Capital Topics

In this Episode, James Parkyn & François Doyon La Rochelle discuss a recent report from the C.D. Howe Institute that highlights the need to revamp the rules surrounding Registered Retirement Income Funds (RRIFs) withdrawals.

They also tackle the current debate over the classic way of building a balanced portfolio which is an allocation of 60% stocks & 40% bonds.

Links to share:

- Episode #52 : The New Tax-Free First Home Savings Account FHSA — Capital Topics by James Parkyn & François Doyon La Rochelle

- Episode 50: 2023 Update on Expected Returns — Capital Topics By James Parkyn & François Doyon La Rochelle

- The silver lining from a tough year in the markets is higher expected returns. — Capital Topics by James Parkyn

- A look back and forward at the 60/40 portfolio | Vanguard Canada By Vanguard Canada

-Live Long and Prosper? Mandatory RRIF Drawdowns Raise the Risk of Outliving Tax-Deferred Saving By William B.P. Robson & Alexandre Laurin at The C.D. Howe Institute

Description:

In this Episode, James Parkyn & François Doyon La Rochelle revisit the basics of the recently launched Tax-Free First Home Savings Account (FHSA) and give their listeners some planning ideas.

They also perpetuate their annual tradition and review of the 15th edition of The Credit Suisse Global Investment Returns Yearbook 2023, Summary Edition.

Read The Script:

1. INTRODUCTION:

François Doyon La Rochelle:

You're listening to Capital Topics, episode #52!

This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss the following points:

For our first topic, we will review and comment on the recently launched Tax-Free First Home Savings Account (FHSA)

And next, for our main topic, we will Review the Credit Suisse Global Investment Returns Yearbook 2023

Enjoy!

1. In the news: The New FHSA

François Doyon La Rochelle: In our first topic today, we will review and comment on the recently launched Tax-Free First Home Savings Account (FHSA). This is a topic that we covered in episode #45 of this podcast back in October 2022 but since then, as of April 1st, the legislation governing these types of accounts has taken effect, so we thought it was a good time to revisit the basics and give you some planning ideas.

James Parkyn: Yes, for many of our clients and our listeners, this is a hot topic that deserves our attention since it's probably the most significant tax break ever offered to help Canadians save money tax-free for the purchase of their first home.

François Doyon La Rochelle: I totally agree, so let's start and remind our listeners of the basics of how an FHSA works. The first question to ask is, who can open a First Home Savings Account? So, to be able to open an FHSA, you must be a tax resident of Canada aged between 18 and 71. Furthermore, you or your partner cannot have owned a home in the current calendar year or any of the previous 4 calendar years.

James Parkyn: One interesting nuance here to highlight is, although you can only participate once in the program, if you are now renting, but you were a homeowner let's say 6 years ago, you could still qualify as a first-time homeowner and open an account.

François Doyon La Rochelle: Correct, once you have opened your account, you can contribute up to $8,000 per year to a lifetime maximum of $40,000. If you don't contribute the full $8,000 in a given year you can carry forward the unused portions of your contribution room up to a maximum of $8,000. This means that if you contribute less than $8,000 in one year, you can contribute your unused amount in a future year. For example, if you open an FHSA in 2023 and you only contribute $4,000, in 2024 you would be allowed to contribute $12,000. That is the $8,000 for 2024 and the $4,000 for your unused contribution room for 2023. Also, like with the RRSP, your contributions are tax-deductible, meaning that any amount you put in will be deducted from your taxable income, therefore reducing your income tax.

James Parkyn: An interesting planning strategy here, especially for younger folks that are just starting their careers and that may not be earning a lot of money, is that you don't have to claim a deduction in the tax year you have made your contribution. Your contributed amount can be carried forward and deducted in a later year when your income will be higher. This way you can get a bigger tax deduction for your contribution. For parents wanting to help their adult kids buy their first home, since attribution rules don't apply, they can give money to their kids for their contributions.

François Doyon La Rochelle: Also, contributions to a FHSA doesn't have any impact on your regular RRSP contribution room so, if someone is fortunate enough and has the funds available, he could contribute to both type of accounts and use the tax refund to contribute to their regular TFSA. There is an important caveat however, once you open your FHSA, it can only remain open for up to 15 years or up to the end of the year when the account holder turns 71. At that point, if the funds have not been used to buy a first home, it can be transferred on a tax-free basis to an RRSP or RRIF or it can be withdrawn.

James Parkyn: We would not recommend withdrawing the funds as the amount withdrawn would be added to your income and taxed. This said, since the transfer to an RRSP would not impact, nor would it be limited to someone's RRSP contribution room there is another planning idea here for renters. Lifetime renters that don't intend to ever buy a house and that have maximized their RRSPs could open an FHSA and maximize their contributions to it. This way, since the funds accumulated in an FHSA can be rolled over tax-free to a regular RRSP the renters would effectively be generating an extra $40,000 of RRSP contribution room.

François Doyon La Rochelle: Yes, this is effectively one of the loopholes of this new program. Even then, if you are unsure whether you will be buying a house in the future, there is not much downside in opening an account and making the contributions because in the end if you don't buy a house, you can rollover the funds accumulated tax-free to your RRSP or RRIF. So, if you don't have the funds to make contributions to both the FHSA and the RRSP it would make sense to put money in the FHSA first. Talking about RRSPs, if you were planning to use the funds accumulated in your RRSP to buy your house with the Home Buyers Plan (HBP) you will be happy to hear that you will now be able to use the funds from both types of accounts to purchase your home. As a reminder, at first, when the legislation was introduced, you could not combine both plans.

James Parkyn: This is huge since prospective first-time home buyers could add another $35,000 in down payment.

François Doyon La Rochelle: Yes, this is very interesting, however unlike with the FHSA, the amount withdrawn from your RRSP with the HBP must be repaid within 15 years, starting the second year after the year of the first withdrawal. So, the HBP is essentially only a way to borrow money from your RRSP.

