Inside the Permanent Portfolio - Why it succeeded and the chances it will continue

Last week's post showed the past success of the Permanent Portfolio (PP), in which only four holdings - a domestic broad stock index fund, long term government bonds, cash or a money market fund and gold bullion - are combined in equal 25% amounts that are annually rebalanced. This week we look inside the workings of the PP to see what has driven that success and why that may well continue.

Consistent low correlation of returns
The single most influential and persistent quality of the PP's construction is that it holds four assets that have consistently worked out of sync with each other. In technical jargon they have had consistently low and sometimes even negative correlation of their returns. A visual impression of this is in the Stingy Investor Periodic Table of Annual Returns for the four holdings. Below are screenshots for annual real returns, which includes a reduction for the year's inflation and another to estimate ETF-level fees, in successive periods starting 1970, 1981, 1992 and 2003. The best performing holding changes frequently, and often dramatically from worst to best or vice versa. Even steady plodding T-Bills sometimes offered the highest return in a year. Not once in all 44 years does every holding lose money - at least one is up though the others are down, such as in 2013, where the positive TSX Composite return was not enough to offset losses amongst the three other holdings.

(click image to enlarge)

1970 - 1980

1981 - 1991

1992 - 2002

2003 - 2013

Putting the same data along with the overall portfolio return onto one graph below shows the often wild swings of the individual holdings result in a much more stable net portfolio result (the red line) year by year.

The way to measure the zigging vs zagging behaviour of the holdings against each other is a statistic called correlation. A correlation of +1.0 between any two assets means they always move in perfect lockstep i.e. in the same direction (though not necessarily by the same amount) while a correlation of -1.0 would mean they always move in opposite directions. The lower the number towards -1.0 the better and the higher the number towards +1.0 the less of the so-called diversification benefit there is. In practice, any correlation amongst available investment asset classes that ranges from slightly negative to around +0.2 is considered excellent. (See our previous post on how different correlation numbers can dramatically change the volatility of a portfolio)

The problem with many historical correlation numbers is that long term averages mask what is often considerable variation of correlation in different time periods. Periods of attractive low correlation may be followed with years of much higher correlations, and this may happen at the worst time such as during a crisis, or there has been a permanent shift from low to much higher correlation. Such instability of correlation explains why many people pooh pooh using correlation numbers to build portfolios, including notably a modern proponent of the PP, Craig Rowland, in this post.

Here's the good news about the PP. William Coaker, senior managing director of equity investments at the University of California, studied the variability of correlations of many asset classes in different time periods in this paper and then in this paper. He did indeed find lots of undesirable changes and instability in correlations. But he also found - see his table Correlation Matrix for 20 Asset Classes during Five Time Periods - that some asset classes exhibited consistent low correlations through thick and thin. Especially good together were the four of the PP - US Treasuries (aka cash), US bonds (as close as we could match to long term US government bonds), gold and S&P 500 (aka US equity). The highest average correlation of any holding with any other of the four over the whole time period 1970 to 2009 was only 0.37 (Treasuries with Bonds). More importantly, through several sub-periods of the 2000s, the highest correlation of all was 0.49 between Gold and Bonds during the 2007-2009 financial crisis (when both provided positive returns offsetting hugely negative equity returns as we can see in the above tables). Every other sub-period for all other correlation combinations, the correlations remained solidly in the best / lowest category of below 0.4. That's what has made the PP so good. The logic of the PP and its strategy to own assets that correspond  and respond to the different economic environments of prosperity, recession, inflation and deflation is supported by the consistently low correlations.

Will low correlations continue?
As long as the PP's four holdings maintain their low correlation, it will be a very effective portfolio. Will they? Of course, it's impossible to tell with certainty but the 44 year history above gives a fair dollop of support to answering yes they will.

The other question many investors would have is about the possibility of continuing the experience of 2013's negative returns, where a small rise in interest rates in mid-year hurt bond returns while remaining so low that T-Bills / cash yielded less than inflation. Most would have confidence in equities when economic growth has renewed. The big question is around gold, which few model mainstream portfolios hold in such large amounts. It's not an income-producing asset but rather a commodity whose long term returns only match inflation. It's principal portfolio role as an insurance policy against very high-inflation and extreme crises means that at other times its price behaviour might be in sync with the other holdings and not provide diversification. In the past that behaviour of being in sync on the downside seems not to have lasted very long. As it happens, gold seems to be recovering in 2014 after a big dip in 2013 as this chart from the World Gold Council shows.

