In the wake of recent gyrations in the capital markets, risk levels—or at least the perception thereof—are elevated. The combination of Europe’s financial crisis and attendant weakness in the euro, the United States’ struggle to resolve its own debt issues and keep its fragile expansion alive, and China’s efforts to suppress inflation while executing a “soft landing” has provided the markets with daily fuel for violent swings. It seems that no sooner does a ray of hope appear in one crisis than the market focuses on another one. Not only are the fundamentals shifting as events unfold, but the markets’ reaction to them seems to exaggerate the impact on portfolios.
Largely because of higher perceived risk and the resultant “flight to quality,” the return on risk-free assets is now extremely low. In fact, the “real yield” (i.e., after adjusting for inflation) on three-month U.S. Treasury bills as of mid-December was negative 2.7%, calculated as the difference between their nominal yield (a meager 0.05%) and the Personal Consumption Expenditure Deflator (the Federal Reserve’s preferred measure of inflation, currently 2.7%). Using the return on five-year Treasury Inflation-Protected (TIPs) securities, the real yield is a negative 0.5%. In the mid-1990s this figure was a positive 3 to 4%.
Three Options
The implications of this shift in risk-free returns are substantial. To illustrate, assume that an institutional or private investor requires a 5% “spend rate” annually to meet operating or living expenses. If inflation is running at 2%, the return on the portfolio must reach 7% in order to preserve the purchasing power of the principal and still cover the 5% annual withdrawal. In a typical balanced portfolio consisting of, say 30 to 40% in quality bonds, the small return on the low-risk portion of the portfolio means that the other assets (stocks, alternatives, etc.) must work harder in order to meet the overall return objectives. Investors have essentially three options: 1) accept low returns for a period of time, allowing the value of the portfolio to decline on an inflation-adjusted basis; 2) reduce the spend rate; or 3) increase the portfolio’s risk in an effort to achieve higher returns. The first two are difficult choices to have to make, and the third is fraught with, well, risk.
Figure 1. Heightened Volatility
Source: Bloomberg
Note: VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index and measures the implied volatility of S&P Index options.
In general, we do not recommend major changes in asset allocation with a view to increasing risk levels unless a client’s circumstances have changed in such a way as to allow for more risk. In looking ahead, however, we remain mindful of the need to detect economic shifts (positive or negative) that would dictate an adjustment in our allocations. In this respect, we pay close attention to what companies are telling us about demand in different parts of their business. This is not to say that we ignore what we read and observe regarding macroeconomic variables, but we are somewhat skeptical of their value for two reasons: First, they are often misleading (either intentionally or unintentionally, depending on the source) and subject to revision; and second, they are, after all, based largely on data collected from the corporate world. We prefer that our analysts go right to the source, through regular discussion with the companies we cover on a research basis and own in our portfolios. The three areas most relevant to our views with regard to asset allocation are:
- Europe: We are particularly alert to signs that the recessionary environment in Europe is spreading to the U.S. in such a way as to threaten our domestic recovery. Our contacts with companies whose operations could be affected, such as Accenture in technology services, tell us that this is not the case, at least at this point.
- U.S. consumers: Since consumption still makes up about 70% of our domestic economy, it is critical to the continuing, albeit sluggish, recovery. Here, we are paying close attention to sales trends of retailers and consumer products companies that operate in the more discretionary segments of the economy—electronics, apparel, home improvement, etc.—as they are most economically sensitive. In recent weeks, sales have shown tentative signs of strengthening. Early cyclicals, such as Canadian National Railway, are also a good indicator of the future direction of economic activity, and there again the signs are positive.
- Emerging markets: Anxiety over the European financial crisis is being felt in the emerging markets, as companies operating there are watching their spending. Macroeconomic data emanating from China is particularly suspect since it comes mostly from the government, which, after all, manages the economy. The main issue here is whether inflation can be tamed without inducing a “hard landing”—meaning, in China’s case, a severe slowdown in growth rather than an outright recession. In speaking with industrial companies like John Deere, we are not seeing signs of a sharp contraction in growth.
At this point, then, we advocate staying the course on asset allocation, although we remain alert to the risks enumerated above. (For further details, see our new quarterly publication, The Advisory, dated December 2011.) We remain committed to our basic asset allocation philosophy: maintaining a balance of fixed income, U.S. and international equities, commodities and alternative assets, with the exact mix depending on specific client objectives and risk tolerance. Within these broad asset classes, we are particularly positive on the prospects for income stocks, small-caps and income-producing real estate. Stocks with above-average dividend yields provide greater predictability of returns by virtue of their current payout, along with lower volatility—a distinct plus in today’s environment. Small company fortunes are generally less susceptible to the vagaries of the global economy since they tend to operate in geographic or sector niches. In the emerging world, for example, they are largely dependent on local economies, like Brazil or India, which are growing at relatively high rates, while larger companies are more reliant on still-stagnant global trade. In a similar vein, we are underweighting non-U.S. developed market equities in recognition of their exposure to ongoing problems in Europe and Japan, along with currency risk related to the euro. Real estate is attractive, in our view, because the continued over-supply opens opportunities for discriminating buyers, and low interest rates enable deals to be financed on exceptionally good terms. The only significant change in our thinking with respect to asset classes has been to dial back our commitment to commodities. Price appreciation and reduced prospects for inflation caused us to remove the “opportunistic” portion of our commodities allocation, although we are keeping a strategic allocation designed to hedge against a rise in interest rates.
Active or Passive?
