Betting on Global Sectors

967563_flagsFocusing on equity, Canada provides rich opportunities across energy, materials and financial sectors but limited exposure to other sectors. Canadian investors can use the global equity allocation to specifically target those sectors that are underweight in Canada. Though Canadian equity is highly volatile, the volatility of the overall equity portfolio is somewhat mitigated by international equities. Constructing the international portfolio with a sector focus may achieve better risk reduction benefits than a traditional (market capitalization weighted) international allocation. Additionally, investors who want to make a bet in a sector which is only modestly represented in Canada should consider implementation through a global allocation.

For example, when expecting an economic contraction, a Canadian investor may systematically increase his allocation to countercyclical sectors such as consumer staples, healthcare, and utilities.  Limited to Canada, that investment portfolio would hold only a couple of dozen stocks across a few industries; a global portfolio accesses hundreds of stocks across a couple of dozen industries, better capturing the intended investment strategy.

The equity allocation is a growth engine for many portfolios.  Investors in Asia and Latin America question whether there will be material growth in developed markets in the future. While the developed world continues to grow modestly, the overall fundamentals are more attractive in emerging and frontier markets. Emerging markets include countries such as Brazil and China, and frontier markets that are the next wave of developing economies, for example, Kenya and Indonesia. The population and GDP growth of these countries far exceeds that of the developed world. Increasing internal demand is being fueled by a rising middle class and export growth is being driven by developed markets’ desire for goods and services.

Canadian pension plans overall are underweight emerging markets, and have not yet materially entered the frontier markets. As such, Canadians should consider investing some portion of the global equity portfolio in emerging and frontier markets.

Turning to the bond portfolio, there is a strong rationale for maintaining the majority of fixed income investments in Canada, particularly for plans following a liability relative strategy.

However, there are two compelling reasons to invest abroad: yield and alpha.

To increase yield, Canadians need to look beyond Canadian corporate debt and consider high yield, leveraged loans, and emerging market bonds. A modest allocation to these sectors can have little incremental risk impact but can provide a meaningfully boost in yield.

The average Canadian pension plan has a 35% allocation to fixed income. This bond allocation may not be generating much alpha (skill-based return). Our analysis of Canadian bond managers indicates that these managers overall rely on a credit tilt, due to limited breadth. By investing in bonds globally, investors can access a much wider opportunity set, including sovereign credits across developed and emerging markets, corporate credits across investment grade and high yield spectrums, opportunistic investments and global rates and yield curve bets, resulting in more consistent alpha for skilled investors.

Stepping back from the individual components of the plan, and viewing the asset allocation holistically, investors can better understand the opportunities and limitations of their investments by examining their exposure to fundamental risk factors such as term risk, inflation risk, credit risk, economic risk, liquidity risk, and political risk.

Knowing the exposure of investments to each risk factor allows investors to improve portfolio construction, better balancing allocations across risk factors. Limiting exposure to any one factor protects the portfolio in the case of a downside event. With this risk-balanced methodology, the investor can achieve portfolio with a higher risk-adjusted return than with conventional asset class optimization.

Catherine LeGraw is director, BlackRock Multi-Asset Client Solution (BMACS), BlackRock