I appreciate a good debate, and Tom Bradley of Steadyhand Investment Funds sparked one on his blog last week when he asked advisors who use ETFs to justify their fees if they offer no chance of market-beating performance. “The combination of ETFs and advice generally costs more than a low-cost mutual fund, which also comes with advice,” he argued. “If I’m guaranteed to lag the market indexes by 1.25% to 1.5%, what do I get for that?”
I respect Bradley for his commitment to investor education and transparency, and his challenge is entirely fair. However, his argument presumes that an advisor’s fee can only be justified if it results in market-beating returns. Beating a benchmark is the measure of an active fund manager’s success, but an advisor can add value in many other ways.
Bradley’s comment that direct-sold mutual funds “also come with advice” implies that Steadyhand’s services are equivalent to what you would receive from an independent advisor. I can’t speak for all advisors who use ETFs, but I am happy to explain how our service goes far beyond what a client would receive from a mutual fund provider.
We offer unbiased advice. Whether you walk into a bank or buy mutual funds directly from Steadyhand, Mawer or Phillips, Hager and North the advice is not unbiased. While their staff can help you select an appropriate asset allocation for your situation, they will ultimately use this information to recommend a portfolio of their own funds. PWL Capital, by contrast, is not tied to any fund provider or product type. Most of our clients’ accounts are comprised of ETFs as well as low-cost mutual funds, GICs and individual bonds.
Moreover, our advisors are held to a fiduciary standard, which means we have a professional and legal obligation to act in the client’s best interest when making recommendations to clients. Most mutual fund companies can’t say the same thing.
This is not only relevant when choosing products, but also when recommending an asset mix. Because our fee is the same regardless of the products we recommend, we have no vested interest in encouraging clients to take more risk than necessary. A mutual fund company that charges 1.78% for its equity funds and 1.04% for its fixed-income funds cannot make that claim.
To use another example, holding GICs instead of bonds in non-registered accounts can save investors thousands of dollars in additional taxes. Would a mutual fund company educate their clients about this topic and send them to the competitors to buy GICs?
We offer financial planning. I would find it impossible to give investment advice based on little more than a phone call. Good advisors collect all relevant information (including expected company pensions and estimated government benefits) and run projections to see if the client’s current savings strategy is sufficient to meet their goals based on expected market returns. This is a much better approach than hoping your actively managed mutual fund will shoot the lights out and make up any shortfall.
Our clients are less concerned with potential market-beating performance than they are with life decisions such as when they can afford to retire. We help them with these decisions using planning software and Monte Carlo simulations. Direct-sold mutual fund firms don’t offer services like this: they can only refer you to planners who charge a separate fee.
We manage cash flow in retirement. One of the important services we offer retirees is modelling withdrawal strategies. We determine the most tax-efficient way to draw down the client’s portfolio for income if they have corporate accounts, personal non-registered accounts, RRSPs, TFSAs or a mix of all of them. These financial projections, together with personal and risk-management discussions, help our clients make more informed decisions and can reduce their income tax liability and their OAS clawbacks.
We defer taxes with tax-loss selling. As Dan Bortolotti and I discussed in our recent white paper, Tax Loss Selling, ETFs are ideal tools for harvesting capital losses and using them to defer taxes. This is an important part of our service for clients with non-registered assets. I can’t imagine implementing a tax-loss selling strategy using actively managed mutual funds: the tracking error between the original fund and the replacement would likely be too large to make it feasible. In any case, such a strategy is impossible for investors using mutual fund providers with a limited number of offerings.
We reduce taxes with proper asset location. When we build our clients’ portfolios we ensure each asset class is in the most tax-efficient account. (This may seem straightforward at first, but as new money is added or withdrawn, the decisions confuse many investors.) Again, ETFs are ideal for implementing an asset location strategy because they tend to hold a single asset class. By contrast, mutual funds frequently hold a mix Canadian stocks, foreign stocks and/or bonds, making it difficult or impossible to optimize asset location.
Holding US or international stocks via mutual funds in an RRSP or TFSA can also lead to an additional cost of about 0.30% from foreign withholding taxes. By using US-listed ETFs, we can eliminate or reduce the impact of these withholding taxes.
We convert Canadian and US dollars cheaply. Although this is generally not an issue for mutual fund investors, it can be a huge obstacle for ETF investors who work without an advisor. By using a strategy called Norbert’s gambit, we can purchase more tax-efficient US-listed ETFs in our client’s accounts while largely eliminating the outrageous currency conversion costs charged by brokerages. (For an example, see Norbert’s Gambit at CIBC: A Case Study.)
We rebalance for you. The majority of our portfolios are managed on a discretionary basis, meaning once the strategic asset allocation is agreed upon, we are free to rebalance as necessary. DIYers or investors who use direct-sold mutual funds must make these decisions on their own, and most people find it extremely difficult to pull the trigger. Rebalancing means selling asset classes that are outperforming and buying those that are underperforming, while investors tend to do the opposite. To Steadyhand’s credit, they have always educated their clients about the importance of rebalancing, but the fact remains they have little or no control over their clients’ behaviour.
