Caution

Questionable Investments & Strategies

Invariably, investors hear about a better mousetrap – an investment or strategy that promises higher returns, lower taxes or a quicker route to financial independence. These ideas often subject the investor to additional risk in one form or another and should be examined with a skeptical eye.

A risk-free investment

A good place to start the conversation about questionable investments is to discuss a risk-free investment. It provides a great contrast to many risky strategies that may seem appealing on the surface.

Canadians who earn $50,000 per year will pay 30% to 35% tax on each dollar of interest they earn but they pay no tax on each dollar of interest they save.

Take the example of a homeowner who has a 5% mortgage. It would take an interest rate of about 7.5% to generate an after-tax return of 5% in a taxable account and in 2012 there were no guaranteed investments that paid anywhere close to 7.5%.

On the other hand, if that money was used to pay down the mortgage, the homeowner has saved 5% after tax because he is no longer paying interest on that money. It is a risk-free way to save 5% after tax.

While there is a chance the homeowner could make in excess of 7.5% by investing his money rather than paying down the mortgage, it is not a risk-free investment. With all returns on investment, investors should consider the amount of risk that must be assumed in pursuit of that return.

The strategy of paying down your mortgage is the opposite of those who advocate taking out a home equity line of credit and investing the money in the pursuit of high returns. Investing with borrowed money is a high risk / low return strategy, while paying down your mortgage is a low risk/ high return strategy.

Once the mortgage is paid, you can begin to invest additional funds in a portfolio tailored to meet your needs and not the needs of a banker or a mutual fund salesperson.

Your home as an investment for retirement

Because real estate is typically a very large investment financed with borrowed money (leveraged), it is worth spending considerable time on this topic.

Recently, many people, aided and abetted by the real estate industry and facilitated by the banking industry, have tended to adopt the idea that my home is my retirement plan. In doing so, they have purchased homes that are in excess of their needs because in their minds, a bigger home will lead to a bigger retirement.

High real estate prices have created a false sense of wealth. The United States has already gone through the painful process of a correction in real estate values. Many of those who expected to sell their homes for a handsome profit and retire on the proceeds have had their dreams shattered. As

US real estate prices dropped, many homeowners were left with mortgages greater than the value of their homes.

We should learn from their experience.

While the price of housing in the US is now at much more reasonable levels, prices in Canada remain stubbornly high. Not only are real estate prices high in Canada, many Canadians are carrying disproportionately high mortgages and have been borrowing against the equity in their homes.

Should real estate prices falter, that equity could be wiped out and banks could demand additional payments.

In June 2011 Mark Carney, the Governor of the Bank of Canada, made the following observation in a speech to the Vancouver Board of Trade.

The full text of his commentary is available at http://www.bankofcanada.ca/wp-content/uploads/2011/06/sp150611.pdf.

Some of the key points made included:

The ratio between the all-in monthly costs of owning a home and renting a home, as measured in the CPI, is close to its highest level since these series were first kept in 1949.

Financial vulnerabilities have increased as a result. Canadians are now as indebted (relative to their income) as the Americans and the British. (Since this book was first published, Canadians now carry significantly more debt than their American counterparts).

The Bank estimates that the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite improving economic conditions and the ongoing low level of interest rates.

This partly reflects the fact that the increase in aggregate household debt over the past decade has been driven by households with the highest debt levels.

Instead of directing some of their excess income into savings, many Canadians have sunk all their savings into a larger home with the idea that they will sell the house upon retirement for a huge profit and live happily ever after on the proceeds.

In the minds of many investors, the arguments for this practice are tempting:

  • Instead of throwing away money on rent, I am building equity.
  • Real estate always goes up.
  • There is no capital gains tax on the sale of a principal residence.

There are other facts and historical evidence that need to be examined:

  • A bigger house than necessary comes with bigger expenses than necessary, including taxes, maintenance, utilities.
  • Using your home as a retirement plan at the expense of other investments violates the principle of diversification.
  • A mortgage is a highly leveraged investment. The risk of leverage will also be discussed later as a questionable investment strategy.
  • Massive corrections in the price of housing in Japan, Spain and the United States illustrate the danger in this strategy.

This is not to say that real estate is a bad investment or that home ownership is wrong, but mixing these two separate ideas into one strategy is a dangerous practice. As many home owners in the US have learned, life savings can be completely wiped out in this very seductive scheme.

Anecdotal stories abound about those who failed to get into the real estate market and are now doomed to rent a second grade apartment for the rest of their lives. While that may happen in some cases, it is far from the norm.

Over the very long term, the value of a home cannot rise much more than the rate of inflation or the growth in wages. If it did, the cost of home ownership would eventually represent such a high percentage of income that there would be little left for other expenses.

While there will be times when the housing market is under-valued, there will also be times that it is over-valued and generally speaking the long term rise in house values is very modest.

Growth in the value of real estate

 Robert Shiller is a professor of economics at Yale and he confirms that claim. The following chart is derived from his website www.irrationalexuberance.com and it illustrates the change in the value of house prices over and above inflation.

 <Chart>

 The results may surprise you:

  • The average annual growth from 1890 to 2011 was about 0.20% per year above inflation.
  • The average annual growth from 1890 to the peak in house values in 2005 was about 0.60% per year above inflation
  • The average annual growth from the lowest values in 1920 to the peak in 2005 was about 1.30% per year above inflation

 Simple logic indicates that growth in the value of real estate that is significantly above the growth rate in the economy (growth in GDP) is not sustainable in the long term. If that were to happen, housing would eventually become unaffordable and prices would fall back to the point where it does become affordable.

Mark Carney’s comments seem to bear this out.

From 2001 to 2010 house prices in Canada rose at a pace of approximately 7.5% per year. During the same period, GDP rose by only 2.9% per year.

 House prices became increasingly unaffordable during this period. Two solutions to the problem of unaffordable housing are rapidly increasing incomes (unlikely in this economic environment) or falling house prices.

 In his comments to the Vancouver Board of Trade, Mark Carney, Governor of the Bank of Canada, also commented that over the long term house prices in Canada have averaged about 3.5x median income. As of June 2011 they were about 4.5x median income.

While the ratio varies from city to city and there will always be exceptions or pockets of opportunity, the overall picture for the potential growth in residential real estate values is dim.

If prices were to return to 3.5x median income, it would require a correction of about 23%.

Expecting growth in the value of an investment that may already be overvalued is optimistic at best and dangerous at worst. If real estate is truly over-valued by 23%, counting on the long term growth in the value of your home to fund retirement could lead to disappointment.

The lesson in this is that your primary residence should be viewed as a place to live, rather than as an investment.

As a simple test, subtract about 23% from the current value of your home and see how you feel about your financial situation. Would you still have equity in your home or do you now owe more than the value of the mortgage? Were you planning on withdrawing equity from your home in the form of a line of credit? Would you still have the ability to do that? A lot of plans can be derailed by those counting on real estate values to fund their lifestyle and their retirement.

As mentioned earlier, evidence of what can happen when real estate becomes unaffordable can be seen by looking at what has happened in the United States since 2007.

In Canada our aging demographic is another factor that could affect the resale value of homes in the future. The Baby Boomers represent a disproportionately large percentage of the population and this group will ultimately downsize or move retirement homes. The pool of buyers available to buy these homes is smaller than the pool of potential sellers.

Rental properties

Rental properties are another story. Owning them is a business asset that should be evaluated on the basis of their ability to create positive cash flow and is beyond the scope of this discussion. One point to keep in mind is that owning rental properties is an active business that requires a great deal of time, while investing is a more passive strategy that requires far less time and physical effort.

Comparing ownership of rental properties to a portfolio of investments is like comparing apples and oranges. Despite their differences, both can help you reach your financial goals if managed properly.

Reverse Mortgages

While on the topic of real estate, it is worthwhile to discuss reverse mortgages.

Retirees who have built significant equity in their homes over time can be tempted to tap into that equity to supplement their retirement income.

