Indexing is also an investment decision

Michael James wrote an post explaining why he invests in index ETFs and not individual stocks, stating that it is about knowing his personal limitations:

After reflection, I’m convinced that my choice to invest passively in index ETFs is fundamentally a statement about my own limitations.

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This brings me to my next limitation: I don’t believe that I can figure out which money managers will outperform.

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As you might guess at this point, I have a third limitation. I don’t believe that I can figure out which advisors can pick winning money managers.

Knowing your own limitations as an investor is a very important skill, and Michael explains why he thinks he can’t outperform the index, nor can he choose money managers (or financial advisers that recommend such managers), so therefore he sticks to index ETFs.

This leads me to my next logical question: What makes him think that investing in an index is going to provide a superior risk/reward than holding cash inside a GIC? Other than pointing to a chart with some very long-term x-axis (30 years or greater), it is not clear to me why equity indexes should outperform cash.

Also, assuming that investing in “the index” is superior, what index should you choose to invest in? The TSX 60? S&P 500? Some midcap or smallcap index? Or a smattering of all of them?

One flaw most people have in the marketplace is the implicit assumption that stocks, as a whole, will outperform alternative investment classes (bonds, cash, commodities, etc.) over the long run. We could continue our historic 9%-a-year nominal climb up in the major indexes, or we could enter into a period of decline (e.g. Russia’s stock market in 1900 was the third largest market in the world by capitalization, and we all know what happened there), and we would not know either way at present which will be the case.

The only way an investor can outperform in the marketplace is by selecting investments that are trading below fair value. If an investor cannot explain why an index is undervalued when they purchase it, I would not automatically assume that the index would be outperforming alternative decisions at the time of investment.

An investor completely unwilling to dabble in equity risk (including preferred shares) would have a morally consistent argument by opting for the 100% GIC-only strategy. You can usually get higher returns with GICs than most bank debentures.

As I have said to some other relatives that have come to me seeking investment opinion, “Making 2% a year is a lot better than losing 10%.” Usually it takes such a loss before people realize the impact of such a statement.

Not much going on in the markets

The end of year trading is dominated by two forces, none of them fundamental in nature to companies’ economic prospects:

1. Window dressing – fund managers do not want to be seen with a year-end holdings of market “dogs”;

2. Tax loss selling – people that jettison positions in their portfolio with unrealized losses so they can harvest the capital loss for the 2010 tax year. Correspondingly there will be some supply at the onset of 2011 of 2010’s gainers.

This is probably why I have not been writing lately – I’ve been drafting up the 2011 outlook.

Since the last two weeks of December are usually a write-off, markets are more illiquid than usual. Retail investors can take advantage of the corresponding price swings to add or subtract positions if such swings are unusually sharp.

Financial referral schemes

This is in direct response to Larry Macdonald’s post with respect to referral schemes and financial services. In his post, he how ING Direct has a referral scheme where people can receive $25 if they refer people that open up an account with ING Direct.

Another example is most Canadian finance websites proclaiming their love for a certain discount brokerage firm, an excellent review, and all the meantime displaying the referral code readers can use to sign up for the same firm.

Another example – pick your average TD mutual fund and tell me how much a financial advisor or salesman would receive by putting his client into the balanced fund of the day. Or the kickback an advisor gets by signing up his/her client in a whole life insurance scheme.

These sorts of marketing schemes absolutely bias the people that try to refer financial services onto others, whether funds, brokerage accounts or ING. This is primarily one reason why you won’t see me posting links to referral schemes. They undermine the credibility of the poster.

The only products and services I will be selling are mine.

Gold Wheaton gets bought

Gold Wheaton (TSX: GLW) sold itself today for 40% cash and 60% stock for about CAD$830 million. The acquiring company is Franco-Nevada Corporation (TSX: FNV). The buyout price caused a jump of about 14% in GLW shares today.

Both corporations are very similar in that their economic interests lie with royalty streams derived mainly from gold mining. FNV has other metals and oil and gas royalties as well.

I have done a lot of research on the valuation of Gold Wheaton, primarily because of its relationship to First Uranium (TSX: FIU), and can safely say that FNV paid what would be the high end of a fair value range for Gold Wheaton’s assets. The primary variable would be the assumption of the future price of gold.

Gold Wheaton does own an equity interest in First Uranium (14 million shares or a 7.7% interest) plus $20 million in First Uranium senior secured notes, which if converted into shares, would result in an increase in equity ownership to about 10% of the company.

I generally do not believe in the royalty trust model of company, in that the administrative costs and management salaries generally are overburdened by economic benefits of purchasing cash streams from mineral proceeds. Royalty companies then become a matter of getting capital cheaply and investing into projects with a higher return, which means that you are investing in a bank that is choosing to align itself with the price of a commodity. There is usually more value created with mining operations than purchasing royalty streams, but it depends on the whims of the marketplace at that time.

Such companies become a bet on the underlying commodity price and the ultimate control goes to the company that you are purchasing the royalty from – if they suddenly decide it is unprofitable to mine from a particular venture, they will have a higher incentive to doing so if they have a lesser share of the revenue. The company purchasing the royalty will be out of luck at that point. In Gold Wheaton’s case, the Quadra FNX (TSX: QUX) venture was quite profitable for Quadra, who wisely chose to sell their nearly 1/3rd stake in Gold Wheaton at an opportune time.

One person to pay attention to in the future is soon-to-be former CEO of Gold Wheaton, David Cohen, who seems to be fairly good at being involved with companies that generate value. He is the chairman of Eastern Platinum (TSX: ELR)

I will disclose I flipped some GLW shares like pancakes in 2010, which created some capital gains that would purchase quite a few pizzas. I currently have no position and have no further intentions of acquiring anything related to FNV.

Speech worth reading

Take a moment to read Bank of Canada chief Mark Carney’s speech, Living with Low for Long. It gives some interesting perspective in terms of the macroeconomic and monetary policy side of the economy.

Export-related economies are “unsustainable” – this is a kick at China for sure:

This is an increasingly uneasy emergence. Growth strategies reliant on exports and excess national savings are unsustainable in the long term. In the near term, for many emerging economies, the limits to non-inflationary growth are approaching and the challenges of shadowing U.S. monetary policy are increasing.

US householders are still suffering:

Unfortunately, the best contemporary analogue to the Japanese zombie firms is probably the U.S. household sector. Problems with the foreclosure process, government programs and forbearance by lenders are all delaying the adjustments. Absent more aggressive restructuring, the impact of negative equity on one-quarter of U.S. homeowners will weigh on consumption for the foreseeable future.

Sensitivity of householders to rising unemployment is significant:

The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock. The results suggest that the rise in financial stress from a 3-percentage-point increase in the unemployment rate would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well.

Apparently if more people adhered to the following quotation, we might not have the 2008 financial crisis:

Similarly, financial institutions are responsible for ensuring that their clients can service their debts.

Makes you really wonder about who’s buying sovereign debt in countries clearly unable to pay it back.

And finally, when rates rise, they may rise very quickly, leading to:

More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.

An interesting speech. Nothing concrete, but you can infer what the Bank of Canada is guessing their tea leaves indicate.