Last August, Rob Carrick of The Globe and Mail wrote a piece about Canadian dividend ETFs and he invited three bloggers — me, Canadian Capitalist and Million Dollar Journey — to offer our picks. My colleagues both chose the Claymore S&P/TSX Canadian Dividend ETF (CDZ), one of the more popular ETFs in Canada, with almost half a billion dollars in assets. I took a different view, suggesting that investors consider buying equal amounts of CDZ and the iShares Dow Jones Canada Select Dividend Index Fund (XDV).

My reason for that recommendation — explained in this August 2010 post — was that the ETFs track two very different indexes, and there was surprisingly little overlap in their holdings. Well, that’s even more true today. The S&P/TSX Canadian Dividend Aristocrats Index, the benchmark for CDZ, was reconstituted in December, and the changes were dramatic: the Claymore ETF now has zero exposure to banks and insurance companies. Its iShares competitor, meanwhile, is more than 51% financials: the Big Six banks alone make up almost 30% of XDV.

How to become an Aristocrat

To understand what’s going on here, it’s important to know S&P’s methodology. The Aristocrats index was originally created in the US, and its most important rule was that a company had to have increased its dividend for 25 years in a row. That’s a very select list—of the thousands of publicly traded companies in the US, only about 50 can claim that track record. If you applied the rule in this country, you wouldn’t have much of an index—actually, you’d probably just have Fortis. So when the Canadian version of the Aristocrats index was launched, it set the bar at seven consecutive years of dividend increases, and it has since dropped that to five. (Companies must also have a market cap of at least $300 million.)

Think about that for a moment. If a company fails to raise its dividend in any year, it will get booted out of the Aristocrats index and be sentenced to five years with no chance of parole. Remember, we’re not talking about eliminating a dividend, or even reducing it: even if a company pays the same dividend two years in a row, that’s grounds for getting expelled from the aristocracy. They’re a tough crowd over at S&P.

During the financial crisis of 2008–09, many companies had a rough time and did not raise their dividends. So when the index was reviewed in 2009, 14 companies were shown the door. Scotiabank and TD were the only banks left in 2010, and both were banished from the index this past December, along with Encana, Great-West Life, Canadian Tire, RioCan and 18 others. Only five new companies were added, including Enbridge, Rogers and Tim Hortons.

Showing no mercy

I have to question the wisdom of the Aristocrats methodology. While failing to raise dividends may have frustrated investors, it may have been the right thing for those companies to do. Sometimes it makes more sense for a business to use its free cash to get through a temporary crisis rather than to raise its dividend. In the long run, that should benefit all shareholders. But the Aristocrats index is merciless and short-sighted. Not only has it kicked out dozens of financially sound companies, it has forced CDZ to liquidate these holdings and stick investors with a hefty capital gains distribution at the end of 2011.

The upshot of all this is that CDZ now holds 39 stocks, none of which are banks or insurance companies. That’s why I think it makes sense for dividend-focused investors to also look at the bank-heavy XDV. The two ETFs actually complement each other nicely, and holding equal amounts of both offers much better diversification than either one on its own. That’s the strategy I recommend in my Yield-Hungry Couch Potato portfolio.

For investors who do not need current income (that includes anyone investing in an RRSP), I continue to recommend broad-based index funds and ETFs that do not screen stocks for dividend yield.

This post is the last in a series in which I share some insights from my recent interview with Meir Statman, one of the world’s leading scholars of behavioural finance. At the end of the post, I’ll tell you how you can win a copy of Prof. Statmans’s fascinating new book, What Investors Really Want.

It’s natural for human beings to be overly confident in our own abilities. You’ve probably heard about the famous famous study in which about four out of five people rated their own driving skill as above average.

This tendency to overrate our own skill is sometimes called the Lake Wobegon Effect, after radio personality Garrison Keillor’s fictional town where “all the women are strong, all the men are good-looking and all the children are above average.”

You can imagine that 100% of active fund managers are convinced that they can outperform the market. But this is impossible, since every invested dollar that beats the market must be balanced by another dollar that lags by an equal amount.

