Robots have arrived on Wall Street

Last week marked the debut of an upstart fund called the AI Powered Equity ETF, an actively managed security that seeks to use artificial intelligence to beat the market. The exchange-traded fund officially launched last Wednesday so it is too early to measure how this fund will perform over the long term.

At its core, AIEQ ETF is powered by the big-data processing abilities of IBM’s Watson. It is responsible to develop a portfolio of stocks that will be able to offer results that are not only better than  human stock pickers  but also the overall market. Most ETFs are passively managed and follow indexes like the S&P 500, the Dow industrials or other sectors. In other words, your new portfolio manager is a computer program.

The fund currently is composed of 70 stocks, plus an allotment of cash, that are spread around sectors. Components are determined by “their probability of benefiting from current economic conditions, trends, and world- and company-specific events,” EquBot said in a news release.

The top five holdings by concentration are Penumbra 4.63%, Boyd Gaming 4.51%, Genworth Financial 4.45%, Mednax 3.8% and Triumph Group 3.52%, according to XTF.com. The turnover is expected to be high around 2% – 3% per day. The fund charges an expense ratio of 0.75%, which is slightly lower than the average expense ratio for actively managed ETFs.

The information explosion has made the jobs of portfolio managers, equity analysts, quantitative investors and even ETF builders more challenging. New technology in artificial intelligence could help solve those challenges. There’s still quite a range in AI models being used. There could be other quantitative groups that are looking at the same raw data but analyzing it in a different way, meaning the same input material can result in different insights and outcomes.

Another example of an unusual method for picking stocks is  Buzz US Sentiment Leaders ETF BUZ, an exchange-traded fund that selects its holdings based on positive chatter in social media and other online sources. The fund is up 17.2% in 2017, above the 13.9% rise of the S&P 500.

If the IBM’s Watson stock picking outperforms over the first quarter and money flows into the EFT, you’re going to see 20 competitors inside of six months.

This is a very gutsy structure, I am putting this ETF on my watch list. I am also going to monitor the top ten holdings of this ETF to get some stock picking ideas.

 

 

 

 

 

 

 

 

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Ignoring investment rules to achieve income

 

A few months ago, I asked readers for advice regarding a $300,000 inheritance. The couple are in their late fifties, debt free with little savings. Although, they are very fugal, they live paycheck to paycheck due to lack of steady full time work. Few companies want to hire older workers when they can hire young people for a lot less.

Being very good friends, they came to me for some free advice. After a few meetings, I realized that traditional investment strategies just wouldn’t work this couple. They have been dipping into their retirement accounts to pay bills. I recommended putting $100,000 back into their retirement accounts. The $200,000 into a joint investment account with a discount broker in order to split the income and save on fees.

Disregarding Asset Allocation guidelines

Based on their age and proximity to retirement, a 60% equities and 40% bonds mix would have been appropriate. However, investing in bonds with low interest rates, inflation and taxation doesn’t give them very much income.

Disregarding Diversification guidelines

Being Canadian, foreign dividends are taxed like interest payments similar to Canadian bonds. Plus, foreign assets are subject to currency fluctuations. The increased value of the Canadian dollar has wiped out all U.S dividends and most of the capital gains from owning U.S. stocks.

Disregarding suitability guidelines

This couple’s investment knowledge is very limited, their only investments have been in mutual funds with high management fees. After explaining how high fees will reduce their income, they agreed to take more risk in owning some individual stocks and exchanged traded funds.

Constructing a portfolio to maximize income and minimize risk

  1. I invested $61,418 in four Canadian Reits that generates $418.16 per month or $5,017.92 per year. The Reits income will be a combination of interest and capital gains. Compared to investing $120,000 in bonds yielding 3% per year or $3,600.00
  2. I invested $63,329 in three Canadian dividend stocks that generates $330.00 per month or $3,960 per year. Due to the couple’s low income, these dividends will be tax free income.
  3. I invested the balance of $75,253 into four covered call ETFs that generates $392.00 per month or $4,704 per year. The covered calls will produced capital gain income and the ETFs also has some dividend income in their monthly distributions.

Grand income total works out to $1,140.16 per month. The average annualized return on the $200,000 portfolio is 6.85% with a minimum amount of risk.  

This is only a temporary solution to achieve some monthly income until their work situation changes. Sometimes investment guidelines have to be broken because one size doesn’t fit all.

Why you should look under the ETF’s hood

A fund’s name might seem like a good starting point for gaining an initial understanding of how it is constructed. Unfortunately, names turn out to offer little help for evaluating funds. There is simply no universally accepted system in use by ETF providers and research to classify funds. For example “Infrastructure” would seem to have something to do with the amenities, roads and power supplies needed to operate society.

