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This is a replay of our third quarter 2018 Litman Gregory research team webcast, held October 18, 2018. Topics covered (among others): our equity market views, the value of alternative strategies, our response to Howard Marks's recent memo, Oakmark and Cove Street funds. The presentation slides are available at the bottom of the page under Resources.
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, Rajat Jain, Jack Chee, Jason Steuerwalt, Kiko Vallarta, and Alice Lowenstein. I said this last quarter, too, but I’d like to give special thanks to Alice for stepping up and joining us today as Peter Sousa is traveling on business.
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 third 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, or audience, prior to the call, showcasing some of the most pressing issues we’re facing when advising clients. We’ll also try to address any questions you submit live, time-permitting. 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 email@example.com or firstname.lastname@example.org.
Now let’s move on to our opening presentation – Here’s Alice:
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:
2018 has been very disappointing after an encouraging run of performance for emerging markets stocks in 2017. Where and how can EM stocks generate outsized positive returns vs. U.S. stocks and/or hold up better in a global stock market selloff based on better valuations to make up the lost ground? We are in dire need of talking points for why we stick it out with EM equities. What are your advisors telling clients?
Rajat, will you please start us off by sharing your thoughts?
Sure, I will try. We have written about this topic quite a bit recently, so I will try to keep it short.
We think EM are relatively cheap. Absolutely speaking, we are not pounding the table on EM stocks…nor are we for any asset class really as QE/sustained low rates have elevated all asset classes’ valuation relative to history. But to the extent we want to take on equity risk in our portfolios, we think taking more in EM than in the US makes sense. In addition, our overweighting to EM stocks is modest—about half that of our typical fat pitch in our conservative models—recognizing risks stemming from China that we have expressed for many years.
There are always risks out there in investing, which also generates tactical opportunities. For every asset class we cover we try to assess to what extent are these risks more than priced such that our odds of success have risen sufficiently to consider a tactical overweight or underweight. With respect to EM stocks we believed we reached that point late Sep of 2015. Since then, and despite this year’s underperformance, EM stocks are up over 12%. So, absolute returns have been okay. But relative to the US stocks, since Sep 2015 EM stocks have trailed US by about 5 percentage points, annualized.
In our base case, we are using 5% nominal earnings growth going as far back as 2004. In essence, this is an attempt to take out the frothiness in EM stemming from China’s potential overspending and developed market’s over-leveraged private-sector demand. We think this is pretty conservative given EM fundamentals and what earnings growth they have delivered over long periods. The multiple for normalized earnings we use to gauge fair value in our modeling is a 25% discount to the US. This is inline with history. We don’t think that’s generous. We are using historically conservative earnings growth assumptions so dinging them more on valuations gives you a sense of the downside risk but as a base case is not reasonable in our view as it would lead us to miss tactical opportunities. Currently EM trade at a historically high discount of over 40%, using PE as a metric, and over 50% discount based on Shiller PE, which is another way to look at normalized PE. In our base case we expect EM stocks to deliver an annualized high single digit returns over five or so years, and a bit higher if we were to think in probabilistic terms.
In terms of when we will get paid, we can’t be sure of that. Valuations are a lousy short-term timing tool we will admit. We could get paid during the last leg of the current cycle: with EM earnings relatively depressed, valuations cheap, their currencies quite cheap, the stage is set for a strong recovery in their stock prices should trade tensions ease and the US and the rest of the world continues to grow at a decent clip. If global growth craters sooner and we enter a recession, EM stocks because of their high beta may underperform, but the stage then would be set for a stronger recovery in their prices as we come out of the downturn.
Rajat. 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:
Doubters of this bull market have given up a lot to be diversified away from U.S. stocks, especially considering low future expected returns from here. Have the actual returns versus LG’s projections caused a reevaluation of your process or the size of the tactical moves you are willing to make in response to your analysis? Have you learned any lessons about weighing certain risks, data, or factors that could help improve asset class modeling in your scenario framework? As one of my advisors put it to me recently, when does a defensive tactical move away from equities become a speculative bet on a market correction akin to market timing?
