This story is eerily similar to the worries about US companies over the last few years.  In 2009 clients were steadily asking me about how much exposure they had to the United States, as if the successful businesses of the greatest economy in the world were going to be an enduring problem.  At the time, I pointed out the government that was the source of the problems seen in the US and that the average business was in good shape (in July 2010 USA today reported that non-financial companies in the Standard & Poor’s 500 have a record $837 billion in cash).  Over the last few years the US equity market has been rising quite strongly and precisely when everyone was worried about it would have been a terrible time to avoid the US.  The same error in reasoning likely applies to people who think they should exit European investments today.

The chart below shows the geographical breakdown of the AGF Global Value Fund (Source: www.Globefund.com), the fund most commonly held by my clients that has what I consider a large European weighting.  Note that only 5% of the fund is directly exposed to even a single one of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and I believe the holdings in Spain derive much of their business from South American divisions.

The source of the problems in the European countries is government spending and borrowing.  As in the United States, the problem will persist for years to come and all through this time the management of great businesses will be busy adapting to whatever challenges they face in a competitive global economy.

When you read headlines about problems in Europe and their slowing economy, it is of little long term relevance to your investments.  These days, the prices of many European companies are at fantastically low levels on both an absolute and relative basis, not because they are about to fail but because so many speculators are worried about their future.  When they worry, they are willing to sell shares at low prices.  This is always happening somewhere and it always will.  With time, the facts and actual profits instead of emotions and speculation come to determine share prices.  By the time the speculators have figured out that things are better, share prices will have already risen significantly and usually very quickly.

I encourage all clients to not pay much attention to headlines about the irrational behaviour of national governments.  As has been the case since the dawn of the industrial revolution, I believe the ingenuity and competitiveness of entrepreneurial business leaders will enable companies to adapt to the errors of politicians and thrive in the years ahead.

Equity mutual funds are not just an investment product, but an investment method.  A mutual fund in most cases does not contain a static group of companies, but rather a collection of shares of businesses, selected by the fund manager, who obviously believes they offer good investment value.  Over time the composition of the fund investments changes.  Investing in an equity fund involves placing a degree of trust in the knowledge, experience and skills of the fund manager.  On the recommendation of a caring financial advisor, the investor is delegating daily investment decision-making to the fund manager, or to a few or even several fund managers as a healthy, diversified portfolio is constructed.

But what does the average “investor” actually end up doing?  The evidence shows they, either alone or with the cooperation or even encouragement of their advisor, if they have one, are doing a very poor job of allocating assets for long term gains.  We regularly see the results of the annual study “Quantitative assessment of investor behaviour” by a research company named Dalbar Inc., that shows average equity fund investors greatly underperforming the average fund because of emotional decision-making.  Well, a recent article from smartmoney.com documented the vast opportunity missed by U.S. equity fund investors over the last few years.

The author referenced U.S. industry data showing that over the last five years $490 billion has been withdrawn from equity mutual funds, and there were only three brief periods where this trend was reversed, each time just before another period of market decline.  He tabulated the monthly flows of mutual funds and the monthly equity market performance.  In a given month, there was a certain amount of money invested, and people either added to this amount or made withdrawals from it, so he estimated the monthly gain or loss for the entire equity fund set.

Amazingly, he calculated that the so-called investors actually managed to miss out on $106 billion of gains through their trading activity.  The two charts below document the madness.  The one at left shows equity market performance, and since the bottom it has been very good indeed.  The one at right shows the flow of money in and mostly out of equity mutual funds. It shows the degree to which fear has driven people to sell their equtiy investments during a period (since the panic bottom of March 9, 2009) when there was a powerful recovery for dollars that had experienced the decline of 2007-2009 or there were extremely large gains for dollars that were added along the way.

I believe this demonstrates one of the most important reasons why clients desperately need my advice: my practice is not based on investment selection and market timing, but on creating and sustaining sound investor behaviour.  There is a whole generation of investors who will never recover from the investment market pain of the last five – nay, the last 14 years – since the internet bubble took off in earnest.  How can they possibly recover now that they have missed much of the large gains from the bottom of the cycle, when they have been desperately pouring the money they withdrew from equities into bonds and other income products?  A 10-year bond these days pays just over 2%.   An investor who sold out of equities at the bottom three years ago and who has missed a 100% gain would require 36 years at 2% to double his money – in other words, it would take the same time many people spend working in life just to break even.

