Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA

Associate Portfolio Manager
  • T613.237.5544 x 313
  • 1.800.230.5544
  • F613.237.5949
  • 265 Carling Avenue,
    8th Floor,
  • Ottawa, Ontario K1S 2E1

The 2014 CFA Society Ottawa Annual Forecast Dinner was terrifying

Last night I attended the 2014 CFA Society Ottawa Annual Forecast Dinner. I have a tremendous amount of respect for CFA charterholders and the work that the CFA Institute does to further the integrity of capital markets, and I am a CFA candidate. Much of the material in the CFA program is focused on prediction, yet I believe that predicting the future consistently is impossible. Entering the Forecast Dinner with skepticism gave me an opportunity to have a few quiet laughs, but it also allowed me to observe the extent to which people want to invest with their emotions over logic.

The main event of the evening was a panel of three economists; Patricia M. Mohr from Scotiabank, Derek Burleton from TD, and Pierre Cleroux from BDC were each asked a series of questions and given the opportunity to share their insights. Each of these economists play a major role in creating the recommendations that are used throughout their organizations. The thing that blew my mind was that each of these economists had completely different outlooks on some of the issues that were discussed. They had different opinions because they interpret data differently due to differences in their training and intuition. If any single person’s way of thinking is so great that their forecast will surely be correct, why isn’t everyone already following their advice? People are constantly hopeful that they have found the next oracle that will make them rich. The one person that does seem to have the intuition necessary to consistently beat the market is Warren Buffet, but his intuition also tells him that investors should just buy index funds. The more I thought about the way that these economists’ outlooks differed, the more disturbed I became. The emotional attraction to a super star economist or portfolio manager is so strong that people will push their logic aside for a great story. They want someone that will turn their humble investment into a vast fortune. If a person can speak well and has knowledge of economies and markets, they will be able to convince some people that they can predict the future. In the years that their predictions are wrong they will have great explanations for what threw off their forecast. In years they are right they will be heroes.

As an investor I’m sitting there listening to these three intelligent people debate about where different sectors are going, and I’m wondering how I would pick which one I should listen to. How does a portfolio manager decide which one they will listen to? How does an analyst decide whether or not they agree with their lead economist’s outlook on China’s economy? It’s all a big guessing game and even the smartest people with the greatest amount of resources are playing it. The terrifying part is that investors are so easily sucked into the stories that economists and fund managers tell them about what they should be investing in that continue to follow their advice. It’s comparable to a big group of people throwing darts at a dart board and assuming that the person that hits the bullseye four times in a row will be able to hit it a fifth time. I would be furious knowing that I am relying on this type of prediction when there exists a scientific approach to investing that eliminates the need for this artistry.

In the scientific approach to investing there is a data backed consensus on the single most effective way to invest, while the art of investing contains thousands of different and conflicting opinions. Maybe I’m biased due to my background in engineering, but when it comes to investing I want science, not art.

By: Ben Felix | 0 comments

Beating the spread

If a bookie presented you with the opportunity to bet on a basketball game between the Raptors with a 5-0 record and the Bobcats with a 0-5 record, which team would you bet on? The obvious answer is that the Raptors with their undefeated record will trump the Bobcats who have not won a game; this outcome is very easy to predict. If bookies allowed people to bet like this they would not make any money, so they use something called the spread. It’s not nearly as easy to predict the outcome if I present you with the same betting opportunity but the Raptors don’t just have to win, they have to win by 30 points. That 30 point differential, or the spread, is what allows bookies to make money. The bookie will go to great lengths to create a spread that has about a 50% chance of being beaten. If this is done properly, the bets on each side of the spread will cancel each other out and the bookie will profit from the premiums people paid to place their bets. When they create the spread, bookies will know everything about the teams in a match; they will know what the star player had for dinner, whose girlfriend is in town, the weather forecast, everything. Once the spread has been set, it will be the new information that develops throughout the course of a game that determines if the spread will be beaten; an injury, a lucky shot, or a bad call could all be the difference makers. In investing, the collective knowledge of the markets is the bookie, and the price of a security is the spread. Every day highly motivated market participants act on massive amounts of information and in doing so they inject the information they have into market prices, effectively setting the spread. It’s easy to look at a company and see that it is well managed, pays a strong dividend, and is positioned to dominate a growing market, but all of this is included in the market price. Whether the price goes up (beats the spread) or goes down will depend on the development of unpredictable new information. Investing isn’t about picking the winning company, investing is about beating the spread.

By: Ben Felix | 0 comments

The risk story behind expected profitability

Investors demand higher returns for taking on more risk. Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market. The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return. The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk? If a company is profitable, wouldn’t the market include that information in the price? To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns. When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability. If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A. Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets. So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class. This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model. It has now been found that the poor performance of small cap growth companies can be explained by low profitability. This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

By: Ben Felix | 0 comments

The Value of Robo-Advice

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor. These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost. Two of the largest providers are Wealthfront and Betterment. Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k). Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement. If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing. A financial advisor should know your personality, your family situation, your dreams, and your frustrations. This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields. When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized. The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication. When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that firms like PWL do for their clients.

By: Ben Felix | 1 comments

High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets. The debate is very interesting. One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

At PWL, we aren't overly concerned by either side of this debate. The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing. As an example, an active manager who wants to trade specific securities within a short time period would be affected by these issues.

The way that we invest our clients money does not require us to make large market orders, and it does not require rapid trade execution. We invest in asset classes rather than the latest hot issue which means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy. The flexibility in our approach eliminates the needs for the immediate liquidity that HFT is able to profit from.

We like to keep an eye on the news, but PWL is able to quietly step away from the turmoil in the financial media while our clients happily capture the performance of global markets. Business as usual.

By: Ben Felix | 0 comments