Robert Wilson, CFA, Head of Portfolio Construction Consultation Service at Picton Mahoney Asset Management joins 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.
If Your Capital Market Assumptions Have Changed, Why Hasn’t Your Portfolio[00:00:00] Pierre Daillie: Hello, and welcome to the Insight Is Capital podcast. I’m Pierre Daillie, Managing Editor of AdvisorAnalyst.com. I’m here with Robert Wilson, Vice-President and Head of Picton Mahoney’s Portfolio Construction Consultation Service, or PCCS. [00:00:12] Disclaimer: [Music]This is the Insight Is Capital podcast.
The views and opinions expressed in this broadcast are those of the individual guests, and do not necessarily reflect the official policy or position of AdvisorAnalyst.com, or of our guests. This broadcast is meant to be for informational purposes only. Nothing discussed in this broadcast is intended to be considered as advice.[00:00:34] Pierre Daillie: Good afternoon, Robert. Welcome to the show. It’s great to see you, and looking forward to catching up with all you’re doing. [00:00:40] Robert Wilson: Absolutely, Pierre. Great to see you again. [00:00:43] Pierre Daillie: Robert, why don’t we recap and I know we’ve talked about this a lot, but why don’t you describe what PCCS is, what Picton Mahoney’s Portfolio Construction Consultation Service involves? [00:00:57] Robert Wilson: Fantastic. Yeah we set this service up for the community and investment advisor community. And the idea is to help them leverage capabilities across our firm’s quantitative risk and portfolio management teams, to give them insights into building portfolios that can achieve client goals with greater certainty.
I’ve got two big beliefs around investing. The first is that the big differentiator in the Canadian investment industry is portfolio construction and risk management. And the second is that we’re undergoing a period of fundamental change in the relationship between investment advisors and asset managers. So it used to be that you’d go out and you’d hire an asset manager to be a specialist firstly to the portfolio. You might have an equity manager, a fixed income manager, alternative specialist. And, I believe advisor will continue to do that but more and more, the investment advisory community will look to form partnerships with asset managers at the portfolio construction level. And they’ll rely on insights, capabilities, tools, and resources that’ll help them think about how the different pieces of the portfolio can fit together more effectively, so that the portfolio is aligned with their clients’ goals.
And so within this sort of risk, really, there’s four main areas that we focus on, it really is multi-disciplinary. The first is strategic asset allocation. So there, we’re helping you think about how to set up your strategic asset mix , based on your capital market assumptions, to align the return objective and the risk objective of the portfolio. We can help you differentiate your strategic asset allocation against a-a broad reference benchmark, to show the value add of the strategic asset decisions that you’ve made.
The secondary area is around tactical asset allocation. There, we can provide some fantastic insights into the sources of risk within the portfolio. And understand both demand to, and the direction of that risk. It’s important to take risks but what you want is for that risk to be intentional, and scale appropriately. And so some of the work we do there are around risk factor models understanding that positioning can be very helpful for advisors. And that’s whether you have your own strong tactical views perhaps you’re relying on your head office view, or maybe you’re sit-in Pictum Mahoney’s tactical view we’re very flexible in that regard.
And then from there, we drill in a layer deeper, we’ll look within asset classes, at style factors, so things like within equity markets value, momentum, quality, and size. Understand those exposures in the portfolio. And then finally, the last there is around alpha identification. We’ll complement the traditional qualitative due diligence that advisors do with quantitative scorecards. Help you identify metrics that align with the outcomes you’re seeking from your asset… from the asset managers you’re hiring. And then create a quantitative ranking system, help save you time, and make sure that you’re getting what you want from different sleeves of the portfolio.[00:03:38] Pierre Daillie: 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 the journey that you’ve experienced?[00:03:49] Robert Wilson: Yeah. Over the past few months, I’ve really enjoyed working with investment advisors across the country. I’m very impressed with the level of care and diligence they put into the work they do for their clients. Overall, the Canadian advisory community is doing a fantastic job constructing portfolios and managing risk. And what we’re just doing is really equipping them with additional information to help with that decision-making. And also helping them demonstrate the value add of the decision-making that they’re doing, right?
It’s very easy to, show someone how much money you’ve made, but equally important is how you made that money. And so, both conversations, and helping people to frame , their sophisticated approach for portfolio construction risk management has been very very insightful.
