nortel effect) and in the case of Canadian broad-market indexes, ii) leave investors weighted toward financial and resource stocks. Let’s deal with these two points in turn:

• as for the “Nortel effect,” Canadian ETFs are no longer exposed to such risk; the fundamental ETFs offered by Claymore in Canada are not market-cap weighted and ETF families using market-cap weighting now limit the weights of individual stocks so that none can have the influence Nortel once had.

• as for achieving a portfolio less weighted toward energy and financial stocks, that would seem to be an asset allocation choice perhaps better left to the individual investor (they can tailor exposures to their preferences better than an equity mutual fund can); ETF investors typically achieve their desired level of diversification through holding a portfolio of ETFs tracking a variety of asset classes such as small caps, U.S. stocks, and international stocks.

Performance

Mutual fund apologists say mutual funds: i) offer the potential to outperform the market, ii) show periods of outperformance, and iii) have relatively better performance in sectors like small caps and U.S. stocks. Let’s deal with these three points in turn.

• as for the potential to outperform indexes, some mutual funds may be able to do so (studies show less than 5% over the long run) — but identifying them ahead of time is hit and miss; odds are that the investor will end up an underperforming fund

• as for periods of outperformance, using more extensive time sampling and adjustments for survivorship and other biases, virtually all mutual-fund-performance studies published in peer-reviewed journals indicate “that mutual fund managers on average underperform their risk-adjusted benchmarks,” to quote Professor Richard Deaves in his book, What Kind of Investor are You? (Deaves own study of the Canadian stock market found that equity mutual funds on average fell short of their indexes by more than 1% a year over the period 1988 to 1998)

• as for relatively better performance in sectors like small caps and U.S. stocks, the odds of picking an outperforming fund may be higher but then again, it is hard to identify ahead of time which funds will do so (or at least avoid management changes, style drift, closure, etc.)

• 62% of Small/Mid Cap Equity
• 71.4% of Canadian Focused Equity
• 63% of International Equity funds

Longer term, fewer active funds outperformed their respective benchmarks. “Only 16.7% and 7.6% of active Canadian Equity funds were able to outperform the S&P/TSX Composite Index over the three and five-year periods,” notes SPIVA.

I’m a believer in exchange-traded funds (ETFs) but out of fairness to mutual funds, a comparison I would also like to see SPIVA  do is between mutual funds and comparable exchange-traded funds (ETFs). ETFs are the practical alternative to mutual funds; that comparison would be informative to those investors considering a choice between mutual funds and ETFs.

The percentage of mutual funds that underperform their comparable ETF (i.e. tracking the benchmark index) shouldn’t be as high as the SPIVA’s comparisons show (on the basis of comparisons to indexes). ETFs not only have costs of their own (annual expenses plus commissions to buy and sell), but also tracking errors. Indeed, given tracking errors for sector and international ETFs are known to be on the high side, I wonder if it is possible mutual funds may hold up well (even over the long haul) against at least these ETFs.

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.

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).

One was how the lending fees are split between fund investors and fund managers. It appears many funds do not fully, or even partly, rebate the income to fund holders in the form of lower fees or higher returns — even though the securities are being held in trust for fund holders.

Zweig said T. Rowe Price Group and Vanguard Group fully rebate lending fees (after expenses) to fund holders. He named some smaller funds that don’t. The elephant in the room he did not mention in this regard is Barclays and its iShares family of ETFs (presently on the auction block).

They take 50% of the security-lending revenues, which are becoming quite large these days. Barclays’ accounts indicate that the British bank earned £389 million from the practice last year on all its funds under management (of which iShares represents about one-fifth).

Barclays gets a 50% cut because it’s specified in the contract that the board of directors at iShares gave them to manage the lending operations on behalf of unit holders. Couldn’t the board have found managers that would be willing to perform the lending function at a fraction of the fees charged by Barclays?

Indeed, this makes one wonder if the iShares board really is functioning in the interests of fund holders. If the lending function were transferred to an arm’s length party, wouldn’t it be possible to allot more of the lending fees to substantially lowering management expense ratios?

Actually, at present growth rates in securities lending, it’s not inconceivable that ETFs could some day be offered to investors without any management fees – and/or with better performance than the indexes they track. Image that: buying the iShares S&P 500 Index Fund (IVV) with a 0% MER and earning a net return that is a percentage or two greater than the S&P 500. What a concept.

