A Preemptive, Timeless, Portfolio Protection Strategy

A participant in the morning Market Cycle Investment Management (MCIM) workshop observed: I’ve noticed that my account balances are near all time high levels. People are talking down the economy and the dollar. Is there any preemptive action I need to take?

An afternoon workshop attendee spoke of a similar predicament, but cautioned that a repeat of the June 2007 through early March 2009 correction must be avoided — a portfolio protection plan is essential!

What were they missing?

These investors were taking pretty much for granted the fact that their investment portfolios had more than merely survived the most severe correction in financial market history. They had recouped all of their market value, and maintained their cash flow to boot. The market averages seemed afraid to move higher.

Their preemptive portfolio protection plan was already in place — and it worked amazingly well, as it certainly should for anyone who follows the general principles and disciplined strategies of the MCIM.

But instead of patting themselves on the back for their proper preparation and positioning, here they were, lamenting the possibility of the next dip in securities’ prices. Corrections, big and small, are a simple fact of investment life whose origination point can only be identified using rear view mirrors.

Investors constantly focus on the event instead of the opportunity that the event represents. Being retrospective instead of hindsightful helps us learn from our experiences. The length, depth, and scope of the financial crisis correction were unknowns in mid-2007. The parameters of the recent advance are just as much of a mystery now.

MCIM forces us to prepare for cyclical oscillations by requiring that: a) we take reasonable profits quickly whenever they are available, b) we maintain our “cost-based” asset allocation formula using long-term (retirement, etc.) goals, and c) we slowly move into new opportunities only after downturns that the “conventional wisdom” identifies as correction level— i. e., twenty percent.

  • So, a better question, concern, or observation during an unusually long rally, given the extraordinary performance scenario that these investors acknowledge, would be: What can I do to take advantage of the market cycle even more effectively — the next time?

The answer is as practically simple as it is emotionally difficult. You need to add to portfolios during precipitous or long term market downturns to take advantage of lower prices — just as you would do in every other aspect of your life. You need first to establish new positions, and then to add to old ones that continue to live up to WCM (Working Capital Model) quality standards.

You need to maintain your asset allocation by adding to income positions properly, and monitor cost based diversification levels closely. You need to apply cyclical patience and understanding to your thinking and hang on to the safety bar until the climb back up the hill makes you smile. Repeat the process. Repeat the process. Repeat the process.

The retrospective?

The MCIM methodology was nearly fifteen years old when the robust 1987 rally became the dreaded “Black Monday”, (computer loop?) correction of October 19th. Sudden and sharp, that 50% or so correction proved the applicability of a methodology that had fared well in earlier minor downturns.

According to the guidelines, portfolio “smart cash” was building through August; new buying overtook profit taking early in September, and continued well into 1988.

Ten years later, there was a slightly less disastrous correction, followed by clear sailing until 9/11. There was one major difference: the government didn’t kill any companies or undo market safeguards that had been in place since the Great Depression.

Dot-Com Bubble! What Dot-Com Bubble?

Working Capital Model buying rules prohibit the type of rampant speculation that became Wall Street vogue during that era. The WCM credo after the bursting was: “no NASDAQ, no Mutual Funds, no IPOs, no Problem.” Investment Grade Value Stocks (IGVSI stocks) regained their luster as the no-value-no-profits securities slip-slided away into the Hudson.

Embarrassed Wall Street investment firms used their influence to ban the “Brainwashing of the American Investor” book and sent the authorities in to stifle the free speech of WCM users — just a rumor, really.

Once again, through the “Financial Crisis”, for the umpteenth time in the forty years since its development, Working Capital Model operating systems have proven that they are an outstanding Market Cycle Investment Management Methodology.

And what was it that the workshop participants didn’t realize they had — a preemptive portfolio protection strategy for the entire market cycle. One that even a caveman can learn to use effectively.

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Income Closed End Funds and Total Return Analysis

What are the two main reasons mere mortals invest in income purpose securities: one is their inherent safety compared to equities… a 50% income asset allocation is much safer and theoretically less volatile than a 100% equity exposure.

There is less risk of total loss in XYZ company bonds or preferred stock than there is in XYZ common stock… a major fact of investment life roundly ignored by most investors/speculators in overpriced stock markets.

Equally important (as retirement looms larger) is the income these securities produce, first for compounding and then for spending.

  • Compound interest/dividends/realized capital gains is the most powerful retirement income force known to mankind… neither total return nor market value can pay your bills, take you on vacation, or pay your grandkids tuition.

Unlike Tom Wolfe’s “Masters of the Universe”, most of us are not bond traders. If our income inventory shrinks in market value, we don’t have to sell our positions. Wall Street fixed income pros don’t care about income production… buying and selling inventory is their business model, and they set the market prices.

The “higher interest rates are coming panic” you are hearing about in the media is a real problem for MOTUs, but it may be an investment opportunity for the rest of us. If I buy an Exxon 4% debenture, a 3% 30 year municipal bond, or a 10 year treasury note, three things are inherently true:

If interest rates rise, their market values will go down and it will be difficult to add to my positions… BUT my income (and their safety vis-a-vis equities) will not change; MARKET VALUE CHANGE HAS NO IMPACT ON INCOME, in high quality securities.

