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Category Archives: Asset Allocation Strategies

Halloween Is Not Just For Children – Time For Some Tax Loss Harvesting!

harvest2At this time of the year people living in the Northern Hemisphere are starting to prep their gardens for winter and if you live in the countryside many people are harvesting their summer crops.

In New England as the days get shorter and the temperatures drop families with young children will often visit one of their local farms and pick their own pumpkins for Halloween.
Just writing this brings back great memories of my children when they were young, but there also a different type of harvest that those of us near or in retirement should take part in – definitely not as fun but maybe of lasting value.

 

What I am referring to is tax loss harvesting. Uh, ah I just filed my taxes for last year and now you want me to focus on the dreaded “t” word again? Please allow me to explain. In my life travels I have never met anybody that does not think that they are paying too much in taxes and would love to lower their annual contribution to the government coffers (in a legal way of course).

One way of doing this which is pretty straightforward but often ignored is tax loss harvesting. Along with enjoying harvesting pumpkins with your children or grandchildren why not harvest your investment losses as well?

After all as we have shown in earlier writings (Leaving Money On The Table) proper tax management of investment portfolios can dramatically alter financial outcomes especially over long periods of time.

 

How does tax loss harvesting work? Tax loss harvesting is an approach to minimizing how much you pay to the government on the (hopefully) gains in your investment portfolio. What it involves is selling those investments where things did not pan out as expected and you incurred losses. You would then offset these losses with the gains that you hopefully have on other investments. A good background read on tax loss harvesting prepared by Fidelity Investments can be found here.

While everybody’s circumstances are different let us look at a simple example. Let’s say that at the beginning of the year the Mitchell’s bought a portfolio of Health Care stocks that unfortunately lost 20% of its value resulting in a loss of $10,000. They also luckily bought some energy stocks In January that currently exhibits $15,000 worth of gains.

The Mitchell’s are now worried about all the negative publicity surrounding oil surpluses and wish to sell their energy holdings. Doing so would trigger short-term capital gains on which they would have to pay taxes. On the other hand the Mitchell’s think that Health Care stocks will soon rebound after the US Presidential Elections turning their current paper losses into winnings.

But just like things do not always work out as expected, tax issues are never straight forward so in order to lower their overall tax bill they would have to sell both their health care and energy investments. Not really what they wanted to do, but a lower tax bill this year would come in handy to pay for that winter getaway vacation to Costa Rica.

However, what the Mitchell’s can do is go ahead with both sales, legally offset gains with losses and then buy an essentially “similar” investment in health care stocks. For example if they previously owned a basket of Pfizer, Mylan and Bristol Myers stock which they must now sell they could buy the S&P 500 Health Care Exchange Traded Fund (ticker XLV) as a replacement. From an IRS perspective that is a permissible transaction. So essentially they have maintained the same exposure to health care stocks but lowered their tax bill.

Assuming that the Mitchell’s are in the 25% marginal tax bracket they would owe $1,250 to the tax authorities using tax loss harvesting as opposed to owing $3,750 if they had sold their energy holdings and held on to the losing position in health care stocks. And their portfolio is still essentially positioned as they want with a bet that health care stocks will rebound post-election. They just turned lemons into lemonade and are able to save $2,500 in taxes which they can use to travel to their favorite winter spot on Tamarindo Beach in Costa Rica!

Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy

Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant part of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more advanced applications encompass security positions across different asset classes.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

 

That Free Rebalancing Dessert Can be Costly!

dessert-1326898-638x428Rebalancing is a topic held near and dear to the heart of many investment advisors and often forms a key building block of what the advisor perceives as his or held value add.  If diversification is viewed as a free lunch then rebalancing is often viewed as free dessert.

Unfortunately while the benefits of true diversification stand the test of time the same cannot be said about rebalancing especially when done in a highly automated way such as frequently seen in many robo-advisor offerings.

What do we mean by rebalancing? There are many reasons why investment advisors intentionally shift the weights of their portfolio components over time.  The manager may have a changed view on future expected returns or they may deem a certain investment to now possess an unacceptable level of risk and thus wish to cut back on the exposure.  Others may wish to more closely track a commercial index and do a wholesale portfolio rebalance to minimize deviations from benchmark weights.

