Island Light Quarterly Commentary (September 2012)
And thus, into the fourth quarter. I am always surprised at this time of year how quickly time goes by. Didn’t summer just begin? Elections are a scant six weeks away and end of year is in 90 days? How does that happen? The photographs reinforce the memories and the memories become selective. How many of us remember the perfect 82 degree sunny day that we spent in our favorite summer place? Do you remember it? The short swim, the cocktail or two, maybe a sail or a nice round of golf, a book on the porch, a barbecue with friends: these are the memories we ought to hold onto. When the summer has passed, and we are back into the grind of running on the never-ending, mouse-wheel of routine work-life, what do you bring out of your memory bag? I recommend that you look back at the good things that happened and make a placeholder in your mind or put a photograph on your desk, to bring the good memories out when times aren’t so good.
To be honest, I don’t necessarily follow my own advice. And I suspect that you don’t either. Most of us, being human, worry about a lot of things like our health, our parents or children, and our relationships with our spouses. We worry about money. We worry a lot about money. Do we have enough? Will we ever have enough? Will I get a raise, or will my husband keep his job? Those of us responsible for others, either as advisors or guardians, employers or friends, know that worrying is part of the deal. So we tend to focus on the bad things that happened, over-remember our recent challenges, and try to avoid the pain.
This behavior is normal. We value the pleasure of gain less than we value the actuality of pain. We think that losing a dollar, or a million dollars, is much worse than finding a dollar, or a million dollars. And we tend to get emotional about these things. Losing hurts, and so we try to avoid losing. We remember the pain of previous losses and try to reduce or eliminate the pain. So we try to control the risks we take by becoming more cautious, sometimes to the point of non-decision. That can make for bad investment decision making. Being too high or too low causes over-reaction, excessive caution in down times, excessive risk taking in up times, and costly mistakes.
This theme is one of the many reasons to work with an investment advisor. We’re not paid to be optimists, nor rewarded for being pessimists. We are paid to be prudent, careful, thoughtful and consistent. As stewards of your investments, we are charged with a standard of fiduciary care and responsibility that is both a privilege and a calling. Those who are building wealth through savings, work and thrift, and those who have already achieved a comfortable degree of wealth, deserve no less than our best work to produce results consistent with your goals. We can neither be too up nor too down. We try to be objective and consistent in thought, method and practice. We think that has shown the best results over the long term, for the long term investor.
Controlling for risk in investments is something that we take very seriously. Using specialized, expert systems for portfolio construction and capital market estimation help us to frame the investment problem into a manageable process. We use this rules-based process to control our own investment behavior and to retain a degree of unemotional response to market gyrations. It is also why we employ tools and information from other sources to develop our investment solutions. Such collaboration leads to solutions that embrace our best thinking and the best thinking of our partners and clients.
Third Quarter Results
Both equity and fixed income markets continue to surpass expectations for the three quarters ended September 30. U.S. and international equity markets have been strong, and fixed income markets have been better than expected. The U.S. market, as measured by the S&P 500 index, returned 6.4% for the quarter and 16.4% for the year. International Developed Markets, as measured by the MSCI EAFE Index, returned 6.9% for the quarter and 10.1% for the year. Emerging Markets, as measured by MSCI Emerging Markets Index returned 7.4% (quarter) and 10.4% (YTD). On the fixed income front, US Bonds returned 1.6% for the quarter and a respectable 4.0% for the year to date, as measured by the BarCap US Aggregate Bond Index. Gold was on a torrid pace in the third quarter, returning 11.1% and 16.0% for the year.
As the fourth quarter begins, we look back at the themes in this economic cycle, which are the weak or in- recession European economy, its impact on the Euro and the response of the ECB, weakening China demand, the Federal Reserve’s quantitative easing (QE3) program, the impending fiscal cliff and continuing monetary and fiscal uncertainty around the globe primarily due to fiscal deficits.
We have written previously about the Goldilocks US economy, running neither too hot nor too cold, with stagnant and weak economic growth and stubbornly high unemployment. In the last month, while the Federal Reserve increased its economic forecasts for 2013 to 2.5% to 3.0%, the Congressional Budget Office forecasts 1.7% GDP growth, less than expected, with the potential of the fiscal cliff sending the US into another recession. Who do we believe? We think that the Fed is nearer to the truth than the CBO. Not only do we remain optimistic about the vibrancy and inventiveness of the US economy, we think that a lame duck Congress will not let taxes increase automatically without action nor allow automatic spending cuts in Medicare and Defense, whatever the results of the Presidential election. If the fiscal cliff issue is not resolved, the CBO estimates that the impact of the policies set to go into effect will cut GDP growth by 4%, a huge problem. We believe there is little chance of governmental inaction. If we are wrong, expect a sudden drop in the US equity markets when it becomes apparent that no policy change is made, which will likely occur in December. Stay tuned.
If the Fed is nearer the truth, then the equity market should benefit. Estimates for 2013 earnings for the S&P 500 are expected to be from 10-15% higher than 2012 expected earnings. In addition, equities are yielding about 0.3% above the 10 year Treasury, which according to the Fed Model, should make equities relatively more attractive than bonds. All else being equal, we believe that equity returns will remain modestly positive in a normal range in 2013 and the remainder of 2012, although we’d be very surprised if increased volatility does not roil the markets during the fourth quarter, particularly in light of uncertainties surrounding the fiscal cliff, elections, and overall debt levels. We maintain a relative overweight to US equities in the investment portfolios.
We do not believe that inflation will increase from the current 2-3% annual rate in the short term, despite the combination of monetary easing and continued deficit spending. On the one hand are the very large amounts of debt on the global balance sheet and continued fiscal and monetary stimulus programs in the United States, which contribute to inflationary expectations. On the other hand, continued weakness in global demand and high unemployment in the US and Europe combine for weak demand for goods and services and a stagnant real wage environment. We believe that overall weak global aggregate demand will more than offset monetary stimulus. We think that inflation will be a concern in the longer run because of monetary expansion and thus continue to maintain inflation hedges (inflation-protected bonds, gold, real estate) in all portfolios. We also recognize that Washington might welcome some inflation in order to reduce its enormous debts.
Interest Rates and Fixed Income
The benchmark 10 year Treasury yield finished the quarter at 1.65%, essentially unchanged for the quarter, despite dropping to record lows (1.4%) during the quarter. Quantitative easing by the Fed (QE3) and Bernanke’s commitment to keep short term rates at or near zero (0.25%) for the foreseeable future helped the Treasury markets. The 30 year bond yielded a scant 2.8% at the end of the quarter. AAA Corporate bond spreads above the Treasury Spot rate are 60 basis points while AA Corporate Bond spreads are nearly 1%, lower than the historic averages. In Europe, the Eurozone benchmark interest rate was pegged at 0.75% and the British rate is 0.50%. Japan retains its 0% interest rate with Australia at a high of 3.25% for the region. The major Emerging Market interest rates range from 6% (China) to 8% (India, Brazil, Russia). The low interest rate environment for sovereign debt makes US corporate and Emerging Bond debt (US denominated) appear to be relatively attractive, despite the low corporate spreads to Treasuries. The portfolios have limited direct exposure to short and intermediate Treasuries and we may increase exposure to Emerging Bonds during the quarter despite its higher risk characteristics.
In August, Eurostat reported that the economies of the European Union shrank by 0.2% in the second quarter of this year, following no growth in the first quarter. Unemployment was reported at a record 11.4%. Inflation increased a lower than average 2.7%. Unemployment is particularly high in the troubled Mediterranean areas of Spain (24%), Italy (10.7%), and France (10.2%) and economists expect weak growth (1.3%) next year. Despite this poor economic news, European markets, measured in dollar terms, grew 8.7% in the third quarter and 11.3% for the year to date. The best performing market for the quarter, Germany, returned 13.9% and the worst market in the quarter, Ireland, lost 1.62%. The ECB and German decisions to stabilize the Euro and recapitalize European banks at the end of the second quarter was a principal reason for this third quarter equity recovery. Longer term, we do not think that Europe is out of its troubles and with unemployment at these record levels, have real concerns about the long term health of European sovereign debt. We maintain a relative underweight to Europe in the portfolios.
The Asia and Pacific regions
Whenever we discuss the Asia Pacific region, we remain disheartened by the Japanese economy, long term trends and equity market performance. Japan lost 0.8% during the quarter while the rest of the Pacific region returned nearly 11%. Tiny New Zealand was the best performing market at 15.4%. Japan is the world’s poster child for economic malaise and has been for more than twenty years, with a staggering debt to GDP ratio, negative population growth, continuing record deficit levels, low consumer confidence, low GDP growth and little hope for an economic turnaround. The rest of the Asia Pacific region is strong in comparison.
