Compass: Broaden Your Horizon with Diversification


Venturing Beyond the Traditional Portfolio Model and What it Means for You.

By Russell Feensta and Kyle Westhaver

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We live in an ever-evolving world, where the pace of change is seemingly accelerating each year. Managing an investment portfolio during tumultuous and turbulent times may feel increasingly more complex with a multitude of asset allocation options now available to the typical investor. You might wonder, “what should I invest in?” and “how do I get the best possible mix of investments?”

Historically, investing was significantly simpler than now. Prior to the 2000s, it was common for most Canadian investors to hold a portfolio in a traditional 60/40 “balanced” model. At the time, many traditional money managers had a fairly narrow universe of assets to choose from. An allocation of 60% equities (Canadian Equities, Foreign Equities, Small Cap, etc.) and 40% bonds (Canadian Bonds, Foreign Bonds) was, and in many cases, still is quite typical for clients of traditional money management firms. However, just because a portfolio had various types of mutual funds, stocks, and bonds did not mean the portfolio would avoid volatility, as many investors experienced during the 2008 financial crisis.

The 60/40 allocation strategy gained momentum during the 1980s when a 10-year Canadian bond yielded 12.5% (1980)1; average historic equity returns were 11.5%3 and Canadians typically had a 10-year gap to fund between retirement (average 65) and life expectancy (average 75). This investment mix assumed that bonds, acting as a “risk-free” asset, should move inversely to equities and therefore dampen equity volatility. The current environment has 10-year Canadian bond yields at 1.57%1, average TSX equity returns of 6.14% since 20002 and double the gap (19 years) to fund retirement (average retirement age is 63 and life expectancy is now 82). As we said, the world has changed, and investors need to adapt as well.

It poses the question: why on earth is a traditional “Balanced Portfolio” still considered satisfactory diversification? A quick internet search of “asset allocation calculators” will bring up a plethora of tools that essentially ask you a dozen questions and in the end provide you an “optimal” asset allocation. We tested several of these online tools, using both a hypothetical average investor and an ultra-high net worth profile as test subjects, and each time were recommended a balance of only stocks and bonds.

What about balanced portfolio mutual funds? Are they truly diversified? In short, no. The largest six financial institutions in Canada all offer a balanced mutual fund made up of only stocks and bonds, averaging 60% stocks and 40% bonds.

At Nicola Wealth, our investment philosophy is one that is shared by some of North America’s largest and most well-respected pension funds, university endowments, institutions, and ultra-high net worth investors; such as the Ontario Teachers’ Pension Fund, Harvard University’s endowment, and TIGER 21 – a membership of 600 ultra-high net worth individuals with more than $50 billion in personal investible assets, collectively. This approach is a disciplined focus on broad asset allocation and acquiring high quality assets that produce sustainable, and ideally growing, cash flows. Judging by the charts to the right, it appears to be working.

Relying on price appreciation and staying exposed to the equity markets (regardless of sector) is simply asking to ride the rollercoaster of stock market unpredictability. Our investment approach uses both cash flow and broad asset allocation to provide stability, increase long-term risk-adjusted returns, and build wealth.

 

Prepare for the Trip of a Life Time

The basic principles behind this proven investment strategy could be compared to how one plans for an epic vacation. Think about it – what’s your bucket-list adventure? A sailing voyage around the world. A soul-searching hike along pilgrimage trails. A cycling tour through old world wineries. Regardless of your destination or preferred mode of transportation, you need to pack strategically. For that, you need the expertise of a trusted tour guide, someone backed by years of experience and who knows the lay of the land inside and out …otherwise you could wind up saddled with a cumbersome backpack full of seasonally inappropriate clothing that never see the light of day (i.e. bonds-heavy portfolios that yield low returns). Worse yet, you might be left out in the cold (i.e. stuck with a traditional portfolio that leaves you vulnerable to unpredictability) – or in this case, holed up in your hotel while other savvy travelers enjoy the trip of a life time. The same goes for your portfolio. You need to be prepared for all eventualities and the best way to do that is through strategic diversification.

