A Review of Private Ocean Portfolios in The Current Market Environment

Given the strong year in markets and the continued global recovery, we wanted to take some time to review what is happening in the various asset classes held in Private Ocean portfolios. The goal of this note is to separate the noise we have consistently seen in the news from the reality on the ground, and to review what forces are acting on various parts of equity, fixed income, and real estate markets. As of this publication we have seen a relatively tame market correction of just over 5% from all-time highs in equity markets. This was due to a multitude of events that compounded late in the third quarter, which continued through to the fourth quarter. Namely, the issues with Chinese real estate developer, Evergrande, the political theatrics surrounding the raising of the US debt ceiling, the on-going debate over Biden’s proposed infrastructure bill, and finally, inflation concerns caused by supply chain disruptions and wage growth. This latter issue raises further concerns over when the Fed plans to begin tapering bond purchases. 

Domestic Stocks

In US equity markets we have seen strong earnings across the board, which has helped lead this recovery and contributed to most of the total returns this year. Year-to-date the value premium has offered modest outperformance, as have small cap companies. Some of this outperformance can be attributed to the threat of rising inflation and rising interest rates, which tend to weigh more heavily on growth-oriented companies. As interest rates rise it becomes more expensive to borrow and fund growth projects, which drives much of these firms’ valuation. Additionally, during periods of modestly higher inflation, those firms that can pass along higher prices to customers more efficiently tend to benefit. Some example industries include energy, financials, Year-to-date, domestic equities have returned a strong 19.1% according to the Russell 3000 Index, even after the recent sell-off we saw in the first week of October. The DFA US Core Equity 2 fund (DFQTX), which targets value, size and profitability/quality factors in US markets has returned 21.6% year-to-date. Meanwhile the AQR Large Cap Multi-style fund (QCERX), which targets value, momentum and profitability/quality in the US has offered 20.2% returns over the same period.

International Developed Stocks

Similar forces have been acting on international developed stocks as have been acting on domestic stocks. Most other developed markets have been facing similar inflationary pressures considering the global supply chain disruptions. While the US has offered outsized monetary and fiscal support relative to other developed economies, European countries and some developed markets in Asia are also facing worse inflationary pressures than the US due to very high energy prices as well as increasing food prices and wage inflation. We may see economic growth headwinds as we head into the final quarter of 2021 and beyond to 2022 if the supply chain disruptions and inflationary pressures persist. Even still, international developed markets have returned 11.9% according to the MSCI World ex USA Index, and the value premium in these markets has pushed that return even further north with the MSCI World ex USA Value Index returning 14% year-to-date. The DFA International Core Equity 1 fund (DFIEX), which targets value, size and profitability/quality factors in International Developed markets has returned 14% year-to-date. Meanwhile the AQR International Multi-style fund (QICRX), which targets value, momentum and profitability/quality in International Developed markets has offered 12.5% returns over the same period.

Emerging Market Stocks

Emerging market indices on average have large weights to China due to China’s outsized market capitalization relative to other emerging market economies. For instance, China represents 40% of the MSCI Emerging Market Index. Given the recent regulatory crackdown across several industries in China including technology, healthcare, and education as well as the recent issues with Evergrande – one of China’s largest real estate developers – we have seen emerging market stock funds take a hit in general. Those funds that focus more intently on smaller, less growth-oriented names, like the DFA Emerging Market fund, have outperformed the index by a reasonable margin. This is also partially due to their underweighting to China with just 34% as compared to the 40% exposure of the underlying index. As far as Evergrande is concerned, our funds have little direct exposure to the company. So far, most of the underperformance in China can be attributed to the regulatory crackdown instead of concerns over financial contagion stemming from Evergrande’s potential debt default. One other headwind facing emerging market countries is the asynchronous recovery from COVID-19 as compared to developed countries as well as a stronger dollar, which can weigh on their economic growth. Emerging market stocks have returned 3.1% year-to-date according to the MSCI Emerging Market Index, whereas our preferred DFA Emerging Market fund (DFCEX) has returned 7.3%.

Real Estate

Real estate in the form of publicly traded Real Estate Investment Trusts (REITs) continue to be a meaningful driver of returns in Private Ocean portfolios. Where we saw the overweight to things like cell towers and data centers and underweights to office, retail, and resorts benefit our funds in 2020, these same differences have led to some underperformance during the recovery period relative to the underlying benchmark. Even still, over longer periods of time (3, 5, and 10-year) the flexibility of our funds and their ability to overweight and underweight some sectors have led to modest outperformance both domestically and internationally. As the global recovery continues, we are seeing office, retail, and other previously hard-hit sectors rebound. Domestic REITs, as measured by the Dow Jones US REIT Index have returned 32% while our preferred fund, the DFA US REIT fund (DFREX) has returned 27.7%. Over the 3, 5 and 10-year period, however the fund has outperformed the index meaningfully. International REIT markets have also rebounded modestly, with the Dow Jones Global ex US REIT Index offering 10% year-to-date. This is in line with how our preferred fund has performed: the DFA International REIT fund (DFITX) has returned 10.6% year-to-date.

