SMAs Tough It Out
They looked to real estate. They looked to energy. They looked to longer duration bonds. They looked to companies that could withstand a weak global economy, and they looked to sidestep the credit nightmares of countries such as Greece.
Those managers who rose to the top of the heap in the separately managed accounts industry carefully researched and weighed their options before making their moves. And it wasn't easy. According to Morningstar, the SMA industry was up only slightly last year, rising a mere 0.68%. After strong asset flows in the first half of the year, the industry shed close to 9% in the third quarter, and then came back 5.34% in the fourth quarter.
In fact, the SMA industry is close to where it was in 2007—before the credit crisis struck. After steadily increasing assets though the 2000s, the industry took a big hit like the rest of the markets, but has been recovering steadily. "It's rebounded nicely since 2008," Morningstar's separate account team leader Adam Baranowski, says. The median minimum in Morningstar's database is $5 million, although some run a more reasonable $250,000 to $500,000. So it's a bit high end, and it costs. But what's the outcome?
The performance of SMAs is trickier to measure than that of mutual funds. That's because all the tailoring for individual clients (a little extra telecoms here, no tobacco there) means a particular strategy can have many different portfolios varying its theme, while a mutual fund has a single portfolio. Money managers offer data providers like Morningstar composites of their separate account strategies. These composites are representative of all of the company's actual separate accounts. But advisors should know this does not capture the entire universe of SMAs. Morningstar only tracks companies whose SMAs comply with certain reporting standards, and many do not. (They also do not all register with the U.S. Securities and Exchange Commission.)
Baranowski says the best way to rank these accounts is by using gross returns. "Each individual investor will have a different investor experience based on their specific fees or their asset allocation, " he says. "Each separate account strategy will negotiate different fees for different clients based on how many assets they'll invest in the account," he says. Accounts generally carry a tiered fee schedule, generally lower than that charged by mutual funds.
Investors' results also vary based on their individual requirements. For instance, Baranowski says, "Bill Gates is not going to want Microsoft exposure in his portfolio because he's already overexposed to Microsoft." But this does have its risks. In the booming tech years of the 1990s, Gates' Microsoft-free separately managed account might have underperformed its peers.
SMA rankings tend to reflect what happened in the broader markets. Long-duration fixed income strategies turned in the strongest performance last year, with median gains of 6.4%, compared with a median loss of 0.6% for U.S. stocks.
Sure enough, all 10 of the top U.S. bond strategies played in the long-duration arena. In fact, seven out of 10 invested in long U.S. government bonds, which had a median return of 26.1% last year, the best performance among Morningstar's SMA database.
Even so, the majority of assets in SMAs are in stocks. There are relatively few programs covering only overseas fixed income, so Morningstar only has one category, called world bonds, which includes fixed-income strategies that invest both in U.S. and overseas bonds. These strategies must invest at least 40% of the assets in foreign bonds. Some favor high-quality bonds from developed markets. Others are more adventurous and own lower quality issues from the emerging markets. The median return for the group was 5.1%.
SMAs investing in U.S. stocks ended fairly flat in spite of a median gain of 12.2% in the fourth quarter. That's due to a horrible third quarter, which shaved a median 16.8% from returns. Only four Morningstar equity categories were able to notch median returns in the black: energy, real estate, large cap blend and large cap value. Those that did well overwhelmingly focused on generating income for investors, whether through specialized vehicles designed to pay out income, or plain old dividend-paying stocks. Energy climbed 15.8%, real estate rose 10.7%, large blend gained 1.1%, and large value edged 0.9% higher. The clear winners were specialist strategies investing in energy and real estate. "[Master Limited Partnerships] and [Real Estate Investment Trusts] outperformed the rest of the equity category because they are income-producing investments, as opposed to traditional equity strategies which are focused on stock appreciation," Baranowski says. MLPs, had an ideal environment last year, with near-zero interest rates, he adds. And, MLPs themselves had been increasing cash distributions.
