Wednesday, 27 July 2011

Investing Risk: The Ouch from Management Costs and Taxes

Next in our rundown putting numbers to the magnitude of investing risks comes the combined effect of the management fees (MER), salaries, trading costs, administrative costs, commissions, trading spreads, price premiums over fund Net Asset Value and taxes. Unlike the more sudden and dramatic single events of most other risks, this type of risk mainly happens slowly and often obscurely but the cumulative effects can cause losses that are severe and permanent too.

Recurring Fees and Costs - Annual recurring charges can significantly damage the value of mutual fund, closed-end fund or ETF investments. Whether it be a fund's MER, trading costs or advisor wrap fees, seemingly modest annual costs of even 2% add up over time.

How bad can the effects be? The chart below from Bylo Selhi displays how much an investor is left with after deduction of annual fees. In order to isolate and reveal the fee effect, the chart is before investment returns, i.e. assuming 0% market returns. Market returns must overcome the constant drag of fees if the investor is to make any headway.

Are fees really as high as the worst numbers on the chart? Unfortunately, in many cases the answer is yes. A search in the Globe Investor Fund listing tool selecting funds where the MER, which is usually the main component of total annual costs, is 3% or more, brings up 2621 funds. Morningstar's report Global Fund Investor Experience 2011, linked to by Canadian Capitalist in his blog post Morningstar Grades Canada an F calculates that the median Canadian equity mutual fund charged 2.31%, while median fixed income fund expenses were 1.31% and money market funds were 0.8%. Note that the MER is charged against a fund's total assets, not against profits / returns, so it takes away a chunk of the investment whether or not the fund has made money.

Michael James on Money in MER Drag on Returns in Pictures took the actual returns of the S&P 500 over a 50 year investment period and calculated that a 2.5% annual expense ratio "decimated returns" leaving less than one third the end value of what it would have been with an expense ratio of 0.17% (an expense ratio available amongst the lowest cost index ETFs such as iShares S&P TSX 60 Index Fund, symbol: XIU).

Independent Investor's Cost of Investing (free registration required) shows other examples and studies of the negative impact of too-high fund fees.

Stocks and Salaries - A company's internal cost for management salaries is the individual stock counter-part to fund MER. Just as fund fees can vary, so can the salary burden of a company. It doesn't always follow, despite the oversight role of a company Board in controlling management, that the shareholder owner gets good value for salary. Some companies overpay and all the profit in effect ends up in management hands. At worst, management can bleed a company and leave the shareholder with a bankrupt worthless shell. That risk of loss is one reason for research into a company, including its management's behaviour, before investing.

Taxes - Fees are not the only thorny all-too-present recurring problem. Taxes can drastically reduce returns too. It is quite difficult to generalize about how dire the effects can be since taxes depend heavily on combinations of factors that vary considerably from one investor to another:
  • tax bracket of the investor
  • tax rates on interest, dividends and capital gains that vary according to the investor's tax bracket
  • the proportions of interest, dividends and capital gains created by the investment mix
  • account type holding the investment - tax-deferred, such as RRSP, LIF, LIRA etc; tax-free TFSA; annually taxable regular account
An example taken from the cited Morningstar report gives an idea of the impact: the effective taxes in Canada consumed 26% (vs only 20% in the USA) of a mutual fund's gains over a 5-year holding period for a couple with $100k income and a $100k initial portfolio composed of 40% fixed income and 60% equities in a taxable account.

Planning and deliberate structuring of investments is the primary way to achieve lower taxes. That can be quite involved and investors may be wise to turn to a professional tax advisor to do it effectively. Amongst those going it alone, a popular planning software is RRIFmetic, which shows how to optimize retirement income flows, factoring in taxes, from different types of accounts during retirement. The Finiki page on Tax-Efficient Investing contains a rundown of practical basic principles to follow.

