There has been some musing lately that much battered insurance company Manulife Financial may be becoming a value play. Manulife’s declining share price may partially have to do with self-created issues caused by the selling of variable annuities which were not hedged to drops in the stock market. However, one of its larger competitors, Sun Life Financial, is also experiencing 52 week lows along with most of the the life and health insurance sector. It appears then that Manulife’s woes are part of a larger downward trend for the entire industry.

Why are life and health insurance companies struggling in general?

Insurance have just as complicated balance sheets as banks and suffer from the same interest rate sensitivities. An insurer’s largest liability are payout of insurance policies or annuities which tend to have much longer payout dates than the primary assets they hold, typically fixed income instruments. Thus, you end up with a fundamental issue of balancing a fixed long term liability versus a short-term asset which changes in value according to the interest rates.  When interest rates decline, the value of the assets decline so more money has to be set aside to rebalance assets and liabilities.

(as an aside, Larry MacDonald pointed out how the mark-to-market rules hurt insurance companies, and most financial institutions, and has basically resulted in Manulife reporting a loss. Mark-to-market is an accounting rule requiring certain companies to report the value of an asset based on its current value and not the purchase price/book value. The issue with mark-to-market is that it works best in a stable market where the price of an asset is knowable. In unstable markets, it produces unintended consequences and can cause jittery investors to over-react. It is something to be aware of if you invest in financial stocks)

The second shoe to drop for insurance companies in low interest rate environments is that demand for annuities and most life insurance policies generally tends to decline. No one wants to lock into an annuity for a relatively low rate of return and yield chasing takes many consumers away from insurance products (here is a short primer on how annuities work).

A bank can continue to make the spread between what it lends out and what it pays its deposit base even in a low interest rate environment. Its spread may be smaller but it is still ahead of the game. An insurance company has the dual issue of propping up balance sheets while sales slow in the same environment. This problem frames the bank stock vs. insurance stock choice in favor of the former in certain economic conditions.

The medium to long term implication is that an extended period of low interest rates will continue to put financial pressure on insurance companies, reducing the chances of dividend hikes and healthy return on equity. The solution to this problem is, funnily enough, to transform insurance companies into large financial empires with banking,  mutual fund and any financial service subsidiaries; in other words, create more too big to fail institutions which are interest rate immune.

In the short term, it may be unrealistic to assume a life insurance company will power your portfolio’s return.

Economist Moshe Milevsky’s book, Your Money Milestones, addresses the interaction between your employment income and your portfolio investment. Among other things, our employment income has equity like or bond like returns and our investment decisions should account for the characteristics of our employment income. In essence, human capital- the ability to generate economic value through our labor- is an often overlooked factor in how we view our financial lives.

Apropos to this point, a lot of the money chatter in my immediate circle is finding a product with yields greater than the meager returns of a money market fund. None of the suggestions I have heard involve investing or upgrading education or skill-set as a means of generating greater human capital. Yet, this is a means of improving one’s financial picture.

The much cited 2007 U.S. Census Bureau survey finds a person with a Bacholar’s degree has a means earning of greater than $25,000 over a person with a high school dipolma. An individual with a professional degree earns over twice as much with a counterpart holding a Bachelor’s degree.

What is interesting to note is that a person going from a Bachelor’s to a professional degree gets the most bang for the buck between the ages of 35-44 and 55 to 64 which tends to affirm the opinion of some that obtaining a MBA or a legal degree at a young age will not bear fruit until later in life when life/professional experience catches up with book learning.

Given that some people began to accumulate enough disposable income to invest in these two age ranges, perhaps the dialogue should not be equity or bonds, active or passive but to invest in the market or to invest in oneself?

To illustrate this point another way, in 1980, the number of female undergraduates slightly outnumbered male undergraduates. By 2007, 57% of all undergrads were female and the number of women enrolled in their first professional programs is now almost equal to men erasing a greater than 2:1 advantage in 1980.  Correspondingly, the gender wage gap, while continuing to be a problem, has narrowed significantly since 1980 whereas from 1960-1980 the wage gap remained basically the same. In other words, women have advanced relatively speaking due to greater investment in themselves.

This is not to suggest the only path to increasing economic output is through obtaining a conventional degree from an educational institution.  Night courses and professional development courses, many of which are subsidized or paid for by government or employers, may also be a means to increase skill set and expand networks (the often hidden benefit of skills-improvement; an old prof referred several legal clients to me over the years).

The point is that we often view our investment choices as merely Product A or Product B when the realm of human capital enhancement is often overlooked. As the educational/training industries start up anew in September, it may be time to consider allocating money to your own professional development.

