Michael James on Money

Mutual Fund Full Disclosure

noreply@blogger.com (Michael James) — Sun, 06 Dec 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many investors seem unaware of the fees they pay to own their mutual funds. Disclosure rules are intended to prevent this sort of problem, but they don’t seem to be effective enough.

Suppose that you meet with a financial advisor and agree to invest with her. She seems like a great person, and her investment advice seems sensible as far as you can tell. Then she hands you the following disclosure statement:

Initial portfolio size: $150,000
Initial investments: 30% bond fund, 50% stock fund, 20% international stock fund
Estimated Fees:
Immediately: $6300
Year 1: $3135
Year 2: $3324
Year 3: $3526
Year 4: $2718
Year 5: $2781
Year 6: $2838
Year 7: $4815
Year 8: $5164
Year 9: $5540
Year 10: $5944
10-year total: $46,086

Gulp. Surely these can’t be right. Will you really pay this much? Yes, you will. These numbers were calculated based on the fees charged by three popular mutual funds offered in Canada. The bond fund has no load, the stock fund has a deferred sales charge, and the international stock fund has a front-end load. The dollar amounts assume a 4% per year return in the bond fund and an 8% per year return in the stock funds.

This type of disclosure would be a real eye-opener for investors and would make it harder for financial advisors to hide fees. It might also encourage more competition on fees among mutual funds.

Short Takes: Another Ponzi Scheme, Exchange-Traded Notes, and Job References

noreply@blogger.com (Michael James) — Fri, 04 Dec 2009 05:01:00 +0000

1. Canadian Capitalist reports on yet another huge Ponzi scheme that ensnared people with “wealth-buliding seminars”.

2. Preet explains how leveraged Exchange-Traded Notes (ETNs) hide snowballing interest charges.

3. Thicken My Wallet explains that references matter more than ever in a job search.

4. Canadian Dream takes a run at figuring out how high CPP deduction rates would have to go to get higher benefits. Former CPP & OAS Chief Actuary, Bernard Dusseault, weighed in with a useful comment. Hopefully he can be enticed to expand on his thoughts.

5. Big Cajun Man found that opening a Registered Disability Saving Plan (RDSP) isn’t as easy as opening RRSPs and TFSAs.

6. Million Dollar Journey looks at how to claim a capital loss on a de-listed stock like Nortel.

7. Mike at Four Pillars decided to collapse his leveraged investing plan. The big danger for anyone considering leveraged investing is that it will seem like a great idea when the stock market is booming (expensive stocks) and will later seem like a terrible idea when the stock market is crashing (cheap stocks). At least Mike stuck it out for the last 9 months while stock prices rose from their lows.

8. We’re number 4! Larry MacDonald reports that Canada has lower economic crime levels than only Russia, Kenya, and South Africa.

9. Potato concludes his story of looking for a place to rent in Toronto and has some advice for landlords.

10. The Wealthy Boomer reports that former regulator and high-profile critic of the mutual fund industry, Glorianne Stromberg, won the fund industry’s career achievement award. This is a surprising choice and may have much to do with the fact that Morningstar had taken over these awards.

The Impact of MERs on Mutual Fund Returns

noreply@blogger.com (Michael James) — Thu, 03 Dec 2009 05:01:00 +0000

In a recent post, Canadian Capitalist showed that the effect of the HST on investor returns in mutual funds is small compared to the drag caused by fund MERs. I thought that while this conclusion is correct, his calculation of the MER impact was a little off. It turns out that we were both (slightly) wrong.

In the example, Investor A puts $100 to work in the equity market for 25 years at an average annual return of 8%, giving a final portfolio value of $685. Investor B makes a similar $100 investment in a mutual fund with a 2.5% MER. Reasoning that Investor B’s return dropped to an average of 5.5% per year, his final portfolio value works out to $381.

With the HST, the MER drag rises to 2.7% leaving 5.3% average return each year, and the final portfolio value is $363. So, compared to Investor A’s $685, the MER costs Investor B $304, and the HST costs him another $18. It’s clear that while the HST isn’t helping, the real problem is the high MER.

At first I thought that these calculations were a little off because the MER would knock 2.5% off the year-ending portfolio size, not the year-starting portfolio size. With this reasoning, Investor B’s return would be calculated as follows:

(1 + 0.08)*(1 – 0.025) = 1.053

This gives a 5.3% average return each year. Adding in the effect of the HST, we replace 0.025 with 0.027 and the average annual return drops to 5.084%.

It turns out that the truth is between Canadian Capitalist’s method and mine because of the way that the MER is reported. Mutual funds take the total costs of running the fund during the year and divide by the average assets under management during the year. The result is the MER percentage.

As it turns out, to calculate the effect of the MER on investor returns, you’ll need the e-to-the-power-of-x button on a scientific calculator or the EXP() function on a spreadsheet. For a detailed explanation of where the formula I’m about to use comes from, see the math section at the end of this post.

Here is how you can find the average yearly return after the MER is deducted:

(1 + 0.08)*(e^(–0.025)) = 1.05333

If we assume that the HST is deducted daily along with the MER, this changes to

(1 + 0.08)*(e^(–0.027)) = 1.05123

So, the average annual return is 5.333% without the HST and 5.123% with the HST. The portfolio ending value for Investor B is $367 without the HST and $349 with the HST. Compared to Investor A’s $685, the MER costs $318, and the HST costs an extra $18.

The conclusion hasn’t changed: The HST is still a minor concern compared to MERs. But, I’ve learned something new about MERs as a result of seeking precision in these calculations. Canadian Capitalist is working on a spreadsheet that takes into account more details of how mutual funds are actually run to see what effect MERs have on returns.

The Math

Given the daily values of an index (including dividends) for a year, we’re looking for the returns generated by a mutual fund 100% invested in this index. We’ll assume that there are no net fund inflows or outflows each day of the year.

Some definitions:

m – MER (expressed as a fraction)
n – number of days in a trading year
A – average assets under management
C – total fund costs removed from the fund during the year
R – index return for the year
F – fund return for the year
v0, v1, ..., vn – index values over one year (v0 is starting value on the first day, v1 is the closing value on first day and the opening value on the second day, etc.)
f0, f1, ..., fn – corresponding fund values over one year

The average assets under management (based on each day’s closing value) are

A = (f1 + f2 + ... + fn)/n.

