By Doug Sandler, CFA, Head of Global Strategy SUMMARY Multiple events underscore the need for active portfolio management, in our view. We believe that the current environment exacerbates some of the inherent risks in popular benchmarks.Active managers with flexible mandates can navigate current market factors, in our view.
If owning the ‘best’ of a ‘bad bunch’ is not your idea of a durable long-term investment strategy… Read on.
Multiple events underscore the need for active portfolio management strategies that are flexible and are thus less tethered to benchmarks, in our view. We believe flexible mandates are especially important in challenging times like today where the Delta variant is spreading, inflation is rising, the Fed will be tapering, and the data shows the economy slowing.
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1. Bond yields and credit spreads remain near historical lows.
Credit spreads are the difference between the yields on corporate bonds and treasury bonds. Narrow spreads and low bond yields mean investors are not getting much extra return for taking risk. The price of getting it ‘wrong’ in a fixed income portfolio is potentially higher than the risk of getting it wrong in an equity portfolio. This is due to the asymmetric nature of fixed income returns, where bonds can go to zero like stocks, but unlike stocks, they rarely have the appreciation upside to offset losses. We believe some of the advantages of a flexible mandate include:
- Ability to underweight bonds: When interest rates rise and/or credit spreads rise, bond prices fall. The cleanest defense against both risks is to underweight bonds in balanced portfolios.
- Ability to adjust sector allocations: Bonds come in a variety of flavors, such as investment grade corporates, mortgage-backed, high-yield, and floating-rate securities. Each sector responds differently to changes in interest rates and credit spreads, which gives an investor with flexibility the opportunity to move within sectors. For example, floating-rate bonds tend to be more protective in rising rate environments.
- Ability to shorten or lengthen a portfolio’s duration: Duration, which measures the length of time it will take a bond investor to get their money back, is particularly sensitive to changes in interest rates. Long-duration bonds, for example, are especially vulnerable to rising interest rates.
2. External pressure on America’s largest companies is growing.
We believe that a company’s stock price is the function of 1) the expectation of its future earnings and 2) investor’s confidence in the company’s ability to deliver those earnings. Therefore, when external pressures on a company rise, the expectation for its future earnings fall, as does investor’s confidence. A quick glance at today’s headlines highlight the growing pressures our nation’s companies are experiencing from the government and the public. Government pressures include anti-trust regulations in the Technology and Communications sectors, trade restrictions in the Industrial, Consumer, and Materials sectors, and profitability limits in the Healthcare sector. There is also increasing public influence on issues that have traditionally been governed by free markets, such as wages, privacy, and corporate governance. Flexible mandate advantages include:
- Ability to underweight/overweight sectors: The S&P 500’s sector concentration has increased significantly with the Technology and Communication sectors now (as of August 25, 2021) representing nearly 40%. In fact, the combined weighting of those two sectors is almost 2.5 times larger than the smallest five sectors combined (Staples, Real Estate, Materials, Utilities and Energy)!
- Ability to underweight mega-caps: The influence of mega-cap companies on the S&P 500 index has also risen significantly over time. Today, the five largest companies, each of which is in the Technology or Communication sectors, account for nearly 23% of the index (see chart). The risk of their outsized representation is compounded by the fact that they are each facing similar external risks related to their concentrated power in the marketplace. Managers with flexible mandates can steer away from mega-caps by favoring individual stocks over broad market-capitalization weighted indices.
- Ability to favor companies who understand how to play the game. When it comes to regulation and government spending, Strategas’ Head of Washington Research, Dan Clifton, says it best: ‘you can either be at the table or on the menu’. What Dan is referring to is the growing power of lobbying. Companies with strong government relations can work with lawmakers on new legislation and are strongly positioned for targeted government spending. Portfolios that favor these types of companies will outperform those that do not, in our opinion.
3. Some Emerging Markets (EM) becoming less share-holder friendly.
China’s crusade against corruption appears to have shifted to be a crusade against capitalism, and they are not the only ones. Flexible mandates allow global managers to limit this rising risk in their portfolios in several ways.
- Ability to underweight China: The Chinese Communist Party (CCP) has recently interfered with the free markets in several ways. Examples include reducing the autonomy of public and private companies, and also the ‘Special Administration Region’ of Hong Kong, attacks on several of China’s largest for-profit companies and their billionaire CEOs, and the squelching of what would have been one of the world’s biggest initial public offerings (IPO’s). Going forward, President Xi Jinping has also stated his desire for a ‘reunification’ of Taiwan and greater ‘social fairness’ (wealth redistribution). Investors do not like uncertainty or government intervention, and we expect Chinese equities to struggle. China comprises nearly 35% of the MSCI Emerging Market Index, as of this writing.
- Ability to underweight countries like Brazil and Russia: The Brazilian and Russian governments also have a history of intervention to the detriment of shareholders. Combined, the two countries account for nearly 9% of the EM index.
- Ability to underweight countries with weak currencies: Several EM countries (Chile, Argentina, Columbia) have seen significant declines in their local currency. Not only does a weak EM currency reduce the value of stocks, but it also creates the potential for higher inflation. This in turn places a greater burden on their ability to service debt, which is often denominated in more resilient currencies like the US Dollar and the Euro.
RiverFront is a believer in active management.
RiverFront’s portfolios and the portfolios of our investment partners are designed to be flexible, providing the latitude to deviate from popular benchmarks when appropriate. We recognize that the current environment exacerbates some of the inherent risks in these benchmarks and believe that current portfolio positioning is reflective of that. If you are interested in the specifics of our portfolio’s current positioning, please contact your financial advisor.