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November 2015
Monthly Investment Commentary
Stocks around the globe rallied sharply in
October, a quick about-face from the fear-driven
declines of the third quarter. Large-cap domestic
stocks returned nearly 9% in October, while midand small-caps also generated strong returns of
6.1% and 5.6% respectively. Year to date, largecap gains have moved back into the black, while
mid- and small-cap stocks remain in negative
territory.
Turning abroad, developed international stocks
were up 6.7% in October, while European stocks
were up 5.9%. Both regions are also back in
positive territory year to date. Emerging-markets
stocks gained 5.3% in October yet remain well in
the red year to date, down roughly 10.8%.
As is often the case in periods with strong equity
gains, lower-quality credit outperformed higherquality credit. In October, the core bond index
was flat, while high-yield bonds gained close to
2.7%. Year to date, however, high quality
continues to outperform.
Research Q&A
We regularly use a question-and-answer format
to address questions from clients about our
investment views and current strategy. This
format permits us to address a range of different
topics and allows readers to focus on individual areas of interest.
PERFORMANCE EVALUATION
What’s the right time frame to evaluate performance? Is it five years?
As with most everything in investing, there is nothing black and white about our five-year tactical
analytical horizon. It is meant to reflect the general time frame over which we assess and estimate asset
class returns. We could have called it a four- to six-year time horizon, or even a three- to seven-year
time horizon. That type of range more accurately reflects the gist of what we are thinking. We do
believe that for many or most market cycles, five years should be roughly enough time for asset class
fundamentals to play out and be reflected in market prices, rather than prices being dominated by
shorter-term technical, speculative, or nonfundamental factors. But again, there is nothing magical or
scientifically determinative about five years, per se.
We’d say this has been a particularly unusual cycle; one can point to the federal funds rate being pinned
at zero for the past seven years as “Exhibit A.” So, we haven’t experienced a full market cycle yet. We
also think looking at the consistency of a manager’s performance over rolling five-year (and longer)
periods is useful as it minimizes the impact of starting- and end-point specificity from any single period.
Successful investing is a process of consistently and repeatedly making good, sound decisions over
time—and over repeated market and economic cycles. No one bats a thousand in this business. Even a
good process sometimes leads to a bad outcome, just as someone with a bad process can get lucky and
have a good outcome. But the goal is to be right more than wrong, to minimize the downside when you
are wrong, and have the magnitude of your winners more than offset your mistakes over the long term.
We believe our fundamental approach and process (honed over our firm’s 28-year history) is very
sound, consistent, and repeatable. We also know that market prices can get out of whack relative to
their fundamentals over shorter-term periods, sometimes lasting for several years. We have trailed our
portfolio benchmark during the recent part of this current cycle, but the full cycle is not yet complete.
A few of your active fund managers have also struggled to outpace the index benchmarks over the
past couple of years. How do you differentiate between a manager that needs to be sold from the
portfolio and a manager that is simply going through a shorter-term period of underperformance yet
confidence still remains for the long-term?
In most cases, selling is a mirror image of buying, meaning the reasons why we buy something are no
longer in place or our confidence in them has dwindled materially. These reasons form the core of what
we call our investment thesis on a manager or fund.
We know when our thesis behind our purchase is no longer valid because we write it down at the outset
and constantly evaluate and update it. This is an important part of our investment discipline and it helps
us in important ways. It provides a sensible template to refer to when a manager is undergoing an
inevitable stretch of short-term underperformance. It keeps our emotions in check, allowing us to
rationally reassess our original investment case. Importantly, it prevents us from making what we’d call
the cardinal mistake many investors are prone to making—selling an underperforming investment, then
buying an outperforming one for the wrong reasons and getting whipsawed (i.e., buying high and selling
low).
Prior to purchasing a fund, we do a lot of upfront work. A few of the important elements we assess are
the key people driving investment decisions, the quality of their decisions, whether they demonstrate a
consistent investment discipline, and if the firm environment or culture is conducive to generating
outperformance.
Sometimes the key people we have identified leave their firms, which can lead us to sell a fund.
