CFA Conference coverage

The conference examined how to strengthen your clients’ trust and diligently guide them through volatile markets.

You can examine the conference agenda here.

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Thanks for joining me on this fun ride through finance and analysis. I hope you learned as much as I did!

Behind Stratfor’s Lens: What’s causing and extending the financial crisis
Speaker: Peter Zeihan, Stratfor, Austin, TX

A. South Korea – trades on its own. Canary in coal mine nationally. Japan’s on one side, China and Russia around, and occupied by US. Hypersensitive to any sort of change. Anytime they’ve had something go right for them, they’ve been smashed by someone else. South Korea has flourished over last 50 years because they’re kind of crazy like the Americans. Koreans have never known it to be good, so they only have overreaction. They reinvent themselves every 6-24 mths and move from crisis to recovery because they don’t know if they’ll survive.

Who will survive EU? Sweden (not in Eurozone), Poland has no intention of joining EU and has good consumption prospects. Germany will come out of this with its infrastructure and labour pool intact.

Canada has done everything right for the last 10 years. That will last for another 5 years. Canada is levelheaded.

Q. What are some good countries to invest in?

China’s social unrest is at an all-time high for the current governing system. And China is dependent on outside world for resources. Surprised if they last more than 3 years. $3.4 trillion in reserves (USD) – these assets are not viewed as assets of the country, it’s viewed as assets of the ruling elite. So when China falls, the money will disappear, just as it did in the Soviet Union.

A. In Egypt, 2.5% of the population protested on the biggest day when the head was already deposed. That’s not a revolution. Central European revolutions – half the population was on the street. This was a military coup that manipulated a few special interest groups that were very Twitter heavy. And what will happen in Egypt is not going to be democracy. This is a reassertion of the old guard.

Q. Is the Arab Spring over or just beginning?

China’s social unrest is at an all-time high for the current governing system. And China is dependent on outside world for resources. Surprised if they last more than 3 years. $3.4 trillion in reserves (USD) – these assets are not viewed as assets of the country, it’s viewed as assets of the ruling elite. So when China falls, the money will disappear, just as it did in the Soviet Union.

A. In Egypt, 2.5% of the population protested on the biggest day when the head was already deposed. That’s not a revolution. Central European revolutions – half the population was on the street. This was a military coup that manipulated a few special interest groups that were very Twitter heavy. And what will happen in Egypt is not going to be democracy. This is a reassertion of the old guard.

Q. Is the Arab Spring over or just beginning?

12:10 China expands credit in good times; expect a credit explosion as economy frays. These are not good times.

Ride the dragon while you can. This is a brilliant system until it all falls apart. Chinese don’t want to fight with US. No matter how bad the decisions of US are, money is going into T-bills.

One-child policy means labour shortages by 2020. Normal growth requires overstimulus. China’s money supply is higher than US’s. 20% inflation unofficially, 6% officially. Social stability in China is not good. China is subsidizing commodities and finished goods.

Enron is case in point of no profits, all throughput. China’s economy is based on a similar concept. China’s been lending like crazy. New loans were equal to 25% of GDP in 2008. China is paying $8 to get $6 of economic output. They don’t expect to pay any of it back. If you have a bottomless supply of 0% loans, you can get a loan to payoff a loan. It’s not China’s money anyways.

China is messed up. Only one navigable river. North is breadbasket of China. Shanghai is NYC of China. Money’s made there. There’s been an agreement between Bejing and Shanghai to swap premiership. South is subtropical and it’s a gateway to foreigners. They’re used to having political autonomy and now feel subjugated. There are 3 distinct parts of China, and it’s only working because they bribe the hell out of everybody.

You’ll have 3 bailouts soon. This is the German golden age, and they want to keep the Euro, but on their own terms.

1. Sept 29 – Germans will ratify the EU bailout (90% chance of passing)
2. We start negotiating EFSF3 (quintuples size of bailout fund)
3. Then we kick out Greece of EU so they don’t have to bailout Greece and scare everyone else (Italy, Spain, etc)
4. Then there will be a cascading failure of banks (2012)
5. 2013: Codified in all EU states

This plan has a 1/3 chance of getting to the end. If this doesn’t work, Euro’s gone in 2012.

Who you need to be concerned about:

3. Belgium is not a country, it’s a compromise (FR, UK, Dutch). Debt burden 100% of GDP

2. Spain – Madrid cannot force 3 regions within to go with austerity. No matter what happens, it’ll always have an overhead financial drain. It’s the healthiest of the PIGS states but it will need a bailout.

1. Italy – it’s isolated from Europe by Alps. This has been the most capital-rich location in Europe for a long time.

Southern Italy is Greece on a good day. Somehow they ended up in the same country. Almost all income is in north, debt is in south. Government is led by a poor leader and it’s in its last days. A political campaign while they’re in huge debt and need to have austerity measures? That’s a big problem.

11:51 Germans have to come up with a plan. When you compete with German productivity on its rules, you have to borrow like crazy. The PIGS have done so. European bailout fund isn’t technically a treaty, it’s just an agreement. Germans can decide who gets a bailout and when. It can even bailout banks. But it’s not big enough, it needs to be about 5x bigger. 2 trillion euros needs, but 440 billion right now.

11:48 All river systems have a different ethnicity and political interest, so there is jealousy in Europe. 28 separate banking policies in Europe, and they don’t coordinate well. It’s a mess. Euro puts the high cap gen countries in the same low cap gen countries, and without unified regulation, there’s a lot of things going wrong. There’s a million people with no credit history with AA credit rating.

11:46 Finance is the primary tool available for a European redesign. Germany’s demographics are great for the next 10 years. They are at the height of their capital generation abilities. But because they’re in the Eurozone with Greece, the euro is artificially low. Export growth for Germany has been highest since the 1950s. Skewing the policies because there is a huge exporter at the heart of 2^nd largest economy (EU). Other countries are being penalized and can’t compete on quality like Germany can.

11:44 Chirac formed EU for France. Germany is now rewiring Europe to its own preferences. Financial crisis in EU? First time since 1940s that the Germans are making their own policy, and we’re seeing the effects of that.

11:43 The US’s blind spot is that it has historically been isolated and xenophobic. When rest of world touches it, overreaction (1812, Sputnik, Japanophobia, 9/11). US hasn’t overreacted since 2001, so it’s overdue (China? Paraguay? Iran?). Canada is good at stepping aside and letting the US go crazy.

11:34 US doesn’t have to be well-led because it’s a resource-rich country. The US has capital to burn and make mistakes with. US has learned how to ship cheaply within and without. Bretton Woods – US twist = we don’t care where or who you are – we will guarantee safety of the seas for all maritime transport. US had a catch – we’re going to rewrite your security process. Join NATO.

11:32 The river network of the US and the intercoastal waterway in southeast of US = the most waterways in the world. Cheaper to move things via water than anything else in the world.

11:31 This is the final presentation of the conference. Not going to lie, my fingers are looking forward to the end.

The Alpha Beta Conundrum
Speaker: Sandy McIntyre, Sentry Investments, Toronto

11:26 Core beta should be free; it’s a commodity. To get alpha, identify companies that focus on strong internal asset allocation: growth regardless of commodity or economic cycle. Don’t be afraid to trade – buy and hold is a tough proposition in a sideways market. I don’t look at EBITDA because I only own the cash flow. We insist on liquidity in the balance sheet.

11:17 Quality income outperforms. Investing in dividend growers is most successful strategy in Canada and US. In Canada, most volatile and least successful strategy is to speculate on non-dividend payers.

11:15 Energy is non-profitable growth. ROE today is lower than it was in early ’00 with oil at 25% of current price and nat gas at 40% of current price.

11:10 We have to take risks, we need to be rational. Understand where you are with demographics – where is the money flow going with the broad population? Stay in front of that flow as long as possible. Respond to fund flows when they give you price opportunity. We try to run our portfolios like a business and establish appropriate hurdle rates for capital allocation – company specific return on capital, assets, and equity. Also, the value of a business cannot be normalized across different capital structures. A highly levered company must trade at a discount.