But it gets worse.  With bonds at historical low interest rates and likely being right around the end of a 31-year cycle that has seen interest rates fall from about 20% to 2%, it is highly likely that the next decade or more will be a period of rising interest rates.  In such a period, prices for bonds fall because new bonds are issued at higher rates, making the old ones less attractive.  For example, from the early 1930′s until 1981, after accounting for inflation, bonds had about a 50-year period where they actually were worth less at the end than the beginning, and the trend was downwards almost the whole time.  Just imagine seeing your purchasing power eroded steadily for such a long time – yet that is what people did, and what they are all set up to do over the next bond cycle, however long and painful it may be.  Stay tuned.

The world economy is not and never will be out of the woods.  On any given day there are many events, trends and ideas that you can worry about and which seem devilishly designed to lead you to make emotional investment decisions.  It is my philosophy that my task is to help you manage the tendencies towards such decisions and that this advice will prove far more valuable to you than the fees I earn providing it.

Funds managed by AGFIA have experienced below average performance over the last four years due to their relatively high investment in European companies and European financial companies in particular.  The companies owned by the funds continue to do brisk business and in many cases are taking advantage of their weaker competitors to emerge stronger for the next economic cycle.

Since the fall of 2011 Rory has adjusted the risk controls on the funds by setting limits on exposure to any particular sector, requiring some content from different sectors and reducing the maximum investment in any one company.  AGF Global Value will now hold no more than 5% in one company and will hold between 50 and 70 companies at any one time.  While this is a modest overall change, the managers believe it will reduce the fund’s price fluctuations over time with the same expected returns.

The dividend yield of the companies in AGF Global Value is currently 4.8% and the earnings yield is about 9%.  Companies pay dividends to investors from their total earnings, and may use the rest of their earnings to build cash, pay down debt, grow their business, buy back their shares or make acquisitions – all of which are good for investors.  This is in an environment where long term government bonds pay about 2%.  This is quite remarkable since on average, dividends double in 10 years and so do share prices, while a bond has a fixed value and a fixed income.  This indicates a deep level of fear in the minds of investors, since by choosing bonds they are accepting an income 60% lower than dividend yields and  78% lower than earnings yields in order to have higher investment price stability.

In summary, equity prices are low in both historical and relative (compared to bonds) terms and this bodes very well for future returns.  Markets have been consolidating for some time now and it appears that phase may be over, with significant gains in just the last few months perhaps indicating the next part of a return up to historically normal price levels.

Consider the following asset allocation strategy.  Let’s assume you plan to withdraw 5% of your investment assets in the following year and hope to continue this for the rest of your life.  Based on your circumstances, we may agree that an initial fixed income reserve of four years of planned spending is appropriate, so your basic asset allocation may look like this, with 80% allocated to equities that are necessary for the long-term protection and growth of asset value and 20% targeted for short-term spending.  It may make sense to build that 20% portion by shifting long-term assets in the four years leading up to starting an investment income.

It makes sense to diversify the 80% equity portion to reduce fluctuations and it may also make sense to diversify the fixed income portion, with one year of planned spending in money market or short term bond assets and the rest in higher yielding income securities.  Thus, a more detailed asset allocation may look like this:

Once the initial parameters are set, we may then want to have a rebalancing policy to further smooth results and avoid the possibility of selling long-term investments during short-term period of low prices.  Thus, the fixed income wedge proportion will change depending on market conditions.  Here is a sample rebalancing policy table:

Of course, this can be customized for your individual circumstances and adapted to fit changing individual circumstances.  Some mutual fund companies now have automatic rebalancing systems that we can use to operate this asset allocation strategy and we can override it (if it seems prudent) following an annual plan review.

If you are within five years of planned retirement or are already retired and we have not discussed this type of strategy, please contact our office to schedule a meeting to discuss it.