Bottom line: As we delve into it the PP looks more credible and solid. It's still a big departure from the mainstream.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

The Permanent Portfolio: Pros and Cons for Canadian Savers and Retirees

Harry Browne's Permanent Portfolio (PP) idea, as explained in his book Fail-Safe Investing: Lifelong Financial Security in 30 Minutes, has been around for over three decades. Though he passed away in 2006 his ideas still influence many investors. It is a portfolio strategy with much appeal.

First, it has achieved excellent returns, a 9.6% annual before-inflation compound growth rate with very few years of losses, and fairly small losses at that, according to stats on present-day acolyte Craig Rowlands' Crawling Road blog.

Second, PP is dead simple to implement and maintain quite cheaply with ETFs - only four holdings - cash (government T-Bills or money market funds), long term federal government bonds, domestic equities and physical gold - that need rebalancing trades once a year back to an equal 25% allocation.

Third, it is based on an intuitive logic, that it's goal is to withstand the four major economic conditions - prosperity, recession, inflation and deflation by the choice of the four asset types which counterbalance and complement each other by having at least one do well while other(s) do poorly. It's a similar idea to the possible range of economic conditions driving the portfolio structure we described last year in New Improved Model Portfolio: the Smart Beta. Though growth of the portfolio is an objective, even more important is the goal to preserve wealth.

This latter idea of protecting against the downside makes the strategy, if it works, especially appealing to retirees who do not want their withdrawals during negative market events or economic phases to irreversibly wipe out capital. We'll examine the PP both for a retiree withdrawing some money every year and for a person in the savings accumulation phase of life, i.e. not withdrawing any money.

Testing required - Is Canada the same?
But the USA is not Canada, things might not work the same, especially since the US dollar is a safe haven currency. When the the 2008 crisis hit, the Canadian dollar got hammered. Did that matter? Would a Canadian have achieved lower volatility and a minimum of mild down years?

For an approximate answer, we turned to a favorite free tool, Stingy Investor's Asset Mixer. We can get roughly the asset classes for a Canadian version, i.e. using Canadian investments, of the Permanent Portfolio. We can even apply MER-like fees, in the form of negative "alpha" in the tool, at ETF levels in this test, to make results more realistic. The data goes back 44 years to 1970 and forward to 2013, so we get coverage through the nastiness of the high inflation 1970s, many recessions and growth periods, and various market crises, including the latest one, the 2008 financial crisis. The main misalignment is that the Asset Mixer uses an index of corporate plus government bonds, whereas the PP includes only government bonds. This matters when, for instance, the financial crisis hit in 2008 and government bonds held up while corporate bonds plunged. We compared results to an ultra-simple conservative Benchmark portfolio - 60% Long Canadian bonds and 40% TSX Composite Index Canadian equity.

Results
Scenario: Retired investor withdrawing 4.5% per year on a $100,000 starting value in 1970 (screenshots of Asset Mixer output below)

• PP ends up after 44 years of retirement with exactly the same amount in real after-inflation pre-tax terms as it started out with (we cheated a bit, just plugging in different withdrawal percentages till we came up with 4.5% as the figure that would leave us even). Pretty darn good, since most of us won't be lucky enough to live 44 years of retirement!
• Benchmark portfolio survives just as well, in fact ending with a bit more than the starting value - almost $114,000.
• PP is a lot less scary along the way. It's on-going year-by-year portfolio value always hovered around the $100k mark, its lowest balance being about $94,000 in 1976 and 1992. The worst single year drop was 21% in 1981. Compare that to Benchmark. It's worst single year was 1974's 27% drop. But Benchmark kept falling, unlike PP, and declined to $53,000 by 1981! Imagine the panic and worry sitting there in early/mid retirement looking at that kind of red ink on your account statement, not able to know that things would bounce back. PP had more down years than Benchmark, 24 vs 18 (more than half of total years too!), yet surely they would not have hurt as much as the sustained losing skid of Benchmark during the 1970s.

