I have written a fair bit over the past few weeks on banks, bail-in, non-viability contingent capital, yield curve effects on net interest margin, etc. Blah blah blah.
Just one more on the topic of banks, I promise and it is the most important of all...Risk-Adjusted Returns.
As Scott and I often write and tell clients, we are 100% focused on creating the strongest risk-adjusted returns we can. A lot of Advisors talk about how they "reduce risk and create low volatility" (how do they do that and with what metric do they measure it?), Well, at High Rock, we really do attempt to reduce risk and lower volatility and we actually do the math and measure it! Here's how.
Its not rocket science really, just a bit of work, some experience, some knowledge, an excel program, and a ton of research. We take different asset classes and sometimes even individual securities and calculate their monthly total returns across a period of time, usually 5yrs. We then regress all of these total returns and calculate the Annualized Compound Total Return and also the Annualized Standard Deviation (a common measurement of risk or volatility). Our goal at High Rock is to get the highest returns while taking the lowest amount of volatility of those returns. Simple.
So then we plot all of the data on a scatter plot graph and see where our data lies. The top-left quadrant always represents the best risk-adjusted returns (GREEN), while the bottom-right quadrant represents the worst risk-adjusted returns (RED).
It looks something like this:
Now that we have an understanding of risk and return, lets look at where our "safe" Canadian banks fall into the graph. They are all denoted with RED SQUARES in the top-right. As you can see, TD, BMO, RBC and CIBC all show 5yr monthly annualized compound total returns of about 10%...pretty good, eh? But they also show risk or volatility of about 14%...pretty high. It is not enough to say "That is a pretty good return" or "My Advisor does pretty well for me because I am up money". Well for Pete's sake, how much risk are you taking to produce those returns? (For another time but it is also important to measure performance against a relevant benchmark). By comparison, the S&P500 is in BLUE and has a similar risk/return profile.
Now look at poor BNS and National Bank in the circle on the right. Returns of only 6% but volatility of 15-17%! Crazy. Probably fair to say these two banks exhibit poor risk-adjusted returns, or at least over the past 5yrs and especially against their peers. (And all of these returns are after a pretty good run in Canadian bank stocks the past 5 months. They might not even be as high on the return scale if we used 5yr data but ended in Feb 2016 instead of May 20216...volatility would be the same or worse tho).
Also, for comparison purposes, I add in the S&P/TSX and a 5yr Gov't of Can bond. The S&P/TSX pretty much...stinks over the past 5yrs. Is it a candidate for re-balancing and a period of out-performance? Maybe (we did add some Cdn equity exposure in the first half of 2016). A 5yr Gov't of Can bond clips along at 4% return with super low volatility of 3%...not so bad is it?
And lastly, I add a 60/40 Equity/Fixed Income portfolio as indicated by ACWI and XBB ETF's. Top-left quadrant...isn't that the best quadrant to be in? Indeed it is.
So why on earth would you be totally invested in Canadian bank stocks to get roughly the same return (10%) but to take 2.25x the amount of risk of a 60/40 diversified portfolio??
Typical Client Answer: "because Canadian banks are "Safe", pay a dividend, are steady", etc.
My Response: Insanity! I have written a fair bit about the new Basel III capital requirements and the possible draconian measures that are bail-in capital regimes and non-viability contingent capital. You can read all about the massively changed landscape for banks in my Apr 29, 2016 Blog titled "I lost 28% in my preferred shares last year".
If your Advisor has not explained bail-in or NVCC in detail to you, I suggest you ask them for an explanation or educate yourself. Or call me...happy to wax on about the potential perils lurking and what these new capital rules have done to increasing volatility across the bank capital structure.
Suffice to say, these are no longer you Father's Banks. What the capital requirements have done is created more volatility in Bank Equity the world over. Canadian banks have the same capital requirements as every other Systemically Important Bank (SIB) and, in fact, some consider the new bail-in regime here, once finalized, could be even more draconian than other jurisdictions.
If it is volatility you want in your portfolio, then by all means, call your broker and start waving in bank stocks, If it is stronger risk-adjusted returns you would like, then call High Rock.
Numbers don't lie.
Full Disclosure: High Rock portfolios do not own any bank securities directly (shouldn't come as a surprise).