11:08 With growth bias, alpha = superior performance. With income bias (baby boomers), alpha = lower volatility. We need investment income for our boomers, but quality sources of income are scarce. Back in the 1980s, we needed $384,000 to earn $45,000 in investment income. Today, we need $1.5 million.

11:06 OTPP has one active teacher for every two retired teachers. They don’t have enough capital. OTPP is going to be harvesting.

11:05 Sectors are bad capital allocators. We’ve thrown out the benchmark. Many of the Canadian companies in the benchmark are bad companies, so we’re not interested.

11:04 The 1974 low was greater than the 1970 low. We had a lower low in 2009 – it will be interesting to see how the next few waves play out.

11:00 When markets collapse, they will have aftershocks. The collapse low is rarely the final low. But markets rarely live at the lows. They recover. The third wave of this cycle should start late summer/early fall.

10:58 Volatility is structurally higher in a world of computers. When you layer in risk-on, risk-off ETF strategies, this injects volatility into the indices. We can modify the volatility in our portfolios by limiting our index exposure – counter-intuitive. Volatility spikes take time to unwind. Rarely would you ever get a low at the peak of volatility.

10:56 Risk aversion has driven bonds to be wildly expensive. Bond yield 2%, inflation 2%, after tax, an investor is getting a negative return for the privilege of 80 cents on the dollar 10 years from now. Hmmm.

10:54 High-yield debt and equities have slightly different volatility, but there’s not a lot of diversification between them. The only portfolio diversification you can get is between government debt and equities, though they have been trading together recently.

10:52 Predicts that after 2009, sequential troughs will be minor bear markets.

10:47 Earnings = nominal GDP growth over 79 years. If you have a slow-growth economy, you might want to modify your growth by adding an income component. You may want to shorten duration, too.

10:43 There are long cycles we watch: if money is flowing into an asset class, it reprices that asset class. We look at valuation cycle. We also look at something no one else does: the savings cycle. Chinese save 20%. I welcome the allocation of that capital. It’s building up in cash and near-cash. Eventually it will look for risk assets.

10:40 Markets will trough within 3 mths of exiting recession. March 2009 trough = consistent. You need a way of predicting turns in the economy. We use transportation stats – we were watching the number of ships in the port of New South Wales. We saw container loads picking up in May/June and Warren Buffett bought Burlington Northern in July.

10:39 I pay no attention to economic forecasts; rather I pay attention to the shape of the yield curve. If a company looked like it would default, we removed it from portfolio regardless of market cap. We held no tech.

10:38 Growth in a world where debt is being repaid is suboptimal. The G8 = the growth 8 economies. BRIC, Nigeria, Turkey, Indonesia, Korea.

The Evolution of ETFs
Speakers: Som Seif, Claymore Investments Inc., Toronto; Mark Webster, BMO Asset Management, Vancouver

A. If spot meets the futures curve, your return is zero. Spot has to outperform the curve for any return. That’s the same with oil, gas, VIX. You can’t buy natural gas and have spot. There are storage costs. Same with oil. You can’t buy spot oil. Closest you can get is some of the businesses. You need some sort of futures-based structure. Then you get contango. You have to use these products with caution and when you understand them.

Q. Tell me about tracking error, slippage with ETNs, futures?

MW: We work with index providers to derive a detailed methodology to look at capital constraints, liquidity, etc. We come up with the matrix and find out which companies pass muster. Some indices may have 14, 17, 20 companies, depending on whether companies meet the threshold.

Q. How do you determine which companies to equal weight?

SS: I’m not nervous about Vanguard because I’ve competed with iShares and won.

MW: iShares has been the gorilla since day 1. Vanguard is similar to iShares. Rather then see them as a threat, we’ll be beneficiaries. Consumers will have more choice.

Q. What do you think of Vanguard’s entry?

9:44 SS: We’ve created a broad commodity ETF. It solves a lot of the problems with investing in commodities long term. Most commodities indices are long-only. We’ve used a long-flat. It doesn’t have to have 100% exposure. Commodities are cyclical. Copper at $4 isn’t going to $8 before it goes to $2 again. We’ve equal-weighted risk across the buckets (metals, etc). If the price of a commodity is below the price over the last 100 days, it reduces to a zero position. If it goes back to the highest price of the last 100 days, it’ll regain a position. We want to capture the upside trend and the non-correlated exposure, but reduce the downside risk.

9:40 MW: We’re the only ones who’ve fully segmented the Canadian bond market. By credit quality, maturity – you can look at the shape of the yield curve to see what areas you want to exploit for your clients. This provides a lot more flexibility.

9:39 SS: Intelligent indexing is still passive. It’s based on rules. That’s a huge evolution that’s happened over the last ten years. It’s a better beta. Beta doesn’t necessarily mean market cap – it’s better beta.

9:30 Mark, can you comment on traditional indexing and more progressive ways of indexing?

MW: Market capitalization is representative, but it’s crude and simple. At times, in an overbought market, you’re taking on additional market risk that may not be suitable for your clients. It’s great on a broad index, but when you drill down to sectors, you get gross distortions that you want to avoid (you might as well go out and buy the stock that constitutes the majority of the index!). We use equal-weight methodology for our sectors. It gets away from the gross distortions. Equal weighting has been shown to outperform indexing. An equal-weight portfolio provides exposure to small caps, too, which provides opportunity for growth. We’ve also taken a hard look at exposures – our EM sovereign bond ETF is GDP-weighted. iShares has launched a market cap weighted EM sovereign bond ETF, but that overweights countries that have loaded up on debt. We get criticized for GDP weighting, but we like giving more exposure to countries who have the ability to pay down their debentures.

SS: Markets are inefficient on a daily basis, and probably long term. If you believe markets are efficient, the market cap weighted makes sense. If you don’t believe in efficient markets, then market cap is a bad way to invest. You’re effectively weighting companies based on inefficiencies. We believe in reversion of the mean – higher weighting to companies that will revert down, and lower weighting to companies that will revert up. Look at RIM – it was largest company in Canada in 2008. Not today. Hindsight is 20/20, but that’s because the markets get company’s value wrong. There’s overconfidence, emotion. What we believe is indexing and passive investing doesn’t mean benchmarking. Take the best of what indexing provides – transparency, low cost, low turnover, and discipline – and then step back and find out to weight and select securities more appropriately.

9:26 What are some opportunities with ETFs?

MW: The appeal for clients is these are transparent instruments. People want to know what they own and why. Low cost is of primary importance. In a slim-return environment, fees are material. Tax efficiency is also driving growth.

SS: They’re like a multi-purpose tool. Whether you’re an asset allocator, stock picker, or tactical investor, active investor – ETFs fit your business. They’re being used in all those different applications. When you think about asset mix, ETFs are a great way to get exposure to various asset classes. If you’re a stock picker, but you don’t care to focus on European or Japanese or commodities, do what you do well and use ETFs to complement the core. If you use active money managers, ETFs complement an active-passive model. I believe the future of investment management will be a blend of passive and active. There is good active and good passive. To think it’s either or is a silly notion.

9:22 SS: All ETFs in Canada are listed and regulated, even the total-return swap ETFs. Their structure is better than what’s going on in Europe.

9:20 SS: Big banks in Europe are issuing ETFs. You can take a lot of the junk on your balance sheet and throw it in the basket of collateral for a swap-based ETF. The spotlight is being thrown on the industry and people are starting to clean that up, but people need to be aware of this. We need proper education for investors.

9:17 MW: Counterparty risk exists for synthetic ETFs. Horizons (only provider of a swap-based ETF) has fully collateralized with cash. In a period of distress on the market, and there are redemptions on the ETFs, you’ll see an underlying spread develop due to illiquidity. And there is a counterparty risk to the gains, you may have to litigate to get your gain.

9:13 What are the risks and opportunities to ETFs?

SS: ETF is simple in its basic form. They’re regulated just like a mutual fund. That’s the traditional product we talk about; 95% of products today. Now people are trying to innovate and we see different approaches. In Europe: We see a more synthetic approach (derivatives, total return swaps). Investors need to understand the difference. Leveraged and inverse products: there’s a lack of understanding. Those types of products were developed during a high-volatility market. They’re only a small amount of the entire industry. They get a lot of attention, though. There’s a lot of people on Wall and Bay Sts. who want ETFs to fail.

