Principles and Practices in Core’s Portfolio Management
memorandum describes investment activities of Core Asset Management Company and
certain ideas that inform these investments. For many of our clients, Core
manages substantially all of that person’s investment capital. For this reason,
Core’s principal investment activity is the determination of the allocation of
its clients’ assets among the various investible asset classes. That is, Core
decides what portion of a client’s assets it will invest in US stocks, in US
bonds, in non-dollar bonds, in foreign stocks, in real estate investments, in
absolute-return hedge funds, and in commodity-related investments.
Core’s investment practice of allocating among different asset classes makes it
a generalist manager, in contrast to specialist managers that focus on single
investment classes. Core is not, for example, a US small-cap value manager, with
expertise in valuations and progress of small, US-based publicly-traded
companies. That is a narrower expertise than Core’s. Core seeks to invest across
a broad range of investment assets in response to global economic and financial
making its determination of the proportions of a client’s capital to invest in
different asset classes, Core’s next step is to choose specialized managers for
each asset class. It makes investments for its clients in various
exchange-traded funds (“ETFs”), mutual funds, real estate investment trusts
(“REITs”), and other securities.
The understanding of one’s investment goal or goals is the first step in
determining one’s investment policy. For those who have accumulated investment
capital, the goal may be to preserve its purchasing power and to generate
sufficient income to meet current and future expenses. For those who are
building investment capital to provide for future needs, growth of capital
probably outweighs an interest in current income. One’s capacity to add to
investment capital in the future may determine the amount of risk to which one’s
present capital may be exposed.
At Core, we begin our work with a client by addressing these issues. Before
considering how to invest a client’s capital, we first reach an understanding
about his or her financial needs and goals. It happens often that different
portions of a person’s capital may have different intended uses--education for
children or grandchildren, charitable purposes, income for retirement,
investment in new business activities, to name a few. In this situation,
investment policy for one portion of a person’s capital may be quite different
than for another portion. After we consider these questions, we formulate a plan
to balance investment goals with investment risk.
The asset allocation decision. Asset allocation determines one’s
investment success to a far greater degree than does security selection. To give
an example, over the last nine decades and more, the return from publicly-traded
stocks as a class has exceeded the return from bonds by an enormous degree.
Thus, a completely ordinary portfolio of common stocks earned a far greater
return over these decades than the best portfolio of bonds.
The time horizon over which
one measures one’s investment success and returns is important in determining
investment allocation. Although we might be confident that, over a period of
fifty years, stocks will earn a better return than bonds, individuals cannot
realistically take such a long view. However, it is not uncommon for people to
save money for retirement and intend not to draw upon it for thirty years.
Because equities generally achieve better returns over time than bonds, it is
usually productive to have a greater weighting in equities than in bonds, except
for portfolios in which capital preservation is paramount and investment risk
must be kept very low.
and correlation of changes in price. Prices of tradable securities, like
common stocks and bonds, change day by day. The extent of price changes of a
given security is referred to as its volatility. Examples of securities with
high volatility are speculative, unseasoned technology companies, whose prices
may swing quite widely from week to week. By contrast, the big oil companies
like ExxonMobil, with steady and predictable earnings, are much more stable in
price: less volatile. Volatility is accepted as a measure of an important type
of investment risk. A security with high volatility is more risky than a
low-volatility security, because one can be less confident about the price of
the highly-volatile stock at any given time in the future when one may need to
sell the security.
For a portfolio as a whole, volatility is likewise an important investment
consideration. A more stable and predictable portfolio is generally more
advantageous than a highly volatile portfolio. However, the volatility of each
individual security in a portfolio is not a measure of volatility of the
portfolio as a whole. Indeed, a portfolio of twenty highly volatile individual
securities may be less volatile than a portfolio of twenty low-volatility
securities. The key is the correlation of the price movements of the individual
securities within a portfolio.
If the individual securities in the portfolio of highly volatile securities do
not move together in price, their separate price swings may cancel each other
out and produce reasonably smooth returns. By contrast, if a portfolio holds
low-volatility securities that are all of the same type, they will all move
together. Such a portfolio may be more volatile than the other portfolio of
securities that swing widely in price but in an uncorrelated fashion. Consider a
portfolio of bonds issued by twenty different companies all of high credit
quality. Assume that all the bonds mature in twenty years. The daily price
movements of the individual bonds may be small, but the bonds will all move in
lock step, in sympathy with price changes in twenty-year, high-grade corporate
bonds. By contrast, if the other portfolio has twenty different volatile, but
uncorrelated securities, it may be more stable over all than the bond portfolio.