Names can be deceiving! To illustrate, I went to one of my favorite ETF provider’s web site to look under the hood. I was looking to find some discrepancies. It took some time but the geographic allocation in the fact sheet on the BMO Global Infrastructure Index ETF (ZGI) wasn’t global at all but had the majority of their holdings in North America.

  • 66.02% United States
  • 25.16% Canada
  • 6.71% United Kingdom
  • 1.56% Mexico
  • 0.56% Brazil

The top ten holdings also have a lot of pipeline companies who pay construction companies to build the actual  infrastructure.

  • Enbridge 10.07%
  • American Tower Corp 8.82%
  • National Grid Plc 6.71%
  • TransCanada Corp 6.68%
  • Crown Castle Intl Corp 6.07%
  • Kinder Morgan 5.87%
  • P G & E Corp 5.17%
  • Sempra Energy 4.25%
  • Williams Cos 96%
  • Edison International 3.82%

It takes years for pipeline companies to benefit from any new capacity to come on line. On the other hand, companies who specialize in construction & engineering like SNC-Lavalin or Aecon would see immediate revenue growth. I would recommend looking for another infrastructure ETF that had more global exposure with holdings of construction & engineering type companies.

Another example is the BMO S&P/TSX Equal Weight Industrials Index ETF (ZIN) which has a small discrepancy. The fact sheet says it has 26 industrial holdings but two of those holdings include airlines. (Air Canada 5.46% & Westjet 4.13%)  Now both of these companies buy industrial products but they specialize in transportation.

Here are some key steps all investors should take when evaluating ETFs:

  1. First, decide if you are going to be a do-it-yourself investor or work with an advisor. As their name suggests, ETFs are traded on exchanges, so they can be bought and sold like stocks through a discount brokerage.
  2. Make sure you understand the index underlying the ETF you are considering. Focus on how the index is constructed, what it tracks and how long it has been around. A longer record will reveal how the index responded to different market conditions.
  3. Check the fund’s fact sheet, are the underlying holdings and geographic allocation accurate? How does the exchanged traded fund compare with similar funds from other providers?
  4. Avoid ultra-short and leveraged ETFs, leave those to professional traders.

Ultimately, the proper implementation of ETFs in a portfolio requires, like all investment decisions, due diligence, caution and persistence. ETFs can offer many attractive features but their long-term value depends on how well they fit into an individual’s portfolio.

To evaluate an appropriate fit, investors have to be prepared to look under the hood.

 

 

 

A few suggestions on how to invest a $300,000 inheritance

Last week’s post contained a real life Canadian couple’s financial dilemma on how to invest a surprised inheritance. I asked writers and readers of financial blogs to email me their suggestions. This couple is in their mid-fifties and are hoping to retire in 8 to 10 years. They are debt free, have poor paying jobs and only managed to save $55,000 for retirement. Unfortunately, my bullet point list of Canadian tax info wasn’t very clear.

Additional clarification of  the Canadian Tax system

Canadians have three choices for saving for retirement if they don’t have a company pension.

Registered Retirement Saving Plan (RRSP)

  • Contributions are limited to 18% of working income (max. $25,370 investment income not included)
  • Tax deductible, refund based on your tax rate (lowest 20%, highest is 53%)
  • Tax free compounding, withdrawals are 100% taxable at your personal tax rate (lowest 20%, highest is 53%)
  • Government requires you to make withdrawals at age 72
  • Not usually recommended for low income families

Tax free Savings Account (TFSA began in 2009), geared to low income families

  • Personal contributions are limited to $5,500 per year, not tax deductible
  • Unused contributions are carried forward indefinitely
  • Tax free compounding, withdrawals are not taxable
  • No restrictions on withdrawals, money can be taken out and put back in the following year.

Taxable investment account

  • Interest income, foreign interest and foreign dividends are 100% taxable at your current tax rate (lowest 20%, highest is 53%) Plus there is 15% foreign tax withheld. If personal your tax rate 30%, foreign dividends of $100 minus  $30 personal tax – $15 of foreign tax = $65
  • Canadian Dividends have an eligible tax credit that increases the after tax yield. In theory, a Canadian could earn $40,000 in dividends tax free if they had no other income.
  • Capital gains has the lowest tax rate because only 50% of the gain is included in income, so only $50 of a $100 gain would be included. High income earners (53% tax bracket) would only pay 26.5%  in income tax.

I only received two suggestions and didn’t receive any input from any Canadian bloggers or readers.  So, I asked a financial planner who works at one of my local bank branches to weight in.