Rather than making a mortgage payment and reducing their liability, those who implement a reverse mortgage are, in effect, withdrawing a mortgage payment and increasing their liability.

The interest charged on this mortgage withdrawal can be very high and in some cases it is compounded annually. Over time the equity in your home can be devoured by withdrawals and accumulated interest. If your personal situation unexpectedly changes, that could be a devastating development.

An article that appeared in Money Sense magazine outlines some of the risks involved in taking out a reverse mortgage. You can read it at http://www.moneysense.ca/2007/12/03/the-mortgage-that-grows/ . According to the article, once you have adopted the strategy, “you can’t change your mind”.

Given the possibility that house prices in Canada may be over-valued as of 2012, additional caution should be exercised.

Before you are dazzled by the potential benefits of a reverse mortgage, learn more about any potential pitfalls and what alternatives may be more appropriate.

Leverage

Leverage is a term used to describe borrow to invest.

Encouraging investors to take out a loan in order to invest in mutual funds is a strategy that has been advocated by some advisors. The rationale is that the loan interest is tax deductible and that the returns on the mutual fund will be higher than the interest rate on the loan. It is presented as a win-win situation.

With interest rates at historically low levels, this strategy can become even more tempting.

The first risk is that returns in the stock market may be less than you expect. In the ten year period from 2000 to 2010 the equity markets in Canada, the United States and Europe provided almost no return to the investor. That would have been ten years of paying interest with nothing to show for it.

Proponents of this strategy say that the markets will always rebound and go up in the long term. It is a self-serving statement. Markets can go sideways for a long time and some have even shown long term declines in value.

For example, the Japanese stock market includes such iconic names as Honda, Toyota, Panasonic and Sony; yet it has been in a state of decline for twenty years. While that may not happen in Canada, the fact remains that it could.

The second risk is interest rates. While rates may be low now, the situation can change quickly and severely. Interest rates are directly tied to inflation which is directly tied to the amount of money a government prints . . . and in the period between 2007 and 2012 a lot of money has been printed.

In other words, interest rates could rise at the worst possible time for someone implementing a leveraged investment strategy.

While the stock market often benefits from inflation, it doesn’t help the investor if those gains are offset by skyrocketing interest rates.

The third risk is timing. It may be that you need to cash in your investments to cover an emergency expense or perhaps a job loss or illness makes it impossible to service your loan payments. Equity markets are volatile and if an unfortunate circumstance occurs when the markets are in the midst of a correction, it can prove extremely costly.

Three out of four people are likely to make money on a mutual fund leverage strategy. The first is the banker who lends you the money, the second is the financial advisor who collects commissions he would not otherwise have earned and the third is the mutual fund company or investment firm which collects the annual management fees on your investment portfolio.

As the fourth person involved in this scheme, you can also make money with a leveraged investment, but you are taking all of the risk and you are at the bottom of the food chain.It is never fun when you lose money on an investment; it is even worse when you lose money that you have borrowed and are saddled with payments with nothing to show for it. Be wary of anyone who promotes an investment strategy that includes investing in mutual funds or stocks using borrowed money.

 Leveraged and Inverse ETFs

Some exchange traded funds (ETFs) use alternative investment strategies that can involve leverage (borrowing to invest).

You may be unaware of these loans but they are embedded in the structure of the fund. These ETFs are subject to significantly greater volatility than non-leveraged ETFs and can result in substantial losses should market prices fall.

Inverse ETFs are designed to increase in value if market prices fall. Some inverse ETFs also use leverage, making them even more complex.

In many cases, the underlying investments are not stocks or bonds but rather they are futures contracts. These types of products should only be used by highly sophisticated investors who have the ability to follow the markets closely and place trades very quickly. Even then, their value is questionable.

For the average investor, leveraged ETFs and inverse ETFs are products to avoid.

Labour Sponsored Venture Funds

Labour sponsored venture funds are a special class of mutual funds that have a tax credit associated with them. These funds invest in very small companies, many of them private companies that have limited access to capital to start or expand their business operations.