The one day share of the MER is m/n. Assuming the MER is taken out based on each day’s closing values, the MER for the first day is (m/n)f1. Continuing this way, the total costs for the year are

C = (m/n)*f1 + (m/n)*f2 + ... + (m/n)*fn = mA

Sanity check: MER = C/A = mA/A = m

On the first day the index rose by a factor of v1/v0. The same thing will happen to the fund on the first day before costs. On the first day, before costs are deducted, the fund will grow to

f0*(v1/v0)

The costs will be m/n times this quantity. After costs, the fund will hold

f1 = f0*(v1/v0)*(1–m/n)

On the second day, the fund grows by a factor of v2/v1 and costs shrink it by a factor of 1–m/n:

f2 = f0*(v2/v0)*(1–m/n)^2

Continuing this way we get

fn = f0*(vn/v0)*(1–m/n)^n

The index return for the year is calculated from the index starting and ending values for the year:

vn/v0 = 1+R

Similarly, for the fund:

fn/f0 = 1+F

Substituting these into the previous equation gives

1+F = (1+R)*(1–m/n)^n

That last factor looks intimidating, but as n becomes large, it approaches e^(-m). In this case, the number of days in a year is large enough that we can use the close approximation

1+F = (1+R)*(e^(–m))

For n=250 and m=0.025, the estimate differs from the real value by only 0.0000012. In Canadian Capitalist’s example, the difference between using the estimate and using the real equation over the 25 years is just over one cent.

If we assume that HST is paid each day, then we can just replace m by m*1.08 in the previous equation. If the HST payments are delayed, then the analysis changes a little, but the final result won't be much different.

What Will Happen to Interest Rates?

noreply@blogger.com (Michael James) — Wed, 02 Dec 2009 05:01:00 +0000

There is no shortage of commentators making predictions about interest rates. This is because they can get the attention of just about anyone who has investments. Those who depend on interest income want higher rates, and those who have stocks and bonds generally prefer dropping interest rates.

It is possible to predict interest rates with better success than flipping a coin, but not in any useful sense. The market’s prediction on interest rates can be found by examining the current yield curve, which is a chart showing short-term and long-term borrowing interest rates. Typically, yield curves focus on government borrowing costs in the form of bond interest rates.

The Bank of Canada maintains data on yield curves going back to 1986. Here is the most recent yield curve data for the last day of August:

Typically, short term rates are lower than long-term rates because investors demand a higher return when their money is tied up longer. So, the yield curve tends to slope up.

Sometimes the yield curve slopes up by less than usual or even slopes down. This amounts to a prediction by the bond markets that interest rates will drop in the future. If the yield curve points up more than usual, this is a prediction that rates will rise in the future.

The problem is that these predictions are already built into the prices of all equities. If you become a yield curve expert who can see what a particular yield curve says about interest rates, you won’t be able to use this information to exploit market inefficiency because it is essentially the market that made the prediction. To make money, you need to know something that everyone else doesn’t know. You need to know something indicating that the yield curve is wrong in some sense.

I’m sceptical that anyone can predict interest rate changes over the next few years any better than the implied prediction of the yield curve. Even the Bank of Canada can’t reliably predict what world events will cause it to raise or lower rates. This is why I rarely listen to talking heads making interest rate predictions.

Understanding Wall Street

noreply@blogger.com (Michael James) — Tue, 01 Dec 2009 05:01:00 +0000

The book Understanding Wall Street by Jeffrey Little and Lucien Rhodes is in its fifth edition and has a history going back 30 years and over a million books sold. The main strengths of this book are the wide range of investing concepts explained with clear language. The main weaknesses, although relatively minor, are the authors’ curious biases and the fact that the book hasn’t quite been updated for the internet age.

The main topics covered are

– the nature and history of different types of investments including stocks, bonds, commodities, and derivatives
– accounting basics and the various fundamental analysis ratios such as price/earnings, dividend yield, and several others
– technical analysis
– the history of Wall Street and some of its colourful personalities
– price bubbles through history

Newspaper and the Internet

Curiously, a separate section is devoted to the internet, rather than just mentioning its use as necessary in the other sections. Some of the discussion of investment information is still discussed in terms of newspaper listings. Although the book’s contents are definitely still relevant in the modern world, the incomplete update for this edition undermines the reader’s confidence. Hopefully the sixth edition will turn newspaper listings into a footnote and focus on how people really get investment data.

The Iraq War

The most amusing part of the book was a brief and pointless foray into politics: “The recent wars in Iraq and elsewhere in that region are additional examples of U.S. altruism.” There is plenty to debate about the Iraq war, but few would call it U.S. altruism.

Traditional vs. Discount Brokers

“A good stockbroker ... can be worth his or her weight in gold.” The authors endorse the traditional stockbroker saying that most investors “need the extra assistance ... that a so-called full service brokerage firm can provide.” Discount brokers “are worth considering if the investor expects to be independent and active.”

Inactive index investing through a discount broker may not be for everyone, but it has many advantages that deserve to be included in a book like this one. The brief discussion of ETFs that focuses mainly on leveraged ETFs and narrow ETFs is further evidence that the passive indexing approach was not seriously considered for discussion in this book.

Technical Analysis

The authors devote considerable space to various types of technical analysis. For the uninitiated, technical analysis is where investors study charts of stock prices and share volume to try to guess whether a stock is headed up or down.

The authors are quite positive about the usefulness of these techniques. I’m sceptical. Most of the methods seem subjective and there are so many different methods. For a given stock at a given time, there will be some methods that give the correct answer and others that give the wrong answer. The problem is that a different subset of techniques gives the right answer each time.

The authors allow that “chart patterns are never 100% reliable.” I’d say that they are about 50% reliable, or about as good as tossing a coin.

Stock Options

“The most reliable and effective technical indicators are found among stock option statistics. Options players ... are wrong more often that they are right.” I don’t know if this is true, but it won’t make options traders happy.

“Writing covered calls and writing naked puts (but strictly against shares that the investor intends to purchase anyway) are the two best and most consistently profitable applications of stock options.” If this is true, then options must be consistently overpriced so that the option writer is favoured over the option buyer.

In a section that does an otherwise good job of explaining the costs associated with option trading, the authors miss bid-ask spreads as a significant cost. The bid-ask spreads on options tend to be larger than those of stocks.

Conclusion

Overall, this book is a useful primer and reference for a broad range of investing concepts. Its shortcomings are minor. Canadian Capitalist also gave a review.

Financial Advisor Self-Regulation

noreply@blogger.com (Michael James) — Mon, 30 Nov 2009 05:01:00 +0000

In an address to the Advocis symposium, Ontario Minister of Revenue John Wilkinson urged financial advisors to adopt a system of self-regulation. He argues that fraud is rare and self-regulation is better than government-imposed regulation. (Thanks to Preet at Where Does All My Money Go? for pointing me to this story.)

While eliminating fraud is a worthwhile goal, outright fraud is not the major problem we have today among financial advisors. The real problem is systemic. Conflict of interest rules this industry. Until the system is fixed, neither self-regulation nor government-imposed regulation is likely to help.

To defend these claims, let’s start with a small story about a couple in my extended family who changed their lives by uprooting themselves and moving to a warm country with nice scuba diving. I prefer not to name the country, but it has been declared the most corrupt nation on earth in the past.