The idiot on the other side of the trade

Prof. Statman uses a fresh analogy to explain our overconfidence as investors. He compares active investors to tennis players who think they are hitting the ball against a practice wall, when in fact they are playing against another player who may be more skilled. He goes on to say that entrepreneurs do not make this same mistake. I asked him to elaborate:

“Investors generally don’t think about this simple question: ‘If I am buying a stock because I think it is going to go up, who is the idiot who is selling it to me?’ They don’t think about investing like playing tennis against a possibly more skilled opponent. They ignore the likelihood that the person on the other side has some inside information, or a computer program that enables them to take advantage of an opportunity. They don’t realize that they might in fact be that opportunity, and that someone else’s gain may come at their expense.

“There is another analogy that I make, which is that if I go to the supermarket and tuna is on sale for $1 and it usually costs $2, I’m going to stock up. If the store runs out of tuna, I can always get a rain check that guarantees me that lower price. That’s a real sale. What investors don’t get is that when the guy on television says this stock is a bargain, other people hear that, too. And by the time you get to the market, it might not be a bargain anymore, even if the person on TV was right at the time.

“Entrepreneurs are different, because they are keenly aware that they are in competition against players on the other side of the net. If they are not aware of their competition they’re going to be in trouble very quickly. So they constantly ask themselves, ‘Is somebody selling the same product at a lower price?’ or ‘Is somebody selling a better product at the same price?’ or ‘Is somebody introducing a new product that is going to kill mine?’ In this sense, they know they are playing tennis against a real opponent.”

I would argue that Couch Potatoes, unlike active investors, are closer to the tennis player who is hitting the ball against the practice wall. Unless they are actively trying to time the market, investors who buy broad-based index funds aren’t doing so because they think they’re outsmarting an idiot on the other side of the trade. They’re simply making the decision to accept market risk with the expectation that they will be rewarded over the long-term.

Win a copy of What Investors Really Want

Now it’s time to give away a couple of copies of Prof. Statman’s book, What Investors Really Want. I’ll draw two names at random from all of the entries I receive before Friday, January 14, at 11:59 pm EST. There are two ways to enter:

• Tweet this post to your followers. Be sure to include @CdnCouchPotato in the tweet so I can track it.
• Post a comment below and share what you think is the biggest behavioural bias you face in your own investing.

Good luck to all entrants. Winners will be announced on Monday, January 17.

These are good times to be a Canadian equity investor. Not only have we enjoyed back-to-back banner years — the S&P/TSX Composite returned over 35% in 2009 and 17% last year— but Canadian stocks have dramatically outperformed both the US and international developed markets over the last decade.

Of course, even when Canadian stocks were lagging the rest of the world in the 1980s and 1990s, investors in this country still loaded up on them. Back then we didn’t have much choice: you weren’t allowed to have more than 20% of your RRSP in foreign holdings, and in any case, investing internationally through mutual funds was extremely expensive. Both hurdles have long since disappeared—indeed, thanks to ETFs from firms like Vanguard, investing internationally is in many ways cheaper than buying Canadian. Yet still our home bias remains.

Are companies safer because they’re more familiar?

In my recent interview with Meir Statman, author of What Investors Really Want, I asked the professor why we suffer from home bias. I suggested that perhaps we were confusing what is familiar with what is safe:

“That makes sense, because in general familiar things are safe. If a certain food was around the house when you were a kid, you got a sense from your parents that it was a good food, and that is likely to persist throughout life. If people are afraid, they stay close to home because venturing out might be dangerous. But of course, we all know you can easily overdo it and become a hermit. So what is necessary is a proper assessment of the risk of venturing out, and the risks and advantages of staying close to home. There is a need, for example, to understand the benefits of diversification, and the risk-reduction benefits that come from a global portfolio, and that might overcome the fear or hesitation to venture abroad.

“There are some other elements to it: for some it’s like a badge of loyalty. You are loyal to your own country if you invest in it: in fact you can see that in the political arena. Sometimes pension funds are required by law to invest no more than, say, 20% abroad. I know that South Africa, for example, has very severe restrictions on pension funds about how much they can invest abroad, because there is just a sense that money should be kept close to home.

“And then there is the question of what it is that my neighbours are doing, and how do I match up against them. If your neighbours are all concentrated in Canada and you venture out not just to the United States but also China and other developing markets, you might either be a big winner or a big loser relative to your neighbours, and that is something that many people find scary.”