From the United States, Bear with the Bull offered the following:

I am not sure I am most qualified to be a financial adviser and I really do not know Canadian tax laws. I would think they might want a mix of income, bond, possibly cash, and growth stocks.  For my 401, I have about a 60/40 split of stocks and income/bond allocation. So if they are looking for more cash / income, maybe they would be more comfortable with something more 40/60 instead. 

They probably would look to a portion to be cash or bond fund that could be used to maximize yearly retirement contributions and or have readily available should they need it.  Since the Canadian real-estate market is seemingly doing well, how about investing in some Canadian REITs?  It would have a short term growth opportunity and dividends as well.  ETF’s also seem to be the latest investing vehicle and generally have lower fees than mutual funds.

  • The 40% equities ($120,000) 50% Canada 40% U.S 10% Emerging markets
  • The 60% fix income ($180,000) Perhaps a 1/3 split.  $60,000 Bonds, $60,000 Reits, $60,000 Cash

Realize that this response and $5.00 will get you a good cup of Starbucks so take it for what it is worth.

From Belgian, Amber Tree Leaves offered the following:

Here is a potential solution, as I am not sure to fully understand the Canadian system, I will skip that part.

General comment: As they have not yet accumulated a lot of assets, it might be tough to retire in the next 8-10 years. It is reasonable to expect a severe correction in that period. As it seems that they have little investing experience, it might be better to go for an approach that generates cash from dividend stocks. The assumption here is that it generates higher yields than ETFs. 

  • allocation: 70 % stock and 20 % bonds and 10 % gold.
  • The 70% equities 20% in Canadian dividend stocks, 50% world wide in dividend paying stocks

The gold is there as a hedge against the really bad times. It should be managed in a way that it needs to be sold and converted into stock/bonds when the price rises a lot. Timing this is hard, it is not the goal to get the absolute top.

Bank Financial Planner

First of all, I believe that money has different weights or “gravity” depending on how you acquire it.  Inheritance money seems to have the most weight as often people feel they “owe” a higher degree of care of duty to it and are less likely to deal with it the way they would a lottery win or an insurance settlement.

Obviously, the first thing I would need to do is get a better understanding of their situation and their time horizon and risk tolerances.  Let’s assume they are comfortable with a balanced approach. I would recommend 60% equity/40% fixed income.  ($180,000 in equity and $120,000 in fixed income.)

I would recommend they start by contributing fully to TFSAs, which would account for $102,000 between the two of them.  In the TFSA, I would use a ladder of market linked GICs to give them diversification, security of capital and the potential for higher returns than offered by traditional GICs.  This allows them their only chance to earn interest without paying tax on every penny of it.  It also means there are no fees to pay on almost one third of their investments. 

For the non-registered account, I would recommend a core holding of a growth ETF portfolio ($100,000 with additional positions in our Canadian ($30,000), US ($15,000 and International ETF funds $25,000), with a portion in our US Dollar ETF $15,000) for additional diversification on currency. 

After the initial investment occurred, I would want to have an annual strategy to move the maximum TFSA contribution for each of the clients.  This would involve selling a position of the non-registered investments (unless there are additional savings available) and reinvesting in the same fund inside the TFSA to maintain the balance in the overall account.   This would allow the gradual transition into the TFSA accounts, helping with taxes and probate fees down the road.  A portion of capital gains (or losses) would be triggered each year, smoothing the tax impact on the clients.

I am not sure if this inheritance is big enough to bail out this couple’s retirement plan. A key element is understanding after tax returns when investing.

 

 

 

Baby Buffett loses 4 Billion on Valeant shares

Hedge fund manager Bill Ackman first came to my attention when he invested in Canadian Pacific railroad. As an activist investor, Ackman started a lengthy proxy battle with the board of directors to remove Fred Green as CEO and appoint Hunter Harrison in his place. Not only was Ackman successful but it was very profitable for his hedge fund since the value of CP shares more than doubled under Harrison’s leadership.

In early 2015, Bill Ackman invested in Valeant, another Canadian company. His hedge fund purchase shares around $196 and recently sold all of them at $11 a share. He accelerated his losses by buying call options and selling put options.

Hindsight is of course 20-20, are there any investment lessons that we can use?

 Lesson: Intelligent people are capable of doing very dumb things.

Bill Ackman is clearly a smart man otherwise his Pershing Square hedge fund wouldn’t manage pension fund money. But if you asked the average investment professional /your grandmother whether it is a good idea to stick over a quarter of your assets into a highly levered pharma roll up the answer would tend to be a firm “no”.

Lesson: Position sizing is very, very important.

