IMCO's CEO & CIO and Why It's Not Time to Hit the Panic Button
How we think at IMCO
At IMCO we believe that short-term volatility of returns is generally unavoidable for long-term investors. We think the key is not to try to alter asset mix to avoid it, but to have adequate liquidity to survive and, in some cases, profit from it.
In retrospect, “down markets” may seem predictable and can cause investors to wonder whether they should stick with their long-term asset mix. Hindsight is 20-20, as they say.
However, as painful as these periods of underperformance feel, we believe that investors should not attempt to tactically adjust their asset mix to avoid short-term weakness in returns. Instead, our view is that investors should stick to their long-term asset mix and seek high quality, long-term investment opportunities during times of market stress.The following sets out our approach to responding to short-term market events.
2022 context
2022 has been one of the most challenging years for most investors. All public assets have been repriced as central banks have begun to withdraw liquidity and raise interest rates in their efforts to combat multi-decade, high levels of inflation. No long-term asset mix has been immune to the repricing impact of central bank activity in 2022. Consider that a traditional portfolio with a 60/40 mix of stocks and bonds would have generated returns of negative 11 percent, while typical LDI (liability-driven investment) and risk-parity portfolios would have generated returns of negative 17 percent.
In general, portfolios that performed well in 2022 (so far) are those dominated by private assets, where valuations are lagged. To avoid losses, investors in public assets would need to have taken dramatic action at the beginning of the year, such as selling most of their assets and sitting in cash. This type of tactical adjustment in asset mix is not realistic (or advisable) for most investors.
A range of models for long-term investing
Although every client is unique in their risk/return profile and objectives, very broadly speaking, institutional investors tend to pursue long-term investment strategies that align to one of four models:
1. Growth Oriented Asset Mix
The 60/40 asset mix, as well as other asset mixes dominated by growth-oriented asset classes subject to significant short-term volatility, fall into this category. The main idea underlying these asset mixes is that over the long-term, investors are rewarded for owning growth assets like equity, credit, infrastructure, and real estate notwithstanding the expected volatility of their returns in the short-term.
One of the greatest risks of this portfolio strategy is inadequate liquidity which can force asset sales at market lows. Long-term growth-oriented investors need to manage their liquidity. The other major risk this strategy faces are periods of sustained weak performance in growth-oriented assets, which can occur. For instance, over the last 90 years, equity markets have outperformed bonds in 9 of 10 rolling 20-year periods. Betting on growth has a good chance of succeeding over the long-term, but it does not guarantee success.
2. Liability Driven Investing (LDI) Oriented Asset Mix
LDI investors select assets that are closely tied to the liability they are seeking to achieve. Often, this is assumed to be long-term bonds because this is what actuaries use to discount certain liabilities. Because the return on these assets is often relatively low, relative to the returns required to meet the liability, investors typically need to use significant amounts of short-term borrowing to increase their total portfolio returns.
One of the biggest risks of this strategy is operational implementation because prudently employing large amounts of leverage is not something many firms can do. Another risk is that actual liabilities and corresponding investments are different from the asset being used to discount liabilities driven by circumstances like changes in longevity and central bank intervention in the markets.
3. Risk Parity Asset Mix
The primary objective of a risk parity approach is to invest in a range of assets (including growth-oriented assets like equities and credit as well as bonds, and commodities) so that the total portfolio performs well in a range of macro-economic environments (e.g., growth with high/low inflation and economic contraction with high/low inflation). If the returns of this asset mix are too low to meet an investor’s return objectives, because of large allocation to bonds and commodities, short-term borrowing is used to increase returns.
One of the risks of this model is the operational risk associated with significant use of leverage. Additionally, there is a risk that the actual correlation among risk-oriented assets, bonds, and commodities do not match the model and the portfolio performs well under a narrower range of macro-environments.
4. Reserve Fund
In many cases, reserve funds require a higher level of liquidity given the unpredictability and variability of cash flow requirements used to fund projects or other activities. The general idea is to invest in assets that are readily available to meet unforeseen needs. Such funds tend to be invested in shorter-term, lower risk assets to avoid having to force sell volatile assets at the wrong time.
At IMCO our clients generally have either growth-oriented or reserve fund type asset mixes.
