Island Light Quarterly Commentary (December 2012)
Investing for All Seasons
One of the great things about living in New England is the particular reference and meaning of each changing season. Spring is a season of warming, rebirth, hope, and new love. Summer is an exuberance of growth, heat, long days of reminiscence and a richness of living. Fall is a beautiful canvas, with harvests of plenty, tinged with the sorrow of summer’s end. And winter is long, cold, brutish and dark, yet full of the celebration of life. We embrace winter because to do otherwise would be to lose heart. Racing on icy slopes, wondering at the starry night, huddling closer to fire; that is winter’s best. The rhythms of the seasons give us points of reference that help us gauge our progress.
Financial types like me are comforted by the cyclical certainty that punctuates each calendar year. We know what to do at the end of the year and the beginning of the month. We buy small caps in December, sell in May and perhaps buy again in October. At quarter’s end we make trades so our holdings look just right. At year’s end, we like to keep score. We take out our pencils and algorithms and check off how we did and plan for what we might do next. We reflect, we summarize, we project, and perhaps we dream a bit as well.
In 2012, we survived the end of the Mayan world and we feared a leap off the fiscal cliff. Many of us had a pretty good year. Stocks and bonds were in positive territory, inflation was held in check more or less, the major economies in the world grew, more or less, and there were no enormous investment disasters. If we made it through the year with our health and a job, we should celebrate 2012.
We now anticipate the wonders and unknowable challenges of a new year of seasons, or in the Mayans’ case, a new millennium.
Fourth Quarter Results
Despite all the political rhetoric and manufactured crises, at the end of the quarter, markets shrugged off the headline news, rallied from mid-quarter lows and stayed even for the quarter. Riskier assets, such as non-US equities and small capitalization stocks out-performed. And we are pleased to report that the Island Light portfolios were positive for the quarter and performed quite well for the year.
The U.S. market, as measured by the S&P 500 total return index, returned -0.4% for the quarter and 16.0% for the year. International Developed Markets did very well, as measured by the MSCI EAFE Index, returning 6.6% for the quarter and 17.3% for the year. Emerging Markets also outperformed expectations returning 5.6% (quarter) and 18.2% (2012), as measured by MSCI Emerging Markets Index. On the fixed income front, US Bonds returned 0.2% for the quarter and a respectable 4.2% for the year, as measured by the BarCap US Aggregate Bond Index. Gold lost some of its luster, losing 5.9% for the quarter and ending the year up 9.1%. All returns are through December 31, 2012.
As we ring in 2013, we look back at our macro-economic themes from 2012 and see what looks different for the coming year. To repeat, we observed a 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 US tax and fiscal cliff situation and monetary and fiscal uncertainty around the globe primarily due to fiscal deficits. We look for more certainty in economic policy due to the results of the US Presidential election and new compromise on fiscal and tax policy. In Europe, the actions of the ECB in the second and third quarter reduced some uncertainty surrounding European sovereign debt. This drop in uncertainty should be an important positive development for equity markets. We now anticipate a continuing low global interest rate environment, continued significant natural gas development in the US, potential reversal of the quantitative easing policy of the US Fed, a slowly recovering Europe, and a slowdown in US GDP growth in the first half of the year as a result of changes in payroll tax policy.
We have written previously about the so-called Goldilocks US economy, running neither too hot nor too cold, with relatively weak economic growth coupled with stubbornly high but declining unemployment. We see nothing ahead to change our assumptions about this economy, although we expect a modest downturn in the first half of the year and gradual improvement towards the end. In December, it was reported that GDP grew at a rate of 3.1% in the third quarter. At the same time, the Federal Reserve reduced its economic forecast for 2013 to 2.6% from 2.9% while leaving its forecast for 2014 at 3.4%. The Congressional Budget Office offers the baseline projection of 1.7% nominal GDP growth (August 2012), assuming the deleterious effects of the fiscal cliff. While too early to assess the impact of the American Tax Payer Relief Act of 2012, we expect the new CBO estimate to be higher by approximately 1.3%. The elimination of the payroll tax relief will likely decrease GDP by about 0.7% everything else being equal. All things considered, we expect nominal GDP growth in 2013 to tally between 2.0% and 2.5%.