It is this “Interest Rate Expectation (IRE) Sensitivity” that CEF Investors are uniquely well positioned to take advantage of. All income focus securities (and funds that contain them) are impacted by IRE:

“Market Value Varies Inversely With Interest Rate Expectations”

The Net Asset Value (NAV) of CEFs is the sum of the values of hundreds of securities, inside a virtual “protective dome”, where only the manager can trade them. BUT we can “trade” the dome itself, reducing our cost basis and increasing our yield as we choose… something totally unimaginable in any othe income investment medium.

So this is precisely what is going on “inside” income CEFs right now. Individual security prices are being forced down by the expectation of rising interest rates and a significant discount is available. Absolutely nothing has changed with respect to the quality of the securities or the income being produced “Under The Dome”. The price of the dome has been reduced, and its “IN YOUR POCKET” income is rising.

Yes, that observation is correct, we can now accelerate the growing power of our Compound Earnings Machine

No change in the securities, their quality, or contractual payments… only the price of the package has changed. So there they are, investors, opportunities just waiting for you to pad your retirement portfolio pocketbooks with income over 6.5% tax free and up to 8.0% taxable.

These sweet discounts are only available through the financial genius of CEFs. Only here can “mere mortals” turn Wall Street’s blood bath into an income portfolio worth bragging about. There has been no news that suggests there is anything wrong with the “securities under the dome”.

So don’t be concerned with the “OMG, bond prices are falling” headlines… that’s Wall Street’s problem. This is the biggest CEF sale since 2011, and… the “Call to the Mall” has sounded!

Is Your Investment Portfolio Prepared For Higher Interest Rates?

I’ve heard a lot of discussion lately pressing the idea that rising interest rates are something to be feared, and prepared for by: accepting the lower rates now, buying the shortest duration positions, or even liquidating the income portfolio entirely.

A rising interest rate environment is super good news for investors… up to a point. When we loan money to someone, is it better to get the lowest possible rate for the shortest period of time? Stop looking at income investing with a “grow the market value” perspective. That’s not what it’s all about. Lower market values or growing discounts to NAV don’t have to be problems… they can be benefits.

The purpose of income investments is the generation of income. YOU are NOT a bond trader. Control the quality selected, diversify properly, and compound that part of the income that you don’t have to spend. Price is pretty much irrelevant with income purpose securities; you don’t spend the market value.

Long, long, ago, many bonds were of the “bearer” variety; my father never owned any others. Each month, he went to the bank, clipped his coupons, cashed them in, and left the bank with a broad smile. If interest rates went up, he knew he could go out and buy new bonds to put larger coupon dollars in his pocket.

He had no reason to even consider selling the bonds he already owned — they were, after all, income purpose securities that (in his experience) never failed to do their job. Market value never fluctuates (visually) if the securities are kept in the (mental) safe deposit box.

No, that’s not at all what I’m recommending… And, even when your brokerage statement shows that your bond prices have risen to chest-pounding wealth levels, just try to convert those numbers into spending money. Despite the profit-taking-temptation your statement reports, the bid you get on your smallish positions is never even close to the “insider” market value…

The thing dear old Dad thought about least was the market value of his bonds. This was his tax free retirement plan. He bought them for income, and the coupons were always redeemed without question. The only problem (actually, no longer a problem) with the periodic decreases in market value was the inability to add to existing positions. The small position bond market has limited liquidity.

Before I move on to the simple solution to this non-problem, a word or two on the only real benefit of lower interest rates — there is no benefit at all if you don’t already own individual, income producing, securities. If you own interest rate expectation (IRE) sensitive securities in a downward interest rate cycle, you will have the opportunity for what I call “income-bucket-gravy”.

This is the opportunity to sell your income purpose securities at a profit, over and above the income you’ve already banked. Income investors rarely are advised to do this, which is why they lament the thievery occasioned by higher interest rates. They didn’t sell at a premium, so now they just sit and watch the premiums disappear.

The only thing this behavior accomplishes is bestowing on investors the lowest possible yields while pushing them into an overpriced market for short duration debt securities. A gift that keeps on stealing investor profits.

The solution is simple, and has been used successfully for decades. Closed End Funds (scoff, laugh, and say “leverage makes them volatile” all you like) solve all the liquidity and price change problems… in a low cost, much higher income, environment.

Answer me one question before you throw stones at these remarks. Is 7% or more on a diversified, transparent, income portfolio, compounded over the past ten years and still growing income, better or worse than the 3.5% or less that most investors have realized in individual securities during the same time period… and then there are the profits that non-bond traders seldom realize can be realized.

Of course CEF market values fell during the financial crisis (the 3nd greatest buying opportunity ever), but at their peak in November 2012, they had gained nearly 65% since March 9, 2009, or 17.7% per year…. nearly outperforming the S & P 500.

But speaking of  “drawdowns”, what do you think the economic activity drawdown of near zero money market rates has been, particularly for “savings account” Baby Boomers. Did the Fed’s messing around with short term interest rates help or hurt your retired relatives… really, think about it.

Rising interest rates are good for investors; so are falling rates. Fortunately, they routinely move in both directions, cyclically, and now can be traded quickly and inexpensively for exceptional results from a stodgy old income portfolio. So much for Total Return, short duration, and leverage-phobic thinking.

  • What if you could buy professionally managed income security portfolios, with 10+ years income-productive track records?
  • What if you could take profits on these portfolios, say for a year’s interest in advance, and reinvest in similar portfolios at higher yields?
  • What if you could add to your positions in all forms of debt securities when prices fall, thus increasing yield and reducing cost basis in one fell swoop?
  • What if you could enter retirement (or prepare for retirement) with such a powerful income engine?

Well, you can. but only if you are able to add both higher and lower interest rates to you list of VBFs.

Mistakes Happen

“Every great mistake has a halfway moment, a split second when it can be recalled and perhaps remedied.”  — Pearl Buck

I think the quote is particularly revealing.  It certainly describes accurately what many of us know intuitively.  But not so many mistakes are recalled.  Why?

Recalling the mistake requires a course change.

Most people dislike change.  Changing a decision or action may involve admitting the early decision was flawed and for some, the ego cost is too high.  Ego and image are expensive luxuries.

I have, in the past, referred to a an Advanced Management Program study at Harvard that found that good managers do not make better decisions than weak managers except in one case.  Good managers stop flawed processes sooner.  Think back to the mid-80s and “New Coke.”  Did not work; killed quickly.

Many people do not change because they have not noticed the need.

Every decision or project must have a measurement system.  It does not need to be numbers but it must be there.  People must check and make new decisions.

Part of the reason for not noticing is not wanting to notice.  Data mining.  Emphasize the good, minimize the bad.  It is difficult to be objective with a pet project, but many pet projects have failed and at great cost.  Persistence is a value but it does not always solve the problem. Rethinking an opportunity sometimes prevents great loss.

Be objective.  The choice is to answer the question, “If I was not doing this already, knowing what I know, would I start?” You would be surprised how often the answer is “No!”  There are two “No” possibilities.  1) I would not start, and 2) I would start but with these variations.  If the second answer appears try the variations.  Evolve a right answer.

Sometimes a problem is so complex that there is no right answer, but someone has created one and sold it well.

It is like the economy or climate change or international relations.  The right answer will evolve over time.  Some blind alleys will be tried.  Some assumptions will be thrown aside.  Some new information will come available. But a better answer appears only if the problem or opportunity remains the central focus.  If proving or applying the “right” answer becomes the central focus, then much time and much observable and helpful information will be lost.

There is little value to spinning the facts to save a failing “right” answer. .

No one knows right answers to complex situations.  There are always more variables than their answer uses and some of the things that disappear matter.  Nassim Nicholas Taleb, author of “The Black Swan”  has built a fine and useful career on this point. Build solutions that are workable even when unforeseen events come to pass.  “Antifragile” in his terms.

In personal plans, the same rules apply.  Analyze – Decide – Implement – Review – Reanalyze – Decide again, and so on forever.  Do not expect perfection.  That is why we review and reanalyze.  We missed something the first time.  Learn from objective experience.

Success is not found in perfect answers. It is found in imperfect answers properly modified.

Many problems will tell you how they want to be solved, but they whisper at first.  Listen to them.

.

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact: don@moneyfyi.com

How to Tell the Difference Between Investing and Gambling!

gamblingI saw a question posted on a popular social network. The question was: ‘What is the difference between gambling and investing?” I’m inspired to reproduce (edited with permission) the following excerpt from A Maverick Investor’s Guidebook (Insomniac Press, 2011) which I believe provides as good an answer as one might find.

How to Tell the Difference Between Investing and Gambling!

“How do you develop ‘smart thinking’ and when do you know you’ve got ‘avarice’?”

My instinctive response would be: “You always know when you’re being greedy. You just want someone else to say that your greed is okay.” Well, I’ll say it then: greed is okay. The proviso is that you fully understand when greed is motivating your decision and live with the consequences. Avarice is driven by desire, which is not a trait of an investor.

Remember, it’s best if investment decisions are rational and stripped of emotion. Greed is associated with elation on the one hand, and anger (usually directed at oneself) on the other hand.

When decisions are motivated by greed, I call it gambling. In my mind, there are different sorts of gamblers. Some gamblers place modest bets, and if they win, they move along to another game. For me this might be roulette. There are those who enjoy playing one game they’re good at, such as blackjack or craps, hoping for a big score. Finally, there are those who are addicts. I can’t help those folks, so let’s assume we’re just discussing the first two types.

It’s okay to do a bit of gambling with a modest part of your disposable income. In fact, investors can apply some of what they know and have fun too. Unlike the casinos, financial markets have no limits or games stacked in favour of the house. It’s the Wild West, and if an investor understands herd behaviour and the merits of contrarian thinking, and does some research, the results can be quite lucrative. Whether using stocks, bonds, options, hedge funds, domestic mutual funds, foreign equity or debt funds, or commodity exchange-traded funds (if you don’t know what these things are and want to know, buy a book that introduces investment theory and the various types of securities), applying investment principles will help you be more successful.

gamblerTo put it plainly: counting cards may not be allowed in a casino, but anything goes when it comes to markets. Just don’t forget that most of the financial industry is trying to make your money their money. There’s a reason why a cowboy sleeps with his boots on and his gun within reach.

The fine line between gambling and investing is hard even for old cowhands to pinpoint. Investing also involves bets, but the bets are calculated. Every decision an investor makes involves a calculated bet—whether it’s to be in the market or not at all, biasing a portfolio in favour of stocks versus bonds, skewing stock selection in favour of one or several industry groups, or picking individual stocks or other types of securities.

