As an active manager one of the toughest psychological tasks is to invest for the long-term but have to deal with the daily noise and chatter of the markets. The unrealistic expectation of having superior performance over all measurable holding periods leads to behavior often inconsistent with the goal of prudent long-term capital accumulation.
Given the volatility of capital markets a lot can happen over the short-term that over time gets washed away and becomes a mere blip on the radar. Conversely, other things that in the hustle and bustle of the markets seem minor turn out to be much more impactful over the long-term. Empirical research shows that returns typically are more volatile in the short-term than warranted by changing fundamentals. The net result is a lot of noise that dissipates once investors take a longer term view.
Taking a Step Back. In recent years we have started thinking that stepping back a bit and watching the whole landscape unfold perhaps gives us a better sense of what really matters.
As archaic as this may sound to a high frequency trader in our research we have started focusing more on looking at company and capital market fundamentals over longer time periods. Looking for example at year by year annual company financials gives us a better sense where business fundamentals are going. Same with broad capital market relationships at the asset class level. Aggregating annual periods to look at secular trends gives us another way to process information in a manner that may seem old-fashioned but that hopefully removes some of the noise.
Shifting our Focus toward Long-Term Performance. We recently put together heat maps of annual performance for a variety of capital market breakdowns. We looked across the major asset classes as well as within each asset class. The results were revealing in each case. We found a lot of surprises especially when looking at cumulative returns over the last ten years!
In this note I will share the heat map for the ten major asset classes used in our asset allocation strategies. The returns for 2016 are as of January 22. All returns are in US dollars and correspond to commonly used indices.
What We Expected:
- Lots of variability from year to year – this we expected. After all this is the point of creating a heat map.
- We did not see a lot of relative mean reversion over one or two calendar years. Again this was expected given the strong empirical evidence that momentum persists for up to three years. We did not see a lot of “going from worst to best” or vice versa.
- Not all higher risk categories outperformed lower risk assets – this we expected given the hits suffered by equity-oriented assets during the Financial Crisis. For example, US bonds have out-performed international equity investments over the last ten years. Needless to say this was achieved with much lower volatility.
- US stocks had below average ten-year returns. The annualized return on US Large Caps (S&P 500) was 7.7%, more than 2% below historical averages. US Bonds (Barclay Aggregate) also had below average returns compared to history.
What Surprised Us?
- A big surprise was the extremely poor performance of commodities (COM) – down 48% over the last ten years. For most investors the promise of uncorrelated returns to the stock market has come at a very high price. Bye-bye commodity super-cycle!
- I was also surprised by the 2X out-performance of US stocks compared to international equity indices. Some was due to currency but not all. There were major geographic performance differences over the last ten years.
- US REITS (RE) edged out US large cap stocks by a slight margin over the last ten years. We expected a larger margin of out-performance but we had forgotten that in 2007 REITS were a precursor to what would happen during the Financial Crisis.
- Emerging Market Debt proved to be a revealing surprise with a 97% total return. Pretty close to US equity market returns and vastly superior to international equities. Much lower volatility too.
- The 91.7% return to the 60% S&P 500/40% Barclay Aggregate portfolio. The balanced portfolio lagged the S&P 500 by only 0.59% on an annualized basis but with much lower short-term volatility. Not bad for such a simple portfolio.
Insights to Share:
- The short-term noise in the capital markets can obfuscate long-term secular changes as well as disproportionally focus the mind on events that over the long-term have little to no significance.
- Expect lots of variability from year to year in terms of performance but over longer-term periods asset values will converge toward the fundamental drivers of return – income generation, growth and valuation.
- To reinforce the previous point, a lot of capital market volatility is just noise and should be ignored unless there is a change to fundamentals.
- Simple strategies such as the annually rebalanced 60/40 portfolio can prove sometimes incredibly effective at managing through the daily fog of markets
- Effectively distinguishing noise from fundamental signal is the key goal of capital market research. Capital markets are always evolving but the fundamental drivers of return and associated risk should be the backbone guiding your perspectives.
Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC