December Market Review
December wasn’t a great month for the global financial markets. All markets finished lower, with the exception of cash. For 2015, overall performance wasn’t much better, and in some cases, losses were in the double digits. The bull market in the U.S. stock market might still be alive, but it has definitely matured and has lost its youthful vigor. For December, the overall U.S. stock market (Russell 3000) lost just over 2%. Large-cap stocks (S&P 500) lost about 2%, while U.S. small-cap stocks (Russell 2000) lost 5%. International stocks (MSCI ACWI ex-U.S.) also lost about 2%, developed economies (as expressed by the MSCI EAFE Index) lost 1%, and emerging market stocks (MSCI Emerging Markets Index) lost 2%.
For the year, U.S. large caps gained 1%, while U.S. small caps lost 4%. In the international stock markets, developed markets lost 1% and emerging markets lost a whopping 15%.
Diversifying asset classes, such as commodities (Bloomberg Commodity Index), lost another 3% last month and finished the year down 25%. Alternatives (Morningstar Diversified Alternative Index) lost 1% in December and 4% for the year.
One important story was in fixed income. Despite the Federal Reserve (Fed) raising short-term rates, the 10-year Treasury rising to a yield of 2.27%, and credit spreads widening, the bond market (Barclays Capital Aggregate Index) barely lost ground last month and finished the year higher by 1% – even slightly outperforming the overall U.S. stock market.
Let’s get right down to it. It’s time for year-end reviews. How did CLS’s managed portfolios perform?
With over 25 years of experience in portfolio management and investment decision-making, I have to admit it’s difficult to ever be fully satisfied with performance. In hindsight, virtually every investment decision could have had better results. We could have bought something later, sold something earlier, or sized a position differently. We have disciplined processes to help with each of these decisions, of course, but there are only so many things an investor can control. Controlling actual market action is not one of them.
With that said, it really wasn’t a bad year for CLS-managed portfolios. As I always like to say, I’m responsible for two manufacturing lines: one is to manufacture and manage investment portfolios, and the second is to manufacture stories and education to support investment counseling. Investors should have clear expectations on how CLS should perform. We should not surprise anybody with our performance, given market conditions, either in how the portfolios behaved or in the stories we tell. Everything should be clear with no surprises. If that isn’t the case, we have failed to set proper upfront expectations.
Let’s examine the performance of CLS portfolios. Did they behave as expected, given market conditions, and based on what we communicated? We manage most investment portfolios and assets using CLS’s proprietary Risk Budgeting Methodology. We are known for our risk budgeting, and that’s not changing anytime soon. With risk budgeting comes two promises. First, we promise to manage a client’s portfolio to a specific risk level. We did that for every portfolio we managed last year. Second, we promise to be active managers. An investor can expect that we’ll move portfolios to where we think better value and expected returns await. And last year, we were definitely active in taking positions different from our benchmarks.
We also improved our investment process considerably last year. It was a solid, disciplined process coming into 2015, and it had been notably enhanced in multiple ways by year-end:
We greatly expanded our portfolio management capabilities.
We significantly increased our risk management, including installing factor-based portfolio analysis to complement risk budgeting.
Our depth of security selection analysis for individual exchange traded funds (ETFs) went deeper than ever before.
Our propriety CLS Score, which effectively creates an expected return for each and every ETF, was expanded to all asset classes.
We brought in some high-powered, institutional-quality, third-party research tools, and we built some great in-house research tools as well.
In the end, our investment philosophy has been fortified and our investment process has never been better.
As for that second manufacturing line – stories and education – we had an excellent year. We hit the road, picked up a lot of air miles, and met with numerous advisors and investors. We wrote more commentary and blogs than ever before, expanded our Quarterly Market Outlook, talked to the media regularly, and enhanced and emphasized new online tools such as clsinvest.com’s “PM Insight” (for advisors only).
Talking to investors and explaining the markets and portfolios is something we do and are known for. We are dedicated to serving investors. According to one investment industry consultant estimate, the CLS Investment Team spends twice as much time on sales support, after-sales support, and overall communication than the typical firm’s investment team. In short, we are known for our portfolio manager accessibility. That’s also not changing anytime soon.
Now let’s get back to the effectiveness of our active management last year. So, the portfolios “behaved” as expected, but how were the actual returns versus peers and benchmarks? We generally did well versus other global asset allocation rms, as we have in recent years. However, we did not beat our benchmarks.
2015 – Investment Themes – How Did We Do?
To understand our performance, let’s review the CLS Investment Themes that all CLS portfolios embodied last year. To quickly summarize, we had three CLS Investment Themes that worked last year, and one that didn’t.
High-Quality Domestic Equities:
This theme emphasized ETFs investing in high-quality companies (i.e., companies with higher profitability and stronger balance sheets) based on the belief that overall earnings growth would slow. It worked.
The tech sector, particularly the larger, higher-quality tech names, was on sale and we bought it up. Tech was one of the best performing sectors last year, which worked to our benefit.
Tactical Fixed Income:
With interest rates low, we felt we had to be tactical within fixed-income holdings. On balance, though every move didn’t help, (i.e. loading up on Treasury Inflation-Protected securities), this worked too. We improved the credit quality of our fixed income holdings in a year when high yield underperformed. We also emphasized actively managed fixed income ETFs, which outperformed the overall market as well.
What didn’t work:
Emerging markets (EM) are on sale and have superior overall growth statistics, better demographics, and much more going for them (at least in our eyes), but the market action did not agree with us on this – at least not yet. Our emerging market emphasis clearly detracted from performance and is by far the leading reason CLS portfolios did not match their benchmarks. (Secondarily, our modest overweight in energy also hurt performance.)
2016 Investment Themes
It’s a new year, and we have updated the CLS Investment Themes:
CLS Investments remains one of the largest active money managers of ETFs, and we are dedicated to this space for a variety of reasons. The leading reason is that we believe ETFs are simply a superior investment vehicle. Within the ETF space, the hottest growing category is something called “smart beta.” In short, smart beta ETFs capture the essence of active management (such as growth investing, value investing, or low-volatility investing), but at a fraction of the cost of the typical actively managed mutual fund. We believe emphasizing smart beta ETFs will help us enhance returns over time. And we’re walking our talk. The ETF universe is about 20% smart beta ETFs now, but CLS portfolios are closer to 30% on average – and that number has been rising. In addition, we believe market volatility will increase this year. Using factor-based investing should complement and enhance risk budgeting and our ability to manage portfolios’ relative risk.
2. International Opportunities: We still like emerging markets, but we also like developed international markets, such as Japan and Europe. In short, at least on a relative valuation basis, everything is on sale compared to the U.S. At CLS, we believe investors should average about 40% of their equity portfolios in international markets over the long term. We call that our preferred strategic allocation. Currently, we are above 45% international and more likely to increase those weights. It’s our tactical decision to emphasize international even more than the strategic allocation. With U.S. stock markets overvalued, we believe extra return can be picked up by emphasizing international markets in the year(s) ahead.
3. Creative Diversification:
We also still believe in last year’s emphasis on tactical fixed income, but we’ve expanded the theme to include alternative asset class segments and strategies. We believe using alternatives will enhance risk-adjusted performance in the year(s) ahead. Within this theme, we might even buy commodities, which is the most beaten-up asset class in recent years.
Our Weekly Investment Team Agenda
To conclude this month’s Market Review, I would like to share what is on every agenda for our weekly Investment Team meeting.
At the top of the agenda, we state our boiled down investment philosophy to this 10-word statement: “Global, risk-budgeted, balanced portfolios of ETFs help investors succeed.” This is the common philosophical ground for our entire team. At the bottom of the agenda, we list the key elements to our philosophy and what we believe as a team.
The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The Bloomberg Commodity Index is made up of 22 exchange-traded futures on physical commodities and represents 20 commodities that are weighted to account for economic significant and market liquidity. The Morningstar Diversified Alternatives Index is designed to provide diversified exposure to alternative asset classes while enhancing risk-adjusted portfolio returns when combined with a range of traditional investments. It allocates among a comprehensive set of alternative underlying ETFs that employ alternative and non-traditional strategies such as long/short, market neutral, managed futures, hedge fund replication, private equity, infrastructure or inflation-related investments. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.
The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not affliated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies.
An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in.