GLC’s Susan Spence shares insights into responsible investing for asset allocation funds

GLC’s Susan Spence talks the importance of responsible investing and updates how asset allocation funds performed at the end of 2017.

Christine: Hello, I’m Christine Wellenreiter, Vice-President of Marketing and Communications at GLC Asset Management Group and you are listening to a regular podcast series that I host featuring quarterly updates from PSG about the asset allocation funds they manage. 

For those of you who don’t already know, PSG is short for Portfolio Solutions Group – a division of GLC Asset Management Group that is solely focused on the portfolio management of asset allocation funds…primarily target date and target risk asset allocation funds.

On today’s podcast, we’re going to be covering two main topics – an update on how the asset allocation funds performed in the fourth quarter of 2017, and then for the second half of today’s podcast, we’ll be covering a topic I haven’t heard much about from asset allocation managers ..but think we should…and that is how they incorporate ESG factors and responsible investing practices into the management of these fund of funds. Part 2 starts around the 10 minute mark* for those who want to
jump to it.

To discuss these two topics, I’ve got Susan Spence here with me today. Susan is the Vice-President, Portfolio Solutions and head of GLC’s Portfolio Solutions Group division. 

Welcome Susan

Susan: Thank you, Christine.

Christine: Susan, let’s talk about the markets at the end of last year. We’ve talked a lot about 2017 having been a go-go risk-on market, and of course, listeners can find GLC’s 2017 Market Review on our website…so I’m not so interested in rehashing the markets, rather I’m interested in hearing from you how this affected the different types of funds you hold in your AAFs….how did this affect the different components of your portfolio?

Susan: As you know, our asset allocation funds are generally a combination of equities and fixed income. Both asset classes achieved positive returns in Q4 and for 2017 as a whole, but equities clearly dominated with very strong returns. As a result, asset allocation funds with the highest equity content, our more aggressive or longer-dated funds, did best from an absolute perspective.

Christine: So that’s broad asset classes….but what about regions? These funds are, at a high level, divided by region…there must have been some distinction there.

Susan: Right…from a regional perspective, within equities the clear winner was emerging markets. Many of our funds have some exposure to emerging markets through global equity fund holdings, but in the more aggressive and longer-dated funds we also have some additional dedicated exposure to pure emerging market mandates.  Looking at developed markets, foreign equities outperformed domestic equities. Almost all of our funds have exposure to both foreign and domestic equities.

Christine: Do you diversify by region within fixed income?

Susan: Yes, within fixed income there are also regional influences, as some funds do have exposure to international bonds. The impact of these allocations on our portfolios are of course a function of both the foreign fixed income markets as a whole and the management of the specific fund, however isolating just the returns for foreign bonds translated into Canadian dollars shows foreign bond allocations being a modest drag on absolute performance.

In keeping with the trends from an asset class perspective, all of these regional influences were also common to both the fourth quarter and the full calendar year.

Christine: Susan, should we break it down further? So…within equity, for example, were there style biases?

Susan: Generally speaking, growth has been outperforming value as a style within equity markets – this is a trend that has been in place for some time – however there are some exceptions, for example here at home in Canada in the fourth quarter as well as for the year value did outperform growth. We also saw a bit of reversal in the U.S. market at the very end of the year. As you know, our asset allocation funds are carefully constructed to achieve diversification across many measures, style being one of them – so although a certain style can sometimes have a disproportionate impact on our funds in any given quarter, over time there are puts and takes and having the style diversification ensures a smoother ride for investors along the way.

Another way we look at equity market performance is by market cap…so larger cap performance versus smaller cap. On this measure too, results were not consistent across regions.  In the U.S., for example, large caps outperformed, but looking on a broader global basis small caps had a stronger showing. Our asset allocation funds have greater exposure to smaller cap stocks at the more aggressive or longer-dated end of the spectrum. Similar to my comment about the international bond exposure in our funds the management of a specific underlying fund comes into play, but from a purely market cap allocation perspective, higher allocations to global smaller cap stocks enhanced the performance of our funds.

Christine: And for fixed income, what about that?

Susan: For fixed income, one way to look at things is how bonds of different duration performed. Throughout 2017 we have seen a flattening of the yield curve in conjunction with longer-term bonds outperforming shorter term bonds. Another observation is that credit has generally outperformed, although corporate and high yield bonds did lose a bit of momentum and lag the broad domestic bond market in the fourth quarter.

Christine: So now let’s hone in on the fourth quarter and expand a bit more on performance trends in the context of the AAFs you manage, linking some of these market moves in with the positioning of the funds you manage and their performance relative to their benchmarks.  The two primary types of AAFs you manage are TD funds and TR funds. Correct?

Susan: Yes.

Christine: So how did you see these broad trends in performance impact PSG’s positioning within the asset allocation funds?

> “Just before we hear Susan’s answer, here’s what you need to know: the target risk funds that PSG manages run from Conservative, to Moderate, Balanced, Advanced and Aggressive…As you might have guessed, the conservative end of the spectrum holds more fixed income (up to 75%), and therefore will be much more influenced by how fixed income markets and bond funds performed. As you move up the risk spectrum toward the Aggressive target risk fund, you increase the equity portion – all the way to 100%. The same principle is true for Target date funds, only its date specific. So, the closer the Target date is to today, like a 2020 Profile fund, the more conservative it will be with a high allocation to fixed income (60% in this case), whereas when you hear Susan refer to longer dated funds, think a target date of 2050 – 30 years out - for example, and they will be heavier weighted in equities and therefore more affected by the performance of stocks markets and equity funds. …now back to Susan’s response about how the PSG funds performed.”

Susan: So for Q4, within our fixed income allocations being positioned with a shorter duration than the FTSE TMX Canada Universe Bond Index, the fixed income benchmark component, hurt performance, as did our overweight to credit and our international bond allocation. The result was that our fixed income allocations as a whole detracted value on a relative basis, across all funds that have an allocation to this asset class.

Christine: That’s disappointing…

SUSAN: Yes, it is on one hand, but on the other hand I would remind you of the third quarter, where we had the opposite experience. Fixed income had a negative return, and in that environment, we were able to add value on a relative basis and protect on the downside.

On the equity side, there were both positives and negatives as a result of our positioning, however the impact on different funds varied – overall, the more aggressive and longer-dated funds were beneficiaries of our positioning, while the more conservative or shorter-dated funds were penalized. Remember, we tailor the composition of our funds to best suit the profile of each one’s investor base over the long term, so they don’t always perform in lockstep over short timeframes. In Q4, the more
aggressive and longer dated funds got a boost from more exposure to emerging markets and global smaller cap stocks as well as dedicated exposure to a pure
resource mandate.  On the other end of the spectrum, the conservative and shorter-dated funds were hurt by their exposure to an equity infrastructure mandate.

The final piece to address is the real estate allocation. As you know, for our funds the relevant benchmark component is the S&P/TSX Composite Index.  Given the strength in equity markets this quarter, it is no surprise that the real estate allocation lagged.  Real estate did achieve a positive return in the quarter, so helped absolute performance, but hurt relative performance.

So if you include RE in with the Canadian equity allocations - our domestic equity lagged during the quarter, but stripping out the RE, the true  domestic equity funds added value as a whole. Foreign equity allocations also added value overall.

Christine:  So those are the broad sweeps, what about some specifics…each underlying fund in the PSG portfolio serves its own distinct purpose within the fund, either to drive return and/or mitigate volatility – were there any standouts we should hear about?

Susan: Of course there are always standouts, but this quarter I would say most of the funds with the biggest impact, either positive or negative, were exactly what you would expect given what transpired in the capital markets.  For example, short duration bond holdings like the Portico short term and government bond funds, as well at the mortgage funds, were detractors.  So was the corporate bond fund.  On the flip side, the long-term bond fund added value where it was held.

On the equity side the Mackenzie emerging markets fund (sub-advised by JPMorgan), some more value-oriented Canadian equity funds, some more growth-oriented global equity funds and the Mackenzie Canadian resource fund added value, while the London Capital equity infrastructure funds and some Mackenzie mandates managed by the Ivy team that is positioned quite defensively right now with high cash level were a drag in the fourth quarter. And of course, as I mentioned, the GWL real estate funds were also detractors.

Christine: Wait a second…I want to hear more about the real estate fund and maybe mortgage fund too. . … you called them out as negatives…but I want to understand more about the purpose they serve within the portfolio. These aren’t proxy investments like the London Capital equity infrastructure fund that invests in the stocks of companies that have infrastructure related business, or like REITs…these are the real assets being held in these funds.

Susan: That’s right. The proprietary mortgage and real estate funds we have access to for our seg fund products directly invest in mortgages and real property.

Christine: So then we are talking about real alternative investments …not really bonds…and not really stock portfolios. Correct?

Susan: Yes, that’s correct. Despite the mortgage and real estate funds being slotted into the fixed income and Canadian equity allocations of our funds and benchmarked against the FTSE TMX Canada Universe Bond Index and S&P/TSX Composite Index, respectively, they are truly alternative investments.

Christine: Is that the norm to hold alternative assets like mortgage and real estate in asset allocation funds?

Susan: It is the norm for us, with the segregated funds, but not necessarily for competitors. We see the access we have to these proprietary products as a real
competitive advantage.

Christine: So why hold them? Why choose to be different
than the norm in this regard? What do they do for the overall portfolio?

Susan: We hold them because of the low volatility nature of the assets and the downside protection they deliver on a standalone basis, but also, importantly, because of how they fit as building blocks within our funds.  Mortgages and real estate have low correlations with the traditional asset classes we invest in, and including them as components enhances the risk / return profile of our asset allocation funds.

Christine: But they are one of the reasons not all of the portfolios kept up with the broad benchmarks this past quarter.

Susan: Right. And the reality is our asset allocation funds won’t outperform all the time. Because of the robust nature of our portfolio construction and the offsets and diversification we build in, we know we will underperform in certain environments. And one of those environments is strong equity markets, like we experienced in Q4, when real estate will lag and be a drag on performance both on an absolute basis and relative to benchmark.  And this is also the case when you look back over the full year period of 2017.

Christine:  …but you are still happy with how the funds
performed, and you think investors should be as well…why?

Susan: It’s a good reminder that the performance of our asset allocations funds really should be measured over a longer time frame and also looked at in conjunction with the risk being taken. These mortgage and real estate allocations help provide steadier returns for our funds, downside protection and a smoother ride (which helps to keep clients invested in the markets and means they are more apt to stick with their financial plans). So despite most of our funds failing to keep up with their benchmarks in Q4, especially at the conservative or short-dated end of the spectrum, they did still achieve solidly positive absolute returns and they did what they are
designed to do in the environment we were in. That gives me confidence that our approach to portfolio construction and the management of the asset allocation funds is a formula that works for the long term and will help investors achieve their financial goals.

Christine: Last question on this…how are you positioning the portfolios today?

Susan: Christine, our positioning really has not changed since we last spoke a quarter ago, and it is consistent with the views you would have heard Brent Joyce, GLC’s Chief Investment Strategist, express in his outlook podcast. We remain short duration and overweight credit with exposure to international bonds within fixed income.  Looking out over the next few years we believe this positioning will benefit the funds as rates rise. Corporations remain quite healthy and although spreads are not as attractive as they were say a year ago, we do still like the yield pick-up from having exposure to corporate bonds. International bonds remain appealing for diversification benefits. On the equity side we have pulled back somewhat on our preference for the U.S. as a region as we get further in the economic cycle. Generally speaking, we are neutrally positioned from both a fixed income/equity perspective and on a regional basis within equities.  We think this balanced approach is prudent, given the direction we think interest rates are going, the elevated valuations we see in most equity markets and the risks that are out there – geopolitical, policy (particularly in the U.S.), trade disruptions and potential for central bank missteps most notably – despite the fact that for now the global economy remains robust.