9:11 MW: We’re seeing appetite from pension funds for asset classes they’ve found difficult to access purely – e.g. commodities. EM bonds, too – they don’t have in-house expertise to go after them and use an ETF.

9:10 SS: ETF trading is dominated by institutions. But 60% of inflows are coming from retail and HNW investors.

9:07 What types of investors use your products?

SS: They’re used by both institutional and retail. Nowhere else do you find that they’re treated the same. It’s democratizing investment management.

Day 2

The Risk Factor Approach to Asset Allocation
Speaker: Sebastien Page, PIMCO, Newport Beach, CA

A. Some investors will accept the tail risk because they have a longer time horizon and less month-to-month liquidity needs. But people care about what might happen during that time horizon. You could get fired. A lot investors get tail risk protection from a career perspective. And it might be hard to stomach large losses. So they still may want to hedge. If you look at risk within horizon exposure (what might happen along the way) and you have a floor for losses, then you should think about tail risk hedging differently than if you look at risk as just what happens at the end of the time horizon. Plus, with a long time horizon, you have horizon risk. What’s your client’s risk aversion?

Q. What is the time horizon for losses? Do daily losses matter when someone has a 10-year horizon?

8:40 Imagine the building’s on fire. Of course everyone’s going to rush out the door. In the markets, you need someone to take your place before you can leave (a buyer). This creates volatility and the rise in correlations. If everyone needs cash at the same time, we’ll sell assets that are liquid and they’ll all go down in value, even if they have nothing to do with each other.

8:39 In high volatility markets, average correlation across asset classes tends to go up. It’s a function of fear, in a sense. The fact that investors’ risk aversion is not diversified – we might be all invested in different risk assets that have nothing to do with each other. In normal times, they won’t correlate. But when volatility strikes, we panic and we all sell liquid risk positions (regardless of whether they are $AU or Apple stock) and things start to converge. Liquidity plays a similar role and can’t be easily separated from volatility shocks.

8:35 Financial engineering and the tools we use to manage risk from the top down have come under scrutiny. In the wake of the crisis, there are 4 key changes in the way investors allocate assets. 1. Need a forward-looking macro view. Our models should reflect that rates may rise. 2. Investors now diversify across risk factors, not asset classes. 3. Investors recognize importance of a dynamic approach to asset allocation. Capital markets expectations should change according to what’s happening in the world, not passage of time. 4. Investors are focusing on exposure to large losses as a measure of risk, not volatility.

8:30 How to hedge fat tail risk? Buy a put option on the equity market (main driver of risk), and cut parts of the left tail (buying insurance on the portfolio). How to think about this? Care about how much I’m spending to do that, and take into account the fact that with a safer car I might drive faster. Once I’ve hedged the tails, I might increase or keep my exposure to risk assets that generate higher return. So for the same tail risk, you can either sell off all your risk-generating assets, or hedge. Think about the world in a non-linear way. You can now buy tail-risk hedging funds for your clients.

8:29 Imagine for 9 years you’re a talented investor and gain 10%+/year. Then in year 10, you lose 25%. Your cumulative track record is now 5.9%. Extreme events can impact your entire career’s track record as a talented investor. The fat tail matters.

8:26 Left tail events tend to occur more frequently than “normal” distributions predict. Volatility tells you why the range of outcomes exists. Skewedness is more interesting: tells you whether a loss of 30% is more likely or less likely than a gain of 30%. If an extreme loss has a higher probability, distribution has negative skewedness. If you use a normal distribution (assuming volatility as your risk metric), the probability of a 7% one-day move in the Dow Jones, is once every 300,000 years. Yet in the 20th century, the DJ has moved by 7% or more 48 times. So in the markets, the tails are always fat, especially the equity markets. Do not rely on the assumption of a normal distribution.

8:24 Imagine: in this room, there is AC/DC in the back = equity risk. String quartet is playing in the front and represents bond risk. Which one are you more likely to hear? (Back in Black, right?)

8:22 Implicit + explicit beta = larger than what you would think based on asset class allocation. Equities are also the most volatile of risk factors. The equity risk factor also correlates with other risk factors. There are only 2 possible asset classes: risk assets and nominally safe assets.

8:20 We’re looking at a pie chart of a typical institutional portfolio – with lots of “diversification” thanks to different asset classes (no one asset class over 24%). Yet when that same pie chart is translated to risk factor allocation, equity risk is 79%. To calculate contribution to risk from a given risk factor, we must multiply our exposure to the risk factor (beta for equities) x volatility of risk factor x correlation of risk factor to rest of portfolio. Each of 3 elements contribute to the 79%. You have more equity beta than your direct exposure to that asset class.

8:19 Asset class diversification sometimes works on average, but not when you need it.

8:17 The myth of diversification: data from 1970s onward shows when US equities and world-ex-US equities are up by 1 standard deviation or more, the correlation between is -17%. But during months when both markets are down by 1 standard deviation or more, the correlation is +76%. There’s an asymmetry in the diversification properties of these two asset classes. In asset class world, you might rely on the average or correlation over time, and infer you are getting diversification. You are, but you’re getting it when you don’t need it (when markets are up). So use a risk factor diversification instead.

8:14 Risk factor vs. asset class correlations – we can see average cross correlations are high for asset class correlations and low for risk factor correlations. Asset class correlations on average increase from 40% to 59% from a quiet to a turbulent market.

8:10 People care about size, value, growth exposure, tilt, momentum for stocks. Duration is number one risk factor for bond investors. They also care about spread duration exposure and exposure to the slope of the yield curve (linked to inflation expectations, drives volatility). Between stocks and bonds, two different asset classes, there are common risk factors: volatility, liquidity.

8:07 Volatility can be a misleading measure of risk. Two asset mixes with same volatility can have different exposure to loss. Standard deviation does not capture “fat tail” risk.

8:05 While historically investors have focused on fixed time horizons, increasingly, investors are recognizing the dynamic nature of markets. The old way is strategic capital markets expectations, hire a consultant, come up with a policy mix, and then forget it for 3-5 years until it’s time to update the study again. Markets change in ways that have nothing to do with the passage of time. If there’s a crisis within your 3 year time horizon, your asset mix should change and so should your expectations. So a static time horizon is changing to become a dynamic horizon.

8:04 Risk factors are the fundamental building blocks of asset classes. It’s better to diversify across risk factors than asset classes.

8:03 A macro view of the world is important, but I’m a quant at heart. People ask, isn’t your approach misleading because it uses past data? I respond, I’ve looked for future data, it’s hard to find on Bloomberg.

8:01 Apparently there is a link to AC/DC in this presentation. Stay tuned, indeed.

8:00 Welcome back, everyone! We’re all back and ready to learn more about asset allocation after a breakfast that included flapjacks and bacon. mmm.

That’s it for now, folks – see you tomorrow for Day 2 of the Calgary CFA Wealth Management Conference 2011. Good night from Cowtown!

Exploiting the Volatility Anomaly in Financial Markets
Speaker: Harin de Silva, Analytic Investors, LLC, Los Angeles, CA

A. We have no sector constraints. Some people are uncomfortable with that. Plan sponsors in institutional community were uncomfortable with missing out on an entire sector. MSCI World Min Volatility Index does have some constraints, something like bringing a sector to no lower than half market cap.

Q. Is there a constraint on sector or industry weighting for low-vol portfolios?

4:35 Short volatility ETFs are relatively expensive. I haven’t seen one yet with a reasonable management fee.

4:31 The golf course effect – people talk on the golf course about how their portfolios are lagging in an up market. If you think of low-volatility as part of a integrated asset allocation strategy, you don’t see this kind of lag. Say you have a portfolio 100% in MSCI World, and take 40% of it and put 20% in low-vol stocks, and 20% in emerging markets, you’ll have same volatility as MSCI World but with higher returns due to EM equities. Therefore no lag!

4:30 To benefit from a low-volatility portfolio, you need a longer run horizon to exploit the benefits of compounding – so likely more persistent than other more publicized anomalies (small cap, value etc). (2009-2011 has been unusual)

4:29 Looking at 6/30/2011 to 8/29/2011, S&P low volatility index down 3.6%, S&P down 8.37%, S&P high-beta down 18.13%.

