X
GO
  • your peace of mind
    is our priority
  • unbiased advice
    to provide financial clarity
  • service is at the heart
    of what we do
  • key principles
    for pursuing a better investing experience
  • a collaborative approach
    to help you create the life you want
Filter Insights By Category
Filter Insights By Tag
Receive Insights in your inbox.

First Quarter 2014 Newsletter

posted on

To Boldly Go Where No Man Has Gone Before

April 23, 2014

You don’t have to be a “Trekkie” to recognize this phrase. It was used in the opening lines of each episode of Star Trek starting in 1966.


Space: The final frontier
These are the voyages of the Starship, Enterprise
Its 5 year mission
To explore strange new worlds
To seek out new life and new civilizations
To boldly go where no man has gone before


To a younger generation, William Shatner is likely just as famous for playing a wacky lawyer during weeknight prime time, or hawking cheap flights and hotel rooms for Priceline, as he was for wearing Captain Kirk’s form-fitting sweaters and making the big decisions from the flight deck of the USS Enterprise. But even tweens watching old reruns of the show can become addicted to all the fun stuff that happened to Kirk and his crew while they zipped around the Final Frontier. Boldly going where no man (or alluring alien female, for that matter) has gone before was a big hit, and continues to be.

A decade before Star Trek, another frontier explorer was all the rage. Remember “Davey, Davey Crockett -- King of the Wild Frontier,” as sung by a full Disney chorus? Disney Studios made Davey Crockett famous with three TV episodes at the turn of the 1954-55 year, and then combined them for a full length motion picture, only its 6th up to that time. It was a fan favorite. Later, we explored yet a different frontier on the TV series, “The Undersea World of Jacques Cousteau.” Although fully non-fiction, these documentaries had their share of beauty, excitement and other-worldly scenes and experiences.

Americans have always been entranced by the unknown frontier, be it air, land or sea, and regardless of its source or degree of authenticity. The investment world fits somewhere in there as well. Investors, researchers, fund managers and others love nothing better than to find an undiscovered source of capital growth in a new, exotic location. Of course we’re talking about frontier markets, an asset class that has received much fanfare over the past few years. In a recent blog article by Russ Koesterich CFA, BlackRock’s chief investment strategist, the attractive differences of frontier markets compared to emerging markets was discussed: (Three reasons Frontier and EM equities are not created equal 2/21/14 Blackrockblog.com)

  1. Frontier markets have enjoyed higher economic growth in recent years. Some economists expect this trend to continue.
  2. Frontier markets have had stronger recent investment returns. Over the last year, frontier market indexes have delivered returns of over 20%, while emerging markets have shown a loss of 5%.
  3. Frontier markets appear to be less “connected” to developing markets. Frontier markets currently have a 50% correlation rate with global stocks, whereas emerging markets have an 85% correlation.

The fact that BlackRock distributes an exchange traded fund (ETF) by the name of iShares MSCI Frontier Market 100 Fund is most likely a coincidence. (Yes, that’s sarcasm.)

So the logical question is: if frontier markets are so great, why haven’t we bought any of them for your portfolio? Frontier markets have some positive attributes, as mentioned above. But they also have enough negative ones that make us think twice about including them as an asset class in your portfolio. Here’s a list, with help from DFA Inc.

  1. Frontier markets represent only about 1% of the world’s total capitalization, and when adjusted for available free float (tradable shares), it falls to ½%. In comparison, emerging markets represents 20% of the world market cap, or 13% on a float-adjusted basis.
  2. Liquidity is a big issue. Whether at the exchange, or the individual security level, low liquidity usually relates to much higher transaction costs. Estimates show that due to low liquidity, frontier markets’ bid/ask spreads are typically twice as wide as emerging markets shares, and emerging market spreads are fairly large to begin with.
  3. Concentration is another issue. A handful of countries represent a majority of the assets in a frontier market index, and usually one or two industries represent the majority weighting of those countries’ stocks.

