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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