First, with respect to the last question as to whether our underweight allocation to US stocks is “a speculative bet akin to market timing.” We would strongly reject that notion. Our tactical positioning is based on well-founded, historically-informed analysis of market fundamentals (earnings) and valuations. It is based on longer-term, multi-year, full-cycle, asset class return estimates balanced against shorter-term risk considerations. It does not depend on a single point estimate that we bet everything on, but instead incorporates a range of potential outcomes and scenarios – acknowledging that the future is inherently uncertain and precisely unpredictable. Our tactical allocation approach is also incremental in its execution – ratcheting up the tactical positioning in increments as the risk-reward outcomes and odds become more skewed in one direction or the other. It is not all-in or all-out of the market. So it is neither speculative nor what most people would consider to be “market timing.”
In terms of lessons learned from our experience over the past several years from being underweighted to US stocks… there are several and I’m sure I won’t hit all of them on this call...
learned the huge potential impact central bank policy in particular can have on asset prices, yields and valuations. We didn’t envision quantitative easing and zero or negative interest rates, and didn’t fully appreciate the impact these policies would ultimately have on financial markets and asset prices – US stocks in particular – even though their impact on the actual real economy was modest, as reflected in subpar growth rates. So this past cycle has reinforced the old investor saying: Don’t Fight the Fed. But also remember that this applies when it comes to Fed tightening policy too. History shows that Fed tightening cycles, stock market declines and recessions tend to coincide
Related to this is the point that U.S. stock market valuation multiples can range very widely; and the notion of a “fair value” market multiple is also variable over time. So I’d say we have become less quick to make incremental tactical moves away from our strategic equity allocations. Put differently we have expanded the upper and lower bounds of our “fair value range” for equities – so we have a higher hurdle – we require a more extreme five-year expected return (high or low) -- to make a tactical change. This higher tactical hurdle can also be seen in that we haven't further underweighted US stocks – at least not yet – despite the very low base case expected return. This also reflects the fact that we do give weight to our “bullish” US equities scenario in our tactical decision process – and a good thing too since that scenario has so far been the one that has played out, despite our thinking it was lower probability than our base case.
More broadly, in terms of the different scenarios we consider, when it comes to risk assets like stocks, we’d say a lesson is that the range of possible outcomes (at least over shorter-to-medium term periods) is much wider than most people think.
There is also a lesson in the length of the current cycle. We used to be more confident that our five-year tactical time horizon was an adequately long period to encompass a market cycle, and in which fundamentals and valuations would prove out and drive asset returns, rather than market sentiment and shorter-term factors. But for this cycle five years has been too short of a time horizon. This bull market is now the longest in US history and likely to be the longest US economic expansion (if it lasts until June next year) – going on ten years.
So the patience and discipline that we often talk about as critical for long-term investment success is even more important as valuation-based investment approaches have been challenged during this extended cycle. (We see that within the US stock market as well, with value strategies massively trailing growth strategies.) We continue to strongly believe that valuation matters – that the price you pay for an asset is a key determinant of your long-term return. We continue to believe that in-depth fundamental analysis and independent thinking matters, and that a long-term horizon is necessary to be a successful investor. We continue to strongly believe that financial market cycles have not become obsolete, and that the current cycle of outperformance for US stocks versus international and EM stocks will turn again as it always has – driven by underlying fundamentals and valuations and human herd behavior that drives markets to excesses and creates these tactical asset allocation opportunities. It’s not “different this time.” But you have to stick with it. Whatever you do, don’t become a performance-chaser, lacking a process and discipline. That is a sure path to investment failure.
Thanks, Jeremy. There was a lot of wisdom you just shared there, and much easier said than done.
Moving on, our next question is about the alternative strategies positions in our portfolios. Jason, if you’ll please address this question:
We’ve been getting a lot of questions from clients about the alternative strategy funds in the portfolios, specifically the fees and rate of return. How do we convince clients that they’re worth holding long-term given the recent performance hurdles and high relative fees?
