Crossing borders on portfolio construction trends
Commentary by Philip Colussi, CFA, Investment Analyst, Vanguard Investments Canada
While the COVID-19 pandemic may have cancelled many of our vacation plans and business trips, our ability to share data, statistics and information across borders continues to be fluid and transformative.
At Vanguard, we leverage our global presence and insights to guide our clients on building portfolios. This inspired the launch of our Portfolio Consulting Service, through which we engage with advisors to provide deep-dive analytics and thought leadership on portfolio construction.
Recently, our team analyzed Canadian and U.S. advisors’ portfolios to identify themes and key trends in the two regions. We discovered some high-level similarities that could provide you with valuable insights to help your clients achieve their long-term financial goals.
Active vs. passive management:
In Canada, active management accounts for 88% of the $1.9 trillion investment fund landscape with the remaining 12% allocated to passive strategies. However, over the last 10 years, active funds have had a lower growth rate than passive strategies, growing at 9% versus a 17% growth rate for passive funds. At the beginning of the year, Canadian advisors managing equity portfolios had more than 50% allocation to passive strategies. But by the second half of 2020, a significant number of passive strategies were being replaced by active mandates, albeit at a higher cost. This may have been a result of wealth managers turning to active management during times of extreme market uncertainty. We also interpret this trend as Canadian advisors’ proclivity toward active investment strategies versus their American counterparts. As we moved into 2021, active equity investments continued to see higher flows compared with passive investments as similar concerns surrounding the virus persisted.
In the U.S., there was a similar trend of passive strategies being less utilized after the second quarter of 2020, during the beginning of economic lockdowns. However, the lowest point of passive funds being used still accounts for over 50% of the equity portfolio within the region, and passive strategies eventually bounced back to pre-pandemic levels.
The size of the U.S. investment fund landscape is substantially larger than Canada’s, standing at approximately US$23 trillion. Of that amount, approximately 57% is invested in active strategies with the remainder in passive funds. Just as in Canada, passive strategies have a 17% growth rate in the U.S., while active fund strategies are growing at a slower 7% rate.
Regional equity allocations:
From a regional investment perspective, we found that 50% of active fund exposure was allocated to international equities whereas 14% was allocated to Canadian equity funds and 25% was allocated to U.S. equity funds (with only 39% allocated to North America). The investment home bias of U.S. wealth advisors was significant, with approximately 73% of equity funds being allocated toward U.S. stocks.
Fixed income trends
Active vs. passive management:
Passive Canadian fixed income portfolio exposure dropped sharply from 77% to 16% during 2020. A higher allocation to active funds resulted in a higher exposure to high-yield credit, which led to increased costs for fixed income portfolios. An interesting observation: Although government bonds helped protect against losses in March 2020, attractive relative valuations and the search for yield could have been key drivers for an increase in high-yield exposure. However, high-yield bonds, due to their relatively high correlation with equities, diluted potential diversification benefits at the total portfolio level.
In the U.S., advisors initially favoured active fixed income strategies in 2020, however passive allocations rose from 29% to 40% of the fixed income sleeve by year-end. There was an overweight to high-yield bonds as corporate spreads tightened but the average credit quality stayed consistent throughout the year, just as we observed for the Canadian advisors. Note that use of high-quality government bonds is important for a well-diversified portfolio, as these bonds can serve as a ballast during an equity market rout, as was evident during the 2008 Financial Crisis and the recent COVID-19 related market downturn.
Individual stock selection:
Although most of the portfolios we analyzed did not utilize individual stocks directly, it is a common practice for advisors to a select a handful of individual stocks to complement their fund holdings. Over the course of the year, we saw an upward trend of large-cap core stocks within these individual stock baskets. Core stocks are generally companies with healthy dividends and stable cash flows with higher barriers to entry. This increased weightage to individual stocks was perhaps a result of low bond yields, which prompted advisors to rearrange their stock baskets to make up for their income shortfalls. Interestingly, we saw the weighting in growth stocks trend downward as valuations rose. Growth stocks also typically provide little to no yield. When we look at the companies that were being selected within these baskets, they are mostly comprised of large-cap companies almost exclusively from North American firms. The split was almost perfectly even between Canadian and U.S. stocks.
ESG portfolio insights
Environmental, social and governance (ESG) considerations are an increasingly important and evolving area for investment advisors. We looked at portfolios in the U.S. with ESG applied and we found that advisors utilize U.S. equity ESG funds at twice the rate of international equity ESG funds. In addition, there is a reduction in energy stock exposure by 45% with lower allocations to small-cap stocks and value style stocks in portfolios containing ESG funds. We also found that the focus on the equity component of the portfolio comes at the expense of the fixed income side. The ESG portfolios analyzed exhibited higher allocations to energy-heavy, high-yield bonds on the fixed income side—actually decreasing the overall ESG efficiency of the portfolio. Moving forward, this irregularity could decline as advisors become more educated on building portfolios with an ESG application along with increased product selection in the fixed income space.
We also found that being more ESG-compliant can come at a higher cost. Active ESG equity funds can be one of the most expensive asset classes. On the other hand, the cost of passive ESG funds is similar to that of non-ESG funds. Therefore, when ESG strategies are implemented, we found that the average equity portfolio cost jumps by 37.5%.
Opinions on the “right” way to reflect ESG considerations in investments vary because of a broad range of approaches and personal values. To further complicate matters, there is currently no industry consensus on scoring criteria for ESG. That is why Vanguard clearly communicates our funds’ approaches and encourages proper due diligence from investors.
What can advisors learn from these trends?
There are several key takeaways from our analysis:
- Both passive and active investment strategies can complement each other to provide a balanced, well-diversified portfolio to weather different market cycles.
- Active management can complement passive investments and allow investors to implement their high conviction strategies. However, added value over a benchmark is not guaranteed and investors should be wary of higher fees.
- Investors should consider the diversification benefits of a high-quality, fixed-income strategy as a shock absorber during times of market stress.
- Utilizing high-yield bonds can add risk within a portfolio because these securities have higher correlations with equities, which reduces overall diversification benefits.
- Portfolios with larger positions in individual stocks result in a higher degree of risk. A core ETF or mutual fund strategy reduces risk by investing in several underlying holdings that provide ample diversification benefits.
- ESG continues to be a focus for investors and there is an increasing need for advice and education to ensure that portfolios are properly constructed to match unique investor preferences.
Please reach out to your Vanguard representative if you are interested in learning more about our Portfolio Consulting Service.
The views expressed in this material are based on the author's assessment as of the first publication date (August 2021), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.
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