Since the low back in February, and as we write this post, the S&P 500 has increased by more than 20%. This is remarkable considering the events of the past 6 months, such as the UK vote to exit the European Union, and the seemingly never-ending flow of terrorists’ acts around the world. Our regular readers know that we believe attempting to time the market is destined to produce poor investment results over time, and this recent period provided another vivid illustration.
Not surprisingly, two of the categories in your portfolio that have done the best recently are the ones that did the worst in 2014-2015: natural resources and emerging markets. As the investments in these categories delivered poor overall returns for a while, some of you may have wondered if we ever sell a fund that is underperforming.
When reviewing our fund selection, we try to stay focused first on the fundamentals rather than solely on performance. By fundamentals, we mean the fund manager’s investment process, fees, investment company’s stewardship, and the long-term track record that attracted us to the fund in the first place. If all of these remain intact, odds are that we’ll keep the fund despite poor short-term performance.
The difficulty comes from being able to discern a fund that is experiencing temporary performance issues from one that is more likely to be a more permanent underachiever. One useful way to determine this is to check whether the fund is behaving like its peers or not. The examples of the previously mentioned emerging markets or natural resources categories provide a good illustration. The funds we use in these asset classes behaved as expected in an environment that was unfavorable to the entire category. Accordingly, we not only stuck with these allocations, but effectively averaged down: we were rebalancing our clients’ portfolios into these funds as the allocations drifted below their target. Particularly with cyclical categories, it also pays to sell a fund when the category is in favor, rather than giving up in a moment of fear during the down part of the cycle.
Are We There Yet?
This brings us back to a frequent subject of ours: the underperformance of value investing. As you know, value permeates our process and your portfolio has a value philosophy overlay in all of its investment categories, including international, emerging markets, or US large companies. Behind that preference is strong intellectual and academic support for value’s long term outperformance. We revisit the subject in this month’ blog because there was a very good piece recently produced by a value firm, Pzena Investment Management, in its 2nd quarter commentary.
We reproduce below the charts for the US and Global markets. They show the valuation of the cheapest stocks relative to the rest of the market. The higher the line, the greater the value opportunity, i.e. value is more likely to outperform over the following 3 and 5 year periods.
We encourage you to read the actual source document, but the authors concluded: “(…) investors willing to be patient for 3-5 years following a widening of spreads are overwhelmingly likely to be well-rewarded.” They also admitted that “history is not without its painful exceptions, including the very recent period. Indeed, the data highlight the misery of value-based strategies over the past eight years.”
We draw a few additional lessons of our own: first, it begs the question of whether the increasing move into passive strategies is creating a self-fulfilling momentum? As big growth stocks outperformed in recent years (think Google, Amazon, Facebook, Netflix etc.), more assets pour into the index funds that are tracking them just by virtue of their price going up, not based on any positive assessment of their fundamental business characteristics. It appears to us that this is an inopportune time to make a dramatic shift toward market-cap weighted passive strategies. Moreover, we’re reluctant to ditch any value fund right now, be it large cap, small cap, or international. We would be giving up at a pretty extreme time by historic measures.
Understanding Your Portfolio’s Benchmarks
In the report that we send out every quarter to our clients, we use anywhere from 2-3 benchmarks to compare performance. We thought it would be helpful to review how these benchmarks are constructed, and how they help you contextualize your portfolio’s progress.
The easiest one to understand conceptually, is used to measure purchasing power erosion over time: CPI + 2%. CPI stands for Consumer Price Index (a measure of inflation). The margin of 2% is completely arbitrary but approximates what a conservative asset allocation (say 30% stocks and 70% bonds?) could deliver over time based on long-term historical returns. It gives an additional margin of safety that offsets other factors such as taxes and the issue that the CPI might not necessarily represent the inflation rate that is affecting the goods and services that you’re buying every day. If your portfolio’s investment returns exceed CPI + 2%, it is telling you that it is at least very likely to keep its purchasing power over time. For most people, this provides a floor to the returns that any investment plan should achieve over the long-term.
A second benchmark that we use frequently is the “segment blended” benchmark. Although its construction is complex, its underlying principle is easy to understand: Your portfolio is divided into a dozen or so asset categories e.g. segments, such as international stocks, US bonds, etc. For each, we compare the performance of your funds to an appropriate, measurable, and investable index. The segment blended benchmark is the weighted average of all the underlying indexes, which you can see in your reports under the heading “Capital Markets Performance”. The weights used in the blending calculation are those of your actual portfolio’s asset allocation and are recalculated every day. In other words, this benchmark represents what your portfolio would return if it had been entirely invested in passive indexes rather than the mix of active and passive funds we selected. Further, the calculation implicitly assumes the portfolio is re-balanced every day without any transaction costs. This is a benchmark that will typically be close to the high end of the portfolio’s expected range of returns. Our goal is to be close to it net of expenses, and ideally, to exceed it over the long-run.
The most important benchmark though, is one that is not on your portfolio’s quarterly report. It is the return that your portfolio needs to achieve to reach your goals. For instance, based on your current income, savings rate, when you’ll retire, and your life expectancy, we may have determined that your portfolio needs to return 5.5% during your lifetime. This required rate of return based on your personalgoals will typically be slightly below the segment-blended benchmark previously discussed. Assuming that the portfolio’s risk profile matches yours, our preference is to incorporate a further small margin of safety when we build an asset allocation.
Does it sound confusing? We understand the need for benchmarks. It allows our clients to monitor if they are on track to meet their goals, and whether we are doing a good job in helping them get there. At the same time, it is important that investors not spend too much time worrying about how their portfolios or funds perform against a particular index.
Benchmarks should be a starting point to understand what happened after the fact, but we don’t let them drive how we invest our clients’ funds. Each of our clients has fairly unique needs and goals, and their life does not fit neatly into a model. There are no benchmarks that will perfectly measure how they are doing. Performance measurement does not provide all the answers. But it is indispensable in identifying issues to monitor and address. We believe that by providing clients more than one tool to evaluate performance, and by being honest and transparent about it, we hopefully demonstrate that we are good stewards of your assets.
Social Security scams you need to watch out for.
Some of you are receiving social security benefits, and we wanted to pass along a warning about two current scams that may affect you:
The first one is where you receive an official-looking email from the Social Security Administration with an invite to create an account so you can receive your benefits. You land on a webpage where the scammers hope you will fill out all your confidential information. Don’t fall for it: Never click on links in any of these emails. If you want to sign up for a Social Security account, or update your information, go directly to https://ssa.gov/myaccount/ and follow the instructions.
The second scam is where the fraudsters actually create an account for you (if you have not created one already), and redirect the payments to a bank account controlled by them. To prevent this from happening, create your own Social Security account now using a strong username and password (You can also activate an extra security step called dual authentication: by entering your mobile phone number, the social security website will automatically generate a security code and text it anytime you’re trying to access your account). This will prevent scammers from creating one under your name in the 1st place.
Another recommended security measure if you receive benefits directly in your checking or savings account rather than by mail, is that when you create your MySSA account, go to the settings and choose the option that any changes to the bank account into which your check is electronically deposited only be done physically at a Social Security branch office and not using your online account.
Let us know if you have any questions.
Thank you for your trust in our services.