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Permanent Portfolio Year-by Year

PP Stats

Benchmark Year-by-Year

Benchmark Stats

Scenario: Younger investor in savings mode - no withdrawals on initial $100k investment

• PP ends up with considerably less end value than Benchmark - only $766,000 vs $991,000, a 23% difference. The avoidance of withdrawing money early on allows Benchmark to power ahead later on. The big question for the investor is thus whether it is worth enduring the greater volatility and the longer lagging periods for the much better long run result. The bad period of the 1970s isn't nearly so bad as for the retiree. The most extreme dip is down to $89,000 in 1974 and 1981 is the last year the portfolio fell below starting value. The PP on the other hand never falls below starting value and experiences fewer (9 vs 11), less severe (-17% vs -23%)  down years.
• Results quite similar to the USA - In nominal pre-inflation terms, which seems to be what the Craig Rowland link above shows, the Canadian PP had only three down years (same as US PP and two of them the same years, 1981 and 2008), a very mild worst drop year in the same year (1981) of 7% (vs 4%) and a compound growth rate of 9.1% (vs 9.6%). It is also interesting that PP in other countries seems to have worked to, as this post shows for the UK, Japan, the Eurozone and even Iceland for different time periods. 

PP Nominal Stats

ETFs to implement a Canadian Permanent Portfolio

Here is the lowest MER cost way to implement a PP in Canada:

• Cash / T-Bills (25% allocation) - High-Interest Savings Account (blog post here)
• Long term government bonds (25% allocation) - BMO Long Federal Bond Index ETF (TSX symbol: ZFL) MER 0.2%
• Domestic Equity (25% allocation) - iShares S&P/TSX Capped Composite Index (XIC) recently lowered management fee to 0.05% and a probable MER (with taxes and other costs) of about 0.06%
• Gold (25% allocation) - iShares Gold Trust, US-based ETF trading under NYSE symbol IAU. MER 0.25%

Bottom Line: Almost surely, the PP will make investors, including this blogger, uncomfortable since it is a marked departure, especially with the high weighting to volatile gold, from mainstream finance and most standard portfolio allocations to the various asset classes. It seems to have worked and its logic in holding assets that respond to different economic environments, makes intuitive sense. There is still the question as to whether it will continue to work in future - is the limited number of assets sufficient to deal with all potential future circumstances, particularly new types of crises? It's hard to say yes, and switch wholesale to such a portfolio model. Yet it's hard to say no too, given the results, especially for a retired investor. We're intrigued but sitting on the fence on PP.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Light at the end of the ACB Tracking Tunnel for ETFs?

One of the few thorns in the side of investors holding ETFs in taxable accounts has been the necessity to track their Adjusted Cost Base (ACB) in order to correctly calculate capital gains for income tax reporting. The T3 and T5 slips received from brokers enable the reporting of yearly income without any problem but figuring out capital gains after a sale of ETF units can be a complicated headache, as our posts explaining how to do it here and here would suggest.

Note that such issues do not arise at all in any kind of registered account so anyone with ETFs only in such accounts can relax. There's no tax reporting or ACB tracking to do.

Return of Capital (ROC) and Re-Invested (Non-cash) Distributions (RID)  - Complexity that matters
The challenge of figuring out the correct ACB in a taxable account arises from the requirement to subtract the amount of any ROC and to add any RID from the starting ACB.

ROC - The ROC has always been fairly easy to find as it shows up on T3 slips in box 42 for Canadian-listed ETFs. (US-listed ETFs don't have the problem of ROC and RID as Canadian Couch Potato explains in Adjusted Cost Base with US-Listed ETFs). Box 42 shows the actual dollar amount to subtract from ACB. Fairly simple.

RID on the other hand has required several extra steps. First was finding a source for data. The various ETF providers such as iShares, BMO, Powershares, RBC etc almost all do so in one manner or another somewhere on their website (usually the Distributions tab on an individual ETF's profile page).