In general there are two basic underlying motivations for rebalancing.  The first is informational – the weighting structure of the portfolio is consciously changed to reflect an updated perspective on forward-looking estimates of return and/or risk.

The second basic motivation for rebalancing is purely driven by an automated rule that is agnostic to changing views on capital market risk and return conditions.  The rebalancing rule is followed religiously regardless of the capital market environment.

This second form of rebalancing and the focus of this note we refer to as a constant mix strategy.  Constant mix strategies take their cue solely from relative asset price changes over a chosen period of time and seek to bring portfolio weights back to a set of pre-defined time-invariant weights.

Why are many automatic constant mix rebalancing strategies viewed as a free dessert? Constant mix strategies trim relative winners and top up relative losers.  Assuming fairly priced asset classes at the beginning of the period a constant mix rebalancing approach can be construed as a value-oriented strategy buying up cheap assets and selling expensive assets.

The working assumption is that capital market forces will correct relative asset class mis-pricings.  Under this scenario markets are constantly displaying mean-reverting behavior.  Asset classes that go up must come down and vice versa.  Kind of a rollercoaster of relative performance.

Rebalancing programs will pick up nickels and dimes by selling relatively expensive assets and investing the proceeds into relatively cheap securities.  Transaction costs and short-term capital gain taxes will be incurred but according to proponents of such rebalancing programs, such costs will be offset by gains in portfolio values and as a side benefit – the icing on the cake – a reduction in portfolio risk. Risk in this context is frequently equated with downside volatility as valuation changes are viewed as the primary cause of mean reversion in asset prices.

The idea of buying low and selling high is alluring and under a mean reverting type of market a constant mix strategy would deliver on the promise. But the romantic notion of mean reverting markets often fades away as real capital market behavior with all of its flaws sets in.

Do real capital markets behave in the idealized mean reverting manner necessary for constant mix strategies to shine? Capital markets are ever changing as asset class fundamentals, risk characteristics and investor demand fluctuate for perfectly sensible as well as irrational reasons.  Capital markets are constantly calibrating supply and demand conditions and over short-term intervals changes in investor sentiment tend to overpower fundamentals.

There is also a lot of both academic as well as practitioner research on time series momentum.  In general the conclusion is that over intermediate time frames such as 12 to 24 months there are trends in asset class performance.  Mean reversion as a concept has been thought of more as a 3 to 5 year concept but over the typical time periods used in rebalancing programs (monthly or quarterly) the evidence is more consistent with trends in asset class prices.

Apart from taking advantage of mean reversion patterns in asset class performance how does rebalancing really work?  In a recent paper titled Rebalancing Risk, Granger, Greenig, Harvey, Rattray and Zou derive analytical formulas as well as provide empirical evidence on the behavior of constant mix strategies versus an approach that allows asset class weights to drift depending on relative performance.

In the paper they neatly decompose the performance drivers of the constant mix strategy.  What they show is that the constant mix strategy can be decomposed as follows:

Constant Mix Portfolio

=

Buy & Hold Portfolio

+

Selling Put and Call Options on Relative Asset Performance

The constant mix strategy carries negative convexity meaning that it outperforms when asset class return divergences are small by collecting the premium received for selling the puts and calls on the underlying portfolio.

However, when asset return divergences are large the selling of puts and calls results in losses and the buy and hold portfolio out-performs.  In extreme cases when one asset class significantly lags the rest of the portfolio such as in a stock market crash the negative convexity of the strategy can magnify the drawdown.

Another way to think of the constant mix strategy is to  put yourself in the shoes of the investor selling puts and calls.  When volatility rises holders of the options will benefit and commensurately sellers of options will see an economic loss. That is why the constant mix rebalancing approach is often described as a short volatility strategy.

The authors of Rebalancing Risk  conduct a set of empirical and simulation exercises using US stock and bond data. What do they find?

  • Constant mix portfolios exhibit small positive returns when relative asset class performance (stocks versus bonds in this example) do not perform too differently from each other.
  • When there are large differences in asset returns the tendency is to exhibit losses relative to buy and hold portfolios. The losses are magnified during periods of extreme relative performance.

The basic prerequisite for constant mix strategies to out-perform buy and hold strategies are reversals in asset class performance.  From a risk perspective, constant mix strategies add an element of risk as the approach involves additional option related features.  Justifying the use of a constant mix approach by implying risk reduction benefits is theoretically and empirically unfounded.

Access the full report here That Free Rebalancing Dessert Can be Costly!

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Keeping It Real – The Impact of Fees, Taxes and Inflation

Real Stock ChartWhat’s more important to investors than real returns? 

In a previous note (Leaving Money on the Table) we wrote about the impact of taxes and fees on net strategy returns. Our focus was more conceptual and we highlighted the highly customized nature of after-tax portfolio management advice.

Some of our readers, however, remembered empirical work we had done a number of years back using broad US stock and bond market returns. We decided to update our previous research on the effect of taxes, fees and inflation on the real return to investors.

Our methodology is simple.  By necessity we employ some simplifying assumptions regarding fees and taxes. We use S&P 500 and US Government Ten-Year Note returns from the end of 1982 to the end of 2015.

We subtract three levels of “costs” from gross returns:

  • Management Fees
  • Taxes (short and long-term)
  • Purchasing Power (inflation)

Real Stock ReturnsReal Bond Returns

 

 

 

 

 

 

 

The results are eye opening and a timely reminder of the drag on investment returns.  A lot of investors would be surprised to see the extent of this drag on their portfolios but in the real world the results may actually turn out to be even worse. 

Why? For one many investors pay high fees on their portfolios and ignore the tax efficiency of their strategies.

While not as sexy as a discussion of strategy returns or smart beta minimizing the extent of the cost drag from fees, taxes and loss of purchasing power is an important part of sustained wealth creation

 Management fees on portfolios should be scrutinized for value add.  Portfolio management has a cost. Index strategies are now available on most market segments in equity and fixed income markets at low cost but the combination of strategies and overall asset allocation still needs to be managed.

Jack Bogle has been talking about the importance of controlling fees for years and investors as a group may have become recently more fee sensitive especially as the realization sinks in that we are most likely going to be living in a low return environment for the next decade.

Paying high fees in a low return environment would certainly impair wealth accumulation targets.  Paying fees commensurate with value add should be the goal of investors.

As Benjamin Franklin once said, taxes are as certain as death and as such the best that one can do is minimize the tax bite of investment strategies. Tax loss harvesting, low portfolio turnover, proper strategy selection, and legal deferment of taxable events are elements of a coherent well-designed tax minimization strategy.

Finally, a huge drag on net real returns has been the loss of purchasing power. While inflation in recent years has been below historical norms the loss of purchasing power can best be thought of as an almost invisible downward pull on wealth creation efforts.

Not all investment strategies behave in the same manner in the face of inflationary forces.  Properly aligning investment strategies to the expected inflationary environment is an important component of minimizing the deleterious effects of a loss of purchasing power.

 If you would like to read our full report please fill out the information below and hit the Send button

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Leaving Money on the Table? Time to Look at Taxes

tax-1351881_1280Thinking about taxes implications for your investments often plays second fiddle in fast moving capital markets and for a large number of investors – pension funds and endowments/foundations the issue is moot given their tax exempt status.

But for many investor be they already wealthy or diligently saving for retirement on their own the issue of taxes is incredibly important.  Proper tax management can dramatically alter financial outcomes especially over long periods of time.

Tax management can be complicated and should encompass the full financial and human capital picture and goals of the household or multi-generational family entity.  Investments are one aspect of this view but properly evaluating the tax implications of different investment strategies is an important component to the long-term success of an entity’s financial plan.

Taxable investors are not generally able to capture the full potential return of an investment for a number of reasons

  • The most obvious and frequently discussed reason are fees and expenses
  • The second and often more significant drag on realized long-term strategy returns is due to taxes

While tax structure and rules vary across geographic domiciles (across countries but also by states ) there are generically speaking two types of taxes that subtract from investor returns – taxes on periodic income received (dividends and coupons) and taxes paid upon the sale of a security.

Measuring the tax bite of an investment strategy depends on individual circumstances but it is still useful to look for generalities to assess the likely impact of different strategies on after-tax portfolio returns

We resort to evaluating four different hypothetical strategies using the theory of tax management as outlined in Chincarini and Kim (Journal of Portfolio Management, Fall 2001).