After several years off, I have been dragged back into playing golf this summer. I am a hacker and, although some of my friends won’t admit it, so are they. If you play golf for any period of time, you probably have noticed the following pattern if your golfing buddies are hackers. Someone in the group with some fundamental flaw in their swing decides the solution is to buy a bigger/better/faster/sexier club that will fix all their problems. Of course, in most instances, this  club makes their slice or pull that much more apparent. The result is that the 50 yard slice right into the rough is now 100 yards slice right into the bush with their new toy and the “obvious” solution is to buy the even bigger/better/faster/sexier club next season.

I feel the active vs. passive investing debt has this similar type of feel. Many people have sliced their portfolio into the rough using active investing methods but, instead of mastering their own emotions, they decide the problem is with the active investing club and go out and buy themselves a passive investing club.

(to be clear, the evidence is pretty over-whelming that high fee active management products make no one rich but the issuer but low fee active management options have existed for many years and the poor returns of many active managers is compounded by many of the errors committed by the investor below)

The passive investment may offer advantages to the active investment BUT ONLY IF IT IS DONE RIGHT. Please remember that the fundamental assumption underlying the advantages of passive investing is to invest broadly in low fee products, allocate among asset class properly, reallocate periodically and to stay invested. Without any of those factors cited above, moving from active to passive investment is equivalent to getting a new golf club without taking any lessons to fix the real flaw in the first place.

Morningstar now estimates slightly over 1 in 5 investors now have some type of passive investment strategy in their portfolio. Where there is money, there’s the financial industry to screw you out of it. Thus, there are now products that are not really passive but claim to be, issuers encouraging investors to purchase a multitude of niche products and products which promote quick-turnover by their very nature (most leveraged exchanged traded funds).

The potential result for an investor pursuing perhaps the right strategy from them (passive) but executing it poorly may look surprising similar to the strategy they previously abandoned: too many products being turned over too quickly with some products not even doing what they are supposed to be doing. To go back to my golfing analogy, the club may be different but still the same old hacker.

There’s an old saying in business: invest in a company with a Grade B idea and Grade A execution over one with a Grade A idea but Grade B execution. The same rule applies to investing. Sticking to a plan, controlling one’s emotions and tuning out the imperative to buy marketing buzz will get you farther, regardless of strategy, than constantly changing approaches, being emotional and relying on the supposed superiority of the plan and not in its execution.

Much attention has been paid to banks offering cash incentives for customers to switch from one big bank to another.  However, a cynic would argue all the banks are doing is churning the same group of customers from one institution to another. In essence, the economic pie is not growing so much as it is being passed around the table.

This is why the next battleground in retail banking is in multicultural market since this is where growth is occurring quickest.  Stats Canada predicts that the non-Canadian born population could grow 4 times faster than the rest of the population and, by 2031, the visible minority will become the majority in such large urban centers as Toronto and Vancouver.

Since bankers know how to chase money, several banks, such as RBC and Scotiabank, now have multicultural markets departments who’s role is to basically attract soon to immigrate or new immigrant money. Without a life-time of branding, the immigrant market is basically green-field to banks which has both its advantages and disadvantages. Since a recent immigrant may not have any connotations of what one bank is over another (especially if a bank had no presence back home), no bank has an inherent advantage over the other and it quickly becomes a race to see who can get to the most desirable clients first.

The potential  benefit to all banking customers, and the double-edged sword for banks, is that many clients from other parts of the world simply won’t put up with the fee regime in Canada (which speaks to the relatively docile nature of the Canadian consumer). In other parts of the world, banking fees are either relatively modest or non-existent.

For example, the commission for foreign remittances, a frequent area of fee abuse, fell once American financial institutions began chasing the Latin American market. One wonders as the multicultural banking market grows whether the same positive effects will occur here. I would take lower fees over trinkets and trash any day of the week.

Not so long ago, most of us were worried that governments printing money freely would trigger inflation. Now, with there are fears of deflation- the decrease in the price of goods- due to slower than expected demand by the consumer. This has left many of us wondering where interest rates will head in the short-term. Even though the interest rate set by the Federal Reserve in the U.S. and the Bank of Canada are nearly zero, the deflationary supporters point to Japan as an example of a country where large government deficits, which typically triggers inflation and rising interest rates, can occur along side a low interest rate environment.

If it already wasn’t apparent before, the average household is being bounced about by the larger marco-economic trends occurring in the global economy. Rather than try to predict where interest rates will go, three practical measures comes to mind.

The first pay off debt and deleverage the household. At the household level, part of the fundamental issue is not the unpredictability of interest rates short-term but the ability of some households to weather any adverse economic change whether in the increase in the price of goods or a general downturn in the economy. Paying off debt and deleveraging the household will at least give people more options and breathing space no matter which way interest rates or the economy goes.

Related to the first point, the second is to reinforce the general investing principle of not being fully invested. Fully invested refers to having all available funds invested into products other than short-term cash or cash equivalents/GIC/high interest accounts. Only the most optimistic of investors are fully invested and, even then, it limits options in the event bargains do appears. To be clear, this is not to support ditching investing strategies due to short-term trends but to keep enough in cash to mitigate against short-term losses in your strategy or having resources to make adjustments to your strategy accordingly.

Finally, the general consensus regardless of an inflationary or deflationary outcome is to stay short-term in fixed income products. The rationale for this is the same as the above two: staying flexible and preserving wealth is more important the guessing where long-term interest rates will go and being on the wrong side of the prediction.

When the equity market began a great decline in September 2008, many investors were caught over exposed to the equity market, some surprisingly so, and their losses were greater than it should have been (especially those who sold at market lows). Since research shows that most average investors fail to re-balance their portfolio, and with the equity market trending downward, will investors be caught over exposed to the equity market again? Since once is an accident and twice is a pattern, what are some things people can do to avoid the same fate?

The conventional rule in asset allocation is 120 minus age equals an ideal percentage weight in equities. Since I am self-employed and have equity like returns in my life (when the times are good, they are great, when they are bad…), I have adjusted the rule to 100 minus age to mitigate against a double loss of income from business and investing income/gains.

If anecdotal evidence and academic research is to be believed, most average investors either do not adhere to this rule or start with proper asset allocation and fail to adjust over time. As the book Nudge indicated, in the former case, most average investors tend to over-allocate towards equities. In the latter case, since equities do out-perform fixed equities over time, an investor who fails to reallocate an initially ideal asset allocation is likely to have be over-weighed in equities over time.

Why does this happen? Some common reasons may include:

• Too many products. Again, as the book Nudge found, the more products offered in a pension plan, the more likely its participants had drifted into being over exposed into equities.  Balanced funds, income funds, income and growth funds have names which imply stability but they continue to hold equities in them. Combine them with pure equity products and an investor may have accidentally over exposed himself to the equities market.
• Too many accounts. Your 2nd cousin becomes an investment advisor so you open an account with her and put some money in to support the family. You have a second account to do all your investing with an advisor BUT you have a self-directed account as well and you just met some hot-shot advisor who you put a little bit of money in to test him out… Pretty soon, it is hard to keep track of your asset allocation because there are too many accounts to keep track of.
• Failure to keep track/failure to adjust asset allocation to life-style. As indicated above, if you fall asleep at the switch, a once ideal asset allocation can drift into too much equities. Or, the 120 minus age rule simply does not apply since you are in a high risk profession already; it has often been recommended that professional traders, entrepreneurs and other high risk/high reward persons maintain a more conservative than usual portfolio.

The fixes to these issues are simple, mainly:

• Simplify and reduce your investment products. Broad based index funds can cover off large investing categories and people with modest sized portfolios should concentrate their investments in a limited number of products rather than a multiple of niche products. To paraphrase, Sun Tzu, if you invest everywhere, everywhere you will be weak.
• Consolidate accounts or be prepared to take the time to determine asset allocation on a consolidated basis.
• Keep track of your money. Sounds easy enough but hard to do in a world with so many distractions. There are various schools of thought on when someone should reallocate. I tend to look at asset allocation yearly. The key is to actually engage in the exercise of looking at your portfolio and then reallocate accordingly.

Assuming that an investment advisor has breached their duties to the client, does the investment advisor actually have any defences? The short answer is that an investment advisor has a lot more than one thinks.

If, despite the advisor’s conduct, the client ended up in a better position than if the advisor had not engaged in the conduct, the client cannot prove that any actual damages occurred and there would be no legal basis to proceed in a claim; the payment of any damages would unjustly be enriching the client.  For example, if an advisor sold financial industry stocks in the summer of 2008 despite the client’s instructions to buy and hold all stocks, the client would be better off than if the advisor had done nothing. Thus, you end up in a peculiar situation whereby the client’s trust and faith may have been broken but, because there was no monetary loss, there are no damages and no claim to pursue. One wonders, however, whether a client would be well-served long term by a rogue advisor.

Similarly, if the advisor had engaged in wrongful conduct, such as selling a stock without authorization, if the client authorizes the conduct subsequent to the fact, the advisor has a defence that the breach of duty was approved by the client.

The less straight forward defence is that a client cannot prove the advisor’s allegedly wrongful conduct lead to a particular (bad) result. In legal lingo, there is no causation between the conduct and the result.  For example, from October 2008 to approximately March 2009, would an advisor’s action(s), in contravention of its duties, actually would have lead to any different of a result than if the advisor had performed their duties within reason (remember again, the advisor’s duty does not necessarily speak to portfolio performance).

One of the more commonly cited defences in an action against an investment advisor is known as the legal doctrine of contributory negligence. In the simplest terms, the person harmed caused part of the damages through some act or omission of their own and the damages to be award will be lessened to the extent the person harmed did something or failed to do something that made the situation worse.

For example, an advisor may give several options to a client- none of which really suit their risk tolerance. However, the client, being reasonably sophisticated,  fails to perform any due diligence on any of the options recommended such as reading the disclosure documents or financial statements and basically picked one of the options willy-nilly. While the advisor breached his duties by giving options inappropriate to the client, the client also failed to protect themselves which could result in the advisor’s potential liability being reduced.

Another example of contributory negligence may be that the advisor had engaged in improper trading for an extended period of time yet the client fails to check her financial statements or, in multiple meetings or telephone conversations to review the portfolio, fails to ask any questions about her holdings.

Finally, damages are capped by a legal concept known as mitigation. In plain English, the wronged party, once they discover they have been wronged, must take some reasonable action to reduce their losses. For example, if a client finds out that the advisor had been investing in money-losing speculative penny stocks against their stated preferences, the client should, within a reasonable amount of time of discovering the trades, give instructions to sell the stock (especially if it continues to go down), file a complaint, switch brokerages etc. The client simply cannot sit still and do nothing. If he/she does, the Courts tend not to award damages after the day they would consider a reasonable person would have taken some action to mitigate their loss.

The above is a quick and dirty over-view of some defences available to the investment advisor. The defences tend to have a common theme. Mainly, while the advisor should be held liable if they breached their duty of care, the client is delegating and not abdicating their authority. A client should continue to be active participants in their own portfolio and, being a completely passive in how their money is managed, can be used as a defence by the wayward advisor.

There is a great deal of debate among policy-makers, regulators and in the blogsphere on whether an investment advisor should be held to a fiduciary duty. In plain English, a fiduciary owes a person a duty of loyalty, not to put his or her personal interest before such duty and not to profit from the duty unless with consent. Those opposing such duties to all financial intermediaries (some class of financial advisors, such as investment counsel, are already are fiduciaries and, depending on the facts, some advisors can be held to be fiduciaries) can be classified into 2 general camps: (i) the usual opposition to change; and (ii) the “how about actually enforcing the current rules” school.

With respect to the latter camp, it has been asserted that the debate about holding investment advisors accountable seems to be occurring in a vacuum. The theory being that it is not that investment advisors are not being regulated but that the current regulation is not being enforced; a very common issue among lawmakers who pass laws to score political points with little thought to implementation or enforcement.

If one subscribes to that theory, what regulations need to be enforced to ensure that investment advisors are meeting their minimum duty of care?

At the very minimum, the law requires investment advisors to act with prudence, diligence, honestly, faithfully and without conflict of interest. What does that mean in the day to day relationship between investment advisor and client?

KNOW YOUR CLIENT

This term is used quite often by the industry. What it means is that an investment advisor must know their client’s personal circumstances, net worth, family situation, risk tolerance, financial sophistication (or lack thereof) and investment objectives.

Flowing from the know your client rule is the duty to follow the objectives as agreed to by the advisor and client and to provide recommendations and products which match the client’s personal circumstances. For example, an advisor should not be recommending a leveraged ETFs to a 63 year old female who has not agreed to any risk taking in her objectives.

ON GOING DUTY TO UPDATE, ADVISE AND REPORT

An advisor has an on-going duty to contact their clients regularly to ensure they continue to know their clients (given that people’s life circumstances change), provide updates as to investment objectives and advise whether their portfolio needs to be changed as time passes.

DUTY TO PROVIDE OBJECTIVE ADVICE FREE FROM CONFLICT OF INTEREST

The advice or recommendations must be prudent and objective (an objective standard is generally what a reasonable advisor would have advised or recommended in similar circumstances without the benefit of 20/20 hindsight) and free from a conflict of interest. With respect to conflict of interests, it is not that an advisor cannot be without a conflict of interest but that the conflict must be declared and the client acknowledge and agree to taking the advice or recommendation having been informed of the conflict.

…the following three heads are a non-exhaustive review of the current standard. It is, in the abstract, a pretty reasonable standard. It requires an investment advisor to understand their clients, keep on-going contact/dialogue and provide prudent, objective advice free from conflicts of interest.