Sometimes a departure does not lead to a sale if we believe a manager has done a good job planning for
succession, or the team in our opinion has a lot of depth and can absorb the loss of a key team member.
Sometimes, through our ongoing monitoring, we discover the manager is not sticking to their
investment criteria (i.e., they are breaking the rules they have stated are dear to them and we know are
an important part of their investment discipline). That’s a strong reason to sell. Another reason could be
that the firm environment and culture deteriorates to such an extent that we no longer believe it’s
conducive for investment success going forward.
But if all the key reasons why we hired a manager are intact, then we will not fire them just because of
underperformance.
EMERGING MARKETS
Can you elaborate on why you sourced your recent tactical increase in emerging markets from
European equities?
While we believe emerging markets are now relatively cheap, we don’t think they are absolutely cheap.
We remain concerned about the potential for shorter-term downside risk and are managing this risk in
two ways. First, we implemented a tactical move that was roughly half the size of our typical fat pitch
increase (2%–3% versus 5%). Second, we funded this increase primarily from equity-like assets, such as
U.S. and European stocks, in order to ensure that we do not materially increase the overall equity risk in
our portfolios.
A logical place to fund this small tactical allocation would be from U.S. stocks, which we consider less
attractive than both emerging-markets and European stocks. However, we are already substantially
underweighted to U.S. stocks, and it takes only a small dose of humility to recognize there is a possibility
an optimistic scenario for the United States will play out, while European and emerging markets suffer
through more bearish scenarios, as they have the past several years. In addition, in a market correction
or an economic downturn, U.S. stocks may outperform other regions of the world as investors seek the
safest place to invest. So from a risk-management perspective, at the present time we do not want to
further underweight U.S. stocks. Moreover, European and emerging markets have common factor risks
through their shared trade and financial linkages, and by funding an emerging-markets tactical position
via European stocks we limit our portfolios’ exposure to those risks to some degree. While we still find
European stocks more attractive than U.S. stocks, weighing these portfolio- and risk-management
considerations, we decided to fund a good chunk of our modest emerging-markets tactical move from
the Europe overweight we initiated earlier this year. (Note: The European allocation was originally
funded from U.S. stocks.) After this move, we remain modestly overweight to Europe, and we believe in
making this decision we have properly calibrated the relative attractiveness of both European and
emerging-markets stocks versus U.S. stocks.
If short-term risks were to play out and emerging-markets equities fall further, would you consider
adding to the position?
Absolutely. We will not be surprised to see emerging-markets stocks fall further due to several risk
factors, some we listed in our recent emerging-markets research update. This is one reason why we are
implementing only a modest overweight to emerging-markets stocks. We expect, or rather hope, we will
get another bite at the emerging-markets apple at more attractive prices. Of course, if or when
emerging-markets stocks decline more versus other regions, and in a material fashion, we will reassess
our earnings and valuation assumptions, including any changes in macro and micro fundamentals, and
weigh those against the risk factors and unknowns in a manner similar to what we did prior to our
recent tactical increase.
FIXED INCOME
Are you concerned that your fixed-income positions are becoming too equity-like and could open up
your portfolio to market declines like we saw in the third quarter? How do you manage the behavioral
risks where clients are accustomed to their bonds performing as a buffer to market declines?
This question boils down to our decision to reduce interest rate risk and take on more credit risk. Let’s
start by reviewing why we reduced interest rate risk. As core bond yields have continued to move lower,
our return expectations for the asset class have become less and less attractive. This is a function of
today’s extremely low starting yield of around 2.3% (as of 10/31/15) as well as the expectation that
rising interest rates will dampen returns over our five-year investment horizon. To be clear, we are not
making a directional bet on rates moving one way or another, but what we are saying is that under the
majority of rate scenarios, annualized core bond returns will be in the lower single digits.
