Note from Our CIO: A Recap of 2014, and a Plan for 2015

Diversification worked again. Many of you may have noticed that your portfolios in 2014 did not do as well as the market that you hear about on the news. The most common of these, the S&P 500 index, earned about 13.7% for the year. Your portfolios comprise about 13 different markets (each called “asset classes”). The U.S. total equity market (3,500 companies) and developed international total equity market (4,500 companies) are two of the largest of these markets. As such, your performance has always and will always represent the performance of these 13 markets. In years when the U.S. market does poorly, we are quite pleased when international companies provide a counterbalance to the U.S. performance, and we say diversification is good in those years. In years such as 2014 when international companies do poorly, the overall performance of the equity portion of your portfolios will underperform the popular U.S. indexes, such as the S&P 500. Also, the S&P 500 and Dow are both dominated by the largest companies in the United States. Small stocks had much lower performance than large stocks in 2014, increasing the underperformance relative to the “nightly news indexes.” But that is exactly what we expect from time to time when using a strategy based on diversification. In that sense, we would say diversification did its job again in 2014.

Capital market assumptions updated. We updated our assumptions for the expected returns of all of our investments, which we use when preparing financial plans. We also advanced our research on the duration of bear markets in equities and the behavior of equity returns over various holding periods. We were able to answer a question that we feel often goes unasked  by most wealth management firms: How long does it take for equities to work? This is particularly relevant when a bear market happens right after retirement or some other major investment event in one’s life. Our conclusion is that we expect equities to beat inflation over five to 10 years, with a seven-year average, even if the period in question starts with a downturn.

Tax impact on each investment updated. We took a significant step forward with our capital markets assumptions by breaking down the total expected return of each investment in terms of the different sources of return, such as capital gains, dividends and unrealized gains. Each of these different sources of return has a different tax treatment. This allowed us to rank every investment in terms of the most tax efficient (meaning the return gets reduced the least by tax) to the least tax efficient (the return gets reduced the most by tax). We then used these rankings to revise our assumptions about which account types to locate each of the investments in (taxable accounts, IRAs, Roths, etc.). This concept is known as “asset location.”

Commodities removed from portfolios. We voted to sell all of our commodity positions in our portfolios. We trimmed our exposure in half in 2012, and so this was the final step in removing commodities altogether. Commodities have no expected return above inflation but do have as much volatility as equities. Their benefit is that in times of sharply higher inflation when equities might drop suddenly, commodities will often go up and provide some balance in portfolio performance. However, our expectation for inflation going forward is not severe, and so the short-term potential benefit of commodities is far overshadowed by their longer-term expected performance drag. In the event inflation does return, most client portfolios now include more inflation protection in other asset categories than they used to (in the form of real estate, trust deeds and certain bond funds).

O’Shaugnessy Asset Management (OSAM) conference. OSAM, the manager of one of the U.S. equity funds we hold in portfolios, held a conference exclusively for Abacus at our Santa Monica office. This gave us the opportunity to analyze more deeply the factors that OSAM emphasizes: low-price companies, high-momentum companies, companies with high financial quality and companies paying high shareholder yield. We also managed to negotiate a 40% reduction in the expense ratio of the fund, to 0.60%. Your advisor would be happy to explain what this means for you in more detail. We continue to expect these factors to drive higher-than-average returns in the OSAM fund.

We are looking forward to another year of accomplishments by our investment committee in 2015. Several of the projects already underway and which we are highly committed to completing this year include:

• Research on climate change and energy policy. As a physicist by training, this is a project near and dear to me and into which I have already immersed myself. Our goal is to approach the problem with a balanced, unbiased and evidence-based perspective.
• Impact portfolios. We have already allocated significant resources to the design and implementation of our impact portfolios, which will allow our clients to align their investments more closely with the social and environmental issues that are important to them.
• International exposure. The investment committee is currently reviewing our exposure to U.S. companies relative to non-U.S. companies, or “home country” bias.