Monthly Investment Commentary

Most asset classes posted gains for the month of August, with the exception of commodity futures, which lost 3.6%. The large-cap S&P 500 gained 2.4%, while the small-cap Russell 2000 index was up 3%. Small-cap growth and value performed similarly, while large growth gained 3.1%, outpacing the 1.6% gain for large value. International equities gained 2.5%. Numbers were positive on the fixed-income side as well, with domestic investment-grade bonds up 1.6% and short-term local-currency emerging-markets bonds up 1.1% for the month.

Changes to Our Model Portfolios

This month we are making a tactical change to our model portfolios by reducing the small-cap exposure and moving the proceeds into large-caps. Most of the metrics we follow show small-cap valuations at or near the high end of their historical range relative to large-caps, and while this doesn’t guarantee anything in the short term, we believe that this relationship will revert in the future, and if it does, large-caps will outperform.

A cyclical argument favoring large-caps over small-caps can also be made. We’re well into the economic cycle, and small-caps’ best periods of relative performance typically come early in the cycle. Furthermore, small-caps have outperformed large-caps for a longer-than-average time period (since 1999 on a calendar-year basis, depending on the indexes used). Neither of these observations alone would cause us to make a move, but when combined with the valuation backdrop, we think the odds are very good that large-caps will beat small-caps on average over the next five years.

In terms of implementation, our preference is to use an index fund or ETF (Exchange-Traded Funds) for tactical overweightings; this provides full exposure to the asset class and effectively eliminates the possibility of getting the asset-class call right, but the fund call wrong.

I also want to emphasize that my decision to be underweighted to small-caps has nothing to do with my conviction in the funds we’re selling: we continue to have a very high level of confidence in Laudus Rosenberg U.S. Small Cap and Westport Select Cap.

A Study of Outperforming Managers Reveals Extent to Which They Underperform Along the Way

When assessing underperforming fund managers, it’s only in hindsight that one can judge whether patience was a virtue or a costly mistake. If a manager in the midst of a tough stretch ultimately goes on to turn in stellar long-term performance, investors who stuck around are credited with foresight and discipline. But if the short-term woes turn to long-term underperformance, investors who go down with the ship are judged as complacent, stubborn, or simply naive. In either case, experiencing an ongoing period of underperformance brings to mind writer Ambrose Bierce’s description of patience as “a minor form of despair, disguised as a virtue.” That despair is forgotten if a fund going through a bad patch eventually rewards investors for their patience. But how often is that the case?

Certainly, there is evidence to suggest that even top managers will test their investors’ loyalty. In a famous 1984 speech and subsequent article for Columbia Business School, Warren Buffett presented returns from nine “Superinvestors of Graham-and-Doddsville” who had outperformed the S&P 500 over various long-term periods. A brief perusal of calendar-year returns achieved by these investors shows cumulative long-term outperformance but not consistent annual outperformance. In fact, three of the nine had periods of underperformance that lasted at least three years. It is worth remembering that while a stock holding may initially decline in value, it is the price at which the stock is eventually sold that determines whether or not it was a successful investment. Common traits shared by many great managers include a willingness to own unpopular names, making decisions based on long-term analysis, and having the discipline to ignore sometimes painful shorter-term swings.

At a time when several of our favorite managers have been lagging their benchmarks over the shorter term, I decided it was worth looking at some historical data to re-assess the value of patience. There were a couple of questions I looked to answer. First, I was interested in determining the extent to which funds that outperform over the long-term (10 years in our study) experience shorter-term periods of underperformance within the same timespan. While I don’t generally worry about how long a manager or fund may lag a benchmark, I was curious to discover how often this underperformance stretched over at least three years—a period that would sorely test the patience of both the manager and the fund’s investors. Second, when these long-term outperformers did experience three-year periods of underperformance, I wanted to measure the magnitude of the underperformance. Certainly sticking with a fund that slightly trails its index over three years is easier than sticking with a fund that trails its benchmark by a wide margin (and that may also be skewered by the financial media). By starting with a group of funds that outperformed their benchmark over the long term, I could go back and test how low managers could go (in terms of length and magnitude of underperformance) and yet still reward investors with superior long-term results. I could also determine how common such periods of underperformance are among managers with top long-term records.

In the case of a market environment that doesn’t favor a manager’s edge, I believe patience is warranted. I know of several managers who have maintained their disciplined approach and suffered for it but were eventually rewarded. Managers that have low turnover and take big bets (like many of the managers in our model portfolios) are also more likely to have multi-year periods of relative underperformance. Loomis Sayles Bond Fund expected the U.S. dollar to depreciate and had very large weightings in foreign bonds in 2000 and 2001. It underperformed its benchmark for almost two years because of those positions. But this bet ultimately paid off. Over the next four and a half years, the fund more than doubled the annual return of its benchmark (12.9% versus 5.4%). In a more dramatic example, Longleaf Partners underperformed its benchmark by over 4.5% annualized for the five years from 1995 to 1999. During the next four years, the fund returned over 13% annualized compared to a 2.5% annual return on its benchmark. Examples like the above lend support to our belief that managers who maintain a disciplined approach through periods of underperformance ultimately position their portfolios for later outperformance. If the majority of long-term outperforming funds have extended periods where they lag, then they typically have very significant outperformance during the rest of the period. To be successful, investors need to be there for that outperformance. This suggests that investors should be clear on their reasons for dumping a poor performer and those reasons should go beyond performance. Otherwise they risk big opportunity cost.

There are steps we take to protect your portfolios in the event that a manager goes through an extended period of underperformance. First, where we have large allocations to an asset class, we diversify across managers. Most clients generally have long investment time horizons, these horizons may not coincide with one particular manager’s period of outperformance and so we seek to reduce the portfolio-level risk of manager underperformance by using a combination of our highest-conviction active managers. Second, we prefer to use index funds and ETFs for tactical allocations to be sure that you benefit from shorter-term asset class movements that our active managers may not participate in. Finally, we will remove an underperforming fund from our model portfolios that we uncover any factors which lead us to question the validity or sustainability of that edge. We are not about to claim that our patience will in all cases prove virtuous. We hope and expect, however, that in the aggregate it will be profitable over the long run.

— Stapp Financial Planning, PLLC

This information is also available at www.stappfinancial.com, or you can download a PDF version. To contact us about the newsletter, send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances.