By Chief Investment Officer Tom Kelly, CFA & Investment Associate Bobby Adusumilli, CFA.
The end of the year provides a great time for us to reflect on recent experience to divine lessons to help us going forward. We want to highlight five lessons that we have learned and re-learned throughout 2022.
Volatility Can Happen Quickly
From a year-to-date performance perspective through November, 2022 has been the worst year for global stocks since the Great Recession from 2007-2009.[1] After more than a decade of positive performance, we knew that global stocks (as measured by the MSCI All Country World Index (ACWI)) having a down year was entirely possible.[1] What has been particularly unusual about 2022 is that U.S. bonds (as measured by the Bloomberg U.S. Aggregate Bond Index) have experienced their worst calendar year performance in the history of the index going back to 1976.[2]
Stock market volatility is to be expected - it is one of the trade-offs in pursuing higher expected returns, as this graph demonstrates:[1]
Source: Morningstar, as of November 30, 2022. Returns are based on total return of the MSCI All Country World Index, which is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed and emerging markets. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. See Important Disclosure Information.[1]
In comparison, bond markets typically have much lower volatility than stocks. However, due to higher-than-expected inflation in 2022, the U.S. Federal Reserve has raised interest rates dramatically throughout 2022, which has led to an upward shift in interest rates across maturities:[2][3]
Source: Department of U.S. Treasury, as of November 30, 2022. See Important Disclosure Information.
As a consequence of the rapid increase in U.S. interest rates, existing U.S. investment grade bonds have had to decline in price in order to compensate prospective investors to buy existing bonds versus new bonds with higher interest rates. This is partially why the U.S. investment grade bond market has suffered this year:[2]
Source: Morningstar, as of November 30, 2022. Returns are based on total return of the Bloomberg US Aggregate Bond Index, which is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. See Important Disclosure Information.[2]
Unfortunately, it is very difficult to know when volatility will occur and what changes to make to investment portfolios ahead of time. While sometimes client portfolios experience short-to-medium-term pain, we believe that strategically designing portfolios for the long-term is most likely to benefit the majority of our clients.
For Investment-Grade Bonds, Duration Is Critical
While current yield is a good predictor of return for investment-grade bonds over their maturities (which tend to be higher-quality bonds with low expected risk of default), duration is the most important factor that influences investment-grade bond prices over the short-term.[4] Duration measures a bond portfolio’s price sensitivity to interest rate changes. Because interest rates have risen dramatically throughout 2022, higher-duration bonds have experienced significantly worse performance than shorter-duration bonds in 2022:
Sources: Morningstar, S&P as of November 30, 2022. Duration measures a bond’s or fixed income portfolio’s price sensitivity to interest rate changes. The S&P indices are broad, comprehensive, market-value weighted indices that seeks to measure the performance of their respective markets. See Important Disclosure Information.
Given recent performance, you may be wondering: if the U.S. Treasury yield curve is nearly flat, meaning investors are getting paid nearly the same interest regardless of maturity, why would you buy longer-term bonds? There are two important factors to consider:
The future is uncertain. It is very difficult to predict how interest rates will change relative to what the market is already pricing in. With longer-duration investment grade bonds currently yielding higher than the market’s priced-in expected inflation rates, we think it makes sense for long-term investors to have some exposure to longer-duration bonds.[5][6] Additionally, shorter-duration bonds have reinvestment risk, meaning that if interest rates have fallen by the time the bond matures, then new bonds may have to be purchased at lower interest rates. Longer-maturity investment grade bonds can allow you to “lock-in” an interest rate for longer.
If / when the U.S. Federal Reserve reduces interest rates, longer-duration bonds will likely benefit more in price compared to shorter-duration bonds.
As investment advisors, we continuously monitor duration and credit quality across the bond investments that we recommend. While this year has been rough, we believe the outlook is significantly brighter for bond investors.
Alternatives Are Becoming More & More Important
Alternative investments include asset classes that behave differently than publicly-traded stocks and bonds. Some of these asset classes include private equity, private debt, real estate, infrastructure, natural resources, insurance / reinsurance, and other more complex trading strategies.
High-quality alternative investments have historically been primarily offered to ultra-high net worth institutions and families. Many of the world’s top investors have had significant allocations to alternatives for decades.[7] With advances in investment technology, more and more investors now have access to alternative investments. As a result, the demand for alternative investments is expected to increase in the coming years.
Alternative investments have important tradeoffs to consider. They typically cost more in fees, are more complex, and are less transparent compared to publicly-traded stocks and bonds. Additionally, alternative investments often have lock-up periods, tax inefficiencies, and usually involve more account management. As a result, it is critical to do thorough due diligence before choosing an alternative investment.
In late 2021, SJS added the Stone Ridge Diversified Alternatives Fund (SRDAX) to MarketPlus Investing models.[8][9] While the timing was fortunate given the recent struggles of publicly-traded stocks and bonds, we believe that alternative investments can provide meaningful diversification benefits to client portfolios over the long-term.[8] We are focusing most of our investment research and due diligence efforts on alternatives, with the hope of finding more beneficial investments for our clients.
There Is Always Something Smart To Do
Even when stocks and bonds are struggling, there are smart things that investors can do to potentially help their investment portfolios over time:
Rebalancing means selling investments that are higher than your target allocations, and buying investments that are under-allocated, with the goal of maintaining your target level of risk.
Tax loss harvesting for taxable accounts allows for realized net capital losses to be used to offset current / future capital gains, sell investments that you no longer want to hold, and offset up to $3,000 of your federal taxable income for the current year and future years.
Adding to investments that have attractive expected risk/return characteristics. For example, we believe that allocating to what we think are high-quality alternative investments may be able to help client portfolios over time, though there are no guarantees. Additionally, we previously wrote about Series I Savings Bonds, which are bonds offered by the U.S. government that pay you interest based on the CPI-U inflation index.
Revisiting asset location, which involves placing the most tax-inefficient investments in tax-advantaged accounts. For example, most alternative investments tend to be tax-inefficient, paying high amounts of dividends, interest, and capital gains. Therefore, we have prioritized placing these alternative investments within tax-advantaged client accounts when possible.
Long-Term Investors Have An Advantage
One theme that shows up over and over again in research and our experience with clients is that investors with long time horizons (10+ years) have an advantage over those with short time horizons (<5 years) when it comes to withstanding volatility in order to capture market performance over time.[10][11] Beyond just their time horizon, we have found that investors who are able to keep recent events within perspective of long-term history are better able to stay committed to their investment plan even in the midst of difficulty. For example, despite experiencing 15 recessions, societal changes, and periods of political difficulties, the U.S. stock market (as measured by the S&P 500) has still grown over 10,000-times its initial value from January 1926 through November 2022, as depicted in this graph:
-Sources: NBER, Morningstar, as of November 30, 2022. Recession start and end dates are based on the US Business Cycle Expansions and Contractions data from the NBER. Gray shaded areas represent periods of recession. The S&P 500 Index is a free float-adjusted market-capitalization-weighted index of 500 of the largest publicly traded companies in the United States. The S&P 500 total return index assumes reinvestment of all distributions. See Important Disclosure Information.
While there are no guarantees that the stock market going forward will experience positive performance like the past, we believe in the global economy and innovation. As a result, we believe that stocks and bonds can continue to provide positive returns over the next 10+ years on average, though volatility will cause year-to-year performance differences. While nothing is certain, we are optimistic about the future.
Important Disclosure Information & Sources:
[1] Source: Morningstar, Dimensional Returns Web, as of November 30, 2022. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed and emerging markets.
[2] Source: Morningstar, Dimensional Returns Web, as of November 30, 2022. The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
[3] “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Federal Reserve Bank of St. Louis, 30-Nov-2022, fred.stlouis.org.
[4] “SJS 2021 Capital Markets Expectations: Making Sense Of The Future“. SJS Investment Services, 04-Feb-2021, sjsinvest.com.
[5] “5-Year Breakeven Inflation Rate“. Federal Reserve Bank of St. Louis, 30-Nov-2022, fred.stlouis.org.
[6] “10-Year Breakeven Inflation Rate“. Federal Reserve Bank of St. Louis, 30-Nov-2022, fred.stlouis.org.
[7] Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. David Swensen, 2009, Free Press.
[8] “Stone Ridge Diversified Alternatives Fund“. Stone Ridge Asset Management, stoneridgefunds.com.
[9] MarketPlus Investing® models consist of institutional quality registered investment companies. Investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor's decision making if the advisor were actually managing client money. Not to be construed as investment advice.
[10] “Quantitative Analysis of Investor Behavior“. DALBAR, dalbar.com.
[11] “Are Stocks Riskier Than Bonds?“ Bobby Adusumilli, 07-May-2021, sjsinvest.com.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains.
Advisory services are provided by SJS Investment Services, a registered investment advisor (RIA) with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice.
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