Below the Waterline
Last year, nearly every asset class advanced as loose monetary and fiscal policies penalized cash and rewarded risk. Gold rallied 30 percent, emerging markets 19, oil 15, U.S. stocks 15, and even bonds rallied 7 percent.
Every sector of the S&P 500 was positive, with consumer discretionary, industrials, materials, energy and telecom all producing above-average returns. Geographically, negative market returns appeared primarily in the weak European regions (a la Portugal, Ireland, Italy, Greece and Spain). Overall, it was hard not to make money in 2010.
2011 to date has provided terrific headline returns for the major US averages, but look below the waterline. The S&P 500 has rallied over +5 percent, while gold has fallen -4, emerging markets -3.5, oil -5, and bonds -1.2 percent. Three sectors have accounted for the lion’s share of the advancement in the S&P 500, including industrials, technology and energy, while telecommunications and consumer staples have negative returns. Rallies in the United States and Europe contrast with sell-offs in Asia and Latin America. Greece has rallied 27 percent, while India has fallen 17. The largest 10 stocks in the S&P 500 have rallied over 7 percent, while the micro-cap index has declined. At this point, market diffusion is not uncommon. Since 1949, the average rate of return in the 3rd year of a new bull market has equaled 5 percent. As trajectories flatten, small differences in performance become much more meaningful.
Active vs. Passive
At W&A, our philosophical bias leads us to select from active managers (stock pickers), rather than passive managers (index replicators). Certain markets can favor one style over the other. 2010’s “everyone in the pool” attitude rewarded active and passive alike. However, 2011’s “feast or famine” environment will reward some and punish others. Given the new landscape, high conviction portfolios of fewer securities may hold advantage. Consider that within the S&P 500, the value of the top 10 holdings accounts for 19 percent of the entire index. On average, our underlying managers allocate 31 percent to their particular top 10 holdings and our most recent fund addition holds 43 percent of its assets within the top 10. As we move into the latter half of this cycle, and as markets become more differentiated, active managers gain an edge.
However, be warned. Concentration in itself can be positive or negative. Consider the famous Third Avenue Value fund. With 70 percent of assets held within its top 10, it qualifies as high conviction. Year to date, however, the portfolio has barely budged. Conversely, the newly famous Cambiar Aggressive Value fund holds 70 percent within its top 10 as well, and has appreciated 16 percent year to date. Picking the wrong one would have been costly against the index, while combining the two would have defeated the index. While W&A favors high conviction managers, we also mitigate the individual manager risk by including several in our portfolios. Popular sites like Morningstar provide detail on holdings and concentrations. Happy Hunting!
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.