"Bob-a-longs"

When I was in high school, I was a self-professed “journalist” taking sports pictures and writing an occasional article for my local newspaper (I was also co-editor-in-chief of my high school newspaper, too, but that is a different story!)  The editor of that local newspaper was Robert A. Long and he wrote a weekly column titled “Bob-a-longs”; a word that usually means to proceed in a disorganized way, but a clever self-deprecating play on his own name for a newspaper column!

Consequently, instead of writing a full-fledged column, he would simply list blurbs that he thought were interesting.  So, in honor of Robert A. Long, here is my investment version of Bob-a-longs; somewhat unrelated things that caught my attention over the past few weeks that bear mentioning.

• Every time the equity markets hit an all-time high, there is always someone who comes out with a forecast for a correction.  Of course, occasionally one of those forecasts will be correct making that prognosticator a “market expert.”  Don’t believe it!

• Exchange-traded funds (ETFs) are wonderful vehicles and are the most efficient and inexpensive way to own broad (and narrow) slices of the markets.  However, some ETFs are both inefficient and expensive, so beware!  An often-overlooked aspect of the ETF vehicle is the bid/ask spread, i.e., the difference between what you buy and sell an ETF for.  For long-term buy-and-hold accounts, this cost can be amortized over a long time horizon so can be minimal, but for actively traded accounts using thinly traded ETFs, this cost can become quite large.

• Many employees of high-flying tech companies are fortunate to receive shares of company stock in either outright grants/options or at a discount to market price.  Some of these stock perks can be large to start with, but add in some tremendous market appreciation and you have the makings of a pretty nice investment portfolio, albeit hyper-focused in one name!  It always depends, but I usually recommend a conservative 20% cap on exposure to the stock of the company you work for.  The road is littered with high-flying tech companies that hit the skids; I know it can’t happen to you, but just think about shareholders/retirees with positions in GE who saw huge volatility and huge writedowns in their market value.

• When I meet someone new in a social setting and they ask what I do, I tell them I manage investments.  Invariably, they then ask me to recommend a good investment.  Of course, without knowing their financial situation there is no way I could recommend any one investment or even any single strategy.  I could easily say that international and emerging market equities are historically “cheap” relative to U.S. equities, but those asset classes are also “risky” investments.  I could also say that U.S. Treasuries are historically “rich” and probably not a good buy unless you need absolutely “guaranteed” return of principal at some future date.  Then there are lots of things in the middle! It really does “depend”.

A Balanced Bullish Q2

As I reported at the end of 2021 Q1, the financial effects of the global pandemic started to ease with many signs of a recovery.  This trend continued into Q2 as the CNN and Moody’s Analytics “Back-to-Normal” Index currently indicates a value of 94% (from 86% at the end of Q1) representing more progress to a complete financial recovery.  Since this an aggregate measure of financial health, however, some of the indicators and individual U.S. states are not at the same strong level so more targeted work is needed for a complete recovery.  Certainly, continued strong fiscal stimulus and infrastructure spending programs combined with an accommodative Fed (despite recent hawkish comments) are in place to support the continued rebound.

I used the term “resiliency” last quarter to describe the markets and that term is apropos again as the markets continue to rebound from bouts of short-lived panic to scale higher.  As seen from the table below, the S&P 500 (IVV) added to its strong 6.33% Q1 return with another 8.38% return during Q2 to produce a year-to-date return of 15.24%.  Also, while not besting the S&P 500, other diversifying asset classes like small- and mid-cap equities (SCHA and SCHM) kept pace with returns of 4.75% and 5.43%, respectively.  Not to be outdone, however, is the real estate investment trust (REIT) asset class with another strong quarter of 11.93% Q2 return working to recover from its negative return during 2020.

Notably, large cap high dividend value stocks (DVY), representing a “re-opening” market view, also kept pace with the broad market indices with a Q2 return of 3.05%, which when combined with its Q1 return continues to lead all the major asset classes with a year-to-date return of 23.29%.  Meanwhile, other global markets including international developed and emerging market equities (SCHF and SCHE) were likewise strong at 5.77% and 4.10%, respectively.

Bond markets, coming off weakness in Q1, maintained their low return profile producing modest Q2 returns.  Broad core bonds (SCHZ) generated returns of 1.76% during Q2 while investment grade corporates were stronger at 3.92%.  High yield bonds (HYG) were in the middle of the pack during Q2 with a +2.01% return but bested all fixed income on a YTD basis with a total return of +2.60%.

As the equity markets seek new highs and bonds come off record low interest rates, return prospects for the future are cloudy, so caution prevails.  In fact, as I reported in my May 6 blog post, Got Risk?:

But nothing is forever, and we need to be cautious.  Some forecasting models, like the one at Research Affiliates, have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!

The REIT Story

Everyone is abuzz about inflation!  And why not?  With out-of-control fiscal spending and perpetual easy money from the Fed it seems like hyperinflation is the only possible result.  However, aside from the “transitory” blips in inflation that we have seen as we emerge from the depths of the global pandemic, we have not seen anything that appears to be long-lasting.