I’ll have more to say on this topic in a column scheduled to appear this Thursday after 4PM (EST) on the home page of Canadian Business (and later, in the column archives). Other issues pertain to the use of the borrowed securities for short selling and the risks in lending securities.

Canada got a grade of F in fund fees, the worse of the countries in the study. Canada’s management expense ratios in the range of 2% to 2.5% were the highest of the group. Mutual fund salespersons won’t like what the report had to say about why fees are so high:

“Canadian investors do not pay much attention to fees. Canadian investors are comfortable with the high fees because they don’t know how low these fees should actually be. Assets tend to flow into average- or higher-fee funds because Canadian investors use financial advisors to help them make decisions. Advisors direct client assets to funds that pay better trailers. And since the trailer is included in the MER, the result is that assets flow into higher-fee funds.”

What pulled up Canada’s score were A’s in investor protection and transparency. Such high scores seems a little odd, to me. I wonder if the Chicago-based research team missed the boat here.

OK, disclosure might be good in the prospectus and elsewhere. In fact, I have applauded the publication of disciplinary hearings against wayward salespersons. But what about enforcement of investor-protection rules by regulators such as the Mutual Fund Dealers Association (MFDA)? The study seems to have overlooked this dimension — at least there didn’t appear to be a category for grading on the report card.

Some consideration of this aspect may have altered Canada’s ranking. There seems to be a fair amount of anecdotal evidence that suggests as much. Just recently (May 13), for example, Barry Critchley wrote a Financial Post piece, MFDA’s sluggish side shows, complaining about MFDA’s delays that allowed a mutual dealer to victimize its clients until it left the industry and was beyond the powers of the MFDA to punish it.

Many regulatory agencies in Canada are trade associations that have been given self-regulating powers. Sure, they catch abusive salespersons and impose fines, but the accused can escape the fines by simply leaving the industry. Heck, most of them don’t even bother to show up for their hearings. There doesn’t seem to be much of penalty in Canada for betraying the trust of mutual fund investors.

Get the full Morningstar report here.

The case histories explain in detail how wayward members of the industry allegedly violated the by-laws and rules of the MFDA. Reading them, the investor is likely to find entertainment (in a Judge Judy sort of way) as well as the kind of edification that could keep them from becoming a victim themselves. Let’s review what MFDA documents say about some of the cases scheduled to appear in hearings before enforcement officials within the next three months. A few could fit right in with Ripley’s Believe it Not.

Selling unauthorized investments (Nigerian scams of all things)

MFDA documents report that Wayne Larson was victimized by an Internet lottery scam in September 2005. Around the same time, he came across information on the Internet about a company called Global Consulting Corp., which advertised short-term term investments paying rates of return between 12% and 20%. Mr. Larson solicited money for investment in this company, collecting $1.76 million from 7 clients. A large portion came from his elderly aunt in a long-term care facility. The MFDA document reports: “it appears that GCC was a Nigerian scam established to defraud unsuspecting investors.” Mr. Larson was terminated by the insurance company and has not responded to MFDA correspondence.

Criminal record (for tax fraud and evasion)

Purisima Dy was convicted of fraud in July 2007 and sentenced to two years in jail and three years probation because, as a MFDA document states, she “knowingly produced fraudulent 2005 income tax returns for 1,190 tax clients that included approximately 1,393 false donation receipts totaling $3,791,338, thereby defrauding the Government of Canada of tax revenues of $1,065,922.32.” She also failed to disclose at the time of her hiring as a mutual fund salesperson that she had been convicted of tax evasion in 1995, fined approximately $150,000 and sentenced to 60 days in jail.

Bad faith (trailer fee rebate program canceled)

ASL Direct Inc. (ASL) offered a trailer fee rebate program to clients for $29.95 a month. Under this program, ASL promised to reimburse or reinvest trailer fees relating to investments in client accounts. “Since approximately July 2006, without written notice to the clients, ASL has ceased payment and reinvestment of the
trailer fees … but ASL has continued charging the clients the monthly fees,” noted the MFDA’ Notice of Hearing document. ASL and owner Adrian Samuel Leemhuis are also charged with maintaining insufficient capital and selling unregistered investments (offshore mutual funds).

