22 YEARS OF RANDOM MONTHS
Geremy van Arkel, CFA | Director of Strategies
Now that 2020 is over, we can collectively look back upon all that happened last year and say, “well, that was obvious and predictable.” The pandemic, the response, the politics, the economy, and how capital markets reacted all make perfect sense, right? I say this in jest, of course, because within any given year, the pattern of events that occur and how capital markets react to those events can all appear quite random. For the most part, how the world unfolds in the short run is random.
In 2020, we certainly saw our fair share of wild and disparate outcomes. The year was somewhat of a poster child for the randomness of outcomes. Return-wise, however, there were two distinct months: March, when the S&P 500 fell close to 10%, and November, when it gained just over 10%. These two months were a tell on portfolio biases as they uncovered the risk associated with portfolios. If you performed well in March, your portfolios were likely heavily risk managed. But in order to perform well in November, a portfolio needed to have taken on considerable risk.
In which random month do you want to outperform?
Frontier strategies experienced a solid year, given the circumstances. They held very close to their expected downside risk targets (how much we would anticipate a strategy to lose within a given period of time) during February and March – no easy feat with stock markets down 30% or more – and ended the year with healthy returns that were beyond what we would have expected for the year. However, we also live in a world where emphasis can be placed on benchmarks. Through October, when equity markets collapsed and then recovered to their approximate beginning year starting points, most Frontier strategies achieved returns that were similar to their relative benchmarks. It was only in November when a certain kind of euphoria took hold and punched equity prices to new highs, when we started to trail benchmarks. While November provided a stunning tailwind for our strategies to end the year with solid returns, it was the type of month where only those with extended risk positioning would likely perform well.
While we all want to outperform when performance in capital markets is good, this type of outperformance can be attributable to simple risk exposure. Further, when performance in capital markets is exceptional, investors are usually making enough anyway. We at Frontier believe that it is far more important to, at all times, maintain risk management to seek to avoid negative surprises when market performance is poor – which is the time when performance matters most.
We know this because we have managed portfolios following our original philosophy and processes for 22 years, and during that time, a lot has unfolded. U.S. Capital markets have experienced; one of the worst decades ever and one of the best, a tech boom and bust, September 11th, corporate frauds, a real estate boom, and bust, interest rates rising and then falling to record lows, inflation and deflation, growth, and value leadership, a financial collapse, and the ushering in of the era of stimulus. You name it, we have probably seen it.
As a reminder, Frontier manages portfolios with an independent spirit and the following client ideals:
- Reduce losses to the best of our ability.
- Allocate portfolios towards future expected returns.
- Provide consistent added value.
- Limit surprises to the extent we can.
- Minimize client friction – trading, costs, expenses, paperwork, etc.
We believe that if we can execute these ideals consistently through most market environments, clients have the ability to, as a consequence, realize investment success, experience less risk, be able to endure and thrive through multiple market environments, and also be able to hold their portfolios for the long-term.
Since their respective inceptions, all of the Frontier Globally Diversified strategies have outperformed their benchmarks. Further, we have done this through multiple market environments, including one of the worst decades in recent history. It should be noted, too, that our core strategies have achieved this performance while enduring less drawdown than their relative benchmarks and while being spot-on to their stated target risk levels. We believe Frontier strategies have executed well, thrived through multiple market environments, and also survived the worst. We have achieved this by focusing on downside risk first.
While our strategies have achieved solid performance over an extended period of time, there are, of course, plenty of months when this has not been the case. One of the most notable periods when Frontier strategies underperformed benchmarks was 1999, when technology stocks dominated all other assets. At that time, the S&P 500 index was, and had been, dominating global assets for some time. This created anxiety and stress for investors who were seeking to outperform, in an environment where performance was already great. Sound familiar? Those investors who chased returns very likely experienced a tumultuous decade of performance following the tech wreck. Alternatively, Frontier Globally Diversified strategies experienced some of their best outperformance relative to benchmarks in our history. As I said previously, we have been here before.
From the vantage point of today, when we look back at the past decade of random months, the pattern for stocks appears only to go up – particularly for the S&P 500 index. Since the recovery from 2008, U.S. stocks have seen only two considerable blips of risk in that history: the 4th quarter of 2018, and the first quarter of 2020, both of which were quickly erased. In hindsight, it might be easy for an investor to jump to the conclusion that risk-seeking wins, and that stocks are never going to have significant risk again. I beg to differ.
I have been known to say, that a short track record is better than a long track record. That is because short track records have not been tested. Today, even track records that are 10 years long have not experienced an extended bear market. Further, it is statistically easier to be “right” over a 3- or 5-year time period than it is over multiple market environments simply based on the number of time-tested investment managers with a longer track record.
Yet it is specifically following periods of excessive equity market performance when the biggest headwind clients face is not the swings of capital markets, but the ever-present allure of performance chasing. It is during these times when investors can be mismatched to short-term or current market environment solutions that we believe are unlikely to continue their performance through multiple market environments.
Just as one day or month does not foretell the next, and each decade is not necessarily indicative of the next. To assume that what happened in the last 10 years will repeat in a similar fashion would be ignoring both history as well as the patterns of all other capital markets.