So, whether we see inflation or not, we must be diversified to protect ourselves from it since a decline in purchasing power over time is a certain way to ruin a retirement!  One of the ways to hedge your inflation risk is to own assets that are positively correlated with inflation.  Academic studies continue to show that equities, including the real estate asset class structured as real estate investment trusts (REITs), are a good hedge against inflation.

The simplest way to get exposure to the REIT asset class is through the exchange-traded fund (ETF) vehicle.  There are many low-cost, passively-managed REIT ETFs that have provided relatively high income, strong historical returns, and low correlation/good diversification to other equity types.  The top five REIT ETFs by assets under management are Vanguard Real Estate Index (VNQ, $40.1B), Schwab U.S. REIT (SCHH, $5.8B), iShares U.S. Real Estate (IYR, $4.8B), Real Estate Select Sector SPDR (XLRE, $3.0B), and iShares Core U.S. REIT (USRT, $2.0B). 

As seen from the chart below, so far in 2021 investment performance has been very good with them all clustered towards the top of the performance chart with 20%+ returns easily outpacing the S&P 500 (IVV, the green line at the bottom) after lagging last year with pandemic-induced negative returns.  No one knows if real estate will be forever damaged from the pandemic, but performance so far this year does offer some comfort.

Being passively-managed, the REIT ETFs all follow a published index and strive to replicate the index performance, less the management fee.  The ETF sponsors all use indices from the major index providers like MSCI, FTSE, and Dow Jones/S&P.  Interestingly, the indices all look relatively similar with the main differences being the level of diversification, the individual REIT weighting approach, and number of holdings.

For example, the Vanguard ETF (VNQ), the largest at $40.1 billion, restricts the sum of the weights of all issuers representing more than 5% of the fund to not exceed 50% of the fund’s total assets whereas the Schwab ETF (SCHH) restricts the sum of the weights of all issuers representing more than 4.5% of the fund to not exceed 22.5% of the fund’s total assets; quite a difference in approach with neither one necessarily being better or worse.  No one knows in advance which indexing approach will be the top performer over any market cycle, so best to select one and stick with it.

All these ETFs are low-cost with investment management fees less than 12 basis points (0.12%), except IYR that is at 42 basis points (0.42%).

There are other asset classes that also provide a good inflation hedge including gold, commodities, and other common stocks, but none of those provides the extra benefit of the REIT asset class with relatively high cash income that can be used to pay living expenses in retirement or reinvest/rebalance into the fund over time.

Rotation Elation!

Here we go!  The “re-opening” economy seems to be getting into high gear!  Some mega cap tech stock darlings from last year are lagging this year while traditional brick-and-mortar plays are leading the pack.  Nowhere is that more fully seen than in the dramatic shift in the holdings of the iShares Momentum ETF (MTUM)!

As you may recall from my previous blog post last September (OMG, MTUM!, https://www.dattilioash.com/our-blog/2020/9/2/omg-mtum), MTUM is a factor-type investment focused on large- and mid-cap US equities that show relatively higher momentum characteristics.  Momentum is broadly defined as a calculation of “excess return” compared to other equities in its universe.  So, this ETF simply buys stocks that have recently outperformed other stocks, rebalanced semiannually.  And, who wouldn’t want to buy investments that have performed well?  This is part of the behavioral bias on why academics show that the momentum factor over time outperforms investments that don’t exhibit positive momentum.

The MTUM ETF turned in phenomenal performance in 2020 with a +29.85% total return compared to the S&P 500 return of +18.4%.  So far in 2021, however, it has lagged the S&P 500’s YTD return of +12.7% with its mediocre +5.70% return; ostensibly since MTUM’s holdings have not yet been rebalanced to reflect the transition of the equity market leadership to the re-opening economy.  During MTUM’s semiannual rebalance cycle that just ended, we can see some dramatic shifts in holdings to boot holdings that have lagged the market and insert holdings leading the re-opening rally.

Kicked out are household tech names like Apple, Microsoft, and Amazon replaced with other household names like JP Morgan, Berkshire Hathaway, Disney, and Bank of America; totaling an 18.5% shift in portfolio allocation worth $2.7 billion (see chart below for chart of relative performance of the leaders compared to S&P 500 (IVV))!  Sticking around during this rebalance cycle are stocks like Tesla, Paypal, and Alphabet.

The trouble with a strategy like this, of course, is that it depends mostly on the stocks with positive momentum continuing their upward trend; generally considered the major weakness seen in momentum strategies.  A reversal in the current leadership would result in a “whipsaw” effect of “buying high and selling low”, not a good thing. Long term commitment to strategies like this, however, have been shown to outperform despite the risks.

A Time for Bonds?

Views on my blog posts have picked up recently, so I checked to see which topics seem to be the most popular.  To my surprise, my recent posts on bond credit spreads have gotten the most “hits”!  So, in honor of that result, here is an update on how credit spreads have trended recently and how that impacts my views on long term strategic investing.

