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Question of the Week - January 5, 2015

Question of the Week - January 5, 2015

Guest Post - Monday, January 05, 2015

How did last year stack up? (2014 Investment Review)

Looking back at predictions for the previous year, as we often do at year-end, is another reminder that what 'should' have happened rarely does—at least not to the magnitude or timeline it was supposed to.

Below, we go through each asset class to show how we've recommended positioning, and what happened in each throughout the year—both contributors and detractors. Over the course of 2014, we recommended several adjustments to our portfolios in order to reflect changes in valuations of various asset classes as well as needed tweaks with individual strategies and managers.

U.S. Bonds

For a number of reasons, including continued deleveraging impulses and slow growth that have led to a lack of inflation and delayed Federal Reserve policy response, nominal and real yields have remained extremely low. In fact, interest rates on the longer end of the Treasury curve are lower than they were a year ago, which led to an unanticipated rally in fixed income this year and rewarded longer-maturity bonds over shorter debt.

One of the biggest investment surprises of 2014 was the decline, as opposed to an expected increase, in interest rates—as inflation remained very low and U.S. yields were somewhat anchored to rock-bottom rates abroad in Europe and Japan. However, the risks of rising rates remain, especially as the Fed is widely expected to bring its emergency zero-rate policy to an end in 2015. The damage to conventional bonds in a rising rate environment is dependent on their maturity/duration, their level of coupon 'cushion,' as well as the pace and pattern of increases. We remain vigilant in avoiding rate risks as well as continually evaluating the ability of certain segments of the bond market to add value versus their role as 'safe havens' during periods of turmoil.

Foreign Bonds

Foreign bonds tend to be one of the more effective portfolio diversifiers—due to the often non-correlated differentials in country-to-country economic and interest rate cycles as well as the impacts of currency. With these challenging elements in 2014 outside the U.S., such bonds offered mixed results but generally ended up in the negative when translated back into terms of the U.S. dollar, which strengthened during the year.

We continue to recommend a flexible and opportunistic approach to investing in foreign bond markets. As circumstances from country to country have begun to evolve in different directions, the importance of active management of developed versus emerging nation debt has become more critical than ever. With many emerging nations improving underlying credit prospects and offering higher rates than larger nations, we feel that opportunities in such areas offer diversification and return benefits to portfolios.

U.S. Stocks

Domestic large-cap stocks ended the year as one of the better-returning asset classes of 2014. Domestic companies have been the recipient of the slow, but improving and steadier economic growth environment at home. Last year's returns, amidst bouts of volatility, came in better than average based on long-term historical measures. Smaller-cap stocks provided positive but less compelling returns in 2014, which was perhaps influenced by their less attractive valuation.

Despite strong returns earned since the low point in valuations seen during the depths of the bear market in March 2009, and some concerns about being 'overextended' at this point, large company stocks remain near fair value by a variety of measures. Large-caps also continue to be somewhat more attractive than smaller company stocks, keeping the rationale for an overweight to larger companies valid. Key risks that generally threaten equity markets, such as extreme overvaluation, high oil prices, tightening credit and other recessionary factors appear to be at bay as the current economic cycle matures and earnings growth remains intact. In addition, many have benefitted and may continue to benefit from merger and acquisition activity as companies seek additional growth and efficiencies.

Foreign Stocks

The year ended up being one of headlines outside of the U.S., with developed regions of Europe and Japan embarking on additional stimulus language and measures to derail stagnant and deflationary economic impulses. Furthermore, emerging markets faced their own set of headwinds with estimates for slow global growth and country-specific concerns (specifically in China and Russia). Performance in foreign stocks over the year was challenging on an absolute level, with generally negative returns in both developed and emerging markets.

The U.S. represents only about half of the world's market basket, as opposed to dominating it several decades ago, so it is easy for investors to lose sight of why foreign holdings are important additions to a portfolio (especially in light of much stronger performance in the U.S. recently). However, such valuation dislocations and pessimistic prospects are exactly where the best investment opportunities have been found historically.

Real Estate

Real estate investment trusts were the best-performing asset class of 2014, as U.S. REITs led the way with strong above-average gains. An environment of low interest rates and an improving economy kept tenant demand fundamentals solid, while supplies of new building have been kept in check. U.S. names outperformed foreign real estate securities, which earned a modest return last year, with Europe outperforming Asia.

Higher-quality real estate continues to look attractive and appears less richly priced than the higher dividend yield names that have experienced a burst of popularity due to the ongoing global pursuit of yield. We feel the fundamentals of such weaker firms are less desirable and could be threatened to a larger degree by rising interest rates. We also see select opportunities for value outside of the United States, which could be unlocked should conditions abroad improve. Foreign real estate provides a strong source of potential return as well as portfolio diversification benefits.


The commodity asset class suffered a terrible year in 2014, with several key components of the group falling dramatically in price. Energy was the most extreme, losing almost half its value, with the West Texas crude index falling from $100 in January to under $55 at year-end. There were several assumed causes, ranging from reduced global demand to larger supplies originating from more sources than anticipated (not to mention a larger contribution from North American shale). While far less dramatic, agricultural commodities were also down as autumn harvests turned out better than anticipated, raising supplies and pressuring prices lower.

Commodities generally are most useful in a portfolio during periods when many other assets are not, such as high and/or rising inflation, unexpected inflation surprises as well as geopolitical turmoil or weather events. Perhaps the good news (for other assets) is that none of these more serious issues has flared up in recent quarters. However, it is often the case (and is preferred) that not all asset classes move in a straight line together—this is the objective of a diversified portfolio with non-correlated assets. In this sense, the 'insurance' component of commodities in a complete asset allocation remains as valid now as ever. Poor sentiment and recent performance here offers a bit of a 'valuation' opportunity of sorts.

Additional Reading

Read our Weekly Review for January 5, 2015.

Read the previous Question of the Week for December 1, 2014.

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