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    Understanding a Bond Portfolio | Shares for Beginners


    Credit, bonds and fixed income? What is the difference? What are the basics of credit markets? How to build a bond portfolio? Mark Mitchell was interviewed by Phil Muscatello of Shares for Beginners Podcast. Mark is a Portfolio Manager at Daintree Capital, the Investment Manager responsible for the eInvest Core Income fund (Managed Fund) (Code:ECOR), eInvest Cash Booster Fund (Managed Fund) (Code:ECAS) and eInvest Income Maximiser Fund (Managed Fund) (Code:EMAX) and his investment insights inform the strategies of these ETFs.

    If you have every wanted a simple, easy to listen to overview of fixed income and credit, this podcast is for you. Some highligts:

    “There’s a spectrum of credit risk. There are people who are much more worthy borrowers and they’re guys that, you know, that a little bit more suspect. And so those people obviously have to pay a lot more to borrow money from people because there’s more risks. They won’t get it back. So, absolutely. It’s similar to the stock world, there’s companies that are really profitable generating a lot of returns, an Amazon for example, that’s a pretty low risk company to lend to.”
    Generating income from bonds. Inverse Relationship between bond price and interest rates

    The inverse relationship of interest rates and bond prices in a bond portfolio.

    “You can have a portfolio of say 25 stocks, 20 of them can all lose money and five of them can do so well that they pay for the other 20. If you contrast that with a bond world, that’s not the case. A bond is a loan, $100 for five years and after five years, you get a $100 back. The bond is never going to go from $100 to $200, $300, $400. So in the bond world we refer to that as asymmetrical risk, which is the idea of one sided risk. There’s very little upside and it’s all downside. In that type of profile, it’s extremely important to be well-diversified. If you bought a portfolio of 20 bonds and unforeseen things happen, over a five or seven year investment horizon any one of those companies could default. As we’ve seen in March and April of this year, people will wake up to the fact that these companies can default.”

    Lastly, We have created a ETF investment guide exclusively for Shares for Beginners Listeners. Sign up for the guide for the chance to win $500 invested in the eInvest Active ETF of your choice. T&C’s apply.

     

    Disclaimer: Please note that these are the views of the author, Mark Mitchell, Portfolio Manager, Daintree Capital,  and is not financial advice.

    To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at www.einvest.com.au

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    Transcription

    Voiceover (3s): Shares for Beginners Mark Mitchell (5s): March, 2020 was absolutely one of the worst periods. The challenge there, you know, there’s a lot of psychology that goes into it. If you’re looking at your portfolio every day and it’s going down day after day after day, and you’re like, well, at some stage you just sort of give up, which is understandable, but you could end up selling at the bottom. When we talk about constructing portfolios, it’s sort of about managing the downside. What’s the worst case scenario. Can I handle that type of volatility? And I might have a situation emotionally and stage in my life where I can actually handle that because everyone can handle the upside. That’s the easy bit, but can you handle the downside?

    Phil Muscatello (36s): Good. I am welcome back to shares for beginners. I’m Phil Muscatello with interest rates at historic lows. Where can investors put their cash? Older investors need steady income and younger investors may be saving money for a home educational family, either way. This portion of your capital needs to be deployed in a way that’s not subject to stock market ups and downs. So I’ve invited Mark Mitchell. Hi, Mark. How are you? Good morning. How are you? Mark Mitchell is a director of Daintree capital, a boutique investment management company, specializing in building fixed income credit portfolios. So tell us a little bit about yourself and your background and how you came to this point in your life.

    Mark Mitchell (1m 13s): Well, I’m a Texas boy actually, so yeah, grew up in Dallas and went to university at Texas and Austin, and then spent some time in, in Chicago, went to DePaul there and just always had a passion for financial markets to just enjoy trying to understand what drives financial assets and understanding the economies and the behavior people and psychology and that subset. So I’ve just always had a passion for it and fell into doing, you know, sort of credit research, looking at companies that issue dad and, and the risk profiles of them, and eventually got into sort of managing portfolios and then down the track launched, launched my own business. So yeah, I really enjoy it. It’s, it’s, it’s quite fun for me. It’s every day is different.