Why we are committed to our clients’ long-term asset mix, despite short-term market events
Systematically managing asset mix is a superior strategy for most investors and this is the approach we take. Once we have worked with clients to help them select a long-term asset mix, we don’t believe in materially adjusting the mix in the short-term to try to navigate short-term market events.While there are a number of investors who have demonstrated the ability to reliably alter asset mix to anticipate and successfully navigate market events, the number of such successful investors is small. These investors must accurately predict market events (before the market) and then adjust their asset mix to a sufficient extent to reap benefits. Assuming they have a long-term asset mix, they then need to correctly time the adjustment of their portfolio back to the long-term mix. This series of tactical adjustments is very hard to time and size correctly, and the consequences of getting these sorts of decisions wrong has the potential to outweigh many, if not all, other return enhancing activities.
How we navigate short-term market events
Instead of trying to materially alter asset mix to navigate short-term market events, we pursue several strategies to reduce risk and enhance returns over the near term.
First, we systematically rebalance. Thankfully, most years are not like 2022 where all public asset classes have repriced downwards. Typically, because most asset classes do not rise and fall in unison (they are not all perfectly correlated) there is an opportunity to systematically “buy low and sell high” simply by regularly selling those asset classes that have risen in value and buying those asset classes that have fallen in value, so that the asset mix returns to the long-term target; this is called rebalancing.
While rebalancing is very effective at capturing opportunities and maintaining a fairly constant level of overall risk, it is not a strategy to deploy excessively. There are explicit transaction costs to rebalancing and an approach that balances cost/benefit is prudent. Moreover, rebalancing less frequently allows investors to benefit from the long-term tendency of growth-oriented assets to rise in value, without harvesting that increase in value too frequently.
Second, we explore buying opportunities within asset classes that are created during periods of short-term market turbulence. These opportunities can be pursued systematically in the same way as rebalancing (e.g., where certain market segments have been impacted disproportionately by market events, such as the private versus public or the high yield versus investment grade credit markets).
Periods of short-term market turbulence can also create individual investment opportunities (e.g., long-term quality company stocks can suffer declines in price, along with the broader market, which do not reflect their relative long-term value). Therefore, we seek to enhance returns during periods of market stress by pursuing both systematic and individual investment opportunities.
The last couple of years has reminded investors that much can change in a very short period. We have gone from a world in which investors worried about lower-for-longer deflation to a world of multi-decade high levels of inflation. Revisiting asset mix and asset mix transition plans annually allows investors to review and update their approaches to reflect changes in long-term return and correlation projections as well as long-term trends, changes in client risk tolerances, new products, investment capabilities or strategies. In most years, these changes should not be significant. But it is prudent to pause annually and, at a minimum, reconfirm the long-term plan.
I would add that we’ve also been cautious for some time of cyclical and commodity-driven parts of the market. We generally prefer to find a great business and a great management team to invest in over a number of cycles, and to patiently build value over time by supplying them with capital. It just fits much better with our culture and our long-term horizon.
Summary: Staying the course and being opportunistic
Periods of short-term volatility are inevitable for long-term investors. At IMCO, we believe that maintaining conviction in the long-term investment strategy and asset mix (versus tactically adjusting it to avoid short-term market events) is the best approach. We also recognize that there are a number of investment strategies that can be used to profit from such periods, which include a mix of systematic techniques like rebalancing at the total portfolio and asset class level, as well as pursuing a bottom-up fundamental investment approach to enhance long-term returns.
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I read this yesterday and thought it would be a great comment to post on another very volatile day as US core inflation rises to a 40-year high and stocks rallied from 2020 lows earlier this morning in big market turnaround, with the Dow ending up more than 800 points.
In $SPY's history, it has only opened down 2%+ and closed up 2%+ four times. Today would make it 5, but a lot of day left. Prior days on the chart below: pic.twitter.com/HLOgFVKiiD
— Bespoke (@bespokeinvest) October 13, 2022
Traders bought the big inflation scare dip this morning, betting we have reached peak inflation.
Is this the beginning of a new multi-week bear market rally, similar to the one we had after the June 13th US CPI report? Probably but who knows.
All I know is investors are happy to see green on their screen and glad this dreaded US CPI report is finally behind them.
And if you think stocks were volatile, check out the intraday volatility in bonds. The 10-year Treasury yield hit 4.08% after the US CPI report came out and bonds were bid hard, with the yield settling at 3.95%:
Anyway, back to Bert and Rossitsa's comment.
They carefully explain their approach to strategic asset allocation and how they pursue long-term investment strategies that align with their clients' objectives.
They also explain that while they don't use tactical asset allocation to capture opportunities in short-term movements, they prefer to do so through systematic approaches like rebalancing at the total portfolio and asset class level, as well as pursuing a bottom-up fundamental investment approach to enhance long-term returns.
