You may have have heard, or likely will soon hear about, a relatively newer investment approach that has gained popularity over the past 10 years called fundamental indexing. Fundamental index vehicles have plenty of aliases such as: strategic beta, smart beta or factor investing. At the core, fundamental indexing is about creating a better index (pool of securities) by excluding certain companies and including others based upon a defined financial filter. It is less about picking the best company and more about picking a pool of securities that has what is believed to be more desirable long-term financial characteristics. The growth of this segment has been impressive to say the least. Morningstar reported growth of the “Strategic Beta” category to $745 billion as of February 2017.
“What goes best with a cup of coffee? Another cup.”
Thus far, 2016 has been an interesting year for money managers. We have seen the recent market rally mask some of the greatest market volatility experienced in five years. If you think back to the beginning of the year, you’ll remember the worst start to the calendar year ever for the S&P 500. As recession fears subsided, stocks rebounded and we closed at a new record high on the S&P 500 yesterday. We have also seen a reversal in commodity prices.
From a total return standpoint, the S&P GSCI, the commodity index, sits atop of its equity counterparts. The increase in commodity prices have helped subdue the concerns of a global recession, but also comes with drawbacks. The clear drawback is the price to fill your car. We have seen prices at the pump increase over the year as oil prices have risen and now hover around $50 per barrel. Another downside, one not as publicized as other commodity prices, is the price of coffee.
Thus far, the 2016 presidential race has been nothing short of surprising. It has been laden with controversy and criticism. With a victory in California, Hillary Clinton is the clear democratic nomination frontrunner. Donald Trump, the only Republican candidate left in the race, has won enough delegates to clinch the GOP party nomination.
While the outcome of the election is still months away, history suggests the markets respond far better to a predictable outcome. Markets hate uncertainty. Investment managers will seek clarity over the coming months by looking carefully at the economic proposals of each candidate. For example, markets might respond well to a reduction in the corporate tax rate, a bullish economic indicator. Party affiliation does not offer much insight into strong or weak performance of capital markets. We can look back to times when markets have performed well under both parties.
The turmoil in the energy sector was widely publicized since the historic decline of prices starting mid-2014. This has largely been due to a glut of oil in the market with relatively flat demand.
As a result, the energy sector was plagued with volatility and decreasing prices as investors fled for safety.
This negative sentiment has spilled over into what should be an uncorrelated segment of the energy industry: mid-stream providers. Think of mid-stream as an infrastructure of toll roads that transport and store units of energy, not just oil. As Jim Callahan discussed in his latest edition of Portfolio Matters, the U.S. pipelines currently transport 70% natural gas and 30% oil. The demand globally for oil has decreased the volume of oil flowing through pipelines, but natural gas production is growing. The Energy Information Administration, estimates that natural gas consumption will increase by 60% on a global basis by 2040. The U.S. is the largest producer and exporter of natural gas and estimates point towards an increase in volume of 9% in 2016. While oil gets all the press, we remind our clients that its natural gas that is more important to the U.S. mid-stream MLPs, and because of this, we are very comfortable with our mid-stream focused investment thesis.
On Wednesday, the Fed decided to put an anticipated rate hike on hold for at least another month. The planned hike was curbed due to the recent volatility experienced in the market. Although the job market has been resilient during this weakened economic period, broader economic factors have caused a period of increased market volatility, measured by the VIX index. U.S stocks have rebounded in the past month, mainly due to improving data, rising oil prices and an accommodative stance by central banks around the world.
When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.
Investors have surely noticed the recent volatility in the global market place. In the first few weeks of 2016, we have experienced very volatile markets both domestically and internationally. The catalysts of the global sell off have been the volatility experienced in the Chinese markets and the plunging price of oil.
On top of the China’s current economic issues, devaluation of the yuan has added angst around the globe. Although China’s economy is the second largest in the world, its stock market represents a fraction of the global equities market. Investors need to remember that China equity falls are more correlated with short-term psychological factors rather than the underlying China economic conditions.
Yesterday the Fed, led by Janet Yellen, made the announcement the investment community has been expecting: A 25 basis point increase in the Federal Funds rate. The Fed voted unanimously to set the new Federal Funds rate to .25%, up from zero. The outlined path will be a gradual increase with a target rate of 1.38% by the end of 2016. Improvements in the job markets and an increasing level of inflation both supported the Feds decision to increase rates.
The increase draws a close to an unprecedented period of low rates that were part of a grandiose plan implemented by the Fed to help stimulate the economy after the turmoil in 2008. The financial markets took the rate increase announcement in stride, reflecting growing conviction among investors that the U.S. is strong enough to withstand higher borrowing costs.
When we determine the appropriate asset allocation for an individual investor, the amount of risk the person can be exposed to not only depends on the amount of risk they can tolerate, but also on the total financial situation of the investor. Earnings exclusive of the investment portfolio are a critical component of determining the capacity for risky assets. Investors with high earnings potential are able to stomach more risk because they can easily recoup negative movements in the financial market.
We have all been told younger investors should take a more aggressive stance with their investment portfolio. This advice is a direct application of the human capital concept. Human capital is the present value of one’s future earnings potential. Although human capital is illiquid and not readily tradable, it is often the largest asset an investor has.
Many investors have the general understanding that fixed income prices move inversely with changes in interest rates. An increase in rates typically results in a decrease in value of the underlying fixed income security. However, many investors are uncertain about the relationship between interest rates and equity markets.
Over the past year, investors have been attentively watching for when, or if, the Fed will raise rates. The Fed has stated its plan to raise rates slowly to avoid derailing previous economic gains. Before assuming that rising rates will detract from the overall health of the economy, let’s focus on how rising rates will affect your portfolio’s allocation to equities.
It is important to understand why the Fed is preparing to raise rates. The Fed has been very accommodating to the economic recovery by holding rates at historic lows. The Fed is not raising rates with a goal of slowing down the economy, but rather to get back to a more “normal” level.