2013 DC Investment Forum: The latest DC strategies

Global outlook for DC investors
The message is positive on the global outlook for DC plan investors, according to Avery Shenfeld, managing director and chief economist at CIBC World Markets.

While he admitted that the pace of economic growth in the last few years was a “steady disappointment,” Shenfeld sees “a crack opening up in the door. The world may be in a better position to generate the economic growth we used to be used to, and that is coming in early 2014,” he said.

“Next year, we’re looking for global growth above 4% and above consensus forecasts—above what the IMF, for example, is looking for today,” he noted, adding that the environment will be characterized by accelerating expectations for U.S. growth as well as a further climb in long-term U.S. interest rates.

“Portfolios need to start thinking about shifting—over the course of the remainder of the year and particularly into early 2014—into the sectors that are going to get the boost from growth,” Shenfeld added. He explained which sectors of the S&P/TSX Composite Index are the most positively correlated with growth and the least negatively correlated with interest rates: energy, insurance, telecoms, base metals and media.

Areas that will no longer outperform are the sectors of the market whose values are a substitute for ultra-low bond yields—for example, real estate investment trusts (REITs) and dividend stocks. “REITs have been underperforming of late and will continue to do so, and dividend stocks have basically been only matching the market this year,” he added.

“Go for growth is the theme for 2014,” he concluded. “The clouds are lifting, and a whole new world is coming to you soon.”

DC Fixed Income Investing in a Low-rate Environment
The recent economic environment has posed challenges for fixed income investing. “Interest rates are likely to remain lower than historical levels, based on low inflation and low GDP growth, a lower ratio of borrowers to savers and potential imbalance from supply/ demand,“ said Patrick De Roy, an institutional portfolio manager with Pyramis Global Advisors. “As rates are now lower, the return expectations for fixed income need to be adjusted lower, because we are starting from a very low environment.”

With a bleak outlook for fixed income, what’s next? “In an environment where we see capital losses on fixed income, do we have to sell bonds to buy more equities for DC plans?” he asked.

Not necessarily. Looking at weak markets historically, De Roy indicated that, out of 24 years since 1929 in which stocks had negative returns, there were only two times that bonds had negative returns in the same particular year. “Bonds are still, and will be, a good diversifier for weak stock returns,” he added.

U.S. data from 1941 to 1981 show that, in a rising rate environment (during those years, rates went from 0.5% to 16%), bonds actually kept pace with stocks, with less volatility than stocks. “And we don’t think, going forward, we’ll have a market where rates will go from 0.5% to 16%,” De Roy noted. “Even if there is no huge increase in rates and even in a rising rate environment, bonds will do that job of protecting capital for the overall portfolio.”

With the current low rates, what fixed income options can help DC investors? De Roy offered four.

High-yield bonds – These bonds are not investment grade, but they will yield a higher coupon, so there will be protection in a rising rate environment, said De Roy.

Floating rate debt (leverage loans) – These are more “senior” than high yield in structure, and the coupon (or yield) is floating. In a rising rate environment, investors will have some protection because of that floating rate, he explained. Floating rate debt is also sensitive to economic growth, but, overall, it diversifies the fixed income portfolio.

Emerging market debt (EMD) – Typically, EMD offers higher yields than developed market investment-grade bonds. The percentage of developing countries that are investment grade is now 60%, said De Roy. “It’s another layer of diversification that you can have in your fixed income portfolio.”

Global bonds – These investment-grade bonds have access to a broader set of opportunities, he noted.

De Roy explained that, on a stand-alone basis, high-yield bonds, EMD or floating rate debt may be seen as more risky. But in a fixed income context, is it really about higher risk for higher return? “For high-yield bonds, floating rate debt and EMD, the additional yield is between 3% and 5% over what we see in the Canadian marketplace for Canadian bonds,” he said. “And also, in a rising rate environment, it’s protection for loss of capital on your fixed income—a way of leading to higher yield and potentially higher returns over time.”

DB-fying DC
The DB world has soaked up nontraditional assets for a number of years now. But according to Sadiq Adatia, chief investment officer and portfolio manager with Sun Life Global Investments, DC investors have to get in the game, too.

“When you look at it, what’s historically been a safe haven for a lot of people has been fixed income, but that egg has finally cracked,” said Adatia. DC plan sponsors should open up their portfolios to non-traditional asset classes—for example, EMD, high-yield bonds, infrastructure and REITs, he explained.

“They will not only diversify assets but also add additional returns in difficult times,” he added.

Adatia acknowledged the perception that these are risky asset classes. “They probably are if you think of them in isolation,” he said. “But don’t think of them in isolation: put them together in a total portfolio and look at them in that regard. By adding alternative asset classes, you’ll get pretty good outcomes.”

When implementing these nontraditional asset classes, Adatia said investors should be mindful of the following:

• governance;
• liquidity issues (in some cases); and
• higher fees for adding EMD and high yield, as they will increase costs.

