IMCO's CEO on Navigating Uncharted Territory

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Bert Clark, President & CEO of the Investment Management Corporation of Ontario (IMCO),wrote a comment for the Canadian Investment Review on finding a path forward for institutional investors amid market headwinds: 

The impact of powerful trends, including aging populations and growing debt levels in the world’s largest economies, has been somewhat mitigated in recent years by the ongoing involvement of central banks in markets and declining interest rates. However, with rates at historic lows, this is not something that can be relied on over the next decade, and returns are likely to be lower going forward across most asset classes.

Ongoing central bank involvement in the capital markets may have been necessary at various points from the start of the great financial crisis until now. However, the overall result today is that we are in uncharted territory. Two decades ago, central banks influenced short-term interest rates, had very small balance sheets and made intentionally vague public statements about the future path of interest rates. That role has evolved dramatically. For example, today, the U.S. Federal Reserve balance sheet is bigger than the largest asset managers in the world, it intervenes directly in the market to influence bond pricing across the entire interest curve, it buys investment-grade and high-yield credit and its pronouncements about future rates are unequivocal.

This presents two challenges for investors: first, over the long term, markets don’t tend to work well when they are dominated by government intervention. Second, by driving rates across the curve into negative real territory, central banks have forced most investors to invest more heavily in risk assets and made it harder for bonds to have the same impact in portfolios they have historically had, namely as a diversifier and a source of return. As a result, investor portfolios are generally riskier today.

Finally, the coronavirus has not impacted all stocks and market segments equally. While many indexes sit roughly at their pre-pandemic levels, this again is tied closely to unparalleled central bank intervention. But, beneath the indexes, there is a high degree of dispersion in terms of individual stock and market segment returns, meaning there are both greater opportunities and risks for investors today.

So, what is an investor to do?

Focus on diversification

Though the term diversification is often over-used, it remains the most important strategy for investors to keep in mind. In a world of lower returns, most investors aren’t likely to have as balanced a portfolio as would be possible if bonds had higher returns and could occupy a larger percentage of their overall assets. Where portfolios are heavily titled to risk assets, it is even more important to avoid large asset class over-weights or under-weights. Investors also need to avoid relying heavily on any one return-enhancing strategy. Investors cannot afford to get it wrong today by placing too much emphasis on one risk asset class or return-enhancing strategy.

Carefully manage costs

Simply put, costs matter a great deal when it comes to investing, and this becomes especially true in a lower return environment. Many of today’s fee structures – like the two and 20 model – were developed when overall returns were expected to be much higher. However, fees have not come down anywhere near the same extent as return expectations. The reality is that every additional basis point of cost erodes net investment returns, so institutional investors must do what they can to reduce costs. This means developing an expanded set of internal capabilities, co-investing with private partners, negotiating preferential terms and avoiding costly external management models like managers of managers and funds of funds.

Ensure adequate liquidity

Liquidity is critical to both capturing the opportunities and avoiding the dangers posed by volatile and unpredictable markets. Most investors’ portfolios are built around the idea that risk assets generate higher returns over the long-term to compensate for higher volatility of returns in the near-term. As a result, they have a large allocation – often more than 60 per cent – to riskier assets. To effectively implement this strategy, investors need to be able to avoid selling at the wrong time, typically when markets are down.

Play to your strengths

Outperforming the markets is difficult, and the asset management industry overall does not have a great record in this regard, especially after taking fees into account. The key to outperforming is to focus on areas where investors or their partners have an actual advantage. For us, this generally means using our longer investment time horizon, our tolerance for illiquidity and our scale (which allows us to partner with some of the best investors in the world).

Watch the big picture

We are careful to navigate the big trends that can significantly impact investors’ portfolios. This does not mean speculating on the future or trying to spot obscure trends before anyone else. It means ensuring that our portfolios are adapted to powerful and often obvious and inevitable trends, like the rise of sustainable investing or the rapid acceleration in online shopping adoption driven by the coronavirus crisis.

While today’s investment climate is very challenging, the key to success is sticking to the core investment strategies that produce higher risk-adjusted returns over the long-term. Investors who can do this well will be strongly positioned to navigate this volatile and uncertain environment and emerge with momentum and confidence.

I thank Bert Clark for sending me this comment this afternoon, it's well worth covering along with his recent Canadian Club discussion with Bloomberg's Amanda Lang where he discussed creating investment value amid unprecedented volatility.

The key themes discussed above are also discussed in more depth with Amanda Lang which is why I embedded the clip below at the end of this comment. Make sure you take the time to watch it.

Also, beginning on Thursday, this blog will be launching a new series on Total Fund Portfolio Management featuring seven episodes (one every week on Thursday) and comments from Mihail Garchev, former Head of Total Fund Management and VP at BCI.

