Faceoff: Taming the tail

Telltale signs

The U.S. Federal Reserve has aggressively been expanding its balance sheet in recent years. This could manifest in much higher infation down the road. The Fed could unwind what it has done, but history suggests it’s a lot easier to inject monetary stimulus than withdraw it.

Besides, the U.S. government has been running deficits north of $1 trillionfor a while now. U.S. federal debt is near $16 trillion —roughly equal to its GDP. Historically, that’s the point you start getting worried. There’s a good chance we’ll see some combination of tax increases and spending cuts in 2013. But you have to be cognizant of the potential for inflationary impact. It’s a very real possibility.

Valuable lessons

The 2008 downturn reinforced the point that low probability events can happen. Lehman Brothers being allowed to go under would have seemed highly improbable, but it happened. The sharp deterioration in credit markets that followed seemed highly unlikely, but it happened and led to a vortex of declining asset prices.

Even if they’re not the most likely outcomes when you’re constructing a portfolio, you have to ask the “what if” questions. If you don’t like the answers, you’d better alter your portfolio construction accordingly.

Each market downturn has been sharply different. But the common denominators of the tech bubble, credit crisis, and housing overvaluation are that you need to maintain your discipline. When sectors or asset classes get overvalued, make sure your portfolio isn’t unduly vulnerable by not being overweight in these vulnerable sectors.

In a really difficult period you’ll see two categories of investors: Temporarily impaired: those invested in high-quality assets that are temporarily marked down but will recover.

Permanently impaired: those invested in lower-quality assets that may never recover.

If you’re in the former category, you’ll ultimately recoup, even if a black swan knocks you offside. The key is not just to survive, but to endure.

As active managers both on the equity and fixed-income fronts, we’re always monitoring our holdings with a view to outcomes that are probable, and those that aren’t.

Risk management

Asset allocation is the most important element of risk management. If there’s a material uptick in inflation, long-term bonds will prove a difficult place to be. You’d want to be underweight in long-dated bonds, especially governments.

Thirty years ago, 10-year government bond yields in Canada were in the mid-teens; today they’re at 1.75%.With yields no different than the rate of inflation, investors will generate modest income and maybe capital preservation. But that’s in sharp contrast to the high income and capital appreciation that bond markets have historically generated. Whether or not there’s a significant rise in inflation, the risk-reward relationship among bonds is not good right now.

Corporate bonds, on the other hand, will pay a higher income stream. And because they tend to be shorter duration, they’ll be less susceptible to the adverse impact of bond yields in the future.

In early 2010, we established a tactical overweight in gold bullion.That’s another good hedge against things really going off the rails. Given aggressive fiscal policies and monetary easing, it makes sense to have gold in most portfolios. It doesn’t generate income, and for that reason may not be ideal for all investors, but generally it’s a good idea in light of potential inflation, and has been beneficial to date.

The other big asset class to consider is equities. We’ve focused on large caps for several years. They provide fairly high levels of income, a tax advantage, and even more importantly these rising dividends provide an inflation hedge—in sharp contrast with bond coupons that don’t change. You really want to focus on companies with pricing power—the ability to increase prices, thereby increasing revenue and dividends.

Companies such as Tim Hortons or Shoppers Drug Mart tend to do well regardless of market circumstances because their products and services are always in demand. Resource companies such as Canadian Oil Sands or Suncor are also good hedges against inflation.Despite generally modest yields, they have good prospects both for increasing dividends and capital appreciation.

Overprotection

There is real risk in being too conservative. People believe they’re being conservative by not taking some market risk. But inflation risk is very real and constantly gnaws at your capital if you are predominantly in cash and fixed income investments. If you look at fund flows, particularly south of the border, you’ve had about $400 billion flow out of equity funds into bond funds in recent years as investors fought the last war, thinking they were protecting themselves. This won’t likely be advantageous in coming years. Don’t overly sacrifice potential returns for lowerprobability events. Learn to hedge against them.

Arthur Salzer, CEO and Chief Investment Officer, Northland Wealth management

Stance: Get real (estate)

The biggest impending risk will be to bond markets and the U.S. currency. Credit crises—and the ensuing deleveraging— typically lead to situations where the government has to print a lot of money to keep buying down the yield curve, or face the possibility of an extreme yield-curve spike.

As long as the doldrums of Europe are unresolved, the U.S. looks in relatively better shape. But once there’s resolution, the market will start focusing on the U.S. and its problems—soaring debt levels relative to assets. It could lead to a point where the bond market starts getting nervous. That’s when the problems begin. Everybody sees it coming, but no one can predict the timing.

We’ve been underweight in bonds for almost three years now. In the face of such massive deleveraging, rates will stay low for much longer. Look at Japan: they have low rates 20 years after the fact. After WorldWar II rates remained depressed for 15 years.

It wasn’t until the boomers came of age in the ’60s and became consumers that rates started going up again. Typically, for rates to rise, demand for borrowing needs to go up. But if governments keep adding massive debt, there could be a bond-market scare, leading to difficult times.

Even during the inflation of the ’70s, returns on bonds—on a nominal basis—were positive. Today, except for on-investment grade bonds, they aren’t even compensating for inflation.

Reap redundancy

You could buy tail insurance as a buffer against extremes, but in the case of drastic events it may not pay out. That’s why you should have investments within a portfolio with redundancy built in. You need assets that can survive that kind of tail risk and come out the other side.

I endorse the Yale pension model, which stresses direct investment in infrastructure and real estate. Market nuances, however, are best interpreted by local players. Take multi-family REITs. In Ontario, they hold less risk than commercial REITs because there are rent controls, and we haven’t added much to supply in the last 40 years. On the other hand, in a market like Texas where supply far exceeds demand, any downturn will impact vacancies and make it hard to service debts.

Bulletproof portfolios

I allocate between 20% and 25% to real estate; 10%-to-15% in private companies. Private companies are higher risk, of course, but we typically don’t focus on companies that are doing leveraged buyouts. They’re likely to fail during a downturn.

For public equity exposure, we focus on low-volatility, dividend growth companies: telcos like Bell, financials, and pipelines that can generate cash flow. Higher dividend-yield equities tend to go down less than the markets, so they’ve got lower beta than the market.

Utilities also protect portfolios. In a regulated market, there are only so many competitors, and rates are fixed regardless of market conditions.

That’s built-in insurance. You lose upside when you buy them, but your business risk on the downside is reduced dramatically.

American private multi-family and commercial REITs are attractive right now with highcap rates in the 8%-to-11% range. We’ve been putting a lot of emphasis in that area over the last 24-to-36 months.

We’ve invested in the high-yield U.S. market, and currency hedged it back to Canada. If there’s a problem in the U.S., the Canadian currency is sure to spike. Pipeline companies like Enbridge and public utilities are all great cash flow dividend payers, and attractive relative to longer-term government treasuries.

You want to invest in assets that are tangible and difficult to replace, for example, a pipeline, a power-generating company or apartment buildings.

In public markets, you can buy companies like SNC-Lavalin, which owns a large percentage of the 407 ETR in Toronto. If you’re going to drive it every day, you might as well own it too.

Kanupriya Vashisht is a Toronto-based financial writer.