We wrote in the third quarter commentary that if the fiscal cliff is averted, then the equity market should benefit. Estimates for 2013 operating earnings for the S&P 500 are expected to be from 13 – 16% higher than 2012 earnings. In addition, equities are yielding about 0.4% above the 10 year Treasury, which according to the Fed Model, should make equities relatively more attractive than bonds. Finally, the current PE ratio for the S&P 500 is approximately 12.7 versus a 20 year historic average of 16.2. All of these factors lead us to believe that US equity returns should be modestly positive in a normal range in 2013, continuing their 2012 growth.
We do not believe that inflation will increase much from the current 1.8% 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, each of which contribute to inflationary expectations. On the other hand, relative weakness in global demand and stubborn but declining unemployment in the US and severe unemployment in Europe combine for low demand for goods and services and a stagnant real wage environment. In December, the Fed announced for the first time that it will link future moves regarding monetary tightening to threshold levels of unemployment and inflation, choosing 6.5% unemployment and 2.5% inflation targets, an important policy message. In 2013, we believe that overall weak global aggregate demand will more than offset monetary stimulus. Longer term, we think that inflation will increase primarily because of monetary expansion and a long anticipated recovery in housing (representing 40% of CPI weight). We therefore continue to maintain inflation hedges (inflation-protected bonds, gold, real estate) in all portfolios. One factor that could lead to a reduction in inflation is the impact of lower energy prices (especially natural gas) on energy and transportation. We also recognize that Washington might welcome some inflation in order to reduce its enormous debts. The current stalemate at the federal level seems highly unlikely to result in either massive tax increases or significant spending cuts, so there will be virtually no Keynesian dampening of the current inflation rate.
Interest Rates and Fixed Income
Nearly every investment strategist is spooked by today’s bond market. Historically low yields, a large supply of Treasuries and a reduction in uncertainty have created expectations that the 30 year fixed income rally will come to an end and that bonds of all stripes will suffer. We hope for a soft landing. The benchmark 10 year Treasury yield finished the year at 1.78%, essentially unchanged for the quarter, and up 35 basis points from its record low of 1.43% (July 25). 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 in 2012 (particularly the intermediate and long bond), and the anticipated lifting of QE3 will likely hurt bond prices in 2013. The 30 year bond yielded a shade below 3% at the end of the year. AAA Corporate bond spreads above the Treasury Spot rate are 0.6%, while AA Corporate Bond spreads are 0.9%, 0.2% below average. Lower credit spreads, while short of their historic averages, are still well above historic lows. In Europe, the Eurozone benchmark interest rate remains pegged at 0.75% and the British rate is 0.50%. Japan retains its 0.0% interest rate while Australia dropped to 3.0%. The major Emerging Market interest rates range from 4.5% (Mexico) to 8.25% (Russia).
The low interest rate environment for sovereign debt makes US corporate and emerging bond debt appear somewhat attractive, despite the low corporate spreads to Treasuries. We are not out of fixed income. We believe that fixed income has a place in a well- diversified portfolio to protect from downside loss. But we have tried to be more defensively positioned within the fixed income class by reducing overall exposure to Treasuries, while maintaining some exposure to corporate and emerging bonds, international sovereign debt, short term floating rate notes and short term corporate bonds. Thus we seek to minimize the effect of a rise in interest rates.
Eurostat reported in November that the economies of the European Union declined by 0.1% in the third quarter of this year, following negative and no growth in the preceding three quarters. That’s a full year of anemic negative growth. As a symptom of the continental recession, unemployment was reported at a record 11.7% overall, led by very high joblessness in Spain (25%). Inflation was at 2.2% and the OECD projects weak nominal growth (1.2%) and negative real growth (-0.1%) this year, possibly recovering in 2014. Despite this poor economic news, European markets, measured in dollar terms, grew 18.2% for the year. This made Europe the best performing region in 2012, albeit from a low base, with Northern Europe generally outperforming Southern Europe. The ECB and German decision to stabilize the Euro and recapitalize European banks at the end of the second quarter remains the most importance news from Europe, for it contributed to a large drop in credit spreads and good equity market performance in 2012. But Europe remains a slow growth region of the world and we prefer to make strategic allocations to faster growing areas. We maintain a relative underweight to Europe in the portfolios.
