Commentary: Portfolio Construction
Updated: Feb 13, 2022
A look under the hood at our philosophy for portfolio construction, and an analysis of recent asset exposure decisions.
“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” ― Harry Markowitz
“What is the market going to do?” A question we get asked all the time, and one that has but a single correct answer: “I don’t know”. Any prognosticator who tells you with conviction and in great detail what will happen, should be immediately disqualified from future inquiries. We are not, however, doomed to wander aimlessly helpless to the chaos of an unknown future. We have a great deal of information about the present, which lies in facts- assuming that our data is correct, and we have 5,000 years of history to examine to develop a set of probable outcomes that we can utilize to position ourselves for likely future outcomes. This is how we approach the world, and how we approach investing. When we say that something is likely to happen in the future, we are not asking for promises, we are asking for confirmation that current circumstances logically lead to us to this path.
When the market drops 10-15% our phone rings with inquiries about whether or not it is time to start buying. This lets me know that we serve many astute clients who understand the value of buying at a discount. Unfortunately, 10-15% may only take us back to where we were a few months ago when prices were already in the stratosphere. It may feel like we are trying to time the market when we adjust portfolio allocations based on high valuations and interest rates, but it should be clear from our sideways performance at the end of last year that timing is not a factor in our calculations. When asked “Are we there yet?”, the only destination we can comment on is valuation. Only value matters.
This can be a confusing statement when we are buying things as divergent as stocks, bonds, mutual funds, closed-end funds, gold, silver, oil, cash, real estate, and other strategies that are none of these things. In some cases, we are concerned with the income that a security will produce on an absolute basis, other times we are concerned with how an investment is likely to respond to an exogenous factor like interest rates, in some cases we are purposely trying to minimize volatility, and in some cases, we are trying to preserve capital against the ravages of inflation. Your portfolio is comprised of securities that are approximately calibrated to take all of these factors into consideration, and to produce a real level of returns that allows you to reach your goals regardless of the political, economic, and market environments. Sometimes we focus on return on capital, and other times we focus much more intently on return of capital.
We believe it is a mistake to trust that mathematics can solve all of these problems with a tidy formula that extrapolates past relationships into the future. This methodology assumes that the relationship between asset classes is static, or at least glacial, and the real world just does not support this conclusion. For the past 40 years interest rates have been dropping, and the “scientific fact” that bonds rise when stocks fall may soon be called into question. As Mark Twain said: “It ain't so much the things that people don't know that makes trouble in this world, as it is the things that people know that ain't so.” We judge the prospects of an investment based on what they pay today, not how much they have paid in the past. We feel like starting from something that we know for certain leads to a more likely outcome than beginning with assumptions that have no guarantee of proving true.
The market correction at the beginning of this year was very instructive as a litmus test of our positioning to see how our asset allocation and security selection responded to the threat of inflation and rising rates. While short-term performance is worthless as a measure of investment skill, seeing how the portfolio performs in real-time to an increase in rates and a correction in the most overvalued securities gives us a chance to recalibrate if we turned out to be wrong about how specific asset classes should perform. This does not apply exclusively to the securities that we have chosen to own; it is even more instructive to look at the securities we have elected not to own to make sure that we did not omit something that gives us a better chance at success should the current trends continue.
Below is a breakdown of why certain decisions were made in order to examine our thought processes. The investment universe contains hundreds of thousands of potential investments. Only a small number of them are worth our attention. Unfortunately, it is common to make a correct decision that leads to poor outcome. In some cases, we may make a decision that limits future returns because the likelihood of losses is asymmetric in relation to possible gains. Sometimes we may omit an asset class because there is a small risk of a catastrophic loss, and a high likelihood of a small gain. It is much better to judge our results in light of the circumstances present at the time decisions were made as opposed to simply looking at the scoreboard. The below return data was accurate as of February 9, 2022 and reflects our company models. Each client portfolio is catered to client needs based on their discussions with their Wealth Advisor and may differ from the general descriptions made below.
