Roles of Equities in a Portfolio

In finance, the growth of a country's GDP is anticipated to be higher than its cost of financing, which can lead to benefits for the country's providers of capital. Suppose you're looking to invest in a country with a high estimated future GDP growth rate and low interest rates. How would you expect your investments to respond to this situation?

No. There's additional capital being generated for capital providers after debtholders are paid.

This shouldn't come as a surprise. Companies with growth in earnings, cash flows, and/or revenues often have excess profits to return to shareholders, especially during periods of strong economic growth. But during tough times, this growth can slow, stop, or even turn negative. How would you expect equities to perform during an economic slowdown or recession?

Not really. The situation's pretty clear in that capital providers are going to benefit from future growth.

No. Economic growth and equity performance are positively correlated.

Similarly, dividends from equity investments also provide a source of return for investors. Providing dividend income is another role of equities in a portfolio. Many times, companies evaluate internal investment projects in relation to returning capital. Usually, companies with higher growth rate opportunities are reluctant to return capital. So what type of company would you most expect to pay dividends?

Nice try, but no. In general, economic growth and equity returns are positively correlated.

No, actually. A maturing company may still have opportunities to add value via acquisitions or special projects.

Definitely not. New and rapidly growing companies are going to use any free cash flow to continue their development.

In addition to returns, equities also provide diversification benefits with other asset classes. Although equity-to-equity correlations are usually high, correlations with other assets are usually much lower, and this helps to diversify a portfolio. Assuming the correlations are lower than 1, how will using equities within a portfolio of risky assets impact the portfolio's standard deviation of returns?

Besides the risk benefits, equities can also provide a hedge against inflation. Not all equities provide this benefit, so you'll need to be careful. Think about how an equity position can provide inflation protection. In times of rising costs, in what situation would an equity investor receive inflation protection by holding a stock?

No. With correlations lower than 1, there's a risk diversification benefit to using equities in the portfolio.

Clearly, no. Equities with correlations lower than 1 will have an impact on the standard deviation.

No. That's going to hurt the equity investor, since net incomes will be negatively impacted.

Not quite. Declining profit margins indicate that the rising costs are hurting net income, which negatively impacts equity holders.

Exactly! When an equity company can pass on its rising costs to customers, stockholders can benefit from the company's protected profit margin and cash flows. Additionally, companies with direct commodity exposure can also benefit from the increase in commodity prices. But just like with the diversification benefits of equities, you'll need to be careful because studies are mixed on the exact inflation benefits of equities. Since inflation is a lagging indicator, and equity prices are a leading indicator, this hedge can depend on the rate of inflation, the country, and time period assessed.

In addition to the benefits that equities provide, it's also important to consider individual client considerations. Through the investor policy statement, an asset manager can understand the client's needs in relation to the benefits that equities provide. For example, think about how the situation for a conservative investor in retirement can dictate the percentage and type of equity holdings in a portfolio. What type of equity holdings would you anticipate in this portfolio?

No. Small-cap technology stocks are risky, which doesn't help an investor already in retirement.

Not quite. Although the energy exposure is nice, this mid-cap stock still presents more risk than is necessary for a retired investor.

Indeed. A large-cap consumer defensive stock will typically pay dividends that can provide income for a retired investor. That's just one example of how equities can fit into the client's needs, and it shows you how important it is to look at equity growth potential, income generation, risk and return volatility, and sensitivity to various macroeconomic variables. In addition to these factors, asset managers also consider risk objectives, return objectives, liquidity requirements, time horizons, tax concerns, legal and regulatory factors, and unique circumstances (like environmental, social, and governance issues, as well as religious issues).

When it comes to a client's unique circumstances, this area of equity client focus has grown more recently as clients are more aware and concerned about global issues. Historically, managers have used negative screening, which excludes certain sectors or companies that deviate from accepted standards. However, as ESG concerns have grown, managers have moved to using positive screening, which identifies companies that score more favorably with regard to ESG risks and opportunities. This has also led to thematic investing, which focuses on investing in companies with a specific sector or theme, and also impact investing, which targets social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies.

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Exactly! You would expect your investments to appreciate as capital providers receive compensation for taking risk. That's a basic illustration of one role that equities play in an investor's portfolio, namely capital appreciation. In particular, long-term returns on equities have been amongst the highest compared to other asset classes.

Clearly, yes! During periods of weak economic growth, equities tend to underperform other asset classes. Capital appreciation is directly tied to economic performance.

That's right! Large and well-established companies often pay dividends that increase over time as there are few projects that can help the company grow significantly. That's also why, over long periods of time, dividends have comprised a significant portion of long-term total returns for equity investors.

Exactly! As long as equities have a correlation lower than 1 with other portfolio assets, they will provide diversification benefits as risk is reduced. But it's important to remember that correlations aren't consistent over time. In particular, during periods of financial contagion, correlations can all head towards 1, which reduces the diversification benefits of equities.

They would depreciate

They would appreciate

It depends on other factors

Outperform

Underperform

Remain relatively flat

Stable and maturing

New and rapidly growing

Large and well established

Equities will lower the standard deviation

Equities will increase the standard deviation

Equities don't have any impact on the standard deviation

When a company has rising input costs

When a company's profit margins decline

When a company can pass on rising costs to customers

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Small-cap technology stocks

Mid-cap alternative energy stocks

Large-cap consumer defensive stocks

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