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This is a replay of our second quarter 2018 Litman Gregory research team webcast, held July 26, 2018. Topics covered (among others): our equity market views, underperformance at Cove Street and Northern Cross, and our thesis on managed futures. The presentation slides are available at the bottom of the page under Resources.
Chad: Hello, and welcome to the Litman Gregory Quarterly Research Webinar. This is Chad Perbeck and I’ll be moderating the event.
Joining me today is Jeremy DeGroot, Alice Lowenstein, and Jack Chee. Rajat, Peter and Jason are traveling and won’t be joining this quarter. I’d like to give special thanks to Alice for stepping into her previously-held role once again to help us out.
To briefly set the stage, the format of today’s webinar will be as follows:
Alice will walk us through an opening slide presentation, which will provide a review of the second quarter. She’ll share a few key points about the global investment environment, asset class performance, our current portfolio positioning, and our outlook. We’ll then move on to answer questions that were submitted by you prior to the call, showcasing some of the most pressing issues we’re facing when advising clients, before ultimately opening it up to a live Q&A session. Please note: For those of you who have only dialed-in by phone, you will not be able to ask live questions since your lines are on mute. You’ll need to join GoToWebinar online to type and submit questions using the desktop control panel.
As always, we welcome your feedback and questions. Please email us at firstname.lastname@example.org or email@example.com.
Now let’s move on to our opening presentation – Here’s Alice:
Alice: U.S. stocks rose to the top of asset class performance charts with strong returns in the second quarter, reversing course from Q1 and boosting YTD performance into positive territory. Small cap stocks outperformed large, highlighting the narrative that smaller companies are more domestically focused and therefore not as exposed to a strengthening dollar or potential trade wars.
Outside the U.S., Developed international stocks continued the decline seen in the first quarter, and Emerging Markets stocks fared worse, dropping 9.6% in dollar terms for the quarter, and dragging YTD performance into negative territory.
Core investment-grade bonds ended essentially flat. The benchmark 10-year Treasury yield pierced the 3% level, hitting a seven-year high, before falling back below 3% and finishing the quarter 16 basis points higher than where it finished in Q1. Floating-rate loans, whose coupons adjust, continued to benefit from rising rates, finishing the quarter up 0.7%.
Within larger cap domestic stocks, growth continued to shine, outperforming value by approximately 5% over the quarter. This continues the longer-term trend of growth stocks outperforming value, which now dates back to 2006.
Returns for larger cap domestic stocks were driven by strong earnings growth as tax cuts, solid economic growth and the recovery in oil prices combined to prolong the earnings recovery that began in early 2016.
Year over year earnings growth for the SPX 500 is forecasted to be over 20% this quarter. However somewhat counterintuitively, historically, stock market performance tends to be poor when expectations for earnings growth get this high. Typically, overly optimistic news has already been discounted in current prices and such lofty expectations can be difficult to beat.
From a macroeconomic and geopolitical perspective, the quarter certainly offered a lot to digest. From diverging economic growth and monetary policies in the United States compared to rest of the developed world, to protectionism and trade tensions between the United States and most of their major trading partners, the quarter didn’t lack for headlines.
In the US, economic growth rebounded strongly in the second quarter on the back of tax cuts and a robust labor market. Jobless claims declined to historically low levels, and the unemployment rate continued on a downward trend, falling to 3.8% at the end of May – an 18-year low. Wage growth accelerated, as average hourly earnings exceeded expectations.
Beyond the strength of the US economy, the global economy remains in pretty good shape. Real GDP growth is expected to be above trend again this year, with consensus estimates for global GDP growth coming in at 3.5% to 4% for both this year and next.
That being said, last year’s highly synchronized global growth may have peaked for this cycle. This loss of momentum can be seen in measures such as the Citigroup economic surprise indexes, which early in the year dropped sharply into negative territory for the eurozone, Japan and the United Kingdom.
On the monetary policy front, strong US economic data gave the Federal Reserve the confidence to continue its path of tightening monetary policy. As expected, in June, the Fed raised the fed funds rate 25bps and signaled a slightly accelerated path of future hikes over the next two years, which if it comes to pass, would bring the fed funds rate to a range of 3% to 3.25% by the end of 2019. Whether the economy can withstand that degree of tightening remains to be seen.
Outside the US, the European Central Bank announced that quantitative easing will end in December 2018, but its June meeting had a very dovish undertone, saying it doesn’t plan to begin raising its benchmark refinancing rate until at least September 2019.
The US economy’s stronger relative growth along with a further widening of the yield gap between US and foreign bonds have been reflected in the rebound of the US dollar.