What we owned:
Cash: Cash was a drag on performance at the end of last year but has provided a buffer against declining equity prices this year. We are losing money to inflation in cash right now, but when The Federal Reserve starts raising interest rates the interest on our cash will start to increase in-line with rate increases. We are currently holding the FDIC insured cash account that is a combination of multiple bank accounts to allow multiple levels of FDIC insurance of up to $2.5 million. If the rate on the government securities fund increases faster than the bank cash, we may decide that it is better to forgo FDIC insurance to earn a higher interest rate. Short-term Treasury Bonds are also starting to increase in yield. As of today, the 1-year Treasury is paying .89%. Our reasoning for not plowing into 1-year treasuries yet is that we do not know how many rate increases we will see this year and are choosing to be patient for the opportunity to utilize 1-2 year treasuries at higher rates in the near future. We also do not want to decrease liquidity too much given the current market environment.
Domestic Equity: Our US Domestic Equity positions have done well. Our Large Cap Value Fund is still positive year-to-date(YTD), and all of our US equity fund positions are outperforming their indexes during the same time period. We had almost no exposure to technology, a sector which has many positions down more than 50% since the beginning of the correction. We are keeping a close eye on equity valuations and will increase both our fund exposure and individual stock exposure if prices continue to become more reasonable. We had much more exposure to US Value investments as opposed to US Growth investments and this tilt has greatly limited our losses YTD. If Growth investments become more reasonably priced in relation to Value investments, we may shift the exposure to a more equal weight position.
International Equity: Our International Equity positions have outperformed both US Domestic Equity (with the exception of Large Cap Value) and their respective indexes. Our International Large Cap Fund is up YTD, and our International Small Cap position is down less than 2%. We are continuing to hold International Equity to counter the risk of a declining dollar, and to take advantage of better valuations in non-US markets. There is a risk that the dollar continues to strengthen if our rates rise faster than other international rates; however, the fluctuations in currencies are typically net-zero over time, and the better valuations should outweigh currency fluctuations over an entire market cycle.
Short-term Bonds: Our short-term bond positions have declined YTD; however, we expect to regain this decline as bonds mature at face value, and as we collect coupons. Our bond positions are down about half as much as the bond index and has a similar coupon. As rates rise we will slowly increase the maturity of our bond positions to take advantage of higher rates assuming the yield curve becomes more steep (long term bonds have higher yields than short-term bonds). In addition, if credit spreads widen, we may begin to accept credit risk if the yield is commensurate with risk.
Non-traditional Bonds: Our non-traditional bond positions have outperformed both their index and our short-term bond positions. This exposure is very flexible and gives the fund manager wide latitude to find the best credits, and non-duration specific bond holdings.
Mortgage Bonds: Our mortgage bond position has declined YTD and we expect that a continued increase in interest rates will put further pressure on the price of these securities. We continue to hold mortgage securities because they have the unique feature of receiving principal repayment each month that gets reinvested at current, higher rates without having to wait until maturity. In a recent conversation with fund management, they estimate that almost 40% of principle will be received back within the next 12 months due to maturities and mortgage receipts. This will allow the fund to reinvest at higher rates much faster than a typical bond fund. We are willing to take a little short-term volatility to reset the interest earned as rates rise.
Precious Metals: Precious Metals have been a mixed bag. Gold is up about the same amount that silver is down. We continue to hold precious metals as a hedge against increased inflation and a hedge against negative real interest rates. While these securities are volatile over the short-term, they have a high potential for upside if inflation continues to worsen. Our precious metals funds hold actual bullion at the Royal Canadian Mint, not futures contracts or other derivatives traded in the paper metals markets.
Energy: Energy has been our best performer YTD, currently approaching a 20% increase since January 1. We continue to hold energy securities due to scarcity and due to inflationary pressure. In addition, the wider adaption of electric vehicles and bitcoin will continue to put pressure on the power grid.
Merger Arbitrage: Merger Arbitrage(MA) is slightly positive YTD, and we expect the performance of MA to continue to increase as rates increase. MA has a unique return distribution because it is simply capturing the spread between the price a security trades at now versus a predetermined prices at which the security will be acquired in the future. This fund will typically decline a little as rates rise and merger spreads expand, but performance will increase as deals continue to close. The major risks in MA are that credit becomes unavailable and merger deals start to fail or that anti-trust regulation becomes much tighter, and deals are prohibited from being consummated.