James Parkyn: Correct, in any case, I would recommend anyone to open a FHSA as early as possible to benefit from tax-free compound growth. If you open your account early and you make the maximum contribution each year, you can invest your funds more aggressively since the account can remain open for up to 15 years before you need to cash it out to buy a home or roll it over to your RRSP or RRIF. If you wait too long before opening and contributing to the account, you are giving up on growth since you will need to invest your funds more conservatively.

François Doyon La Rochelle: Yes, investing the maximum early, that is $8,000 per year for the first five years for a total of $40,000 at a 6% annual growth rate could result in approximately $85,000 in 15 years. If you combine this amount with the HBP of $35,000 that's a total of $120,000 in down payment. If you have a partner that has been as diligent as you that's $240,000 that could be available for a down payment.

James Parkyn: Yes, and again whatever your investment goals, the key is to let the magic of compounding work for you.

The sooner you start the better you will end up in the long term.

François Doyon La Rochelle: James, many Early Savers ask themselves when they are starting what should I prioritize? The TFSA, the FHSA, or the RRSP, and for those starting a family we can add the RESP. What do you recommend for Early Savers who have competing needs for their savings and can't contribute to all of them?

James Parkyn: Great question Francois. The answer to me is likely to do your TFSA first because it has the most flexibility in that there are no tax consequences on funds withdrawn and you can put the amount taken out back in but you have to wait the following tax year. There is going to be a lot of FHSA promotion about the tax deductibility but if for any reason you would need to withdraw the funds it will be fully taxable, and you will not have the option to put the funds back in. So, there is no one size fits all answer. If you are sure of buying a home and have sufficient income to claim the deduction, then the FHSA will be a great option. You could even consider withdrawing from your TFSA and contributing to your FHSA and then using the tax savings to put money back in your TFSA.

François Doyon La Rochelle: Finally, for the moment there is only a handful of financial institutions that are presently offering these types of accounts. When I verified, Questrade, the Royal Bank, and the National Bank were the only ones offering it, but you can be sure that other institutions will follow suit in the coming months.

James Parkyn: Lastly, if you are currently in the process of buying a house since there is no holding period before you can withdraw funds from your FHSA to buy a house, you could technically open an account and make the maximum contribution for the year to get a tax refund and then withdraw the money the following day if needed.

François Doyon La Rochelle: Yes, that's a good point James, thank you!

1. Main Topic: Review of The Credit Suisse Global Investment Returns Yearbook 2023 – Summary Edition:

François Doyon La Rochelle: Our Main Topic today is a Review of the 15th edition of The Credit Suisse Global Investment Returns Yearbook 2023 Summary Edition. Our regular Listeners will know we make this an annual tradition. Last year, we put a lot of effort into preparing our Podcast #38 in which we reviewed the 2022 edition of the Credit Suisse Global Investment Returns Yearbook, and we recommend our Listeners to go back and listen to it as the content (The impact of High Inflation on Stocks and Bonds and Update on the benefit of International Diversification) is still very relevant to what is happening in financial markets now. That being said, James, could you give our Listeners an Intro about the Yearbook and explain its purpose?

James Parkyn: Absolutely, I will quote directly from the Introduction: "The Credit Suisse Global Investment Returns Yearbook documents long-run asset returns over more than a century since 1900. A key purpose of the Yearbook is to help investors understand today's markets through the lens of financial history." The Yearbook details the returns and risks from investing in equities, bonds, cash, currencies, and factors in 35 countries and five different composite indexes. The Global Investment Returns Yearbook is produced in collaboration with renowned financial historians from the London Business School Professors Elroy Dimson, Paul Marsh, and Mike Staunton who produce the DMS Database. They are also the co-authors of the book "The Triumph of the Optimists" published in 2003.

François Doyon La Rochelle: Reviewing the Yearbook is an annual must-read for us. I would add that it is also a core part of our Podcast mission to share with our Listeners relevant evidence-based research. OK so now James, I'm going to start today's review by asking you the same two questions as last year. First, why do you as a Portfolio Manager find the Yearbook useful?

James Parkyn: Francois, our discipline, as our regular Listeners know well is to invest with "The Investor Mindset, focused on the long term". We don't want to be led astray by short-term noise in the financial media and recent financial market volatility. This challenge is daunting and applies to all Investors including us Professionals. We have said it often on our Podcast: "It is simple to say but not easy to do: We must always be cognizant that we can fall into a trap of trying to "Forecast the Future". This is why the Yearbook is so useful to us as portfolio managers. The Yearbook helps put current financial market events into context and compare them to long-term capital market history.

François Doyon La Rochelle: I agree, after all the major economic and geopolitical events of last year, it is crucial to take time out and look at financial market history to appreciate the importance of risk management.

James Parkyn: The 2023 Yearbook, like the ones before it, addresses this topic of why a long-term perspective is needed to understand risk and return in stocks and bonds. The events of 2022 should have reminded investors to fear complacency. Larry Swedroe said it well in his article "Lessons from the Markets in 2022. His Lesson #1 for 2022 was: "Just because something hasn't happened doesn't mean it can't or won't."

François Doyon La Rochelle: Now for my second question to you James: what are the highlights of this year's Report?

James Parkyn: I will share my Five Highlights of this year's Yearbook.

My first highlight is they make the case for the importance of a long-term perspective and with it an appreciation of the laws of risk and return in stocks and bonds. This starts with explaining how even 20 years of data is too short a period to help make asset allocation decisions.

I quote from the Yearbook: "The volatility of markets means that even over long periods, we can still experience "unusual" returns. Consider, for example, an investor at the start of 2000 who looked back at the 10.5% real annualized return on global equities over the previous 20 years and regarded this as "long-run" history, and hence guiding the future. But, over the next decade, our investor would have earned a negative real return on world stocks of −0.6% per annum."

François Doyon La Rochelle: This is very true and that's why it's so important to be careful about "Recency Bias". The Yearbook also talks about having a long-term perspective on Bonds. What does it say, James?

