Yin and Yang: The Importance of Effective Implementation, along with Planning

The storm that raged through the financial markets in the first quarter of 2020 has eased somewhat, allowing investors a chance to catch their breath and assess the impact. While the possibility of further market distress and upheaval in the coming months remains, we can and should take advantage of this moment of relative calm to survey the landscape and learn which investing approaches have and haven’t worked in this tumultuous environment.In previous papers over the past month, we’ve discussed the importance of clear-eyed planning and being well-prepared, because navigating a significant downturn effectively has to start well before a crash. Among other things, proper preparation includes:

• A definition of the cost, timing and priority of investor goals
• A clear strategy for how all of those goals will be funded, including a suitable cash and fixed income reserve to cover near-time goals, such as living expenses
• Conservative investment return estimates and stress testing of extreme scenarios
• Building a portfolio of quality, understandable assets and not over-reaching for extra yield and return
• Diversification over geographies, asset classes, investing styles and industry groups

This kind of planning is the first step and main defense against disaster. But the next step—the implementation choices you make—are also a major influence on the results you achieve.Surveying the investment landscape in the aftermath of Q1 feels a bit like looking back at one’s footprints after having walked through a minefield. Reflecting on a previous market downdraft, Warren Buffett, in his 2001 letter to Berkshire Hathaway shareholders, uses a more colloquial analogy: “…You only find out who is swimming naked when the tide goes out”.

As if intent on proving Buffett correct, a number of investment strategies have been suddenly and unceremoniously revealed to have had much more risk than they were previously letting on. We won’t single out anyone in particular, but as the first quarter results come in, some of those risky strategies have reported truly disastrous performance. In that context, we remain extremely comfortable with our conservative approach to the management of investments.Temporary market price movements aren’t a major cause for concern, assuming you have the liquidity and resilience to ride them out. The real concern is permanent losses of capital: funds that implode, debt securities that default, equities that end up in bankruptcy, funds that have insufficient liquidity and become forced sellers at fire-sale prices, and structured products that crater because they didn’t take the possibility of extreme events into account. There’s often no recovering from these sorts of incidents.This is not a new phenomenon. Investors are notoriously subject to the shiny, enticing opportunities that can seem tempting and can lure them off track. While blow-ups might not all be avoidable, proper diversification, a conservative approach, and the avoidance of leverage prevents these unforeseen events from compromising the achievement of your overall goals.

In our role as a family office and manager of investment managers, we see a wide range of investment products and performance across all sorts of styles, asset classes and jurisdictions. We also are particularly plugged in to the developments at the investment managers that we have hired to manage funds for our own clients. Additionally, the CIOs of the Wigmore Association have been holding weekly update calls to share their regional observations, which gives us a vantage point covering most of the globe.This wide array of perspectives is instrumental in helping us stay abreast of what is actually happening out on the front lines of capital markets. These first-hand accounts offer much greater detail, nuance, and insight than is available from raw market data or from financial media reporting, and helps us provide guidance and counsel to our own client families.

Surveying the Investment Landscape

Here is a quick tour of how each asset class fared in the first quarter, starting with the best performers:

The Good:

• Cash – Cash turned out to be the world’s safest harbour in the Q1 2020 storm. US dollars in particular were the single most attractive asset. Much of the panic selling everywhere else was driven by liquidity concerns. Market participants with liabilities denominated in US dollars became forced sellers of all other asset classes, which effectively created a “short squeeze” on USD, prompting the Federal Reserve to inject $2 trillion of additional liquidity.
• Government Bonds – Except for some brief liquidity-driven panic sales, bonds issued by fiscally stable governments provided security and even gained value as interest rates fell. Some of the appeal of longer-maturity bonds was tempered by the massive deficit spending programs being undertaken, resulting in steepening yield curves.
• Gold – Despite a very bumpy ride, gold gained 4% during the quarter, amid a fear-driven rush toward more liquid, tangible assets and growing concerns about the potential for inflation. While gold has provided modest returns relative to stocks over the long term, it often shines in periods of market weakness and inflationary pressures.

The Not So Bad:

• Investment Grade Credit – Credit spreads (the difference between yields on corporate bonds and government bonds) widened significantly during the quarter as corporate bonds sold off. There was wide divergence among different managers’ investment strategies, demonstrating the critical importance of HOW a strategy is implemented. The best performing managers were those that focused on high quality issuers with sound balance sheets and resilient cash flow. These cautious, defensive strategies approximately broke even. Moving further out the risk spectrum (“reaching for yield”) or adding leverage proved to be highly detrimental, with some more aggressive credit managers losing in excess of 20% during the downturn.
• Infrastructure - Early indications suggest that private infrastructure assets have mostly fared well, generally due to their lower economic sensitivity and the longer-term nature of contracts. Publicly listed infrastructure holdings companies didn’t fare as well, experiencing heavy selling but rebounding into the quarter end, regaining some of the lost ground.
• Private Real Estate - Results among real estate investments varied significantly by strategy. Private real estate investments were less affected than public vehicles and mortgage funds, but private valuations tend to lag, so the gap between private and public markets may narrow over time as appraisals are completed. The amount of leverage used and the degree of debt service coverage are proving to be the differentiating factors among the winners and losers.
• Public Equities - Depending on the approach taken within public equity markets, investors may have experienced dramatically different results during this period. Here are some of positive performing sectors and styles:
• Technology Sector – What did best in Q1, surprisingly, was exposures to the FANMAG stocks (Facebook, Amazon, Netflix, Microsoft, Apple, Google) that had driven the market’s momentum on the way up. These stocks had been relatively expensive before, and now appear even more expensive relative to other sectors.
• Health Care & Consumer Staples Sectors – Mostly classified as essential services and able to avoid shutdowns, these sectors proved to be solidly defensive and declined less than the broader market, delivering relative returns not far behind the tech sector.