Finally, in a year where Europe was roiled by debt crisis, overseas stocks fared poorly compared to domestic stocks and bonds. The median return was a loss of 11.8%. And no category within the broader asset class posted positive returns for the year. The strongest performing group was Japan, which lost a median 7.7% last year. Now, on to the top performers.
SMA: Invesco Master Limited Partnership/Atlantic Trust
Co-managers: Adam Karpf and Paul McPheeters
The Good Alpha Generator
Master Limited Partnerships boast high cash flow and relatively high yields, which draw investors eager for income in today's low-interest rate environment.
Invesco Master Limited Partnership posted the best performance in the domestic bunch, racking up gains of 18.9% in 2011.
Co-managed by Paul McPheeters and Adam Karpf of the company's Atlantic Trust subsidiary, the strategy edged out several other worthy MLP-focused offerings, thanks to an extra-deep research bench. Invesco boasts a five-person team to cover a sector with just 75 securities.
That may sound like overkill, but McPheeters insists it is necessary. "We're in an inefficient sector and have a lot of people doing work for our size. We only run $1 billion in MLPs and we're in a space where size can be a determinant. It's happened [that] our peers ended up being asset gatherers. We keep to a size where we can be a pretty good alpha generator."
Top picks include Enterprise Products Partners, Plains All American Pipeline and Williams Companies.
Like REITs, MLPs don't pay corporate taxes, and must generate 90% of their income from qualifying sources, such as drilling for and transporting oil and natural gas. They are often compared to toll roads, because in many cases they receive a fee for the volume of product moving through their pipelines, not necessarily owning the product. Karpf and McPheeters have positioned the portfolio to be heavily exposed to positive volume trends, while having limited exposure to the actual product. This puts the portfolio at an advantage to many companies in the sector, which have exposure to both volumes and prices, which has led to a mixed result.
Helping performance, they are avoiding companies involved in propane and natural gas storage, as those sectors have struggled with steep drops in prices.
Karpf says the team's intensive proprietary models keep tabs on a wide range of factors including movements in commodity pricing, drilling activities and volumes. He adds that one of the most important keys to the success of an MLP is the location of assets, including pipelines and storage. Other aspects of success are growth prospects.
The team's top picks all ratcheted up growth spending plans, and have excellent growth prospects, Karpf says. They expect strong growth to continue in the industry, although market valuations reflect the sector's robust gains. "We still have positive returns ahead, have a sector that remains fairly inefficient, which remains a good place for active management," Karpf says.
The average MLP yield is around 6%. Karpf expects growth in the companies themselves to clock in around 7% for the next three years or so. Add the two together, and you get a return in the mid-teens percentage, with little change in the valuations of the MLPs themselves. "That's the beauty of this space," Karpf says.
SMA: Newton Capital Management
Manager: James Harries
Strong Balance Sheets and Predictable Dividends
London-based Newton Capital Management takes a global approach to investing, and selects investments along themes. The big theme that served the group well last year, and continues today, is the idea that the high degree of indebtedness in the developed world spells a slower economic outlook for the foreseeable future.
To manager James Harries, that means boosting income by filling his Global Higher Income portfolio with companies that have strong balance sheets and pay predictable dividends. "We think in this kind of environment you should seek to have a greater degree of quality inherent in the portfolio," he says.
That bias towards quality helped the portfolio post a net return of 3.04% in 2011, while the average strategy in the international equity category lost 11.8%.
Harries takes the view that the investment environment today is substantially "less good" than it used to be, for a host of reasons. He notes that at the start of the bull run in equities in 1982, interest rates were 12%, bond yields were 14% and valuations were more attractive than they are today.
Further, the era was marked by long business cycles, which benefited investors, because down cycles could be softened by governments dropping interest rates and inducing people to borrow more. "The credit crunch marked the end of those trends, and we're returning to the world like it used to be," Harries says. "We're in for a period of lower returns, more volatility and less favorable investment environment." As governments' ability to dampen and lengthen the economic cycle has weakened, many companies "will simply struggle, because they were set up for a different time when debt was cheaper," he says.