Emergence of risk factor investing
In risk factor investing, every asset class comes with a different set of risk factors: economic, credit, liquidity or inflation risk, for example.

“If you invest across risk factors, you’re going to get diversification,” explained Vincent de Martel, managing director of global market strategies with BlackRock. “There will be good years, but, on average, you’re going to lose less money, and you’re going to earn a premium that’s more stable over time.”

When adding a new asset class, investors usually need to find out the expected return, risk and correlation to other asset classes in the portfolio. In a risk factor world, it’s much simpler, said de Martel. When adding asset classes, investors just need to check what exposure they have to the other risk factors and decide whether these exposures are the right amount. However, the challenge is that there isn’t an official list of risk factors—each money manager will have its own list.

While it’s not prevalent now, de Martel expects that a risk-based option will likely be available soon in many DC plans. “It’s definitely coming,” he said. “The logic of it is so obviously powerful that, at the end of the day, the market will recognize there is value in adopting this kind of approach for the long term.”

Risk Parity: Redefining Asset Allocation
Holding both equities and fixed income may make investors think they have a balanced portfolio—but nearly all the risk is on the equity side, because stocks tend to be more volatile. Trying to reduce volatility has led to the emergence of risk parity investing.

Most portfolios have a lot of equity risk, and money managers often try to diversify by investing in hedge funds or private equity. “Unfortunately, a lot of those elements tend to mimic equity risk,” explained Michael McHugh, client portfolio manager with Invesco Global Asset Allocation. “So what you’ve done is increased your optical diversification but not your effective diversification.”

Because common portfolio construction relies heavily on equity risk, these portfolios aren’t set up well for periods of macroeconomic shock, and they’re more susceptible to market declines, noted McHugh. Risk parity looks at ways to minimize these risks by building a portfolio that can deal with different economic environments.

While a risk parity portfolio will fall much less than a typical balanced portfolio during a market downturn, the gains won’t be as large when there’s a bull market in equities, McHugh explained. That’s the trade-off that plan sponsors have to make.

Non-traditional Index Funds
Smart beta is often characterized as a new way of investing—although what’s new is that it has only become popular recently. “Think of it as a hybrid of traditional active management and passive management,” explained Nicolas Richard, chief investment strategist with Desjardins Asset Management. Managers using smart beta will try to outperform the broader market, like traditional active managers, and also replicate an index, like passive managers. Richard said the main advantage of smart beta over active management is that the ongoing expenses are lower since active management, on average, doesn’t add much value after fees.

A smart beta approach is also more appealing than passive management, because traditional indexing strategies use market indexes that are weighted by market capitalization, he added. With that, there’s the risk that some indexes will concentrate risk in a sector, a small group of stocks or even a single stock. Nortel, for example, made up about one-third of the TSE 300 (now the S&P/TSX Composite Index) at its peak in 2000.

Smart beta can be very simple, such as the S&P 500 Equal Weight Index, where all 500 stocks are weighted equally instead of by market capitalization. “There are an endless number of ways you can build a smart beta portfolio, but what they have in common is, they all reject the notion of using market cap as a smart way to build long-term solutions,” Richard explained.

However, there are drawbacks. Sometimes, there will be a bias toward value and small cap equities that could lead to significant periods of underperformance. Also, plan members might not understand or accept smart beta, so education will be key.

Despite that, Richard believes smart beta strategies are here to stay. “They don’t have to replace everything you’ve done before, in terms of traditional management,” he added. “Instead, you could use smart beta to complement your existing program.”

Expert Panel: De-risking DC
DC plans are always looking for ways to de-risk, and an expert panel at the event offered possible strategies for plan sponsors and members. Target date funds (TDFs), better default options and increased savings were just a few of the options discussed.

TDFs make investing easier for plan members, as they likely aren’t disciplined enough to rebalance their portfolio on a quarterly basis, said Kin Chin, director and investment strategist with BlackRock. “The TDF, from a risk management perspective, removes the pressure from members to be their own chief investment officer and, as such, reduces the chance or the risk of them making bad investment decisions.”

Having a TDF as the default investment option, instead of a money market fund, is another way to de-risk, said Patrick De Roy, an institutional portfolio manager with Pyramis Global Advisors. “But we have to combine this with limiting the number of investment options, and forcing participants and members to contribute more and use those funds.”

Pat Leo, director, institutional business development, with Sun Life Global Investments, agreed that employees need to save more. Canadians aren’t putting away enough money for retirement—and this should concern plan sponsors as well. “Auto enrollment and auto escalation are two levers that can help address that,” he noted.

Martin Belanger, director of investments with Western University, provided examples of how its plan approaches de-risking. The university limits the number of investment options available to plan members; made a balanced fund with 70% equity its default option; added a low-volatility equity strategy to its largest equity investment option; added a commercial mortgage component to the bond fund to protect members in a rising interest rate environment; and forced members to increase their required contributions.

In addition, said Belanger, “we’ve hired an external provider of financial and pre-retirement planning to provide workshops to our employees.”