2018 Q1 Investment Report Commentary
Low Volatility, I Knew Thee Well
A historic era is over. For 18 months prior to January of this year, the S&P 500 experienced zero pullbacks of 5% or more. This might not sound impressive in and of itself, but put in historical perspective, this was a period of extremely low volatility. In a normal calendar year, the S&P 500 typically experiences five pullbacks of 5% or greater and one pullback of 10% or greater. However, for an extended period markets confounded this norm as asset prices experienced unabated appreciation. At the beginning of this 18-month period, a reasonable investor would assume seven or eight sizable equity market pullbacks, yet equity markets experienced none.
This protracted period of low volatility ended in January. Since then, global financial markets have whipsawed between substantial losses and large gains on a day-to-day (and even intraday) basis, driven by fears about inflation expectations, uncertainty regarding global central banks’ policy forecasts, backlash against tech companies (both in valuation and privacy), and the possibility of tariffs and trade wars. During the first quarter of 2018, the S&P 500 experienced four pullbacks of at least 5% and one pullback of over 10%, easily on pace to exceed the five-and-one pullbacks characteristic of a typical year. Year-to-date, the S&P 500 has closed up or down more than 1% on 27 trading days, compared to just eight days in all of 2017. Volatility is truly back; the pendulum has swung from the low end to the high end of the spectrum.
Investors would do well to remember that this low volatility period was the aberration, not the current market environment. In the short-term, asset prices normally do not continually appreciate. Markets can—and will—go down. Volatility is a normal and healthy aspect of financial markets. It makes possible proper risk assessment, tax-loss harvesting, and valuation-driven investment opportunities. These are all key tenants of Daintree’s investment strategy and should add value to portfolios over time.
Not surprisingly, some market participants began to speak of a “new paradigm,” one of perpetually low volatility. New paradigm thinking is often dangerous, and that again seems to be the case. The late January reversion walloped some strategies geared to exploit this low volatility—one non-Daintree fund was down 85% in January—as they neglected proper risk management. Some managers have over-allocated to risk assets as the decade-long bull market and 18 months of low volatility clouded the fact that markets can experience negative price shocks. This may be the worst result, but we still expect some reverberations as select market participants relearn that volatility is perennial. The good news is that Daintree’s discipline combats “new paradigm” thinking, as we believe long-term history carries more weight and validity than current market trends.
Here are a few additional items of note:
- All four asset classes (Equities, Diversifying Strategies, Real Assets, and Fixed Income) were down between 1% and 2%. The majority of Daintree portfolios were down less than 1%.
- Daintree portfolios benefited from an overweight to emerging markets stocks. These stocks, as measured by the MSCI Emerging Markets Index, were market leaders up 1.4% while most stock indices finished in negative territory.
- High quality stocks, which struggled in previous quarters due to investors’ preference toward lower quality stocks, performed well on a relative basis in the increased volatility environment. This was an affirmation of a facet of high quality’s appeal – to dampen losses when markets turn negative.
- Mid-stream energy companies, as represented by “MLP” investments, experienced a significant decline of about 10% on the back of an unexpected regulatory change that will lower revenue for some companies. On receipt of this news, many investors took a sell-first, analyze-later stance, causing a sharp drop in prices. Daintree has been in contact with leaders in the MLP space in order to conduct further due diligence on the issue. We believe the change will not have a material impact on long-term return prospects as the financial impact is on fewer companies and often to a lesser degree than originally perceived. We remain positive on MLPs given current price levels.
- Daintree portfolios benefited from an increased allocation to Core Short-Term bonds, which are less sensitive to rising interest rates and subsequently fell less than the benchmark as rates rose. Non-Core bonds also contributed as they produced slightly positive returns. Overall, Daintree Fixed Income outperformed the Bloomberg Barclays US Aggregate Intermediate Index by around 0.50%.
Despite large fluctuations, first quarter market returns and Daintree client performance generally finished close to where they started the year, albeit down slightly. Although negative returns never feel good regardless of how small, we are pleased that most clients outperformed their respective Policy Benchmark. While volatility returned, we still possess an optimistic outlook. Fundamentally, global economic growth continues to tick up—interest rates are generally low and company earnings are rising. Moreover, Daintree portfolios are globally diversified and have a long-term investment horizon, both of which should help mitigate the effect of market swings on portfolio returns.
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