1)   INTRODUCTION:

François Doyon La Rochelle:

You’re listening to Capital Topics, episode #59!

This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss the following points:

For our first topic, we will review the 2023 market statistics.

And next, for our main topic, we will discuss how to measure your portfolio performance.

Enjoy!

2)   2023 CAPITAL MARKETS YEAR IN REVIEW:

François Doyon La Rochelle: Before we start, I would like to wish our audience a happy, healthy, and prosperous New Year. This being said we have two timely topics to cover today. So, with another year passing by, I will start and cover the global capital markets performance for 2023. To help with the discussion, I will be going through our market statistics page, a document you can find on our website Capital Topics in the resources section, or directly on our team’s page on the PWL Capital website.

So, after a dismal 2022 when both the stock markets and bond markets fell at the same time, most pundits and strategists were pessimistic entering 2023.

We now know that 2023 turned out to be another example of how hard it is to make predictions about markets and the economy. 

James Parkyn: Totally François, despite all the warnings at the beginning of the year, 2023 ended out being a very good year for investors with returns in the double digits for most equity markets. Early in the year, the talk was all around inflation and the central banks aggressively hiking interest rates to fight it. The fear was that the Central Bank’s historical interest rate tightening cycle would push global economies into recession and that would hamper returns in the stock and bond markets.

François Doyon La Rochelle: Yes, and central banks did continue to hike rates in 2023 but at a more moderate pace than in 2022. Here in Canada, the Bank of Canada increased rates on three occasions but by only 25bps at a time from 4.25% to 5.0%. In the U.S., the Federal Reserve increased rates four times, but again by increments of only 25bps from 4.50% to 5.50%. These rate increases did have an impact on inflation since inflation rates were cut in half, here in Canada, from 6.3% to 3.1%, and in the U.S. from 6.5% to 3.1%. However, the dreaded impact of these rate increases has yet to be felt particularly in the U.S., where the economy is still expanding, and job creation remains strong.

James Parkyn: I would add François, that other major central banks also pushed rates higher and were also successful in lowering inflation rates. For example, in the UK, the inflation rate dropped from 11.6% to 5.3%, and in the Euro Area, it went down from 8.6% to 2.9%. 

François Doyon La Rochelle: We are not out of the woods yet on the inflation front but it is getting much closer to the 2% target aimed by most central banks. In addition to the economic fears related to interest rate increases, on the geopolitical side, there was still uncertainty related to the lingering war between Russia and Ukraine, tensions in Asia surrounding Taiwan, and later in the year, a war breaking out in the Middle East. So, plenty of things to worry about. And let’s not forget, on top of that, in March, we were in the middle of a banking crisis with the collapse of the Silicon Valley Bank and the Signature Bank in the U.S. and later in the month the collapse of Credit Suisse, a major international bank.

James Parkyn: Needless to say, François, these bank failures caused a lot of turmoil in financial markets. Most of the gains realized up to then were lost as equity markets sold off losing between 6% and 7% in a matter of weeks. This was not the end of the wild ride during the year. We even experienced a market correction in the U.S. market between July 31st and October 27th when the market dropped about 10.3%. Other equity markets also sold off but avoided being in technical correction.

François Doyon La Rochelle: Yes, and from the lows of October, we witnessed a powerful year-end rally in the global stock markets helped by the Central Banks putting a pause on their interest rate tightening. In December the Fed even signaled that no other increases were expected and that they were considering 3 rate cuts in 2024.

James Parkyn: This is a great example of why you need to stay invested to capture market returns. That short period of two months generated over 60% of the gains for 2023 in the U.S. and almost 100% of the gains in Canadian equities. The S&P500 gained 15.8% in USD, the S&P/TSX Composite here in Canada gained close to 11.9% and international developed markets increased by roughly 10% in local currency. The bond markets also rallied in those two months. Most of the gains with bonds last year occurred in those last two months.

François Doyon La Rochelle: We never know when a strong rally will occur, so again don’t try to time the markets. This strong rally came right after a 10% market correction in the U.S. when investors tend to capitulate.

James Parkyn: Exactly right, and this again is a stark reminder to avoid timing the market and to stay invested. One thing is for sure, 2023 had a lot of ups and downs. It was anything but smooth sailing. 

François Doyon La Rochelle: With that being said let’s now look at the market statistics as of December 31st. Again, as a reminder our market statistics can be found on our website Capital Topics, and in our team’s section on the PWL Capital website. We will provide the link for the market stats on the podcast page.

