January 11, 2016
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
In life, we realize that there are some things we are able to control, and others over which we have no control. We can control what time we wake up by using an alarm clock, but we cannot control our car being rear-ended by another while driving to work. We have control over what we eat and how much we exercise, but not over catching a cold from a sick child.
We face the same challenge regarding control with investment markets. We have control with our selection of investment managers in each asset class, and we have control over the asset allocations we use. However, we have no control over broad market performance, which has a significant impact on absolute performance. On a relative basis, our client portfolios outperformed a comparatively weighted portfolio of indexes in 2015. On an absolute basis, however, performance was underwhelming for the second straight year. In this commentary, we identify what helped and what hindered investment performance on both an absolute basis and relative basis. We will also share our outlook for the year ahead and our approach given current investment market challenges.
Global Equity Markets
Global equity markets as a whole were down 2.4% for the year. While the S&P 500 managed a slight gain of 1.4%, it was carried by growth stocks (orange bar, +5.2%) substantially outperforming value stocks (red bar, -4.5%) by nearly 10%. A report by Goldman Sachs about 2015 market performance identified five stocks that were responsible for the bulk of market returns of the S&P 500 during the year: Facebook (+33%), Amazon (+114%), Netflix (+141%), Google (+42%), and Starbucks (+44%). Hundreds of other stocks in the S&P 500 underperformed the market. U.S. Large Cap is the only equity asset class where our client portfolios underperformed. This was due to our academically supported long-term belief that being overweight in value stocks outperforms the market indexes and growth stocks, and our belief in using non-market cap weighted structures, which generally outperform market indexes over longer periods.
Lack of return in the U.S. can be attributed to the uncertainty markets dealt with throughout the year, particularly from the Federal Reserve. The continuous delay of a Fed funds rate hike reflected the Fed’s lack of confidence in the U.S. economy, which was somewhat substantiated by weak economic data. While unemployment hit the Fed’s target level, the economy continues to struggle with low growth and low inflation. Even a Fed rate hike late in the year was not enough to encourage investors, and the S&P 500 was down 1.6% in December during what is typically the best performing month of the year.
Small cap markets fared worse than large cap, down 4.4% for the year. International developed markets nearly reached positive territory, down 0.8%. However, emerging markets had another disappointing year, down 14.9%. Despite negative performance, our firm’s implementation of equity risk hedges in late 2014 led to outperformance in all three categories for our client portfolios. These hedges are designed to provide a buffer to negative markets, and they performed exactly as expected.
While relative performance in the global equity markets was good, the negative returns hurt overall portfolio returns. This was particularly true in emerging markets, where the strong U.S. dollar and global demand concerns continue to be headwinds for emerging market investors. In fact, in local currency emerging markets were down only 5.4%. The remainder of the loss can be attributed to weakening currencies relative to the U.S. dollar. Our client portfolios have been overweight in emerging markets for several years, which has not delivered the outcome we expected.
Despite continued challenges in emerging markets, we continue to believe that these economies will be the drivers of global economic growth over the next few years. One key reason is the cyclicality of markets and currencies. Looking back historically, we recognize that developed and emerging markets tend to operate in alternating cycles. Given that we have just experienced five years of greater-than-12% returns in U.S. markets, it is reasonable to expect the U.S. to slow down and other equity markets to take the lead. Another reason is the impact of currency cycles on economic growth. The strong U.S. dollar follows a period where U.S. economic growth has played a greater role in the global economy than emerging markets. A strong dollar leads to fewer exports and more imports for the U.S., shifting demand to countries where currencies have weakened. A third reason is the impact of commodity prices on several emerging markets. Stabilization of commodities or even a slight recovery will quickly shift the outlook for commodity-driven markets. Although international equity exposure has been challenging over the past several years, time and again it has been proven to lead to better returns for investors with lower volatility.
