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 but 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 health 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.

The Ivy team seeks to invest in companies that have:

• high quality, multinational growth companies having a a sustainable and strong competitive advantage
• conservative borrowing practices and healthy financing
• a price and valuation that makes compelling investment sense
• a business that is easy to understand
• a trustworthy management team

They have chosen not to invest directly in emerging markets at this time, preferring the higher legal protections, disclosure and accounting practices and corporate culture of the developed countries.  Most of the businesses owned in the fund do have customers all over the world or may buy from emerging market countries where they have a competitive advantage.  The managers have no bias towards any particular industry or country, and so represent the best investments the managers can find on the planet.

The managers may spend years researching and following a company and so are highly comfortable with the decision to invest in that business.  The fund typically holds on to an investment for several years once it is bought for the fund.  An example is McDonald’s, which was bought for the fund five years ago and has done very well since then.  McDonald’s has transformed itself in the last several years and found new ways to grow the business.  I know a McDonald’s in Orleans that has a stone fireplace, suspended mood lighting and a feel much more like a relaxing living room than a fast-food joint for young families.

I continue to have confidence in the team that manages the Ivy Foreign Equity Fund.

Portfolio management

• Canada represents only 4% to 5% of the world market
• The Canadian market is almost totally concentrated (80%) in only two sectors – resources and banks
• The average portfolio of a Canadian investor has 90% exposed to Canada and is thus severely underdiversified
• Only 11 of the top 500 companies in the world are in Canada

Investment opportunities

• The U.S. has many more companies than Canada and other countries, a stronger focus on business, and one of the very best legal/regulatory environments
• Opportunities are everywhere these days.  Prices are at levels that imply poor business results for a very long time and thus represent great bargains.  Some of the most hated business names of the last few years (Bank of America, Citigroup, AIG) are perhaps the best opportunities in large companies in a lifetime.
• The Cundill team saw 2008 as a once in a lifetime opportunity to buy large U.S. companies, taking their U.S. weight from under 10% to about 50%.  Their next action will likely be to reduce the U.S. in favour of European companies, which they describe as ridiculously cheap.
• The Cundill team invests in things that other professionals don’t, can’t or won’t.  This has been essential to their long term success.
• U.S. manufacturing is starting a renaissance because higher transportation costs mean it is once again more economical to produce locally than to ship in from foreign countries.
• Businesses have more cash on hand than they have had for 30 years, about $2 trillion.  They will eventually use this for three things: increasing dividends to shareholders, buying back shares so the future profits are more concentrated in the remaining shares, or acquiring companies that are weaker and whose value can be increased.
• 80% of global economic growth in the next few years is expected to come from emerging markets.  This is what will “bail us out”.  Many of these areas are at pricies similar to the last cycle bottom in early 2009.  It is safer to seek exposure to these areas by owning established companies that are active in emerging markets and are trustworthy with good governance and reporting.
• When fear and panic in all parts of your body is telling you to be safe, that is the best time to buy the shares of the great businesses of the world.

The Value of Advice

• Households with financial advisors have much higher assets than those without
• 69% of households with an advisor have RRSP’s vs. 29% of those without
• 27% of households with an advisor have TFSA’s vs.15% of those without
• 15% of households with an advisor have RESP’s vs. 6% of those without
• Households with an advisor have a higher allocation towards long term growth assets

The Canadian stock market has three dominant sectors that make up 78% of the entire index: energy, materials and financials.  Energy and materials are really all about natural resources. The global stock market is much more balanced, with greater representation in areas such as consumer staples, health care, information technology and comsumer discretionary.