The timing of this question is fortunate, as I was reading on my commute the lengthy essay that Cliff Asness published about a month ago called “Liquid Alt Ragnarok?” - I highly recommend reading it. It’s available on AQR’s website. While Cliff is much smarter than I am, I did feel pretty good that a lot of the points he makes are ones that we’ve tried to articulate over the last few years regarding our alternatives allocations. Now I know there’s definitely some element of my thinking that’s been influenced by reading and speaking with folks at there over the years (as well as plenty of other investors I respect), so it’s not surprising that it has seeped into the way we discuss these things. Nonetheless, it still feels like an important sanity check on our thinking that well-managed alternative strategies deserve a place in most investors’ portfolios absent compelling evidence or at least a highly plausible explanation why they shouldn’t work anymore. We of course recognize that it’s in a managers’ interest to make that assertion, but we feel that they’re very credible and intellectually honest, and we have evidence that their strategies have experienced rough periods in the past and then returned to performing well. I don’t mean to make this a commercial for AQR, as we’ve had conversations that covered a lot of the same topics with a number of firms over the last year or two, but I thought this was a very worthwhile read.
The big picture answer to this question lies in the key phrase “worth holding long-term given recent performance.” If you have a diversifying strategy that you expect to generate positive returns over the long term based on historical evidence and economic or behavioral justification for why it works, you shouldn’t be in a hurry to get rid of it based on short term performance. Or even medium-term performance of a few years, provided that it’s consistent with the range of historical performance and you don’t have evidence to strongly suggest that something has changed in markets, investor behavior, or some other reason that leaves the strategy “broken.” I’ll go back to value investing as a parallel here – it’s worked very poorly compared to growth for years now, but most people don’t think that value investing will never work again.
Obviously, it’s really hard to hold positions that aren’t performing the way you’d like. We all know the studies about about loss aversion – the asymmetry of feelings about gains and losses, with losses hurting far more than gains feel good. Similarly, “losing” unconventionally with alternatives hurts more than losing conventionally in traditional assets or strategies. By “losing” in this case, I’m generally talking about underperforming a traditional 60/40 portfolio, although in the case of managed futures, it’s a negative total return over the trailing 1 and 3 years. I’ll point out here that over the span of most people’s investment lifetime’s, a 3-year window is a very short time, and starting and ending points matter a lot – our allocation to the strategy missed a very strong year of absolute and relative performance by about a year.
Okay, thanks Jason. So continually orienting clients to the long term, educating them with history, and discussing behavioral biases and heuristics that are inherent in us human beings that make us wired to be terrible investors. But what about the fee objection, when coupled with a period of underperformance?
As for the part about fees, well, fees matter. This is obvious. But while you can get exposure to broad long-only asset classes at extremely low costs (now zero in some cases), and it’s increasingly difficult to consistently add value (to varying degrees, for a number of reasons), many alternative strategies don’t fit that same mold. There is no investable index fund of trend following, for example. While it’s conceptually simple, the actual process and implementation isn’t easy. It’s also become more competitive, which is why you now see institutional quality managed futures funds available at well under 2% flat, whereas 10 years ago, it was almost exclusively a private 1.5 and 20 or 2 and 20 strategy. There are cheaper options, but we think they’re generally not great implementations. Now, you can say why should I bother to pay 1 and a half percent for something that’s underperforming my traditional assets, and is more expensive. That goes back to the first part of the question. We think the alternative strategies we have in the portfolio are additive to the portfolio from a risk-adjusted return basis net of fees. Some things we expect to have higher returns and higher volatility (managed futures), while others, like arbitrage-type funds, should have lower volatility and lower long-term returns (at least as implemented within the constraints of a 40 Act fund with little to no leverage), with diversification benefits. I hate to sound like a broken record, but if you have a strategy that has positive long-term expected returns net of fees, with little or no correlation to the rest of your portfolio, that’s extremely beneficial to add. Most alternative strategies require some combination of specialized research, model design, programming, portfolio management, risk controls and trading systems to implement, and those aren’t available for 20 or 50 basis points. Is it possible we get to that point someday? Possibly, I guess, but even if we never get much cheaper than those things are now, I think it will prove valuable over the long term to pay that cost to make your portfolio more resilient.
Of course we’d all have been better off to just be long the S&P 500 and nothing else since March of 2009, but unless you truly have an iron will and unlimited time horizon, that isn’t a prudent asset allocation. 10 years of quantitative easing have a way of making people forget that asset prices can go down more than a few percent and a for a few weeks. There’s a laundry list of concerns out there that we can all rattle off that could potentially cause markets to decline, but the reversal of QE and rising rates is certainly a very major factor that by definition becomes a big headwind for asset prices. It’s hard to predict when things happen, and we’ve been skeptical on valuations for several years, but now certainly seems like an inopportune time to throw your diversifying strategies overboard.
