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The quest for the investment holy grail — an index of everything – Financial Post

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One man has been on a quest to create the ultimate index for more than a decade. Now he thinks he’s getting close

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Financial benchmarking giant MSCI is working on an “ultimate index” tracking the performance of all markets, which could mark the culmination of half a century of academic theory and practical financial engineering.

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Indexing is a booming business, slicing markets up into geographies or categories such as equities or bonds, and then subdividing further by size or industry. These are then used as benchmarks for fund managers, or packaged up into investable products. But a way to combine everything from commodities to venture capital in one gauge has proven elusive.

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“It’s the holy grail,” says Mark Makepeace, the head of index provider Wilshire. “It solves a core problem of investing and would be hugely beneficial.”

When Makepeace led FTSE Russell, the group teamed up with Nobel laureate and Stanford economics professor William Sharpe to create an adaptive asset-allocation tool that started to tackle the idea of an ultimate index, but included only stocks and bonds.

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A true ultimate index would go further, including other big asset classes, like commodities, and even private assets that do not trade on an exchange, like real estate, infrastructure, bank loans and stakes in hot Silicon Valley companies.

Peter Shepard, head of analytics research and product development at MSCI — one of the indexing industry’s Big Three, alongside FTSE Russell and S&P Dow Jones Indices — has been working on the quest to produce an index of this kind for more than a decade. He thinks he is getting close, although he is reluctant to term the final result an “ultimate index.”

Before he joined MSCI in 2007, Shepard was a theoretical physicist at Berkeley — his PhD thesis was titled On non-perturbative quantum gravity: Holography and matrix models in string theory — and he spent much of his time chasing the holy grail of physicists, a unifying Theory of Everything. He is therefore wary of applying the same label to the realm of indexing.

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“I need to be careful about not falling into that trap again,” he said. “I think we may be able to find a grand unified theory of physics at some point, but we’re not going to be able to find a grand unified theory of markets.”

The standard investment industry benchmark has long been the 60/40 portfolio — 60 per cent stocks and 40 per cent bonds. Vanguard’s US 60/40 fund has returned 168 per cent over the past two decades. Yet what to include in a broader index is hotly debated, and how to construct it is fraught with practical complications in sourcing reliable up-to-date data in areas like private markets.

Despite that, Shepard is convinced they must be included. Private equity has returned about 12 per cent a year on average over the past 15 years, and private debt about 8 per cent, according to Morgan Stanley. “If you leave private assets out of this Platonic ideal, you’ll be leaving a whole lot of performance behind,” Shepard said.

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Even if one can come up with a decent mix of asset classes, figuring out how to sort by geography and other factors is not straightforward.

Of the many ways that a chief investment officer adds value, some can be standardized

Peter Shepard

What is the best mix of U.S., European, Chinese or Brazilian stocks? How much exposure should there be to larger stocks or smaller ones? Should the bond allocation be weighted by the volume of debt issuance — as is standard for fixed income benchmarks — or is there a smarter way? The optimal answers are still uncertain, Shepard admits, but “simplicity and transparency are key.”

“I could come up with a great black box, but if you don’t understand it, you won’t trust it and you won’t use it,” he said. “My hypothesis is that of the many ways that a chief investment officer adds value, some can be standardized.”

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The prospect is not just an object of geeky fascination in the indexing industry. If well constructed it could form the basis of cheap but powerful investment products for everyone from retirees to sovereign wealth funds, by simplifying the often arduous and expensive task of splitting money between different markets.

While the cost of investing in individual asset classes has been hammered down thanks to the invention of index funds, deciding on how to mix them is often handed over to a pricey financial adviser, or in the case of a pension plan, to a team of expensive professionals.

If one could assemble one broad investable benchmark for all assets — a true reflection of what Sharpe termed “the market portfolio” back in the 1960s, rather than a messy or facile proxy — then one could perhaps create a single, simple financial product suitable for most investors.

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“I think there’s a huge opportunity here,” Shepard said. “The asset allocation decision is the most important decision for a lot of investors . . . But we’re leaving this really critical decision to people who may not be that skilled, like my parents, or they turn it over to someone who charges fees for it.”

Despite the considerable hurdles, Shepard is optimistic that the quest for the Ultimate Index will soon bear fruit. However, he thinks that in practice the final result will be different flavours of a broad multi-asset benchmark.

“It might be a grand unified theory in terms of the framework. But customization will be essential, as one size will not fit all investors,” he says. “At the same time, it has to be simple.”

