Written by: Robert Broad, Vice-President & Investment Counsellor, CIM, CFA
This is the first in a three-part series.
Our approach is to find solutions that work and stick with them. Generally, we wouldn’t buy into an approach unless we thought it was going to work for the long term. Markets won’t always cooperate, but sound investment approaches should provide value over time. This can be misconstrued as a lack of activity, but people are often unaware of the work going on behind the scenes.
Occasionally, our clients wonder if there are more exciting things they should be doing with their investments. We are always on the lookout for new ideas and approaches that might benefit our clients. The reality is that there aren’t all that many worthwhile new ideas! Investing is pretty basic: blend together stocks, bonds and cash to participate in the long-term growth of the global economy. If we can find more opportunities for diversification and enhance returns, we’ll take full advantage. But, in the retail or high net worth space it is seldom that easy. Sometimes investing is about what you don’t buy, rather than what you do.
We see dozens of pitches a year from our peers in the investment management industry. With $2 billion in assets, T.E. Wealth is generally considered worth talking to. The firms we do end up doing business with can certainly benefit and attract quite a lot of assets. Many of these meetings will entail one manager telling us why what they do is different than what anyone else is doing. A smaller subset will be new products or strategies sold to retail or institutional investors.
Unlike most counseling firms, we have the ability to buy and custody almost anything in the marketplace. In fact, we maintain investments in many quality products in the ETF space and have also been adding mortgage funds as alternatives where appropriate; not all innovation in this industry lacks merit. However, a significant proportion of new product ideas seem to run the risk of benefiting the sellers more than the buyers, at least in our view.
We believe it makes a difference that we are not dependent on commissions at T.E. Wealth. Most new products sold to clients in the investment world attract commissions for those who are selling it. While we certainly charge our clients a fee, our compensation is not affected whatsoever solutions we recommend.
In the next couple of blog entries I thought it would be interesting to highlight some of the products we chose not to recommend to our clients over the years and some of the reasons why. We are not trying to suggest that these alternatives are bad or that no one should ever purchase these investment products. On balance though, our feeling is that most of these just don’t make sense for a broad range of our clients. This list is by no means exhaustive, but covers some of the more popular ideas to surface in the last decade or so. I will start with just one product, and add a few more in future posts.
Indexed Linked GIC’s: These are a way for investors to buy a product that provides a capital guarantee, but still participate in the potential upside of the equity markets. Rather than collecting interest, the return profile of these GIC’s is linked to an equity index or basket of indices. Therefore, investors can participate in the upside of markets without having to live through the potential downside. This sounds like a great deal! But, of course this security comes with a cost.
Our issue with these products is that the upside is generally quite limited. Most of these GIC’s will only pay a portion of the market return over the holding period. Usually, the portion of market return they provide is from 30-60% depending on the issuer and the terms of the GIC. So, if the stock market is up by 30%, you will only be up by 9-18%. Note that dividends usually don’t factor into the potential return for these investments either, which leaves more money on the table.
So, let’s assume that we buy into index linked GIC’s as a long-term strategy. If we assume the stock market has a reasonable chance of providing a 7% return over time, how would this work if we used index linked GIC’s instead of direct investments in the market? To begin with we miss out on the 2.5% return that comes from dividends. This brings the expected stock market return down to 4.5%. If we assume a 50% participation rate, the investors return will be 2.25% per year over 5 years. This is then taxed as income. So if you are in a taxable account you would pocket about 8% in total over five years assuming a relatively low 30% tax bracket.
An investor who just buys the index will do much better. You would have pocketed after-tax dividends of almost 9% and seen growth in value of almost 21%, for total growth of about 30% after tax (this assumes capital gains tax is also paid at the end of five years, but there is no reason an investor would have to sell). If we were to compound this difference over many 5 year periods, you can see how it would really add up. Now sometimes the GIC will win. There are certainly periods when market returns will be below zero. But these periods are quite rare and over a lifetime of investing, you are much more likely to be in the 7% or better range.
In our view, rather than buying a bundled product, risk reduction is generally best managed at the portfolio level. Investors would be better off owning more bonds or GIC’s directly and having an equity they can live with. The likelihood of any index linked GIC providing equity-like returns over the long term is very limited.
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