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2024 Q2 Investment Review

2024 Q2 Investment Review

Tactical Asset Allocation is an investment strategy that seeks to help control our natural human emotions as investors, such as fear and greed, and aims to address two large concerns for portfolio managers and retirement planners. In this issue of Innova Market Insights, we will dive into those motivators and this unique approach to investing money.

The Past Shapes our Outlook

I bought my first stocks in 1998, based on a ‘tip’ from one of my high school teachers. Later on, during my university years, I stumbled across an annual report by the Globe and Mail that listed Canada’s 50 fastest growing companies. For the next three years, I followed the companies on that list and bought shares in a few before the release of the next version of the Globe and Mail article. I made a good profit on this strategy, enough to finance my early travels around Europe! Seeing those results, my parents wanted to try one of my stock picks with a few hundred dollars of their own.

I distinctly remember how differently I approached choosing an investment for them, compared to the high flying picks I was making for myself, at that time. They had entrusted me with their savings and I felt the weight of that responsibility.

Later that year, they introduced me to their financial advisor who offered me a job. Following the completion of my licensing requirements, I began managing investments in late 2006.

At the time, a popular investment strategy was borrowing money to invest. The premise was simple; borrow at 5% and earn 7% by investing in banks and other stocks. A portion of the portfolio was withdrawn monthly for the loan payments and investors pocketed the difference. Tax savings were reinvested, leading to smooth sailing straight into retirement for clients!

However, the 2007-2008 Financial Crisis had other plans. Bank stocks dropped 20-30%, which significantly hampered the ability to breakeven for anyone drawing dollars from their portfolio monthly. With borrowed dollars on the line, I felt the weight of my responsibility to these clients.

Vowing to better understand the economic cycle, the investment markets, and my chosen vocation, I went back to school and completed a Master’s specializing in Finance, and obtained the Certified Financial Planner’s (CFP) and the Chartered Investment Manager’s (CIM) designations.

It was during these studies that I came across an often-overlooked risk that affects all retirees. Tactical asset allocation was an investment theory I vigorously studied to attenuate this risk, while ‘stacking the odds’ in favour of our clients reaching their goals.


Sequence of Return Risk

Fundamentally, financial advisors are in the business of providing our clients with peace of mind. By considering risks like disability, critical illness and premature death, and attenuating political, economic, or interest rate risk through investment diversification, or addressing longevity, inflationary, and solvency risks through retirement planning, we are focused on identifying risks to your financial well being and minimizing them.

Given my history with the markets, one such risk, known as the sequence of return risk, was a major cause of concern for me. This risk is best explained with a hypothetical example:

Consider two portfolios, A and B, each begin with $100,000 and aims to withdraw $7,000 per year. Both experience exactly the same returns over a 21-year period — only in inverse order.

Portfolio A has the bad luck of having a sequence of negative returns in its early years and the portfolio is completely depleted by year 13. 

Portfolio B, in stark contrast, scores a few positive returns in its early years and ends up two decades later with more than triple the assets with which it began.

Portfolio_AB.png

Source:https://moshemilevsky.com/wpcontent/uploads/2018/02/WHITEPAPER_2.pf

As you can see, the fluctuation of returns can have an enormous impact on the success of a retirement plan. Despite having earned the same rate of return over the same time-period, one investor has dollars for years to come while the other has emptied their savings. Controlling portfolio volatility and delivering a more consistent return profile greatly attenuates this risk, and so constructing a portfolio that would do just that became my obsession.

Here is another example that takes investors aback. In this hypothetical, an individual invests $100,000 and earns the following rate of return over six years, averaging 5% per year over the time period:

Table_1.png

At first glance, as investors, what would you estimate your $100,000 is worth after six years? The answer is often quite different than the positive territory we would expect to be in:

Table_2.png

As you can see, because of geometric returns, we have actually lost $5,881 over a six-year period, even though we averaged a positive 5% rate of return and our gains in good years were 10% better than our losses in bad years!

Beyond the sequence of return risk, another major risk brought by the highs and lows of the market weighed on me as well.

 

Beyond Stocks and Bonds

For the first decade of my career I worked exclusively with mutual funds, seeing these investment vehicles as a useful tool in executing my investment approach. Drawing from my Master’s research, my strategy focused on embracing the highs and lows of the investment market by increasing risk when markets were down and decreasing it following periods of strong returns. This tactical approach to investing seeks to reduce the volatility experienced by investors without sacrificing too much in the way of returns, producing a better risk-to-reward ratio.

As retail investment vehicles, mutual funds had two major drawbacks: high fees and a limited investment set of stocks and bonds. When markets were down, I would increase the stock exposure for clients by trading mutual funds inside client accounts, or vice versa when markets were up. With more than 100 households holding an average of four accounts each and each requiring verbal authorization to transact, tactical changes took several days to execute.

While attending a conference in 2016, where I met my co-founder and partner Cliff Richardson, one of the presenters shared the evolution of pension fund holdings over the past two decades. In the face of falling interest rates, large retirement schemes and endowments had to diversify beyond the pure fixed-income portfolios that were once so commonplace. The best example of this approach was the Yale Endowment Fund:

Over the past 30 years, Yale dramatically reduced the Endowment's dependence on domestic marketable securities by reallocating assets to nontraditional asset classes. In 1989, nearly three quarters of the Endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for less than one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent over nine-tenths of the Endowment.[1]

This knowledge hit me like a ton of bricks. I was in the business of helping clients retire without worrying about their money and I could only access what the world’s largest pension considered appropriate for a maximum 1/10 of their investment strategy! Thus began my evolution beyond stocks and bonds and into the world of alternatives.

