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Dan Chornous, Chief Investment Officer, RBC Global Asset Management, joins Dave to discuss the importance of evolving our strategic asset mix over time. Dan also highlights the importance of time horizon when determining asset allocation in order to ensure that return targets are realistic. (Recorded July 6, 2020)


Hello and welcome to the Download. I’m your host, Dave Richardson, and I am joined by a very special guest today, Chief Investment Officer at RBC Global Asset Management, Dan Chornous. Dan, we wanted to get you on this podcast for a bit. It’s great to have you here this morning.

Well, thanks very much for asking me, Dave.

So, Dan, we had your colleague Sarah Riopelle a couple of weeks ago and got a little bit into the thinking that one of the things that’s evolved — not just because of the virus and current economic conditions, but this has been coming on for quite some time, — is really the need for investors across almost all risk tolerance, except the very, very risk averse, to shift their strategic asset allocation and think more about equities and maybe even think differently about their fixed income holdings. And I wanted to get your perspective on that.

I appreciate the opportunity, Dave. We wrote a paper on this several weeks ago on evolving strategic asset mix. So when we think of strategic asset mix, through many years, what asset exposures would you tend to have? Now, you move those up and down tactically, but you anchor it through the cycle averages. How much bonds do I generally want to own? How much stocks do I generally want to own? Then you move up and down off those numbers. But we think of them as being permanent, but they’re really not. And they’ve never been permanent at RBC, Global Asset Management. You need to evolve a strategic asset mix over time. You think of things that would cause you to evolve that. New asset markets come available to you, different long-term pricing considerations, the way these assets work relative to each other, change over time. So there’s really no one size fits all for all time. And I think right now is a very critical time to be rethinking one’s asset mix. Not just because of Covid-19 but Covid-19 reinforces trends that have been developing over many, many years. I think the most important of these is that we’re coming off of a 40-year bull market in bonds. We all know about the deep decline in nominal interest rates, but inside that nominal interest rate is a thing called the real rate of interest, the after-inflation interest rate. It’s fallen by 4.5 % since the early 1980s. And look at the causes of that decline. One needs to be concerned about the future. It doesn’t necessarily mean reverting around some number. What happened was, the demographics changed in the industrialized world. As the world became older and richer its savings versus spending preferences shifted. And almost as important — or perhaps going forward, more important — is the emergence of the emerging world. As they’ve moved their economies and lifestyles closer to the developed world, their demographics are starting to look a lot more like those of the developed world. And so the same pressure is at work everywhere. So what does that mean? If you take the factors — and the Bank of England did this a couple of years ago — if you take the factors that reduced the real rate of interest from 4.5 % to 0 % over the last 40 years, and you run those factors forward and you say, well, what happens to our real rate of interest? Not much. You’re probably stuck pretty close to zero for a very long period of time. Now, that sounds highly theoretical, but it’s critical to all savers and investors because this is the base rate of return. If you have a 0 % real rate of interest, that’s truly the risk-free rate. And to that you add an inflation premium. Right now, inflation is not much, but let’s say it gets back to 2 %. To that, you add a term premium to get to what a 10-year bond yield should be, about 150 basis points or 1.5 %. So it looks like, if we could get back to 3.5 % on a bond yield, we’re probably not going to go much higher. I’m talking for many years — maybe more than 5 years, maybe more than 10. We’re below 1 % right now, so it’s going to be a grind. It’s not going to take us back to levels of yields that we grew used to over the last 30 or 40 years. And then you add an equity risk premium to that of 3.5 % and you get something like a 7 % return for equities. Now, that’s really interesting because now we can start to forecast what the future might be for balanced funds. Or really a portfolio you might choose to put together out of different assets that you choose. But this will ripple through all asset markets. So if you used a 60/40 balance fund, 60 % equities, 40 % bonds, and those are the numbers, you’re going to earn about 5.7 % going forward. That’s below the 7 to 8 to 9 % you’ve earned over the last 5, 10, 20, 30, 40 years. So these are very, very important changes that begin with the real rate of interest and manifest themselves really at all asset markets. So you can accept: well, I’m not going to make money going forward like I did in the past. Of course, most investment programs are anchored on some type of a return expectation, and that builds in what you need for your retirement or whatever it is you’re saving for. So you don’t have to accept that. There are some things you can do to protect yourself as an investor, but you need to think that through, and I would argue that you should think that through right now. Don’t leave it. One thing you can do, if you have the risk tolerance, is boost your equity exposure. Maybe not a lot. But if it used to be 55, maybe 60 works for you. When we do the testing — and you can see this in the paper we wrote, — time horizon is really important. Nobody knows what’s going to happen in the stock market tomorrow or next week. But we can forecast that, we got a reasonable batting average at that. We have a high degree of certainty over the next 5 years or 10 years what those outcomes will be. Much higher than the near term. And when we project that forward and use history to guide those expectations, we see that beyond 5 or 10 years, the risk of actually losing money on a 60/40 program has almost never happened. Even if you invested in 1929. And that risk is almost the same at 55/45. So if you have a time horizon beyond five years, you can accept generally the slightly higher equity exposure to offset the drop in returns you’d otherwise get. And then I think the second thing one wants to do: you need to look inside that fixed income portfolio and say, what did sovereign bonds used to do for me? And can I find assets that will substitute those things? So these used to give you cash flow. If they had a 5 or 6 % coupon, that’s now going to be a 1 or 2 or 3 % coupon. So I think you need things that have higher yields. Well, the investment grade bond market, like the high yield bond market, even the emerging market bond market, we started transitioning out of sovereign in each of those credit markets 20 years ago. Thankfully, we’re early on that, we’ve developed the capabilities around the world to access credit markets, and I think we’ve done a good job. And it’s critical you have access now to credit markets to sit alongside a diminishing sovereign bond position. We’re building a mortgage facility that we’re taking advantage of more and more in RBC Global Asset Management. You’ll notice we did the first of a four-tranche commercial real estate deal at the end of last year and we intend to do another one this year. So we’re building real estate into that space between sovereign bonds and equities. We think going forward that we’ll be able to fill it with other assets. GAM has many, many things that we’re looking at. How will they work as a substitute for prior sovereign bonds? Will they offer us the diversifying properties of sovereign bonds? Will they offer us cash flow? Will they give us safe haven in a sell off? So there are many ways to protect oneself against what’s happening and what’s likely to stay with us. But the key thing is to rethink your strategic asset mix and do it right now.

Yeah. And so it’s really, as you say, thinking differently about how you want to position yourself for the future. It’s going to take some different tools. It’s going to take a different approach. And you’re clearly putting that in place where you are, at the top of the house at RBC Global Asset Management. Dan, love to dig into some of these topics on a future podcast. Thank you so much, though, for joining us and outlining the base case for what you’re in the process of doing right now.

Thanks for your time Dave.


Recorded July 6, 2020

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