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
We’ve pulled together a collection of recent charts, which we believe provide not only a concise recap of the major market moves defining 2014, but also some of our broad views heading into 2015. Click below to view the slide deck.
As always, please feel free to call or email us with any questions.
On December 5th, the Nottingham team volunteered at the Food 2 Families food drive. Food 2 Families is WGRZ 2 and Tops’ annual outdoor food drive that brings out the WNY community to support local families in need. The event raised over 100,000 pounds of food and benefits over 96,000 individuals served monthly by the Food Bank of Western New York. Click here to learn more about Food 2 Families.
Additionally, the Nottingham team got into the holiday spirit by purchasing gifts for the Gateway Longview Adopt-An-Angel Campaign. To learn more about the program, click here.
Let’s not mince words – for almost all investors, the S&P 500 Index is a terrible benchmark for their overall portfolio. Unfortunately, however, it tends to be the index that people are most familiar with and thus, the one they use. Each evening on the nightly news, the anchorman or anchorwoman will cast a broad summation of that day’s performance in the financial markets by citing the move in the S&P 500. For many, it’s the investment “barometer” that they see the most. This is likely a function of tradition as the S&P 500 Index was founded in 1957. At the time, large U.S. stocks made up the lion’s share of an investor’s assets and the performance of such was enough to pass judgment on the performance of one’s own portfolio. Over time, the S&P 500 became quite recognizable.
However, during the next 60 years, changes in the investment world have markedly changed an investor’s opportunity set. For example, an investor can now easily access a much larger variety of asset classes through the use of mutual funds or exchange-traded funds (ETFs). Despite this change in the make-up of investment portfolios, the S&P 500 and its strong recognition just stuck. In looking at it, the S&P 500 represents the largest 500 stocks in the United States. A quick analysis of that brief description alone is enough to realize that the index is clearly not built to measure the relative performance of a global portfolio allocated across multiple asset classes.
The index represents a collection of just stocks – not fixed income, not cash, and not alternatives. For everyone except maybe the most aggressive of investors, these are critical components of a well-diversified portfolio. Fixed income and cash provide downside protection in investors’ portfolios and provide the perfect counterbalance to much more volatile stock allocations. Moreover, alternatives have the ability to both mitigate risk and enhance returns.
Not only does the S&P 500 represent just a collection of stocks, it represents only stocks from the United States. Stocks from the rest of the world are completely excluded. As we’ve mentioned before, it is hugely important for investors to broaden their view and dedicate an allocation of their portfolio to stocks outside of the United States. Over the long haul, investors benefit from utilizing the most robust opportunity set. This is true because investments from different parts of the world are driven by different factors (growth rates, government policy, currency levels, valuations, economic activity, etc.).
Lastly, not only does the S&P represent a collection of stocks from just the United States, it represents only the largest stocks from the United States. While it is true that the overwhelming majority of the U.S. stock market is made up of the country’s largest companies, a still significant portion is made up of the companies that don’t make that cut – so called mid- and small-cap stocks. These smaller offerings provide a slightly different risk-return profile than their larger brethren and, therefore, they more often than not make it into many investors’ portfolios.
It’s pretty easy to see that the S&P 500 suffers from a broadness problem. It is much too narrowly focused to be used to correctly evaluate the performance of a well-diversified portfolio.
Let’s look at an example to see how using the S&P 500 as a yard stick may lead investors astray. Consider an aggressive investor with a portfolio made up entirely of global stocks. The chart below highlights annual performance over the past 15 years for domestic stocks (represented by the S&P 500 Index) and international stocks (represented by the MSCI ACWI Ex USA Index).
As you can see, in some years, domestic stocks outperform and in some years, international stocks outperform. If the hypothetical investor above uses the (narrowly focused) S&P 500 to evaluate performance, he or she will identify periods of both outperformance and underperformance based purely on the direction of foreign stocks. He or she may also attribute this performance to the overall management of the portfolio, when in reality it is purely a function of improper benchmarking. It is important to make sure that the benchmark is representative of the portfolio’s overall exposure to ensure an “apples-to-apples” comparison.
At Nottingham, we believe all investors should monitor and track the performance of their portfolios. If they’re managing it themselves, it provides some much needed self regulation. If they’re using an advisor (like us), it provides a high level of accountability. We’d simply advocate for making sure you are using the right “yard stick” to measure performance. We believe investors should view performance in the context of multiple assets classes, particularly domestic equities, international equities, fixed income, and cash. The weight afforded to each asset class should be derived from an individual’s specific risk tolerance. In many cases, those managing portfolios for themselves will find that an appropriate benchmark often introduces an unpleasant dose of reality as previously thought outperformance turns out to simply be the spoils of a bad benchmark. For those with advisors, it provides a much more fair and accurate view to evaluate their success or failure.
So the next time you see the S&P 500 quoted somewhere in the national news, be it in print or on television, just remember that it’s only part of the story…
Below please find a link to the Nottingham Advisors NASMP Quarterly Review. This is the third publication of a quarterly review for the Select Managers Program, and is aimed at offering color on both strategy and individual fund performance, as well as any portfolio changes that were made during the period. As always, feedback on our publications is always welcome. If you have any questions or comments, or would like to discuss any of the NASMP strategies in further detail, please do not hesitate to contact our office.
As most of our readers know, we use exchange-traded funds (ETFs) to gain access to different areas of the market. An exchange-traded fund is a basket of securities designed to track the performance of a particular market index. One of the distinct benefits of using ETFs is the diversification of holding multiple individual securities as opposed to just one or two individual names.
However, as the ETF industry has evolved and providers continue to offer granular exposure to smaller and smaller slices of the investment universe, some funds have become increasingly concentrated. The result is a growing number of ETFs that are skewed towards their top holdings. While a certain level of concentration does not make an ETF any better or any worse, it is important to realize the impact of it.
For a simple example, let’s look at the Technology Select Sector SPDR ETF (NYSE: XLK). Technology stocks have performed well this year and XLK is up +13.7% so far in 2014. For comparison, the SPDR S&P 500 ETF (NYSE: SPY) is up +9.9%; XLK has outperformed the broader market by +3.8%. A closer look at XLK’s current holdings reveals something interesting:
XLK has a total of 71 holdings and because the underlying holdings are weighted by their overall value, Apple (the most valuable company in the world right now) makes up 15% of the fund. Now, for the holders of XLK, Apple’s weight in the ETF has been a big boost to performance of late. The company has been on quite a move, up +25.5% on the year:
Doing some quick arithmetic, we can strip out the impact of Apple’s performance and get a sense for how the rest of the fund performed. Excluding Apple, the rest of XLK is estimated to have returned +11.7% year-to-date. That’s still a pretty good number versus SPY’s +9.9%, but without Apple’s large weighting and strong performance, an investor’s alpha (or outperformance) would be cut almost in half. With a meaningful portion of the ETF invested in a single security, it is not surprising that the performance of Apple has a direct bearing on the overall performance of XLK.
A quick screen of the options available to U.S. investors reveals that there are 23 ETFs with holdings of less than 25 individual securities and greater than $100 million in assets under management. While XLK’s concentration is largely the result of Apple’ market capitalization, this list is largely populated by ETFs with a very tight focus. Their concentration is the result of the narrowness of the fund’s mandate (think of areas like small individual countries or very specific industries).
Regardless of why an ETF might take on a higher degree of concentration, the moral of the story is the same. Just because an ETF is diversified across multiple securities does not mean that it cannot be concentrated among only a few. A basket of securities can still be affected by the idiosyncratic movements of its largest individual holdings. With one of two individual holdings making up a significant portion of some indexes, it is increasingly important that managers of ETF portfolios (like Nottingham) spend time not only understanding the fundamentals of a broader investment theme, but also that of the notable individual companies underpinning it.
Until Next Time,
Chris Hugar, CFA
Larry Whistler, Nottingham’s Chief Investment Officer, comments on the current state of the stock market in the WSJ article “U.S. Stock Prices Drop On Ukraine Fears”. Click here to read the full article.