One last specific thing I want to call out, that, again, we’ve mentioned before, is judging each line item in a portfolio vs the portfolio as a whole, particularly over a relatively short time horizon. In a footnote, Cliff Asness actually calls this “one of the great errors in investing.” I couldn’t agree more. During this period where alternative strategies have been underwhelming or potentially even negative, the rest of portfolios that are generally long risk assets should have been performing very well overall, so the fairly small allocation to diversifying strategies hasn’t been a major detractor. Different pieces of the portfolio are there for different reasons, like parts of a car or a house, and understanding that is important. Being overly focused on those particular line items that aren’t working increases the temptation to bail out, which we think is the wrong thing to do. It’s not the best analogy, but if you’re cruising down the road on a beautiful day in your convertible, that seatbelt sure is annoying and it would be great to have more freedom to move around, but we wouldn’t recommend taking it off.
All of this is just to reiterate that we think that well-executed alternative strategies deserve a place in most portfolios, despite the fact that they don’t work all the time (nothing does, despite the fact that being long US equities has worked for an incredibly long uninterrupted stretch now). And we know that’s frustrating. Fees matter, but some things you still actually have to pay for. That’s also frustrating, particularly when they’re not working. However, if the long-term thesis is still intact, we have to stick to our discipline.
Makes sense, thanks for sharing those points and the suggested additional reading for those that are interested, Jason. Moving on to our next question, related to where we are in the credit cycle, Jack will you take this, please? The question reads:
We’re curious on your team’s thoughts on Howard Marks’ latest memo where he describes increasing imprudence in the debt markets and advises safety rather than trying to fully participate in gains. How aligned are the flexible income managers - Osterweis, Guggenheim, and Loomis – with this approach?
Across our line-up of credit managers, the common belief is that we’re later in the credit cycle, and risks are increasing. What we’ve seen over the past year to two, is our managers continuing to posture their portfolios more defensively. They’ve done this through a combination of upgrading credit quality, reducing duration, being willing to hold some short-term reserves, and overall, being increasingly mindful of risk they’re taking.
Starting off with Guggenheim Macro Opportunities Fund, over the past two years or so, they have been reducing their corporate credit exposure, which today is at a multi-year low. They see several risks including tight yield spreads, the potential for a recession in 2020, the imposition that trade tariffs could present, and what could be a tight liquidity environment during a sell-off in credit. Therefore, they have been shortening spread duration, opportunistically moving up in credit quality, and maintaining a liquidity buffer to serve as dry powder during periods of market weakness. Approximately 90% of the portfolio is in floating-rate securities as they forecast more Fed rate hikes. They continue to favor high-quality collateralized loan obligations (CLOs) with short average life, non-agency residential mortgage-backed securities (RMBS), and floating-rate loans. We spend a significant amount of time with the broad investment team at Guggenheim and are highly confident they are considering the risks.
Moving to Loomis Sayles Bond, the combination of rich corporate bonds valuations and uncertain macro conditions have resulted in an increasingly defensive positioning. The portfolio’s duration is down to just over three years, which is the lowest in the fund’s history, and roughly half the duration of the Aggregate bond index. Even still, the fund’s recent yield of 3.7% is higher than the low 3% yield for the Aggregate bond index. Meanwhile liquid reserves have increased to a high of 30%, which the team expects to put to work when more attractive investment opportunities arise during market declines. That said, the team notes that corporate health remains strong, and they don’t expect a spike in default rates over the next 12-15 months. So they have reduced exposure to the credit sector with a focus on issue selection and attractive income.
Osterweis Strategic Income is technically a flexible bond fund, but for the past decade it has primarily been a short-dated high-yield bond fund. And like our other fixed-income holdings, the fund’s positioning has been relatively conservative. The team continues to wait for pockets of market weakness to create buying opportunities. Cash in the portfolio is recently in the mid-teens. And like Guggenheim and Loomis, Osterweis is increasing the quality of the portfolio and has around 5% in some short-term investment-grade bonds where they thought it made sense.
So we strongly believe that our managers are appropriately considering risks in the credit market and taking only what they believe are prudent risks.
