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Investment Bargain Boot Camp

Breaking Out of Large Cap Buy and Hold
Joe Timmath

T

ry this experiment: ask a few investors if they’re bullish or bearish on investing right now. I’m guessing that in almost every case they’ll answer you in terms of a leading stock market index, the S&P/TSX Composite or the S&P 500. They’ll answer by telling you which direction they think the index is headed, up or down, and why. They could talk about a whole slew of markets (gold, high-yield bonds, crude oil, corn, commercial real estate, currencies, interest rates, etc) but I don’t expect they will. You see, in answering your question, they’ve told you a lot about how they see investing. They’ve betrayed a strong bias towards one investment approach.

It all adds up to what I call the myopia of large cap buyand-hold investing. My concern is that too strong a bias towards buy and hold can lead to tunnel vision. That restrictive view may prevent investors from seeing alternatives that could be useful to them in the years ahead.

Why look outside of buy and hold?
Why should investors even consider looking outside the well-worn comfortable confines of buy and hold? Here’s why – because they need alternatives in case large cap buyand-hold investing is in for a difficult future. But even if it has a bright future, doesn’t it deserve a little competition from other valid approaches? Looking outside of traditional buy-and-hold investing might feel like dangerous ground to some investors. After all, most of us have been told that investing in anything other than large cap stocks is just speculating. Point taken, but consider that both Japan (as measured by the NIKKEI 225) and the United States (as measured by the S&P 500) have provided long-term index investors with negative returns for years. In fact over 20 years of deeply negative returns in the case of Japan, and over 10 years of negative returns, even after the recent near 60% rally, in the case of the U.S. That Japanese and U.S. indexes could put in such terrible performance for so long and still be seen as dominant choices for investing shows how strong the mindset towards this sort of investing is and its persistence in the face of contrary circumstances. I’m not suggesting that large cap buy-and-hold investing is flawed. It’s not. In fact, it’s a strategy I favour when appropriate. However, recent history (in Japan and the U.S.) demonstrates that buy-and-hold strategies do not always work, even if your patience extends to ten or more years. I can tell you from experience that I’ve never met a client willing to persist through over a decade of negative returns.

The majority have a narrow view of investing
When I talk to investors, or listen to pundits, I get the impression that the majority have a narrow view of investing. They see investing as buying and holding large cap stocks. Of course, the managers of the big Canadian and U.S. equity funds really have little choice in the matter; their mandates only allow them to buy publicly traded stocks and their huge size effectively limits them to the index heavyweights. Buy-and-hold investors are unidirectional. They only invest long (stock markets will go up) and don’t invest short (stocks markets will go down). This is consistent with the widespread faith in buy and hold. The case for buy and hold has been made time and again, including in Stocks for the Long Run, Jeremy Siegel’s seminal 1994 book that convinced a new generation of the soundness of buy and hold. The Washington Post called it one of the 10 best investment books of all time. Well I guess Jeremy Siegel wasn’t writing for Japanese investors of the early nineties or the coming generation of American investors. Since the great majority of financial products – think mutual funds and pension funds – are institutional size and only allow for “long” investing, it’s evident that the great majority of investors are unidirectional – they only play the market long.
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What’s left out?
The problem with a sole reliance on one style is what’s left out. What’s left out is a whole slew of viable investment alternatives that might just help investors’ performance during times when large cap buy-and-hold investing can’t. A broader view of investing that encompasses many products (stocks, commodities, options, mutual funds, exchangetraded funds, hedge funds, technical trading, market timing, etc.) can allow investors access to a myriad of asset classes, approaches, and markets on both a short or long basis. The good news is that with a broader view of investing you can now invest in the following areas and many more, long or short: • Precious metals and gems: gold bullion, sterling silver, platinum, diamonds • Private companies, venture capital • High-yield bonds, convertible debentures • Agricultural commodities: wheat, soybeans, corn, lean hogs, potash, etc. • Currency futures: USDollar futures, short “puts”, long “calls” • Real estate: commercial, residential, condo, etc. • Energy: crude oil, natural gas The last few years have seen an explosion of products (commodity funds, ETFs, leveraged ETFs, hedge funds, etc.) but many of these “innovative” products are still fairly new and not time tested. Over time we will see that some are useful while others turn out to have been ill conceived and dangerous to investors. So here is, I believe, the quandary investors face. I’m suggesting investors broaden their investment outlook but that process will be difficult and carries risk. Investors and their advisors are best to go slowly and work hard to try to harness the benefits from these changes while trying to avoid the pitfalls, poor approaches, and shoddy products. One example of a new “innovative” family of products still experiencing growing pains is the leveraged commodity ETFs. Several companies now distribute leveraged commodity ETFs. One of the most popular is a 2X leverage crude oil ETF, an example of which is Horizons Betapro NYMEX Oil Bull+ ETF (HOU on S&P/TSX). This ETF aims to provide investors with a daily return equal to 2 times that day’s change in the relevant price of crude. That seems pretty clear doesn’t it? Well, you can imagine the surprise some early investors had to find out that what is true for one day may not be true at all for longer periods. It’s possible to buy a 2X leverage crude oil ETF when oil is at say $50 and sell the position six months later with oil at $70 and lose money. Even though, in this example, the price of crude oil ultimately increased by 40%, the ETF investor could lose money on the position. The first time I
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found out about this was when a similar circumstance happened to another broker. It turns out that with leverage and the daily re-balancing it is quite possible for a downtrend and volatility to suck all of the economic exposure out of the investment so that there is nothing left to recover if markets turn up. Readers who want more detail on this should carefully read the “risks” section of the prospectus for a leveraged commodity ETF. The leveraged ETF industry is now responding to this problem. Product providers are beefing up disclosures and warnings to potential clients. Firms, including my own, are letting advisors know that these products are not appropriate for the vast majority of clients and that their use will be closely monitored. The point I want to make crystal clear is that new nontraditional approaches must be approached slowly and cautiously. Clients and advisors should take the time required to learn about the risks and start small. Having said all that, I still believe that broadening your investment outlook beyond traditional buy and hold is well worth the work and risk for the right investor. I can think of millions of Japanese and U.S. investors who could have benefited from just such an exercise over the last twenty years. For myself, I embrace the process of extending my work past the traditional boundaries of buy-and-hold investing. It will take inquiry and study but that is the price of competence. Good investing is not static. While investable markets offer us opportunity, they also demand something of us if we are to capture and extract the value they offer. Below are two investments that encompass a broader view of investing.