James Parkyn: I remind our Listeners that for most Investors Recent bias is based on what happened in the last year. The Yearbook makes the case for a much longer time frame. So, to answer your question about Bonds I share another quote from the yearbook: "Long periods of history are also needed to understand bond returns. Over the 40 years until end-2021, the world bond index provided an annualized real return of 6.3%, not far below the 7.4% from world equities. "I believe and the Yearbook concurs that extrapolating bond returns of this magnitude into the future would be foolish. The rapport goes on to say: "Those 40 years were a golden age for bonds, just as the 1980s and 1990s were a golden age for equities. In fact, the real return on world bonds in 2022 was −27%."

François Doyon La Rochelle: It is so difficult if not impossible to forecast and successfully time big market directional shifts. In our last Podcast #51, we addressed the Active vs Passive results in 2022. The worst category out of the 20 was Global Real Estate with a success rate of only 20%, it was slightly surpassed by the corporate bond category with a success rate of 22.6% and by the diversified emerging markets category with a success rate of 23.4%. So, the vast majority of Active Managers missed the boat and performed poorly in these Asset Classes compared with the passive funds.

James Parkyn: Exactly. My second highlight of the 2023 Yearbook is linked to the first one: "A historical risk premium in equity and bond returns relative to T-bills exists for a reason, that being a necessary payment for the risk of volatility and drawdown." As our Listeners well know, we have experienced four equity bear markets since 2000 and we need to be paid for such a risk.

François Doyon La Rochelle: This makes total sense when you think that in 2020 with the Pandemic, the world experienced its third bear market in less than 20 years. Markets then staged a remarkable recovery and volatility fell once again. However, in 2022, volatility again rose, and both stocks and bonds fell sharply on inflation and rate hike worries and concerns over the Russia-Ukraine war. This was the fourth bear market since 2000. The Yearbook addresses how portfolio diversification can mitigate such risks.

James Parkyn: Yes, but reaping the benefits of diversification is also a long-term concept and can let you down in the short term. The historically extreme negative returns in 2022 of the classic balanced 60/40 equity/bond allocation are the perfect example.

François Doyon La Rochelle: To me, this point was also made in last year's Report, specifically that the negative correlations between stocks and bonds were not the long-term norm. The Yearbook makes it clear that stocks and Bonds have a historically positive correlation and that the last 20 years of negative correlation before 2022, were not the norm.

James Parkyn: We have addressed this topic a lot in recent Podcasts. Again, Investors must have a Long-Term Mindset.

My third highlight of the 2023 Yearbook is the topic of stagflation.

François Doyon La Rochelle: For our listeners, it might be good to clarify that stagflation is a term from the 70s, and early 80s, which characterizes an economy with low growth, high unemployment, and high inflation.

James Parkyn: The Yearbook warns there is a "growing consensus that conditions will return to normal with low inflation re-established." They quote academics Arnott and Shakernia: "A keener look at history would highlight how rare this happens". They state this would in their view be a "best quintile" outcome with the "worst quintile" being inflation persistence for a decade.

François Doyon La Rochelle: To me, this point is about forecasting the future or trying to guess "the markets' prevailing psyche."

James Parkyn: Agreed, but the Yearbook makes the case that inflation and interest rates may not come down as fast as expected based on the very long-term perspective of the data in the DMS Database. My fourth highlight is when they tackle the big question: "What does it mean to be an Inflation hedge?" For instance, most Investors believe that Equities are a hedge against Inflation. The Yearbook provides extensive evidence that stocks, as well as bonds, tend to perform poorly when inflation is higher. It also makes the point that both stocks and bonds perform worse during hiking cycles.

François Doyon La Rochelle: Stocks are not, as is often claimed, the best hedge against inflation. The Yearbook makes a great case that "returns deteriorate for both" stocks and bonds as inflation rises. The Yearbook also makes the case that "Equities performed especially well in real terms when inflation was low." In periods of deflation stocks actually "produced lower returns than on government bonds." We discussed this in last year's Podcast #38.

James Parkyn: Yes, we did, and the 2023 Yearbook makes the point very clearly again this year about the long-run evidence on equity returns. I quote: "While equities have enjoyed excellent long-run returns, they are not and never have been the hedge against inflation that many observers have suggested. Despite this, it is widely believed that stocks must be a good hedge against inflation to the extent that they have had long-run returns that were ahead of inflation. However, their high ex-post (after the fact) return is better explained as a large equity risk premium. The key nuance is that: "It is important to distinguish between beating inflation and hedging against inflation."

François Doyon La Rochelle: Financial Market returns in 2022 proved the point. Stocks went down in a year of high inflation. The Yearbook makes the case that "Most finance professionals are too young to remember high inflation, bond bear markets, and years when stocks and bonds declined sharply together."

James Parkyn: The Yearbook provides the long-run analysis needed to place the events of 2022 in context. Now I will share my fifth and final highlight when the Yearbook tackles the topic of Commodities as an asset class and the benefit of holding it in periods of inflation.

François Doyon La Rochelle: We hear a lot of noise about investing in Commodities as an Inflation Hedge and the fact that they are not correlated to Equities and Bonds. What does it say about the role that commodities play as an asset class? Do they offer a hedge against inflation that equities do not?

James Parkyn: To answer your question, I will quote from the Yearbook: "A key conclusion to take away, and highly pertinent today as 60/40 equity/bond strategies have let investors down, is that commodity futures do prove a "diversifier" from an asset allocation perspective, being negatively correlated with bonds, lowly correlated with equities and statistically a hedge against inflation itself." They go on to say that: "The problem is that the limited size of the asset class cannot solve all the asset allocator's prevailing inflation-induced dilemmas." So, it's nice in theory but not realistically investable for both Institutional and Retail Investors.

François Doyon La Rochelle: James, you refer here to commodity futures but it's also interesting to raise that the Yearbook also looked at direct investing in commodities.