Aggregate Bond Market

We invest in many fixed income asset classes in part to diversify across maturities, credit quality, and international bond markets. The goal of fixed income in our portfolios is to build a robust and conservative component to the portfolio to act as a ballast in times of volatility and general uncertainty. Fixed income markets have mostly recovered from the bottom of the market in March 2020 when liquidity dried up causing spreads to widen and dislocation in market prices to appear. Now fixed income markets in general face an upward sloping yield curve and the potential for rising interest rates. This type of environment is usually best suited for lower duration in the portfolio, which our portfolios aim to achieve by staying in the 4 to 5-year range. The US Aggregate Bond Index by comparison tends to have a longer duration at around 6.8 years. This year, considering moderately higher inflation and the rising interest rates, has been somewhat tough for the overall fixed income markets. The US Aggregate Bond Index has lost -1.8% year-to-date. As illustrated in the chart below from JP Morgan’s Guide to the Market, the market expects interest rates to begin rising as early as mid-2022, which has been supported by the recent information gleaned by the Federal Reserve’s September meeting minutes. In the meeting minutes the Fed discussed potentially raising rates as early as year-end 2021.

Short-Term Corporate Bonds and High Yield Corporate Bonds

Corporate bonds have fared a bit better, especially those with a shorter maturity and duration profile like our short-term corporate bond fund and our high yield corporate bond fund. Year-to-date the Bloomberg 1-5 Year Corporate Bond Index has been flat, returning -0.11%. The Bloomberg US Corporate High Yield Bond Index has returned a solid 4.4% year-to-date as market participants have favored more risky bonds for their attractive returns and solid yields relative to other bonds. Strong corporate earnings, strengthening of company balance sheets, and accommodative monetary policy has been helpful for this segment of the fixed income market with this latter force being a positive tailwind for most fixed income markets. 

Emerging Market Debt

Emerging market countries still face some headwinds as mentioned in the section discussing emerging market equity. The fund we employ in this portion of our portfolio looks to invest only in US dollar denominated bonds to avoid exposure to emerging market local currencies. The fund also follows an equal weighted scheme to avoid allocating too much of the portfolio to the most indebted emerging market countries. A strong US dollar, as noted in this chart from JP Morgan, can be bad for emerging market countries because it makes the debt burden greater when these countries go to pay down their debts or make interest payments. Additionally, as some of these emerging market countries continue to battle with COVID-19 and virus-related lockdowns, we have seen an asynchronous recovery in some of these markets versus their developed counterparts. Additionally, since these bonds are purely sovereign in nature, they tend to have a longer duration, which can be adversely impacted by rising interest rates. Nevertheless, our overall fixed income portfolio remains relatively short in duration. As such, emerging market debt is down -2.3% year-to-date. Regardless of this drawdown, we view emerging market debt as an important part of the fixed income portfolio as it adds diversification and a meaningful yield to the portfolio – over the past 12 months our emerging market debt fund has yielded 4.7%. 

Treasury Inflation Protected Securities (TIPS)

Another core view that we hold in fixed income is to have some exposure to inflation-linked securities to combat against periods of higher inflation. TIPS are one of the most commonly used instruments to express that view. Our TIPS fund, as well as the municipal bond fund that has a built-in inflation protection overlay, have both done well year-to-date given the moderately inflationary environment that we find ourselves in. TIPS year-to-date have returned 4.5% as measured by the Bloomberg US Treasury TIPS Index. The DFA Municipal Real Return fund (DMREX) has returned a solid 5.7% return over the same period. The JP Morgan Guide to the Market chart below, which looks at real and nominal interest rates, shows that real interest rates still remain in negative territory, especially in light of the recent rise in inflation. TIPS benefit from periods of higher inflation as the market prices in these increases and seeks protection from inflationary pressures in fixed income markets.

Municipal Bonds

Municipal bonds continue to be a valuable source of tax-free yield across our national municipal funds, California specific funds, and the high yield municipal fund. On a tax-equivalent basis, we are still seeing municipal bonds offering very attractive yields, and they continue to be the main holding across our clients’ taxable accounts. The high yield municipal market has been strong this year, with our fund SPDR Nuveen High Yield Muni Bond ETF offering 6% returns. National municipal bonds have returned only 0.2% year-to-date according to the Bloomberg 5-10 Year Muni Bond Index while California Intermediate bonds are slightly down on the year returning -0.4% over the same period, per the Bloomberg Municipal CA Intermediate Term Index. The main reason is California municipal bonds being tax exempt at the Federal and State level, whereas the national municipal bonds are exempt only at the national level – that state tax differential is usually taken into account when pricing these bonds, but on an after-tax basis they are relatively in line with one another. 

Liquid Alternatives

The final fund we wanted to highlight is the BlackRock Systematic Multi-Strategy fund (BIMBX), which invests across active fixed income, defensive equity, and currency markets. The fund tends to benefit from periods of high volatility when there are many price dislocations in the market that they can profit from. We saw this during some bouts of volatility last year surrounding COVID-19 as well as the elections in the latter half of the year. Our expectation is that this fund will perform somewhere between the overall bond portfolio and the equity portion of the portfolio, and the fund has done just that. Year-to-date the BlackRock fund has returned 3.9%. It has done so while also offering diversification in the overall portfolio due to it being uncorrelated with the other components of the portfolio.

Conclusion

Private Ocean invests in many areas of the market, each one with their own unique economic factors that drive risk and return. When taken holistically, the Private Ocean portfolio aims to be defensive from a fixed income and liquid alternative standpoint and looks to drive returns through the broad equity and real estate markets. Each component of the portfolio plays a critical role to the success of the overall portfolio. 

Sources:

All return figures are year-to-date as of 10/15/2021 unless stated otherwise

  • Morningstar Direct, Private Ocean Analysis
  • Blackstone Q4 Presentation
  • JP Morgan Guide to the Markets (daily)
  • Bloomberg, FactSet, Federal Reserve, J.P. Morgan Asset Management, Bureau of Labor Statistics

IMPORTANT DISCLOSURE INFORMATION

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