Arrow High Yield
Arrow High Yield (Arrow Hedge Partners Inc, hedge fund, front-end load, MER: 2.25%, minimum initial investment: $25,000) diverges from traditional large cap buyand-hold investing in at least two respects. First, the fund primarily invests in high-yield bonds (also known as junk bonds). This asset class has a record of providing superior risk-adjusted returns coming out of the last three recessions. That’s why I like the timing for this asset class right now. Second, the fund is managed using a capital arbitrage approach. The manager seeks to exploit pricing discrepancies between various securities in a company’s capital structure. This includes techniques such as shorting the stock and going long the bonds. The fund is managed by Barry Allan, the president and founder of Marret Asset Management. Marret has the largest team of fixed-income analysts in Canada. Barry Allan has over twenty years of experience managing high-yield bonds and is widely considered one of the top high-yield bond managers in the country.

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Two thousand eight was the worst year ever for highyield bonds. The Merrill Lynch High Yield Canadian Issuers Index (hedged to the CDN$) was down 32.8% for the year. Barry Allan also manages a mutual fund called the Dynamic High Yield Bond Fund, which was down 12.9% in 2008, while the Arrow High Yield Fund was down only 3.6% for 2008. I’m encouraged that during the worst year on record for high-yield bonds the Arrow High Yield Hedge Fund managed to limit losses and outperform the index. To buy this hedge fund investors must qualify as an accredited investor. Residents of the following jurisdictions: BC, Newfoundland and Labrador, New Brunswick, Nova Scotia and the Yukon, who do not qualify as accredited investors can still purchase the fund by signing a Risk Acknowledgement Form.

Claymore Natural Gas Commodity ETF (GAS on the S&P/TSX)
Here the difference from traditional large cap buy-andhold investing is the direct one-to-one exposure to commodity price movements. The investor has direct exposure to changes in the price of natural gas while avoiding equity risks like changes in stock market valuations, success or failure of exploration activities, operations, or other companyspecific factors. This investment is appropriate for those who think that the price of natural gas is likely to appreciate and would like to position themselves to benefit. The ETF invests in physical natural gas forward contracts and seeks to track the performance of the benchmark NGX (Natural Gas Index), less fees and expenses. The NGX Canadian Natural Gas Index replicates an exposure to the monthly contract (one month spot price) for physical natural gas for delivery on the TransCanada Mainline (AECO/NIT) in Alberta that is rolled to the next contract prior to delivery. AECO is the most quoted and liquid physical natural gas delivery point in Canada. The index is posted daily at www.ngx.com. This ETF does not use leverage and targets a 1:1 relationship between assets and natural gas. As always, before making any purchases, do your homework and consult your advisors. Joe Timmath CA, CFP, Financial Advisor, Raymond James Ltd, Vancouver, BC (604) 639-8608, joe.timmath@raymondjames.ca.
This article is provided as a general source of information only and should not be considered to be personal investment advice or a solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. The information contained in this article was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. The views expressed are those of the author, Joe Timmath, and not necessarily those of Raymond James Ltd. Securities-related products and services are offered through Raymond James Ltd., member CIPF. Financial planning and insurance products and services are offered through Raymond James Financial Planning Ltd., which is not a member CIPF.

Canadian MoneySaver

• PO Box 370, Bath, ON K0H 1G0 •

(613) 352-7448

• http://www.canadianmoneysaver.ca

NOVEMBER/DECEMBER 2009