Per the chart below, it is clear to see that credit spreads (red and blue lines) have normalized to flat-line over the past few months in the face of generally rising rates (green line).  This is in no doubt due to significant pricing support from the Fed through bond ETF purchases and other actions.  Through April 30, 2021 the Fed holds $8.6 billion of bond ETFs in the investment grade and high yield sectors (source: federalreserve.gov) including $2.3 billion of iShares IBOXX Inv Grade Credit (LQD) and about $1 billion in iShares IBOXX High Yield (HYG) and SPDR High Yield (JNK).

As of today, 10-year Treasuries yield a modest 1.64% with corporate investment grade credits yielding 2.56% (+0.92% spread) and high yield corporates yielding 5.04% (+3.40% spread).  Unlike late last year with 10-year rates in the 0.70% range, these higher yield levels offer a better entry point into bonds and provide a better, but not necessarily meaningful, alternative to equities.

The best way to handle this market dynamic is to opportunistically rebalance outsized equity market gains back into bonds consistent with long term strategic asset allocation targets that are meant to help an investor achieve their goals.  In this way, you will be selling equities “high” and buying bonds “low” after the recent rise in rates.  Of course, if rates trend higher from here, there is the potential for bond values to erode further, but there is also the added benefit from the higher “carry” from the higher yield to offset that erosion plus preserving the equity market gains with lower risk fixed income holdings.

Mortgage or Pay Cash?

Oftentimes, couples heading into retirement either trade up to their dream house or put a sizable amount of cash into their existing house to celebrate their retirement.  Should you finance it with a mortgage or pay cash?  Aside from the qualitative aspects such as the comfort knowing that a cash transaction eases the stress of required cash flow payments to fund the liability on the property, what are the quantitative aspects to consider?

At Dattilio & Ash, we use the quantitative software package MoneyGuidePro to help us answer this question.  The software allows us to look at the situation holistically with a full financial profile of the situation including expected expenses and income during retirement plus all invested assets and then run an investment scenario test to calculate the “probability of success”.

Our hypothetical couple is a husband and wife, both 66, who just retired.  They are both in good health and plan that they will live to an average life span of 92 years for the husband and 94 years for the wife. 

They live a simple lifestyle and expect to spend about $7k per month on basic expenses plus another $10k per year on Medicare/health expenses.  They also plan to spend $15k per year on travel for the next 15 years.  This totals about $109k of expenses in the first year, not including the model’s 2.25% inflation rate each year.  For income, they do not have a pension but do have close to a maximum social security benefit of about $35k per year each totaling about $70k income each year. This translates to a deficit each year of about $39k per year.

But, not to fear!  The couple did a good job saving during their working years and have accumulated about $1.5 million in assets for retirement including a $1 million IRA between them and $500k in taxable accounts that includes $225k in cash.  Invested assets are managed to a moderate risk profile including 60% equities and 40% bonds.

When we run this situation through the model with 1,000 different investment scenarios, the results are very positive with a 94% probability of success, i.e., there will be enough cash flow and investments to fund all expenses through to the “end of plan”.  So, despite the negative cash flow of about $40k each year, the invested assets are invested appropriately with the right risk profile to fund all cash flow needs. 

But what about the major $200k kitchen and master bath renovation they wanted to add to their house?  Should they reduce their cash holdings to pay for it with cash or take out a home equity loan and fund it over 15 years?  Let us simply add in a new cash expense of $200k in the first year or a 15-year mortgage of $1,500 per month to see how it shapes up!

When we add a 15-year mortgage with a 4% interest rate at $1,477 per month, the probability of success decreases from 94% to 79%; still a good result but maybe lower than a preferred answer.  On the other hand, paying $200k cash for the major renovation only lowers the probability of success from 94% to a better solution of 82%; still a good answer and better than taking out a mortgage (see chart below showing the paths of all scenarios and the Average Return green-colored line). Quantitatively, this is the best solution!

But, what if the client would rather stay in the 90% range for probability of success?  Downsizing the major renovation by half is one alternative, improving the probability of success for the cash purchase from 82% to 90%!

These are just some of the ways Dattilio & Ash can help you plan and manage your investments.  

Got Risk?

Target date funds do it one way; simply systematically reducing equity content as time marches towards its funding horizon.  Thoughtful investment advisers, on the other hand, think it through and customize an approach that factors in all investment considerations for the specific investor.  We are talking about managing exposure to risky equity investments.  Aside from tactical funds that make it their business to go “risk-on” or “risk-off” depending upon their current views of the markets, a long term strategic approach focuses in on your long term objectives and tolerance and/or capacity for risk.

The equity markets have been risky, but very beneficial to investors in stocks over the last 10 years.  Certainly, if you could tolerate the risk, a 100% allocation to the S&P 500 index (IVV) has been a rewarding, if not nerve-wracking, experience generating a 14.32% annual total return and a risk level of 13.62% standard deviation of return over the last 10 years.

A first step to deciding on your risk tolerance is to understand the tradeoff between risk and return.  Risky assets like stocks often need to be offset by less risky fixed income holdings.  A good way to judge the relative attractiveness of risky portfolios is to compare portfolios with different broad equity weightings.

