Monthly Investment Commentary
June 8, 2012
Global stock markets dropped sharply in May amid renewed macroeconomic fears. Large-cap U.S. stocks fell 6%, while small and mid-cap stocks lost 6.6% and 6.7%, respectively. Domestic stocks are still well in positive territory for the year, with returns ranging from just over 5% for large-caps to 3.4% for small-caps.
Foreign markets fell further, as questions over the stability of the eurozone dominated headlines. Both developed and emerging-markets were down 11% for the month and in negative territory year-to-date (down 3.3% and 0.4%, respectively).
High-quality fixed-income continued to attract investors in this risk-off environment, with investment-grade bonds returning 1% in May and 2.3% year to date. Foreign bonds slipped 0.6% for the month, but are positive 0.3% on the year.
Despite mixed returns in May, each of our active portfolios remains ahead of the respective benchmark by over 1% year to date.
Investment Strategy Update
Our ability to add value in this low-return environment depends on the ongoing work of our research team. In today’s highly uncertain environment, it’s possible that some of the investment decisions we make could feel uncomfortable. We are sharing some of our current asset class analysis this month, most importantly our updated valuation work on Europe, to be sure readers have a full
understanding of the research and thinking that underlies these decisions.
As we’ve written in past commentaries, the problems we are seeing in Europe are a symptom of the excessive debt in much of the developed world and the need for them to reduce this debt (delever). The deleveraging process is never easy, but it is further complicated in the case of Europe because of a few
The most acute need for deleveraging is in peripheral Europe (Greece, Ireland, and Portugal). Because they are in a monetary union, they cannot depreciate their currencies to help them grow their way out of debt.
The problem has festered for nearly two years and, as a result, has become a bigger problem that has enveloped larger countries, such as Spain and Italy. The problem has intensified in large part because conflicting political motivations have not allowed for a sufficiently aggressive and coordinated policy response.
European banks have huge exposure to the sovereign debt of struggling European countries (in fact, it is being encouraged by the European Central Bank and national governments), so there is a risk of a serious banking crisis, and a credit crunch, that impacts not only European economies and financial markets but also the rest of the world given the financial linkages across the globe.
While it has been very difficult to confidently conclude what the ultimate outcome will be given the politics involved, the uncertainty stemming from Europe has led its equity markets to cheapen relative to the U.S. equity market to the extent that we believe Europe now presents an attractive tactical
Our Framework for Analyzing Europe
In the past we have closely monitored two variables in order to assess whether or not Europe is a fat pitch - the current price-to-cash earnings (P/CE) discount between Europe and the United States, and the relative valuation of currencies. Over the past year, we have enhanced our analysis by adding a third variable: a cash earnings-based model. We outline the merits and shortcomings of each of these valuation criteria below.
The first variable we assess compares the current P/CE discount between Europe and the United States with historical averages. Currently, this metric (displayed in Figure 2) shows Europe is trading slightly cheaper than it has historically on average. On its own, this is not at a level where we’d consider Europe as a fat pitch.
It is worth noting that the efficacy of this variable is weak. As the scatter plot (Figure 3) shows, P/CE discount seems to work as a reliable indicator at the extremes, leaving us with limited opportunities to tactically over- or underweight Europe. The same issue exists with our second variable, currency.
The second variable we’ve traditionally considered is whether or not Europe’s currency, mainly the euro and the pound, are undervalued versus the U.S. dollar. Historically, when Europe’s currency has been extremely cheap (such as in the early 2000s), Europe has significantly outperformed U.S. equities in dollar terms (i.e., after factoring in the currency translation effects). Our research on currency and how it impacts relative performance in the past shows that currency can be a major factor in determining the success or failure of a fat pitch such as European equities. Because currencies are tough to value, and they can be out of sync with longer-term valuation metrics such as purchasing power parity (PPP) for very long periods, they lend significant uncertainty to our analysis. Currently, based on an adjusted PPP metric (see Figure 4 below), the euro is only slightly undervalued versus the U.S. dollar. While that is encouraging in that it suggests the euro has the potential to appreciate slightly versus the U.S. dollar over the long term, it could also decline significantly from present levels and detract from total returns, especially in light of the ongoing credit and balance-of-payments crisis in Europe. (One mitigating factor is that the euro has already declined over 20% from its peak as the crisis has unfolded.)
