February Market Review
Global financial markets closed slightly lower in February, however it provided far better results than what many expected a month ago when investor sentiment and expectations were quite negative.
The overall U.S. stock market (Russell 3000) was at, with small U.S. stocks (Russell 2000) slightly outperforming large U.S. stocks (S&P 500). Overseas, developed markets (MSCI EAFE) lost just under 2%, while emerging markets (MSCI Emerging Markets Index) closed at.
Commodities closed lower in February, however the asset class showed signs of strength during the second half of the month. I’ll discuss this asset class in more detail in the second section of this Monthly Market Review. Bonds also posted a gain last month, with the overall bond market (Barclays Aggregate Bond Index) gaining just under 1%. The 10-year Treasury bond yield ended the month at 1.74%.
CLS Portfolios: Performance and Positioning
It was also a decent month for globally balanced portfolios. CLS portfolios were no exception. In the aggregate, the portfolios participated in February’s gains after losing less than the markets did in January. From a relative standpoint, CLS portfolios have performed well so far in 2016. Risk budgeting has worked, ensuring portfolio behavior is in line with expectations (if not better).
The CLS Investment Themes have been a major reason for the positive relative performance. The X-Factor theme, an emphasis on smart beta exchange traded funds (ETFs built on factors, such as value or growth instead of market capitalization), has been working, especially with its added emphasis on ETFs that focus on higher-quality companies (those with stronger profitability, balance sheets, and dividend growth). Some portfolios have also performed well with their respective emphasis on lower-volatility smart beta ETFs. We continue to hold a strong conviction toward this theme. Expect larger weights toward smart beta ETFs as we move further into the year.
The International Opportunities theme, an additional emphasis on international equities relative to CLS’s historical positioning, has also helped. The theme’s focus on emerging markets was especially beneficial. In short, expect this tilt to remain in place for the foreseeable future. Relative valuations are far better for international markets than the U.S. stock market. In other words, while we expect below-average returns for the U.S. stock market in the year(s) ahead, we expect far better results abroad.
The last theme, Creative Diversification, has been far more active recently. The rationale behind this theme is that while fixed income is the premier diversifier of equity-dominated portfolios, we believe in being tactical and taking advantage of changes in relative valuations. Over the last month, we accelerated buying in the high-yield asset class. High-yield has been hammered as of late, but we expect default rates to increase and higher yields to compensate for risk. We might be early, which is often the case for value-oriented investors, but we believe high-yield will provide compelling, attractive returns in the years ahead. Those returns may even better than those of the overall U.S. stock market.
The Creative Diversification theme also means an increased use of alternatives and commodities. In both asset classes, we have been “better buyers” (i.e. buying more than we’re selling). In fact, a few portfolios have become more aggressive in buying commodities. In the next section, I’ll discuss why commodities have been in the news lately, why they’ve been beaten down in recent years, and what we can expect from this asset class in the future.
Creatively Diversifying with Commodities
Commodity prices have been at the forefront of investors’ attention, particularly as prices rebound from lows not seen in more than a decade. CLS’s resident expert on commodities, Portfolio Manager Grant Engelbart, CFA, believes commodities have a place in portfolios for their inflation-fighting properties and diversification benefits. Not to mention, many commodities and related companies are now attractively valued.
Allocating to commodities does present a number of challenges. Investors must decide if they should buy commodities themselves, the companies that extract them (natural resource companies), or commodity futures contracts? Physical commodities present additional taxes and can be illiquid. Natural resource companies can have other idiosyncratic issues to consider. Commodity futures contracts can suffer from a condition known as contango, which burdens investors when they try to “roll,” or buy a new futures contract, as the new contract costs more than the previous month’s contract.
Luckily, ETFs are here to help. At CLS, we utilize ETFs that hold commodity futures contracts and/or natural resource companies. There is actually a lower correlation between commodity futures and natural resource companies than what investors may think, and this blends well in a portfolio. There are a variety of ETFs that utilize “dynamically optimized futures roll” techniques to allocate amongst commodity futures. Basically, this means they buy futures contracts further out and at smarter locations to reduce the e ects of contango. We’ve also utilized smart beta and even actively managed ETFs in the commodity space to better allocate to an important asset class.
