CAPTRUST Chief Investment Officer
A few years ago, as a gag gift reminiscent of my late teenage years, my Mom gave me the complete first season of “thirtysomething,” the 1980s television drama chronicling a group of Philadelphian baby boomers adjusting to life as, well, thirtysomethings. My parents used to marvel at why a high school student focused on sports, girls and school (probably in that order) would be even the slightest bit interested in a television drama about career angst, parenting woes and other existential issues obviously well beyond my then — adolescent ken. While I recall my brother teasing me for allowing the TV show soundtrack’s cassette case to occupy the same shelf space as enduring classics like the Rolling Stone’s Exile on Main Street or The Freewheelin’ Bob Dylan, I remained a devoted fan through the show’s final episode, and truth be told, I may still have some dusty VHS tapes of recorded shows packed away in a box somewhere.
A few decades later, my episode memories are faint at best, but I do recall one in particular that I shared with my wife the other day. Two characters, Gary and Susannah, are marveling at their firstborn child and newborn baby, Emma. One parent half-jokingly proposes to the other that Emma shouldn’t venture outside her nursery and should be raised in their home’s safe confines, declaring the world is too harsh and cruel a place for such a delicate, beautiful creature. As a father of three, I can relate; I can already see life’s complexities — increasingly difficult school assignments, standardized tests, competitive sports and dynamic interpersonal relationships — encircling my kids, and sometimes I want to freeze time and shelter them from the harsh realities of life. While confining them to a safe harbor may satisfy my own paternal urges, doing so would deny my little “Emmas” much of life’s worthwhile experiences.
As CAPTRUST’s Chief Investment Officer, I feel paternalistic about our Clients’ portfolios. 2011 reminded us how cruel financial markets can be, and at times the natural instinct is to want to shelter portfolios from the seemingly arbitrary market reactions resulting from the latest news flow permeating into the investment mainstream. With integrated and interdependent global financial markets, bound together through global trade and a complex web of financial market derivatives and cross holdings, a debt crisis in Greece, the 37th largest global economy in purchasing power terms, can snowball into a credible threat to the European Union. Since no playbook exists for what may happen in Europe and no one can definitively predict the investment implications of a disorderly sovereign or large financial institution default, it felt at times that rushing to the exits was the right investment strategy. A quote (accurately attributed to Mark Twain, not Will Rogers, contrary to popular belief) about being more interested in the return of one’s money vs. the return on one’s money seemed to ring true among investors as they digested the European news flow amidst a series of U.S. political misfires ranging from the partisan debt ceiling debate to the failed Supercommittee and the U.S. debt credit rating downgrade by Standard & Poor’s. An about-face rally in risk assets on October 4th — a day when global Equities touched thirteen month lows — kicked off an ascent higher that lasted through the end of the year, with U.S. Equities, REITs and certain Commodities ending the year in positive territory.
Despite some positive asset class returns, 2011 was a brutal year for actively managed investment strategies. In the final toll, 92% of U.S. core Fixed Income managers underperformed their benchmarks for the year. Several high profile money managers, including Morningstar Equity and Fixed Income managers of the last decade, suffered severe losses relative to their benchmarks and peers. In the Hedge Fund community, several venerable managers “went dark” or effectively closed shop in 2011, with others wishing they had following brutal losses. All told, fundamentally based strategies, quantitative strategies and fund of funds each had difficult years, and in many cases for the second or third sequential year.
I don’t list these shortfalls and departures for any reason other than to indicate with specific examples how difficult the investment climate has been. Some of the brightest minds, most sophisticated algorithms, and largest research staffs have been perplexed by movements across major asset classes (stocks, bonds, precious metals) and within asset classes (interrelationships between different bond sectors like Governments and Mortgages, for example). Performance within European government bonds, including previously perceived safe havens Spain and Italy, added additional complexity for global investors. Seemingly no asset class appeared immune from these massive swings manifested most publicly by Equities, which despite its small aggregate market size relative to Fixed Income and currencies, continues to dominate media attention.
The concept to keep in mind when feeling particularly paternalistic, whether in regards to children or investment portfolios, is that both need room to grow; relegating a child to the safe clutches of home may keep them safe in the short-term, but doing so will surely stunt their growth in the long-term, and as the age-old maxim suggests (and applies to the investing world), nothing ventured, nothing gained. Given a stubbornly stagnant recovery profile, the U.S. Federal Reserve has kept short-term interest rates, and by extension, long-term interest rates at historically low levels in an attempt to spur economic growth. The Fed continues to incentivize investment through their attempt to cap borrowing costs for mortgage holders, credit card debtors, and others still feeling the 2008/09 financial crisis aftershocks. This creates a favorable environment to borrow short (at the front end of a low yield curve) and lend long (at higher longer-term rates, which are still attractive to would-be borrowers from a historical perspective) encouraging banks to make loans, and would-be consumers to borrow for current consumption. However, while low interest rates appear to be a good deal for both lenders and borrowers, savers have not been invited to the party.
Paternalistic views in the portfolio sense have historically translated into higher investment grade corporate, government and mortgage bond allocations, and lower exposures to areas like global Equity, high yield Fixed Income, Real Estate and Commodities. As Figure 2 (which we have shared in prior editions) clearly outlines, seeking portfolio shelter via the U.S. government bond market does not pay much in yield terms (sub 2% currently).
Back in the late 90s and just prior to the Credit Crisis (in addition to the 70s and early 80s when rates peaked at over 15%), it “paid” in yield terms to invest in government bonds. We have long heard cries to abandon bonds, including government bonds, due to low historical yields. We have and continue to rebuff the notion of abandoning Fixed Income given low yields, instead encouraging investors to spread out their Fixed Income allocations across a variety of attractive subsectors, including parts of the investment grade and high yield corporate market, non-agency mortgages as well as government bonds. The European structural issues and ongoing global macroeconomic volatility have favored U.S. Treasuries as a safe haven asset; while U.S. 10-year yields hover around a paltry 2%, investors should note that precedent exists for yields to go even lower; Japanese 10-year bonds yield about half of the U.S. 10-year.
While interest rates could head higher in the near-term, Figure 3 reflects the forward curve, or market participants’ expectations for interest rates in the future. As you can see, investors do expect interest rates to head higher, but not in a dramatic fashion. A driver of this phenomenon is low expected inflation given considerable slack in the global economy as deleveraging continues.
So while being paternalistic has its merits, it will not get you paid yield in short or even longer duration Fixed Income. But focusing on yield alone is not the answer in any environment. Given correlation breakdowns, market reversals and general oscillations, investors would be well-served to retain their core Fixed Income holdings while looking to spread out their overall exposures within the bond market and in higher quality global Equities across market capitalizations. We expect large structural economic issues that are prone to violent market reactions, most specifically the European debt crisis and the potential for slowing emerging market growth, to remain central stories. In short, spreading exposures across and within asset classes will remain an investor’s friend.
The same day I received the “thirtysomething” anthology, my Mom also gave me a small book filled with fatherly wisdom on raising a daughter. After pages of mostly lighthearted tips, I specifically recall reading the last page that offered this advice: “In the end, let her go.” In the face of considerable market volatility, which we think could persist, our advice to investors is to “let go” by letting asset class and sub-sector diversification work in their favor. Being heroic in this market environment is a seemingly futile and potentially dangerous decision.
I am almost certain I know where those “thirtysomething” VHS tapes are and I definitely still own the video equipment to play them. I can’t however, bring myself to pick up that book my Mom gave me, for fear I may read that last page again and have to think about letting my oldest daughter go. I’ll deal with that bittersweet milestone when I have to; I am having way too much fun now to even think about it.