Tackling tough markets

At the best of times, portfolio management is a balancing act: managers must stick to their mandates while remaining flexible.

This is especially important when markets are hard to read—as they are now. Over the summer and into the fall, experts have pointed to the mismatch between market fundamentals and performance. As well, currencies may be overvalued and economic outlooks too bright, especially considering housing risks and rising rates across North America.

With all that to account for, portfolio managers face difficult decisions. “A lot of managers are at the upper boundaries of their cash positions right now due to uncertainty and [because they want to] hedge against day-to-day movements,” says Ron Schwarz, an independent portfolio manager in Toronto. Under such conditions, managers who want to stay on mandate can start by monitoring portfolio risk.

Walter Posiewko, senior portfolio manager, global fixed income and currencies at RBC, does so on a monthly basis, but says more frequent reviews are necessary when markets shift dramatically. “We have thresholds to make moves in the portfolio if certain spreads or prices are met. We’ll call an immediate huddle if, let’s say, energy bonds have just fallen out of bed and they’re really cheap. If people are selling them, is it worth adding to our portfolio?”

When he expects extreme moves, he exercises restraint. “If you think there’s going to be a violent reaction to a market event, then thresholds don’t mean anything because they’ll just get blown,” he says. Rather than reset the thresholds right away, he finds it’s best to wait and see.

We asked Schwarz, Posiewko and other managers to share how they protect portfolios when markets are unpredictable and economic crises might be looming.

Strategic positioning and cash

When risk runs high, even rebalancing and resetting cash targets can be challenging—let alone employing complex strategies.

To help offset risk, Schwarz is mainly adjusting the weightings of specific names in his portfolio along with his cash balance—to a point. He caps cash at 20%, saying, “while exceeding that level could be a great hedge, you give up opportunity.”

Veronika Hirsch, senior portfolio manager with Arrow Capital Management in Toronto, also adjusts cash levels to deal with market movements, as well as seasonal trends. For the latter, she’s able to plan ahead. “Usually August is weak and September is flat, and then you start to have a rebound in October. Generally, I always raise cash ahead of the seasonality.” In September, two of her funds were between 10% and 20% cash, compared to her typical low of 5%.

Hirsch cautions, “You don’t want to be sitting outside the market when it makes a fresh high every day, but there’s a lot of risk these days.” Conversely, if your cash level is too low, you could miss out on buying opportunities.

She also watches her sector exposures. She invests across North America, with about 30% of her exposure in the U.S. “If I have a big technology position, I balance my portfolio by having some representation of consumer stocks, which generally act more defensively,” says Hirsch.

“I try not to have a heavy weighting in two or three high-beta sectors,” she adds. As a result, the high-beta sector she’s chosen to focus on for 2017 is information technology; she’s been underweight volatile oil stocks.

Yet the energy sector’s poor performance in 2017 has been a positive for Felix Narhi—much to his surprise. As a portfolio manager at PenderFund Capital Management in Vancouver, he mainly focuses on looking for long-term opportunities and undervalued gems. He typically avoids the oil and resources space due to its volatile and cyclical nature, but found opportunities over the last year. “It’s a cheap sector right now,” says Narhi.

In all market environments, Narhi’s mandate across all funds is to buy and sell at price extremes. He explains, “If we can find investments that make sense, that are better than cash and that we have high conviction [about], then we can go all the way to 0% cash.” He tends to hold between 0% and 40% cash.

He, too, sees holding cash as a way to protect his portfolio and gain flexibility. “Right now, there are certain mandates that have close to 30% cash and others that are almost fully invested,” says Narhi. As of mid-September, his fund that’s invested primarily in U.S. and Canadian equities was sitting at close to 24% cash.

To react or not to react

Successful portfolio management depends on much more than knowing what to buy. Managers must also know when and why to show restraint.