Always be aware of your risk of ruin, no matter how much you are convinced the odds are in your favor. Regardless of how amazingly smart and brilliant you are and how many hundreds of hours of research you have done, it is perfectly possible that you will lose money on any given investment. Pershing Square had too large a position to simply sell its stake and walk away when things started to go wrong.

Lesson: Highly incentivized management teams can still blow themselves up, and take you down with them.

Part of the original appeal of Valeant to the hedge funds that backed it was how the CEO’s stock options had been structured to make him highly incentivized to get the share price as high as possible. Having management teams with “skin in the game” is clearly important but this does not mean they will not do something very stupid.

Lesson: Auctions are not usually very good places to find bargains.

Ackman admits that he now believes Valeant “substantially overpaid” for Salix, its last big acquisition before things fell apart. A big problem with a role up strategy is paying high prices for third rate assets that no one else in the world is willing to buy.

Lesson: Beware of political risk.

Valeant used aggressive drug pricing to help pay for their acquisitions which got the attention of American lawmakers. Bill Ackman had to testify at a hearing held by the U.S. Senate aging committee which was reviewing escalating drug prices. It also became a big issue during the U.S. 2016 presidential election.

Lesson: Take a loss, don’t let your Ego get in your way.

There is no doubt that billionaires tend to have large egos. Being labeled “Baby Buffett” on the cover of Forbes is quite the ego booster. But there is an old saying, “the bigger they are, the harder they fall”. Ackman’s buying call options and selling put options on a losing position is a clear sign that his ego wouldn’t accept taking a loss on Valeant shares.

Postscript: The share price of CSX railroad jumped up 35% on rumors that Hunter Harrison would be the new CEO. Harrison got the job but can he deliver another turnaround? It may be too early to tell. However, I bought some shares of CSX for my investment club. 

 

Active or passive investing? Why I now use both approaches

There is perhaps no controversy in the investing world more contentious than active versus passive equity investment management. Members of both camps constantly argue that their way is unequivocally the best, despite real-world results that support one side’s argument one year and the other’s the next.

Blackrock, the world’s largest money manager, is overhauling its actively managed equities business. They are cutting jobs, dropping fees and relying more on computers to pick stocks. This is a clear indication how difficult it has become for humans to beat the market.

“BlackRock  CEO Larry Fink has sometimes expressed disappointment in the performance of the company’s actively managed stock funds, and he has pivoted increasingly to focusing on the company’s data-driven “Scientific” equity teams.”

Most investors seem to be in either the active or passive camp, few use both methods. For years, I have been in the active camp because I use options to make money during up and down markets. However, providers of exchange traded funds (ETF’s) have evolved beyond just offering low cost sector and index funds.

The growing popularity of ETFs have increased competition among providers to attract investors to purchase their products. I have notice an increase in the number of products that include covered call and also some put right options.

                               A Partial list of Covered Call ETFs

Advisor Shares STAR Global Buy-Write ETF (VEGA)
CBOE S&P 500 Buy Write Index ETN (BWV)
Credit Suisse Gold Shares Covered Call ETN (GLDI)
Credit Suisse Silver Shares Covered Call ETN (SLVO)
First Trust High Income ETF (FTHI)
First Trust Low Beta Income ETF (FTLB)
Horizons S&P 500 Covered Calls ETF (HSPX)
Recon Capital NASDAQ 100 Covered Call ETF (QYLD)
S&P 500 BuyWrite Portfolio ETF (PBP)
BMO Covered Call Canadian Banks ETF (ZWB-TSX)listed on the Canadian TSX stock exchange
BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA-TSX)listed on the Canadian TSX stock exchange
BMO Covered Call Utilities ETF (ZWU-TSX)listed on the Canadian TSX stock exchange
BMO US High Dividend Covered Call ETF (ZWH-TSX)listed on the Canadian TSX stock exchange
First Asset Can-60 Covered Call ETF (LXF-TSX)listed on the Canadian TSX stock exchange
First Asset Can-Energy Covered Call ETF (OXF-TSX)listed on the Canadian TSX stock exchange
First Asset Can-Financials Covered Call ETF (FXF-TSX)listed on the Canadian TSX stock exchange
First Asset Can-Materials Covered Call ETF (MXF-TSX)listed on the Canadian TSX stock exchange
First Asset Tech Giants Covered Call ETF (CAD Hedged) (TXF-TSX)listed on the Canadian TSX stock exchange

A key advantage of ETFs with covered call option writing is investors have some downward protection during these uncertain times. Plus you don’t have to be approved by your financial institution to trade options. Keep in mind that the management expensive ratios are going to be higher than index funds and these ETFs are also fairly new so it may be difficult to evaluate their past returns.

 

Disclaimer: These are not recommendations, do you own research before investing.