Mihail was also my colleague at PSP Investments years ago and he has produced unbelievable research and comments which will benefit all pension fund managers no matter how sophisticated they are (think of it as the Canadian model 2.0).

We are looking forward to launching this series in order to generate much needed discussion on a subject that garners too little attention (David Swensen's book remains the classic but it doesn't cover the details in depth and it certainly doesn't have a pension fund focus).

I mention this because it's very much related to a lot of the concerns Bert Clark raises above and in his discussion with Amanda Lang. 

Let me begin by looking at the role of central banks. Readers of this blog know I'm very cynical these days on capitalism and the expanded role of central banks. You should all read the comment I posted last month criticizing Ray Dalio's 'shocking' warning on capitalism for missing the mark. 

Basically, just like Ray Dalio, I have zero tolerance for nonsense and total BS. Central banks always talk about saving the financial system from collapse, which they did back in 2008, but the truth is they're bailing out the power elite -- tech moguls, corporate titans, uber-wealthy families and hedge fund and private equity managers that manage billions.

What's going on now isn't capitalism, central banks are creating money out of thin air, pumping unprecedented liquidity into the financial system to backstop markets, all markets, effectively bailing out speculators who are enriching themselves at an unprecedented level.

Failure is simply not an option, at least not in capital markets. In the real economy, hundreds of thousands businesses are failing and crumbling, unable to survive the fallout from the pandemic and closures which have decimated them.

But as long as the power elite keep getting richer, central banks have fulfilled their true mandate.

Keep in mind, this is me, Leo Kolivakis, talking, not Bert Clark although he too expresses concerns on how central banks are interfering in markets, increasing inequality and where we are heading with all this. 

Over the long Thanksgiving weekend in Canada, I read an article on Bloomberg on how a rare regime-change in economic policy is under way that’s edging central bankers out of the pivotal role they have played for decades.

Fiscal policy, which fell out of fashion as an engine of economic growth during the inflationary 1970s, has been front-and-center in the fight against Covid-19. Governments have subsidized wages, mailed checks to households and guaranteed loans for business. They’ve run up record budget deficits on the way -- an approach that economists have gradually come to support, ever since the last big crash in 2008 ushered in a decade of tepid growth.

No doubt, fiscal policy is a critical response to the COVID-19 crisis but I'm skeptical that zero bound or negative rates means the end of monetary policy. 

It means the end of conventional monetary policy as we know it but I'm afraid that unconventional monetary policy (quantitative easing) is only getting started and if stock markets crash, I wouldn't be surprised to see the Fed expand its mandate and go all BoJ (Bank of Japan) and start buying stock ETFs outright (BoJ owns 50% of Japanese stocks, effectively nationalizing the entire market).

If you think that's a stretch, I submit to you before the pandemic hit, nobody thought the Fed would be buying junk bond ETFs (to bail out private equity industry).

We are living in interesting times and I don't think we're anywhere close to having seen it all.

One thing that Bert Clark and the rest of the team at IMCO are right about, low rates and low returns are here to stay, and so is unprecedented volatility.

You need to adapt and for IMCO that means diversifying properly across geographies and public and private markets, focusing on areas where they see growth (credit, including private debt), managing costs extremely carefully (more co-investments to reduce fee drag), managing liquidity carefully to capitalize on opportunities (rebalancing portfolio and use of leverage are becoming more critical at all large Canadian pensions), and focus on its comparative advantages (long investment horizon, taking on illiqudity risk with strong partners, etc.).

IMCO's in-house experts have shared their insights on these topics and so has Bert Clark.

In his discussion with Amanda Lang, he also discusses why the traditional 60/40 stock?bond portfolio will disappoint investors given how low long bond rates are.

This has been a topic of much discussion lately:

And the answer always seems to invest more in alternatives but I caution my readers, the answer isn't investing more in high fee alternatives, if you don't get the approach right to reduce fees (through more co-investments), don't bother with alternatives.

You should all read a discussion I had with HOOPP's CEO Jeff Wendling on LDI 2.0 in a zero bound world where they are looking at a lot of options, including taking more concentrated positions in high yielding securities.

Sure, you're not a pension plan but when retirees ask me how to navigate markets in a zero bound world, I tell them to buy utilities, telecoms, pipelines and big banks to collect some yield, have some cash to buffer against market drawdowns and pray to God nothing explodes. 

What about REITs? Sure, buy some REITs but make sure your REIT is well diversified and not just Retail and Offices. 

There too, Bert Clark said they are reevaluating their real estate holdings and he said "he's getting used to working from home" (trust me, it grows on you and once you're used to it, going back to the office will seem foreign).

Lastly, a little note on diversification. The tech weighting on the S&P 500 ETF (SPY) is 26% and six mega cap tech stocks make up more than 50% of the Nasdaq-100 Index (NDX).

When people tell me "I just blindly buy the SPY or QQQs", I don't think they realize how much mega cap tech exposure they're actually getting and they're underestimating this concentration risk.

Do your due diligence on any ETF you're buying, if a couple of companies make up the bulk of that ETF, you're probably better off buying the shares of those companies and taking more idiosyncratic risk.

But if you think your stock holdings are well diversified because you're buying the SPY, think again, you're much more exposed to a tech selloff/ meltdown than you think. 

Diversification is a free lunch, just make sure you're using it properly.

Pension and investment experts reading this comment know what I'm talking about, that last observation above was for novices reading this comment.

Alright let me wrap it up here. One last thing, all you smart folks at IMCO and elsewhere, make sure you read Hoisington's latest economic quarterly comment here. It's superb.

Below, a recent Canadian Club virtual event featuring Bert Clark, President and CEO of the Investment Management Corporation of Ontario (IMCO). He discusses "Creating Investment Value Amid Unprecedented Volatility" with BNN Bloomberg's Amanda Lang. Great discussion, take the time to watch it all.

Also, this Thursday, Mihail Garchev and I are launching a seven part series on Total Fund Portfolio Management on Pension Pulse. It's basically seven short guest comments Mihail has prepared along with an in-depth clip discussing each comment in more detail. It will be posted each Thursday over the next seven weeks.

Take the time to watch the promo trailer below and we look forward to exploring Total Fund Portfolio Management in a lot more depth and generating great discussions on a LinkedIn group Mihail is putting together (sorry,  by invitation only, not open to public, more details to come).

Update: Mihail Garchev, the former Head of  Total Fund Management at BCI shared this with me after reading this comment:

Bert is right. The central banks have effectively borrowed the returns from the future to give these to us over the last 10 years. This is why being aware of the path of returns, not just the end return becomes increasingly important. 

Because the bonds are no longer the same hedging asset they once were (low level of yield, correlation, less efficiency in a fiscal policy setting, extreme valuations, and low "dry powder", etc), investors need to rethink the portfolio construction. 

A natural inclination would be to increase private assets and alternatives and these do help, especially because of the accounting mark-to-market diversification but there is a limit to how much privates a portfolio can have and this limit is dictated by liquidity and in relation to the liabilities. Most funds are at the 40% privates mark so there is a bit more room to expand but not much. As one approaches the 50% liquidity starts to break (of course this depends on individual fund circumstances). 

So, what is left, are two other approaches to complement the hedging properties of bonds. 

First,  to adopt path-dependent outcome-oriented portfolio management (which is what total fund management (TFM) is, it is meant to avoid negative outcomes and maximize end wealth (what we care about, not returns). Another way to avoid negative outcomes and maximize wealth is to have a dedicated and dynamically managed multi-asset asset class called "risk mitigation" and have it as a line in the policy portfolio to complement bonds. This is an outcome-oriented asset class, and not an asset-based one. 

 Such "risk mitigation" is not a pure market-based one but needs to complement the embedded structural risk mitigation in the plan design (actuarial smoothing, surplus, etc.). This structural risk mitigation is the cheapest one that anyone can get. Think of this as communicating connected vessels physics experiment. When the structural actuarial protection weakens, one complements and rebalances with a market risk mitigation specifically constructed to match what is lost from the structural one. There are very interesting properties, and leads and lags how the structural protection behaves. Surplus, for example, would buffer the initial impact but once it's used is gone and cannot be restored. Most importantly, structural mitigation does not provide a dry powder. This is important because if the portfolio dollar size becomes from $100 $80 dollars, even if one does the heroic thing of rebalancing, the weights are right but the dollars are not. One still has an $80 dollar portfolio. What is needed is something that will give a dry powder to give back the $20 lost. It then self-destructs but fulfills its function. 

My final point is about the cost. Bert is absolutely right and people often forget this powerful side of the equation. It is great to have privates and alternative and new strategies but these come at a cost. This cost is such that could potentially, if not already eroded the economies of scale that many of the Canadian pension funds are pursuing. The question then becomes, outside being cost-conscious on the organization and investment side, are there any other second-order efficiencies that could partially offset the cost and maintain the economies of scale. You will be covering this in detail in one of your upcoming posts, but it is extremely important for organizations to evaluate the hidden cost of size and scale and the hidden inefficiencies that come with those, and design a portfolio approach that could restore to the extent possible the overall efficiency. In a way, this is the second mission of total fund management. 

I thank Mihail for his very wise insights and look forward to more insights to come on Thursday and in the weeks ahead we kick off the Total Fund Portfolio Management series.

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