As a fixed income manager, Posiewko treats short-term income portfolios and larger, broader portfolios differently. Consider that “a short-term income portfolio will have a maximum duration, a maximum term it can invest in and will typically be tasked with investing only in short-term bonds (with some exceptions),” he says. In contrast, “The other type of portfolio will be mandated to buy anything along the yield curve, will typically have a higher duration, and a wider scope of permissible investments,” says Posiewko.

Both types of portfolios require daily monitoring, he explains, but have different overall strategies. “If you have an income portfolio that is nothing but short-term bonds, then you’ve got to be much more strategic,” says Posiewko. For portfolios with a longer-term focus, he adds, you still have to keep an eye on markets, “but you may not have to jump the gun on [trends] immediately.”

When the Bank of Canada took a hawkish turn in mid-June, for instance, Posiewko “immediately resorted to a more defensive strategy by cutting back on duration, increasing cash [and] setting up [my short-term] portfolio [to] mitigate the risk of higher interest rates.” But he didn’t touch his long-term portfolio.

That wasn’t even a “panic situation,” he acknowledges. If rates were rising very quickly, “I would be building up more aggressive cash positions, and I would be more aggressively selling some bonds that are most vulnerable.” But he wouldn’t go to 100% cash, he says.

Posiewko’s typical cash minimum is 0% and his maximum is 10%. Plus, “there’s usually a minimum and maximum duration in the investment mandate that ranges around its benchmark, plus or minus a year or two.” In a defensive market environment, both his short- and long-term funds can have cash levels of 10% and, says Posiewko, “they’ll also be short duration relative to their benchmark.”

Possible protective plays

Even while you stick to your mandate, there are tactics to consider if you want to fortify your portfolio—so long as you understand the risks.

Hirsch has turned to gold for defence, for example. Starting in summer 2017, she bought bullion ETFs as opposed to gold stocks. “If the market were to have a substantial correction, gold could still act counter to that. I sold gold stocks into the rally we had but I bought bullion ETFs.”

If you hold foreign investments and are worried about currency volatility, Posiewko suggests managing risk through active currency overlays. These are “tactical positions a portfolio manager will take to hedge an asset that moves in some kind of pattern with currencies. If a fund holds U.S. dollar high-yield bonds, for example, their price movements will typically move in tandem with the greenback.” As a result, “to hedge these bonds, the manager would sell currency contracts to hedge against the prospect of these bonds losing value,” he explains.

Another challenge is some firms require managers to be invested in all, or most, sectors at all times, says Schwarz. If you’re in this situation and markets are unpredictable, he suggests dropping to your minimum weightings and only owning the companies that best meet your mandate criteria. For him, that means companies with the best balance sheets and management teams, low debt levels and strong margins.

As for derivatives, says Schwarz, “You can use options, but that can be costly due to the cost and premiums built into those,” he adds, noting he wasn’t allowed to use them in the past and doesn’t like to nowadays.

Shorting is an option, but timing can be tough, says Hirsch. “I can short in both of my funds, but it’s been tricky the last little while.” For instance, “I’ll short QQQ [a Nasdaq-tracking ETF in the U.S.] because it has reasonably high beta and it’s a go-to for me as a trading play. I also short XIU, which is the Canadian markets. And sometimes, depending how I feel about each sector and if there is a good liquid sector ETF, I might short that as well.” Hirsch may also short stocks.

Then there are leveraged ETFs, says Schwarz. He warns, however, that for some, “you only want to hold for a couple days at most because the volatility of those can come back to hurt you very quickly. You need to understand the underlying components of those ETFs.”

The main message? Turning to more complex hedging strategies may not be the best move, especially if they’re unfamiliar.

Dealing with tough markets, and getting low returns to boot, can be frustrating. But stepping outside your mandate isn’t the answer. Instead, make measured moves that are within your expertise.

Today’s common investment theses

Even bottom-up managers can’t ignore macro issues. Portfolio managers share how they’re accounting for potential market crises.