Value of $ After TaxThe wealth path of the four strategies that we evaluate for tax implications are shown to the left.

All strategies assume an annual gross return of 8% and a management fee of 1% per year. The strategies vary by the type of trading incurred.

 

 

Main Conclusions:

  • The advantage of the more tax efficient strategies for creating wealth for investors are clear especially as one extends the holding period.  Tax efficient strategies compound at a higher rate because of a smaller proportion of gains paid out as short-term taxes and the deferral of trading events leading to fewer taxable consequences.
  • Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy.  Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant portion of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more sophisticated applications encompass security positions across different asset classes.  It is also very important to properly account for the intended final disposition of investment assets.

Finally, we would remiss to not point out that tax policy is not only highly specific to geographic areas (say countries and states) but also subject to significant rule changes over time.

If you would like to read our full report please fill out the information below and hit the Send button

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

 

Even A Wide Moat Won’t Save This Brexit

caerlaverock-castle-1220664-639x479In the weeks leading up to the Brexit referendum vote our assumption was that while the vote would be close the “remain” side would eventually prevail.  Our feeling was, I must admit, more based on our observation that under most circumstances electorates prefer to stay with the status quo.

My relatives in the UK had warned me against making such an assumption, but from a pure economic perspective the evidence seemed stacked in favor of remaining within the EU.

Now that we know the outcome of the vote and Brexit has become a reality it downs on me how out of touch we can sometimes be when dealing with unhappy electorates.  The evidence is scant for any positive economic benefit for separation from the EU, but the hope for change is sometimes so strong so as to overwhelm rational thought.  In my opinion, while the world may have recovered economically from the depths of the 2008 Financial Crisis the seeds of discontent are still alive within large segments of the population. 

The rise of nationalism in many countries is tied to the search for simple solutions for promoting adequate growth in the face of weak labor markets and rising income inequality.  These simple solutions are often expressed in the form of isolationist strategies with the underlying assumption being that inadequacies in economic growth are caused by outside forces.

But just as building a moat around one’s castle is a totally inadequate way in today’s world to keep outside influences at bay so are policies pretending that world economic forces can be neutralized at one’s door step.

Markets for goods and services today are truly global in nature and while pockets of every economy will remain domestically driven the vast majority of global economic activity takes place in the context of highly competitive supply and demand conditions involving companies frequently conducting business from multiple geographies.  Borders don’t matter as much as the ability to offer a value proposition to both producers and consumers.

The 52% of voters in the UK that voted for pulling out of the EU are betting that the UK economy will be better off long-term not being part of the larger economic union.  Stifling regulations imposed by the EU are one shackle that UK domiciled companies will no longer have to bear. Another, it is argued, will be removing the burden of subsidizing weaker members of the union.

But while the long-term ramifications of Brexit will not be known in totality for at least a decade or two the shorter-term issues are likely to wreak havoc with investor sentiment.  “Risk-off” is likely is to stay with us for a bit longer than expected!

Another Brexit casualty will be sterling denominated assets.  Not only will the British Pound depreciate significantly but the demand for UK domiciled stocks and bonds will decrease as well.  Sellers will remain highly incentivized so prices will need to drop for buyers and sellers to meet.  None of this is rocket science and markets on t+1 are already reflecting these negatives.

While the short-term implications for UK equity owners are negative we do not believe that Brexit will lead to the end of the world.  After all our belief is that company fundamentals drive long-term investor rewards and spikes in investor sentiment both positive and negative appear as mere blips in long-term performance charts.

Especially for companies not directly tied to the regulatory consequences of Brexit the news may be good in the short-term as investors express an increased preference for lower uncertainty situations.  Even for many UK companies the news does not constitute a death sentence as many already conduct operations in geographically diversified locales.  For some export-driven companies the depreciation of the pound will provide short-term competitive advantages.

UK-domiciled assets will not doubt remain under pressure for the foreseeable future.  Withdrawing from the EU bloc is fraught with technicalities and will require the negotiation of dozens of trade agreements.  Article 50 of the Lisbon Treaty will have to be invoked which will then allow for a two year period of negotiation between the EU and the UK government.  Pro-Brexit politicians have openly discussed delaying invoking Article 50 leading to most likely a period of 4 to 5 years of uncertainty. While the Brexit side rejoices today the withdrawal from the EU will not be immediate.

