Push clients toward equities

Clients have earned virtually nothing during the past three to four years on their cash and short-term bond investments, notes Michael Jones, founder and CIO of RiverFront Investment Group in Richmond, Va. in a talk at the Investment Management Consultants Association’s conference in National Harbor, Md.

To add insult to injury, prices have gone up 14%-to-15% in the same period. “A big chunk of their portfolios aren’t keeping pace with the rising cost of living,” he says.

Yet, clients continue to buy fixed-income because coupon payments are comforting and predictable. And those same investors continue to “redeem out of equity in droves,” says Jones, because they’re scared of stocks after 2008’s crash.

As a result, boomers in particular put their retirement income at risk of “death by a thousand cuts.”

Joel Clark, managing partner at KJ Harrison in Toronto, says boomers face a tripartite threat.

“Interest rates are low, the stock market is volatile, and inflation is strong,” he says.

“So you have a triple whammy of issues making it hard for someone in retirement who doesn’t have a pension to generate some safe income. The impact of the financial crisis of 2008-2009 is financial repression; hence, you’re killing the savers.”

Those savers, then, must put more money into instruments that will generate returns higher than inflation—equities. Yet many find that unpalatable.

How do you persuade them?

Getting comfortable

The first thing to explain: “There is no risk-free asset,” says Jones.

Phaby Utomo, executive director and senior private wealth manager at UBS Wealth Management in Toronto, agrees.

“Traditionally, people think of sovereign debt as being risk-free,” she says.

“But even certain countries have defaulted; Argentina did it in 2011. Recently, investors in Greek government bonds got back around 30% of their original investments.”

So, Scott McKenzie, regional vice-president and general manager at T.E.

Wealth in Toronto, encourages his clients (primarily those in or near retirement) to consider a higher equity allocation. To do so, he uses this real-life example.

“A former colleague’s wife was a teacher,” he says. “While she was working, salaries were frozen, yet the retirees had a fully inflation indexed pension. So people who’d been retired for 15 years were now making more from their pensions than people who were working.”

That story usually shocks clients into realizing the effects of inflation.

Most of McKenzie’s clients then ask if their bond allocations should match their ages (the traditional standard). He steers them away from this approach, and encourages them to remain at a 60% equities, 40% fixed-income split, even into retirement.

“You still need to have money growing in order to keep up with your lifestyle, especially when you start tacking on 2% or 3% to the required return every year [to account for inflation],” he says.

“Also, if you’re invested in bonds you’re going to lose half in tax.”

To increase clients’ comfort level with that allocation, McKenzie demonstrates how the liquid portions of their portfolios can sustain them.

“If markets are going down, you still have 40% of your portfolio to draw from in the meantime. When markets rise, you can sell high. [That helps them] buy into the fact that they need to have money growing, not sitting still.”

As clients pass 65, their portfolios stay close to 60/40. McKenzie only ratchets down equities if someone needs more cash flow. And if a client wants her investments to fund an inheritance, McKenzie may recommend an equity allocation that’s higher than 60% since the time horizon is longer.

Even if clients see the logic behind higher equity allocations, they may not be able to stomach market swings.

Jones puts it this way: Stocks are well priced right now, in some cases a bargain, so history would suggest they’re almost certain to make money over the next five years. “But they’re going to put you through hell.”

This is a good entry point, he adds, because stocks are “about 20% below the longterm trend” and because “historically, during periods which begin with [valuations that are] 20% below the long-term trend, investors have made money relative to inflation.”

This has happened 95% of the time during the five years following a large value drop—even in the Great Depression. Stocks are only inexpensive because there’s something to be worried about. “Every period that’s been this cheap was also extremely volatile.”

Returns by the numbers
Scott McKenzie, a vice-president at T.E.Wealth in Toronto, uses this rough calculation to demonstrate the effects of inflation and taxes on bonds.
Bond return	4%
Less taxes	2%
Less inflation	2%
Real return	0%
Equity return	8%
Less taxes*	2% (25% of gain)
Less inflation	2%
Real return	4%
*Assuming the equity is sold (all returns rates are estimates)

To keep clients on an even keel, Clark relates required returns to goals, not market events. “If a client has $1 million and needs [annual income of] $50,000, that’s a 5% return,” he says.

“I’ll say, ‘If you want to go into a Government of Canada bond, that’s 2%, and below what you need.’ Relate the portfolio construction to the growth and objectives of the client.”

McKenzie “does a lot of handholding. We tell them, ‘You are going to see some swings.’”

His firm is also a discretionary manager, so he pulls out the investment policy statement and refers to it during discussions.

“We say, ‘Have your circumstances changed?’ Generally, [clients say] their goals haven’t changed, or what has changed is we’re in a bad spot in the market. That gives them clarity.”

He also brings the discussion back to fundamentals, asking clients, “Do you believe Coca-Cola or Shell will stick around? You’re buying a little piece of those companies. [What happens] this year or next doesn’t really mean much for what they will do over the next ten years.”

Finally, he frames the current market as a buying opportunity. As a result, about 95% of his clients stick to their allocations, and hang on to their stocks.

What to buy

Once clients are fully on board, what do you buy?

Jones’s typical portfolios are “60% stocks that look a bit like bonds (high yield), 25% bonds that look a bit like stocks (high dividends).” The remainder’s in cash.

He’s been bulking up on lower-volatility stocks that will perform well over the long term but have been left behind, so far, by the market. And in his bond portfolio, he has a lot of high-yield and emerging-markets sovereigns.

Utomo also looks to nontraditional fixed-income.

“High-yield bonds are currently paying about 7%-to-8%, which offers considerable premium above investment-grade corporate bonds,” she says.

On the equities side, dividend-paying stocks are the most bond-like, says Jones. “I’ve studied all kinds of asset classes, and the most stable relative to inflation is the dividend off of stock.”

McKenzie uses “direct investment in stock and bonds, pooled funds and ETFs. We’re looking to keep the costs down as much as possible” because they eat returns.

Utomo suggests preferred shares, but cautions investors to get into the right kind. There are two: perpetual, which have stable rates; and variable, where rates reset every five years.

“In a rising-interest-rate environment, the perpetual preferred shares could be hurt more than variable.”

For her clients, all of whom are wealthy, she also considers a structured strategy called barrier reverse convertibles, which uses derivatives.

The strategy links a coupon to an underlying equity index—the TSX, for example. This structure pays a guaranteed coupon and is linked to the performance of the index. It also provides a conditional downside protection down to the barrier level, typically 20%-to-30% below the current market value.

If the TSX falls below the barrier, the client then gets exposure to the performance of the underlying index. But if the barrier is not breached, the principal is fully returned.

“It’s worked well for clients who want to replace some of their equity exposure,” Utomo says. “This is a satellite strategy to help them achieve a more steady return. At the same time, they build in a conditional downside protection through the volatile times.”

And downside protection is what clients will need if they stay in bonds.

“Bonds are going to go from the best investment over the last 30 years to probably the worst investment for the next 20 years,” Clark says. “It’s just going to be horrible.”