If Your Capital Market Assumptions Have Changed, Why Hasn’t Your Portfolio?

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  • 14 mins 52 secs
Mike Lynds, Managing Director, Head of Retail Business and Robert Wilson, CFA, Head of Portfolio Construction Consultation Service at Picton Mahoney Asset Management join us to discuss how changing capital market assumptions are creating misalignment between investors’ goals and the strategic asset allocation of their investment portfolios. Given the low interest rate environment, many investors have been seeking thoughtful ways to reduce their allocation to core bonds. Robert explains the tradeoffs involved with this decision and how investors can design portfolios with the potential for improved outcomes by thinking alternatively and taking a total portfolio approach to “fixing” fixed income.
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Mike Lynds:                  00:09                Good afternoon. My name is Mike Lynds and I am the managing director and head of the retail business for Picton Mahoney. And with me is Robert Wilson, vice president, and head of Picton Mahoney's Portfolio Construction Consultation Service, or PCCS. Good afternoon, Robert.

Robert Wilson:              00:24                Hi Mike.

Mike Lynds:                  00:26                Now let's jump right into it. We spoke earlier in the year, and since then you've been working to bring your service platform to life. Why don't you start by telling us a little bit about that journey?

Robert Wilson:              00:36                Yeah. So it's been a fantastic few months here, Mike. What we've done with this services, is repackage a lot of the capabilities we use internally at our firm, things that our quant and risk teams do to support the portfolio managers in managing their portfolios and we've turned that into a service offering for the Canadian investment advisory community. And what's been great and also very humbling, is seeing the fantastic work that advisors across the country are doing. Their hunger and desire for more and better tools to manage risk for their clients so they can build portfolios that will achieve their client's goals with greater certainty. So I've enjoyed working with advisors across the country, understanding the outcomes their clients are looking to achieve, and then identifying actionable ideas and pieces of information those advisors can incorporate into their practice to help solve for those client goals more efficiently.

Mike Lynds:                  01:26                Good to hear. Okay. Now, I know we're here to talk about a particular topic that you've been waving a flag on for some time, has to do with the evolving Capital Market Assumptions. So to start, tell us a little bit about what these assumptions are and why they are still important to advisors and investors today.

Robert Wilson:              01:43                Yeah, so Capital Market Assumptions are incredibly important. They really form the foundational input into the asset allocation and financial planning decisions that you make. Right? So when you build a financial plan, there's going to be a return number in there. And the way that number gets built is based on your assumptions about capital markets, right? So there's really three things that go into that. The first is, one, what is the expected return of different asset classes and strategies? Number two, what is the expected risk or volatility of those asset classes and strategies? And then number three, what is the correlation expected to be between those asset classes and strategies? And based on that, you can understand what the expected return might be for an investment portfolio or asset allocation, as well as the level of risk you might be taking.

Robert Wilson:              02:34                Now, what's really interesting about that is there's two approaches to building out the capital market assumptions. Okay. And the industry is kind of divided about the best way to do that. The first approach is to simply take the historical data, right? We've got fantastic data on Large Cap Equities going back 150 years. You've got some fantastic fixed-income data, and we can take those long-run averages and use that as our input, right? So, people taking that approach are basically saying, the future is unknowable, market returns are random, so the best thing we can do is use the historical numbers. And that actually tends to work really well if you're looking at a 30 to 40-year time horizon, but where it breaks down is if you're thinking more about the next 10 years or 15 years.

Robert Wilson:              03:15                And so the second approach is to say, you know what, the price that I pay for an asset matters, right? The yield on a bond when I buy it is going to be a good predictor of the potential return. The price I pay for equities is going to help decide what kind of return I can expect from those. And so this approach means modifying those capital market expectations and those beliefs, based on prices in the market. And so depending on which approach you take, you end up with very, very different asset allocation decisions, very, very different portfolios. So it's important to think about what Capital Market Assumptions are you using? What methodology are they based on? And is that an agreement with your own philosophy as an advisor?

Mike Lynds:                  03:55                Interesting. And you've said before that, as beliefs change, so too, should your Capital Market Assumptions. So what's going on here and how important is this?

Robert Wilson:              04:05                Yeah. So, when you look at the changing beliefs, the biggest thing has to be around fixed-income, right? So there's a ton of academic and practitioner research showing that the expected return on a bond is the yield when you buy it. So if you were taking that approach of just using the historical long-run returns, you might be ascribing 5% plus expected return to fixed-income. Whereas if you agree that the price that you pay matters, your capital market expectation is going to be more like one or 2%, right? The vast majority of bonds in the world yields less than 2%, there's actually a ton of bonds with negative yields. And so, if that adjustment takes place, and then you think about designing an asset allocation to meet a return target in a client's financial plan, potentially has significant knock-on effects for how you build a portfolio.

