We will explore what some people are afraid to talk about: Actual Historical Returns, What Do They Mean? What did we learn? How do we apply these realities to our future investment decisions?

Please be our guest over lunch and learn about how you can improve your chances. This is also a great opportunity for you to bring along a family member, friend, or colleague to engage in our discussion.

Speaker: Patrick Mullins CFA, Director- Wealth Management, Richardson GMP

Date: September 22nd, 2010 Time: 11:50 a.m to 1:00 p.m

Location: 343 Preston Street, Suite 300 Ottawa, ON K1S 1N4

Lunch will be served

Please RSVP to Lisa Beartup. lisa.beartup@richardsongmp.com or 613-788-8015.

Unfortunately, from a purely statistical basis it takes about 30 years of data to make a confident assessment of skill for investment management.  The evidence of “beating the street” simply cannot be identified in one, three and five year tables.  For practitioners, this presents a big problem as 30 years is an investment lifetime. Also, the skillful manager is generally about to retire once you have confidently identified his or her ability. It would be much more convenient if we could confidently identify future out-performance. Unfortunately, there is always uncertainty. If we knew the outcome, returns on stocks would be equal to returns on bonds.

In my opinion, the time and effort to identify a hot hand is better spent on good portfolio construction. Good financial advisors have processes that generally guide clients towards strategies designed to minimize errors of judgement. They focus on cost control. They provide guidance around matching fixed income from your portfolio to income you require from the accounts in retirement. Good advice often encourages investors to patiently allow stock market return to be realised by the portfolio in a consistent repeatable approach. There is generally much less of a focus on market timing. They recognise that the recent past offers little in the way of predictive power.

In our practice we focus on repeatable investment success. Our portfolio approach has been refined through more than thirty years of combined, on the job, experience. If we are already working with you great – if not, let’s meet to see if we can be of service.

Patrick

Diversification improved the outcome. A dollar invested into the US S&P 500 total return index is worth about 66 cents after currency adjustment. Not really compelling, but 66 cents beats 41 cents. A dollar invested globally in MS EAFE in 2000 would be worth about 65 cents, currency adjusted. A dollar invested in Canada, as represented by the S&P TSX60 total return would have actually grown to about $1.72 in 10 years. Bonds as represented by DEX Universe Canadian Bond index, increased from a dollar to $1.62 in 10 years.

A common benchmark for pension return of 7% would have seen a dollar grow to $1.97 in 10 years. Inflation, as represented by core CPI, represents a change of 20 cents from 2000 to the end of 2009.  For pension managers, the benchmark return is the rate of investment return that will balance cash inflows with cash outflow and cover for the effects of inflation. As the above statistics indicate, this has been a very challenging period for investors and investment professionals.  Many pension plans are now underfunded and similarly, retirement accounts are not achieving the growth that was expected to fund retirement spending. Those most acutely affected include those investors who retired at the beginning of the decade. Many now have to choose between lower spending and/or adding back some sort of employment income. Some will of course follow the path of chasing higher returns and tolerating much higher levels of risk. It is likely that this final choice will be too difficult a path to follow over any meaningful period of time.

Last week Mullins Capital Management hosted a luncheon with the head of BGI Canada, Heather Pelant, as our speaker. You may know many of their products as “i shares” or exchange traded funds (ETF). Ms Pelant’s presentation reviewed the reasons for owning ETFs instead of actively-managed mutual funds. She pointed out that market exposure explained more than 90 percent of investor return. In addition, she discussed how few active managers deliver returns greater than the market. There is a good body of academic research backing up her views. So, a real problem exists for investors trying to find persistent out-performance for their investment portfolios. Return is further challenged when fees and expenses are considered.

Short term stock market performance is not predictable.  The risk of “not knowing” is rewarded by investment return for fully diversified portfolios. This investment identity explains some of the under-performance of active management. To paraphrase Heather Pelant, active managers get it wrong by focusing on the seven percent of total investment returns attributed to market timing and stock selection. The math adds up like this: the average investor can beat more than 90% of professional managers by simply achieving the returns provided by the common indexes representing various stock markets. Most pension managers can be considered active managers. The overwhelming majority of mutual funds offered to individual investors are actively managed. Exchange traded funds are designed to track specific reference markets. Their “tracking error” is usually quite small and mostly attributed to the fees they charge to manage the effort. Perhaps somewhat surprisingly then, according to BGI, ETFs are represented in only 5 percent of investor portfolio’s in Canada.