Long-Short Exposure: Our long-short exposure has performed well YTD and is up approximately 6% this year. We did have a decline in this holding last year, so we are still net negative on the position, but continued market volatility should be positive for the fund, especially if Large Cap Value continues to outperform growth at the current rate. This fund provides a nice volatility buffer in declining markets and provides fresh capital to redeploy to declining equities when we need it.
What we did not own:
Emerging Market Equity: Emerging Market equity performance was mixed between gains and losses depending on specific country exposure. While we do not have current positions in EM, we do have a fund in this category that we use when we take EM equity exposure. Our fund is currently up around 1.9% and we may have increased performance YTD with exposure. We are going to continue to hold off on EM equity exposure until the major supply chain disruptions have been resolved, and we have a better picture of the global interest rate environment. This is a case of large downside exposure due to multiple circumstances that may not be rewarded adequately by likely returns.
Emerging Market Bonds: Emerging Market Bonds were negative, and clustered in the -3% range. This would have been negative on performance. We continue to avoid emerging market bonds because we may see an increasing dollar as rates rise, which is negative to foreign countries with dollar-denominated bonds, and due to political risk as defaults are historically high in EM Bonds.
Technology Stocks: We avoided most of the losses in technology where many stocks were down over 50%. The most surprising factor here is that even after a 50% loss these companies are still significantly over-valued. We have a list of technology stocks that we would like to buy at the right price, however, they are still very far away from where we would be buyers.
Inflation-Adjusted Bonds: Inflation-adjusted bonds are negative YTD which may be confusing given the increase in inflation. The issue lies in the fact that real rates are significantly negative and have been rising. As real rates rise the price of inflation-adjusted bonds fall, and sometimes to a much greater level that the compensation from inflation. The threat of rising real rates is why we have avoided inflation-adjusted bonds so far and will continue to do so until real rates have increased.
Floating-Rate Bonds: Floating-Rate bonds are slightly positive YTD and would have helped performance. Our concern lies in the possibility of spread expansion as rates rise. The difference between the Treasury Bond and the Yield demanded on inferior credits should increase if the economy begins to slow down. In addition, underwriting on floating-rates was very poor at the end of this rate cycle, and just because higher interest is due, it does not mean that higher interest can be afforded. We would look to add floating-rates after an expansion in spreads or after the default cycle has played out.
High Yield Bonds: High-yield bonds were mostly negative due to spread expansion. A continued rising rate environment should continue to increase spreads which will be negative for pricing on high-yield bonds, and further a slow down in the economy would be negative for default rates. We think the low return does not adequately compensate for the risk of spread expansion and defaults.
Real Estate: Real Estate is down significantly YTD. This is because real estate is sensitive to both interest rates and the economy and is usually backed with significant debt. We will continue to evaluate the real estate market for improvements in capitalization rates and will add exposure when the income from the properties outweighs the probability of losses from declining interest rates and debt defaults.
While we do not expect to give this type of detailed summary very frequently, especially over such a short-term period, I wanted to give you a glimpse of how we think about allocating your assets to strive for the best return given the risks and prices available. Your portfolio will change over time as these different risks are repriced in the market. For instance, if the real rate of return turns significantly positive, we may add inflation-protected bonds, if credit spreads blow-out we may add floating-rates or high yield bonds, if the gold/sliver ratio gets closer to the long-term average we may eliminate silver and only hold gold, if technology stocks fall to the point that they offer a high probability of decent future returns we will buy them. Each of these components work together to build a portfolio that is intended to reach your required return over your lifetime. We may find that equity prices do not require a deep correction to become more reasonable. Earnings could increase sharply, or prices simply not increasing much over a period of years may be sufficient. Our decision will always be based on what offers the best potential for returns given the risk of loss.
Your portfolio has many moving parts that are meant to counterbalance different risks and possible scenarios and work together to produce the return that you need to ensure your success. While it is possible that our allocation will underperform, we will err on the side of protecting your capital when the downside risk is elevated due to very high prices in both equity and bond markets. So far it looks as though most of the decisions that we made heading into this year are performing exactly as intended. We will continue to keep a close eye on your positioning, and on your needs.
Thank you for trusting us to help you reach your financial goals. If you have any questions, please do not hesitate to contact your Wealth Advisor, or me personally.
W. Allen Wallace, CFA
Chief Investment Officer
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.