After surprising market consensus by dropping roughly 12% over the prior 15 months, the US dollar index (DXY) rebounded 5% and ended the second quarter at an 11-month high.
The dollar’s appreciation was a meaningful headwind to returns for dollar based investors, as reflected in this chart, comparing US dollar and local currency returns for US and international stock markets.
Over the near-term, it’s possible the rally in the dollar could continue for a while as currency momentum can take on a life of its own. And the short-term divergence of economic growth and monetary policy between the US and the developed world certainly support that view.
However, there are also fundamental reasons to believe the dollar may weaken, looking a bit further out. For instance, the ballooning US federal deficit in the coming years, a large US trade deficit, and the eventual convergence of central bank monetary policies. Plus, the Trump administration seems to prefer a weak dollar.
Regardless, from a portfolio management perspective, we don’t have a high conviction view on the dollar that we would want to tactically reflect in our portfolios. We are comfortable maintaining our strategic diversified approach of having both dollar and non-dollar exposure – with the latter coming primarily from our foreign stock funds.
In addition to a stronger US dollar and rising interest rates in the US, international stocks, especially emerging-markets, were also battered by escalating trade tensions between the United States and its major trading partners, China in particular.
I think we have a question in the Q&A section of the call dedicated to the potential impacts of ongoing trade issues, so I won’t spend too much time here. But, generally speaking, our base-case view is that an all out trade war will be averted because it is in the best interest of the US and China to do so.
However, the potential for a severely negative shorter term shock to the global economy and risk assets, not just emerging markets, cannot be dismissed. Even absent an actual trade war, the negative impact on business and consumer confidence stemming from the uncertainty and fear of a trade war is a risk to the economy and financial markets.
These macro developments, in particular the risk of a US trade war with China and the rest of the world, are indeed risks to EM stocks, at least in the short term.
However, these are not new risks to emerging-markets, nor do we believe they overwhelm the attractive fundamentals, valuations, and potential longer-term returns of emerging markets stocks.
Our analysis indicates that emerging markets are fundamentally better placed today than in past cycles.
The sector composition of emerging-market indexes has changed meaningfully over the past decade, from traditional heavy-cyclical industries like materials and energy to more growth-oriented technology and consumer-driven sectors that are less sensitive to shifts in global growth.
Corporate earnings growth for emerging market stocks remains steady with expectations of 18% growth in 2018 and 11% in 2019.
As to the underlying fiscal health of emerging-market economies, emerging markets, in aggregate, have much better debt coverage than in the late 1990s-Asian crisis era. Additionally, most emerging-market countries now have floating rather than dollar-pegged currencies, which should help release pressure in these economies and reduce the likelihood of a currency devaluation–driven crisis.
Finally, evidence also suggests emerging-market stocks can perform well when interest rates in the United States are rising, provided global growth is solid, which we expect it to be. As we can see in this chart here, emerging market stocks have generated strong returns in the three most recent Fed tightening cycles.
In conclusion, we remain confident in the positioning of our globally diversified portfolios, which we believe are structured to perform well over the long term while providing resiliency across a range of potential short-term scenarios.
Should the current trade tensions resolve, and the global economic recovery continue, we expect to generate good overall returns, with outperformance from our European and emerging-market stock positions, active equity managers, and flexible bond funds.
Alternatively, should a bear market strike, our portfolios have “dry powder” in the form of lower-risk fixed-income and alternative investments that should hold up much better than equities. We’d expect to put this capital to work more aggressively following a market downturn by, for example, reallocating to US equities at lower prices and higher expected returns sufficient to compensate us for their risks.
Chad: Thank you, Alice. Great summary and set up for the rest of the webinar.
Before we move on, I’d like to encourage our audience to start submitting questions via your GoToWebinar desktop control panel. We’ll aggregate them to be addressed during the webinar, if time permits, or our research consulting team will follow-up with you afterwards.
The first question is by far the most asked over the past quarter and seems to be top of mind for many investors. It reads:
1. As US Equities have continued to outperform, and emerging-markets flows and prices have reversed course for a marked performance differential in Q2 relative to Q1, has your view changed at all? We understand from an earnings growth and valuation standpoint it is a good place to be for the long term…but is there anything that would cause you to lower your emerging-markets weighting in the short term? Jeremy, will you please start us off by sharing your thoughts?
Jeremy: First, and importantly, it’s very unlikely a quarter or so of underperformance or outflows alone would impact our view on longer-term, normalized, valuations, earnings or cash flows. However, depending upon the magnitude and direction of relative price moves across asset classes, it might present a tactical opportunity to (further) overweight or underweight an asset class or asset classes. But that was not the case with EM stocks last quarter.
