Turbulent Times: CMS Model Portfolio Update

It has been nothing short of a wild last couple of months for markets and investors. Many aspects that have likely been taken for granted as ‘the norm’ have seen seismic shifts such as the idea of $100 oil (image 1) as well as a Canadian dollar that trades at parity with the US (image 2) while preferreds have been absolutely punished (image 3, represented by the ETF ‘CPD’). If you are an investor that is concentrated within Canadian equities, it has been a tough month or two. Fortunately, if you have been diversified across geographies and assets, you have likely been impacted far less in the downturn compared to others and this is where the CMS portfolio, in our view, continues to shine. So with all of these changes in the markets, is it time to make changes to the portfolio? In true passive investment fashion, we do not think so. The portfolio continues to be diversified and exposed to various markets but let’s look at the areas we could change and some potential criticisms against doing nothing.

Dump Or Double Down On Energy:

This would be the most likely move to make if we were to make any change and while the prospects of the energy sector do not look great in the shorter term, at a 6% weight for an ETF, the portfolio is not overexposed to the sector while still allowing it to enjoy any potential upside if or when the energy markets turnaround. So why not double down? Simply, there is too much uncertainty and no-one knows where oil is going to go next. We would far prefer a prudent exposure over speculating on which way a commodity will move.

Give Up On Gold:

This is a similar problem to that of the energy sector. No-one likes commodities right now and in the case of gold, no one has liked it for years now. This type of sentiment is often reason enough to hold some exposure and at a ~3.5% weight, we are comfortable with holding for a bit of a general hedge against equities. Also, if the US dollar begins to weaken, we would expect gold to see some strength, which will help hedge against the US dollar exposure held in the portfolio.

Reduce Canadian Exposure:

A lot of recession talk is going around right now. We have a piece on the composition of this recession over at 5i Research that goes a bit deeper into our thoughts on this but we do not think this will be a ‘deep’ recession. It is being felt more in certain industries and provinces but that does not make the situation any better or worse as these are fellow Canadian’s going through tough times. However, we do not think it is a broad based downturn being felt by everyone across Canada. Some have even argued that the Canadian exposure is too high. We would disagree with this argument for a few reasons. First, the CMS portfolio really only has a 39% Canadian equity exposure. Is this more than the proportion of the global markets that Canada makes up? Yes, but there are tax considerations as well as psychological and currency issues to consider if you are holding the majority of your capital in foreign assets. We also wanted to be realistic. Investors hold a large proportion of their net worth in the geography from which they live for reasons such as those cited above. If we had released a portfolio with 10% Canadian exposure, we would have been confident it would have been dead on arrival. The portfolio may not be perfect, and no portfolio ever is, but we decided to satisfice in this regard. We have seen a large amount of investors’ portfolios holding 80% to 90% Canadian exposure.

Secondly, we have seen some claim that when you count the fixed income component, it actually holds closer to a 60% Canadian exposure. This may be a matter of preference but we would be far more concerned about geographic concentration on the equity side versus fixed income. For most, from a tax perspective, diversifying the fixed income component to any significant degree leads to over-complication and as long as the credit quality of fixed income is investment grade, we are not overly concerned with Canada falling into an abyss and companies/governments defaulting on debt. Yes, there is always a possibility, but if high quality companies and Canadian governments are defaulting on debt, we think there will be much bigger problems to be concerned with. This thought can be debated day and night but it is simply our opinion on portfolio structure and think there are ‘bigger fish to fry’ for most investors than worrying about fixed income geographic diversification when you hold high quality fixed income.

Increase Fixed Income:

This gets a bit more into the individuals personal circumstances but we are looking at an ‘average’ investor who would look something like a 35 to 40 year old that is gainfully employed, a net saver (i.e saving more than spending) with a manageable debt load.  In this situation, where there is no need for a reliable cash flow from the investment portfolio, we have opted for a lower fixed income exposure in the model portfolio (nearly 20% if we include preferreds). We continue to think this is appropriate given record low interest rates that, while they may remain low for some time, they cannot go much lower and are more than likely to go up at some point.  With changes in the level of interest rates determining the high majority of fixed income returns we think the situation is best posed like this: You could have a high probability chance at losing only X% in fixed income or a lower but less certain probability  of earning a positive return in any given year with equities. Psychologically it can be broken down as whether you want to take a more certain and predictable loss or take a ‘gamble’ with a larger range of outcomes but less certainty as to what that outcome will be.  This is why timeframe is key, as this gamble may not be appropriate if you are retired, but if you have a long timeframe through which you will not need to draw on funds, the ‘gamble’ starts to make a lot more sense.

Increase US Or International Exposure:

On the US side, having some exposure in the first place has sort of taken care of this consideration for us, as the strong US markets have grown in size within the portfolio. Because of this, we feel letting this exposure continue with the momentum is appropriate. An argument could be made for adding even more to US investments but with 25% of the total portfolio in US securities, we think the CMS portfolio is fairly well covered in this respect and would also go against the idea of rebalancing where you trim the strong areas and buy the underperformers. On the international front, we will likely consider adding to this exposure at some time, as these are the most underrepresented areas but with China’s growth under the microscope and some currency issues developing, we simply do not think a position needs to be rushed.

With just over a 12% return since October 18, 2013 to August 31, 2015 compared to the TSX composite return of 7.55% over the same period we are pretty happy with the portfolio performance so far. We are even more satisfied with the fact that very little in the way of changes were made to the portfolio, helping to limit transaction and taxation costs. As usual, we want to leave readers with a final comment on the appropriateness of the portfolio, as we seem to get some comments on this every time we post the CMS model portfolio. It is a very general guide to a general audience. It in no way attempts to suggest that a reader should drop everything and follow the allocations blindly and also in no way suggests that it is a one size fits all portfolio. Every investor is different and a portfolio needs to be adjusted in a way that meets your specific needs and views. We don’t and can’t know what every individuals’ needs are so please keep this in mind when reading and do your own due diligence before making investment decisions. When in doubt, consult a financial advisor who understands your specific needs and feel free to check out the new advisor database that Canadian MoneySaver has created if you are looking for some suggestions.

Ryan Modesto, CFA, is Managing Partner at 5i Research Inc. in Kitchener, Ontario. He can be reached at ryanmodesto@5iresearch.ca