We won’t soon forget 2020.
This tumultuous year was characterized by a global pandemic, lockdowns around the world, spiking unemployment levels and business failures. Increasing political polarization in developed countries resulted in clashes between governments seeking to control COVID-19 and anti-mask factions, all amid a U.S. election, the results of which the sitting president continues to contest.
In the face of these economic and political headwinds, institutional investors experienced a dynamic and challenging investment environment. Here are four of the year’s defining features.
- Extreme equity market volatility
As of the end of the third quarter, year-to-date equity market returns varied by region. U.S. equities performed well year-to-date, with the Dow Jones industrial average breaking through 30,000 for the first time in November, and emerging market equities gained around two per cent. However, both Canadian and EAFE equities lost ground.
All equity markets corrected sharply in March and April in response to pandemic-induced economic shutdowns, and then rebounded sharply in May and June. At its lowest point in the correction, the S&P 500 index lost 34 per cent of its value from its peak in February. The S&P TSX composite index, which was also hit by a slump in oil prices, lost 37 per cent of its value over the same period.
Equity market volatility also spiked in March and April and remained elevated throughout the balance of the year. For example, volatility levels in the S&P 500 index, measured by the VIX, hit all-time highs in the spring (fluctuating between 65 and 85). They’ve currently settled in the 20 to 30 range, which is still elevated, relative to a pre-pandemic trading band in the 10 to 20 range.
- Falling bond yields
Bond yields dropped sharply at the time of the COVID-19 correction for two main reasons: a flight to quality increased demand for government bonds and central bank quantitative easing programs drove down government bond yields.
The 10-year government bond yield fell from a pre-crisis level of 1.70 per cent to 0.55 per cent in the second quarter. As of the end of the third quarter, it sits at 0.76 per cent. While corporate bond yields initially widened, they’ve since rebounded to close to their pre-pandemic levels. As a result, bond returns for the year have been quite strong, with the FTSE Canada universe bond index returning eight per cent through September, and the FTSE Canada long term overall bond index returning 11 per cent. The fall in long bond yields has eroded solvency levels in pension funds, driving many to near or below the minimum 85 per cent solvency threshold.
- Impacts on alternative asset classes
The market correction also negatively affected alternative asset classes, such as real estate, mortgages and infrastructure assets, as lockdowns impaired the income-generating capacities of these assets. The long-term impact on the real estate market may be the most serious, as long-term vacancy rates in certain types of properties — downtown office buildings and shopping centres — may permanently impair rental income levels, due to changes in business patterns. Because of the illiquid nature of the asset class, fund valuations may not immediately fully reflect these impairments.
- Benefits of inertia in defined contribution pension plans
DC plans often struggle to get members to review and realign their asset mix over time, as their risk tolerance changes. Target-date funds were introduced to address this concern, as they easily slot members into an asset mix strategy reasonable for their stage in life and adjust it over time, to reflect declining risk tolerance, as members approach retirement age.
However, plan sponsors worry members will react to a market crisis like retail investors, by selling an asset class that corrects to invest in more stable asset classes. This panic reaction hurts long-term portfolio performance. Based on discussions with DC recordkeepers and sponsors, we saw very limited movement in DC portfolios, and this inertia helped DC members in 2020. Investors in TDFs, in particular, benefited from portfolio managers rebalancing the portfolios, as equities corrected and later recovered, to maintain constant asset mix positioning.
Colin Ripsman is the founder of Elegant Investment Solutions. These views are those of the author and not necessarily those of the Canadian Investment Review.