Market Commentary - 12.26.14
The Case for Active Management and Diversification
In the beginning of the year, global economic growth appeared on the mend, unemployment was stabilizing, and the markets weighed the impact of the Federal Reserve ending its Quantitative Easing (QE) program. A year later, insufficient stimulus in the Eurozone and slowing Chinese output, along with geopolitical tensions in Ukraine and the Middle East have put a substantial dampener on global demand. As a result, oil prices have dropped to their lowest levels in five years, deflation is looming larger, and a flight to quality assets has driven long-term U.S. rates down to levels not seen since before Federal Reserve Chairman Ben Bernanke's now famous "taper" speech.
Developments over the last year have unraveled the predictions of many, as the markets remain more sensitive to macro developments and have yet to return to fundamentals. This has resulted in macroeconomically-driven market movements that are less affected by company-specific factors, creating an environment in which active management tends to struggle. This can be illustrated by the performance of indices relative to the mutual fund universe. Typically index performance can be expected to be close to the middle or slightly above median of a similar fund universe. This is because mutual funds represent the broad market, and, generally speaking, about one half of the fund universe is expected to outperform with the other half lagging the index. But when analyzing returns since the beginning of quantitative easing, large core indices have moved to the top quartile relative to core managers, and after a short downward trend in rankings during the third quarter, index returns are now back to the top quartile of performance. This data is as of the end of November, but the trend has continued into December as well.
As the data above suggests, the average manager return has lagged the broad benchmarks as well, with less than 20% of large cap managers beating their respective indices. Analysis compiled by Merrill Lynch indicates that blend managers fared slightly better, with 23% outperforming their benchmark, compared with 16% for large growth managers and 12% for large value managers. This development was caused by relatively low dispersion of returns as continued monetary easing supported low cost financing and lifted equity returns. Another factor noted by analysts is that in over the course of 2014 lower quality names outperformed, with the ten most underweighted stocks by mutual fund managers outperforming the ten most overweighed stocks by close to 0.3%. We should note that the underperformance is only relative, as most U.S. large cap managers have posted positive returns, and the universe in general tends to have a small dispersion between managers, often with 1% to 2% of relative return separating the top quartile of the managers from the bottom quartile.
We believe that fundamental valuation will begin to play a larger role in equities as monetary policy normalizes. Typically, supportive economic policy leads to a period of rapid recovery, and in such periods, lower quality names outperform as they have this year. But as the markets shift toward growth, higher quality names, which continue to deliver on earnings and maintain dividends, tend to perform better. Active stock selection based on fundamental research is likely to perform better in conditions of expansion and slow GDP growth - as history shows us in periods of slow GDP expansion, stocks with high or steady earnings per share growth (EPS) may outperform lower EPS growers by as much as 30%.
Active management has also struggled on the fixed income side during 2014. With U.S. growth continuing to find solid footing, many bond portfolios had been positioned for a rate increase, with a focus on shorter term bonds and yield at or above duration. This is a sensible approach that would protect investors against a rate increase, but instead, rates fell in 2014, causing longer duration portfolios and most bond indices to outperform. In hindsight, the rate decline can be explained by a flight to higher quality U.S. dollar denominated assets which became more attractive as the rest of the world slowed relative to the U.S. The relatively higher price for short duration bonds at the beginning of the year, which was bid up as many investors feared rises in interest rates also resulted in lower YTD returns for short term fixed income. Both of these developments caused shorter term bonds to lag relative to long duration bonds.
We are also positive on active management in fixed income. Heightened regulations have constrained liquidity in this space, and active managers are better positioned to weather and take advantage of periods of distress. We also believe that in this space, the increased availability of exchange traded derivatives gives active managers a broader tool kit to manage duration and position portfolios defensively if the need arises. Finally, improved credit research may be critical to adding value in a period when dislocations cause stronger company-specific credits to outperform. In this case, a solid fundamental research team is likely to outperform a broader and market weighted benchmark.
Source: Morningstar; Data as of 11/30/14.
|Index||Total Return YTD (11/30/14)|
|S&P 500 TR||13.98%|
|Russell 1000 TR||13.50%|
|TRussell 2000 TR||1.99%|
|Barclays US Agg Bond TR||5.87%|
|BofAML US HY Master II TR||4.04%|
|FTSE NAREIT All Equity REITs TR||26.44%|
|MSCI EAFE NR||-1.49%|
|MSCI EM NR||2.54%|
|Barclays Global Aggregate TR||1.28%|
|Bloomberg Commodity TR||-10.16%|
The stronger performance of U.S. assets, as indicated by the stronger index performance discussed above has also resulted in weaker relative returns for diversified portfolios. Developed international and some emerging market assets have weakened as global growth slowed, causing detraction from relative return. Some corporate credits have also weakened as oil prices declined, resulting in a drag on income-oriented portfolios. We believe that some caution over the short term is warranted, but for investors with a longer time horizon, a portfolio that is diversified internationally and across the credit spectrum may be more optimal for an increasingly globalizing marketplace.
While investors have been encouraged by the strong U.S. equity index returns, some have noted that valuations relative to fundamentals have also moved higher. We believe that the equity markets are about fairly valued at current levels, given the prospect for continued growth in the U.S. However, we also believe volatility is likely to be elevated, and in these conditions a diversified approach may be used to mitigate portfolio fluctuations.
Returns of diversified portfolios with exposure to high yield bonds, international equities and emerging markets have lagged U.S. portfolios last year and YTD in 2014. However, the performance of more broadly diversified portfolios has been superior over time, outperforming a domestic only allocation in 7 of the last 10 years. We believe that over time this pattern may continue as international markets begin to recover and returns abroad improve as well.
|Annl. Return||Russell 100 TR||Barclays US Agg||60% S&P/40% Agg||Diversified portfolio|
Source: Morningstar; data as of 11/30/14. Diversified portfolio allocation – 30% Russell 1000, 20% Barclays U.S. Aggregate Bond, 17% MSCI EAFE, 8%MSCI EM, 5% Barclays Global Aggregate Bond, 5% Russell 2000, 5% BofAML US High Yield Master II, 5% Bloomberg Commodity index.
The securities markets by nature are forward-looking, and typically price in both good and bad news. But investors should note that market participants may also be focused on the short term, and investors who only follow recent returns often miss the turning points. This signals to us that remaining diversified is still the best way to position a portfolio to benefit from a turn in the market. We believe that going forward, as monetary policy normalizes, markets may return back to fundamentals, creating an environment conducive to the success of active management.
Volatility is likely to remain elevated, and we do not know where the markets will head next. But we believe diversification is the best approach to mitigating downside risk, and a continued focus internationally may allow for improved returns as conditions abroad stabilize. We also retain a conviction in active management, as we believe a focus on fundamentals may better serve investors in the intermediate to long term.
This information is compiled by Cetera Investment Management.
About Cetera Investment Management
Cetera Investment Management LLC provides passive and actively managed portfolios across five traditional risk tolerance profiles to the clients of financial advisors, who are affiliated with its family of broker-dealers and registered investment advisers. Cetera Investment Management is part of Cetera Financial Group, Inc., which includes Cetera Advisors LLC, Cetera Advisor Networks LLC, Cetera Financial Specialists LLC, and Cetera Investment Services LLC.
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No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The opinions expressed are as of the date published and may change without notice. Any forward-looking statements are based on assumptions, may not materialize, and are subject to revision.
All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.
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