Podcast: Diverse fixed income in the conservative end of the risk spectrum is important

Listen to Susan Spence, Vice-President of Portfolio Solutions Group discuss Q1 2019 markets and the sophisticated mix of fixed income in the Conservative, Moderate and Balanced asset allocation portfolios that PSG manages.

Milos: Hello my name is Milos Kostich, Vice President at GLC Asset Management Group, and you have tuned into the PSG Quarterly Update Podcast – a quarterly discussion with GLC’s Portfolio Solutions Group about the asset allocation funds that they manage. This podcast, and all of GLC’s podcasts can be found on GLC’s website, iTunes, Google Play and Spotify….simply search for GLC Asset Management and find us there. You can also subscribe to get new episodes automatically when they are released.

Although PSG’s asset allocation products are designed for a variety of investor risk profiles, today we will focus somewhat on the more conservative side of the spectrum.  Risk management and risk-adjusted returns are always a focus, and the PSG team is acutely aware of how important these factors are in the management of all their products.

I am pleased to have Susan Spence here once again in our studio, Susan is the head of GLC’s Portfolio Solutions Group division – PSG for short.

Welcome back Susan and thanks for joining us for another quarterly discussion, this time, first quarter 2019.

Susan:  Thanks, Milos.

Milos:  Susan – one of the first things investors will have noticed YTD, in contrast to Q4 of 2018, are the very respectable equity market returns, both here in Canada, the US and overseas.

Susan:  You’re right, Q1 of 2019 saw a sharp rebound in equity markets from their Q4 2018 sell-off.  The S&P/TSX Composite Index led major indices on the upside, with a return of over 13%, the S&P 500 Index wasn’t far behind, up over 11% in Canadian dollar terms, and the broad developed equity MSCI World Index was up double digits as well, at about 10% in Canadian dollar terms.

Milos:  And it wasn’t just developed equity markets, was it?

Susan: Correct. Emerging markets also fared well, up almost 8% in Canadian dollar terms. And what is striking is that those are not annualized returns – they are the actual returns, achieved in just three months!

Milos:  A big move, indeed. So how have PSG portfolios fared in this environment, specifically those that are on the more conservative end of the risk spectrum?

Susan: Well, the more conservative PSG-managed portfolios, the Conservative and Moderate risk profiles, recorded very solid absolute returns in the quarter too – but these gains were more in the range of +5% on a gross basis.

Now, there are a few key reasons for the more muted absolute returns:  first, the Conservative and Moderate funds have significant allocations to fixed income, 75% and 60% respectively – and in contrast to the strong moves in equities, the broad Canadian bond universe was up approximately 4% in Q1.

Milos: Right, we can’t forget about the important role of fixed income in the more conservative-oriented funds…and fixed income certainly has a more positive impact in other market environments. As I recall, having varying amounts of fixed income in the asset allocation funds went a long way toward protecting capital in the Q4 2018 sell-off, for example.

Susan: Absolutely. And tied to your comment, a second reason the funds lagged the strong equity index returns in Q1 was that, as you know, the portfolio construction of asset allocation funds emphasizes overall diversification, beyond just equity and fixed income, with the goal of helping to smooth the ride for investors and provide strong risk-adjusted returns over the long term.

Milos: So there are always some offsets to the strongest performance drivers within the portfolios, I suppose.

Susan: Exactly. So in addition to the fixed income allocations, one notable offset this quarter, in funds that can hold it, was real estate, one of the proprietary alternative investments we have access to, which saw returns of less than 2%. Like fixed income, real estate significantly helped performance in Q4 but limited the upside to returns in Q1. And foreign bond allocations were also a drag in Q1.

Milos:  Diversification – that’s an important concept to keep in mind when putting performance into perspective.

Susan: Definitely, at least for the asset allocation funds PSG manages.

And then the third point I want to make about the performance of the more conservative asset allocation funds in Q1 is the value style bias within the equity allocations. We know conservative investors are particularly mindful of preserving capital, so we focus more on value style mandates for the Conservative and Moderate funds. Not surprisingly, value mandates didn’t keep up as well as growth style mandates in the frothy equity markets of Q1.

Milos: So to summarize, if I may, in Q1 the more conservative asset allocation funds experienced solid returns, but because of how they are constructed, emphasizing diversification and a bias to value-oriented equity mandates in order to achieve longer-term risk and return goals, returns did not match those of pure equity indices.

Susan: Correct. And for similar reasons, along with the fact that some of our other longer-term strategic positioning within the funds didn’t work this quarter and because in general it was a tough environment for active equity managers to add value in such a frothy market, the funds also underperformed their benchmarks somewhat in Q1.

But remember, as we’ve already mentioned, these same elements also led to outperformance versus benchmark on a gross basis for the more conservative funds in the Q4 2018 sell-off.

Milos: Susan, that’s an excellent reminder that participating in most of the upside and helping to protect capital on the downside over time can combine to deliver those smoother, strong risk-adjusted returns that PSG strives for.