The risk of a trade war or increasing protectionism has resurfaced and has been a factor behind EM stocks’ weakness in recent months. But as we have stated before, US companies and their stocks are also likely to suffer in a protracted trade-war scenario. And protectionism may impact US companies, especially the larger ones in the S&P 500 index, more negatively than EM companies. This is because US corporations have benefited tremendously from free trade and globalization via access to cheaper labor and efficient and cost-effective global-supply chains. We believe this has contributed to the historically high profit margins US companies have achieved in the past decade-plus, as shown in this chart. (We’ll discuss this point a bit more later in the call.) The S&P 500 net margin actually hit an all-time 45-year high in June at 9.6%.
According to Capital Economics, in 2015—the latest year for which data have been published—the sales of the major foreign affiliates of US multinational corporations in China exceeded $350 billion. That is roughly the same as China’s trade surplus with the United States last year. Moreover, China’s exposure in the United States through its foreign affiliates is only a small fraction of this number. US companies’ linkage with China and the rest of the world is one of many reasons why we believe the likelihood of a full-blown trade war is relatively small. However, some damage may have already begun. For example, the Federal Reserve reported that companies are scaling back or postponing capital spending plans given the trade policy uncertainties and risks. This may negate at least some of the shorter-term benefits of the recent tax stimulus and fiscal spending to the US economy. The bottom line is we just cannot know with certainty whether and to what degree a trade-war scenario may play out.
Chad: Thanks, Jeremy. The US may be better or worse off than EM over any shorter-term period. Since it’s unknown what type of scenario will ultimately play out, can you share some thinking about the potential longer-term effects if the less likely, but more negative trade war scenario were to play out?
Jeremy: The question of who would be worse off longer-term in the event of a deep and prolonged trade-war is one we continue to ask ourselves and other analysts we respect, although we would put this question squarely in what seems to be a growing list of geopolitical and economic “known unknowns.” It is certainly possible EM countries and companies in aggregate are hurt more: after all, they are levered to global growth. It’s fair to say the longer trade-war fears loom, the greater the risk this business cycle ends prematurely and we enter a recession sooner than we would have otherwise. In that scenario all risk assets would perform poorly, and we wouldn’t be surprised if EM stocks, and developed international stocks, underperform the US, their cheaper valuations notwithstanding. The key question we’d ask ourselves is whether in a trade-war scenario EM normalized cash flows are negatively impacted to the extent we need to bring down our expected return forecast for EM stocks.
However, given our base case for EM already factors in a pretty conservative earnings-growth and valuation scenario, at least relative to their observable history, we think that’s unlikely. But we’d certainly change our minds and reduce our weighting to EM stocks if that were warranted based on new evidence or analyses. If our view remains unchanged, we are likely to continue holding EM stocks through that downturn, and even add to them if the relative expected return differential vs. other asset classes becomes materially more attractive than it is now.
Chad: Okay, so the potential to add at more attractive prices in a sell-off. Will you please also address whether or not we might lighten up on EM stock exposure if total portfolio risks outweighed the outsized relative return potential in the asset class?
Jeremy: There’s one other scenario where we may reduce our current weighting to EM stocks (other than EM stocks outperforming their US counterparts materially, of course). We may reduce EM stocks, and other risk assets in proportionate amounts if we believe our portfolios, especially the more conservative ones, are at a greater risk of violating their downside risk thresholds than we are comfortable with. Weighing various possible scenarios and their likelihoods, we don’t believe we need to do so now. After factoring in our meaningful underweight to stocks – in the range of 6 to 11 percentage points depending on the risk model -- which is offset partially by increased credit-risk exposure from some of our flexible bond and absolute-return-oriented investments, we believe we are adequately underweighted to overall equity risk in our balanced portfolios.
Importantly, we believe there shouldn’t be a need to lower overall equity risk further in most scenarios, and this includes normal market corrections that are part of investing, if clients are in the appropriate portfolio for their risk tolerance and temperament. Assessing and implementing an appropriate risk portfolio that a client will be able to stick with through market cycles and volatility over the long-term is a hugely valuable role for an investment advisor. Unfortunately, it often takes a bear market or sharp price decline for many investors to realize their true risk tolerance.
Chad: Thanks, Jeremy. We appreciate you laying out the potential scenarios and how they relate back to our thinking and analysis.
