Yields are back, diversification still needs work with John Wilson

While yields may be back for the bond component to your portfolio, alternative assets still have a place. Ninepoint’s John Wilson tells Michael Hainsworth how he’s helping clients weather the economic and geopolitical uncertainty in 2023.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:
While yields may be back for the bond component to your portfolio, alternative assets still have a place. If inflation and policy uncertainty continue to undermine the diversifying properties of traditional fixed income, certain alternative strategies can take advantage of higher yields and differentiated return streams to provide an added layer of diversification. John Wilson is a founding principal, Co-CEO and Managing Partner of Ninepoint Partners. With Canada’s inflation rate cooling in march to 4.3% and the Bank of Canada predicting 3% within a few months, I asked John if the interest rate tightening cycle over in Canada.

John Wilson:
Well, that's a billion dollar question.

Michael Hainsworth:
Literally.

John Wilson:
There's a variety of opinions on that. The real answer of course is nobody knows for sure, including the Bank of Canada. Our personal opinion is that it has proven to be stickier than many thought. If you went back a year ago, the expectations are that inflation would've cooled more rapidly than it has so far. I guess from our perspective, you look particularly at wages in the labor market, those have been especially sticky. So our view is that they've gone on pause in Canada, they'll stay on pause in Canada until one of two things happens. Either inflation starts to reverse and go back higher, in which case they'll have to start raising rates again, or it continues slowing down and we see a gradual cooling of the economy. Right now we're in that second camp. That's what the Bank of Canada has decided to do, but it's far from certain that inflation will meet their projection. We'll just have to wait and see.

Michael Hainsworth:
What about the United States?

John Wilson:
The broad consensus is they'll go on pause like the Bank of Canada has. Their expectation in the United States is that the banking crisis they've had underway there over the past month, a month and a half, is effectively creating a tightening effect in the economy. The smaller regional banks have seen deposits leaving. I've had three of the four biggest bank failures ever in the last month and a half. And so that's making lending standards much tighter in those banks.

The smaller regional banks actually are especially important for small, medium sized business in the United States. They get a lot of their borrowing capacity from those banks. The degree that those banks now are trying to preserve capital and not lend is going to have a slowing effect on the economy. Our view is the Fed is still very concerned about inflation. It's still like in Canada above their 2% target, but they're going to sit back here and see just how much impact this banking crisis in the states is going to have on the economy.

Michael Hainsworth:
Is this creating a better backdrop for bonds in 2023?

John Wilson:
Well, certainly yields here are obviously much more attractive to investors than they were 12 short months ago. One of the things that people have historically liked about bonds were really its ability to generate income for you, but also there generally been a much lower volatile asset class. They have a nice smoothing effect in a portfolio. While yields have improved from obviously close to zero before, and that is helping on that income benefit, the volatility has also stayed relatively high in fact. Their ability to smooth out your portfolio is still, I guess, under pressure if you want to think of it that way. I'm not sure that the volatility is going to return back to where we saw it about a year ago and be much more muted anytime soon. I think it's going to stay elevated. As I said to your last question, there's a ton of uncertainty about where the economy is going and where actually rates end up. That's going to keep volatility in bonds.

Michael Hainsworth:
If inflation persists and greater macroeconomic uncertainty continues, it feels to me like we can't rely on bonds like we used to. Aren't we at risk of negative stock bond correlation in which both stocks and bonds fall again lockstep?

John Wilson:
Well, we certainly had that last year. That was painful for your traditional stock bond portfolio where both stocks and bonds were down materially and both had much higher volatility. You got the worst of both worlds in 2022. This year certainly the equity market's gotten off to a better start and bonds have at those higher yields been a little better for people. The volatility for bonds stays elevated, and I think we're a long way out of ultimately what this cycle is going to look like. Our personal view as the economy remains quite strong, both in the US and Canada, I think it's unlikely we get to a recession this year. I think that's probably more than likely next year. There's no way the Fed is cutting rates this year. I guess when you look at building a portfolio, what you're really trying to do is two things.