Among the many amusing stories of life in a different country, this couple explained how all services seem to require bribes. Opening a bank account, arranging for telephone service, and just about anything else requires a bribe for the clerk. Bribes are so deeply ingrained in the culture that the bribe amounts are standardized and posted on the walls. At some point, they stop seeming like bribes and seem more like service fees.

In the same way, for those of us who understand how most financial advisors are paid, the system seems normal. But if we take this system to a new context, the problem becomes evident. When a politician awards a $25 million contract to a firm that then kicks back $250,000 to the politician, we are properly outraged. But when a financial advisor recommends mutual funds to a client who doesn’t understand that the advisor will collect a substantial commission and possibly yearly trailing commissions, it all seems normal. One big difference between the politician and the financial advisor is that the politician’s actions are illegal, but beyond that, they look very similar.

Some may argue that commission-based models for salespeople are a way of life. This is true, but financial advisors don’t look like salespeople to most of their clients. We expect the guy at the electronics store to push us to buy a big-screen television because he wants his commission. But, financial advisors look more like lawyers or accountants to their clients. These clients have a right to expect objective advice. Instead, our current system encourages financial advisors to recommend whatever investments pay the greatest commissions. What’s worse is that many of their clients have no idea this is going on.

One step in the right direction would be proper disclosure of fees to clients. Currently, fees are disclosed in percentage terms with confusing language. Better disclosure would be for the advisor to take the amount of money the client will be investing and show the client how much money (in dollars) he or she expects to pay in fees over the upcoming decade based on the investments the advisor is recommending.

Wilkinson says that the relationship between advisor and client should be based on trust. I agree wholeheartedly. Unfortunately, the current system does not encourage advisors to act in a way that is worthy of this trust.

These problems don’t mean that all financial advisors are dishonest. In fact, a great many advisors work very hard to do what they think is best for their clients. These honest advisors are no doubt discouraged by the actions of their less honourable colleagues. Good advisors do their job well despite the system not because of it.

Deferred Sales Charges Permit Up-Front Commissions

noreply@blogger.com (Michael James) — Sun, 29 Nov 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

All mutual funds have a management expense ratio (MER) that covers the costs of running the fund. In addition to the MER, some mutual funds charge “loads”. Loads are fees paid either when you buy into a fund (front-end load) or sell out of a fund (back-end load). Back-end loads are also called deferred sales charges.

The purpose of a front-end load is simple enough. The financial advisor who sells you a mutual fund is paid out of front-end loads. But what about funds that have deferred sales charges? Does the financial advisor have to wait until you sell to get his money?

Things look even worse for the financial advisor when the deferred sales charges are “contingent”. This means that the sales charge declines over time. In a typical arrangement, if you sell in the first year, you get charged 5% of your initial investment, but only 4% if you sell in the second year, and so on until it drops to zero in the sixth year.

Does this mean that if you hold on for more than 5 years your financial advisor doesn’t get paid? No, it doesn’t. The financial advisor gets paid up front regardless of whether the load is up front or deferred. This is easier to understand if you look at deferred charges another way.

Suppose that you invest $100,000 into a mutual fund with a 2% MER with a declining deferred sales charge starting at 5%. A better way to think of this is that you pay $5000 up front and get a $1000 rebate on the MER for the first 5 years. After the fifth year, you pay the normal MER. While your account won’t actually be docked $5000 up front, you are committed to paying a minimum total amount of fees either through several years of MERs or the deferred sales charge.

With this view, the only difference between front and back-end loads is the MER rebate. It is easy to see now how the financial advisor can get paid up front either way.

If two funds have the same MER, then a deferred sales charge is preferable to a front-end load, but both types of load are equally painful for the investor who wakes up to the fact that mutual funds have high fees in the first year or two and wants out. Deferred sales charges ensure that when you enter a fund you are committed to paying a minimum total amount of fees regardless of how long you stay invested. In this sense they aren’t much different from front-end loads.

Short Takes: Save by Paying for Advice, a Fifth Birthday, and Property Management

noreply@blogger.com (Michael James) — Fri, 27 Nov 2009 05:01:00 +0000

I had the opportunity to give an invited talk to an investment club called the Ottawa Share Club on Wednesday night. I was peppered with many interesting questions some of which are likely to inspire future posts on this blog. Many thanks to the club members and specifically co-founder James Palmer for the invitation.

1. Rob Carrick explains why you can save money by paying explicitly for financial advice rather than taking seemingly free advice.

2. The Canadian Capitalist blog has been going strong for 5 years and is giving away $500 to celebrate. Congratulations on 5 years of sound information and analysis.

3. Mr. Cheap has experience as a landlord, and he explains some of the problems with hiring property management companies.

4. Jonathan Chevreau notes that the recent bear market has motivated financial advisors to recommend more alternative investments. I think this characterization is too charitable for financial advisors. Clients are more inclined to buy alternative investments because of the perception that standard investments don’t work any more. Financial advisors are willing to sell whatever the client will buy as long as the advisors make money from it. My characterization may be a little too uncharitable, but I bet it’s closer to the truth.

5. Canadian Financial DIY reports on research into how long it takes for stocks to give positive real returns. This should resonate with investors who have little stomach for volatility.

6. Preet has a guest writer, Ken Kivenko, to explain how you can get hit with tax distributions from mutual funds even if you didn’t own the mutual fund when it earned the income.

7. Larry MacDonald looks at the issue of whether to go with a bond ETF or a bond ladder. I think he’s overdoing it by having 10 bonds in the bond ladder, but seeking to minimize costs is definitely the right approach.

8. If you enjoy a good rant, check out the latter half of Potato’s discussion of searching for housing and dealing with real estate agents.

9. For more ranting, have a look at the Big Cajun Man’s thoughts on gifts to charity in lieu of presents and battling with Bell. You may or may not agree with him, but he is funny.

10. Do you make a lot of transactions in your bank account and want to minimize fees? Guest writer Kathryn at Million Dollar Journey has information on unlimited banking packages and how to get the fees waived at major Canadian banks.

RRSPs and the GIS Don’t Mix Well

noreply@blogger.com (Michael James) — Thu, 26 Nov 2009 05:01:00 +0000

Canadian seniors with low incomes receive a Guaranteed Income Supplement (GIS) from the government. Within a certain income range, each additional dollar of income reduces the GIS payments by 50 cents. This amounts to a 50% tax on this income. Combining this with the regular income taxes, the effective tax rate on RRSP withdrawals can be over 70%.

When Canadians draw money from a registered plan (RRSP, RRIF, or a registered annuity), the payment counts as income for tax purposes. Low-income seniors who collect the GIS may end up keeping only a small fraction of their registered plan withdrawals. I have looked at some test cases to try to come up with a strategy to keep more of the money.

Be warned that my analysis is based on a number of assumptions that may prove to be false. At the end of this post I outline some of the reasons why this analysis may have to be modified.