Staying on the topic of our equity outlook, but focusing on U.S. Stocks, Jeremy, if you’ll tackle this next topical question:
2. How long can profit margins stay above long-term trend in the U.S.?
Jeremy: This is another of those important variables that are hard to know with certainty. For the past several years our base-case US stock expected returns looking out over five or so years has incorporated higher-than historical average margin assumptions. But current margins are much higher than that. We already mentioned the likely benefit to profits from globalization. Sustained very low interest rates in this cycle have also boosted profits. And more structurally, service businesses and tech giants (like the FAANGS) with their massive network effects have (much) higher profit margin structures than older-economy and more capital-intensive businesses. Some of the very recent surge in margins also undoubtedly stems from the corporate-cut tax benefit. You can see from this chart that corporate profits have taken a larger share of US GDP over the past 20-30 years, at the expense of a declining share for wages and salaries.
In our optimistic scenario for US stocks, we basically assume profit margins stay similarly high in the US as they are today over the next five years. As you know, this scenario has led us to not underweight US stocks more than we already have, so we are factoring in the possibility of “elevated margins staying that way for longer” in our portfolio management. (But we don’t believe this should be our base case because margins cannot defy gravity forever.) Our optimistic scenario implies at least high-single to low-double-digit returns from US stocks. Only if expected returns in this optimistic scenario come down much lower from those levels would we consider reducing US stocks further in our portfolios.
Chad: Okay, thanks. So profit margins could remain elevated, but what might cause margins to revert to more sustainable levels?
Jeremy: Trump’s election, as well as Brexit, and election results in other countries, such as Italy, shows populist forces are alive and well in the developed world, not just in emerging markets (such as Mexico and Brazil). The Trump administration may be unleashing forces that at the very least slow the benefits US companies have accrued from globalization. The process by which recent tariffs have been implemented alone creates uncertainty for companies, and they may approach outsourcing their operations further with greater caution than in the past at least until there is more policy clarity. New laws may pass making it harder for an administration to introduce wide-ranging and deep tariffs. Or, China may give enough concessions for globalization forces to muddle along for longer, in which case our optimistic scenario may continue to play out, as it has in large part the past several years. As always, there are many possibilities, scenarios and sub scenarios.
But globalization and companies grabbing a larger share of the economic pie may be starting to mean-revert now, albeit this will likely be a gradual process. This is happening when we are late in the economic cycle in the US. Unemployment is at or near historical lows, which in the past has led to upward pressure on wages and a downward force on margins. We are not saying margins should mean revert all the way back down to the historical average: that’s not our base case. But a reversion to roughly the margins that are implied in our base-case normalized earnings estimates is quite a high likelihood in our opinion. And in that base case scenario, we expect very poor returns from US stocks, which is why we are underweighted to them to the extent we are.
Chad: Thanks, Jeremy. It’ll be interesting to see how the protectionism vs. globalization themes play out over time, and as you said, the impact on margins and investor returns.
Moving on, our next question is about recent manager performance. Jack, if you’ll please address this question:
3. Over almost any reasonable time frame (YTD, 1 year, 2 years, 3 years, 4 years, 5 years, and 10 years), Cove Street Capital Small Cap Value Fund (CSCAX) trails the Vanguard Russell 2000 Value index ETF (VTWV) significantly. At what point does performance trump the confidence you have, inspired by your research?
Jack: We view performance as a tool. Performance, in and of itself, especially over the short-term, is not a reason to hire or fire a manager. In fact, I can’t think of one example in my nearly 18 years here, that we made a buy or sell decision based on performance alone. We believe it’s much more important to understand why a fund has performed well in the past by determining if the portfolio management team has an identifiable edge, and assessing if that edge is sustainable. To answer these questions requires intensive and extensive upfront contact with the fund managers and their teams. Now, once we buy a fund, we obviously get a scorecard every day in terms of managers’ performance relative to their benchmark. Of course, we are long-term investors and a day, a month, a quarter, or even a year does not indicate success or failure in our eyes. What’s critical to us is that the investment discipline remains intact. So, monitoring the manager is critical, and is as important as the initial due diligence. We continually verify that nothing has changed through conference calls, monthly and quarterly commentaries, semiannual and annual reports, performance, and most importantly, frequent contact with our managers throughout the year. Should we hit a stretch of underperformance, the longer the underperformance, the shorter our leash gets, and the more frequent our contact with the team. During our ongoing work, it’s quite possible that we uncover something has changed in the investment process or team dynamics that lead to a change in our opinion. Or, we could identify something that we missed in our initial due diligence. But at the end of the day, performance does not trump our qualitative assessment of a manager. Before I move on to Cove Street, let me give another example to give additional context on how we use performance. We are in the final stages of forming our opinion on a small-cap manager who is strongly outperforming their benchmark, more than we would have expected in this environment. We are using this stretch of outperformance to make sure we understand their valuation and sell disciplines, and that they aren’t straying from their discipline. So importantly, we use performance to assess our opinion, not only during periods of underperformance, but also outperformance.
