Over the recent holiday season I was again reminded how much I enjoyed playing board games as a kid. One game in particular was a favorite—the game of Risk (now, produced by Hasbro). If you ever played this amazingly simple, but equally addictive game, you may recall the primary tactical decision is either to attack or to fortify one’s defenses. While we are not targeting global domination at Threshold Group, we see the “game” of investing through a very similar lens.
In previous commentaries I have referenced either playing offense or defense or a bit of both as components of our investment strategy. Ushering in 2016, we expect that the concept of flexing between “attacking” and “fortifying” as part of one’s portfolio strategy will be critical to success. Our headline call in the beginning of 2015, “Volatility-Welcome Back, We Missed You,” should prove to be enduring through 2016 and beyond.
The fourth quarter began with a strong rebound as the broad equity markets bounced back from the painful results of the third quarter. Yet, the enthusiasm for risky assets in general waned during the remaining months, resulting in a lackluster “Santa Claus” year-end rally in the equity markets.
When we closed the books on 2015 and surveyed the global capital markets, we spotted more red than green in terms of results. And, even in the latter case, the gains experienced in those asset classes were muted. On a price basis, the S&P 500 Index (S&P 500) declined 0.73%, the Dow Jones Industrial Average (DJIA) lost 2.3%, while the international markets as measured by the Morgan Stanley All Country World Index excluding the U.S. (MSIC ACWI ex U.S.) –gave back 5.66%, driven primarily by the substantial decline in emerging market equities. In fixed income land, we experienced marginally positive to flat returns in the domestic investment grade market, while U.S. high yield bonds declined by nearly 5%. International and emerging market bonds fared even worse, primarily due to economic woes and the strength of the dollar.
I make it habit to review the previous year’s inaugural kick-off thematic piece with a critical eye. Were we focused on the key issues that would drive economic and market performance? When we welcomed 2015 with our volatility resurgence theme, we listed the pivotal questions that, we felt, would have the most impact on market outcomes and, in large part, we hit the mark. The headline stories driving much of these disappointing outcomes were:
- China’s struggles with growth as well as pivoting from a manufacturing to a consumer-based economy;
- The collapse in oil prices and the commodity complex in general;
- Central bank machinations;
- Another round of challenges with Greece;
- Russian military engagement in the Middle East;
- The massive influx of refugees in Europe; and
- Recent terrorism and the resulting major socioeconomic and political risks.
While investors may have paid little attention to these issues prior to the second quarter of 2015, they ultimately catalyzed the change in sentiment and a recalibration of investor views toward risk and reward.
Portfolios in Review
As you already know, we build portfolios aligned to your goals, needs and intrinsic tolerance for risk. As such, your advisor is best equipped to review performance specific to your portfolio. With that said, we can review, at a general level, how our investment approach performed in 2015. The good news is that many of our themes, which drove over- and under-weights to various asset classes, were additive to client portfolio performance during the year. Themes such as favoring core fixed income over credit, U.S. over non-U.S. equities, U.S. large cap and growth over small cap and value, and underweighting commodities, benefited portfolios.
Unfortunately, the themes and resulting weights that detracted from performance, while fewer in number, contributed significantly to outcomes. While exposures to emerging market equities have been actively reduced over the years, the sizable decline in the asset class proved to be a substantial headwind for our managers. In addition, an overweight to global infrastructure and master limited partnerships (MLPs) proved painful as evidenced by the year-to-date returns in those categories. While both were affected by concerns related to the oil and commodity collapse as well as the prospect for higher interest rates, we remain committed to both exposures.
Global infrastructure remains a long-term theme predicated on our belief that there is a major supply-demand (favorable) imbalance given growing populations in the emerging world. This should drive the need for new infrastructure, coupled with the aging infrastructure in a developed world in dire need of upgrading. In defining a thesis for a long-term theme, we set the expectation that the theme may be affected negatively by changes in short-term sentiment from time to time. Defining a theme as “long-term” helps mitigate the risk that long-term investors get sidetracked by short-term changes in sentiment that should not diminish the compelling prospects for growth as a result of the theme playing out. Global infrastructure was challenged by the effects of both slowing emerging growth rates on cyclical companies and the potential for rising U.S. interest rates on yield oriented positions.
A focus on master limited partnerships has been based on the potential for a multi-decade build-out of energy transportation infrastructure in the U.S. and the essential role MLPs can play in this infrastructure operation. With the price dislocation that began in the second quarter and worsened in the third, we believed we were being presented with one of the few investment “fat pitches” that we’d been served in quite some time given the sizable gap between the fundamentals and the price. We continue to believe that the decline in prices was driven by retail investors who naïvely believed that declines in oil and gas prices should equate to a decline in MLP prices. MLPs have been largely the domain of the retail investor and, as a result, have historically had periods of major downside volatility driven by the irrational decisions of that investor class. As our exposure is mostly focused on the sector of the MLP space dependent mostly on transportation and, as a result, collecting “tolls” based on volume, one could argue that lower oil and gas prices could result in higher demand and, consequently, higher volumes running through the MLP “highways.”
As we reviewed in last quarter’s piece, the Opportunistic strategies held up very well during the most acute market drawdowns experienced in August and September. While the exposure generally met expectations by finishing the year marginally negative, sitting between global equities and global bonds in terms of performance, we are less than satisfied with the results. The adaptive market segment, as expected, helped protect on the downside but failed to capture as much of the market upside given the rapid reversal we experienced in October. The capital allocator segment, designed to capitalize on macroeconomic trends more so than market exposure, was challenged by an environment that did not favor those strategies. In addition, we experienced very disappointing performance by one manager that was ultimately terminated for failing to deliver on our expectations of nimbleness and risk management.
Having fought the many market battles of 2015, we look forward to assessing which opportunities and battles may be lurking around the corner. At the risk of being repetitive, we see the volatility as a constant and very high profile companion -- as opposed to an occasional visitor -- in 2016 and beyond. There are many questions that are on our radar screen and, as previously stated, these questions belie issues that we expect to drive the markets. We will pay close attention to them as the year unfolds. These include, but are certainly not limited to:
- The Consumer. Will the consumer in the U.S., China and elsewhere come back to drive an extension of growth?
- Europe. Has Europe’s erecting of border controls in response to terrorism and the refugee crisis mark the beginning of the end of the European Union as we know it?
- Russia and China. Does Russia’s aggression and massive arms build-up (coupled with China’s growing military aspirations to divert attention from slowing growth) lead to increased tensions and Cold War II?
- Life After Lift-Off. How will the move away from the Federal Reserve’s zero interest rate policy affect asset valuations that may be extended due to an excessive and extended period of easy monetary policy? Does the worst performance after a quantitative easing cycle experienced in Europe late last year mark the end of the golden age of the central bankers’ “control” over capital markets?
- Re-evaluating the Consensus Views. Consensus views abound including, but certainly not limited to, the extreme bearishness toward oil and commodities in general, negative sentiment related to high yield, China’s economy, emerging market debt and MLPs, as well as positive views on the U.S. dollar, the U.S. economy and U.S. equity markets in general. Is there a contrarian case, and therefore, opportunities, to be made related to any, many or none of these?
- Political Dysfunction or Alignment? Does the recent bi-partisan, albeit controversial, budget deal mark the beginning of positive structural reform in the U.S.? How will the favorable trends toward more free-trade agreements affect the world economy? Will the leftist parties in Europe continue to gain ground elevating risk in Europe?
- Impact Investing Goes Mainstream. While we have more than an eight year history of experiences in impact investing, the rest of the investment industry appears to have begun to see the merits. The latter development brings with it good and not so good outcomes (e.g. greenwashing) but, on par, should be a net positive to attracting institutional capital and smart investors (and therefore, high quality investment strategies). Yet, in many areas, there remain compelling supply-demand imbalances. We will continue to do the good work in this space to identify and capitalize on them.
- Cyber and Tail Risks. Will the world experience a major cyber-attack or any other “Black Swan” event that drives a major inflection of sentiment to the negative?
Many years of easy monetary policy and the resulting financial repression have enticed capital to move into and inflate risky assets beyond their fundamental value in many cases. As we watch the global equity markets struggle through the first few days of 2016, the recent stressed market dynamics reinforce the extension of our overarching 2015 theme that volatility is back. Fortunately, a heightened sense of risk should help wash out some of the excesses embedded within asset classes - a cathartic and healthy but often painful process. More than in previous years, the current environment compels us to take more extreme and, seemingly, opposing positions to fortify and attack as one of the keys to a winning campaign in 2016. Observing the seemingly endless and, for that matter, trendless market churning and the increased potential for downside risks, we are actively reviewing our current portfolio allocations. We are keenly focused on opportunities to concentrate exposures in those areas of the market that can provide the greatest diversification benefits, can support portfolios in down markets, all while providing upside potential in a volatile yet trendless market.
The game of Risk is an exciting, yet very simple exercise in tactical strategy. Portfolio management, however, is anything but simple. While both feature the need to make tactical decisions, whether to attack or defend, that’s where the similarities end. Risk is a one-dimensional board game, played by children, where the outcome is somewhat determined by rolling the dice. Navigating the markets, building portfolios, and helping adults meet their unique goals is ultimately more complex, with new challenges at every turn. At Threshold, we are passionate about meeting these challenges head-on and designing the most effective strategies considering the multitude of variables present at any given time. That is much more exciting than Risk.
 Source: see chart sources.
©2016 Threshold Group is a Registered Investment Adviser.
Information and recommendations contained in Threshold Group's market commentaries and writings are of a general nature and are provided solely for the use of Threshold Group, its clients and prospective clients. This content is not to be reproduced, copied or made available to others without the expressed written consent of Threshold Group. These materials reflect the opinion of Threshold Group on the date of production and are subject to change at any time without notice. Due to various factors, including changing market conditions or tax laws, the content may no longer be reflective of current opinions or positions. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, Threshold Group does not warrant the accuracy of this information. The information provided herein is for information purposes only and does not constitute financial, investment, tax or legal advice. Investment advice can be provided only after the delivery of Threshold Group's Brochure and Brochure Supplement (Form ADV Part 2A&B) and once a properly executed investment advisory agreement has been entered into by the client and Threshold Group. All investments are subject to risks. Investments in bonds and bond funds are subject to interest rate, credit and inflation risk. Past performance is not a guarantee of future results.