Terrific. Thanks for sharing the thinking of the managers and how that’s impacting their underlying portfolio positioning, Jack.
Our next question is a more philosophical question, about how to best gain exposure to foreign markets. It reads:
I would be interested in your thoughts on the merits of standalone EM exposure versus using a foreign stock fund that includes both EM and DM. It has obviously been a difficult period for EM (2017 notwithstanding) on a relative basis. Given the embedded EM exposure of many developed country companies and the generally weak governance of many EM countries, perhaps it makes more sense to delegate that allocation decision to an international manager. Thoughts and comments would be appreciated.
Rajat, will you please share your view with us on this?
I understand why this question may arise in some clients’ minds. We have gone through a long stretch of EM underperformance relative to the US. When EM are outperforming, the weighting appears low and when they are underperforming it appears too high. It’s important to continue to think strategically about our EM allocation though.
Several years ago when EM had outperformed over a long period our strategic allocation of 12% in a typical balanced portfolio some criticized was low compared to what large institutions and endowments had (up to 50% higher). You could argue for a higher weighting to access the large investment opportunity set in emerging markets. We didn’t because we wanted to factor in the higher beta of emerging markets. We consider EM stocks a higher beta way to access global growth—both domestic emerging markets and developed world. Also, we do factor in the look-through EM exposure we are getting from our current international managers to ensure we are not more weighted to EM stocks than we intend to be.
Second, delegating this decision to international managers defeats the goal of wanting to access a broader investment opportunity set in emerging markets and to get diversification benefits from doing so. International managers typically have mandates that limit how much they can go into emerging markets and when they do tend to limit themselves to larger companies in a few emerging market countries. Finally, the amount of EM exposure they can have varies significantly: we cannot count on international managers to successfully time entry into emerging markets nor expect they will have a strategic exposure to the asset class.
Third, a strategic allocation to EM diversifies portfolio away from risks stemming from US stocks—the risk of a long period of US dollar decline and high relative inflation, risk of peak margins in the US, political and/or populist risk in the US (as we are seeing) etc. And, let’s not forget our strategic weighting to US stocks is 3x as much as EM stocks, so we are definitely factoring in US’ higher quality. The fact we have chosen to tactically underweight US stocks in favor of foreign stocks and absolute-return oriented investments is a separate decision from the strategic one and we have talked about it at length in the past.
It’s interesting I heard these questions in the late 1990s/early 2000s when I was working at an institutional consulting firm and some clients in fact did move from a dedicated EM stock allocation to an ACWI allocation, meaning delegated EM stock allocation to international managers. Some sold EM and put proceeds into the overvalued US market. This was post the Asian crisis and the Russian rouble devaluation. The trend had become strong enough that some large fund companies folded their dedicated EM teams into international teams or fired them. This was a classic case of throwing in the towel at the worst possible time, of letting emotions dictate investment and business decisions, of not having a long enough time horizon and selling near the bottom and/or buying at the top. As advisors, we can add significant value for our clients if we can help them navigate through this time and avoid making a similar mistake.
Rajat. It’s always good to have that long-term historical perspective to try and educate clients and keep them on track with their financial plan.
The next question is one that’s been coming up more in my recent conversations. Jeremy, I think it’s best suited for you to tackle:
The return differential in value vs. momentum factors has been large and persistent and has had an impact on our clients’ performance. Data and analytics tools have evolved a lot in our industry over recent history. Do you talk about factors and the historical cycles of return, variance, and correlation as a tool when explaining performance attribution of managers and portfolios to private clients? We wonder if this would help or hurt (just confuse more).
It’s true that there has been a wide divergence in the performance of value vs. momentum stocks since the end of the financial crisis. Historically, over the long-term, both the value and momentum factors have generated meaningful excess returns above the market return. But that hasn’t been the case for Value over the past ten or so years. Meanwhile, Momentum has beaten the broad market, and has outperformed Value by a very wide margin.
From an analytical perspective, we do think there is some benefit in looking at underlying factor exposures and factor performance attribution of actively managed funds. It can provide some useful insights into a portfolio’s structure and shorter-term performance headwinds and tailwinds. But we don’t currently see factor analysis attribution as something we would incorporate into our private client discussions or reporting, nor have our investment client advisors been asking for it.