James Parkyn: The Yearbook finding is that direct investing in Commodities does not provide a hedge against Inflation. I Quote "We find investing in individual commodities have themselves yielded very low long returns.

François Doyon La Rochelle: There is more in the Yearbook that is significant: As we point out to our Listeners regularly on our Podcast, history can provide clues to the future, so we should be cautious about any forecasts.

James Parkyn: Yes, the Yearbook results are long-term averages spanning many different economic conditions. As discussed at the beginning of this podcast, this is because stocks and bonds are volatile, with major variations in year-to-year returns. We need a very long time series to support inferences about investment returns. The Credit Suisse report shows us that even 20 years is often not long enough.

François Doyon La Rochelle: So, James, to wrap things up, given the insights from this Yearbook, and given the backdrop of higher rates and high but slowly declining inflation, how should investors be thinking about their portfolios today?

James Parkyn: François, I think it's appropriate to repeat our Conclusion from Podcast #38 when we covered the 2022 Credit Suisse Yearbook. I think it's also important to remember that rising rates and high inflation are just two risk factors that investors face. Equity investors have experienced periods when safe assets, for example, bonds and cash, have been good counterweights to the volatility of stocks. Remember, there are many different risks that you are trying to defend against. There will be times when bonds will be really helpful. I recommend that our listeners always consider their long-term goals, their risk profile, their ability to take risks, and their time horizon. In addition, they should consider the decumulation plan of their portfolios. All these elements should be considered when thinking about the structure of their portfolios.

François Doyon La Rochelle: In conclusion, I quote from the Yearbook: "Bad years happen and, when they do, it is consoling to remind ourselves of the long-run record from global investing. For investors in risky assets, especially equities, the long-run record truly does represent the triumph of the optimists."

James Parkyn: That is a great quote Francois and hopefully, our Listeners will take inspiration from it. On another note, we hope the recent merger of UBS with Credit Suisse into a mega bank will mean that the tradition will continue, and we will see a 2024 edition.

1. Conclusion:

François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge.

James Parkyn: You are welcome, Francois.

François Doyon La Rochelle: That's it for episode #52 of Capital Topics!

Do not forget, if you would like to submit questions or suggestions for the show, please email us at:[email protected]

Also, if you like our podcast, please share it when with family and friends and if you have not subscribed to it, please do.

Again, thank you for tuning in and please join us for our next episode to be released on June 8th.

See you soon!

Links:

- Episode 51: Update on Active Vs. Passive & Global Banking Solvency — Capital Topics by James Parkyn & François Doyon La Rochelle

- Episode 45: Bond Investing A New Landscape — Capital Topics by James Parkyn & François Doyon La Rochelle

- Episode 38: Review of the Credit Suisse 2022 Global Investment Returns Yearbook — Capital Topics by James Parkyn & François Doyon La Rochelle

- First Home Savings Account (FHSA) - Canada.ca by Government of Canada

- Global Investment Returns Yearbook 2023 – Credit Suisse (credit-suisse.com) by Credit Suisse

- Triumph of the Optimists: 101 Years of Global Investment Returns: Dimson, Elroy, Marsh, Paul, Staunton, Mike: 8601416069784: Books - Amazon.ca by Elroy Dimson, Paul Marsh & Mike Staunton

In this Episode, James Parkyn & François Doyon La Rochelle discuss the following subjects:

• In the news: Global Banking Solvency

• Main Topic : Update on Active Vs. Passive

In this episode, we invite our listeners to check our latest feature below. For the first time we share the Podcast Script which was a request from some of our audience.

Links:

- The Grumpy Economist: How many banks are in danger? (johnhcochrane.blogspot.com) by John Cochrane

-The Non-Bailout Bailout – Foreign Policy by Adam Tooze, Podcast "Ones & Toozes"

-How Bank Oversight Failed: The Economy Changed, Regulators Didn't - WSJ by Andrew Acherman, Angel Au-Yeung & Hannah Miao

-Chief Risk Officer: The Most Thankless Job in Banking - WSJ by Ben Cohen

-Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe: Ip, Greg: 9780316286046: Books - Amazon.ca by Greg IP

-The Price of Time: The Real Story of Interest: Chancellor, Edward: 9780802160065: Books - Amazon.ca by Edward Chancellor

-Episode 44: Central Banks and Recessions — Capital Topics by James Parkyn & François Doyon La Rochelle

-When Headlines Worry You, Bank on Investment Principles | Dimensional by Dimensional

-What Gets Lost When You Rescue Markets - WSJ by Jason Zweig

-It Wasn't Just Credit Suisse. Switzerland Itself Needed Rescuing. - WSJ by Margot Patrick, Patricia Kowsmann, Drew Hinshaw & Joe Parkinson

-SPIVA U.S. Year-End 2022 - SPIVA | S&P Dow Jones Indices (spglobal.com) by Tim Edwards, Anu R. Ganti, Craig Lazzara, Joseph Nelesen & Davide Di Gioia

-Active Funds Continue to Fall Short of Their Passive Peers | Morningstar by Bryan Armour

Read The Script:

1. Introduction:

François Doyon La Rochelle: You're listening to Capital Topics, episode #51!

This is a monthly podcast about passive asset management and financial and tax planning ideas for long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss the following points:

For our first topic, we will discuss news on bank solvency.

And next, for our main topic, we will give you an update on the results of active management versus passive for 2022.

Enjoy!

1. In the news: Global Banking Solvency:

François Doyon La Rochelle: Our first topic today is news about Bank Solvency. James, you will address the major news story of the failure of Silicon Valley Bank, also known by the acronym SVB, in the US and the fear of contagion spreading to other US and International banks, especially after the news of the forced merger of the Credit Suisse bank with UBS in Switzerland. Credit Suisse bank was among the top 30 globally systemic important banks. Now, many of our Listeners are wondering: Is this the beginning of a major Banking crisis as we saw 15 years ago in 2008-2009 with the Global Financial Crisis?

