A Lap Of The Blogs

Posted by Preet on Aug 28, 2008 | 5 comments

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world.

There is a Lindt Chocolate Outlet store near my office so tomorrow I’m going with a friend to check it out. Apparently they have a lot of discounts and for a chocoholic this is music to my ears! I’ll write a bit about my experience next week… I remember I brought back over 20 different types of chocolates and chocolate bars on a trip to Switzerland a few years ago – ah, the memories! :)

From Around The Blogosphere

The Canadian Capitalist takes a look at a report on RESPs which highlights some interesting facts.

A lot of people talk about retiring early, but Canadian Dream: Free at 45 hosts an interview with someone who retired recently at the age of 44. Good read.

Michael James on Money isn’t a fan of pennies and normally refuses them when getting change for cash transactions. Personally I always toss them into the “take a penny, leave a penny” jar if there’s one around.

Canadian Financial DIY asserts that Pros will not automatically beat DIY investors.

Thicken My Wallet writes about the upcoming changes to income trust taxation and what it could mean for your distributions.

Million Dollar Journey has a list of celebrity chefs and how much they earn.

Four Pillars discusses that higher priced items can cost less over the long run than lower priced, and lower quality alternatives.

Ellen Roseman explains that many Canadians have walked out of a store due to lack of service. I fall into this camp as I regard customer service to be paramount if you want my money in most cases.

This Week’s Racing Video

If you ever watched Saturday morning cartoons, you know that the coyote can follow the road-runner off a cliff and just hang suspended until he reads a text book on gravity and then falls. I’ll just leave it at that and let you enjoy the video. :)

Dimensional Fund Advisors Part VIII

Posted by Preet on Aug 28, 2008 | 3 comments

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

The Problem With CAPM

A quote taken from a piece written by Eugene F. Fama, Jr (son of the researcher Dr. Eugene Fama, Sr):

“The single-factor model (CAPM) is grounded in an elegant theory. The rationale is sensible. It’s a great model in every respect except for the fact that it doesn’t work. It did a decent job when the world of investments was mostly managed versions of the market, but the further the portfolios got from the market, the less the model explained their returns.”

What is being said here is that CAPM does a poor job explaining the variability in returns when a portfolio is too different from the broad market. I think the best way to explain this is with hard data.

Dissecting The Market

First of all, we need to be clear that the data is regarding the US stock markets in US dollars. We’ll discuss other markets (i.e. Canada) in due course. Fama and French looked at many ways to dissect the market in order to find other factors that lead to higher returns – two factors they identified were Size and Value, but let’s see why they think these are additional factors over and above the market factor.

The Size Factor

The chart below is the US stock market which consists of all stocks in the NYSE, NASDAQ and AMEX except for ADRs, closed-end funds and tracking stocks from July 1926 to  December 2006. The ‘market’ portfolio is all stocks that fit this criteria. The ‘large’ portfolio is composed of stocks with market caps in the top 30% of NYSE market cap. The ‘small’ portfolio is composed of stocks with market caps in the bottom 30% of NYSE market cap. The performance shown is the annualized average of the monthly rates of return and is originally sourced from Fama & French’s research.

You’ll note that Small cap stocks outperformed Large cap stocks quite handily. The difference in this case is an annualized average of 4.69% and is a statistically significant result (i.e. not due to chance according to the data).

The Book-to-Market Factor (Value Factor)

I suppose I should avoid calling this the “value” factor where possible since calling it that is a bit of a misnomer. For the most part, investors today relate “value” as stocks that are temporarily mis-priced by the market and you’ll see that the data does not actually support such a notion. This is one of the areas which will seem to contradict conventional wisdom (i.e. that value stocks are less risky than growth stocks).

First we need to define Book-to-market. This is simply the Book Value of a stock versus the Market Value of a stock. Book value is like the accountant’s estimate of the value of a company based on assets minus liabilities and market value is just the overall market capitalization as determined by the stock price. So if a stock is trading at a low price, than the ratio of Book value to Market value is higher – and this indicates a “value” stock. If a stock is trading at a higher price, than the ratio of Book value to Market value is lower – this indicates more of a “growth” stock. For the purposes of explanation, I will use value and high book to market interchangeably, and growth and low book to market interchangeably.