Alas, we must roll forward. From the perspective of the current precipice, I will leave you with just one question. Are capital markets going to perform exactly as they have over the past decade over the next, or are they going to do something different?
Just because you got away with it, doesn’t mean you didn’t take any risk.
Capital Markets Overview
Clifford Stanton, CFA | Director of Investments
On the heels of November’s spectacular gains, investors might have expected a cooling-off period for risk assets in December, but that was not to be. Instead, Citi’s Euphoria/Panic Index hit an all-time high, surpassing its 1999 tech bubble apex. This Index was just one of the many indicators reflecting how enthused investors are about the combination of low rates, an unabashedly accommodative Fed, and the prospects of a vaccine-related recovery. So, who benefitted the most from investor attitudes? Small caps: the Russell 2000 gained almost 9%, while large caps advanced by about 4%, international developed stocks returned almost 5%, and emerging market equities jumped slightly more than 7%. Thank the U.S. dollar’s decline of almost 2% for a good portion of the return to foreign equities.
A question that’s been asked by many is just how important were those stimulus checks to the market’s gains this year. As reported by Seeking Alpha, research from Envestnet Yodlee found that “…securities trading was among the most common uses – across nearly every income bracket – for the government stimulus checks issued in May.” Those questioning the sustainability of that dynamic can count us among their ranks.
Not to rain on the parade, but stock market gains pushed the price-to-sales ratio for the S&P 500 Index to an all-time high. With both euphoria and valuation indices setting records, caution is certainly warranted – but then again, we may just be old-fashioned.
Interest rates crept higher, with the 10-year Treasury ending at 0.93%, up from 84 bps at the beginning of the month. Despite the increase, the Barclays U.S. Aggregate printed a return of slightly more than 0.1%, thanks once again to credit. Duration was costly: the Barclays U.S. Treasury Long Index fell by about 1.2%. Finally, Junk bonds’ equity-like characteristics were on display, as the Barclays U.S. Corporate High Yield Index gained nearly 2%. With a falling dollar and improving economic fundamentals, especially in the manufacturing sector, commodities enjoyed another strong month, with the Bloomberg Commodities Index advancing by approximately 5%. Silver, corn, and soybeans all enjoyed double-digit gains.
During the month of December, Frontier shifted some of the equity exposure within the Long-Term Growth strategy from global value to U.S. small cap. We also trimmed global value exposure within the Absolute Return strategy in favor of long-term Treasuries. Within our taxable strategies, we upped exposure to U.S. small caps at the expense of short-term TIPs (Growth & Income), reduced short-term munis and Treasuries in favor of long-term Treasuries (Absolute Return Plus), and reallocated cash to an unconstrained bond fund (Short Term Reserves).
Post-trading, our strategies remained more conservatively oriented relative to their long-term strategic allocations, but at the sub-asset class level we are overweight in certain risk assets. While Frontier is underweight equities in total, within our more conservative strategies we are overweight U.S. small caps, and within the more aggressive strategies, we have modest overweighting to international small caps and emerging markets.
As was the case in November, Frontier’s overweight exposures to domestic small caps within our more conservative strategies and to international small caps within our more aggressive strategies were beneficial. Further, the overweight to emerging markets in the more aggressive strategies boosted relative performance. However, the overall underweight exposure to equities – namely, international and U.S. large cap stocks – was detrimental, given yet another month when stocks dominated bonds of all kinds, and in particular, long-term Treasuries fell. On average, fund selection had a modestly negative impact across our strategies for the month.
Frontier’s long-term return expectations for all equity classes decreased yet again, as did the expectation for high yield bonds, given the valuation changes over the month. Conversely, the outlooks for high quality bonds and long-term Treasuries improved but remain at unattractive levels and are held primarily for risk reduction.
Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains and losses, but gross of advisory fees. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an s investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses.
Frontier does not directly use economic data as a part of its investment process.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within. Frontier reserves the right to remove these links at any time without notice.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions. Additional information on performance and mutual fund added value is available upon request.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or overcompensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether backtested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results in that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts. Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results reflected, or any corresponding benchmark presented. In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance.
Frontier provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance of model strategies may vary from the performance of strategies managed by Frontier.
It is generally not possible to invest directly in an index. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
Measures international equity performance. It is comprised of the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
MSCI Emerging Markets
Measures large and mid-cap equities across 23 Emerging Markets (EM) countries which include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
Bloomberg Commodity Index
This is a broadly diversified index that allows investors to track commodity futures through a single, simple measure. The DJ-UBSCISM is composed of futures contracts on physical commodities.
Barclays US Aggregate Bond
Measures the performance of the U.S. investment grade bonds market. The securities must have at least one year remaining to maturity, must be denominated in U.S. dollars and must be fixed rate, nonconvertible and taxable.
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
Barclays U.S. Corporate High Yield Index
Represents domestic non-investment grade corporate bonds. Floating rate and convertible bonds and preferred stock are not included.
Measures the performance of the small-cap segment of the U.S. equity universe
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