From Vineyards to Portfolios: Cultivating Long-Term Wealth

During these ruminations it’s occurred to me that there are parallels between a vineyard and an investment portfolio: both require regular, sustained cultivation effort over time by a “farmer”; both are long-term undertakings, with not much action in the short term, or even year to year, but plenty of impressive growth over the long haul; and both generate “output” that is important for other parts of our lives. With this in mind, I’m struck by how many people are “planting annuals” in their portfolios these days, rather than adding to their vineyard.

Huh? “Where on earth is he going with this?” you’re wondering. Stay with me.

Stories abound in the media about investors who are so enamoured of the seemingly high interest rates available on money market instruments, GICs, and the like, that they are committing meaningful amounts of surplus cash to these sorts of short-term investments. (Indeed, we’ve heard the same from several clients.) I’m not talking about people’s “rainy day” money, or that appropriate amount of liquidity that one sets aside to help “sleep at night” and thereby sustain the commitment to keeping long-term capital fully invested. I’m talking about those who are deliberately holding away from their investment portfolio cash that is actually part of their long-term capital. Usually this is “recently-arrived” cash — from selling a recreational property, a big bonus, or liquidating a successful private holding. Occasionally we hear of people actually removing capital from their long-term portfolio and redeploying it into short-term instruments.

The motivation is easy to understand. As we’ve noted frequently in our presentations and quarterly commentary, the world is rife with things to worry about, any of which could trigger a sudden and/or large pull back in markets. Seeking a safe haven against a possible storm until the uncertainty abates seems, on the surface, pretty appealing. At the same time, after many years of exceedingly low interest rates – which gave rise to the derisory expression “cash is trash” – the reappearance of 5-something percent interest rates is bound to attract, at a minimum, attention.

The problem, however, is that for as long as long-term capital is held aside in short term instruments, it’s not really properly invested. It’s unavailable to participate in the long-term growth of the main portfolio. It’s like planting annuals rather than vines. Annuals flower quickly and look pretty for one season. But they die and must be replanted for next season. Moreover, if it takes many years of growth before vines mature enough to produce grapes (both quantity and quality), each year spent growing annuals instead of vines adds yet another year until the harvest is ready. By contrast, properly tended vines will grow gradually, building each year on the previous year’s growth. And by “investing” long-term capital in vines at each opportunity, one neatly side-steps having to figure out the truly unknowable: when the time is just right to flip the field from annuals to vines.

Having identified the issue, it’s reasonable to ask, “What should I do with additional long-term capital that I’m not immediately comfortable with adding to my portfolio?” Expressed differently, “If not annuals, then what?”

One way we tackle this at Nexus is by using our Income Fund as a transitional holding. To be sure, in many clients’ portfolios it is a core component, serving as a highly cost-effective way to allocate part of a portfolio’s capital to a diversified collection of investment grade bonds that can then act as “ballast”, dampening the portfolio’s overall volatility. However, we also often use the Fund as a form of “staging area” – for transitioning a portfolio’s recently-added capital from a low proportion invested in equities to the portfolio’s higher target proportion. Because the Fund itself can have up to 20% of its assets in income-oriented equities, client capital invested in the Fund is arguably more fully invested than if it were relegated to short term, near-cash instruments. In our “annuals-vs-vines” metaphor, the Income Fund is something of a “hybrid” that can be evolved over time into a full-fledged portfolio.

For reference, as a stand-alone investment the Income Fund has exhibited several appealing performance characteristics. First, the Fund has had negative returns for only 18 of the 239 different 12-month periods since its inception – i.e., only 7.5% of the time. Second, over the last 5 and 10 years, the Fund has had a quarterly downside capture ratio of less than 35%, but an upside capture ratio of more than 85% – which is to say, during 3-month periods when the Fund’s benchmark, the FTSE Canada Universe Bond Index, has lost money, the Fund’s losses have been 65% smaller than the benchmark’s, but have been only 15% lower than the benchmark’s returns when those 3-month returns have been positive. Third, over the last 5 years the Fund’s returns have been approximately 70% less volatile month to month than those of the Equity Fund (and nearly 58% less volatile than the Balanced Fund’s).⁽¹⁾ Indeed, they have even been 30% less volatile than the returns of its benchmark, which is notable, considering that nearly 20% of the Fund’s portfolio has been invested in equity securities. Admittedly, absolute rates of return have been uninspiring lately – as a consequence of the run-up in interest rates in the last year or so. However, that same run-up in interest rates, which is the very reason money market instruments and GICs look interesting these days, is doing precisely the same for the short- and medium-term bonds held by the Income Fund.

This approach is just one way to address the temptation to plant annuals rather than vines. There are others.  In any case, setting money aside, especially now that interest rates are higher, is an understandable temptation. But successful long-term investors need to maintain a match between their assets and their investment horizon. Today’s attractive GIC rates do not insulate most investors from the risk to their portfolios of even moderate inflation. A well constructed portfolio that adheres closely to a sensibly chosen long-term asset mix is the best way to generate a bounteous harvest and fund a comfortable retirement.