Home bias has been observed in every country, but it’s a potentially bigger problem in small countries like Canada. The average US investor holds 70% of her equities in American stocks, but the US makes up more than 40% of the global markets, and its economy is the most diversified in the world. Canada is not only tiny (4% of the global markets), but also highly concentrated: an investor in a broad Canadian index fund has more than three-quarters of his money in financials, energy and materials.

The benefits of global diversification

Here’s a sector breakdown of the Canadian market compared with the US, international developed markets, and emerging countries. Look at how much more broadly diversified your portfolio would be if you split your equity holdings equally among them:

To be sure, there are some legitimate reasons for concentrating your investments in your own country. One is that it reduces currency risk: if your expenses are in Canadian dollars, it makes sense to hold most of your assets in the same currency. (Foreign currency can be hedged, of course, but the process is costly and not very precise.) It’s also wise to invest in Canadian stocks to take advantage of the dividend tax credit and other tax breaks. However, as Statman explains, the reasons for our home bias are mostly behavioural. It’s another obstacle we need to overcome on the road to investing success.

I recently had the opportunity to interview Meir Statman, author of the new book What Investors Really Want, and a professor of finance at Santa Clara University in California. Professor Statman is one of the world’s leading experts in behavioural finance, and his new book explores the ways that our emotions and desires affect the way we invest.

In a series of posts this week and next, I’d like to take a detailed look at some of the ideas that Prof. Statman and I discussed. At the end of the series, I’ll announce a contest where readers can win a copy of What Investors Really Want to add to their own financial library.

Let’s open with one of the main ideas that Statman introduces in the book. Why do we invest? The answer may seem obvious: to build a retirement nest egg, or a college fund for our kids, or for some other specific financial goal. But our desires go beyond these utilitarian benefits. Statman explains that we also get expressive and emotional benefits from investing. For example, active investors savour the thrill of trying to beat the market, while hedge fund investors enjoy the status of membership in a fund that’s closed to all but the most wealthy.

Honk if you drive a Honda

I began our conversation by asking Prof. Statman how this applies to index investors, who clearly don’t enjoy any market-beating thrills or exalted status when they focus low-cost index funds:

“What I want from my investments is mostly the utilitarian benefits that I speak about, and I want expressive and emotional benefits from other areas of my life. As an index investor, I economize in the area of investments, but I don’t mind, for example, buying an expensive painting that may cost thousands of dollars, when in fact a $20 poster is going to cover more of the wall.

“But, in fact, I am deriving expressive and emotional pleasures from index funds as well. Let me explain: there are people who take pride in having a $10,000 watch, and there are other people who actually take pride in having a $10 watch, because they consider people who buy $10,000 watches to be idiots and show-offs. They know that a $10,000 watch shows the same time as a $10 watch. So there is kind of a pride in being smart, and in being frugal— not cheap, but just plain frugal.

“I liken index investing to buying a Honda Accord. A Honda Accord is a car that gives you a high Sharpe ratio—a high ratio of returns to risk. If you can live with that, that is fine. But understand that some people want to have the Acura—which is a dressed-up Honda—because they also want the prestige that comes with luxury buying. This might be because they are in the company of people who always brag about their possessions, and they feel that they are going to be regarded as low-class if they drive a Honda. So it’s important for us to know what is people want.

“I should note that while I belong to the index fund crowd, I am not religious about it. I don’t regard people who belong to another persuasion, or another religion, as destined not to go to heaven. I happen to have have a $100 watch, and somebody might say I’m wasting my money, because a $10 watch shows the same time. But I like it—it’s beautiful in my eyes, and it’s worth it to me.

“So what I am saying is give people some space—cut them some slack. Some people like the hope that comes with active funds. Some people like to be socially responsible, and perhaps they find it hard to do that with the available index funds. People want different things, and the fact that they choose differently does not necessarily mean they are ignorant or stupid. They might just have different tastes than you have. I find that in both camps there is an increasing level of shrillness, where it is ‘my way or the highway.’ But I say we’ll all end up in heaven.”

Can’t we all just get along?

I liked Prof. Statman’s message of tolerance, and confessed that I’ve probably added to the shrillness by coming down hard on investor success stories and media reports about market-beating mutual funds. Here’s how Prof. Statman responded:

“Let me just add that the index group is right in saying that outperformance might just be a fluke: this is another distinction I make in the book. There is a distinction between what is a preference and what is an error. To the extent that people in the active group say, ‘Don’t tell me that I cannot beat the market, because such-and-such a fund beat the market,’ I think somebody has to point out the usual analogy of coin tossing, and that you are always going to have winners. I think index investors are right in pointing out the errors that many active investors make. But at the same time, they should not press their case too far and say that people should focus only on the utilitarian benefits of investing, and that anyone who diverges from that is an idiot. Maybe they’re not: maybe they just have different tastes.”