Over the past year we have been working on a new cash earnings-based model to improve our framework for analyzing Europe. This model suggests that European equities have become quite attractive and that the odds of Europe generating superior returns versus U.S. equities are quite high. We discuss this new model below.
Further Detail on our Cash Earnings-Based Model
We have focused on cash earnings as one of our key metrics to compare Europe with the United States because it mitigates the accounting differences related to depreciation and amortization among countries—within Europe and versus the United States— that existed in the 1980s and 1990s. Over the past year we put together a time series, going back nearly 40 years, of cash earnings per share. We then proceeded to study the long-term trends in cash earnings for both Europe and the United States, using a similar approach to the one that underpins our U.S. equities earnings-based valuation framework. While 40 years of history is still not as long as we’d like (for the U.S. earnings-based framework, we have data going back nearly 100 years), it is nevertheless instructive to analyze and it gives us a reasonable estimate of normalized cash earnings power for Europe and the United States. Although a shorter data history does limit our confidence in this model, we can manage this by demanding a higher margin of safety, i.e., requiring a higher return hurdle to overweight Europe than we’d require for U.S. equities when using our U.S.-only framework.
Once the data series was in place, our next step was to build a cash earnings-based model to estimate returns for Europe and the United States, using normalized cash earnings levels (five years out), historical median P/CE multiples, and dividends. These inputs allow us to calculate expected returns for Europe and the United States over our tactical investing time horizon, which is roughly five years from now.
Our last step involved testing the excess cash earnings-based returns estimated by the model historically to see how good it was in predicting actual excess return outcomes five years out. The scatter plots on the next page demonstrate the results for both U.S. dollar-denominated returns and local currency returns (Figures 5 and 6). The correlation between returns predicted by the model to actual excess returns is higher for U.S. dollardenominated returns (0.8) versus local currency returns (0.6). The factor that is creating this difference is currency, again highlighting the importance of this variable. But, the absolute positive correlation for both is very encouraging. As Figures 5 and 6 show, when the model is suggesting relatively high or low excess returns, then it may indicate an opportunity to over- or underweight Europe versus U.S. equities. Historically, when the model suggests 5% or more excess returns based on our cash earnings model, then the odds have been in our favor. Currently, our cash earnings model suggests Europe will generate close to 7% higher returns than the United States.
Looking deeper into the results, we find that there were quite a few observations where high, expected cash-earnings-based returns coincided with an undervalued Europe currency (based on the adjusted PPP measure discussed above), and these were the times when Europe subsequently significantly outperformed the United States. Coming to the present, as we noted earlier, we think the euro is roughly fairly valued versus the U.S. dollar, and the same is the case with the British pound. So, our base-case expectation is that currency should neither be a headwind nor a tailwind, but it remains a significant risk factor—one that can work in or against our favor; we just can’t say which with confidence. If the euro and the pound were undervalued by 20%, or more, versus PPP, then our confidence in an unhedged European fat pitch would be higher than it is now.
Evolving Market Sentiment and Its Impact on Our Assessment of Valuations
Over the past two years it should be no surprise that Europe has been an active topic of discussion and analysis within the Litman Gregory investment team. Because the set of conditions this crisis generates was not present in our historical data sets, we’ve had to qualitatively factor the impact of this crisis into our historical framework. One way we did so was to observe market sentiment as a means of gauging what is and what is not priced in, and torequire a higher margin of safety, i.e., require returns beyond the 5%–6% (suggested by our cash-earnings model) that would have been acceptable historically.
For at least 18 months now, we have been considering two points of view on the European debt crisis. One was a bearish view that the eurozone will not stay in its present form and that the break—partial (likely) or in full (less likely)—would be disruptive to the markets. This view was, over a year ago, either dismissed altogether or considered a very low probability event by most strategists and investment managers we talked to and/or read. The other view was a more optimistic one, and one that was held as the likely outcome by market participants outside Litman Gregory, where Europe would muddle along and find a way to contain the crisis and hold together. (Even with this more benign outcome, we would still expect major headwinds to economic and earnings growth from deleveraging.) Suffice it to say, we could not as a group attain a high level of confidence in any particular outcome given that politics—an important variable in this crisis—are difficult to assess. In our balanced models, therefore, we maintained only a slight incremental underweight to international equities (relative to our overall equities underweight) to reflect the increased risks we saw stemming from Europe. Meanwhile, of course, we continued to watch events evolve in the region and assess the markets’ response to them, alert for the potential for markets to overreact to short-term developments (either positive or negative) and create a tactical opportunity for us.
