Value Creation with. ETFs: Case Study. Graham Westmacott MBA, CFA Portfolio Manager. ETF Summit, Toronto 3 rd October 2018

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1 Value Creation with ETFs: Case Study Graham Westmacott MBA, CFA Portfolio Manager ETF Summit, Toronto 3 rd October 2018

2 Current State vs Future State: ETFs alone are not enough Not drowning. But waving.

3 The Big Picture Value creation for clients requires: A shift from portfolio alpha to advisor alpha Mass customisation that focuses on client s goals and delivers a consistent client experience Sources: Mass Customisation versus Mass Production in Retirement Investment Management, Lionel Martellini & Vincent Milhau, 2017 Noise: How to Overcome the High, Hidden Cost of Inconsistent Decisions Making, Daniel Kahneman, Andrew R Rosenfield, Linnea Gandhi and Tom Blaser,2016

4 Improving the Signal to Noise ratio ETF tracking error is biased (e.g. fees) and noisy (e.g. mostly everything else) But small compared to advisor tracking error: Your had lunch with your favourite fund salesperson You delegated the portfolio design You last ate six hours ago You are late for your child s hockey game Bias Noise

5 Some ETF Housekeeping items Fees (MERs and TERs) Tracking Error Trading Practices Index quirks Reconstitution Effects Currency hedging

6 The anxiety of simplicity Build me a portfolio of interesting ideas backed by original research. It does not take much to tell me to buy an ETF or to design a 60/40 asset allocation Client quote from Sarah Grillo, CFA. Advisor Perspective, 18 th July 2018

7 And Yet.. The nastiest, hardest problem in finance William Sharpe, 1990 Nobel prize for economics, on decumulation in retirement, June 2017 Image Source:

8 Alice & Bob Contemplate Retirement Alice (age 62), Bob (age 62) Retire at end of 2018 Investment Capital Owner Account Market Value Alice RRSP $240,000 Alice TFSA $60,000 Bob LIRA $300,000 Bob RRSP $400,000 Alice/Bob Investment $500,000 Total $1,500,000 Source: Morningstar Direct, PWL Capital

9 Alice s & Bob s perspective They don t understand how current holdings deliver their income goals: Required Real Income: $35,000 Desired Real Income: $52,500, after fees. Bob worries about spending too little, Alice worries about spending too much. What is a safe withdrawal? Focused on asset volatility rather than income security Concerned about fees (as a measure of value) Concerned about tax (over time and across accounts)

10 Tax (I): The Capital Gains Trap 100% 90% 80% 70% Example: Cumulative Portfolio Value & Capital Gains 60% 50% 40% Portfolio Capital Gain 30% 20% 10% 0% % of capital gains concentrated in 5 stocks! Use ETFs to systematically harvest capital losses and defer capital gains Source: PWL Capital

11 Tax(II): Withholding Taxes (WHT) WHT can be more of a performance drag (~0.30%) than ETF fees. US-listed ETFs have a tax advantage in RRSPs but incur currency conversion costs. Avoid Canadian-listed ETFs that hold U.S. ETFs of international stocks in registered accounts. Source:

12 Alice & Bob s Initial Portfolio Cash % Bond % Equity % Other % Source: Morningstar Direct, PWL Capital

13 Portfolio Fees & Turnover Estimated Fees Annual Expense Current portfolio 1.90% $28,500 Typical Indexed Balanced Portfolio 1.40% $21,000 Portfolio Turnover Current portfolio 42% Typical Indexed Balanced Portfolio 28% Source: Morningstar Direct, PWL Capital

14 Safe Withdrawal:3.5%? $2,000,000 $1,800,000 $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 Portfolio Value: Impact of Fees $ Average Worst Best Average+0.5% Worst+0.5% Best+0.5% Source: PWL Capital

15 The challenge: secure stable income from volatile assets Maximize lifetime withdrawal (ARVA) Safe withdrawal is a function of: Portfolio Value Time to Go (Mortality) Real interest rates Minimize risk of income shortfall (ALM) Use bond ETFs to match future liability Partial hedge against interest rate changes Smooth income variability Source: The Only Spending Rule Article You Will Ever Need, M.Barton Waring and Laurence B. Siegel, FAJ, Vol 71, 2015

16 The Retirement Income Process Retirement Plan T, X Retirement Plan Required Income Desired Income Desired Income Security Portfolio Growth Portfolio Dynamic Spending Rule Required Income Total Return Cash Client Security Portfolio Duration Matching Dynamic asset allocation Bond ETFs Growth Portfolio Diversified Long Horizon Positive real return Bond/equity mix

17 Alice & Bob s: Income Goals Required Income: $35,000 Desired Income: $52,500 Assets last until age 95 (with mortality weighted residual) $120,000 $100,000 $80,000 Projected Withdrawals $60,000 $40,000 $20,000 $0 Average Worst Best Required Age Source: PWL Capital