4:27 You can short high-beta stocks/ETF – don’t want to sell stocks and realize the capital gain. There is an S&P High-Beta Portfolio. You can use this as a hedging tool.

4:25 MSCI World Minimum Volatility Index and MSCI World only have a correlation of 0.92. With Dow Jones Emerging Markets, correlation is 0.72 (versus 0.8 with MSCI World). With HFRI Fund of Funds Composite Index, correlation is 0.57 (MSCI WMVI) versus 0.66 (MSCI World). So the correlation is lower, which brings a lot to the table.

4:22 In a crisis, low-volatility portfolios do well – look at Pacific ex-Japan during Asian Financial Crisis. Most people don’t have something does well on a relative basis when there’s a crisis, so these low-volatility portfolios can be added.

4:19 If people are running away from risk, low-volatility portfolios do better. When people run towards risk (2009), they underperform. In the long-run, risk aversion goes nowhere. That means the portfolio gets a higher return overall through the compounding effect.

4:17 The market portfolio should outperform the minimum variance portfolio. What if the min variance portfolio outperformed the market with less risk? 1968-2005, that happened, with lower volatility (MVP=6.5% return, 11.7% standard deviation; Market Portfolio=5.6%, 15.4%)

4:16 The highest quintile of beta is doing the worst as of Aug 2011 on MSCI World.

4:14 60/40 stocks cash beta = 0.6. If you buy a portfolio 100% invested in 0.6 beta stocks, then you get 100% equity risk premium but 60% of the volatility.

4:13 Over the long run, there has been no extra reward for choosing volatile stocks over stable stocks.

4:10 Style = small cap, momentum, value, large cap — but think of volatility as a style. Volatility minus Stable = VMS style. Or defensive and dynamic (as per Russell Investments) = not just price volatility, but quality of earnings, etc.

4:09 People buy 2x levered ETFs because they don’t have enough borrowing room, even though 2x ETFs are far more expensive (fee-wise) than ETFs that you would just lever up yourself.

4:06 It’s a systematic anomaly. So why does this exist? 5 years ago this was a hot topic in academic finance community. More than half of PhD theses were on this topic. 3 explanations: 1. market portfolio is inefficient 2. investors treat high-beta stocks like a lottery ticket (negative expected value, but people still buy it because of a small chance of an outsized gain. same thing with high-beta stock) 3. limits to borrowing create “overpricing” of high volatility stocks. If you’re aggressive, you’d borrow money and lever up, but many people don’t do that. Investors buy high-beta stocks and they get overpriced because of limits to borrowing.

4:05 Every region of the world, if you hold a high-risk portfolio, you’re much worse off because the volatility drags the return down.

4:04 The higher the volatility, the lower the geometric return is going to be. Investor wealth is tied to geometric return, so higher volatility = lower client wealth.

4:01 Low-beta portfolios tend to have lower volatility and higher returns than higher-beta portfolios.

4:00 In other words, it’s not a upward sloping straight line as we’ve been taught.

3:58 We separate stocks into volatility quintiles each month based on historical info and calculate cap-weighted monthly returns. We found no penalty for lower volatility. Some higher-volatility stocks return less than lower-volatility stocks.

3:56 What is it? Think of the risk/return linear relationship we’ve seen in textbooks. But if you look within an asset class, you don’t see a relationship like this. Investors misprice risk in global markets.

3:55 Last session of the day. We’re going to talk about an anomaly worth exploiting: the volatility anomaly.

The Use of Trusts in a Tax and Estate Planning Context
Speakers: Sandra Mah, Gowlings LLP, Calgary; Dennis Auger, KPMG, Calgary

Must document that trustees meet in Alberta (or desired province) once a year at least so that it’s a Alberta-resident trust.

3:25 Example: $1,000,000 invested at 6%. Spouse, two children with no income. Loan to trust @1% = $10,000 beneficiary must pay to loaner (can be in form of paying for kids’ private school tuition or something like that). $60,000 – $10,000 = $50,000 in income to be divided among spouse and two children. Each pays $1,000 in tax (Alberta). You would pay $19,500 in tax (39%) so you’re saving $16,500.

3:24 If trust invests in straight portfolio investments with the loan, kiddie tax will not apply. (cannot be a related organization, like your own business)

3:23 Loans for value – as long as you charge a prescribed rate of interest and it’s paid – currently 1%, then attribution rules don’t apply. Doesn’t have to be a trust, but useful in trusts. Rate is locked in at time of making the loan, so now is a good time to lock in 1%. Income split: loan the trust money for the beneficiaries. To avoid reversionary rules, it has to be a cash loan with interest – a bona fide loan.

3:22 Age 40 trust – non-discretionary trust. Allows a parent to utilize a child’s lower marginal tax rates until the child turns 21 years old. Minor beneficiary is vested with the right to income and taxable capital gains of the trust on an annual basis. Income and taxable capital gains earned by the trust before the minor turns 21 can be retained in the trust until the minor turns 40; after 21, the income and taxable capital gains is paid to the beneficiary, however, everything earned before age 21 can be retained in the trust until age 40.

3:20 Capital gains taxable to the child; s.74.1(2) attributes interest or dividends to the parent. If it’s a true trust, you have to file a T3 and make sure the amounts are paid back to the beneficiary. Another downside: what if the minor passes away? You can’t amend the trust. What if the person setting up the account dies? Only works if everyone is alive. The law of the default is that the public trustee maintains until age 18. If beneficiary dies, intestacy laws apply. Can’t just get the money back.

3:18 In-trust accounts prolific, but may or may not actually be a trust. e.g. grandparent or parent wants to set up an account for their child or grandchild, but no written document exists. If you have 3 certainties, you have a trust. But what is in-trust? Is it a gift? Bare trust? True trust? If you don’t ask, someone can interpret it for you. CRA leans towards bare trust (child takes full control at age 18).

3:17 You can give all the benefits of ownership without physical ownership with a trust.

3:14 Trust should be settled with cash from owner of property. Beneficiaries are spouse and children. I’m no longer owner. There is no estate tax if I die. But if my spouse dies, then I’d have to pay rent to my kids.

3:12 Owning US real property with a Canadian trust. Advantages – Avoids “shareholder benefit” issues; Preserves ability to obtain beneficial US long term capital gains rate on sale; Avoids US estate tax for Canadian residents. Disadvantages – 21 year rule, Death of beneficiary spouse before settlor spouse – surviving spouse should rent at FMV

3:11 Principal residence exemption possible for at least one “specified beneficiary” or a qualifying family member of a specified beneficiary who “ordinarily inhabits” – but there are lots of issues here, so not easy and likely not worth it.

3:08 Utilize trusts to hold domestic vacation property for future generations. Trust doesn’t have cash, just property, so it’s ok if the trust funds operating costs.

3:07 Charitable remainder – not sure what the magic age is, but likely 70s. Private foundations are being seen a lot more. It’s a way to instill the charitable feeling within whole family.

3:05 Assume Mrs. A has a son with a successful business, but does not have much wealth; Mrs. A establishes a testamentary trust for the benefit of her son, daughter-in-law and children and provides a contribution of $1.00 to the trust; Son undertakes an estate freeze; the testamentary trust uses the $1.00 to acquire new common shares of son’s business. Income earned by the testamentary trust is taxed within the trust at its marginal tax rate. Since the income is taxed in the trust, no income is allocated to the beneficiary to attract the kiddie tax for minor beneficiaries.

3:03 A charitable remainder trust: if someone owns land and knows it will be targeted for a charitable donation, makes the donation today, gets the tax credit while alive, and on death, the asset passes to the charity. Benefit: the donor gets the tax credit while alive and can use it while alive. But for this to work well, the person has to be older, because you have to figure out the discounted value of the donation today. He gets the benefit of the use today, too. The discounted value would become so low when the person is younger as to not be useful.

3:00 Disadvantage of spousal trust: Only spouse can access trust funds (but can then give to others). You can easily taint the spousal trust. One of the sentences in most wills is the executor can make loans as they see fit. If the executor makes a related-party loan, that is sufficient to taint the terms of the spousal trust because not all the income is being used for the spouse. Therefore, to un-taint, you have to obtain a court order to give the spouse back all the assets.