James Parkyn: I can understand why our Listeners and indeed most Investors would be very worried about this news. It is everywhere in the financial press. You can't escape it. In this segment, we will try to summarize what happened and what is important for Investors to know and what is noise so they avoid making bad decisions that could negatively impact their Long-Term Investment Plan.

François Doyon La Rochelle: So, let's start with SVB in the US. What happened and why did it fail so quickly?

James Parkyn: The story of what happened is not yet fully known. What we do know so far is that the collapse of Silicon Valley Bank was driven in part by assets it held (mostly high-quality US Treasury Bonds) that lost value when interest rates rose from near zero.

A mismatch between its assets and liabilities caused a liquidity trap. Events moved so rapidly that it kind of resembled the storyline in the classic Christmas Movie "It's a Wonderful Life" by Frank Capra starring Jimmy Stewart. Most Listeners know the storyline where Jimmy Stewart's brother in the movie lost the deposit money of the Bailey Building and Loan in a deposit-envelope mix-up at the bank owned by the dreaded Mr. Potter. Very quickly news spreads in the small town that the Bailey Building and Loan were insolvent, and customers rushed to withdraw their deposits.

François Doyon La Rochelle: Yes, this movie is one of the most loved of all time. It also perfectly illustrates a classic bank run.

James Parkyn: Economist John Cochrane in his Blog titled "How many banks are in danger?" on March 14, 2023, explains it best: "SVB failed because it funded a portfolio of long-term bonds and loans with run-prone uninsured deposits. Interest rates rose, and the market value of the assets fell below the value of the deposits. When people wanted their money back, the bank would have to sell at low prices, and there would not be enough for everyone. Depositors ran to be the first to get their money out." And there you have it, that's what happened to SVB, a classic run on the bank.

François Doyon La Rochelle: To better understand, we must remember the economic picture prevailing in 2022 and what precipitated this. Last year, the key issue for both the economy and the banks was inflation, which jumped above 5% after decades of around 2%. The Fed had until mid-2021 to signal it would hold rates near zero for years then shifted gears dramatically and raised them at the sharpest pace since the early 1980s. Many investors, including SVB, were caught unprepared for this new reality of higher rates.

James Parkyn: The mechanics of Bond investing is that rising rates cause bond prices to fall, especially bonds that don't mature for many years. It has been widely reported that SVB favored longer-term bonds for their additional yield. A fall in the value of a bank's bond holdings could in theory reduce their capital, the cushion between assets and liabilities that absorbs losses.

François Doyon La Rochelle: How did the Regulators let this happen?

James Parkyn: In the WSJ on March 24th, 2023, in an article entitled "How Bank Oversight Failed: The Economy Changed, Regulators Didn't". The article states: "As interest rates surged after years of quiescence, regulators didn't fully anticipate the hit banks would take to the value of their bond holdings.

The Fed as late as mid-2021 expected the era of ultralow rates to continue. Not until late 2022, when rates had already risen substantially, did regulators warn SVB that its modeling of interest-rate risk was inadequate."

François Doyon La Rochelle: So, can we say the Regulators were not doing their job?

James Parkyn: A second factor was the failure to appreciate the danger where SVB became dependent on very large deposits. and these deposits could be withdrawn virtually any time with today's technology.

The WSJ article goes on to say, "Banks had come to depend more on such deposits. Regulators acknowledge they didn't stress such a concern because the big deposits were from SVB's and Signature's core customers, who, it was thought, would stick around.

François Doyon La Rochelle: The WSJ article goes on to say: "… deposits fled far faster than had ever happened before, aided both by social media-fueled fear and by technology that allowed people to move vast sums with a few taps on a smartphone." I find it hard to believe that a large Bank with a reported USD 209 Billion in Assets would fail at such elementary risk management. Can we say it was a sort of perfect storm of events?

James Parkyn: I don't believe it is. We often say in our Podcast, we don't know what we don't know, and a Black Swan type of event is not forecastable. But this is just a case of bad risk management.

François Doyon La Rochelle: The economist John Cochrane in his March 14th Blog seems to agree. He stated: "In my previous post, I expressed astonishment that the immense bank regulatory apparatus did not notice this huge and elementary risk. It takes putting 2+2 together: lots of uninsured deposits, and big interest rate risk exposure. But 2+2=4 is not advanced math".

James Parkyn: The storyline gets better. Bank regulations in developed countries like Canada and the US require that they have a senior executive in a role called Chief Risk Officer or CRO. It is unbelievable but at the time of failure, SVB had no CRO.

Journalist Ben Cohen of the WSJ wrote an Article on March 23, 2023, titled "It's the Most Thankless Job in Banking. Silicon Valley Bank Didn't Fill It for Months." He wrote: "Silicon Valley Bank's lack of an executive in that role for eight critical months is a reminder that risk doesn't have to be excessive or exotic to be existential. SVB's alarming exposure to rising interest rates wasn't hard to see coming and should have been easy to hedge against. It remains flabbergasting how a bank that served the most innovative corner of the economy could have been doomed by a basic mismatch of assets and liabilities. But tech's favorite bank failed because its risk management did first."

François Doyon La Rochelle: But the SVB would've had other risk-reporting regulatory obligations. Ultimately, would the Board of the Bank be accountable?

James Parkyn: Yes, I agree even with no Chief Risk Officer, at the very least there should have been an acting CRO, and regulations would require regular reporting to the board on Risk management. Ben Cohen of the WSJ said it best: "Of course, the presence of a Chief Risk Officer isn't necessary to know when the Federal Reserve hikes rates and regulatory filings suggest SVB was aware of its vulnerabilities long before the run on the bank: The board's risk committee met nearly as many times last year (18) as it did in the previous three years combined (19)." So here again we see a big-time failure of basic governance processes.

François Doyon La Rochelle: So, what about the Credit Suisse Bank and the merger with UBS? Is the situation like SVB? What's the impact of Credit Suisse and UBS merging?

