Managed Money Reporter Newsletter — Issue 266, November/December 2011


Editors: Carl Spiess & Allan McGlade


Featured Articles



Fundamental Indexing: A sensible approach to passive investing?

By Carl Spiess, CFP, CIM, FMA, FCSI, MBA

It's tough out there for investors right now. At the Spiess McGlade Team, we are constantly reviewing new investment approaches and products to see if there are better ways to help our clients. 5 years ago, fundamental indexing was introduced in Canada, and we decided it was worth keeping an eye on it. After an initial period of underperformance, fundamental indexing fell onto the back burner for us.

FTSE RAFI Canada Index 5-year performance

A few weeks back though, something interesting came walking into our boardroom, literally. It came in the form of a personal visit from Rob Arnott, who developed the concept called Fundamental Indexing. Fundamental Indexing is a variation on the structure used to create the index funds and ETFs we are most familiar with.

Arnott gave a special presentation to me, Allan, Andrew and 4 other advisors. He is Chairman and CEO of Research Affiliates, and their brand of fundamental indexing is called RAFI (Research Affiliates Fundamental Indexing). Arnott's RAFI strategy now manages over $78 billion in assets – huge growth for an organization under 10 years old.

To explain RAFI properly, we need to compare it to the original index structure.

Traditional indexes are "cap-weighted"
Most index investment products, like the traditional stock market indexes they track, include companies on the basis of their market capitalization—a dollar amount calculated by multiplying the number of outstanding shares by the current share price. The higher this amount is, the greater the representation or "weighting" of that company in the index.

What's the problem with that? This approach creates a natural drag on performance by systematically overweighting overvalued stocks (like Nortel) with less room to grow and systematically underweighting undervalued securities with more room to grow. And when markets turn down, those overweighted overvalued securities are also ripe for a bigger drop creating volatility for investors. This is part of the reason we don't automatically believe that indexing is the best or only strategy for investors.

This is what Arnott discovered. His remedy, the "fundamental index," gives companies representation and weighting on the basis of four easily obtained financial measures of a company's size:

  1. Total sales
  2. Book equity value
  3. Cash flow
  4. Gross dividends

In other words, Arnott's formula weights companies by some of their financial fundamentals, which is more meaningful than simply weighting by stock price. This is similar to how value oriented investment managers construct their portfolios.

Incremental advantage
Fundamental indexing appears to work- the back tested models from 5 years ago certainly did. Long-term modeling with historical market data and now real market experience over the past several years have shown an incremental advantage of a few percent over "cap-weighted" index products—even through volatile markets.

Why did traditional index funds structure their products with this cap-weighted flaw? Because passive, index investing was originally all about replicating existing indexes as investment products so they would represent the market, be inexpensive to track, and be easily understood by investors. So, is RAFI the dawn of actively managed index funds with higher fees? Yes, and no. No, because fundamental indexing is still just an arbitrary formula and does not involve the same personal judgment as active management. But yes, because many index funds are becoming more sophisticated in their approaches, so some of these RAFI index funds are more expensive than the original ones.

The concept of Fundamental investing has begun creating converts from some previously die hard index investors. Jeremy Siegel, who wrote the book "Stocks for the long run", generally promoted the idea of simply buying the index. His new book "The Future for Investors" has the added information on how he now likes fundamental indexing. His reasoning is the same as the RAFI research, namely simply buying the most expensive names in an index must certainly mean you are overpaying. Focusing on the investment fundamentals of a company may well reveal bargains.

How to get and pay for Fundamental Indexing
Claymore Investments has a family of 10 solid performing and well regarded fundamental indexing exchange traded funds (ETFs). They have MERs ranging from 0.71% on the low end to 1.56% on the high end. That's lower than the average actively managed investment fund, but higher than many traditional index funds or ETFs.

Investco has also introduced RAFI indexing through their Powershares investment funds and ETFs. This will help increase investor choice and access to RAFI indexing, no matter whether the preference is for a fund or ETF.

Despite the higher cost compared to the largest cap weighted index ETF in Canada (XIU), we think that fundamental indexing is an approach with significant merit. If you are wondering about the pros and cons of index investing, please contact us to review the many different options now available.

More on fundamental indexing

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Scotiabank launches a new daily interest investment savings account

Every investment vehicle has its purpose. If you need to park some of your investment assets in a safe spot for a shorter period of time, these new investment savings accounts offer competitive rates on short-term deposits. They were created in collaboration with Dynamic Funds – a benefit of the recent Scotiabank acquisition of Dundee Wealth.

