In this episode, Robert Wilson, Senior Vice President, and Head of Portfolio Construction Consultation Service at Picton Mahoney Asset Management shares the rationale behind Picton Mahoney’s 40/30/30 framework which involves redirecting 20% of your portfolio from stocks and 10% from bonds to create a third 30% sleeve, which can be allocated to alternative investments.
In recent years, market forces have caused stocks and bonds to move almost in tandem, making the diversification of the traditional 60/40 portfolio less effective. Alternative investments, however, can introduce a new level of robust defence for your portfolio in turbulent or uncertain markets.
He explains how historical assumptions about the benefits of high-quality bonds as diversifiers no longer hold true, particularly during inflation shocks.
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Robert Wilson: Always great to see you, Pierre. Looking forward to our discussion today.
Pierre Daillie: Likewise. Today we’re discussing Picton Mahoney’s new math of portfolio construction, a game-changing approach that challenges traditional norms. For decades, we’ve relied on a traditional portfolio model consisting of 60% stocks and 40% bonds. A model believed to effectively balance risk and returns.
However, with market forces causing stocks and bonds to move almost in tandem, the 60/40 model is showing its age. Enter Picton Mahoney’s 40/30/30 model, a thoughtful strategy that restructures 20% from stocks and 10% from bonds into a separate third sleeve allocated to alternative investments.
Alternative investments aim to be less influenced by market movements, providing a robust defense for investor portfolios amid turbulent or uncertain markets. In this conversation we’ll explore this new model, the rationale behind it, and discuss the essential role advisors play in navigating this new landscape.
Robert, Picton Mahoney has been talking about a new framework, the 40/30/30 or the new math for today’s markets. Can you walk us through the framework and the reason behind Picton Mahoney’s framework for allocating to alts?
Robert Wilson: Yeah, Pierre, I think before we go on the deal, it’s good to take a little bit of a step back and why is a new framework really needed? So obviously we all saw what happened last year, but what’s important is to understand the broader stroke of history and how asset classes has behaved over time.
So one of the things I think about in portfolio construction and risk management is that the assumptions you have that maybe are not true can sometimes be very dangerous for you. So we all saw this before the financial crisis in 2008. A bunch of financial models were all built on the assumption that US housing prices could never decline in a meaningful way. And that caused people to take risk and expose themselves in ways they would not have, had they had more accurate assumptions.
Now, one of the assumptions a lot of investors have is that high quality bonds are a great diversifier for equities. So a 60/40 portfolio, 60% equity and 40% bonds can be a way to build a diversified portfolio, navigate market volatility and smooth out the ride while achieving your long-term goals. So we wanted to test that assumption. So we did some research and what we looked at was the largest selloffs in the Canadian equity market since the 1930s.
So we looked every time using monthly data that the stock market had declined by 15% or more. In recent history, we’ve had seven of those declines, six of those declines taking place between 2000-2020, and then we had the decline more recently. So when you look at the 2000 and 2020 period, what’s really interesting is that every time that stock sold off in a meaningful way, government bonds generate large outsized returns relative to cash. So six out of six times, you get a very positive result off of the government bonds. On average, they outperformed cash by 9% cumulative journey to those periods. It’s fantastic.
2022, not the case. We had this underperformance relative to cash from our government bonds. So the question is, is 2022 the outlier or is it this 2000 to 2020 period? So when we look back further from 1940 to 2000, you have 15 large selloffs in the Canadian equity market. 15 out of 15 times, the government bonds underperform cash, and on average. So it’s a very meaningful underperformance relative to cash.
So there are plenty of times and more often than not that a 60/40 portfolio has acted like a single asset portfolio. So what’s the reason for that? It’s that while stocks and bonds are good diversifiers against one another when there are growth shocks, you get unexpectedly high growth, stocks tend to perform particularly well. You have a recession, high quality bonds tend to perform well.
They’re not great diversifiers against one other if the volatility is coming from an inflation shock. In that 2000 and 2020 period, inflation was low at average, less than 2% here in Canada, and it wasn’t very volatile. It had the EKG of a potato. Compare that to the prior period, inflation averaged over 4% from 1940 to 2000, and it was much more volatile.