    Mark Mitchell (1m 54s): You know, you’re always learning something, always trying to sort of understand how the pieces fit together a little bit, a little bit better. So I’ll solve the puzzle. Phil Muscatello (2m 2s): So you were attracted to credit markets from an most people go straight into stocks. Really? Yeah. That’s a good question. Look,

    Mark Mitchell (2m 9s): I, I do like stocks and, and a lot of people go into the stock side of things because the returns are bigger. There’s a lot of stock stories. You know, people love to talk about the stock that they own and how that stock has gone from $5 to $20 in how smart they are. So I sort of ended up in credit just because it started so doing research and sort of the high yield credit markets, which is, you know, sort of the riskier insurers. And it just sort of stayed on that path. I mean, I don’t really have a problem per se with the stocks. I mean, certainly that’s fine, but I mean, I still sort of look at stocks and have interest in stocks, but as far as a career, I just sort of found this little niche for myself, but you’re looking at very similar sorts of things and, you know, and understanding risks and how business operate and those types of things.

    Mark Mitchell (2m 51s): So it’s a similar skillset, similar things that you look at, but to sort of fell into the credit side,

    Phil Muscatello (2m 56s): To drill down people that are studying stocks, they’re, I’m looking at fundamentals of a stock and the fundamentals of a company and how it’s operating. But what you’re looking at is the money that these companies seek to fund their growth. Is that how it works? Is that what a credit market is sort of, so if we could just go right into the basics of the yeah,

    Mark Mitchell (3m 17s): Sure. Just to sort of understanding at a grassroots level. So generally, you know, there’s a university with studying something called Porter’s analysis, which is like the five forces that affect a business. So whether you’re a credit investor or a debt investor or an active investor, you’d probably look at those things, but the outcome is a little bit different. So if you’re an equity investor, you want to know if the overall value of the business is going to grow. And in theory over time, that should lead to a higher price for the stock. Whereas the debt investor, what you’re really concerned about is that, you know, I’ve lent them money. I want them to pay me my interest regularly. And then at the end of that term, I want them to give me my money back. So it’s a little bit different approach and then you’re much it’s. So in a sense, the equity investor probably looks at a broader range of things because they’re worried not only about paying back the debt, but also the growth, whereas the debt investor, they don’t get paid for that upside investing.

    Mark Mitchell (4m 8s): So it’s much more about I’m want these guys to stay in business. I don’t want them to go out of business and I want to get my money back from them. So you’re looking at very similar sorts of things, but the objectives and outcomes

    Phil Muscatello (4m 17s): A little bit different, let’s tend to interest rates. They seem very low at the moment. Do you have any kind of long-term view about interest rates and where they’re heading? Yeah, sure.

    Mark Mitchell (4m 25s): Rates are low. And unfortunately for, for listeners and for investors, I mean probably would have heard this already, but they’re going to stay low for a long time as is our view. So there are lots of reasons for that without being too technical in this type of medium, but yeah, but interest rates are a function of the demand for money. How much people actually need to borrow a function of cash rates that are set by central banks and central banks, particularly the U S you know, they’re trying to balance the idea of having a full employment, but also they don’t want inflation. So if you’re a central banker and inflation is an anathema to, you want a small amount of inflation, but in a very controlled way.

    Mark Mitchell (5m 5s): So they’re very aggressive about trying to control inflation, but also trying to balance balance employment. So we’re in an environment where there’s very little inflation and there are a number of drivers of that. Lots of academics spend a lot of time looking at these things, but some of the more obvious things, you know, are that there is a bit of a surplus of capital that’s available there that can be lent out things like demographic factors play a role in inflation. So generally speaking, you know, the older people get the older, an economy is less demand. There is for money, less people are spending, they’ve already sort of accumulated wealth. Those things, those things definitely definitely play a factor. So, and then one of the other ones that gets talked about quite a bit of technology, you know, the influence of technology and the ability to, you know, you’re sitting in Arizona and you need a project on, you can get someone in India online to do that project for you.

    Mark Mitchell (5m 54s): And so the mobility of labor and those types of things that really all those help keeps sort of wage costs under control, and that sort of leads on to inflation. So a sort of a long-winded way of saying, you know, inflation is relatively low, there’s an excess amount of savings. So those things would likely point to, to interest rates staying low for a long period of time.

    Phil Muscatello (6m 11s): Okay, well, let’s then move on to bonds because credit markets, we’re actually talking about bonds here and there’s different kinds of bonds aren’t there.

    Mark Mitchell (6m 18s): Yeah, absolutely. No, that is a big, big range of bonds. It’s a little bit different than stocks. You know, if you go to buy a stock of, of Microsoft you on the same stock as your neighbor owns and your uncle and your cousin, it’s all the same stuff for the most part, you know, it’s just, they’re, they’re, they’re very homogenous. Bonds are very specific instruments that are negotiated under specific terms at a point in time with certain conditions. So they’re very, very different. So when you go to buy a bond, you have to understand the structural features of that particular bond. And so a large bank, for example, like a JP Morgan, they will have thousands, literally thousands of bonds on offer. They issue them, they issue the bonds and bonds themselves, right?

    Mark Mitchell (6m 59s): That’s right. So they’re, they’re, they need money to fund their operations. They don’t want to fund it all with equity because the more equity they sell that reduces the return for the equity holders. So they don’t want to be a hundred percent equity funded, so they need debt to help fund their operations. So if you’re a bank, you get that money generally from three different sources, you get it from, from the equity investors, but you also get it from people who give you a term deposit. So it turned from a bank’s perspective, a term deposit is a short term loan. And so from our perspective, you know, we put the money in the bank and we get a return, but from their perspective, it’s it’s alum that eventually has to get paid back. And the other way they generally get their funding is to selling a bond offering to, to investors like, like ourselves.

    Mark Mitchell (7m 39s): And so our job is to look at the range of companies that are out there and all the different types of structural features and what, what sort of return we get for those bonds. And then we construct a portfolio of them. So it’s a diversified portfolio of bonds. So look, it’s hard for the average individual, to be honest, just to sort of buy a bond off the shelf if you like, because they are so different. So if you are as an individual going to invest in bonds, you know, you definitely need to devote some time to understanding all the straps and government bonds as well. Yeah, exactly. Right. So even within the bond space, there’s, there’s safer assets, they’re riskier assets, and then they’re, they’re quite risky assets. So the safest, generally speaking is government bonds issued by the U S government or the Canadian government or whoever it is, those tend to be the safest bonds.

    Mark Mitchell (8m 28s): And so when you think about investing in a bond, there are a number of risk factors that you look at, but the one most people focus most heavily on, you know, is the default risk, you know, the risk that you’re not going to get your money back. So we would have seen, you know, very recently, you know, your listeners would have seen some pretty high profile defaults, you know, Hertz, for example, you know, these, some of these car companies that really got into trouble and

    Phil Muscatello (8m 50s): In terms of governments, Argentina, and Argentina.

    Mark Mitchell (8m 52s): Yeah, exactly. So within the government space sort of high quality borrowers, the people who have a good chance, you’re going to get your money back. And then those that are quite risky. So it’s the same for governments Phil Muscatello (9m 2s): And for companies exactly what credit risks

    Mark Mitchell (9m 5s): Exactly. Right. So there’s a spectrum of credit risk. There are people who are much more worthy borrowers and they’re guys that, you know, that a little bit more suspect. And so those people obviously have to pay a lot more to borrow money from people because there’s more risks. They won’t get it back. So, absolutely. So there’s a similar, you know, in the stock world, you know, there’s companies that if you imagine a company that’s really profitable generating a lot of returns, it’s growing an Amazon, for example, that’s a pretty low risk company to lento. Or if you imagine, you know, at the moment an airline where traffic is way down, they might be fine. But if I’m going to lend you money, it’s a very risky time. So just a spectrum of different types of burrows.

    Phil Muscatello (9m 45s): Absolutely. And to provide some perspective, the bond market is way bigger than the any equity market is

    Mark Mitchell (9m 52s): It is, it is, it is much bigger, but it’s not as sexy. You know, that’s the thing. And if people don’t like to talk about, you know, because as a bond investor, you know, you might buy a bond at a hundred dollars, let’s say, for example, you might get $3 a year in coupon. And at the end of five years, she’d get a hundred dollars back. You know, that’s not sexy for the financial media at, to talk about. You can talk about a very simple transaction, a very simple transaction <inaudible>. But if you’re a, you know, it’s very exciting to talk about the fact that you’ve owned Amazon and what’s happened with that sort of stuff. So certainly it doesn’t get as much attention, you know, in financial media,

    Phil Muscatello (10m 32s): Let’s drill down a little bit further towards people’s individual portfolios. One of the traditional ideas of investing is the 60 40 portfolio. What is the 60 40 portfolio?

