Expert Opinions and Market Timing

Research into investor performance has shown quite convincingly that for the average investor, market timing does not work. I don't think that this statement is so controversial that I should spend time providing supporting information on this blog. (Search engines will provide plenty of reading on the topic.)

If this is such a well-known fact, why do we so enthusiastically consume speculative commentary on the markets? Or rather, why do we believe that we can make the jump from "expert speculation" to successfully timed investment?

The field of behavioural finance strives to answer questions like these with a scientific approach. On an individual level, we can also perform a thought exercise to find our personal stumbling blocks. Here's my list. I encourage you to think about your own, and share them in the comments.

In no particular order:

1. It's comforting to believe that someone has an expert handle on this stuff. In many parts of our lives, we make use of products and services that we do not fully understand. In many ways this requires a leap of faith. For instance, that cell phones are safe and are not causing us brain tumors, that the formula we feed our babies is a good substitute for breastmilk, or perhaps that the water filter we just bought makes the water more fit for drinking (how many people know what those filters actually do?). We assume that somewhere along the way, some experts have proved that the products we use do what they say the do (and don't do anything else). In financial matters, where are our experts, and where is their proof?
2. We're all above average (the Lake Wobegon Effect). Since I'm smarter than the average person, I can make use of information to formulate and execute a superior plan.
3. Spectacular stories of people who have made it big. Is it luck? Is it skill? I don't know, but every once in a while, we'll hear about someone who bet it all and made a fortune. We all want to be that person.
4. Market timing is fun and exciting. Feel the thrill of a money-making trade! Quickly forget the rest.
   
5. Not tracking personal portfolio after-tax performance against a representative benchmark. You might think that you did a great job earning a 10% return, but if your benchmark (not a benchmark of your choosing, but a representative benchmark) returned 12%, you actually did poorly.
6. Lack of understanding of the investment products. Sure, you could read about bonds, stocks and other investment instruments so that you could judge investments for yourself, but isn't it easier to just take the recommendations of experts? They're experts, after all.
7. We don't know the track record of experts' opinions. This is a complicated issue:
1. We need to separate a commentator's own advertised performance (maybe through the fund he/she manages) from the performance of the expert's recommendations that we hear or read about.
2. The "experts" may make frequent recommendations. Make enough guesses frequently enough and you'll eventually get it right. Maybe we should count each recommendation as a buy or sell execution in our tracking system.
3. Recommendations on an investment does not make a portfolio. Did Mr. Expert recommend buying ABC 5 years ago? Has he said anything about it since then for those who added it to their portfolio? Maybe your expert concentrates only on tech stocks and consequently a portfolio of his recommendations would be unbalanced.
   
4. No indication of investment horizon. This is linked to (b) and (c) above. Maybe you buy something based on a recommendation. How long is that recommendation supposed to stand for? Maybe a new recommendation (based on better information, of course) will be made soon (b). Or perhaps your expert will become bored with that particular security and you'll never hear about it again (c).
   
5. There are lots of other issues I invite you to think about, but the point is that until we have a good way of tracking the experts' opinions, we don't have a basis for taking their recommendations.
   

When it's so easy to make very close to benchmark earnings, and study after study shows that the average investor is making less than that, it is really an interesting exercise to think about your own situation and decide how average you want to be.

BMO ETFs Have Started Trading

Four ETFs from BMO started trading on June 4, 2009. Descriptions directly from the press release:

• BMO Canadian Government Bond Index ETF (BGB) has been designed to replicate, to the extent possible, the performance of the Citigroup Canadian Government Bond Index.
• BMO Dow Jones Canada Titans 60 Index ETF (BCA) has been designed to replicate, to the extent possible, the performance of the Dow Jones Canada Titans 60 Index.
• BMO US Equity Index ETF (BUE) has been designed to replicate, to the extent possible, the performance of the Dow Jones U.S. Large-Cap Index (CAD hedged).
• BMO Dow Jones Diamonds^SM Index ETF (BDJ) has been designed to replicate, to the extent possible, the performance of the Dow Jones Industrial Average (CAD hedged).

BUE and BDJ both hedge exposure to the USD. The MERs for the funds are pretty low, undercutting iShares funds. Here's a comparison vs comparable iShares offerings:

Ticker	MER	# Holdings	Comments
BGB	0.341	28	Weighted Avg Duration 6.49; All Federal holdings; All AAA rated
XGB	0.35	86	Weighted Avg Duration 6.34; 63% federal, 34% provincial, 2% municipal; 68% AAA, 19% AA, 12% A
BCA	0.158	61
XIU	0.17	60
BUE	0.231	250
XSP	0.24	501	Invests in IVV, which has 501 holdings
BDJ	0.242	31	No iShares equivalent

BMO also plans to launch 3 other ETFs at a later date covering International Equities, Emerging Markets, and Global Infrastructure.

There isn't that much to say after only a couple of days of trading, but I will keep my eyes on these ETFs. There are only a few ETF sponsors in Canada, and before these BMO ETFs started trading, iShares was the only one tracking traditional market-cap indices. Here's hoping some competition gives rise to better (and lower cost) products.