Some may quibble that costs and taxes are not really a risk at all since there is no uncertainty about them - they always occur. We prefer to include them because, a) their negative effect is considerable and, b) there is great variability in their level. Fortunately, the investor can reduce this risk a lot through advance research by looking at published information on fees and costs and picking investments with lower costs. Costs are a much bigger risk for the unwary, the heedless and the careless.

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.

Tuesday, 19 July 2011

Investing Risk: Default or, How often do investments go belly up?

Greece has been much in the news lately, scaring investors and governments around the world at the prospect that it will default on its debt. The fright is no surprise as default - not paying money back as promised - is perhaps the most serious and devastating risk an investor can face. But what are the facts? Often fear of the unknown is worse than the real threat itself. This week we therefore try to reduce the unknown and pose the question: what are the chances of default for bonds and stocks, and does default necessarily mean complete loss of funds or has there been some money recovered afterwards?

Governments - Greece's predicament is not an isolated incident. Governments around the world have a habit of issuing more debt than they can pay back. University professors Carmen Reinhart and Kenneth Rogoff have looked at records going back hundreds of years. They tell us in Eight Hundred Years of Financial Folly, from which comes the chart below, that there are periods of high financial stress when 40% or more of countries are in default or restructuring their debt.

A Canadian investor mulling over such statistics is no doubt grateful that the most likely destination for their investments, the debt of the federal and various Canadian provincial governments, has not yet seen a default, though the provinces do not enjoy the very highest triple A / lowest likelihood of default rating enjoyed by the federal government. For those interested, a search of ratings agency DBRS for each province will reveal the ratings for each province.

Corporate Bonds - Periodic peaks of defaults also bedevil corporate bonds, especially amongst bonds rated speculative or below investment grade. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows spikes in default rates nearing 6% at times in recent decades.

Speculative grades of corporate bonds show highly variable default cycles. In some years, like 2005, there have been no defaults. In other years, like 1989 and 1990, defaults have spiked upwards to extreme levels - up to 50% default rates, as bond rater Moody's shows in Default and Recovery Rates of Canadian Corporate Bond Issuers 1989 - 2005. Investment grade bonds on the other hand, have been quite stable and have stayed at very low default rates. Of course, that can be deceiving. Buying only investment grade bonds does not necessarily ensure safety, as the rating agencies quickly change their ratings downwards as problems mount at companies so that by the time of default the bonds are no longer investment grade.

Recovery Rates - The same Moody's document mentions the significant fact that all is not automatically lost when a default occurs. Recovery rates vary by the bond's priority of claim. As one would expect, bonds with higher priority have higher recovery rates on average. Senior secured bondholders got 54% of their money back over the 1989 to 2005 period, while senior unsecured bondholders only managed to recover 36.5% (see Exhibit 9 for all the rates by categories). Moody's also states that US and Canadian recovery rates are roughly similar.

Equities - Stockholders are residual owners, having a claim to assets upon default only after all other claimholders have been satisfied. It is seldom that anything is left over for stockholders when a company goes bankrupt. What is more, life for the vast majority businesses is short, much shorter than that of humans. According to the Business Week article The Lifespan of a Company, the average Fortune 500 company only lasts 40 to 50 years. Moreover, the Fortune 500 consists of large successful corporations and thus represents more winners than losers. United Capital Funding's post Small Business Survival Rates in the United States, cites various US government sources that indicate only about a quarter of small businesses last even 15 years.

The situation in Canada is much the same. Though statistics and studies are hard to find, consider the following. In our comparison of the top 25 stocks in the TSX index between 1995 and 2009, we found that about half had disappeared. In the entire TSX index, only about a quarter of the companies from 1995 still appear in 2011. Not all were eliminated in spectacular bankruptcies like Air Canada, Nortel and Canwest that completely wiped out stock value, but a number did. When a company weakens over time and is eventually acquired by another, often the stock will have declined considerably to a tiny fraction of the peak value. This latter kind of "default" loss of capital takes place over months or years.