The chart below shows the annualized average rates of return for the market versus ‘value’ (or ‘high book to market’) stocks and ‘growth’ (or ‘low book to market’) stocks, again based on monthly rates of return from July 1926 to December 2006. Value stocks are identified as stocks with positive BtM’s in the top 30% of NYSE BtM distributions and Growth stocks are identified as stocks with positive BtM’s in the bottom 30% of NYSE BtM distributions.

This time we see that Value stocks handily outperformed growth stocks by an annualized average of 4.79%, which is again reliably different from zero (i.e. not due to chance).

To Be Continued…

We’re not done yet. While we have looked at 80 years of data to see that small stocks outperform large stocks and value outperforms growth, there is more data to sift through before we look at the model that Fama and French proposed that is now known as the Fama-French Three Factor Model, which has significantly more explanatory power than CAPM. You’ll remember that CAPM was a one factor model (it looked at exposure to the market factor). The FFTFM (Fama French Three Factor Model) essentially looks at exposure to the market factor, exposure to the size factor and exposure to the value factor – hence the name.

CLICK HERE TO GO TO PART IX

Does Buy And Hold Work?

Posted by Preet on Aug 26, 2008 | 7 comments

Question From A Reader

A reader has asked me to comment specifically on an article that recently appeared in The Globe and Mail titled, ‘With funds, buy and hold doesn’t always pay off’ written by Mr. Rob Carrick. You’ll probably need to read the article to put my answers in context. (I don’t really have anything negative to say about it, but if you read through the comments at the bottom of the Globe article there are some readers of the Globe who took issue with it.) Specifically, the reader mentioned that her advisor always touts the buy and hold philosophy and she was beginning to question the blind practice of this strategy.

The Quick Answer

Long answer short: buy and hold is the way to go, so long as you are in the right investments and understand the ride you can and should expect when investing in equities. Trying to time the market, or constantly switching between strategies or investments more often than not produces sub-standard results.

Food For Thought

One of the questions posed by the author was to ask if readers thought 5 years or even 10 years was a good, long time to hold a fund (in order to reap the benefits of equity investing). He then goes on to show some funds that have had poor performance during this time. This is actually quite good from an educational perspective: consider a post that I wrote earlier which indicated that some academics indicate that you may need 30 years before you can say with statistical confidence that stocks will outperform T-bills. And in actual historic performance, T-bills outperformed US stocks for 17 years from 1964 to 1981. If you are going to invest in equities, you need to be prepared for years of negative performance (perhaps even decades although this would be extremely, extremely rare). Given that even the largest stock market in the world (the US) can have years of negative performance, it is worth looking into diversifying into other markets. Of course, staying the course is really a matter of easier said than done!

A Wrinkle…

Since this article is dealing with actively managed funds, then there is an extra variable to consider: relative performance of the manager versus the peer group and the index. In the context of the article, you certainly need to pay attention to the manager’s relative performance. It’s a given that equities can have long periods of negative performance, but periods of relative underperformance (even if the absolute performance is positive) is an investing sin – but can also occur over short periods of time. I’m not much of an ajudicator of active funds, I gave that up a while ago, but the logic that a longer leeway should be afforded to managers with longer track records seems prudent. Even Warren Buffett can underperform his benchmark during short timeframes.

Side Note

I suppose there is one minor point to which I might offer up an alternative approach. Mr. Carrick suggests that with newer managers, it would be best to let them demonstrate good performance for a while before investing your money with them (in the hopes of benefitting from their good performance after they have established themselves as being worthy). An alternative would be to just stay away from them altogether since research has shown that newer, unidentified managers who provide good performance will eventually lose this ability as more and more money is given to them. One way of thinking about this is that if a manager has $50 million dollars worth of good ideas per year then they look great when they are managing $50 million dollars. But as the fund grows organically and then from money invested by new investors, perhaps the fund is now worth $500 million. $50 million of good ideas and $450 million worth of less than good ideas doesn’t seem so attractive.

Conclusion

In the end, if you are investing in actively managed funds I think the article raises good points. If you are still unsure about your advisor’s recommendations, it never hurts to get a second opinion (or a third). If you would like to subscribe to Rob Carrick’s RSS feed you can click here for the feed details.