The better comprehensive source is CDS Innovations (kudos to Canadian Couch Potato for noting this site, which is not well enough publicized) where the ETF providers are legally required to upload the data for all their ETFs within 60 days of year end. You need to have Excel to open the files (free software such as OpenOffice unfortunately does not work). Each ETF has a file for each year. A screenshot of part of the 2013 list with some BMO ETFs is below.

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The second step is to actually do the calculations. That involves taking the per unit/share amount and multiplying by the number of ETF units/shares held at the RID distribution date, which is usually, but not always, bundled with the regular cash distribution in the last distribution of the year in late December. If you do not sell the units before the indicated Ex-dividend date (see explanation in the Globe and Mail of the various types of dates relating to dividends) then you can add the RID amount to your ACB. That's important for the investor since a higher ACB means less of a capital gain (Sale price minus ACB = Capital Gain) to report upon sale of the units. As we noted in our previous posts on ACB, the RID amount is taxed in the year that it is allocated, so to avoid double taxation when the units are sold, it is necessary to add the RID to ACB.

Example: How important RID is can be seen in an example. Take a popular ETF, the iShares S&P/TSX Capped Composite ETF (TSX symbol XIC) which conveniently does show a complete distributions history on one page. Suppose an investor had bought 1000 units on March 1, 2001 at the closing price that day of  $9.84 and sold on December 30th, 2013 at the closing price of $21.33 (historical prices here on Yahoo Finance). The sum of Re-invested distributions in that period is $1.96422 and represents 17.1% of that gain. At a 40% marginal tax rate, forgetting to add in the RID would mean paying an extra $393 in income tax (1000 units x $1.96422 x 50% capital gains inclusion x 40% marginal tax rate = $393). Of course, the summed ROC of $0.31571 would need to be subtracted to properly peg the ACB. But the net of RID and ROC would still mean a saving of about $330 on a capital gain tax bill of $2300 had no adjustment for RID and ROC been done.

This example illustrates another reality. Over time the amount of Re-Invested Dividends given off by ETFs vastly outweighs ROC, so it is even more important not to forget it. The government certainly doesn't want you to forget subtracting ROC from the ACB, since that increases the capital gain and therefore tax, but it certainly won't mind or care if you forget adding the double-tax eliminating RID!

Online brokers to the rescue with automatic ACB updating
A solution that seems to work in most circumstances at most brokers is simply to use the Book Value tracked and updated automatically by the online broker. Brokers update the ETF Book Values for both ROC and RID data. Below is a sample entry in a broker account for RID distributed to a shareholding of 2200 shares of the BMO Low Volatility Canadian Equity ETF (ZLB) owned at the end of December 2013.

(click to enlarge)

The offsetting positive and negative dividend transactions of $692.96 serve to increase the Book Value but leave no extra cash in the account, since RID is a non-cash item. This type of book-keeping helps explain why RID is sometimes called a phantom or special distribution. We can check that the amount is correct by going to BMO's webpage for the ETF where the Distributions tab shows a RID amount of $0.312144, which when multiplied by 2220 shares equals $692.96.

A similar annual entry would update Book Value with the same amount that appears in the T3 box 42 total year ROC and would reduce Book Value.

That's the good news, now the caveats. The accuracy of automatically updated Book Value aka ACB will not be reliable in certain circumstances:

• Distributions made in years before the date such automatic updating started; at one broker it was 2005, but check with your own.
• ETFs transferred, especially partial transfers, between online brokers - the Book Value may not follow; it is possible at some brokers to manually adjust the Book Value yourself online or phone the broker to request it be done to the correct figure you have calculated. After that, it should update correctly.
• The same ETF held in multiple brokerages - each broker keeps its own Book Value correctly but you must, according to the Canada Revenue Agency, sum and average all your shares for ACB. If you sell from one of the accounts, the proper ACB per unit is the average of all units, not the Book Value per unit of the units in that particular account.
• Delay between the time the RID or ROC was distributed and when the adjusting transaction shows up in the account - as we see with the ZLB example above, it took two months from January to March for the RID to show up and the ROC has still not done so; yet this is not a big impediment since any sale in January this year would not need to be reported for income tax until next year's return.
• Mistakes can happen and some brokers may be more diligent or careful than others updating RID and ROC, as some comments in this Couch Potato post suggest. Spot checking transactions for ETF on statements for March and April when RID and ROC adjustments should show up is a good idea. The brokers disclaim any legal responsibility for the accuracy of Book Value, so the onus is always on us the investors to verify what happens in our accounts. 

