Heritage Investment Review: Q2 2017

The Liberating Feeling of an Investment Plan

An investment plan is far different from buying and selling hot stocks and dreaming of turning a small amount of money into a fortune. It starts with a well-thought-out financial plan that carefully evaluates your financial position and cash flows. The investment plan is then created out of the financial plan, and recognizes each individual or family has a certain capacity to take risk with the assets that make up their portfolio.

As a Heritage client, one of our goals is to understand your ability and desire to take risk. We then build a portfolio to deliver the best returns we prudently can, consistent with your capacity to take risk. We’re professional risk-takers on your behalf, to generate returns. Taking risk means you have to stay the course, even when the world appears to be a frightful place.

In every period there are (often legitimate) concerns in the world. If it’s not Grexit (2012) it’s Brexit (2016). If it’s not Kim Jong-il (1994 to 2011) it’s Kim Jong-un (2012 to present). Since the Financial Crisis of 2008 it’s been the PIGS (2010), the Fiscal Cliff (2011), Grexit (2012), the Taper Tantrum (2013), The Oil Collapse (2014), The Chinese Implosion (2015), and Brexit (2016). And whether you’re a Democrat or a Republican, from your perspective, about half of the time the wrong party is in charge. Every year there’s something scary—and scary things can be an excuse not to invest.

A reasonable portion of most individuals’ wealth should be participating in financial markets’ gains. This doesn’t mean you should disregard the risks of markets (indeed, some of your investments likely have the explicit purpose of capital preservation)—but it does mean you should be a long-term investor, year-after-year reaping the returns provided by assets in financial markets.

Despite angst about relatively high stock and bond prices, an aged bull market, and divisive politics in the United States, it was important to remain invested throughout the first half of 2017. Stocks enjoyed a strong second quarter on top of a strong first quarter. While the Fed continued gradually raising interest rates, the investment grade bond market generated a healthy real return.

Global Investors in Stocks

Across the globe, investors tend to ‘over-invest’ in their home countries. If you’re ever having a conversation with an international friend, ask her how much she owns, as a percentage of her stock portfolio, in her home country. The answer will probably be very different from your portfolio.

The tendency for individuals to own stocks of companies in their home country is called the home country bias. In investment management, this is a common behavioral mistake. It results in ‘under-diversification,’ which means an individual accepts a lower return, higher level of risk, or a combination of both, relative to a globally well-diversified portfolio.

In the United States, this is less of a problem than around the world (mostly because the United States has such a large stock market). The United States accounts for about 52% of the value of the entire world’s stock market. The average United States citizen invests 75% of his stock portfolio within the United States. In many countries whose markets make up a mere fraction of the global stock market, individuals have a much more serious problem. Imagine the unnecessary risk of investing over 90% of your stock portfolio in India or Turkey.

Heritage starts by investing its stock portfolios according to the percentage each country makes up of the global stock market. By avoiding a home country bias, we believe our clients receive a diversification benefit relative to their peers. The main benefit of diversification is a reduction in risk. To balance the benefit between a better return and a reduction in risk, Heritage tilts its portfolio in the international segment towards emerging markets. Although this allocation decision doesn’t work every year, it has worked well in the first half of 2017.

Alternative Investments

The private wealth management industry tends to hew a close line to a 60% stock, 40% bond portfolio for most everyone. A money manager dealing with individuals is unlikely to lose business if her returns are close enough to the crowd’s. At Heritage, we use an institutional framework for asset allocation, including significant non-traditional investments. We’re willing to be different from the crowd to produce what we think are better portfolios at the end of the day.

Part of being different from the crowd is experiencing periods during which your positioning isn’t paying off. In 2016 and the first half of 2017, our alternative investments have dribbled out small negative returns. The underlying sub-strategy managed futures is the main cause of this drought in performance.

Managed futures is a trend-following strategy covering most traded assets (stocks, commodities, bonds, and currencies). The strategy tends to perform particularly well during the worst environments for stocks. Although its recent performance has not been good, we remain confident that over time it’s an appropriate strategy to include in a portfolio.