One of my favorite data sets includes the return profiles of the S&P Dow Jones Portfolio Indices.   They include five separate modelled portfolios from Conservative to Aggressive with equity weightings ranging in 20% increments from 20% (for Conservative) to 100% (for Aggressive).  Not surprisingly, the chart below shows the DJ Aggressive Portfolio (the aqua blue line on top) with a 100% equity content leading the pack over the last ten years!

But, what about the road it took to get there!  This ten-year time frame does not include the Credit Crisis of 2008/09, but it does include other crises including the Pandemic crash of 2020.  Looking at the chart you can observe that during 2020 the Aggressive portfolio actually lost so much return that it came close to the cumulative return value of the Conservative Portfolio (the darker blue line at the bottom); thus, negating almost all of the accumulated excess returns garnered over the previous nine years.

So, what lessons can we learn from this chart.  At least four things, including:

1.      No one knows when the next credit crisis or pandemic is going to hit and how long the crisis may last.  Trying to manage equity risks based on a “gut” feeling will only work if you get “lucky”.

2.      Over a long time horizon, the riskier portfolios with a larger equity content outperform the less risky portfolios with less equity content, but depending upon the selected time horizon, the less risky portfolio actually could outperform the more risky portfolio!

3.      The return profiles for each of the DJ portfolios show an incremental pickup of about 1.5% of excess total return for each 20% increase of equity content.  In other words, over the 10-year horizon the Moderately Aggressive portfolio with an 80% equity content generated total return of 9.02% compared to the Moderate portfolio with a 60% equity content that generated only a total return of 7.53%; an average annual give-up of 1.49% over 10 years, something that is very material.  If you can tolerate the risk and have a long time horizon, it certainly paid off to accept more risk.

4.      But nothing is forever, and we need to be cautious.  Some forecasting models, like the one at Research Affiliates , have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!

Next Week's Blog Post, Today!

I had a few ideas for this week’s blog post but had a difficult time deciding which one to develop into a full-fledged post.  Instead, I am posting here my random thoughts about the current capital market and economic environment, so you know what I am thinking about.  I will pick one out of this list and fully develop it for Next Week’s Blog Post.  Stay tuned!

• With interest rates and credit spreads now just off their historic lows combined with an accommodative Fed, unless you need to fund an absolute cash flow guarantee in the future or need to reduce risk in your portfolio, mathematically, now is a bad time to buy bonds.

• Equities, on the other hand, now seem to be a good place to allocate capital since the economy seems primed to continue its strong recovery from the global pandemic.  This view is mostly supported by Q1 earnings results so far, where 81% of S&P 500 companies have reported positive earnings surprises through last week, the second highest percentage of positive surprises since FactSet started tracking the data in 2008.

• Though minimizing investment fees is a good way to help investors achieve their investment goals, getting the right asset allocation is even more important.

• Inflationary fears are heating up due to the huge amount of fiscal stimulus with huge budget deficits.  Traditional inflation hedges like stocks and real estate should be part of everyone’s portfolio to hedge that risk.  The consensus view on commodities and inflation bonds (TIPs) is less clear based on current market levels.

• What is ESG (environmental, social and governance) investing?  Should I get involved?

• Do you have enough income and assets to retire?  I am ready to do an update on the generic analysis posted last year, Is there a “Number” for You? where I calculated the probability of success of a hypothetical investor.  If you want me to customize it specifically to you with our MoneyGuidePro analytical software, let me know and I would be happy to help!

We Must Forecast!

Many of the large investment banks provide free analytical services on their web sites to registered investment advisers.  One of the most interesting tools they provide is a scenario generator; a tool to shock the capital markets for external events to see how a portfolio will perform.  Let’s take a look!

Depending upon the web site you visit, the available scenarios to test against vary a bit.  Some common scenarios include COVID-19 Conquered and COVID-19 Continues, as well as more generic scenarios like Oil Spike, Inflation Spike, and Interest Rates Rise.

I am a firm proponent of long-term strategic investing targeted to a client’s specific objectives and not prone to making tactical shifts based on market outlooks, but I find it interesting to see how client portfolios would perform under different scenarios.  I ran the scenario generator from the JP Morgan Asset Management web site and came up with the following statistics based on an income strategy I currently manage (see chart below).

As seen above, the Sample Income Portfolio performs better than the benchmark portfolio in half the scenarios (and worse than half!) while the variance amongst the scenarios is relatively small.  My view is that this is the best anyone can do when trying to outguess external events.  I would not be happy if the Sample Income Portfolio showed a strong bias in either direction implying bets are being taken on a specific scenario.  In that case, I would need to re-think the management of that portfolio since I might be taking unknown bets.

Alan Greenspan, former Fed Chairman, is known for his outspoken opinions on all kinds of topics.  His view on forecasting is well documented and goes something like this (paraphrased), “we aren’t very good at forecasting, but we must forecast since embedded in every portfolio is a market outlook.”  So, in the above case, the embedded long-term strategic forecast of the Sample Income Portfolio delivers an outcome that mostly mirrors the benchmark to satisfy client objectives over different scenarios; a satisfactory result for most investors. 

Investments 101: Risk and Return

Everyone knows about the tradeoffs between risk and return.  Generally, the more risk you take, the greater the return and vice versa.  A way to express this graphically is the classic risk-return chart; returns are along the y-axis and risk is on the x-axis.

The chart below represents the forecast 10-year returns for the major asset classes, including U.S. large cap equities, international and emerging market equities, and U.S. aggregate core bonds (chart and forecasts provided by Research Affiliates, LLC).  I removed the axis values for the forecasted returns and risk since I think the most value can be garnered from the relative placement of the dots.  Let’s talk about them!

As one would expect, emerging market (EM Equity) and international developed equities (EAFE) (the two red dots in the upper right quadrant) take the prize as having relatively more risk than most all the other major asset classes (along with U.S. small cap and REITs), but they also provide the highest expected returns.  U.S. large cap equity, perhaps not unsurprisingly given its phenomenal 10-year run and relatively higher current earnings multiples, shows a much lower relative level of returns despite having only modestly less risk.

Bonds (light blue dots) cover the lower left quadrant forecasting low risk and low return.  Again, this is not surprising given the recent historic lows in yields. 

The six dark gray dots connected by the dotted line represents “efficient” portfolios of combinations of all the major assets classes.  In other words, for a given level of risk, each dot represents a combination of assets that produces an expected return that is superior to any other combination.  From an academic perspective, there are many assumptions that cause this framework to be merely a theoretical exercise, but it still provides an interesting thought process.

From this data we can see that a portfolio management approach of diversified investments is superior to any individual asset class for a given level of risk over a long-time horizon.  This approach is core to my investment philosophy.

By the way, if you are curious what Research Affiliates has forecasted real returns and risk to be for U.S. Large Cap equities they are -0.5% return and +15.4% standard deviation risk.

Are you Feeling Normal?

How do you feel?  Are you 86% back to normal?  CNN and Moody’s Analytics created the “Back-to-Normal” Index to measure progress from the pandemic back to “normal” at the state and national level based on a large set of indicators including unemployment rates, small business work hours, job postings, and consumer credit.  Based on continued Fed support and a huge $1.9 trillion fiscal package, it is not inconceivable that normalcy seems nearby.  At the end of March 2021, the Index showed a level of 86% at the national level, where 100 is back to the pre-pandemic period, with most individual states over the 80% level.  This is the highest the Index has been since its low of 60% on April 16, 2020.

Certainly, capital markets have shown much resiliency, and volatility (!), during Q1 2021 with the S&P 500 index reaching new all-time highs at the end of March.  As seen from the table below, the S&P 500 (IVV) produced a strong Q1 return of 6.33%, while a rotation to better performing small cap (SCHA) and mid cap (SCHM) equities bested that with 12.24% and 9.28%, respectively.  Large cap high dividend value stocks (DVY), representing a “re-opening” market view, led the broad market indices with a robust 19.64% return.  Meanwhile, other global markets including international developed and emerging market equities (SCHF and SCHE) were likewise strong at 4.47% and 3.69%, respectively.

Bond market returns, as postulated at the end of last year, kept their part of the bargain producing weak Q1 returns coming off all-time low interest rates last quarter.  Broad core bonds (SCHZ) produced -3.35% returns during Q1 while investment grade corporates were slightly weaker at -5.47%.  High yield “junk” bonds (HYG) eked out a small positive return of 0.58% mostly due to its credit spread component.  Current 10-year Treasury yield rates of 1.7%, as part of the “back-to-normal” view, are now at levels seen near the beginning of 2020 before the pandemic took hold.

As I reported in my February 10, 2021 blog post, The Trouble with Tribbles, a return to “normalcy” will support investment strategies targeted to long term strategic views:

 So, the pandemic has hurt the total return of income strategies though today, but there are signs that as we emerge from the impact of the pandemic and the economy starts approaching “normalcy” there will be a “rebound” recovery within that universe of investments.  My blog post of January 3, “2020 Q4, Reversion to Mean” addresses the shifting trends we have started to see.

+27.4% Return per Year?

Sounds great, right? Well, per my blog post last week regarding the Callan Periodic Table of returns, if you were lucky enough over the last 19 years to have guessed correctly which major asset class would be the best performer in each year, +27.4% is the average annual return you would have earned (see table below for the “winner” each year)!

Alternatively, if you were unfortunate enough so as to pick the worst performer, your average annual return would be a miserable -8.88% over the past 19 years. Finally, to balance things out, if you picked the major asset class that was in the “middle of the pack”, your average annual return would have been +5.89%.

There is nothing magical about these numbers and no one should strive to try to pick the “annual winner” ahead of time (since it is impossible to do, except by pure luck!). Again, as always, it is best to have a diversified investment strategy that is consistent with your goals and stick to it!