James Parkyn: Economic Historian Adam Tooze in his Podcast Ones and Toozes on March 17th, 2023called it a "Confidence shock that killed Credit Suisse". Regular listeners will remember from Podcast #44 that he wrote the highly regarded book "Crashed" detailing what happened in the banking system during the global financial crisis. Unlike SVB it was not a liquidity crisis but a counterparty crisis. Other global banks and large customers were losing faith in Credit Suisse's ongoing viability.

This is a major issue for Switzerland and its role in the global banking system. A recent WSJ Article titled "It Wasn't Just Credit Suisse. Switzerland Itself Needed Rescuing". For any country, it would be a financial emergency. For Switzerland, the stakes verged on existential. Its economic model and national identity, cultivated over centuries, were built on safeguarding the world's wealth. It wasn't just about a bank. Switzerland itself needed rescuing.

François Doyon La Rochelle: The Credit Suisse bank crisis added the Global contagion dimension to this crisis. For the Swiss, it threatens an economic model and national identity built on safeguarding the world's wealth.

James Parkyn: Credit Suisse, the second-largest Swiss bank, and Top 10 Global Bank, has had risk management issues for over a decade. Adam Tooze in his March 17th Podcast called it a "Confidence shock that killed Credit Suisse". Now that Credit Suisse and UBS, the larger Swiss bank, have merged, the question is the combined bank, with over 50% of the Swiss banking market, too big to bail?

The WSJ reported on March 22nd, 2023: "Its banking system is five times the size of its gross domestic product and larger than in most economies. UBS combined with Credit Suisse has a balance sheet twice the size of the Swiss economy."

François Doyon La Rochelle: It is clear to me that all this turmoil will have an impact on the Central Bank's Policymaking and their inflation-fighting maneuvers of raising interest rates. The bank collapses in the United States and the emergency rescue of Credit Suisse is likely to force central banks to weigh the trade-off between systemic risks and inflation risks.

James Parkyn: Higher rates will continue to weigh on banks' balance sheets. They will also cause problems in other parts of the economy. Economic Historian Adam Tooze in his Podcast on March 17th, 2023 said "when Central banks increase interest rates, they are trying to impact inflation thru negative events. With such a rapid rate hiking cycle engineered by Central Banks, it was to be expected that negative economic shocks would happen. It was only a question of what would bend and what would break."

François Doyon La Rochelle: What is the role of Bank Regulators in this mess?

James Parkyn: Well! you know, it seems they're always fighting the last battle with the last battle strategies and so, if you recall in our Podcast #44, we quoted Mervin King, the former governor of the Central Bank, that said: "Central Banks have to come up with new ideas and we got to forget about the mistakes of the recent past and focus on what needs to be done." So, let's go back to Jason Zweig, who wrote in the WSJ article on March 17th "Over the past couple of decades, the Fed, the Treasury, and other authorities have stepped in time after time to stabilize the financial markets, as if failure were no longer an option. This all goes to illustrate an even bigger problem: Central authorities aren't omniscient and omnipotent, and their efforts to wring risk out of the system may make it more dangerous, not less. Even as rules have proliferated and bailouts multiplied, the U.S. stock market has suffered four crashes of least 20% since the year 2000."

François Doyon La Rochelle: Well now we are talking about Moral Hazard.

Another quote from Jason Zweig of the WSJ: "The attempt to eradicate failure from the financial system, of course, is part of modern society's broader push to make life itself riskless and idiot-proof, with indestructible baby strollers, child-resistant drug packaging, almost self-driving cars and shoe removal at airport security."

James Parkyn: Another WSJ Columnist Greg Ip pointed out in his 2015 book "Foolproof,": "…making an environment feel safer can lull many people into complacency and excessive risk-taking." I am also reading a highly recommended book by financial historian Edward Chancellor, called "The Price of Time," a history of interest rates. This author makes the point "The attempt to control risk by lowering interest rates reduces the cost of taking risk, and so ends up increasing the aggregate amount of risk in the system." We have talked a lot in our podcast about normalized interest rates. We have had rates that are too low for too long and too many people have taken for granted this would simply continue.

François Doyon La Rochelle: James, what is your advice for our Listener?

James Parkyn: In preparation for this Podcast, I went back to our Podcast #44 on Central Banks that we published in September 2022. The big fear last fall was about recessions and the potential impact on financial markets. We highlighted Dimensional research that showed that Markets around the world have often rewarded investors even when economic activity has slowed. Many now feel that the specter of Bank failures will reduce lending activities by banks further increasing the likelihood of reduced economic activity. We recommend that our Listeners stay disciplined in their LT Investment plan and forget about all the noise of the moment such as Inflation, Interest rates, recession, and now we can add to the list of bank failures.

François Doyon La Rochelle: Yes indeed, our regular Listeners know, this is one of our mantras as a disciplined Investor with a Long-Term Mindset you can't forecast the future.

James Parkyn: In conclusion Francois, we turn to our friends at Dimensional, they produced a great article entitled "When Headlines worry you, bank on Investment Principles."

"While every investor's plan is a bit different, ignoring headlines and focusing on the following time-tested principles may help you to avoid making short-sighted missteps.

1. Uncertainty Is Unavoidable: uncertainty is nothing new and investing comes with risks.

2. Market Timing Is Futile.

3. "Diversification Is Your Buddy" a quote they attribute to Nobel laureate Merton Miller.

François Doyon La Rochelle: I like the following quote from this article: "When the unexpected happens, many investors feel like they should be doing something with their portfolios. Often, headlines and pundits stoke these sentiments with predictions of more doom and gloom. For the long-term investor, however, planning for what can happen is far more powerful than trying to predict what will happen."

As usual, we will share the link with our Listeners.