So in our belief, it’s going to take a while for inflationary pressures to work their way out of the market, it might take multiple cycles, and these could be shorter, sharper cycles, and that requires a rethink of portfolio construction. Just using high quality bonds won’t do the job. So that brings us to 40/30/30. We think this is a fantastic framework for building a portfolio, that it makes a ton of sense, especially in the context of why a client hires a financial advisor.
So the reason someone hires a professional, whether that’s a financial advisor, a doctor, a lawyer, you name it, is they have some type of goal and that they believe with that professional’s expertise, experience, relationships and advice, they’ll achieve that goal with greater certainty. You’re sick you go to the doctor because you think they’re going to help you get better. You got a financial goal, you go to an advisor because they’re going to help make sure it happens, and that you don’t miss the mark.
So with 40/30/30, we really enhance the ability for advisors to deliver on client goals with greater certainty, because we’re reducing exposure to the largest source of risk of the portfolio, equity risk and industry risk, and we’re reallocating to strategies that are less dependent on the level of direction of the market. And if we can do that, we can help provide a portfolio that not only has a good depth of diversification, but also has a good breadth of diversification. So could navigate shorter, sharper cycles and offer a higher quality of return to investors.
Pierre Daillie: And to your point, Robert, I think we’re in this transitional period of range bound uncertainty, and this really addresses that. I mean in terms of repositioning parts of the traditional portfolio, it really addresses the uncertainty of markets. We just saw an unexpected rate hike this week from the Bank of Canada.
Everybody’s hoping that inflation is tamed and interest rates start to recede from the levels they’re at right now.
But it looks like in fact, we can’t have any certainty for that. And it looks like we’re in for a period of higher for longer. We’re in for inflation volatility. We’re in for interest rate volatility as the markets vacillate between these two viewpoints. We’re vacillating between bear steepening and bull steepening, once again. There’s been rumblings of that over the last couple of months. But now it looks as though that viewpoint has validity.
How do you implement the framework and how does an advisor determine how to allocate the new 30% in a way that not only addresses the uncertainties of the market, but also aligns with investor goals. What’s the key role that this new alternative sleeve should play in an investor’s portfolio?
Robert Wilson: So our belief is that high quality bonds have an important role for diversifying stabilizing portfolio, but they’re not enough. If you’re relying on only one source of protection, you may find yourself let down just like you were last year. And looking at history, that is what has happened more often than not.
So what you need to do is you need to build in multiple layers of fortification into the portfolio so that you can weather a variety of risks, while still achieving meaningful returns. So we have a three-part playbook. Now the first thing that you want to do is you want to incorporate enhancers. These are alternative strategies designed to take similar risks to what you’re doing with your equities and bonds, but deliver a better outcome. They could be return amplifiers, like private equity strategies or 130-30 funds.
They could be risk mitigators like long short funds that are not taking off full market risk.
So with those enhancers, we encourage a focus on risk mitigators. The reason for that is if you are not getting as much protection out of your bonds, then you need to build downside protection directly into your credit and equity exposure. So that’s part one, enhance with a risk mitigator.
The second thing you want to do is diversify your diversifiers. Don’t just rely on interest rate risk or government bond as diversification. Incorporate absolute return and adventure driven strategies that can meaningfully outperform cash over time, but that don’t load up on the risks that are in the rest of your portfolio.
And then the third piece is recognized that the traditional assets in your portfolio are going to be particularly challenged if and when there’s an inflation shock. Returns on ballast portfolios can contain traditional assets, tend to be pretty good when inflation’s low. They’re okay when inflation is moderate and they tend to be poor when inflation is high.
So your return potential breaks down when you get the unexpected inflation. On the other side, the diversification breaks down too. Diversification tends to be quite good in environments with low inflation, but during periods of moderate or high inflation, stocks and bonds start acting more like a single asset portfolio.
So you want to build in direct exposure to strategies and asset classes that seek to offer protection from inflation and generate outsized returns when there’s an inflation surprise. A decent starting point is to have a mix of those three, and then overweight or underweight depending on your client’s specific goals.
Pierre Daillie: It’s interesting because building a portfolio is like building a sports team. And if you look at the 60/40 as the traditional team, it looks as though you have 90% offensive assets, 90% of offense and 10% defense, or virtually no defense given the way correlations work. But what you’re proposing is to balance the team between offensive assets and defensive assets and-
Robert Wilson: Well, it’s even more than that, Pierre, right?
