Portfolio Balance

It happens in times like these (equity market duress), we get to see how the other side of the equation in the balanced portfolio actually holds up to scrutiny.

We often get the question: why do we want government bonds in our portfolio when the (coupon) interest rate is so low?

If your risk assets (equities) are undergoing price re-discovery (how is that for a term to replace "trounced"?), the fixed income portion of the portfolio is intended to provide some temporary relief (upside in price) as it balances out (mitigates) some of the downside from the equity portion.

In times of equity prices rising, this may seem like a bit of a drag on the total portfolio, but as we saw yesterday (and over the last couple of weeks) having the counter balance is somewhat soothing in light of the turbulence in your portfolio provided by your equity holdings.

As I mentioned in my blog on the weekend, limiting the downside in times of duress means a quicker recovery and getting back sooner to the growth trajectory, which is ultimately the purpose of investing.

When you do peek at your statements and / or performance summaries next, it might be a major disappointment to see all the gains of 2019 disappearing with the losses of 2020 and taking you back to the beginning of 2018 with little to show.

 With the right balance, it may not be as disappointing.

Unfortunately through an 11 year bull market in stocks, the whole balance theme tends to get watered down. When we should be focusing on true balance, some start to cheat a little on yield.

Preferred shares were one such animal. When they were fixed rate perpetual preferred shares, they provided excellent, tax efficient dividend yield and until they reached the dates that the issuers were allowed to redeem them (so they were never truly "perpetual" really). 

Sometime in about 2014, however, when many of the remaining perpetual preferred shares started to get redeemed, the financial institutions (mostly), reverted to issuing something called rate reset preferred shares, which allowed the issuers to reset the dividend every 5 or so years. This added some complexity to these preferred shares and took away the "fixed" returns that the perpetuals had provided and became more of a floating rate investment. Good when interest rates go up, but not so much when they go down (not so much "fixed" income anymore).

The problem is that through 2014 and into 2015 the proliferation of these rate resets found their way into the preferred share indexes and hence the ETF's.

More astute portfolio managers (my High Rock partner Paul, who has developed an expertise in these issues, for one) realized that these new preferred's were not going to be a good defense against plummeting stock markets and central bank interest rate policies (lowering rates) as good balance in a portfolio.

So we took appropriate action and reduced our exposure back in 2015. Subsequently, rate reset preferred shares tumbled when oil prices fell (last time the Saudi's amped up production) and they actually became very cheap as the BOC lowered rates, so we added them to our portfolio.  Then in 2016, when rates started rising again, so did the prices for these rate reset preferred shares. 

Point here is that the underlying change in the structure of these issues has to be considered. When a new client transferred in last December with a whopping 15% of this DXP ETF, we could not get rid of it quickly enough.  Preferred share ETF's have fallen by close to 17% this year, 9% yesterday alone. Ouch if they were 15-20% of your total portfolio or 1/2 of your fixed income balance, because that is no cushion to falling equity prices.

For buy and hold type portfolios, this has to be a big problem. You are going to have to wait for interest rates to start going up again for these rate reset preferred shares to do the same. If you think that this is going to happen soon, given the current economic concerns, think again.

Real portfolio management means re-assessing what exactly offers a portfolio protection and balance.