Therefore, the companies Harries finds most attractive are those not dependent on a strong global economy.
In 2011, winners in his portfolio were companies selling products consumers buy on a non-discretionary basis like tobacco-an industry he notes has a high and growing dividend yield—and household goods. He bought stocks in consumer staples, but shunned general retailers, on the grounds many were built for a time when debt was cheap. Health care and telecommunications were his other favorite industries serving consumers. Within health care, he likes pharmaceuticals and biotech, where he thinks the valuations are attractive. He also likes the robust demand for the services of both industries, thanks to an aging developed world and a wealthier Asia. He also likes mobile telecommunications, where he believes there is real growth, especially in the emerging markets.
Yet, Harries is steering clear of industries and countries that have benefited from China's recent red-hot growth, on the grounds that country is due for a slowdown. He says cycles in the Chinese economy have been "remarkably absent," and that the economy ought to have seen a slowdown in 2008-2009. He believes that was staved off by the Chinese government forcing the country's banks to lend aggressively, but that is likely to end in coming years.
Investments that Harries expects to feel the effects from China's slowdown include building materials, such as steel, and even entire economies including Australia and Canada. That goes for both stocks and currency.
An industry Harries particularly dislikes is banks. "We continue to feel that banks were the great beneficiaries of the buildup of debt in the 30-year credit super-cycle, and they'll struggle in a world where debt is being paid down," Harries says. He also believes the industry will be subject to greater regulatory scrutiny and will probably have to raise more capital, which will both likely dampen profitability.
SMA: PIMCO Global Government Unhedged
Manager: Scott Mather
Avoiding Credit Disasters Like Greece and Even France
Looking across the asset class divide to world bonds, PIMCO Global Government Unhedged boasted returns of 9.6% last year, compared with 5.1% median growth for its peers. Scott Mather, head of global investments at PIMCO, is at the helm. He attributes his success to calling the macro environment correctly. "We consider that the low-hanging fruit," he says, explaining that heading into 2011, he anticipated most of the world would have low growth and low inflation. Generally, if an investor thinks growth and inflation will be low, the traditional move is to own long duration bonds. Until, that is, "countries are at a tipping point," Mather says.
Last year, what was more important than duration was simply avoiding the credit disasters. "The key was to avoid those [investments] that would be contaminated by the rising credit risk premium," Mather says. "As things got riskier in Europe, we avoided all the peripherals—Greece, Ireland, Spain and Italy." As of early last year, many market observers and participants did not consider Italy a peripheral country like small, troubled Greece and Portugal. But the cautious Mather did. He even steered clear of France, long considered a core country, but which lost its coveted triple A-rating last year.
Instead, Mather loaded up his portfolio with bonds from Germany, the United Kingdom, the United States and Australia—none of which he thought showed signs of a rising credit risk premium. He focused on higher quality corporate bonds, as well as mortgage-backed securities. He completed his move towards higher quality by lightening up on riskier corporate credits, especially high-yield bonds.
However, with a portfolio with more than 500 positions, none of his bets were enormous. "There's no reason to be exposed to any one credit or country," he says. "Yes, you need to make geographic choices, make credit quality choices, but we always have very diversified portfolios so we're not betting the farm on one country or issuer," he says. "A lot of people say they're managing a portfolio that way, but when you look at what they're doing, they have large exposures to certain corporate credits, or a particular emerging market."
Mather also believes the unhedged aspect of the portfolio—owning bonds from across the world in their original currencies, rather than in U.S. dollars—is helpful, rather than risky. PIMCO offers the portfolio in a hedged and unhedged version. In fact, the unhedged offering is for the investor who is overexposed to the U.S. dollar, which Mather suggests is most U.S. investors. He notes that for the last decade, the U.S. dollar has been declining in value. Investors who went unhedged may have suffered a bit more volatility over a one- or six-month basis, but overall, have come out ahead, thanks to the exposure to other currencies.
