2017 Q1 Market Update

State of the Markets

The first quarter of 2017 saw a continuation of the momentum that drove equity market performance last year, leading to positive returns across all of our investable asset classes. The U.S. stock market delivered a 6% return for the quarter, but better results were achieved by non-U.S. stocks, with Emerging Markets advancing over 11% as of the end of March.

The total returns for major asset classes are below.

Recent headlines in the press have highlighted big shifts in investor behavior, implying that the investment landscape is changing. We’d like to take this opportunity to address some of these themes and how they relate to our investment philosophy and implementation.

The Rise of Index Investing

Below is a recent headline from an article published in the Wall Street Journal that sums up the current state of equity investing:

Wall Street Rout: Indexes Beat Stockpickers 92% of the Time

The article is referencing research published by S&P Global which indicates that over the 15 year period ending December 2016, greater than 90% of all mutual funds investing in the U.S. markets trailed their respective benchmarks. These are incredible, though not surprising, numbers. The idea that beating the market is hard has been around, in theory, since the 1960’s. Over time, actual results have proven this theory to be true.

Another industry theme is depicted in the following headline from a recent New York Times article:

Vanguard is Growing Faster than Everyone Else Combined

As investors come to terms with the reality that actively managed mutual funds don’t generally deliver on the promise of outperforming the market, more and more money has shifted to indexing.

Vanguard started its indexing strategy in the 1970s with a mutual fund that replicated the holdings of the S&P 500 Index, a list of 500 companies published by Standard and Poor’s. The S&P 500 index (and most others) is market-cap weighted which means the size of each holding is determined by the size of the company in the market – the bigger the company, the bigger the position. This is a simple and efficient way to build a portfolio.

Dimensional Fund Advisors is another mutual fund provider that has been in the headlines recently. They are the sixth largest and second fastest growing mutual fund company but they take a different approach than Vanguard. The folks at Dimensional believe that, rather than market-cap weighting, it would be more beneficial to weight portfolios towards those companies exhibiting qualities that could result in a higher expected return. Original examples of those qualities (or factors) include company size (smaller versus larger companies) and valuation (cheaper versus expensive companies).

Recognizing the obvious benefits of indexing (low cost, trading efficiency, and substantial tax benefits), Dimensional embraced as many of them as possible while adopting a factor weighting approach that systematically owns more of those companies that have a higher expected return. They are true pioneers in the area of investing which is now referred to as Smart Beta or Strategic Beta with a track record that goes back decades.

This is why a recent article in the Wall Street Journal profiling Dimensional was titled:

Dimensional: The Active-Passive Powerhouse

The article highlights their long-term track record of outperforming their benchmarks and several other things that have heightened  Dimensional’s success, such as their focus on research, their emphasis on patient trading, and their alignment with fee-only advisors (of which Century Wealth Management is one) who embrace their philosophy and are driven to provide a quality investment solution to their clients. 

Have Hedge Funds Jumped the Shark?

Hedge Funds have also received a lot of press lately. The following headline comes from the website Zero Hedge:

Pensions Slash Hedge Fund Allocations after Decade of Subpar Returns

Hedge fund strategies (which we categorize as Absolute Return or Hedged Equity) have been lackluster in recent years, especially compared to traditional stock and bond exposure. This is a good opportunity to review their potential role in diversified portfolios.

Hedge fund strategies, whether implemented through mutual funds or partnership structures, are trying to achieve their results without traditional exposure to stocks and bonds. This means they may own non-traditional assets like distressed debt and convertible bonds or they may structure their portfolio in a way that significantly reduces exposure to market risks.

If successful, a hedge fund investment will deliver on three levels – a reasonable return, reduced volatility, and low correlation to stocks and bonds. The last criterion – low correlation – is important because it means that hedge fund strategies, by design, won’t follow the same path as other investments. These characteristics are valuable in the creation of overall diversified portfolios and allow investors to target a return profile similar to that of a traditional stock and bond portfolio while actually having less exposure to those traditional asset classes.

While it’s true that some investors have been exiting these alternative strategies (headline worthy), most are staying the course and sticking with their long-term allocation decisions (not headline worthy). Given the relatively high valuations of U.S. stocks and the relatively low interest rates of U.S. bonds, these alternative strategies may provide desirable outcomes to those investors who stay the course.

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