The other thing is actually learning from advisors. , over the next decade five million Canadians are gonna turn 65. And there’s a big difference in terms of how you build a portfolio during the accumulation phase and how you build it for that critical decade of five years being into and out of retirement. And so seeing the different approaches people are taking, and understanding, the trade offs between them, and helping people identify ways to solve for that sequence of return or risk more efficiently, has been very useful. And it’s just great seeing how the proffered construction and risk work can translate directly into achieving investor goals.[00:05:07] Pierre Daillie: We’re here to talk today about a particular topic that you’ve been waving a flag on for some time, which has to do with capital market assumptions. First of all, tell us a little bit about what these assumptions are, and why are they so important to advisors and investors today? [00:05:25] Robert Wilson: Capital market assumptions are the key fundamental input that goes into a financial plan. And the strategic asset allocation that’s- that’s designed to deliver on that plan. It’s your belief around the return, the volatility, and the correlation between different asset classes and strategies over the investment time provides.
And what’s really interesting is there’s a lot of disagreement within the investment industry over how best to form- formulate your capital market assumptions. One approach is to say, what? The future’s unknowable, we’re just gonna use the long-term historical data as our input and say, that the past their best guide to the future and that actually works fairly reasonably if you’re looking at over 30 to 40 year time horizon. We’ve got about 150 years of good data for example on developed market equities and we’ve got pretty good data on some of their asset classes.
And the dispersion of return over that 30, 40 year period is actually pretty tight so it’s reasonable. The problem you get into, is if you’re looking at more of the 10 year to 15 year time frame where all of a sudden there can be very wide dispersion and the results for different ask class and strategies. And so we have to ask ourselves is, do I just want to use history as my guide or do I believe that there’s data and information that can help inform my assumptions to make them a more effective of the actual stats we might have over the next few years?
So you might think about, does the price that you pay for an asset matter? Can you expect to get 5% return from investment grade US bonds over the next 20 years, like you get over the past 20? And when the starting yield is much lower? Maybe yes but potentially no. So does the price you pay matter? The next thing would be, what are your beliefs around long-term growth? Are we gonna see the same growth over the next 10 years as-as past 10 or the past 30 right? So if your beliefs have changed then your capital market assumptions need to change to reflect those beliefs and that means that your portfolio should change as well. So what I’ve seen in my conversation with advisors, is there’s been a very large shift in belief around the forward looking returns for traditional assets, particularly high quality fixed income. But there’s only been a small shift in the actual portfolio so there’s this misalignment between belief a-and the action’s being taken. And-and it makes sense, if you think about whether it’s investing or-or anything you may do your life the safe thing is to do what you’ve always done, right? Making a change feels risky but in this case perhaps the risk is to-to stick with the status quo and alternative thinking might be beneficial.[00:08:16] Pierre Daillie: So speaking of these evolving beliefs believe about these capital market assumptions, what’s going on here in your view? [00:08:26] Robert Wilson: Yeah if you look at the historical data, what we’ve seen is the starting yield on a bond is very reflective of the level of return you’ll earn over the time you hold that investment and so when we see that core bonds globally the vast majority are yielding less than 2% and there’s actually a large number of bonds of negative yields. The assumption of a four or five percent return of fixed income seems less realistic. We-we’ve seen different ways of addressing this and I think what you want to do, is you want to be humble and recognize the future is unknowable.
So an approach that I love is, Financial Planning Standards [Council] right, there’s an industry body for financial planners, they give you assumptions you can use for a financial plan. They recommended assumptions and they take a very humble approach. They say okay, we’re gonna look at some large institutional investors, the Canada Pension Plan and the Caisse de Depot in Québec and see what-what are their beliefs? And then we’re going to blend that out with a survey that we send to practitioners as well as the historical data and-and that way they’re not, being overconfident in-in their assumption but they’re taking a blend of different inputs to get to the result.