Basic Scenario

Annie is a single 71-year old living in Ontario collecting Old-Age Security (OAS) of $6203.52 per year. She has additional income from the Canada Pension Plan (CPP) and other sources (we’ll look at scenarios for additional income of $0, $5000, and $10,000). She has $100,000 in an RRIF and has to withdraw at least $7380 next year (according to the minimum RRIF withdrawal rate rules).

Case 1: Non-OAS income of $0

The entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.

Case 2: Non-OAS income of $5000

Once again the entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.

Case 3: Non-OAS income of $10,000

Only $5660 of the $7380 withdrawal will cause GIS clawback. Annie’s tax rate on the first $5660 is 71.05% and is 21.05% on the rest. She gets to keep $2996.51 of the withdrawal.

None of these scenarios is very appealing because Annie is losing too much of her savings to taxes and the clawback. A possible strategy for Annie is to withdraw more than the minimum and put the excess in a TFSA. The idea is that most of the excess wouldn’t cause any clawback and she would keep a higher percentage of it. In future years when Annie’s RRIF is drained, she can live on her TFSA.

It seems unlikely that Annie should withdraw the whole $100,000 in one year. For one thing she won’t have enough TFSA room. Other problems are the higher marginal tax rates for such a high income and the 15% OAS clawback that begins at income $66,325. So, I looked for the withdrawal amount that leads to the lowest percentage of tax plus clawback.

Here are the results based on Ontario marginal tax rates:

Case 1: Non-OAS income of $0

If Annie withdraws $60,132 per year from her RRIF her percentage of taxes plus clawback will be 38.6%.

Case 2: Non-OAS income of $5000

If Annie withdraws $55,132 per year from her RRIF her percentage of taxes plus clawback will be 35.7%.

Case 3: Non-OAS income of $10,000

If Annie withdraws $48,679 per year from her RRIF her percentage of taxes plus clawback will be 32.1%.

In cases 1 and 2, the optimum withdrawal amount was just short of the start of the OAS clawback. In case 3, the optimum point was just a little less than this. Once the RRIF is drained, she can collect the GIS and live on the money transferred to her TFSA (assuming she has sufficient TFSA room by the time she begins draining the RRIF).

Warnings

There are a number of reasons why this analysis may give the wrong answer for you:

1. I may have overlooked some important considerations.
2. You are not single or don’t live in Ontario.
3. Tax rules may change in the future (such as TFSA income contributing to GIS clawback).
4. You may not have enough TFSA room for excess withdrawals and end up having GIS clawed away by income from non-registered savings.
5. Other age-tested benefits actually make the total clawback higher than 50%.
6. I have assumed that a large income would eliminate GIS payments for only one year. If they actually cause the loss of GIS payments for more or less than one year, then the analysis changes.

This whole issue is complex enough that it seems unlikely that many low-income Canadians will succeed in minimizing the taxes on their registered savings.

Understanding Car Lease Payments

noreply@blogger.com (Michael James) — Wed, 25 Nov 2009 05:01:00 +0000

Frugal Trader at Million Dollar Journey had an interesting post explaining how car lease payments are calculated. The formula is simple enough until it adds a lease fee that involves a mysterious “money factor”. It all seems like extra profit for the dealership, but the truth is less nefarious. According to commenter Robert, this money factor is only used in the US; Canadians use the exact calculation given at the end of this post.

An Example

I’ll use the same example that Frugal Trader used:

– Honda CRV: MSRP + freight + PDI: $29,880
– Residual Value after 3 years: $15,276.60
– Depreciation (price minus residual): $14,603.40
– Depreciation per month: $405.65

So, if the interest rate were 0%, then the payments should be just this $405.65 per month. But interest is a fact of life and we need to figure that out too. The accurate way to calculate interest involves present value calculations. I’ll leave the details of this accurate method to the end of this post for those who are interested.

Estimating Interest

At the beginning of the lease the customer owes the entire value of the car. At the end of the 3-year lease, the customer will owe only the residual value. On average over the 3 years, the balance owing by the customer will be about halfway in between these two values:

– Approximate average balance owing:
($29,880 + $15,276.60)/2 = $22,578.30
– Annual lease rate: 4.9% (1/12 of this per month)
– Monthly interest = $22,578.30 x 4.9%/12 = $92.19
– Total Lease Payment:
$405.65 + $92.19 = $497.84 per month plus sales tax

Typically, the interest part of the payment isn’t explained the way I did. The official method begins with a mysterious money factor which is the annual interest rate divided by 24 (0.049/24). This is then multiplied by (purchase price + residual value) to get the “lease fee”. This lease fee calculation amounts to exactly the same thing as the estimated interest calculation I did.

How good is this interest estimate?

Many readers are no doubt suspicious of this method of estimating the lease payment. Using the proper calculation for this example gives a lease payment of $499.40. So, the estimation method actually gives slightly lower payments.

However, dividing the yearly interest rate by 12 to get the monthly rate isn’t really correct because the yearly rate becomes larger when the monthly rate is compounded 12 times. If we adjust the monthly rate to give a true yearly rate of 4.9%, then the payments should be $497.34, which is 50 cents less than the estimated payment. So, it’s a matter of taste whether the estimated payment is too high or too low, but either way it is very close.

The truth is that there is nothing sinister going on with the “money factor” and “lease fee”. There are no extra profits hidden in the math. The real problem is the advertised price. Few cars are worth as much as their MSRP (manufacturer suggested retail price). An error of a dollar or two on the lease payment is small potatoes compared to thousands of dollars added to the MSRP.

Exact Lease Payment Calculation

Some definitions:

M – price of car (MSRP + freight + PDI)
r – interest rate
n – lease duration in months
V – residual value
P’ – estimated payment (without sales taxes)
P – exact payment (without sales taxes)

The estimated payment is

P’ = (M-v)/n + (M+V)r/24

To get the exact value of the payment, the price should be equal to the present value of the payments and residual value:

M = V/y + (P/(r/12))(1-1/y), where y = (1+r/12)^n.

With some algebra we get

P = (r/12)(M + (M-V)/(y-1)).

If we treat y as an unknown variable and set P = P’, we get

y = (24 + rn)/(24 – rn).

This turns out to be a reasonably close approximation to the true value y = (1+r/12)^n. This can be verified by examining the power series of each expression. Aren’t you sorry you asked?

Are Financial Advisors Worth 1% of Your Savings Each Year?

noreply@blogger.com (Michael James) — Tue, 24 Nov 2009 05:01:00 +0000

The recent introduction by of mutual funds that hold a single ETF and pay financial advisors 1% trailers each year for selling these funds has stirred a debate: are financial advisors worth 1% of your savings each year? Of course, the answer depends on the investor and financial advisor.

