Heritage Investment Review: Q3 2017

Year-to-Date Summary

The first three quarters of 2017 has been a good period to invest; the stock market produced significant gains with exceptionally low volatility. Our clients have participated in this steady appreciation.

Embedded in the strong returns we achieved through the first three quarters of this year are investment decisions that may seem simple at first glance, but upon closer review required careful thought and discipline.

We allowed our stock exposure to grow through the political turmoil—letting our winners continue to win. This worked particularly well. Now that we’ve captured a large benefit from having our stock exposure increase through the stock market’s rise, we believe it’s prudent to take profits.
We maintained a global allocation to stocks. Developed international markets outperformed the United States by 6.05% over the first nine months of the year and emerging markets outperformed the United States by 13.87%.

We preserved the vast majority of gains we’ve made in the reinsurance asset class by reducing exposure at the end of 2016 and again at the beginning of 2017, and by switching managers. We were an early adopter of direct reinsurance contracts, adding a position with the first viable entrant to market in late 2013. Reinsurance outperformed stocks and bonds over the subsequent three years i. After accruing market-beating returns, we scaled back our exposure by 65%; this benefited us as the strategy sustained its first meaningful losses in the third quarter of 2017.

We added a new position in high-yield municipal bonds where we deemed it appropriate, based on clients’ marginal federal income tax brackets. Post-2016’s presidential and congressional elections, high-yield municipal bonds sold off while high-yield corporate bonds continued to perform well along with the stock market. The opposite performance in these two markets reflected anticipation of a lower tax policy. While this reaction may still be directionally correct, we viewed the magnitude as an over-reaction.

Global Investors in Stocks

The United States stock market has been a great place to invest since the end of the Financial Crisis of 2007 – 2009. A difficult discipline when investing is staying true to your philosophy after periods during which it doesn’t play out.

At the beginning of 2016, we reviewed our thesis that investors should have a global perspective in portfolio construction. After re-examining theory and recent empirical evidence, we concluded it made as much sense as it did in the past—and due to the relative performance over the preceding years, it was possibly even a better time than ever to diversify across the globe. We bought international stocks in January 2016.

Our perseverance in this course paid dividends almost immediately thereafter. Through the third quarter of 2017, investing internationally has added considerably to return.

With strong returns in stocks across the globe, we believe it’s a prudent time to take profits from each of these markets and reallocate the capital to other asset classes.

Reinsurance Exposure

In 2013 the private wealth industry was introduced to direct exposure to reinsurance contracts through an innovative structure, the closed-end interval fund. Heritage was a pioneer in this asset class, adding an allocation to client portfolios.

In the subsequent three years, reinsurance produced strong returns with low volatility, and without any meaningful correlation to other capital market assets. Our position outperformed stocks and bonds ii.

As time passed, we monitored the reinsurance market and recognized two important developments. The first involved a new entrant to the space. The second involved the return-to-risk tradeoff following years with few events and additional third-party capital flowing into the industry.
Our original manager enjoyed a first-mover’s advantage in a unique space. As time passed, a new entrant came to market with a competitive product at a lower cost. After due diligence, we decided to change managers.

While making this transition of managers, we also made the decision to reduce our average exposure to the reinsurance asset class by 65%. The reinsurance market is one in which the insurance premiums received are largely known at the beginning of the year. The risk of an event that triggers an insurance contract is fairly stable from year-to-year. When one sees premiums come down, the logical portfolio adjustment is to reduce the positon’s size.

Hurricanes Harvey, Irma, and Maria produced losses in the reinsurance industry in the third quarter of 2017. Our decision to reduce exposure saved the gains we made over the past three years. Our decision to change managers also helped, as our new manager outperformed our original manager.

We believe the combination of reducing exposure to reinsurance with switching managers controlled risk appropriately, and preserved the gains we’ve made in this strategy over the past three years.

Municipal Bonds

Municipal bond interest is generally exempt from federal income tax, state income tax (if issued by a municipality in the state of the filer), and not subject to the Medicare surtax on investment income. As such, municipal bonds tend to trade with lower yields compared to similarly risky corporate bonds.

Post President Trump’s election and the election of a majority of Republicans in both houses of Congress, the municipal bond market reacted (perhaps overacted) to the likelihood of income tax reductions. Municipal bond prices fell while corporate bond prices and stock prices rose. At June 30, 2017, high-yield municipal bonds were trading at over 100% of the yield of high-yield corporate bonds.

Although income tax cuts would reduce the benefit of municipal bonds compared to corporate bonds, municipal bonds should still provide a tax benefit relative to corporate bonds. Municipal bonds trading at a yield effectively equal to corporate bonds, in our opinion, is a relative value. Taking the extreme scenario in which the municipal exemption is eliminated, like-for-like credits should trade at an equal yield.

The dislocation in the high-yield municipal market provided an attractive opportunity to add an allocation to clients’ portfolios, provided they’re in a high federal income tax bracket and don’t have the ability to shelter a significant amount of income-producing assets in tax-advantaged accounts.

Concluding Remarks

Across most asset classes, the first three quarters of 2017 brought strong returns with historically low levels of volatility. We’ve let our winners win, which was beneficial as stocks continued to rise. We now believe it’s prudent to take profits and reduce risk in stocks.

This year we’ve orchestrated investment allocation decisions that have added value. We persevered in our global approach to investing and captured the excess returns produced by international markets.

We reduced exposure to the reinsurance asset class after years of strong performance and switched to a manager who outperformed during a time of stress, preserving the gains we’ve reaped from the strategy.

And we took a contrarian position in the high-yield municipal bond market, with the thesis that the market over-reacted to the potential for revisions in tax policy.

The more important decision, however, has been to remain invested for the long-term. Missing a strong year by selling out of the stock market may be unrecoverable for over a decade. Participating in capital markets and taking profits through disciplined rebalancing after good years is a prudent way to harvest gains while managing risk.

Disclosures And End Note

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, accounts with limited investment options, tax considerations, investment accreditation and personal preferences. Past performance may not be indicative of future results.

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  • i. Source: Stone Ridge Asset Management LLC. The mutual fund Heritage allocated to over the period (SRRIX) is used to represent reinsurance. The MSCI All Country World Index represents stocks. The Bloomberg Barclays U.S. Aggregate Bond Index represents bonds.
  • ii. ibid