• INSIDE THIS ISSUE
• 
• Opening Article
• Global Economies Decoupling
• 
• Economics
• A Greek Tragedy and the Effect on Europe
• 
• Equities
• Developed Countries Finally Outperform
• 
• Fixed Income
• Home Country Bias in Fixed Income
  – No Thank You
• 
• Currency
• Sterling Weakens
• 
• Commodities
• Strength in Metals and Soft Softs
• 
• Special Report
• It won’t last
• 
• MASECO Update
• 
• Indicators
• 
• Contact & Disclaimer

Equities: Developed Countries Finally Outperform

Looking back at the historic equity returns of 2009, it is natural to want to carefully scrutinise the continued performance of equities in 2010. The beginning of 2010 proved to be a strong quarter for global equities with North America leading the pack and, setting new highs since the beginning of the financial crisis. The S&P 500 posted a return of 5.39% with value and small stocks performing even better and gaining 6.78% and 8.85% respectively. Some of the best performing sectors with double digit returns were the financial, industrial and consumer discretionary sectors. It is worth highlighting that the Canadian financial sector demonstrated incredible strength which was illustrated by Toronto Dominion Bank setting an all-time high and the other major Canadian banks near all-time highs.

Europe trailed the US and the MSCI Europe returned 3.51% in the quarter. European value stocks slightly under performed, returning 2.04% but European small stocks appreciated 9.05%. Non-US stocks as measured by the MSCI EAFE (Europe Australia and the Far East) index, were almost at 0.22% with good performance coming from small stocks which gained 9.05%. The laggard in the major economy’s equity performance was the FTSE 100 which showed a negative return of -0.44% for the quarter.

Interestingly, it was the developed economies – which were the biggest victims of the financial crisis – outperforming the Emerging Markets (up 2.41%) by about 0.72%. Regardless, we are seeing the equity risk premium returning globally and investors being compensated for taking equity risk as well as small and value risk in general. A year ago we wrote in our Investment Quarterly ‘Historically, small and mid-cap stocks have outperformed their large cap peers when the economy starts to recover.’

Being greedy like everyone else

Isn’t it surprising how fast the financial news forgets the lessons of the bad times? Recently, the Intelligent Investor’s Bull/Bear Ratio illustrated that there is a strong pull back of bears while the bulls are stampeding forward. This is an emotional behaviour that translates to participants in the equity markets being more greedy than fearful. Fondly enough this behaviour is a characteristic typical of many portfolio managers – where the strategy effectively sells weakness and purchases strength.

Today we have a prime example of the shortcomings of this strategy. An examination of equity fund flows show that although global equities had a modest net inflow for the quarter, emerging markets benefitted the most by a serious margin. In turn, the cash to asset ratios for mutual funds are currently testing historic lows. Typically, investment managers will rotate their portfolios to purchase equity strength which can collectively cause sector bull cycles and in this case the victims are the emerging markets.

After emerging markets received massive inflows late last year, the asset class underperformed in the first quarter of 2010 against the MSCI World and most developed nations. Meanwhile, the region most avoided by active managers for years, Japan, outperformed emerging markets last quarter. We highlighted this behaviour in our Investment Quarterly from the first quarter of 2009 and during our Investment Philosophy presentations. This lesson has regularly been observed in the past as recently as 2000/1 and 2008/9. As the dotcom bubble was reaching new highs, speculators were chasing the past performance of dotcom companies. Bond funds experienced heavy outflows while equity funds were receiving enormous inflows. Soon enough, the bubble burst with individual investors losing a great deal of wealth and investors selling equity funds in 2002 and buying bond funds near the respective lows and highs The same phenomenon happened at the end of 2008 when $320bn worth of equity mutual funds were sold (the most ever) contributing to the ‘lost decades’ of equity returns.

Separating from the herd – rebalancing

Research has shown that it is not possible to accurately forecast in advance this herd-like behaviour. Instead one should implement a disciplined rebalancing strategy that sells after strength and purchases after weakness.

As strong performing equity assets create a larger presence in a portfolio, the original allocation begins to shift and eventually becomes unbalanced. A disciplined rebalancing strategy will look to sell the outperforming assets and reinvest in the underperforming assets which at first sight appears counterintuitive. Taking the Far East as an example, the strategy would have sold the appreciated emerging market assets to purchase Japanese equity. In this example, it is clear that emotional behaviour is excluded from the decision-making process as the investor would not be a bear or bull regarding Emerging Markets, but only repositioning back to allocations that were in line with their profile.

Rotating the asset allocation of a portfolio can prove to have some adverse effects. As highlighted above, selling or buying positions does not mean taking a side with regards to the future expectation of returns. Only that it is most beneficial for continued and balanced exposure to risk premiums. In the table below we illustrate what investors experience when they rotate a portfolio’s asset allocation and the effect of reinvesting new contributions.

At the start of year one $100,000 is invested. Negative markets reduce the value of the original investment to $60,000 by the year end. An additional $100,000 is available to invest at the start of year two. The following tables show the outcome of various investment choices:

A Hypothetical Illustration of the Benefits from Rebalancing

The returns shown here are used as examples only. The figures shown may or may not be achievable in the current market. Past performance is no guarantee of future results. The hypothetical illustration shown does not represent trading in actual accounts and the performance results do not represent the impact that material economic and market factors might have on the decision-making process of a prospective investor or its financial adviser if the assets had been actually invested.

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