Knowledgeable investors won’t find it worthwhile to pay anyone 1% of their assets for financial advice every year. Poor financial advisors aren’t worth 1% each year no matter how little the investors know about investing. But what about the combination of investors with medium to low knowledge and advisors who are middling to very good?

People differ on this question, and I don’t have the data to answer it definitively. However, I can examine my own experience. When I first began investing in more than bank GICs, I turned to a financial advisor who gave a presentation at my workplace.

For about 5 years I owned mutual funds recommended by this advisor. For two years during this period I owned more mutual funds sold to me by another advisor. If we assume that these advisors collected 1% of my savings each year, then they got a total of $2781 (in present-day dollars) from me. Of course, I paid more than double this in MERs, commissions, and deferred sales charges, but let’s assume that just 1% went to the advisor.

For this $2781, I estimate that over the 5 years I took up about 5 hours of these advisors’ time either speaking to them in person or on the telephone. No doubt these advisors spent more time doing things not visible to me behind the scenes related to my accounts.

About half of this time was spent on a brief initial interview to collect information about me and a few brief meetings where I handed over more money to place in my accounts. The other half was spent in a few meetings where they tried to convince me to borrow money to invest more.

One advisor convinced me to borrow enough to use up all my available RRSP room. The other failed to convince me to take out a big mortgage on my nearly-paid-for home. The RRSP loan worked out well because I managed to pay it off in one year. Taking out a mortgage would have been a disaster because the stock market tanked shortly afterward.

Throughout this period, I was pretty naive about investing (but was learning on my own). I should have been a good candidate for getting help from a financial advisor, but it seems clear to me that the “help” I got was not worth the $2781 I paid.

My experience is just one data point. I’ve met investors who are happy with their advisors and others who are unhappy. However, I’d like to see investors figure out how much they’ve paid their advisors and then decide if the money was worth it.

Beating the Odds in Vegas

noreply@blogger.com (Michael James) — Mon, 23 Nov 2009 05:01:00 +0000

I actually enjoy the occasional trip to Las Vegas, but I’m not the kind of gambler casinos want to see. It’s nearly impossible to beat the odds playing games against the house in a casino, but I do have one small idea for beating the house (sort of) at the dice game craps.

Before I go any further, I should mention that this idea hasn’t worked for anyone else who has played craps with me. It requires patience that the typical gambler doesn’t have. So, I don’t recommend trying this.

I start by finding a craps table that allows bets as small as $5. Some casinos don’t have any tables with bets this small. Then I only bet what is called the pass line. It is the most boring possible bet, but it has very close to fair odds. Out of 495 bets, the casino expects the player to win 244 times and lose 251 times, a net loss of 7 bets. Out of 495 bets, I expect to lose $35, which works out to just over 7 cents per bet.

It takes about 3.2 rolls of the dice, on average, to decide each bet. So, my loss per dice roll averages about 2.2 cents. In a very unscientific experiment, I timed the rolls at one table and found that each one took about 40 seconds. That’s 90 rolls per hour for an average loss of just under $2 per hour for me.

So far, all this sounds like losing money: where does the beating the house come in? They bring free drinks while you play. I wander over to a craps table and play for an hour before dinner and (statistically) lose $2, but have a couple of drinks while playing. The way I see it I come out ahead.

Of course, I could actually win or lose money each time I do this, but the long-term average will be losing roughly $2 per hour. And I enjoy the fun of being part of a group of excited people who tend to all win and lose together.

A few friends who have tried this with me couldn’t resist making bigger bets and making some of the other more exciting bets on the table that have worse odds. So, be warned: if you try this, it is likely to work out badly for you.

Dominated Strategies and Index Funds

noreply@blogger.com (Michael James) — Sun, 22 Nov 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

A strategy is said to be dominated if it is guaranteed to give the same or worse results than some other strategy. This term is usually used in game theory, but it can apply equally well to investing.

Most of the time when we have a choice between two alternatives, we don’t know for certain which choice will lead to a better outcome. Should you buy stocks or bonds? In a given year, stocks might give better returns or bonds might give better returns.

In some cases, the choice turns out to be clearer. Suppose that I offer you a bet: we’ll toss a coin, and the winner gets $100 from the loser. I see you hesitate, and I make a second offer: I’ll give you $10, and then we’ll toss the coin for $100.

No matter which way the coin comes up, you’ll be ahead $10 taking the second offer rather than the first. This means that the first choice is dominated by the second.

This doesn’t necessarily mean that you should go for the second offer. Depending on your circumstances (and whether you think I have some sort of trick coin), it may be sensible for you to reject both offers. But one thing is certain: it makes no sense to accept the first offer.

How well does an index fund track its index?

How does all this relate to index funds? If two companies both offer equity index funds based on the same index, then the funds should hold exactly the same stocks in the same proportions. The only difference between the two funds is how well their returns track the returns of the index.

The main reason for a fund lagging an index is its Management Expense Ratio (MER). If an index fund charges a 1% MER each year, then the fund must return 1% less to investors than the stocks produce.

Another contributor to index funds lagging their index is cash holdings. Funds vary in the amount of cash they keep around. Because stocks tend to give better returns than cash, over the long term, more cash means lower returns. Similar to this case is the possibility that the shares held by the index fund do not accurately mirror the index for whatever reason.

Another possibility is that the price of an index fund’s units does not accurately reflect the value of the underlying stocks. This is called a premium or a discount depending on whether the price is too high or too low.

Yet another reason for two index funds to track their index differently is securities lending. Many index funds lend shares to short sellers for profit. How much of this profit gets retained by the management company can affect returns on the index units.

The right choice of index fund is usually clear.

Suppose that we have two index funds A and B that hold the proper mix of stocks, do not sell at a discount or premium, hold very little cash, and return about the same amount of securities lending profits to unit-holders. The only thing left to distinguish them is the MER. Fund A has a 0.2% MER, and fund B has a 1% MER.

This means that no matter what happens in the stock market, fund A will always give a 0.8% higher return than fund B. As an investing strategy, fund B is dominated by fund A. So why would anyone invest in fund B?

The only reasons I can see why anyone might invest in fund B come down to ignorance. Maybe fund B manages to market itself without focusing on the MER. Maybe people aren’t aware of fund A.

In theory, all index funds that track a particular index can be evaluated, and everyone should invest in the one that lags the index by the least. In practice, things don’t always work out this way.

Short Takes: Credit and Debit Card Rules, Improving TFSAs, and 35-Year Mortgages

noreply@blogger.com (Michael James) — Fri, 20 Nov 2009 05:01:00 +0000

1. Finance Minister Jim Flaherty has finally come out with new proposed rules for credit and debit cards (thanks to Lyne who found this link for me).

2. Rob Carrick collected together several proposals for improving TFSAs. Most of them amount to increasing the amount that Canadians can contribute to a TFSA, in some cases favouring older people. These sound great for old rich people (something I aspire to be one day).

3. Canadian Capitalist wonders what are homeowners thinking when they take on 35-year mortgages that they can barely afford when it seems that interest rates (and payments) can only rise in the future? This one generated quite a barrage of comments.

4. Gail Vaz-Oxlade explains how minimum payments on credit cards actually decrease the amount that people pay towards their credit card debt each month due to a phenomenon called anchoring.

5. Making a claim on your insurance is often something you have to do at a traumatic time in your life. MoneyNing explains the four things you shouldn’t say to your insurance agent if you want you claim approved.

6. Canadian Financial DIY reports on rule changes with Locked-in Retirement Accounts making it possible to shift money to a regular RRSP.

7. Big Cajun Man likens the choice between a fixed or variable rate mortgage to the choice for New England to punt or go for it on fourth down in a recent football game against Indianapolis. He’s right that fixed rate mortgages are the more conservative choice, but this doesn’t apply to the football game. Football games don’t have intermediate outcomes; the only possibilities are win, loss, or tie. New England coach Belichick made the right choice.

8. Guest writer at Million Dollar Journey, Ed Rempel, thinks that faith is an important part of successful investing. I should add that he doesn’t mean the religious kind of faith, but rather optimism in the future of humanity. If this is what it takes to avoid selling out when prices are lowest and news reports are darkest, then it sounds good to me.

9. Mr. Cheap thinks it’s OK not to save for retirement in your 20s and 30s. This is another one of those cases where a message will resonate with the wrong people. Mr. Cheap wants to reach people who save every penny and fail to enjoy life. He’s more likely to reach spendthrift fools who are happy to have another excuse to speed towards a painful bankruptcy. This is often the way it goes with giving out advice as Jason Zweig explains.

10. Jonathan Chevreau has an amusing story of people showing real interest in a fictional 100-times leveraged ETF.

Gold Hits Record High! Or Maybe Not

noreply@blogger.com (Michael James) — Thu, 19 Nov 2009 05:01:00 +0000

We’ve had no shortage of headlines proclaiming “Gold Hits New Record!” When you’re in the business of writing something new every day, it’s easier to write about gold prices than to find something substantial to talk about.

Leaving the value of such reports aside, are they true? Well, recent stories announced that gold had reached US$1150 per ounce. Back in 1980, gold peaked at US$850 per ounce, which is obviously a smaller number than US$1150, but what about inflation?

This US consumer price index calculator says that US$850 in 1980 had the same buying power as US$2230 has today. So, an ounce of gold today has a little over half the buying power it had at gold’s peak in 1980. I’d say that this is a much more reasonable way to judge the price of gold, but it makes for less exciting headlines.

If we look at everything in absolute dollars, we can pump out headlines for record prices of many items every time inflation nudges up another 0.1%. Alarmist stories are great for reporters, but not much good for readers.

Wake me up if gold punches through US$2230.

Credit Cards with 0% Balance Transfer for Life

noreply@blogger.com (Michael James) — Wed, 18 Nov 2009 05:01:00 +0000

We’re all familiar with the idea of introductory rates. They are a good price that starts low to draw you in and jumps up later. This is common with internet providers, cable television, and credit card balance transfers. But, what if the fantastic deal stays in place indefinitely? There has to be a catch, right?

MoneyNing wrote about a variant of the 0% credit card balance transfer that I hadn’t seen before. Usually, the deal is that the debt transferred to the new card is charged no interest for a few months, and then the interest rate shoots way up.

There are two main ways people get caught with this deal. The first is that they are unable to pay the balance off before the interest rate shoots up and they have to pay excessive interest. The second catch is that if they use the card for new purchases, payments go toward the 0% balance and the new purchases start collecting high interest right away (although there is pending legislation to force credit card companies to apply payments more favourably for cardholders).

With a 0% for life balance transfer, we could beat the credit card company by just never using the card for new purchases. But that’s where the catch comes in. When credit card issuers offer 0% for life transfers, they require cardholders to make at least two purchases per month or else the interest rate would shoot up.

This could still be a good deal if the cardholder pays off the balance fast enough that the new purchases don’t accrue high interest for too long. To test this, I looked at the following scenario. Andy owes $5000 on a credit card. He is considering one of two approaches:

1. Use the 0% for life balance transfer. Andy will make two $20 purchases each month and make a $150 credit card payment each month until the card is fully paid off. We’ll assume that the interest rate on new purchases is 1.5% per month. (This is what the credit card companies would call 18% per year, but is actually 19.56% per year.)

2. Take out a line of credit for $5000. With the $150 available each month, Andy will make the two $20 purchases with cash and use the remaining $110 as a payment on the line of credit.

The question is what interest rate on the line of credit would cause the two debts to be fully paid off in the same number of months? It turns out that the credit card balance would be wiped out after 4.5 years. The equivalent interest rate on the line of credit that gets paid off after the same length of time is 5.7%. So, if the best rate Andy can get on a line of credit is more than 5.7%, he’s better off with the 0% transfer deal.

However, this analysis is very sensitive to the initial assumptions. What if Andy spends $100 per month and makes $200 payments? Then the credit card debt takes 5.5 years to pay off, and the equivalent line of credit interest rate is 10.6%. In this case, Andy is very likely better off with the line of credit.

Almost every special credit card offer is a potential trap to get you paying high interest on debt. Be wary.

ETF Pollution Rises to a New Level

noreply@blogger.com (Michael James) — Tue, 17 Nov 2009 05:01:00 +0000

Among investors who have heard of exchange-traded funds (ETFs), their level of understanding often doesn’t go much beyond “ETF good and mutual fund bad”. This shouldn’t be too surprising. We can’t all be experts at everything. But the line between ETFs and mutual funds is becoming blurred and investors will need more knowledge to make good choices.

As Jonathan Chevreau reports, many investors demand ETFs from their advisors, and now Invesco Trimark is offering “hybrids” of ETFs and mutual funds to meet the demand. We should be suspicious about calling these products ETFs when they can be sold by advisors who are only licensed to sell mutual funds.

As Rudy Luukko of Morningstar explains, most of these new products are actually regular mutual funds that invest in a single ETF. These new funds pay a trailer fee of 1% per year to advisors who sell the funds to their clients. Hapless clients, who can now be told they are buying ETFs, will pay a management fee that includes the 1% trailer plus the management fee of the underlying ETF for a total between 1.65% and 1.9% each year.

This solves financial advisors’ problems nicely. If clients want ETFs – no problem – they can have ETFs. Never mind that the underlying reason why clients want ETFs is to pay lower fees. These new products are hybrids only in the marketing realm. In reality, they walk and talk like mutual funds, but advisors can call them ETFs.

Until investors seek lower fees and demand to be told what their investments cost, they can expect more marketing efforts like this to keep them paying high fees.