Bond Investing

For the bond portion of my portfolio, I prefer to use short term bonds and the DEX Short Term Bond Index is probably the closest index to my bond strategy. In Canada, iShares' XSB is the best single ETF tracking the DEX Short Term Bond Index.

However, it still irks me to pay ongoing MERs on bonds when I could buy them individually and just hold them. I also don't like that bond funds' NAVs fluctuate such that it is quite possible to lose money holding bonds through a fund. Bond funds do, however provide the kind of diversification that is not really possible for anyone with less than $500,000 (or some big number like that) to invest.

Lately I've been thinking about how to solve this little problem, and I think I'll try it this way: Government bonds do not really require the diversification that corporate bond holdings do. There is only one issuer of Canada bonds, and only a handful of Provincial issuers. So for government bonds, it is easier to buy individual bonds without worrying so much about diversification.

Thus, appeal of something like iShares' XSB (MER 0.25%) is the diversified holding of corporate bonds. Looking at the iShares offerings, there isn't anything especially appealing for corporate bonds. XCB (MER 0.40%) has a duration that is a bit too long for my liking. Looking over at the Claymore offerings, though, we find the 1-5 Yr Laddered Corporate Bond ETF, CBO (MER 0.25%). CBO is fairly new, but trading volume is not bad for a Claymore fund. I do like that Claymore is offering DRIPs on all their funds now, so that is another plus for CBO.

CBO seems to hold about 70% A-rated bonds, and 30% AA bonds. The number of holdings is somewhat low, at 25, but 25 is also more than I would be able to buy on my own. The duration of the fund is 2.65, which I like. On the down side, there is no getting away from the possibility of losing money in the fund since its value fluctuates, but I think the diversification makes up for it as a corporate bond fund.

So in effect, my short term bonds will be split into government and corporate holdings. Asset allocators will probably like the opportunities to rebalance that this will allow for. There is only one ETF involved, so only one set of transaction fees are incurred when buying or selling. On the down side, when buying bonds from a brokerage, you don't really have a good idea what commissions are being charged. However, in Hank Cunningham's 2nd edition of In Your Best Interest, he investigated the bigger discount brokerages and found that TDW and BMO Investorline were the best for prices and in general found that discount brokerages were charging reasonable commissions on bonds.

The pros and cons of this approach:
Pros:

• Lower overall MER paid.
• Government bond component can be held to maturity.
• More control over allocations to government vs corporate bonds.
  

Cons:

• Overall less diversification than XSB.
• CBO has less diversification than XCB for the corporate component.
• A bit of a hassle to maintain the ladder of government bonds.
  

Preparing To Invest: Read Some Books!

For many of us, the web has become an important learning tool. Search engines have made it wonderfully easy to find information on specific topics. But to me, the web, with no promise that content has been edited or is correct and complete, is not a great tool for getting comprehensive information on broad topics, which is exactly what you want as you prepare to invest.

There is also the question of how the site stays in business. For most, it means selling advertising, which raises issues of conflict of interest. For instance, can I trust a review of credit cards to be fair if the site also runs ads for certain credit card companies? How do I know that a comparison of brokerages is not biased when I see ads for banks running on the site?

The use of hyperlinks on web sites, while at the very core of what makes the web great, means that users can read about whatever pages they like on a site. But it also means that they will probably read only what they like. So structuring information on a broad topic is very difficult.

Newspapers and magazines have similar issues, and also need to constantly generate new content. It does not matter if there are not any new and useful ideas to write about--staying in business for them means writing new articles.

There are plenty of other learning methods, each with their own issues, like learning from chats with friends, or from TV.

To me, the best learning tools are books. Here's why I think so:

• Content is structured: Unless this book was written and edited carelessly, the content is presented in a logical progression. Focus is given to points that are important in the context of the broader topic. Articles on the web and in magazines and newspapers lose this context.
  
• Content is comprehensive: To many people, investing means buying stocks. I'm always surprised by how many people do not understand or consider bonds or other asset classes like real estate. A good investing book will teach you about the different asset classes and how they may (or may not) fit into your portfolio. Articles from other sources mainly focus on one point (usually stocks) and are not as able as books to present information in the context of the full spectrum of investing options.
  
• Once the book is in your hands, the sale is complete. Unless you've picked up a book that is trying to sell you another product, the content is not as influenced by advertisers.

To be sure, there are some books out there that are real stinkers--books written to evangelize the latest mania, to sell another product, short-sighted books, and just plain bad advice books. But all these problems also exist in the pages of non-books, without the positive points that books enjoy.

There is still a place for non-books, especially for doing quick research into specific topics or getting the beat of current trends. But while you are building a foundation of knowledge as you prepare to invest, go read some books!

More Increases To Vanguard ETF Expense Ratios

It looks like the expense ratios on many of Vanguard's ETFs have changed recently. It wasn't that long ago that the expense ratio for VWO was raised by 0.02%.

Some other Vanguard ETFs of interest to Canadians have changed in the last few weeks:

• Vanguard's Total Stock Market ETF (VTI) has raised its expense ratio from 0.07% to 0.09% as of 04/29/2009.
• The expense ratio for the Vanguard Europe Pacific ETF (VEA) was raised from 0.15% to 0.16% on 04/24/2009
• All of their bond ETFs now have an expense ratio of 0.14%

Vanguard's expense ratios are still very low, but I hope this trend doesn't continue.

When to Buy a Currency Hedged Fund

Many international index funds have a version that is currency hedged as well as one that is not. For instance, in the TD e-series funds, there are non-hedged and hedged versions of the TD US Index and TD International Index funds. These funds can have drastically different performance numbers when the Canadian dollar fluctuates against the native currency or currencies of the companies in the index. Here are they yearly performance numbers for those TD funds.

Fund	2003	2004	2005	2006	2007	2008
TD U.S. Index	4.5	2.2	1.7	14.7	-11.1	-21.7
TD U.S. Index Currency Neutral	30.0	11.1	3.3	14.0	3.1	-39.0
TD International Index	13.4	10.9	10.2	25.5	-6.0	-27.9
TD International Index Currency Neutral	21.7	11.1	27.8	16.6	3.4	-42.2

Notice how in certain years, the performance of a fund's hedged (currency neutral) version can be quite different from the performance of the non-hedged version. This is because of currency fluctuations (tracking error also plays a part). In the case of the US index, the currency fluctuation is between the CAD and the USD, and in the International index, it is between the CAD and the various currencies in the international index.

Let's take a look at currency movements from 2003 to 2008:

So the currency neutral versions of the funds did better in years when the Canadian dollar rose against the US dollar. The non-hedged versions did better in years when the Canadian dollar fell versus the US dollar. Note that it is the change in the exchange rate and not the actual value of the exchange rate that affects returns.

Ideally, then, you want to buy the currency neutral version in years when the Canadian dollar is low, hoping to cash in when the CAD rises. Similarly, you want to buy the non-hedged version when the Canadian dollar is high, to take advantage of when the CAD falls.

Of course, timing such a move is pretty difficult, but we can look at historical data to get some idea of what could be considered a high or low Canadian dollar. Here is a chart of exchange rate data beginning in 1971 and ending May 2009:

I won't claim to know where the USD/CAD exchange rate will go, but this chart tells us that during this period, 1.00 CAD = 1 USD was pretty high, and around 1.00 CAD = 0.70 USD was pretty low. Again, I am not saying that this is how things will be in the future.

Using these numbers as a guide, we could perhaps set a rule to buy the currency hedged versions of the funds when 1.00 CAD is under 0.80 USD and buy the non-hedged version when 1.00 CAD is above 0.80 USD.

I can't guarantee that this will work in the future, but looking at the historical numbers, this appears to be a reasonable idea. There maybe other factors that would discourage this kind of thinking. For instance, you might not want to have two versions of the same index because of transaction costs or perhaps your currency hedged fund costs a lot more than your non-hedged version.

Also note that I've looked only at the CAD versus USD exchange rate. In international funds, you should consider the native currencies in the fund.

Another consideration: I am assuming that the investor wants to keep his/her investments in Canadian dollars. If you are open to holding the fund in US dollars, for example the TD U.S. Index ($US) (TDB952) instead of the TD US. Index Currency Neutral fund (TDB904), the fund in native dollars usually performs better than the one hedged in CAD due to tracking error. However, I think that the observations on currency fluctuations still holds.

And finally: Since currency movements are not predictable, and seem to even out over long periods, the choice between hedged or non-hedged funds probably isn't that important for the long term buy-and-hold investor, which is why this post is filed under the Noise tag.

Note: All chart graphics used in this post are © 2009 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada and were generated using the tool at http://fx.sauder.ubc.ca/plot.html.

Get All The Benefits That You Qualify For

When we enter the various stages of our lives, we are often so busy adjusting to the changes that we don't look into benefits that we should be getting. Since you must apply for many of the benefits available, a lot of us miss out on those benefits for some time while we sort out our lives. Some of the significant events that can qualify you for benefits that you were not previously collecting are:

• Marriage
• The birth of a child
• Change in income or employment status
  
• Health changes and deaths in the family
  
• Retirement

For instance, with the birth of a child, here are some of the things you can do:

• Set up an RESP for the child's education
• Collect the Universal Child Care Benefit
• Collect the Canada Child Tax Benefit

It is hard to keep track of all the programs that are available, both from the federal government as well as from your province, but the government has set up a handy web site to help you find all the benefits that you qualify for at CanadaBenefits.gc.ca. Tell it your province of residence, and head over to the Benefits Finder. You'll be asked a few questions and then be given a nice list of applicable benefits. Each benefit is marked as either federal or provincial.

Using this site, you can make sure that you are getting all the benefits for your current situation, and you can also use it see what you may be qualified to receive in hypothetical situations. Use the tool to plan ahead for events like the birth of a child so that when that event happens and you're busy waking up at 3am to change diapers, you won't need to also scramble to learn about and apply for (or put off for a few years) the benefits that you are entitled to.