While CLS portfolios had a great year, some of our strongest portfolio tilts, such as our emphasis on emerging markets, wasn’t rewarded. In fact, global investing has yet to truly reassert itself in terms of relative performance. Recent years have seen domestic, large-cap blue chips and growth names perform best. This is typical when growth is relatively scarce (as it has been since the Great Recession), and when central bank policy trumps fundamentals (for example, keeping interest rates near 0%). But, these factors are cyclical — like everything in the markets — and fundamentals are starting to reassert themselves.
To predict what this means for investors, we can look back to the late 1990s when fundamentals played second fiddle to the technology fever that gripped investors. (This was also the last time domestic, large-cap growth stocks dominated performance.) If that period is indeed a viable template for our current environment, it suggests a few changes in the markets. First, international stocks will likely outperform domestic stocks. Second, smaller companies will likely perform better than larger companies. Third, value stocks (those that trade at lower valuation ratios, such as price/earnings) will likely outperform growth stocks (higher valuations and higher earnings growth over time). It also means that active management (aiming to exceed benchmarks) has a much stronger chance of beating passive management (aiming to match benchmarks).
There has been much discussion about the growing popularity of passive management, but at CLS, we believe investors still prefer active management. The perceived popularity of passive management stems from a shift to lower-cost portfolios from high-cost, mediocre active managers.
From a structural investment standpoint, active management has two advantages and two disadvantages.
First, the strikes. Actively managed portfolios are more expensive. The costs are coming down, but they are still higher and will stay higher for the foreseeable future, which creates headwinds for relative performance. Actively managed funds also often include cash to meet investor cash flows. Since markets generally go up over time and outperform cash, this is another negative (but a plus in down markets). However, this factor is no longer as significant as it once was. Most managers don’t carry around as much cash as they did in the past because investors want their portfolios invested. It’s also much easier to equitize cash by using ETFs, for instance.
Now, the advantages. Active money managers tend to weight their positions based on attractiveness, not overall size or representation in the markets. Thus, they tend to be underweight large-cap stocks relative to the overall market. This has hurt in recent years when larger companies performed better. But, if small-caps are now poised to outperform, this should provide a tailwind. Actively managed funds compete against rules-based portfolios. Effective analysis should indicate when the basic rules are giving bad reads, when they can be taken advantage of, and when the rules should just be broken.
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 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 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 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 MSCI EAFE 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 Emerging Markets Index is a composite index which tracks performance of large and mid-cap firms across 21 countries classified as emerging market countries. 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 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. 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 graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. While some CLS portfolios may contain one or more of the specific funds mentioned, CLS is not making any comment as to the suitability of these, or any investment product for use in any portfolio. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. 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.
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