One other point I’ll make since the question also asked whether we talk about historical cycles of factor returns …. We do spend a fair amount of time in our research commentaries and with clients talking about historical financial market cycles more broadly – whether having to do with the performance cycles of investment “styles” or factors (such as growth, momentum and value), asset class cycles, interest rate and credit cycles, or economic cycles. Having a strong historical understanding of the cyclical nature of markets is really important and hopefully also useful in helping to manage client expectations and their emotional reactions to market volatility.
Our discussions of cycles also highlight the importance of having a diversified portfolio, because while we are highly confident cycles will continue to occur, no one can consistently predict the timing, duration or magnitude of any given cycle, nor which investment styles or factors or markets will be in favor at any given time. But an understanding of historical cycles is a critical input to our tactical investment approach and our assessment of when the longer-term risk-return odds favor tilting a portfolio towards certain asset classes or away from others.
Thanks, Jeremy. Helpful and timeless context for us all to consider when communicating with clients. The next question is manager-specific. Kiko, will you please address this?
What are your latest thoughts on recommended funds Oakmark and Oakmark Select, subadvised by Harris Associates, considering a stretch of underperformance? I know they’re different situations, but I can’t help but draw parallels to the recent Harbor/Northern Cross sub-advisory situation.
First off, the sub-advisory relationship between Oakmark and Harris Associates is different than the Harbor/Northern Cross relationship. Harris and the Oakmark fund family are the same company, whereas Harbor funds is separate from Northern Cross. Harbor is a “manager of managers” and does the selecting/monitoring/firing of sub-advisors for their funds. Harris will not be firing themselves from their own fund family.
But the point about recent underperformance of Oakmark and Oakmark Select is understandable given both funds are underperforming the S&P 500 and Russell 1000 Value index over short- and intermediate-time frames. I’d make a general point about performance before jumping to the specifics for these funds:
Short-term performance is just that: short term. As many on this call already know, we are long-term investors and are more concerned about results over full investment cycles. That’s not to say it doesn’t matter. We are aware of short-term differences in performance and want to understand if there is something materially different with the investment process that’s leading to the underperformance.
That said, I recommend reading Bill Nygren’s Third Quarter 2018 Commentary (if you haven’t already). He is an excellent writer and has always been transparent in his letters. In this commentary, he addresses the recent performance of the funds. I will borrow some of the stats he used in the commentary.
For context, both funds are trailing YTD and over the trailing 1-year, 3-year and 5-year periods. Nygren and the Oakmark team are all value investors so while our expectation is for the funds to beat the S&P 500 over the long-term, a value index (Russell 1000 Value) is also a relevant measuring stick, particularly over shorter/intermediate periods where styles can run in and out of favor. Point-to-point performance figures are often misleading and offer just a single snapshot in time – we prefer to look at performance over rolling periods. Since the Oakmark Select’s inception in November 1996, it has actually underperformed the S&P 500 in 35% of rolling 5-year periods. However, an investor at the inception of Oakmark Select would now have more than 12x their original investment. This compares to 6x for an investment in the S&P 500 over the same time period. Doubling your capital relative to the market index over 22 years is a huge additional return, but you’d have to handle the discomfort from underperforming the index about a third of the time along the way. Easier said than done.
Thanks, Kiko. Again, we hear the theme of historical perspective adding value when seeking to manage emotions and expectations. It helps to put the recent period of underperformance in context. Understanding that we and Nygren are long-term investors, can you talk about the main drivers of the poor relative performance this year?
This current period of underperformance can be attributed to a large of number of stocks that have been unable to match the index in the last year. Within Oakmark Select, Nygren points to 24 stocks owned by the fund in the past 12 months – and only 8 of them have a return greater than 10% (during a period when the S&P 500 is up 18%). With two-thirds of the portfolio returning less than 10% (and in many cases negative returns), Oakmark Select has been flat over the last 12 months – so this is a wide return differential and warrants performance questions. The largest detractors from performance have been Adient, Weatherford, and General Electric. Nygren says Adient and GE have fallen short of their expectations, but management changes and the more valuable pieces of each business have performed as they expected – so both remain in Oakmark Select.
