Within wealth management there is still a lot of confusion with respect to whether or not an investor should have a discretionary or non-discretionary investment portfolio.In other words, should your family manage its investments by itself, or outsource the decisions to an individual or a firm of experienced professionals?
Discretionary investment management services are a popular option for those who lack the investment experience, time or discipline to be involved with day-to-day decision making. However, not all discretionary services offered by banks, brokers, or portfolio managers are the same.
Here are some important factors to consider – does the advisor or firm:
Have the skill, experience and resources to evaluate and manage assets across public and private markets?
Only offer a one-size-fits all approach that only utilizes one or few asset classes, such as stocks and bonds? If so, look elsewhere.
Have the ability to allocate capital without conflict-of-interest, to any independent asset managers from around the world in areas such as direct lending, real estate, private equity and hedge funds? This is known as an “open architecture” approach.
Have the ability to access “best-in-class” institutional quality traditional and alternative asset managers?
Provide a culture centered on client relationship management and strong communication?
Offer robust performance reporting along with relevant custom benchmarks?
Allow for clients to meet or speak with underlying asset managers?
Take tax considerations into account to optimize returns on an after-tax basis?
Firms that provide this comprehensive style of discretionary management are called “outsourced Chief Investment Officers”, or “OCIOs” for short. These firms should be licensed as a Portfolio Manager with a provincial securities regulator such as the Ontario Securities Commission.
If your family opts for hiring an outsourced CIO, you and the Advising Representative (a registered individual who can provide investment advice at a Portfolio Manager firm) will start your relationship by discussing and documenting your unique investment objectives and constraints. Topics covered should include how much investment risk you are willing to take, the desired level of return to receive for taking on that risk, liquidity needs, tax considerations, performance reporting and benchmarks, and the asset classes and markets you will allow your portfolio to be invested will be addressed. A written investment policy statement is then provided as a best practice which documents all of the above.
Your Advising Representative is then authorized to make all of the necessary investment decisions (within the agreed upon guidelines) and will not require consent for individual transactions. This service, which also consists of regular communication through methods which best suit your family whether it’s in-person meetings, web cam meetings, telephone conversations, emails and newsletters form an important part of the ongoing relationship. What should be understood is that this ongoing relationship is of prime importance as conditions within your family change, the investment objectives and strategy may need to change as well to provide a tailored fit.
Northland Wealth Management is an internationally recognized multi-award winning wealth manager who provides outsourced CIO and family office services to successful business families and their members. The firm was built with the purpose of advising families in an unconflicted manner on their financial and human capital with the objective of preserving and growing the wealth over generations.
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 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.
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.
Once we recognize that all investment portfolios eventually become retirement income portfolios, we can begin to focus on the regular recurring income that they produce… retired or not, the market value of your private portfolio (or of your 401k plan) has no purchasing power.
Yet all 401k programs are performance evaluated on market value growth as opposed to income production.
In late 1999, Microsoft Corporation (MSFT) common stock was at an all time high of $58.38 (split adjusted), and there were thousands of MSFT multi-millionaires out there confident that their retirement was secure…. with a guaranteed monthly income of ?
Please send me an email with the amount of income produced by a million dollars worth of Microsoft in 1999… or your favorite ETF or TDF today.
Several years later, one of those millionaires, and a golf buddy of mine, disclosed that he had just sold the 7 series BMW he had purchased with the proceeds of his MSFT stock… the one “asset” he still had from his dot.com fortune. Pushing 65, he just couldn’t bear the memory any longer.
If only he had sold the entire portfolio… or converted enough to tax free Closed End Funds to assure a lifetime income.
Yet no 401k programs today will hold income Closed End Funds (yielding 7% or so right now). Why? Because, according to the Department of Labor, 2% after low expenses is better than 7% after higher expenses.
By September 2000, MSFT stock had fallen by almost 50%; nearly 15 years later, with the market near its highest numberl ever, MSFT (at $47.60) remains 18% below its 1999 level… it didn’t pay a dividend until 2003, and its dividend yield today is only 2.6%, after many increases.