One of my favourite tales of investment stupidity is the story of the Beardstown Ladies. This group of grannies from a tiny Illinois town became famous in the 1990s when their investment club reported annualized returns of more than 23% for a decade. These Buffetts in bonnets wrote five books about their stock-picking acumen, which sold hundreds of thousands of copies, and they toured the US, celebrated as folksy, common-sense geniuses. Then someone checked their numbers.

It turned out that when the ladies calculated their returns, they included new money they had added during the year. Their actual investment returns over the decade were 9.1% annually, compared with almost 15% for the S&P 500. If you happen to find a Beardstown Ladies guide in a used bookstore one day, grab it: they’re collectors’ items now.

As the year-end approaches, you’ll likely want to know how well your own portfolio has done during the last 12 months. If you didn’t add or withdraw any money during the year, calculating your return is easy. Let’s say your portfolio’s value was $50,000 last December 31, and at the end of this year it has grown to $60,000. You can figure out the rate of the return with this simple formula: ($60,000 – $50,000) / $50,000 × 100 = 20%.

But as the Beardstown Ladies discovered — unfortunately, it was only after they appeared on Donahue — this formula doesn’t work if your account has experienced cash flows, either in or out. What if the above portfolio started the year at $50,000 and you contributed another $500 on the 15th of each month? Your balance has increased by $10,000, but $6,000 was new money and only $4,000 came from investment growth. Now what is your rate of return for the year? Not so simple anymore.

You don’t have to do the math

Most annual statements from brokerages, mutual fund companies, and financial advisors do not include your personal rate of return, also called the internal rate of return, or the dollar-weighted return. So you’re probably on your own when it comes to figuring it out.

There are several formulas for calculating a portfolio’s return when money has moved in and out during the year. Most use that squiggly line that looks like a sideways W, and I’m pretty sure one of them includes the emblem of the Green Lantern. You are welcome to use these.

Fortunately for people like me, Weigh House Investor Services in Toronto created this handy online calculator that will do the math for you. All you need to do is enter the value of your portfolio at the start of the year, the value at the end of the year, and the dates and amounts of any contributions or withdrawals.

I used the calculator to figure out the rate of return in my own RRSP, taking into account three lump-sum contributions I made during the year. (My ETF retirement portfolio is 30% bonds and 70% equities, spread across Canada, the US, and international developed and emerging markets.) How did I do? Just over 10% for the year. That means I accomplished my investment goal: beating the 10-year performance of the Beardstown Ladies. In your face, Grandma. (Just kidding.)

This week both Canadian Capitalist and I were dismissive about the Dynamic Funds that swept this year’s Canadian Investment Awards. We argued that it’s easy to celebrate past performance, but impossible to identify managers whose success will continue in the future. One commenter on CC’s blog, a financial advisor, disagreed and suggested that choosing a manager who will outperform is no different from identifying a skilled hockey player.

This comparison just doesn’t hold up. If a hockey player scores twice as many points as the average player for several years in a row, it is highly likely his superior performance will continue, because skill determines virtually 100% of a player’s results. Sidney Crosby can be fully expected to outscore the average NHL player for a very long time.

Investing is nothing like playing in the NHL. The bulk of an investor’s return comes from simply accepting market risk, which requires no skill whatsoever. Anyone who buys an index fund can instantly obtain near-market returns, and indeed, he or she will beat most professional managers after costs. I accept that it’s possible to identify skilled managers, but the best they can hope for is returns that are incrementally better. One can never hope to identify a money manager who will dramatically outperform his or her peers, or the market averages, with anything like the consistency of a Sidney Crosby.

The NHL’s Couch Potato

All these hockey metaphors made me wonder: what NHL player best represents the index investor? The name that comes to mind is Mike Gartner. Most non-hockey fans have probably never heard of Gartner, even though he played in the NHL for almost two decades before retiring in 1998. He was never a household name because he never had a single season with mind-blowing numbers. In fact, he never once led the league in any major scoring category:

So was Mike Gartner an “average” player? Hardly. Gartner scored 708 goals in his career, which places him sixth overall, ahead of Mario Lemieux, Steve Yzerman and Jaromir Jagr. In 2001, he was inducted into the Hockey Hall of Fame.