Over the past few months, the bearish view has been playing out with a relatively high level of intensity. Many market participants are now actively factoring in a Greek exit in their analysis and even considering that further contagion in peripheral Europe’s banking system could lead to exits by other countries, such as Portugal or Spain. Previously this was unthinkable to the mainstream. As we have been observing this shift in sentiment, European equities have cheapened more, though not as much as we’d hoped at the time of this writing. However, it is important that we gauge what risks might already be priced into the market. We believe at least some of the risk of a disorderly exit of Greece and other countries has by now been factored into equity prices. Adjusting for current sentiment, we are now more open to considering a tactical fat pitch when our cash-earnings model suggests 5%–6% excess returns from Europe relative to U.S. stocks than we would have been a few months ago. However, we continue to balance that potential excess return from Europe over our five-year tactical horizon with what we view as the relatively higher downside risk that Europe’s currencies may decline further versus the U.S. dollar and that all of the contagion effects of disorderly exits by a few eurozone countries are not fully priced into European equities yet. However, our analysis and weighing of potential risks and returns is leading us toward implementing a modest tactical overweight to Europe versus U.S. equities across our portfolios.
While U.S. equity markets have declined in recent months, they still are not attractive enough to warrant a full strategic weighting in our model portfolios. Moreover, because they are looking less attractive than European and emerging-markets equities, it is possible we will reduce our weighting to U.S. equities further and increase our foreign equity exposure.
As we have written repeatedly over the last few years, the primary reason why our expected returns for the United States, and much of the developed world, are low relative to many strategists is because the current deleveraging environment will lead to slower earnings growth than in normal times. That said, as time passes without major policy mistakes or as long as the economy does not fall into another major contraction, we are deleveraging (notably, our financial sector has to a large degree, though households have much farther to go, and the federal government has not yet begun) and the economy is becoming healthier.
Last year, we assessed the question of how long this deleveraging process might last and for how long might it remain a headwind to earnings growth. We determined that deleveraging started in late 2008 and estimated it will probably take roughly 10 years to complete the process. Therefore, our base-case scenario expectation is that by December 2018 we will remove the earnings reset we have currently factored into our analysis (i.e., we assume an earnings path that gradually reverts to the long-term normalized earnings trend-line as of that date). During this analysis, we also increased our expectation for how high earnings might go above the long-term trend-line in our optimistic scenario (we assume they can go up as high as 20% above trend once deleveraging ends versus our assumption over the past few years that they will just be at trend). The implication of this work was that since the second quarter of last year, we have been rolling earnings forward at a slightly higher rate than we did for a few years prior and, as a result, our fair-value point for the S&P has been increasing at a slightly higher rate as well (though this may not be apparent to an outside observer because our five-year return expectations have not changed much, until more recently, as the market rose sharply, especially in the beginning of this year, more than offsetting the growth in our fair-value estimate).
We will continue to follow our long-term earnings framework in a disciplined fashion, while always evaluating and factoring in other valuation metrics, especially those that may cause us to question our assumptions. We believe that as the developed world delevers, economies and markets will remain volatile and a patient, disciplined valuation-based tactical allocation approach such as ours can add a lot of value.
Our research indicates investment-grade bonds are likely to generate very low single-digit annualized returns over our five-year investment horizon, which incorporates a range of economic scenarios. Our current return expectations are well below the long-term historical average for the asset class. Over the past 35-plus years, the Barclays Aggregate Bond index returned 8.2% annualized for the period ended April 2012. Our return expectations are also lower than any historical rolling five-year average annual return we have seen since the mid-1970s.
Our lower return estimates are driven largely by expectations for rising interest rates. For the past 30 years or so, interest rates have trended lower, serving as a tailwind to bond returns. Looking ahead over our five-year investment horizon, we think higher rates are the most likely outcome as government policies are likely to contribute to longer-term inflationary pressures and/or the credit risk premium for Treasuries rise. As rates rise, the capital losses associated with rising yields (higher yields equal lower bond prices) will cut into income from coupon payments.