Mutual funds: What they are and how they work

1. History of Dynamic Funds

2. Why invest in a mutual fund?

3. How does a mutual fund work?

4. What is a prospectus?

5. Do mutual funds charge fees?

Performance and taxation

6. How do I make money on a mutual fund?

7. How am I taxed on mutual funds?

8. Tax sheltering with RRSPs

9. How can I track my fund’s performance?

10. What is asset allocation?

Understanding risk

11. What are the risks of investing in mutual funds?

12. How is my money protected?

Types of funds

13. What are the different fund types?

Buying and investing strategies

14. How do I buy a mutual fund?

15. How long should I hold a mutual fund?

Frequently Asked Questions

Glossary

An RDSP may be suitable for Canadians who are under the age of 49, qualify for the Disability Tax Credit Certificate and are expected to continue to qualify for life and who wish to save and invest for income after the age of 59.  For 2011, there is a government grant of $1,500 for the first $500 contributed and $2,000 for the next $1,000 contributed if family income is below $83,088.  For higher incomes there is a grant of $1,000 for the first $1,000 contributed.

We have already helped some clients open RDSP’s and have considerable knowledge about financial planning for the disabled and their families, including various tax saving measures and estate planning using Henson Trusts in your will.  If you know someone with a permanently disabled family member, please ask them to contact us to learn if they should be taking advantage of the extremely generous RDSP grants.

Financial services market research firm DALBAR has surveyed individual households for more than 20 years and created their Quantitative Analysis of Investor Behavior (QAIB). This measures the returns of the S&P 500 Index against the returns of the individual investor.

Here are two surprising facts:

The S&P 500 Index had an annualized return of 9.14% for the period ending December 31, 2010.

The average equity fund investor only made 3.83%, ignoring taxes and inflation, in the same time period.

Source: Dalbar Inc, Quantitative Assessment of Investor Behaviour, 2011

Recently, a school of thought has emerged called behavioural finance. The key point of this discipline is that the decisions people make are influenced just as much—if not more so—by psychological and emotional factors as by logic.

Psychological and emotional factors lead people to buy high and sell low. They react to the latest news and make ill-timed changes in their portfolios. They make important investment decisions based on limited information, facts and research—on yesterday’s news.  A caring financial advisor who understands these factors and how these bad behaviours affect performance can help individuals manage their behaviour and achieve better financial results.

People value gains and losses differently, basing decisions on perceived gains rather than perceived losses. A loss has much more of an emotional impact than the joy of a gain.  Some studies suggest the pain of a loss is twice as great as the joy from a win. This is known as loss aversion. As a result, people sell winners quickly to consolidate the gain and hold on to losers too long because they don’t want to realize the pain of the loss. A caring behavioural advisor can help you through periods of market declines by offering perspective and sharing confidence.

Thanks to the modern media, we are inundated with news that has a strong negative bias and often manages to make good news seem bad.  Once an idea gets in our head, we look for information or ideas that confirm our preconceptions about an investment rather than for information that might contradict it.  A caring advisor can offer objectivity and insight while sharing facts and truly successful strategies.

Another bias investors have is overconfidence. Overconfident investors tend to be more active traders, presenting another problem. They believe they are better at choosing when to enter and exit a fund or markets. They must make two good decisions – when to buy and when to sell.  A financial behaviour coach can point out such errors and help build confidence based on an objective view of what really works.

Humans want to follow the crowd. This tendency can be deadly in investing. Average investors don’t research, read, or educate themselves so they often make decisions with limited information and follow the crowd right over the cliff.  Such peer pressure can be nearly impossible to resit, but a behavioral financial advisor can point out the many past occurrences of this tendency and help you stay on track.

We all want to be liked and in investing it is easier to promote a viewpoint that is consistent with the group consensus than to offer a contrarian one. After all, a large group can’t be wrong, can it?  An advisor who really cares is willing to offer a distinct and sometimes unpopular opinion precisely when it is most needed and realizes that fact are not subject to opinion polls.

Over a market cycle, emotions get in the way of logic. Traditional education and training doesn’t equip financial advisors to deal with the emotional side of decision-making. They have been taught modern portfolio theory and the efficient market hypothesis. They learn things like alpha, beta, and standard deviation, and used them to build portfolios for clients.  Much financial advice is logical but tragically incomplete unless it assigns a central role to behaviour management.  The most elegant portfolio will not do the job if an investor will not stay in it through market cycles.

The emotional right-brained side of people is especially dominant in times of economic uncertainty. People’s emotions are triggered and they revert to defensive behaviours because they feel threatened.  While additional left-brain knowledge can certainly be helpful, what people most need is to lean on a strong relationship with a dependable professional advisor who understands investor behaviours.

