Podcast: Active management and capital preservation in a volatile market with asset allocation funds

Listen to Susan Spence, Vice-President of Portfolio Solutions Group discuss active management and capital preservation in volatile Q3 markets with asset allocation funds.

Christine:  Hello.  I’m Christine Wellenreiter, Vice-President of Marketing and Communications at GLC Asset Management Group, and you’ve tuned in to the PSG update podcast – a quarterly discussion with GLC’s Portfolio Solutions Group about the asset allocation funds they manage. This podcast, and all of GLC’s podcasts, can be found on GLC’s website, iTunes, Google Play and Spotify – just search for GLC Asset Management and find us there and get new episodes automatically when they’re released.

Once again, I’ve got Susan Spence, Vice-President, Portfolio Solutions here in studio.  Susan is the head of GLC’s Portfolio Solutions Group division – PSG for short.  Hello Susan, welcome back and thank you for joining us again.

Susan:  Hi – thanks, Christine. 

Christine:  Now, I know the third quarter of 2018 was a tough one for fixed income and Canadian equity investors.  So I want to touch on some concerns and questions that are on the minds of investors right now. You know…the US equity market banks a record bull market run in August and ends the quarter with a very strong, roughly 6% return in Canadian dollar terms, but if you were investing on this side of the border, whether you were in stocks or bonds this quarter you saw negative returns.  What’s the deal?

Susan:  Well, this past quarter it was really global trade that was the dominant concern for markets, and while there were issues brewing between the US and other countries, Canada was definitely in the cross-hairs with efforts to negotiate a new NAFTA deal.

Christine:  Which they eventually managed to do…

Susan:  Yes, they came to an agreement in principle, with the new USMCA deal….but that wasn’t until the final hours of the last day of the quarter – so throughout the quarter this was still a big source of uncertainty for the markets.  And there really was a distinct ‘U.S. against the world’ feel to the investment landscape and that weighed on a lot of global markets.  Although economies are still generally very healthy around the world, we are seeing some divergence in growth rates and economic data.

Christine:  Things aren’t as synchronized as they were for a while…

Susan:  Right – but the US kept chugging along during the quarter, helped of course by tax reforms and the impact those are having on earnings and economic growth, which has helped to extend the bull market there.

Christine:  Yet trade wasn’t the only issue for Canadian equities and bonds…

Susan:  Right, there were also oil pipeline project delays, a tumbling price for gold weighing on the materials sector and rising interest rates that posed a headwind for bond returns.

Christine:  So if I’m a conservative investor and I hold mostly fixed income and mostly domestic Canadian equities…there was no where to hide. 

Susan:  You’re right, it was a tough quarter for Canadian investors…and while some conservative portfolios consist almost exclusively of Canadian fixed income and/or maybe some Canadian equity, PSG’s Conservative asset allocation funds are further diversified, beyond Canadian bond and equity markets.  And that makes a difference, a value added difference, for investors – especially at times like this.  We also have allocations to foreign equities and some foreign bonds, and we include allocations to mortgages and direct real estate where we can.

Christine:  So that helped?

Susan:  Having some of these diverse exposures helped to mitigate the negative returns during Q3…and we also saw some benefit from active management, particularly in our more conservative funds – both at the underlying fund level and as a function of portfolio construction.

Christine:  Okay, can you give me specifics?

Susan:  Yes, having the foreign equity allocations certainly helped returns from an absolute perspective, however foreign bond allocations had a negative impact, mostly due to currency exposures within the funds we hold. Back on the plus side, the shorter duration nature of the mortgage allocations helped mitigate losses within fixed income in a rising rate environment, and real estate allocations continued to deliver steady positive returns.

Christine:  And what about that active management element? How did that add value for Conservative funds?

Susan:  The two areas where the benefits of active management were particularly evident were within fixed income allocations and Canadian equity allocations.  On the fixed income side, there was some value add from the underlying fund managers, but also our overall short duration positioning and overweight exposure to credit, including some select high yield exposure, added value versus the broad fixed income benchmark component.

Christine:  That’s really your top-down call, isn’t it?

Susan:  Right – those are elements of active management that we are implementing as the top level fund manager.  And then within Canadian equity allocations most of the underlying fund managers did a really good job at outperforming the S&P/TSX Composite Index through active management within the context of their mandates – and most Canadian equity managers were actually able to achieve positive absolute returns.

Christine:  Okay, so does that mean that overall your Conservative asset allocation funds had positive gross returns during the quarter?

Susan:  No, we weren’t able to avoid negative returns at the very conservative end of the risk spectrum, but on a gross basis, most of our Conservative funds did outperform their benchmarks.