In short, default risk has been and continues to be a critical risk, requiring the investor's close attention and indicating a serious need for countering action.

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.

Monday, 11 July 2011

Investing Risk: How Badly did Inflation and Currency Hurt Past Returns?

We have been dissecting the impact of various types of risk, seeing what historically has been the worst result for the Canadian investor, starting first with the list of all the main risks, the nature of their effect and counter-measures and then last week with the historical numbers on past market crashes. This week we factor in historical inflation and currency shifts to see what were the net combined worst effects.

When Canadian inflation goes up unexpectedly, that is bad for an investor. Though rates have generally been quite stable within the Bank of Canada's target 1-3% range for the last 20 years, data back to the early 1950s shows periods of big jumps and high inflation, such as the chart below from has another chart going back to the 1870s in his discussion of inflation risk. It show huge swings between high inflation and deflation.

Rampant, totally out-of-control inflation can have the same effect as outright default. The chart below from the Credit Suisse Global Investment Returns Yearbook 2011 shows the devastating impact of hyper-inflation on bonds amongst major European countries of France, Italy, Germany and the UK during the 20th century.

Currency Swings
It wasn't just inflation that experienced large swings in the past. An investor in US securities would also have been affected by the shifting value of of the US dollar against the Canadian dollar. Investments in non-US foreign securities, which have become ever more popular and accessible through funds and ETFs in the last quarter century, would also have been strongly affected by the movement of the Canadian dollar against many foreign currencies.

The Oanda website, from which the chart below is copied, shows Historical Exchange rates for major foreign currencies going back to the early 1950s. Retail has a chart on this page for the US vs Canadian dollar back to 1925. These charts show major shifts and upward /downward movements lasting decades, which might, at first glance, be thought to depress returns for the Canadian investor caught on the wrong side of the long term trends.

In a summary of the renowned book Triumph of the Optimists by the same authors as the Credit Suisse Yearbook, the CXO Advisory blog notes that once exchange rates and local country inflation are netted out the real equity return is what counted most and "local exchange rate fluctuations have not presented a significant disincentive to diversifying internationally in equities over the long term".

Including both Inflation and Currency, what were the worst returns for a Canadian investor?
The best available free online resource for seeing the combined effect of inflation and currency for the Canadian investor appears to be Stingy Investor's Asset Mixer. By filling in 100% allocations to each asset class in turn, it is possible to see how each fared over the maximum period of available data. Results are in real-after inflation Canadian dollars and assume no fund fees, which we will look at separately in a future post.

Canadian T-Bills
  • Worst drop 1971 -11.6%, recovery 11 years
  • Total down years 9 / 41 or 22%
This is quite a contrast with the finding in our previous post that T-Bills, in nominal terms, had never had a down year. Inflation can be a harsh risk. It undercuts T-Bills' oft-cited safety. T-Bills may be safe but they are still risky!

Canadian Bonds 1970 to 2010
  • Worst drop 1980 -10.9%, recovery 2 years
  • Total down years 5 / 41 years or 12%
Canadian Stocks TSX Composite 1970 to 2010
  • Worst drop 1973 -39.6%, recovery time 6 years
  • Total down years 13 / 41 or 32%
US Bonds 1971 to 2010 - corporate and government bonds together
  • Worst drop 2003 - 26.9%, still recovering; next worst 1972 -25.5% recovery time 12 years
  • Total down years 17 / 40 or42%
US Stocks S&P 500 1970 to 2010
  • Worst drop 2000 -49.7%, still recovering 11 years later, next worst 1973 -49.1%, recovery time 10 years
  • Total down years 13 / 41 or 32%
The 2008 drop only amounted to -23.5% in Canadian dollars. The S&P 500's enormous drop of -40.3% in US dollars was significantly cushioned by a simultaneously falling Canadian dollar as we discussed at the time in this post. However, the opposite happened in 2000. The 39.7% drop of the S&P 500 in US dollar terms was made much worse - down 49.7% per the above figure - by the currency movement at that time. Currency is a double-edged sword.