Fixed Income Markets
The broad fixed income market returned 0.5% year to date, reflecting the ongoing challenge of earning a return in bond markets. Most client portfolios outperformed the broad market due to manager selection, but not by much. The challenges in fixed income continue to be our highest concern for client portfolios. The diversification benefits of fixed income cannot be ignored. There are few asset classes as low correlated to equities as fixed income, and historically fixed income has been the anchor to stabilize portfolios when equity markets have been volatile. Today, fixed income returns are just slightly better than cash, which is a challenge in light of lower equity market returns and lower overall portfolio returns. In response to this, we have constructed a solution to provide our clients with access to private debt markets where returns are much more in line with the risk taken. Our goal in private debt is to earn a higher return by accepting the tradeoff of less liquidity and attempting to maintain similar credit risk. In addition, we want to maintain the qualities of fixed income, which are low correlation to equities and consistent interest earned. We believe investing in private debt will substantially improve client outcomes over traditional fixed income. For those clients who cannot invest in private debt due to illiquidity or tax reasons, we continue to look for fixed income alternatives to address the low return environment.
Within multi-strategy we experienced both the best and worst returns in our client portfolios. Reinsurance was the best performing asset class, up 4.3% for the year. On a relative basis, our reinsurance position returned closer to 7%, generating a meaningful contribution to overall portfolio returns. On the other hand, MLPs ended the year down 33%. Given that we take a market approach to MLPs for clients, relative returns were in line with the index.
We are nearing the three-year mark of our experience with reinsurance. That period has been fairly benign in terms of natural disaster risk that would affect investment returns. We would welcome a decade of consistent, low volatile returns in reinsurance. However, we want to remind investors that risk does exist in reinsurance investments, and at times may be as risky as equities, which is why the returns are in the high single digits. We fully expect, as we continue to invest in reinsurance, that an event large enough to cause a loss will occur. The key, however, is that such an event will not be related to an equity market decline, interest rate movements, or any other traditional asset class. Just as reinsurance delivered uncorrelated positive returns when equity markets were negative, the opposite can and will occur at some point.
We detailed our thoughts regarding MLPs in a recent communication, and we continue to believe they represent a valuable part of our client portfolios. Returns over the last 18 months have followed oil prices and the broader energy sector, despite the fact that the midstream MLPs we invest in are not dependent on the price of oil. The majority of midstream MLPs continue to have strong earnings and maintain distribution levels. Our strategy is to use cash distributions from portfolios to rebalance MLP allocations to their targets. By doing so, we are taking the opportunity to buy MLPs when prices are lower, with the hope of benefiting from a meaningful recovery in the future.
The remainder of multi-strategy consists of exposure to two quantitative diversifying strategies managed by AQR Capital Management. These strategies are designed to have low correlation to, and drive return different from, traditional markets. The two products offset one another in 2015, with one being up approximately 8% and the other being down approximately 8% for the year, resulting in a neutral impact on client portfolios. Some client portfolios own farmland, which had a positive return in the low single digits this year even with weak corn prices. Given the performance of most other asset classes, farmland’s low return was a welcome benefit to client portfolios.
In 2016, we expect returns in traditional asset classes to continue to be challenged. While we anticipate a mild increase in economic growth, uncertainty remains regarding the path of interest rates by the Federal Reserve and the impact of central bank policy in foreign markets. Lower return expectations can be absorbed over short periods of time, but they become problematic over longer time periods. For this reason, we continue to look for alternative sources of return that are less dependent on U.S. GDP growth or corporate earnings. Earning a fair return for the risk taken is becoming more difficult in the stock and bond markets alone. As we did for reinsurance, farmland, and private debt, we will continue to examine the global investment landscape for unique ways to generate return. At some point growth and inflation will recover, but this is unlikely to occur in any meaningful way in 2016. In the mean time we remain focused on our objective: to deliver value to clients, net of fees, that provides a high probability of success for our client’s goals and objectives.
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