Cheques written in name of advisor

Michele and Jeffrey Longchamps sold $1.6 million in GICs and other financial products to 22 clients but allegedly directed the money to themselves by having clients write checks in Ms. Longchamp’s name and the name of their private companies. Acknowledgements were sent out on the letterhead of their companies or of the GIC supplier (without latter’s knowledge). Statements were also issued bearing the logo of the GIC supplier (never issued by the supplier). In June 2007, the couple advised co-workers that they were going on vacation and did not return.

Pre-signed forms (81 of them)

A 2004 MFDA compliance review found Gary Alan Price was in possession of blank investment instruction forms signed by two clients. He agreed to destroy them. In 2007, a MFDA audit found copies of pre-signed forms and he again agreed to destroy them. During an unscheduled inspection by the MFDA a month later, he was found to have in his possession 81 signed blank investment instruction forms.

Conflict of interest (selling securities in companies)

Barry James Raymer became a shareholder and director in two companies and then arranged for 24 of his clients to purchase more than $1 million in high-yielding promissory notes issued by those two companies. These were not investments authorized by his employer. They were also high risk investments, yet many of the clients had indicated on their Know Your Client forms they were low- or medium-risk investors.

Churning accounts

Tony Tung-Yuan Lin “processed 34 related redemption and purchase transactions in 8 client accounts, generating sales commissions in the total amount of $65,020.16” over an eleven week period. In other words, the funds were sold to collect early redemption fees and then repurchased the same day, only to collect other fees such as front-end commissions. Tung-Yuan Lin apparently obtained the consent of clients but later said the majority were for the purpose of generating commissions.

Serious students of investing, however, know there are a number of empirical studies from academia and elsewhere that conclude there is no need to hedge currencies if the investing horizon is long term. Going by the historical data (for U.S. investors venturing into multiple foreign stock market), returns are nearly the same — as noted in this post last May.

Yet, structural imbalances (e.g. trade and fiscal deficits) in the U.S. continue to accumulate beyond thresholds that typically have triggered sustained currency depreciation in other countries. Perhaps past empirical studies, covering periods when U.S. imbalances were less extreme, need to be taken with a grain of salt.

Even if currency fluctuations do average out over the long run, such an outcome provides little solace to investors who do not have a long time before they need the funds, such as persons who will be retiring in less than 15 years. Unhedged foreign funds are more suitable for younger people — although even here there seems to be a major caveat.

What’s the caveat? While stocks can be expected to return 6% to 10% annually over the long run (going from the past record), there is no expectation of a similar long-run, positive return for currencies. Currencies are only expected to cycle in long swings around the investor’s breakeven point, which means there is a risk the cycle may not be at, or above, breakeven when the time for withdrawal comes.

Perhaps, then, the decision to hedge depends on one’s risk tolerance. Some may see the extra 15 basis points or so in the fund’s annual fees (plus any tracking error) as an acceptable insurance premium to pay for a more certain outcome. Others will see the premium as too expensive, especially when the currency contribution can be positive just as well as negative.

Canadian investors often ask whether or not they should hedge the currency when investing in funds that track U.S. stocks. This is a different situation from what most empirical studies examine (i.e. impact of several fluctuating currencies in terms of the U.S. dollar).

There seems to be, to a greater extent, certain regularities in the Canadian and U.S. dollar exchange rate that open the door to an active approach. Specifically, the loonie has a lengthy history of trading in a range roughly between $0.70 (U.S.) and $1.00 (U.S.), so one may benefit from overweighting currency-neutral funds when the loonie descends toward the lower boundary (as it is now) and shifting to an overweight in unhedged funds when the loonie approaches its upper boundary.

When the loonie is getting close to its lower boundary, history says it is more likely to go up than fall further, so a currency-hedged foreign fund may be the answer for the Canadian investor. Conversely, when the loonie approaches its upper boundary, it is more likely to fall than rise, so an unhedged fund may be more appropriate.

The day before, markets retested the Oct. 10 lows in convincing fashion. They looked past the jump in U.S. jobless claims to stage a spectacular rally in the afternoon. On Friday, a plunge in U.S. retail sales hit markets in the morning but a rally again took hold during the afternoon and was edging into the green by 3PM when dumping by mutual/hedge funds brought the market down the express elevator to the day’s lows.