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Canadian Aerospace, Waste Management and Engineering Companies - Sustainability, Social, Environmental and Governance Ratings

Today we continue the series of posts examining corporate sustainability, often called environmental, social and governance factors, of Canadian companies. In the past, we have looked at Consumer companies, Mining, and Oil and Gas stocks, and just last week, Transportation companies. It is now the turn of three more industrial sub-groups - aerospace and defense, waste management and engineering & construction firms. As in previous posts, we'll also have a look at their financial and stock performance.

The Methodology - 3 Key Factors
The data comes from reports like the annual Management Information or Proxy Circular filed on Sedar, or through a Sustainability report filed on the company website or on the Global Reporting Initiative database, on three key aspects that researchers have found (see especially the Mining post for the details and further links) are especially useful in finding companies that will outperform for the investor.

1) Board of Directors committee with a sustainability mandate
2) Executive compensation tied to ESG performance
3) Formal stakeholder engagement processes

We combine that data with other evidence that a company has been taking sustainability seriously:
4) Published, annual, up to date corporate sustainability reports, preferably audited and submitted to GRI
5) Membership in voluntary sustainability-related reporting and promotion organizations like Carbon Disclosure Project, Canada's Top 100 Employers, Canada's Best Managed Companies, Sustainalystics / Macleans Top 50 Socially Responsible Corporations 2013, Randstad Award for Canada’s Most Attractive Employer 2013
6) Constituent of the iShares Jantzi Social Index ETF (TSX: XEN) that holds only companies with better social and environmental ratings
7) High rating in the Board Shareholder Confidence Index published by the Clarkson Centre for Business Ethics and Board Effectiveness
8) Women on the Board of Directors

Sustainability Results
The results are similar to those for transportation companies - the larger the company, the more explicit and extensive the adherence to sustainability. In delving through the data we got the impression that many of the smaller companies may actually do more than is evident or documented or formalized. For example, smaller companies with a board of limited size may not find it necessary or cost effective to have a separate board committee devoted only to sustainability.

Surprisingly, no company seems to look green, aka good, across the table on every ESG rating dimension. Bombardier comes closest with a lot of green, but it doesn't have a board committee (see the three committees here) dedicated to Sustainability, not even one for Environment, Safety and Health, which comes closest as a partial effort for several others. Stantec is another that gives a better impression when we read through its latest Sustainability report than the absence of a dedicated board committee or explicit tied executive compensation would suggest. SNC's severe ethics failings of the last few years stand in contrast to the very green image our table presents. The various company reports suggest it is trying to rectify the problem but the question is, of course, whether that effort is genuine and will succeed. The experience of time will provide the answer.

Even more surprising, given that the companies are specialized in waste management, is that neither Newalta nor Progressive Waste Solutions, ties a significant part of company executives' pay to ESG performance. At least, it is not stated explicitly in the Proxy Circulars, where such data should be found.

Financial and stock performance seem opposite to Sustainability
The biggest surprise is in the next table, which sorts the companies by their annualized total stock return (capital gains plus reinvested dividends) over the last five years. Bombardier and SNC-Lavalin, which look so good in Sustainability, have had the worst stock performance, even worse than the benchmark TSX Composite's 12.0% annualized return, as represented by the iShares ETF that tracks the index under symbol XIC! All the other companies we show in these sectors (there are other smaller companies we do not show) have had consistent, solid profitability and profits.

A few of the stocks still seem value-priced according to Price/Earnings and P/Book ratios compared to XIC - Magellan and perhaps Bombardier. The other stocks appear to be priced in the expectation of further strong earnings growth. This suggests that an investor needs to look further into company prospects before buying in.

Bottom Line: Similarly to the results for Transportation, Oil & Gas and Consumer stocks, the research-established relationship between sustainability action and corporate success may take longer to manifest itself than the past five years. Nevertheless, this sustainability assessment may assist those investors who wish to select their investments on philosophical grounds in addition to the financial numbers.

Disclosure: This blogger owns shares of SNC-Lavalin.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.