And essentially if you look at their result they’re suggesting that the capital assumptions for core fixed income should be about 50% lower than it was 10 years ago. So it’s a very dramatic shift and so you get into the situation where if you’re building a portfolio the same way you did 10 years ago, and your clients financial plan is the same return targeted 10 years ago potentially , there’s a misalignment there and the portfolio no longer is is taking sufficient risk or the right risks in order to deliver the number in that financial plan.[00:10:05] Pierre Daillie: Yeah, , I think one of the things that sort of complicates things is, in terms of the forward investment construction is that the 60/40 portfolio is still performing rather well. And-and so the impetus to change it is a little slow right now there’s really not a lot of motivation considering, for example recently the 10 years and longer have crept back down. The 10 year US Treasury at 1.3%. The markets are looking at it and-and saying, the bond market’s sending a signal and whether or not that’s true or whether or not that signal’s correct is another, is a whole other discussion. [00:10:48] Robert Wilson: So what P-Pierre that point about the 60/40 portfolio having performed well for investors is actually an important one and there’s really two reasons for that right. The first is that as an advisor you might recognize that your clients need to make a change if they want to be successful. But it’s hard to make a change if you’re not dissatisfied with your current situation right. And whether it’s investigating or in in life, the time you usually make changes is if you’re dissatisfied, you’ve got a clear picture of a better outcome and you have a easy first step towards that.
So with the 60/40 having done well, that dissatisfaction might not be there and so that’s where educating your client and helping them understand the assumptions that are going into the plan and why those assumptions mean the strategic allocation needs to shift is incredibly important. And really what is about at the end of the day it is what’s your client, you’re-you’re driving down the highway in a car towards this destination of retirement or whatever the goal might be and you ask yourself, “Am I better off driving, staring in that rear view mirror?” you want to look cause it’s helpful you get some information, you can see the risks around you, what are the other drivers doing and how-how-how-how is the trip gone so far? What you really want to be doing is looking out that front windshield right?
And so that’s what you doing with the capital market assumptions, is you’re looking out the front windshield. you’re understanding the road that lays out ahead of you and then you can figure out how best to-to drive to get to your destination safely.[00:12:04] Pierre Daillie: That’s a great point. We all know that-that investment portfolios serve to grow wealth and preserve wealth and to generate income or both. So let’s talk about the role of fixed income in this dynamic. In your writing and your advisor engagements, I’ve heard you talk about fixing fixed income, so what-what do you mean by that? [00:12:28] Robert Wilson: So generally speaking , a fixed income allocation h-h-has three goals right. It’s a source of return at income for the portfolio. It’s meant to provide diversification against equity risk, and it’s meant to be a source of stability. And across all three of those objectives, traditional core bonds have done a fantastic job over the past let’s say 30 to 40 years. It’s been a really positive experience for investors. The challenge is, if the capital market assumptions that you believe in differ from that historical experience. So perhaps you’re expecting less return bonds or you think that thyre going to offer less ballast against equity risk, then what do you do with your portfolio because at end of the day nothing is replacement for a government bond other than a government bond right?
But there are other things that you can do and so when we talk about the fixing fixed income, it’s not just about the return potential, it’s also about the risk. And the perfect example I’ll give is, there’s been some great research published on what happens with 10-Year Government Bonds when the overnight rate is low and what is it offers less ballast. So we saw this first in 2008. The Japanese 10-Year Government Bond did not outperform the uh-uh a Japanese investor would’ve had a similar return holding cash as if they held their 10-Year Government Bond.
It was very different from the experience here in North America. Our-our bonds provided a nice ballast. We started from much higher rate levels and then we saw it again in-in the Spring of 2020, where all of a sudden the Japanese 10-Year Bond, the German 10-Years Bond and Swiss 10-Year Bond- all three of those failed to outperform the local cash. So a local investor didn’t get any additional ballast from the fixed income. They still got the stability that they wanted and they still earned a yield where that yield is better than the cash rate though most countries did deliver a negative yield.
But they didn’t get the ballast. And we saw it here in North America this past fall there was a three, four week period where equity sold off and-and during that time period the Canadian 10-Year Bond didn’t outperform cash, the US 10-Year Bond didn’t outperform cash. So if it’s potentially true that there’s a bit less balance within fixed income, if it’s true that there’s less return potential with fixed income then how can you you deliver those characteristics to your portfolio? And so what we’ve seen a lot of investors do, is they’ve shifted their fixed income. Within fixed income they’ve tilted into credit and there’s a number of way to do that.
There’s a number of very popular multi-sector bond funds that provide allocation across a diversified range of credit. There’s managers offering different types of credit strategies where that’s focused on investment grade or high yield or a-across the spectrum, going to Emerging Markets, bank loans there’s all types to credit problems. So we tilted into credit and that helped solve return problem, but it doesn’t solve the problem without us right because credit’s gonna be more correlated with equities, right, so it’s not a complete solution. It’s a great first step but doesn’t get you all the way there.
