14 Apr 2021
Mouth-watering returns? You may want to temper your enthusiasm
It’s been roughly one year since the market bottomed on March 23, 2020, and oh, what a year it’s been. Investors may want to frame their first quarter statements because the 1-year returns ending in March could very well be the best absolute returns they’ll ever see over such a short period of time. Of course, the endpoint sensitivity of this moment, however ephemeral it may be, is going to cause a lot of heartburn, as the optics will likely put emotion in the driver’s seat and place logic in the trunk. With perfect foresight, investors could have made approximately 120% in micro-cap stocks, 103% in MLPs (Master Limited Partnership), 97% in small cap value names, or – on a relative basis – a rather prosaic return of about 56% in the S&P 500® over the past year. If only we could buy those historical returns! But alas, we buy (or should I say borrow?) them from the future.
What happened in the markets?
- Value Continues its Run
Whether this is “The Great Rotation” or just a rotation, the quarter concluded with a continuation of the first couple of months of the year. In March:
- Value stocks beat their growth counterparts yet again – not only in the small, mid, and large cap spaces in the U.S., but globally as well.
- S. small caps witnessed the most pronounced split, as small value stocks gained about 5.2% and small growth names fell by approximately 3.2%; a nice pairs trade for the hedge fund crowd, if they were able to pull it off.
- International stocks performed admirably, too, but for us U.S. – based investors, the dollar’s strength mercilessly chipped away at our fragile asset. Our fully hedged return on international developed equities was reduced from nearly 5.2% to a still respectable, but ultimately disappointing, slightly less than 2.4%.
- At the sector level, utilities, materials, and industrials led the way, while tech sank to the bottom, albeit with a still positive return of just over 1.6%.
- Inflation Takes Center Stage
Without much in the way of earnings news to digest during the month of March, investors focused their attention on inflationary indicators and the Fed. There is currently a sizable disconnect between the Fed’s statements about when they will raise rates and the market-based probability of an increase next year. Only four FOMC (Federal Open Markets Committee) participants think they’ll raise in 2022, while seven say they’ll do it in 2023. Mr. Market, however, is putting the odds of the Fed blinking in 2022 at close to 80%. Inflationary pressures are no doubt mounting, as input costs, transportation costs, and wages for ever harder to find qualified labor are all rising. At the same time, supply chain bottlenecks – including a minor reckless driving incident in the Suez Canal – and pent-up consumer demand all seem to point to higher near-term inflation. But looking at the inflation breakeven rates (“IBRs”) suggests that the market believes any inflationary spikes will be confined to the next couple of years, as according to FRED (Federal Reserve Economic Data), the 5-year IBR at the end of March was 2.5%, while the 5-year, 5-year forward IBR stood at 2.2%.
- Bonds Hang Their Head in Defeat
All the hand wringing about inflation did take a toll on the bond market, which could be forgiven for getting caught gazing out the window, reminiscing about its glory days. U.S. investment grade bonds fell by nearly 1.3% for the month, capping its worst quarter in decades. Duration was again penalized, with long-term Treasuries getting thumped by about 5%, while credit risk paid off slightly in junk at around +0.2%. However, not in the investment-grade sector, where interest rate sensitivity is more pronounced, and corporates fell by approximately 1.7%. The yield on the 10-year Treasury increased by 30 basis points, ending the month at 1.74%.
How are Frontier strategies positioned?
Allocation Changes
It was a quiet month in terms of trading activity. In fact, the only trades that we placed were to harvest losses from Treasury positions in certain taxable strategies. As such, our risk exposures were static for the month, and we remain generally underweight REITs, commodities, and absolute return, and overweight to Long-term Treasuries, TIPs, and managed futures. Specific to our more conservative strategies, we are also overweight T-Bills. Our positioning on equities remained slightly south of neutral, with a preference for U.S. small caps and emerging markets.
Performance Attribution
Our more aggressive strategies all turned in solid absolute returns for the month but were marginally behind relative benchmarks, while our conservatively oriented strategies danced around zero. Equity positioning as a whole was a slight headwind to performance, as our small cap tilts in the U.S. and abroad, along with emerging market exposure, underperformed U.S. large caps, where we are moderately underweight. An overweight to managed futures and an underweight to commodities was beneficial. Simultaneously, long-term government bond exposure continued to weigh on results, even as our total exposure to the asset class has come down meaningfully from last year. But since we at Frontier are committed to seeking the best risk-adjusted results that we can for our clients, as opposed to just accepting the risk of the moment, we believe the need for broad diversification with a limited toolbox for hedging equity risk requires some fixed income duration exposure.
Long-Term Return Expectations
With yet another month of positive returns to risk assets, our long-term return expectations for most equity classes declined – most notably for U.S. large caps. Emerging markets were the one equity class that experienced modest improvement and tops the return expectation chart. As for fixed income, the glass-half-full perspective of rising rates is better expected outcomes. But with high quality and high yield bonds offering low expected returns, there isn’t, according to our estimates, much to celebrate at present. Investors eyeing the mouth-watering returns of the past year would be wise to temper their enthusiasm as they look to the future.
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 may modify its process, opinions and assumptions at any time without notice as data is analyzed.
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. Frontier does not directly use economic data as a part of its investment process.
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.
Hypothetical expected returns have certain limitations, are discussed for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns referred to. 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 expected. 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 expected. 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 and holdings of model strategies may vary from strategies managed by Frontier.
The Federal Reserve Economic Data (FRED) is an online database of economic data maintained by the Research division of the Federal Reserve Bank of St. Louis.
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ASSET CLASS |
ASSET CLASS DESCRIPTION |
U.S. Large Cap Stocks |
US large company stocks traded on the NYSE, AMEX, and NASDAQ |
Master Limited Partnerships (MLPs) |
Energy Master Limited Partnerships (MLPs) sector |
Information Technology Stocks |
The information technology sector of the U.S. Equity Market. |
International Stocks |
Large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada |
Emerging Markets |
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 |
Commodities |
Futures contracts on physical commodities |
U.S. Investment Grade Bonds |
U.S. investment grade bonds with at least one year remaining to maturity, denominated in U.S. dollars and that are fixed rate, nonconvertible and taxable |
Treasuries |
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 |
High Yield Bonds |
Represents domestic non-investment grade corporate bonds. Floating rate and convertible bonds and preferred stock are not included |
U.S. Small Cap Stocks |
The small-cap segment of the U.S. equity universe |
U.S. Small Cap Growth Stocks |
The small-cap growth segment of the U.S. equity universe |
U.S. Small Cap Value Stocks |
The small-cap value segment of the U.S. equity universe. |