While the attributes of ETFs are compelling, for our investment practice we think there are additional improvements we should and can make for investors in their fully diversified portfolios. For statistically relevant periods, we expect stocks to outperform bonds. We expect small capitalization stocks to outperform large capitalization stocks. We expect low price-to-book value stocks to outperform high price-to-book value stocks. These ideas are embodied in the three factor model of Fama and French and applied to the real investment world through Dimensional Funds. In our 10 year example a dollar invested in US large and small companies through Dimensional US large Value and US small value funds would have turned into about $1.60 or about $1.33 after currency conversion. This is a meaningful improvement when compared to the return of the S&P 500 total return index (a dollar to 66 cents) for the period.

The randomness of short term investment return adds a great deal of confusion to the choices investors must make. It is frustrating when properly diversified portfolios designed to achieve investment goals of clients and their families over a meaningful period simply fail to do so. If the under-performance is a random outcome we should stick to the approach. We assume the return for risk assumed will manifest. Similarly, if our performance is much better than expected based largely on randomness we should consider a change in approach. Like pension funds, individual investors should consider current assets and future savings along with their longer term income requirements to define the appropriate risk level they can assume. After the quantitative definition, an important second check is to determine how much risk you are willing to assume. Your game plan becomes clear if these two definitions are compatible. In addition, keeping costs lower by managing taxes and management fees will provide a permanent, sustainable improvement in the management of your assets.

Finally, I fully expect the financial media to explore the returns to this past decade. In my opinion, there is little insight gained by assuming the past will equal the future in the investment markets. Measuring returns from a date like 2000 to 2010 is a good test but probably not very good roadmap. Good advisors have strategies that consider this when developing game plans for their clients.

In continuing the discussion of the concept of fairness, lets now look at lotteries. Lotteries are different; we don’t seem to demand fairness to participate. In a series of fair lotteries below the gross proceeds are evenly distributed among the participants. (For a review of my definition of fairness see my previous post).

Mean is the average payout: (total payout/ number of players). For all the three lotteries above the mean is 1, or your money back. Though this doesn’t describe what we see in the chart very well. For all lotteries above, mean returns look okay, no matter the payoff distribution or skew.

Median is the middle value of a series; the median is useful when distributions have extreme values which skew the mean value. In this example the median return for series 2 and 3 is zero. Median is a better approximate of the probable payout for those games.

Lottery payoffs are best represented by series 3 – one winner of all the money. It is unlikely that anyone would be motivated to play game 1, since simply getting you money back plus a little is not a very exciting proposition.

If we had our lottery promoter hat on, it is likely that we would prefer to sell tickets for lottery two or three rather than one. My take is that random large rewards are viewed as exciting.

In 2006, average proceeds for all US state lotteries were distributed as follows:

• approximately 65% in winnings payout
• 4% Sales General and Administrative expenses
• 31% retained by the state treasury.

Perhaps the old line “you can’t win if you don’t play” should be modified to “they can’t win if you don’t play.”

This is why economists refer to lotteries as a form of voluntary tax. In the case of all US State lotteries, initial government take of 35% compares favourably to regular income tax rates since most lottery participants pay less than 35% in average tax rates. In many instances, the proceeds are also taxed for an additional win for the sponsor state, when they receive essentially a double taxation dip of more than 50% of the bets.

So why do we suspend our sense of fairness to play these games? In the case of charity lotteries it is perhaps the excuse we need to give to a good cause. For regular lotteries, it appears that lottery operators are successful at building excitement by focusing on the mean and highlighting skewed results. This is how lottery tickets are sold. In our example more tickets will be sold for the next draw if a picture of player 10 appears in a newspaper advertisement with the proceeds check, smiling for the camera. The advertising campaigns are celebrations of non-probable random events. We don’t expect fairness in this type of game; we are satisfied with buying the excitement.