What Drives People to Public Transportation?

noreply@blogger.com (Michael James) — Mon, 16 Nov 2009 05:01:00 +0000

When my wife decided to go back to school, at first I thought she might be losing her mind. But she’s having a great time. A decision she agonized over for a while was whether to drive or take the bus. It’s nice to think that we take the bus for green reasons, but it really comes down to cost and convenience. I’ll let her tell you the rest.

When the City of Ottawa reversed their decision to limit student bus passes to students under the age of 27, I decided to buy a bus pass and take the bus to school every day instead of just the two days a week I start at 8:00 am.

A monthly student express bus pass costs $76.60 compared to the full adult express rate of $106. If you are paying with cash or tickets, there is no discount for being a student. A monthly parking pass at school in the cheapest lot would cost me $71. Of course, there are 700 people on a waiting list to get one of these coveted spots and the college doesn't guarantee that even with a parking pass you will actually have a parking spot when you get there with your car. It doesn't seem like that good a deal to me.

Now I'm not as good at analyzing financial matters as my dear husband but I'm going to go out on a limb and say the gas, depreciation and wear and tear on my car would cost me more than the difference of $5.60 per month.

It took awhile to figure out that the bus schedule is more of a suggestion than something written in stone and that when coming home in the evening with the thousands of public servants returning to the suburbs, any bus in the 70 range that has room will get me closer to home where I can transfer onto the proper bus once said public servants have gotten off the bus and into their cars that they left at the park and ride that morning. And it has been fun trying to figure out who is going to give me H1N1, but I will diligently continue to not touch my face and wash my hands when I get to my destination.

Time-wise taking the bus in the morning is more convenient than taking the car because of the transitway and dedicated bus lanes. I almost feel sorry for all the people in traffic as we zip by them. The off peak trips take a bit longer and are more unpredictable but it's not a big enough hassle to get me back in my car at this point.

The interesting pricing even makes it more economical for me to purchase a student monthly pass in December when I am only in school for 3 weeks instead of paying full adult fare with tickets. And next year the city is going to make it even cheaper to buy a semester pass. I don't see using public transit for grocery shopping but for back and forth to school, it is working out pretty well.

Basics of TFSAs vs. RRSPs

noreply@blogger.com (Michael James) — Sun, 15 Nov 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many Canadians are confused about whether they should be saving money in Tax-Free Savings Accounts (TFSAs) or in RRSPs. In some situations this can be a complex question. Let’s look at the basic differences between TFSAs and RRSPs.

The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows.

1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes.

2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed.

3. TFSA contribution room accumulates at $5000 per year. RRSP contribution room calculations are more complex.

4. Any amount withdrawn from a TFSA becomes new contribution room for the future. Regular withdrawals from an RRSP don’t increase future contribution room.

A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is better.

Both RRSPs and TFSAs are better than investing in a regular account where any gains are taxed. So, if you are able to save enough, contributing to both RRSPs and TFSAs is the best option over the long term. Not paying taxes each year on investment gains is a huge advantage of both types of accounts.

An interesting difference between RRSPs and TFSAs is the perception of how much money you have. If you are in a 50% tax bracket, you will only get to spend half the money in your RRSP. However, all of the money in a TFSA is yours to spend.

So, having $200,000 in an RRSP may feel better than having $150,000 in a TFSA, but it isn’t better (if you are in a 50% tax bracket). This psychological difference may make people happier with bigger dollar amounts in an RRSP even if they are better off with a TFSA.

Short Takes: Debt Gene, Long-Term Disability, and Passive Investing

noreply@blogger.com (Michael James) — Fri, 13 Nov 2009 05:01:00 +0000

1. A fascinating study shows that people with one of two variants of a particular gene are 8% more likely to carry credit card debt, and people with both variants are 16% more likely to carry credit card debt. These gene variants are low efficiency versions of a gene that “encodes an enzyme that degrades neurotransmitters — such as serotonin, dopamine, and adrenaline — in parts of the brain that regulate impulsiveness and cognitive ability.” These gene variants have been linked to addictive behaviour. Does this mean that banks will want to do genetic testing to better target their credit card offers?

2. Canadian Capitalist shows that a technicality in how Nortel’s Long-Term Disability plan was set up has had devastating consequences from those who depend on it.

3. Larry MacDonald pulled some great quotes from books on passive investing. If you like the first set of quotes, he has a second and third set as well.

4. Canadian Financial DIY can’t find any advantage to foreign diversification in 22 years of investing returns.

5. Big Cajun Man has a story about the worst investment advice he ever gave a friend.

6. Preet explains how high-frequency traders make money. This is definitely not a system for the average overconfident day trader.

7. Mike at Four Pillars looks at the pros and cons of various potential ways to prevent future pension plan failures.

8. Gail Vaz-Oxlade has an entertaining rundown of the 8 reasons why you don’t save.

9. Frugal Trader lost his wallet and has some advice for making life easier if you happen to lose your own wallet.

Portfolio Rebalancing Experiment

noreply@blogger.com (Michael James) — Thu, 12 Nov 2009 05:01:00 +0000

Following up on last week’s musings on using portfolio rebalancing with a 100% stock portfolio, I decided to run an experiment using real stock prices. The goal is to see what benefit rebalancing brings over buy-and-hold.

Fairly arbitrarily, I decided to divide the portfolio into half Canadian and half US stocks. Each half consists of one individual stock and two index ETFs (one large cap ETF and one small cap ETF). The starting portfolio contains equal values of 6 different equities:

BMO – Bank of Montreal stock
XIU – iShares Canadian Large Cap ETF
XCS – iShares Canadian Small Cap ETF
BRKB – Berkshire Hathaway stock
VV – Vanguard US Large Cap ETF
VB – Vanguard US Small Cap ETF

The starting portfolio size for the experiment is $400,000 (Canadian). Because XCS began trading 2007 May 18, the experiment begins on that day with money divided equally among the 6 equities, rounded to the nearest 100 shares, except for BRKB which is rounded to the nearest share (because of its high price). Two different portfolios start this way: one is buy-and-hold and the other uses rebalancing.

The following costs are assumed:

– Trades cost $9.95 (Canadian or US depending on the shares bought or sold).
– Bid-ask spreads are two cents, except for BRKB whose spreads are one dollar.
– Currency conversion costs 0.5% on top of the exchange rate in each direction.
– Funds are in a tax-sheltered account so that no capital gains taxes are paid.

The buy-and-hold portfolio does no trading for the roughly 2.5 years from portfolio inception to the present. The other portfolio rebalances whenever the allocations drift too far from equal allocations in the 6 equities. It was surprisingly difficult to settle on a set of rules for how to do the rebalancing.

To minimize currency conversion costs, I wanted to rebalance from one Canadian equity to another or one US equity to another, where possible. I settled on the following rules to trigger a trade:

– If the total Canadian side gets outside the range 45% to 55%, then rebalance.
– If one of the Canadian equity’s proportion of the Canadian side is outside the range 33.3% plus or minus 5%, then rebalance the Canadian side. Handle the US side similarly.

