Strategies for the new normal

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(JEFF DURHAM ILLUSTRATION / MCT)

Quick facts

A glance at NEI's funds: All three funds from NEI Investments are extremely flexible in their asset allocation. In fact, they stretch the boundaries of their respective categories. Each fund can invest in futures, forward contracts, options and even short selling as defensive strategies.

• Northwest Macro Canadian Equity Fund: Judging by its name, it should invest mainly in the Canadian stock market, the TSX, but this fund can invest in more than its name suggests. At any given time, half of its investments can be foreign equities. Ten per cent of its assets can be invested in precious metals -- the commodities, not the companies that produce them. And as much as half of its capital can sit in cash. It charges an annual 2.63 per cent management expense ratio (MER).
• Northwest Macro Canadian Asset Allocation: This fund belongs to a category of mutual funds that a Wall Street Journal article from earlier this year called "actively managed funds on steroids." The official name of the category is tactical balanced, and fund managers have almost total discretion to move capital to whatever asset class necessary. NEI's fund can invest between 10 and 90 per cent in Canadian equities or fixed income (bonds). Its assets can also consist of as much as 50 per cent foreign equities. Its portfolio can contain up to 10 per cent precious metals (gold and silver) and it can have a maximum of 30 per cent of its assets in cash. It charges a 1.95 per cent MER.
• NEI Ethical Balanced: This fund has been around since 1989 and has a two-star rating from Morningstar Canada. But now it's been revamped with more flexibility and new management (Hughes). Its asset allocation can range from 30 to 60 per cent Canadian equities, as much as 30 per cent foreign equities and 20 to 60 per cent fixed income. It can also hold as much as 10 per cent of its value in precious metals and up to 20 per cent of its holdings in cash. Its MER is 2.35 per cent.

Most of us have come to grips with the so-called new normal by now.

And no, this has nothing to do with the new TV sitcom.

The real new normal was coined by PIMCO bond gurus Bill Gross and Mohamed A. El-Erian and refers to a long period of poor economic growth, high inflation, high unemployment and debt crises.

As a result, stock markets will be volatile -- up one year and down the next -- and bonds or GICs offer little safety, earning less than inflation.

Naturally, the mutual fund industry is adapting to this new investment ecosystem, too.

Case in point is NEI Investments, known for its socially responsible funds, among others. It recently launched two new funds -- the Northwest Macro Canadian Asset Allocation and the Northwest Macro Canadian Equity -- and it revamped another, its Ethical Balanced Fund.

All three have investment mandates aimed to roll with the punches in the years to come.

To promote its new, improved product line, NEI's chief investment officer, Daniel Solomon, along with a newly hired top-gun fund manager, Christine Hughes, were in Winnipeg earlier this month meeting with advisers.

NEI's pitch is this: Traditional funds are obsolete. They can't cope with the new investment landscape.

The theory on which most fund strategies are based, Modern Portfolio Theory, is a 1950s relic. The theory underpins the strategy of buying and holding a diversified portfolio of investments, and it's based on a 50-year market history that's no longer applicable, Solomon says.

In its place, a new theory has come to the fore: Conditional Value-at-risk Theory.

"With this theory, risk is defined as losing money, so you want to minimize the risk of things going really bad," Solomon says.

"It accounts for the fact black-swan events will continue to happen often -- not once every 1,000 years."

Indeed, NEI's Ethical Balanced Fund is testament to this change in strategy. It's been around since 1989 and has a subpar track record over the last decade.

Both newcomers to NEI, Solomon and Hughes aim to reinvigorate the Ethical Fund with the same strategies used in its two new offerings -- the aforementioned Canadian equity and Canadian asset allocation funds.

These funds are built to be flexible. They can hold large positions in cash, short sell, buy and sell options, futures and precious metals -- all hedges against market downturns.

They require managers who can make the right call on the market. That's why NEI pursued Hughes, Solomon says.

Hughes has a 10-year-plus track record of making the right calls.

In 2006, she managed AGF's Canadian Asset Allocation fund, ranked fifth among hundreds of funds. That was during the good times. During bad times (2008), the fund's performance was even more impressive. It was second-best of all funds in its class. Still, it posted a seven per cent loss, but that was better than 16 per cent-plus losses by many of its peers.

After 2008, Hughes took time off to have another baby, her third. Earlier this year, she started her own investment firm, OtterWood Capital Management, around the same time NEI hired her to run the three funds.

Hughes says she has a unique skill set for the new normal because of her early experience 20 years ago as a private portfolio manager for high-net-worth clients.

"What I learned from them is: 'Don't lose my money.' "

Her early work also gave her a solid foundation in fixed-income investing.

"So my understanding of equities is within the overall context of the bond market."

This is important because every major stock market shakeup is foreshadowed by stresses in the bond market, knowledge that helped Hughes avoid the 2008 crash.

"I was waiting for confirmation of the housing crash in the bond market and got it in 2007," she says.

"By the time the crash happened, we were very defensive."

But Hughes says she had wanted to be even more defensive at the time. She had wanted to short-sell the S&P 500, a broad index of the top U.S. stocks. But the AGF fund she managed couldn't short-sell markets. She also wanted to buy gold. That, too, wasn't allowed, so she bought gold stocks instead, which didn't produce the same results.

"The fund would have gone up eight or nine per cent if I had been able to own physical gold," she says.

Today with NEI, she says she can make those calls.

It's the flexibility required to deal with unpredictable market conditions, which will certainly ensue now that the U.S. and European central banks have "hired a person to push a button on the wall to print money without an end in sight," she says.

Like many other market analysts, Hughes predicts loose monetary policy will be good news for the stock market in the short term.

"What happens is, the price of stuff goes up because the value of currency is going down," she says. "This is good for investors, but it's bad for consumers and those living on fixed income."

Flooding the markets with money punishes savers, forcing them to move money out of safe assets such as government bonds into riskier assets to keep pace with inflation, which inevitably will come to the fore as a result of loose-money policy.

This creates what Hughes calls "a reluctant bull" opportunity. Stocks will rise, but a bad hangover will follow.

"We're bullish for now, but it is not a panacea," she says. "This will not end well."

Her best educated guess is the party won't flame out in Europe. It will end in Japan, the most indebted major economy on Earth. It owes twice as much as it produces annually and has only managed to maintain its debt load by selling low-interest government bonds to its own citizens. The Japanese population, like ours, is aging and shifting from saving to spending. In turn, Japan will be forced to fund its deficits in the global bond market, which will drive it up its cost of borrowing.

"So its central bank will press the button and buy the bonds itself, and its currency will collapse," she says. "This will be massively destabilizing."

Japan is the second-largest bond market in the world.

Just as in the U.S. subprime mortgage crisis, when the tide finally rolls out, we will find out who didn't have a life-jacket.

"There will be hedge funds that are positioned for small movements in the interest rates that will be offside and leveraged 50 to one, and they'll take down Goldman Sachs," she says.

On the upside, this collapse is likely a year or two away.

But watch out, because when it starts, it will unfold fast.

Yet amid all this expected volatility -- the bulls and bears -- will be buy-low-and-sell-high opportunities, just as long as you can anticipate the hazards.

And that is exactly what Hughes intends to do.

"We can have some degree of predictive value of what is going to happen, but we don't know when, so we watch for clues," she says. "We're trying to retain and preserve the purchasing power, all the while avoiding the pitfalls of these intermittent crises."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition October 13, 2012 B10