Further, Mather believes the trend will continue for the next five years or so. In that time, he expects currencies of the emerging markets, as well as the Canadian and the Australian dollar, to outperform the U.S. dollar. And he has tipped the portfolio slightly in favor of those currencies.
SMA: NISA 15+ Strips
Managers: Jess Yawitz and William Marshall (also Kenneth L. Lester, David G. Eichhorn, C. Robert Krebs, Joseph A. Murphy, Anthony R. Pope and Gregory H. Yess)
Capitalizing on Moderate Inefficiencies
In the domestic bond market, three of the top 10 strategies were managed by NISA Investment Advisors, a St. Louis-based institutional money manager specializing in bonds. All three specialized in long duration bonds, the clear winner in 2011. The top performer, NISA 15+ Strips, posted a return of 50.7% last year, by investing in Treasury STRIPS, or separate trading of registered interest and principal of securities. These are zero-coupon securities that don't mature for at least 15 years. "With long duration, and low or declining interest rates, the asset class does the rest for you," Baranowski says.
NISA did not respond to repeated requests for an interview. But according to information it shared with Morningstar, it said that as active traders, the management team is able to find "frequent opportunities to trade very similar bonds for small gains at little or no incremental risk." Under a category of investment philosophy, NISA said that higher yielding treasuries are not necessarily a good deal, and that execution costs are crucial given the long duration of STRIPS. NISA was founded by Jess Yawitz and William Marshall, a pair of professors from the business school at Washington University in St. Louis, Missouri. The two of them built Goldman Sachs' Financial Strategies Group.
SMA: Good Harbor U.S. Tactical Core
Co-managers: Neil Peplinski and Paul Ingersoll
Abandoning Buy-And-Hold for Tactical
The balanced strategies blend stocks, bonds and cash in ways that Morningstar categorizes as aggressive, moderate or conservative. Portfolios with 90% or more stocks were aggressive; 50% to 70% in stocks were moderate and 20% to 50% in stocks were conservative. Lower than 20%, and the strategy is classed as fixed income. In last year's top 10 balanced SMAs, there were two types: conservative, whose bonds saw them through a difficult time in 2011, and tactical, or actively managed strategies. Those who rightly got out of equities and into bonds as the year wore on posted superior performance. Seven of the top 10 performers were tactically managed. While the entire group's median return was a mere 1.1% in 2011, the conservative crowd did best, with gains of 2.4%, ahead of the moderates which rose 0.9% and their aggressive colleagues who shed 1.5%.
Best of the shifters was Good Harbor U.S. Tactical Core. It gained 12.9% last year. It has also posted the best returns of the group over the last five years, with profits of 13.9%. Managers Neil Peplinski and Paul Ingersoll don't invest in individual equities. Instead, they use ETFs to get broad market exposure. For stocks, they use a combination of ETFs tracking the Russell 2000, the S&P 500 and the S&P 400. When they're feeling defensive, they move to a Treasury-based ETF. Last year, they were in equities for the first half of the year, and were defensive in the second half. They missed the August sell-off entirely, with 100% of the portfolio in Treasuries. Peplinski says their strategy involves rebalancing the portfolio on a one-to-three month basis. Before 2008, the managers had a hard time convincing investors to go tactical, even though their portfolio performed as it should have from 2003 to 2007. The strategy did well, but so did the broader market, and advisors weren't interested.
"What really gave us the opportunity to showcase what the model was intended to do was using tactical moves to avoid the downturn of 2008, and be in a position to reengage in 2009," Ingersoll says. Three years ago, advisors "had such a firm grip on the idea that diversification comes with a buy-and-hold portfolio, that we got less of a hearing," he adds. "But the world has changed quite a bit in three years. There has been a revolution in the way investors have been thinking." Now advisors, who make up the majority of their clients, come to them specifically requesting tactical management. "They say, 'I used to be buy-and-hold, but this is the second time this has happened to me in a decade. I'm leaving it behind; it hasn't worked,'" Ingersoll says.