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Asset allocation, 2.0: Low and rising rates require reboot of classic portfolio

It’s time to revisit and refresh the most important part of investing: basic asset allocation

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Social media, smart phones and hailing a taxi have all changed dramatically in a short time, and now so has portfolio construction for individuals, families, foundations and endowments.

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A well-diversified portfolio may still adhere to the classic 65/35 format, but the best choices for each section, along with some total portfolio considerations, have evolved. Larger endowments and Canadian public pension plans have led the way, embracing better solutions as they optimize portfolios within risk parameters.

For review, here’s an example of the “old” portfolio:

Fixed income

Bonds, 20-30% of portfolio
U.S. pay bonds, 0-5%
High yield bonds, 0-5%
Total percentage of portfolio: 35%

Equities

Canadian equity, 25-35% of portfolio
U.S. equity, 15-25%
EMEA (Europe, Middle East, Africa) equity, 5-15%
Equity hedge fund, 0-10%
Total percentage of portfolio: 65%

The old portfolio worked well for a long time, bolstered by high and falling interest rates that caused bond prices to rise and produced sufficient income. The “safety, income and portfolio buffer” bucket that we have learned to call “fixed income” provided the crucial capital preservation and important offset to the “growth” equity bucket.

Today’s ultra-low and now rising rates have been the major catalyst for the evolution to a new optimal portfolio, along with new tools and solutions. This evolution was also charged by advances in thinking around liquidity needs and valuable illiquidity, correlation of exposures, risk management and experiences from various economic and market events.

Here’s what the “new” portfolio looks like:

Income/safety/portfolio buffer (aka fixed income)

Bonds, 5-10% of portfolio
Infrastructure, 5-10%
Real estate, 5-10%
Lending/Mortgages, 5-10%
Long/short credit, 5-10%
High yield, 0-5%
Private credit, 0-5%
Market-neutral equity, 0-5%
Total percentage of portfolio, 35% (unchanged)

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Capital appreciation/growth (aka equities)

Canadian equity, 15-20% of portfolio
U.S. equity, 15-20%
Global equity, 10-20%
Emerging markets equity, 5-10%
Commodities/agriculture, 5-10%
Private equity, 5-15%
Equity hedge fund, 5-10%
Total percentage of portfolio, 65% (unchanged)

Most high-net-worth and institutional portfolios have adopted new asset classes and exposures in order to optimize today’s asset allocation. Obviously not all portfolios look exactly like the refined one above, but the optimized ones are more similar to this evolved portfolio. Investing is a step process of choosing calculated risks, selecting amounts and exposures that work together to create the highest return for appropriate risk for a particular mandate or portfolio.

Within these new and often more involved asset classes, there is still an enormous amount of differentiation. For instance, the strategy of one private equity fund will often produce a very different result than another PE fund. Within fixed income, avoiding interest rates while adding exposure to investment grade corporate bonds can provide an effective alternative to traditional fixed income, while exposure to high yield or unrated securities may or may not be within your approved asset classes or risk targets.

Compensating for risk

Total portfolio risk assessment still needs to be a priority as well as an ongoing process. Depending on your chosen exposures within the fixed income or equity buckets, the astute portfolio manager may need to reduce risk in one to allow for optimal risk in another. For example, a particularly high risk/return private equity strategy might require a decrease in public equity exposure or an offsetting decrease in something like high yield or private credit within the fixed income bucket.

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Access to many of these useful exposures was until recently restricted to only the largest investors with the longest time horizons. That, too, has evolved, with a variety of new funds and vehicles with the tools, structure, market access and experience to manage the assets and the strategy.

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However, some of these useful new offerings are not necessarily the panacea they are at times held out to be. Consider that:

  • There is only so much liquidity that can be offered within certain asset classes.
  • The experience required to effectively manage an active approach is available yet scarce.
  • Passive solutions may not work as well in volatile market environments.
  • Investor due diligence needs to get past simple fund names to understand the true exposure and risks, to avoid unexpected exposure to equities or poorly rated bonds.

Set it and forget it?

A rethinking of your asset allocation should set up the portfolio for several years or through a market cycle. Asset allocation is not meant to be altered often, although short-term tactical decisions by astute investors can enhance total return.

Done right, the portfolio should create a mix of capital gains, dividend payments, income payments and unrealized mark-to-market gains. Further, some strategies will perform well at times while others will not, providing a buffer and ongoing capital preservation. This is created by establishing an effective diversification of exposures and by including uncorrelated assets.

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It would be easy to allow an above-target exposure to growth assets to run, especially in today’s environment, but investing is a long-term plan and optimal asset allocation will allow you to stay invested, even when markets turn.

Asset allocation is crucial, and even more so today than usual. Central banks are raising rates, traditional bond portfolios are losing money, fiscal policies are becoming more restrictive, many assets are fully valued and current positive sentiment makes it easy to ignore advice to diversify effectively.

Kevin Foley is a Managing Director, Institutional Accounts, at YTM Capital in Oakville, Ont. YTM manages a credit and a mortgage strategy as alternatives to traditional fixed income. Kevin spent more than 20 years as a managing director in capital markets at a major Canadian bank and he currently sits on three Canadian foundation boards and investment committees. Kevin.foley@ytmcapital.com.

Kevin Foley
Kevin Foley

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