The Investment Environment as 2013 Comes to its End
strategy is to build
portfolios with substantial equity orientation, to take advantage of the
long-term favorable performance of equities. Core also seeks to invest in asset
classes whose price movements have low correlation with each other, so that
month-to-month swings in overall portfolio value are rather low. (Consider,
however, that in some periods, virtually all securities become highly
correlated. For example, during the most intense months of the financial crisis
of 2008 - 2009, most securities fell in price, regardless of their lack of
correlation during ‘normal’ periods.) Additionally, Core seeks to invest greater
amounts in asset classes that appear to be rather underpriced, and to decrease
investment in riskier, higher-priced assets.
A brief recapitulation of the financial crises and the policies undertaken to
ameliorate the economic and financial system calamities will provide the context
for a review of the present economic conditions in the world. This in turn
suggests a framework for a discussion of various investment asset classes in
which Core invests.
financial crisis and its aftermath. The crisis of 2008 and 2009 and the
responses by governments and central banks in its aftermath give rise to the
conditions that now prevail in various asset classes. The crisis arose from the
collapse in prices of pools of mortgage-backed securities that were held in vast
quantities by many banks, insurance companies, and other financial companies in
the United States and Europe. When housing prices fell, the prices of these
ostensibly AAA-rated securities fell even more sharply and threatened the
capital bases of major global banks and investment banks in the US, the UK and
Europe. Governments stepped in to provide emergency capital to a large number of
banks and forced others to merge into more creditworthy banks. The failure of
Lehman Brothers, a large US investment bank, in September 2009 ushered in the
acute phase of the crisis. Commercial paper markets froze over night; money
market funds showed huge losses. Overnight the Federal Reserve guaranteed the
assets of all money market funds and began to participate directly in the
commercial paper market. Congress passed emergency authorization to permit the
US Treasury Department to recapitalize distressed banks to the tune of $800
billion. The global financial system, at the edge of the precipice, was hauled
back from the brink by these emergency measures.
The scare was so great, however, that private companies and people realized the
fragility of the system and the great extent of private debts. The response was
to cut spending and increase savings to rebuild balance sheets. The curtailment
of spending and increase in savings caused economies, especially in Europe and
the United States, to shrink dramatically. The recession that ensued was the
most severe since the Second World War.
policy. Beginning in 2008, central banks of developed countries, led by the
example of the US Federal Reserve, vastly increased their assets and began a
series of unconventional monetary policies that persist to the present. To give
an indication of the scale of central bank actions, consider that before the
crisis, the Fed held about $800 billion in assets, virtually all in Treasury
securities. Through its ongoing series of asset purchases designed to restore
economic growth, the Fed now holds about $4 trillion in assets, including nearly
$1.5 trillion in mortgage-backed securities. The various programs of the Federal
Reserve, the Bank of England, the European Central Bank (the ‘ECB’), and the
Bank of Japan have provided unquestioned support for economies of the developed
countries and, in the case of the ECB, have supported the weak member countries
of the European Union during the Eurozone crisis. An ancillary consequence of
these central bank actions has been exceptional support to stock, real estate,
and bond markets.
policy. By contrast to the supportive monetary policies of the
central banks, governments in Europe, the UK and the US have engaged in
restrictive fiscal policies, that is, the policies of taxation and
spending of these governments. Out of concern for the expanding government
deficits that arose in the great recession (as tax revenues fell and spending on
unemployment insurance and the like rose), governments began to cut spending to
prevent what were thought to be dangerously high levels of government debt.
These policies of fiscal austerity, in the context of constrained spending and
increased savings by the private sector, brought the UK and the Eurozone back
into recession and caused economic growth in the US to slow to a crawl. Thus the
recovery from the Great Recession of 2008 - 2009 has been halting and weak,
causing unemployment in Europe and the United States to remain at high levels.
fiscal and monetary policies have been timed differently than those in the
US and Europe. A year ago, as the election in the lower house of its parliament
approached, it became clear that Shinzo Abe would lead his party to a large
majority and serve as Prime Minister. He pledged very easy monetary policy--it
would be his prerogative to appoint a new head to Japan central bank--and
expansionary fiscal policy. He has delivered on his promises, although whether
Japan will enjoy sustained economic growth and an end to its long era of
deflation remains in doubt.
torrid rate of growth from a decade ago has slowed, but it is still strong.
Emerging markets generally were less afflicted by the great recession than were
the developed economies, but these economies are generally growing more slowly
now than in the last decade. Meanwhile, the expansionary policies of the Federal
Reserve, which poured liquidity into the global financial system, caused large
inflows of foreign capital to developing countries. Now, as the Fed tells us
that its huge asset buying program will be coming to an end, capital is flowing
out of developing countries, raising risks to their financial markets and their
As 2014 is set to begin,
the economic picture is of slow growth in the developed countries and somewhat
more rapid growth in developing economies. The US economy is likely to expand at
2.5% to 3% in 2014; Europe at perhaps 1%; Japan will grow somewhat faster than
Europe; the UK somewhat faster than Japan. China and India may grow around 6% to
7%; the other East Asian countries at about half that rate. Latin American
economies are likely to be weaker than Asian economies.
The Asset Classes in which Core Invests
been quite strong in the last year and have exceeded the highs set in late 2007,
before the crisis began. In the recovery from the crushing bear market of 2008
to early 2009, corporate profits have been exceptionally strong, while the share
of corporations’ revenues that go to employees has been weakening. This
phenomenon, in which capital enjoys such an advantage over labor, has had the
effect of keeping wages low and constraining employment in the United States.
This trend appears intact and, in light of moderately accelerating economic
growth, the US stock market appears to be only somewhat overvalued. It is
reasonable to expect modest further gains in US stocks.
offer different opportunities. During the intense periods of the Eurozone
crisis, from 2011 to the middle of 2012, European stocks fell far behind US
stocks, as concerns rose for the viability of the single currency and the
solvency of the so-called peripheral countries. Since the promise of ECB
President Mario Draghi in the summer of 2012 to do ‘whatever it takes’ to
preserve the Euro, European stock markets have rallied strongly and somewhat
closed the gap with the performance of US stocks. More ground is still to be
made up. With strengthening European banks and modest economic growth, it seems
likely that European stocks will continue to perform well.
Japanese stocks enjoyed a very strong rally in 2013 with the implementation of
the promised policies of Shinzo Abe. Further stock appreciation probably depends
upon the realization of promised economic growth, by no means a sure thing. With
its new and forceful president, Xi Jinping, China’s path to continued growth
seems a reasonable bet, but the translation of that growth to stock market gains
is not a foregone conclusion. Other Asian and Latin American stock markets are
at risk to further capital flight as the Fed pulls back from its $85 billion per
month in asset purchases.
bonds present serious challenge to investors. From 1981, when the yield on
the US ten-year Treasury bond stood at 15.7%, yields fell and bond prices
rallied until May 2012, when the ten-year Treasury yielded a mere 1.4%. This
extraordinary three-decade rally in fixed income appears to have come to an end.
At this writing, the ten-year yields 2.9%. With the near certainty that the Fed
Reserve’s long-standing asset purchase programs will draw to an end over the
coming years, it is reasonable to expect Treasury yields to rise further,
probably to 4% or so. In this environment, most other bonds around the world
will also fall in price and rise in yields. A very careful approach to fixed
income investing is needed.
bonds and foreign currencies. Non US bonds will generally not fare well as
US interest rates rise, although there will be exceptions. The differences
between Fed policy (which is heading toward the realm of less easy--if not
tighter--monetary conditions) and ECB policies will tell on European bond prices
and the value of the Euro. Given the greater economic weakness in Europe and the
persistent frailties the banking sector and of sovereign liquidity and solvency
in many European countries, it is likely that ECB monetary policy will be easy,
even as the Fed becomes somewhat tighter. This probably will support the prices
of European bonds as compared to American and it should weaken the Euro in
relation to the dollar.
US investors can fare well in foreign bond markets when the dollar’s value is
falling in relation to those of other major currencies. When a US investor owns
a bond denominated in a foreign currency that is rising in dollar terms, that US
investor will earn the interest paid on the bond as well as the increased dollar
value of the currency in which the bond is denominated. This situation does not
obtain now. The US dollar on a trade-weighted basis has been fairly flat in
recent months, rising against the Japanese yen and falling against the Euro.
Expected monetary policies suggest that the US dollar will be stronger rather
than weaker in the coming year.
Although currencies do not offer appealing opportunities at present, they often
do. Currency markets are characterized by long-trending cycles and by the
tendency of valuations to go to extremes. For example, the value of the dollar
fell fairly steadily throughout the 1970s, then nearly doubled in value against
a basket of major currencies in the early 80’s as the Federal Reserve, under
Paul Volcker, began its successful campaign to lower interest rates and
inflation. From 1985 until 1995, the dollar lost half its value, then increased
by 50 percent from 1995 to early 2002. After 2002, the dollar fell again until
the financial crisis of 2008 and 2009, when the dollar’s safe-haven status
caused its value to rise sharply.
investments represent ownership of real property. Publicly-trade, pooled
investments vehicles called Real Estate Investment Trusts (“REITs”) trade on the
New York Stock Exchange and elsewhere. These offer the liquidity of common
stocks and offer ownership in broad pools of commercial real estate properties.
REITs are characterized by relatively high dividends and modest growth in the
underlying properties. At present, Core holds no real estate investments,
although it is quite likely that Core will make such investments in the future.
Core makes unleveraged investments in broad baskets of physical commodities
during favorable periods in the commodities markets. For several years recently,
Core made gold investments for clients. At present, the commodities cycle is
weak and Core’s clients’ portfolios hold no commodity investments.
John N. Mayberry