Transcript - Winter 2019: Designing portfolios with downside protection

February 5, 2019 Rose Arthurs

Ed: [00:00:05] Hi everyone. Thanks for joining us today. My name is Ed Golding. I am the portfolio manager and assistant vice president with the investment management team at MD and my area of responsibilities include U.S. equities, Canadian dividend equities, Canadian core equities and our private real assets, real estate and private equity.

Mark: [00:00:24] I am Marc Fairbairn. So I am also an assistant vice president on the investment management strategy team at MD Financial and my primary areas of responsibility are foreign and international funds, as well as our strategic asset allocation.

Ed: [00:00:36] The topic for today that Mark and I want to discuss is downside protection. We've seen over the fourth quarter of this year a very volatile equity markets all across the globe. There are a number of reasons that, obviously, go into why markets can become volatile, but today Mark and I want to focus a little bit on downside protection. Why is downside protection important? Where does it come from? How Does MD try to achieve downside protection for its clients investments and a couple of examples of our funds and pools that have provided downside protection historically, and in the most recent volatile period. So with that all in mind, the first question that comes up is you know why is downside protection important? Volatile markets can be a very big challenge for investors. Nobody likes to lose money but there are also behavioral aspects such as fight or flight responses and loss aversion that can lead investors to bail out at the worst time, after periods of negative returns. Unfortunately periods of negative returns are inevitable when investing in riskier assets such as equities. However, through active management we can seek to invest in companies that are more likely to hold up better in down markets, protecting capital versus the market. This can ease the pain of periods of weakness. While no one likes to see losses, knowing one has held up better than the market can provide some comfort, making clients more likely to remain on their investment strategy. Beyond the behavior benefits the asymmetry of loss also provides a benefit of downside protection, as has been mentioned many times - you have to double your money to breakeven if you lose half of it. Following this, less volatile strategies that decline less than the market, tend to provide superior returns over the longer term.

Mark: [00:02:26] Thanks Ed. Downside protection can come from a variety of sources and it's important to note no one source, well outside of cash is foolproof. At the most basic level downside protection comes from not owning what declines most in a correction. But what this is, depends on the nature of the market correction. For example, in a valuation bubble, such as we saw during the tech, media and telecom bubble of the early 2000s or Japan in the 1990s, not being exposed to those segments of the market, when they reversed, provided huge sources of downside protection. Often Avoiding these major blowups lead to the most dramatic downside protection. In the case of the IT bubble of the 2000s, many value strategies it wasn't even possible to get positive return when the market was falling. But it is important to note, these don't happen all that often. So one should be careful not to link expectations or downside protection based on these environments, it could lead to future disappointment. In A more classical correction, linked to fears of recession, it is generally more stable in defensive businesses, that are not as economically sensitive, which have low degrees of leverage that tend to do better. These are often high quality businesses or those in non-cyclical industries like consumer staples and utilities, where there is a high degree of visibility and resilience built into their revenues. In these cases, the degree of downside protection tends to be more modest. Starting Valuations can also present a risk to the degree of downside protection. There can also be correction's linked to crisis's, such as a geopolitical crisis, or a commodity shock. In these cases the areas of the market most directly linked to the crisis tend to be most effective. These types of corrections can be more challenging to predict and position against. All else equal, generally higher quality end companies and defensive companies tend to do better and commodity linked and deeper cyclicals tend to perform worse, especially for example energy companies during an energy market shock. But given the event driven nature of these, it is entirely possible for even a high quality portfolio to get hurt in one of these environments. The good news is these types of corrections tend to be shorter term and ultimately a higher quality portfolio is very likely to recover over time.

Ed: [00:04:33] Thanks Mark. At MD protecting our client's capital during periods of high volatility is a hallmark of our investment philosophy and process. We take our role as stewards of our clients wealth very seriously and take every action and measure available to us to ensure the risk embedded within our client's portfolio is calibrated correctly. MD's proprietary fund management process goes through several steps dedicated to understanding the key ingredients that have led to successful downside protection in the past, but more importantly what market factors sectors and manager portfolio characteristics are expected to provide downside protection in the future. When Identifying top manager talent, our fund management process undergoes a number of steps to identify managers who are expected to provide downside protection. We review firms stated investment philosophy and processes, historical track records and their full holdings to get a full understanding of a management team skill and downside protection capabilities. After all these steps are completed, our fund management process then projects a forward return expectation for each prospective investment manager. Once we have calculated our future projections on manger performance we then select the manager with the highest risk adjusted return expectations, with the strongest downside protection expectations. The final step in our fund management process, that is dedicated to ensuring downside protection in our funds and pools, is the allocation of capital between complementary investment strategies that assures the highest level of return for the lowest level of risk. All while factoring the downside expectation at the fund level.

Mark: [00:06:34] Thanks Ed. Two Funds that we've chosen to highlight, that did well in the fourth quarter volatility, and that were designed with our process focus on downside protection are the MDPIM dividend pool and the MD international equity pool. Starting With the MDPIM dividend pool, with the fund management process described earlier by Ed, We've revamped our entire Canadian dividend solution for MD clients in mid 2016, with a focus on providing an elevated income from investments primarily in Canadian equities while providing for strong downside protection. Since we've revamped our dividend solution in June 2016 through the end of December 2018 the MDPIM dividend pool is outperform the S&P TSX composite by an annualized one point five percent with most of that excess return coming from the market correction experienced in the fourth quarter. Since June 2016, the fund has captured only 69 percent of the market downside. The sources of downside protection during the fourth quarter were an underweight to the very volatile energy sector and overweight to the defensive utility sector, with strong stock selection within the healthcare sector. Moving onto the MDPIM international equity pool. Earned International funds have traditionally done very well volatile markets. The MDPIM International pool has outperformed in each correction with the MSCI EAFE fell more than 10 percent and Canadian dollar terms over the past 10 years. This has come from a strong focus on quality and a persistent underweight to the financial sector.

Ed: [00:09:02] Thanks Mark, that's very helpful. And Thanks again for everyone to who decided to listen in to our podcast today. We'd like to leave you with one final thought, and that thought is just how important downside protection is embedded within MD's investment philosophy and process, to ensure that we are preserving our client's capital in volatile markets as we have just experienced in the fourth quarter.

 

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