A potential housing crash

In the Toronto and Vancouver housing markets, the main theme is demand due to the “continued migration of populations into those city centers,” says Greg Vorwaller, president of mortgage lender Trez Capital. He oversees portfolios with exposure to Canada and the U.S.; mortgage terms range from six to 36 months, with the average maturity being 18 months.

To assess where to invest in real estate, he projects performance for the Canadian and U.S. markets for the next five years, and compares them to their global peers. To date, Vorwaller is confident in real estate due to “the moderate growth that’s being experienced both in the U.S. and in Canada.” When asked how he’s preparing for a future housing crash, he says, “We don’t see signs of inordinate risk.”

Walter Posiewko of RBC is less sanguine. He points out a strong correction would dampen consumer sentiment, employment and financial sector performance. But he’d still buy banks: “You can’t really stay in the corporate market in Canada without being involved with banks [and] the financial sector. So it [wouldn’t] mean that we’[d] going to start cutting back banks, which are well-capitalized.” In fact, he’d be more likely to buy banks as the market overreacted, depending on the correction’s severity.

If she saw a pending housing correction, Arrow Capital’s Veronika Hirsch would likely short CIBC. Why? “They have more mortgage loans relative to assets than the other banks, and Commerce has been gaining market share in the mortgage business. A lot of those mortgages were put on in recent years later in the cycle, meaning they may not have as much cushion as the other banks,” she says.

Another strategy is owning banks with good RoE and dividend growth, and those with U.S. exposure, says portfolio manager Ron Schwarz. “Would I be overweight banks? No. But would I be zero on banks? That would be too big of a bet.” Still, he’d prepare for prices to cool and the supply-demand balance to shift.

Rising rate pressure

From an equities perspective, rate movements aren’t always a major concern, says Hirsch. While she holds dividend growers and issuers, she says, “My portfolio generally would be below average in terms of dividend yield.” Why? She’s looking for growth. “The average company that’s growing its earnings, by acquisition or organically, needs cash flow to invest, grow or boost R&D, so they’re not heavy dividend payers.”

Still, equities managers should know that “if investors got spooked because a central bank is tightening too quickly, that would discombobulate the whole market, with high-yield stocks suffering,” she adds.

For fixed income managers, it’s a different story. When an event occurs like the BoC unexpectedly hinting at a rate hike, says Posiewko, “you notice that the first thing affected is short-term interest rates, which impact short-term income or short maturity bonds.”

He reacts by evaluating his exposure and considering whether to sell or hedge. “In an environment where interest rates are going up or policy is tightening, then all the short-term assets on your book are going to be vulnerable to a loss of valuation or capital.” One option is to build up more cash as well as more exposure to good-quality, investment-grade credit.

Low growth for longer

Low growth has weighed on global economies for years. Even so, “I would discount any kind of projections that go much further than two years out,” says Posiewko.

However, if growth were likely to be weak for the next six months or longer, he’d look at what it means “for central bank policy, and for the credit cycle and the interest rate cycle.”

As for how to respond, “You might want to buy more government bonds, sell more credit bonds and reduce your cash,” says Posiewko. “You may also want to cut back on emerging market debt exposure if you’re thinking that the overall global economy is going to weaken.”

Demographic shifts

Figuring out how labour markets and consumer trends will change over the next few decades is nearly impossible. One reason, says Hirsch, is that government policies can change how trends play out. For instance, one may think that an aging population means drug stocks will soar in future, but future healthcare policy could mute the demographic effect.

Nonetheless, you can still bank on the boomers affecting markets, even if you’re a predominantly GARP-focused manager like Schwarz. “I look at the demographics shift and at the retirement residence real estate space,” he says, adding that he sometimes incorporates thematic plays. As well, “The other side of the barbell would be millennials. I think about what the next generation is doing and how they’re living; that can be related to everything being done on a smartphone versus in person.”