Using cash flow investing, our investment philosophy doesn’t rely solely on the price appreciation of assets. We are less focused on whether a stock moves up or down, rather concentrating on the income – the cash flow – generated by each investment, because a steady and reliable income from assets effectively reduces risk.

What is Broad Asset Allocation? Traditional asset allocation as described above is often 60% equities and 40% bonds, where ‘diversification’ means owning various kinds of “stocks and bonds.” In our view, however, most investors aren’t truly diversified with the typical model of only stocks and bonds. Nicola Wealth’s in-house team of portfolio managers utilize an extensive array of asset classes, far more than an industry-standard portfolio, to further diversify out of equities and into areas such as investment-grade hard asset real estate, private equity, private debt, commercial mortgages, and other alternative strategies such as hedge funds, infrastructure, and renewable resources.

Having a truly diversified portfolio and consistent cash flow has been the cornerstone to our ability to provide historically consistent above-average returns during all market conditions.

 

Enjoy Life’s Little Excursions

Think of cash flow as one of those unexpected side trips, the ones that take you off the beaten path and wind up being the highlight of your journey. If you don’t have access to extra spending money, you might be left waiting at the dock, while the rest of your tour cohorts board a last-minute ferry to an ancient, cobble stoned island. Packing properly means having enough accepted currency on-hand for life’s little excursions. It also means including a strategic mix of big-ticket items like durable hiking boots you know you’ll use (equities and bonds), and smaller day tripping accessories such as a lightweight windbreaker, Gravol and yes, dare we say… a fanny pack (mortgages, real estate and private debt). Likewise, at Nicola Wealth, we make sure your portfolio provides the flexibility you need to enjoy every aspect of the journey, as you work towards your long-term goals.

Why is Asset Allocation Important?

The importance of asset allocation lies in creating a portfolio which will have one area doing well when another is not. This can result in a portfolio that has less volatility by mitigating investments that drop in value with investments that go up. The objective is that over the long term, the entire portfolio is generating a reasonable rate of return. In fact, studies have shown that 90% of investment performance is due to asset allocation, as opposed to market timing or securities selection. The asset allocation that’s best for you at any particular point in time depends on your current personal circumstances, your comfort level with risk, and most importantly the goals and objectives you have set out in your financial plan.

In the same vein, not everyone has an appetite for adrenaline fueled expeditions (high-risk portfolios). For example, you may not have the stomach for heli-skiing untouched terrains in BC’s back country or trekking the Himalayas – but if you did, surely you’d consult with your Sherpa about how many oxygen tanks versus how many water bottles you need to pack before leaving the base camp. Your dream vacation may be more along the lines of soaking up some Vitamin D on a hot tropical beach (low risk portfolios), and that’s great but even then, packing a swimsuit and sunscreen won’t cut it. After all, sometimes it rains…even in Hawaii. Point being, a diverse customized portfolio is paramount when it comes to building personal wealth at a pace that meets your goals and always stays within your comfort zone.

Varying market conditions can cause an investment’s value within those asset classes to rise and fall and, up until relatively recently, the returns of the two main asset classes (stocks and bonds) have not moved together. In fact, market conditions that resulted in one asset class doing well, often resulted in another asset class under performing.

Here’s an example. In 1999, Emerging Markets had an average return of 56.70%, Foreign Equities had a 18.20% return, and who could forget U.S. Technology with a 68.24% return. The Canadian Bond market had a lack-luster -1.14% return.4

The following year, Emerging Markets were down -28.10%, Foreign Equities were down -9.55% and U.S. Technology was down -38.65%. Canadian Bonds, however, were up 10.26%.4 There are numerous other examples of similar situations throughout market history. Prior to 2008, by including a traditional balanced portfolio, investors could, for the most part, protect themselves against significant losses when market conditions changed.

Unfortunately, it appears this convenient negative correlation is not what it used to be, from August through October 2008, U.S. stocks lost more than 22% of their value and U.S. bonds lost nearly 14% of their value. Clearly 2008 was a uniquely dire financial crisis, but the ‘no place to hide’ trend could materialize more often with the outlook of higher inflation and interest rates. One would be justified to worry if stocks and bonds continue to experience drawdowns at the same time.

