Faceoff: Asset allocation

Participants: Andrew Beer, manager of strategic investment planning, Investors Group, Dave Velanoff, CEO, MGI Financial.

Your philosophy?

Dave Velanoff: We don’t really have a philosophy. We broach asset allocation much further down the financial planning chain. Every client is different. We start off by meeting with the client and conduct a comprehensive needs analysis and then figure out what his or her needs are. A client in his or her late 40s, wanting to save for retirement, will have enough time to run through a few investment cycles, as opposed to an older client on the cusp of retirement.

We assess what’s right for our clients and then move them in the direction of the benchmark best suited for them. We analyze their current risk tolerance and objectives with the help of a questionnaire, which then provides us a benchmark for asset allocation.

Andrew Beer: Our approach to asset allocation is strategic. This approach focuses on long-term forecasting—the exact opposite of a tactical approach based on short-term forecasts.

We centre the process around dividing investments among different kinds of assets, such as stocks, bonds, mortgages, real estate — some instances even cash—in order to optimize a risk-reward trade-off based on each investor’s unique situation and long-term investment goals.

We are firm believers in having access to a variety of different markets, simply because in any given year you don’t know what the best or worst performer is going to be. By maintaining exposure to a number of different markets you’ll typically be exposed to the best-performing market. But when certain markets tumble you are never fully exposed to the worst-performing market, consequently your downside is mitigated.

Role of asset allocation

Velanoff: In portfolio management, it plays a big role. In the total financial planning picture, it’s but a component. We’re obviously big believers in asset management as a potential solution for a client. But we arrive at the correct asset allocation benchmark through an analysis of a client’s needs, objectives and risk tolerance.

We have to go with the bigger picture before we get to asset allocation. And the bigger picture for us is comprehensive financial and lifestyle planning. That means we look at objectives on the basis of what the client’s goals are. A goal could be something as simple as wanting five weeks of vacation a year; or putting kids through college in five years; or buying a cottage in the next three and retiring in 20. The risk tolerance and objectives for each of these goals vary widely.

Beer: Asset allocation plays an important role in that it eliminates an ongoing need to assess where the best area to invest might be.

Year after year, the worst-performing and best-performing markets are constantly changing and investors miss out if they jump on a particular market trend too late.

The year 2008 is an example: one of the best-performing markets that year was global bonds, which returned 35.8%, and one of the worst was Canadian small cap. Trend chasers would have considered it safer to move into cash or perhaps the safety of global bonds as equity markets continued their downside through the beginning of 2009. Unfortunately for them, by the end of 2009 global bonds were down 11.5% and Canadian small caps were up 75%.

Time horizons

Beer: For an asset allocation approach to work your investment has to be exposed to a number of different economic cycles, so you’re able to smooth out the market highs and lows. A minimum of 10 years and preferably longer is required to properly assess the success of an asset allocation strategy. Sometimes even a 10-year period is not long enough to effectively assess performance, especially when you encounter a recession such as we’ve just been through with its extreme negative effect on performance.

Velanoff: That again depends on individual clients. If they have a short time horizon, they go for a more conservative portfolio. With longer time horizons, we ask additional questions to determine how aggressive their portfolio can be—they might still have a low tolerance for risk. From a compliance- and risk-management perspective, if a client tells us clearly he or she would not like to lose much money in the downside, we have to manage their money conservatively.

Who benefits most?

Velanoff: The clients benefit most by undertaking a detailed evaluation of their financial situation, goals, objectives and risk tolerance in order to determine their appropriate asset allocation. Going through this process results in a much greater likelihood of not encountering any negative surprises down the road. On the whole, asset allocation and diversification do make sense for the vast majority of investors.

Beer: If you’re looking at less than three years, I don’t think they should be diversified at all. I think they should be parked in a money market fund or cash in order to preserve their capital. Beyond that, investors absolutely benefit! There’s so much danger in the marketplace if you aren’t properly diversified. I’ve seen countless situations where investors chasing returns were concentrated in a single market, and unfortunately the market collapsed.