• Dividend Equity – Dividend equity strategies performed relatively well in the downturn, building on positive performance over the last ten years. So far, there have been very few dividend suspensions or reductions, although some will surely come.
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• Private Equity - Because of the lag in reporting and valuations, it’s a bit too early to comment on private equity in Q1. We’ll learn more about performance over the coming months, but we can make some generalizations about the major segments of this asset class:

• Private Equity Buyout - Larger, more heavily leveraged companies have in some cases begun to run into loan covenants, forcing GPs to invest additional follow-on equity to shore up balance sheets. Fortunately most funds have substantial “dry powder” (uncalled capital commitments) available to keep portfolio companies afloat.
• Venture Capital - There’s very little debt to cause problems in this segment of the market, but falling valuations and “down rounds” create concerns for equity investors who risk dilution if they’re unable to maintain their previous level of participation.

The Not So Good:

• Public Equities – Here are the sectors and styles that were relatively poor performers:

• Preferred shares – Preferred equity performed surprisingly poorly, declining more than common equity markets despite having higher yields. The decline in interest rates was especially negative for rate-reset securities.
• Value stocks – One of the biggest surprises in this particular downturn was the underperformance of value stocks. The MSCI World Value Index fell by almost six percentage points more than the broad market. This was exactly opposite to nearly everyone’s expectations. While value managers underperformed this quarter, we still believe that the fundamental value investing approach of buying solid companies at below-average prices will bear fruit over the long run, especially given these “even better” valuations.
• Small and Mid-Cap Stocks – The perception of greater risk and less resilience among smaller companies led to significant underperformance in Q1, a gap of more than ten percentage points between the small/mid cap Russell 2000 Index and the large cap Russell 1000 Index.
• Energy Sector – The collapse in the price of oil has left the already-struggling energy sector as the hardest hit in Q1. Strategies that avoided exposure to the energy sector in general were fortunate to escape the losses here.

• High Yield Credit – A flood of downgrades overwhelmed the junk bond market, and a number of issuers have already defaulted or are seeking bankruptcy protection. The losses to high yield investors were especially acute in the energy sector. Junk bond issuance rose significantly in the years leading up to this downturn, and like the ‘naked swimmers’, the reveal hasn’t been pretty. This part of the market is considered highly speculative and generally does not play a role in conservative investment strategies.
• Public Real Estate/ Mortgage Funds – Public REITs, Mortgage REITs, and Mortgage Investment Corporations (MICs) lost significant value as uncertainties escalated over near-term cash flows and longer-term vacancies or foreclosures. As mentioned above, high leverage and poor debt service coverage have exacerbated the problems for some managers.
• Hedge Funds – It’s impossible to distill all of the hedge fund universe into a single category, because the range of outcomes has been extreme. Some “black swan” funds hit the jackpot and gained thousands of percentage points after years of losing money, while other funds ended up on the wrong side of trades and suffered enormous losses. Volatility trading strategies had some of the most extreme results, as the wild daily swings in markets, coupled with unexpected exchange halts made trading a precarious exercise. Most alarming, a number of funds who were met with withdrawal requests from their investors, had insufficient liquidity and found it necessary to “gate” redemptions. Some hedge fund investors who thought they had liquid capital available were suddenly disappointed.
• Structured Products – Some of the worst “blow ups” (again, not naming any names), occurred in triple-leveraged ETFs and other derivative-like trading products, where catastrophic losses resulted in 1-for-25 reverse stock splits to avoid delisting, or the wind down of the vehicle and the return any remaining cash to unitholders, or simply the announcement of a “complete loss”.

Implementation and Planning

You can see from our survey of the investment landscape that prudent implementation is as important as good planning and preparation.Our implementation strategy remains unchanged – focus first on funding your goals with the appropriate assets (e.g. non-risk assets for near-term or high-priority goals, and risk assets for longer-term or optional goals), and then observe some timeless rules: diversify, keep a close eye on liquidity, shun leverage, stick to fundamentals, avoid the too-good-to-be true pitches that can become blow-ups, and be sure to choose high quality, transparent investment managers.

With all of these good steps in place, an investment strategy doesn’t need to rely on trying to accurately predict the future. Instead, you can be can be confident that a well-planned, well-implemented investment strategy will be able to preserve wealth and meet goals in whatever market conditions it faces.