Advisor explains how bucketing allocations into yield, market, and defense has freed his asset allocation approach and eased client communication
It might be approaching cliché at this point to declare the ‘death’ of the 60/40 equity/bond portfolio. The trauma of 2022’s bear market has etched itself in advisors’ psyches. More economists and asset managers are highlighting past periods of higher resting inflation and interest rates to show that in moments that resemble our own, the negative correlation between stocks and bonds has sometimes proved positive. The case is being made for advisors to seek alternative asset allocation models that can better offer their clients access to non-correlated assets. Scott Starratt pursues that goal by looking past asset classification and allocating based on the utility a particular asset provides.
Starratt, the investment advisor and portfolio manager at Starratt Wealth Management of Canaccord Genuity, prefers to group his clients’ portfolios into three buckets: market, yield, and defense. The market category is largely comprised of equities and other risk-on assets meant to drive growth. The yield category includes bonds and other income-paying securities. The defense category holds assets uncorrelated to stocks or bonds, merger arbitrage funds, music royalties, hard real estate, and — until a few years ago — gold. While this may seem like just a semantic distinction, Starratt argues that using these categories allows for a more nuanced approach to portfolio management.
“It's a little bit nuanced and a little bit about language, but it comes back to how realistic an allocation is,” Starratt says. “Probably the most important thing is asking what you are trying to get out of it. If you're trying to diversify and reduce volatility you're probably looking at more conservative type true hedge assets, not performance hedge but true hedge. And in that way, you're attempting to protect the client portfolio against any horribly adverse reaction to a market drop.”
To explain how he buckets certain investments, Starratt notes the example of a long-short credit manager’s fund. By classical definition, that fund would be called an alternative and put into the alts sleeve of a client portfolio. Starratt argues, though, that the fund is a bond strategy, just run by a manager with a bigger toolbox. That strategy, therefore, would fit in the yield bucket of his model.
So much of Starratt’s approach is built around controlling for client behaviour. He notes that some clients may be able to handle an 18 per cent downturn when the market is down 20 per cent, understanding that they are technically outperforming. Many others, though, would balk at all that red and expect more muted downside, even if they know it comes with a similar dampening of the upside. Volatility is the enemy of behavioural advice, which is why Starratt puts AAA rated government bonds in the yield bucket, rather than defense.
“When I look at defense, I don't look at it from the standpoint of risk of losing principle or risk of losing money. The rating agencies would say that the risk of losing principle on AAA rated government bonds is very, very, very, very low. However, the risk of price volatility, depending upon the term of the bond, can be high. Although the actual security itself may be defensive, the pricing on such a security, especially if it's seven or longer years, can be quite dramatic.”
Defensive allocations, therefore, are less subject to daily volatility, or are capable of offsetting that price volatility in other assets. Among certain alts strategies like music royalties and M&A, or hard real estate assets, Starratt notes that gold used to play almost a textbook role on the defensive side of portfolios. That has changed, he notes, in more recent years as gold’s price has appreciated well beyond its traditional range.
Without commenting on whether gold’s appreciation is well founded or not, Starratt notes that purely from a price and volatility perspective, the yellow metal is now split between what he would categorize as defense and what he would put in the market bucket. Because its behaviour has been so hard to define, he has largely avoided direct allocations to gold bullion beyond access to diversified commodities funds. He also notes that gold equities may not be the diversifier that some present them as. Despite their beta to gold, he says, they’re stocks first and a stock market downturn will likely be felt in the price of gold stocks, even if gold bullion doesn’t follow.
Some of the recent ‘melt-up’ in gold prices, as Starratt puts it, has been accompanied by exhortations to use gold as a bond replacement. Starratt cautions against that kind of approach, arguing that what bonds and gold deliver for portfolios are deeply different. One comes with cash flow and a government or corporate guarantee, the other is simply a precious metal. Describing gold as a bond replacement stems more from a 60/40 mindset, rather than one built around the utility of a particular investment.
Taking that approach to asset allocation requires educating both advisors and clients, Starratt notes. Despite the upfront work required to establish an understanding of this approach, Starratt emphasizes the value it can bring to the client relationship and how much easier it makes communication.
“It opens up the conversation to the purpose of that particular investment and what's it doing in the portfolio,” Starratt says. “It allows the client to better understand the positioning of the overall portfolio and the thoughts of the advisor, hopefully it results in better agreement when it’s time to be more defensive or when its time to take on more risk.”
Scott Starratt is a Portfolio Manager at Canaccord Genuity Wealth Management. His views, including any recommendations, expressed in this article are his own only, and are not necessarily those of Canaccord Genuity Corp (Member: CIPF/CIRO). Investing in any of the asset-class(es) mentioned here may not be suitable for all investors, as there are different types of risks involved with this investment strategy. Even if suitable to your level of risk tolerance, they may not be appropriate for your portfolio, depending on what other investments you hold. Commissions, trailing commissions, management fees, and expenses all may be associated with fund investments. Fund investing is not guaranteed, values change frequently, and past performance may not be repeated. Diversification and asset allocation do not ensure a profit or guarantee against loss.