It’s easy to forget the benefits of alternative investments. In 2014 and 2015, our alternative investments added significant value to clients’ portfolios.

Investing is hard emotionally because the timeframe for rational choices to bear fruit is measured in decades. Even though alternative investments have been difficult for the past year-and-a-half, they have produced strong absolute returns, and a different stream of returns from the crowd.

A different stream of returns, and better overall returns, is the goal of alternative investments. That tends to feel good when others are not performing particularly well and bad when others are thriving.

The past year-and-a-half has been a calm time to invest in stocks. In this environment, traditional stock-bond investors have had their day. But it doesn’t take many years in the rearview mirror to understand the balancing effect of alternatives on a portfolio’s stream of returns and its potential to add to total return.

We believe the psychological cost of being different is worth the better outcome in the end—a smoother overall ride to a higher return. Looking back over the years, alternative investments have smoothed the ride to higher returns.

Concluding Remarks

Heritage’s job is to walk the very fine line between investing humbly and boldly. We believe you should always be invested in stocks for the long-term—it’s a great way to compound wealth. We make sure our clients have enough of their money in the stock market to materially participate in its returns. We’re humble enough to know we can’t call peaks and troughs in the stock market; we take the long-term view of investing without buying in and selling out frequently.

However, we’re also bold enough to invest in non-traditional strategies when the investment case is strong. Some believe it’s better to fail conventionally than to succeed unconventionally—we disagree.

One of the best ways for us to succeed in being unconventional is to communicate clearly and paint the whole picture for our clients. You’ve participated in strong returns along with the market. We differ from other market participants in a few important ways. Over any short period, some of those differences will be working in your favor while others will not. During the first half of 2017, investing globally worked in your favor, while investing in alternative investments did not. However, over the past three years, investing in alternatives investments has worked in your favor.

As we move into the second half of 2017, we believe you are well positioned to continue to participate in the returns of the global stock market; we also believe our alternative investments should smooth out the path of returns should traditional markets slow down, while providing opportunistic capital for rebalancing.


Table 1: Performance from each segment of the global stock market are represented by the mix of mutual funds managed by Dimensional Funds Advisors (“DFA”) that Heritage targeted across its portfolios. The United States is represented by DFA U.S. Core 2 (DFQTX); Developed International Markets are represented by 2/3 DFA International Value (DFIVX) and 1/3 DFA International Small Cap Value (DISVX). Emerging Markets are represented by 2/3 DFA Emerging Markets Value (DFEVX) and 1/3 DFA Emerging Markets Small Cap (DEMSX).

Table 2: HFS Managed Futures is the chain-linked performance of Altegris Futures Evolution Strategy (EVOIX) from the beginning of 2014 through mid-August 2015 with that of ½ AQR High Vol Managed Futures Strategy (QMHRX) and ½ LoCorr Market Trends (LOTIX) through the end of the first half of 2017. HFS Style Premia is the chain-linked performance of PIMCO All Asset (PAAIX) from the beginning of 2014 through mid-August 2014 with that of AQR Style Premia (QSPRX) through the end of the first half of 2017. HFS Reinsurance is the chain-linked performance of Stone Ridge Reinsurance Risk Premium (SRRIX) from the beginning of 2014 through mid-November 2016, with ½ Stone Ridge Reinsurance Risk Premium (SRRIX) and ½ Pioneer ILS Interval Fund (XILSX) from December 2016 through February 2017, and Pioneer ILS Interval Fund from February 2017 through the end of the first half of 2017.

Table 3: Stocks are represented by Heritage’s global stock performance, composed of the internal mix of funds by geographical segment as noted above. Each segment is held in the following ratio: United States, 50%; Developed International Markets, 25%; Emerging Markets, 25%. Bonds are represented by the Bloomberg-Barclays U.S. Aggregate Bond Index. HFS Alts are the target-asset-weighted time series of returns of its major sub-strategies, as disclosed above. We believe these measures accurately represent the aggregate client experience.

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