CAPTRUST Chief Investment Officer
My oldest daughter, Hailey, started to really concentrate on golf this year. Many readers who chase after “the little white ball” can attest that golf is a cruel game, even recreationally between friends. Tournament golf, however, can be especially punishing, and I am not just talking about juniors facing the same tough greens, pin positions, and, in some cases, distances as players 50 years their elders. A 7:00 am tee time is not in sync with a 13-year-old’s normal sleep schedule; pre-round breakfast, stretching, and warm-ups necessitate waking up long before the sun.
Living in North Carolina provides Hailey with ample opportunities to play at some of the finest courses anywhere, and a few years ago when she first showed interest in playing golf beyond the recreational round with me, my wife, Jamie, and I signed Hailey up for a low-key tournament at a very playable golf course. When the starter announced her name and hometown, followed by claps from the handful of fellow caddie parents standing behind her, Hailey turned to me with one part anxious, one part proud smile. She ripped her drive down the fairway, and we were off with a spring in our steps. She loved the experience, and I never had more fun on a golf course than when I was carrying her bag that day, helping her with yardages, raking sand traps, and reading putts.
As her play progressed, we scouted additional tourneys, including one hosted by a tour rumored to be a notch above her initial training tournaments. We found a two-day event in Colonial Williamsburg, and on a warm late June day, we headed up for her first round. Her tee time was early afternoon, and as we drove north, my car’s external thermometer rose to 92 degrees. No worries, I thought. I will subtract a few yards per club to adjust to the high humidity. All she has to do is hit shots and stay hydrated. Piece of cake; I had enough sports drinks with me for the entire Commonwealth.
As we approached the first tee, a tour official stopped me and asked where I was going. I told her I was caddying for my daughter, and we were up next. The tour official scowled and spoke into her Secret Service – style microphone, indicating to a colleague that a father was intending to carry his daughter’s bag. “That’s a negative” she quipped. “No caddies allowed. Parents must remain on the cart path at all times and not interact with their children while playing except to deliver snacks.” It had been a hectic week in the office, and I neglected to read the fine print. I remember saying to Jamie “We don’t need to bring a push cart with us” just as Hailey’s playing partner strolled by with a shiny red contraption, complete with an umbrella to shade the sun on what turned out to be the hottest June day in Virginia history. “Well, there goes my father-of-the-year nomination,” I muttered sarcastically.
They called Hailey’s name as I was breaking the news to her. “But Dad, I don’t really remember how far I hit each club.” She quickly wrote down the ranges I had memorized, as if cramming before a midterm. I blurted a stream of advice; this would be the last time Hailey and her advanced tournament neophyte father would speak outside of yours truly pouring Gatorade down her parched throat. Just after invoking timeless morsels straight from Ben Hogan’s Five Lessons, I ended my brain dump with “Remember Hailey, golf is like what Papa says all the time don’t let the highs get too high and the lows get too low. Birdies will happen, double-bogeys will happen. Just keep a level attitude and have fun out there.” She nodded, looking one part anxious and two parts overheated; I couldn’t tell if the latter was due to the weather or my ineptitude.
Investors have had their share of highs and lows over the past 10 years. As measured by the S&P 500, U.S. equities hit their all-time high in late May, and as we have documented in several publications, interest rates remain near historical lows despite recent selling pressures. So with U.S. stock and bond prices so high, why are broadly diversified portfolios not following suit? The answer rests in asset class performance outside of the more familiar domestic equity and fixed income asset categories. Before we explore those asset classes, let’s take a step back and consider some of the core asset allocation tenets that drive our portfolio construction.
First, no one knows with any degree of certainty what the future holds. While my investment committee and I track key upcoming events like Federal Reserve meetings and macroeconomic statistical releases, we do not know three important things: (1) those events’ outcomes, (2) what the capital market reaction to said events may be, and (3) likelihood of any “unscheduled” events like political tumult in Egypt or an influential company’s surprisingly positive earnings preannouncement. Because of future uncertainty, we believe investors should have exposure to a variety of asset classes that protect them in the event of both highs (positive earnings preannouncement) and lows (political unrest). Asset classes tend to react differently to various events, and having a mix of asset classes to absorb whatever event permutations unfold should help investors over time.