>Before we start the second half of the podcast – the part where we discuss PSG’s Responsible investing approach, I want to put something in perspective. As a division of GLC Asset Management Group, the Portfolio Solutions Group manages $28 Billion dollars in asset allocation funds…and for even more context…a little less than half of that $28 billion is from the individual segregated fund business – about $12Billion or put another way, they are responsible for about 10% of the entire individual seg fund market in Canada!

….let me throw out some more numbers about PSG. PSG monitors 24 firms that have mandates in the asset allocation funds and a dozen or so more that are potential candidates for future consideration.  And these managers want to be a part of PSG’s AAFs… even a small allocation within the asset allocation funds can equal many hundreds of million dollars. So make no mistake, PSG is a big player in the Canadian asset allocation fund market, and an important client with a fair amount of influence for any manager looking to manage an underlying fund for them. That’s going to matter when you hear more about PSG’s commitment to responsible investing.

Christine: Susan, I want to start by asking you about GLC becoming a signatory to the United Nations-supported Principles of Responsible Investing (UN PRI)…that was back almost two years ago in February 2016. What did that mean to you?

Susan: PSG joined GLC around that time. So as a division of GLC it meant that we to would need to uphold the commitment that GLC had formally made, which is stated clearly and plainly in GLC’s Responsible Investing policy…that being: “As a signatory to the UN PRI, GLC aims to contribute to the development of a more sustainable global financial system.”

Christine: Okay, as an on-the-ground portfolio manager, that must sound pretty aspirational…but what are the tangibles…what did that mean you needed to do?

Susan: It meant we as a team needed to ensure we consider environmental, social and governance (known as “ESG”) factors on an ongoing basis and in a defined manner as part of our decision making in managing the asset allocation funds, as the purpose of the GLC RI policy is essentially to formalize the inclusion of ESG factors into all of GLC’s investment management processes in order to uphold that commitment we made as a firm.

Christine: As an asset allocation fund manager, you’re not doing the individual stock or bond selections? You’re a manager of

Susan: That’s right, so it’s a bit of a different proposition than for the other divisions of GLC that are investing directly in the equity and bond markets. For us it factors into the decisions we make about what funds to hold within our asset allocation funds. We decide on all the underlying funds that are included as components of the asset allocation products, and a huge part of our job and a key part of our investment process is the monitoring and rigorous oversight of those managers to ensure they are doing what they are supposed to in order to fulfill the role they are meant to play within our funds.

Christine: How much time do you spend on the monitoring and oversight?

Susan: That’s hard to quantify exactly, because realistically some aspect of monitoring or oversight comes into play on a daily basis. With focused, deep review of underlying funds on a monthly and quarterly basis. Each of those meetings lasts several hours. We also meet in person or have a direct conversation over the phone with all our managers at least once a year through our participation in the broader company’s investment manager review process, in meetings we set up as a team or at events that the managers themselves put on (earlier this week, for example, I attended a one-day seminar that Fidelity hosted in Toronto). 

Christine: What if you spot an issue or an event occurs?

SUSAN: In that case we can just pick up the phone. If it warrants immediate attention, it gets it.

In all, we estimate that we spend the equivalent of approximately 40-50 business days a year meeting directly with underlying fund managers (a combination of those we currently use and those that essentially form our broader universe of funds offered as a standalone basis on Great-West Life’s investment fund platforms). As it relates to responsible investing specifically, ESG considerations by third party managers are drawn out in a couple of ways.

Christine: Okay, so how do you do that?

Susan: First, we work with the Investment Funds area of GWL on questionnaires. On a semi-annual basis, some high level responsible investing questions are asked of
all managers in that broad universe of funds, and then once a year a more in-depth questionnaire goes out to third party managers we currently include in the asset allocation fund products. 