I met a lady once in line at a convenience store. She bought a handful of lottery tickets, and I asked her, “Aren’t the odds of winning pretty remote for those lotteries?” Her reply was, “The odds are good. There’s a fifty/fifty chance of me winning.” Confused, I asked, “How do you figure?” I laughed aloud when she said, “Either I win or I lose; that’s fifty/fifty, isn’t it?”

A maverick investor knows there’s always a probability that any decision to buy or sell or hold can prove to be incorrect. The objective is to minimize that probability as much as is feasible. It’s impossible to make it zero. This is why financial firms have sold so many “guaranteed” funds lately. People love the idea, however impossible, of being allowed to gamble with no chance of losing. Whenever there’s a promise that you won’t lose or some other similar guarantee, my senses fire up a warning flare.

There’s usually a promise of significant upside potential and a guarantee that at worst you’ll get all (or a portion) of your original investment back. Many investors a few years ago bought so-called guaranteed funds only to find that the best they ever did receive was the guaranteed amount (extremely disappointing) or much less after the fees were paid to the company offering the product. If you think this stuff is new, trust me, it’s not.

guaranteedA fancy formula-based strategy back in the ‘80s called “portfolio insurance” was popular for a brief period. An estimated $60 billion of institutional money was invested in this form of “dynamic hedging.” It isn’t important to know in detail how the math works. Basically, if a particular asset class (stocks, bonds, or short-term securities) goes up, then you could “afford” to take more risk because you are richer on paper anyway, so the program would then buy more of a good thing. If this better-performing asset class suddenly stopped performing, you simply sold it quickly to lock in your profits. The problem was that all these programs wanted to sell stocks on the same day, and when everyone decides they want to sell and there are no buyers, you get a stalemate.

The “insurance” might have worked if you actually could sell the securities just because you wanted to, but if you can’t sell, you suffer along with everyone else—the notional guarantee isn’t worth the paper it’s printed on. Remember these are markets, and even though you see a price in the newspaper or your computer screen for a stock, there’s no trade unless someone will step up to buy stock from you. The market crash that began on Black Monday— October 19, 1987—was, in my opinion, fuelled by portfolio insurance programs. The market was going down, so the programs began selling stocks all at once. There weren’t nearly enough buyers to trade with. By the end of October ’87, stock markets in Hong Kong had fallen 45.5%, and others had fallen as follows: Australia 41.8%, Spain 31%, the U.K. 26.4%, the U.S. 22.7%, and Canada 22.5%.

Minimizing the Probability of Stupidity

If you’re gambling, follow the same steps you would as if you were investing. If it’s a particular stock you are anxious to own, do some homework, or at least look at someone else’s research available through your broker or on the Internet. When I was a younger portfolio manager, there were limited means to learn about a company. I would have to call the company and ask for a hardcopy annual report to be sent to me. When it arrived after several days, I’d study it a bit so I didn’t sound too ignorant, then I’d call and try to get an executive (controller, VP finance, or investor relations manager) to talk to me. If asking questions didn’t satisfy my need to know, then I’d ask to come and meet with them in the flesh. Nowadays, you have all the information you need at your fingertips.

Money.ca is a PRIME example of just one such source of valuable information available to investors today!

Mal Spooner
Mal Spooner

Investment Industry needs independent players!

The most recent print issue of Money noted that the big Canadian banks managed to earn $31.7 billion in 2012, just a few years after there was grave concern that they’d even remain solvent.

“There is no question that Canadian banks play a vital role; locally, provincially, nationally and inter-nationally. Without the banks, our economy could simply not function efficiently or effectively. But are the banks getting too big and going too far to gain market share and profits at the expense of their own customers?” (Quote from Spring 2013 issue of Money Magazine.)

In November of last year I published a piece entitled Banks own the investment industry! A good thing? In many respects allowing the banks to provide everything from our mortgage to investment services is incredibly convenient. But at what price? It has become near impossible for many smaller investment dealers to stay in business. Fraser Mackenzie is a recent victim of an industry that requires scale in order to compete:

At their shareholder meeting on April 29th, 2013 it was decided: “Our assessment of the current business climate has led the owners to conclude that deploying our capital in the continuance of our regulated investment dealer businesses can no longer generate an acceptable rate of return. Institutional interest in early stage mining and oil & gas companies, sectors to which we have been heavily committed, has dried up: as has the associated trading in the equities of early stage resource companies. Furthermore, the regulatory cost burden is increasing at a time that industry-wide revenues are declining. On balance, it makes sense for our shareholders to re-deploy their capital.”

Indeed, well over half of the total value of trading done on the TSX in a typical month is conducted by the banks.

My guess is their actual market share of all trading is far above half if we were to also include trading platforms not part of the Toronto Stock Exchange. The banks keep growing, and the regulatory burden also grows more onerous. In my estimation, the larger financial companies relish regulation as an additional barrier to entry. Regulatory oversight is a minor inconvenience to the big banks, whereas for less diversified specialty businesses (mutual fund companies, standalone investment dealers, investment managers) the added expense can be devastating.

