Monthly Investment Commentary

Returns were positive in October for all asset classes we follow. The Dow Jones Industrial Average continued to make news last month as it reached record highs. The S&P 500, a broader measure of large-cap U.S. equities, is also near record levels after returning 3.3% for the month. Small caps gained 5.7%. Growth stocks outpaced value stocks across the market-cap spectrum. Foreign stocks were up about 4%, while short-term local currency emerging-markets bonds gained approximately 1%. Domestic investment-grade bonds had a decent month, gaining 0.7%. Commodity futures reversed course to return 4.7% in October. Our model portfolios trail their benchmarks year to date, but many of our active managers outpaced their respective benchmarks in October, narrowing the gap of underperformance. All models continue to outperform their respective benchmarks over longer time periods.

Stapp Financial Questions & Answers

We regularly use a Q&A format to address questions commonly posed by clients about our investment views and current strategy. The Q&A format has the advantages of letting us address questions individually without worrying about being limited by a particular theme or subject, and allows readers to focus on areas that are of concern or interest to them. This question-and-answer piece addresses questions we received during the past several months.

In September, you overweighted large caps relative to small caps by buying an ETF that tracks the S&P 500 index. If Stapp Financial believes actively managed funds can add value over time, why use an index fund?

It is true that we believe that we can identify active managers who will beat an index fund over time, and we spend considerable resources on this effort. Our confidence in the active managers we select is based on long holding periods, and so we own active managers as long-term, core positions in our portfolios.

On the other hand, we prefer index vehicles for tactical exposure for the simple reason that we aren’t confident that our holding period for a tactical position will be long enough for an active manager to add value. In order to outperform in the long run, good active managers take “benchmark risk,” meaning they are willing to look significantly different from their benchmark. Without benchmark risk, outperformance is not possible, but we know that even top-performing active managers over the long haul commonly have periods, sometimes lasting years, during which they trail their index.

Our confidence in a tactical asset-class weighting, such as our overweighting of large-caps relative to small-caps, is based on fundamental analysis of relative valuations, and is independent of our assessment of managers in those asset classes. We are confident that we’ll make money over time as the valuation disparity unwinds, but we are not confident that an active manager will beat that index during that potentially shorter timeframe, so we see no reason to take the risk of using an active manager. Indeed, there have been periods in the past where our tactical positions would have added more value had we used an index fund, and those experiences are the reason for the evolution in our thinking.

With respect to implementing a tactical position with an index fund versus an ETF, we are agnostic, as it will depend on individual factors such as availability and the frequency and size of trades (which determine the impact of ETF transaction costs).

In light of their strong performance in recent years, what is your outlook for foreign stocks?

We view foreign stocks, overall, as being in a fair-value range both in absolute terms and relative to U.S. stocks, and we think they should generate decent returns over the next five years. A declining dollar would enhance returns from foreign stocks thanks to currency translation, though this same effect would hurt profits of some export-driven foreign companies. Global funds can invest in both foreign and U.S. stocks, and most of the global stock pickers we respect are overweighted to foreign stocks in their portfolios. However, they’ve been saying more recently that they are finding good opportunities in the U.S. among large-cap stocks. Neither argument is sufficiently compelling to sway us from our neutral weighting between domestic and foreign stocks.

What is your expectation about Fed policy over the next few years, and how does that impact your investment strategy?

First, we should point out that Fed policy will be mostly dictated by the economy, and we don’t think it’s realistic to expect to be able to successfully predict the economy. We do consider various economic scenarios in setting our investment strategy. Right now, there are forces pulling the economy in both directions, and we think the housing market downturn will be a key. Recession risk is rising but it’s also quite possible that we will have a soft landing. A strong bond market has historically provided support to housing, but the question is whether this time is different. In terms of investment strategy, we’re not willing to bet either way. Our scenario analysis suggests to us that we have a sufficient level of risk protection in our portfolios at this time.

Has the falling price of oil and gas impacted your case for holding PIMCO CommodityRealReturn?