Now, specific to Cove Street we are certainly disappointed with recent performance, which mathematically dings long-term performance numbers. But there are some things to keep in mind when looking at Cove Street’s performance.
First, the portfolio’s composition is meaningfully different from the benchmark. The slide on the left shows the sector exposure of the fund vs. the Russell 2000 value benchmark. You can see meaningful differences in sector weightings. With respect to the financials, as we’ve discussed in the past this large weighting disparity will either help or hurt over a short-term period. Cove Street has been leery of bank stocks in general given they represent geographically narrow, highly leveraged bets on commercial real estate, not to mention what they feel are high valuations in the commercial real estate space.
Second, this is a concentrated, index-agnostic portfolio, and these are not “beta guys.” Their portfolio moves when company-specific fundamentals change and get recognized by the market. The chart on the right shows that over time, periods of big out- and underperformance are not unusual for this fund. Now, importantly, this past performance pattern isn’t an excuse for us to say everything will be fine over time because it’s worked out in the past. The underperformance means that we are disappointed, and our leash is getting shorter, and we’re lowering the microscope a bit.
Specific to performance, the stock prices of some of the fund’s largest positions have been relatively stagnant over the past year, while there were some company-specific laggards that contributed to the relative underperformance. Bronchick says his research suggest their “spring” has coiled more tightly as most of businesses have gotten more valuable, while their stocks have lagged. He also believes that there are some highly visible catalysts for near-term improvement.
Just as an example, Millicom International Cellular is a leading cable and wireless provider in Columbia and Central America. The company is refocusing on its leading position, shedding valuable but disparate media assets, as well as other assets such as cell phone towers. The stock declined due to a sell off by investors of all emerging market related assets. Focusing on the long-term, Bronchick sees a severely undervalued stock that is continuing to develop into a premier Latin American cable/telecom player and is approaching a crossover point where its legacy voice revenues will be eclipsed by new cable and 4G customers.
So again disappointing, but one year of poor relative performance does not mean that something is broken.
Chad: Makes sense, thanks for sharing those points and for sharing that additional portfolio-level details, Jack.
3a. Is the fund under review at this time?
Jack: The fund is not formally under review, but three of us are spending a day with the team in their offices in mid-August. And should we uncover concerns, we would obviously want to dig in, and would put the fund under review. We will share some of our findings in September.
Chad: Okay. Thanks, Jack. We’ll stay tuned for any updates to your thinking. Moving on to our next question, related to our tactical overweight to European stocks. Jeremy will you take this next question?
4. What is your outlook for a European slowdown or recession? While the conference board’s LEI still is trending positive for the Euro Area we notice a slight tick down for Germany and way down for the UK.
Jeremy: We have often noted we do not prognosticate on macroeconomic variables. This is because we don’t believe we can forecast economic variables, such as conference board’s LEI or when the next recession will occur, with a high level of confidence or consistency needed to execute a disciplined investment process. (We believe a U.S. recession is likely to occur over the next five or so years given the economic cycle in the US is quite extended, but we don’t know whether we’d see one in the next 12 to 24 months.)
We do believe in cycles: economies go in cycles; sometimes they are shorter or longer. The same applies to markets and earnings. And all three cycles are seldom in sync nor can they be timed consistently in our view. History does not exactly repeat. We also know markets tend to price in recessions in advance of them occurring better than we can call them. So, the key for us is what the long-term earnings and cash-flow scenarios are likely to be over our time horizon, and what they might be worth. To assess these factors, we rely on available history, based on what we know how company-level fundamentals might evolve relative to history, and our assessment of the various economic and market scenarios and sub-scenarios we may face over our investment horizon and the likelihood of those scenarios. We model out key fundamentals, such as earnings and valuations, over five years. But there is nothing magical or determinative about five years: we know economic and market cycles can last much longer and, as a result, are prepared to be patient. Patience and remaining disciplined go hand in hand within our process.
Chad: Terrific. Thanks Jeremy. That really gets the heart of what Alice was conveying in the last slide of her opening presentation … focusing our efforts analyzing the things that matter most to long-term investment success in our process, rather than the shorter-term noise that most of the media and pundits focus on.
Our next question is another manager-specific question, again related to performance.
5. Are you reviewing Harbor International given the protracted trend of statistically significant risk adjusted under performance? Jeremy, will you please address this for us?
Jeremy: HAINX’s performance in recent years has been disappointing. While performance has been better so far this year (first half of 2018 HAINX is down 1.32% compared to down 2.82% for VEA and down 2.75% for MSCI EAFE), the last handful of years have been difficult (the fund has not finished in the top half of its foreign blend category since 2012).
