Are institutional portfolios prepared for the next market tumble?

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Closeup down trend arrow line chart on blurred stock board textured background in investment concept : © NITIPONG CHOOSOMPOP /123RF Stock PhotosInstitutional portfolios have been tilted towards growth assets as they’ve reached for higher returns during the bull market of the last decade. But as the business cycle continues to stretch, it’s a prudent time to consider downside protection measures.

Wylie Tolette, executive vice-president and head of client investment solutions for Franklin Templeton Investments Canada’s multi-asset solutions business, recalls how surprised investors were after the 2008 financial crisis to discover some of the vulnerabilities in their portfolios. Many institutional portfolios weren’t prepared to handle major extremes to the downside, he says.

“Despite how much work we did before the financial crisis to make sure people really thought about their tolerance and capacity to take on investment risk, my observation was that people thought, in general, they had more tolerance for investment risk than they actually did. And many of the institutional governance structures that oversee portfolios were basically set up to absorb volatility and risk when it was in the normal boundaries of what we typically observe. But they weren’t always set up properly to function correctly and make the best decisions when markets really move to the extreme end of the environment.”

Today, investors have been piling into assets heavily tied to economic growth, says Tolette, noting this is largely because they feel they need to achieve a certain return. In doing so, portfolios have become heavy with assets that are more likely to fair poorly in an economic downturn.

“Over the long term, economic growth looks like quite a rational thing to tie your portfolio to, but there are two issues with that. First, you really need to make sure your governance is prepared for that shift. Many institutions, if you look back 40 and 50 years . . . at that time, they were flipped in terms of their portfolio allocations. They were 20 per cent equities and 80 per cent long-term bonds, because a long-term bond actually correlates very nicely with a long-term pension liability.

“That works great when your long-term bonds are returning six, seven and eight per cent, as they were 30 years ago. As long-term bond yields have come down to one, two and three per cent, many institutions . . . have flipped their portfolios.”

Institutional investors, then, need to be better prepared for the periodic shocks to growth-driven assets, says Tolette. “The interesting thing about growth-driven assets is they tend to rise like a feather on the wind but fall like a stone into the water.”

Now is the time for institutional investors to prepare for such an eventuality by stress-testing whether the decision-making policies in place are resilient enough, he says.

However, rebalancing away from some equity exposure may be a frustrating process as markets continue to push higher, he adds. Positioning well for the next downturn would mean cozying up to bonds. “In the short-term, are you going to potentially have to grit your teeth because markets might continue to run for a while, with you sitting with more money in shorter-term or immediate government bonds? Yes. That’s part of the risk. You can never get these timing decisions perfectly right.”

This article originally appeared on CIR’s companion site, Read the full story here.

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