A Winner in any Given Year

Each year, the investment consulting firm Callan LLC publishes their “periodic table” of investment returns.  The table arrays the nine major asset classes (i.e., large cap equity, small cap equity, U.S. fixed income, etc.) by total return by year.  It always amazes me how the leaders and laggards change positions each year.  The 2020 edition is shown below.

Let’s walk through a couple of asset classes to see how they have done over time.  The annual total returns for the “Large Cap Equity” asset class are shown by the dark blue box above.  As you can see, it has had quite an amazing run over the last 8 years with that asset class finishing in the “top 3” in seven of the last eight years.  However, in the 8 years prior to that it was in middle of the pack.  And, in the 4 years before that starting in 2001, it settled in at the bottom of the pile. 

Likewise, “Emerging Market Equity” (the dark orange box) had a great run from 2003 through 2009, until it hit the skids in 2013 through 2015, with a decent recovery in 2017 and 2020. Also, interestingly, “Cash” was the best returning asset class in 2018; an unusual feat for the historically lowest risk, lowest return asset class.

Of course, evaluating this data is more complicated than just noting the places where they finish since the relative and absolute returns are ultimately more important to overall long term performance, but it is still instructive to see the trends shown.

The important message, as always, is to be diversified in a manner consistent with your investment objectives since there is almost no telling which “box” will be a winner in any given year.

"The Trouble with Tribbles"

I wanted to title this blog post “The Trouble with Income,” but that did not have the nice ring to it of this old Star Trek episode.  That episode dealt with cute little furry alien creatures called Tribbles that everyone loved, but they had a characteristic that was very bad for the crew of the USS Enterprise (check in at the bottom of this post for a summary of that episode)!  This is not unlike income strategies; everyone loves them, but they have some unfortunate side characteristics.

I have written a lot about income strategies in this post-pandemic environment.  I often cited the prospects of dividend cuts, missed lease payments impacting real estate investment trust (REIT) earnings, and general malaise in earnings growth being the cap that limits return potential from traditional income-generating assets.  Also, traditionally high yielding asset class sectors like energy and utilities have been especially hard hit by the pandemic.  However, there are other more basic factors impacting the difficulty facing income strategies.

As seen from the chart below, over the past 12 months that includes the beginning of the pandemic, some popular income-generating assets like the iShares Select Dividend (DVY) equity fund, a broad core bond Barclay’s Aggregate Bond (AGG) fund, and the diversified State Street Income Allocation (INKM) fund all significantly lagged the S&P 500 (IVV, the black line on top) and the moderate risk diversified iShares Core Moderate (AOM) fund.

Though we can discuss this issue in much more detail beyond the scope of this blog, the major problem of an income strategy is that it is NOT a total return strategy!  When an investor has a need for “income,” that is, regular distributions from an invested base that is NOT a return of principal, the universe of investable securities is smaller and by definition LESS diversified than if the focus is total return; a strategy that opens the universe to all investable assets.

For example, in the case of today’s post-pandemic situation, income strategies have underperformed since they would NOT be invested in “growth-type” equity investments; the class of investment that typically DOES NOT pay much, if anything, in the form of dividends.  Growth stocks, of course rebounded strongly after the initial shock of the pandemic and then continued on to new heights.

Likewise, equity investments in the small and mid-cap space generally do not pay a high yield rate so those sectors (that also rose to new all-time highs) are generally NOT part of an income strategy.  This phenomenon is seen in the international and emerging market equity space, as well.  Compounding the problem, investment in some bond funds struggled with weak price performance due to fears of bond defaults resulting from the pandemic (that has partly reversed recently).

So, the pandemic has hurt the total return of income strategies though today, but there are signs that as we emerge from the impact of the pandemic and the economy starts approaching “normalcy” there will be a “rebound” recovery within that universe of investments.  My blog post of January 3, “2020 Q4, Reversion to Mean” addresses the shifting trends we have started to see.

Notes:

Star Trek Original Series Episode Synopsis - Season 2, Episode 15:

To protect a space station with a vital grain shipment, Kirk must deal with Federation bureaucrats, a Klingon battle cruiser and a peddler who sells furry, purring, hungry little creatures as pets.

Not Improbable, but Probably Unlikely

As readers of this blog well know, I am a fan of diversification and long term strategic investing. Though Q4 last year showed some significant “catch-up” from previously underperforming asset classes like emerging market equities and real estate investment trusts (REITs), there is still a lot of catch-up to be done. The thought leaders at Research Affiliates, led by Rob Arnott, recently published a paper titled “Is Diversification Dead” (here) on this very topic. Their conclusions are telling.

The authors start by identifying the three main groups of asset classes: core equities, core bonds, and diversifiers. Core equities include the S&P 500, small cap equities, and international developed markets; core bonds include U.S. Treasuries and investment grade corporates. Diversifiers are a more disparate group including inflation-protected bonds, high yield and emerging market bonds, emerging market equities, and commodities.

A historical review of these three main groups of assets showed that diversification worked comparably very well since 1975 but has lagged significantly over the past 10 years. In fact, some are calling the 2010’s the “lost decade of diversification” because of the relatively weak performance of the diversifying asset classes.