© 2021 The Financial Times Ltd

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Investing inside a corporation: what you need to know – MoneySense

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FPAC responds:

Congratulations on your successful retirement! At a stage when most people are focussed on decumulation, you’re asking about establishing an approach for long-term, tax-efficient investing inside your corporation. Let’s walk through these important considerations:

Investment decisions: robo-advisor or DIY—and ETFs or bank stocks?

A robo-advisor is a great choice for automated, tax-efficient and low-cost investing. A robo-advisor will be able to set you up with a portfolio of low-cost, widely diversified ETFs. Regular rebalancing, quarterly reporting and ease of use will make this option attractive if you are looking for a hands-off approach. Most of the leading robo-advisor platforms in Canada will help you set up a corporate account. 

If you’re comfortable being a little bit more hands-on, you might consider implementing a multi-ETF model portfolio. This approach will require you to open an account at a brokerage and do some regular investment maintenance, including allocating cash, reinvesting dividends and rebalancing

Alternatively, you could also consider implementing an asset-allocation ETF solution. These “all-in-one” ETFs are available in different stock/bond allocations to suit your risk preferences, and they are globally diversified. 

You mention tax-efficiency being important to you. Broad index-based ETFs track an underlying market index. The stocks and bonds in these indices do not change often, so there isn’t a lot of buying and selling of stocks—also known as “turnover”—happening inside of your ETFs. A portfolio with low turnover will not stir up a lot of unwanted capital gains in years that you don’t want to take money out of your accounts, and less turnover means less tax payable year-to-year, leaving more of your money working for you. All in all, tax efficiency is a huge benefit of an index fund ETF approach to investing, especially if you’re investing inside of a corporation. 

You also mentioned bank stocks as an alternative. I can understand the appeal of this approach, as buying stocks of Canada’s large financial institutions has proven to be an effective strategy over the past several years. Unfortunately, the past performance of any investment strategy does not tell us much about its performance in the future. And, in the case of bank stocks, your investment will be very concentrated on a single sector, in a single country. This approach to investing carries risks that can be easily diversified away by using broad, globally diversified index-based ETFs. (In fact, Nobel Prize laureate Harry Markowitz famously called diversification “the only free lunch in investing.”)

Understanding the ins and outs of corporate investing

Investing inside of a corporation can be complicated. A corporation is taxed differently than an individual in Canada. As individuals, we are taxed based on a progressive income tax system, meaning higher amounts of income are taxed at higher rates. In your case, if you are earning (or realizing) a lower income in retirement, your last dollar of income is likely taxed at a lower rate than it was while you were working. When you combine lower tax rates with other benefits that the tax system provides to seniors—such as pension income splitting and age credits—it is possible that you will not be taxed at the high end of the marginal tax table in retirement. 

Passive investment income generated inside a corporation, on the other hand, is taxed at a single flat rate of around 50% in Ontario, or close to the highest marginal tax rate. Passive income tax rates are so high because the Canada Revenue Agency (CRA) doesn’t want us to have an unfair tax advantage by investing our portfolios inside corporations.

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Poland Belittles Media-Law Impact as US Warns on Investment – BNN

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(Bloomberg) — Poland played down the impact of a draft law ousting U.S.-based Discovery Inc. as a senior Washington official warned that a perceived erosion in media freedom could hit investment sentiment toward the nation.

The ruling party wants to pass legislation that will force Discovery to sell control of its Polish unit TVN, the largest privately owned television group in the country. The media regulator has also for more than a year not extended the broadcasting license for TVN24, the group’s news channel whose award-winning investigative reports have unveiled corruption at various government levels.

The draft law proposes to ban companies from outside the European Union, as well as the associated economic areas of Iceland, Liechtenstein and Norway, from directly or indirectly controlling television and radio stations. That would only impact Discovery, one of the biggest U.S. investors in Poland.

“This law only imposes the obligation to find a capital partner in the European Economic Area, and does not infringe anyone’s freedom of expression,” Marek Suski, a ruling party lawmaker and promoter of the TVN bill, told public radio on Friday. “I think that great American lawyers will find a way to do this.”

The legislation — which the ruling party wants to approve in parliament next month — has already prompted concern from the U.S. and the EU.

U.S. companies have invested more than $62 billion in Poland, second only to Germany, and provide employment for 267,000 people, according to the American Chamber of Commerce.

”This is a very significant American investment here in Poland,” Derek Chollet, a counselor at the State Department, told TVN24 in an interview during his visit to Warsaw on Thursday.