Moreover, they explain different approaches to asset mixes and state: "At IMCO our clients generally have either growth-oriented or reserve fund type asset mixes."
They don't pursue highly levered liability driven investing (LDI) that has shaken many UK pensions but thus far, hasn't affected any Canadian pension (read Jim Keohane's comments here, he explains why well).
Now, I realize this comment is meant for IMCO's clients and if you look at IMCO's asset mix as of the end of last year, 55% is in public equities and fixed income/government bonds:
The high exposure to public markets will be a drag on returns this year (unless we end with a bang). They even state: "In general, portfolios that performed well in 2022 (so far) are those dominated by private assets, where valuations are lagged."
To be fair, it's not just because valuations lag (I don't think this is what Bert and Rossitsa meant), some investors are doing well in private markets because they were able to add value in their investments, but it's true that valuations lag in private markets and investors who have a higher proportion of their assets in private markets are outperforming this year.
I just want to be very careful and not say it's only because valuations lag, that would be wrong and feed into critics' wrong views about private markets.
Secondly, they write:
The last couple of years has reminded investors that much can change in a very short period. We have gone from a world in which investors worried about lower-for-longer deflation to a world of multi-decade high levels of inflation. Revisiting asset mix and asset mix transition plans annually allows investors to review and update their approaches to reflect changes in long-term return and correlation projections as well as long-term trends, changes in client risk tolerances, new products, investment capabilities or strategies. In most years, these changes should not be significant. But it is prudent to pause annually and, at a minimum, reconfirm the long-term plan.
I would add that we’ve also been cautious for some time of cyclical and commodity-driven parts of the market. We generally prefer to find a great business and a great management team to invest in over a number of cycles, and to patiently build value over time by supplying them with capital. It just fits much better with our culture and our long-term horizon.
I agree, structural changes in the economy happen, central banks are more concerned about inflation than growth, you need to sit down every year and think about your asset mix, especially after a year like this one where rates went up significantly because of persistent inflation pressures.
The real killer, and they allude to this, is what if we are in a prolonged downturn where inflation remains higher than usual and growth slows considerably (stagflation)? Or what if central banks cause another major crisis and we relive a deflationary bust, but a much longer one?
What if stock indexes go nowhere for a very long time, much like they did from 1966-1982?
This too is another reason why large Canadian pension investment managers (including IMCO) are shifting more of their assets into private markets where they have more control and can better implement their value-add and ESG strategies.
As far as tactical allocation, it's very tough. Ontario Teachers' and HOOPP seem to do it very well consistently but they are pension plans managing their assets and liabilities very closely (it's more of a total portfolio approach).
I think the most important point in Bert and Rossitsa's comment is the need to manage liquidity risk carefully so you don't end up forced to sell assets at the wrong time.
Lastly, more sophisticated approaches to asset mix also find alpha in balance sheet management, but this isn't a topic for IMCO's clients, it can get complicated.
Just understand that sophisticated investors use derivatives (eg. swaps) to maximize their returns from balance sheet management (IMCO is probably doing this too).
So, don't hit the panic button just yet, we might end the year on a positive note if nothing breaks in the market as the Fed continues to raise rates.
I encourage my readers to read more IMCO Insights here.
I also liked the role of leverage in client portfolios written by Hrvoje Lakota, Vice President of Portfolio Construction.
I enjoy reading these insights by experts and I'm sure IMCO's clients do too.
Also, IMCO Forum keynote speaker, world-renowned historian, author, and commentator Dr. Niall Ferguson examines what breaks in trends really mean, and in so doing, offers us a new, hopeful perspective – one that straddles the optimistic trends and doomsday events that dominate our discourse -- and help us make sense of the biggest “trevents” unfolding before us today.
“We have entered a new and more dangerous era, in which a new superpower rivalry is likely to be associated with economic crisis, a ‘democratic recession’…and increased conflict. And yet there may just be a different and more positive way to look at the world today.”
You can read his thoughts here.
Below, CNBC's Halftime Report Investment Committee discusses why equity markets are performing well during Thursday's trade, Kari Firestone's thoughts on stocks, and more.
And Jeff Degraaf, research chairman with Renaissance Macro, joins 'Closing
Bell' to discuss poor market sentiment staging the space for a market
rally, the importance of discretionary stock performance, and signs of
strength in industrials (financials rocked today led by JPMorgan).
The bear market isn't over, it's still early innings, but this bear market rally might surprise us just like the last one did (all indexes might retest their 200-day moving averages, but it will be volatile).
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