Unfortunately, we can draw many parallels to financial services from lottery marketing schemes. Instead of focusing on the plentiful returns available to market indexes, and building portfolios to capture those profits, financial service companies focus on the excitement of beating the averages. The incentives appear unbalanced. High fees paid to capture random large rewards don’t work in your investment accounts, though it may be more exciting.

Adult bargaining games designed to test understanding of fairness, reciprocity and altruism can be helpful to clarify our understandings of these concepts. Two of these games are the ultimatum game and the dictator game.

Ultimatum game: In this game there are two players, a proposer and a responder. The proposer offers any amount of a given total stake to the responder and the proposer keeps the remainder of the stake. If the amount is accepted, both receive the agreed upon amount. If rejected, neither player receives anything.

In this game participants have to consider the concepts of reciprocity and fairness.

Dictator Game: In the Dictator Game, the responder must accept any offer by the proposer. The proposer’s stake remains constant so they don’t have to give anything to the responder.

In this game altruism motivates the proposer to give.

Game results are consistent across western cultures. In the ultimatum game, proposers offer, on average, 40% of the stake. They usually keep 60%. Offers of less than 20% are rejected half the time.

In the dictator game, an average offer is 20% of the stake, though the proposer has nothing at risk and is offering more than is necessary.

These results support the idea that people are perhaps genetically wired to be co-operative. They will also exhibit altruistic tendencies when there is no cost to them. The results also show that children have an innate propensity for fairness, reciprocity and altruism. There is a tendency for these traits to moderate as we age, perhaps from learned behaviours. In general these studies paint a positive view of basic human wiring. We expect and tend to benefit from a fair game.

Several studies are available on these games, both for adults and children. For a good review see A fair Game: Intuitive economics of Resource Exchange in four-year olds, Lucas, Wagner, Chow. Journal of Social, Evolutionary, and Cultural Psychology www.jsec.com – 2(3):74-88.

Economists assume we all want more money. This makes analysis of their data easier. It seems to me this simplifying assumption creates misunderstanding. Money is important to the extent that it provides the things we want. While some may want the largest accumulation, most users of money don’t see simple accumulation as satisfying a higher order need. However they are concerned that they may run out. They want to ensure that their lifestyles are protected. They would like to have some financial flexibility if events don’t unfold as expected. Hording and having “the most” is usually not top of mind for consumers in general.

Users of money are concerned with purchasing power and therefore, perhaps indirectly, inflation – and rightly so. The rate of US inflation in the past 50 years has averaged about 3.3% per year. Today’s dollar has the same buying power as 8 cents in 1929 money. In the past 15 years, purchasing power of the dollar has dropped to 67 cents. By comparison, Canadian inflation has been higher in the seventies and eighties, somewhat lower since. But how have consumers generally faired in North America?

Behavioural finance is increasingly interested in relative personal consumption expenditures (PCE). The chart below suggests a strong relationship between real disposable personal income (DPI) and real consumption. This chart illustrates an inflation adjusted income of $5,000 in 1929 continues to be worth $5,000 today. Currency in this example is held constant at year 2000 levels so that the average gain in consumption to 2008 for an American is a real $22,000 (27,000-5,000). This equates to a 2% real gain in spending power each year. If you simply kept up with inflation, you would be able to consume only 20% of the amount of your neighbours and keeping up with the Joneses would become impossible.

Per Capita Real Disposable Personal Income (DPI) and Personal Consumption Expenditures (PCE) 1929-2008

North American consumers have done very well. But what has been the source of the excess buying power? Some of the gains are the result of increased wages. The attribution of wage increases can include such things as better labour participation rates and higher education levels leading to better paying jobs. Investment gains have also contributed to higher disposable incomes. Below is a review of excess returns to the public investment markets. These are positive returns after removing inflation and PCE changes of about 2% per year.

Improvements in living standards are a good thing. But people who don’t fully participate in the growth can quickly start to feel left behind. Fully diversified fixed income investments have generally reduced disposable income. An investment in a fully diversified stock portfolio has added to disposable income.  Taxes, fees and concentrated portfolios with higher volatility have probably reduced the benefits to consumers of this affect. Since diversification reduces volatility a sensible approach would include both stocks and bonds in the mix.