Pierre Daillie: Yeah.
Robert Wilson: So your analogy is perfect, a 60/40 portfolio is balanced, is not diversified. 90% of the risk is equity risk. You got half and again more stocks, and they’re three to four times more how than the bonds are. And during inflationary periods, the bonds can actually amplify the equity risk rather than mitigating it, right?
Pierre Daillie: Right.
Robert Wilson: So you’re right. You got to balance the offense and defense, but what makes it even worse, is it’s as if your defense, let’s use football as a sports analogy. Imagine if every single player was a cornerback. You need linemen, you need linebackers-
Pierre Daillie: That’s right.
Robert Wilson: … you need safeties. So what we’re arguing is that if you do this approach, reducing 20% of your equity, 10% of your bond exposure, well that’s going to balance your offense and defense better. And then if you diversify your diversifiers, that’s going to get you… So you’ve got a well-rounded defensive team instead of just relying on a position specialist.
So to us, it’s a much more prudent way, it’s a more thoughtful way. And if you start with a framework like this, we think it gives you a headstart. Obviously you need to then build on that through manager selection. Particularly with alternatives. It’s very important to use the highest quality building blocks. But starting from a stronger framework gives you a nice headstart over someone else who’s got a much more lopsided approach to asset allocation.
Pierre Daillie: And you’ve got a much better chance of winning a championship with a well-balanced team, with a well-balanced offense and defense than you do if you just only have an offensive line.
Robert Wilson: Yeah. Absolutely. And we’re a long-term goal. So in sports as like a dynasty, right?
Pierre Daillie: Yeah.
Robert Wilson: So what’s interesting is the process to get that goal. How do we make sure over the next 5, 10, 20, 30 years that our clients achieve their financial goals, and that money is not the limiting factor of why they can’t do what they want to do in their lives? So what we need to do is we need to figure out how to do it as consistently as possible. And the way you do that, is you find as many different strategies and asset classes as you can find, that will meaningfully outperform cash, but don’t load up on the same source of risk.
Now, this really requires an expert advisor, because emotionally it’s challenging. Every year you have a reason to be frustrated. Stock market’s up, you didn’t make as much money. Now, stock market’s down, you probably still lost as not as much. So every year you got a reason to be upset. But at the end of that decade, two decades, three decades, you achieved that goal and the path to get there, was much more direct. You didn’t get tested on whether or not you need to stick to your plan because you had a high quality return. So it’s just a much better approach.
But yeah, it requires expert financial guidance to help an investor understand that, yeah every year we’re going to be looking at things and we’re going to be feeling either that we missed out or that we could have done better.
Pierre Daillie: Yeah, absolutely. I mean, it reminds me of Moneyball. I think you want to have a well diversified group of players in your portfolio, some which present convex opportunities, but asymmetrical to the rest, to the core. And some which are players who run the ball five to 10 yards at a time. And that way of having a group of diversified movers who act differently at different times and in different plays, it’s a great analogy because sports is a universal conversation that people can have and relate to.
How do advisors adopt this framework for their clients? I mean, I think analogies are helpful, but part of your role, Robert, is to also provide the background and the education. You do that as a firm, but also your team is there to provide support to advisors in terms of adding that expertise and that experiential learning that they can take from you. How would advisors adopt this framework for their clients?
Robert Wilson: So I think there’s some education required. And one thing that’s useful for clients to learn is that you don’t need to take full on stock market risk to generate really good returns. So an example you could show a client is if you took the Canadian stock market and you did a little thought expert, you said, “What if every time the stock market was up, we got 70% of the upside, but every time it dropped, we only had 50% of the downside.” Well that sounds nice. When I lose money, I lose half as much, but I’m not going to make as much money.
Well, that’s not true. 70 up and 50 down if you do the math, is actually more than 100 up 50 down, because of the way money compounds. When your losses are smaller, you don’t need full upside participation. So if you run that on the TSX and you go back to your 2000, over the last 22 years, you would’ve made about 40% more money, by getting 70 up 50 down.
But each time the market dropped, you only would’ve lost half as much. So helping the client understand that we don’t need to take full market risk to achieve your goal, and actually your money might compound better if you’re paying less volatility tax. So that’s the first part.