Higher interest rates may not be a near-term risk. The Federal Reserve has indicated that it expects to keep the federal funds rate at historic lows through late 2014, an extension from their earlier expectation to keep rates low through the middle of 2013. (Keep in mind that this is a Fed forecast, not policy.) And, with ongoing uncertainty around U.S. fiscal policies, Europe’s debt problems, higher oil prices, and potential ripple effects from a slowdown in China, it’s quite possible that today’s low rates could persist. It’s also reasonable to expect that any of these concerns could trigger a sudden and sharp demand for the perceived safety of Treasury bonds. Over the past eight months we have seen three instances of a 40–50 basis points rate decline; most recently with the 10-year Treasury yield dropping below 1.5% in early June.
While rate declines are counter to our longer-term rate outlook, the potential for lower rates in the short term has been, and remains, a risk that we are fully aware of, and are willing to take in exchange for what we believe is a superior longerterm risk/reward profile with the more opportunistic flexible and absolute-return-oriented bond funds we hold in our balanced portfolios (more on this below).
The risk/reward outlook we see for investment-grade bonds is heavily skewed towards risk. Even if we assume a severe recession scenario, which would be a good scenario for high-quality bonds as yields would move even lower (prices higher), returns for investment-grade bonds remain paltry at roughly 2% annualized for the next five years. (This return compares to a less than 1% return in our base-case scenario.) Such a negative scenario is not one we view as most likely, but because a recessionary scenario is possible, maintaining some exposure to investment-grade bonds is an important defensive position in the event stock markets and Treasury yields drop. Our balanced portfolios remain underweighted to equities and overweighted to fixed-income.
Within our fixed-income allocation, we are maintaining an extremely diversified posture. Examples include funds that we believe offer attractive risk-reward trade-offs such as flexible and absolute-return-oriented fixed-income funds that can pursue return and lessen the impact of potential rate increases by investing across a broad opportunity set of fixed-income securities such as short-duration high-yield bonds, floating-rate securities, short-dated credit default swaps, etc.
Emerging-Markets Local-Currency Sovereign Bonds
Typically, our tactical views on asset classes have a five-year horizon, but our time horizon for assessing emerging-markets local-currency sovereign bonds is much longer. This is in large part because currencies (in this case, emerging-market currencies) are much harder to value than, say, equities or bonds with precision to a specific point in time. Having said that, we are confident in the direction emerging-market currencies are likely to take versus the U.S. dollar over the very long term. We believe the U.S. dollar will likely depreciate versus many emerging-market currencies because of the latter’s superior balance sheets (positive trade surpluses, low debt), superior growth and productivity, and cheap currency valuations based on longer-term metrics such as PPP.
Looking at cyclical metrics, such as real effective exchange-rate averages over trailing five and 10 years, emerging-market currencies do not look cheap (in fact, some like the Brazilian real look somewhat dear). But real effective exchange rates are end-point-specific and fail to factor in the fundamental improvements that have taken place in many emerging-market economies, including superior productivity and growth dynamics, greater monetary and fiscal flexibility to pursue countercyclical measures during economic downturns, and relatively more anchored inflation expectations/targeting. It is because of these two factors, emerging-market currencies being cheap versus the U.S. dollar on long-term valuation measures and their superior fundamentals, that we have a 3%–6% weighting to emerging-markets local-currency sovereign bonds, depending upon the model, in our portfolios.
In addition, we believe emerging-markets local-currency bonds are a great way to hedge the risk of a decline in the U.S. dollar over the long term, while clipping a relatively healthy yield to give us total expected returns in the high single digits over the long term. Because emerging-market currencies have equity-like risk, our allocation to emerging-markets localcurrency sovereign bonds is funded via equities.
High-Yield Bonds and Floating-Rate Loans
Year to date, high-yield bond and floating-rate loan performance is the result of risk-on/risk-off market activity driven by shifting investor sentiment around macroeconomic outlooks. At the start of the year, high-yield bonds were yielding 8.11% before reaching a year-to-date low of 6.9% during the latest risk-on chapter, before increasing to 7.7% amid increasing macro concerns. Loans followed a similar pattern, starting the year with yields of 7.3%, before hitting a year-to-date low of 6.4% just a few weeks ago, before increasing to 6.9% at the end of May.
Despite the recent increase in yields, we believe fundamentals among below-investment-grade issuers are strong. We think the healthy fundamentals will keep default levels in the low single digits through 2013. Beyond generally stronger balance sheets, high-yield issuers have meaningfully reduced near-term maturities. For these reasons, we believe that even if the economy slips back into a recession, a spike in defaults is unlikely.