In short, it looks like the customary rally from a retest of the bear-market’s low faces greater headwinds compared to past cycles. In one corner, we have the technicians bidding up the market on expectations historical patterns will repeat. In the other, we have the immeasurable impact of forced deleveraging (including a contraction in lending).

Then, fourth-quarter earnings are due in January. Brokerage analysts, as usual, are still behind the macroeconomic curve as it enters the downturn phase. Their estimates are starting to come down, but they are still “far from throwing in the towel on their earnings forecasts,” as Peter Lim wrote in the New York Times.

According to a Thomson Financial survey, analysts still expect S&P 500 companies to grow profits more than 12% in 2009. Given they aren’t expecting much for the first two quarters of 2009, the estimates imply “a tremendous profit surge in the latter half of 2009,” noted Lim. In January, therefore, there could be a raft of poor earnings releases that knock earnings projections down even lower. So it looks like a toe-dippers’ market still.

- in Canada, net outflows from mutual funds in October were an estimated $8.2 billion to $8.7 billion – the largest in history

- in the U.S., outflows from equity funds ballooned to a record $70.7 billion (U.S.) last month, according to data from TrimTabs — 26% higher than in September, the previous record high.

People are not only showing a loss of faith in buy-and-hold investing by their actions but are also verbalizing their disenchantment, as discussed in this article.

A reservation I personally hold about the “stocks for the long run” view is that it’s based on inductive reasoning, i.e. it extrapolates what has been seen in the past to the future. In other words, there is no mathematical certainly of receiving an average annual return of 7% to 9% over the long run. Indeed, as discussed in this piece, “black swans” can appear and drag long-run returns below other assets or even breakeven.

Last year, I took a whimsical poke at buy-and-hold investing in “Indexing a portfolio to financial Armageddon.” It doesn’t look so whimsical now, unfortunately. The point is not that stocks should be avoided. There is a place for them in portfolios but I would tend to differ with those who recommend investing 100% in stocks (or otherwise very large exposures). I personally would prefer to be diversified over other assets just in case my 15- to 30-year investing horizon turns out to be the one with flat or negative returns in the stock market.

If you are increasing your allocation to equities by purchasing mutual funds, you may get hit with taxable year-end, capital-gains distributions. And they can be significant this year because many funds in once-hot sectors like emerging markets and commodities took a lot of profits earlier in this year.

The Wall Street Journal gives two examples from the Oppenheimer fund family: its Developing Markets fund has capital gains of nearly 20% of net asset value for the first nine months of 2008; its Global Opportunities fund has capitals gains of more than 11% of net asset value.

Most mutual funds by now have projections for their year-end distributions and have either published them or will disclose the information on request. So check with the funds before buying and go with the ones planning lower distributions, ceteris paribus.

Year-end capital distributions also provide another reason for selling a loser fund for tax-loss reasons. You’ll not only get a capital loss to offset capital gains but avoid the extra tax hit in December. And if you have a choice of funds to sell, pick those headed for big distributions.

You may be reluctant to sell because you regard the position as a long-term holding and fear the price will jump before you can buy back in after the 30-day waiting period (required to avoid the superficial-loss rule). In that case, you can buy a proxy such as an exchange traded fund, or switch to a similar mutual fund with no planned distributions.

Mutual-fund sales are a contrarian indicator of the stock-market’s direction for many investors. Look at how the previous peak of $1.7 billion roughly coincided with the end of the last bear market. If September’s redemptions are more than double the latter, might the bottom to the current bear bottom be at hand?

It’s important to look at the data carefully and to consider the current context. First, approximately half of the September outflows were from money market funds — so the flight from stocks was actually closer to $2.25 billion. That still beats the record, but by a smaller margin.

Second, a number of fund companies reported net inflows of money. As Som Seif, of Claymore Investments points out, this had a lot to do with new product offerings, i.e. segregated mutual funds used in variable annuities such as Manulife Financial’s IncomePlus.

People buying these popular instruments are looking for retirement income indexed to the upside of stock markets but protected from the downside — so to get a purer measure of sentiment, these inflows should be netted out. Roughly extrapolating from past data, the adjustment would bring industry net outflows closer to $3-$3.5 billion in September.

Thus, we may indeed be getting near the point of maximum pessimism and the bear market’s bottom. A caveat, though, is the once-in-a-lifetime nature of the current financial crisis, a “five standard deviation event” in which traditional signals and yardsticks may no longer be reliable guides.