Welcome to the July edition of the Brighton Bulletin. I hope everyone is preparing for a terrific Fourth of July holiday weekend! Hopefully, the weather will cooperate and we'll all have the chance to watch a spectacular fireworks show!
I will cover a few topics this month that are front and center for me at the moment. First is a quick overview of the 2nd quarter of 2009 with a note on a new service I intend to initiate in July. Next is a discussion about inflation which I see a real threat over the next several years, though not likely in 2009. Finally, I'll address active vs passive investment management. Lot's of good stuff!
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What a Quarter!
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 The quarter draws to a close today as I write this column. Despite decidedly mixed economic news during the quarter, the markets rallied spectacularly to post quarterly gains we haven't seen in years. The chart above shows only the S&P, Dow Jones, NASDAQ and Russell 2000 benchmarks. The global equity benchmarks did just as well.
What caused such a strong rally? Economic data doesn't appear to support 15%+ quarterly returns (actually over 20% from the bottoms). The last 3 months equity market performance could be driven by a number of factors. Market participants may be more optimistic than the data would suggest, they may believe that stocks sold off more than they should have and were therefore undervalued, or they may just be irrational currently. I tend to think market participants over-reacted during the fourth quarter of 08 and first quarter of 09 and thus equities were undervalued relative to fundamentals. This lead to a re-pricing during the second quarter that brought prices in line with "fair value". So, where do we go from here?
Summers are almost always quiet. Markets can be volatile as they trade on low volume but I wouldn't be surprised if the quarter ends up flat. That would mean we'll go into the last quarter of the year with the various indexes all slightly positive year to date. I'm skeptical that the equity markets can post strong performance if the economic data remains mixed at best. Equity performance is ultimately driven by the ability of the company to consistently improve cash flow and earnings. Without confirmation that companies fundamentals are improving, equities will struggle. It's really no different than managing your own checkbook. If you consistently earn more than you spend, you will improve your net worth. If you spend more than you earn, you will eventually face difficulties.
Market participants will ultimately invest in companies with a good history of earning more than they spend and will short companies that spend more than they earn. The challenge in difficult economies is identifying the good from the not so good. If participants can't make a determination, they'll hedge their risk by staying on the sidelines (in cash or short-term fixed income) until better data is available. I think that is what we'll see for the third quarter and possibly the fourth. We opened the year at 902 for the S&P 500 and will probably close the first half of 09 at between 910 and 920. In January I thought if the S&P finished 09 at 950 most of us would be pleased. My thinking hasn't changed.
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What Do You Think?
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Going forward I will host an on-line meeting at the end of every quarter and will provide an overview of the economic and market performance of the prior quarter. I'll also provide my thoughts on the coming quarter and possibly cover an additional item of interest during each meeting. The meetings will be kept to 30 minutes and will offer a Q&A session at the end. The intent is to provide information useful to you as you consider your 401k and/or personal investment account allocations.
Please take a moment to click through to a brief survey and to register for the first call. I will be send a meeting invite to all who register with a date and time. This is a very easy process - the meeting invite will have all of the instructions for participating. For anyone who has used Webex or GoToMeeting, this will be second nature. For everyone else, its very straight forward.
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Inflation? What Inflation?
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When you see the term "inflation" in the newspaper, it refers to a
change in the Consumer Price Index (CPI), which tracks the costs of goods and
services typically purchased by consumers. This government figure is good for
measuring economic activity for the country at large, but does little for
individuals who have buying habits based on their age, lifestyle, and where
they live that are different from the typical consumer's. If you spend a lot on
goods and services with high inflation rates, such as college and medical
expenses, the CPI significantly understates the impact that inflation is having
on you. I believe nderstanding inflation and it's impact on your portfolio is critical as I believe inflation will be a significant issue in the near future. Preparing for and attempting to hedge against the damage caused by inflation should be a consideration for everyone over the next 12 to 18 months.
Most consumers don't understand how damaging inflation can be on
their purchasing power over long periods of time. One dollar today simply
doesn't buy as much as it did in 1970 and will buy even less 30 years from now.
Inflation has averaged about 3% annually from 1926-2008. Three
percent may not seem like much, but it can significantly erode your purchasing power over long
time horizons. Take for example the impact a 3% inflation rate can have on a
fixed annual income of $100,000 over a typical 30-year retirement. Your money would be worth 14% less in five years and in 30 years, the purchasing power of your income would be
reduced by nearly 60% to $40,101.
There's a good chance that the rate of inflation you will
experience in retirement will exceed the long-term 3% average, simply because
goods and services that you will be purchasing won't resemble what the typical
consumer is buying in the CPI aggregate. Medical expenses in particular are
likely to be a significantly higher portion of your overall spending. A recent
estimate from the Centers for Medicare & Medicaid Services suggests medical
inflation may be as high as 6.9% annually over the period 2006-2016. College expenses, as well, have tended to average closer to 5% inflation.