Healthy fundamentals combined with a generally supportive technical environment (i.e., supply/demand for high-yield and floating-rate securities) will likely prevent yield spreads from spiking far beyond prior cycle highs of 1,000 basis points, save for spreads observed during the 2008–2009 financial crisis. Positive technical factors include the high level of yields (i.e., level of income), and favorable supply/demand dynamics, which we suspect will ebb and flow, but remain generally supportive. Bonds and loans do not need strong economic growth to generate decent returns. To the extent the U.S. economy continues to muddle through, this should cause rates to remain low and corporations to remain cautious which we believe will be supportive of bond and loan pricing. From a technical perspective, we believe demand will persist given the relatively attractive level of yields. We suspect this trend will benefit the higher-yielding bonds more than floating-rate loans, whose yields are tied to LIBOR rates, i.e., higher rates equal higher loan yields. With relatively attractive yields, and generally lower levels of volatility compared to equities, bonds and loans could be perceived as a favorable risk/reward option, which could result in continued demand.
From a valuation perspective, at current price levels, high-yield appears pricey and does not justify a tactical allocation. Pricing for loans is more attractive on both an absolute basis and relative to high-yield bonds.
We continue to hold floating-rate loans in our most conservative portfolios to protect against a sharp rise in interest rates. These conservative portfolios have very large strategic weightings to core investment-grade bonds because this has historically been a low-risk asset class and one that we expect to perform well in a recessionary or deflationary scenario that would be harmful to riskier assets such as equities. However, because of the very low level of current investmentgrade bond yields, the asset class faces potentially significant downside risk if rates were to rise sharply. Thus, our most conservative portfolios are more exposed to interest rate risk than our other portfolios where the core investment-grade bond allocation is smaller. While our expectation is not for a sharp rise in interest rates any time soon, it is a stress scenario we factor into our five-year return scenarios, and as we assessed the potential 12-month downside risk for this portfolio, we felt it made sense to reduce the duration (a measure of interest-rate sensitivity) somewhat through the addition of floating-rate loans.
As for our return expectations, though our focus is on a five-year investment horizon, we are cognizant of the near-term return outlook since we manage to 12-month downside-risk thresholds. Over the next 12 months, our base case is for high-yield to generate a return in the 7% range, while our loan estimate is in the 5.5% range. These estimates are based on a benign maturity schedule, which should result in low single-digit defaults, recoveries near or above the historical average, a relatively low interest-rate environment (by historical standards) that creates some demand for yield, and forecasts for a slow and gradual economic recovery. In this environment, we expect yields to remain near current levels, and price appreciation to contribute little, if any, to total return from these levels.
Over our five-year investment horizon, our base case is for an annualized return in the 3.5% range for high-yield bonds, and 4.5% for loans. Our lower long-term estimate for bonds is due to our expectation for a meaningful rise in Treasury interest rates over our forecast period; this is true for all of our scenarios. For example, if 10-year Treasury rates increase from the current level of below 1.5% to 5% over the next five years, the yield on high-yield bonds will certainly increase from the current level of 7.9%. Exactly how much yields increase will be a function of the macroeconomic backdrop, supply/demand conditions in credit markets, default and recovery rates, etc. Our estimates assume high-yield spread levels versus Treasuries that are consistent with historical averages, given certain default expectations. Loans, which have yields that are tied to the level of rates, would benefit from an increase in rates.
Actual inflation has outpaced inflation expectations so far in 2012 as the 10-year inflation rate hovered around 2.65% as of the end of May. Inflation predictions had ranged from 2% to 2.4%. Average inflation over the past 50 years has been 4%, and if we remove the period containing double-digit inflation from 1973 to 1982, the average falls to 2.9%, which is still above current inflation expectations. This suggests investors believe subpar economic growth will lead to lower-thanaverage inflation over the next 10 years.
We continue to view TIPS as unattractive based on what we believe are rich valuations. The yields on TIPS with maturities as long as 10 years have been negative since the middle of 2011. At current price levels, we believe TIPS will generate little if any return over our five-year investment horizon. Specifically, our potential returns for TIPS are slightly negative to modestly positive (annualized) across the wide range of five-year economic scenarios we consider, which factor in a range of forecasts for interest rates and inflation. Even when we assume mid-single-digit inflation rates, TIPS returns are unattractive and do not justify a tactical allocation in our portfolios.