You're trying to diversify your risk so you can smooth out the performance of that portfolio over time. And you do that by adding elements to your portfolio that don't carry the same sorts of risk together. We call that a lower correlation to give you that diversification benefit. The second thing you're doing, of course, by doing that is when things go wrong on one part of your portfolio, because the other parts offset it, you don't go down very much so you can recover quickly, and that means you can get back to positive compounding faster. What we've certainly seen the larger most sophisticated institutions do to answer your question, is they've introduced other types of allocations to their portfolios that are not correlated to stocks or bonds. In particular, they've lowered the allocation to bonds because of the lack of that smoothing effect given it's higher volatility.

Michael Hainsworth:
Well, Jeffrey Rosenberg over at BlackRock is telling us that alternatives are also benefiting from the current interest rate environment. Are you seeing higher yields in certain alternative asset classes?

John Wilson:
Sure, and it can vary by the strategy. As you know Michael, there's a wide variety of ways to invest in the alternative asset space. I can give you a few examples that are very different about how a higher rates benefit alternative strategies. We run a couple of different strategies, very different that invest one in the carbon credit market using carbon credit futures. We have another strategy that invests, that invests in the foreign exchange market using foreign exchange futures. Both of those strategies actually carry very high cash balances upwards of over 90% of their fund assets are carried in cash because when you own futures, your margins, so most of your money is still held in cash, and those rates have gone up, those funds are now earning 5% basically on their assets while still benefiting from owning the futures of the underlying asset that they're invested in.

So it's a nice kicker into those types of strategies. Other types of alternative strategies that people generally think about are things like private credit where your borrowers, two really good things happen as rates go up in private credit. First, a lot of those loans are a floating rate adjustments. As rates come up, the borrowers rate goes up as well. Certainly as those loans come off and new loans get done, they get done at higher rates. That's a benefit. Another big benefit as rates go up, and if you think of, again, the banking pressure that's happening in the United States, you actually access a higher quality borrower. A borrower that typically would've been a bank borrower maybe gets pushed out to the private credit market, and that's a borrower that was a higher quality borrower than you would've had access to a year ago. That's another example of how higher rates affect an alternative strategy like private credit.

Then finally we run, we call it alternative strategies in the bond world where we can hedge out rate risk and own high yielding corporate bonds. Certainly, those are now yielding much higher rates. That's a much more lucrative and attractive return profile for those types of strategies. There's a whole host of ways that higher rates benefit, and I guess I'm at a loss to think of one where it doesn't help.

Michael Hainsworth:
Yeah. Well, we know that everyone's goals and risk tolerances are different, but what it sounds like is that alternatives still can tap into opportunities that come from this higher interest rate environment that wouldn't be found in a traditional 60-40 equity to bond ratio. How do you see a traditional portfolio performing through 2023, and what would it mean for mixing alternative assets into that traditional 60-40 mix?

John Wilson:
The benefit of mixing alternatives into a portfolio and providing that diversification is generally best demonstrated over a period of years. Certainly that obviously came to the fore in a single year last year, where your traditional asset classes were both down. Again, the real benefit of doing it over a longer period of time is, one, reducing your draw down risk so that you never get too far down from your last high watermark. That's just math. Right? If you're down, imagine you only owned one thing and you were down 50% in a year. Well, you don't have to go back up 50% to get back where you were. You have to go back up a hundred percent on what's left. So the math works against you, the more you lose. So by limiting your losses, you can limit how much you need to get back to get back above zero. The opposite is true when you're making money, right? It's the positive power of compounding. I think Einstein once called it the most powerful force in the universe, or at least that's the rumor. I don't know if that's true.

You want to be always positively compounding. Recovering quickly from losses is incredibly important, and that diversification benefit helps you do that. Then the second thing that I think people lose track of overtime is that the biggest enemy of investing, of course, is not being able to stay invested and reap the benefits of positive compounding. Historically, this is certainly true for retail investors. They tend to get in and out of the market at inopportune times. Something dramatically bad happens in markets, they're in their stock and bond portfolio, and they tend to sell when things are down. Then as things recover and do really well, they come back in after a period of time and missed a lot of those gains. They tend to sell lower and buy higher. That's a really destructive thing over the long run in terms of achieving an investment return. By diversifying and smoothing out those downs, you keep people invested. By staying invested, you're able to reap the long run rate of return in your portfolio. We think that's actually one of the most powerful reasons to introduce these non-correlated strategies into your portfolio.

Michael Hainsworth:
Alternative assets being incorporated into a portfolio, maybe say 10 years ago, one might argue that a model portfolio should have maybe 3%. I know that BlackRock points out that by 2019, it went as high as 25%. Again, back to the idea that everybody's got a different goal and their risk tolerances are different. We can't have a blanket statement, but can you give us a sense as to the evolution of the percentage of one's portfolio that ought to be in alternative asset classes?

John Wilson:
Well, first of all, obviously to your point, it depends on who you are. And I'll just zoom out a little bit. If you're the Canadian pension plan or The Case, or Ontario Teachers with hundreds of billions or even trillions under management, you have very long time horizons and you can think of your allocations very differently than you can if you are an advisor with clients who have a longer time horizon, maybe 5, 10, 15 years, but clearly not 50, 100 years like a pension plan would have. That obviously comes into it. If you look at that evolution in terms of where allocations have gone, there've been really, I think two factors. One is just the industry itself has innovated a lot of different ways and attractive ways for people to access these types of strategies. They just frankly, weren't available to people 20, 25 years ago.
Then the second piece has been just a learning process for investors to realize and actually experience the benefits of introducing these to their portfolios. Pension plans traditionally didn't do any of these, and now those pension plans I mentioned have upwards of over 50% of their assets allocated to alternative strategies. That's just frankly because over the last 30, 40 years, they've saw how well that worked and they realize that they should go higher. The same thing has happened in the individual investor market where people have been in markets where they've had the opportunity to experience the benefits of that, their allocations have consistently gone higher.

Canada is somewhat unique, and I think you and I have talked about this before, and that historically we've had a low allocation to alternatives, and that's just because frankly, they weren't really available for people to experience. Even in Canada, as they get more access to these types of products and experience the benefits, their allocations have gone higher as well.

Michael Hainsworth:
Then maybe we should talk about the role that alternative asset classes play when it comes to recessionary fears. You touched on the recession possibility a little bit earlier. Let's talk about the role that alternative asset classes should play amidst that fear.

John Wilson:
If you think generally about a recession and every recession is somewhat different, but if you look at your two traditional baskets of equities and bonds, a recession has a negative effect on both of those. Clearly, a recession can depress earnings, and because people get sort of shaken out and maybe scared in the equity market, it can also depress multiples. Both of those things are negative for your equity returns. In the bond market, it's a little different. On the one hand, you get typically in a recession, there's a credit cycle, meaning companies can default on bonds and that can push up the yield on bonds, which means if you're not as familiar, you lose money on a bond when the yield goes up from what nominal bond yield is. That can be negative for your bond investment.

On the other hand, if the recession's bad enough and inflation's contained, the central bank can start cutting interest rates, so your treasury rate can start going lower, which is positive for bonds. Bonds is a bit of more of a mixed bag. I think what makes the current situation somewhat unique is that it is possible we could get a recession and still have elevated inflation, which could mean you get a credit cycle that causes credit losses, but also restrains the central bank's ability to really cut rates because they'll be worried about inflation. That would be a really difficult situation for bonds as well. That's where they get hurt.