Patrick

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

Since April all major investment markets have rallied. This is true of both stock and bond markets. Much of the rally is due to the coordinated policies of central bankers, especially the US Federal Reserve. Toxic assets (TARP, TALF) were purchased from commercial banks and insurance companies dramatically reducing risks, visible and hidden, of commercial bank asset bases. The twin policies of de-risking and improving disclosure provided the needed incentive for those investors looking for a reason to buy.  A return to risks assumed has been re-established across the globe. Few would argue with the assessment that these efforts have resulted in the desired policy outcome of bringing order and stability to a global financial system that was unable to function in the last half of 2008.

The mandate of the Federal Reserve Bank is to use monetary policy to promote “maximum employment, stable prices and moderate long term interest rates.” Money supply is the major lever the Federal Reserve has to control the negative effects of inflation. This past year saw a unique policy response by the Fed. The unorthodox monetary policy that ensued presents many challenges today and especially in the future timing of unwinding the current position. The question remains: Will high levels of inflation result from the measures implemented by the Federal Reserve in 2008-09?

Money is created by the Fed in two ways: directly and indirectly. In the direct route, the government can print it or mint it. This is sometimes referred to as central bank money and includes net money assets of the government. This money is backed by market confidence in the ability of the issuer to meet its obligation through future tax revenues.

The indirect method is creating money through a fractional reserves system. The Federal Reserve controls the reserve of capital commercial banks are required to maintain in their operation. Today, Commercial Banks must deposit 10% of their assets in a reserve account with the Fed. From the perspective of the commercial lender, they can lend up to 10 times their asset base. This leverage creates money in the economy. This is commercial bank money also known as check book money.

Money supply has several definitions. For our purposes I will define Money supply as MB or monetary base which includes currency in circulation and demand deposits, minimum reserves and excess reserves held by the central bank.

The Fed enters into open market operations buying and selling t-bills, notes and bonds to principal dealers. The effect of a sale of bills or notes is to reduce the money supply by retiring money back to the fed. Alternatively, the when the Fed buys notes (or other assets) money supply increases. These operations also reduce or increase the leverage available further affecting the overall money supply.

Prior to October of 2008, increases in bank reserves ended up as currency in circulation. However in the fall of 2008 the fed began paying interest on excess reserves providing incentive for commercial banks to leave the money on deposit and out of circulation. This rate is equal to the upper limit of the fed funds rate of 25 basis points. The result is the increase in monetary base has had little impact on currency in circulation but has resulted in a dramatic increase in the Feds excess reserves account. This account increased from about 2 billion in mid 2008 to more than 750 billion in June of 2009.

University of Chicago economist Milton Friedman and others observed a long term relationship between money supply and inflation: (The quantity theory of money)

MV = PY

Where;

M= quantity of money

V = velocity of circulation

P = price level

Y = level of output of the economy

Friedman and other monetarists pointed out that change in money supply control the level of nominal output of the economy. Furthermore, in the long run, changes in money supply determine changes in prices or inflation. For Friedman “inflation is always and everywhere a monetary phenomenon, in that it can be produced only in a more rapid increase in the quantity of money than in output”.[1]

Inflation erodes purchasing power. This is how it affects the average family. For the US market, in the past 15 years the purchasing power of a US dollar has dropped to 67 cents. So a consumer needs fifty percent more dollars to buy the same basket of goods. Consumer Price Index (CPI) is the common measure of inflation along with the Core CPI which excludes the prices of food and energy. In the past 50 years the average annual change in CPI has been 4.2%, 4.1% for Core CPI. There has been a big range of values for CPI; greater than 14% in 1980 and -1.2% in June of 2009 (deflation). The Fed is believed to have a target for inflation of 2%. The Bank of Canada has an explicit target of 1-3% for Core CPI.