Christine:  So what you’re saying is they directionally moved with the market, but managed to ….I guess preserve more capital than if someone was just investing in the benchmark or in the passive ETF versions of the indices. 

Susan:  That’s right – on a gross basis, apples to apples, we did better than the benchmark in most of our Conservative funds – and, in fact, in most Moderate and Balanced funds too.

Christine:  And when you construct the portfolios, you focus more on capital preservation at the conservative end of the risk spectrum, don’t you?

Susan:  Yes.

Christine:  Why?

Susan:  Well, we know that conservative investors are particularly focused on capital preservation – so it’s in keeping with their mindset.

And while it is always uncomfortable for people to experience a negative return, especially at the conservative end of the spectrum, this downside protection relative to the broader markets when things are challenging –achieved through active management and strategic portfolio construction – is just as important as capturing upside when markets are doing well, in terms of being able to achieve financial goals… Think about it this way…capital preservation (managing to keep more of your assets) is what sets you up to do better when the markets are ripe for growing your assets.

Christine:  And how do I know that’s true?  What is the long-term experience of these funds, especially at the more conservative end of the spectrum?

Susan:  So when we look at long-term numbers, specifically 10 year gross returns to the end of the third quarter, almost all of our target risk funds have outperformed their benchmarks – and this next part is also key – they did so with lower levels of risk (as measured by standard deviation).  The only exceptions are at the aggressive end of the Folio mutual fund family.  But across the board at the conservative end of the risk spectrum this has been the experience.

Christine:  Okay, so we’ve talked a lot about the conservative end of the risk spectrum, because that has been a particular area of focus for investors…but, just quickly, how did the other asset allocation funds do this quarter?

Susan:  So, at the aggressive end of the spectrum, where there are greater allocations to foreign equity and little or no fixed income, it shouldn’t be surprising to hear that gross absolute returns were stronger than at the conservative end – in fact, solidly positive.  However, relative to benchmark, although the more aggressive funds also had the benefit of some of the positive drivers I mentioned, some of our longer-term positioning within the foreign equity components was a drag on performance – specifically our strategic exposures to small cap and emerging market equities were detractors versus the broad developed market equity index.  Another notable detractor that impacted the more aggressive funds, within Canadian equities, was the specific exposure to resources.  The end results was that funds at the more aggressive end of the risk spectrum underperformed their benchmarks – although, again, they had the strongest absolute returns.

Christine:  Essentially the opposite of what you saw at the conservative end…

Susan:  Exactly!

Christine:  Now, changing gears a little, I have bit of a different question for you – but again, this is something that we hear is on the minds of advisors (and also some investors) and I think would be helpful for you to explain…in terms of portfolio construction, you have many underlying funds within each portfolio…why?

Susan:  You’re right, Christine, some advisors, in particular, seem to have a view that there is an ideal number of underlying funds that should be used within asset allocation funds – generally a pretty low number.  But in our minds, the number of underlying funds is not relevant.

Christine:  Why not?

Susan:  It comes back to how we construct the portfolios…ultimately, we want well diversified portfolios, across many measures, with good offsets; and we want effective levers within the funds to allow us to implement our strategic, forward-looking views and actively manage the portfolios over time.

Christine:  So it’s not about the specific number of underlying funds, but what each underlying fund contributes to the portfolio as a whole?

Susan:  That’s right – it’s about correlations amongst the funds and how the holdings within the underlying funds are differentiated and how in combination they build up the characteristics we are looking for in our portfolios.  We use the term “building blocks” when we talk about portfolio construction – and we focus on having the right building blocks in place and ensuring underlying funds are consistently delivering on the role they play within the portfolio.  The number of underlying funds used is merely an output of our portfolio construction process, not a starting goal.

Christine:  And I guess we did see elements of that approach to portfolio construction working this quarter…

Susan:  Yes, I think you can tie it back directly with the key performance drivers we spoke of earlier, which highlighted some of the different building blocks in the portfolios, and in Q3 you can also recognize the value of the diversification within our asset allocation funds.

Christine:  And what about looking down the road?  We keep hearing about being in the later stages of the market cycle…and market volatility is creeping up…so how do the asset allocation funds you manage help investors stay on track?

Susan:  In this type of environment, this is where the asset allocation funds can really help smooth the ride for investors.

Christine:  Susan, we are almost through 2018 and next time we speak it will already be 2019.  I look forward to speaking with you again in 2019!

Susan:  Thanks Christine.  We’ll talk again in 2019!

Copyright 2018 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).

This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.