9 Critical Factors You Must Consider Creating Long-Term Investment Success

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1 Tulett, Matthews & Associates portfolio management 9 Critical Factors You Must Consider Creating Long-Term Investment Success There are 9 critical factors you must consider when thinking about your longterm investments. Ignoring them can lead to costly outcomes, while implementing them together will help you reach your personal financial goals and increase your odds of creating a successful long-term investment experience. We pay close attention to each and every aspect detailed in these concepts. Careful diligence is part of who we are and how we work with our clients. We embrace these core components and implement them in our investment and client service philosophy. These 9 critical factors are relevant in all market cycles good or bad. By Keith Matthews Partner & Portfolio Manager Tulett, Matthews & Associates Inc. Adapted from the bestselling book The Empowered Investor: A Canadian Guide to Building a Better Investment Experience by Keith Matthews (

2 1. PLANNING IS CRITICAL TO BUILDING A SUSTAINABLE LIFESTYLE Are you on track to financial independence? Knowing what is required to reach your goals is only half the battle; implementing your action plan completes the planning process. To discover and learn more about the planning process, see the Creating Long Term Investment Success white paper entitled Take Control of Your Personal Financial Plan. Figure 1: Set Planning Targets Financial Independence Your 60 s Your 50 s Your 40 s Your 30 s Your 20 s As Figure 1 shows, financial independence means something different to everyone. Different people attain it at different ages. Each of us has a unique financial puzzle that requires an understanding of several important factors: your goals and life targets, saving rates, consumption or lifestyle expenses, portfolio and other asset levels (personal or business assets). By becoming aware and bringing together these factors, you can better prepare to live a sustainable lifestyle. According to a poll conducted by Tangerine (formerly ING Direct) in 2012, more than two thirds of Canadians have no financial plan for their retirement Seeking advice with a financial planning professional is an important part of this process. We coordinate our efforts with Edmond Fhima (Licensed Financial Planner) of EFConsulting, who conducts comprehensive retirement and estate planning analysis for our clients. 2. ACHIEVE LONG-TERM SUCCESS WITH ASSET ALLOCATION Asset class investing is the most prudent and successful long-term investment management strategy available to Canadian investors. More so than any other deciding factors (such as market predictions, investment TV shows, manager strategies, newsletters, or the latest trendy ideas), asset allocation research shows that over 96% of the variation in returns is due to three risk factor exposures (See Figure 2). These risk components are: equity markets vs. bonds, small company stocks vs. large company stocks and value company stocks vs. growth company stocks. Asset class investing is a much more prudent way to invest than either stock picking or market timing ~ The Empowered Investor Nine Critical Factors You Must Consider 2

3 This leaves only 4% of the variation to explain. Figure 2: Portfolio Structure and Asset Allocation Determine Performance 96% Structured Exposure to Factors Market Size Value/Growth 4% Stock Pricing and Market Timing Source: Dimensional Fund Advisors 3. PRACTICE GOOD DIVERSIFICATION Asset allocation is one of the most important decisions investors and advisors must make, and that is why it is a cornerstone of our investment philosophy. Most investors know that it is prudent to diversify, but do they truly practice diversification in their portfolios? Many people who believe they are well diversified actually have highly concentrated and risky portfolios. Investors often discover that their portfolios are filled with overlapping strategies resulting in poor asset class diversification. Good asset class diversification occurs when many distinct and productive asset classes are added together to build an effective long-term portfolio strategy. Asset classes to consider holding in a diversified portfolio include: Short-term government bonds Investment grade corporate bonds Real return bonds Global REITs Canadian large companies Canadian value companies Canadian small companies U.S. large companies U.S. value companies U.S. small companies International large companies International value companies International small companies Emerging market companies Figure 3: Poor Asset Class Diversification vs. Good Asset Class Diversification Poor diversification Good diversification As Figure 3 aims to show, good diversification is achieved by holding positions across a wide variety of asset classes. A client s personal objectives, life stage, cash flow needs, and tolerance to risk or uncertainty all vary and will impact the percentages of asset classes used in their portfolios. Harry Markowitz discovered that by combining asset classes that have good longterm prospects but behave differently, investors can achieve better returns with less risk. His work won him the Nobel Prize in Nine Critical Factors You Must Consider 3