No. To understand why, it’s important to remember that we did not invest in PIMCO CommodityRealReturn as a bet on rising oil prices or any other particular commodity for that matter. Our basis for wanting exposure to the asset class is its unique characteristics from a portfolio risk/return perspective. The DJ-AIG Commodity Index, on which the PIMCO fund is based, is a basket of 19 commodity futures, not just oil/energy. Energy’s total weighting in the index (including crude oil, natural gas, unleaded gasoline, and heating oil) is currently about 25%. Other commodity types represented in the index, for example, include base metals (26%), grains (19%), and livestock (9.5%). The evidence suggests that a diversified basket of commodity futures provides great diversification for a balanced portfolio since it is practically non-correlated with stocks and bonds. This can lower overall portfolio volatility at the margin, even though the commodity futures asset class by itself can be highly volatile in the short term (as has been the case this year). Importantly, commodity futures have performed very well historically during periods when stocks and bonds have done very poorly, thus providing diversification when it is needed the most.

When we originally established the commodity futures position in our balanced models, we believed the return potential to be in line with, or greater than the potential return for a 60/40 mix of equities and bonds. Our return outlook for commodity futures is not as good as it originally was (in part because the economic cycle is getting mature), while our return expectations for stocks and bonds are slightly better than they were. As a result, we no longer expect commodity futures returns to be competitive with stocks, but we still expect returns to exceed bonds. Combined with the diversification benefits and the hedge it provides against unexpected inflation, we think a small commodity futures position, taken from our bond exposure, contributes positively (albeit slightly, given the small position sizes) to both the risk profile and return potential of our balanced portfolios.

How does the major demographic influence of retiring baby boomers impact your portfolio strategies?

We are familiar with arguments expressed by PIMCO’s Bill Gross and others that retiring baby boomers will increasingly be sellers of their homes and financial assets, and since there could be more sellers than buyers, this may put downward pressure on the markets and the economy.
It is true that the boomers are approaching the winter of their lives, but it’s also true that it will be a long winter. We think the impact on financial markets is likely to be very gradual. While we are looking at an eventual entitlement-related crunch (Social Security and health-care benefits costs) boomers are not going to change their portfolio strategy when they hit 60 because they will have long life expectancies and most will realize that their assets have to last them 20 or 30 years or more. In our opinion it’s premature to be factoring that into our investment strategy.

It’s also worth noting that looking out over the next couple of decades, demographics are not the only major change, so we want to be careful about focusing on one particular development. Another potentially material factor will be the further development of emerging markets. The emerging markets now make up more than 50% of world GDP on a purchasing-power-parity (PPP) basis. Their economies are much improved. For example, foreign debt for emerging market countries is now 75% of exports versus 174% in 1998. A range of factors, including emerging markets’ increasing consumption and capital investment, their impact on the environment, productivity, wages, resource usage, and technology developments could all have a huge impact on the global economy. And who knows, emerging markets may even be buyers of our stocks. So while the certainty and materiality of demographic changes is not debatable, the overall market environment over the next few decades still has plenty of question marks and in our view it’s a bit early to be making portfolio adjustments.

Most of the large-cap funds in your model portfolios are underperforming this year, some of them by a lot. What’s going on?

All managers underperform at times, but it is historically unusual to experience a period where most of our larger-cap equity managers are underperforming at the same time. This has been the case over the past year or so. While this is a source of disappointment, it is not a source of concern for us. First, we’ll discuss some of the reasons for their underperformance, and then we’ll explain why we aren’t concerned.

Managers like Bill Nygren and Bill Miller have gravitated toward high-quality, large-cap companies, many of them former growth-stock darlings. At the same time, they have been underweighted to the better-performing cyclically sensitive stocks. Also, Miller and the team at TCW Select Equities have large allocations to Internet names, like eBay, Yahoo!, Amazon.com, and Expedia that have performed very poorly this year. TCW’s top holding, the auto insurance company Progressive Corp., is also down about 17% this year.