Obviously there are huge benefits to scale – but do consumers really benefit or are these economies of scale all kept as bank profits? MER’s for their proprietary mutual funds might appear very reasonable, but it’s impossible to determine whether or not the plethora of fees I pay for other services are subsidizing these seemingly lower expense ratios. Transparency is near impossible. Although many banks did collapse as a result of the the financial crisis, the massive rebound in the profitability of those surviving banks (even though they lost ridiculous amounts of capital doing stupid things with asset backed securities, derivatives trading etc.) suggests that those everyday fees paid by consumers and businesses must exceed the marginal cost of providing these services by quantum leaps and bounds.

Another concern I have – besides the demise of competition in the financial services industry – has to do with motivation. It’s true that every business is designed to make money, but in days of yore a mutual fund company, investment manager or stock broker had to have happy customers in order to succeed. If they didn’t help the client make money, the client would go somewhere else. I believe that as each independent firm disappears, so does choice. Making a great deal of money from you no longer requires you to be served well. What are you going do? Go to another bank?

The prime directive (to borrow an expression from Star Trek) of the financial services behemoths is profits. The financial advisor’s role is to enhance corporate profitability. Financial advisors today are increasingly handcuffed not just by regulatory compliance, but also ‘corporate’ compliance. Wouldn’t an investment specialist whose only mandate is to do well for his client be more properly motivated (and less conflicted professionally)? Would your investment objectives be better served by an independent advisor who is rewarded only because you the client are earning profits (and not because you are earning his employer more revenues)?

It isn’t necessarily true that an independent advisor is any better than one employed at a bank. I personally know of hundreds of outstanding advisors working at banks and insurance companies. But it must also be true that a satisfied, properly motivated, objective and focussed financial professional will do a better job whether he/she is at an independent or a bank.

We can’t begrudge the banks their success but left to their own devices, they’d all have merged into one by now. In December of 1998 then Canadian Finance Minister Paul Martin rejected the proposed mergers of the Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank. We know from our U.S. history that government and regulatory authorities are frequently frustrated by the political muscle (lobbyists, lawyers) of the large financial firms. Ultimately having one gigantic Canadian bank – providing all our financial services, investment needs, insurance requirements – might (or might not) be a worthy corporate ambition, but it’s hard to imagine such a monopoly being good for the likes of us. After all, just consider the progress that has been made in telecommunications since Bell Canada (or AT&T) was forced to reckon with serious competition.

The banks need independent players. Not only should banks discourage the obliteration (by bullying or by absorption) of non-bank competition, they should use their political muscle to keep the regulators from picking on Independent players. Government agencies cannot help themselves – if they are impotent against the strong they naturally attack the weak – even though when all the weak are dead the regulators would have no jobs. You don’t need a police force when there’s nobody you can effectively police.

Independent players create minimum standards of service and ethics, and fuel industry innovation. In every instance, the independent is a bank customer too. Mutual fund and investment managers pay fees to banks, buy investment banking offerings, custodial services and commercial paper and also trade through bank facilities. Independent dealers provide services and financing to corporations deemed too small to matter by larger financial companies; that is, until these businesses grow into large profitable banking customers. Put another way, why not adopt the Costco model where smaller independents can shop for stuff to sell to their own customers, and higher end specialty shops and department stores can all remain standing, rather than the take-no-prisoners approach of Walmart?

Let’s hope that the few surviving independent firms can be allowed to thrive, and if we’re lucky perhaps new players will arise to provide unique services to Canadian clients and homes for advisors who are inclined to specialize in managing and not just gathering assets.

Mal Spooner

 

 

 

 

 

Canada’s most flexible and legitimate tax shelter!

In 2004 I wrote a book (with my friend Pamela Clarke and published by Insomniac Press) called Resources Rock: How to Invest and Profit from the Next Global Boom in Natural Resources. Since taxes are fresh in everyone’s mind at this time of year, I thought I’d reproduce a chapter in the book that explains one of Canada’s most flexible and robust tax planning tools. It’s not widely understood but has the advantage of being 100% legitimate – it is written right in our tax code. Here’s the chapter:

“Certainty? In this world, nothing is certain but death and taxes,” said American scientist Benjamin Franklin over two hundred years ago. The only difference these days is that while death is still final, taxes can be deferred or reduced. Canadians didn’t always have to worry about taxes. Income tax was introduced as a temporary measure (sounds like the GST saga) to help cover the country’s military expenses during World War I. By 1948, the wars were over, but the government decided to not surrender. Instead, the Income War Tax Act became the Income Tax Act. Since then, Canadians have had to declare income from all sources, including capital gains on the sale of investments or property. We’re allowed to deduct some expenses and there are a few tax credits, but by and large, there aren’t too many opportunities for us to reduce our taxable income. Taxes are steep and vary greatly depending on where you live.

But that’s not all. You pay tax on everything you earn as well as on everything you buy. Take the price of gas, for example. It was pumped up to over $1.40 a liter in some provinces and more than one-third of the price was taxes: provincial sales tax, GST, and something called the Federal Excise Tax. It hurts even more if you consider that you’re paying for the gas taxes with after-tax dollars. Ouch.

One of the best means of minimizing the pain is to take advantage of all the tax deductions that you can. Standard ones include childcare expenses, family support payments, moving and medical costs, and of course, RRSP contributions. Unfortunately, not too many taxpayers are familiar with the deductions that are available from investing in the “flow-through” shares of junior Canadian resource companies, or ventures that qualify for the Canadian Exploration Expense (CEE). You should consult your tax advisor for precise information on the benefits of these deductions for your portfolio, but in the meantime, here’s a brief introduction to these tax-deductible investments.

