Andrew Suthern, Senior Investment Advisor, National Bank Financial, CFA, CFP, FCSI, CIM
Stance: Get innovative
Of headwinds and tailwinds
We’re in the aftermath of a deep recession with more headwinds than tailwinds. Traditional long-only mutual funds won’t cut it. Clients require tactical allocation.
Modern portfolio theory isn’t about protecting you during a stock market downturn; it’s about diversifying unsystematic risk. So your return becomes your beta; that’s systematic risk. If the market goes down 20% and your beta is one, you go down 20%.
But when Harry Markowitz proposed MPT in the 1950s, stocks and government bonds were, for the most part, the only available options. Unfortunately many of today’s asset-allocation questionnaires are still based solely on those asset categories. The 2008 correction, though, has taught us anything’s possible; even that 1% chance can play out. So our industry’s become more innovative. The market offers asset-backed securities; REITs; commodities; uncorrelated hedge funds (not just leverage long); convertible, high-yield, real-return, and inflation-protected bonds; covered-call ETFs; investment trusts; etc.
We can build better portfolios by finding uncorrelated assets that help reduce standard deviation in portfolios without affecting returns.
We use strategic allocation with a tactical bent. If the goal is to have 40% bonds, we have a tactical range, say 15% above or below that.
We’re also allocating a larger percentage to alternative assets, such as covered-call ETFs or high-yield bonds with a layer of derivatives, because everything becomes highly correlated when volatility picks up—even bonds.
A traditional balanced portfolio would typically constitute 5% cash, 45% bonds, 50% stocks. Now our average portfolios are more like 5% cash, 30% bonds, 25% stocks and 40% alternative investments that can increase overall yield. Alternative assets help lower overall portfolio correlation; therefore a higher alternative component does not mean a higher volatility level.
Government bonds offer guarantees; however, they have incredibly low yields. While interest rates can get lower, the 30-year bull market for bonds is over.
High-yield and investment-grade corporate bonds are low too, but there’s room for growth, especially in high yields because the spread versus government bonds is still reasonable at just over 5%. Default rates are also extremely low as companies are flush with cash and can pay the interest (currently, Canadian companies have a third more cash than they’ve had historically).
We continue to build positions in the fixed-income category with a large focus on investment-grade and high-yield bonds. We started loading up these positions four years ago, when spreads were north of 18%. With spreads compressing, clients have received good yield and capital appreciation from these investments.
Since 2009, the high-yield bond market has outperformed the stock market in total returns and on a risk-adjusted basis. This market may continue in the near future. Last year, the high-yield bond market did extremely well and capital appreciation rose. We prefer not to hold government bonds unless they are indexed to inflation.
For the next few years, most returns will come from stock dividends and interest income from investment grade and high-yield bonds. We don’t anticipate much capital appreciation. Covered-call ETFs also increase yield in a sideways market.
We review client portfolios at least once a month (and some almost daily). Our larger clients own individual stocks that require more rebalancing. If we can’t diversify them properly, we use actively managed ETFs or mutual funds. We’ve stayed out of exempt markets because liquidity is a big factor, and most of our clients are retired.
In this environment, downside protection is more important than upside capture. So for larger clients we buy individual stocks with stop-loss orders. That gives them long-only positions without uncertainty.
Back to the future
If we have a correction, we would increase our allocation to long-only, dividend-paying equities. As for Canadian stocks, we continue to own pipelines, REITs and telecoms. They pay good dividends, and have provided capital appreciation. We’ve also added banks.
We’re finding better value in U.S. dividend-paying stocks because there are more choices. Also, there are some undervalued European dividend stocks. And we recommend mutual funds in the emerging market space.
Nancy Graham, Portfolio Manager, PWL Capital Inc., CA, CIM, CFP, TEP
Stance: Stay the course
Risk is always present; yet you can’t predict it. My job is to develop an asset mix that’ll allow clients to stay the course.
Right now interest rates and returns are low and equities are up, but we’re still buying fixed income because that’s the asset allocation we promised to keep. We’ve been glued to our investment philosophy for a decade and it works.
Tactical isn’t for us. We help clients comprehend how emotions interfere with returns. We discuss recency, loss aversion and confirmation bias. We also talk about asset mix regularly to make reassure people about their decisions.
This recession absolutely endorsed the traditional buy-and-hold theories of investing. If you didn’t have bonds in your portfolio, went all out on equities, didn’t diversify, or had select companies, then in all likelihood you got hurt.
Our portfolios have about 7,000 securities. We use ETFs as pools so we don’t have to wait for a stock to come back. We seek to capture asset-class performance. I don’t care whether one REIT did well or another did poorly. We’ve got 20 REITs in our Canadian pool; maybe 200 internationally. We’re leaning toward ETFs extensively, and using some specialized pools so we don’t have to monitor for the one that goes bad because it’s a tiny part of the portfolio.
We’re invested in fixed income, REITs and utilities. We have exposures to Canadian, U.S. and international equities, with some level of currency protection. On the equity side, we prefer broad market exposure with a tilt toward value companies and small companies. Research shows that, over time, value companies produce a premium over growth companies.
A value company is usually part of a mature industry. It may have old technology or significant debt on its balance sheet. There’s more risk attached to a value company, and in lieu of the extra risk, investors seeking higher returns beat down the prices of securities.
We deal with wealthy clients who tend to be accumulators. They’re looking for lower-risk investments because they’re already taking risks in their businesses. Younger clients tend to own more equities.
When selecting tools in portfolios, I prefer transparency. I’m not willing to wager my clients’ hard-earned money on somebody’s instincts about where the markets might be headed next.
The dividend-paying stocks story is a great example of emotional investing. People feel they’re getting guaranteed returns. I don’t buy that. There is a lot of discussion about substituting bonds with dividend-paying stocks because bond yields are so low. They forget it’s still a stock, and fraught with risk.
The buzz around dividend-paying stocks could also have resulted in them being bid up. But if a company—or the broad market—faces troubled waters, prices will drop whether it pays a dividend or not. I’d call these emotionally appealing fads.
It’s the same with hedge funds. Investors rush in, and when things get thorny they leave. Even if you wish to stay on, other investors might bail and the fund might close. We don’t feel the need to get into these expensive products to capture risk. It’s unreliable, idiosyncratic and way too expensive.
Kanupriya Vashisht is a Toronto-based financial writer.