One commonality across these managers is that they run concentrated portfolios. In addition, they are all very long-term investors who are willing to hold onto their names if they believe their fundamental thesis will play out over the course of years, rather than try to jump in and out of names based on shorter-term news flow. They often take positions in unpopular or volatile stocks, and often wind up buying well before a stock begins to turn around. This type of approach requires the very strong discipline to ignore negative short-term sentiment and remain focused on their long-term analysis. Ultimately, whether a stock pick is successful is determined by the price when they sell it, not the price at a given point along the way.

Another common aspect of our managers is that they are bottom-up stockpickers who are not benchmark sensitive—we like this because we believe you need to look different from the benchmark in order to beat the benchmark over the long term. We think this will result in significant good “tracking error” over the long term, meaning they will differ from the benchmark on the upside. But we also recognize that there will be periods when they experience bad tracking error and underperform over some time periods. It is impossible to predict when the variations in either direction will occur.

While we don’t like seeing our managers underperform, we aren’t concerned. The reason is that our extensive initial and ongoing due-diligence process gives us a good understanding of a manager’s investment approach and the edge that we believe will enable our recommended funds to outperform over the long term. The advantage (both for them and us) is that we should be able to distinguish between times when the market environment doesn’t favor a team’s edge and times when that edge has disappeared due to inconsistency, a lack of discipline, or various other reasons. With regard to the specific managers in our model portfolios, we continue to have a very high level of confidence in their ability to beat their benchmarks over the long-term.

Understanding performance cycles also provides important context in assessing manager performance. Underperforming isn’t as much fun as outperforming, but it is an inevitable fact of investing, even for the very best managers. As a published September 2006 study on manager performance made clear, almost all long-term top-performing funds experience lengthy (at least three-year) periods of underperformance relative to their benchmark. Investors must be prepared for this or face the risk of getting whipsawed.

In a recent conference call, Chris Davis (manager of Selected American Shares and the Clipper fund) discussed active management and made the following observation: “Any active manager will go through periods of underperformance. It is inevitable. And when you go through periods of underperformance the question is, does the end client have the conviction to stay invested in those periods of underperformance? If you’re invested in an index you will by definition never underperform. And so it may be the case that there are clients where you will not be able to keep them invested in an active manager when that active manager underperforms. And for them, even if that active manager is going to have a record better than the S&P over a long period of time, that client will not get the benefits of the active management because they will have fired the manager after two or three years of bad performance, which will be inevitable over a 5 or 10 year period.”

We believe that managers who maintain a disciplined approach through periods of underperformance ultimately position their portfolios for later outperformance. Since the majority of long-term outperforming funds have extended periods where they lag, it follows that they typically see very significant outperformance during the rest of the period. To be successful, investors need to be there for that outperformance.

Studies have demonstrated convincingly that most investors show consistently poor timing. They typically buy recent strong performers, often as they approach a cyclical peak in relative performance. They patiently heed the conventional wisdom to remain disciplined through a period of relative weakness, but grow increasingly frustrated, and ultimately throw in the towel somewhere close to the relative performance bottom. Determined not to buy another loser they direct the proceeds into something that’s been working and the cycle repeats. They often own funds that outperform over the long haul but fail to benefit from it.

We believe that the funds we are invested in will perform better than their benchmarks over the long term, and we have a clear understanding from our due diligence of the reasons for that confidence. We also recognize that reaping the benefits of that long-term outperformance requires the patience and discipline to ride out the inevitable periods of underperformance.

Are small- and micro-cap funds really impacted by trading practices of hedge funds? There have been articles in the paper suggesting this is the case, and that mutual fund owners pay for this in the long run. What about other asset classes?

