If you’re going to be cautious, get paid

Market-timers who say they’ve found the bottom are just as likely to have the floor fall out from under them. Instead, investors should be looking at ways to maximize their earnings from more conservative investments, portfolio managers say.

One of the ironies of this bear market is that a flight to safety is not even a flight from returns. Indeed, the one asset class that has posted remarkable returns during the downturn is arguably the safest around: government bonds.

Take, for instance, the SEI Enhanced Global Bond fund. While many equity funds are happy to wear a loss of less than 5% as a badge of honour, this fund has had a year-to-date return of 34.73% and a three-month return of 15.6% during the worst of the downturn.

Those returns have been attained through prudent management of a portfolio of mainly government bonds, says Scott Gives, a senior portfolio manager with SEI Canada.

“What that particular fund focuses on is government bond exposure. There is no credit and there is no leverage in that particular fund,” he says. “Government [bond] funds have benefited and anything that is not government [issued] has suffered.”

In particular, the American dollar has driven a lot of returns. The currency that was so maligned earlier this year has staged a remarkable comeback.

“I think that anything that has not been denominated in the U.S. dollar has suffered,” Gives says. “The flight to quality on the American dollar has been quite prevalent.”

Jumping on the currency bandwagon would be market-timing — and probably ill-timed at that. Gives says the success of SEI’s well-diversified bond fund not only provides the safety of income, but outsized returns in a down market, which highlights how important it is for investors to build diversified hedges in their portfolio.

“Diversified strategies, like the use of global bonds in a portfolio, have done well,” he says. “Given what’s gone on in the equity markets, it’s important to have the diversifiers. Investors need to look at having risk-controlled solutions and trying to match the risk profile of the client with that of the investments.”

It’s critical to maintain appropriate asset weightings in a portfolio. Clancy Ethans, the chief investment officer at Richardson Partners Financial, notes that the market has likely decimated most equity allocations; however, he says the market is too uncertain for most clients to take an aggressive equity stance right now. Instead, he’s advocating that clients employ an investment strategy where they get paid to wait.

The investor flight to safety has pretty much damaged every asset class apart from government bonds. It’s left a lot of conservative investments, like blue-chip dividend stocks, preferred shares and corporate bonds undervalued, Ethans says.

“We would encourage people to get back to their proper asset allocation. That’s not to say you should take a more aggressive allocation than you had going into this,” he says. “If you’re going to put your asset allocation back to where it should be, [I] recommend that you have a conservative portfolio until we’re all sure the bottom is in place. When the market does come back, you’re going to get a bounce in the things that have been hit hard.”

On corporate bonds, Ethans and his colleague, Andy MacLean, director of private client investing, note in their latest MarketPoint report that corporate bond spreads are the highest they have been since the Great Depression, yet an economic crisis worse than the Depression would have to occur for the implied default rates to materialize.

The corporate bond fears have had a spillover effect into devaluing quality preferred shares, Ethans says.

“The BAA-corporate bond spread in the United States is 620 bps over treasuries. That is an extremely high yield that is probably warranted for some companies, like General Motors. It’s not warranted for a number of high quality companies,” he says. He recommends preferred shares of companies like RBC, Bank of Nova Scotia, Enbridge, Great-West Life and Power Corporation. “These companies are long-term companies that will remain a going concern. When confidence comes back, these will also come back.”

Of course, the equity bounce on preferreds will not be as high as common shares in the case of a turnaround.

“They will never participate in the upside to the extent common equity will. You’ll never get the same capital appreciation that you will in common equity. The problem is common equity could bounce around for some time,” he says. “That’s why we’re saying, if you’re not going into a sustainable rally for a while, why not get paid to wait around in some other things where you get a heck of a nice dividend yield?”

For a little more risk premium, a nice dividend with upside share price potential can be gleaned from dividend-paying shares.

“Things like Manulife and Great-West Life — we think their dividends are quite safe. We’ve liked Royal Bank, TD and Bank of Nova Scotia,” he says. “You have to be careful. Don’t go out and buy the highest dividend — you do need to make sure that the company you buy from has a dividend that is well protected.”

(11/27/08)