While asset allocation is the most critical determinant of portfolio returns, much depends on exactly how the various asset classes are populated. Among the choices one can make is between active and passive approaches. Some investors believe a passive approach using index funds or Exchange Traded Funds makes sense, in part because of the relatively low cost of owning these funds compared to actively managed mutual funds or separate accounts. Indeed, we have chosen to use index funds in certain circumstances. For example, when investing in commodities, we have generally preferred using Exchange Traded Notes, which provide broad exposure and are efficient from a cost perspective.
On the other hand, as active managers, we believe strongly that individual security selection can add materially to results within each asset class and thereby contribute to overall client portfolio objectives. While studies show that active managers as a group perform generally in line with the market averages, they also indicate that active managers with certain characteristics do, in fact, tend to achieve better results than passive managers—and typically do so over time. The current issue of Financial Analysts Journal (FAJ, a research-driven forum for scholarly contributors) summarizes a number of academic studies highlighting the qualities that typically distinguish managers with exceptional records. These fall into two general categories: 1) the characteristics of the managers and their organizations; and 2) the nature of their portfolios.
Looking at the managers, the FAJ cites numerous factors including educational backgrounds of the individual portfolio managers, their equity in the firms for whom they work, their “skin in the game” (i.e., do they own a share of the portfolios they manage?), flatness of their organization, etc. We believe that Brown Advisory’s organizational philosophy and the qualities of its individual managers are generally consistent with these characteristics, but we leave it to clients to make those judgments.
What we find more interesting—and more objective—is the nature of individual portfolio holdings in various asset classes and how they behave over time. In general, studies indicate that managers with less rigid adherence to a particular “style” (momentum investing, growth vs. value, etc.) tend to produce better results than those more tightly confined to style "boxes.” Brown Advisory’s philosophy is consistent with this approach, as we focus on companies that we believe have the best fundamental prospects within broad investment categories such as large-cap growth, small-cap growth, etc. Our portfolio managers have the ability to own a reasonably wide range of stocks, in terms of market capitalization, growth rate, sectors, etc., within each style. One of the results of this latitude is that our portfolios generally differ materially from their respective benchmarks or indices rather than emulating them.
“Active Share”
In this connection, Morningstar recently published an article (September 2011) describing how it distinguishes among mutual funds that perform well against their respective benchmarks. One of its tools in this regard is a concept dubbed “active share,” developed by two professors at the Yale School of Management. The Yale paper titled “How Active is Your Fund Manager? A New Measure That Predicts Performance” is one of the more fascinating studies we’ve seen, in that it goes into great detail to quantify the extent to which a portfolio deviates from its benchmark and then relates the degree of deviation to investment results. Basing its conclusions on mutual fund data from 1980 to 2003, it quantifies “active share” as the proportion of a portfolio’s holdings that differs from the stocks in the relevant benchmark (i.e., the index that most closely resembles the portfolio; for instance, the Brown Advisory Large-Cap Growth portfolio would be compared to the Russell 1000 Growth Index.) “Active share” refers to the presence of stocks in a portfolio that are not included in an index at all and to the degree to which stocks that are part of an index are over- or under-weighted in a portfolio. As an example, if XYZ is 1.5% of the Russell 1000 Growth Index but 2.5% of the Brown Advisory Large-Cap Growth portfolio, our portfolio would be considered to have a larger active share than a fund that had a 2.0% position in the same stock.
The interesting aspect of the Yale study is that it found a clear correlation between active share and strong relative portfolio performance (that is, results compared to benchmark). Of course, portfolios with high active share can underperform their benchmarks as well as outperforming them (owning stocks that differ from the benchmark cuts both ways), but the study concludes that, in general, the higher the active share the greater the degree of positive relative performance. Not only that, the outperformance of managers with high active share tends to persist over time—presumably because their investment philosophy promotes ongoing differences in portfolio holdings relative to benchmark. Similarly, managers with low active share (“benchmark huggers”) tend to underperform. The active share of Brown Advisory’s U.S. equity portfolios is high—a characteristic that is consistent with our particular bottom-up, fundamental investment philosophy.
Figure 2. Indexing: Pathway to Profits?
Source: Bloomberg
Avoiding the Index
A simple, real-world way to think about the active share phenomenon was brought home to us in a recent meeting we hosted in Northern Virginia. Our keynote speaker was Ed Mathias, a director of Brown Advisory and a senior executive of The Carlyle Group, a major private equity firm in Washington, D.C. Ed showed a chart along the lines of the one in Figure 2, indicating that some of the largest, most recognizable stocks in the market in the fall of 2000 were poor performers over the ensuing 11 years, while lesser names such as Apple and Starbucks performed far better. If a portfolio were a benchmark hugger, it would have to have held significant positions in the largest capitalization stocks, if only because those were among the most important stocks in the index. To achieve a high active share, one would have owned stocks more like the ones in the bottom part of the table, which have produced better returns over the period shown.
Active management certainly holds the potential to achieve returns in excess of relevant indices, and various studies suggest that it, in fact, delivers on that potential under the right conditions. Properly executed, it offers an approach to achieving the returns necessary to offset inflation and maintain spend rates. In today’s low-return environment, adding, say, one or two percentage points to equity performance can make a meaningful difference in a portfolio’s total return. Recalling the three choices investors have for dealing with today’s paltry risk-free returns, we don’t believe that clients should have to accept eroding their purchasing power or reducing their cash flow, and we do not recommend shifting asset allocation in order to significantly increase risk in search of higher returns. Instead, by boosting the productivity of one’s existing allocations, active management can be a vital part of creating returns that meet overall portfolio objectives.
We take this opportunity to wish all of our clients and friends a healthy and prosperous New Year.
William L. Paternotte, CFA
Strategic Advisor and Partner
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The Russell 1000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics. The Russell 1000® Growth Index is a trademark/service mark of the Frank Russell Company. Russell® is a trademark of the Frank Russell Company. An investor cannot invest directly into an index.