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Saturday, March 25, 2017 10:17
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DOUG By Guest Blogger Doug Rowat

Building a portfolio is a bit like putting together a puzzle: each small piece plays a role in creating an overall coherent picture.

Performance, of course, is only a part of the final picture. If all our clients had cast-iron stomachs we’d throw 100% of their assets into US small-cap stocks, which have pretty much had the market’s best long-term returns, and be done with it. But, naturally, it’s also about controlling risk. There’s no point in building an aggressive portfolio if every time there’s volatility the strategy is abandoned. Therefore a smooth journey becomes equally as important as a high-returning one.

Which brings me back to puzzle pieces.

Portfolio managers are wrong—a lot. So, while it’s important to build a forecast and position portfolios in a way that supports this outlook, it’s also important to guard against the fact that often the forecast will be incorrect. With this in mind, let’s consider a ‘Japan equity’ puzzle piece.

2015: TSX Composite returns Vs Nikkei 225: When oil is weak, Japan serves a Purpose

Source: Bloomberg, Turner Investments

On the surface, the Japanese market seems dismal: the average Japanese citizen is comparatively ancient, the Japanese economy has spent much of the past eight years mired in recession and, long term, the country’s equity market has been the virtual definition of underperformer.

However, we hold a small amount of Japan in our client portfolios. Why? First, we never underestimate central bank power and the asset-purchase programs enacted by the Bank of Japan have, more recently, strongly supported Japanese equity markets (the Nikkei 225 is up 16% annually over the past five years, for example). But secondly, and more importantly, we are aware of how the Japanese market has behaved historically. For a variety of reasons, including Japan’s dependency on oil imports, the Japanese equity market tends to have a negative correlation to the oil price (-0.38 over the past 10 years) and therefore acts as a useful hedge against weakness in our own Canadian equity market. This is one reason why the Nikkei 225 appreciated 9% in 2015 while the S&P/TSX Composite dropped 11%. So, when it comes to smoothing equity returns, Japan did its job. In other words, it was a small but stabilizing piece of our global equity puzzle.

However, global equity markets are still generally positively correlated, so to even more effectively control risk, it becomes necessary to own offsetting asset classes. Briefly, there are two major forms of equity risk: systematic and non-systematic. Systematic risk refers to market risk. For example, the 2008–2009 financial crisis more or less indiscriminately dragged down all stocks. Unsystematic risk refers only to company-specific risk. For example, Enron went bankrupt because management was fraudulent. Unsystematic risk can be eliminated through diversification, but systematic risk cannot be. Therefore, when the overall equity ‘system’ is failing, you can’t look to other equities to meaningfully control portfolio volatility. You need an entirely different asset class—usually bonds—to stabilize returns.

We all know the basic rationale for holding bonds—they provide safety and tend to be negatively correlated to equities. However, the beauty of bonds is that they also have a certain amount of ‘flex’. That is, when equity markets are under stress, the negative correlation increases. If bonds constantly maintained a high negative correlation to equities then they would likely only act as a permanent and unproductive drag on performance. We don’t want this. We want bonds to transition only occasionally to higher levels of negative correlation. And indeed this is often how they work, as the chart below showing the ROLLING correlation between the broad US bond market (Barclays US Aggregate Bond Index) and the broad US equity market (the S&P 500) indicates. Notice how the negative correlation between bonds and equities increases during times of equity market stress.

Rolling Correlation: Barclays US Aggregate Bond Index

vs S&P 500

Source: Bloomberg. Red=Negative Correlation

So when we consider a specific bond ETF for our clients’ portfolios we often examine rolling correlations to assess how effectively it might control risk. And sometimes it’s useful to include bonds that more frequently have positive correlations to equities. To parallel bonds with hockey: it doesn’t help your team win if your defensemen never leave their own zone. We want defensemen who occasionally try to score. So, more puzzle pieces get added and matched together. Perhaps we add a bond ETF that acts more like Bobby Orr to offset one that acts like Doug Harvey (if you’re of that particular generation). And so it goes, one puzzle piece at a time.

Building a portfolio is really just a careful process of hedging risk to get the best return possible.

The objective being to create the most efficient portfolio: one that controls volatility while sacrificing only the minimum of expected performance.

It can be painstaking work, but one strategic puzzle piece at a time and suddenly the bigger picture reveals itself.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.


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