Insider

Heritage investment review: q1 2017

Twelve Months of Calm Seas in the Wake

For the past twelve months, stock returns have been high and the bumpiness experienced to achieve those returns has been low(1). Despite two major events in 2016—Great Britain voting to exit the European Union and a presidential election in the United States—it has been a tame period in which to invest.

During the first quarter of 2017, the volatility index fell to its lowest level since 2007(2): investors are pricing in low stock market risk. Some investors have short-term memories. It’s after calm periods like these that they question the merits of defensive assets. If they become complacent and take more risk than they realize, it may lead to an unpleasant surprise—or even panic— when the markets get choppy.

Although we are pleased you have benefited from high returns without experiencing significant downward swings in your investments, we know this path of performance is unsustainable(3). We believe we can continue to produce returns that will work in your financial plan, meeting the goals we helped you articulate and for which we helped you budget. However, we caution you not to let down your guard and let the past year’s stock market performance lull you into complacency.

Global Stock Markets & Return Premiums Q1 2017

Heritage returned 7.25%(4) in its stock allocation for the first quarter of 2017. This compares favorably with global stock markets, which increased 6.91%(5), and the United States stock market, which increased 5.47%(6).

While the United States stock market’s 5.47% rise for the quarter is strong, developed international countries’ stock markets increased by 7.25%(7) and emerging markets’ stock markets increased by 11.45%(8). Being a global investor helped Heritage achieve a higher return in its stock allocation, relative to investing only in the United States. Having an above-market weight to emerging markets’ stocks further added to return.

In the United States, Heritage’s stock allocation underperformed the market. This is because small capitalization stocks underperformed large capitalization stocks and value stocks underperformed growth stocks. Heritage returned 4.13%(9) in the United States.

In developed international markets, Heritage’s stock allocation slightly underperformed the market. Small capitalization stocks outperformed large capitalization stocks, but value stocks underperformed growth stocks. Heritage returned 6.53%(10) in developed international markets.

In emerging markets, Heritage’s stock allocation well outperformed the market. Small capitalization stocks outperformed large capitalization stocks, but value stocks underperformed growth stocks. Heritage returned 14.41%(11) in emerging markets.

The combination of Heritage’s returns within global stock markets and the significant positive effect of our overweight to emerging markets resulted in outperformance in your stock allocation.

The U.S. Bond Market Q1 2017

Interest rates changed very little over the first quarter of 2017. The Bloomberg-Barclays U.S. Aggregate Bond Index increased 0.82%. Heritage’s investment grade bond allocations slightly outperformed the index(13).

A return of 0.82% from investment grade bonds for a quarter is reasonable, especially given the current rate of inflation. Investment grade bonds are meant to reduce portfolio risk, preserve capital, and produce positive real returns over time. According to these criteria, the bond market is continuing to produce the sought-after results.

Heritage also targets higher returns in bonds with credit and currency risk. Our strategy in this area, that invests in global bonds, including emerging markets’ bonds, produced a return for the quarter of 4.61%(14). This return buoyed our bond allocations’ returns, resulting in outperformance of the index.

Alternatives Underperform Traditional Markets

Heritage currently allocates to three alternative strategies: trend-following managed futures, reinsurance, and style premia.

Trend-following managed futures, our only strategy to underperform stocks and bonds in 2016 and during the first quarter of 2017, ended the quarter down 0.91%(15).

Reinsurance accrues its return relatively steadily over the first few months of the year, with an acceleration in risk and potential return in the latter part of the summer and early fall. Our strategy was up 1.57%, which is a strong pace in general, and especially for this low-risk time of year.

Our style premia strategy was up 1.11%(17) for the quarter. While positive and within range of our quarterly goal, it is tracking a bit behind pace of our target annual return for the strategy in the middle-to-upper single digits.

It is important to remember the combined alternative investment strategies Heritage has utilized over the past three years has been the strongest performing segment of its portfolios—ahead of either stocks or bonds. It also serves the critical purpose of reducing overall portfolio risk by having returns that differ from stocks and bonds.

From this standpoint, despite the unimpressive first quarter to 2017, over the past three years, alternative investments have been working by adding to return and lowering risk. Should stocks perform poorly in a future period, we will look to our alternatives to perform well and allow us to reallocate capital profitably when we can buy stocks at a bargain.

Concluding Remarks

Individuals who took stock risk in the first quarter of 2017 were rewarded, particularly in emerging markets. The more aggressive your investment objective, the higher was your return. Each investment objective performed at a pace beyond the rate we project in your financial plan—meaning that your plan, from investments, is healthier than projected at the start of the year.

The last twelve months has been a smooth environment in which to invest. We were able to materially participate in the returns of the stock market during this period. But, we implore you to consider the few months that preceded the most recent twelve—the beginning of 2016 when the United States’ stock market had its worst start to a year in history. The stock market is volatile; the average intra-year decline in the S&P 500 is 14%(18). Risk has been dormant, but is unlikely to remain so. Do not get lulled into a sense of complacency and enter unprepared into a harsher environment.