Our estimated returns are meaningfully lower than the approximately 7% average total return (income plus price change) that TIPS have generated since they were first issued in 1997 (through February 2012). The large disparity between historical returns and our five-year return expectations can be explained by our anticipation of higher interest rates, both nominal and real. Though TIPS offer protection from inflation, they have similar risks as conventional bonds, the most important of which is interest-rate risk. When interest rates rise, bond prices fall, and vice versa. From 1997 to early 2012, interest rates trended lower, declining from close to 6% to below 2%, serving as a tailwind to bond prices. But, over the next five years our expectation is that interest rates will remain near current levels (in a severe recession scenario) or rise to levels between 5% and 7%, depending on the scenario, and that there will also be a rise in real rates, though the two rates will not move uniformly. So, while we generally assume that inflation will persist over our investment horizon such that the principal value of TIPS will adjust higher, these income gains will be offset by principal losses in the form of lower TIPS prices when real rates rise.
One of the few investment strategies that delivered positive performance during 2008 was managed futures. Historically, these strategies have been offered through private funds, typically with limited liquidity and high investment minimums, and just one managed futures mutual fund was in existence entering 2008. With product providers responding to increased interest following the financial crisis, there are now over 30 managed futures mutual funds and exchange-traded products available to retail investors, with many of these launched during the past year. (Morningstar reported that assets in their managed futures category nearly doubled in 2011, to around $7.4 billion.) Although not among our highest priorities, we have spent time over the past several years researching some of these products, but to date we have not made an investment in managed futures.
While certain managed-futures managers will specialize in a particular asset class, they typically implement trades using exchange-traded futures contracts on various commodities, currencies, government bonds, and equity indexes. Most managed futures strategies utilize trend-following methodologies which rely on quantitative systems to evaluate price momentum and determine the assets in which to invest, the direction of each trade (long or short), and the specific contract or contracts to use. Other managers try to profit from mean-reversion or employ fundamental analysis of supplydemand factors to inform their trades. Different time frames are used to assess price trends, but usually these systems evaluate trailing periods of days/weeks/months, which can produce a high number of “round turns” (entered and exited trades) each year. Most managers use risk management systems to measure volatility and other factors in an effort to limit the damage of losing trades while hoping trends continue in winning trades.
We have reviewed research that suggests managed futures have consistently provided “crisis alpha,” outperforming due to trends created by the synchronized herd behavior of investors during severe equity declines. Outside of such periods, this research concludes the performance of managed futures approximates the risk-free rate. (Investors should bear this in mind given today’s low interest rates.) Further, many trend-following systems will perform poorly in environments of high volatility without sustained market direction, as has occurred over much of the past two years. The potential for managed
futures to provide a “tail risk” hedge is appealing, but a critical question is whether these strategies are likely to provide acceptable returns across a full market cycle, and we do not yet have confidence that they will. In our view, the academic literature in behavioral finance offers the strongest theoretical argument for investing in managed futures, as human tendencies such as anchoring, herding, and confirmation bias may lead to persistent trend opportunities. However, to justify an allocation in our portfolios, we must have confidence that one or more specific managed futures strategies are likely to exploit these inefficiencies on a consistent basis.
One challenge in viewing managed futures as an asset class is a lack of underlying fundamental drivers of long-term returns. Without the contractual cash flows of bonds or the earnings growth potential of equities, the erformance of managed futures are entirely dependent on the successful execution by managers of their trading strategies. Even the passive investment options available in this space are based on proprietary or licensed rule-based approaches that (though often simplified) are not unlike the systems utilized by many managed futures traders. While an investor typically gains much greater transparency with a passive methodology, there is no assurance that the approach will maintain its effectiveness across a variety of market environments. This same risk exists with single-manager active strategies, and the majority of experienced managed futures investors with whom we’ve had contact ecommend diversifying broadly among managers and systems.