Most times when a political event such as Brexit occurs the size of the overall economic pie does not change materially at least over short and intermediate terms. What tends to happen instead is that the pie gets splits up differently creating losers and winners. 

Capital markets are reacting post-referendum as if the size of the pie has permanently shrunk and everybody will go hungry. The reaction of global capital markets would suggest dire consequences for global growth. Risky assets are getting uniformly destroyed and investors are flocking to safe heavens such as the US dollar, long-term US government bonds and precious metals.

Our view is that while global economic growth will experience a hiccup the longer-term effect for global growth will not be significant. For long-term investors with multi-asset class portfolios we do not expect a lasting effect from Brexit but understanding the likely short-term winners and losers could actually yield some very rewarding tactical trades.

In many ways this crisis while most likely painful for the UK economy resembles other periods in history when political events led to a spike in capital market volatility and a rise in investor risk aversion.  Such periods were uncomfortable for investors but also yielded tremendous opportunities to add value.

What can we reasonable expect over the next few weeks?

  • Investor risk aversion will remain elevated as investors seek to understand the long-term implications of Brexit
  • The US dollar, Swiss Franc and the Yen will strengthen at the expense of the Euro and the British Pound
  • Commodities apart from precious metals will face downward pressures as the US dollar appreciates. We, however, believe that oil will find its footing reasonable soon as supply/demand conditions seem to be close to equilibrium
  • Investors will increase the demand for high quality bonds leading to further interest rate decreases. Long duration bonds will benefit the most. Interest rate sensitive assets such as real estate will likewise benefit.
  • The US Federal Reserve will not raise rates in July and we would be surprised if they institute any hikes this year. The ECB and the Bank of England will cut rates and increase monetary stimulus. Global liquidity will remain plentiful.
  • Investors with short time horizons will flee risky assets en masse.  We should expect outflows from equities to accelerate in the short-term.  European and UK portfolios will see the sharpest outflows
  • Extreme contrarians will advocate buying into UK equities but there will be few takers. We would advocate passing on this trade for now
  • Contrarians will also advocate buying stocks domiciled in the US. Such a trade won’t require, in our opinion, as long as of a time horizon as buying UK stocks and it will thus entail less risk. Our two top equity tilts remain low valuation and above-average company profitability

 

In general, we would advocate making only small adjustments to multi-asset class portfolios.  The adjustments would be more driven by risk management considerations as we expect asset class volatility to remain elevated for the remainder of 2016.  Our risk aversion index (RAI) has also recently moved into the “extreme fear” zone thus calling for a more defensive risk posture.

From a tactical perspective we see opportunities emerging more from bottom-up stock selection activities rather than from sector or country allocation decisions.  When whole markets sells off as we saw on the day after Brexit the good gets thrown out with the bad.

In a crisis company fundamentals are often ignored as investors are forced to sell their most liquid holdings first.  Market turmoil tends to create attractive entry points for investments with robust long-term fundamentals.  We expect global equity markets to remain under pressure next week and we would thus advocate waiting a bit longer to put any excess cash to work.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Apples to Oranges – The Case Of Commodity Indices

commodity indicesCommodity investing dramatically increased in popularity with both institutions and retail investors in the last decade as it became cheaper and easier to invest in the asset class.

 

The two primary indices for commodity investing have been the S&P GSCI and the Bloomberg indices.  These indices are dramatically different in terms of weighting structure with the S&P GSCI being very energy heavy (63% weight) while the Bloomberg index tends to be more balanced across the primary commodity sectors. As a consequence both indices can have significant performance differences.

Both indices aim to cover the broad spectrum of most actively traded commodities.  Commodity pricing is primarily determined by global supply and demand conditions, but that is where the similarities among  commodity sub-groups often end.

When investors think of constructing their portfolios usually the starting point are broad asset classes such as stocks and bonds.  Asset classes tend to possess fairly well defined risk and return characteristics and represent aggregations of “similar” investment types.