I will start with a fixed income. At the beginning of the year, with the prospect of further rate hikes, bond investors were worried that we could see a third year of losses in the bond markets but that fortunately did not materialize. The Canadian short-term bonds were up 5.02% for the year and the total bond market, which holds longer-dated maturities was up by 6.69%. Yield to maturity on these two indexes was over 5% for part of the year but they have now settled in the mid-4 % range.

James Parkyn: It’s a relief to see positive returns in the bond market, especially considering the Central banks were still in tightening mode at least in the first half of the year. With interest rates going up to 5 % and more during the year, investors were massively tempted and put a lot of money into GICs and high-interest savings accounts. 

François Doyon La Rochelle: Indeed, James and I can understand that after the miserable returns of 2022, investors are looking for the stability and safety of these investments to preserve their capital. However, I think a word of caution is warranted here, if you are a long-term investor and the bulk of your investments are in GICs and investment savings accounts, when inflation stabilizes lower and interest rates fall, the returns on these safe assets will drop. This in turn will make it difficult for you to reach your long-term financial goals.

James Parkyn: I completely agree François. With these levels of yield on safe assets, it seemed like a no-brainer to load up. But I caution our listeners, that returns on equities in 2023 massively outperformed those high interest rates. The key lesson to remember is to stick to your long-term plan because the expected returns on equities are higher than fixed income and cash. This will increase your odds of reaching your goals. 

François Doyon La Rochelle: GICs certainly have their purpose in a well-diversified portfolio but investment savings accounts, despite their current high interest rates, are poor long-term investments. Over the long term, these cash instruments should underperform bonds and equities as they have in the past.

James Parkyn: Talking about equities François, why don’t you tell us how the different equity markets performed last year?

François Doyon La Rochelle: Well, James, it was a very good year with double-digit returns everywhere in the main indexes we follow except in the emerging markets. In Canada, the S&P/TSX Composite Index returned 11.75%. The information technology sector did the heavy lifting with an extraordinary performance of 69.19% followed by the healthcare sector at 18.34%. The financials and industrial sectors also did a bit better than the S&P/TSX Composite Index.

James Parkyn: With the information technology sector being the big winner, I’m guessing that growth stocks outperformed value last year in Canada. 

François Doyon La Rochelle:  Correct James, large and mid-cap growth stocks had a performance of almost 14% at 13.97% and value stocks returned 12.58%. As for the small-cap stocks they underperformed large and mid-cap stocks with a performance of 6.02%. This is not entirely surprising as small-cap stocks tend to underperform large-cap stocks when there is a fear of recession.

James Parkyn: What about the U.S. equities Francois, what happened there? 

François Doyon La Rochelle: Well, it was a great year in U.S. equities. The total market gained 25.96% in U.S. dollars, and in CDN dollars since the CDN dollar rose against the U.S. dollar, the performance was a bit lower at 23.26%. However, in contrast to last year, large and mid-cap growth stocks dominated value stocks with a spectacular performance of 39.63% versus only 9.08% for value stocks.

James Parkyn: Well, if I’m correct the story for U.S. equities last year was the craze surrounding Artificial Intelligence stocks and other big tech companies. The FAANG stocks were replaced with a new term, the Magnificent Seven, a group of high-performing stocks that are also the seven largest stocks in the S&P500. In that group, you have Alphabet (Google), Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.

François Doyon La Rochelle: Yes, and collectively those seven stocks make up close to 27% of the entire index. Their performance in 2023 ranged from 48% for Apple to an astonishing 239% for NVIDIA. Their performances apart from Apple were more than double the gains of the S&P 500 last year. These seven stocks alone contributed to almost half of the gains of the U.S. market last year.

James Parkyn: At some point, in the first half of 2023, these Magnificent Seven generated all the gain on the U.S. equity market. By year-end, we could see the market broadening out even though over 70% of stocks underperformed relative to the index. I presume François, that like in Canada, the Information Technology sector had the best returns last year?

François Doyon La Rochelle: You are right James, the information technology sector had a performance of 57.84% and the communication services sector followed with a performance of 55.8%. I remind our listeners that only three of the Magnificent Seven are included in the information technology sector. The worst performing sector was the utilities at negative 7.08%. To finish off with the U.S. market, U.S. Small cap stocks also had a good performance in 2023 with a performance of 14.43% in Canadian dollars, similar to their large and mid-cap counterparts, small-cap growth stocks outperformed value with a performance of 16.12% compared to 12.19% for small value, again all in Canadian dollars.