Developed World Stocks EAFE 1970 to 2010
  • Worst drop in 1973 -45.8%, recovery time 5 years, next worst 2000 -42.1%, still recovering
  • Total down years 14 / 41 or 34%
Emerging Market Stocks 1988 to 2010
  • Worst drop in 2008 -43.1%, still recovering, next worst 2000 -35.6%, recovery time 5 years
  • Total down years 8 / 23 years or 35%
Currency has accentuated the downward extremes of foreign stocks for the Canadian investor. The good news is that it exaggerated the upside too. We previously showed how this has worked within a portfolio combining multiple asset classes in Historical Effect of Currency and Inflation.

Bottom Line: Currency and inflation contribute to return downside over periods of up to a decade. The investor must be able to exercise patience.

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.

Monday, 4 July 2011

Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises

Last week, we explained how the various investing risks come about but only gave a general idea of their extent and magnitude. It's time to rectify that by attaching some numbers to the risks. History will be our guide. We'll cover the risks in several posts. This first post will deal with downward market moves.

Rather than try to split hairs about what distinguishes short-term volatility from business cycle moves, crashes or crises we have lumped all these market events together. The important thing to know is: how far down can down be and how long does it take to recover losses?

S&P 500 USA 1928 to 2010 in US dollars, i.e. not converted into the Canadian dollars that a Canadian investor would experience
  • Worst one-year drop: -43.8% (1931) then -36.6% (2008)
  • Max peak to bottom drop (drawdown): -79% real/inflation-adjusted (1929-32) shown as blue area in the chart below; Recovery period to 1929 peak - 1945 / 16 years
  • Tech Bubble Crash: -52% real drawdown 2000 to 2002, Recovery not complete
  • Financial Crisis: -48% real drawdown 2007 to 2009, Recovery not complete
TSX Composite Canada 1958 to 2010 -
  • Worst one-year drop: -33.0% (2008), then -25.9% (1974)
  • Worst drawdown real/inflation-adjusted: -39.6% (1973-4), Recovery period 6 years
  • Total down years nominal dollars (1958 to 2010): 14 years / 26%
  • Total down years real/inflation-adjusted (1970 to 2010): 13 years / 32%
T-Bills -
Worst year USA (1928 to 2010): 0.03% return (1940)
Worst year Canada (1970 to 2010): 0.5% return (both 2009 and 2010)

Treasury Long Term Bonds -
Worst one-year drop USA (1928 to 2010): -11.1% (2009)
Worst one-year drop Canada (1970 to 2010): -7.4% (1994)
Maximum real drawdown USA (1900 to 2010): -67% (1940 to 1981) shown as red area in the chart above, Recovery period to 1991 - 51 years!
Maximum real drawdown Canada (1970 to 2010): -37.9% (1973), Recovery period 12 years

Some of the above numbers look quite scary indeed, especially the effect of drawdowns and extended recovery periods. One might be tempted to invest only in Treasury Bills. They are low risk in terms of annual nominal returns ... but there is also inflation to consider, which creates losses in real value in many years. Inflation is another risk we will quantify in a another future post.

It's also good to remember that the above are the worst historical results. Averages over extended periods of years are positive and many years or periods offer large upward moves.

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.

USA Returns: Aswath Damodaran, Professor of Finance, NY University, Historical Returns on Stocks, Bonds and Bills - United States
USA Drawdowns: Credit Suisse Global Investment Returns Yearbook 2011, compiled by Elroy Dimson, Paul Marsh and Mike Staunton
Canada Returns: Libra Investment Management, Spreadsheet of Annual Returns
Canada Drawdowns: Stingy Investor, Asset Mixer
World Stock and Bond Drawdowns: Wade Pfau's Retirement Researcher blog post 13 January 2014