In the Dalbar study, they regularly find a difference of five to seven percent compounded over twenty years between what the equity market has gained and what individual investors with all their human emotional choices have gained.  The greatest challenge a financial advisor faces is to close this gap and help you achieve the very real benefits of long term equity investing.  This is akin to building an ark to protect clients from the storms and flooding.  Are you on board?

a) equity investments are necessary to protect retirement income from the ever-rising cost of living; and

b) diversification is essential to avoid permanent losses

you can see that there are really only four ways to manage that equity portfolio, as shown in the diagram below.

1) You can  run the portfolio yourself (without the advice or cost of a professional financial advisor) in one or more passive equity indexes, wherein the investments are not selected by money managers but rather are constructed to broadly represent  specific market areas.

2) You can run the portfolio yourself and choose from among the many active money managers.

3) You can invest in a portfolio of passive indexes with the advice of an advisor to help you with behaviour management to avoid the very common and costly mistakes as well as comprehensive financial planning.

4) You can invest in a portfolio of actively managed investments with the help of an advisor.

There is a continuing debate about active versus passive investing, but I will leave this alone for the moment as I believe it is of relatively little significance.  No one can say for sure whether 1) will outperform 2) or 3) will beat 4).  There is, however, overwhelming evidence that choices 3) or 4) built and managed with the help of the few advisors who do what I do will be more successful than one you try to manage yourself.  No one has much, if any, control over how investments perform but we do have great control over how an individual investor behaves, and this is of far greater significance as shown repeatedly by research.

The past few years, not to mention the last couple of decades, has been filled with excuses to panic out of equities and in fact most people have participated in just this type of activity but my clients did not.  Successful equity investing requires above all the virtues of patience and persistence and these are entirely behavior management issues, not financial forecasting techniques.

If you have not already done so, please recognize that the true value of a financial advisor does not come from promises to pick superior investments or to forecast investment markets since these are unknowable; it comes from comprehensive financial planning to address the major issues in your life, and caring, behavioural investment advice to help you stay on the right path when it is very hard to do.

The question of dividends when it comes to mutual funds is a tricky one, so let me try and share some perspective that I have gained over the last 18 years in the financial business.  I will try to explain the role and importance of dividends paid by individual companies and why this is a different issue at the mutual fund level.

First I’d like to say that the reinvestment of dividends by of business typically forms a large part of the total return that comes to investors in the business. The total return is composed of capital gains and reinvested dividends and if we look at the market indexes then we can clearly see that the gain attributed to dividend reinvestment is the largest part of the total return. What this means is that the owners of the shares have not spent the income produced by the shares but have bought more shares using that income.

The same thing takes place when a business conducts a share buyback. For example, a number of companies these days have excess cash on their hands that they don’t need for continuing business operations and they have to choose what to do with it.  They may:

a) invest it in new capital projects to improve the production of the company;

b) acquire other businesses that they think can be run more efficiently;

c) pay it out as a dividend to shareholders;

d) see that the shares of their own company are significantly undervalued and go out into the marketplace and buy back shares from the market and put them back into the treasury of the company.

This last strategy concentrates the future earnings of the company in fewer shares and so increases future returns. For example the family of Sam Walton, the founder of Walmart, has recently been buying back shares from the market because they see that their own business is one of the best investment opportunities available today.

Most money managers that I have recommended are what I would call active dividend seekers. In other words, with other things being equal they have a preference for companies that have paid dividends reliably over the past years and appear to have a sustainable dividend payout policy. However, this is not universal. For example, the Cundill Value Fund has often made investments in companies that pay little or no dividends and sometimes this is in fact preferred.  Since the Cundill team seeks companies that are priced very significantly below their intrinsic value, this may mean that the shares are viewed as distressed by the financial markets and in fact sometimes the companies are experiencing significant short-term distress.  A company in distress may seek to preserve its cash on hand by reducing or even eliminating dividends.  In some cases, the  Cundill team prefers that the company is not paying dividends so that they can keep their eyes on the cash and it stays inside the company where the business owners (and through them the fund managers) can see how it is being used.

