With both stocks and bonds in freefall in 2022, it was a tough year for traditional 60/40 portfolios. David Picton, president and CEO of Picton Mahoney Asset Management (Picton Mahoney), and Robert Wilson, head of Picton Mahoney’s portfolio construction consultation service, agree that while the 60/40 model isn’t dead, pension funds must recognize and address some of its weaknesses.
PRESIDENT AND CEO,
PICTON MAHONEY ASSET MANAGEMENT
HEAD OF PORTFOLIO CONSTRUCTION CONSULTATION SERVICE,
PICTON MAHONEY ASSET MANAGEMENT
WHY HAS THIS ENVIRONMENT BEEN SO CHALLENGING FOR TRADITIONAL 60/40 PORTFOLIOS?
WILSON: Heading into 2022, we had stretched valuations across public markets, with elevated equity multiples, tight credit spreads and low interest rates. Those valuations ran headfirst into a macro backdrop of decelerating economic growth, high-inflation readings and a tightening monetary policy. That resulted in a recalibration of asset prices and large losses for investors holding a 60/40 portfolio.
PICTON: Smaller pension plans in particular discovered they had more interest rate exposure than they thought. This is a natural fallout from a 40-year bull market in bonds, which drove rates from their highs in the early 1980s down to the lows we saw in the last year or two. Now we’re in an environment where the inflation and interest rate pictures have changed dramatically.
Compounding the problem in recent years, many institutions moved their equity exposure out of the Canadian market and into global markets, including emerging markets. In doing so, they gave up the relative inflation protection Canada provides. The fact is our currency and resource-heavy equity market tend to hold up better than many others in an inflationary environment. Also, in the long run, our research shows that Canada is very correlated with a lot of emerging markets but demonstrates more stability than emerging markets at times when the global economy slows down.
WILSON: Today, the 60/40 strategy is an antiquated investing framework. Stocks and bonds should absolutely be a key component in almost every investor’s portfolio; however, plenty of academic and practitioner research shows that blending additional assets and strategies alongside those core building blocks can improve diversification. In addition, allocating dollars to different asset classes is a poor way to manage risk. It’s kind of like trying to figure out how tall someone is by measuring the length of their shadow. If you want to build a more precise portfolio, your framework should allocate risk, not dollars.
WHAT ARE SOME OF THE BIGGEST RISKS, INCLUDING UNINTENDED RISKS, IN CANADIAN PENSION PLANS?
WILSON: The two main sources of risk are longevity risk and investment risk. Within investments, the biggest risk I see is concentration risk, where too much of the portfolio depends on the direction of developed markets and interest rates. In portfolio construction, there’s a need for an allocation to assets that perform well during periods of higher inflation, such as commodities.
PICTON: Liquidity risk can be significant, too—especially for pension portfolios that moved into private equity and private debt late. Public markets reflect information quickly. There’s a lag in private markets, so some plans probably have unintended losses that haven’t been realized yet. In the past, private equity would pay distributions on earlier funds that would help fund capital calls on new funds. As markets have come down, those distributions have fallen, which presents a challenge for liquidity.
WHAT SHOULD PLANS CONSIDER BEFORE MOVING INTO PRIVATE EQUITY OR PRIVATE DEBT?
PICTON: Ask how much underlying stock, bond or interest rate beta you already have in the portfolio because moving into private equity or private debt amplifies those betas—then look for ways to offset that exposure or at least diversify some of it away. Also, there are different vintages of private equity and private debt tranches over time, and some of the best are found in the middle of recessionary environments. Keep in mind that new vintages of private equity and private debt might be intriguing, but continuous offerings may have valuation lags that do not properly reflect deteriorating underlying assets.
WILSON: It’s very important to understand the role private equity and private debt are meant to play in the portfolio. Generally, they’re a return amplifier that give you exposure to the same risks as on the portfolio’s traditional side but seek to deliver a better outcome from taking those risks. Because these vehicles are illiquid, it’s important to adjust their track records to reduce the bias from return smoothing and lagged betas. When you do that, you see that private assets provide a diversification benefit and an opportunity for active managers to add value. That said, these benefits might be less than expected, so be realistic with your expectations and make the necessary adjustments to the data you’re using to assess these strategies.
YOUR FIRM HAS BEEN IN THE HEDGE FUND AND ALTERNATIVE INVESTMENTS BUSINESS FOR ALMOST 20 YEARS. WHAT ENABLED YOUR STRATEGIES TO SUCCESSFULLY WEATHER THE STORMS OF 2008, 2020 AND 2022?
PICTON: Twenty years ago, many hedge funds weren’t well hedged. They had exposure to individual sectors or broad markets, and they made a lot of money when times were good. However, they ran into difficulties, especially around the global financial crisis in 2008. There’s more to being hedged than being long and short securities. Our firm understands the different market risks. We strive to build a diversifying return stream that’s differentiated from underlying markets and isn’t exposed to the beta in a major crash. We’ve come in and out of favour, but our strategies—whether it’s market neutral, long short equity or credit or 130/30—have all delivered on their mandates. We’ve got a pretty good pedigree of building diversifiers to traditional assets, and now to private equity and private debt assets.
WILSON: Picton Mahoney has built our reputation on how we manage through difficult markets. One of the great aspects about our style of investing is that when you enter challenging periods, dispersion in the market increases and the range of outcomes between winners and losers widens. That creates a very target-rich environment where we’re able to add a lot of value through thoughtful security selection. To build a resilient portfolio, you want to find assets or strategies that are going to outperform cash but don’t load up on the same underlying source of risk. That’s the portfolio that can perform well across a broad range of scenarios.
We’re proud to manage strategies that have provided this combination of performance and diversification through difficult markets because we understand that when we do this well, our clients are able to achieve their financial goals with greater certainty.