These are only a few of the issues that occur when determining the overall risk/reward of owning frontier markets. A full listing would include the above, along with concerns about market regulation, settlement practices, listing requirements, taxes, repatriation and other foreign restrictions as well as sovereignty issues.

Remember, we are talking about very small, often weak countries. Countries in frontier market indexes typically are represented by African, Middle Eastern, Caribbean and Eastern European regions. We may recognize names like Cyprus, Bangladesh, Serbia and Trinidad and Tobago, but certainly not for reasons relating to strength of their economy.

Lastly, a poster child for sovereignty issues is Ukraine. A few months ago you might have been concerned because of the civil unrest occurring inside their borders. This month the concern morphs into whether Russia will stop at Crimea or continue beyond that area and perhaps take over all of Ukraine in a reversion back to the iron-curtain era. If the last alternative occurs, what happens to Ukraine’s publically held companies? Countries this small and militarily weak always leave open the possibility of a complete collapse of their stock market.

There are risks in investing. Some risks can be diversified, some cannot. All of the reasons mentioned above make it easy for us to skip this asset class for the time being. We suggest that if you really love frontiers, stick with those found in space, wilderness, or sea – using whatever medium you enjoy. But don’t try to be too bold and go where no man has gone before when it comes to investing. Those frontiers may be much more dangerous than aliens or wild Indians or sharks.

FIRST QUARTER 2014 ASSET CLASS PERFORMANCE
FIRST QUARTER 2014 ASSET CLASS PERFORMANCE

During the first three months of 2014, global stock markets proved to be resilient. The S&P 500 had its 5th quarter in a row of positive returns for the first time since 2007. The broad market pulled back in late January and early February, but slowly reversed. Most equity asset classes rose enough to be profitable by the end of the quarter. The size and style (growth/value) of domestic asset classes made little difference during this quarter. Internationally, Small Caps took the lead. Emerging Markets continued to have trouble breaking out of their doldrums.

The two most interesting asset classes were Real Estate and Bonds. During the quarter, yields of 10 and 30 year Treasury Bonds decreased 3/10ths and 4/10ths, respectively. That was enough to give generous returns to asset classes that both lost money in 2013. Real Estate proved to be the worst performing equity asset class in 2013, yet came roaring back and beat all others with nearly a 10% quarterly return. Both of the classes proved that following any kind of a trend is not a good long term investment practice. With the virtual certainty that interest rates will move up over the next few years, who would have believed that the two asset classes most closely tied to interest rates would do so well? Hopefully all of our clients have seen by example that timing markets with long term success is fruitless. Rather, rebalancing among outperforming and underperforming classes makes sure to not only keep your risk/reward parameters in line, but guarantees that you will be “selling high” and “buying low.”

The economy is continuing to move forward at a modest pace. Consumer data has been supportive, while housing activity has moderated. The markets trudged through multiple negatives, including one of the coldest winters on record, an aggressive Russian agenda with Crimea/Ukraine, China reporting more negative news in key segments of their economy and Janet Yellen taking over as Fed Chairman and announcing a continuation of the Fed’s tapering of bond purchases, as well as bringing up the topic of future rate increases.

Through it all, corporations kept reporting generally positive earnings, which is vitally important. With the market increases experienced over the past few years, valuations are fair, if not a tad overvalued. This means further upside is much more dependent on continued corporate earnings gains. This appears to be possible, but one should not expect 2014 to have the same type of performance as last year. Moreover, after 5 quarters of positive returns, the market could easily have a 10% or greater pullback, which has not been experienced since June 2012. Although unnerving, that type of pullback would not be historically unusual, and may even be healthy at this point in the current bull market.

Over the remainder of this year, we will start getting a better idea of how the economy reacts to a lack of federal stimulus. Over the last few years, the Fed has appeared to balance the weak recovery with the need for stimulus rather well. We will all see if they can continue the delicate equilibrium. In the meantime, take off your thermal underwear and start enjoying a well-deserved springtime.

Sincerely,

Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC