Advisors Claim Fiduciary Duty Would “Sink Many Small Dealers”

May 29, 2013 Leave a comment

The long line of excuses for poor service continues with this Investment Executive article, which details all the good reasons that advisors should not be held to a fiduciary standard of duty (in other words, legally bound to do what they keep promising).

The article goes into all the liability that they would face if they made a bad recommendation that caused a client to lose money. For example it says that advisors couldn’t protect themselves by saying the client understood the risks, because “CSA’s consultation paper indicates that the vast majority of clients are assumed to have little financial knowledge, and therefore can’t be expected to comprehend the risks – even if they were appropriately disclosed and explained”.

The article goes so far as to make it sound like advisors would be sued by every client just because they could have made a slightly better decision if they knew the future, saying “The client bears absolutely no responsibility for his or her poor choices, even though the client is the ultimate decision maker”.

However, I wonder if this opens up a big hole in the concept. A lot of clients probably don’t follow their advisor’s recommendations. So if the advisor recommends one thing and the client tells them to do another, is the advisor still liable? If not, that could leave a lot of clients still vulnerable to bad investment decisions. In fact there might be room for sneaky advisors to softly say the “right thing to do” while also hinting that there is a much better investment (that also generates more fees) to entice clients to override the advisor’s recommendation.

On the other side if the advisor is still liable for following the client’s instructions, then a lot of clients would probably end up being upset that their advisor won’t do what they want and will even leave the advisor.

There don’t seem to be any easy answers for this, but I would imagine that full disclosure of the fees that clients are paying would also help avoid many hidden dangers. That way clients could at least see that certain investments pay the advisor a much higher fee, without having to dig in to a 90-page report. They might still choose to believe that it costs more because it’s better, but I think a lot of people would be more cautious if they knew that their choices resulted in thousands of dollars in additional income for their advisor. In the end I’m glad that I don’t need to trust someone else to make decisions for me.


The S&P 500 Has Risen by 1000 Points in 4 Years

May 17, 2013 Leave a comment

After the quick rise that I noticed last week, the US stock market index has kept going to reach another milestone. As we know the recent low was $666 during the day of March 6th 2009 (if you search for that now you will find some seriously weird websites – including one blogger who takes credit for calling the bottom a full month after it happened). As I watched the Google Finance page this afternoon it rose to $1,666, marking a gain of a full 1000 points in 4 years, 2 months, and 11 days. It actually went up to $1,667 for a few minutes before traders wised up and brought it down to close at a more significant number.

It’s interesting to note that if you read anything about investment back in early 2009, all you saw was warnings about how the stock markets were sure to crash again soon and you had to get out before that happened. And that is much the same as what you will read today. Obviously the price was a lot better in those days. But we still seem to be lacking the blind over-enthusiasm that marks a bubble. We’ll all be better off if it doesn’t come back.

The Trigger for Stock Price Gains: Falling Gold Prices

May 13, 2013 Leave a comment

For a while I’ve been wondering what it would take for investors to pile back into stocks. A lot of investors left the market in the last 5 years and haven’t returned, but eventually rising prices should be enough to convince them that it’s safe again. Of course by the time they jump in again it won’t be safe and they’ll have missed out on the best gains. Still, the recent price rises in the US market seem to only be fuelling fears that keep people away from stocks.

But I think I’ve finally found what it will really take. While I was reading an article on the Globe and Mail, a sidebar linked to a video titled “With Falling Gold Prices, Investors Turn To Stocks”. So it turns out I was missing part of the story. People weren’t content to merely sell low and buy high in stocks, sitting in unproductive cash or bonds while waiting. They had to go out and lose more money speculating on gold first. I guess that leaves them with less to move back into stocks now.

The S&P 500 Has Risen 100 Points In 3 Weeks

May 10, 2013 1 comment

One of the nice things about switching our portfolio to ETFs is that I can do my weekly update on Friday at 2PM when the market closes instead of having to wait until the next day to get the latest e-Series unit values. While doing that I noticed that the S&P 500 closed at $1,633 today, and it was at $1,537 on the week of April 19th. That means it has gone up by nearly $100 over those 3 weeks.

Although the market can be quiet most of the time and dangerous at other times, things like this also happen regularly. A lot of the long-term returns seem to come over a few short periods. Those who try to time the market can easily miss out on moves like this.

Breaking News: Stock Markets Can Go Up

May 7, 2013 Leave a comment

A lot of people are talking about the dangers of investing in the stock market now that it has risen so much in recent years. There are a few flaws in these arguments but one of the interesting things is that the true reason behind them is the same one that drove investors to be very aggressive in 1999 and 2006.

If you go back 10 – 15 years, many investors had seen a very long and seemingly unstoppable bull market for stocks starting in the early 80s. There were a few crashes, but what they learned was that these were great buying opportunities because the market always came back fast and reached new highs. They had completely forgotten the multi-decade bear markets earlier in the last century. As a result, if the market was going up they thought it would go up further and if it was going down they thought it would turn around soon.

This rush of confidence led to a peak in 2000 and again in 2007. Finally the news 5 years ago was enough to break investor confidence and they really sent the markets down. But now we’re seeing the same logic play out with a different reference point.

Many investors can look back and see that the stock market hasn’t increased by much since 2000. Many indexes have barely passed their levels at that time. If you account for inflation the picture looks even worse; the peak S&P 500 value 13 years ago would be around $2000 today. So investors have learned that stock markets don’t really go up and if they do they will probably crash again soon. We are forgetting the times when the market has done well.

Despite the large gains we’ve already seen this year, this seems to still be the dominant mindset among investors. In 1999 it was easy to think that the stock market goes up a lot, and hard to believe that it should come down at such an exciting time. Now it’s easy to think that the stock market never really advances in such a dangerous time.

We need to remember that since it tends to have an increasing value over time, there is nothing particularly dangerous about reaching new highs. This should happen regularly. And prices that were once normal eventually become so low that we will never see them again.

It’s entirely possible for the market to set a record high and then never fall below that level again. It’s possible for the market to rise a lot, and then rise some more. The rate of return may decline for a bit after a large jump, but if the fundamentals have gotten ahead of the prices then it’s still a safe market. The highest price we’ve ever seen might also be the start of a bull market.

For example in early 1985 the S&P 500 reached a price of $177. It had never been that high before and was never that low again apart from a few days later in that year. And this was only two and a half years into the recovery from a long bear market that had seen a closing price in 1982 that was 7% below the price from 9 years prior. Over the next 15 years it reached many new highs only to keep going higher.

I also believe that a correction or a crash is possible. I would welcome that. As much as people say that the market is overpriced, I believe they would be even more afraid if it did crash again. This would just confirm their fears. They are more likely to buy in if it keeps rising and they see others making money.

With so many people still being scared of the stock market, I wonder how much further it has to rise before they believe that it is safe again. And I wonder how much higher they will push it once they do change their minds. If that’s what plays out it will be very expensive for investors who thought they were being cautious.

Ironically the level of fear these days in the media and on blogs sounds a lot like what everyone was saying in 2009. It’s a hard time to invest in stocks. But it just might be a good time.

The Tax Drag of Dividends

April 23, 2013 Leave a comment

It is regularly pointed out that stock market dividends have fallen significantly from what they were 20, 40, or 60 years ago. At one time it was normal for stocks to yield more than bonds. That didn’t happen in major markets from the 60s up to 2010. But that dividend yield in 2010 that once again topped the bonds was much lower than the dividends you could get even 20 years ago. It’s now normal for US stocks to yield about 2% and other markets about 3 – 4%.

Some people react to this by saying that stocks are simply overvalued because investors are willing to accept such a low yield. If prices fell by a lot then the dividend yield could rise to a good 4 – 6% as it did in 2009. While that is true, it doesn’t mean that stock markets are about to crash. This analysis is overlooking the fact that part of the lower yield is intentional. In recent years preferences have turned to capital gains over dividends, and a major reason is taxes.

Dividend Taxes

I’m not familiar with all the US tax laws but it sounds like the tax treatment of dividends has varied quite a bit over the past decade, from being favorable to being one of the worst forms of income. Here in Canada, of course, dividends are a long-favored form of retirement income because of their consistently low taxes. In the end that isn’t as good as it sounds since individual investors are just being taxed for the corporation’s pre-tax earnings and part of that tax has already been paid. Like many other things there is a hidden tax that most people aren’t aware of.

Capital gains have consistently had tax advantages in both countries (again the US has varied more). Because of this and the fact that dividend taxes have to be paid every year while capital gains taxes are only paid at the time you sell an investment, dividends often result in paying more taxes earlier than an equivalent amount of capital gains. This is complicated even further by tax shelter accounts.

Tax Free (Except For…)

In Canada it is very tricky to navigate the various combinations to avoid paying taxes on foreign dividends. In a TFSA you will lose some taxes on any foreign dividend, and sometimes get taxed twice (yes, double taxation in the Tax Free account exists) if you’re holding a US ETF with international stocks. In an RRSP you can avoid the US taxation but you still lose most international taxes.