2:58 After death of second spouse, residual beneficiaries say “you shouldn’t have spent so much” because you had obligation to make sure there was enough for the residual beneficiaries (can lead to litigation against trustee due to even-hand rule).

2:57 You get to know your clients well when you dig in this area – which spouse wants more control? Advantages: Avoids deemed disposition of assets on death of taxpayer (executor can elect out for some assets); Access of spouse to capital could be restricted or at discretion of trustees during his/her lifetime; Not subject to 21 year rule

2:56 Spousal testamentary trust requirements: Trust set up by will; Spouse must be entitled to receive all income during his/her lifetime; No person other than spouse may receive or otherwise obtain the use of the income or capital of the trust during lifetime of spouse; Spouse must be Canadian resident at taxpayer’s date of death. This helps because it defers everything until the second spouse dies.

2:54 A lot of people overlook insurance trusts. It’s created on death (testamentary). Advantages: Avoids probate and creditor attachment, avoids public trustee involvement for minor children, Separate trusts for different people or objectives. Disadvantage: Subject to 21 year rule.

2:52 Disadvantage of alter ego: like all trusts, it’s a one-way street – cannot change once started. That causes a lot of people not to go ahead. Other disadvantages: no rollovers on death to spouse or spouse trust or testamentary trust; on death, trust assets are treated separately resulting in no utilization of losses or gains in trust against estate losses or gains; can’t carry back losses; any gifts at death are not eligible for “gift by Will” benefits.

2:50 Alter ego trusts quite common in estate planning. Transferor must be 65 or more and Canadian resident; only transferor/spouse can receive income or capital from trust during lifetime. This trust reduces probate fees, no FMV disposition on transfers in, asset management in event of incapacity, possible creditor protection, avoid spousal or dependent relief claims, no 21-year rule.

2:47 CRA is auditing HNW individuals. Asking details about trust, where trustee(s) lives, where bank account is, how much input beneficiaries may have. Trustees need to consult with beneficiaries as part of fiduciary duty but if they do, could raise the CRA’s concern due to where the beneficiaries live.

2:46 Rule against perpetuities – don’t want to take an asset out of the system forever. If you have a client that wishes to create a trust that doesn’t offend the rule of perpetuities, can establish it in Manitoba because it doesn’t have that rule.

2:43 “Trust in the middle” – more common these days – used to see Trust > Holdco > Opco. Now we want Opco to pay cash into Holdco. But if someone says they want to buy Opco, but buy shares from Holdco, but Holdco not exempt from capital gains since it’s not an individual. So “trust in middle” means Holdco accumulates and then trust allocates any capital gains to Holdco. This allows for creditor protection if someone wants to buy Opco.

2:41 Corporate ownership of a trust is good for creditor proofing, income splitting/estate (succession) planning. Also you can multiply the QSBC capital gains exemption and gain control.

2:39 Trusts are resident/taxed where the central management and control is located and not necessarily where the trustees are located.

2:38 Trusts deemed to dispose of assets at FMV every 21 years unless exempted. Accumulating income (tax paid) accrues to capital.

2:37 Assets transferred to trusts usually occur at fair market value with tax consequences to transferor unless exemption (alter ego, joint spousal, bare).

2:36 A trust is normally treated and taxed as a separate individual, and in the province the trust resides in. Allocations are deductions from taxable income. Trust income retains its character: dividends, capital gains, foreign income to beneficiary. Cannot allocate losses or donations.

2:32 Different provinces have different rules about what constitute prohibited investments.

2:31 This all may seem easy and clearcut, but it’s not. For example, in AB, if you just have “spouse” and it’s not defined more specifically, a spouse can only be a married person according to law. I came across a trust that was established in the late 90s, and it wasn’t further defined. Much to everyone’s horror, the person that was thought to be the beneficiary wasn’t actually the beneficiary.

2:29 Trusts are taxed as separate taxpayers. There are three elements to establish that you have set up a trust:

1. Intention: Settlor must have the intention to create trust by the transfer of property in trust
2. Subject matter: The property being transferred must be clearly identifiable
3. Objects: The beneficiaries must be ascertainable

2:27 Inter vivos trust is set up during lifetime, used to save probate fees from other jurisdictions (e.g. BC and ON). Taxed at highest marginal tax rate with a December year end. In Alberta, $400 is max for probate fees, a taxi ride in Toronto.

2:26 Testamentary trusts arise as a result of death. Can create multiple trusts within a testamentary trust. Taxed at marginal tax rates, has a fiscal year end. And taxation of income earned in trust reduced by amounts paid or payable.

2:23 CRA is paying a lot of attention to trusts, and what actually constitutes a trust. The basic elements: settlor (living – inter vivos, testamentary – deceased); trustee (holds and owns property, has fiduciary duty, and can be sued by beneficiary); beneficiary.

2:22 HNW owner-managers are increasingly using trusts. We’re seeing this a lot on death and in the will.

Real Assets: Should you be looking at Infrastructure, Real Estate, and Agrilands?
Speaker: Eric Bonnor, Brookfield Asset Management, Toronto, ON

A. Farmland owners looking to increase their land base can afford those prices, but anyone looking to invest is probably paying too much.

Q. Is US farmland in the midwest in a bubble?

A. Direct private investments are quite popular, it just depends on whether there is enough capital. 3Ps occur because the government doesn’t have enough money to build schools, hospitals, etc. ON, BC have established 3Ps, and AB, QC are starting to go down that route. Many contracts being signed are not inflation protected. And 85%-95% debt, equity the rest, so that may not be attractive. Returns are usually sub 10%. Governments are going to try to push things to private sector, though, since 3Ps are still expensive.

Q. Why are public-private partnerships (3Ps) so popular in Canada?

2:10 China now accounts for about one third of globally traded logs.

2:08 Pine beetle is threat to North American timber supply – has reduced it by 25%. With housing demand being so low, there are a bunch of trees that are dead and aren’t being harvested. But once housing starts get back to a reasonable level, there won’t be enough trees to feed that because the current dead stumps will only last 5 years or so.

2:07 As countries develop, they consume more animal protein. We won’t be able to feed them all, and we are seeing declining yields in agricultural crops. We can’t keep up with the demand.

2:06 Re: timberlands, US Pacific Northwest has most opportunity; U.S. in general has the most opportunity of all countries. There is also a lot of regional variability.

2:05 For timberlands, purchase price and returns are a function of several characteristics, including: species mix, land productivity, cost structure, regional converting industry, country risk and fibre supply agreements

2:04 Brazil has a lot of grains, beef, cattle, chicken, orange juice – has the best climate, soils, and lots of land. It’s also not subsidized. So an attractive investment.

2:03 Political risk in emerging countries is a factor in agrilands. Also, weather risk, commodity price risk, currency risk, technology risk, etc.

2:02 However, there are only a small subset of private managers that you can go to invest in timberlands. Also small number of listed securities, but ETFs can help investors get access. There are also very few pure play companies to get access to farmland.

1:58 Now we’re going to look at agrilands and timberlands. They provide stable, long‐term total returns. Returns provided through current income from the ongoing sale of commodities (crop or livestock or timber) or lease income; capital appreciation of land including conversions to Higher and Better Uses (“HBUs”). Also, returns outpace inflation, there’s a positive correlation with inflation, and they provide portfolio diversification. Agriland and timberland investments have historically provided high returns with low volatility.

1:57 Large institutions are investing directly. Pooled funds another option, but has fees.

1:56 Another way to invest: listed securities. ETFs, trusts. And also debt: Project finance, Long‐term debt, Commercial Mortgage Backed Securities, Residential Mortgage Backed Securities (RMBS). Debt investing means you’re not subject to certain cap gains taxes.

1:55 How to invest? Directly – unlisted vehicles, including through limited partnerships (private funds or fund‐of‐funds). Or direct ownership of an asset or private company, either wholly‐owned or partially‐owned through co‐investment.

1:52 Pension funds interested in infrastructure because it’s good to invest in for long-term liabilities.