Correlation refers to the way in which two securities move in relation to each other. A perfect 1.0 correlation means two securities always move in the same direction. A negative 1.0 correlation is the exact opposite: two securities always move in different directions. To diversify, a correlation needs to be below 1.0, the lower the better.
The correlation between global stocks (MSCI All-Country World Index) and commodities over the last 15 years is 0.51. It’s a positive correlation, but it’s clearly not 1.0. Commodities are able to generate equity-like returns over time but still provide strong diversification benefits, and thus deserve a place in balanced portfolios.
Recently, however, the talk is that correlations have been rising. Not only have returns been poor, but they are not diversifying well. While the five-year time frame does show slightly higher correlations, it’s actually much lower over the last one- and three-year periods.
Still, even if the data doesn’t support it, the common narrative these days is that commodities and stocks are moving in tandem.
It’s Still A Free Lunch – It’s Just Not as Large
More unsubstantiated talk I’ve heard lately is that diversification isn’t working for investment portfolios, or at least not very well. That argument has been made against global investing, particularly as international markets have trailed U.S. stocks recently, and against commodities. Remarkably, I’ve even heard the same argument made against fixed income. Supposedly we’re in trouble if longer-term interest rates move higher (which that has been expected since the late 1990s). And, of course, we all heard diversification didn’t work in 2008 and 2009. But you know what? Every single one of those comments was and is dead wrong. Diversification worked in each and every case, and it will continue to work.
Diversification is about risk management. Mixing assets provides real risk reduction at the portfolio level. Let’s review the basic definition of Modern Portfolio Theory (MPT) directly from everybody’s favorite free dictionary, Wikipedia:
“MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has lower overall risk than any other combination of assets with the same expected return. This is possible, intuitively speaking, because different types of assets sometimes change in value in opposite directions. For example, to the extent prices in the stock market move differently from prices in the bond market, a combination of both types of assets can in theory generate lower overall risk than either individually. Diversification can lower risk even if assets’ returns are positively correlated.”
To illustrate how diversification reduces risk, let’s look at a scenario mixing Asset A and Asset B together. Asset A has an expected return of 10% and an expected risk (standard deviation) of 8%. Asset B meanwhile, has an expected return of 6% and an expected risk of 4%. If you mix the two assets together in equal proportions (50/50), the expected return is simply the average ((10%+6%)/2) = 8%. But, assuming the two assets are not perfectly correlated, which is almost always the case, the risk is not the average. It is less than that. The lower the correlation, the lower the overall risk will be. That risk reduction is the magic of diversification. It’s the “free lunch” of investing.
Usually, when people say diversification isn’t working, they are usually looking at returns, not risk reduction at the portfolio level. And that’s just not the proper way of looking at it. Though, to be fair, some will look at risk reductions and say diversification isn’t working if correlations are rising. That thought is on the right track, but it still isn’t quite right. Diversification is working – period – as long as correlations are not at 1.0. There is still a free lunch – it’s just not as large if correlations are rising.
CLS Portfolios: Construction and Benchmarks
If correlations were actually rising for an asset class segment or strategy, what would that mean for CLS portfolios? At CLS, we build and manage globally balanced portfolios by looking at risk first and asset allocations second. This is the opposite of how most investment managers look at portfolios, but we think looking at risk first is a better way to approach portfolio management.
When we build portfolios according to risk, we need to remain disciplined to a certain risk level. Because market risk changes within and between asset classes, we need to also be exible when it comes to asset allocation. If an asset class gets riskier, all else being equal, we are more likely to sell it. When an asset class gets less risky, we’ll buy.
When we build a benchmark for our portfolios, it is a risk-based benchmark. Again, this is different from how most people look at benchmarks, but we strongly believe it is appropriate because that is how we build portfolios. We have different benchmarks because we manage money differently.
Another significant and arguably more important benefit is that managing risk is a better way to manage investor expectations.
For example, if we tell investors we’re taking 80% of the risk of a globally diversified equity portfolio, they should expect a few things. First, the portfolio should be managed to that risk level and behave as expected. That’s the first promise of our risk budgeting process. Our second promise is, of course, is that we’ll be active and adjust the portfolio based on shifting risk and expected returns. Investors should next expect that, that we will attain a return similar to (if not better than) to 80% of the return of a globally diversified portfolio over time.
Thanks for reading. Stay balanced.
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 signi cant 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.
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