So you should really take a total portfolio approach and think about what should you be doing with your fixed income sleeve? What can you be doing with your equities and then how can alternative assets and strategies contribute to help address the potential drawbacks of-of a core bond allocation?[00:15:47] Pierre Daillie: Yeah I-I think quite often investors and advisors get bogged down in the parts of their portfolio evaluating one is evaluating one asset class, one sector, one product in isolation. You’ve talked about a total portfolio approach so help us understand this concept better. [00:16:09] Robert Wilson: Maybe an example would help right, so let’s say that you’ve had a view that you were concerned about rising rates because rates are low, and so you made a shift with your fixed income, you’ve replaced some of your core bonds, with more Government Bond, more interest rate sensitivity. You’ve reduced that, you’ve added credit. So okay, that helps with the immediate problem the chance that credit is going to be correlated the equities, it’s going to be economically sens-sensitive so the risk level in your overall portfolio is probably gone up.
So the next step you have to take if you’re taking a total portfolio approach and say, where else can I source ballast, since I then have less core bonds. Because, okay I’ll get it within my equity seal, I’ll get it directly from my equities. And now you need to think about the fact that an equity exposure is not pure risk exposure, it could be a blend of different risks. And the traditional of buying into defensive equity has been the focus on interest rate sensitive stocks right, whether that’s defensive sectors, they’re more rate sensitive.
Defensive styles like a low beta or a low volatility style tends to be more rate sensitive, and so now you’re bringing back in the exact same risk that you’re looking to take out I’m fixed income side. So this is such a great area to incorporate strategies like liquid alternatives because rather than being fully invested in defensive interest rate sensitive stocks you could bring the risk down your equity portfolio by using a long-short equity strategy. It’s gonna hedge the risk right to bring down your volatility. But you could be overweight cyclical stocks and now all of a sudden you’ve got the defensive equity strategy that brings the balance back into your portfolio but that owns the kind of stocks that would do better in in a rising rate environment.
So it really expands your toolkit, it offers a lot of options too. And then the last aspect would be… What opportunity to have a diversification, right? So you need to replace some of that ballast from the bonds, are there other asset and classes or strategies you could identify that you believe will outperform cash and that don’t load up on the same risks that you’re already gave from the stocks and bonds in your portfolio. The more unique asset classes or strategies you could have that outperform cash and that have unique risk sources, the higher quality of return.
The more consistently you can seek to achieve the goals in your clients’ financial plan. So that’s the great thing about where you start with a problem within fixed income, then you realize, I’m gonna fix this, I need to make a change on the bonds and you think about the knock-on effects that affect to my equities and then what you can actually do on the Alts-side that is gonna help solve for what’sreally a truly total portfolio approach.[00:18:32] Pierre Daillie: So that-that’s amazing. Day-to-day, Robert your team is busy helping advisors. What are three things that you recommend advisors act on right away? [00:18:47] Robert Wilson: So the first thing you want to do is you want clearly state what your beliefs and objectives are. If you don’t have that clearly mapped out, it’s gonna be very hard to align your actions and your portfolio to have consistency and as part of that question you’re gonna want to ask yourself is, why am I doing things the way that I’m doing it? Is it because it’s the way it’s always been done? It’s just how we do things around here, which is maybe not the best reason or is it because the actions I’m taking, the decisions I’m making are aligned with my beliefs and my goals?
The other thing to think about is that you have a much wider toolkit available today than you did even three or five years ago. So with the proliferation of ETF’s, the ability to get low cost, indexed exposure, any slice or dice of the market is there to you, you couldn’t do that 10 years ago in definitely 20 years ago, absolutely not. That’s a fantastic opportunity for an investor and similarly the d-democratization, the access to alternatives right.
Liquid alternatives in Canada will be coming up on-on three years this winter and the ability now for the mass market for Canadians to incorporate these strategies that previously really were only available to the ultra high net worth community an institutional investors. So you’ve got this expanded toolkit and you want to think how you can incorporate that. The-the last thing you would say is that really as an advisor you have a ton of resources available to you right. Whether that’s colleagues at your firm, whether that’s resources from your head office, whether that’s 3rd parties, whether that’s asset managers; leverage those tools and capabilities right.
If you can bring as many of those tools capabilities to-to your clients benefit as possible. And you can assemble a team around yourself of high performing individuals and firms that’s going to create so much value for your client.