Buried deep in the Income Tax Act (Section 66 (1) to be exact) there’s a clause that says:

“A principal-business corporation may deduct, in computing its income for a taxation year, the lesser of (a) the total of such of its Canadian exploration and development expenses as were incurred by it before the end of the taxation year…”

The Section goes on ad nauseam, but only tax accountants need to get into that level of detail. What you do need to know from the clause is that most junior energy and mining companies spend all of their money on exploration programs and usually have little or no revenue. Because they have virtually zero income, they’re not able to use all the tax deductions that they’re entitled to as a resource exploration company. Mining companies are allowed to deduct prospecting, drilling, geological or geophysical expenses, but if they don’t have any revenue, then these deductions remain unclaimed or“wasted”.

In a rare moment of generosity, the government decided to allow exploration companies to give up those tax deductions and pass them on to people who can use them. Companies can bundle the tax deductions with their shares, then sell them to investors and use the proceeds from the sale of these shares to finance their exploration projects. The ventures don’t mind selling off their unused deductions. If they can’t afford to keep digging or drilling, they’ll be out of business anyway. These deductions, sold as shares, are called “flow-through shares” because they transfer the tax deductions from the company to the investor.

In other words, the government allows a tax deduction that would usually only be granted to an exploration venture to be passed on, or “flow-through,” to their investors. It’s a win-win situation as the company gets the money to finance their exploration work while investors can claim up to 100% of their investment as a tax deduction. The government created this program as a means of encouraging people to invest in resource exploration companies. That’s nice of them, but given our incredibly high tax rates, it’s a good idea to understand how investing in exploration—either in flow-through shares, or in shares of a limited partnership that owns a portfolio of flow-through shares—can help you lower your taxable income.

Investors can buy flow-through shares directly from a company, or own them indirectly by purchasing units in a limited partnership specially created to buy shares in a portfolio of several junior exploration companies. Buying units in a limited partnership can be beneficial for individual investors because it gives them the tax deduction from the flow-through shares, in addition to reducing their investment risk. A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor could afford to purchase on their own. Therefore, investors in a limited partnership end up owning shares in a basket of startups, rather than just in one venture. Given that a lot of exploration companies could go bankrupt or walk away from their projects, buying shares in several of them minimizes the risk that you could lose your entire investment. The answer varies from one investor to another, but as long as the exploration company – or companies if they’re in a portfolio owned by a limited partnership – spends all the money they raised from selling flow-through shares on eligible exploration expenses, then almost the entire amount invested in the shares can be deducted.

A word of caution: Don’t let the tax appeal of flow-through shares affect your decision-making skills as an investor. Remember that even though the tax deductions alone are beneficial, you’re still investing in the riskiest side of the resource industry. It is possible for you to lose all your money if the exploration team repeatedly comes up empty-handed. On the other hand, investing in an exploration startup by means of flow-through shares does mitigate the risk of losing your investment to some extent. Depending on your marginal tax rate, the after-tax cost of buying the flow-through shares (or portfolio of flow-through shares) is virtually cut in half, compliments of the government .

In the Economic Statement and Budget Update of October 18, 2000, the Minister of Finance announced a temporary, 15% investment tax credit (applied to eligible exploration expenses) for investors in flow-through shares of mineral exploration companies. Oil and gas exploration companies were excluded. This announcement introduced a credit, known officially as the Investment Tax Credit for Exploration(ITCE), which reduces an investor’s federal income tax for the taxation year during which the investment is made. Although deemed ‘temporary’, after expiring at the end of 2005, the credit was re-introduced effective May 2,2006 and is currently subject to annual review.

The ITCE is a non-refundable tax credit that can be carried back three years or carried forward twenty years. So if you invest in flow-through shares (of mining exploration companies only) this year, you can use the deduction any time up to 20 years in the future, or back three years. It’s a real bonus being able to use this deduction when you need it the most. Keep in mind, however, that the ITCE has to be reported as income in the year after you claimed the tax deductions from the flow-through shares. The only downside is that when you sell your investment, or trigger a “deemed disposition”(which means the government thinks you’ve unloaded the investment even if you haven’t actually sold it), then you’re on the hook for capital gains tax. That’s not so bad, as capital gains tax rates are better than regular income tax rates.

Let’s look at how these tax credit programs can help you reduce your taxes. For example, if you live in Ontario and your annual taxable income is $300,000, and you’re taxed at the highest marginal tax rate of 46.41%, then you’d pay $139,230 in tax. (Of course, to make it simple,we’re unrealistically assuming there are no personal exemptions or other allowable deductions and that all income is taxed at the same rate.) If you invested $50,000 in flow-through shares, and the entire amount qualified as a CEE, then 100% of your investment could be deducted from your taxable income. Your taxable income is reduced to $250,000 and you now owe $116,025 in taxes—a savings of $23,205! That’s a nice chunk of change that stays in your pocket.

It can get even better. If a part of your investment in flow-through shares is with companies that are exploring for metals and minerals that are eligible for the Federal Investment Tax Credit, you’ll get an additional tax credit of $7,500. That extra credit would cut your total tax bill down to $108,525. In a perfect world, you could save yourself $30,705 in taxes. Serious money by any standards.