We’ve touched on the drivers behind this underperformance in recent fund reports, and have talked with the Northern Cross team on numerous occasions. But to recap: the team has been hurt by a handful of stocks, at various points in time, that have had severe price declines (such as Teva, Freeport, Rolls Royce, Schlumberger, Shire and Glencore). These stocks account for a good chunk of underperformance in recent years. The team has always looked for “good franchises” that are undergoing short-term difficulties and opportunistically buys these stocks. Sometimes, with the benefit of perfect hindsight, the quality of a franchise may not be as high as the team believed it to be or some issues may not be priced in the stock prices to the extent it seemed (e.g., this was the case with Teva, Freeport and Rolls Royce). We have known they are willing to invest in relatively more cyclical areas, such as mining and oil services (e.g., Schlumberger) if they believe longer term these companies will remain strong and durable franchises in their respective areas. (And we don’t expect them to load up on their preferred stable/compounding businesses regardless of the valuation risk in them.)
In short, the team has made some stock-specific mistakes, and in other cases it’s taking longer for them to get paid for their views (e.g. Schlumberger). Importantly, the team acknowledges its mistakes, is looking to improve, and we haven’t yet seen evidence the team is not sticking to its investment discipline or the quality and rigor with which it’s executing it. Without that evidence, we believe sticking with the fund makes good sense.
Chad: Thanks for that background. Are you able to share some more detail as to what we’ve been able to observe as key learnings or takeaways from our recent interactions with the team that affirm our conviction in their process and discipline?
Jeremy: The team has recently implemented some marginal changes to their decision-making process to improve their investment process and hopefully performance going forward. First, they have formalized the devils-advocacy part of the process by assigning specific members of the team to raise concerns on each stock. The goal is to challenge thoroughly any purchase and sell decision. The team has always done this (it’s been a natural part of their collaborative process), so we are not sure if this will have a material impact. But to the extent it makes debates more thorough, we’d consider it a positive.
Second, while the three-member portfolio-management team strives to achieve a consensus on both buys and sells, and they will continue to do so, on sell decisions the team would be more willing to decide on a majority vote. This stems from their willingness to improve the timeliness of their sell decisions, a point they have discussed with us going back several years. Given their very long-term orientation, selling well is difficult and we think it’s a positive the team is thinking of ways to improve this aspect of their approach. So this is something we will also be monitoring.
I’ll end with some long-term perspective on the fund’s performance. The fund remains a consistent performer over long-term investment horizons. It has outperformed MSCI EAFE in 88% of monthly rolling 5-year periods. The last few years are the only periods during which the fund has ever trailed over a 5-year period. Of the 247 monthly rolling 10-year periods since 1988, it has only trailed MSCI EAFE in 3 periods (i.e., outperformed 99% of the time). The most recent three months (10-year periods ending April 2018, May 2018 and June 2018) are the only times the fund has ever trailed over a 10-year period.
Chad: Thanks, Jeremy. It’s always good to have that long-term historical perspective to try and educate clients that holding on during periods of underperformance can lead to outsized returns over time when investing with skilled managers.
The next question is one we’ve addressed in the past, but likely bears repeating given the reversals we’ve discussed from Q1 to Q2 this year. Jeremy, I think it’s best suited for you to tackle:
6. Do you benchmark yourself internally to a more generic ACWI / Agg Bond composite, in addition to your strategic? We ask because your decision to be OW the investable opportunity set to foreign stocks in your strategic is a challenge for us in client communications…when we’re saying we’re slightly OW foreign (tactical relative to strategic), but we’re quite OW vs. the ACWI/Agg investable opportunity set on a tactical basis. Do you face the same issues with clients?
Jeremy: I think this question largely refers to our relatively higher strategic allocation to EM stocks. In the equity portion of our active portfolios, the long-term strategic allocation to stocks is 60% US, 20% developed-international, and 20% emerging-market stocks. This allocation is different from what you see in the market-cap weighted ACWI index at present. To be sure, the EM weighting in the ACWI index has varied with EM’s relative performance. Our primary goal with adding a higher-than-ACWI EM weighting as our very long-term or strategic allocation (where our time horizon is 10-plus years) is to access a broader investment opportunity set outside the US. Also, over the very long term we expect EM weighting in ACWI index to rise as China and other EM economies mature further and their capital markets deepen, consistent with their important role in the global economy. As a reminder, emerging market economies account for 60% of global GDP on a PPP basis (and nearly 40% on a U.S. dollar basis). Moreover, EMs have contributed more than 2/3rds of total global GDP growth since 2010.
While we expect hiccups (or even some heartburn) along the way, we’d rather be ahead of this long-term trend than follow an index, and we are comfortable doing so because of our longer-term horizon (that’s what a strategic allocation means). As the regional weightings ebb and flow, unlike an ACWI index, we rebalance to our strategic weights. This also may cause our equity allocation to look different than the ACWI index at any point in time.
We acknowledge that protectionism risks are real and could turn out to be more than a hiccup and, depending upon how this risk evolves, it may lead us to re-evaluate our long-term 20% allocation to EM stocks in the equity portion of our portfolios. Another reason that may lead us to re-evaluate this weighting is if one or more major EM countries graduate to developed status, increasing the “beta” of the remaining emerging-market stocks overall: These changes occur very slowly; when they happen we’d evaluate what they mean for the overall riskiness of our portfolios.
Chad: Thanks, so that addresses the strategic allocation. Can we talk about the tactical overweight part of the question to give our audience some context there, too?
Jeremy: Aside from this relatively high strategic allocation, we have had a modest tactical overweight to EM stocks since Sep/Oct of 2015. Before that time frame, on a look-through basis in our actively managed portfolios, we were slightly underweight EM stocks because our active managers were underweighted to them versus the ACWI index. We knew this all along but did not make changes (we didn’t care whether attribution gave us the benefit of EM underweighting vs our strategic allocation via asset allocation or manager selection). More recently upon further thought and discussion internally, we decided to account for this more explicitly. As a result, we have gone from being slightly underweight to EM stocks to slightly overweight now.
We deal with this relatively higher weighting to EM stocks by reiterating to our clients the reasons behind our strategic and tactical allocation to EM stocks. We also remind them that EM stocks are part of an overall well-diversified portfolio and while they may introduce some short-term volatility, longer-term they will enhance returns and provide diversification benefits, such as a hedge against a risk of a declining US dollar and US inflation.
Chad: Okay, simple enough. Thanks, Jeremy.
Moving on, this next question is one we’ve been getting for some time now, on a portion of our allocation to liquid alternatives strategies. Jeremy, if you’ll please address this question:
7. Managed Futures continues to be a difficult strategy to explain to our clients, not to mention the protracted stretch of negative performance. Are you able to share any recent performance attribution, as well as your current thinking on the longer-term merits of the strategy to your overall portfolio construction process?
Jeremy: From a big-picture standpoint, the year started strongly, with our managers up between 3% and 7% in January, with positive trailing 12-month returns, but took a turn for the worse starting in February with the sharp spike in volatility and sharp drop in equity markets. The first quarter saw our managers down between about 2% and 5%, while the benchmark SG Trend Index was down almost 4%. Long equity exposure, which had been one of the drivers of positive performance in trailing quarters, was generally the largest detractor.
Most managers in the trend-following space had been close to or at their maximum allowed equity exposure since trends there were the strongest across most trailing periods, short or longer, and across most countries. This impacted returns more negatively for managers that had greater equity exposure and/or have longer trend signals on average, since it takes them longer to go from long a market to neutral or short. One manager, for example, went from max long equities to flat in approximately a week, while another took closer to a month, and one was still slightly net long by the end of the quarter. As a reminder, we diversify with multiple managers because it’s impossible to know ahead of time what implementation approach will work best in any given time period. In this particular set of circumstances, having a faster-reacting set of signals and lower equity exposure worked best, but that won’t always be the case. Other exposures were more of a mixed bag. Agricultural commodities were detractors while energy generally contributed positively. Currencies mostly hurt performance, as the Japanese yen staged a sharp reversal in its downtrend during the quarter.
Q2 was another difficult period, with losses in April and May, but positive returns in June. Manager performance for the quarter ranged from up half a percent to down 4%. The SG Trend Index was down 1.4%. Currencies were the biggest culprit, driven by sharp, strong reversals in the US dollar’s bearish trend and the euro’s bullish trend. Other areas were mixed, without huge movements either way at the asset class level.
We’ve gotten questions about Trump’s impact on trend following strategies. I really don’t think we can say with any degree of confidence one way or the other that Trump is better or worse for the strategy than the “average” president. The short answer is that we haven’t seen data that suggests with any confidence that Trump is the cause of the poor performance (outside of the initial surprise of his election reversing a few trends initially in Q4 2016). There has been a paucity of large, sustained trends the last couple years relative to average, but it’s really hard to say that’s due to Trump vs any number of other factors. There are always a multitude of factors that move various markets. Arguably, the speed and ready availability of information causing investors to react constantly (and massive amount of quant trading capital that’s mostly mean-reversion based) is a threat to trend following working as well as it has historically, although we are still very confident it will work very well in a true bear market. But we really just don’t have enough data to say that with any level of confidence.