The authors showed that over the past 47 years a core 60/40 portfolio (60% S&P 500 and 40% Barclays Aggregate bond) generated an annualized return of 10.4% compared to an equal-weighted fully-diversified portfolio annualized return of 10.9%. The results during the decade of the 2010’s, however, showed the 60/40 portfolio with a 9.2% annualized return compared to only 6.4% for the equal-weighted fully diversified portfolio; an underperformance “cost of diversification” equal to 2.8% annualized! The results are worse if you extend the 2010’s to include 2020!

The authors then tried to explain the cause of the underperformance of diversification and identify where we might go from here. The single most important determinant was the expansion of S&P 500 stock valuations with markets reaching record heights that the diversifiers could not keep pace. In fact, for this trend to continue the S&P 500 would need to see valuations continue to grow by 40% from here; something that is not improbable, but probably unlikely!

So, not surprisingly, the authors make a strong case supporting the academic work in favor of diversification despite the recent decade of underperformance relative to a 60/40 portfolio. In closing, they say words that I echo per my blog post from January 3 (here) :

Can we really count on another round of speculative good fortune—indeed, to trust that continued escalation in valuations will successfully serve trillions in future pension obligations? If not, now is not the time to abandon diversification and diversifying asset classes. Certainly, if mean reversion does occur, heeding the lessons of the 2000s we must acknowledge that diversification is needed today more than ever.

Another AIEQ Update

There is no such thing as a “sure thing”, except for death and taxes! But, I am heartened to see a new innovative investment that is currently living up to its marketing hype and investment potential. I am talking about the AI Powered Equity ETF (AIEQ).

I had written about AIEQ on Seeking Alpha, an investment blog where that particular post got 1,200 “hits”, when it launched back in 2017 and wrote blog posts here in 2019 and 2020. Despite my focus on “passive” investing, I was interested in AIEQ since it was “active” in a passive way and had the potential to provide “low-correlated” returns to its benchmark the S&P 500.

As I have previously reported, the benefit to the investor of this ETF is its active strategy guided by artificial intelligence that is insulated from behavioral biases and scours all financial and unstructured (news articles) information as the portfolio management approach. Its investment goal is to outperform the broad equity market (investing in all market capitalization sectors) at a similar level of risk. In theory, it should provide a good low-correlated complement to an index-based approach to portfolio management.

As you can see from the most recent total return chart below, AIEQ has done a good job tracking and beating the S&P 500 index (IVV) over the last year with less risk (one-year standard deviation of return of 32.0% compared to 33.9% for IVV) with cumulative total return of 34.6% compared to the S&P 500 of 18.9%.

Clients with a higher tolerance for risk and a long term investment horizon could benefit from this type of performance. Due to its “go-anywhere” U.S. stock universe, it is able to gain exposures in any sector where it thinks it can outperform the S&P 500. Recent underlying stock holdings in this ETF are popular names like Tesla, AMD, and Alphabet, as well as lesser known names like Enphase Energy, Roku, and Sunpower Corp.

2020 Q4: Reversion to Mean?

Amidst pockets of economic distress due to the global pandemic, the capital markets showed strong resilience during 2020.  The strength in markets is mostly due to unprecedented fiscal and monetary stimulus programs of government spending and Fed interest rate easing and security buying programs.  Talk of the “Fed Put”, a reference to the view that the markets will never irrevocably collapse since the Fed will always put a “floor” on how far it will let markets fall, certainly came to light during 2020.

During Q4 we began to see some strength in market sectors that previously lagged the broad market leaders as the gap between winners and losers began to narrow.  As seen in the table below, the S&P 500 (IVV), led by large cap tech-oriented stocks, rose to record heights while producing a YTD return of 18.40%.  Small caps (SCHA) finally recovered during Q4 with a strong 28.84% return after a dismal Q1 finishing with a YTD return of 19.35%.  Diversifying positions in mid-cap, international, and emerging market equities all rallied strongly during Q4, but not enough to catch up to the YTD return of the S&P. US REITs (SCHH) and value-focused high dividend stocks (DVY) continued to struggle with negative YTD returns of -15.06% and -4.91%, respectively, but showed future promise with some recovery in Q4.

Fixed income returns were spotty during Q4 with core bonds delivering as much return as it could in the first part of the year; mathematically, with rates so low there is almost no potential return left in the U.S. Treasury market.  Consequently, core bonds only delivered 0.52% during Q4; we should not expect much return in 2021 from these holdings.  On the other hand, inv. grade corporates (LQD) and high yield bonds (HYG) still had something to offer the bond investor in the form of excess credit spread with Q4 returns of 3.11% and 5.44%, respectively.