It is worth noting that the standards themselves require a two-way dialogue. An advisor cannot advise a client with unclear investment objectives, who fail to respond to advisor questions or who over-ride otherwise prudent advice. It would be unfair to throw all investment advisors under the bus when investing mistakes are sometimes self-inflicted. Next week, I’ll tackle defenses investment advisors have to client allegations their advisor failed to meet their duty of care (for those with unrealistic expectations, there is no duty to make money for the client-just to provide honest, prudent and reasonable care).

Some believe that because the current standard is reasonable and, if enforced properly, would protect most of the investing public, a movement to a higher fiduciary standard would be a symbolic but hallow gesture. If the regulators and government is doing such a relatively poor job enforcing the current duties of care, what makes one believe merely moving to a higher standard will mean people in charge of protecting the investing public will do their job properly? Should not the emphasis be on better enforcement?

This is not an outlandish objection to moving to a higher duty of care to investment advisors. After all, if you believe the system is broken, to mix metaphors, putting a new coat of paint on a run-down home and calling it a “fixer upper” still doesn’t change the fact the house needs a lot of work. It just sounds better to the public.

On a more practical level, regardless of one’s position on moving to a fiduciary standard, review the above duties of care and see if your advisor is meeting them.  If not, take pro-active action to ensure you have a productive relationship with your investment advisor.

Addendum: I would be remiss in not mentioning Preet’s excellent post on doing a background check on your financial advisor.

Congressional gridlock may make most citizen’s eyes roll but it eventually has consequences to you and I. Much like there is much uncertainty in U.S. Estate taxes due to Congress fighting for the sake of fight, the dividend tax cut of 2003 in the U.S.  is set to expire in 2011. In essence, qualified dividends received in the hands of U.S. citizens will no longer be taxed at 15% and will revert to the pre-2001 rate of 39.6%.

But does tax policy actually affect dividend policy? On this count, what executives say and what executive do are two different things. Dividend payout policy, or determining how much of earnings to pay to the shareholders, is a puzzle to most economists. In short, there is no defining characteristics of why Firm X may payout 40% of its profits  in dividends while its competitor pays out 45% of profits.

In surveys, corporate executives seem to suggest that tax considerations play a secondary consideration in setting dividends. However, this seems to contradict what companies actually do when dividend taxes are cut. The 2003 dividend tax cut produced an immediate blip in the number of companies either beginning to pay dividends or increasing dividends. In other words, it carried out part of its intended effect on the market.

How do we rationalize the survey results, however small a sample size, and actions? Perhaps, human nature being human nature, people only respond how they think the surveyor wants them to respond publicly but have different thoughts privately.  Alternatively, it may reinforce an academic opinion that setting dividend policy is more “behavioral” in its approach than quantitative. The implication of a dividend policy being less about numbers and more about feel, for lack of a better term, is to simply dismiss any public statement made about a CEO publicly about dividends and rely solely on action (a lesson learned quite harshly by shareholders holding shares in American financial institutions in 2008/2009).

Porter Aviation Holding  is a niche airline that flies out of Toronto’s island airport. Founded in late 2006, it has turned an operating profit in one quarter to date. At the very least the company is gutsy. It flew out of the island airport despite fierce opposition from the city and, recent market turmoil be damned, it is moving ahead with its initial public offering, albeit at a lower share offering of $5.50 from the original $6-$7 range. Trading is set to start June 1.

The company’s largest operating advantage is that it is the sole airline to fly commercial flights out of the island airport. Air Canada and Continental Airlines have applied to fly routes out of the same airport. It has a load factor (the average number of passengers per flight) of 47% which is 2% lower than its break-even. Its revenue is growing but it continues to post a loss (although reducing the loss is seen as a victory for the airline). In other words, its barrier to entry may be eroded and its not exactly an efficient operation.

So why move ahead? IPO’s are liquidity events. In plain English, they are exits for early investors, lenders and the insiders who took the risk of starting up a business. This is an often over-loaded fact of IPO’s. One of the reasons for an IPO is for certain people to cash out. Where the underwriter is also the lender (like in Porter’s case),  if the proceeds of the IPO is to pay out or pay down loans, it is an elegant way to transfer risk off the financial institution’s books to the general public (another one of those walking conflict of interests that are a facet of large financial institutions).

There is nothing inherently wrong with this. Risk takers who have innovated, created jobs or made other people money should be rewarded. The question becomes whether the general public should assume some of the risk by investing. Is Porter worth the risk? As the saying goes, “how do you become a millionaire? Start a billionaire and buy an airline.”