Robert Wilson:              04:54                Now, it's kind of tough because, if you're going to reduce your allocation into bonds or into government bonds, those have been such a fantastic source of ballast for your portfolio, right? And a lot of it has to do with the fact that bonds react differently to growth and inflation than stocks do. So you kind of need to be thoughtful about this. How can I find an asset allocation that gives me the potential to achieve the return target of my client's financial plan, but that has the level of risk that my client has the capacity and tolerance to bear? So we've done a ton of work with advisors across the country, thinking about this problem, thinking about different toolkits, strategies, asset class, that they could incorporate to make the portfolio more aligned with their beliefs, because beliefs have changed a lot over the past decade, but portfolios haven't changed all that much.

Mike Lynds:                  05:42                Now you touched on fixed-income there and I've seen and heard you in your writing and in your speaking, talking about this idea of fixing fixed-income. What do you mean by that?

Robert Wilson:              05:51                The first thing you would look at, right, if you decide, okay, you know what, we have a problem with bonds, is, can I make adjustments within that fixed-income sleeve? Can I replace the bonds I owned with other bonds or other fixed-income strategies that are going to address this issue? And that makes a ton of sense, right? We talked to advisors about the benefits of balancing interest rate and credit risk, right? These are very diversified sources of return. They make the bond portfolio able to perform well across a broader range of scenarios, but there's a knock-on effect to that. So you really need to think about the decision in a total portfolio context, right? If you're going to change the fixed-income sleeve, what impact does that have on the overall portfolio and what changes might you need to make in your equity or alternative sleeve to accommodate for that?

Robert Wilson:              06:36                So for example, if you were to simply replace core bonds with high-yield bonds or credit, you're going to be more economically sensitive, right? Those higher bonds have a higher correlation to equities, they're more sensitive to growth, like equities are. And so the risk in your portfolio is going to increase. So, what are the knock-on effects? How can you take a total portfolio approach? You might still make that adjustment, but then you go to the next step further and say, within my equity sleeve, I'm going to search for ballast directly there. I'm not going to be getting as much downside protection from my bonds, so I'm going to find it within my equities.

Robert Wilson:              07:08                And that's also really tough for advisors because a lot of the strategies that we've relied on over the years, the way they do that is they focus on interest rate sensitive equities, right? Defensive equities, whether you think about defensive equity sectors or defensive equity styles, things like low-volatility stocks or dividend stocks, they tend to have a higher rate sensitivity than the broader stock market. So you might be bringing that interest rate risk down on the bond side and dialing up on the equity side. And so this is where liquid alternatives have become so valuable and so useful to investors is, they offer an opportunity to have increased ballast within the equity portfolio, but do it in a way that doesn't necessarily rely on interest rate sensitive equities.

Mike Lynds:                  07:49                I heard you provided a little teaser there on this notion of total portfolio approach. Can you flesh that out a little bit more and help me understand this concept better?

Robert Wilson:              07:58                Yeah. So asset classes are not pure risk exposures, right, they're a blend of underlying risks. So what we want to understand is, what is the overall portfolios risk and how do you want to adjust that so that we can achieve our clients goal with greater certainty. Five million Canadians are turning 65 this decade, right, and so they're in that critical tenure period, those five years prior to retirement and the five years after retirement. When you look at the financial planning literature, the outcome during that 10-year window is one of the biggest determines of whether or not a client's financial plan is successful and the quality of life they can have in retirement and the standard of living they can have off their portfolio. So what we want to do with the total portfolio approach, is we want to understand, what is the aggregate risk exposure? How sensitive am I to changes in the level and direction of the stock market, of interest rates of credit spreads, of different commodities.

Robert Wilson:              08:50                And then using that knowledge, we can get insight into asset classes or strategies that might have above average diversification potential for our portfolio. So for example, if the bulk of your risk is coming off of rates and equities, maybe commodity exposure could offer diversification or strategies that have a small Beta-footprint that don't really depend on the level of direction of those markets. So those are often strategies designed to be market-neutral or event-driven in construction, could have a very high diversification potential. The [inaudible 00:09:19] result is, you could design a portfolio that has a bunch of different assets and strategies that all have the potential to help from cash, put that load on unique and diversifying risk factors. And a portfolio like that should have the potential to achieve the client goal with greater certainty. You're not going to get pushed around as much by the market, you're not going to be as depended on what the stock market does as to whether or not your client exceeds or fails in achieving the goal in their plan.

Mike Lynds:                  09:42                So, how do you turn this thinking into action? What are the three things that you recommend advisors act on today?