The Asia and Pacific regions
If we leave out the performance of Japan, the Asia Pacific region enjoyed remarkable returns of 24.6% in 2012. However, the Pacific region as a whole, including Japan, returned only 14.4%. Japan’s poor relative performance was not due to its local equity market but due to the weakness of the yen relative to the dollar. In local terms, Japan returned 22%, but only 8% in dollar terms. Japan has remained the world’s poster child for economic malaise 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. We are now splitting our Pacific investments into Japan and Pacific ex-Japan securities to adjust to this investment reality. As a result we have a relative underweight in Japan.
Emerging market performance in 2012 was 18.2% with performance ranging from minus 12% (Morocco) to a whopping 64% (Turkey). The largest emerging markets in terms of market capitalization in the index achieved these returns: China, 22.8%; Korea, 21.2%; Brazil, 0.1%; Taiwan, 16.7%; South Africa, 18.7%; Russia, 13.7% ; India, 26.0%. The disappointing economy in the group, Brazil, suffered from a slowdown in economic growth and decline in consumer confidence, due in part to regulatory and policy uncertainty.
Emerging markets economies by and large are in better shape than the developed world’s economies with regard to growth rates, level of sovereign debt, unemployment and other economic factors. Manufacturing advantages due to a low labor rate and pro-growth policies remain systemic advantages in productive capacity. Russia, South Africa and Brazil enjoy natural resource advantages and China and India’s enormous populations provide demand for goods and services and low labor rates to the advantage of local companies. Mexico enjoys proximity to the largest consumer market in the world. Their relatively low wage rates, growing at a slower rate than other emerging economies, work to their manufacturing advantage. These advantages and rapid growth rate are the primary reason to invest in emerging markets long term, despite the higher volatility, political and environmental risk present in these areas. In December, we introduce an exposure to emerging markets small cap companies which tend to be less financial and more domestic consumer oriented. Our portfolios retain a relative overweight to emerging market economies.
Our investment methodology, process and optimization technology give us a disciplined and stable framework for the introduction of non-traditional and alternative asset categories. The expected lower correlations among these non-traditional asset classes provide important diversification and risk control benefits. Because the type of risk control will vary with the desired risk target of the portfolio, these non-traditional asset diversifiers carry different weights depending on whether the portfolio is conservative or aggressive. For example, the fixed income portion of our conservative portfolios includes short duration fixed income and floating rate notes while our more aggressive portfolios will have an exposure to low volatility equities. Because of the stability of our process, we can introduce these different ideas into the portfolios and provide a more consistent long term outcome. It is hard to do this with less stable processes.
Attractive liquid ETF alternatives are difficult to find but are an important component of our investment portfolios, with their diversification contributing to reduced volatility. One of the challenges in finding an alternative asset ETF is our reluctance to invest in securities that are not “pure” ETFs, such as ETNs (exchange traded notes) or ETFs that create K1 income, due to their capital structure. In time, we expect that additional attractive liquid alternative categories will be introduced into the marketplace.
We consider “alts” to fit into two categories: alternative strategies and alternative asset classes. The first is an investment technique different and perhaps unique 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. The second type of alts constitute a non-traditional investment class of securities that also show 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 go on to break down alternatives into three components: fixed income complements, equity complements, and diversifiers. Fixed income complements, such as strategic income, help to diversify within the fixed income class. Equity complements, such as hedged equity and merger arbitrage strategies, are designed to get equity exposure while reducing equity risk. Diversifiers including gold, managed futures and market neutral strategies, help to reduce the volatility of a traditional stock/bond portfolio. We believe this form of categorization can help in the investment decision making process. During the quarter, we replaced iShares Diversified Alternatives Trust, a relative value strategy, with IQ Hedge Multi-Strategy Tracker, a macro hedge replication strategy.