Recognizing this backdrop, we are underweight to core bonds in our balanced (stock/bond) portfolios in
favor of more flexible, unconstrained strategies we think will generate better long-term returns. We
believe these higher returns will come from the funds’ duration flexibility—which can help them better
navigate a rising-rate environment—but also from credit risk. At times, this exposure to credit risk will
result in some downside. For example, if there is a risk-off environment, which generally benefits core
bonds, our exposure to spread sectors will likely experience price declines to varying degrees depending
on the strategy. Our flexible bond fund returns in the third quarter ranged from flat to down four
percentage points. Our tactical allocation to floating-rate loan funds was down 60–70 basis points. We
are willing to live with temporary underperformance in exchange for longer-term outperformance.
As for client communications, the landscape for bond returns has changed. We are coming off more
than three decades of secularly declining interest rates, which also started off at much higher yield
levels, both of which have been tailwinds to bond returns. Over the past 40 years, core bonds have
returned 7.6% annualized (through September). Today, as mentioned, we’re expecting lower single-digit
returns. It’s a different paradigm, and clients need to understand that bond returns will be lower. That
said, we still think core bonds can serve as a buffer, which is why we continue to maintain some
exposure in our balanced portfolios. For example, in a sharp risk-off environment, where there’s a flight
to safety and 10-year Treasury yields decline 100 basis points, we think core bonds can generate a six
percentage point return, providing the downside buffer.
In your strategic benchmark, why do you use the domestic bond index as opposed to the global bond
index like you do on the equity side?
When we developed our strategic benchmarks, our starting point was a collection of asset classes with
long data histories that allow us to build a valuation framework around them, as well as those asset
classes that were often represented in client accounts. Beyond that, another central consideration has
always been the role that investment-grade bonds play in our portfolios. As mentioned above, core
bonds play a vital role in managing to our downside risk thresholds in poor performing equity markets,
as our confidence that investment-grade domestic bonds would perform well in a sour economic
environment is high. With that background, we have been increasingly looking at international credit
markets.
Going forward, we need to dig deeper to understand how the addition of foreign investment-grade debt
would impact our portfolios across various economic environments. For example, would adding foreign
bonds to our portfolios give us the same level of downside risk protection in a sharp equity market
decline? We also have to look at the data history more closely to evaluate our level of confidence in that
data. So far, the foreign credit exposure we have had in our portfolios has been a result of our active
bond managers being opportunistic and finding more attractive ideas overseas relative to the United
States.
MANAGED FUTURES
With the understanding that it’s been a very short holding period, have managed futures strategies
met expectations thus far, and can you reaffirm your thesis on the strategy?
It has been much too short a holding period to declare victory, but in the sense that the performance of
the funds we hold was positive to varying degrees in the third quarter while almost all risk assets
suffered significant losses, the managed futures strategies have met expectations so far. But it’s
important to remember what our expectations are and how they’re achieved: we expect managed
futures to diversify traditional portfolios by providing competitive long-term returns that are largely
uncorrelated with traditional assets. The way these funds do that is heavily dependent on efficiently
capturing existing trends across a wide group of markets and assets globally. If there are no trends, or
sharp reversals in markets, the funds are likely to struggle. The third quarter offered good opportunities
across a number of markets, over both shorter-term and longer-term signals (although stronger in
longer term), with profitable trends in most asset classes—most notably in commodities and currencies.
However, as we have tried to emphasize, there is no fundamental valuation or other indicator to give a
clue as to whether these strategies are likely to experience strong or weak returns in any given short to
medium time period. With that in mind, we would caution investors not to read too much into the
strong start for our allocation to these strategies. We view them as an attractive long-term complement
to traditional assets, but the performance in any given quarter is unpredictable and may vary
dramatically. For example, our timing of the investments seems quite good, but it was based purely on
the logistics of when we were able to complete our research and add the funds to our models. If we had
happened to complete all the necessary work a quarter earlier, our clients would have experienced one
of the worst quarters for the strategy in the last several years due to sharp intraquarter reversals in a
number of markets and trends. This obviously wouldn’t have been a pleasant introduction to the
strategy, and highlights the necessity of sizing the managed futures allocation at a level clients will be
comfortable with in order to maintain the investment during the inevitable periods of poor
performance.
Dave Repka and the CFS Research Team