For the actual rebalancing, I usually sold one overweight stock and bought one underweight stock. All trades were in multiples of 100 shares (except BRKB).

The initial portfolio size and rebalancing rules are set so that the typical trade size is about $10,000. In cases where two equities were roughly equally underweight or overweight, the buy or sell was split into two separate trades. I used my judgement rather than trying to define all the rules completely precisely.

However, I did not use any discretion in deciding when to rebalance. Whenever the portfolio was out of balance, I brought it back into balance that day.

The following chart shows how the rebalanced portfolio fared against the buy-and-hold portfolio. The red triangles mark the 8 rebalancing days that were needed over the 2.5 years.

In the end, the rebalanced portfolio won out by 3.95% (about 1.6% per year), but it wasn’t a smooth ride. For the first year and a half, rebalancing lost money. Rebalancing seemed to do a good job of exploiting the high volatility earlier this year.

Overall, this experiment doesn’t prove one way or the other whether this strategy will profit over buy-and-hold. If a basket of equities each rise at about the same average rate of a long period of time, then rebalancing can capture extra profits from the relative volatility. However, if one or more of the equities’ average growth rate is significantly lower than the others, then continually rebalancing into the underperforming equity will hurt returns.

Remembrance Day – Veterans’ Pensions

noreply@blogger.com (Michael James) — Wed, 11 Nov 2009 05:01:00 +0000

Canada owes its war veterans a great deal. It’s hard to put a price on freedom. Looking for a connection between money and Remembrance Day, I wondered how we support our injured war heroes. It’s nice to stick ribbons on cars, but wounded soldiers need cold hard cash to put food on the table.

According to this Veterans Affairs Disability Pension Program document, a soldier wounded during war time who is considered to be 100% disabled gets a disability pension of $2322.14 per month. Soldiers who are judged to be only 50% disabled would get half of this amount.

This figure is smaller than I was expecting. I suppose it doesn’t make sense to turn war heroes into millionaires, but it’s hard to imagine $2322.14 per month stretching very far for someone who is completely disabled.

Investment Advice Often Reaches the Wrong People

noreply@blogger.com (Michael James) — Tue, 10 Nov 2009 05:01:00 +0000

There is no shortage of investing advice in the world. Some of it is good, some bad, and much of it is contradictory. However, just because two opinions are contradictory doesn’t mean that one of them is necessarily wrong. Unfortunately, we often gravitate to the advice that is wrong for us.

For example, consider the following two very general opinions:

1. Investors should be careful with their money.

2. You have to take some investment risk to get rewarded.

These opinions are somewhat contradictory, yet both true. They are also vague enough that people will read into them what they want. Let’s look at a couple of extreme examples to illustrate how this advice affects two investors.

Action Andy has his investment account leveraged to the maximum and owns just two stocks. He reads the first piece of advice about being cautious and rejects it because it sounds like his mother talking. The second piece of advice prompts him to re-mortgage his house and buy into the latest hot Initial Public Offering (IPO).

Fearful Frank has all his savings stuffed into his mattress. He rejects the advice about taking some risk because he can vividly remember all the bad things that have ever happened to him when he took a chance. The advice about being careful prompted Frank to get rid of his dog so that the money in his mattress wouldn’t get chewed up.

In these extreme examples, Andy and Frank rejected the piece of advice they most needed to follow. Most of us tend to reject ideas that don’t already fit into our beliefs. However, it can be a good idea to think about new ideas sometimes, even if you end up rejecting most of them. The odd idea that doesn’t sound right at first may be beneficial.

Some advice I encountered recently that will likely reach the wrong people came from Larry Swedroe who advises you to reassess your investment strategy in light of the recent bear market. The idea is to lighten up on stocks if you couldn’t stomach the paper losses.

The investors Swedroe has in mind are the overconfident stock pickers who take on far too much risk. For these people, Swedroe is spot on. Unfortunately, his message isn’t likely to resonate with these investors.

However, consider the investor who had a conservative 50/50 split between a stock index and a bond index and sold all the stocks near the market lows. This investor is likely to see Swedroe’s advice as supporting the stock index sale. Well into the next bull market this investor may decide to reassess his risk tolerance again and buy back in.

So, this hypothetical investor has used Swedroe’s perfectly good advice to justify a terrible strategy of selling low and buying high. Giving advice is a difficult game (when you genuinely want to help people) because often the wrong people take it.

Some Index ETFs Understate Fees

noreply@blogger.com (Michael James) — Mon, 09 Nov 2009 05:01:00 +0000

Until recently, the leader in index ETFs for US stocks has been Vanguard. Their great reputation combined with rock-bottom MERs has made them the clear choice. However, Schwab has come out with several index ETFs with management fees matching or beating Vanguard with the added bonus of paying no commissions when trading in a Schwab account.

As Larry MacDonald points out, some ETF companies generate extra revenue through a practice called securities lending. This is the practice of lending stock to short sellers for a fee.

Some commentators are speculating that Schwab is keeping the proceeds from securities lending to augment the MER. The Schwab prospectus doesn’t seem to clear up the matter:

“When the fund lends portfolio securities ... the fund will also receive a fee or interest on the collateral. ... The fund will also bear the risk of any decline in value of securities acquired with cash collateral.”

So the fund gets a fee and the fund bears the risk. What do they mean by “fund” in this context? Is it the unit-holders or the management company?

In my opinion, because unit-holders own the securities they should keep the proceeds of securities lending (net of reasonable costs). If a management company keeps some or all of the proceeds, then they are essentially understating the fund costs.

Until Schwab makes it clear who gets the securities lending proceeds, I’ll stick with Vanguard. Vanguard has a clear policy:

“Unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds. Other securities lenders may divert up to 50% of the revenues derived from their securities lending programs.”

Debt Problems and the Dangers of Consolidation Loans

noreply@blogger.com (Michael James) — Sun, 08 Nov 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid of quickly and others over a long period of time.

The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle.

To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC).

On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I ever thought about this much, but a HELOC seemed to make sense if you are in debt trouble.

However, Suze Orman is dead set against this strategy saying in her book Women & Money “never use home equity to get rid of credit card debt.” Her reasoning is that if you got into trouble once, then you are likely to run up your credit cards again. Then you will have credit card debt and the HELOC to pay off. And if you can’t pay them off you will lose your house.

My first thought was that I disagreed with Orman. A rational person would consolidate the loans and then bring spending under control. But a rational person probably wouldn’t have had debt problems in the first place.

It is possible for someone who manages money well to have some big expensive event occur that throws him into more debt than he can handle. But this is infrequent compared to the number of people who make poor choices that result in having debts spinning out of control.

So, Orman is right. Most people with debt problems probably should not consolidate their debts into a HELOC.