We report your performance. Clients with discretionary portfolios receive a semi-annual performance report that calculates their overall rate of return using the Modified Dietz method, which takes into account any contributions and withdrawals. Mutual fund companies and other advisors may or may not provide this level of reporting, but it is another way we add value.
I’m happy to acknowledge not every investor needs the suite of services PWL Capital provides. If you don’t need planning and all your investments are in an RRSP, a low-fee, direct-sold mutual fund firm may well be a better choice. But let’s agree that the level of service in these two models are dramatically different.
I share Bradley’s disdain for the countless advisors who collect a fee of 1% or more for “advice” that amounts to nothing more than gathering assets. But whenever I speak to prospective clients who ask “what do I get for your fee?” I have no difficulty answering the question. No, my fee won’t help them beat the market—a trait I share with the vast majority of active fund managers. But compared to investors who work without an advisor, I’m confident our fee pays for itself by reducing taxes, eliminating unnecessary risk, and preventing costly behavioral mistakes. And the planning services we provide have enormous value for clients making important life decisions, even if that doesn’t show up directly in their portfolio’s returns.
In his recent blog, Dan Bortolotti, discusses the basics of factor analysis. If you are one of the few who are actually interested in running your own 3-factor regressions, pull up your sleeves and let’s get started.
I’ve attached the 2008-2012 monthly Canadian regression factors from Andrea Frazzini’s Data Library (along with various ETF and fund returns that Dan Bortolotti will be discussing in his upcoming posts. The data is all in US dollars (so don’t input any monthly fund returns in Canadian dollars).
You may also notice a 4th factor, UMD (up minus down) – this is the Canadian “momentum” factor. Dan will be sure to explain this factor in more detail when he discusses the Morningstar Canada Value and Momentum indices.
Please feel free to try it out for yourself and send me a quick email with any questions you may have.
In the example below, we’ve chosen to analyze the monthly returns of the Beutel Goodman Canadian Equity Fund Class D (BTG770) from January 2008 to December 2012. BTG770 had a 5-year annualized return of 2.6% as of December 2008, while its benchmark index, the S&P/TSX Composite, returned only 0.8% annualized over the same period.
If you do not see the Data Analysis option at the far right, please continue to Step 3. If this option is visible, please skip ahead to Step 6.
Input Y Range: Select all the cells with data in column D (including the Fund-TBill labels).
Input X Range: Select all the cells with data in columns E through G (including the Mkt-TBill, SMB and HML labels)
Labels: Select the Labels check-box
New Worksheet Ply: Give a name to your new worksheet – in the example below, we’ve used the fund code BTG770. Click OK
My colleague, Dan Bortolotti, did an excellent job explaining the main outputs of a regression analysis in his recent blog Going on a Factor-Finding Mission. We’ve summarized our results below for the Beutel Goodman Canadian Equity Fund Class D (BTG770):
Adjusted R Square: This tells you how well the data fit the model. In this case, a figure of +0.9644 indicates the three factors we’ve analyzed explain 96.44% of the monthly performance of BTG770. It’s a fairly tight fit (a value of +1 would be even better).
t Stat: This value tells you whether or not the results are significant. An absolute value of 2 or more (i.e. more than +2 or less than -2) means that you should probably pay attention to the results.
Intercept: You can think of this as a fund manager’s “alpha” (it can be either positive or negative). As this is a monthly regression, the alpha is also a monthly value (so multiply the result by 12 to get an approximate annual alpha value). In our example, the annual alpha is about +0.07% (0.005730188 × 12), but the results are not significant (with a t Stat of only 0.32).
Mkt-TBill: This is referred to in finance as “beta”. A fund with a beta of more than +1 is more equity-like (relative to the market index) while a fund with a beta less than 1 is less equity-like than the market index. Our fund has a beta of +0.85 (with a t Stat of +36.65), so it is less equity-like than the index.
SMB: This is the small cap “slope co-efficient” - it measures the portfolio’s sensitivity to the small cap risk factor. Since this value is -0.21 (with a t Stat of -2.94), we are probably dealing with a large cap fund.
HML: This is the value “slope co-efficient” – it measures the portfolio’s sensitivity to the value risk factor. Since this value is +0.28 (with a t Stat of +6.20), we are probably dealing with a value fund.
So what does all of this factor-based analysis tell us? In this example, it shows investors that the impressive outperformance of BTG770 over that 5-year period was almost entirely due to its exposure to known risk factors (which they could’ve gained exposure to through lower-cost index funds). Its true alpha plummets from 1.8% per year, to a measly 0.07% per year. As William Bernstein so eloquently put it in his Efficient Frontier blog:
“Factor analysis is to active money managers, what a light switch is to cockroaches.”