AQR has given us permission to use some of their charts from their quarterly presentation. As you can see from the slides, the “hit rate” of winning trades hasn’t been that different than average in recent years – it typically hovers around 1/3 even in good years, and there are years where it’s lower than that where performance is still strong (2013 and 2014 are examples). But the win/loss ratio is the larger determinant of success, and that has been below the “breakeven” ratio of 2x (winner trades make 2 times what losing trades cost in performance). In years of strong performance, like 2013 and 2014, the ratio is multiples of the breakeven ratio of 2:1, while in bad years like 2016 and this year, it’s less. So the winners just aren’t making enough to overcome the more numerous losing trades. And the third chart shows this in more detail, where you can see the average gain from winning trades the past three years has been meaningfully lower than normal and the average loss has also been slightly worse than normal. Finally, AQR points out in the next slide that there haven’t been that many sustained, strong trends in recent years (shown as the dark green boxes), which results in the lower win/loss ratio.
There are many theories about why this is, but the role of randomness certainly has some impact. Trend-following strategies in general have been going through a multiyear period of rough performance—in absolute terms and relative to a mix of US stocks and bonds. The current stretch of performance is undoubtedly bad, among the worst, but it’s not a historical outlier compared to other major drawdowns. During the second quarter, we spent time revisiting our thesis for allocating to these trend-following strategies within our balanced portfolios. This included a lengthy internal vetting session among our entire research team, as well as in-depth meetings and discussions with two of our managed futures fund managers. While one can never have 100% certainty about any investment decision, we came away from this exercise still confident that holding these non-correlated strategies will pay off, improving the risk and return performance of our portfolios over the longer term.
Adding strategies with positive expected long-term performance, no correlation to the rest of the portfolio, and strong expected performance in extended equity market sell-offs is extremely valuable. Managed futures benefit should be most apparent during the next bear market, where the positive performance divergence between managed futures and stocks should be sizeable. While we won’t predict the precise timing, there will be another bear market—and we think likely within our five-year tactical horizon. However, we are not blindly committed to owning managed futures. Should there be a bear market and managed futures do not perform as we expect, we would likely declare the thesis “broken” and exit our positions. In the meantime, while acknowledging the frustrating recent performance, we continue to believe our patience and long-term discipline will be rewarded with this allocation.
Chad: Thanks for sharing the additional detail about the current environment, Jeremy, and a special thanks to our friends at AQR for allowing us permission to use their slides in this portion of our presentation.
There’s another question I’d like to address. It came in, Jack, if you’ll address this one. This advisor writes in:
8. How meaningful is the 3% 10-year yield. Jeffrey Gundlach has indicated it’s somewhat of a trigger point. Do you independently have an opinion on it?
Jack: I would say, Jeremy feel free to chime in, but 3% is not a trigger point for us at all. When we think about our fixed-income allocations or even our equity allocations for that matter what we’re doing is looking at a range of 3-5 year economic scenarios so we’re not predicting short-term interest rate outcomes or even equity market outcomes because frankly we don’t think we’re very good at it. Nor do we think many other people are. I guess I’d say we’re more interested in understanding what can happen and what outcomes can occur and what the impact would be on our portfolios.
You know, if we just rewind the clock a bit and the 10-year was at 1.50 or even below for a while, we were looking at various rate scenarios, what if they go low, what if they stay flat, what if they rise by 100, 150, or even 200 bps. My point is we’re constantly evaluating interest rate scenarios over the long term directionally so not short term whether rates will hit 3% or 3.25% or whether that technically means they can spike one way or the other. When we go back and rewind the clock we did look at various rate scenarios and that’s what led us to our current positioning recently—today, where we are underweight to core bonds.
And we’re still doing the same exercise I mentioned. We’re looking at various rate scenarios. What we’re constantly doing is thinking what can rates do? We’re looking at different magnitudes of rate change, how compressed is the rate change, is it spread out over 3 years or does it happen over 1 year? So we’re looking at a bunch of interest rate scenarios and understanding what can happen to our fixed-income exposures. So it’s not about one bulleted rate number.
Chad: With that, I’d like to conclude today’s event by thanking our audience for all of the great questions and their continued support, and thank Alice and the analyst team for sharing your perspective with us.
A replay of the webinar and a copy of the presentation slides will be available on AdvisorIntelligence.com later today.
For those advisors accessing our fully outsourced Portfolio Strategies via a turnkey asset management platform or UMA, we will make a replay available to you as soon as possible.
Thank you all for joining us and have a great day.
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