As an incentive for investors to take the additional risk and invest in these companies, a tax credit for investing in these funds has been approved by the federal and provincial governments. As with anything in the real world, there are no free lunches. Once the fund has been purchased and the tax credit claimed, the investor must hold on to the fund for eight years or be forced to repay the tax credit.

That is only part of the bad news. With a couple of exceptions, performance has generally been abysmal, the cost to manage these funds has been high and the expertise in the area of venture capital has been lacking.

An article published in the Globe and Mail on October 24, 2010 revealed that only 6 of 17 funds that had an eight year track record showed positive returns to the investor.

A paper released in March 2012 by the School of Public Policy at the University of Calgary called for an end to government funding of labour sponsored ventured funds. For those who want to take the time to read the findings of Professor Jeffrey MacIntosh, the link to the website is http://policyschool.ucalgary.ca.

Day Trading

This strategy involves buying and selling a stock on the same day. It has been facilitated by the low commission structures of discount brokers and online brokers. The unintended consequence was that large numbers of inexperienced investors were lured into the market where the prospect of quick profits and low fees promised easy riches.

And it worked . . . for a while. The late 90s were the days when the markets climbed exponentially higher day after day and stocks like Nortel were trading at over $200 per share. It really didn’t matter much which stock you bought because they all went up. It created a false sense of security among investors and some even quit their jobs to focus on trading their own portfolios.

When the ‘tech wreck’ occurred early in the new millennium, many of the high flying stocks crashed to earth, destroying the wealth of numerous day traders. Unable to sell at a profit by the end of the day, some would hold on, hoping for a bounce in price. Instead, prices cascaded lower day after day and the glamorous image of day trading quickly became tarnished.

Yet advertisements still appear on television advocating trading strategies that will put you a step ahead.

Trading and investing are two completely different approaches that happen to participate in the same market. The average Canadian should probably be an investor – not a day trader. The cards are stacked against them when it comes to strategies like day trading.

The rise and fall of day trading may have served one purpose. It has clearly illustrated that low commissions do not guarantee success. In fact, it has shown that investors can be tempted into irrational behaviour when some of the barriers are removed.

RRSP Meltdown Strategy #1

This strategy is actually terrifying. It can work out unbelievably well, it can have minimal benefits or it can be financially crippling.

The idea is to collapse your RRSP account and withdraw all the money in the account. That immediately creates a huge tax bill but with the meltdown strategy, the investor takes the proceeds from the RRSP and purchases flow-through shares.

Without going into a lengthy explanation, flow-through shares are tax advantaged investments where the purchaser of the shares gets a big tax credit. The reason there is a tax credit associated with them is because the proceeds received from the sale of the shares is used in exploration projects in the energy and mining industries. These are considered high risk undertakings and to encourage investors to take risk, the government offers tax credits.

The theory is that the investor is able to get most of the money out of their RRSP while paying only minimal taxes. It may be very tempting but the key phrase is ‘high risk’. If the exploration projects do not work out as well as hoped for, the value of flow through shares can plummet and in extreme cases become worthless.

Investors should not throw caution to the wind in an effort to avoid taxes and this strategy does exactly that. In an effort to save a few dollars in taxes some investors have invested inappropriate amounts of money in flow-through shares using this strategy.

It can work out and your advisor may point to past success, but make no mistake, an RSP meltdown strategy that uses flow-through shares to offset taxes is a high risk strategy.

 RRSP Meltdown Strategy #2

This is another strategy of questionable merit. It involves taking out a bank loan and making an investment with the proceeds of that loan. Because the loan is for investment purposes the interest you pay is tax-deductible.

The next step is to withdraw an amount from your RRSP each year that covers the interest cost on your loan. The tax on the RRSP withdrawal is offset by the tax-deductible interest.

The theory goes that your investments grow faster than the rate of interest on your loan over time and you have gradually withdrawn all the assets from your RRSP without paying any tax on those withdrawals.

It can work if all the pieces fall into place but it is fraught with danger. For many who implemented the strategy at the beginning of the new millennium it has likely been an unmitigated disaster.