In addition to these federal government programs, there are several provincial flow-through initiatives that we won’t address here as they vary tremendously from one province to another. Flow-through shares are starting to sound like they’re the best discovery since Chuck Fipke dug up some diamonds in the Northwest Territories. As wonderful as they are, keep in mind that since money is made and taxes are paid in the real world, things aren’t always as rosy as simplified examples in a book on investing. Before buying into the example above, remember that:

  • Taxes Vary: Everyone pays taxes on a sliding scale, so not all of your income is taxed at the top marginal rate.
  • Diversify: Your entire portfolio should never be solely invested in just mineral exploration stocks—diversification is advisable even for investors with an incredibly high tolerance for risk.
  • No Guarantees: An exploration company is obligated to spend 100% of the money it receives from selling flow-through shares on expenditures that qualify for tax deductions, but if for some reason it doesn’t, then you can’t claim 100% of the deductions.

The bottom line is that there are many variables that will influence the impact of flow-through shares on your tax situation. Investment advisors can provide details on the limited partnerships or flow-through shares that are available in the market today. Ask them to help you research and screen limited partnership funds so you end up investing in a portfolio of companies that meets your investment objectives.

That’s the end of the chapter, and before you say this is more complicated than it’s worth let me excessively simplify and round in order to provide an example of how powerful this tool can be.

Imagine you’ve sold an income property for $500,000 and long ago used up your personal capital gains exemption. To keep it simple, you are not subject to minimal tax and are at the highest marginal tax bracket which I will round to 50%. Let’s ignore all the other deductions and stuff too. Your options are:

1. Report the proceeds as income and let the CRA (government) keep half of your money.

2. Invest the entire sum in one (or more) flow-through limited partnerships.

Let’s examine #2. The $500,000 can now be deducted against income, so your taxable income (money going to CRA) is reduced – you keep half at 50% tax rate or (roughly) $250,000. So far you’re no worse off right? Even if your get nothing back (I’ve never seen this happen personally and I’ve managed dozens of these funds myself) you’re no worse off.

Say after two years (the lifespan of most of these funds) you get your whole investment back (it happens). Once the fund is wound up your $500,000 is now subject to capital gains tax (roughly 25% rather than 50%) so you’ll net $375,000. Isn’t keeping the extra $125,000 for yourself worth the effort? Whether you end up with half that amount, or double you are still ahead.

By the way, when a flow-through limited partnership is ‘wound up’ your money is usually rolled into a more liquid mutual fund – you can leave some or all the the money in there and not pay the capital gains taxes until you redeem. If you can afford it, use the tax shelter every year and watch your tax savings grow over time. You will have to pay a tax accountant (since filling out the tax returns correctly is critical and often you have to re-submit them when you receive additional or more precise information from the fund company after-the-fact), and seek advice from a good investment advisor. If either of them tells you not to do it without a really good explanation….it’s because they don’t understand them or want to avoid the added work. Find someone else.

Mal Spooner

 

One Day Makes All the Difference

So last week we made a commitment to make changes in our life to bring us to a happy conclusion with our financial goals. It is the small steps that are actually taken that get us through the journey.

This week we have a very simple step to take and that is choosing our annual Financial Day. It can be any day that is consistent that you will remember. Your wedding anniversary, Thanksgiving, Canada Day, Ground Hogs Day … Whatever works!

The next question is what do you do on your Financial Day? Well it is a day of review and update. So much stuff can happen in one year that affect us financially or otherwise and it is a good idea to stay current. A baby is built and born in less than a year and we all know how much of an impact that has on us. But how many of us haven’t reviewed anything in years if not decades?

Go through and do a household inventory, preferably on video. Open up your closets, cupboards, storage room and highlight any new and / or valuable items. Keep the video in a safety deposit box or fire proof lock box.

Pull out your home and auto insurance policies. Are you properly insured for the full replacement value of your stuff? Do you have groupings of belongings (example: sports equipment, books, computer stuff, tools, etc) that could be worth more than $1,500? How are they protected under your policies? Do you run a home based business or bring work home? Are you covered for that? Have your driving habits or commutes changed? Do you have coverage you don’t need or do you need to increase coverage? Have you gotten all available discounts?

Review your life, critical illness, disability, group insurance, travel insurance policies. What are you covered for and for how much? Is it adequate based on your financial situation? Have you had another child or have you had a child grow up? Are you covered for what you need and not what you don’t? Has your work coverage changed?

Review your Will, Enduring Power of Attorney, and personal directives (also known as Representative Agreements in some provinces). First off do you have these documents? Can you read them and understand what you signed? Is everything still relevant? Have any of your choices for Personal Representatives, Guardian, or Trustee changed? Have you added minor children, had children turn into adults, gotten married or divorced, moved, business changes, or any other significant life change?

Look over all of your investments: RRSPs, pensions, TFSAs, RESPs, Scholarship Trusts, Universal and Whole Life policies, stocks, bonds, exempt market securities, non-registered investments, and bank accounts. Where is everything? How is it doing? Do you want to be contributing more, differently, changing your investments?

