July 12, 2016
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
Given the proximity of this commentary to the outcome of the Brexit vote and subsequent market response, we are providing a follow-up to our commentary that was sent out on June 24th. At the time, we identified four reasons not to panic about Brexit, despite the broad investor reaction and ensuing market volatility. Now, more than two weeks removed, we can look back at how markets responded and evaluate investment performance.
From a market perspective, the Brexit vote led to a two-day decline across equity markets of approximately 4-10%. MLPs (energy pipelines) participated in the decline as well, down 6.5%. Diversifying investments such as fixed income, reinsurance, and the style premia strategy were all positive, while the risk parity strategy was slightly negative. Illiquid investments such as private debt, farmland, and life settlements were unaffected by the market volatility.
Two-day declines of this magnitude in equities are shocking, but reflect an emotional overreaction by investors that often is not supported by actual changes in businesses or the economy. We remind readers that the market primarily determines prices based on expectations of future growth and earnings. Changes in expectations are reflected in the market prices by the activity of market participants. In the week following the Brexit vote, we see that expectations adjusted to the reality that nothing had fundamentally changed for the time being, and all equity markets experienced a recovery of 5-7%.
When we look at the period from June 24th to July 1st, from the Brexit vote through the end of the following week, only European stocks (MSCI EAFE) were meaningfully impacted, down 3.9%. MLPs were down 2%, but were the best performing asset class for the month of June. In fact, looking at June as a whole, U.S. equities were relatively flat, European equities were down 3.4%, and all other asset classes listed were positive.
In this very short window of time, we witnessed that daily price movement in markets did not reflect true economic value, as is frequently the case. The longer the period one looks at when evaluating performance, the higher the probability that it will be positive, based on the fact that equity investors should receive a return for taking risk in equities. We can illustrate this by looking at returns in the S&P 500 from 1950 to present. Daily and weekly returns are positive approximately 50% of the time, monthly returns 63% of the time, quarterly returns 70% of the time, annual returns 78% of the time, three-year returns 88% of the time, five-year returns 92%, and ten-year returns 97% of the time. While prices move up and down over short periods, a consistent return is earned for stock investors over longer periods.
A Challenging Low Return Environment
For many investors, second quarter performance reports will show 3- and 5-year annualized return numbers in the low to mid-single digits. While several periods historically have experienced consistently low returns, the current environment is unlike anything we have seen in the last fifty years. To illustrate the differences, we looked at different rolling return periods  using a portfolio allocated 50% to global equities (MSCI All Country World Index) and 50% to fixed income (Barclays Aggregate U.S. Bond Index). While this allocation does not exactly reflect the fully diversified portfolios we build for clients, our internal analysis shows that our portfolios of similar risk perform as well or better than a 50/50 global index portfolio. We looked at data back to 1970 (the inception of the MSCI ACWI Index) and identified periods that could be considered “low return environments”, characterized by returns less than 6%. This represents about a 30% discount to average returns over 1-, 3-, 5-, 7-, and 10-year periods.
 Rolling returns are an evaluation of multiple overlapping periods. For example, 1/1/1970 – 12/31/1970 is a period of one year. We roll forward one month and look at 2/1/1970 – 1/31/1971 for another year. Our data looked at 1-, 3-, 5-, 7-, and 10-year rolling time periods with monthly steps from 1/1/1970 – 6/30/2015. This resulted in 547 1-year periods down to 439 10-year periods.
Prolonged periods of low returns are rare. Historically, less than 20% of the time, a 50/50 global portfolio experienced both 3- and 5-year returns of less than 6%. When including the 3-, 5-, and 7-year time periods, low returns occurred less than 6% of the time. When adding the 10-year period, low returns occurred less than 3% of the time.
Conclusions from the Historical Data
Historically the drivers of low return environments have been poor equity performance combined with average fixed income performance. This is not the case in the most recent 3- and 5-year return periods. In fact, global equity returns (plus 6% and 5% respectively), particularly in the U.S. (plus 11% and 12% respectively), have been overcoming low fixed income returns (plus 4%) in the most recent periods.
Looking back, we have seen only one other time period where a low return environment occurred when equities were outperforming fixed income. During the early 1980s, particularly the period ending March of 1980, 3- and 5-year returns for a 50/50 global portfolio averaged 5%, with equities returning 8.5% and fixed income 1.5%. However, the difference between that time period and our current environment is that the low fixed income returns at that time were not due to record-low interest rates like those that we have today. In an effort to fight inflation, the Fed raised interest rates to more than 15%, leading to bond price volatility and losses in the value of existing bonds. Shortly after this period, the 30-year bull market in bonds began as rates decreased and contributed substantially to overall portfolio returns. Given historically low yields today, the forward-looking upside for bonds is challenging.
Is This Time Different?
In the past, low return environments have normalized once equity returns recovered. The challenge with the existing environment is that equity returns have not been substantially depressed with the expectation to move higher, and in fact returns have been strong (domestically) over the last several years. At the same time, the yield on fixed income is so low that it will not contribute meaningfully to overall portfolio return and will have limited ability to provide protection should equities move lower. Investors are disappointed with low returns; however, until interest rates normalize and deliver some return, low portfolio returns are likely to persist.
Our firm’s response to this environment has been to reduce fixed income in client portfolios and allocate more to investments where returns are not dependent upon changes to the current market or economic environment. Investments like private debt, reinsurance, farmland, and life settlements are all delivering competitive returns and provide quality diversification in an equity market decline.
We do not know if the low return environment will end soon. The 7-year return on a 50/50 global portfolio is currently 7.3%, but that may drag lower over the next two years if global economic growth continues to be slow, inflation remains low, and the interest rate environment does not change.
Where Do We Go from Here?
As we mentioned previously, the existing environment is unique, unlike any other time period over at least the last 50 years. As investors, we face the temptation of comparing what our returns are versus what we think they should be. However, without context this can lead to poor decision making and excessive risk taking. Consistent success in investing requires patience, discipline, and a commitment to a process.
In a recent podcast interview, Howard Marks, founder of Oaktree Capital which manages more than $100B in assets, reflected on a conversation he had early in his career with the chief investment officer (CIO) of a successful pension plan. The CIO told Mr. Marks that throughout his career his pension plan’s portfolio had always performed in the 2nd quartile, meaning somewhere between the 25th and 50th percentile of his peers each year. However, over a 20-year period, his pension plan’s portfolio performed in the 4th percentile, or better than 96% of his peers. He attributed his success to the fact that he was not trying to outperform peers by chasing returns on an annual basis, but instead adhering to his disciplined approach in order to generate returns that would sustain the retirement income needs of the pension plan’s beneficiaries over their lives. During those twenty years, there were likely moments where the board of directors was frustrated with shorter-term returns, and yet they remained committed to the process for which the plan benefited over the long-term.
At MRA, we remain patient, disciplined, and committed to our investment process, which we believe will lead to better outcomes over the long term. At the same time, we continue to look for ways to improve outcomes over shorter time periods despite the low return environment. While investments such as private debt, farmland, and life settlements also require patience, we expect clients will begin to see meaningful benefits from these investments over the next few years, which should help portfolios regardless of whether market or economic conditions improve.