1:51 Infrastructure recognized as a separate asset class. For listed pure‐play securities – globally there are over 232 listed companies with a current market cap of approximately $1 trillion. For unlisted funds – over $150 billion has been raised since 2003 for private unlisted funds.

1:50 Lots of people interested in real estate, but too much capital chasing will force yields down.

1:48 Infrastructure has attractive Sharpe ratios for infrastructure and low correlation in a normalized world = low volatility.

1:47 Good idea to invest in infrastructure because of need in both developing and developed countries for maintenance, replacement, and new builds.

1:46 Real estate has more attractive risk-adjusted returns than other asset classes compared to emerging markets, for example.

1:45 Real estate investments have generally done quite well compared to other asset classes. Over 20-year period, has done well. Also has low correlations (historically, aside from 2008 crash) with other asset classes.

1:43 Why invest in real estate and infrastructure? The commercial real estate debt market faces a looming challenge in the form of rising maturities. Rapid growth in the mortgage market during the last eight years has created what will be record volumes of maturing mortgages, at a time when capital has become constrained. Falling valuations and a weaker economy are expected to put further pressures on this market.

1:41 Drivers different for different types of real estate – commercial is driven by interest rates, for instance.

1:37 Sector is attractive because of diversification, inflation hedging, steady current yield. However, varies across regulated utils, transportation, social (schools and hospitals), core real estate.

1:36 We’re going to look at real estate and infrastructure, then agrilands and timberlands.

1:32 Aaaand we’re back from a delicious Greek lunch (complete with baklava). Conference to reconvene shortly.

Alternative Beta Investment Strategies
Speaker: Mark Armbruster, Armbruster Capital Management Inc., Rochester, NY

A. There is probably no risk-free asset out there. That’s an academic question; I’m not sure whether the downgrade is going to affect whether or not to include those assets in your portfolio. Get things that will be additive, even if they’re not perfect. In many cases, the data I’ve used here isn’t complete, so ultimately you have to be comfortable with some qualitative factors – take a leap of faith based on quality of managers, how long the company’s been in existence, etc. While you can’t do the hardcore analysis, it might be good enough for now, otherwise you’re stuck with stocks and bonds.

Q. Can you comment on whether risk-free assets exist if the US has lost its AAA status?

Private REITs have advantage of only being evaluated quarterly or semi-annually, and aren’t priced daily. The numbers are smoother because of that, but who cares? It’s an issue, but I’ve made my peace with it.

A. Canned response: 80% over time do not beat the market. You can also look at SPIVA stats. I tend to be more of a passive guy.

Q. What % of active funds beat the S&P?

A. Hedge funds pick up nickels and dimes and apply leverage to that. That will continue. Risk management is hopefully more robust, but I’d rather get my exposure through more transparent vehicles.

Q. Hedge funds are vulnerable to margin calls. Has this risk been lowered?

12:14 In sum: don’t just use stocks and bonds. Hedge fund’s alpha proposition is dubious. Diversification, low costs, and tax efficiency are proven drivers of portfolio value added. Add alternative asset classes through beta instruments.

12:12 Over time, alpha becomes beta. Value investing is now beta, when it used to be alpha. The lines are blurring. Traditional beta is tax-efficient and boring. Now I am focusing on exotic beta.

12:10 Everything I’ve shown so far has been passive, but you can overlay some tactical asset allocation and active management.

12:08 This all works because there is low correlation (-ve, single-digit) between alt asset classes and S&P 500. There are other opportunities: frontier markets (ETFs), private equity (direct or ETF/mutual funds), British soccer players, water rights, patent portfolios – sky’s the limit!

12:07 Point is, we shouldn’t be restricted to just stocks and bonds. So start using alt investments. Using Brazilian farmland is no less valid than a bond.

12:05 With Portfolio 1, the min variance portfolio = 30% alternatives. Portfolio 2 = 60%, Portfolio 3 = 90%. But I don’t advocate that unless your client has really deep pockets; it’s just here to make a point.

12:00 Ran Portfolios 1-3 through historical markets March 2000 to June 2011. There has been downside protection. 2008-2009 bear market – everyone says diversification didn’t work, but it did help to have these alt portfolios. Saved 600-700 basis points in downside. There is some degree of protection, but it’s not treasury bonds. So I argue that diversification does work, even in extreme markets.

11:59 Farmland, timberland and private REIT are now added to Portfolio 2 to create Portfolio 3. Volatility now lower than HFRI and returns still higher.

11:58 We now add backtested alternative strategy sample data – including hedge fund beta, managed futures – to Portfolio 1 to create Portfolio 2. Return is now higher than HFRI and volatility similar.

11:57 Portfolio of equal weighting high-yield bonds, commodities, EM debt, REIT, int’l REIT, and currency investments have similar return to HFRI and slightly higher volatility. However, keep in mind the HFRI returns are likely overstated! We’ll call this Portfolio 1.

11:53 Ok, so use ETFs instead. They’re low-cost, liquid, mostly beta, low minimums, easy access, and often tax-efficient. Alternative ETFs aren’t as tax-efficient as stock ETFs, however. Hold them in an RRSP.

11:52 Hedge funds are short on style, value stocks; there is some momentum exposure, they are investing globally. They’re not overly exposed to developed markets outside the U.S. You get an R2 of 84% – so F/F model explains hedge fund returns well.

11:50 Alpha is 0.32 but that’s unadjusted. If you adjust for the 4%, there’s probably none.

11:49 Ran the HFRI through the Fama-French model and found an R2 of 78% – the model does a good job of explaining hedge fund returns. You are getting a lot of US stock market exposure when you buy hedge funds. In practice you’re not seeing the “alternative” aspect.

11:48 Alpha isn’t there when you adjust for 4% bias inflation. You also don’t get absolute returns – you still see drawdowns. The volatility is actually understated because of data problems. Lack of correlation is actually 73.5% when you correct for bias.

11:45 Studies show that there is survivorship bias, backfill bias (don’t report to database until you have great numbers) — the performance is based on voluntary reporting. Funds tend not to report at end of life. Also hard to value investments that trade on private exchanges. Hedge fund returns could be overstated by more than 4% annually.

11:44 Hedge funds promise alpha in return for high fees. They’ll give you absolute returns (protection in downside) and uncorrelated to traditional asset classes. Yet there are problems: high fees, lack of transparency, tax inefficient, lack of oversight, lockup periods, moral hazard, high minimums. They can be roach motels. And it’s tough to play.

11:43 HFRI (hedge fund research index) has annualized return of 11.8% versus S&P500 of 8.6%. Annualized volatility only 7% compared to 15.1% with S&P500.

11:42 Find something that complements your existing portfolio.

11:40 Alt investments = asset classes that are uncorrelated to stocks and bonds (e.g. commodities, Brazilian farmland, real estate). They can also be defined as investment strategies that use traditional asset classes like stocks and bonds in unique ways (e.g. arbitrage, long-short, managed futures). There is a beta component to these strategies.

11:39 You should be using alt investments to enhance your risk-adjusted returns and they should be a part of your diversification strategy. Also, they shouldn’t be defined with an alpha focus, but rather unique risk exposure (exotic betas for lower cost).

11:37 I’m a proponent of hedging risks, and I’m also cheap. But hedging involves paying something. Those all weigh on the expected returns of a portfolio. So I’ve taken the poor-man’s hedge: massive diversification.

Opportunities and Risk in the Coming Double Dips
Speaker: Sean Egan, Egan-Jones Ratings Company, New York, NY

A. I’m cheap. I would put some in short-term safe deposits to wait for the EU storm to pass. Then put a good portion in some safe funds – there’s an ETF that invests in biz development companies that’s yielding more than 8%. Then find a company like Boeing that’s like a utility – where you don’t have to worry about future demand or income, and they can weather the EU storm coming in the next 2 years. The EU is the biggest buying bloc on the face of the earth. If that is off to the side for 3 years, then it affects the global economy. China slows down; it’ll continue to grow, because it’s developing, but it won’t grow at too high of a rate. All the assumptions built into investor pricing get thrown out the window. The resource-rich producers won’t have the demand they used to, and pricing won’t be there. It’s a reset to the global economy. We don’t fully understand how massive this is. Will the good continue to ship from Brazil, Canada, US, to China? Yes. But the level and pricing will be lower. We don’t think these assumptions are priced into stocks.

