3 Reasons to Ignore Dow 20,000 and Focus on Better Portfolio Outcomes

By in Institutional, Media Appearances, Risk Parity, Uncategorized

File this post under the category “GET OFF MY LAWN,” but it’s time to stop talking about “Dow 20,000”.  Instead, let’s stay focused on what’s important:

  1. Overcoming “home bias” to take advantage of global innovation and growth.
  2. Diversifying structurally by expanding into asset classes that thrive in a wide variety of economic environments.
  3. Striving for performance consistency by incorporating truly-balanced approaches such as risk parity.

When properly implemented, these steps are likely to provide meaningful improvements to long-term portfolio outcomes.  And in our current environment – where rising rates, high valuations, and frequent policy shocks are the norm – diversification is more important than ever.

Note: The following piece was first published in BMO Nesbitt Burns’ Fall 2016 Quarterly Newsletter.


 

Three Simple Steps to Better Portfolio Outcomes.

Despite good intentions, many advisors overlook relatively simple ways to increase the likelihood of positive investment outcomes. This is largely due to a combination of behavioural biases, firm level constraints on portfolio holdings, and a lack of available tools to help advisors make best use of diversification opportunities.

Fortunately, advisors can take three simple steps to meaningfully improve the probability that clients will hit financial targets. First, advisors who overcome a strong client ‘home bias’ can make better use of all the investment opportunities the world has to offer. Second, advisors who think about asset allocation in terms of exposures to different economic outcomes can engineer more resilient portfolios. Lastly, by thinking about asset allocation in terms of risk allocation rather than capital allocation, advisors can offer clients genuinely balanced portfolios that are more likely to thrive no matter what happens in the future.

Step 1: Take Advantage of Global Innovation and Growth

Canadian investors tend to heavily overweight investments in their domestic market.  A 2016 Vanguard study calculated that Canadians held 59% of their equity investments in Canada. This represents about 18 times more than Canada’s 3.3% share of the world equity markets. And Canadian investors are not alone. This same effect is observed across every major developed market, including the U.S.

In contrast to private investors, major Canadian pensions have materially cut their portfolio allocations to publicly traded Canadian equities in the past three years.  The Ontario Teachers’ Pension Plan has lead the way, reducing its Canadian equity exposure to 1.6% in fiscal 2015 from 9.0% in 2012.  The Canada Pension Plan cut its Canadian equity holdings to 5.4% from 8.4%, and the Caisse de Depot’s allocation fell from 12.6% to 9.0%.

Source: ReSolve Asset Management.  Data from Vanguard, OTPP, CPP, Caisse de Depot

“Home country” bias is a common theme in behavioral economics literature about investing, but a multiple of 18 seems excessive.  Canada’s most sophisticated institutions have moved to take advantage of global opportunities in their equity allocations.  Individual market participants in virtually any global jurisdiction might benefit from a similar line of thinking.

Step 2: Think Differently About Diversification

In addition to expressing a strong home-country bias, investors worldwide tend to think too narrowly about diversification. It is useful to think about diversification in terms of how asset classes would be expected to behave in different economic environments. For example, developed market stocks produce strong returns during periods of benign inflation and strong growth. Bonds do well during periods of declining inflation. But history provides many examples of periods that are hostile to both stocks and bonds.

Source: ReSolve Asset Management.  Data from Global Financial Data.

Consider the 1970s, which were characterized by persistent upward inflation shocks coupled with regular negative growth shocks. Stocks and bonds both produced negative real returns during this decade. But gold and commodities gained about 800% and 400% respectively. A portfolio equally balanced between stocks, bonds, gold and commodities would have produced near double-digit real annualized returns. 

It pays to expand one’s asset allocation to include asset classes that thrive in a wider variety of economic environments. By introducing satellite assets like inflation-protected bonds, commodities and gold, REITs, and peripheral bonds, your portfolio stands a greater chance of producing positive returns in most periods.

Source: ReSolve Asset Management.  Data from Global Financial Data.

Step 3: Find Balance With Risk Parity

Of course, considering a larger universe with unconventional assets prompts an interesting question: how should we think about asset allocation?

Most investors are led to believe that the division of assets they observe in their portfolio is consistent with their diversification of risk. But this is rarely the case. Consider a typical 60/40 “balanced” portfolio of stocks and bonds. An investor might naturally conclude that risk in the portfolio is divided up 60% to stocks and 40% to bonds. But this analysis fails to account for the fact that stocks are much riskier than bonds. In fact, stocks contribute over 90 percent of the risk in the portfolio, while bonds are responsible for less than 10 percent.

Source: ReSolve Asset Management.  Data from CSI.

It is illustrative to see how a truly balanced global risk parity portfolio, with calibrated exposures to a diverse basket of global assets, can produce positive returns in both friendly and unfriendly markets. The chart below shows the historical performance of one risk parity implementation* from 1970 through present day.

If the objective of a portfolio is to deliver consistent returns in any market environment, it is critical to allow all of the assets to contribute an equal amount of risk, return, and diversification benefits. A global “risk parity’ portfolio has precisely this objective. The portfolio is formed by performing an optimization that ensures each asset contributes the same amount of risk after accounting for different volatilities and correlations. As a result, assets with lower volatility and correlation will receive a larger allocation than assets with higher volatility and correlation.

Source: ReSolve Asset Management.  Data from Global Financial Data.  Simulated and hypothetical results.  Please see ReSolve disclaimer page here.

It’s interesting to note that the U.S. 60/40 portfolio and the Global Risk Parity portfolio both end in the same place after almost a half-century, producing just under 10% annualized returns. However, the risk parity portfolio imposes just 2/3 the volatility of the 60/40 portfolio, and inflicts just half of the largest peak-to-trough losses. Moreover, the Global Risk Parity portfolio produces positive returns in 95% of years, and 100% of 3-year periods. Of particular note, observe how Global Risk Parity thrived even during the challenging 1970s.

Next Steps

As advisors, we know that the key to sustainable portfolios – and happy clients – is to produce consistent positive returns. It is a relatively simple matter to achieve better portfolio outcomes by going global, thinking differently about diversification, and targeting optimal portfolio balance. A Global Risk Parity portfolio combines these concepts systematically to target steady returns in any economic environment. To learn more about how to implement Global Risk Parity for your clients, visit riskparity.ca, or go straight to our more comprehensive Risk Parity Solution Brief.


* Simulated results for Equal Risk Contribution portfolio. Please see disclaimers here.

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