Again, the appeal of just diversifying your portfolio across a bunch of different things, and by the way, we no means don't mean people shouldn't own equities or bonds, of course you're going to have equities and bonds. All we're saying is you can add other things that don't necessarily react to those types of environments the same way as your equities and bonds do. An FX strategy I mentioned earlier, is not going to be impacted in a recession. That carbon credit strategy is not necessarily going to be impacted in a recession. Even a private credit strategy, depending on the strategy, can ride out a recession really well.

There's a lot of different ways, and again, it's not that one strategy is necessarily better than equities or better than bonds, it's just they're uncorrelated. What we try really hard to work with our investors on is helping them understand the benefit of staying in these allocations and not thinking that the game is all about which number on the roulette wheel I need to have all my chips on, and then when do I move all to another number and then move over to this? That's a hard game to play. In fact, I would argue almost impossible. You're way better off keeping your chips spread across these different strategies and again, letting them work for you over the life cycle of each of those strategies.

Michael Hainsworth:
You pointed out that investing is quite an emotional ride and that we all know we should buy low sell high, but often we do the exact opposite of that. What's your best advice as far as staying the course, especially in volatile times, aside from just not opening your statements at the end of every month?

John Wilson:
Yeah, that sounds easier than it is in practice I think. Although actually, just on that note, the evidence on investor behavior is, first of all, when things get bad, the evidence is apparently people do not open their statements, which I think is kind of funny because a lack of information is never helpful. The second, the proof is it's not just it seems like, but if the average mutual fund returns something like, well, let's just say the equity return over the last, whatever, 50 years was, let's just say 8%, which is, I think it's actually been a little bit higher than that. The average mutual fund return equity mutual fund return over that period has been about one and a half points lower than the equity return because they have fees. Let's say six and a half. The average mutual fund investor return is closer to 2%, and that's precisely because of the behavior you talked about getting, rather than getting in low and getting out high, they tend to get in higher and get out lower, which is not helpful.

Yeah, that's a behavior that is not conducive to long run rates of return. Again, they do that because they get shaken out as things get bad and they get fearful, and this is their nest egg, and oh my god, what if it goes much lower? I can't afford to lose any more money. It's crowd behavior. By the time you're feeling that way, it turns out almost everyone else is. That generally means you're pretty close to the bottom, which ironically is when you don't want to be doing that. It's a bottom precisely because everyone does. Again, building a portfolio that keeps you from getting to that threshold, that keeps your losses minimized because your allocations are more diversified, it allows you to relax.
It allows you to open your statement and just look at the total number and not get caught up in what one little piece is doing versus the other and say, oh, well look, it's not that bad. I can ride that out. Sure enough, if you do, you'll recover much faster than someone who's just, for instance, in an equity fund, that might be down 30%. If they're down 30, they need 43 to recover. If you're down eight, you need like 9% to recover. It's a much faster journey back to that positive compounding territory that everyone loves to be in.

Michael Hainsworth:
Then if there was one key takeaway from our conversation today, what would you like it to be?

John Wilson:
It's a different world than we're in now. We went through a period, I think, for a lot of people the last 15 years, that's been a bulk of their investing experience for a lot of our clients, and that was a really unique period of time. Rates were at zero. Central banks were very worried about deflation, and were doing things like quantitative easing, which were very asset friendly. Equity markets had a tremendous run. I think the S&P return from the great financial crisis up until the start of this rate hiking cycle was closer to 15% a year. That's abnormally high. We're in a very different environment now. Inflation that everyone thought was dead forever is back. Rates have been rising. That presents a whole host of different risks that are not necessarily as friendly to the same asset classes that outperformed in that period of time.

It just calls for a more sophisticated approach, which is not complicated. It just means it's not as simple as just owning a bunch of stocks with a few bonds. Now you need to think about spreading your risk out a little more widely so that you have other sources of return that aren't as correlated to some of the things that might hurt you in the equity and bond market.

Michael Hainsworth:
John, it's always great speaking with you. Thank you for your time and insight.

John Wilson:
All right. Thank you, Michael.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.