Traditional approaches to constructing a portfolio’s core relied on selecting individual stocks, bonds and mutual funds. However, in recent years, index strategies have become more prevalent and specialized, allowing advisors to access targeted exposures in a cost-effective wrapper. Kurt Reiman, BlackRock’s Chief Investment Strategist for Canada, explains why he believes indexing the core is generally the best approach for investors and advisors.
What does the core need to achieve for a portfolio?
The core’s role is to provide diversified exposure to the drivers of returns that will enable investors to meet their long-term objectives. Cash can’t do that, but too often we find investors are holding too much cash. That’s partly a legacy of the financial crisis. Ten years ago, portfolios were constructed largely of individual stocks, bonds and mutual funds and it was difficult to see how the components were interacting. As a result, many investors realized too late that their supposedly diversified portfolios were exposed to a substantial amount of economic and credit risk. Much more commonplace now, index strategies can give investors and their advisors a more nuanced understanding of the risk and return drivers of a portfolio and how asset class, sector and geographic exposures fit together.
Why are index strategies often best for the core?
Using index strategies at the core enables advisors to construct portfolios with the same building blocks in different proportions depending on risk tolerance and time horizon. Index strategies’ transparency helps avoid situations where portfolios are exposed to inadvertent concentrations of economic and credit risk, and it enables advisors to more closely conform portfolios to a client’s risk tolerance and time horizon. When selecting core index strategies, advisors should look for index managers who can demonstrate low tracking error and look to combine complementary and comprehensive index strategies to avoid exposure gaps and duplication.
How can advisors get value from index strategies?
There’s a fee compression everywhere, and advisors can build a portfolio of index strategies at a low cost. In contrast, picking the best alpha-seeking managers is time-consuming and costly, and on average alpha-seeking managers don’t deliver alpha net of fees. Another point of value for advisors is the ability to scale these portfolios across their entire business. You can have multiple portfolios across the risk spectrum and adjust them to meet each client’s needs. That’s not as easy to do with mutual funds.
Should part or all of the core be hedged against foreign currency fluctuations?
It depends on the investor’s home currency – typically, where an individual’s longer-run liabilities will be based. The Canadian dollar is pro-cyclical, so when investors are risk-on, the economy is doing well and the stock market is rising, the Canadian dollar generally appreciates, and vice versa. The U.S. dollar is counter-cyclical, and a lot of the academic literature is written based on a U.S. dollar perspective. For Canadian investors experiencing the global financial crisis 10 years ago, having exposure to foreign currencies minimized the downside because the euro and U.S. dollar strengthened versus the loonie. Based on data going back 30 years, I believe it’s best for Canadian dollar-denominated investors to hedge currency exposure to global fixed-income because foreign exchange swings are often greater than the volatility in the underlying asset, but to leave global equity exposure unhedged.
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