    Mark Mitchell (10m 42s): Yeah. So 60, 40 portfolio. So if you studied finance and university, and, you know, you talked about this idea of looking at the risk of a portfolio of an overall portfolio versus the expected return and said the ideas that you want to try to, they have this idea of an efficient frontier up, you know, what, what’s the best combination of assets that gives you the maximum return with a minimum amount of risk. And so you can draw out for your listeners, but just imagine a little sort of almost a lot of Nike shape type sort of graph, and depending on what your risk profile is, that’s kind of the portfolio you come up with. And traditionally, probably for the past 30 to 40 years, one of the mainstays of that approach has been this idea of a 60, 40 portfolio.

    Mark Mitchell (11m 25s): And the idea is that very, roughly you own 60% of your portfolio in stocks and you don’t own 40% in bonds. And the reason why you had that approach is because in most cases, up until recently, you’d have what you call a negative correlation between those two. So what does that mean? So generally speaking, if you own a, an equity or a portfolio of equities, or say the SMP 500 index, and that sells off most lower in price, generally speaking, the more defensive assets, like you mentioned before, like government bonds, those will tend to rally in price. So there’s an offsetting effect there. And so it makes sense for you to diversify your overall portfolio risk, if you have equities than to have bonds.

    Mark Mitchell (12m 8s): And so 60 40 has been sort of a traditional type of asset allocation. Now, of course, that’s very generic and it all is always varied based on where you are in your life. And you know, what your risk profile is generally speaking. You know, if you’re 80 years old, it doesn’t make a lot of sense to hone 80% of your portfolio in equities because you need income, certainty and capital stability. And if you’re, and if you’re 20 years old, it probably doesn’t make a lot of sense down a heck of a lot of bonds because you have a very long time until you retire. And so you want that the ability for that capital to grow and compound, and so equities will tend to provide a higher return over time. So, yeah, so that has been the traditional approach, but I mean, our, our view, and I think what’s becoming probably more of a mainstream view is that that approach may not work in an environment where, as you mentioned before, Phil interest rates are very low.

    Mark Mitchell (12m 55s): And so eventually rates will get to a level where they can’t go much lower. And so the idea of, you know, when the equity sell off that your bonds are going to go up, that’s nowhere near as effective because you’re sort of approaching a level where rates can’t move much slower and the prices can’t go into too much higher. And so that’s a real challenge for a lot of people, because for the past 20, 30, 40 years, people have really kind of leaned on government bonds and those sort of defensive assets to protect their equities. That that’ll be a struggle, I think, in the next sort of decade or two or longer, Phil Muscatello (13m 28s): That’s one of the confusing things. A lot of people find about bonds that there’s a correlation between interest rates and the value of a bond. Yeah. Can you just explain that really simple terms now?

    Mark Mitchell (13m 40s): Totally, absolutely. So if you imagine, let’s just imagine today, a company issues a bond and it pays you a coupon of 5%. You agree the terms they say, well, based on who you are and how risky you are, and the general level of interest rates, I expect a 5% return on this bond and that’s fine. And the bond is priced set up at a hundred dollars. But then if you imagine let’s fast forward a year from now, and the general level of interest rates has moved lower. So now, if you were striking that deal for the exact same company, you’d only expect a 4% coupon that the general level of rates has gone down. So that bond, which has now been outstanding for a year has a coupon of 5%. Mark Mitchell (14m 20s): And the new bond that will be outstanding for that same risk has a coupon of 4%. So that on a relative basis, that old bond has actually become more valuable. And so what, so the price of the bond trades to actually equalize the value of that bond for the new bonds would be outstanding. So the price has to go up. So because bonds will tend to mature at a certain price. So if you’re, if I lend you money and we agree a price of $100, five years from now, I need you to give me that hundred dollars back. And that a hundred dollars doesn’t really change. But because of this idea of the interest rates, the price might go up to say one Oh three, but whenever the bond actually matures, it’s going to eventually, it’s going to what they say, pull to par, which means it’s going to go from one to three, it’s going to move back down a price until it gets to a hundred.