Susan:  That’s right.

Milos: Okay, so that’s a great recap of Q1 performance overall. Now, given that one of the main tools in managing risk in the more conservative asset allocation products is fixed income, as you alluded to earlier, I’d like to circle back to bonds and explore what’s been going on in that portion of the funds in some more detail.

Susan:  Sure.

Milos:  With lower bonds yields since Q4 of last year, I am wondering how your fixed allocations have affected overall returns?

Susan: The fixed income allocations in the Conservative and Moderate portfolios are composed of a well-diversified mix of underlying funds. As a whole, fixed income allocations contributed nicely to absolute returns in Q1, but detracted value relative to benchmark primarily due to the exposure to foreign bonds and overall shorter duration.

Because the Canadian dollar strengthened relative to major currencies, the unhedged currency exposures in the foreign bond allocations detracted value. And as you mentioned, after an initial upward move in January, yields declined overall in Q1, particularly at the longer end of the yield curve. This resulted in longer-term bonds outperforming shorter-term bonds, so our overall shorter duration positioning and specific holdings such as mortgage and short-term bond funds were detractors.

Milos: So given what transpired in Q1, has PSG adjusted any bond sector weightings within your overall bond allocations?

Susan: Aside from some small changes in certain Folio mutual funds as a result of fund mergers on the Quadrus shelf in Q1, the answer is no – we have not adjusted our fixed income weightings.

The foreign bond allocations in the Conservative and Moderate funds are long-term, strategic allocations – we recognize there will be short-term currency fluctuations that can affect performance, but over longer time periods, we believe these holdings will continue to add value to the funds.

In terms of our duration positioning, Q1 saw Canadian and US central banks taking a more accommodative stance, but we still expect yields have more room to increase before the central bank tightening cycle is over and thus are holding course and trying to benefit from the longer-term trend knowing it won’t be a straight line up.

Milos: It’s clear from your comments that you do have some active positioning elements within the asset allocations funds. Susan – one of the more common misconceptions about the PSG asset allocation products is that they are more of a “set it and forget” type of fund structure, that there is really not a lot of active management on a day-to-day, week-to-week, month-to-month basis. Can you reiterate how the PSG team manages the PSG assets on an ongoing basis?

Susan: Milos, you are right to point out that thinking of the asset allocation funds as having a “set it and forget” type of structure is a misconception.  PSG is dedicated to focusing on the management of the asset allocation funds, so we are constantly monitoring and assessing the holdings and exposures within the funds.

The more tactical element of the funds occurs at the underlying fund level, where managers are more responsive to day-to-day, week-to-week moves in the capital markets.  But, in addition, over time PSG makes adjustments to weights and/or holdings to position the funds with the objective of adding value relative to benchmark through a cycle, with less volatility than benchmark.  We make active calls and adjust them opportunistically as markets shift.

Milos: In traveling across various regions and speaking to a diverse group of advisors, a question I get frequently is whether the asset allocation products are nimble enough in their structure and management to be able to weather shocks and movements in a variety of markets?

Susan: I would say PSG’s robust approach to portfolio construction is perhaps more important than being nimble when it comes to weathering shocks. By definition, a shock to the capital markets is quick and unexpected – so ensuring there is good diversification within the funds, incorporating offsets and combining assets with low correlations to each other, sets the asset allocation funds up well for navigating through bumps in the markets.

And I think the two levels of active management, more tactically at the underlying fund level, and more strategically at the top fund level, do make the asset allocation products nimble enough to deliver on the objective of strong long-term risk-adjusted returns.

Milos: Okay, Susan, just feeding off of that, I have one last question for you today. In discussing recession and slowdown worries last quarter, I think advisors are still concerned about the inevitable equity market correction and they pose the question:  Am I protected on the downside having invested in some of the more conservative allocation models with PSG?

Susan: Milos, I hope some of the points we touched on today do provide comfort for more conservative investors with respect to downside protection. The large, diversified fixed income allocations, the exposures to alternative asset classes of real estate and mortgages where we can hold them, and the emphasis on value style and income-oriented equity mandates should all help to protect capital in the Conservative and Moderate funds in the event of an equity market correction.

In addition, in most funds PSG has the ability to underweight equities somewhat versus benchmark equity exposures – that said, currently we are comfortable with our neutral positioning relative to benchmark from a high-level asset mix perspective, as we view the risk/reward opportunities in fixed income and in equities as balanced in the near term.

Milos: Susan – I want to thank you for your insight and overview today and I believe that we have covered a broad range of topics as they pertain to the PSG portfolios overall. I would like to remind listeners that if they are interested in accessing specific information regarding the PSG managed portfolios as well as the overall PSG approach to managing portfolios , they can obtain that on the GLC website at www.glc-amgroup.com.  I also want to thank you our listeners for tuning in and hope that you will join us next time as we look at the PSG portfolios in our 2nd quarter PODCAST review.

Copyright 2019 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.