Over the next three years, I obtained new licenses and changed investment dealers for  a more progressive firm that granted me access to more than just mutual funds. With these pieces in place, we could now diversify across commonplace alternative investment products such as real estate, infrastructure, long-term care, and private equity.

Along with overcoming the volatility of the stock markets, the Tactical Asset Allocation investment strategy also seeks to avoid another major pitfall that commonly derails a good investment plan: the client’s emotions!

The Human Factor

With more than 18 years each in working with clients, Cliff and I have grown to understand that in some cases, clients (and their emotions) are their own worst enemy. As the old Wall Street saying goes, “financial markets are driven by two powerful emotions: greed and fear”.

This tug of war is generally ballasted by a ‘balanced portfolio’ that holds stocks for growth and bonds for safety. Over the past five years, greed has been by far the dominant emotion on the markets with stock allocations now making up a larger percentage of household assets than at any other time since the 1960s, apart from the post-Covid bubble[2]. Fueled by near-zero interest rates and, more recently, the exuberance surrounding Artificial Intelligence, US stock market valuations as measured by the Price to Earnings ratio and the ‘Buffett Indicator’ have risen to historically alarming levels[3] [4].

Frequently, and unbelievably, this situation is when investors look to increase their risk levels, or at very least, do not rebalance back to appropriate levels. A healthy dose of FOMO (see: Fear of Missing Out) and comforted by recent history (see: Recency Bias), investors tend to stray from their long-term strategy in favour of short-term trends.

Table_3.png

As can be seen in the chart above, investors have a habit of selling (negative flows) when markets are low and buying (positive flows) when they are high. Not surprisingly, this trend has devastating implications for these investors. Emotions and biases are likely the largest threats to retirement plans, as a single ‘cut and run’ can debilitate years of careful planning.

Each market crash will be caused by a unique ‘Black Swan’ event that very few see coming, otherwise the market would have priced-in the risk. This unknowable and uncontrollable factor led famed investor, Sir John Templeton, to warn “The four most dangerous words in investing are, ’it’s different this time.’"

During the last market correction, caused by a once in a lifetime pandemic, staggering numbers of retirement focused investors sold ALL their equity holdings during the market troughs of 2020.

Cut_and_Run.png

What percentage of these investors bought back just in time for the fastest stock market rally of all time?[5] The impact of missing out on the recovery, especially when you are withdrawing regularly, compounded by the sequence of return risk discussed above, can derail even the best laid plans.

Table_4.png

For all these reasons, the primary purpose of Tactical Asset Allocation is controlling volatility. If your retirement portfolio does not swing as wildly as the markets, you are more likely to ‘stay the course’ and allow your portfolio to weather the storm, regardless of the cause.

Fee Transparency –Driving Real Value

Perhaps the greatest hot-button topic in investment circles is fees. According to a 2022 study, Canadians’ pay some of the highest investment fees in the world[6]. A 2020 survey found that more than half of Canadian investors did not know how much they paid. It’s no small wonder that Questrade’s commercials on fees have resonated with many.

Morningstar’s 2023 Global Investor Experience study showed that the average Canadian pays investment product fees, measured by the Management Expense Ratio (MER), of ~0.9%[7] for balanced funds. According to their website, Questrade portfolio fees or MERs, range from 0.17% to 0.35%[8], a huge improvement over the median on fees alone. At present, the MER of the Innova Tactical Pool sits at 0.27% and should continue to drop as the fund continues to grow and benefits from economies of scale.

In the wise words of Warren Buffett, “Price is what you pay. Value is what you get.” In an example of the pendulum moving a bit too far on the fee conversation, fees have become the only measuring stick used by some investors. Personally, I would gladly pay additional fees if that translated to a better risk or return outcome. Unfortunately, higher fees certainly do not correlate to better outcomes and so investors need to be careful and establish clear objectives before determining an appropriate investment policy and strategy.

We remain committed to helping our clients achieve Financial Peace of Mind, and to reach their investment objectives through providing fee leadership and transparency.

 

Summary

Tactical asset allocation is an investment strategy inspired in part by greed and fear. Greed encourages us to seek more than what has been available historically for investors, while fear motivates us to find a solution that would help our clients attenuate sequence of return and emotional risks.

Family, Health, and Wealth are among the three things that people consider to be the most important in their lives. As financial advisors, we recognize that we are stewards of one third of what people hold most dear and take that responsibility very seriously.

We acknowledge that it took a leap of faith for clients to trust us on this journey to building our own investment products and we would like to share our deepest appreciation with you. We will continue to work diligently to help you exceed your investment objectives – and we Thank You for your partnership.

 

[1] https://investments.yale.edu/about-the-yio

[2] https://realinvestmentadvice.com/household-equity-allocations-suggests-caution/

[3] https://www.reuters.com/markets/us/sp-500-breaches-5000-its-valuation-hits-lofty-levels-well-2024-02-08/

[4] https://finance.yahoo.com/news/warren-buffett-indicator-sounds-alarm-220009350.html

[5] https://www.cnbc.com/2020/06/03/this-is-the-greatest-50-day-rally-in-the-history-of-the-sp-500.html

[6] https://www.morningstar.com/lp/global-fund-investor-experience

[7] https://www.camberco.ca/news-articles/what-are-the-average-financial-advisor-fees-in-canada

[8] https://www.questrade.com/pricing/questwealth-portfolios-fees

This publication is for informational purposes only and shall not be construed to constitute any form of advice. The views expressed are those of the author alone. Opinions expressed are as of the date of this publication and are subject to change without notice and information has been compiled from sources believed to be reliable. This publication has been prepared for general circulation and without regard to the individual financial circumstances and objectives of persons who receive it. You should not act or rely on the information without seeking the advice of the appropriate professional.

 

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