Robert Wilson:              09:49                Yeah, so, we've built a playbook here, in terms of taking action. If you decide that your beliefs have changed and that you need to adjust the portfolio, but the first thing to you ask yourself is, "What are my beliefs?" and lay those out explicitly. What are my expectations for stocks? What are my expectations for bonds? And with those expectations, is the portfolio I own today, a portfolio that can achieve my client's financial goal, right? And why is my asset allocation what it is? Am I simply doing things this way, because it's the way it's always been done or are there specific reasons why I believe this is the best allocation to achieve that goal? If you ask yourself that question and you decide the answer is no, that you need to make changes because the market environment today is different than it's been in the past. And if you agree with us around this idea, that valuations matter and the price you pay for bonds matter, then our playbook for you has three pieces.

Robert Wilson:              10:41                So the first thing you want to do is you want to look at augmenting or fixing your portfolio by switching out some core bonds for defensive credit exposures. Now, the reason for defensive credit exposures, is credit tends to have a lot of tail risk, right? Typically, you make an above average return, you get a bigger coupon and then every once in a while, there can be a big loss. So a defensive credit strategy is going to be one that's mindful of that tail risk and is seeking to generate the average term of credit without exposing to a tail risk. So, there's a number of skilled managers that have designed and built products that seek to deliver that outcome.

Robert Wilson:              11:16                The second thing you can do then is know that, okay, I own less core bonds, I don't have as much government bonds in my portfolio, within my equities, I'm going to see ballast. So we spoke about that a little bit earlier. What you want to be careful of is a lot of the strategies that have that type of return profile. All you're doing is you're just bringing in straight risk back in again, right? So, understand the Beta-footprint of that equity strategy, know where the defensiveness is coming from, right? Is it coming from the fact that it has unhedged currency exposure and the U.S. dollar typically goes up when stocks are dropping. Is it coming because the stocks are more rate sensitive? Is it a liquid alternative that's hedging out the market risk and reducing your market risk, but replacing it with some manager risk, that's going to seek to add additional return? Where is that resilience coming from? But find resilience within the equity sleeve.

Robert Wilson:              12:02                And then the third is, incorporate and add a third sleeve the portfolio, don't just paint with two colors. Add a sleeve of alternative strategies and if the goal is to have a resilient portfolio, but be less dependent on interest rate risk and government bonds, then what you're really looking at is absolute return and event-driven strategies, right? These are strategies that do not depend on level or direction of stock market, they're strategies that tend not to be interest rate sensitive. So you could find a group of those strategies that are going to have a low-volatility, similar to a bond fund. You're going to see returns, maybe a little bit better than what you might get off of core bonds. And they're going to offer diversification to the rest of the portfolio. So, if you put the three pillars of that playbook, any one of those ideas, may or may not be working at any given time, you've got a better chance of success because perhaps one of them will be working for you. So the portfolio can achieve that goal that you've set out for the client.

Mike Lynds:                  12:59                Okay. Let's try to tackle a common hurdle here. You know so much of what we do with advisers is actually in service of investors. So how do we help investors appreciate what's at stake here?

Robert Wilson:              13:12                I think it's really important to have a conversation with investors about risk and to educate investors about what you're doing to manage risk. And it's especially important, because we mentioned all these Canadians that are turning 65 and retiring, the impact of risk, once you start drawing down from the portfolio and decumulating, is very different than in the accumulation phase, right? If you have a drawdown during that accumulation phase, it's actually a net benefit to the investor, because they can put more money to work at a lower price. They'll probably actually end up accumulating more wealth over their lifetime. But if you have that drawdown early in the decumulation phase and you're pulling money out of the portfolio, those are the scenarios where all of a sudden the money runs out before it's supposed to. Those are the scenarios where the client has to make hard decisions, like adjusting their standard of living or potentially selling their home so they have more cash, right?

Robert Wilson:              14:10                So in that decumulation phase, the sequence of returns, the drawdown risk is incredibly important. The way you address that, is that you look to reduce the largest source of risk in the portfolio. For a balanced portfolio that's typically equity risk, right, you own as much or more stocks than bonds and the stocks are three to four times more volatile than the bonds are. So you dial that risk down and then you reallocate that risk to other sources of return that aren't dependent on the same risk factors as equities. And so, again, if you are of the belief that the price you pay for assets matter, it's not about reallocating that equity into core bonds, but really into diversifying asset classes or strategies.

Mike Lynds:                  14:51                Okay, well, let's wrap up here. Let me make it real for the advisors here. How do advisors gain access to your service? What's their next best action?

Robert Wilson:              15:00                Yeah. So, we've got a web presence. You can check us out at pccs.pictonmahoney.com or reach out to your local Picton Mahoney wholesaling team. They'll be happy to introduce you to our service, show you the different ways that we can work with you. And we're thrilled to hear from advisors and to help you think through and overcome the challenges your clients are facing. So looking forward to getting to know you and to working with you.

Mike Lynds:                  15:25                Okay, well, thanks so much for your time and insights, Robert, it's well served. As well, thanks for listening to our discussion and do please get in touch with your Picton Mahoney sales professional, and we do look forward to serving you. Thank you.


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