As an example, stocks are usually broken down into economic sectors but most investors would agree that stocks are driven to a large extent by what happens to the broad equity market.  Similarly, while fixed income investments are frequently broken down by maturity and credit worthiness, the key driver of fixed income returns tends to be the general direction of government bond rates.  In general, return correlations within asset classes such as stocks and bonds tend to be high and frequently exceed 0.8.

commodity correlationsWhen evaluating investment returns within the commodity complex the high within asset class correlations typically seen among stock and bond investments are absent.  More common are correlations in the 0.2 to 0.4 range.

The low correlation among commodity groups is a manifestation of a less homogeneous asset grouping than typically seen for other broad asset classes such as equities and bonds.  Given that each commodity group has its own supply and demand dynamics and the vastly different swing pricing factors this result is to be expected.

Thinking of commodity investing as a broad concept has been useful for investors as a way to get their feet wet, but given the current depth of commodity markets, the variety of liquid investment vehicles available, and most importantly the dissimilar behavior within the commodity complex we think that looking at the space as one homogeneous asset class is like comparing apples to oranges. 

Other sections in this report include:

  • Thinking of commodity return behavior in terms of risk exposures
  • What do the risk estimation exposures tell us about commodity sub-group behavior?
  • What does our research imply for commodities in the context of a multi-asset portfolio?

Download The Full Report Below

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Feeling Unsettled – An Update on Investor Risk Aversion

New England Spring DayInvestors have been feeling a bit unsettled this year. Right off the bat risky assets fell off the cliff only to recover strongly in March. Since then financial markets have felt like a typical spring day in New England –at times warm and sunny followed by cold winds and clouds.

Investors have become highly sensitized to changing capital market conditions – one moment feeling upbeat and confident and the next being rife with doubt and stress.

Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

At Global Focus Capital we measure investor sentiment using our Risk Aversion Index (RAI).  The higher the RAI the more fearful investor are, or in other words the more risk averse.  As a reminder to readers we classify investor risk aversion into three zones – Extreme Risk/Risk Allergic, Neutral, and Risk Loving/Seeking.

RAI MAY 2016Thus far in 2016 we have spent most of our time in the Extreme Fear/Allergic and the higher end of the Normal Zones.  Investors are clearly nervous.

The chart shows the ten day moving average of our daily risk aversion index.  During the early part of the year risk aversion was in the very high end as global stock and commodity markets were tumbling.

As risky assets found their footing in mid to late February so did investor risk aversion.  After almost reverting back to the Extreme Fear/Allergic Zone in mid-April, investor risk aversion has been trending down while still remaining in the high end of the Neutral Zone. Investor sentiment remains fragile.

What does it mean to be in each one of these risk zones?  Without going into all the portfolio construction issues let us just focus on returns.  A separate note will explore the risk management aspects of each risk regime.

We illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also include alternatives such as real estate and commodities.

RETURNS ACCORDING TO RAI.png

Periods of capital market stress such as those when the RAI is in the Extreme Risk/Allergic Zone (red bars) are difficult for investors holding risky asset classes such as equities.  In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market).  US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving/Seeking Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments. 

When in the Risk Loving/Seeking Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward.  Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved.  In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Neutral Zone with a reading in the 59th percentile.  The RAI has been trending down (becoming a bit less risk averse) but remains in the higher end of the Normal Zone.  Pick your poison – low global growth, negative policy rates, disappointing corporate earnings, Brexit, a Greek default – investors are finding lots of reasons for remaining nervous.

ACTION PLAN ACCORDING TO RAI

In looking at the pattern of how investor risk aversion typically evolves our research has found that investor risk aversion tends to be sticky over the short-term

There is about a 65% probability of remaining next month in the current risk zone, a 25% chance of moving to the contiguous zone (say from Neutral to Extreme Risk) and only a 10% chance of moving from one extreme to the other (say Risk Seeking to Risk Allergic).

Our current reading of 59th percentile is on the high side for the Neutral Zone.  Coming off the Extreme Risk/Allergic Zone at the beginning of the year the portfolio implication is a lowering of tracking error and an increase in investment volatility.  We are thus advocating becoming less dissimilar from the benchmark if a relative return orientation is applicable.

When investor risk aversion is in the Normal Zone, low volatility strategies lose their effectiveness and we, therefore, do not recommend a low volatility tilt anymore.

Should investors get spooled again and our RAI return to the Extreme Fear Zone our recommendation would be to tilt toward lower volatility investments and sectors.  Such a set of moves would increase deviations relative to the benchmark and we would expect to observe higher levels of strategy tracking error.

