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5/17/2018

​Diversifying the Balanced Fund: Q&A

Low-return environment drives new fixed-income investments



If you keep a close eye on the markets, you may already be aware of a looming low-return environment expected in the capital markets.

In a nutshell, future investment returns are expected to be lower than they have been in the past 30 to 40 years – an outlook supported by the Plan’s investment consultant, Mercer, and the marketplace.

In light of the overcast financial forecast, there are opportunities for the Plan to diversify the fixed-income (i.e. bonds) component of our default investment fund, the Balanced Fund – which holds the funds of over 38,000 Plan members, or 80% of the Plan’s membership.


Q: What is the Plan doing to lessen the impact of the expected low-return environment?

A: The Plan is diversifying the fixed-income component (i.e. the bonds component) of the Balanced Fund, our default investment fund, by adding emerging market debt (EMD) and increasing the fund’s allocation toward commercial mortgages. We expect these modifications to improve the Balanced Fund’s return expectations while maintaining a similar level of risk in the portfolio.

The Balanced Fund is currently in the process of transitioning from a traditional mix of 60% equities and 40% fixed income to a portfolio of 55% equities, 35% fixed-income and 10% real estate investments. Within the fixed-income component of the Balanced Fund’s asset mix, the Plan made an allocation of 7% to EMD and has funded approximately 7% of the 8% target allocation to commercial mortgages.


Q: What exactly are EMD markets?

A: Emerging market debt (EMD) includes both corporate and government debt issued by borrowers in emerging markets – essentially any country that is not considered to be developed.

According to Mercer, even though EMD assets are expected to deliver more positive returns over the long term, the asset class is susceptible to higher market volatility due partly to the movement of emerging market currencies.


Q: How will the Plan manage the increased volatility of the EMD mandate?

A: The combination of higher volatility EMD, lower volatility commercial mortgages, and the broad diversification within the Balanced Fund produces a similar level of risk to which existed prior to adding the new asset classes. In addition, the Plan has selected a specific type of “total return” product called the BlackRock Flexi Dynamic EMD. The aim of using this product is to reduce the overall volatility while delivering on the return objective.

Since total return investing relies more on manager skill to drive returns rather than investing against a market-cap benchmark or blended benchmark, there may be greater opportunity for higher returns and diversification across different risk factors such as duration risk, credit risk and currency risk.


Q: Why did the Plan specifically choose EMD and commercial mortgages?

A: The Plan’s consultant, Mercer, continues to support investment in emerging markets as part of a diversified global approach, because the size of these markets makes them hard to ignore. 

With the increasing importance of emerging markets and the diverse features offered by these economies, it is believed EMD has the potential to deliver attractive returns over the long term. It is possible for emerging market growth dynamics to produce gains due to improvements in infrastructure, equipment, labour-force skill development and demographic tailwinds due to younger populations – all ingredients that are expected to positively influence economic growth.

Commercial mortgages, a type of private debt, offers an additional spread or return over traditional bonds of similar credit risk. In addition, the asset class has less volatility than Canada Universe Bonds. There is, however, a tradeoff in that the Plan must accept the reduced liquidity that comes with these private market investments.

The returns for the EMD and commercial mortgage asset classes are expected to be higher than historic fixed-income (bond) returns. The Plan’s current median 10-year return expectation for Canada Universe Bonds is 2.02%, while EMD has a return expectation of 5.93%. Commercial mortgages are expected to return 3.95%. 


Article from the spring 2018 issue of TimeWise