2014 was a bi-polar year for the global equity markets: US Large caps up 14%, the rest of the world down 4%. That disparity of result shows both the challenge of investing and the benefits of diversification.
The Tale of Two Markets played out among CSCM’s strategies and portfolios, just as it did across the global capital continuum. At the end of a volatile year, our S&P 500-based hedged-equity strategies (LCBW, LCBO, LCBS and LCPW) lead the parade, returning on average a little more than one-half of the annual return of the base equity market. That is a “sacrifice” we are happy to make, since the average down-market capture (an important measure of risk) of the four strategies was just 45%, compared to the S&P 500.
More of the Upside, Less of the Downside
Our objective in our hedged strategies is to present our clients with more of what they want - the long-term growth of equities - and less of what they don’t - short-term volatility. In 2014, we won that wrestling match with the S&P 500 again. To be sure, an unhedged position in the S&P 500 would have performed better than our hedged strategies but one doesn’t know that a priori, does one? In our view, protecting the value of a portfolio is more important than squeezing every last basis point of gain out of a frothy market.
The value of that protection was perhaps best illustrated last year in the Emerging Markets: where the MSCI EEM index lost 1.82%, our hedged EMBW strategy gained 3.43%. Even if both returns are smallish numbers, the fact that one is negative and the other positive is an important consideration. And, since the valuation difference between the S&P 500 and “all other” markets is now so stark, we are grateful that our simple, consistent hedging discipline means we can increase our exposure to undervalued markets (like EEM and Developed Markets) with greater confidence.
As one of our investing mentors once said: “Every investor has to ask himself the question: how do I want my regret?” We come down firmly on the side that the regret of a sharp, realized loss far outweighs that of forgoing the last bit of the bubble in a frothy market about Blackout Curtains For Kids.
2014 was a bi-polar year for the global equity markets: US Large caps up 14%, the rest of the world down 4% (see the image below). That disparity of result shows both the challenge of investing and the benefits of diversification. The US Large cap market appears to be levitating on a sea of Federal Reserve liquidity and a myriad of investors seeking returns in a zero percent risk-free rate environment. We wonder how much money would leave the equity markets if we woke up tomorrow and the T-Bill rate was 5%, where it was as recently as 2006. Investors who would normally prefer the safety of a risk-free T-Bill rate have effectively been told by the Federal Reserve to look elsewhere. And elsewhere is universally riskier than a T-bill. When investors who would rather not take that risk have the chance to earn a modest, safe return and de-risk, they will. That will probably put a little pressure on the equity markets.
There are a few things on the horizon in the capital markets that we are following closely, including: increased hedge fund skepticism, the growth of the market for ETFs and the ongoing debate about so-called smart beta, which in the proud tradition of Wall Street is an effort to package up passive investing in a new wrapper and charge more for it. We will expand on these topics in the future.
Outsized Equity Returns Can't Continue
We are not prognosticators here at CSCM, and that’s on purpose. We avoid the self inflicted wounds of active management and trying to outguess the random short-term action of the market. We are willing to predict however, that the equity markets will not continue to advance at twice their historical average, as they have done the past six years.