Manager diversification seems obvious, but it comes at a high cost. In addition to having management fees (exclusive of fund operating costs) ranging from 1.45% to 2% annually, the multi-manager funds we have researched utilize separate accounts with incentive fees. These further weigh on fund returns, especially during periods when the dispersion of manager returns is high, since incentive fees paid to an outperforming manager reduce the net return available to offset losses of underperforming managers. Multi-manager product sponsors argue they can select superior traders, who are sufficiently skilled to justify these fees over time. We intend to more thoroughly investigate the due diligence processes of several sponsors as we consider whether outsourcing manager selection makes sense, given the high expense hurdle these products must overcome to deliver value for clients.
We will continue to monitor the growing universe of managed futures funds, including lower cost single-manager and passive strategies. In conducting additional research over the coming months to deepen our knowledge of managed futures, we hope to reach definitive conclusions as to whether an allocation can enhance the long-term performance of client portfolios; if so, which product approach is most likely to capture the desired risk and return characteristics; and can we identify one or more active managers worthy of recommendation based on our conviction in their ability to outperform competing options.
At current price levels, we do not believe that REITs justify a tactical allocation. In our view, REIT valuations are rich and reflect expectations for a meaningful and persistent rebound in operating fundamentals. Our analysis indicates the recovery in fundamentals will continue, but at a slow pace as real estate fundamentals lag economic trends.
In our most likely base-case scenario, we anticipate tepid demand for space as GDP forecasts continue to decline, while still-high levels of unemployment should dampen demand for property. In our view, job growth must accelerate to sustain a widespread recovery in REIT fundamentals. The good news on the fundamentals front is that supply in the form of new construction remains subdued across all property types. Unlike prior real estate cycles, oversupply is not the key risk. This should help to support property fundamentals in the subpar recovery we’re expecting.
While growth is one question mark, a key risk we continue to see for REITs is a potential increase in interest rates. Our view remains that the decline in interest rates we’ve seen has been a key driver of higher property values, as property investors are willing to accept lower returns in an interest rate environment where 10 year, risk-free rates were recently 1.5%. Today’s low interest-rate environment will not last forever, and when rates rise, the low levels of returns investors are accepting today will be a thing of the past, putting downward pressure on property values and therefore REIT valuations. We should mention that in all of our economic scenarios we estimate that interest rates will move higher over our five-year investment horizon, with the magnitude of rate hikes dependent upon the specific economic scenario.
As rates do rise, it’s also going to make REIT dividend yields less competitive as a yield instrument relative to other securities. For example, REITs’ current dividend yield of 1.5%, while very low in absolute terms, could be perceived as attractive relative to a 1.5% Treasury yield. But, any meaningful backup in rates will exert some pressure on REIT valuations. We suspect that REITs’ relatively attractive dividend yield has been a driver of demand for REITs, and therefore REIT returns over the past year, as we haven’t seen tremendous growth. This doesn’t mean that REIT yields can’t go even lower, but it’s not our approach to speculate on short-term moves.
More than one REIT fund manager we have spoken with has said that at current price levels, it’s extremely difficult to make the case for owning blue-chip REITs, and that the implied total returns at current price levels are miserable. This comment corroborates the valuation metrics we’ve observed. At current price levels, REITs’ price-to-AFFO ratio (based on 2012 AFFO—adjusted funds from operations—estimates) is 18.8x, the highest levels observed over the past 15 years. The average price-to-AFFO over that time frame is 13x, implying nearly a 30% decline to get back to that norm valuation levels. The price-to-AFFO ratio is similar to a price-to-earnings ratio, but instead of earnings, REITs’ funds from operations are used and are adjusted to account for ongoing maintenance costs associated with upkeep of the properties.
As mentioned earlier, we believe that at current prices, REIT investors are anticipating a meaningful and persistent rebound in fundamentals, a scenario we think is unlikely given the economic backdrop. Aside from low absolute-yield levels and high price-to-AFFO ratios, our view is supported by our dividend growth assumptions where (in some scenarios) we are assuming dividend growth that is well above prior REIT recovery cycle levels of 4.8%. In fact, in some of our scenarios we are assuming dividend growth that is more than twice historical recovery levels. Some of our higher numbers are based on lack of supply, which gives landlords more pricing power, while we are also baking in a very modest benefit from accretive acquisitions. We are not baking in a very big accretive impact from acquisitions for two reasons: One, the REIT universe has grown tremendously since the last period when REITS were acquirers of property (1993–1996), so it’s harder for the accretive needle to move. And two, there are not many high-quality properties for sale at price levels that would be accretive to REITs.
—Litman Gregory Research Team (6/4/12)
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