It’s October of 2017, and we’ve been seeing low, single‐digit returns this year. Last year wasn’t great, either. Of course, these most recent years follow the long term recovery boom that began after the 08/09 financial collapse, and this is worth noting. Today, we wanted to touch base with our clients and talk a little about the current market environment and why returns have slowed down.
Let’s start with the ‘why.’
Why have investment returns slowed?
1) Balanced portfolios will always lag the equity markets during growth years
If you have a balanced portfolio, which is one that holds stocks/equities as well as bonds/fixed income ‐ which are used to mitigate investment risk in your portfolio – it will never keep pace with upward movement in the stock markets. It’s not supposed to. This is because that protection in your portfolio is built to withstand movement in the other direction: market corrections. It’s not supposed to capture all Why have investment returns slowed down?
of the gains when markets have strong years and grow upwards. It has been a while since a correction, so the purpose of those fixed income holdings haven’t been obvious for a while. This is what helps keeps your investments safe, and you’ll be reminded of why you hold them when the markets correct. And sooner or later they will correct, because they always do, eventually. A 15% ‐ 20% decline or more in 100% stock/equity portfolios is a certain occurrence if you invest over a long enough period of time. Those who invested through the 2000 and 2008 crashes will recall declines closer to 30%+.
2) Fluctuation in the Canadian dollar
When you hold investments outside of Canada, they are denominated in their local currencies. For instance, if the Canadian dollar goes up while you hold US equities, that will act as a drag on performance, because to sell those US equities, you must first convert those assets to US dollars, which then convert to Canadian dollars at the current exchange rate, making your investment less valuable in Canadian dollar terms if that exchange rate has gone the wrong direction. In January of 2016, the CDN/US dollar exchange rate was $0.69*. As of recently, around the beginning of October, the exchange rate has been hovering around $0.80*. That’s a 16% increase in the value of the Canadian dollar relative to the US dollar, and it has most certainly affected portfolio gains. This was easily the biggest factor in our clients’ returns in 2015 (positive) and 2016/2017 (negative) as the Canadian dollar has seen high levels of volatility over that time span.
An excellent quarterly review was just released from the team at Mawer Investments. Here is a small excerpt that fits in nicely with the above comments:
“The Canadian Dollar (CAD) reached a high of 82 cents to the USD in this period [in the last 3 months]. One consequence to this surge has been to investments held in foreign currencies—i.e., a higher CAD has muted what would have otherwise been strong returns. As ever, we view the increase in the CAD as a temporary headwind— sometimes currency works for you, sometimes against you—and the longterm case for investing globally remains compelling.
Overall, world equity markets performed strongly, with the MSCI All Country World Index gaining 4.4% in local currencies (1.3% in CAD).” (Emphasis and italics added – and this is only the last 3 months.) *Information sourced from The Globe & Mail
3) We positioned client portfolios underweight in Canadian equities
We build diversified client portfolios that hold assets all over the world. One of the areas where we try to add value is by choosing to be ‘underweight’ or ‘overweight’ in certain areas of the world. If we think US equities are primed to have a strong year, we’ll overweight our client portfolios in the US. Those portfolios still hold equities in Canada and outside of North America, they just hold less of them – those positions might be considered underweight in this scenario.
Since 2015, we have recommended underweight positions in Canadian equities in client portfolios. In 2015, that worked out well, as a downward‐sliding Canadian dollar help prop up weak stock market returns, especially in Canada, where stock market returns were negative on the year. This meant that a declining Canadian dollar provided a big performance boost to those holding US equities at the time, as the currency effect works in both directions.
In 2016, the Canadian stock market did well, recovering much of what it lost in 2015. During the course of 2016 and 2017 so far, the Canadian dollar shot back up. The result of this underweight position in Canada in the context of the above was that client portfolios were not able to take advantage of strong market returns here in Canada in 2016 (though they avoided some of the losses in 2015), and they were more exposed to the currency fluctuation over 2016 and 2017.
What adjustments should be made to the portfolio right now to adapt?
At the risk of sounding like a typical Financial Advisor that preaches patience when it comes to investing, we’re still going to preach patience. The story behind our belief that the Canadian stock market will lag many other geographic options available still stands true today. Our economy is narrow in that we lack anywhere near the level diversification that can be found by investing abroad, as approximately 66%* of the Canadian stock market (TSX/S&P Composite) is comprised of only 3 sectors: energy, materials, and financials. We don’t believe the current $0.80 CDN/US exchange rate, which was pushed up in part by our recent interest rate hikes, accurately reflects the value of Canadian currency, and we also believe that the next 1‐2 years will yield a moderate decrease in our Canadian dollar. We also believe Canadian equities are overpriced relative to the value we can get investing elsewhere, and it’s all about the value you get for the dollars you invest. We believe the best value can be found in the emerging market economies, Europe, and, to a lesser degree, the US. The global stock market is a big pond, and Canada is but a tiny drop in that bucket, relatively speaking.
Sometimes in investing, you make decisions based on fundamentals, yet the market goes another direction for reasons that don’t fundamentally make sense. A glaring example would be the tech boom of the late 90s – where people bought software company stocks at ridiculously high prices. But up they went. Value investors couldn’t understand this, but many could only watch for so long, missing the earlier gains in a rising market before they jumped on the bandwagon. I recall an old interview with Warren Buffet in the late 90s in which he was questioned by his interviewer as to why he was not investing at all in tech. Mr. Buffett simply replied that he couldn’t understand it, and didn’t know why people were paying these prices for companies that didn’t seem to justify these high share prices. Mr. Buffett sounded like an old man who ‘didn’t understand’ the way things were in today’s investing world. He believed in fundamentals, and we all know how that story panned out in the end. This isn’t to say we are the investing equivalent to Warren Buffet. We aren’t; he is much smarter than we are. What we are saying is that sticking to the fundamentals can sometimes look like a bad decision as markets move in a different direction. Sometimes, being right or wrong is a case of waiting for the erratic stock market fluctuation to come back to the fundamentals, because value eventually determines the price of stocks, though short term noise can often do a wonderful job in distorting this reality. It can take time for that realization to take place, and switching strategies in the short term to try and catch momentum in the direction you didn’t choose earlier almost always results in you being late to the party and missing out.
We continue to review all client portfolios to make sure allocations match the best growth projections at the most reasonable level of risk going forward. We won’t, however, be recommending that anyone increase their Canadian equity allocation. If anything, we’ll be recommending an increase in international equities, and emerging market equities for those with a higher tolerance for risk.
We’ll close with a quote from Warren Buffett: “The investor of today does not profit from yesterday’s growth.”
*Information sourced from The Globe & Mail