This has happened with American financial companies over the last few years and also with European financial companies that have recently dominated headlines. For example, banks maintain a capital reserve that forms part of their financial stability. In several circumstances, regulators have required that banks increase their capital reserve and so the banks have been building their cash while paying less dividends than they could have. As an example, the managers of the AGF Global Value Fund have significant experience with and exposure to European banks and have been monitoring not only what the companies actually pay out in dividends, but the changes in their capital reserve ratios and the stream of income that they are earning that could be used to pay out in dividends as soon as they reach the new target reserve level. They have thus found that there are many companies that could increase their dividends by very large amounts on very short notice when they reach their target reserve. In a similar fashion, the Cundill team has made some significant investments in a few large American financial companies where the share prices have declined so significantly that they now represent what the Cundill team describes as the opportunity of a lifetime to own companies like this.  In cases like this the current dividends do not tell nearly the full story.

In other cases, the payment of dividends does not form a significant part of the investment policy of the fund manager. This is normally the case for fund managers that describe themselves as having a growth style. These managers are seeking companies that are using their cash flow to grow the company at above average rates and so the most efficient use of that cash is internal business growth.  When a company reaches a very large size it gets more difficult to find ways to continue to grow the business at the previous rate and this is often when companies will start paying  dividends or will increase their dividends instead of reinvesting inside the company. Microsoft is an example of a company that has grown so large that it has very little room to continue growing and so has become a cash and dividend generator instead of a business growth machine.  The Cundill Value Fund owns Microsoft because the managers believe the market does not fully recognize the strong cash flows the company can generate in the years ahead and its strong current position.  Inside the Mackenzie Universal American Growth Fund the manager has had tremendous success in identifying companies that are able to grow their business through good and bad economic times at a rate that is well above average.  While I am not sure about the average dividend rate of the companies in this fund I expect that it would be very low. Despite this, the fund has had higher than average returns and has held its value well during market declines.

Now let’s consider dividends in the context of a mutual fund. There is a category of mutual fund called dividend funds, which generally indicates that the funds are actively seeking a high dividend yield, but this is not exclusively true.  There are cases where most of the total return of the fund comes from capital gains, with a small portion attributable to dividends paid out to investors and then reinvested in the fund. In order to minimize the tax liability of the fund for all investors, the normal accounting policy of funds is to deduct the expenses of the fund against the income of the fund and in the case of equity funds dividends represent the bulk of the taxable income.  Expenses cannot be written off against capital gains.  Note that this is an accounting procedure and does not change the total return of the investment.  In all cases, the dividends earned by a fund are part of the total return of the fund and it does not matter whether those dividends are, for accounting or marketing purposes, paid to investors and then reinvested.

There are a number of funds where the distribution that the fund pays to investors is composed of both income and a return of capital. The return of capital portion is paid out by the fund to reflect the managers’ expectation of the sustainability of a long-term income stream.  For example, the manager may expect to earn a total return of 7% over the years after deducting expenses, but will almost  never have a 7% dividend net of expenses available to pay out to investors.  In a case like this the fund may set a distribution policy of 7% but the composition of that 7% will vary depending on the net dividends available for payment.  In a number of cases these days, investors can choose multiple versions of the very same fund that have different distribution percentages.  For example you may opt to receive no distributions and have perfect tax efficiency or to have 4%, 5% or 6% distributions from the fund.

When you change perspectives from dividends at the level of an individual company to dividends at the level of mutual fund you are looking at quite different  things. The one that counts for investment returns is the one that takes place at the level of business ownership.  When a fund manager examines the financial statements of a business he can see what the company is doing with its cash flow. Depending on the circumstances of the company it may make sense to pay dividends or not to pay dividends and there is no single right answer.  I think it is fair to generalize that most successful long-term money managers have a preference for companies that pay significant dividends over the long term.

Let’s take the case of the Trimark Fund, where we will find only a couple of dozen companies, many of which are currently paying very healthy dividends. The dividends are received by the mutual fund and form part of its total assets and its total return. Whether the dividends are retained by the fund and used to buy more shares by the fund manager or are paid out to the investors and then automatically reinvested to buy more shares of the fund has no impact at all on the total return of the investor who does not spend the money but reinvests it, but may impact the investor’s tax return.

I believe that many investors do not fully understand the potential effects when examining the dividend policy of an individual company and the policy of the mutual fund that owns that company.  I hope this little essay adds to your investment knowledge.

At the time of the merger, investors could pay a fee to redeem matured shares and those transactions have been completed.  Covington will communicate with financial advisors when the back office conversion has been completed and the first redemption window has opened. The  back office conversion is expected to be completed by the spring of 2012.

Covington posts their latest news at http://www.covingtonfunds.com/default.asp?contentID=80.