Although many schools in North Carolina were closed multiple days this week due to snow, ice and dangerous driving conditions (never-mind that the roads have been blacktop all week), some of us still managed to brave the weather and get a few things done in Lenoir. Those things included preparing for BMC Fund Investment Committee and Board of Director meetings which wrapped up yesterday. Below are a few excerpts from those presentations to provide a sense of how we are positioned in the current market:
Expected returns remain very compressed across asset classes today. As a result we continue to hold short-term reserves in cash and equivalents which provide an option on tomorrow’s opportunity set.
Our fixed income allocation today remains below normal as yields have been forced lower due to the zero interest rate policy of major central banks. This chart shows the expected real returns on offer from various fixed income sectors. Note that outside of emerging markets, most bonds are priced to return about nothing for the next ten years. The exception, at least on these numbers, would appear to be EM, but given the elevated macro risks in emerging market economies today, we are not interested in stretching for yield here.
The speed of the rise in emerging market debt since the financial crisis has been extraordinary. China’s private sector external debt has risen from a mere $140 billion in 2008 to $1.2 trillion today. In aggregate, emerging market private sector external debt levels are as high as they were before the Asian crises in 1997-1998. The odds of the dollar carry trade unwinding as emerging market growth slows are not immaterial.
We are finding value in other segments of the bond market. The high yield market has had a rough few months. Much (not all) of this can be linked to the sell off in oil.
If we step back and look at the long term trend in high yield bond spreads we can see that the recent sell-off has created a pretty nice opportunity as these bonds are now priced at a healthy premium to treasuries. While we are nowhere near the levels we say in 2008 – which was a “once in a generation” event – high yield bonds are now trading at levels on par with what we saw in the wake of the tech bubble.
And while spreads have spiked in recent months, default rates remain low. It’s safe to say that defaults will rise in the quarters ahead, particularly given the stress in the energy sector, but we think there is enough value in the rest of the sector today to warrant greater attention.
Our investment in Third Avenue Credit is well positioned to capitalize on opportunities in stressed and distressed credits. Unlike traditional high yields funds, Third Avenue can invest up and down the capital structure and is not limited to owning an index-like portfolio. The average price of its bonds today is 75 cents and the fund yields over 10% with minimal interest rate risk. The portfolio’s duration is under two years.
In GMO’s most recent quarterly letter, Ben Inker recommended investors “Ditch the Good, Buy the Bad & the Ugly.” The argument was essentially that all the good news was priced into US stocks, so despite a relatively healthy economy, expected returns at home are well below average. US equities are represented here by the large red circles at the bottom of the chart, priced to provide returns similar to cash with a lot more volatility for the next decade.
Inker’s recommendation was that investing where the valuations are lower has been a far better strategy historically, and, despite all of the worrying features of the economic environment outside of the U.S. today, investing in the various bad and ugly places in the world is going to wind up far more rewarding than the admittedly good-looking U.S. This is illustrated well here.
And while international diversification acted like an anchor on portfolio returns last year, equity market performance YTD has been a much different story.
Last year was a particularly challenging one for active management. GMO discussed our challenges in a recent white paper. A few excerpts below:
Between 80% and 90% of active U.S. equity managers underperformed their benchmark last year, making it one of the worst years for active management in the recent past. Those particularly prone to hyperbole will use this as a clarion call to further embrace passive management and rid themselves of their active managers. After all, if only 1 in 10 active managers can actually generate alpha, why would investors bother with the time, headache, or cost of active managers? Not so fast …
It is incredibly important to avoid extrapolating short-term results. Just because active management in general has been through a difficult period, it does not necessarily follow that what is past is prologue. In today’s increasingly short-term-oriented investment culture, winning stock pickers are deemed to have exhibited superior foresight and brilliance while the losers have suddenly become idiots and are often shown the door.
Reality is something quite different. In any given year, there can be a substantial amount of luck involved in outperforming a benchmark. Over a longer horizon, we think it is easier to make the determination between skill and luck.
As you look across your roster of equity managers, there will be a myriad of explanations as to the reasons for poor performance. Some of those explanations will be valid and others will sound much more, um, creative. But for active management as a whole, 2014 was a year when forces were aligned in such a way as to make it an especially difficult environment for active managers to outperform. U.S. equities trounced non-U.S. equities, large cap stocks trounced small cap stocks, and equities trounced cash. That was a lot of trouncing going on. And, sure enough, active management was trounced. But you cannot let the results of 2014 dictate the outcome of any debate on the merits of active investing versus passive investing. Extrapolating a short-term trend into the future can be a very difficult way to compound wealth.
There are merits to passive investing. But there are also merits to active investing. Active management allows for the continuous assessment of the state of the market and to make intentional choices about how best to take advantage of opportunities and mitigate risk. Passive management precludes the ability to add value in this way.
If you did appropriate due diligence and the people, philosophy, and process of your investment manager has not changed, the short-term pain you are feeling may simply be due to the ebb and flow of style. Reacting to the short-term pain of underperformance and locking in a loss may feel good but can be very costly. It is unlikely that 2015 will result in the same performance for active managers as 2014. It is certainly possible, but we think it is unlikely.
We couldn’t agree with the authors more. “Investors are much better served by focusing on their investment philosophy and process than by responding to short-term results and headlines.”