While both funds are trailing the S&P 500 and Russell 1000 Value indexes by meaningful amounts at the end of the third quarter. It is interesting to note that just 9 months ago, the funds were outperforming the value index in all intermediate and longer-term trailing periods. In that short time frame, we do not think anything suddenly changed at Harris to make us question their people or process.
Regarding our due diligence on Oakmark, late last year and into early 2018, we spend a lot of time with the domestic analyst team. We met with 6 different team members for more than an hour each. We spent the time deepening our understanding of the team and their investment process. We have always had a high opinion of Bill Nygren, but our recent interaction with the broader team gives us greater confidence in the overall firm and strategy. We published our updated Oakmark due diligence report on Advisor Intelligence in April.
Thanks, Kiko. It’s good to have you on the webinar this quarter, and we look forward to hearing more from you. Moving on, this next question is about short-term rates and risk management. Jack, if you’ll please address this question:
With the yield on money funds increasing of late (around 2% on some institutional funds) and with the expectation of additional interest rate hikes by the Fed over the next several quarters, could it make sense to go to cash with some of the money in the core bond portion of our portfolios at this point in the credit cycle?
Historically we have seldom held cash in our portfolios. But then again, we’ve also been in a declining rate environment for the last thirty-plus years. So this is a good (and fair) question considering that we’re currently faced with historically low core bond yields and rising interest rates.
Stepping back, when we think about portfolio construction, an important component of our asset allocation and portfolio-construction approach is managing to our 12-month downside loss thresholds. When managing our portfolios, we’re balancing short-term downside risk with longer-term returns across a range of economic and market scenarios.
Specific to this question, there are three key components to consider. One is the direction of interest rates, two is over what timeframe, and third is the size of the allocation.
Let me address the first two pieces and if I’m interpreting this question correctly, it’s referring to rising over a shorter timeframe. In that specific environment, cash certainly makes sense as it’s safe to assume that cash would outperform core bonds. However, and importantly, that’s only one scenario. And as most of you on the call know, we do not manage to a single outcome. If we were to manage to that one scenario, I would argue for allocating to other credit-based asset classes that would likely outperform cash.
Our approach is to consider multiple outcomes and try to maximize longer-term returns within the framework our downside risk thresholds. To this point, I’d highlight that we are, and have been for years, meaningfully underweight core bonds in favor of flexible bond funds such as Guggenheim, Loomis, and other tactical opportunities such as floating-rate loans and short-dated high-yield. As you can imagine, we have considered further reducing our core bond exposure. Core bonds are there to serve as a ballast to our portfolios in the event of a sharp market decline. In that environment, we would expect core bonds to beat cash. If we did allocate farther away from core bonds and into cash, that would further reduce the remaining ballast in our portfolios. A lower core bond exposure would impact the exposure to risks we’re willing to take in other parts of the portfolio, such as credit or equity risk.
I’d also add that the core bond funds in our portfolios, William Blair, DoubleLine Total Return, and Guggenheim Total Return, are positioned for higher rates. While their durations are close to that of the Aggregate bond index, their durations are shorter, and the composition of these portfolios is meaningfully different from the core bond benchmark. Our expectation is that during a downturn, these funds will protect or insulate our portfolios, but will not keep pace with the Agg during a sharp flight to quality.
So the combination of being meaningfully underweight to core bonds, and the characteristics of the core bond exposures we do have, we believe we are already leaning pretty decisively away from the risk of rising rates.
If we look longer-term, starting bond yields are a very good predictor of subsequent five-year returns. So if we look longer term (3 to 5 years), we expect core bonds will beat cash.
Last, I’d highlight the challenge of correctly timing portfolio trades. As much we would we love to pretend we can time the market, we don’t think we, or anyone else is really good at it. And while we expect rates to continue rising, that doesn’t rule out bouts of market volatility just as we did last week.
I’ll wrap up by saying that one needs to look at our fixed-income exposure in the context of our overall portfolio exposures. The essence of balanced portfolio management is not to focus on how any individual piece of the portfolio may perform in a vacuum, but how each piece of the portfolio plays a particular role in the overall portfolio, how the sum of the parts will perform across a range of scenarios, and the risk/return profile of the entire portfolio.
Thanks for sharing the additional detail about the current rate environment and how we think about it in terms of positioning the income components of our balanced portfolios.