Emerging market performance for the third quarter was also strong, up 7.4% for the quarter and 10.4% for the year. Each of the largest emerging markets has experienced slowing growth prospects with Brazil, experiencing 0.5% growth in the second quarter down significantly from 8.8% in the second quarter of 2010. Brazil’s woes are due to a combination of a weak manufacturing base, relative to Mexico, its biggest Latin American competitor for export to the US, weak commodities demand from China and the slow European economy. India was the best performing emerging market for the quarter, returning 15.4% for the quarter and 25.4% for the year. India’s prospects for economic growth (5.5%) are better than much of the world despite over-regulation and an entrenched bureaucracy. China is also growing, albeit less rapidly than previously, at 7.6% higher than the comparable period last year. Economists forecast a decade of 7% growth versus the 10% or more annual growth of the last ten years. Overall, while emerging markets growth is slowing, this growth is higher than in the developed world and we expect emerging equity markets to continue to outperform developed markets. Our portfolios retain a relative overweight to emerging market economies.
As dedicated readers of this commentary are aware, we introduced liquid alternative strategies into the portfolios during the quarter. We categorize alternative investments into alternative asset classes and alternative strategies. An alternative strategy is an investment technique that is unique or different in that it has low correlation to traditional asset classes. Some examples of alternative strategies are managed futures, hedged equity, merger arbitrage, and global macro. Alternative strategies have been poorly represented by ETFs, although some new products, such as iShares Alternatives Trust, ticker ALT, are attractive additions to the marketplace. An alternative asset class is a non-traditional investment class of securities that also shows low correlation to traditional asset categories. We consider such an alternative asset class to include low volatility equities, gold, emerging bonds, REITs, TIPs and similar assets.
We further break alternatives into three components; equity complements, fixed income complements and diversifiers. Fixed income complements, like strategic income, help to diversify within the fixed income class. Equity complements, like hedged equity and merger arbitrage strategies, are designed to get equity exposure while reducing equity risk. Diversifiers, such as gold, managed futures and market neutral strategies, help to reduce the volatility of a traditional stock/bond portfolio. We believe that this form of categorization can help in the investment decision making process. During the quarter, we added the iShares Diversified Alternatives Trust, a relative value strategy and the PowerShares Low Volatility S&P 500 ETF, which we consider a proxy for hedged equity strategies, an equity complement. Other alternative class ETFs did not make it into the portfolios at this time.
The information below reflects our composite portfolio performance for the month and quarter ended September 28, 2012 and since December 31, 2011. Returns are net of investment management fees and transaction costs.
The Island Light Global ETF Income Portfolio was up 0.8% in September, 3.1% for the quarter and 8.2% for the year with a beta of 0.43 relative to the Russell 1000 and a current yield of 2.6%. Its index gained 1.3% for the month, 3.8% for the quarter and is up 8.2% for the year.
The Island Light Global ETF Balanced Portfolio gained 1.4% in September, 4.0% for the quarter and is up 9.8% for the year, with a beta of 0.73 relative to the S&P500 and a current yield of 2.7%. Its index gained 2.0% for the month, 4.9% for the quarter and is up 10.0% for the year.
The Island Light Global ETF Growth Portfolio gained 1.8% in September, 4.3% for the quarter and is up 10.6% for the year, with a beta of 0.96 relative to the S&P 500 and a current yield of 2.8%. Its index gained 2.4% for the month, 5.6% for the quarter and is up 11.4% for the year.
We measure our portfolios against an index of US fixed income investments (the BarCap Govt/Credit Index) and an equal-weighted index of Large US Stocks (Russell 1000 value) and non-US stocks (MSCI ACWI ex US).
Our relative performance for the third quarter was somewhat below our indexes for the quarter. The major impact for the short term performance shortfall was in our non-US equities, where our relative underweight to European equity hurt performance. In addition, the Vanguard Emerging Markets Index exhibited negative tracking error relative to its benchmark, an anomaly that we expect to correct in the fourth quarter. Finally, our overweight to small capitalization equities was a modest negative. Our fixed income investments and alternative investments were modest contributors to relative performance.
Because we traded the portfolios at the beginning of September, we make no material changes to the portfolio at quarter end. We remain cautiously optimistic for the equity markets, although we continue to monitor the political winds with regard to the fiscal cliff. While there is still a lot of negative news, and we remember too well our portfolio losses from the past, the good news of the last quarter and year, and our expectations of continued US economic modest growth with stabilization of the European market give us hope for the future.
Island Light’s investment methodology is designed on a process called “Enlightened Investing”. Enlightened Investing is a stable approach to portfolio management, emphasizing quantitative principles and proven investment practices, while accentuating asset allocation as the most important determinant of long term success in investment planning. This approach is designed for the long term investor.
For more information about Island Light’s Enlightened Investing methodology, or for further information regarding any of our portfolio construction, tactical overlay, estimation methods, performance information or anything else that comes to mind, please contact us at 508-687-0061 or email us at email@example.com
Matthew V. Pierce, President
October 2, 2012