Happy New Year everyone! From the entire Nottingham team, we hope that your 2015 is off to a great start. Here at Nottingham, the start of the new year brings about something that we believe is one of the most important parts of the investment management process: year-end reviews. As a firm that prides itself on both transparency and client service, we enjoy the opportunity to sit down and catch up with our clients, but also share with them how their portfolios performed. It’s also a good time for us to answer any questions that they may have.
Usually, the questions that we receive are as unique and diverse as the individuals that we serve, but occasionally we come across one that seems to be coming up in almost every review session.
Over the last month, one such question has popped up over and over again. It is also our experience that if several of our clients are asking it, the rest of them are probably thinking it. Fortunately for us, we started this blog to have an informal way to reach our clients and share our thoughts and, for that reason, we thought we’d take the time to tackle it in its own post.
Going into several portfolio review meetings or conversations, we’ve felt very upbeat about the portfolios and their performance. The portfolios posted another positive year and we were able to successfully navigate the markets in 2014, posting strong performance relative to our benchmarks. However, after sharing this news with clients, some have looked a little disappointed. They’ve often asked:
The S&P 500 did great this year…up +14%! Why didn’t my portfolio do as well?
Now, we don’t blame clients for anchoring their expectations to the S&P 500, which is more often than not the market proxy that they are most familiar with. However, as we’ve mentioned before, it is a less-than-ideal yardstick in measuring the performance of a global multi-asset class portfolio. The S&P 500 tracks the performance of large U.S. stocks, while the portfolios that we manage also include exposure to international stocks and bonds. Last year, while U.S. stocks did well, one of those other asset classes did not. The culprit? International stocks.
As you can see from the chart above, international equities diverged from U.S. equities in May and actually finished the year down -5%.
This divergence seems particularly striking this year. We’ve managed global portfolios for more than 10 years now and this question hasn’t come up nearly as much in the past. The reason for this has been the size of the divergence in 2014. The performance gap (19%) between international and domestic equities was the widest it’s been in 16 years! No wonder the impact on portfolio performance seems so apparent. Last year was a truly unique year.
In light of this, some clients may wonder why we even own international equities in the first place. In a nutshell, investors win when they use the broadest opportunity set. However, the truth of the matter is that this only works over longer periods of time. In any given year, this exposure can serve as either a drag or a boost on the performance of a portfolio. As we found this to be a hot topic for clients this year, we did a little more research to help them better understand the issue. We looked at performance between domestic and international equities over the last 44 years to review the distribution of outperformance. During that period, U.S. stocks outperformed 21 times and international stocks outperformed 23 times. It was practically a coin flip. With no reason to believe that the future will be different from the past, this means we are just as likely to be sitting here a year from now being thankful for that “global perspective.” In fact, with valuations attractive and the economic dynamics shifting, many market participants are starting to sing the praises of international equities once again.
In closing, remember that the year-to-year gyrations amongst asset classes can be noisy; the chart below proves as much. It highlights the annual performance of different asset classes as well as the performance of a diversified portfolio combining all of them (yellow box).
For any given asset class, there isn’t a discernible pattern. However, the diversified portfolio’s performance does appear to move in a consistent pattern. It doesn’t wildly jump from top to bottom. It stays in the middle, providing a smoother ride. Sure, that means that in years like 2014 when the S&P 500 ranks towards the top, a diversified portfolio might not match its performance (so called “diworsification”). However, over the long-run, you can bet it will make the ride a lot more comfortable.
So for those of you that have asked it and for those of you that have thought it, hopefully this helps answer the question.
Until Next Time,
Chris Hugar, CFA