We’ll help you navigate and stay the course with your investment objective; rebalance, taking some gains off the table when appropriate; and remain firm in the non-stock allocations in your portfolio, that may well come in handy should there be rougher waters over the horizon.

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Sources:

  • The MSCI All Country World Index, TR, USD, representing stocks broadly, increased 15.04% between the end of March 31, 2016 and the end of March 31, 2017. During this time, its annualized volatility with a daily observation frequency was 8.54%. The Raw Sharpe Ratio was therefore 1.76, which is historically high
  • “VIX Options and Futures Historical Data.” CBOE.com/products/vix-index-volatility/vix.options-and-futures/vix-index/vix-historical-data. CBOE. 13 Apr. 2017.
  • This applies broadly to Heritage’s base of clients, particularly those with larger proportions of their portfolios in stocks; this may not apply to individuals based on, but without limitation to, portfolio legacy securities, portfolio size, outside accounts, tax considerations, investment accreditation and personal preferences
  • Heritage’s target stock allocation is: 50% DFA U.S. Core Equity 2 (DFQTX), 16.67% DFA International Value (DFIVX), 8.33% DFA International Small Cap Value (DISVX), 16.67% DFA Emerging Markets Value (DFEVX), and 8.33% DFA Emerging Markets Small Cap (DEMSX); returns assume daily rebalancing to target weight
  • The global stock market is represented by the MSCI All Country World Index, NR, USD
  • The United States stock market is represented by the Russell 3000 Index, TR, USD
  • Developed international countries’ stock markets is represented by the MSCI EAFE Index, NR, USD
  • Emerging markets’ stock markets is represented by the MSCI EM Index, NR, USD
  • Heritage’s stock allocation in the United States is 100% DFA U.S. Core Equity 2 (DFQTX)
  • Heritage’s stock allocation in developed international countries is 2/3 DFA International Value (DFIVX) and 1/3 DFA International Small Cap Value (DISVX)
  • Heritage’s stock allocation in emerging markets is 2/3 DFA Emerging Markets Value (DFEVX) and 1/3 DFA Emerging Markets Small Cap (DEMSX)
  • The United States Market is represented by the Russell 3000 Index, TR, USD; the United States Small segment of the market is represented by the Russell 2000 Index, TR, USD; the United States Value segment of the market is represented by the Russell 3000 Value Index, TR, USD; the Developed International Market is represented by the MSCI World ex USA All Cap Index, NR, USD; the Developed International Small segment of the market is represented by the MSCI World ex USA Small Cap. Index, NR, USD; the Developed International Value segment of the market is represented by the MSCI World ex USA Value Index, NR, USD; Emerging Markets are represented by the MSCI EM Index, NR, USD; the Emerging Markets Small segment of the market is represented by MSCI EM Small Index, NR, USD; the Emerging Markets Value segment of the market is represented by MSCI EM Value Index, NR, USD; Heritage’s United States stock return is that of DFA U.S. Core Equity 2 (DFQTX); Heritage’s Developed International stock return is the composite return of two funds held at constant weights, DFA International Value (DFIVX) 2/3 and DFA International Small Cap Value (DISVX) 1/3 Heritage’s Emerging Markets stock return is the composite return of two funds held at constant weights, DFA Emerging Markets Value (DFEVX) 2/3 and DFA Emerging Markets Small Cap (DEMSX) 1/3
  • Heritage’s investment grade bond allocations are composite returns of bond funds held at constant weights: 100% DoubleLine Total Return Bond (DBLTX); 50% DoubleLine Total Return Bond (DBLTX), 50% FPA New Income (FPNIX); and 1/3 DoubleLine Total Return Bond (DBLTX) 1/3 FPA New Income (FPNIX), 1/3 Vanguard Intermediate Term Investment Grade (VFIDX). Heritage may, based on tax considerations, variously replace the abovementioned funds as follows: FPA New Income (FPNIX) with Vanguard Short Term Tax Exempt (VWSUX); DoubleLine Total Return Bond (DBLTX) with Vanguard Intermediate Term Tax Exempt (VWIUX); and Vanguard Intermediate Term Investment Grade (VFIDX) with Vanguard Long Term Tax Exempt (VWLUX)
  • Heritage’s fund in its credit-and currency-driven bond allocation is Templeton Global Total Return (TTRZX)
  • Heritage’s trend-following managed futures allocation is 50% AQR Managed Futures Strategy High Volatility (QMHRX) and 50% LoCorr Market Trend Fund (LOTIX)
  • Heritage’s reinsurance allocation is a composite of funds, held at constant weights, with two sets, chain-linked and time-weighted. Data from January 1, 2017 through February 17, 2017 include the following funds in the following proportions: 50% Stone Ridge Reinsurance Risk Premium (SRRIX) and 50% Pioneer ILS Interval Fund (XILSX); data from February 18, 2017 through March 31, 2017 only includes Pioneer ILS Interval Fund (XILSX)
  • Heritage’s Style Premia strategy is 100% AQR Style Premia Alternative (QSPRX)
  • “Guide to the Markets.” J.P. Morgan Asset Management. 31 Mar. 2017. Slide 13.