Risk versus reward

Velanoff: The more the risk, the greater the potential for higher returns; but the potential of the downside is higher too. If you work within the efficient frontier—a somewhat controversial topic because everyone seems to build their own efficient frontier based on their own product lines—you might determine a particular client could end up rebalancing an account and actually get a better return on the portfolio by taking lesser risk.

Beer: To reduce risk, we limit exposure to any type of asset class. Typically we recommend no more than 20% of any asset class or mutual fund. The more narrowly defined funds with higher risk such as small cap funds, we’d limit to no more than 10%. We typically wouldn’t even recommend them for the more conservative clients. The same goes with emerging markets.

Rebalancing portfolios

Velanoff: Depending on how many clients you have, you really should meet with each once a year to review the financial plan and objectives. Mutual funds, in general, have a rebalancing requirement in order to meet their prospectus objectives. Now portfolio-managed solutions also are incorporating that so they can rebalance to meet the objectives of the portfolio. Rebalancing is a crucial element of portfolio management and client portfolios should be evaluated at least quarterly in order to determine if the portfolio has significantly deviated from its target asset allocation, and if so, the portfolio should be rebalanced to target. Rebalancing forces a client to buy low and sell high and over time should add value to portfolio returns.

Beer: Rebalancing should be part of an ongoing process. Investors should have an awareness of their portfolio at all times, but at the very least they should review their portfolio every 12 months. If exposure to an asset class moves beyond 3% to 4% of the original target, the portfolio should be rebalanced back to the original target allocation.

Has recession impacted asset allocation theory?

Beer: I don’t think so. Rising correlations in global equity markets may have led to some criticism about diversification not working when the global equity markets all came tumbling down at the same time. But even as most markets were melting down in 2008 and the beginning of 2009, bond markets held steady. Rather than believing asset allocation no longer has a role in investment planning, investors need to maintain a broader view of what it means to be diversified. Rather than focusing just on different types of equities, investors should include a wider range of securities in their investment plan.

Velanoff: Definitely not. Every recession psychologically impacts clients and advisors in the marketplace. The most experienced advisors expect a recession, know it occurs, know the markets melt down and then they go up. They manage and discuss those scenarios with clients before they happen. The most experienced and high-quality advisors tell their clients to expect severe downturns from time to time and upsides too. As long as you can ride the roller coaster, it historically always goes up. But you don’t want to jump off the roller coaster when it’s going down at 100 miles an hour. That unfortunately happens with clients who get scared and advisors who haven’t done the best job of coaching their clients.

Beer: It’s important to note that an asset allocation strategy won’t always eliminate losses but what it does is ensure your investment is not fully exposed to the full impact of the downside when markets come tumbling down.

What asset mix would you suggest this year?

Beer: That will depend on each individual investor and how comfortable they are with investment risk. Unless their investment objectives have changed, we highly recommend they stay the course and not alter their long-term investment plan. We aren’t going to change our approach to portfolio construction and we’ll continue to build customized diversified portfolios geared toward each investor’s unique financial goals. If an investor has a long-term horizon and they are comfortable with investment risk, we would suggest a portfolio heavier-weighted in a diversified basket of equity investments. For the more conservative investor, however, we would recommend a portfolio more exposed to fixed income type investments and less exposure to Canadian and Global equities.

Velanoff: My recommendation is for each client to stick to their long-term target asset allocation. We do not make bets on which asset classes will do well going forward. We deal with every client individually and work on his or her individual risk and objectives. We wouldn’t be projecting that equities are the way to go right now or the bond market is strong or the small caps have great potential. It’s all about what clients can stomach.

Beer: Right now there is a great deal of uncertainty with respect to where markets are headed, and no one knows for certain just how exactly things will play out. Market performance is cyclical, and the trick is not to get greedy.

Velanoff: The most important thing in our industry today is the value proposition an advisor offers—it isn’t simply about picking the right asset allocation model, or the right fund; it is much bigger than that. Today’s advisor needs to be a comprehensive planner who looks at a client’s tax position, financial planning objectives, mortgages, budgeting, estate planning. He needs to stop selling himself as someone who can get the best rate of return on a portfolio versus the other guy. Our role is much broader than that. Make your value proposition the quarterback of the financial affairs of the client with a portion of it the asset allocation model best suited for the client.