Managing Through a Recession

Many investors are becoming increasingly concerned that a recession may be on the horizon as North American markets continue to climb higher despite global trade concerns.

A recession is defined as a temporary economic decline during which trade and industrial activity is reduced.  It is typically identified by a fall in Gross Domestic Produce (GDP) over two successive quarters.

While our view of the current economic environment supports continued, modest growth for the near future, it is important that our clients understand that we are actively managing client assets according to changing economic conditions.

Croft investment mandates are weighted towards a specific allocation to our 3 core funds, TCG531 Equity Growth Share Class, TCG534 Income Share Class and TCG539 Option Writing Share Class. This allocation is based on meeting the objective and risk guidelines of our 3 standard investor profiles:

  1. Conservative
  2. Balanced
  3. Growth

Investors will fall in to 1 of the 3 categories based on their Investment Profile Questionnaire and further conversation with a Portfolio Manager.

The 3 funds used within each mandate are designed to complement one another with all being actively managed on a day to day basis to adjust to changing market conditions.

With that in mind, the Income Pool is 75% of the Conservative Mandate, 50% of the Balanced Mandate and 25% of the Growth mandate.

Conservative clients would be most sensitive to a market contraction given many have a
shorter investment horizon and are less tolerant to risk and volatility. Several adjustments may be made within the Income Pool to adapt to market conditions.  We can also increase exposure to the Income and Option Writing Pools and reduce the exposure to our Equity Growth Pool in the Balanced and Growth Mandates to further insulate a client’s portfolio from recessionary pressures.

The Income Pool is designed to have minimum market volatility, generate a steady stream of income and provide stability in our client’s portfolios. The Income pool is composed of four different “sleeves” (fixed income, high yield/low beta, covered call strategies, and long Puts)

The Income Pool has a 35% allocation to Fixed Income. During a recession, the yield curve traditionally inverts causing the Fixed Income allocation to increase in value.

The 29% allocation to the “high yield / low beta” sleeve is concentrated in the Telecom, Utilities, Real Estate sectors that exhibits certain degree of duration. The duration will cause these securities to increase in value

during an inverted yield environment.  In addition, this sleeve is invested in companies that have low revenue sensitivity to GDP growth.

The 36% allocation to covered call strategies is invested in companies that have just experienced significant drop in price and exhibited multiple contraction. The effects of a market pullback should be diminished because of already depressed multiples and the inherent hedging properties of short calls. During a recession the VIX (fear index) will be trading at elevated premiums and will provide increased income and hedging properties. This is an ideal environment for the Covered Call strategy.

Currently, there is a 9.10% SPY Put hedge acting as a type of “insurance policy” on the equity exposure in the Income Pool. This hedge will increase in value in an inevitable pullback in the market. This strategy has been in place since the end of last year and will continue to be an important strategy moving forward.

Because the objective of the Equity Pool is growth of capital, during expansionary macroeconomic periods the pool will invest in a variety of stocks across a variety of sectors with a strong focus on Momentum and Growth with a smaller focus on other style factors such as Value, Yield and Low Beta.

When macroeconomic conditions begin to mature and slow down we begin shifting our factor exposures to tilt more toward Quality
stocks.  These companies are normally large cap with features such as high Return on
Equity, low Earnings Variability and low Leverage.  Because these companies have strong cash flows and strong balance sheets they are exposed to less risk since they can support their financial position.

During a recession the focus shifts toward defensive sectors and stocks with Low Beta and Value factor exposures.  These are companies that tend to be less volatile than the broad market and would be expected to go down less when the broad market is falling.

With respect to options, during expansionary periods we may write Out-Of-The Money Covered Calls to enhance return and provide some downside protection while maintaining some upside exposure if the stock appreciates.  We can also choose not to write Covered Calls as to not limit the upside.  We may also write In-The-Money puts to capture high implied volatility through the time value of the option along with some intrinsic value.

During market corrections and recessions, we can hedge with tighter Covered Calls or with long put options.  At deep market troughs, we also would write In-The-Money puts on an expected rebound.

During a recessionary period, we would also hold a higher allocation to cash.

The Option Writing pool shares many of the same characteristics as the Income fund except for a higher concentration in option strategies that are designed generate cash flow. These strategies can be modified to benefit from a bearish to neutral market if we enter in to a recession.  This fund will also benefit from higher option premiums from an uncertain and more volatile market.