Second, irrespective of market events, we want to provide investors with what are termed factor exposures or long-term trends that will benefit investors.1 Stocks are a great example; they provide access to corporate profits, and as long as indices and active managers (stock pickers) capture “winning” companies, having exposure to rising corporate profits over time should lead to positive returns over inflation. Of course, recessions and other dynamics make stock returns anything but linear, but as long as an investor has an appropriate time horizon to endure stocks’ ebbs and flows, they can add value.
Third, when properly deployed, asset allocation can provide a hedge against costs an investor endures. For example, while not appropriate for all investors, commodity investments fluctuate with prices of assets like oil, industrial metals, agriculture, and other goods. Often these goods are tied directly to inputs that surround an investor’s daily life, so having some offsetting portfolio exposure can help against price fluctuations, especially when input costs move higher.
Aggregating these three considerations, we strive to create portfolios that incorporate both protection against adverse events and long-term factor exposure. Asset classes can have overlapping factor exposure and the correlations or co-movements between asset classes can fluctuate, so by no means is the construction process a static exercise.
Figure One, which provides a snapshot of nine different asset classes and one blended portfolio’s returns over the past decade, reveals why having a portfolio construction process with the three principles highlighted can be additive. If you notice where the broad-based asset allocation portfolio (which incorporates each of Figure One’s standalone asset classes) ranks year after year relative to the individual asset classes, it is no worse than sixth place and no better than fourth place. This time period covers a considerably volatile and instructive period in the capital markets for this discussion.
Of course, one cannot directly invest in an index, and these returns are gross of any fees or transaction costs, but many useful takeaways emanate from this illustration. Asset allocation portfolios seek to do what I imparted on Hailey before she began her round that sweltering June day: not allow the highs to get too high or the lows too low. It also shows how individual asset classes can be extremely volatile from year to year and, as a corollary, how fleeting first- and second-place finishes can be. While U.S. stocks as measured by the S&P 500 have had a great year thus far, note they have lagged the broad asset allocation portfolio over the past 10 years by almost 30 percent, and this is a period where U.S. stocks have hit two all-time highs (first in October 2007 and again this May). Note also, emerging market equities, which have had the best cumulative performance of any of these asset classes, have had poor performance so far this year and were sharply negative in 2011. For all the talk of a 30-year-plus bond bull market, broad fixed income returns as measured by the Barclays Capital Aggregate Bond Index are in seventh place out of nine asset classes, including cash.
Behavioral finance, which studies the human mind’s proclivities related to investment choices, provides some clues as to why investors look at trending asset classes and extrapolate how those asset class trends relate to their situation. For example, some investors may look at recent U.S. stock strength and question why their portfolios are not at all-time highs, ignoring other asset class returns. According to psychologists Neal Roese and Kathleen Vohs, hindsight bias occurs when people “knew it all along” or deem an event more predictable after it occurs than before it happens.2 Similarly, investors may deem that they themselves, their financial advisor, or money manager should have the prescience to know what asset classes will be in first and last place. So, when the financial media cheers all-time highs in a familiar index like the Dow Jones Industrial Average, investors take notice and make inferences about their portfolio performance, perhaps forgetting that other asset classes helped stabilize their portfolios during the dark days of 2000 and 2007.
We continue to see the glass as half full with respect to global capital markets, and we see momentum for both global equities and potential value emerging as the bond market stabilizes. Despite a very experienced investment committee, independent investment research supplemented by outside services, and a deep team at our headquarters and regional offices, we do not have perfect foresight about the path forward. We do, however, strive to provide clients with durable portfolio strategies across market dynamics, remaining mindful of fees and our clients’ objectives. Different asset classes will contribute to those objectives over any given time period, despite their popularity or unpopularity at any given moment. While all investors would love to have all of their assets in the best-performing asset class at any given time, the market timing path is fraught with peril and usually, as the Wall Street adage goes, ends in tears.
Hailey’s two-day tournament did not end in tears; she had memorable experiences in Williamsburg that furthered her love for the confounding game of golf. She took her grandfather’s words to heart, letting near birdies and near blowups roll off her back, as well as her old man’s pre-tournament foibles. My eyes get misty whenever I see that ponytail bob up and down as she marches down a tournament fairway sure to present her with challenges and rewards aplenty; I am hard-pressed to find a more beautiful sight.
1 For further reading, see Fama and French, 1993. “Common Risk Factors in the Returns of Stocks and Bonds.” Journal of Financial Economics, vol. 33, no. 1.
2 Roese, Neal and Kathleen Vohs. “Hindsight Bias.” Perspectives on Psychological Science. September 2012, vol. 7, no. 5, pp 411–426.