Finally, the international developed markets also had a good year. Large and mid-cap stocks returned 16.16% in local currency, in Canadian dollars, returns were very similar at 15.71%. However, as opposed to Canada and the U.S., International large and mid-cap value stocks have outperformed growth stocks returning 16.41% compared to 15.06% for growth stocks. Small-cap stocks trailed with a performance of 10.74%. 

To conclude, in the Emerging Markets, large and mid-cap stocks returned 7.91% with value outperforming growth and in contrast to other markets small-cap stocks, had a strong return of 21.82%. These last performances were all in Canadian dollars.  

James Parkyn: Thanks for the update, François. As you highlighted, the market pundits were not forecasting good things for the markets in 2023. The markets surprised everyone and showed resilience in the face of adversity, and as the proverbial saying goes, they climbed a wall of worry.   

3)   HOW TO MEASURE YOUR PORTFOLIO PERFORMANCE:

Francois Doyon La Rochelle:  For our main topic today, we will tackle How to Measure your Portfolio Performance.  This topic goes hand in hand with our first topic.

So, where do you want to start, James?

James Parkyn: Well, Francois, this Topic is near and dear to my heart. 

We have been producing Performance Reports since we started the firm in 1996. The Regulator, however, only came around to making it a regulatory obligation that firms must produce a Performance Report for clients starting in 2016.

François Doyon La Rochelle: Wow, that is 20 years later than PWL!

James Parkyn: So, François, What I want to talk about today for our Listeners, is how to Measure their Portfolio Performance and most importantly understand where their returns came from. Why is this important? Well, we want to make smart investing decisions and remain disciplined with your Long-Term Investment plan.  

François Doyon La Rochelle: The challenge this year for some Listeners will be to deal with the disappointment after they see how strong the numbers are for equities, particularly in US equities.  As we mentioned earlier, the classic lesson from 2023, is: Ignore all market forecasts. Market movements are often dominated by surprises, which, of course, can’t be predicted.

James Parkyn: Exactly. Again, as we said earlier, If you go back to January 2023, Market Pundits were all doom and gloom about the Outlook for Equities for the year. The market noise was all about forecasting a recession which never happened, at least in the US, and now most Market Pundits are forecasting a soft landing.

François Doyon La Rochelle: As economic forecasts are often wrong, it’s unlikely that market strategists will be able to forecast future performance. The lesson for investors is to tune out predictions. Instead, stick to your investment plan, focus on diversification, and rebalance your portfolio when needed.

James Parkyn: So, getting back to our Topic of How to Measure Portfolio Performance, you must look at how your Portfolio was invested. Generally, your Investment Plan will set out your target allocations between stocks and bonds.  

François Doyon La Rochelle: This is pretty basic, but we often speak to new clients, and they have no idea what their asset allocation is. In effect, most of them don’t have a Long-Term Investment Plan.

James Parkyn: Our clients, all have a signed Investment Policy statement or IPS in our jargon. This document sets out how accounts will be managed, including the Target Asset Allocations. Our Performance Reports break out the Total Return for the Portfolio applied to the aggregate of all the accounts included in the IPS.

François Doyon La Rochelle: A typical Client IPS covers their Taxable accounts, TFSA’s, RRSP’s or RRIF’s and if applicable their Investment Holding Companies Taxable accounts.  Our Performance Report gives a Total Return net of fees. We also generate returns per asset class broken out to show returns for 5 components.

1. Bonds

2. Other Income Securities (Which include your REITS and utilities)

3. Canadian Equities

4. US Equities, and finally

5. International Equities (Which included emerging markets) 

This is how our clients can see where their total returns come from by being able to see how each asset class performed.

James Parkyn: For our Listeners, the next step is to find an appropriate benchmark to measure the performance of each asset class. The CFA Institute is well recognized as an industry standard setter. The CFA Institute believes that “a benchmark is essentially the starting point for evaluating success. It is defined specifically as “an independent rate of return (or hurdle rate) forming an objective test of the effective implementation of an investment strategy.”

François Doyon La Rochelle: This is a lot of jargon, what this means is that the benchmark is a measuring tool that must be appropriate for how your portfolio is invested. If your portfolio is invested with a lower allocation to equities, it’s normal that your return will be less than someone who has a higher allocation to equities. So both investors have a different benchmark comparison.

James Parkyn: Thank you, François, for clarifying that but I’m going to add some more jargon. In determining what makes a good benchmark, the CFA Institute believes that:

1. The most effective benchmarks are the ones most representative of the asset classes in your portfolio. As you said François how your actual portfolio is invested.