4 4. INCLUDE VALUE & SMALL CAP STOCKS While many investors believe the best way to grow their investments over time is to invest in growth companies, results in virtually every geographic region around the world show that investments in value companies (low market priceto-book ratio, out of favor, neglected companies) have actually produced higher returns. Small companies have also produced higher returns than their larger, better known counterparts. Value and small companies are perceived as riskier investments and accordingly should provide investors with higher expected returns. Figure 4 highlights the additional returns derived from investments in value and small company exposures in various global markets. Figure 4: Value and Small Cap Stocks Outperform Growth Stocks Large Value S&P 500 Large Growth Small Value Small Small Growth Value Small MSCI EAFE Intl. Growth S&P/ Value TSX Growth Composite Emg. Markets Value Emg. Markets Small Emg. Markets Market Emg. Markets Growth US Large Capitalization Stocks US Small Capitalization Stocks Non-US Developed Market Stocks Canadian Market Stocks Emerging Markets Stocks Annualized Compound Returns (%) Source: Dimensional Fund Advisors (see endnote #1) While there are many possible explanations for these return outcomes, we subscribe to the research of Eugene Fama and Ken French (both highly regarded financial market economists who are actively involved with Dimensional Fund Advisors, and the former a Nobel Prize recipient in 2013); who concluded that risk and return are related. Value and small companies are perceived as riskier investments and accordingly should provide investors with higher expected returns. So how do we implement this concept in your portfolio? Highly diversified investment funds managed by Dimensional Fund Advisors are used to include Nine Critical Factors You Must Consider 4

5 value and small companies in your portfolio. We tilt the portfolio to these asset classes and include others such as general market exposure (which will include large growth companies). Diversification within each asset class as well as across multiple asset classes is always a key component in each and every client portfolio. 5. AVOID MARKET TIMING AND SWITCHING BETWEEN ASSET CLASSES No one can consistently predict future asset prices. Making bold moves based on previous forecasts and predictions is an unproductive and risky strategy ~ The Empowered Investor The truth of the matter is that no one can consistently predict future asset prices. As seen in Figure 5, markets and asset classes often move in random and unpredictable fashion. Each colour represents a different asset class that is worthy of being included in a Canadian s investment portfolio. They are laid out year by year in a stacked format with the best performance within that calendar year on top and the worst performance at the bottom. Figure 5: Don t Try to Predict the Unpredictable Annual Asset Class Ranking: Canadian Fixed Income Canadian Large Cap Canadian Value Canadian Small Cap US Large Cap US Value US Small Cap International Value US Real Estate International Small Cap International Large Cap Source: Dimensional Fund Advisors Nine Critical Factors You Must Consider 5

6 We do not attempt to switch back and forth between various asset classes as research shows that it is unproductive. Market timing and tactical asset allocation produces unneeded stress for investors. A BRIEF HISTORY OF INDEX INVESTING: 6. DISCOVER INDEX OR PASSIVELY MANAGED ASSET CLASS INVESTING Over the long-term, few actively managed strategies have been able to match index or asset class returns. Figure 6 shows the percentage of actively managed strategies that have outperformed relevant benchmarks in the last five years ending June 30th, Figure 6: Most Actively Managed Strategies do not Outperform Relative Benchmarks (Percentage of actively managed mutual funds that beat the market over the last 5 years ending June 30th 2013) : John McQuown of Wells Fargo and Rex Sinquefield of American National Bank developed the first passive S & P index funds 1973: Burton Malkiel s A Random Walk Down Wall Street challenged the financial services industry to provide a better way to invest. "Fund spokesmen are quick to point out you can t buy the market averages. It's time the public could." Only 30.36% beat the S&P/TSX (Cdn equity) Only 2.36% beat the S&P 500 Index (US equity) Only 11.36% beat the EPAC Large/Mid Cap Index (Int l equity) 1976: John Bogle launches the first index investment trust (now known as Vanguard 500) The good news is that Asset Class Strategies that track asset classes and indices are available to private client investors around the world. There are many reasons why we prefer to use index (in the form of Exchange Traded Funds) or passively managed asset class investments (in the form of Dimensional Fund Advisor funds) when building and managing your long-term diversified portfolios. Long-term performance is one of them. Other benefits to your portfolio include: transparency, no manager drift risk (this empowers us to keep and maintain accurate asset allocations for your portfolio), low fees, lower survivorship risks, and higher levels of tax efficiency. 2013: Eugene Fama wins the Nobel Prize for his work on the Efficient Market Hypothesis. 2014: Indexed, factor-based pension plans, institutions and individual investors continue to drive the growth of investing in capital markets worldwide. Nine Critical Factors You Must Consider 6

7 7. DISCOVER INDEX OR PASSIVELY MANAGED ASSET CLASS INVESTING Major asset classes will always survive. Investment management offerings, however, may not. One in three actively managed investment strategies do not survive as shown in Figure 7: Figure 7: Many Actively Managed Funds do not Survive (Percentage of actively managed mutual funds that ceased to exist over the last 5 years ending June 30th 2013) 32.1% of Canadian equity funds did not survive a 5 year period and were merged, liquidated or ceased to exist % of U.S. equity funds did not survive a 5 year period and were merged, liquidated or ceased to exist % of International equity funds did not survive a 5 year period and were merged, liquidated or ceased to exist. (Percentage of actively managed mutual funds that ceased to exist over the last 5 years ending June 30th 2013) 4 Investing in passively managed asset class strategies or ETFs that track indices can significantly reduce survivorship risks in your portfolio and can produce a more consistent long-term investment experience. 8. PROTECT YOURSELF AGAINST INVESTMENT OBSTACLES & PITFALLS Common obstacles and pitfalls include: conflicts of interest in the financial services industry; building portfolios based on forecasts; miscalculating your time horizon; lacking an investment plan; timing the market; buying high & selling low; chasing asset class or manager performance; lack of proper diversification. For winning strategies to work, investors must be aware of, and protect themselves from, the pitfalls that await the unsuspecting. We manage your assets on a discretionary basis to reflect the goals agreed upon in your Investment Policy Statement. This protects you from many of the common pitfalls facing investors. The structured portfolio approach is also another layer of protection against these pitfalls. Our fiduciary responsibility and our means of Nine Critical Factors You Must Consider 7