Back then, most Mutual Fund portfolios contained MSFT and hundreds of similar NASDAQ securities… and this was OK with all varieties of regulators and plan fiduciaries because the markets, after all, were trending upward.
MCIM portfolios contained no NASDAQ equities, no Mutual Funds at all, and a growing income component of at least 30%… hmmm.
It took more than 15 years for NASDAQ to regain its 1999 level… how many of the heroes survived?
Today, most Mutual Fund investment portfolios and ETF gaming devices contain 1999 Microsoft look alikes, and most pay very little income…
MCIM portfolios? Well, no… no Mutual Funds, and no ETFs, just IGVSI (NYSE dividend paying) equities, and an income CEF component of at least 40%.
Can you get an MCIM Income Purpose portfolio in your IRA… absolutely; in your 401k… it’s a long sad story.
March 2000 witnessed the S&P 500 Index breach the 1,500 barrier for the very first time… seven and a half years later, it was in just about the same position.
Inter-day October 15th, after an incredible bounce from its 56% drop through March 6th 2009, the S&P was just 20% above where it had been 14.5 years earlier… a gain of roughly 1.4% per year.
Just how low will it go this time? and are you prepared… this time?
The long term chart (Google “s & p 500 chart”, look mid page and click “max”) shows the volatility over the past fifteen years. Just for kicks, see if you can find the “crash” of 1987 (October 19th).
Could any stock market image be more beautiful? Could any be more in-your-face damning… tactically?
What if your 401k investment strategy had required selling before the profits started to erode?
What if your 401k strategy made youhold equity-destined cash until Investment Grade Value Stocks fell at least 20% before selective, patient, cautious buying began?
What if your 401k investment strategy called forat least 40% of your investment portfolio to always be invested in income purpose securities?… securities rising in price so far today, in the midst of a major sell off.
Such an approach has been available since the 1980’s for a lot of happy investors who have never had to change their retirement dates; and the same program has been available to 401k investors since March 0f this year… but you have not been allowed to know about it!
You can’t use it because your 401k plan rules don’t allow you to invest in 40 year old “makes-a -lotta-sense” strategies, just because they have a new label and/or not enough millions under management… who’s protecting whom?
This is precisely how the big operators keep new and innovative solutions on the sidelines. Tough luck investors… you’ll just have to bite the bullet and watch your “by-design” speculative portfolios crumble for the third time in fifteen years.
Pity, but one-size-fits-all rules are every bit as bad for your financial health as one-size-fits-all products. How are those TDFs doing… and with all that experience and mega millions under management.
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.
Decades ago, the academic community and financial services industry, in an effort to better understand what causes good versus bad rates of return in stock markets, began studying differing styles of investment management. There isn’t a hope of my staying awake long enough to cover even a sampling of the variety of styles that are out there, so I’ll keep it simple. Two styles in particular get plenty of attention: growth and value.
With the growth style, portfolio managers use their ingenuity to identify companies that are growing most rapidly. Since I carried around a BlackBerry (aka CrackBerry) for many years, I’ll use its creator Research in Motion(RIM) as an example. When the company was first getting its legs, it offered me and other research analysts a free trial of a little device with a monochrome screen that allowed you to send and receive text messages. We became addicted to them overnight and believed that this kind of service would catch on. Early movers can grow businesses very quickly with sufficient research depth, management expertise, and capital. We professional money managers provided the capital to RIM and the rest is history.
Early on, RIM was a growth company because even though they weren’t profitable and wouldn’t be making money for many years, the company kept selling more and more units. Revenues grew like crazy and, with some occasional disruptions (a market crisis, the technology bubble bursting), so did the stock price.
Portfolio managers who specialize in companies such as RIM are commonly called growth managers. The funds they manage are “growth funds.” The portfolio will usually have many stocks in various industries. They can be fast growing companies in slow growth industries or companies benefitting from an industry that is suddenly growing. Growth stocks can be very expensive. Investors expect the company to grow fast and so are willing to pay a higher price. However, you’ll have to buy a book explaining price/earnings (P/E) ratios, P/E to growth rate ratios, price/sales (P/S) ratios if you really want to get into security analysis yourself.
A value manager is more interested in buying and owning cheap stocks. Some companies grow slowly but pay their shareowners high dividends as compensation. A stock can be in an industry that is out of favour with the investment herd, or an industry can be out of favour entirely, making all the stocks in the sector cheaper. There are measures such as price/book ratios (P/B) and price to net asset value ratios that analysts use to gauge whether a stock is cheap or not.
Growth funds are considered riskier or more volatile than value funds. For instance, if the market is going higher because of a particularly strong economy, then the growth fund should go even higher still. A value manager might not perform as well as a growth manager in a bull market but won’t do as poorly in a bear market. A value manager is therefore considered more conservative.
A strategist friend of mine of TD Newcrest Research allows me to use his charts on occasion. One of the most telling charts compares growth stocks in the S&P 500 Index to Value stocks. The adjacent chart is an older one. When the line is rising, growth stocks are significantly outperforming value stocks. You can see vividly the technology bubble – growth stocks skyrocketing relative to value stocks – prior to the bubble bursting in the year 2000.
The shaded areas are periods of economic stimulation (US Federal Bank monetary easing). During these periods it’s not unusual for growth funds to perform much more strongly than value-oriented funds.
Conventional wisdom says that conservative investors who can’t stomach as much volatility should use value funds and that investors who don’t mind a wild ride should use growth funds. Alternatively, you can invest most of your money into a value fund while also putting some into a growth fund so that you might occasionally get more returns in a buoyant market with at least a portion of your savings.
Why not growth when growth is performing and value at other times?
There are portfolio managers like me who hate being pigeonholed into either one of these styles. However, it is inevitable that one label or the other will be associated with a money manager because of the way consulting services are compensated and the way mutual funds are marketed (when growth is sexy, it only makes sense to promote the growth manager).
A maverick investor who understands the ebbs and flows of market sentiment will want to be invested in their favourite growth fund at the right time and to switch into a value fund at other times.
Whenever I’ve recommended a more active approach to selecting mutual funds in print or on television, such as using a growth fund and switching into a value fund when appropriate, I always get the same question: “How do you know when to switch?”
There is an easy answer, but nobody likes hearing it. The answer is: “You will know!” You should switch when your intuition or emotions tell you nottoo. It is that simple. If the fund you own has been doing extremely well and drifted up towards the top quartile or is now in the “best performing funds” category (rankings are available from a wide variety of publicly available services) and so you’ve begun to love it dearly, it’s time to switch into a different style of fund.
Here is a more current chart. In this case the shaded areas are periods of recession, and we are all aware that for the past few years monetary stimulus has been the norm. Not surprisingly then, growth stocks – avoided by most investors like the plague – have been outperforming value stocks.
As investors divest their income biased stocks (and bonds) they will naturally be tempted to move the money into the better performing growth style. However if history (and experience) is any guide, they’d be well advised to focus their attention on stocks and funds that have not yet participated in the recent market rally. In the event that government policy, encouraged by the rebound in the housing market, strong corporate earnings and slowly improving employment outlook, becomes less stimulative then value will in all likelihood become the place to be.
Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.
Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:
A great track record of top quartile performance over at least three to five years.
Billions of dollars invested in it, so it is “safe.”
Offered by an investment firm with a long and “distinguished” history.
Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.
It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.
The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.
A great track record might actually guarantee poor performance.
When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”
There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.
Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?
I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:
100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.
Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.
It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.
Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:
Fund performance begins to soar.
Fund attracts lots of new money.
Marketing folks want more and more time from portfolio manager for meetings.
Money pours into the fund in droves.