1. Main Topic: Update on Active Vs. Passive:

François Doyon La Rochelle: For our second topic today, we will give you an update on the results of active management versus passive for 2022. I believe that by now, after all the podcasts that we have released, most of our listeners understand that we are strong believers in market efficiency and that our investment philosophy is based on the empirical evidence that using broad-based and low-cost investment passively managed products are the best way to capture market returns and increase the odds of long-term success for our clients.

James Parkyn: Correct and it's been more than 20 years now that we have adopted this investment approach based on the belief that active investing is a negative sum game. However, this does not mean that we don't question ourselves and look at the latest research papers and articles to make sure our investment philosophy is supported by evidence.

François Doyon La Rochelle: Yes, and that's why year after year we analyze the SPIVA report, from S&P Dow Jones Indices which measures the results of the S&P Indices versus active funds, and also the Morningstar Active vs Passive Barometer report which measures the performance of active funds against their respective passive peers, to see if the results for the last year were any different than in the past. Unfortunately for active managers, this year was no different than in the past, since once again active managers were not able to beat their passive comparable.

James Parkyn: This is particularly interesting after a difficult year like 2022 when stock and bond markets unusually sold off at the same time. The old narrative from active managers is that good active management will outperform passive investments during times of market volatility, so what happened?

François Doyon La Rochelle: Well, we would certainly expect given all the market volatility in 2022, that active managers would have plenty of opportunities to beat passive strategies.

James Parkyn: Effectively, we covered the major geopolitical and economic events in our podcast over the last year, but it is worthwhile to highlight some of them for our listeners to get a feel for the opportunities that active management could have exploited to generate better results. The year started with the war in Ukraine and the subsequent geopolitical turmoil, then followed multi decades of high inflation rates, and the subsequent swift and strong reaction from central banks to increase interest rates. Again, I am just highlighting the obvious here but getting back to our topic Francois, how well did active management do against passive last year?

François Doyon La Rochelle: To answer your question, James, I will base myself predominantly on the Morningstar active versus passive barometer report. This report is comprehensive as it covers nearly 8,400 actively managed funds in the U.S. with approximately $15.7 trillion of assets under management. I prefer this report to the SPIVA since it measures the rate of success of active managers against the results of actual passive funds and not benchmarks.

James Parkyn: This is an important nuance. The Morningstar report "benchmarks" reflect the actual, net-of-fees performance of investable passive funds and not simply the performance of an index that is not investible without incurring fees.

François Doyon La Rochelle: Correct James and that's a very important nuance.

Now let's look at the results. Again, based on the narrative that active managers will do better in times of market stress I think the results for 2022 are not very conclusive for active management.

Based on the 20 different investment categories reported by Morningstar only 40.5% of active managers were able to beat their respective benchmarks in 2022. This is a weaker result than in 2021, a very good year in the markets when 51.1% of active managers were able to beat their benchmarks.

James Parkyn: As you mentioned this is very interesting as it goes against the active management's narrative that they will perform better in difficult years. So out of the 20 categories, what were the best ones?

François Doyon La Rochelle: Out of the 20 different categories, 6 of them had a success rate above 50%. Meaning that in each of these 6 categories, more than 50% of the managers were able to beat their benchmarks. By way of comparison, that number for 2021 was 7. That being said, the best-performing categories in 2022 were, one, the US small value category with a 61% success rate, second, the US small growth category with a 56.9% success rate and third the world large blend category with a 56% success rate. I must mention in all objectivity that the U.S. large blend category, which is probably the largest fund category by assets under management, was also amongst the best categories in 2022 with a success rate of 54.1%. This means that 54.1% of the active managers in that category beat their benchmark last year.

James Parkyn: Now which categories fared the worst?

François Doyon La Rochelle: The worst category out of the 20 was Global Real Estate with a success rate of only 20%, it was slightly surpassed by the corporate bond category with a success rate of 22.6% and by the diversified emerging markets category with a success rate of 23.4%.

James Parkyn: What I find interesting in these results is that the highly interest-sensitive categories like global real estate and the corporate bond category were amongst the worst-performing categories last year.

François Doyon La Rochelle: Yes, I was also surprised by these results and by the fact that the other bond categories, the intermediate core bond category, and the high yield bond category have also had poor results with low success rates of 37.9% and 27.2% respectively. Therefore, vastly underperform their passive counterparts.

James Parkyn: Wow, I would have thought that in a year like 2022 with all the talk surrounding inflation, interest rates, and central bank decisions active management would have prevailed. Given the narrative, you would expect that active managers would be able to adjust their portfolios and reap the benefit of predicting interest rate changes.

François Doyon La Rochelle: Indeed James. I also looked at the 2022 SPIVA U.S. and Canadian reports and although they don't analyze the performance of active versus passive in the same way as Morningstar, there were some very interesting takeaways in their report regarding the inability of active managers to outperform their respective benchmarks. The report highlights that the market conditions for equities and fixed income were uncommonly challenging in 2022, underlying however that these difficult markets gave active managers material opportunities to generate relative outperformance. Opportunities that most active managers were unable to exploit.

James Parkyn: What do they mean by that unable to exploit?

François Doyon La Rochelle: Well, if we examine the example provided in the U.S. SPIVA report, the S&P500 Growth, and the S&P500 Value indices, which are both large-cap U.S. equities indices, were respectively the worst and best-performing equity benchmarks in 2022. The report goes on to mention that more than 20 percentage points were separating their full year's performance. Our regular listeners will remember that we highlighted in our podcast #48 that value stocks vastly outperformed growth stocks in 2022.

James Parkyn: Wow, this type of dispersion in returns should in my mind been a great opportunity for active management.

François Doyon La Rochelle: Yes, but the active managers were not able to seize the opportunity since most of them, who are benchmarked to the S&P500 Index, failed to beat it. Since large-cap growth stocks were the worst-performing asset class, a large-cap growth manager could have simply purchased stocks of another U.S. asset class to beat its benchmark. Despite this fact, close to 74% of active managers in that asset class still failed to beat their benchmark. Here is a quote from the report, "the prospect for skilled stock pickers in large-cap U.S. equities were above average and the tailwinds for even unskilled managers were unusually favorable" The report goes on to say "An examination of the particular market segments that over and underperformed shows that they should have given the advantage to active managers, in particular thanks to their ability to deviate from broad-based, market cap weighted allocations to large-cap U.S. equities.