Go over your credit cards, mortgages, loans, and lines of credit. Who all do you owe money to? Do you have open and available debt that you don’t need or use? Should you be looking for a better interest rate? Could you increase the payments on any of them to get out of debt faster? Also, make sure you get your current credit reports from both Equifax and TransUnion. See where you are and what you need to fix / update to protect yourself.

The first time you do your Financial Day it will take a few hours, but after that, as long as you keep it annual, it is a relatively fast and painless exercise. It helps you know where you are standing financially, helps you prepare to meet with your financial advisor to plan for the next step in your money life, and allows you to see your positive progress.

Go ahead, pick your day, and get ready to see your life move forward in the right direction.

“Eighty percent of success is showing up.”
Woody Allen

Banks own the investment industry! A good thing?

Let’s face it!  In the battle for investment dollars the Canadian banks are clearly the winners!  Is this a good thing?

Once upon a time, the investment business was more of a cottage industry.  Portfolio manager and investment broker were ‘professions’ rather than jobs.  Smaller independent firms specialized in looking after their clients’ savings.  There were no investment ‘products.’  The landscape began to change dramatically – in 1988 RBC bought Dominion Securities, CIBC bought Wood Gundy and so on – when the banks decided to diversify away from lending and began their move into investment banking, wealth management and mutual funds.

Take mutual funds for example.  Over the past few decades Canadian banks have continued to grow their share of total mutual fund sales* – this should not surprising since by acquisition and organic growth in their wealth management divisions they now own the lion’s share of the distribution networks (bank branches, brokerage firms, online trading).

An added strategic advantage most recently has been the capability of the banks to successfully market fixed income funds since the financial crisis. Risk averse investors want to preserve their capital and have embraced bond and money market funds as well as balanced funds while eschewing equity funds altogether. With waning fund flows into stock markets, how can equity valuations rise?  It’s a self-fulfilling prophecy.

Many of the independent fund companies, born decades ago during times when bonds performed badly (inflation, rising interest rates) and stocks were the flavor of the day, continue to focus on their superior equity management expertise.  Unfortunately for the past few years they are marketing that capability to a disinterested investing public.

The loss in market share* of the independent fund companies to the banks continues unabated. Regulatory trends also make it increasingly difficult for the independent fund companies to compete.  Distribution networks nowadays (brokers, financial planners) require a huge and costly infrastructure to meet compliance rules.  Perhaps I’m oversimplifying, but once a financial institution has invested huge money in such a platform does it make sense to then encourage its investment advisers and planners to use third party funds?  Not really! Why not insist either explicitly (approved lists) or implicitly (higher commissions or other incentives) that the bank’s own funds be used?

Stricter compliance has made it extremely difficult for investment advisers to do what they used to do, i.e. pick individual stocks and bonds.  In Canada, regulators have made putting clients into mutual funds more of a burden in recent years.

To a significant degree, mutual fund regulations have contributed to the rapid growth of ETF’s (Exchange-Traded Funds).    An adviser will be confronted by a mountain of paperwork if he recommends a stock – suitability, risk, know-your-client rules) or even a mutual fund.  An ETF is less risky than a stock, and can be purchased and sold more readily in client accounts by trading them in the stock markets.  Independent fund companies that introduced the first ETF’s did well enough for a time but not surprisingly the banks are quickly responding by introducing their own exchange-traded funds.  For example:

TORONTO, ONTARIO–(Marketwire – Nov. 20, 2012) – BMO Asset Management Inc. (BMO AM) today introduced four new funds to its Exchange Traded Fund (ETF)* product suite.

In fact, the new ETF’s launched by Bank of Montreal grew 48.3% in 2011.  When it comes to the investment fund industry, go big or go home!  You’d think that Claymore Investment’s ETF’s would have it made with over $6 Billion in assets under management (AUM) but alas the company was recently bought by Blackrock, the largest money manager in the world with $29 Billion under management.  It will be interesting to see if the likes of Blackrock will have staying power in Canada against the banks.  After all RBC has total bank assets twenty-five times that figure.  Survival in the business of investment funds, and perhaps wealth management in general depends on the beneficence of the Big Five.

Admittedly, the foray of insurance companies  into the investment industry has been aggressive and successful for the most part.  With distribution capability and scale they certainly can compete, but the banks have a huge head start.  Most insurance companies are only beginning to build out their wealth management divisions.  I can see a logical fit between insurance and investments from a financial planning perspective, but then the banks know this and have already begun to encroach on the insurance side of the equation.  Nevertheless I would not discount the ability of the insurance companies to capture signficant market share.

So, is it a good thing that larger financial institutions own the investment industry?  Consider the world of medicine.  No doubt a seasoned general practitioner will feel nostalgic for days gone by when patients viewed them as experts and trusted their every judgement.  The owner of the corner hardware store no doubt holds fond memories of those days before the coming of Home Depot.  Part of me wants to believe that investors were better served before the banks stampeded into the industry but I’d just be fooling myself.  Although consolidation has resulted in fewer but more powerful industry leaders, the truth is that never before have investors had so wide an array of choices.  Hospitals today are filled with medical specialists, while banks and insurance companies too are bursting at the seams with financial specialists.

It is not fun becoming a dinosaur, but this general practitioner has to admit progress is unstoppable.

Malvin Spooner

 

 

 

 

 

 

 

 

*The industry charts are courtesy of the third quarter Scotiabank research report Mutual Fund Review.  The annotations are my own.