  Dundee Bank of Canada
Investment Savings Account
Bank of Nova Scotia Investment Savings Account
Product Existing New
Issuer Dundee Bank of Canada Bank of Nova Scotia
Minimum and maximum No personal limit
Corporate cap of $7.5mm
No personal limit
Corporate cap of $7.5mm
Redemption type Redeemable on demand Redeemable on demand
Deposit insurance CAD ISA is CDIC eligible
within CDIC guidelines
CAD ISA is CDIC eligible
within CDIC guidelines
Currencies CAD and USD CAD and USD
CAD Rate 1.20% 1.20%
USD Rate 0.20% 0.20%

Along with Cashable GICs (current best rate 1.4%), we are pleased to offer a variety of high interest savings vehicles for you. So the new high interest fund would be a good option if you believe interest rates will be going up in the coming months, the cashable GIC is the better option if you worry that rates will just continue to decline.  Either option is better than being in a money market fund. Please call us for recommendations based on your personal situation.

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Investment funds top Canadian investor confidence list

When markets are plagued by uncertainty, as they have been for several years now, do Canadians maintain confidence in their investment funds and the financial advice that helped select them? Spiess McGlade clients regularly tell us that you do, but are you the same as most Canadians in that respect?

A new survey conducted by Pollara for the Investment Funds Institute of Canada (IFIC) answers some of those questions. For the first time since the financial crisis of 2008, Canadians with investment funds are more confident about their funds than any other type of investment—including their principal residence! Both investment funds (84%) and the principal residence (81%) enjoy similar high levels of confidence among Canadians.

Advisors and clients work as partners
According to the survey results, the main purpose of investing continues to be growing retirement savings. Fund investors tend to work with their advisors to choose the right investments—they are much less likely to be self-directed investors or to simply do what their advisor recommends without question. Four out of five fund investors purchased their investments through an advisor, and about two thirds of investors receive other services from their advisors, such as budgeting or planning for future expenses.

The survey also addressed one issue that causes many people to wonder: Do advisors make people wealthy, or do people seek out advisors after they become wealthy? Half of investors who now have significant savings started with less than $25,000 when they began using an advisor. Three quarters had less than $50,000. Clearly, financial advisors do help their clients build wealth.

See the survey results:

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Employees choose Scotiabank as one of Canada's 50 Best Employers, again!

50 Best Employers in CanadaScotiabank is among the 50 Best Employers in Canada for the eighth consecutive year. Scotiabank ranked 23rd within the top 50. The result is based on a national employee survey that is published in Maclean's magazine. It is the only employer award determined primarily by employees. Each year, an independent HR consulting firm surveys employees, executives and HR professionals to arrive at the short list:

We are pleased to be a long standing professional team that are happy to be helping you with your investments.

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Two tips for year-end investment planning

Seasonal revelry will soon be in full swing, but the end of the year has a practical meaning as well in our personal tax system. By paying attention to a few small details in December, you might be a happier person in April when you file your T1!

Tip no. 1 — Tax-plan your charitable donations
You're probably accustomed to making donations in cash. But if you invest some of your money in a non-registered account, you can donate securities that have increased in value and essentially "give away" your capital gains tax liability at the same time. The recipient—a tax-exempt registered charity—won't have to pay it either.

Then take an equivalent amount of cash you would otherwise have donated, and reinvest it in the non-registered account—even buy back the same securities you donated. If you do that, you'll start fresh again with no capital gain and zero tax liability.

Mackenzie, Dynamic and Scotia have developed programs around this concept. Check them out at the links below.

Tip no. 2 — Think about tax loss selling No one enjoyed the market correction in August and September, but if there is a silver lining it might be tax loss selling. Any investments you hold in a non-registered account that have a current market value lower than your purchase price can be sold before year-end to create a capital loss.

Capital losses cannot be deducted from income for tax purposes, so don't get too excited. They can, however, be used to reduce taxable capital gains in the current year or be carried forward to reduce taxable capital gains in a future year.

This may not have a lot of impact for investors in their asset accumulation years, especially if they are buy-and-hold investors who don't generate capital gains very often. However, tax loss selling can be extremely useful for retirees who are receiving income in the form of capital gain. Not only is that income tax-advantaged to begin with, but any offsetting capital losses also reduce the amount of that income for tax purposes. Losses can also be carried back to recover taxes paid on taxable capital gains in any of the previous three years.

The Canada Revenue Agency has rules for buying back the same investments you sold for tax loss selling. Please contact our office and we will be happy to advise you.

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Recommended Link of the Month

We thought long and hard about recommending this site. The concepts that are presented at behaviorgap.com are good. But the financial advisor who created it is in the news since he didn't take his own advice.

But if he can put his credibility on the line as an advisor (and a financial self-help author) to educate people on the perils of living beyond your means, then maybe we should help to spread his message. This kind of story is much more common in the U.S. than in Canada… and we can be thankful for that. The story behind the advisor is at: http://www.nytimes.com/2011/11/09/business/how-a-financial-pro-lost-his-house.html.

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     1.800.387.9273
F.  416.863.7479
E. carl.spiess@scotiawealth.com
    allan.mcglade@scotiawealth.com

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