8 compensation are your greatest protection from the conflicts of interest found within the sales & commission culture of the financial services industry. 9. CONTROLLING EMOTIONS Humans are not hardwired to be good at investing. Emotions and cognitive biases often get in the way. Fear, greed, hindsight and overconfidence may lead smart people to make costly investment mistakes. By keeping your emotions at bay, you can build a structured, rigorous and disciplined portfolio ~ The Empowered Investor Understanding how we think about our money, our security, and our wealth can be a very complex undertaking. Being aware of how the mind can play tricks or how we can possibly have hang-ups or mental obstacles when we think of wealth & portfolios is very important if you wish to become a successful long-term investor. Success in investing doesn t correlate with IQ...once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing ~ Warren Buffet Nine Critical Factors You Must Consider 8

9 Tulett, Matthews & Associates 1. TULETT, MATTHEWS & ASSOC. INC. Keith Matthews is a partner and portfolio manager at Tulett, Matthews & Associates Inc. Tulett, Matthews & Associates specializes in discretionary portfolio management services and wealth management solutions designed for Canadian investors who are serious about achieving their long-term investment goals. Our unique consultative approach ensures that we only work with clients for whom we can add real value to their pursuit of a successful investment experience. Keith Matthews Partner & Portfolio Manager Tulett, Matthews & Associates Inc St-Charles Blvd, Suite 703, Kirkland, Quebec (ext. 106) keith@tma-invest.com Portfolios created, managed, and monitored by Tulett, Matthews & Associates Inc. are subject to market fluctuations. The value of most investments, particularly equity investments, can be negatively affected by changes in general market conditions caused by corporate developments, changes in interest rates, changes in the level of inflation, and other political and economic developments. 1 Source: Dimensional study (2002) of forty-four institutional equity pension plans with $452 billion total assets. Factor analysis run over various time periods, averaging nine years. Total assets based on total plan dollar amounts as of December 21, Average explanatory power (R 2 ) is for the Fama/French equity benchmark universe. Endnotes: #1: US indices in US dollars; all others in Canadian dollars. Developed markets value and growth data provided by Fama/French. The S&P data are provided by Standard & Poor s Index Services Group. US Small is the CRSP 6-10 Index, provided by the Center for Research in Security Prices, University of Chicago. Non-US Small data compiled by Dimensional from Bloomberg, Style Research, London Business School, and Nomura Securities data. MSCI EAFE Index (net dividends) copyright MSCI 2009, all rights reserved. S&P/TSX data provided by S&P/TSX. Emerging Markets data simulated by Fama/French from countries in the IFC Investable Universe; simulations are free-float weighted both within each country and across all countries. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. #2: In Canadian dollars. Charts are for illustrative purposes only. Canadian Fixed Income is Canadian One-Month Treasury Bills. Canadian Large Cap is the S&P/TSX Composite Index. Canadian Value is the MSCI Canada Value Index (net dividends), and Canadian Small Cap is the MSCI Canada Small Cap Index (price only). US Large Cap is the S&P 500 Index. US Value is Russell 3000 Value Index. US Small Cap is CRSP 6-10 Index. US Real Estate is the Dow Jones Wilshire REIT Index. International Large Cap is the MSCI EAFE Index (net dividends), and International Value is the MSCI EAFE Value Index (net dividends). International Small Cap is compiled by Dimensional from Style Research securities data; includes securities of MSCI EAFE countries in the 10%-1% of ME range; market-capitalization weighted; each country capped at 50%; value defined as the top 30% of book-to-market; rebalanced semiannually. Canadian T- Bills provided by Scotia Capital Inc. S&P/TSX data provided by S&P/TSX. MSCI data copyright MSCI 2009, all rights reserved. The S&P data provided by Standard & Poor s Index Services Group. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. #3: Survivorship bias correction: Many funds might be liquidated or merged during a period of study. However, for someone making an investment decision at the beginning of the period, these funds are part of the opportunity set. Unlike commonly available comparison reports, SPIVA removes this survivorship bias. Nine Nine Critical Critical Factors Factors You Must You Consider Must Consider 9 9