Portfolio manager’s head swells (the “I’m a genius” syndrome).
Performance begins to deteriorate.
Money leaves the fund in droves.
Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
Performance sucks, and it takes two to three years for things to get back to normal.
Size really doesn’t matter…unless the fund is humongous.
A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.
Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.
Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.
The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?
Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.
Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.
Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.
This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.
With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!
When RRSP season rolls around, it’s not unusual for dissatisfied clients to consider firing their investment adviser and finding a new one. Even though most of the time it’s the client who’s the problem and not the adviser (more about this later), once the decision is made the question is how to select a new adviser?
Out of the several thousand investment advisers and financial planners I’ve met over the years, at least a few ‘hundred’ have what I consider to be the savvy to do an excellent job for their clients. If only 10% of potential advisers are exceptional, finding one will require some work. Ideally some of what follows will make the job a bit easier for some.
The most important thing to remember is that a capable stockbroker or financial planner doesn’t have to meet the stereotype. For example, I was looking to hire a new sales rep for my fund company and received a resume from a fellow who was actually an investment adviser looking for a change. I arranged to meet with him, and just happened to be standing on the street in front of our building when this black BMW pulls up, and a jittery youngster (young compared to me anyway) gets out. He has his hair gelled straight back like Gordon Gekko, the fictional bigwig from the movie Wall Street, wearing the well-tailored pinstripe suit complete with suspenders that weren’t really necessary. I didn’t hire him.
Beware of those advisers that are into role-playing. It is okay I suppose to have a nice car, but a ‘look-at-me’ aura is a warning sign. When someone deliberately adorns the trappings of success, I believe there’s insecurity in their personality. Certainly your adviser should exude confidence but shouldn’t need or want to stand out from the crowd by adorning themselves with accoutrements.
You must be realistic. Your adviser does work for a financial services firm, so expect to be using products and services offered by his company. However any evidence that he/she is willing to deviate from the company’s party line for your benefit is a very good sign.
Ask him/her what he/she thinks about the market or a mutual fund, or even an individual stock or two. If he/she simply regurgitates the newspaper headlines or is in love with a top performing mutual fund (you can’t ‘eat’ past performance is one of my favorite expressions), or his/her favourite stocks are everyone else’s favourite stocks too, you might want to avoid this adviser. On the other hand, if you sense a real independent thinker willing to disagree with conventional wisdom, the adviser is a keeper.
Larger firms are especially good at marketing their wares, and I would recommend that it is infinitely better that you look for the right adviser rather than to just agree to hire the one that lands on your doorstep. Keep in mind that good investment managers are not always good with people. A good first impression is not necessarily an indication that the adviser does good work. Ask questions. For example, ask exactly how they handled themselves in the financial crisis?
Even though it is extremely difficult (likely impossible) to predict market declines, anyone can certainly “do something” about their circumstances once the proverbial poop hits the fan. Investment professionals often respond differently depending upon depth of experience or temperament:
Some are no more experienced (or no smarter) than their clients – they panic and sell at the bottom of markets.
Some proclaim a new respect for caution, and hold more cash and bonds….after it’s too late.
Some boldly acknowledge they didn’t see the Bear Market coming, apologize and admit that they are buying cheap assets aggressively ‘near’ the bottom (a good sign indeed).
Asking tough questions will enable you to determine whether you’re talking to a pro. Don’t be afraid to sound stupid – it’s your money we’re talking about here and not your ego.
You may want to stay with the big firm you’re banking with for convenience, or choose to find a smaller firm that is more specialized in managing money for individuals. It is much easier to learn about what motivates the professionals in a smaller wealth management boutique, learn about their investment philosophy and get personal attention.
Heads up! When a firm’s performance presented to you seems too good to be true; it probably is. A prime example was the case of Bernie Madoff.
In March 2009, Madoff pleaded guilty to 11 federal crimes and admitted to turning his wealth management business into a massive Ponzi scheme that defrauded thousands of investors out of billions of dollars. Madoff said he began the Ponzi scheme in the early 1990s. However, federal investigators believe the fraud began as early as the 1980s, and the investment operation may never have been legitimate.
Even small wealth management companies ordinarily have their performance numbers calculated and audited by third party services. Make sure any performance data you see has been vetted by an independent third party. Although instances of fraud get volumes of press coverage, they are one in millions.
Most boutique investment firms aren’t gifted marketers, and they rely heavily upon word-of-mouth to get new clients. Ask friends, your accountant or lawyer for referrals. There’s no harm calling and arranging to visit a few firms.
Never hire a Wealth Management firm based only on past performance.
Don’t complain about investment results. Ask for an explanation.
Never second guess your adviser.
Pay the fees – sure hey hurt when performance is poor, but you won’t care at all when performance is good.
Be patient. Good things don’t happen overnight or every day.
Don’t pretend to be smarter than your adviser, you’re not! Tips number 2 and 3 are very important. I mentioned earlier that oftentimes the client is the problem, not the adviser. In times of stress, we have a tendency to let our emotions get the better of us. It’s kind of like swimming – if you panic then you’re more likely to drown. Your investment adviser cannot walk on water, but is trained to swim. There is an infinite number of things that can and do damage investment portfolios. The most damaging crises cannot generally be controlled, but wealth can be salvaged and even restored if level heads prevail. Click on the picture to watch a funny video I made – are you at all like this client?
I’ve been reading lots of articles suggesting that the stock market is ‘overbought’ (an expression meaning that we’re in some sort of a bubble, stocks are overvalued and risk is high that they’ll plummet) but then I’ve been reading the same thing over and over for a few years. In fact I’ve been hearing the same thing ever since I suggested buying stocks while writing my book (A Maverick Investor’s Guidebook, Insomniac Press) back in 2010. I’ve been a portfolio manager for a very long time, and find it fascinating that investors – even professional money managers – let their judgement be unduly influenced by their opinions which are biased by experience. Experience is a funny thing. For instance, the wife of a good friend of mine went to the trouble of working towards getting her motorcycle license. Although she passed the test with little difficulty, she hopped on her husband’s bike to go for a ride, lost control and dropped the bike. She never tried riding a bike ever again because of one bad experience.
Consider this quote from a smart friend of mine:
‘How much has your equity portfolio given on a yearly basis from January 1 , 2007 to today ( 6 years in 3 weeks. By bet is around 2%. You are doing some wishful thinking Mal. The growth game is over.”
Why did she pick that particular date? It’s probably not an accident. Timing is everything when it comes to volatile assets and the stock market is nothing if not volatile. Randomly chat with folks (like I do) and you’ll find some just can’t believe the stock market has made anyone any money…..EVER! Talk to someone else and they might tell you they’ve been very happy with their experience. Have a look at this graph:
If you’d invested your money (starting point) five or six years ago, you’d understandably be disappointed – see the red line. If you’d decided to include stocks in your financial plan ten years ago (green line), it’s likely you’re satisfied and have no difficulty weathering a temporary storm. An investor who read my book and put money to work coming out of the financial crisis (orange) will not only be ecstatic, he/she will no doubt have an exaggerated sense of their own investment ‘skills.’
In my estimation (which could be dead wrong) economic growth has only just begun to accelerate and I am not the only soul that believes it. John Aitkens is an old friend and an excellent investment strategist at TD Securities. These are his words (and his chart):
“We continue to believe that global policy stimulus is driving a re-acceleration of US and global growth that will become increasing evident over the next few months. We therefore continue to recommend an overweight in stocks and an underweight in bonds. We recommend overweighting non-price sensitive cyclical areas (technology, industrials, consumer discretionary), while underweighting defensive sectors (utilities, telecom, consumer staples). We have financials, resources and health care at market weight.”
Over many years John and I have been in agreement about the direction of markets…..i.e. he’s usually right.