Time to take on risk, managers say

(May 2008) Not only is it safe to get back into the markets, investors should have been systematically increasing their risk exposure for a couple of months now, according to the team that runs Franklin Templeton’s Quotential Portfolios. They have been overweighting their positions in equities and even moving more money into risky asset categories, like commercial-backed fixed income, in anticipation of a market rebound.

Brent Smith, chief investment officer of Fiduciary Trust Company and lead portfolio manager of the Quotential program, and his associate Steven Lingard, explained to about 200 advisors at a road show in Toronto that they believe a market recovery is imminent — particularly in the U.S. — and they have rebalanced their portfolios accordingly.

“If you think back two months, everybody was bearish on the market and that was the time we were actually adding to the portfolios,” said Lindgard, vice-president and director of research for Franklin Templeton managed investment solutions. “We’ve been ratcheting up the risk profile from a top-down asset mix perspective, and also ratcheting up the risk within the risk profile.”

His team uses tactical asset allocation, which means they will vary the weights within a predetermined asset allocation, depending on their outlook.

Using their Balanced Growth Portfolio as an example, which has a default 60% allocation to equities and 40% to fixed income, Smith and Lingard outlined that they are overweight on equities and underweight on fixed-income. Within fixed-income they have increased their holdings of riskier high-yield debt.

“We are overweight on equities versus fixed-income, but even though we have taken fixed-income down quite aggressively, we have allocated more to spread sectors like high-yield debt and commercial mortgage-backed securities. We think the riskier part of the fixed income sector will perform much better than government bonds,” Smith said. “Government bonds have really rallied significantly as part of a flight to safety. People aren’t buying U.S. treasury bonds because they think there is tremendous value there, because there isn’t any.”

Smith says this flight to safety has caused historically high spreads between the high-yield debt market and U.S. treasuries.

“Historically, the yield spread of commercial mortgage-backed securities is probably about 0.75% to 1% over government bonds — right now it’s about 4%,” he says. “We really lost a lot when they went from 75 to 400 basis points, but if they come back to normal, there is a huge amount of capital appreciation there. We do think there are still some issues with the crisis, but I think the worst is factored in.”

Smith says his California-based colleagues are in charge of the actual security selection in the asset category.

“They are telling us that they are kids in a candy store because there is so much value out there,” he says.

The Quotential team is also ramping up its exposure to global commercial real estate, another beaten-down asset class.

Lingard noted that the last time commercial real estate values dropped so dramatically was in the early 1990s; shortly after that drop the asset class had a massive two-year run-up in value of 47%.

“We’ve seen a similar retracement in commercial real estate today,” Lingard said. “Coming out of that recession, the asset class went up about 50% in a couple of years. For us it looks like an interesting time. I’m not going to promise you 47% return over the next two years — I don’t think the odds of that are high — but we do think the transit is likely to be much better in that market going forward.”

Smith believes the low U.S. dollar has made this a great time to invest in U.S. equities, because those companies are enjoying a competitive advantage.

“We’re starting to decrease our exposure to European equities,” Smith says. “The ECB is really fighting inflation. They are very different from the U.S. Federal Reserve. The U.S. Federal Reserve is very pro-growth. They want to stimulate the economy; they are way ahead of the ECB. Europe will pay the price eventually and we think that the European stocks and corporations will underperform in the years ahead.”

To emphasize this argument, Smith says investors should look at how the low greenback benefits certain companies based in the U.S. versus the E.U.

“The Euro is probably up 70% versus the U.S. dollar over the past five or six years. U.S. corporations have a huge competitive advantage today,” he says. “I use the example of saying if you’re Air Canada, and you want to buy some new aircraft, do you buy from Boeing or do you buy from Airbus? Air Canada can buy that aircraft 60% cheaper from Boeing than they could five years ago.”

Despite the dollar troubles though, Quotential remains neutral on the Canadian market. Smith does have concerns about its overdependence on commodities.

“The Canadian stock market is much more concentrated than it’s ever been. Take a look at the TSX stock market in 2000 and 2001. Nortel was 35% of the index. When Nortel rolled over, the market got hammered,” he says. “If oil and gas goes from $125 to $80, it doesn’t matter if you have 50 companies in the Canadian oil and gas market, they are all going to go down, and it will have a huge negative impact on the Canadian stock market. You have to be aware of the concentration risk in the Canadian marketplace, even though longer term we think it’s going to do quite well.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(05/16/08)

Mark Noble