Adjusting the Focus
The first half of 2018 has been a difficult investment environment. United States stocks narrowly produced a positive return of 2.06% while developed international stocks were down 4.94% and emerging markets stocks were down 7.59%. Heritage’s alternatives allocation was down 5.75%. Investment grade bonds were down 0.43%.
This comes on the heels of a strong 2017. Stocks were up in the high-teens to 34.26%. Heritage’s alternatives allocation was up 5.05%. Investment grade bonds were up 3.57%. This was a great year to be an investor.
One of the challenges for investors is adjusting their focus properly. If you focus on what’s six inches from your nose you lose clarity of the big picture. Conversely, if you focus on what’s off in the distance, you lose the details of objects in the foreground.
We view the proper focus to be the one that most closely matches an investor’s time horizon—which isn’t a straightforward, precise number. Yet, nearly all of us who are investing for the future have an investment time horizon that’s far longer than six months.
When we zoom out from the first six months of 2018 a little bit to include the twelve months of 2017, there are a few important bigger picture points to pick up.
Over the full period, stock returns were healthy. Annualized returns were as follows: United States stocks, 13.79%; developed international stocks, 13.21%; and emerging markets stocks, 15.46%.
Investment grade bonds’ annualized return was 1.85% (above the average yield on 1- to 3-year Treasury notes over the period). Heritage’s alternatives allocations effectively produced no return.
We don’t believe investors can accurately and consistently time short-term market returns; but we have some insight into what long-term average returns for various asset classes should be. Therefore, we operate with a broader focus.
We instill discipline in our investment process to help our clients achieve the long-term asset class and strategy returns we believe exist and which are supported by empirical data. For this long-term expected gain (such as with emerging markets stocks) we accept the inevitable short-term bumps along the way. We are willing to do this because, in the big picture, the next step isn’t as important as going in the right direction.
Not to Lose the Details
Focusing on long-term asset class returns and the return premiums we believe should add value over time doesn’t mean missing the important details in the investment process, it is a detail.
We believe emerging markets stocks will provide a return premium to developed markets. Seeing emerging markets stocks go from the top of the list to near the bottom of the list is normal; it’s a volatile asset class and its high average expected return is a result of its high volatility. Expect to see near-top and near-bottom rankings from this asset class again in the future.
It’s in strategies, as opposed to asset classes, that try to exploit mispricing where we believe particular care needs to be taken. Heritage’s alternatives allocation is the obvious location of strategy-driven returns as opposed to asset class-driven returns. Before reviewing Heritage’s alternatives allocation, however, it’s worth examining our strategies within our traditional stock funds.
The Value Premium
In addition to market returns, Heritage’s stock allocation includes a strategy to capture the value, small cap, and profitability premiums. The value premium is the tendency for inexpensively-priced stocks to provide higher returns than expensively-priced stocks. The small cap premium is the tendency for smaller companies to outperform larger companies. And the profitability premium is the tendency for highly profitable companies to outperform unprofitable companies or companies with low profits.
The value, small cap, and profitability premiums within stocks don’t work out every year, but we believe the empirical evidence and economic intuition are strong that they do over time. Value underperformed growth significantly in the first half of 2018. We believe this is another instance where focusing on the big picture is important in gaining perspective on recent performance.
The value premium in U.S. stocks in the first half of 2018 was -8.60%. From an historical perspective,—zooming way out over the past 90 years,—this appears to be a small bump in an overall good strategy. Living it over half a year feels less benign. Heritage gains exposure to value stocks in two ways: modest tilts in its traditional stock funds; and AQR’s Style Premia Strategy (Absolute Return) which uses a long-short approach to extract the value premium without market exposure. The value premium hurt Heritage’s performance both within stocks and within Heritage’s alternatives allocation in the first half of 2018. AQR’s Style Premia Strategy was down 7.40%. Losses of this magnitude over a relatively short period of time are frustrating, especially when it affects a non-correlated alternative investment while it’s affecting the traditional stock funds.
Many famed investors are self-proclaimed value investors, implementing strategies with the same general premise as Heritage. However, as with any rational style of investing, there are extended periods during which it underperforms. After the decade leading to the peak of the “Tech Bubble” in the late 1990s, value investors were persecuted for not appreciating the potential of growth stocks in a newly defined investment landscape. Certain investors got weak knees and fled their value-investing strategies to participate in the tech boom. Then, starting in 2000, the value premium flourished for seven years (with 34% and 22% outperformance in 2000 and 2001 alone). For the past decade, growth-priced stocks have again outperformed value-priced stocks (modestly). These are times when discipline matters most. At Heritage, we do not intend on abandoning value investing.
Alternative Investment Strategies
Particular care needs to be taken when investing in strategies where exploiting mispricing drives returns. Our alternatives allocation deserves to be placed under the magnifying glass. The strategies within our alternatives allocation include: reinsurance, absolute return, and systematic trend-following managed futures.
Reinsurance was at the bottom of the return list in 2017—it lost 7.16% in a year during which most asset classes performed exceptionally well. It was down due to the string of natural disasters in the late-summer and early-fall of 2017.
Through the first half of 2018, reinsurance is at the top of the return list. This is not surprising. In an environment in which global stocks and bonds are down, we would make an educated guess that reinsurance would end up near the top of the list.
We added to our reinsurance position in 2018 based on the belief that the prospective base-case return—independent of the stock market’s return—is strong. Should there be an average hurricane season and no other major natural events in 2018, we expect a strong return through the second half of the year.
Our absolute return strategy is our liquid alternative to what many consider “hedge fund strategies.” It aims to provide returns that are at all times independent of stock market and bond market returns.
The fund was up 12.10% in 2017 and is down 7.40% in the first half of 2018. Although below expectations, over the full period, it slightly outperformed investment grade bonds.
The strategy is based on strong evidence of certain styles or return premiums that have persistently and pervasively manifested themselves in financial markets over time. The value premium (or style), as discussed above, resulted in the strategy’s drawdown in 2018. We look at the evidence from a distance, and conclude the theory behind the strategy is still sound.
It’s also worth mentioning valuations in stocks and bonds remain historically elevated. It’s in these environments that forward-looking returns (again, over a longer timeframes) tend to be lower than average. An absolute return strategy is relatively more attractive when traditional asset prices are high.
Systematic trend-following managed futures sat near the bottom of the list in 2017 with a meager return of 1.12%. It sits at the bottom of the list through the first half of 2018 with a decline of 8.50%. Over the whole period, the annualized decline is 5.05%.
The strategy will have both positive and negative net market exposures over time. It’s founded on data showing asset prices trend (their own past returns help explain their future returns).
The data supporting this strategy are strong. Given the recent performance, it’s natural to search for reasons why it hasn’t worked recently and extrapolate them into the future. One can come up with subjective, feasible stories that things are different this time in almost all investments.
At the end of the day, we allow long-term, historical data to lead us objectively. To recognize the possibility of a changed environment, we stress test historical returns. Even with large discounts to the strategy’s historical record, maintaining an allocation helps produce a superior portfolio for a wide range of return targets.
All of our alternative strategies are thoughtfully selected and thoroughly scrutinized. As we step back farther from the last year-and-a-half (as we have in investment reviews in the past) it’s evident that our alternatives allocation has added value. We believe it will again.