2020 was a good reminder that there is no way to predict what future capital market returns will be, but there are good reasons to be optimistic about the future as I reported in my October 15, 2020 blog post recounting a Wellington Management report: 

“In summary, the authors state that there are three main factors leading the way. First, even though there have been some bumps along the road, we are moving in the right direction regarding COVID-19.  Treatments and vaccines are moving forward and there is reason to view this as a positive trend.  Secondly, there has been strong fiscal and monetary support to bridge the economy over this crisis and more is hopefully coming.  And thirdly, economies are opening slowly and there does not seem to be a prospect for another shutdown.”

2020 Year-End Video Blog!

Dear Clients, Potential Clients, and Friends -

I am happy to produce and post a 2-minute “video” blog to report my observations from 2020 and offer some thoughts for the future.

After summarizing a few notable things from 2020, I focus in on a key reminder from 2020: It is important to have an investment strategy that is consistent with your goals and sticking to it! Regardless of where you are on the risk spectrum, the most important thing is to be positioned to achieve your goals and a well-defined investment strategy will help you get there. It is our commitment to work hard with you to this end.

I hope you enjoy the video blog post! If you want to see more of me (!), just reply to this post and I will do more video blogs on interesting investment and retirement planning topics.

Thanks and Happy Holidays!!

Tony and Dave

As Good As it Gets?

The recent all-time highs in the Dow, S&P 500, and NASDAQ all conjure visions of robust capital markets and a bustling economy. Certainly, the major equity indices, with all of their flaws and blemishes (e.g., overweights in large cap tech distorting overall market health) have performed better than most anyone would have expected back at the dawn of the pandemic in March.

By most measures, the economy is still struggling in “risk-off” mode with still high unemployment at 6.7%, depressed oil prices at $45/bbl, industrial production (NAICS) just over 101 (compared to 106 in February), and weak consumer sentiment of 81.8 (compared to 101 in January). Partly offsetting those weak stats is some hopeful prospects from the Conference Board Leading Economic Indicator showing a 0.7% increase in October pushing the index to 108.2; a healthy level that is closing in on the 112 level seen in January 2020.

Another favorite measure of mine is the credit spread level of the high yield bond index (see chart below). As we know, this indicator cratered in March 2020 at the dawn of the pandemic with credit spreads spiking to 10.87% (1,087 basis points for the bond gurus out there!) We have seen these spreads come in significantly since then due to dramatic action by the Fed, including the outright purchase of bonds and bond ETFs and fiscal stimulus spending. High yield spreads currently sit at 4.03% (403 basis points); a recent low since March.

Historically, bullish periods for high yield bonds track down to normalize around a 300 basis point credit spread like we saw in 2014 and 2018. Are we headed there now? It is certainly possible, but no telling if there is enough oomph left in the recovery arsenal to get us there. No reason to abandon high yield bonds at this time since a long term allocation to this risky asset class historically outperforms less risky bond sectors.

And the Winner is...

We will be talking about 2020 for a LONG time!  It is hard to believe that the capital markets have recovered so strongly in the face of “the worst event this country will face” per Dr. Birx, White House Health Advisor.  But, there are plenty of reasons for the positive market response, including the points I reviewed back on October 15 from a Wellington Management piece titled, titled Politics, Policy and the Pandemic (click link for more info).

As I said back in October, “In summary, the authors state that there are three main factors leading the way. First, even though there have been some bumps along the road, we are moving in the right direction regarding COVID-19.  Treatments and vaccines are moving forward and there is reason to view this as a positive trend.  Secondly, there has been strong fiscal and monetary support to bridge the economy over this crisis and more is hopefully coming.  And thirdly, economies are opening slowly and there does not seem to be a prospect for another shutdown.”

Since September 30, we have seen multiple new market highs and a rotation away from previous market leaders to new sectors that had previously lagged.  Which sectors have started a market recovery and which sectors have paused (or lost steam?)

From the table below we can see some dramatic swings.  The S&P 500 (IVV) continues to show strength with a Q3 QTD return of 10.45% and an impressive YTD return of 16.56%.  But, the previously lagging sectors like small cap, mid cap, and high dividend are outpacing the S&P during Q3 with outsized returns of 25.75%, 20.60%, and 19.62%, respectively.  On the other hand, previous market winners like the momentum stocks (MTUM), are lagging Q3 QTD with a 6.43% return, but still strong YTD with a 26.06% return.

Bonds, meanwhile, have achieved as much return as they can in this market with not much upside left.  YTD through September 30, aggregate and investment grade bonds performed well due to extraordinary efforts led by the Fed and fiscal policy.  Q3 QTD, however, has shown a flip flop. Aggregate bond returns have stalled during Q3 as Treasury yields touched all-time lows, while corporate and high yield markets continued to benefit from spread compression due to Fed actions. Going forward, as I have written at length, the Treasury bond market has “mathematically” topped out; the only likely return in bonds is from “spread” product.

Short term market dislocations will always emerge as the economy rotates from despair to exuberance.  Some sectors will outperform while others lag.  For long term investors, it is important to stay the course and let the market sort itself out over time.  For short term or conservative investors with a potential need for a stable portfolio to fund expenses and other outflows, the benefits of a long term focus are foregone, but replaced by a conservative portfolio that better reflects the investors risk profile and risk tolerance.