Christine: So, some annual reporting.

These questionnaires provide a good overview of the ESG landscape at each of the third party managers we
invest in, and a high level picture of other standalone third party managers on the shelf.

That leads to the second way we explore ESG considerations…in our due diligence meetings with managers. During these meetings, we can draw out more responsible
investing-related information through discussions about investment process and performance of mandates and resolve any questions we may have regarding previous responses in the questionnaires.

Christine: How do you find that working?

Susan: Through these initiatives, we are able to build a picture of if and how ESG considerations factor into each manager’s process for every mandate. This knowledge base then becomes another input for our team in terms of assessing the strengths of mandates that we currently hold or may consider for use in our funds in the future.

Christine: Re: questionnaire? What have you learned from those questionnaires?

Susan: First of all, all the third party managers do give consideration to ESG factors…but there is a wide range of levels of integration and/or engagement as well as
differences in reporting practices with respect to responsible investing.  To throw some numbers at you, 74% are UNPRI signatories as of the end of September of last year, and 43% of them even have dedicated ESG teams.

Christine: Do you expect that number to grow?

Susan: I do expect the numbers to grow, because already we have observed increased emphasis on responsible investing over just the last few years since we have been formally tracking ESG-related information on third party managers. For a lot of managers ESG considerations have always been a part of their investment processes, but
like GLC they are putting more effort over time into developing their approach to responsible investing and formalizing their documentation and reporting of it. There does seem to be momentum building in terms of managers recognizing the value of becoming a UN PRI signatory and also the benefits that ESG considerations bring to an investment process.

Christine: I would imagine that seeing inquiries from stakeholders like PSG helps managers to realize that it is in their interest to take ESG considerations into account…

Susan: I agree – they must think, if we are engaging them on these issues, then maybe they should be doing the same…

Christine: Give me an example of a question you might ask one of those managers at these regular meetings?

Susan: ESG considerations often come out in discussions about fund holdings that are controversial for some reason. One
example that readily springs to mind is from a couple of years ago when Valeant Pharmaceuticals was in the news a lot – questions were emerging about the lack of clarity around the company’s accounting practices and overall governance.  At the time it was also a style issue in our minds, as while the stock became a bigger and bigger part of the S&P/TSX Composite Index it caused a lot of benchmark risk for Canadian managers, particularly those with value-oriented mandates – style drift is something we are always watching out for. So we had a lot of discussions around managers’ views on Valeant, including around governance issues, and why or why not it made sense for them to hold the stock in their portfolios. These discussions helped us as asset allocation fund managers to assess whether fund managers were
incorporating ESG considerations into their investment decisions in a thoughtful and appropriate manner.

Christine: Our fiduciary duty is to maximize total return within the prescribed guidelines of the investment mandates. Perhaps some don’t think considering ESG factors contributes to that. What do you think?

Susan: I think it comes down to having a disciplined investment process and a holistic investment philosophy.  Formally considering ESG factors is another means of assessing risks and opportunities within a portfolio.  And that is just as important for a fund of fund portfolio as it is for a standalone mandate.  We believe that being aware of and understanding all types of risks and opportunities allows us to best deliver on our fiduciary duty.

Christine: One final question for you Susan…do you think people care? Do they care that the managers of their asset allocation funds are pursuing responsible investing practices by considering ESG factors in their investment decisions?

Susan: I think people do care.  Responsible investing is becoming more and more topical within the investment community, especially as the mindset is shifting from not just thinking of the benefits of considering ESG factors from a risk management perspective but of the opportunities it can also provide in terms of helping to drive superior investment returns.

Christine: Thank you Susan, it was great hearing from you today.

If listeners want to learn more about GLC’s approach to responsible investing, or read our policy on responsible investing, just go to our website and search ‘responsible investing’ it will take you right there.

Copyright 2017 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.