Client Letter 2Q 2019
We have arrived at the end of another quarter, and it has been one of more change. As you know, we have been going through a “re-boot” with a new logo and a new web site. Those were easy and cosmetic changes. The changes being made now are more fundamental to the business. You may have noticed a fair amount of trading throughout the quarter. We were gradually reallocating client accounts into select mutual funds.
This goes to the heart of one of the key changes I have implemented. In the past I have attempted to pick good stocks for client accounts. I would try to find stocks that were “mispriced” – selling for less than a calculated intrinsic value. However, times have changed. This worked reasonably well for several years. It took a lot of work, but that was the fun part for me. It was often a labor of love and when we bought into a stock that then did very well, that was gratifying.
Information travels much faster now. When I was buying individual stocks, my starting point was to look at key factors that had been shown to lead to higher investment returns based on academic research. This has now evolved into a major business for large institutional investors. These firms have created funds that invest based on these “factors”. With billions of dollars pouring into these funds, it is far more challenging for old hands like me. If you Google search “factor investing” you will get 102 million search results! These firms have computers that can scan the investing universe in seconds and find stocks that meet their criteria virtually in an instant. Worse, because these funds are targeting the same factors that I was looking at the end result is that any advantage we had is arbitraged away. A decade ago, there were not a lot of people investing the way I was. Now there are billions of dollars in mutual funds and exchange-traded funds using the same factors I do and all at the same time. This results in a loss of an investment advantage and reduced returns. Therefore, I am moving my clients more and more to mutual funds. This is what you have been seeing in your accounts – the move to a few key mutual funds.
This does not mean that I will stop looking for individual stocks based on the factors that I think make sense. However, I am leaving the purchase of these individual stocks to larger accounts and limiting the amount I invest in any one name to limit the risk. These larger accounts will also have a large mutual fund component as well as a “core” around which to build with the individual stocks. Everyone is benefitting from this shift to mutual funds.
I can tell you the move to mutual funds has not come without a few growing pains. The search for the right funds to use in client accounts has been very challenging. There are a number of factors that I consider before settling on an appropriate fund. While performance is certainly one key factor – we definitely want funds that will provide a good long-term growth rate for us – I am looking at far more than just the best 1-year or 10-year return. I am looking at consistent performance over time. Ideally, we want funds that consistently perform in the top 25% of their peer group. However, there is far more to it than “how much did it grow?”. Another key factor is what we in this business refer to as “upside versus downside capture”. This sounds complicated but is easy to understand. I am looking at how well a fund performed when the market went up and how it performed during down markets. If a mutual fund grew faster than the markets during up times this may be good but if it lost a lot more during downturns that could be very troubling. We don’t want a fund that grows 5% more than the overall market during good times but loses 15% more during bear markets. This digs a deeper hole to climb out of for the managers. I am looking for funds that control risk – that is, funds that lose less during down markets. We can win by not losing.
We have added several mutual funds across client accounts. Chief among the relatively newly added funds is the Janus Henderson Balanced fund (ticker: JABAX). This fund and the T. Rowe Price Capital Appreciation (ticker: PRWCX) fund – which is currently closed to any new investors – are the “core” funds in client accounts. Both funds will hold 50 – 70% of the fund in stocks with the balance in bonds. The manager will decide when to tilt more toward stocks and when to cut back and tilt toward bonds. Both have a long history of being relatively conservative in their investment style while not sacrificing returns. One of these funds will generally comprise anywhere from 25% up to 50% of a client account depending upon the situation, the risk tolerance and risk capacity of the client.
In addition to these two core funds, we are supplementing them with the T. Rowe Price Small Cap Value (ticker: PRSVX) fund for exposure to small company stocks and a blend of the Parnassus Mid-Cap (ticker: PARMX) fund and the BlackRock Mid-Cap Growth (ticker: BMGAX) fund for exposure to mid-sized company stocks. Both small company stocks and mid-sized company stocks generally have greater growth potential but may also come with additional risks. To offset some of the risk of these additional funds, we are using the PIMCO Income fund (ticker: PONAX) which invests in bonds.
So now that we are using mutual funds, what is my role? My key task now is asset allocation. That is, trying to find that blend between stocks and bonds that will serve to offer the best return that we want or need for your account with the least amount of risk. It is also my role to monitor what is happening in the economy and adjust portfolios as needed. For example, currently there is much talk of a coming recession. The big worry is the “inverted yield curve”. I wrote about this recently but let me touch briefly on it again. An inverted yield curve happens when you can earn more interest on a short-term loan (bond) than on a long-term loan (bond). Historically, whenever there is a yield curve inversion, a recession will typically occur within the next twelve to eighteen months. With the timing of the recent yield curve inversion, this would indicate a possible recession sometime between the end of this year and the middle of next year if it were to occur.
As I have mentioned in past letters the Federal Reserve is largely responsible for setting interest rates within the economy. They have a couple of tools to do this, but chief among them is what is known as the Fed funds rate – the interest rate banks are charged to borrow money overnight. The Fed raised this interest rate back in December setting it effectively at a 2.38% rate. In January, the Federal Reserve turned “dovish” – that is, they indicated they were less inclined to keep raising interest rates given the on-going trade wars and signs of slowing economies around the world.
Currently, markets are predicting the Fed will cut interest rates. That would be a very odd thing to do. The economy is doing reasonably well. Job growth continues at a moderate pace, unemployment is near historically low levels and inflation is virtually non-existent according to the measures the Federal Reserve uses. Typically speaking, interest rates are raised when the economy is very strong. The key reason for raising interest rates in that type of environment is to keep inflation from being a problem. Conversely, the Fed will lower interest rates when the economy is slowing, and things are turning bad. To cut interest rates now – during a strong economy – is somewhere between silly and dangerous. If the Fed were to cut interest rates by the typical 0.25%, this little if any effect. If they cut by more than that or had several rate cuts the market might infer that the economy is much weaker than it appears, which could actually spark a recession. Besides, if the Fed cuts rates now – in an economy that is still reasonably strong – when we do move into a recession there will be less room to cut interest rates to spur growth which could exacerbate any recession. I think Fed Chair Powell knows this and would like to preserve the interest rate tool for when it is really needed.
With that said, should our economy slip into a recession I will be reallocating portfolios. Currently, almost everyone’s account holds more stocks than bonds. There are two key reasons for this. The first is that bonds – those with the safest credit rating – generally do not pay a very high interest rate. A very safe corporate bond would only pay about 3% interest per year. Meanwhile, you can get a dividend yield of 2.4% on high quality stocks and the potential to see your money grow 8 – 10% per year. The bond is only going to give you the 3% interest and the original investment back. The second key reason that I will reallocate to bonds should our economy start to slip into a recession is the Federal Reserve would cut interest rates to reignite growth. When interest rates fall bond prices will rise. This makes holding bonds and bond mutual funds a nice hedge to stocks in tough times. If a recession seems imminent, accounts will lean more heavily on bonds than stocks.
As you can see, this investing thing is not simply “buy an index fund and forget about it”. There is a lot more involved here. While I feel like I have a great fund lineup for clients, I am always keeping my eye out for funds that may be a better fit – either because they offer a slightly better return with the same level of risk or they offer comparable returns with far less risk. In addition, I am remaining focused on how things are going in the economy, so I can adjust client accounts in order to continue meeting our investing goals.
Let me emphasize that it is my job to assist you. If you have any questions or would like to discuss anything, please feel free to give me a call! As always, I am honored and humbled that you have given me the opportunity to serve as your financial advisor.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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