Dimensional Fund Advisors Part VII

Posted by Preet on Aug 25, 2008 | 3 comments

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

Continuing from Part VI, where we saw the formula for CAPM (the Capital Asset Pricing Model), we found that the model suggests that, given a diversified portfolio, your sensitivity (β, or “beta”) to the market factor (also known as the “equity factor”) should explain your expected return.

As a refresher, here is the formula:

E(Rp) = Rf + β(Rm – Rf)

Let’s look at a hypothetical 10 year period where the risk free rate was 3%, the market returned 10% and a mutual fund manager we selected to run our portfolio earned 15% on our portfolio. The portfolio was 1.5 times as volatile as the market. According to CAPM, we can calculate what performance we should have expected, given the level of sensitivity to the market:

E(Rp) = 3% + 1.5(10% – 3%)

E(Rp) = 3% + 1.5(7%)

E(Rp) = 3% + 10.5%

E(Rp) = 13.5%

So we see that CAPM says that we should have expected an annualized return of 13.5%. BUT – you’ll note that I indicated that the manager returned 15%. (N.B.: returns are assumed to be after fees.) So in other words, the expected return (Rp) was less than the actual return. This is where Alpha comes in….

Alpha

Alpha is represented by the symbol “α”. If you go by some standard definitions, α represents the excess return of a manager over and above that which is expected by a benchmark or predicted return of a model. Calculating α is very simple. In the example above it’s 1.5%, which is calculated by taking the actual return (15%) and subtracting the return of the benchmark (which in our case is the return predicted by the model to account for the fact that the portfolio is 1.5 times as volatile as the market) which is 13.5%. This is where we get 1.5%. Note that it is possible to have negative alpha (in fact that seems to be the norm) – this indicates that the manager is underperforming what is expected, after having taking into account the risk adjusted return of the portfolio. To put it into a formula, the actual return of the portfolio (Rp) (and not E(Rp) which is the expected return) is as follows:

Rp = Rf + β(Rm – Rf) + α

I’m going to write it again and highlight a few terms:

Rp = Rf + β(Rm – Rf) + α

What I’ve highlighted is E(Rp), the expected return and is simply the CAPM formula from the top of this post. If we simply substitute E(Rp) into the above formula we get:

Rp = E(Rp) + α

Which is basically saying that the return on the portfolio equals the expected return plus alpha. If we re-arrange the terms to bring E(Rp) to the left hand side we get:

Rp – E(Rp) = α

Which is exactly what we defined alpha above when we said alpha “is calculated by taking the actual return and subtracting the return of the benchmark or expected return predicted by the model”.

Prevalence of CAPM

CAPM is very prevalent. If you go to morningstar, globefund, etc. you will see Beta numbers (usually 3 year Beta numbers) for every fund. Alpha is harder to find (my guess is because it’s usually negative). And when you do see a fund with positive alpha, it gets trumpeted by advisors (or by wholesalers to advisors) endlessly. Positive alpha is a good thing and is supposed to measure the excess return earned on a portfolio over and above what is predicted by CAPM.

Now that you are up to speed on CAPM, I regret to inform you that it has been all but invalidated. However, it is still used extensively in the retail financial services (and even institutionally) and is still taught in MBA schools.

Part VIII will begin to look at some data that is behind part of the research and theories behind DFA (Dimensional Fund Advisors).

CLICK HERE TO GO TO PART VIII

Visualizing Walmart's Growth Over Five Decades

Posted by Preet on Aug 24, 2008 | 2 comments

My brother sent me this link a few weeks ago and I’ve watched it about 10 times since because I’m just in awe of it. Someone took the time to graphically plot the growth of Walmart in the United States from 1965 to 2007. It takes about 5 seconds to load up once you see the map, but once it starts going – hold on to your hats. A few stores pop up per year in the 60′s, but by the time you get to the 80′s there are hundreds of stores popping up per year and by 2007 you have over 3,000 points showing up on the map. You don’t have to do anything other than click this link and sit back and watch. The whole thing takes about one minute.

A Lap Of The Blogs

Posted by Preet on Aug 21, 2008 | 4 comments

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world.

I had the pleasure of having dinner with John Chow tonight who is in town for a wedding this weekend. For those of you who don’t know, John Chow earns over $30,000 per MONTH on his blog about blogging. In fact, if you go to his site, JohnChow.com, you will see that he “makes money online by telling people how much money he makes online”.

