Real resilience in Canadian portfolios

In our third and final installment highlighting themes from the 2020 midyear outlook, Kurt explores how investors can build real resilience into portfolios at a time when allocations to nominal government bonds are likely to provide less diversification of equity risk.

In our recent post highlighting the emerging policy revolution in Canada and around the developed world, I noted the risk of higher inflation over the next several years and the potential negative impact this could have on nominal government bonds. A recent edition of our Global weekly commentary discusses our decision to reduce allocations to nominal government bonds in strategic portfolios and overweight inflation-linked bonds. But given the small size, long maturity and limited liquidity in the Canadian inflation-linked bond market, such a shift would only go so far. More action is needed.

What additional options are available to investors who seek greater resilience in their investment portfolios during this period of elevated stock market volatility and a future of potentially more compressed investment returns relative to history, and especially after netting out the effects of higher inflation? I would highlight two options: the role of sustainable investments and the importance of country and style factor choices.

Building resilience through sustainable investing

Sustainable investing enhances traditional fundamental analysis by incorporating material environmental, social and governance (ESG) insights into the investment process. Some sustainable investments exclude controversial companies and certain types of businesses, such as firearms manufacturers, unconventional oil production, thermal coal and tobacco, while maximizing ESG ratings and providing broad exposure to a particular investment universe. Sustainable investing is also broadening beyond stocks to include the bond market and private investments.

The coronavirus pandemic has accelerated a trend toward sustainable investing amid concerns about racial justice, income inequality, fragile supply chains and companies’ social license to operate. In many countries, including Canada, government relief measures and the actions of regulators have restricted share buybacks, placed constraints on dividend payments, limited executive compensation and mandated climate change disclosures. Moreover, companies that take a long-term view and transition their business models to changing economic circumstances may also be more resilient to future shocks. Investment flows bear out this increased interest in sustainable investing, capturing more assets by May of this year than in all of 2019 (see chart below).

Assets under management at ESG-mandated funds,2014-2020 YTD

Sustainable investing is still in its early days. As investors reallocate capital with sustainability considerations in mind, companies and portfolios with stronger ESG metrics could stand to outperform those with weaker scores. This one-time boost to returns through the transition runs counter to perceptions that sustainable investing involves a return sacrifice. Sustainability factors might also help reduce portfolio risk at a time when returns are lower than recent historical experience.

Geographic and factor tilts may matter more

Another way to think about managing equity risk and improving resilience in portfolios is through tactical tilts to various style factors. In our 2020 midyear outlook, we opted to raise our exposure to the quality style factor to a strong overweight given its focus on companies with stable cash flows, healthier balance sheets and a strong track record of producing above-average return on equity. The quality factor also captures many of the companies and platforms that have seen strong demand throughout the coronavirus pandemic, such as technology and healthcare, and that will continue to experience structural growth as the economy slowly reopens. We also closed a long-standing underweight to the value style factor after a period of epic underperformance extended into 2020 (see chart below).

Performance of MSCI World style factors 2020