|Over the tumultuous 12-month period that began with the onset of the credit crisis we have benefited from a series of very successful decisions in the midst of as tough an environment as we’ve ever seen.
Looking ahead, considerable economic challenges remain. The consumer is highly stressed and the job market is very weak and forecloses will continue.
We currently have tactical posi-tions in emerging-markets equities and bonds, domestic high-yield bonds and large company US stocks.
Quarterly Investment Commentary
Stocks continued to climb in September, bringing the third quarter gain for the large-cap Vanguard 500 Index Fund (which replicates the S&P 500) to 16%. For the year to date, that benchmark is now up 19.3%. In terms of market cap, the small-cap iShares Russell 2000 gained 19.2% in the quarter, and is now up 22.4% for the first nine months of 2009. Mid-caps outperformed both larger and smaller-caps, gaining almost 21% for the quarter and more than 32% for the year to date. Foreign stocks continued to outpace their U.S. counterparts, with Vanguard Total International Stock Index Fund gaining almost 20% in the third quarter and 32.5% for the year to date. Emerging-markets equities (based on Vanguard Emerging Market Stock Index Fund) continued their sharp rally, with a near double-digit gain in September bringing their third-quarter return above 21% and their year-to-date return just north of 62%.
Turning to fixed income, the intermediate-term, investment-grade Vanguard Total Bond Market Index Fund was up 3.7% for the quarter and is now up 5.9% so far in 2009. High-yield bonds, as measured by the Merrill Lynch U.S. High Yield index, nearly matched the gains of domestic equities in the third quarter and their 47.7% year-to-date return is more than double that of the Vanguard 500 Index Fund.
Despite our slight underweighting to US equities the majority of our portfolios beat their benchmarks in the third quarter, and are now well ahead year-to-date, a welcome change after our lagging performance last year and the run up to the credit crisis. The good showing is a function both of our tactical positions adding value (which has been the case for many years now) and our active equity managers reversing their underperformance and beating their benchmarks by very large margins. Our fixed income money managers have also added significant value over their benchmarks over the past 12 months.
We talk more about the drivers of our performance and our current views and expectations in the commentary below.
In our effort to communicate candidly with clients, we are honest about when we make mistakes and don’t try to sugarcoat them. In our communications last fall, we discussed openly why our portfolios had struggled against benchmarks and also about some opportunities we were seeing as a result of the sell-off in many investments. Now, after navigating through one of the most challenging environments we’ve ever seen, we are pleased to be able to report on a very successful series of decisions that we have made since November of last year. In response to these opportunities, we have made tactical asset class decisions at a greater pace than any other time in recent history and nearly all were successful at the asset class level.
Let’s first discuss what we did on the equity side. We significantly increased our exposure to US based Large Company Growth stocks. We completely eliminated our US Small Company position and made a small increase to our Emerging Market position this Spring. The big picture viewpoint on all of these decisions are as follows:
- Emerging Market economies do not have the Bank/Credit problems that the Developed World does and they are potentially going to grow faster over the next period of time.
- We want exposure to companies than can grow without accessing the capital markets. Capital / Debt is going to be constrained for some time.
As for fixed income, we focused on Municipal Bonds, Mortgage Bonds, and Corporate Bonds – specifically Corporate Bonds on the low end of the quality scale. Corporate Bonds and High Yield Bond may not be the type of position that one might consider holding during the first of a credit bubble, however, the asset class had been crushed and, as we wrote last fall, our analysis suggested strong returns were likely even if defaults and recoveries matched what was experienced in the 1930s.
We also made the right decision to continue to invest with a number of underperforming managers after considerable dialogue with them confirmed our confidence in them in the midst of the vastly different environment we were entering. At the time, we believed that major pricing opportunities were being created by forced selling (from hedge funds and others) and that it could become a very good environment for active managers. This belief has turned into a reality for the managers we use, as both our core equity and fixed-income funds have significantly outperformed their benchmarks so far this year.
While we will see more bank failures and as real estate-related loan losses (residential and commercial) continue, we are confident that the government has taken the financial-system meltdown risk off the table. The economy is probably already growing again. But there remains the important question of how strong the recovery will be, and whether it will be sustained or whether there will be another leg down for the economy and the markets (which is commonly described as a W-shaped recession).
Opportunities and Risks
We are always assessing opportunities and risks. Do asset-class fundamentals and valuations justify significant risk taking, risk aversion, or something in between? Our weighing of risk versus opportunity is always driven by our fundamental and valuation analysis. Valuations have certainly been affected by the recovery in financial asset prices we have witnessed and participated in this year. Stocks are no longer undervalued unless one believes that earnings growth will be very strong over the next few years. If one believed the recovery from this recession to be in the range of all the other post-WWII recoveries, then we would expect much more upside from stocks. But if the housing and debt bust triggered a transition to an economic re-set at a lower level, then economic history clearly suggests a period of subpar growth and lower returns.
We know that no one has a crystal ball and there are experienced and very savvy investors on both sides of the argument.
As we look ahead there are a few thoughts we’d like to leave you with:
First, we believe the last year underscores the appeal of tactical asset allocation. As we’ve stated over the years, great tactical opportunities come along only occasionally, but when they do, they can provide an opportunity for a significant performance advantage over the long run. For example, over the past 10 years our portfolios have beaten their benchmarks. This outperformance was primarily driven by tactical asset-class opportunities early and late in the decade.
Second, our approach to tactical allocation requires a multi-year time horizon. We will not always be rewarded quickly so patience is required—a critically important investment trait that is lacking among many investors. We were fortunate with our Fixed Income/High Yield move. We only had to wait about two months after our first investment in the asset class before underperformance turned into outperformance. Other times we have had to wait for many months or over a year (as we did in the late 1990s with Small Cap stocks, for example). But over the years our track record has been strong in terms of ultimate success.
Finally, when making tactical moves, we are by definition investing our portfolios differently than their benchmarks because we believe it makes investment sense to do so. This therefore requires a willingness among investors to accept results that are different from the benchmark. Over time, if we can continue our long-term success, this different performance will mean periods of outperformance will more than offset periods of underperformance, resulting in overall long-term outperformance. But shorter term, we will enjoy and suffer through both types of periods.
It is important to note that we are currently postured very differently from our benchmarks, with emerging-markets bond and equity exposure, high-yield bond exposure, and significantly below-benchmark to Treasury bond exposure and no small company exposure. Overall, we believe that our positioning makes sense in the environment we consider most likely in the years ahead, and reflects prudence in our weighting of risk versus potential return.
In addition to what the markets give us, we are also optimistic both that our active managers can continue to add value (though probably not at the same pace as what we’ve experienced this year) and that a still-challenging economic environment is likely to present us with additional tactical opportunities in the years ahead.
As always, we will attack our asset class and manager due diligence work with determination and enthusiasm and remain focused on making the best decisions possible on behalf of our clients.
We remain strongly committed to focusing everything we do on rewarding you for your confidence.
Jon Houk, CFP®