Q. If you had $5 million to invest, how would you do it?

A. There’s a crisis on, and forget about printing drachmas. You can do it, but it’ll take time. The bigger issue is solving the problems in the EU banks so you don’t have deposit flight. You want to do that quickly. Europe needs a Hank Paulson who can understand the situation and has the gravitas to act. It’ll take 3-5 years to restructure the EU. It should be a future solution.

Q. What are you views on the euro?

A. The munis are a lagging indicator. The US credit calling has improved over the last 18 mths or so. We don’t worry too much about most municipalities. There’s still problems with breaking contracts and there will be progress. We’re not spending a lot of time there.

Q. State budgets in US – can you comment on municipal bonds?

A. It’s not obvious they will get a bailout. UK government is dealing with other fires like the Murdoch scandal. They won’t get a lot of support.

Q. Do you include UK banks in EU banks?

A. They’re some of the best capitalists in the world, and if they’re there, they will look at assets (Italian, Portuguese companies) and they’ll buy them to get access to raw materials, markets. It’s highly unlikely they will save the EU, they’re too smart for that.

Q. Is China a credible source for a bailout of EU banks?

11:14 We haven’t figured out how to get paid by the issuer and still rate it effectively.

11:12 Safe havens over the next 6 mths: US and Canadian banks, US and Canadian sovereigns, utilities, India (safer than China, anyways)

11:10 2012: return of buyout. EU banking crisis will only be solved with a TARP-like program.

11:09 2011 major themes: stabilization of US banking, recovery of North American auto industry, recovery and structural change for airlines, improvement of technology industry, EU crisis. Waiting for the return of the buyout to happen.

11:07 We’re living through market aberrations. Boeing has a 5-year backlog. Market cap is $40 billion, TTM net income is $3.5 billion, so 8.8% and growing. Compare that to U.S. Treasuries at 2.6% for 15 years. I’ve never seen anything like this. So what will happen? Will Boeing’s net income slide? Or will market be so difficult that U.S. Treasuries are safe haven? I have no idea.

11:05 No one knows where we are going. The answer is in the EU’s handling of the crisis.

11:04 China is manufacturing-based – so huge financial and operating leverage. When orders go down, the profits go down by 2-3 times as much. China is on thin margins. India – service sector demand goes up, increased efficiencies due to software improvements.

11:02 Today’s negatives: baby boomer retirement. High sovereign debt for U.S., Japan, EU. Real estate overhang (3+ years). Global structural imbalance (China), flaws in construction of EU.

11:00 Today’s positives: Huge emergence of middle class in Europe. Productivity gains continue (3%+). Most of the world believes in capitalism. No major wars. U.S. credit crisis has passed.

10:58 Other firms had monolines at AAA, we had them at B.

10:54 Germany’s debt is $1.4 trillion, and do citizens want to absorb other countries’ debt?

10:52 Sovereigns need to inject capital at shareholder level.

10:50 Hope is closing for the EU banks. The only hope is for a TARP program – government buys the assets @ 100 cents on the dollar. They’re doing a bit of that in Germany. These banks need capital. Can’t absorb the losses from the periphery countries, which is a big problem.

10:49 The periphery banks and European banks aren’t looking very good. That was a sweet call. My 16 year-old son agrees. Those banks are now down 40%-80%.

10:47 Portugal and/or Italy will be next after Greece.

10:45 There will be a 90%+ haircut. It may not happen right away, but it will. They don’t have the revenues to support the debt.

10:42 I was saying a year ago, Greece is going to default. Recovery rates aren’t going to be near what people think they’re going to be. As of 6 mths ago, they’re talking about a 10% haircut. Ain’t gonna happen. With restructuring, 20% haircut isn’t realistic. You have an entity, Greece, with a primary deficit (their revenue minus expenses, excluding interest, is negative) and people are avoiding taxes. The situation isn’t getting better. Greece can only support a nominal amount of debt.

10:40 We’ve been threatened with suit 12-15 times, death a few times (in connection with Ford and GM crisis).

10:33 Egan’s rating company cut the U.S.’s rating before S&P did, incidentally. Not paid by issuers, only institutional investors. Luxury of calling it as we see it. Put them on negative watch on March 1, ahead of everyone else.

Meeting the Challenges of Intergenerational Wealth Management
Speaker: Lisa Gray, grayMatter Strategies, LLC, Richmond, VA

A. I’m not advocating abandoning prudent risk management. The best form of risk management is opening up the lines of communication. But there are things we can’t do anything about, like external threats. So creating a check and balance is a good idea. If you educate the trustee and beneficiaries about each role, they can understand why those checks and balances are there and avoid resentment. You have to have an apprenticeship for understanding wealth and how to use it.

Q. Re: spoiling children – I’ve seen where kids don’t get capital unless in an emergency, with permission of trustee. It seems practical. Is that a good strategy?

9:54 There’s a secret marriage between family governance and private wealth management to help families succeed.

9:50 When a family with a business doesn’t communicate – two things can happen. A dissatisfied child starts a competing business, and takes away market share and expertise. Meanwhile, the wrong sibling runs the family business into the ground. The parents, seeing the disaster, divorce. Or, the parents can realize they need to talk to their kids and realize they can leverage their kids’ strengths into making the business better.

9:41 The two questions I hear most often: How can I keep my wealth from spoiling my children? How can I make sure my wealth passes onto the next generation? Those are the wrong questions. The act of asking promotes the inevitable fulfillment of spoiling children and wealth not passing on. You can’t think of just one wealth pie being sliced into smaller and smaller pieces. Think of the dynamics of the family instead and the family’s hidden assets.

9:39 The longer a person occupies a role, the more they become acclimated. E.g. a son who always feels inadequate tries but doesn’t do. The father sets things up so the son is prevented from making decisions or receiving money from an inheritance because he sees his son as incompetent. Don’t let those perceptions run the family. Where do those right brain issues show up? In the bottom line of families’ portfolios.

9:37 We have to open to a new definition of assets. Some family members have “hidden assets” that can mitigate the damage of the poor capital markets performance. e.g. a family had spent 15 years developing a governance system. Yet family council not empowered to make decisions. If they had been empowered to make changes in the investment committee (some had been there too long and were too comfortable in their roles), their portfolio would have suffered much less during the 2008 market crash.

9:33 What can relationship risk lead to? A family doesn’t communicate, and only focuses on wealth management. That can lead to a lawsuit, inability to make a decision on a merger, resentment that can build into a family breaking apart. Then what good is the wealth?

9:31 That doesn’t always happen for families. Family members need to talk about their values and differences.

9:29 Case study: daughter really interested in art, most families would want her to get a “real job” but father gave her a chance. Now she is the art curator for the family. She’s added to the family’s assets.

9:27 Families think you’ll be asking only about financial issues during a meeting, so they forget about/don’t reveal why they’ve earned the wealth, their motivations, dynamics, etc. That leads to siloization.

9:26 By defining intellectual and social assets as assets, we can manage them alongside financial assets. Governance should be the interface through which all family assets converge.

9:24 Family governance is a set of rules, decision-making structure — but it pains me to hear it defined in this way! Why not think of governance as the keeper of the family joy. What’s the money for? Ask your clients.

9:21 We often overlook or don’t know about assets other family members have. Social/intellectual assets actually make up 75% of our families’ wealth. 25% is financial, yet that’s where we focus all our energy.

9:19 There are lots of family secrets. Understanding relationship risk can mitigate decision risk.

9:18 There are 3 governance components: family itself, family business, family office. The family is an entity unto itself, as Jay Hughes says.

9:17 How do we link the left and right sides? There’s a connection with family governance. Governance covers the right side.

9:15 Right brain issues: problem family members, communication and trust, health, etc. Thus far, we’ve been treating both left and right in a siloized fashion. We’ve not been operating with a full set of facts or acknowledgment of the assets a family has.

9:12 What matters to families? We split issues into right and left brain issues. Left brain is “easy”: trust and estate, insurance, investment, etc.