It’s truly, it’s truly a great time to be an investor relative to history it’s-it’s amazing, it’s true what you said that it’s-it’s really, it’s the proliferation of all the different kinds of ETF’s that are available today, whether it’s active, passive liquid alts, Beta, Smart Beta. There’s a, there’s really just an unbelievable selection of-of solutions available to investors today. So much of what you do is in service to investors, how do you help investors appreciate what’s at stake here?
Yeah, I think that, what you really have to think about is purpose. That client account, that portfolio, it is designed for the client to be able achieve the goals they have in life. They want, whether that’s to send kids to school or to retire with a the standard of living and the level of dignity. So we have a very important task ahead of us with the financial industry and we can have an incredibly positive impact on these people’s lives and their ability to achieve their goals.
And, the advice that the advisor can provide , it’s never been more important like, all these tools are fantastic but adds a lot of complexity and the ability to c-cut through that complexity and focus in on what’s really important, what’s gonna make a difference in achieving the client goal is hugely important.
And so that’s where things like capital market consumptions and zooming out, you’re really thinking about , not when it, with only thinking about the next month or three months or next year but how do I, can just set things up for the next decade?
And if you can stick that setup right, you’ve got such a big headstart over everyone else. If you, if you’re in the wrong vehicle, changing the tires it’s not going to make big difference, really you need to make sure you’re driving the right-right car.
This idea that if you’re going in the wrong direction, running faster just can get you to the wrong place even quicker. It-it’s hugely worthwhile. You want to be humble, because the future’s unknowable. That’s why we diversify. We live in a world where it-it’s tricky. It’s easy, if you’re bullish it’s easy, you buy more stocks. If you’re bearish it’s easy okay, more cash or Government Bonds.
What do you do when you’re uncertain right, and when you live in a world of uncertainty? So helping the investor navigate that uncertainty helping them think about having a-a truly diversified portfolio that’s not just dependent on the level of direction of the stock market or of interest rates. There’s a lot advantage to that right. The clients’ goal’s too important to depend on-on how the stock market is.[00:23:37] Pierre Daillie: Yeah we-we’re at this-this-this really sort of bizarre juncture in markets where we’ve we’ve been coping with this pandemic all this last year and a half and then, and then as a result of that we’re-we’re coping with sort of trying to understand a K-shaped recovery, we’re trying to understand why how the equity market is behaving, we trying to understand how-how all of the Fed stimulus and Fiscal stimulus is going to have an impact on-on things like inflation on-on, the economy in general and-and then where do , given that markets have reached, equity markets have reached all time highs, bond markets have also reached all time highs in the traditional-traditional bond markets.
This couldn’t be a more complex or complicated market climate to navigate, I think it’s exciting to know that-that advisors and investors can turn to you for that kind of help.[00:24:48] Robert Wilson: A-absolutely and it’s a great time to do it because often when people look to make changes they’re doing it because they’re dissatisfied. Here we’re in a situation where from past decade you’ve made fantastic returns because it’s very likely if you’ve had a reasonably balanced portfolio, that you outperformed the return target of your clients financial plan. The fact that you follow some of these capital market assumptions and of this wide range some people are more bullish or bearish but if you do believe the next 10 years are different than the last 30 or the last 20 the fact that you’re able to make that adjustment from a position of strength and what it really means doing, is locking in some of those big wins and then diversifying the portfolio that’s-that’s a fantastic situation to be in. [00:25:34] Pierre Daillie: Robert, thank you very much. That-that was that was very, very interesting and to wrap up, how do advisors gain access to your services? [00:25:45] Robert Wilson: Yeah, absolutely. There’s three ways to-to reach out. The first is to contact your local Picton Mahoney sales rep. They’re happy to provide you with more information about service and introduce you to the team. Secondly we’re on the web at pccs.pictonmahoney.com and third, feel free to add me on Linkedin it it’s Robert Wilson. [00:26:05] Pierre Daillie: Terrific and what’s their next best action here? [00:26:09] Robert Wilson: Yeah, so reach out. We’ve got a ton of research and insights to share and we love to connect with you on that and give you some actual ideas to put this into practice and download the-the article we wrote this month about capital market assumptions, we go into some of these ideas in greater depths so there’s some great information in it for you on this. [00:26:27] Pierre Daillie: That’ll be in the show notes. Robert thank you so much for your time and insights. [00:26:30] Robert Wilson: Thanks Pierre great seeing you.
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