Draft text of my MoneyShow talk

2011 MoneyShow Talk by Jonathan Chevreau

Financial columnist and author of Findependence Day

Sept. 8, 2011

It’s been two years since I’ve spoken at this conference, which means I’m two years closer to reaching my personal Findependence Day. Today I’m going to talk about how YOU can decide on your own day of Financial Independence, or what fee-only certified financial planner Jason Heath terms Dream Day.

Jason is here and after I finish in about 20 minutes, will describe the process he uses with clients at EES Financial. He’ll describe how fee-only financial planning works and how it differs from fee-based or commission-based advisory services.

Apart from writing a column in the Financial Post, Jason is one of five CFPs who helped me vet the manuscript of Findependence Day and he was at the original book launch late in October 2008.

Yes, great timing, wasn’t it?

2008 financial crisis is not over

I’m also going to talk about several important books that have been published since the 2008 financial crisis because it’s becoming pretty clear that despite the rally that began in March 2009, that the crisis continues.

This will not be a surprise to those who have read Rogoff and Reinhart’s This Time is Different. It surveys 800 years of financial folly and concludes that financial and banking crises, debt repudiation, currency debasing and inflation are all too common, both in emerging and developing economies.

They argue the next recession will be about deleveraging. 2008 was about governments coming to the rescue of corporations crippled by debt. Today, it’s about governments overwhelmed by debt, up to and including the United States.

John Mauldin’s Endgame: The End of the Debt Supercycle quotes liberally from Rogoff and Reinhart, focusing on the lingering impacts of rising government debt around the world. Mauldin believes we’ve only entered act 2 of the financial crisis.  He expects the United States will resort to “financial repression” – some combination of inflation and devaluing the greenback.

Like Anthony Boeckh in The Great Reflation, Mauldin foresees several years of lackluster growth or recession, though neither attempt to predict how the tug of war between inflation and deflation will turn out. Not so Gary Shilling in the Age of Deleveraging, who foresees a decade of deflation and low growth.

My own book includes an episode of a stock market crash like 2008, even though it was fiction when I wrote it. And it’s set in an environment of recession and widespread unemployment: including a job loss for Jamie, the protagonist.

But the environment we’re in underlies the point that investors need good financial advice but also need to contain costs in an era of single-digit returns. These days, achieving financial independence is no easy matter.

The three underlying principles of Findependence Day

The main underlying principles behind Findependence Day are three-fold: the importance of using a financial planner, how you can cut costs using a discount brokerage, and how you can safely create a low-cost diversified asset class portfolio with index mutual funds or ETFs.

The book is a kind of financial love story, covering life cycle investing from the perspective of a modern couple. They marry at 28, raise kids, buy houses, wonder about pensions, RRSPs and TFSAs, paying down the mortgage, saving for university and all the rest.

When we first meet Jamie and Sheena, they are participants on a financial reality TV show. Sheena has a spending problem and is humiliated when the host asks her to tear up her credit cards on camera and she can’t do it.

At this same show they meet a financial planner, Theo, and beg him to take over their financial lives. But he declines, telling them to come back to him when they’re free of all debt.

One reviewer called it a “Financial Pilgrim’s Progress.” But instead of striving to reach a spiritual city, Jamie is striving to reach the financial city of Findependence Day. And instead of being weighed down by a sack of sin, our couple is weighed down by debt.

You can buy copies at the National Post booth throughout the show: in fact, if you subscribe to the paper for at least six months, you can get a free copy. You can also order copies via PayPal at www.findependenceday.com at half the original retail price. The relaunched web site went live just last week.

So let’s get into more depth about the basic model.

Many of you may have started with mutual funds or a full-service stock broker. In a way, the model you’re accustomed to is that your financial professional is driving the boat and you’re the passenger.

Under the Findependence Day model, you’re going to take the steering wheel and your advisor won’t even be in the boat with you. He or she will be on shore, shouting out the odd instructions with a megaphone but for much of the time you’re going to be doing the heavy lifting.

I went this route myself and it was my current fee-only planner who urged me to open up a discount brokerage account. We chose the same bank where we did most of our banking: it’s convenient to have one place where your paycheque enters and your bills exit, tied to mortgages, credit cards and ATM withdrawals.

There are differences between them but in the case of the big banks, the differences are not so great that it would pay to depart from the convenience of being in one place.

I have found RBC Direct Investing to be good for registered investments, because they have a simple way to segregate US and Canadian dollar accounts and you don’t get dinged so often on currency exchange.

But if you want to do complicated portfolio hedging strategies with options, TD Waterhouse is more flexible in permitting these techniques for non-registered accounts.

A decade of sideways markets?

Given the recent volatility of the markets, some hedging may be advisable. I think we’re in for several years of sideways markets and suggest you read The Little Book of Sideways Markets, written by Vitaliy N. Katsenelson.

It’s essentially a book about deep value investing but he makes it clear that buying and holding is no longer viable. Clearly, nimble investors need to trade more to exploit such markets, so cutting costs through a discount brokerage makes even more sense.

Once you’re up to speed with a discount brokerage, you’ll naturally want to have your RRSP, TFSA and non-registered accounts set up there. The book has some primer material on TFSAs: suffice it to say, I think TFSAs are great, we should all max out the $5,000 a year we can put in them and look forward to the Tories eliminating the deficit so it rises to $10,000.

TFSAs should be self-directed and able to own whatever you own in an RRSP: individual stocks and bonds, mutual funds, index funds and exchange traded funds.

The model in the book is low-cost passive asset-class investing. Typically this is implemented with ETFs but it can also be accomplished with index mutual funds.

Fundamental or enhanced indexing

Fundamental or enhanced indexing is probably the best route to go: as opposed to market-cap weighted index funds or ETFs; or equal weighting.

Many fee-based advisors swear by DFA Canada’s index funds which have value and small-cap tilts. Other index mutual funds that do this include Pro-Financial and RBC O’Shaughnessy Funds.

For ETFs, consider those that use the RAFI funds licensed by Research Affiliates. RAFI stands for Research Affiliates Fundamental Indexes. The famous founder is Rob Arnott. In Canada, Claymore Investments sells four or five RAFI-based ETFs.

Greenblatt’s Big Secret for Small Investors

There’s an excellent book by Joel Greenblatt called The Big Secret for the Small Investor. Greenblatt wrote two previous books shown on this slide. Each of his books takes indexing to a more sophisticated level and the final spot he arrives at in The Big Secret is essentially fundamental indexing. Whether you talk to DFA, Claymore or RAFI, they all claim 2 to 4% better annual returns than first generation market-cap weighted index funds or ETFs.

The biggest firms, including BlackRock’s iShares and Vanguard, tend to have more market-weighted funds. They are of course highly diversified and liquid but the fundamental indexing crowd claims market cap weighting tends to make over valued stocks still more overvalued in bull markets, while minimizing bargains.

I recently chatted with a friend at one of the full service banks and he told me the investment piece is the easiest to implement – especially if you go this route of low-cost asset-class investing. You set up a good portfolio, keep saving by setting up PACs and remember to rebalance every year – so if stocks get ahead of themselves, you take partial profits and build up the underperforming asset classes like bonds.

But investing is only one piece of the puzzle. The CFP you’re engaged is also going to help on the less-fun stuff, like taxes, estate planning, insurance protection and many other things you may not be so competent at.

Some readers complain they can’t find a true fee-only planner. It’s true they are rarer in Canada than in the U.S. Here there are many more fee-based or asset-based advisors and in fact as John De Goey describes in his book, The Professional Financial Advisor, many commission-based advisors are moving to the fee-based model. This is a positive since it eliminates one potential conflict of interest. Still, fees can range from 1 to 1.5% of a total portfolio so if you’re willing to do your own trades using a discount brokerage and use a true “fee-only” planner charging by the financial plan, by the hour or even an agreed quarterly retainer, you can get the best of both worlds.

True fee-only planners more common in U.S. than Canada

You can find lists of these fee-only planners on the web. One place to start is www.iafp.ca. Two of the bigger true fee-only shops are Vancouver’s MacDonald Shymko and Markham’s EES , which is the firm Jason Heath is with.

The model described in Findependence Day of fee-only planning, discount brokerage and index funds or ETFs is based on low-cost asset class investing: the belief that active management –whether through actively managed mutual funds, hedge funds or individual stock picking and attempts to time the market – cannot overcome the hurdle of its own costs, including transaction costs and taxes.

One DFA advisor I met recently, Marshall McAlister, wrote an interesting book titled The Brilliance of Boring Investing.   If I were starting from scratch I’d probably put most of my portfolio in these kinds of funds. As it stands, however, my personal portfolio is more what many would call Core and Explore.

Core and Explore

Core and explore is sort of a compromised indexing system where the “core” or lion’s share of a portfolio is devoted to indexing.

Explore lets you indulge in a bit of stock-picking or market timing or sector rotation in the periphery outside the serious “core” of your portfolio. Indexing purists of course will argue that adding an “explore” component will only break down your discipline and sabotage your results.

To some extent it’s what I do with my own portfolio. As I explained it to one advisor, if you like some of the top ten holdings in the Claymore US Fundamental Index ETF and have “high conviction” about some of them – perhaps a Procter & Gamble or an AT&T – why not make a few concentrated “explore” bets on them and take down your MER on that part of the portfolio. (Unlike index funds or ETFs, you pay no ongoing expense ratios on individual stocks).

Some prefer to make small “explore” bets with sector ETFs or country ETFs.

With the troubles in Europe, some see no reason to have any exposure to Greece or the other PIIG countries. You could pick iShares ETFs focused only on Europe’s strongest economy, Germany, or even a country that’s not adopted the Euro, like Switzerland or the UK.

My friend the pure indexer believes this kind of core and explore dabbling to be a mistake since you’re adding risk to the portfolio with no offsetting gains.

Most of you will know that David Chilton of The Wealthy Barber fame has just come out with his long-awaited sequel to The Wealthy Barber.
He covers a lot of ground and continues to make the case for saving till it hurts, paying yourself first and being an owner, not a loaner, or investing mostly in solid diversified dividend-paying stocks.

But he’s also embraced indexing big time: a departure from his original take on actively managed mutual funds. He now views investing as a zero sum game and active management as unlikely to generate outperformance once fees, trading costs and taxes are factored in.

There are two main screens some believe can be used to “beat” market cap weighted indexes. One is value-based indexing; the other is to overweight dividends.

Wharton School’s Jeremy  Siegel, author of the bestselling Stocks for the Long Run, has shown total real returns of major asset classes between January 1802 and December 2010. $1 invested in a U.S stock grew 6.7% annually to almost $700,000 over those 208 years, while bonds grew only 3.6% to $1,530 and short term bills grew 2.8% to just $295.

So in the long run, from the vantage point of protecting purchasing power, stocks are safer than fixed-income, according to Siegel. Over all long-term periods, stocks averaged 6 to 7% annual returns.

Jeremy Siegel and sorting by value and dividends

But Siegel also showed how U.S. stocks sorted by high dividends or low P/E ratios generated outsized returns for investors during the “lost decade” of 2000 to 2010. While the highest P/E stocks would have lost 5.7% a year, the lowest P/E stocks would have returned 9.6%.

Similarly, the lowest quintile of dividend paying stocks would have lost 2.8% while the highest yielders returned 5.1%. CIBC recently announced a new 5-year note based on Siegel’s strategy: the CIBC Wisdom Tree Value Strategy Notes, Series 1.

Speaking of Wisdom Tree, if you’re a mature income-seeking investor and agree dividends are the way to go, you can find dozens of Wisdom Tree ETFs that invest ONLY in dividend-paying stocks, sorted by various market caps and geographies.

For older investors seeking reliable income, quality dividend-paying stocks have always been a compelling alternative to bonds. With interest rates still near record lows, payouts on cash and bonds are negligible, plus there are other disadvantages.

Bond ETFs will do well under Shiller’s deflationary scenario

Until the August stock crash, many analysts believed it was just a matter of time before rates start to rise again. As we know, the Fed has said it will keep rates low at least until 2013 – suddenly bond ETFs don’t look so unattractive as six months ago. Certainly if you agree with Shilling’s deflationary scenario, you’d want quality government or corporate bonds. One bond ETF I like is the Claymore 1-5-year Laddered Corporate Bond ETF [ticker CBO/TSX.]

Still, many stocks now have higher yields than bonds and also offer the hope of boosting dividends to help investors keep up with inflation. That’s an important consideration for retirees living on otherwise fixed incomes and non-indexed pensions.

Canadian investors must consider two types of dividend ETFs: those holding Canadian stocks eligible for the dividend tax credit, and U.S. or international dividend ETFs whose payouts are taxed just as harshly as Canadian interest.

From a tax-optimized asset location point of view, you want to put foreign dividend ETFs inside an RRSP (or TFSAs) and put Canadian dividend ETFs in non-registered plans to take advantage of the favorable tax treatment.

Canadian Dividend ETFs

There are two main contenders for Canadian Dividend ETFs. The iShares Dow Jones Canada Select Dividend Index Fund (XDV/TSX is over 50% invested in big Canadian bank stocks and other financial services companies.

If you’re like me and have plenty of exposure to the banks, you might consider instead the Claymore S&P/ TSX Canadian Dividend ETF (CDZ/TSX. This ETF replicates the Canadian Dividend Aristocrats Index, an exclusive club that insists on a record of increasing ordinary cash dividends every year for at least five consecutive years. MER is 0.66%, compared with 0.53% for the iShares ETF.

Now to the U.S. and international sphere.

International Dividend ETFs

Various ETFs (from firms like Vanguard or Wisdom Tree) use a similar “dividend aristocrat” approach, although the track record of consistent dividend growth is generally longer than five years.

In March, BlackRock’s iShares supplemented two older dividend ETFs with the new iShares Dividend Equity Fund (HDV/NYSE). It holds 75 quality American dividend paying blue chips such as AT&T, Procter & Gamble, Johnson & Johnson and Pfizer Inc. Its MER is 0.4%.

These are the kind of stocks many investors may already own individually. Keep in mind these are all U.S. stocks priced in U.S. dollars: depending on your view on currency, you may wish to expand your search to products that hedge back to the Canadian dollar (BMO ETFs have several that do this).

HDV partly duplicates the older iShares Dow Jones Select Dividend Index Fund (DVY/NYSE) so you won’t need both. Instead, diversify further with the iShares Dow Jones International Select Dividend Index Fund (IDV/NYSE) or several competing international dividend ETFs. (like Global X’s XDIV for those who read Barron’s)

Dividend ETFs aren’t immune to bear markets but the quality holdings should hold up relatively well and the dividends “pay you for waiting” for the market to come back.

Of course, ETFs aren’t perfect and some believe indexing in sideways markets will lag stock-picking. The Economist magazine recently ran an article cautioning that superspecialized ETFs have gotten too far away from the original “good idea” of the broadly diversified ETFs originally marketed by iShares/Blackrock and Vanguard.

With 2,750 ETFs on the market worldwide, it should come as no surprise that some weird, narrowly focused products have been unleashed on an unsuspecting public. Perhaps the most egregrious is the HealthShares Dermatology and Wound Care ETF, closed in 2008 due to lack of interest.

The big ETF makers like BlackRock and Vanguard tend to have similarly broad sector funds covering important niches such as energy, financials, consumer staples and health care. However, some of the more aggressive newer players are drilling down into pretty tiny sectors. For example, Global X also has an ETF focused on global automotive manufacturers, sporting the memorable ticker symbol VROM (as in Vrroooom!).

The Economist’s concern about the proliferation of specialized, costlier ETFs echoes a similar warning years ago from Vanguard founder John Bogle. It certainly appears some newer ETF entrants are going down the same path as mutual funds did a decade earlier, with marketing goals trumping investment ideals.

Hedging with Reverse ETNs

The 2008 crash highlighted the shortcomings of a particularly risky type of specialized ETF known as leveraged or “inverse” ETFs. These let investors make big double-or triple-bets or contra-bets on any number of small market sectors.

Some leveraged bear-market funds lost money over several months when investors had expected significantly positive returns.  However, a  newer type of reverse ETN appears to have gotten around some of the problems and may have a place in portfolio hedging strategies.

Barclays iPath has several interesting reverse ETNs, such as   on NYSE/Arca [iPath Short Extended S&P500 TR Index ETN.]

Because the leverage factor is roughly 3 to 1 – but varies as markets go up or down —  you need only about $33,000 in SFSA to hedge $100,000 of long stock exposure: the S&P500 in this case. Of course, if the market keeps rising, you won’t be happy with such a hedge.

Unlike mutual funds, you can short ETFs, which is another way to hedge the downside if you believe a particular geographic or industry sector is likely to fall in value. This is best done with a qualified advisor, ideally one licensed to sell both securities and options.

Like any tool, ETFs and ETNs can be used or misused. Buyers need to have a full understanding of the underlying mechanics.

The original plain-vanilla ETFs can still serve as the “core” of diversified portfolios. In that context, it’s an exciting development that cost leader Vanguard is coming to Canada.

Canadians can already buy Vanguard ETFs trading on American stock exchanges, but the arrival of TSX-listed Vanguard ETFs will likely give us C$ hedging and probably lower cost versions of what iShares, Claymore and BMO already offer.

Vanguard’s new ETFs in Canada

Late in August, Vanguard Canada filed for its first six ETFs, shown here:  One tracks the MSCI Canada Index and there are two C$ hedged ETFs for the US broad stock market and MSCI EAFE index. It also unveiled an unhedged Emerging Markets ETF and a couple of domestic bond ETFs.

Hopefully, they’ll also unveil a line of index mutual funds, which would be something new because Canadian laws currently do not let Canadians buy mutual funds domiciled outside Canada.

Vanguard tends to provide “core” products rather than “explore.” And for most investors, that’s probably a good thing.

Broadly based core funds can be bought and held for the long term, providing the accompanying benefits of low cost and tax efficiency. The more focused ETFs popular with traders and market timers tend to have higher MERs. Also, the more often you trade ETFs, the more the transaction costs and tax consequences (if in non-registered portfolios).

Growing ETF choice needs qualified advisors to help

The irony of all this ETF choice is you may well need the assistance of a financial advisor to put it all together, just as in the old days you needed help with picking stocks, then picking mutual funds.

Investors seeking objective, conflict-free advice that’s in their best interest should prefer a fee-based or fee-only financial advisor when creating and monitoring ETF portfolios.

This help is probably most needed in keeping the ETF selection within the parameters of proper asset allocation and the Investment Policy Statement (IPS). Yes, you can save costs by picking your own ETFs (or individual stocks or bonds, or both) at a discount brokerage but my friend the purist indexer insists only one in 10,000 can go it alone. His view is the other 9,999 are well served with a fee-based advisor charging, say, 1% of assets.

Given the low-growth sideways markets that Mauldin, Shiller and others are expecting, I believe most investors – even users of discount brokers – will need some form of advice or guidance.

There are certainly a growing number of ETF-based advisory services that provide ETF oversight: firms like PWL Capital in Montreal or Hahn Investment Stewards in Vancouver.

These services are like mutual fund wrap programs like Franklin Templeton’s Quotential, which assembles portfolios of 10 to 12 mutual funds. These cover all the major asset classes, all within the investor’s stated risk tolerance, which may range from conservative to aggressive.

The ETF equivalents will be lower cost to the extent the underlying ETFs charge less than retail mutual funds.

If you’re lucky you may be able to find an advisor who offers clients a choice of any of commission-based, fee-based or fee-only.

Now let me introduce you to a true fee-0nly financial    planner, Jason Heath of EES Financial. I asked him to elaborate on EES’s concept of Dream Day, and to assess how it’s similar to and differs from Findependence Day.

— 62 —


Jonathan ChevreauAbout Jonathan Chevreau


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