My F&M

Diversification & Discipline

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As we’ve pointed out before, the unusually low interest rates of recent years and the elevated valuation of the stock market depress expected returns over a short to intermediate term time frame. Stock valuations have been driven up by the low interest rates orchestrated by the Federal Reserve, which has set short-term rates at zero for most of the past seven years and has bought trillions of dollars of bonds to help force long-term rates down as well. Over this same time frame, the other major central banks of the developed world (Bank of Japan, European Central Bank, and Bank of England) have adopted similar policies. These banks have been even more aggressive than the Fed by pushing interest rates into negative territory.

By directly or indirectly driving up bond and stock prices, these actions have boosted recent investment returns, but at the cost of reduced future returns across a wide variety of asset classes including traditional fixed income (bonds), domestic stocks, and developed international stocks. So, what are we doing in client portfolios to respond to these challenges?

We follow the same philosophy that has always guided us. First, we are sticking to our discipline. It’s tempting to increase bond income by either taking more credit risk or by buying longer maturity bonds. We are doing neither. Our discipline in fixed income is to add to credit risk only when we’re paid enough in extra yield to compensate for the extra risk. Those opportunities usually arise when investors are scared and are retreating to the safest bonds. That is emphatically not the case today as investors are desperate for income and are driving up the prices for bonds of weaker issuers. The other option of buying longer maturity bonds to pick up extra income only works if interest rates stay steady or go lower. If rates rise, the value of those long bonds will be decimated, and with 10 year treasuries at just 1.5%, there is plenty of room for higher rates and precious little room to fall further. Moreover, our discipline is to maintain an intermediate maturity bond portfolio and not assume that we or anyone else can accurately guess the future path of interest rates.

Second, we seek very broad diversification, both within and across asset classes. Broad diversification is particularly important in the current environment where many traditional asset classes (investments) look less appealing than usual. This sounds easy, but it’s often put to the test when one sees large disparities in performance across asset classes. The temptation is to concentrate dollars in what has been working recently at the expense of what hasn’t been working on the often mistaken assumption that past is prologue. A recent example is inflation hedges, which have performed poorly over the last couple of years amidst deflation in commodities, gold, and oil. But many of the dogs of 2015 have become the darlings of 2016! The price of gold fell 12% last year and gold stocks were far worse, but so far this year gold is up 26%, and gold stocks have more than doubled. The same thing happens within asset classes. Within stocks, as of the end of 2015, emerging markets had been the worst performing category over the last 5 years, underperforming the S&P 500 by an average of 17% per year! Did that make them a poor place to invest or a cheap opportunity in a high priced world? It’s too soon to know, but we’ve been adding to them to rebalance portfolios and emerging markets are up over 13% in 2016, making them the best performing stock category this year.

Third, we are constantly searching for new ways to add value to portfolios across all asset classes. We are finding income opportunities in areas where many investors don’t look or don’t have access. For example, emerging market bonds are one of the few areas where one is receiving sufficient extra income to compensate for the additional risk undertaken. We’ve also recently added significant exposure to direct consumer and business lending through the first ever mutual fund offering in the space. It offers very short-term loans (under 3 years) that protect against rising rates, broad geographical diversification to reduce risk, and yields of 8% to compensate for the credit risk. A third opportunity is a small fund on the debt side of real estate where yields of 10% can be earned. Small size is an advantage here as it allows for the exploitation of a unique real estate lending niche in situations requiring very fast funding. Call it real estate or call it fixed income; we call it value added diversification in a challenging investment environment.

So while the current environment is an exceptionally challenging one, that doesn’t mean changing our basic philosophy of broad diversification and discipline. On the contrary, it reinforces the need for both.