Forever In Search of Greener Pastures

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Fun for the family, not for your RRSP…

Over the past few years, the growing chorus from the media about Exchange Traded Funds (ETFs) and their necessity within a portfolio has approached a near deafeining volume. In case you’ve forgotten, ETFs are the low cost investment strategy – frequently referred to as passive investments – that mimic indices, providing both the maximum up- and down-sides of the market.

I continue to harbour my doubts about the attractiveness of such investments, though I do use them from time-to-time when the situation calls for it. On the whole, though, I find it interesting that Canadian investors have been reluctant to walk away from their mutual funds, despite the assurance by talking heads that costs are too high and that ETFs are more attractive.

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This isn’t the first time that Canadians have been encouraged to broaden their investment horizons and adopt “better” vehicles for their money. Hedge funds were once an investment option for only the most wealthy, but eventually they found their way into the mainstream of investment solutions. The result was a flood of new money, which made some star managers household names, extensively broadened their investment reach and lined their pockets. The industry, once a niche, became far more commonplace. And why wouldn’t Canadians want a slice of an investment strategy that promised to be able to make money regardless of the market conditions? There has been a regular supply of managers promising to short stocks, juggle derivatives, and leverage cash to deliver positive returns regardless what was transpiring in the world. All of them (or almost; I will assume that there were some lucky ones) have fallen decidedly short. Canadians were largely let down by the last “big thing”.

The appeal of investments that are not mutual funds is understandable. Mutual funds are boring, and ubiquitous. Canadians have a lot of them, and almost without exception they make up the majority of any average portfolio. The workaday nature of these investments gives people the nagging feeling that the wealthiest among us very likely have something different, something better than what can be bought at any bank or offered by any financial advisor.

In some respects, this is true: more money does, in fact, open doors to different investment opportunities. However, people might be surprised at how small a percentage they make of any portfolio, even those that belong to the wealthiest 0.01% of Canadians, and before seeking to participate in these, we should be mindful of the lessons associated with the broadening hedge fund market. For the last three years, hedge funds have been badly underperforming in Canada, well out of line with either mutual funds or indexes. The reasons for this are not immediately obvious, as hedge fund managers offer many explanations as to their lacking performance while giving a mix of investment bombast and optimistic views about “next year.” 

One idea, floated back in 2013, was that hedge funds were good because they were smaller, when money was limited but opportunities seemed abundant. As more money has poured into the hedge fund world, that balance has shifted. Now there is too much money and the opportunities are too sparse. This is an explanation that I think has merit, but will unlikely be echoed by the proprietors of such products.

ETFs, of course, are a different animal altogether and are therefore unlikely to befall the same existing fate of hedge funds and their rock star managers. But the ease and cost effectiveness of these funds has inspired a slew of new products that either invest in smaller, more volatile markets, or are so complicated that they cannot be properly understood, and thereby expose investors to risk they may not be prepared for.

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A colleague of mine described the coverage in the press as being one of “getting all the facts right and still drawing the wrong conclusion”. Canadians don’t continue to stick with Mutual funds because they are oblivious to higher costs, but because volatility and the fear of loss is of much greater concern and poses a bigger set of risks for investors than the cost of their holdings. And while it is true that, over time, ETFs may perform slightly better than actively managed funds, most of us cannot afford to be approaching our investments on a decade-by-decade level. In bad markets people are loath to sit back and simply “wait it out” as their portfolio value continues to drop without alternative. As a result, this “passive investment” strategy, while seemingly attractive, is not realistically an appropriate alternative to the traditional “active management” strategy of mutual funds, which provide an opportunity to deal with risk and keep people invested – which, to my mind, is what truly counts for long term success.

Canada Has Always Been a Weak Economy

real-estate-investingIt may come as a real surprise to many Canadians but we have never been a strong economy. From the standpoint of most of the world we barely even register as an economic force. Yet a combination of global events have conspired to make Canadians far more comfortable with a greater sense of complacency about the tenuous position of Canada’s economic might.

Don’t get me wrong. It’s not that Canada and Canadians aren’t wealthy. We are. But having a high standard of living is largely a result of forces that have been as much beyond our control as any particular economic decisions we’ve made.

Consider for a second the size of Canada’s economy in relation to the rest of the world. While we may be one of the G8 nations, the Canadian economy only accounts for about 2-3% of the global GDP, and has (according to the IMF) never been higher than the world’s 8th largest economy. Even with the growth in the oil fields Canada hasn’t contributed more than 2.8% to global growth between 2000 and 2010.

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The Rise and Fall of Nortel Stock.

It’s not just that Canada isn’t a big economy, we’re also a narrow one. In the past we’ve looked at how the TSX is dominated by only a few sectors, but the investable market can play even crueler tricks than that. If you can remember the tech boom and the once great titan Nortel, you might only remember their fall from grace, wiping out 60,000 Canadian jobs and huge gains in the stock market. What you should know is that as companies get bigger in the TSX they end up accounting for an ever greater proportion of the index. At its peak Nortel accounted for 33% of the S&P/TSX, creating a dangerous weighting in the index that adversely affected everyone else and skewed performance.

Similarly much of Canada’s success through the 90s and early 2000s had as much to do with a declining dollar. While it may be the scourge of every Canadian tourist, it is an enormous benefit to Canadian industry and exports. Starting in 2007 the Canadian dollar began to gain significantly against the US dollar. This sudden gain in the dollar contributed to Canada’s relative outperformance against every global market. The dollar’s rise was also closely connected to the rise in the value of oil and the strong growth in the Alberta oil sands.

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This mix of currency fluctuations, oil revenue and narrow investable market has created an illusion for Canadian investors. It has created the appearance of a place to invest with greater strength and security than is actually provided.

Some studies have shown that the average Canadian investor will have up to 65% of their portfolio housed in Canadian equities. This is insane for all kinds of obvious reasons. Obvious except for the average Canadian. This preference for investing heavily into your local economy has been coined “home bias” and there is lots of work out there for you to read if you are interested. But while Canadians may be blind to the dangers of over contributing to their own markets, it becomes obvious if you recommend that you place 65% of your money in the Belgium or the Swedish stock market. However long Canada’s relative market strength lasts investors should remember that all things revert to the mean. That’s a danger that investors should account for.