Luckily, not all asset classes have joined the positive correlation theme, which can be illustrated by Nicola Wealth’s broad diversification and corresponding out performance compared to the Morningstar Canadian Neutral Balanced Index in 2008 and 2018.5

The same can be said for how climate change has affected travel planning. There was a time when all you had to do was check out the weather channel prior to packing your suitcase. Now, with more and more extreme, and often unpredictable, weather systems becoming the norm in all parts of the world, you need to be prepared for all eventualities. Political landscapes can be just as volatile these days too. You never know when a world leader will befriend a ruthless dictator or launch a trade war with a long-time ally. Consequently, you may need different visas for various ports of entry, customary clothing to appease newly instated cultural practices and lightweight luggage for hasty exits from areas of civil unrest. In short, you need someone who stays abreast of the latest travel advisories (market upsets), and can plan, prepare and adjust your itinerary (portfolio) accordingly.

 

Conclusion

At nicolawealth.com we have the chart (below) which illustrates that it has not been a good time to be invested in a 60/40 stock/bond portfolio for a long time. After fees, the Morningstar Neutral Balanced Index has a net return of about 4.5% annually or about 2.5% after inflation. Well below the 4% real rate of return we feel clients require to build wealth and retire comfortably.

Expertise is at the core of what we do. Sure, you can Google around for some financial advice, or in our example, vacation pointers, but you run the risk of getting one-size-fits-all advice – at best. It’s not the most reliable way to get information for sound decision-making. Put it this way: if you’ve spent the better part of a lifetime dreaming of, and saving up for, an epic vacation, you wouldn’t rely on unsourced travel tips from a fly-by-night, social media influencer, would you? No, you’d turn to a well-versed expert who can back their travel advisories with facts, extensive knowledge of the landscape and years of experience.

Our client’s returns (represented by the blue line called Nicola Wealth Core Composite Return) has returned 7.05% net of fees since January 1st, 2000 or 5%/year after inflation.

This has been achieved through our diversified broad-based approach to asset allocation and our commitment to cash flow investing. Today, we feel this strategy is more important than ever and we will continue to utilize this approach when constructing and managing client portfolios. Your goals are our goals. In other words, we invite you to enjoy the journey while we take care of the destination.

 

[1] Source: Statistics Canada

[2] Annual returns from January 1, 2009 to September 30, 2019

[3] Source: BloombergCOMPASSA

[4] Source: Bloomberg

[5] Refer to Conclusion and final page of newsletterGROWTH

This presentation contains the current opinions of the presenter and such opinions are subject to change without notice. This material is distributed for informational purposes only and is not intended to provide legal, accounting, tax or specific investment advice. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. The Nicola Core Composite returns represent the total returns of Cdn. dollar denominated accounts of all fee-paying portfolios with a Nicola Core mandate. The composite includes clients who are both fully discretionary and nondiscretionary. Historical net of fee composite performance returns are calculated using individual realized time-weighted client returns net of fees and is presented before tax. The Nicola Wealth inclusion policy is based on clients’ weights at calendar month end. The composite returns are asset-weighted based upon ending monthly market value. The Nicola Core mandate may change throughout time. Additional information regarding policies for calculating and reporting returns is available upon request. The composite returns presented represent past performance and is not a reliable indicator of future results, which may vary. The Nicola Wealth Core Portfolio Fund past performance is not indicative of future results. Returns are net of fund expenses. Please refer to the Nicola Wealth Funds sales disclosure document for additional details and important disclosure information. The Nicola Wealth Core Portfolio Fund Asset Mix takes into consideration only the primary asset class of the aggregated funds but does not take into consideration the underlying fund’s holdings of other asset classes. For example, the Nicola Primary Mortgage Fund is allocated in its entirety to “Mortgages” even though it holds some “Cash.” Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. Client returns are net of Nicola Wealth portfolio management fees.