From Around The Blogosphere

Larry MacDonald hypothesizes about the effect of differing restrictions on day traders in Canada versus the US. Could relaxed rules increase volatility?

Ellen Roseman is frustrated with the problems consumers face and creates a short list of things she would like to change first.

Canadian Capitalist reveals that there is a new option for those looking to save money on their chequing accounts (a no fee option).

Michael James on Money explains a different way of looking at risk versus return that might be more intuitive than standard deviation numbers.

The Million Dollar Journey hosts a guest post about The Psychology of Money.

Canadian Financial DIY surveys some information on executor and trustee fees.

Four Pillars writes about how some grants are handed out to everyone who applies because fewer people apply than might be expected.

Last but not least, Canadian Dream: Free at 45 explains how you can cut your energy bill and keep your home cool in the summer with a great list of tips and tricks.

This Week’s Racing Video

This is actually a commercial for Shell, but it’s nothing short of beautiful. Shell is the fuel partner for the Ferrari Formula 1 team and this commercial (presented in it’s full length form which runs two minutes) chronicles the evolution of the Ferrari F1 cars over decades. Check it out:

Dimensional Fund Advisors Part VI

Posted by Preet on Aug 20, 2008 | 4 comments

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

The Capital Asset Pricing Model (CAPM)

As I mentioned before, this series on DFA is going to be long if you really want to understand what they are about. Further, there is some background knowledge that is required before we can truly make sense of what is going on. At the same time, I don’t want to go too far down some tangents so I am going to provide the coles notes on many topics.

To that end I thought it would be best to have a refresher on CAPM. CAPM stands for Capital Asset Pricing Model and the acronym is pronounced “Cap-ehm”. Basically CAPM is model that predicts what your expected return should be in your portfolio based on a few factors (actually just one factor). First let’s begin with some logic…

The “risk free” rate is equivalent to the T-bill rate (or the high interest savings account rate, if you prefer). This is basically the rate of return you can get on a portfolio without taking any risk. If you were to subject your portfolio to any risk, then you would expect to be compensated in the form of extra return, over and above the risk free rate. But the question then arises: how much extra return should you expect for each unit of risk? CAPM basically says that the expected return you get should be based on how much exposure you have to the market factor plus the risk free rate.

The “market factor” is also known as “the equity premium” or the extra return of stocks over the risk-free rate. So, to re-iterate, CAPM is saying that your exposure to the market factor explains your expected return on your portfolio.

The Formula

Here is the CAPM formula:

E(Rp) = Rf + β(Rm – Rf)

Where:

E(Rp) = Expected return on the portfolio
Rf = The Risk Free Rate
β = Beta (Which is the measure of exposure to the market factor)
Rm = Return of the Market

Note: the term in brackets, (Rm – Rf), is “the market factor” (or “equity premium”)

Before we use some test numbers to see how this works, lets first put on our thinking hats. Let’s assume we are investing using an index tracking fund (like an ETF). Since our portfolio will move in tandem with the market, we have a β of 1. Let’s put this in the formula (and nothing else).

E(Rp) = Rf + 1(Rm – Rf)

So if we multiply (Rm – Rf) by 1 we will have (drum roll please)… (Rm – Rf). So this makes the equation as follows:

E(Rp) = Rf + Rm – Rf

You can see that the Rf terms cancel each other out, leaving:

E(Rp) = Rm

Which is what we want with an index fund. We want the return to equal the market return. But now let’s plug in some numbers for a non-index portfolio and see what happens. We’ll assume that the “risk free rate” is 3% since that is what a high interest rate savings account might yield. We’ll assume our portfolio tends to move up and down one and a half times as much as the market, therefore β is equal to 1.5. The return on the market is 10%. Now we can solve to see what CAPM says our expected return should be.

E(Rp) = 3% + 1.5(10% – 3%)

E(Rp) = 3% + 1.5(7%)

E(Rp) = 3% + 10.5%

E(Rp) = 13.5%

So in this case, CAPM says that if our portfolio is 1.5 times as volatile as the market, then for it to be a worthwhile investment, our portfolio needs to earn 13.5% versus the market’s 10% in order to be fairly compensated for taking on the extra risk over the risk free rate.

I’ll stop there for today, but will continue in the next post in the series to discuss what happens when the ACTUAL return of the portfolio does not match the Expected Return.

CLICK HERE TO GO TO PART VII