Failure to extend the Discovery unit’s broadcasting permit “will have implications for future U.S. investments. But it’s also a question of values” as “media freedom is absolutely crucial — a free press is important to empowering society,” he said.

©2021 Bloomberg L.P.

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Martin Pelletier: How anti-vaxxers can impact your investment portfolio – Financial Post

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Three things to watch for to gauge the sustainability of the post-COVID recovery

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Equity markets appear to be taking a breather as we move from early to mid-cycle in the post-COVID recovery, with market participants trying to figure out what that means and where we go from here. Many are wondering if we have seen peak earnings and peak growth, and if the rise of the variant will cause another shutdown.

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You can see this in the muted reaction to some recent impressive quarterly earnings reports in the United States, with some high expectations already priced into share prices. And then investors hit the panic button on Monday, taking the S&P 500 and S&P TSX down to 3.5 per cent from its recent high, while the Canadian dollar has now lost all of its gains and is now flat on the year.

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During these times its important to remember that markets don’t always go up and near-term volatility doesn’t necessarily imply that a looming meltdown is on the horizon. For example, did you know that we’ve counted that the S&P 500 has fallen more than two per cent eight times this year alone?

However, market corrections are quite common and can actually be quite healthy as they flush out those participants on the margin (excuse the pun) without the wherewithal to stand by their longer-term convictions. In that regard, looking ahead there are three main factors worth watching, not only as to the sustainability of this post-COVID recovery but also overreactions allowing for the opportunity to rebalance portfolios.

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The bond market

We continue to believe that this very much is still a central bank-driven market environment. Macro policy will weigh heavily as markets react to indications of where the Fed and other central banks are positioning. For example, markets corrected more than 15 per cent when Bernanke signalled tapering back in 2010, and some argue that the tech bubble was burst when Greenspan indicated hikes were coming in early 2000.

That said, this time around central banks are in a bit of a pickle with rising inflationary pressures offset by the need to keep debt servicing costs down for massive government fiscal programs currently being funded by printing money. In addition, we’ve read that there are a record amount of job openings, but wages aren’t high enough to entice those unemployed going off government assistance.

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This is where the bond market can be a good indicator and worth keeping a close eye on, but at the same time recognizing they don’t always get it right. More recently, long-term U.S. Treasuries (20 year +) have rocketed nearly 12 per cent from their May lows, nearly recouping all of their losses this year-to-date. For those overweight bonds, especially longer-dated ones, we wonder if they’re being given a rare second chance?

Oil prices

Don’t kid yourself. Despite the plethora of talk around the transition to clean energy, high oil prices still have a material impact on the economic recovery in the U.S. Five of the last six recessions have been preceded by a spike in the price of crude oil, with the only exception being the recession in 2020 caused by the COVID lockdowns.

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The good news is that WTI oil prices have fallen from last week’s highs of nearly $75.50, down more than 11 per cent to below $67 a barrel on Monday. This couldn’t come at a better time as main street is in the midst of struggling with supply chain shortages causing inflationary pressures in key household staples such as food, clothing and gasoline.

Household spending & anti-vaxxers

We received some good news out of U.S. retail sales last Friday, showing a rebound month-over-month in consumer spending, which is a primary driver of GDP growth. People are tired of being locked up and have now been given a taste of what it’s like to experience a pre-COVID world again. This also appears to be in its early stages, as U.S. households are still sitting on quite the nest egg, having accumulated trillions in excess savings during the pandemic.

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  4. The U.S. Federal Reserve is extremely limited in its ability to materially raise rates given the massive amount of debt being taken on by its government to fight the COVID-19 pandemic, writes Martin Pelletier.

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Looking forward, the trillion-dollar question, therefore, is if the stupidity of those choosing not to get vaccinated is greater than many expect, resulting in the rise of the variant this fall and forcing another lockdown. We hate to position portfolios around stupidity, but it is a risk nonetheless and worth keeping a very close eye on.

In conclusion, pullbacks are signs of a healthy market and more so, given they present a great chance to reposition and rebalance portfolios. This can be a rather difficult thing to do in today’s headline-grabbing environment, but it helps to strip out the noise, have a long-term plan and deploy some form of near-term active risk-management.

Martin Pelletier, CFA, is a portfolio manager at Wellington-Altus Private Counsel Inc. (formerly TriVest Wealth Counsel Ltd.), a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.

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In-depth reporting on the innovation economy from The Logic, brought to you in partnership with the Financial Post.

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