    Mark Mitchell (15m 5s): So that’s sort of the Mark to market volatility around bonds. But as we talked about before, it’s not like an equity portfolio. So in many ways what goes up must come down. So it goes up to one Oh three. It eventually is going to go back down to a hundred because you’ve only agreed. We’ve agreed. A hundred dollars. That’s all it’s ever going to get. Yeah. So, so what happens when there’s an interest rate differential is that price will go up to one Oh three to make the value because the bond, the bond is going to go from one to three to 100, the expected for return will be lower, right? Because I’m paying $103 for it. But in four years time, I’m only going to get a hundred dollars for it. So now the expected return to that bond is now 4%, which equates to what the new market clearing level is for that type of risk.

    Mark Mitchell (15m 51s): Was that straightforward enough? I’m not sure. Phil Muscatello (15m 53s): It’s, it’s, it’s very, it’s very difficult thing to explain on that, but really what it simply means is is that when general interest rates go down, the PR the value of bonds Mark Mitchell (16m 3s): Go up exact exactly right. That’s just really very simple terms. Exactly. Right. And the converse is true. And so rates go up, those prices tend, tend to go down. And so to your question earlier about the 60 40 portfolio. So that’s why generally has, has been valuable because in an environment where <inaudible> tend not to do very well, there’s not as much demand for money. And typically what you’d see as central bank sort of like the U S federal reserve, lowering those cash rates, interest rates are going down in that environment. And therefore the price of the bonds that you have, particularly the government bonds they’ll tend to be going up. And that’s kind of how you get the offsetting effect of that 60, 40 portfolio.

    Phil Muscatello (16m 41s): And because the interest rates are low. Now, there’s no perspective. Mark Mitchell (16m 44s): You can’t go too much lower the kid. They can’t go too much lower. I mean, there are certainly economies around the world, Europe, obviously everyone is aware of, you know, those, those rates are negative, but they’re not materially negative. You know, so you’re not talking, it can’t go another two or three or 4%. Maybe it can go another one, one and a half percent if that, but there’s no real appetite in the U S and the federal reserve to, to take interest rates, negative, and people ending economies where it has been done for the most part, you know, jury sort of still out as to whether or not it was actually a good decision. Generally, the mainstream thought is that it probably wasn’t a great decision. And probably in retrospect, they shouldn’t have done that. But the general view is that, you know, you’re not going to take rates from, you know, plus 1% down to minus five or 10%.

    Mark Mitchell (17m 24s): It’s just not going to happen. And so in that environment, you’re approaching a floor how low they can go. And therefore it’s harder and harder to expect your, your bonds to rally on the back of lower interest rates.

    Phil Muscatello (17m 35s): So as with stocks, it’s important to get diversity in the bonds that you buy. It’s very difficult for an individual investor, with a small amount to, to invest in the market in this particular kind of market. It’s very difficult for them to get that kind of, can you tell

    Mark Mitchell (17m 50s): Us about this? Patea now, look, I’m glad you brought that up. It’s something that we have quite a strong view on an organization. So, you know, people who want to do investing and they go out and build their own stock portfolio. There’s been a lot of academic research that, you know, you can get a reasonable level of diversification, probably with 20 to 25 stocks, depending on what you read. But by the time you have 20, 25 stocks, you diversified what they refer to as idiosyncratic risk, which is the, the risk of an individual name you have sort of have the impact on the portfolio is relatively small, but what’s unique about stocks is that, you know, Amazon or Microsoft example, you can buy a stock at $10. It can go to 50, it can go to a hundred, it can go to 200.

    Mark Mitchell (18m 32s): So there’s really no limit in terms of where it can go. You can have a portfolio of say 25 stocks, 20 of them can all lose money. And five of them can do so well that they pay for the other 20. And then, then some, and still give you a very nice return. If you contrast that with a bond world, that’s not the case kind of, as we talked about before, you know, a bond is alone loan, a hundred dollars for five years and five years, you get a hundred dollars back. The bond is never going to go from 100 to 200, 300, 400. So, so in the bond world, we refer to that as, as asymmetrical risk, which is the idea that one sided risk, one sided risk. Exactly right? So there’s very little upside and it’s all downside. So in that type of profile, it’s extremely important to be well-diversified because if you bought a portfolio of 20 bonds, unforeseen things happen and absolutely over a five or seven year investment horizon, any one of those companies could, could default, as we’ve seen in March and April of this year, people will wake up to the fact that these companies can default.