James Parkyn: Anything to report on the longer-term results of active versus passive?

François Doyon La Rochelle: Well, for the last 10-year period the success rate for active management in the Morningstar report is at 31.5%, meaning only 31.5% of the active managers were able to beat their passive counterparts. If you look at the 20-year results, the success rate drops even further to a low of 16.2%. In the U.S. SPIVA report what I found interesting there is that it gives the quartile breakpoints for Equity funds in the U.S. The takeaway here is that if you would have bought an S&P500 Index fund or a broader market S&P1500 Index Fund you would have effectively bought a fund that ranked in the first quartile of all active and passive funds in the over the last 5,10- and 20-year periods.

James Parkyn: Well François that's very compelling evidence because I wrote a blog recently and you got all this financial press "There is a recession coming…you should do this and do that with your portfolio..." and I said "Yeah, but then what? What do you do?" and often the market is going to react before the recession ends. Maybe active managers, as you mentioned earlier, the large-cap blend, 54% beat the benchmark. But then what? What about the second year? And there are taxable events and you have got to guess both events. If you're riding a horse in active management, it's got to continuously be at par with the market. When you show only 16.2% over 20 years beat the market and we haven't even gotten into the tax and efficiency of active management vs. taxes. So again, based on these reports and our experience with client portfolios, we're very confident that staying the course with our investment philosophy is doing the right thing with our customers and we believe that our listeners would agree as well.

François Doyon La Rochelle: That's correct, no changes are planned, again it's proof that over the long term, disciplined passive investors will earn higher returns than active investors.

1. Conclusion:

François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge.

James Parkyn: You are welcome, Francois.

François Doyon La Rochelle: That's it for episode #51 of Capital Topics!

Do not forget, if you would like to submit questions or suggestions for the show, please email us at: [email protected]

Also, if you like our podcast, please share it when with family and friends, and if you have not subscribed to it, please do.

Again, thank you for tuning in and please join us for our next episode to be released on May 11th.

See you soon!

In this Episode, James Parkyn & François Doyon La Rochelle welcome back their dear colleague Raymond Kerzerho, PWL's Senior Researcher & Head of Shared Services Research. Together they discuss the update of the Capital Market Assumptions for Expected returns titled "Financial Planning Assumptions", that he produced with PWL's Head of Research & Client Education, Ben Felix.

- Financial Planning Assumptions (Market Capitalization Weighted Portfolio) - PWL Capital by Raymond Kerzerho & Benjamin Felix (February 22, 2023)

-Financial Planning Assumptions (Factor Tilted Portfolio) - PWL Capital by Raymond Kerzerho & Benjamin Felix (February 22, 2023)

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle discuss the following portfolio management and financial planning subjects:

• Main Topic: Ken French: Five things I know about Investing

- « Five Things I Know About Investing » by Kenneth R. French : Five Things I Know about Investing | Dimensional

-Podcast #48: 2022 Investing Lessons & 2023 Outlook : Episode 48: 2022 Investing Lessons & 2023 Outlook — Capital Topics

- « Getting Wealthy vs. Staying Wealthy » by Morgan Housel : Getting Wealthy vs. Staying Wealthy · Collab Fund

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle discuss the following portfolio management and financial planning subjects:

• In the News: 2022 Market Statistics

• Main Topic: 2022 Investing Lessons & 2023 Outlook

-Market Statistics – Parkyn Doyon La Rochelle – December 2022: Market Statistics - Parkyn Doyon La Rochelle - December 2022 - PWL Capital

-Podcast #45: Bond Investing A New Landscape: Episode 45: Bond Investing A New Landscape — Capital Topics

-Podcast #44: Central Banks and Recessions: Episode 44: Central Banks and Recessions — Capital Topics

-Podcast #43: Retirement Income Planning: Should Your Portfolio Withdrawals Vary with the Market?: Episode 43: Retirement Income Planning: Should Your Portfolio Withdrawals Vary with the Market? — Capital Topics

-Dimensional's Article: Market Review 2022: After a Down Year, Looking to the Past as a Guide | Dimensional

-Jason Zweig's Article: Mirror, Mirror on the Wall, Who Knew That Stocks Would Fall? - WSJ

-Larry Swedroe's Article: Fourth Quarter 2022 Economic Review and Outlook - Articles - Advisor Perspectives

"The Psychology of Money" by Morgan Housel: The Psychology of Money: Timeless lessons on wealth, greed, and happiness: Housel, Morgan: 9780857197689: Books - Amazon.ca

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle will discuss the following portfolio management and financial planning subject:

• Update on Year-end Tax Planning for Capital Market Investors

Why aren't more Canadians maxing out their TFSAs? — Capital Topics

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle discuss the following portfolio management and financial planning subjects:

• In the News: Review of Q3 market results
• Main Topic: Managing your Emotions in a sea of negative Financial Market Noise

How to Invest Better - and Live Better (dimensional.com) by David Booth

Seven deadly sins of investing - PWL Capital by James Parkyn

Sources:

Microsoft PowerPoint - Quarterly Market Review (QMR) - Q2 2022 (sagebroadview.com)

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle discuss the following portfolio management and financial planning subjects:

• In the News: Update on the new FHSA'S
• Main Topic: Bond Investing, the New Landscape

Design of the Tax-Free First Home Savings Account - Canada.ca

Financial Planning Assumptions - (Factor Tilt Portfolio) - PWL Capital

In this episode of Capital Topics, James Parkyn and François Doyon La Rochelle discuss the following portfolio management and financial planning subjects:

• In the News: Bear Markets and tax-loss selling
• Main Topic: Central Banks: Policy making challenges and Recessions