The second thing would be the fact that you now actually have the products available to do this well. This is one of the really great things that’s happened over the last four years here in Canada with the liquid alt framework, is there are now dozens of products available from reputable firms like Picton Mahoney, that you can use as building blocks to implement an alternative portfolio. And if you haven’t already started doing it yet, now’s a fantastic time. Because you can go to your client and say, “Hey, look, I didn’t want to use you as a test case or an experiment, so I waited to see how these things performed.” And over the past four years we’ve had the most violent equity selloff since the 1980s and, the most violent fixed income selloffs since the 1930s. So you can tell which products do what they say on the tin, and you can now allocate to them with confidence, right?
Pierre Daillie: Yeah.
Robert Wilson: Finally, it is a major change, going from say 60/40 to 40/30/30. It’s a large shift. So you might describe it to the client as, look, this is our goal. This is what we’re going to move to over time, so that the portfolio is more in line with how serious money, institutional money is being invested. We’re not going to do it all in one shot. This year we’re going to take care of this part or this part, and make it a process where every six months or every 12 months, you’ve move closer towards that goal.
That’s if the client is not comfortable to do it all in one go.
But really this is not a tactical idea. This is a strategic idea and it’s something that’s meant to make sense across the market cycle and through time. So best time to do it would’ve been a year ago, and next best time is today.
Pierre Daillie: Perhaps the rebalancing opportunity is also a healthy starting point for this process as well where you’re going to go through this process of rebalancing anyway. And there’s obviously a lot of benefit in doing that in this gradualistic approach as opposed to let’s just make this wholesale shift.
Robert Wilson: Yeah, absolutely. And the great thing about this is that these concepts are foundational concepts. It’s just that the tools to apply them are now more readily available, right?
Pierre Daillie: Right.
Robert Wilson: People have been talking about diversification since 1952 when Harry Mark was published portfolio selection. It’s just that now instead of painting with two colors, you could paint with three or four or five. So you can really have a breadth of diversification where five, 10 years ago, all you could really have is you could own stocks and bonds a bunch of different ways. So you’d have depth of diversification, but you wouldn’t have the same breadth that you can today, with the additional asset classes and strategies that are available to you.
Pierre Daillie: Well, I definitely agree that it’s very appealing and it would be very appealing to wealthy families, investors to show them that they don’t need to take all that equity risk all the time, that they can actually reduce their risk and improve their returns. That’s actually a great lead in for an advisor discussion with their clients to make that point, which is that the way that we’ve traditionally done things required you to take this much risk. And what I’m proposing is that we reduce the risk, but in doing so, we actually improve the behavior of the portfolio and also over the long term improve the return. It’s the overall return.
Robert Wilson: It’s directly tied into a foundational concept that portfolio construction is built on. Which is that the returns of the different assets in your portfolio are additive. The risks are not if they’re diversified. If half my portfolio makes 5% and the other half my portfolio makes 5%, I made 10%. If half my portfolio has 5% risk, the other half has 5% risk. I don’t have 10% risk if those are diversified. I’m going to have 9, 8, 7 or 6% risk, right?
Pierre Daillie: Right.
Robert Wilson: So that’s why this diversification thing, they call it the only free lunch, returns are additive, diversified risks are not.
Pierre Daillie: Excellent point. It’s worth discussing that a large proportion of today’s wealthy families achieve their wealth as entrepreneurs. They’re accustomed to risk taking and risk management, and the last thing they want to do is take risks that jeopardize their wealth, their hard gotten wealth.
What’s a high value proposition advisors can approach these entrepreneurial families, this wealthy class of investors with what will compliment their entrepreneurial risks so they don’t find themselves in a double whammy position, if and when markets take a downward or volatile turn.
Robert Wilson: So when our team is working with advisors, one of the first thing we do is we help them build a risk factor model for their portfolio. We want to understand not just how much risk they’re taking, but where it’s coming from. That way it can be intentional and scaled appropriately. What’s really interesting is how advisors are applying this risk budgeting thinking, and risk modeling thinking to high net worth individuals that have concentrated risk exposure.