We can only guess the extent to which hedge funds are impacting specific markets. We do know that hedge funds control more than $1 trillion in assets, so it’s likely that their activities are having an impact in many different markets. That said, areas characterized by less-efficient pricing and with limited liquidity, such as small- and micro-cap stocks, are particularly susceptible.
By way of an example, in some cases short-sellers may have created self-fulfilling prophecies with certain small companies, such as Fleming. In Longleaf Partner’s third-quarter 2002 report, they wrote: “Fleming is by far the most controversial company we hold, with the largest short position in it that we have ever experienced as an owner. Whether the shorts end up being right or wrong, their actions are also unprecedented. Their influence in the press, their activism in spreading negative stories, and their personal attacks on Fleming executives represent a level of aggressiveness that is fairly unusual in normal markets.”

Another potential problem would be if fund managers were systematically being front-run by hedge funds that got wind of the fund’s upcoming trades, which obviously could hurt fund performance by bidding up the price of the stock before the fund was able to acquire it. We’ve heard from one manager that this is in fact going on. But again, we don’t know how widespread this is. It seems likely to us that if it continues or spreads, regulatory agencies will take action.

On the positive side, to the extent that stock prices are temporarily moved up or down by hedge funds, at least in theory that could create good longer-term buying and selling opportunities for fund managers. Disciplined long-term investors can take advantage of short-term volatility that isn’t based on a solid assessment of fundamentals.

Do you see any opportunities in hedge-fund-type mutual funds and how they can be used in an overall asset allocation strategy?

Our view is that the appeal of hedge funds is twofold: first, there may be an opportunity to access some highly skilled investors, and second, there is potential diversification benefit from certain hedge-fund strategies—though this may be somewhat oversold.
There are more and more mutual funds that use hedge-fund strategies, which make these strategies accessible to a much larger audience of investors. At this point, though, the overall universe of options in the public mutual fund world is still small. The majority that we have looked at are either unproven or unappealing for any one of several reasons (e.g., excessively high fees, absence of a disciplined investment process, a large asset base, etc.). Another downside is that costs are high, so you really have to be highly confident in the manager’s skill, especially for strategies that are long/short and don’t have an inherent market tailwind behind them.

Consider that even though costs on funds employing hedge-fund strategies are high relative to the rest of the mutual fund world, the profit margins for a public mutual fund are lower than in the hedge-fund world. You have to ask yourself, why would a skilled hedge-fund manager work in the public mutual fund world for a lower profit margin than they can get in the private hedge-fund world?

Another negative of many hedge-fund strategies is that they deliver most of their return as ordinary income or short-term capital gain, and so they are very tax inefficient. Tax inefficiencies and high costs create a considerable headwind. Add to this the growing number of dollars in hedge-fund strategies, often chasing the same opportunities, and it seems unlikely that the level of returns attained in the past will be sustainable.

We’d like to be able to find available hedge-fund strategies that can deliver the return potential and diversification benefit that would make them a positive addition to our portfolios, and we’ve done considerable research in this area. At this point, however, we haven’t found any compelling opportunities.

We are in the season for fund distributions. How do you decide when to avoid buying a fund to avoid getting hit with a big distribution?

It would be convenient if we had a simple algorithm to make this determination, but the truth is that it depends on several factors, and we look at it on a case-by-case basis. The factors we consider include:
• How large is the distribution, and how much is long-term capital gain versus short-term capital gain and ordinary income?
• How significant is the purchase in the context of the overall portfolio? If it’s small and/or discretionary, it might make sense to hold off. If it’s an allocation to an undervalued asset class, where timing could be more important, it’s a tougher call. We don’t have a hard and fast rule, but we weigh the potential opportunity cost of waiting (an uncertainty) against the tax impact (a certainty). If we felt that the potential opportunity cost of missing a market move was large, and/or the tax impact was minor, it would impact our decision.
• Another option is to temporarily buy a different fund (or ETF) in the same asset class, then swap into your desired fund after the distribution. There is a risk that if the ETF moves up you’d trigger a short-term gain to swap into the desired fund, but a short-term gain would be a better outcome than missing the upward move altogether, and in the event the gain was large, you’d still have the option of holding the ETF until it went long term.

— Stapp Financial Planning, PLLC

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