U.S. Equities Continue to Look Attractive: Equity Investment Outlook

As we sit down to write this Outlook we are struck by two trends: the consistency of the economic recovery in the U.S. and the dramatic escalation of geopolitical turmoil. Whether these two trends will collide to derail the bull market is an open question, but usually geopolitical flare-ups have only short-term effects and do not overwhelm long-term economic trends. Thus, they tend to appear as hiccups in stock market progress.

The U.S. economy suffered a weather-induced slowdown in the first quarter but now appears to be back on track. Employment levels are gradually improving. Inflation remains low, albeit having risen a bit recently. Corporate profit margins hover at record levels, and the stock market trades at slightly above average valuation levels. In other words, the economic and stock market trends we have been writing about for several years remain largely intact. Rather than repeat all the arguments for this, we refer our readers to our April 2014 Investment Outlook in which we extensively reviewed the economic landscape and both the bull and bear cases for equities. We continue to find the bull market case more compelling.

Besides the economic case for a continued bull market, we briefly articulated a technical (or money flow) argument. We would like to expand that argument here. Below, you’ll find what we discussed in April:

“…we believe U.S. equities are very attractive relative to the alternatives. The great bull market in bonds appears to be over. The great decades of emerging market growth appear to be behind us. Hedge funds in aggregate have been mediocre performers for some time. We expect money to flow back into stocks, particularly U.S. equities. This is a technical (money flow) argument for a continued bull market. It augments the fundamental case based on earnings and valuation.”

To get a better understanding of why this technical argument makes sense, it helps to look at how the investment management world has changed. If we look back at 1970, retail stock brokers called their clients and recommended individual stocks; bank trust departments invested their clients’ money largely in blue chip stocks and investment grade bonds; and large endowments more or less used a balanced 60/40 portfolio (60% stocks/40% bonds) focused on stocks and investment grade bonds.

Between the 1970s and now a big driver of change in the approach to investment management has been the development and application of Modern Portfolio Theory. This academic research about portfolio risk and return suggests that if one structures portfolios not just with stocks and bonds but with other types of assets (which supposedly are not correlated with the stock market), the portfolio could be optimized to a more efficient frontier of risk and return.

One of the biggest proponents of this new, modern thinking is David Swensen at Yale University. Under his leadership, Yale diversified its endowment aggressively into alternatives such as hedge funds, private equity and venture capital. The results were impressive and soon others started copying the concept. This resulted in some dramatic changes in asset allocation away from U.S. equities and toward non-U.S. equities and alternatives across the foundation and endowment world, as exemplified below in the allocation of Swarthmore College endowment between 1979/1980 and 2012/2013.

Figure 1:

Swarthmore College Endowment and Debt


  Portfolio Weight (1979/1980) Portfolio Weight
Domestic Equities 81% 21%
International Equities 0% 21%
Alternative Equities 3% 43%
Fixed Income & Cash 16% 15%
     Total 100% 100%

Source:  Swarthmore College Endowment and Debt. Investment Office.
Allocations and holdings should not be construed as a recommendation to buy or sell any security.

Now the alternative-oriented diversified approach is de rigueur. Basically, everyone is doing it in various forms. It is no longer the norm for retail stock brokers to recommend individual stocks. Instead they recommend a mélange of various mutual funds and structured products. They are asset gatherers who put their clients into a broad array of “products” managed by other professionals.

Bank trust departments do pretty much the same. Instead of researching individual stocks and bonds, they research other managers and create investment products of their own. Out of this they build highly diversified portfolios, not just of stocks and bonds, but also alternative assets. Thirty years ago, a diversified portfolio might have owned 30 stocks and 20 bonds. Today, a professionally managed portfolio might include 25-50 different funds!

So what is the upshot of all this diversification? Looking at the latest data available for foundations and endowments for the 10 years ending June 30, 2013, a good old-fashioned 60/40 stock/bond portfolio has performed nearly inline or better than the more diversified portfolios that use alternative investments. How could that be? Quite simply, when Yale started to invest in alternative strategies, it was early, and Yale was able to capture excess returns in largely overlooked strategies. But once everyone else piled in, the excess returns evaporated, which led to less compelling returns in recent years. Figure 2 shows this quite clearly.

Figure 2:

Annualized Returns as of 6/30/2013

  1 Year 3 Year 5 Year 10 Year
60% S&P 500/40% BC Agg Index 11.7% 12.5% 6.7% 6.5%
U.S. Higher Education Endowments/Affiliated Foundations (Average) 11.7% 10.2% 4.0% 7.1%
S&P 500 Index 20.6% 18.5% 7.0% 7.3%
MSCI AC World Index ex. U.S. 14.1% 8.5% -0.3% 9.1%
Barclays U.S. Aggregate Bond Index -0.7% 3.5% 5.2% 4.5%
HFRI Fund Weighted Composite Index 7.9% 4.8% 2.5% 6.1%

Source: Bloomberg. 2013 NACUBO-Commonfund Study of Endowments.

Past performance is not indicative of future results.Index performance is not indicative of performance in any investment and an investment cannot be made directly in an index.

So Swensen’s genius was not diversification itself, but his willingness to invest in areas which others overlooked. The key to investment outperformance — then and now — is to ferret out under-exploited opportunities. If you want to be above-average, you cannot do what the average investor is doing. You have to be different.

Once everyone else became a great diversifier, focusing on U.S. stocks and bonds and avoiding alternatives turned out to be the winning strategy. So now we are seeing article after article about how disappointing hedge fund returns have been over the last 10 years. Additionally it appears that private equity and venture capital are not really diversifiers due to relatively high correlation to the stock market, and they can be toxic to investors because of their illiquidity in market drawdowns.

We sense that the diversification pendulum is starting to swing back to a more classic asset allocation with greater emphasis on stocks and bonds and away from exotica. Hedge funds have evolved from nimble “special ops” forces into large, conventional armies, primarily serving big institutions and that seek to deliver predictable, “absolute returns,” more akin to enhanced bond funds than stock market rock stars. Venture capital is alive and well, but the best deals tend to go to the top tier funds. If you don’t have access to these select few funds, your returns are likely to be mediocre. The same is true of private equity.

In sum, our argument is not that the move to more diversified portfolio management was wrong or that it is over, but only that the approach to diversification needs to be tempered by a more nuanced assessment of the real risks and opportunities in the various asset classes. If one takes a hard look at the available investment options, one can make the following observations:

Bonds: The great bull market in investment grade bonds has probably run its course. Interest rates have fallen fairly consistently from 1983 until today and are now at record low levels. Returns today are skimpy, in the low- to mid-single digits on all but the most
credit-challenged bonds.

Hedge Funds: Hedge funds have largely disappointed and have become institutionally oriented absolute return strategies. They actually managed to lose a fair amount of money in 2008 — less than the stock market but still a lot of money in absolute terms.

Venture Capital & Private Equity: Venture capital and private equity are still alive, but most of the performance is concentrated in the top-tier funds, which are difficult for most investors to access.

Emerging Markets: Twenty years ago, emerging economies offered above-average growth and profit potential at below-average valuations. Today that is not the case as lots of money pours in, valuations are up, returns on capital are falling and growth is now slowing.

Therefore, we conclude that the pendulum is likely to swing back in favor of U.S. equities and a simpler approach to diversification. This makes sense as long as the factors behind the bull market which emerged from the 2008 ashes are still in place. We believe this is the case and that the bull market will continue a while longer. Therefore, a more classic approach to investing may prove rewarding. What was a “modern” trend that looked particularly attractive based on the early results of Yale model is now turning out to be a bit dated. We believe it’s time to return to the tried and true.

We thank you for your continued confidence in our management.




John Osterweis                                              

Matt Berler

Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.


The 60% S&P 500/40% BC Agg Index is composed of 60% Standard & Poor's 500 Index (S&P 500) and 40% Barclays U.S. Aggregate Bond Index (BC Agg) and assumes monthly rebalancing. The S&P 500 is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The BC Agg is an unmanaged index that is widely regarded as a standard for measuring U.S. investment grade bond market performance.


U.S. Higher Education Endowments/Affiliated Foundations (Average) shows the average performance of the data collected from 835 colleges and universities as reported in the NACUBO-Commonfund Study of Endowments®.


MSCI AC World Index ex. U.S. is a market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets.


The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in U.S. Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.


Diversification does not assure a profit or protect against a loss.


Correlation is a statistical measure of how two securities or asset classes move in relation to each other.


Stocks are generally perceived to have more financial risk than bonds in that bond holders have a claim on firm operations or assets that is senior to that of equity holders. In addition, stock prices are generally more volatile than bond prices, with international equities and emerging market equities potential more volatile than U.S. equities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. A stock may trade with more or less liquidity than a bond depending on the number of shares and bonds outstanding, the size of the company, and the demand for the securities. Similarly, the transaction costs involved in trading a stock may be more or less than a particular bond depending on the factors mentioned above and whether the stock or bond trades upon an exchange. Depending on the entity issuing the bond, it may or may or may not afford additional protections to the investor, such as a guarantee of return of principal by a government or bond insurance company. There is typically no guarantee of any kind associated with the purchase of an individual stock. Bonds are often owned by individuals interested in current income while stocks are generally owned by individuals seeking price appreciation with income a secondary concern. Hedge funds, venture capital funds and private equity are generally perceived to have more financial risk than stocks due to their types of investments and potential ability to use leverage.  They also generally have high fees and limited liquidity. The tax treatment of returns of bonds, stocks, hedge funds, venture capital and private equity also differ given differential tax treatment of income versus capital gain, as well as partnership related issues.


One cannot invest directly in an index. [9830]

© Osterweis Capital Management

© Osterweis Capital Management

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