2. The benchmark must be investable by that means a viable investment alternative.

3. The benchmark must be constructed in a disciplined and objective manner.

4. The benchmark must be formulated from publicly available information.

5. The benchmark must be acceptable as the neutral position; and finally.

6. The benchmark must be consistent.”

François Doyon La Rochelle: For our listeners, we at PWL have done the work for our clients, and we make this information publicly available with our Market Statistics page that I referred to earlier.

James Parkyn: Finally, François, I would add that the CFA institute guidelines highlight that “choosing a bad or inappropriate benchmark can undermine the effectiveness of an investment strategy and lead to dissatisfaction.”

François Doyon La Rochelle: The overall objective of performance measurement is to evaluate your performance against measurable standards to ensure you meet your long-term goals.  Bottom line: if your benchmark is inappropriate, then any interpretation of your performance against the benchmark, will result in useless or misleading information, putting you at risk to deviate from your long-term investment plan.

James Parkyn: I completely agree with you François. You can’t compare a classic balance 60/40 portfolio against a 100% U.S. equity or the concentrated bets in the Magnificent Seven Stocks.

François Doyon La Rochelle: Another way to measure your performance would be to compare it against the Expected Returns in the mid-year 2023 PWL Financial Planning Assumptions Guide.  If we look at the long-term expected returns for major asset classes, fixed income should deliver 4.19%, Canadian equity at 6.99%, U.S. equity at 6.41%, and international equity developed and emerging markets at 7.35%.

James Parkyn: Going back to the market statistics page for 2023, which we spoke about earlier, the appropriate benchmarks for these asset classes all significantly outperformed compared to the long-term expected returns estimated by PWL. 

François Doyon La Rochelle: So James, in your mind, what is the biggest danger of making the wrong interpretation of your Portfolio Performance?

James Parkyn: François, it’s the same danger every investor faces in January looking back at the previous year. Be aware of Recency Bias – don’t invest in something just because it has done well or sell because it has done poorly. Historically, investors tend to buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred). 

François Doyon La Rochelle: Well said James. But I also will remind our listeners that the markets are a random walk. You can’t forecast the future. Unfortunately, past returns don’t predict future returns.

James Parkyn: That is why diversification is as important as ever. After the Great Recession, many argued that diversification no longer works because risky assets have become too correlated. However, diversification benefits also come from the dispersion in the range of returns in a group of stocks. 

François Doyon La Rochelle: Last year we saw a wide dispersion of returns once again, consistent with the last 20 years, showing that diversification still has strong benefits.

James Parkyn: Finally, François, I would remind our listeners that active management is a loser’s game in bull or bear markets. Last year was another in which the majority of active funds underperformed even though proponents claim active managers outperform in both bull and bear markets. 

François Doyon La Rochelle: And even in the rare instances when active management does lead to an investor’s portfolio outperforming benchmarks, it’s typically short-lived.

James Parkyn: Okay François, so let’s conclude today’s main topic. We recommend our listeners stick with their long-term investment plan and that they maintain their Investor Mindset. As I said last year, there’s no way to know where markets may be headed. At this time last year, it was hard to imagine an upturn when prices had fallen so dramatically in 2022. It was hard to imagine an upturn when there was so much uncertainty about the direction of the economy. 

François Doyon La Rochelle: And there is always uncertainty in the economy and consequently in the capital markets.

James Parkyn: This is an important lesson on the forward-looking nature of markets, highlighting how current prices reflect market participants’ collective expectations for the future. History argues for persistence and patience. 

François Doyon La Rochelle: A look back at recent history makes the case for sticking with a plan. Our message to our Listeners at this time last year in our Podcast #48, was that handsome rebounds often happen after steep declines like 2022. These rebounds help investors capture the long-term returns the markets offer. Those who sold their stockholdings in early 2023 to invest in safe GICs with the allure of much higher rates than what we’d seen in over 20 years may have made a mistake.  They will have lost out on double-digit equity returns in 2023.

James Parkyn: This history is great to anchor our thinking François, as long-term investors. We also remind our listeners that they should have an “Investor Mindset” and continue to buy and hold investments with an owner’s mentality. Stay disciplined and focused on the long-term and avoid being deterred by the short-term noise.

François Doyon La Rochelle: That is our mantra. 

4)   CONCLUSION:

François Doyon La Rochelle:  Thank you, James Parkyn for sharing your expertise and your knowledge. 

James Parkyn: You are welcome, Francois.

François Doyon La Rochelle: That’s it for episode #59 of Capital Topics!

Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com

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Again, thank you for tuning in and please join us for our next episode to be released on February 15th. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.

See you soon!