Yale vs. Norway, Income Splitting, and Avoiding Ponzi Schemes (EP.107)

Episode Summary

Executive Summary: In episode 107 of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore cover a range of financial topics including a book review of 'Essentialism,' observations on Tesla's surging market cap, an explanation of payment for order flow, and a defense of their stance on behavioral finance. The main focus is a detailed analysis of institutional investment models, contrasting the Yale Endowment and Canada model with Norway's sovereign wealth fund, and an overview of Canadian income-splitting strategies. The episode concludes with a cautionary tale about a Ponzi scheme targeting police officers.

Main Topics: Book Review: Essentialism (Priority: 2/5): A review of Greg McEwen's book 'Essentialism: The Disciplined Pursuit of Less,' which advocates focusing on the right things rather than doing more. The hosts discuss the concept of protecting one's highest priority and avoiding the trap of being busy for the sake of it. Tesla's Market Cap Surge (Priority: 3/5): Analysis of Tesla's dramatic increase in market capitalization, which added $35 billion in a single day and surpassed the combined value of GM, Ford, and Fiat Chrysler. The hosts discuss whether this is a sustainable growth story or a glamour stock with high expectations. Payment for Order Flow (PFOF) (Priority: 2/5): Explanation of how brokers like Robinhood make money through payment for order flow, where wholesale firms pay for the right to execute retail trades. The hosts discuss its prevalence in the U.S. and its absence in Canada, as well as regulatory concerns. Behavioral Finance and Active Management Debate (Priority: 4/5): A response to a listener question about confirmation bias, where the hosts soften their previous stance on behavioral finance. They play clips from experts Marlena Lee, Cliff Asness, and Ken French to argue that both risk and behavioral explanations can coexist. They also critique a paper advocating active management, particularly the 'active share' concept. Institutional Investment Models: Yale vs. Canada vs. Norway (Priority: 5/5): A deep dive into three major institutional investment approaches: the Yale endowment model (high alternatives, active management), the Canada model (in-house active management, total portfolio approach), and the Norway sovereign wealth fund model (largely indexed, low-cost, belief in efficient markets). The hosts highlight that most endowments underperform simple indexes on a risk-adjusted basis. Canadian Income-Splitting Strategies (Priority: 4/5): A comprehensive overview of income-splitting opportunities in Canada, including spousal loans at the 1% prescribed rate, spousal RRSPs, RESPs, family trusts, and post-retirement pension splitting. The hosts provide numerical examples of potential savings and stress the need for professional advice. Crazy Bad Advice: Ponzi Scheme Targeting Police Officers (Priority: 1/5): A cautionary story about a Ponzi scheme run by a police officer that defrauded dozens of OPP and municipal officers of $15-20 million, promising returns of 21-26%. The hosts emphasize the importance of verifying advisor registration and custody of assets.

Key Arguments: Essentialism is about doing the right things, not just doing less; failing to prioritize your own life means someone else will prioritize it for you. Tesla's high market cap reflects enormous growth expectations, but history shows that glamour stocks often underperform, and competition from established automakers is significant. Payment for order flow is a widespread U.S. practice that some argue improves market efficiency via lower spreads, while others question whether it extracts value from retail investors. In Canada, it is not permitted. Behavioral finance and risk-based explanations for investment factors like value are not mutually exclusive; both likely contribute to observed returns, and limits to arbitrage prevent behavioral anomalies from being eliminated. Most endowments that follow the Yale model underperform simple stock/bond indexes on a risk-adjusted basis; only the largest endowments have less negative alphas, but none have statistically significant positive alphas. Norway's sovereign wealth fund, the world's largest, deliberately follows a low-cost, largely indexed approach based on the belief that markets are largely efficient, achieving returns on par with more complex strategies at a fraction of the cost. Income splitting in Canada, through strategies like spousal loans at the 1% prescribed rate and family trusts, can generate significant tax savings, illustrated by a net present value of $271,000 for a $2 million spousal loan over 21 years. Ponzi schemes rely on trust and greed; investors should always verify registration, custody of assets, and never make checks payable to an advisor.

Data Points: Tesla single-day market cap gain (July 13, 2020): $35 billion - Tesla's market cap reached $322 billion, surpassing all but nine S&P 500 companies. Tesla week-over-week market cap increase: Combined value of GM, Ford, and Fiat Chrysler - Tesla added an average of $14 billion per day over five trading days. Payment for order flow revenue (Q1 2020): Robinhood: $90 million; E*Trade, TD Ameritrade, Schwab combined: >$300 million - U.S. brokers receive payments from wholesalers for executing retail orders. Yale Endowment annualized return (30 years ending June 30, 2019): 12.6% - Standard deviation of 6.8%, outperforming a 60/40 stock/bond mix on a risk-adjusted basis. Harvard endowment 10-year return vs. 60/40 portfolio: Harvard: 8.6%; 60/40: 10.5% - Harvard was tied with Cornell for worst performance among Ivy League endowments over the decade ending mid-2019. Average alternative allocation for endowments >$1 billion vs. <$25 million: 51% vs. 7% - Larger endowments allocate significantly more to alternatives, yet risk-adjusted returns are similar across cohorts. Total cost at CPP Investments vs. Norges Bank: CPP: ~84 basis points; Norway: ~8 basis points - Norway's cost is an order of magnitude lower despite managing a larger fund. Net present value of a $2 million spousal loan at 1% over 21 years: $271,000 - Assuming a 70/30 portfolio return, with significant tax savings for the higher-income spouse. Amount invested in Ponzi scheme targeting police officers: $15-20 million - Promised returns of 21-26% and a 5% bonus for bringing in new investors.

Pivotal Quotes: "If you do not prioritize your life, someone else will. And he says your highest priority should be to protect your highest priority." — Cameron Passmore (quoting Greg McEwen): Discussion of the book 'Essentialism' and the importance of focusing on what matters most. "In both cases [Yale and Canada model], you have a lot of complexity and you have high costs, which come with complexity. I think it definitely appeals to the agency issue." — Benjamin Felix: Critique of institutional investment models that rely heavily on expensive alternative assets and active management. "Norway believes that the Ministry of Finance believes that markets are largely efficient, diversification is absolutely necessary. ... Yale is trying to diversify sources of alpha, Norway is trying to diversify sources of beta." — Benjamin Felix: Contrasting the philosophical underpinnings of the Yale endowment model versus the Norway sovereign wealth fund model.

Implications: Investors should be skeptical of complex, high-cost institutional models that claim to beat the market; the largest fund in the world (Norway) succeeds with simple, low-cost indexing. For Canadians, proper use of income-splitting strategies can yield substantial tax savings, but professional advice is essential. Ponzi schemes thrive on trust and greed—always verify custody and advisor registration.