Three lessons 2020 taught institutional investors
December 17, 2020
After years of relatively stable appreciation in global fixed-income and equity markets, investors were thrust into dramatic turbulence in the first quarter of 2020, as COVID-19 sent shockwaves through markets.
From Feb. 20 to March 23, the S&P/TSX Composite Total Return Index lost 37.20 per cent of its value in a mere 22 trading days, inflicting significant damage on investors’ portfolios. As future prospects for the economy and corporate profits became clearer, markets began to regain lost ground at a steady pace. By Dec. 7, the Canadian stock market had rebounded 60.3 per cent from its bottom, reaching a new high for the year and fully recovering from the losses in March.
Investors’ portfolios are in a decidedly better position now than they were in the spring. Nevertheless, institutional investors can learn some important lessons from a year that will be spoken of for decades to come.
- The stock market is a leading indicator
Nearly as quickly as markets faltered, equities rallied as investors began to understand the scope of the impact of COVID-19. The sharp drawdown preceded much of the real economy impact we would see from the virus, and the rapid recovery came before economic data began improving significantly. Deep, liquid equity markets allow prices to reflect rapidly changing views extremely quickly. Fuelling the recovery was the fact that, even though the pandemic wasn’t expected to be resolved for months into the future, investors saw light at the end of the tunnel and believed in the prospect of eventual improvements in corporate profitability. As a result, equity markets currently sit near all-time highs, even with many of us still working from home and economies still challenged. With a vaccine on the horizon and surprising resilience from the corporate sector, market participants have chosen to look beyond the near term and remain optimistic about the long term.
- Understand your partnerships
As COVID-19 wreaked havoc on the real-world economy, institutional investors such as pension funds and not-for-profits were forced to turn inward and play defence. Some had to turn attention away from their investment portfolios and focus on their core businesses. Communication from asset managers was critical during this time to provide institutional clients with peace of mind by sharing business continuity procedures and regular market updates. Many investors saw for the first time how their investment management providers performed in times of stress. Investment managers with strong readiness were a significant asset to their clients, whereas those that stumbled during the crisis may have permanently impaired client trust. Investors that don’t yet understand their service providers’ business continuity planning, disaster recovery procedures and overall readiness for non-normal working environments should make this a priority in 2021.
- The last decade’s playbook may need a rewrite
On Dec. 8, 2020, the yield to maturity of the FTSE Canada universe bond index sat at 1.28 per cent, a full percentage point lower than at the end of 2019 and 1.44 per cent lower than at the end of 2018. Barring further downward movement in interest rates, the core Canadian fixed-income portion of investor portfolios is set to return only a fraction of what it generated in recent years, with the sustained decreasing interest rate environment propelling Canadian bonds to a 4.47 per cent annualized return over the 10 years ending November 30, 2020. With equity valuations arguably stretched, investors expecting a similar return going forward with static asset allocation are likely to be disappointed. As reducing portfolio liabilities is not typically a feasible option, investors can first look to increase risk asset allocations in their portfolios. This will likely improve long-term returns, but also introduces greater volatility. Another option is to improve portfolio construction by adding uncorrelated asset classes — alternative or traditional — with the aim of reducing portfolio risk without weakening expected returns. This can often also improve expected returns.
The bottom line
Stabilizing markets and greater certainty in the operating environment for many organizations may make this an opportune time for institutional investors to review their investment policy, governance procedures and investment management arrangements to ensure preparedness for the future. Though long-term thinking and staying the course are important for success in institutional investing, the current market environment presents a stark contrast to what we’ve become used to in recent years. Institutional investors that take the necessary steps and adjust appropriately for this new environment will be able to ensure long-term sustainability.
Emerson Savage is an institutional portfolio manager at Louisbourg Investments. These views are those of the author and not necessarily those of the Canadian Investment Review.