The problem with this strategy is that the investor is once again using leverage and betting their retirement on that leverage. It is a wolf in sheep’s clothing.

Speculative Stocks

‘Penny stocks’ is a term synonymous with highly speculative low priced shares. They don’t necessarily have to trade for pennies but many of these stocks have one thing in common . . . they have no revenues, never mind earnings (profits).

When you invest in companies that have no revenue, they are simply taking your money and working on a project in the hope that it will at some point become viable, generate some revenues and eventually realize a profit. Buying shares in companies at this stage of their development is the definition of speculation and has very little in common with buying shares of well-established companies that have a solid track record of earnings and growth.

Yet the temptation to abandon a disciplined strategy can increase when an investor hears a friend or colleague talking about a ‘hot tip’ and they begin to dream of remarkable returns.

Pursuing speculative investments is not a strategy that should be part of a long term financial plan.

Investors who still want the rush of buying speculative stocks should set up a separate trading account for that purpose and should not cannibalize their retirement assets to fund the new account.

These stocks are not appropriate investments if you are relying on them to fund your retirement.

Unfortunately, some investors will lump all stocks into the same category, shying away from a good company with solid earnings and a reasonable dividend because of a bad experience with a penny stock. While the ongoing viability of these companies compared to a ‘penny stock’ is as different as night is from day, they are painted with the same brush.

Hedge Funds

Investopedia (www.investopedia.com) defines hedge funds as funds that “use advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns”.

When it comes to investing, the term hedge should mean “hedging your risk” and that is what authentic hedge funds do; they hedge your risk.

Unfortunately the strategies used to hedge risk can be mutated into a form that actually increases risk . . . exponentially!! Unfortunately this part the financial services industry is largely unregulated and a plethora of these highly volatile funds have been created.

They should be tagged performance seeking hedge funds rather than risk management hedge funds.

Unfortunately, most hedge funds operate as a black box. In other words, the manager will rarely disclose exactly what they are holding and how these advanced strategies are being applied. For investors, that means they are buying something they cannot see and must rely on the managers’ abilities to outsmart the market.

While there are probably some very good hedge funds, there are also some very bad ones. Those that fail can fail in a spectacular manner, often because leverage is widely used in hedge funds and leverage can magnify losses as well as gains.

A good example is Long Term Capital Management, a hedge fund whose board of directors included former Nobel Prize winners in economics.

Logic would seem to indicate that if anyone knew what they were doing it would be Long Term Capital Management. Stunningly, its failure in 1998 not only wiped out those who invested in the fund, it almost led to a collapse in the world financial markets.

The entire story can be read in the book by Roger Lowenstein, “When Genius Failed: The Rise and Fall of Long-Term Capital Management”.

Renowned financial writer and author of “Moneyball”, Michael Lewis, also wrote about Long Term Capital Management in a 1999 New York Times article entitled “How the Eggheads Cracked”.

Authentic hedge funds, on the other hand, can add stability to a portfolio but determining whether a fund is an authentic hedge fund or a performance seeking hedge fund is a difficult task. Your financial advisor can help.

One final note about hedge funds. Their fee structure usually differs substantially from the fee structure you may be used to with mutual funds. That is code for “the fees can be very high”. For the average investor, hedge funds are a questionable investment.

Commodities

Physical commodities can be simply described as things that you can touch and feel; they have a physical presence. They include metals such as copper or nickel, foodstuffs such as grains, meats or orange juice and energy products such as crude oil or natural gas.

The list of tradable commodities is extensive but few investors understand exactly how they trade.

When you trade commodities on a commodities exchange you are not buying the physical commodity. Rather, you are entering into a contract whereby you promise to buy and take delivery of that commodity at a future date at a pre-determined price.

When you enter into that contract, you put up a ‘good faith deposit’, known as initial margin, which represents only a very small portion of the total value of the contract.

Once again, leverage is involved and in this case it is substantial.