We use these alternatives to protect us from the investment winters we know will occur.
The information below reflects our composite portfolio performance for the quarter and year ended December 31, 2012. Returns are net of investment management fees and transaction costs.
The Island Light Global ETF Income Portfolio Composite was up 0.4% for the quarter and 8.6% for the year with a beta of 0.43 relative to the Russell 1000 and a current yield of 2.2%. Its index gained 1.4% for the quarter and was up 9.8% for the year. We maintain approximately a 40% equity and 60% fixed income ratio in the Income Portfolio.
The Island Light Global ETF Balanced Portfolio Composite gained 1.2% for the quarter and returned 11.1% for the year, with a beta of 0.71 relative to the Russell 1000 and a current yield of 2.2%. Its index gained 2.0% for the quarter and was up 12.2% for the year. We maintain approximately a 60% equity and 40% fixed income ratio in the Balanced Portfolio.
The Island Light Global ETF Growth Portfolio Composite gained 1.7% for the quarter and was up 12.6% for the year, with a beta of 0.91 relative to the Russell 1000 and a current yield of 2.2%. Its index gained 2.3% for the quarter and was up 14.0% for the year. We maintain approximately a 75% equity and 25% fixed income ratio in the Growth Portfolio.
The Signal Rock Dynamic Balanced ETF Portfolio, offered in conjunction with Newfound Research of Boston, gained 0.9% for the quarter and returned 0.6% since inception (4/1/2012) with a beta of 0.77 relative to the Russell 1000 and a current yield of 2.24%. Its index (the Balanced Portfolio index) gained 2.0% for the quarter and was up 4.5% since April 1.
In December, we introduced two new Portfolio models, the Island Light Global ETF Conservative Portfolio and the Island Light Capital Preservation Portfolio. The Conservative Portfolio is invested to approximately a 20% equity and 80% fixed income allocation and the Capital Preservation Portfolio has no allocation to equities.
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).
We are pretty pleased with our overall performance during the year and quarter, even if our returns are slightly below our index. We invest for all seasons. In a strong equity environment, we expect to be a little behind our index, while in declining equity environments we hope to outperform a little. Our diversifying positions in low volatility equities, non-traditional asset categories and alternative assets are designed to keep returns more consistent over time and to aid in risk control, which we believe will help the long term investor. Our global portfolios are positioned to have more US equities than non-US equities because our investors live in the US and are most impacted by US economic growth. Both developed and emerging markets outperformed the US in 2012. Our modest over-weightings to value stocks, small capitalization stocks and emerging markets helped our relative performance in the year while an underweight in European equities hurt performance a bit. Our exposure to high yield fixed income and emerging bonds also helped performance, as did our exposure to longer duration fixed income in the first half of 2012.
Because we traded the portfolios at the beginning of December, we make no material changes to the portfolio at year end. We believe in our process and have given great thought to the positioning of the portfolios with respect to our long term expectations of capital market returns. We remain cautiously optimistic for the equity markets and not yet ready to abandon fixed income markets, where we remain shorter duration with exposure to credit risk. We believe that it is important to maintain downside protection from investor loss through exposure to alternative and lower volatility assets, even at the expense of somewhat lower returns when markets are positive.
We take comfort from the regularity of seasons, with the knowledge that economies and investments also move in cycles. While there is always negative news amid the good, and we remember portfolio losses from the past, there has been good news over the last quarter and year. These victories were rung up amid expectations of continued US economic growth, stabilization of the European economy and a return to growth in most emerging markets. All this gives 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 firstname.lastname@example.org.
The end of December marks the first full year of Island Light Capital’s incorporation. We had a pretty good year for a start-up, and believe ourselves to be positioned for a strong 2013, with new partnerships, expanded existing relationships, and a set of new investment series and ideas that should have us positioned well for all the coming seasons. We profoundly thank our partner clients, investors, friends and family for supporting our vision in helping to bring institutional process to a broader audience.
Matthew V. Pierce, President
January 5, 2013