Goals-Based Wealth Management in Practice
Speaker: Jean Brunel, GenSpring Family Offices, Palm Beach, FL

A. This is the weakest part of the whole process. My view: we are at a major inflection point – I fear the returns we will experience over the next 15 years are going to be, on average, not a good predictor of sub periods. In other words, say equity is supposed to return 7%. As we go forward, I suspect the number will be really wrong at some points. We have a capital market forecast. We apply short-term discounts. 3% for returns from bonds, not treasuries, right now. I’m using something close to 5% for equities.

Q. What fixed-income ROR assumption are you using?

A. If you go back 5 years, we were weird. Now, product people are talking about it. If you give me 5 years, it’ll be the norm.

Q. How popular is goal-based investing?

A. When the markets have been normal, rebalance annually. When markets good, we may top up the income portfolio to 16 years instead of 15 and so put that money aside. When markets lousy, we live with the idea that we’ll have 14 years instead of 15 of income. I would be prepared to wait 2-3 years to rebalance if the markets are really bad. Revise the assumptions if things drag on.

Q. Rebalance strategy?

A: Feedback loop – one of the things that’s most important in the goals-based environment. The client needs to feel successful. Performance review is conducted in relation to each goal. 1. Have I met the goal? (shorter the time horizon of goal, easier to evaluate). 2. Is the portfolio where I expect it will be after x years? Analogy: flight plan of airplane. You don’t fly in a straight line. Pilot and I as passenger have same goal – get there, one time, and without too many bumps. Just as many takeoffs as landings. Once I’m in the cabin and had my gin and tonic, I don’t think about the process. Yet the pilot does have a plan and makes the necessary maneuvers. The benchmark remains the same: get from Calgary to Toronto. Pilot can’t prove things are going right but you have to trust his or her knowledge.

Q: Performance reviews – how do you do them?

8:57 This works for an organization running 10 or 2,000 portfolios. This is the future of our industry.

8:55 You have a benchmark for each client (yes! traditional finance!) yet each model is completely different for each client.

8:53 Individual subportfolios for each goal have limited assets available for each of them. The modules (available asset classes) are common to all clients. From the point of view of client, allocation to each portfolio/goal is individualized. Think of a bicycle. I can create tubes of different lengths for each bike. Yet I can manufacture each tube in mass amounts. Then I measure each client and then pick one of the tubes. It’s the client’s bike. Yet the manufacturer uses mass-produced tubes.

8:51 Patriarch wants 10% for “opportunistic investing” so he doesn’t miss out. Look at short-term lifestyle, long-term, lifestyle refills, cap growth. Portfolio isn’t divided by assets, but by goals and time horizons. Portfolio is solely driven by goals of the client. Advisors provide guidance on return expectations and change asset allocation based on probability of reaching each goal. Each client portfolio is unique!

8:48 Case study: family with $35 million and annual $1 million expenses. Internal cap preservation of $2 million (apartment complex, rental income is meant for upgrading the complex), so don’t count it as income gen. $1 million internal growth (venture capital startup and managed by member of second generation. Might start ven cap company). To create a declining balance portfolio for 5 years, $4.7 million (4% return). $7.2 million for next 10 years with 6% return. $11.9 is less than total assets (good news!) – you have plenty of money to live on. Imagine the feeling of relief – I don’t have to worry about that. In 15 years, patriarch will be 65. We’ll replenish at 65 to get him to 80.

8:47 What are the tradeoffs a client has to make? That is what an advisor has to explain. Protects against misunderstanding because you have a constant feedback loop. “This is what I heard. Is that what you meant?”

8:46 The advisor is a translator. Our jobs are to translate English into financial terms, and vice-versa.

8:45 Non-lifestyle assets can be in capital preservation, growth, or other stages.

8:40 Families should seek or avoid growth. Risk in portfolio should be proportional to discretionary vs. non-discretionary wealth. If you don’t need it, gamble it – that’s not rational. Don’t take risk just because you don’t need the wealth. There are many reasons to be conservative (e.g. unexpected inflation, lifestyle changes)

8:38 For lifestyle assets, two separate time horizons: short term (3-5 years) and long term (6-15 years). If you’re going to draw from an endowment portfolio, it has to be in your name, and it has to be transferred when you die. So create a declining balance portfolio, but for how long? But in volatile markets, you don’t want to have to sell assets in your non-lifestyle portfolio at a loss to fund your lifestyle – becomes a permanent loss. You need to cover about 15 years of income. Negative returns for 20 years is somewhat unlikely (but tell that to the Japanese).

8:36 For external assets: break into lifestyle and non-lifestyle assets. Families’ biggest nightmare is changing their lifestyles. Middle Eastern client’s nightmare is to change his lifestyle in a way that his neighbours will notice. If he has to stop buying art, it’s not the end of the world, because nobody notices. But if they have to cut out the money they donate to their favourite foundation that lets the wife be chair, that will be noticed and it’s a nightmare.

8:33 Clients have two types of assets. Internal (managed and controlled by family – such as a laddered bond portfolio or timberland; internal capital preservation) and external (controlled by family but managed by external managers). Don’t try to model internal assets. How do you know the return on something like that?

8:29 1. Describe goals of investor. 2. Dollar weigh and prioritize those goals. 3. Structure a sub-portfolio for each goal (“structure” = decide what are the assets/strategies that have a good chance of getting me to that goal. e.g. don’t put private equity in a portfolio meant for food and shelter needs) 4. Optimize the portfolios across the whole. Then start all over again and keep evolving the goals as your clients needs/lives change.

8:27 As you move into more esoteric goals, they become less crucial to achieve, so investment risk can increase. Your least important goal will always bear the highest amount of residual risk. $100 to spend. $80 for kids and lifestyle, $20 for philanthropy. Philanthropy out of luck if I lose the $20 if it’s my least important goal.

8:26 Behavioural finance says people who buy both insurance and lottery tickets aren’t idiots. We care about protecting our wealth but also want more. Meir Statman took these 3 goals one step further: we have different goals, but we also have different risk profiles for different goals. The goals with the highest importance are the goals where failure is unacceptable. (e.g. food, shelter)

8:25 HNW families have 3 types of goals: personal (current needs), dynastic (how much future generations should get), philanthropic.

8:24 What is your most cherished dream? It’s the one the client wants to achieve most, and the one where failure would be felt the most.

8:21 Integrated wealth planning is about more than just returns. Individuals have assets for a variety of purposes, so managing their financial wealth is only one part of wealth planning. You have to think in dollars and cents, but bring it in a way that makes sense to them. What matters to the family? Many wealthy people care about more than just absolute returns. A tough 67-year-old businessman cried because he had lost money for his grandchildren. Talk about money in terms of dreams and nightmares, not numbers.

8:20 Das, Markowitz, Scheid and Statman wrote a piece and shut everybody up: mental account processes are just as efficient as mean variance processes. Change the definition of risk. It’s no longer the standard deviation of return – it’s the probability of not achieving your goal.

8:19 Families discovered diversification is always there when you don’t need it. It costs you returns or doesn’t protect you.

8:16 The world has changed and clients are asking for different solutions due to the meltdown. Families now think that 2008 wasn’t just another cycle – it’s the beginning of something else. Their returns over the last decade were far too low.

8:13 am We’ll be hearing about three main points: a different environment, process architecture, and managing the process. Putting into practice goals-based wealth management doesn’t have to be complicated, even if you have 700 clients. Brunel is focusing on mass customization – each client feels like the plan has been tailored just for them, but from a practical perspective, he’ll tell us how to scale things up.

Day 1

8:06 Jean Brunel will be presenting next on Goal-Based Asset Allocation. He’s also receiving an award from the CFA Institute.

8:02 am Opening remarks are beginning. This conference is coming at the right time due to market volatility and unrest. It’s the first-ever CFA-endorsed wealth management conference in Canada.

7:36 am MT Morning everyone from chilly (3C!) Calgary. Unfortunately the Starbucks in my hotel wasn’t open but I’m now happily ensconced in the TELUS Convention Centre having a warm breakfast. Attendees are trickling in and we’re getting ready for opening remarks. Back to you soon!