July was the best month of the year for the stock market, with
the gains strong enough for the technology-laden Nasdaq to go into
the green for its year-to-date return and for the Dow Jones Industrials
to almost turn positive for 2005. The S&P 500 meanwhile, is
now up 2.9% as of the end of July. Client portfolios generally
performed in line with expectations, given their respective market
exposures and risk characteristics.
For the most part, our tactical asset allocation moves are working
this year. However, there are some areas where our positioning
has detracted from our relative performance and we thought it would
be useful to review those areas and give you our current thinking
about them.
Small Caps vs Large Caps
Over the 12 months or so, we have gradually eliminated our large
overweights in small and mid-sized companies and are now roughly
neutral between large and small companies. The graph at right,
shows how small caps have dramatically outperformed large caps
for the past five years. As a result of this lengthy period of
outperformance, the relative valuation picture had come to favor
large caps and this was the primary reason for our moving to a
neutral stance. A secondary reason was the assumption that economic
growth would likely begin to slow, since a slower growing economy
tends to favor larger companies.
Through the first four months of 2005, this looked like the right
move as stocks of larger companies indeed gained ground on small
company stocks. But since May, small caps have once again begun
to outrun their larger brethren. While our relative valuation argument
is still valid, to be fair, there have recently been signs of a
potential re-acceleration of economic and earnings growth in the
back half of the year.
Large Cap/Small Cap Ratio
(S&P 500 / Russell 2000)
Thanks to soaring oil and real estate prices, commodities and REITs led the way in the first half. Both emerging market stocks and bonds were strong, and, in general, U.S. bonds outperformed U.S. stocks. Hardest hit were technology stocks (Nasdaq) and foreign bonds, the latter being damaged by the U.S. dollars strong 10%+ gain.
While we would question the sustainability of any re-acceleration
of growth, it also seems fairly clear that the recent wave of economic
data supports expansion not contraction and positive surprises,
not negative surprises. We are closely monitoring the tradeoff
between small and large caps and moving forward, we will, as usual,
adjust our strategy if necessary.
Real Estate
We have carried no dedicated exposure to real estate investment
trusts (REITs) in recent years (we do have some exposure to real
estate in a number of underlying funds). REITs continue to be a
pocket of relative strength, rising 7.5% last month alone. Our
research, however, continues to show that REIT valuations are quite
rich, suggesting average to below-average return potential going
forward (even more so now given their appreciation this year).
In addition, REITs have not been acting like REITs normally do
in terms of risk characteristics. Their relative volatility remains
high as do their correlations to the broad market. This means that
REITS do not offer their typical diversifying characteristics which,
under normal circumstances, would offer important risk reduction
properties to diversified portfolios. In short, we don’t
like the risk/return tradeoff currently offered by REITs.
Bonds
Given the renewed strength in stock prices, bonds have recently relinquished
their total return advantage over stocks for 2005. While we don’t maintain
that bonds have a higher return potential than equities over the long term,
bonds still make sense for diversified portfolios. (We would, however, argue
that the difference between stock and bond returns over the next decade may
be narrower than what long-term averages suggest.) Not only do they provide
the shock absorbers for a smoother investment experience, which is often crucial
to staying with your investment plan, they can also add to returns in specific
market environments. (Note: over the last 5 years, through 6/30/05, bonds were
still beating stocks by nearly 10% a year!)
International
Despite international markets significantly outperforming the
U.S. this year, at least in local currency terms, one could not
tell that by looking at those same returns when denominated in
U.S. dollars. Due to a stronger dollar, the Morgan Stanley EAFE
Index, a proxy for developed foreign equities, was trailing the
S&P 500 by 1% this year through the end of July. Nonetheless,
moving forward, we remain big fans of international securities,
primarily because of higher growth prospects and lower valuations.
In addition, we also remain bearish on the dollar longer-term (twin
deficits) and think the recent strength in the dollar was a counter-cyclical
rally. All else being equal, a weaker dollar translates into higher
returns for international securities (assuming the currency exposures
are unhedged). In addition, international markets offer diversification
as well as an expanded opportunity set for active managers to add
value.
Another “P”
Shifting gears a bit, when we talk about our Research Process,
we often mention our “7 Ps”: Product, Price, People,
Philosophy, Process, Portfolio, and Performance. We have found
that list a good way to simplify the presentation of our investment
approach when trying to describe what
we look for in analyzing money managers and mutual funds.
Rob Arnott, who is the manager of the alternative mutual fund
Pimco All Asset, as well as one of the leading academics and practitioners
in the investment industry today, has yet another P: Progress.
To quote Rob: “Progress and innovation, often ignored,
are actually very important. The nature of market inefficiencies
is constantly changing. The manager who cannot or will not adapt
to a changing world is doomed to steadily diminishing performance.
Some investment managers proudly claim that they are using the
same process they used five, ten, or fifteen years ago. Sponsors
often find such a claim reassuring. They should not. It is an admission
of failure by the manager. Such managers are admitting that for
several years they have found no substantial way to refine or improve
their process. They are admitting that they have found no subtle
change in the way that the capital markets respond to their process.”
Committed To Improving
At Kobren Insight Management, we are always looking at ways to
improve our process. We have added significant resources in recent
years, in terms of both personnel and analytical tools. We have
also pushed traditional mutual fund analysis into new areas, constantly
studying and testing new ideas, to uncover more profitable ways
of analyzing the markets and managers.
A partial list of our recent work includes:
- Developed a proprietary internal fund scoring methodology to
add structure to our fund selection process.
- Studied the process of “mean reversion” momentum
on sector funds and ETFs.
- Examined the connection between portfolio manager compensation
and portfolio performance.
- Built an extensive database that allows us to examine the asset
allocation of the mutual fund industry as a whole to determine
whether or not we can derive valid investment signals (contrary
or otherwise) from how asset “bets” are being made
industry-wide.
- Created internal “Research Portfolios,” which in
effect are buy lists of mutual funds. These Research Portfolios
have consistently added value since we’ve introduced them.
- Developed a variety of in-house tools to monitor fund performance,
as well as to manage portfolio market exposures and risk characteristics.
We have also made strides in improving our client service and
communication including conference calls, a revamped website, and
a variety of articles and publications such as this Portfolio Manager’s
Report. We hope you have found them useful in understanding our
investment philosophy and process.
In the end, we believe that for investment firms to be successful,
they must continually grow and adapt to evolving markets, new technologies
and products, and the changing needs of their clients. We will
continue to ask our research team to question our process, explore
new ideas and create new methodologies to improve what we do. We
can always get better.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio ManagerCo-Portfolio Manager
