October 5th, 2017
Dear Valued Clients & Friends:
Third Quarter 2017 Market Review:
The rally in stocks continued in the third quarter, with international equities again outperforming their U.S. counterparts. Emerging markets stocks were the top performer, with an 8% return for the MSCI Emerging Markets Index in the quarter. This benchmark now stands at a robust YTD return of 28.1% and remains the strongest performing index of the year. Second place belongs to the Russell 2000 Index (small company stocks), which returned 5.7% in the 3rd quarter and is now up 10.9% for the year. International developed stocks, as measured by the MSCI EAFE index, rose a respectable 5.5% for the quarter and are now up 20.5% YTD. The S&P 500 Index returned 4.5% in Q3 and is up 14.2% YTD.
Data provided by J.P. Morgan as of 9/30/17.
Improving economic data and earnings forecasts aided the increase in international stocks. A weaker U.S. dollar has also contributed to the relative outperformance of international companies in 2017. U.S. small cap stocks outperformed U.S. large cap stocks in the quarter, which was a change from Q2. This is attributable to improving economic data and increased hopes of tax reform.
Lower than anticipated inflation caused investors to be less concerned about the Fed increasing interest rates. This led to relatively unchanged yields for the quarter with the 10-year Treasury finishing the quarter at 2.3%, which was within basis points of where it started. High yield bonds outperformed government bonds for the quarter.
Why Don’t I Just Put Everything in the S&P 500?
This is a question we have been asked frequently in recent years as the S&P 500, represented as Large Cap in the below table, experienced three years of strong relative outperformance versus other asset classes (highlighted below). It is atypical for an area of the market to lead for three consecutive years and we wouldn’t be surprised if international and emerging markets stocks continued to lead for some time as a result. Interestingly, during the 2002–2016 period, a diversified portfolio of just 55% stocks, represented by Asset Allocation in the below table, had a slightly better annualized return at 6.9% than Large Cap’s 6.7% result – and with about 30% less volatility.
How did the S&P 500 end up so far down the annualized return list in the above table? Well, between 2000 and 2012, the S&P 500 returned a mere 0%. That’s right, twelve years of results that you would not have been happy with if all of your eggs were in the S&P 500 basket. During that same time period, emerging markets stocks returned 200% and real estate was up 100%. The financial media labeled this period the “Lost Decade” for U.S. stocks given the lack of returns for the S&P 500.
Data provided by J.P. Morgan as of 9/30/17.
What investors can take away from these previous two exhibits is that they make another strong case for asset allocation, via a thoughtful and professionally managed approach to portfolio design. Relative asset class underperformance or outperformance typically reverts to the mean, as has recently been the case for the S&P 500. Over a long period of time, a thoughtfully designed and managed investment portfolio can deliver strong risk-adjusted returns.
In the 3rd quarter, we identified a number of opportunities to help insulate clients’ portfolios against temporary selloffs, while continuing to offer participation in global growth over the longer-term. There were two primary portfolio changes in the quarter, which are described below in detail:
1. In July, we adjusted one of the structured note holdings in our clients’ portfolios. Once again, we had a structured note that had gained significant value. This note had a downside buffer which would now only come into play if those gains were first wiped out. As we have done in the past, we replaced this note to lock in the gains and reset the buffer to current market levels, to restore “first dollar” protection in the event of a correction while still maintaining upside leverage.
The note we replaced was linked to the S&P 500 index. Since inception, the price gain on the S&P 500 was 31.1%, and the note had gained 39.9% over the same period. We locked in this outperformance and swapped into a new 3-year S&P 500 note with a 10% downside buffer and upside leverage of 1.78x. This note’s return will be capped at 40.5%.
As a reminder, structured notes allow us to participate in the upside of equity market movements (at times with leverage as in these notes), while providing downside protection at maturity if the index declines over the term of the note. We are able to secure favorable pricing for our clients on these instruments because of the buying power that we have in the marketplace when we aggregate our clients’ assets. Then by making a number of investment banks bid competitively for each note, it further enhances the terms we obtain. These instruments are a valuable risk control component for us in our ongoing endeavor to protect client assets. For additional details on this note and structured notes in general, please read “October 2017 Structured Notes Program” PDF.
2. 2017 has been the worst Hurricane Season for the U.S. since 2005. The names Harvey, Irma, and Maria now hold a place in our memories similar to how Katrina, Rita, and Wilma do from 2005. Many are still suffering but thankfully insurance claims are paying out for a lot of folks. Individuals and businesses need insurance to protect against losses, such as natural disasters. Insurance providers, including Travelers, State Farm, etc., must also purchase something called “reinsurance” to protect their book of risks against losses due to outsized claims payouts (for more, see *Reinsurance Background below). The events of 2017 have brought demand for and investment opportunity in reinsurance that is higher than at any time since 2005.
We were approached by Stone Ridge in mid-September regarding once-in-a-decade-type opportunities in the Reinsurance marketplace. Our Investment Committee deliberated, and after consultation with Stone Ridge, we tactically increased our exposure to the Stone Ridge Reinsurance Fund. We view this tactical increase in our model weighting as an opportunity to provide capital to the reinsurance industry, but at bargain prices thereby benefiting investors. We are also encouraged that this additional reinsurance investment will, in its own small way, help those recovering from insured losses by allowing insurance companies to honor and pay out claims. The Stone Ridge Reinsurance Fund committed $700 Million in additional capital to the reinsurance industry in September to assist with hurricane related losses.
*Reinsurance Background – The insurance industry has generally been profitable over time because insurance is not sold at fair value; it is sold at fair value plus expected profit. By building up retained earnings in low-loss years and by having a portfolio of unrelated risks on their books, insurers have generally been profitable over long periods of time. Reinsurers, or sellers of insurance to insurance companies, have also generally been profitable for the same reasons. In contrast to primary insurers, reinsurers hold more remote risks and also typically hold a far more diversified set of risks across geographies and perils. Like insurers, reinsurance companies expect to earn an underwriting profit because they provide a service to the market via putting their own capital at risk to take on their customers’ uncertainty. This underwriting profit is the reinsurance risk premium that Stone Ridge Reinsurance Interval Fund seeks to capture. This fund will allow clients to participate in this unique return stream alongside of the reinsurers. As you can imagine, it will also have a low correlation to other holdings in client portfolios.
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This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable. This presentation may not be construed as investment advice and does not give investment recommendations.
The securities presented may not be representative of the current or future investments for Compass Ion clients. You should not assume that investments in the securities identified in this presentation were or will be profitable.
Additional information, including advisory fees and expenses, is provided on Compass Ion’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Compass Ion does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.
Sources: Tamarac, J.P. Morgan