Mike Gartner was one of the fastest skaters in the NHL, but he was not more skilled than Lemieux, or even Yzerman or Jagr. He didn’t have to be. Gartner had longevity: on average, he missed no more than five games per season — he was “fully invested” for 19 years. More important, he was extremely consistent: while he never beat the 50-goal benchmark in any season, he scored 30 or more goals a remarkable 17 times, something neither Wayne Gretzky nor Gordie Howe ever managed.

The lesson for investors is this: Gartner was not the best performer in any given year, never won a major NHL award, and never won a Stanley Cup. He never got the respect he deserved — The Hockey News insulted him by ranking him 89th in their Top 100. Yet despite all of this, his long-term performance was not merely good, or even great: he was one of the most successful hockey players of all time.

Next time someone asks you why you would invest with index funds that will never beat the market or win a Canadian Investment Award, take them to the Hockey Hall of Fame and tell them the story of Mike Gartner.

Update on June 27, 2010: The Government has decided to provide relief to taxpayers whose net TFSA contributions never exceeded $5,000 in 2009. The deadline for responding to the TFSA return letter from the CRA is August 3, 2010. You are asked to respond to the CRA letter by providing additional information or explanations that you may have in respect of your over-contributions. Details here.

If you are one of the reportedly more than 70,000 or so tax payers who has been penalized by the CRA for excess TFSA contributions and the error arose as a consequence of a reasonable error and are looking for relief, I urge you to read Rob Carrick’s column in the Globe and Mail today (See Confusion over TFSA rules leads to costly penalties for some investors):

Accidentally contributed more than $5,000 to a TFSA? It may still be possible to avoid penalties for over-contributions. Paul Hickey, partner at KPMG’s national tax centre, suggested using CRA’s tax fairness provisions by submitting a Request For Taxpayer Relief form.

“Interestingly the TFSA provisions contain a special rule which allows the CRA to waive or cancel all or part of the penalty if you can establish “to the satisfaction of the Minister that the liability arose as a consequence of a reasonable error,” and that the individual acts without delay to fix the problem,” Mr. Hickey said in an e-mail.

Here are the specific provisions in the TFSA legislation that would allow taxpayers to request a waiver of tax payable:

Tax payable on excess TFSA amount

207.02

If, at any time in a calendar month, an individual has an excess TFSA amount, the individual shall, in respect of that month, pay a tax under this Part equal to 1% of the highest such amount in that month.

Waiver of tax payable

207.06

(1) If an individual would otherwise be liable to pay a tax under this Part because of section 207.02 or 207.03, the Minister may waive or cancel all or part of the liability if

(a) the individual establishes to the satisfaction of the Minister that the liability arose as a consequence of a reasonable error; and

(b) the individual acts without delay to cause one or more distributions to be made, under one or more TFSAs, the total amount of which is not less than the amount in respect of which the individual would otherwise be liable to pay the tax.

Also see Money Smarts Blog’s post on this topic.

How to apply

I should note here that I’m not a tax professional or accountant but here’s how I’d apply for a excess TFSA amount penalty waiver.

1. Fill out the form Schedule A, Excess TFSA Amounts (Form RC243-Sch-A) and attach a cheque for the TFSA penalty amount. Mail it in to the nearest tax centre before June 30, 2010.
2. File a Request for Taxpayer Relief (Form RC 4288). Ask for a waiver under 207.06 of the Income Tax Act. Show how the penalty arose as a result of a “reasonable error” AND the steps you have taken to rectify it (by removing the excess amounts). Mail it in to your nearest tax centre.

Rob Carrick writes in the Globe and Mail that the CRA may provide relief on a case-by-case basis.

James Daw in The Star (Don’t panic! Appeal penalty tax on tax-free savings) has a step-by-step process to apply for a waiver of TFSA excess amount penalties.

Related Reading:

• Government Waives Some TFSA Penalties
• TFSA Excess Contribution Penalties Ensnare Taxpayers
• This and That: TFSA penalty waivers and more…
• Should U.S. Estate Taxes Affect the Choice of Investments?
• Surplus Allocation Act

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