    Mark Mitchell (19m 28s): And if one of those defaults, you’ve lost 5% of your capital and what’s supposed to be for most people kind of the defensive part of the portfolio. So our view is that it’s extremely important to be well-diversified when you’re investing in bonds. Now, as an individual, you, in theory, you could do that, but you do have to have a fair bit of money because in our view, depending on what, how, how much risk you’re taking in that portfolio, but at a minimum, you’d probably want to have at least 50 different companies. And that’s for a very high quality portfolio. And if you start going into sort of high yield and low, the lower parts where you probably want two, three, four, five times that number, it needs to be extremely well-diversified because those companies are going to default. And so when they do default, you don’t want it to have to two material have an impact on your portfolio.

    Mark Mitchell (20m 12s): So, but looking at a high quality portfolio of 50 companies, you know, it’s generally hard to do that as an individual because there are minimum trade sizes associated with that. There’s brokerage costs, all those sorts of things and just the sheer amount of racing and the sheer exactly right? The sheer amount of research you would have to do to even have a modestly well-informed view on those companies and the bonds as we talked about before they are quite different. And so, and then there’s structural features of those bonds that, you know, if you haven’t been working in the industry or don’t have a law degree, it can be really difficult to understand what those features are and what they mean, what they, and how you should price them. So, you know, it takes fixed income teams many, many years, and very, some very experienced people to, to look at these structural features and understand how significant they are or not.

    Mark Mitchell (20m 57s): So kind of a long-winded way of just saying, yeah, absolutely. As an individual, you can construct your own bond portfolio, but you know, you need to have lava a lot of capital to have a properly diversified, and you really need to devote a lot of time to make sure you understand them what those risks are. And for a lot of people, you know, they might view it as this more work than then it’s worth, you know, because you might end up having a bond portfolio. And because interest rates are quite low in this day and age, you might be doing well to get a bond portfolio yields one, one and a half percent. Whereas if you, you know, look out on picking Amazon or Microsoft, you know, and that, that can be a massive home run for you. So it becomes even harder in this environment probably to justify spending that, that sort of time

    Phil Muscatello (21m 36s): Probably you’d have to be continually researching because they’re going to expire and you’d have to keep on replenishing part of the portfolio.

    Mark Mitchell (21m 43s): Exactly. Right. So it’s on ongoing work and then monitoring the profile of those companies. And then actually, if you actually want to sell the bond market is, is a little more liquid than the equity market. So the transactions costs associated with the moving in and out of a $10,000 worth of bonds is much higher than the transactions cost moving out of $10,000 worth of stock. I manage, you know, some, some places actually offer, you know, broker tree trading now. So that’s another, that’s another big factor to consider.

    Phil Muscatello (22m 16s): So speaking of diversification, most people think that by having a, you know, a certain number of stocks that 25, that, that equals diversification, but people don’t realize that asset allocation is an important part of a diversified portfolio there, like we were saying before about the 60, 40 portfolio. So bonds can provide another dimension to your diversification.

    Mark Mitchell (22m 39s): Yeah, absolutely. Absolutely. So look, I think most academic research would support the idea. And if you go to a financial advisor, they’ll probably tell you that what’s critically important is your asset allocation decision. It’s not that you necessarily choose stock a or stock B, or even that you choose the fund manager, a over fund manager, B those things do matter. But what really matters is, you know, how much do you have in stocks at this point in the cycle? Or how much do you have in certain types of interest rate products or property or gold that’s, that’s where the vast majority of the returns come from. So it’s extremely important at the same time. It is very difficult to get, right. And, you know, there, they’re very experienced smart people who spend a lot of time trying to forecast how this particular asset class is going to return and they get it wrong regularly.

    Mark Mitchell (23m 24s): So it is very difficult. So as an individual, it can be quite challenging to forecast, you know, well, the optimal asset allocation for me over the next 18 months is X. So, so I think people that I’ve listened to, I’m not a financial advisor obviously, but people that I’ve listened to and heard talk about it, you know, what seems to make the most sense to me is, you know, you sort of work under assumption that there’s going to be volatility. You can’t really forecast what these things are going to do, but you have, it’s understanding more what your risk tolerance is and how much risk you want to take. And so managing it more from a risk perspective, as opposed to an expected return perspective, because you don’t really know what the returns are going to be, but you do know you as an individual, what your risk tolerances are, you know, you have on buying a house in the next 12 months.