So I was recently working with an advisor and they have clients that are extremely wealthy, $100 million plus net worth. They built that wealth investing in multifamily housing in Canada. And in this particular case, what they want to do, the clients working with a few different advisors is come up with a solution that would differentiate themselves and provide very high level of advice for someone who has concentrated real estate risk.
So the idea being is instead of offering that client their typical model portfolio, they would build a custom offset portfolio. And the way they went about doing that was identifying the largest sources of risk for an investor that owns multifamily residential real estate, and then identify ways they could modify their model portfolio to mitigate and reduce the sensitivity to those risks.
So it involved taking a look at academic research, doing some risk factor modeling of different investment strategies to understand where the risk comes from, but ultimately they were able to come up with a proposition of a portfolio of liquid assets that are much better complement to the illiquid assets that this investor has exposure to.
And that type of thing I think is very well received by investors. It shows a level of thought and care, and also potentially could be very meaningful in terms of the value it adds, should that concentrated risk exposure they have ever go the wrong way on them.
Pierre Daillie: Thanks for sharing that. That’s a terrific example. There’s another underappreciated aspect to your investment approach to the 40/30/30 approach that addresses what you call fee budgeting. Can you talk about that too?
Robert Wilson: Yeah. So this is such an important topic. So there’s lots written about fee pressure in the investment industry and the growth of low cost products. But what maybe isn’t talked about as much is how investment professionals are really raising their game and adding value for their clients through a thoughtful fee budging approach.
So a great article to read each year is from the Boston Consulting Group. They do a report on global wealth and AUM, in the asset management industry. And over the past 15 odd years, the share of AUM that’s invested in alternatives and in passive strategies has doubled. And the share of revenue or fee budget that goes to those strategies is now more than 50%. And where that’s come from is from traditional assets.
So the thinking is that as an investment professional, there’s a cost to hiring you. You’ll never be the lowest cost solution. And if you simply bring the lowest cost solution to a client, you’re not adding that much value. They can read a price list just as good as you can, and figure out which asset manager they can hire for five basis points.
Where you could add a lot of value is taking on that role of discernment and identifying what asset classes or strategies are ones where you can save money on fees and access in a low cost-efficient way. And what are the asset classes and strategies where it makes sense to spend, because there’s a high value add. It’s much like if you’re hiring a contractor to renovate your house, they need to be a real expert to know, “Hey, we better spend on the kitchen, but we could save on this bathroom.”
So what you see advisors that take that approach too, and this is what you see in the data from Boston Consulting Group, is they start barbelling the portfolio. So maybe their government bond exposure, they get really cheap, or maybe US large cap stocks or whatever it might be. But then they don’t just take those fee savings and sit on them, they use that to invest in high value add alternative strategies.
So at this point in time, based on the AUM and the revenue of the industry, if you’re spending less than 50% of your fee budget, and this is before performance fees, on alternatives, you are underweight alts in your portfolio. And if you’re allocating less than 21% of your dollars, you are underweight relative to the industry as a whole.
So fee budgeting, really important. Dollars are both in this industry, and this approach of allocating half of the fee budget to high value alternative strategies is like well entrenched. And every year the numbers just keep reinforcing this.
Pierre Daillie: That’s very smart. Amazing discussion. Where can advisors get more information about Picton Mahoney’s 40/30/30 framework and PCCS?
Robert Wilson: Yeah. So I encourage you to reach out to your Picton Mahoney wholesaling team. They’ll be happy to inform me on that. I’m very active on LinkedIn, posting content around us. So add me. Look forward to hearing from you guys directly. And then join us in our website, pictonmahoney.com. We just published a new article all about this topic. It went out yesterday as we’re speaking here in early June, around “What if bonds are still broken? “And it really goes into depth on some of the stuff we talked about today, around when are bonds a good diversifier against equity risk? When are they a poor diversifier, and what can you do about it to help protect your clients? So check us out on the website. Take a look at what if bonds are still broken, and we’ll look forward to continue the discussion with you guys.
Pierre Daillie: Yeah. Amazing piece, Robert, by the way. Very timely. You were bang on. Thank you very much for your incredibly valuable time and your insight.
Robert Wilson: Thanks Pierre. It’s always a great time joining you on Advisor Analyst.
Where to find Robert Wilson, Picton Mahoney Asset Management:
Article mentioned: What if bonds are still broken?
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