Investment Review

Winter 2018

At the beginning of 2017, a common view among money managers and analysts was that the financial markets would not repeat their strong returns from 2016. Many cited the uncertain global economy, political turmoil in the U.S., implementation of Brexit, conflicts in the Middle East, North Korea’s weapons buildup, and other factors. The global equity markets defied their predictions, with major equity indices in the U.S., developed international, and emerging markets posting strong returns for the year.

Though 2017 was a positive year for absolute equity returns, it marked a change in premium performance from 2016 when the size and value premiums were generally positive across global markets. Taking a longer-term perspective, these premiums remain persistent over decades and around the globe despite recent years’ headwinds. It is well documented that stocks with higher expected return potential, such as small cap and value stocks, do not realize these returns every year. Maintaining discipline to these parts of the market is the key to effectively pursuing the long-term returns associated with the size, value, and profitability premiums. In 2017, the small cap premium (the return difference between small and large cap stocks) was generally negative across U.S., developed international, and emerging markets. The value premium (the return difference between value and growth stocks) was also negative.

The broad global advance underscores the importance of following an investment approach based on diversification and discipline rather than prediction and timing. Attempting to predict markets requires investors to not only accurately forecast future events, but also predict how markets will react to those events. The 2017 markets were a good reminder that there is little evidence suggesting either of these objectives can be accomplished on a consistent basis.

Instead of attempting to make predictions about future events, investors should appreciate that today’s price reflects the expectations of market participants and information about future expected returns. The following quote by the late Merton Miller, Nobel laureate, describes this view:

“Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.” ―Merton Miller

For the 2017 year, international and emerging market stocks returning 27.2% and 37.3% respectively far outperformed their U.S. counterparts, as the Russell 3000 returned 21.1%. While stock returns across the board were exceptionally high, holding a significant position in international and emerging market stocks increased returns for our clients. This is a good reminder about the importance of diversification.

 
Selected Headlines from the Past 12 Months Graphed with the World Stock Market Performance (MSCI All Country World Index)

 
The chart above highlights some of the year’s prominent headlines in the context of global stock market performance as measured by the MSCI All Country World Index-Investable Market Index (MSCI ACWI IMI). We are not offering these headlines to explain market returns. But they do serve as a reminder that investors should view daily events from a long-term perspective and avoid making financial decisions based solely on the news.

 
Investment Review

Benchmark Funds	Q4 2017	12 Months Ending 12/31/2017
U.S. Large Cap Vanguard 500 Index Fund	+6.6%	+21.7%
U.S. Large Cap Value iShares Russell 1000 Value Index	+5.5%	+13.5%
U.S. Small Cap iShares Russell 2000 Index	+3.3%	+14.6%
U.S. Small Cap Value iShares Russell 2000 Value Index	+2.0%	+7.7%
International Vanguard Total International Stock Index Fund	+4.8%	+27.4%
Emerging Markets Vanguard FTSE Emerging Markets ETF	+5.9%	+31.5%
U.S. REITs Vanguard REIT ETF	+1.4%	+4.9%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	+0.5%	+3.6%

 
Individual Asset Classes

World Asset Classes

Looking at broad market indices, emerging markets outperformed U.S. and non-U.S. developed markets during the quarter. The value effect was negative in the U.S., non-U.S. developed markets, and emerging markets. Small caps outperformed large caps in non-U.S. developed markets and emerging markets but underperformed in the U.S.

U.S. Stocks

Although U.S. small cap stocks, as described by the Russell 2000 Index, provided a healthy 14.7% return in 2017, the U.S. small cap premium (as measured by the Russell 2000 Index minus the Russell 1000 Index) was negative, ranking in the lowest third of annual return differences since 1979. However, over the 10-year period ending December 31, the small cap premium was positive.

U.S. value stocks returned 13.2% in 2017, as measured by the Russell 3000 Value Index. While double-digit returns from value are appealing, U.S. growth stocks performed even better, with a 29.6% return as represented by Russell 3000 Growth Index. The difference between value and growth returns, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, made 2017 the fourth lowest year for value since 1979 and pulled the five-year rolling premium return into negative territory.

Even over extended periods, underperformance of the value premium or any other premium is within expectation and not unusual. Over a 10-year period ending in March 2000, value stocks underperformed growth stocks by 5.6% per year, as measured by the Russell 1000 Value and Russell 1000 Growth indices. This underperformance quickly reversed course and by the end of February 2001, value stocks had outperformed growth stocks over the previous one-, three-, five-, 10-, and 20-year periods. Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.

The U.S. equity market posted a positive return for the quarter, outperforming non-U.S. developed markets but underperforming emerging markets. Value underperformed growth in the U.S. across large and small cap indices. Overall, small caps in the U.S. underperformed large caps.

International Developed Market Stocks

In developed international markets, small cap stocks outperformed large cap stocks while value stocks underperformed growth stocks. High profitability stocks outperformed low profitability stocks.

Over both five- and 10-year rolling periods, the small cap premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World ex USA Index, continued to be positive.

Similar to the U.S. equity market, value stocks posted a healthy 21.0% return for 2017 as measured using MSCI World ex USA Value Index. However, growth stocks performed even better with a 27.6% return, as measured by the MSCI World ex USA Growth Index.

The profitability premium was positive in developed ex-U.S. markets viewed marketwide. Looking within size and style segments of the market, high profitability outperformed low profitability in all but the large growth segment.
For the quarter, in U.S. dollar terms, developed international markets underperformed the U.S. and emerging markets.

Emerging Markets Stocks

In emerging markets, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. Similar to the U.S. equity market, high profitability stocks outperformed those with low profitability.

Value stocks returned 28.0% as measured by the MSCI Emerging Markets Value Index, but growth stocks fared better returning 46.8% using the MSCI Emerging Markets Growth Index. The value premium, measured as MSCI Emerging Markets Value Index minus MSCI Emerging Markets Growth Index, was the lowest since 1999.

For the quarter in U.S. dollar terms, emerging markets outperformed the U.S. and non-U.S. developed markets.

Real Estate Investment Trusts

Non-U.S. real estate investment trusts outperformed U.S. REITs, with global REITs returning 6.5% versus a return of 2.0% for U.S. REITs.

Fixed Income

Both U.S. and non-U.S. fixed income markets posted positive returns in 2017. Interest rate changes across the U.S. fixed income market were mixed during the fourth quarter. The yield on the 5-year Treasury note rose 28 basis points (bps), ending at 2.20%. The yield on the 10-year Treasury note increased 7 bps to 2.40%. The 30-year Treasury bond yield decreased 12 bps to finish at 2.74%.

In terms of total returns, short-term corporate bonds declined 0.04% during the quarter but increased 1.85% for the year. Intermediate-term corporate bonds gained 0.17% for the quarter and 3.92% for the year.

The total returns for short-term municipal bonds were –0.65% for the quarter and 1.61% for the year. Intermediate-term municipal bonds fell 0.09% for the quarter but gained 4.70% for the year. Revenue bonds outperformed general obligation bonds for the year.

In global bonds, the Citi World Government Bond Index 1-5 Years (hedged to the U.S. dollar) returned 1.1% for the year, while the BofAML 1-Year U.S. Treasury Note Index returned 0.6%.

Conclusion

The year of 2017 included numerous examples of the difficulty of predicting the performance of markets, the importance of diversification, and the need to maintain discipline if investors want to effectively pursue the long-term returns the capital markets offer.