What could sour the mood of global investors leading to a jump up in risk aversion? Potentially a whole host of issues frequently best understood in hindsight.  But on a more practical note we would highlight three areas of concern. First, should the UK vote to withdraw from the European Union we would expect a large spike up in investor risk aversion.  Risky assets such as stocks and commodities would likely take a big hit should this event occur.  We think that investors will react extremely negatively to Brexit especially in terms of their European stock and bond holdings.

The second concern involves contagion effects should a Greek default occur.  At the very least the interest spread between safe and riskier debt should jump up.  This would lead to a higher RAI and riskier investments will likely bear the brunt. Haven’t we seen this movie before? Yes, too many times but unless debt relief is in the cards we will we seeing another re-run this summer.

Finally, a Chinese growth scare could also trigger investor fears and bring about very negative consequences for emerging market equities and commodities.  The official target growth rate is between 6.5 and 7% with a focus on internal consumption and services growth.

The wildcards remains the health of the real estate market and the credit worthiness of off-balance sheet financing.  According to the IMF China currently accounts for over 16% of Global GDP when adjusted for purchasing power parity. The US accounts for a similar fraction of global growth. A significant negative revision to growth in either country would no doubt roil equity and commodity markets while leading monetary authorities to expand their loose monetary policy further into the future.

At Global Focus Capital we continue to believe that investment risk has been underpriced for a while and that there is no better time than now to evaluate one’s willingness to trade off risk in relation to potential reward.

Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally.  Lackluster global growth and seemingly high absolute valuation levels for stocks and bonds are likely to lead to a decade of lower than average capital market returns where many investors will struggle to meet their stated target portfolio returns.

A proper understanding of realistic sources of potential returns and associated risks together with a willingness to remain tactically flexible with a portion of the overall portfolio will reward investors with a higher likelihood of achieving their goals without going too far out on the risk curve.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Mind the Gap! Emerging Markets Are Out-Running Developed Market Stocks

mind-the-gap-1484157-640x480Many years ago when my family and I took a trip to London my children took great delight in hearing the loud warning of “mind the gap” when taking the Tube.

To this day we still joke about it and hearing the expression always brings back a flash of fond memories.

But what I had in mind for this note was a different type of gap. Specifically, the gap that is developing between developed equity markets and emerging market stocks.

Going into 2016 sentiment was pretty bearish on emerging market equities.  Institutional investors were having a hard time hanging on to allocations that significantly under-performed expectations and retail investors had long been fleeing the asset class.

Moreover, over the prior ten years (2015-2006) emerging markets had only out-performed international developed markets by an annualized 0.45%.  Clearly not enough once transaction costs and the usually higher management fees are taken into account. Never mind the higher volatility of the asset class.

So what had happened to the emerging markets story? Investors once justifying their EM allocations on the growth of the middle class in these markets (the shift from export-driven to domestic consumption growth) had reverted back to explaining the disappointing performance of EM equities as a function of the collapse in global commodity prices.

At the end of 2015 it was hard to find investors willingly delinking expectations for EM equities from those of global commodity markets. Both asset classes ranked at or near the bottom of the pile in terms of 2016 prospects.

Not that every investors was bearish but you had to be a true contrarian to in the face of public ridicule increase allocations to EM or commodities.  The short EM/Commodity trade had become very crowded indeed!

What usually happens when you have a crowded trade? The short answer is nothing good for the crowd except for the small number of contrarians still hanging on.  Let’s think back to two recent examples of crowded trades:

The rise and subsequent bursting of the TMT bubble of the late 90’s.  Every portfolio manager back in those days felt the pressure to increase their exposure to companies in these sectors despite a lack of sound fundamentals and exorbitant valuations.

  • The real estate finance smorgasbord of builders, mortgage issuers, insurers and credit re-packagers of the 2004-2007 period.  The finance sector as a whole was gorging on low interest rates in the context of a low volatility capital market environment.  The end result was not unpredictable but in its day there was comfort in numbers and the possibility of something seriously going wrong was summarily dismissed by the vast horde of investors then making money on the trade.
  • The funny thing about crowded trades is that before they burst few people are willing to take a count of the players at the party.  Sometimes people will fail to even acknowledge that a party is taking place.  Tunnel vision sets in and investors are subsequently surprised when a turn of events has party attendees suddenly sprinting for the exits.