    Mark Mitchell (24m 10s): I don’t need to have probably shouldn’t have 80, 80% of that money sitting in the stock market. I’m 20 years old. And, and I don’t, I’m putting money away that I’m not gonna touch for 40 years. I probably don’t need any of it sitting in bonds. Cause I’m not worried about the drawdowns that the stock market’s going to give me, you know, most, most, most 10 year horizons, you know, stocks are, are positive. I think all 10. And I believe so. So if you have a long-term investment horizon, and that makes sense. So it’s about marrying up what your risk tolerance is, is as well as your investment horizon

    Phil Muscatello (24m 40s): We’re using, what, what, what, how you want to deploy the cash that you existing at the moment I got the 20 year old might say, okay, I’m just going to put this money away and not touch it for 40 years, but they might be saving for a home. Mark Mitchell (24m 51s): That’s exactly right. So you, maybe you said that portion of side, you put it in something that’s much more conservative or defensive. It’s a lower expected return, but you have a high level of confidence that that capital will be there.

    Phil Muscatello (25m 0s): And it’s going to be getting just a little bit more interest than you’re going to be getting in.

    Mark Mitchell (25m 3s): Yeah, that’s right. Then you get in the bank. Exactly. Right. Isn’t the right. So it’s just balancing all those things. I mean, one of the things I, I, one of my bugbears about people who do investing is that they often associate the best investment allocation is the one with the highest return. And I have a strong view that that’s not the case. You know, it’s what is the right portfolio for me and my lifestyle and where I’m at in my life. And my priorities is going to be different than you or anyone else. So it’s about, what’s the right portfolio for you. And in many cases, that’s a lower expected return portfolio because it makes the most sense for you. So it’s not wrong because a lot of people do. I think you want to sleep

    Phil Muscatello (25m 39s): At night as well. Some people just really want to sleep at

    Mark Mitchell (25m 41s): Night. Exactly. Right. And it’s, some people are very, very secure in their job and their income that comes from that. And so they don’t need their investment portfolio to work as hard as others like to roll the dice, you know? And if it doesn’t work out, they’re okay with that. So neither of those approaches is wrong. It’s what makes the most sense for you. Phil Muscatello (25m 59s): So investors to get that diversification can invest in ETFs to invest in, and this is the kind of products that you, that you’re working with. So some of these are actively managed and some are passively managed. Is that the case? And what’s the difference.

    Mark Mitchell (26m 16s): So there’s been an explosion of exchange, traded funds in the U S and generally speaking, not all all the time, but the most of that growth has been in what we refer to as passive products. There, there is a growing segment of actively managed exchange, traded funds, but predominantly it’s been passively managed. And generally if you’re a Vanguard or a BlackRock or something like that, and you’re, you know, you sell these products that they typically mirror some established index or customized. So maybe the S and P 500 or the Russell 2000 or whatever it is. And what they try to do is they just try to mirror the performance of that index and minimize the transactions cost and minimize the phase. So you effectively largely get the return to the market with a relatively low, low fee.

    Mark Mitchell (26m 60s): So, and there’s been lots of research that shows particularly in sort of the, the large cap well-established equity, equities, and equity indices, that, that, that can make some sense. It absolutely can make some sense. It is hard in those types of markets for, for active investors to add value because so many people cover them and everyone in the world has a view on Amazon and Microsoft. So they’re extremely well covered. And so people might refer to that as the more work that’s done on a particular company or the stock, the more efficiently it’s priced, the more accurately it’s priced. That’s not always the case, but as a general assumption. But if you compare that, like let’s say to a part of the market, like my far too, is the micro cap or the small cap part of the market.

    Mark Mitchell (27m 43s): It’s a really small business, only been going for two or three or four years. No, one’s really covering it because they’re not incentivized to cover it because they’re not really selling equities. There aren’t that many people invested in it. That’s when you can find some mispricings, you know, something is trading at $5, but if you really understood the value of that business, it should be trading at eight or $9. So if you’re able to go and do that sort of work, you can definitely find cheap cheap assets. And so that type of that’s sort of a difference where certain parts of the market, you know, absolutely passive can make a lot of sense in equities, but in other parts, it probably makes a little less sense because those assets are not very efficiently, efficiently priced when it comes to fixed income investing, there has been an explosion of investing in, in passively exchange, traded products.

    Mark Mitchell (28m 26s): And sort of to the point I was making earlier is that I think that’s made a lot of sense, you know, for the past 10 or 20 years, because as we talked about Phil with rates, as interest rates move lower, the prices of those bonds have tended to move higher. So if you’re in a passive product, that’s invested against those types of indices and they all tend to be relatively long interest rate exposure they’ve been doing pretty well. They’ve done well. And you’ve got an exposure to that at a relatively low cost that the challenge now becomes as rates are low and probably staying relatively low, you can expect those, those funds to perform well because most of the return really has come from rates, right? It’s moving lower. So it’s challenging. It really is challenging. You know, we talked a little bit before about the challenge with a 60 40 portfolio and that 40% of the portfolio we talked about that applies to whether it’s actively or passively managed.

    Mark Mitchell (29m 14s): And so I do feel like that’s going to be a bit more of a challenge. So my business and, and some of the groups that we partnered with, you know, we’re looking at, at running actively exchange traded funds, because we think in this environment where rates are low and staying low, you have to do more than just expect rates to keep moving lower. So there are other ways to add value in these portfolios, through actively trading and other types of strategies and investing more in sort of credit type exposures, you know, bank of America, JP Morgan’s, rather than investing in the U S government debt or Canadian government debt. We think those can make a lot of sense in an environment where rates rates are low

    Phil Muscatello (29m 52s): With your fixed income ETFs. There’s a range of risk profiles going from absolutely safe, which are only going to give you a, you know, a little bit above the, whatever the interest general cash, right. Is to more riskier, but higher rates of return kind of ETFs.

    Mark Mitchell (30m 10s): Yeah, absolutely. So, you know, as we talked about before, within, within fixed income, there’s a large range of risk profiles. And so it’s a matter of what makes the most sense for you. You know, if you are taking more risk, you just need to make sure that you have a longer investment horizon because March, 2020 was a great example of how just about every financial asset in the world that had any sort of risk to it was, was punished quite, quite severely, you know, and our, our higher risk fund was the same, same dynamic. And so if you’re only investing for a three or six month window, and if you’re on lucky enough to be in that product during that time, you’d very easily could have a bad return and maybe even lost some of your capital.

    Mark Mitchell (30m 50s): But if you have more of a five-year investment horizon, which is what we in our higher risk product, that’s what we say. You know, we say, please don’t give us any money if you can’t say there for five years, because we are going to have these bouts of it. And so the longer your investment horizon, the longer the likelihood is that you will hit that expected return. Even if you have a fair bit of market volatility, March, 2020 was you listeners are probably aware, but it was absolutely one of the worst periods we ever saw, both in equity land and incredible land compressed into a very short window of a few weeks. We’ve had big moves before, but never in such a short space of time. Hopefully that won’t happen again. And might never, never say never, but it was an extraordinary period, but, but it’s just a reminder of, of what can happen.

    Mark Mitchell (31m 33s): And, you know, it’s the challenge there, you know, there’s a lot of psychology that goes into it. You know, it’s often difficult for people to just sort of sit there and if you’re looking at your portfolio every day and it’s going down day after day after day, and you’re like, well, at some stage you just sort of capitulated, I just give up and which is sense of which is understandable, but I mean, it could end up, you could end up selling at the bottom so that you have to have that sort of, when we talk about constructing portfolios, it’s sort of about managing the downside, you know, and managing what’s the worst case scenario. Can I handle that type of volatility? And I might have a situation emotionally and stage of my life where I can actually handle that because everyone can handle the upside. That’s, that’s easy, that’s easy bit, but can you handle the downside?

    Mark Mitchell (32m 16s): And that’s, that’s why it’s really important to construct your portfolios. And it makes your selections with that sort of thought thought process in mind. Yeah.

    Phil Muscatello (32m 23s): Mike Mitchell, thank you very much for joining

    Mark Mitchell (32m 25s): Me. I love it. Thanks so much for having me. I appreciate it. 4 (32m 27s): She has for beginners is for information and educational purposes, only it isn’t financial advice and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only, not for beginners. This podcast doesn’t replace professional advice regarding your personal financial needs circumstances or current situation. Thanks to Christopher Sula for music production out of garlic wet studio. Remember music flows when the money don’t.

     

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