Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

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

If you think you need an options strategy, a hedge fund, or an active fund manager, you probably just need to revisit your time horizon

I often hear the phrase protect your downside. It’s the sales pitch that a large part of the investment management industry thrives on, and it plays to the myopic loss aversion that most investors exhibit. Myopic loss aversion is the tendency of investors to evaluate their portfolios frequently with greater sensitivity to losses than gains, causing them to act as if their time horizon is much shorter than it actually is. Let’s look at the example of John who wants to invest for his retirement 30 years from now. After happily watching his portfolio increase with steady returns for a few years, he panics when the market trends down slightly for a week. He knows that he doesn’t plan to touch the money for a long period of time, but the thought of a decline, even over a relatively short period of time, makes him feel sick. He may even pull his money out of the market until things feel safe again.

An obvious path to safety would seem to be hiring a person or a company that knows how to protect your downside, and the investment industry has answered this calling. John Wilson’s Sprott Enhanced Equity Class “provides downside protection through the use of option strategies and tactical changes to the amount of its equity exposure...”, while Cecilia Mo, MBA from Dynamic Funds “focuses on delivering consistent strong performance while providing downside protection”. If these sales pitches were not enough to satisfy our myopic loss aversion, Jeffrey Burchell, Portfolio Manager and Co-CIO for Aston Hill Asset Management makes it clear that he’d “rather make less money than lose money!”

These sales pitches may give confidence to the naive investor, but downside protection strategies inevitably add significant costs to the portfolio over the long-term, resulting in performance that lags a benchmark index. The funny thing about this is that over long periods of time, say 10+ years, global financial markets have tended to increase in value. Lets reflect on that; we are accepting additional costs and underperformance to avoid short-term declines, but we have a long-term goal, and over long periods of time the short-term declines are just noise because the market tends to increase in value given a long enough period of time. Many portfolio managers will have you believe that it makes sense for long-term investors to accept lower returns in order to avoid being witness to short-term, albeit unrealized, losses; this sentiment can’t be expressed any more explicitly than “I’d rather make less money than lose money!”

What’s an investor to do? The risk of losing your money is only real if you need to sell investments while they are worth less than what you bought them for. Investing requires putting thought and care into matching your portfolio with the time horizon associated with it. If a short-term loss is intolerable because you might need the money soon, then investing in stocks and bonds is probably not the appropriate course of action. As for using options and tactical allocation for downside protection, long-term investors are better off minimizing their costs and capturing the returns of the global markets using index funds and ETFs. If short-term declines cause an emotional issue, you can simply increase your exposure to bonds.

By: Ben Felix | 0 comments

The TFSA Should Not Be Overlooked by Incorporated Individuals with Long Time Horizons

When people have corporations it is common for them to retain all earnings in excess of their living expenses inside of their corporation to avoid paying personal tax. This seems logical. By leaving the money in the corporation there is more money to invest in the corporate investment account, and we know that about $50,000 of dividends can be taken out of a corporation nearly tax-free, making the idea of leaving everything in the corporation until it’s time to draw a conservative retirement income appear very attractive.

With the TFSA’s annual contribution room now sitting at $10,000 per year, we thought it was time to put this common logic to the test. Does it make sense for incorporated individuals to withdraw additional dividends in excess of their living expenses to contribute to the TFSA? To answer this question we modeled the total after-tax value of $1 of active small business corporation income in the personal hands of the individual. The individual can retain the $1 of excess earnings in the corporation, pay the 15.5% small business corporation tax, invest $0.845 in the corporate investment account, and eventually pay personal tax on the withdrawal of a dividend. Alternatively, they can pay small business corporation tax on the $1, take out a dividend (paying personal tax at 38.29%*), and invest $0.521 in the TFSA where there are no tax implications on an eventual withdrawal.

The results of the analysis are intuitive. While using  the TFSA involves taking a significant haircut upfront, all future growth will be tax-free. This means that the rate of growth in the TFSA will be higher than the after tax rate of growth of the corporate investment account. Given a long enough period of time, the TFSA will overcome its initial tax hit and surpass the after-tax value of the corporate investment account. The TFSA has no time restrictions, and can remain untouched to eventually pass to a beneficiary tax-free on the death of the individual – depending on the age and health of the owner, it can have a very, very long time horizon.

These issues are discussed in more detail, alongside similar analysis for the RRSP, in our recent whitepaper, A Taxing Decision.

Note that to maximize the $10,000 annual TFSA limit, the individual would need to start with $19,193.86 of excess earnings in the corporation.

*The examples discussed consider an individual with income between $150,000 and $220,000 in Ontario in 2015.

By: Ben Felix | 2 comments