Is the short EM equities trade finally nearing exhaustion?  It sure feels like it. Systematic ways of looking at the “numbers” will invariably lag price behavior.  Our own allocation models have been pointing to a closing of the gap between expectations for developed and emerging market forward returns but we still slightly prefer the former.

Let’s take a look at major asset class performance in 2016.

AA_WEEKLY_HMAP

  • Last week EM equities were up 3.3% – best of the major asset class categories.
  • For the year, EM equities are up 4.4% -best among all equity sub-asset classes.
  • The gap between emerging and developed international market (EAFE) performance is widening.  Year to date the gap stands at over 7%.
  • The MSCI EAFE index is down 2.68% for the year while the MSCI ACWI-x US index (which has an EM weight close to 20%) is down approximately 0.4%.

The performance gap between developed international and emerging market equities is already causing some anxiety among international equity managers. Managers tied to the broader ACWI index are clearly having to swim upstream given their likely beginning of year under-weight to EM stocks.

Last year the consensus underweight to EM equities paid off handsomely.  EAFE out-performed EM equities by a whopping 14%.  An under-weight to EM equities could have hidden a lot of sins elsewhere in the portfolio but this year the tide has turned.

Having been a money manager for over 20 years I know the feeling when a previously ignored/disliked segment of the markets suddenly changes course and gaps up.

It’s never a good feeling and leaves portfolio managers in search of answers.  In the course of my career I have seen three types of generic responses by managers:

  • Ignoring the problem and remaining steadfast in the belief that the portfolio is correctly positioned.  The likely outcome of the “no action” manager is binary – at the end of the year the manager will either be a hero or a goat.
  • Gradually changing course acknowledging that the trade might have been crowded.  The manager works at finding investments with the right exposures thus gradually minimizing the under-weight to the previously ignored/disliked segment.  In all likelihood the manager will initially make small adjustments and is praying that the performance gap does not widen too rapidly
  • Throwing in the towel and joining the new party by aggressively over-weighting the previously maligned investment.  The potential to be a hero or a goat is large.  Such a response is usually driven by “gut” feelings that things have changed

Only in hindsight will investors be able to tell which course of action resulted in the best outcome.  Portfolio managers live in the present and must make decisions.  With that in mind here is set of principles to adhere to:

  • All predictions contain a certain amount of error – be humble about your ability to predict the future. Low probability events happen more frequently than we would like to
  • Seek to understand opposing points of view as a way to discover flows in your thinking.  You will gain a greater appreciation of what can go wrong
  • Strike a balance between what is happening now (recent evidence) and longer-term information. Don’t let your decisions succumb to feelings of either fear or greed
  • Research-based views are better than reactive off-the cuff conclusions – at least you will understand why you made certain decisions. Do your homework
  • Gradually changing one’s views given changing/new information is not a sign of weakness.  Making better decisions involves the constant calibration of new probabilities
  • There is no substitute for experience in providing context to the decision at hand, but experience without analysis is no way to make decisions in an ever evolving capital market environment
  • Understand the consequence of your decisions – never bet the farm on one major decision unless you (and your clients) are comfortable with binary outcomes

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

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Can This Russian Bear Learn To Samba?

I have my own moves!

Last week we wrote about the amazing year to date performance of the Brazilian equity market. Despite all the awful headlines and negative investor sentiment the Brazilian market was up over 20% and last week it went up a further 4%.

A similarly widely disliked equity market fraught with negative headlines having a great start to the year is Russia.

Russian equities were up 2.5% last week and in 2016 they are up about 11%. Not bad for a market that like Brazil comes with lots and lots of baggage.

All resource-oriented equity markets have benefited from the resurgence of commodities and both economies are expected to contract further in 2016, but Russia and Brazil are not cut from the same cloth.

There are at least three key differences that investors should note before lumping these emerging markets together:

  • Economic Sector Composition
  • Fundamental Drivers of Return
  • Value Add of Top-Down versus Bottom-Up Implementation Approaches

Click to read the full report  Can This Russian Bear Learn To Samba?

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

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