The next question is topical given the timing, and one we tend to get fairly often. Jeremy, if you’ll please address this for us. It reads:
We’d be interested in any update on your review of Cove Street.
Last quarter we touched on disappointing performance of Cove Street Small Cap Value. On this table, you can see that performance improved in the most recent quarter, but the longer-term trailing numbers continue to lag the Russell 2000 Value benchmark. It is interesting to look back two and a half years, and the fund’s performance looked strong across all time frames. Anytime a fund goes through a prolonged period of underperformance, we’re digging in and re-underwriting our thesis, ensuring that nothing has changed, or that we’ve missing something.
Over the last quarter we’ve done a significant amount of follow-up work on Cove Street. This included an all-day site visit to their Los Angeles offices where we spent a couple hours with portfolio manager Jeff Bronchick and a couple hours with the four analysts. Subsequently we’ve had nearly five hours of follow-up calls with the team. We have not identified any red flags, and we are actively wrapping up our work on this fund, which will involve a call with Bronchick in the next few weeks.
Thanks, Jack. Switching gears again from managers to asset classes, here’s a question on our analysis of the opportunity in European stocks. Rajat, will you please take this question?
Does your team still consider Europe to be a fat pitch? This seems to be the case but with 80% of Europe’s GDP tied to trade and the trade war talk escalating, coupled with other political problems like Italy's budgetary woes, immigration and Brexit, these seem like never-ending stories weighing on perception and ultimately returns. Should the expected returns in the bear case scenario get more weight? In other words, while domestic equities are overvalued, we’ve seen that they can continue to fetch higher valuations for good fundamental reasons, while European stocks may be justifiably valued due to all these uncertainties and issues that have been happening for years.
Yes, we consider Europe to be a relative fat pitch, not as much an absolute one (as noted earlier, nothing is attractively priced in absolute terms after years of quantitative easing around the world). We have high conviction over our time horizon Europe will generate high single digit returns, and there’s a decent chance we could get more. US stocks on the other hand we expect to generate near zero in our base case, although they could match Europe in our optimistic scenario.
Yes, we have witnessed a never-ending stream of negative political news from Europe. This has depressed sentiment and we think a lot of the negative macro news might be priced into Europe stocks. We have never assumed that the risk of Eurozone break-up is zero. The odds of Europe acting in their own self-interest and muddling through all the political issues over a long period are in our view higher and then these developments you point to would largely be considered noise in hindsight. Even in a break-up scenario, while our overweight we’d expect to hurt us in the shorter term, with some countries suffering more than others, longer term it’s reasonable to expect companies will adjust and even this event should not materially impact their normalized cash flows—but we cannot be sure obviously and will have to evaluate this question when and how this event is playing out. Finally, when we initiated our fat pitch in Europe, because of some of these risk factors we did demand a higher margin of safety than what history would suggest in that we waited for a higher excess return.
We will get paid when Europe earnings normalize. Based on the same analysis as we do now, we had initiated a relatively small Europe fat pitch soon after the Greek debt crisis flared up and investors started to worry about a Euro break-up. That fat pitch lasted for nine months and added value in our portfolios. Our current Europe overweight was initiated spring of 2015 and has taken longer obviously to play out.
We believe markets go in cycles. History suggests Europe and US markets also go in cycles. Looking at it in simple terms, since 2007, when Europe underperformance cycle began, it has underperformed the US by about 150% cumulatively. We entered much later in that underperformance cycle and are expecting about 60% of relative outperformance from here for our fat pitch to work out nicely (we are not assuming we will get back all of Europe’s underperformance starting from 2007). We are not saying this simple price chart suggests fair value. What it does suggest though investors go from fear to euphoria that can depress or overextend prices from what might be a reasonable fair value; that fundamental variables like earnings and cash flows also do under and overshoot. We will stay disciplined with what we think is a reasonable fair-value estimate.
So, to summarize going into our Europe overweight we had a higher margin of safety than history would suggest. And we expect to get out sooner than what historical performance cycles would suggest. Hopefully this gives you an indication of our relative conservatism with regards to Europe.
Excellent. Thanks, Rajat. We’ve covered a lot of ground today.
CLOSING - 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.
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Thank you all for joining us and have a great day.
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