Despite the risk
inflation can pose to retirement savings, the natural tendency for many
retirees is to protect their investment assets by investing conservatively. As
a result, many retirees' portfolios are largely allocated to bonds and cash
with minimal exposure to stocks. History shows, however, that of these three
asset classes, stocks were the only one to provide significant growth after
accounting for inflation. Government bonds returned very little
after inflation. Cash fared even worse. That said, you may be hard-pressed to
meet income needs over a 30-year retirement if your portfolio is invested
primarily in bonds and cash. Given this, you
should consider having some exposure to stocks. A long-term horizon can cushion
the impact of
short-term volatility and extra risk associated with stocks. The payoff for
accepting this extra risk is a portfolio that has a better chance of keeping
pace with inflation and protecting your purchasing power.
There are other portfolio options to hedge inflation as well. This recent article by Research Affiliates highlights several potential asset classes for consideration.
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Active vs. Passive?
or both?
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One of the longest-standing debates in investing is over the relative merits of active portfolio management versus passive
management. With an actively managed portfolio, a manager tries to beat the performance of a given benchmark index by using his or her judgment in selecting individual securities and deciding when to buy and sell them. A passively managed portfolio attempts to match that benchmark performance, and in the process, minimize expenses that can reduce an investor's net return.
Each camp has strong advocates who argue that the advantages of its approach outweigh those for the opposite side.
Proponents of active management believe that by picking the right investments, taking advantage of market trends, and
attempting to manage risk, a skilled investment manager can generate returns
that outperform a benchmark index. For example, an active manager whose
benchmark is the Standard &
Poor's 500 Index (S&P 500) might attempt to earn better than-market returns by overweighting certain
industries or individual securities, allocating more to those sectors than the index does. Or a manager might try to control a portfolio's overall risk by temporarily increasing the percentage devoted to more conservative investments, such as cash alternatives.
An actively managed individual portfolio also permits its manager to take tax considerations into account. For example, a separately managed account can harvest capital losses to offset any capital gains realized by its owner, or time a sale to minimize any capital gains. An actively managed mutual fund can do the same on behalf of its collective shareholders.
Advocates of unmanaged, passive investing - or indexing -have long argued that the best way to capture overall market returns is to
use low-cost markettracking index investments. This approach is based
on the concept of the efficient market, which states that because all investors have access to all the necessary information about a
company and its securities, it's difficult, if not impossible, to
gain an advantage over any other investor. As new information becomes available, market prices adjust in response to reflect a security's true value. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.
Indexing does create certain cost efficiencies. Because the
investment simply reflects an index, no research is required for securities selection. Also, because trading is relatively
infrequent-- passively managed portfolios typically buy or sell securities only when the index itself changes--trading costs often are lower. Also, infrequent trading typically generates fewer capital gains distributions, which means relative tax efficiency.Popular investment choices that use passive management are index funds and exchange-traded funds (ETFs). However, some actively managed ETFs are now being introduced, and index funds and ETFs can be used as part of an active manager's strategy.
I am a proponent of an approach to asset allocation called
core/satellite investing. I tend to favor active management as well but will incorporate passive management in the right situations, such as with certain fixed income strategies. The approach is essentially an asset allocation model that blends active and passive management. The bulk, or "core," of your investment dollars are
kept in cost-efficient passive or
enhanced index investments designed to capture market
returns by tracking a specific benchmark. The balance of the portfolio is then invested in a series of "satellite"
investments, usually actively managed, which typically have the potential to boost returns and lower overall portfolio risk. Always keep in mind that no investment strategy can assure a profit or protect against losses.
While core holdings generally are
chosen for their low-cost
ability to closely track a specific benchmark, satellites are
generally selected for their potential to add value, either by enhancing returns or by reducing portfolio risk. Here, too, you have many options. For example, satellite investments might include hedge funds, private equity, real estate, stocks of emerging companies, or sector funds, to name only a few.Good candidates for satellite investments include less efficient asset classes where the potential for active management to add value is increased. That is especially true for asset classes whose returns are not closely correlated with the core or with other satellite investments. Since it's not uncommon for satellite investments to be more volatile than the core, it's
important to always view them within the context of the overall portfolio.
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As always, feel free to forward this bulletin to anyone you believe will find it beneficial. If you have any questions, comments, concerns or if I can be of assistance please feel free to contact me at john@brightonfinancial.com or at 908-892-5958.
Enjoy your Fourth!
Sincerely,
John Middleton, CFA, CAIA
Brighton Financial Planning, Inc.
1728 Rt. 31
Clinton, NJ 08809
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Core/Satellite
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The idea behind the core-and-satellite approach
to investing often involves using both
tactical
and strategic asset allocation.
Strategic asset allocation is essentially a
long-term
approach. It takes into account your financial
goals, your time horizon, your risk tolerance, and the
historic returns for various asset classes in determining how your
portfolio
should be diversified among multiple asset
classes. That
allocation may shift gradually as your goals,
financial
situation, and time frame change, and you may
refine it
from time to time. However, periodic rebalancing
tends to keep it relatively stable in the short term.
Tactical asset allocation tends to
be more
opportunistic. It attempts to take advantage of
shifting market conditions by increasing the
level of
investment in asset classes that are expected to
outperform in the shorter term, or in those the
manager
believes will reduce risk. Tactical asset
allocation tends to
be more responsive to immediate market movements
and
anticipated trends.
Tactical asset allocation frequently involves higher risk and should be limited within a portfolio which is why it is often employed in a core/satellite approach. The core is strategically invested and then infrequent rebalanced within pre-set parameters. The satellite is tactically allocated and rebalanced more frequently.
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