Portfolio reset: Considerations from the board investment committee

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After a tumultuous year for investors, the dawn of this new year feels a little more important. We need to assess the damage, digest the forecasts and fine-tune our portfolios to start rolling the ball back up the hill again.

I sit on a few foundation boards and associated investment committees. Foundations are prevalent themes within family offices, and I am convinced that the foundation-board and the family-office approaches to investment management are similar. They both typically have long time horizons, a tolerance for well-positioned risk without swinging for the fences, and access to a broad set of asset classes.

But times have changed, and this environment requires a refreshed asset allocation. Many foundation boards recognize that we are likely in a different economic and market environment and that the portfolio that worked for many years – or perhaps failed in 2022 – is unlikely to be optimal now.

The realization that we are in a new investment era is largely based on the potent effect of inflation and recognition of the end of ultra-low interest rates and cheap funding. We have seen the impact of these themes in rattled stock markets, higher bond yields and reduced growth forecasts. This new era might be the end of a 40-year bond bull market, it might temper the post-global financial crisis growth expectations, it might recognize that the relationship between stocks and bonds will at least be different, ushering in a more modest period of returns and triggering a shuffle in the priority among asset classes.

We have been taught that once you have set goals, established risk parameters and decided on a suitable time horizon, asset allocation is the most important choice that investors make. Therefore, a review of your strategic asset allocation is crucial, whether you do this on your own or with an investment partner.

The boards I sit on have been doing exactly that, ahead of our normal schedule, and the following are some of the major themes being debated. We are also reviewing our tactical asset allocation, which I will touch on below.

Bonds are back

While government bond yields of 3 per cent and 4 per cent – along with some 5-per-cent corporate bond yields – do not meet most return targets, yields have come a long way in a short time. Some say that bonds should always be a part of a strategic asset allocation, both for their return and for the protection they provide as a ballast in the portfolio, while others decreased allocations to bonds almost entirely as yields approached zero.

Bonds once made up the entire fixed-income portfolio allocation. More selective bond allocations now reflect views on current prices and the outlook for yields, including views regarding the very inverted curve beyond 1-year bonds. Bond allocations are now also often bifurcated between allocations to government bonds and allocations to corporate credit which, with the currently elevated level of corporate credit spreads, offers a higher expected return.

The fixed-income allocation has evolved to include real estate, infrastructure, mortgages, private debt and possibly a small investment in high yield. Some include exposure to agriculture in the fixed-income bucket due to its ability to deliver income, but I am inclined to include that in the equity bucket instead due to its valuation properties. We expect to increase our exposure to short bonds, an investment-grade credit fund, and potentially to agriculture after introducing it to the portfolio in 2022.

Private investments

Privates encompass most of the non-public assets, differentiated from publics by their valuation methodologies, including their typically lagged and smoother valuations, and by their long time horizons and illiquid nature. Many private assets are believed to be valuable during inflationary times. Private asset classes include real estate, private equity, private debt, infrastructure, mortgages and agriculture.

Generally, the key to investing in privates is ensuring that you are being paid a sufficient premium for their inherent illiquidity. The current debate is about how private valuations have not fallen as far as their public comparables recently, potentially due to lagged valuations, or maybe because they were never marked up to the same extent. These uncertainties make it difficult to judge current valuations, and if you are sufficiently being paid for illiquidity, but privates remain high on the list of recommended asset classes in this uncertain 2023 environment. The question might be focused on what maximum percentage of your portfolio should be in private assets, considered along with liquidity needs – especially in light of new 5-per-cent annual disbursement rules for foundations.

Several asset classes have both public and private options. The simple fact that a fund is public can affect fund valuation since it is considered and traded as a stock alongside other stocks, which can distort the value from its true value based on the underlying assets. Real estate and mortgage funds are two examples of this, and both have a role in today’s updated portfolio. Our current focus is again on corporate, commercial and residential real-estate valuations and ensuring that we own the right defensive, shorter-term mortgage fund. We see employment remaining strong, which should support an individual’s priority mortgage payment, and we expect returns to rise along with interest rates.

Private equity has been a standout private asset class in recent years. Opinions vary on current opportunities, the reality of rising PE funding costs, potential forced sellers and the amount of money chasing private equity assets, along with the current valuation debate.

One thing we are debating is the role of a secondary PE fund. Secondaries is a portfolio of PE investments that were sold for one reason or another, often at a discount. These funds are compelling because they have a shorter lifecycle, they are arguably de-risked since the private companies have been in a PE fund for several years, and they often allow you to put money to work immediately, rather than waiting in a long queue and enduring the J-curve effect. We are considering adding a secondary fund alongside our primary PE allocation, and we are debating the timing of that new investment.

We will likely allow our total public exposure to fall, to further position our portfolio in some of these private and other select asset classes. We expect public market returns to be muted for a reasonable length of time. We prefer asset classes such as pure-credit exposure without rates, agriculture and secondary PE. Note that we have a long-term horizon and that we will maintain sufficient liquidity. We are also aware that while markets feel “okay” now, illiquidity can quickly become an awfully bad word in tougher environments.

Portfolios have changed. They may still be divided into an essentially 60/40 stock/bond, or income/growth, framework, but the makeup has evolved to look entirely different. Once we are done, we will likely have 13 or 14 distinct exposures, hiring good active managers where possible.

What the industry once dubbed alternatives, or “alts,” are now essentials in portfolio construction. If alts seem fancy or risky to you, it is past time to understand and embrace some of these effective and often risk-reducing solutions.

Cost of advice

Another thing that has changed is the decreased cost of advice or even fully discretionary asset management services.

I don’t think it’s too exaggerated to say that at current prices you are failing your fiduciary duty not to have an expert investment management partner. That partner should have the experience and technology and data to go through this planning and asset allocation process with you. They should research and monitor and have access to best-in-class managers and their funds. They should offer tactical asset allocation services or overlays, with a compelling track record of adding value, especially to optimize for the year that 2023 promises to be. The overlay might even include protection via a tail risk strategy.

All of the performance, changes in outlook and new investment considerations should be reported to you regularly, with sufficient detail, in a digestible format.

The right partner enhances the likelihood that your thoughtful planning will outperform. In fact, your investment partner’s best feature might be that they save you and your board from your own market whims and knee-jerk reactions.

Active management

A note on tactical asset management. I suppose this is implicitly a nod to active management, and I am okay with that, within prescribed limits.

This upcoming year is expected to be anything but uniform. We have calls for recession in the first half followed by bull markets in the second, and vice versa. Strategic asset allocation can only do so much, and the right shift or tilt between asset classes or parts of the world or parts of the yield curve can make an enormous difference to your total return. The right tactical overlay, perhaps intended to add 50 or 100 bps of additional annual return, alongside an optimized strategic asset allocation, is likely the best laid plan. Proven active allocators and active fund managers seem poised to make a big difference in total returns in 2023 and beyond.

In a nutshell, revisit your goals and refresh your plans. We are. Consider new asset classes. Embrace alts. Consider adding or upgrading your investment partners, all in expectation that the future looks different than the past and the fact that there are new beliefs, tools, and solutions required for portfolio optimization.

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.

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