Those who have a need for that commodity in the future (an end user) and who are willing to take delivery of the commodity would be classified as hedgers. An example may be a food processing company that wants to ensure it will be able to secure a supply of corn in the future at a predetermined price.

Those who have no need for the commodity in the future but who are simply expecting the price to rise are speculators. They hope the price will rise and they can sell their contract before the delivery date.

As an example, a speculator may have taken out one contract for crude oil with an initial margin payment of $9,000. If he has to take delivery of that contract, he must pay the full price for 1000 barrels of crude oil and must find a place to store those 1000 barrels (roughly 170,000 litres) until someone is willing to buy it from him.

Depending on the price specified in the contract, the sums of money can be enormous. At $90 per barrel, the cost would be $90,000 plus storage. Very few investors want to cough up an additional $90,000 on an initial investment of $9,000.

While this short explanation oversimplifies the commodities markets, it does serve to illustrate some of the challenges of investing in commodities.

Be cautious and research the commodity markets extensively before considering an investment in this area.

Most of the familiar names among retail investment firms in Canada do not offer commodity trading services to their clients.

Company Shares

Investing in the shares of the company you work for can be a good idea; over-investing in those shares rarely is.

There have been too many cases where employees have the bulk of their life savings tied up in company shares. They are not only relying on the company to provide them with a paycheque, they are relying heavily on them for their retirement income as well.

It is the extreme example of putting all of your eggs in one basket. Companies like Enron and Nortel are prime examples of what can go wrong with this strategy.

Part of the employee bias can be a result of loyalty to the company. It can also come from employees confusing their familiarity with the company with its potential, or it can come from unrealistic expectations regarding the industry in which the company operates.

In the case of loyalty, some employees strongly believe in the company they work for and conclude it would be disloyal not to own as many shares as possible if given the opportunity. They become emotionally tied to the company rather than looking at their situation in an objective manner.

Employees may also have a lot of confidence in their co-workers and their efforts to make the company a success. This familiarity with their own company often precludes a broad overview of the economy, the markets and other investment opportunities. Those who fall into this category tend to overlook the big picture.

The unrealistic expectations can stem from seeing the financial success that senior executives in their company achieved through share ownership.

The circumstances under which their shares were acquired, however, may have been far different from those of a new employee. In addition, these shares may represent only a small portion of the total net worth of the executive.

There can also be an element of naïvety. Employees may understand the workings of their company but not how its value is perceived by the market. The relationship between a company’s operations and its share price is not linear. The market can view and value a company far differently from an employee and it is the market price that counts.

While there is nothing wrong with owning company shares in a company that you work for and believe in, it needs to be kept in perspective.

Perhaps the biggest danger in this strategy is that employees may have over half of their total investments held in the shares of their company. It is a situation known as portfolio concentration and it can subject the value of your portfolio to wild swings . . . both up and down.

The percentage of a portfolio held in shares of a single company should rarely exceed 10% of the total value of your investments and 5% is a far better guideline. If part of your compensation is in the form of company shares, monitor how much of your total portfolio these shares comprise.

When the opportunity arises, adjust your holdings to appropriate levels and diversify your holdings using the principles discussed earlier.

Notes: 

There is an old hockey adage that states, ‘offense is exciting but defense wins championships’. The same theory applies to investing. When trying to achieve investment success, minimizing mistakes is as important as maximizing opportunities. It is about treating your money well.

 The list of investment strategies that should be scrutinized closely or avoided altogether is relatively long. Some of these may be exciting and the rewards can be great, if you are lucky, but there is the potential to make a big mistake and jeopardize your financial health. These strategies include:

  • Relying on an increase in the value of your home to fund retirement.
  • Reverse mortgages.
  • Leverage (borrowing to invest).
  • Investing in leveraged and/or inverse ETFs.
  • Investing in labour sponsored venture funds.
  • Day trading.
  • Investing in speculative (penny) stocks.
  • RRSP meltdown strategies.
  • Investing in hedge funds.
  • Investing in commodities.
  • Over-investing in the shares of the company you work for or the industry you work in.

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