In July of 2008, prior to the default by Lehman Brothers in October of that year, US inflation levels were relatively high at 5.4%. US money supply was about 850 billion and had been stable at that level for several quarters. By June of 2009 CPI was -1.2% and money supply had doubled to more than 1.6 trillion dollars. In addition, through large scale purchases of agency debt and mortgage backed securities, the Federal Reserves assets base increased from about 900 billion to more than 2 trillion, though this was done in such a way as to avoid increasing money supply. The Federal Reserve funded the purchase of toxic assets through a special t-bill issued by the US Treasury. The deposit accounts of the Treasury are not part of the monetary base.

The challenge for the Federal Reserve is to shrink their balance sheet and reduce the money supply before inflationary expectations rise above their target. Moving too early will delay the economic recovery. Waiting too long will result in inflation. The incentives line up behind waiting too long.

Paying interest on reserves is a temporary solution. In the long run it adds to the monetary base. As well, commercial banks will find more profitable alternatives for the money. This is a big problem. 750 billion in the hands of commercial banks can result in as much as 7 trillion in additions to the money base.

Some options for the Fed to curb future inflation – exit strategy

1. The fed could use its powers to limit the leverage for commercial banks.

2. They can enter into reverse repurchase agreements (REPO) with commercial banks for the toxic assets on the feds balance sheet. If commercial banks enter into these agreements the monetary base will decrease through a reduction in the excess reserves account.

3. Treasury could issue debt and deposit the proceeds with the Fed.

4. Fed could issue its own debt directly reducing the monetary base, in competition with the Treasury.

5. Fed could let assets mature, or sell them into the markets.

Finally, the fed must be able to conduct monetary policy independent of political pressure. To avoid inflation there must be a shift from propping up credit institutions to one of price stability and oh yes they must get the timing very right.

We should probably get ready for inflation.

Milton Freidman, “The Counter—Revolution in Monetary theory,” Wincott Memorial Lecture, Institute for Economic Affairs, London, 1970.

While most of the worries and economic turmoil persists, there has been some measure of relief to the stock markets. We are at a point of growing divergence between wall street and main street. More evidence is expected of shrinking economies in North America and overseas yet these backward looking measures were not reflected in the recent buoyant return to stocks across the world.

The short term return to investment returns is random but momentum trends do make themselves known. For this positive return environment to continue investors will have to ignore the results from main street. They will have to ignore the fact that consumers are saving more and deferring large purchases. The market will have to rally in the face of lower earnings reports from companies and yes more bankruptcies and higher unemployment figures. There are no assurances, risk is pervasive even from these price levels. If this is the beginning of a turnaround in fortune for the stock markets then it would be consistent with the beginning of other bull markets, shrugging off the bad news and climbing higher in spite of the evidence.

The incentives have to be generous enough so as to attract private investors but not so generous that a risk free return is funded by tax dollars to the benefit of private interests. So what is a reasonable return for assuming this risk? How will these prices be established?  The public purse will be best served by a wide and broad market with many participants. Some will get better deals than others but on average many participants will serve to get the prices right and move the market to an equilibrium position, balancing risk assumed and return yielded. If we end up with a closed shop -where access is limited to a few players, then the likelihood of a subsidy from taxpayers to a small number of market dominant players is enhanced.  PIMCO spokesman Bill Gross has already voiced his firm’s intention to support the program.

Joint ventures between government and private investors are complex and rightly the subject of increased scrutiny by all interested parties. If you are a tax payer then you are a stakeholder. There is a big cost to focusing on limiting return through regulation.  There have been a series of announcements from AIG that executives will return some bonuses. These relatively small victories act as a dis-incentive to those that are considering participation. There is a view that so called excessive future gains may be clawed back by government after the fact. Increased perceived risk (regulation) will require an offsetting increased future return.

In my view, well executed programs will result from a large number of independent private interests bidding for these assets. More participants results in better asset pricing. Better asset pricing will reduce the likelihood of subsidies to private interests from taxpayers.  It is in all of our interest that the program become accessible to all parties willing and able to assume the risk. We need many participants and we should encourage bidders. We have had enough focus on punishing executives and managers of financial firms. It will not help to discourage their participation. We need to get past the need to find and punish the  parties responsible for this mess and instead focus on the task at hand. Increased effort to identify and pursue manager bonuses is an unnecessary additional cost to the bailout.