I’ve been going through the options to figure out which ETFs we want to buy and where. As a result the RRSP account holds VXUS (total stock market, non-US) since it has the highest yield of the foreign indexes we want to own and the RRSP avoids US taxation. The TFSAs have more VXUS, VTI (US total stock market), and the Canadian ETFs ZCN and ZRE. Only those Canadian ETFs will be truly tax-free. This seems like the best way to minimize taxes on dividends which is a funny thing to have to do in a tax-sheltered account.

The taxes involved here aren’t very large. The US withholding amount typically seems to be 15% and that’s only on the dividends. Other countries may take different amounts. I’ve heard the average withholding tax on the EAFE index is around 12% or less. If you held $100,000 of VXUS in a TFSA at a dividend yield of 3%, the withholding taxes might cost you $810/year. In an RRSP you would only lose $360/year. To put that in perspective, switching $100,000 from the e-Series EAFE fund to VXUS would save you $350/year in management fees.

I don’t think this taxation is enough to switch to all Canadian stocks and lose the diversification. An international portfolio which can hold 9000 stocks in 2 ETFs, while ZCN has less than 300. It is worth avoiding that US withholding tax wherever possible though. If you’re holding ETFs in a taxable account then you can get most or all of the withheld taxes back, but it takes more work and you still end up having to pay the regular tax on the dividends.

Capital Gains Save Money

As this shows minimizing the taxes on dividend income can range from difficult to impossible. This is one reason that investors and corporations, especially in the US, are favoring capital gains instead. Corporations can convert dividends to capital gains by using their cash to invest in the business, buy other companies, or buy back shares instead of paying a dividend. With these options the corporation can also defer taxes (I think share buybacks are the exception).

This move to prefer capital gains should save investors from some taxes. However dividends have one big advantage: putting cash in your account that dumb executives can’t lose. With the increasing reliance on capital gains we have to trust that the company’s stock price and earnings are reasonable and accurate and that it is well-managed. When I’m allocating these ETFs I’m glad that the dividends are fairly low, but that means I’m relying a lot more on someone else being willing to buy at a higher price in 10 or 20 years. That is an increased risk to investors no matter how you look at it.

It may still be true that investment income is taxed more lightly than working income, though part of that is because taxes have already been paid and you just aren’t counting them. It’s certainly not easy to make that a reality for yourself.

Stock Market Mystery Or Everyday Behavior?

April 22, 2013 Leave a comment

The Economist writes today about the mystery of emerging market stock performance. Since emerging markets are believed to be more sensitive to the global economy, many people think they should be doing very well since other markets have had big increases already this year. Instead they are down by over 4% while the global market is up by over 6%.

The mystery is played up with a research note from a big bank that goes into detail on eight reasons for the underperformance. While some of these would be very good reasons for the difference, there is another simpler explanation: emerging market stock prices have gotten ahead of themselves over the last year (or the last few years) while other markets have been held back by bad news, and now investors are repositioning. Stock market activity happens in bursts as much as it does in a smooth progression, so we may have gotten emerging market gains last year and developed market gains this year. This kind of thing seems to be a very common pattern.

The fact that many investors believe emerging markets act as a more extreme version of developed markets may be exactly why they didn’t. Whenever we get to the point of maximum investor belief in any idea, the opposite turns out to be true as some investors lose faith in it and reverse their decisions. This is unpredictable because we never know how many believe it takes to reach the maximum. It can happen in small waves that come and go frequently or the occasional big bang that turns the market upside down. There is no mystery in this, and it’s a good reason to focus on several different asset classes and avoid the ones that have done well recently.

In fact this highlights another useful thing: despite all the talk about correlations rising, we are seeing what we should see here. Emerging markets should not be perfectly correlated with developed markets which means that things like this are expected. The rise of global trade means that many companies around the world are influenced by the same factors, but they still typically have an exposure to local and regional events. That’s why there is still reason to believe that major markets such as the Canadian, US, European, and emerging indexes will not always do the same thing.

Since we have just started buying into emerging markets through the VXUS ETF, it’s exciting to see that they are getting cheaper at the same time that other holdings are rising quickly. If this trend continues it might be worth adding a bit into VWO to increase the weight of emerging markets. Currently I’m leaning in the opposite direction though, and considering putting a bit into VEA since the emerging market component in VXUS is a bit more than we want.

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