Heritage Investment Review: Q2 2016

An investor with $1 million set her allocation on the last day of 2015 to 60% in global stocks and 40% in bonds. She left for Tuscany determined to completely relax. As part of this she resolved to avoid reading any newspapers or articles on the markets. She took a deep breath and determined to not check in on her investments at all. She called this her financial sabbatical.

Returning home refreshed on July 13th, 2016 she picked up The Wall Street Journal from her walkway. She energetically strode into the house, put down her bags, and plunked the newspaper on the table. Glancing down at the front cover she noted the headline.


Source: Otani, Akane. “Dow, S&P 500 Close at Record Highs.” The Wall Street Journal. 12, July 2016. Web. Heritage has created the image of a newspaper on which the actual article date and title are displayed for visual purposes only.

After settling in that evening she sat down with her laptop and cup of tea. Scrolling through her e-mails she found her quarterly performance report for the first half of 2016. Opening her portfolio summary for June 30, 2016 she perused her performance data.


Source: Morningstar Office, Inc. U.S. Stocks are represented by the Russell 3000 TR index. Developed International Stocks are represented by the MSCI EAFE NR USD index. Emerging Markets Stocks are represented by the MSCI EM NR USD index. Bonds are represented by the Barclays U.S. Aggregate Bond index. Investors are unable to access indices directly, which don’t include fees and implementation frictions.

This investor might close her portfolio with a slight (although, possibly unenthusiastic) smile and once again get on with her life; she’s on pace for a 5.35% annual return, which is decent given her asset allocation.

What she didn’t see—what didn’t cause her to panic—what didn’t cost her a whit of sleep—is that U.S. stocks had the worst start to a year in history. China was on all the pundits’ lips: surely it was headed for a deep recession that would drag the world down with it. Some of The Wall Street Journal headlines she missed are reproduced below.1


Source: All article titles and dates from The Wall Street Journal. A list of bibliographical citations for each of the articles is available upon request. Heritage has created the images of newspapers on which the actual article dates and titles are displayed for visual purposes only.

An individual closely following financial markets witnessed U.S. stocks down 11.29%, developed international stocks down 12.95% and emerging markets stocks down 13.28%, all less than two months into the year. In the chart below, our investor saw the returns represented by the dots, but didn’t experience the emotional swings of the volatility represented by the wide ranges.


Source: Morningstar Office, Inc. U.S. Stocks are represented by the Russell 3000 TR index. Developed International Stocks are represented by the MSCI EAFE NR USD index. Emerging Markets Stocks are represented by the MSCI EM NR USD index.

We stress to our clients to be investors, not speculators. We coach them to settle on a good financial plan; we assist them by determining and implementing an appropriate asset allocation; and we ask them to resolve to stay the course and allow the vagaries of the short term to disappear in the long term. The long term is much longer than half a year. And this isn’t to say ignore your quarterly performance reports. It is meant to demonstrate that market psychology can cause people undue stress and short-term opinions are generally fallacious. Trust your advisor—feel free to let go a little: pay attention to those things that matter most in your life—and trust your plan and your asset allocation to work.

Emerging markets led global equity returns, up 6.41% over the first half of the year. The United States equity market was up 3.62% and developed international equity markets were down 4.42%. The U.S. equity market makes up approximately half of the global equity market—it also makes up half of Heritage’s equity allocation. In their international equity exposure, Heritage’s clients are underweight developed international markets—Japan, the United Kingdom, much of Western Europe, Canada, Australia—and overweight emerging markets— China, South Korea, Taiwan, Brazil, South Africa, India. Relative to the global equity market, Heritage’s clients held a higher percentage in the equity markets that performed the best and a lower percentage in the equity markets that performed the worst.


Source: Morningstar Office, Inc. U.S. Stocks are represented by the Russell 3000 TR index. Developed International Stocks are represented by the MSCI EAFE NR USD index. Emerging Markets Stocks are represented by the MSCI EM NR USD index.

On top of the benefit from asset allocation, security selection also added to Heritage’s clients’ returns. Heritage targets return premia within equity markets, as suggested by evidence-based, academic research. These are most prominently the small company premium and the value premium. These premia offset across the developed world. In emerging markets, they drove outperformance of the index by 3.47%. The combined effect of asset allocation (more in emerging markets) and security level outperformance (performance better than the index) was a strong half-year of performance in equities for Heritage’s clients.


Source: Morningstar Office, Inc. Heritage’s return in: United States stocks is represented by DFA U.S. Core II (DFQTX); Developed International stocks are represented by 2/3 DFA International Value (DFIVX) and 1/3 DFA International Small Cap Value (DISVX) and Emerging Markets stocks are represented by 2/3 DFA Emerging Markets Value (DFEVX) and 1/3 DFA Emerging Markets Small Cap (DEMSX).

After adding significant value in 2014 and 2015, Heritage’s alternative investments produced small positive returns over the first half of 2016. Heritage’s alternatives allocation underperformed the ratio of capital moved from stocks and bonds to purchase it. Heritage’s alternatives allocation returned 1.23%; its four major sub-categories ranged from 2.75% to -0.30%.


Source: Morningstar Office, Inc. Style Premia is represented by AQR Style Premia Alternative (QSPRX); Reinsurance is represented by Stone Ridge Reinsurance Risk Premium (SRRIX); and Managed Futures is represented by two funds held at constant weights: ½ LoCorr Market Trends (LOTIX) and ½ AQR Managed Futures Strategy HV (QMHRX).

Bonds continued to perform well. The Barclays U.S. Aggregate Bond index increased by 5.31% over the first half of 2016. The majority of this return is the result of continued interest rate declines and, therefore, higher returns for investing in longer-maturity bonds.


Source Information: Daily Treasury Yield Curve Rates are published by the U.S. Department of the Treasury.

In order to fund alternative investments, Heritage holds less in bonds than a portfolio consisting of only traditional assets. Within the bond portfolio, our underlying holdings have a low duration. Heritage’s primary investment grade bond strategy was up 3.22%. While this return is below the increase in the Barclays U.S. Aggregate Bond index, we note that it is still a healthy absolute return in a low-yield environment. Our clients are positioned to outperform this index if the yield curve doesn’t change or if interest rates rise. Our clients will likely underperform if rates continue to move lower, but will still achieve acceptable absolute returns. We are willing to accept lower upside if interest rates decline for lower downside if interest rates increase.

We sincerely appreciate the trust you place in us to manage your wealth. We take our job seriously to keep you focused on the long term and to coach you to behave as an intelligent investor. We look forward to helping you navigate thoughtfully in an investment environment with record-low interest rates and through the inevitable highs and lows of equity markets that throw so many others off course.

This newsletter has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security, product, service or investment. The opinions expressed herein do not constitute investment advice and are subject to change without notice. Heritage customizes client portfolios based on individuals’ financial situations. Various components of this commentary may not be relevant to each client’s personal portfolio due to, without limitation, portfolio legacy securities, portfolio size, outside accounts, tax considerations, investment accreditation and personal preferences. Past performance is not indicative of future results.