Tue, 30 Apr 2013
From high correlations to macroeconomic uncertainty to rock-bottom interest rates, investors face a large number of headwinds today, says Morningstar's Shannon Zimmerman.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're looking forward to the 25th Morningstar Investment Conference this June. The landscape that investors face right now is one of the most challenging in the quarter century that we've had this conference. I'm here today with Shannon Zimmerman, associate director of fund analysis here at Morningstar, to look at some of these challenges. Shannon, thanks for joining me.
Shannon Zimmerman: Good to be with you, Jeremy.
Glaser: So let's start with correlations. This has been kind of one of the big stories since the financial crisis. Different asset classes have been much more correlated to each other than they have been in the past; all stocks kind of move in lockstep instead of potentially security selection being more important. Why is this a challenge for investors?
Zimmerman: In some cases it's not even just stocks or certain movements that are highly correlated within an asset class, but even across asset classes you're seeing higher levels of correlation, as well. It's a challenge because it becomes much more difficult for investors to achieve effective diversification in their portfolios. I mean, why do you want diversification? Not just for the sake of having your assets dispersed across a number of asset classes, but so that one part of your portfolio will move in a different way. And when one part of the portfolio is up, the other will be down, and vice versa. It's harder to do that now for lots of reasons. A colleague of mine, Kevin McDevitt, has done some research and has put out a pretty good argument that one of things that's going on is that with the rise of passive investing has come a greater level of correlation because more and more people are investing in the market. So you get the market's return. When all that money is going behind passive vehicles, it's easier for correlations to get tighter and tighter.
So one of the ways that we're going to try to address that at the conference is to talk with Bill Nygren of Oakmark and Steve Wymer of Fidelity. They come to investing from very different perspectives. Nygren is a value hound; Wymer is a growth investor. But they have one thing in common at least, and that's that they have achieved pretty impressive returns over the course of many years with portfolios that don't look at all like their benchmarks. So that's an opportunity for investors, particularly investors who are paying a premium in terms of actively managed funds. They're not just investing in the index. They're investing for the sake of getting a premium on their returns, something higher than they would get with an index fund that would cost a fraction of what they are paying. So these managers have done quite well, as I say, with portfolios that aren't as closely correlated as most are with the broader equity markets.
Glaser: Let's take a look at income now. With the Federal Reserve's policies of keeping interest rates incredibly low, it's been challenging to find income both in bonds and also in dividend-paying stocks, which have seen their valuations bid up quite aggressively over the last few years. Is this a big problem, not be able to get that big kind of headline yield? Or are investors really in a challenge in trying to find that income?
Zimmerman: Yes and no. I mean, to the point that you're making about the headline yield, in some ways I think that's overstated, right? So if at the end of the day you have a high yield, the price erosion takes back what the yield has given you, and you haven't earned anything. So really investors need to focus not just on yield and just on generating income, but on what the total return of the investment that they have made is providing because, like I say, if one just cancels out the other, then you haven't earned anything. But it is a challenge.
Historically low interest rates for a protracted period of time makes it very difficult for people who are income investors to find what they are looking for at least in their traditional vehicles. So the way we'll address that at the conference is from a multiangle perspective. My colleague, Dan Culloton, will lead a panel on whether or not there's been a bubble for dividend-paying stocks. That type of stock has enjoyed a pretty healthy runup in recent years for the very reason that we're discussing. People are increasingly discouraged by the yields they don't see on the fixed-income side, and looking to take on a little bit of additional risk if the payoff is not just the total return, but also the yield that the stock pays. So Dan is going to lead a panel focused on whether or not there is a bubble. So we'll address it from that perspective. Then we have a number of fixed-income panels as well, including one that will be led by Josh Charlson from the Morningstar's funds research group, talking with managers from JP Morgan and Vanguard, I believe, and the focus there will be on how to generate a stream of income through a multiasset portfolio. So I think that will be beneficial for investors who are looking for yield, but again not just for yield.
Glaser: It's really the total return that they should be focused on?
Zimmerman: That's certainly what I think.
Glaser: So what about retirement? A lot of folks who are looking for yield are people who are in retirement, who need that income stream to live on. How has planning for retirement changed, and why is it so much more difficult now? Are there any good solutions?
Zimmerman: So that's always been an important challenge, maybe the most important challenge in terms of how you arrange your investment portfolio, your asset-allocation game plan. And now it's probably more difficult than it ever has been for a number of reasons. I mean, folks are living longer, so you're going to be in retirement for decades in many cases, and hopefully so, right? So that represents a special challenge, because you need to live on your investment proceeds for a longer period of time than folks have had in the past. Then, you have a heightened period and a protracted period again of stock market volatility, correlations getting closer and closer among asset classes. So we'll address that [at the conference] in a number of ways, too. And I should also add the macroeconomic environment, at least in the short term, it does seem that the market is much more susceptible to macro vibrations than it has been in the past rather than company-specific fundamentals.
So Morningstar's Christine Benz, who I'm sure most folks watching this video may know, will lead a panel on the challenges that we just sort of ticked off in terms of optimal withdrawal rates in this day and age. A 4% rate seems to be the golden rule, but does that golden rule still apply now? Then, the optimal level of equity exposure is always a big hot topic for people who are approaching retirement or are in retirement. How do you go about deciding, not only what the level of exposure there is, but what the best fit is for you in terms of a retirement investor? So we'll cover all the bases on that. Like I say, it's a big-ticket challenge.
Glaser: Back to your comment about macro problems. It seems like we're much more susceptible to that. There is the idea of this risk-on/risk-off trade, and when people see something happening abroad or in the United States that maybe the economy isn't growing quite as fast, that all of a sudden there is a rush out of risky assets and into things like Treasuries. Is that something that you would think is going to continue to happen? What are the implications of this extra volatility for macro issues on investor portfolios?
Zimmerman: It feels unprecedented, right? There certainly have been periods in market history where the market is more susceptible to movements that are macroeconomic rather than microeconomic in terms of company fundamentals or just the specifics of your own domestic economy. But now there does seem to be a period of heightened sensitivity to that. Kevin McDevitt, who I mentioned earlier, will run a panel on the macro environment, how that is shaping investment decisions, and he'll have some fairly major league folks who will weigh in on that hot topic. Even people who are bottom-up and pride themselves on being bottom-up fundamental investors who focus narrowly on company-specific issues acknowledge, "That's my style, I'm sticking to it, and I think over the long run it will continue to do well." But in the short run, people just have to get used to a lot more volatility, because it isn't just that that's driving performance now. People are worried about--even people who are primarily invested in domestic equities--what's going to happen to Europe, because so many companies that are domiciled here in the U.S. generate revenue from that region. It's not just sort of people being worrywarts. There are real reasons why macroeconomics drive stock market behavior more than they used to because we're much more interconnected than we ever have been.
Glaser: Shannon, thanks for the preview.
Zimmerman: Good to be with you.
Glaser: For Morningstar, I'm Jeremy Glaser.