18 The Security Portfolio at Retirement Maturity Securities Weight Allocation Duration YTM 1 to 5 Years GIC/Bond ETF 45% $156, % 5 to 10 Years Bond ETF 40% $145, % 10 Years + Bond ETF 15% $54, % TOTAL 100% $364, Duration match rolling 12 years of Required Income Security Portfolio depends on yield curve and time to go Trade-off between income volatility and income security Source: PWL Capital, BMO Financial Group

19 The Growth Portfolio Asset Class Allocation % Allocation $ Comments Bonds 25% $283,808 Investment grade universe Other Income 5% $56,762 REITs, High Yield Bonds TOTAL FIXED INCOME 30% $340,570 Canadian Equity 24% $272,456 2/3 Cap weighted, 1/3 factor weighted U.S. Equity 23% $261,103 As per Canada+ 50% Currency Hedged International Equity 23% $261,103 As per Canada + up to 1/3 emerging market TOTAL EQUITY 70% $794,662

20 Putting It All Together $1,600,000 70% $1,400,000 60% $1,200,000 $1,000,000 50% 40% $800,000 $600,000 $400,000 30% 20% $200,000 10% $ Security Portfolio Growth Portfolio Equity Allocation 0% Source: PWL Capital

21 Frequency Age % 90% 80% 70% 60% 50% 40% Constant Withdrawal Variable Withdrawal/ALM 30% 20% 10% 0% Bin Source: PWL Capital

22 Frequency Age 68 20% 18% Constant Withdrawal Variable Withdrawal/ALM 16% 14% 12% 10% 8% 6% 4% 2% 0% Bin Source: PWL Capital

23 Frequency Age 73 20% 18% Constant Withdrawal Variable Withdrawal/ALM 16% 14% 12% 10% 8% 6% 4% 2% 0% Bin Source: PWL Capital

24 Frequency Age 78 20% 18% Constant Withdrawal Variable Withdrawal/ALM 16% 14% 12% 10% 8% 6% 4% 2% 0% Bin Source: PWL Capital

25 Frequency Age 83 20% 18% Constant Withdrawal Variable Withdrawal/ALM 16% 14% 12% 10% 8% 6% 4% 2% 0% Bin Source: PWL Capital

26 Frequency Age 88 Constant Withdrawal 20% Variable Withdrawal/ALM 15% 10% 5% 0% Bin Source: PWL Capital

27 Frequency Age 93 40% 35% Constant Withdrawal Variable Withdrawal/ALM 30% 25% 20% 15% 10% 5% 0% Bin Source: PWL Capital

28 Frequency Age 93 40% 35% Constant Withdrawal Variable Withdrawal/ALM 30% 25% - Significant reduction in risk of ruin with Variable Withdrawal/ALM 20% - Portfolio outcomes more predictable 15% 10% 5% 0% Bin Source: PWL Capital

29 Outcomes Before After Number of Securities Probability of Ruin 34% <1% Income $52,500 $54,786+/-$4,958 Median Wealth (age 95) $186,757 $172,177 Standard Deviation of Wealth (age 95) $496,221 $87,407 Fees 1.9% 1.4% Client focus on income not assets Relatable goals around required/desired spending. Continuous process with annual safe spending guidance. Source: PWL Capital

30 Optimal Asset Allocation for Retirement Success Given annual savings and retirement spending over a specified period, what is the optimal investment strategy that maximizes success?

31 Optimal Lifecycle Asset Allocation Method Terminal Wealth (thousand $) Terminal Standard Deviation (thousand $) 5% CVAR (thousand $) Stocks = 35% Target Date Stocks = 55% Stocks = 75% Optimal Control Source: Forsyth, P., Vetzal, K. and Westmacott, G. (2018) in preparation Example: Joe, age 50, retires age 65. Initial capital, $500K. Invest $20K(real) for 15 years, spend $40K(real) for 30 years. Two-security portfolio: risk free asset, risky asset (global index fund)

32 The optimal asset allocation is an output not an input. 100% 90% Optimal Control: Fraction in Risk Free Asset Asset allocation determined by time to go and minimize quadratic deviation from target. 80% 70% 60% 50% 40% 30% 20% 10% Retirement Median 5th Percentile Easily implemented using ETFs. Mass customization of the retirement problem? 0% Age (years) Source: Forsyth, P., Vetzal, K. and Westmacott, G. (2018) in preparation

33 Conclusions ETFs have some positive product attributes ETFs real opportunity is to free your mind By W.carter - Own work, CC BY-SA 4.0,

34 Disclaimer This document is published by PWL Capital Inc. for your information only. Information on which this document is based is available on request. Particular investments or trading strategies should be evaluated relative to each individual s objectives in consultation with the Investment Advisor. Opinions of PWL Capital constitute its judgment as of the date of this publication, are subject to change without notice and are provided in good faith but without responsibility for any errors or omissions contained herein. This document is supplied on the basis and understanding that neither PWL Capital Inc. nor its employees, agents or information suppliers is to be under any responsibility of liability whatsoever in respect thereof. PWL Capital Inc. 20 Erb St. W. Suite 506 Waterloo, Ontario N2L 1T2 Tel Fax