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Globally diversified investors were rewarded in the third quarter as the market rebound broadened beyond Large Cap US stocks. Diversification has been referred to as "the only free lunch in investing. The "free lunch" diversified investors receive refers to the benefit of decreased portfolio investment risk without negatively impacting expected return. Investors have found the "free lunch" of global diversification unappetizing in recent years. US stocks have led the market for the past five years posting 16.4% returns, significantly ahead of international (7.4%) and emerging market equities (3.0%) or other diversifying risk assets such as Global Natural Resources (0.0%) and MLP's (5.0%). The free lunch of global diversification is only available to those with a long-term perspective. A review of 15-year returns, a period which encompasses two full market cycles, provides an important reminder that the benefits of global diversification do accrue to those with a long-term horizon. Despite the recent strength, over 15 years US Large Cap stocks underperform most risk assets including: US Small Cap, Emerging Markets, MLP's, Global Real Estate and Natural Resource Equities.
Equities posted impressive gains amidst a backdrop of significant global uncertainty. Global growth continues to be anemic. S&P 500 earnings are expected to report a sixth consecutive quarter of negative growth in the third quarter. The implications of the UK's vote to leave the EU remain highly uncertain, not only for the UK, but also more broadly for Europe. The Fed appears poised to resume its interest rate hikes later this year. There are increasing concerns about the systematic threat European Banks may pose to the global economy. Despite this uncertainty, equity markets produced strong returns ranging from 3.9% for US Large Cap to 9.0% for Emerging Market and Small Caps during the quarter.
An interesting development in the third quarter was a shift in leadership within equities. Active equity managers have cited numerous examples in recent quarters of what they perceive as disconnects between market prices and fundamentals. The most commonly cited mispricing relates to the extremely strong performance of defensive sectors such as utilities, telecom and consumer staples. In the one year period ending June 30th, defensive sectors increased 16% on average while the remainder of the market was flat. These stocks have benefitted from investors' demand for yield and the tremendous flow of funds into ETFs targeting low volatility stocks and high dividend payers. Market prices of many defensive businesses have moved to levels beyond which most believe are fundamentally justified. A modest rise in interest rates in the third quarter led to a decline in defensive sectors (-2.3%), while cyclical sectors performed well (+5.5%).
Interest rates rose during the quarter, with the 10-year US Treasury Note increasing from 1.5 to 1.6%. Fed minutes from the September meeting reflect increasing concern about a tightening labor market and the potential for continued cheap money to cause asset bubbles. According to Bloomberg, markets now believe there is a 68% probability of a rate hike in December. Credit spreads, which widened significantly early in the year due to fears of a recession, have declined significantly in the past seven months. High yield bond investors have benefitted from strong returns including a 5.5% return in the third quarter.
The HFRX global hedge fund index earned its highest quarterly return of the past three years in the third quarter. The bifurcated equity market highlighted by many active investors creates opportunities for long/short equity managers who had a strong quarter. Managed futures demonstrated the value of their non-correlated return pattern post-Brexit. In the three day period post-Brexit, global markets declined nearly 7% while managed futures produced strong returns. For the quarter, due to the reversal in trends described above, managed futures were flat to modestly negative.
One of Oxford's core investment principles states: "No one can predict the future. Investment decisions should be a function of value and risk." The past year provides numerous examples of the challenge of predicting the future. A year ago, few would have predicted the the Fed had only raised interest rates once, the outcome of the UK referendum or the current US Presidential candidates. Our positioning is not driven by short-term predictions, but includes an assessment of multiple scenarios and consideration of the degree to which we are compensated given the numerous risks present in markets today.
We remain conservatively positioned with a modest underweight to equities. We are biased towards international markets due to more attractive valuations, opportunities for margin expansion and generally more supportive monetary policies. Within markets which are broadly richly valued, opportunities do remain for active managers.
Our fixed income strategy is primarily focused on investment grade bonds with an intermediate duration. We do not believe investors are currently compensated for assuming credit or duration risk.
Alternative investments have relative appeal in an environment of low interest rates and high equity valuations. We seek investments which can offer uncorrelated returns (i.e., Managed Futures) or managers with a unique skillset focused on a complex niche of the market which we believe can lead to excess returns. In real assets, we continue to favor Natural Resource Equities and MLP's over REIT's, which have benefitted from investors' chasing yield.
The above articles represent the opinions of the authors as of 10.27.16 and are subject to change at any time due to market or economic conditions or other factors.Print