Meet a Strategist is a weekly feature where Evan Harp talks to different strategists about how their firms are responding to the current moment. This week, he sat down with Confluence Investment Management’s chief investment officer of asset allocation, Greg Ellston, and analyst Sean Long.
Evan Harp: What’s keeping your clients up at night?
Greg Ellston: What we hear from advisors are two things: inflation is top of mind for just about everybody among the advisors and their clients who use our products. That’s really age-related as well, because a lot of people have seen heavy inflation before in their lifetimes and they’re seeing it again. Although it’s waning, the other concern has been geopolitical events, particularly war in Ukraine. These are not surprises to anyone.
Evan Harp: Do you have any recent changes in your allocations?
Greg Ellston: As of today [July 19, 2022], yes. We’ve changed a few things with our most recent quarterly rebalance, which resulted in mostly trims. In the bond allocations, we moved out of some corporates in favor of Treasuries, because we think the probability of a recession is elevated. I know, again, no big surprise to you, Evan. I’m telling you the obvious things. The other thing that we did was we took some exposures from equity risk assets and moved them into another category of risk assets, speculative bonds. This is an ETF that only has BB-rated paper. We thought it was prudent to pull out some allocation from the equity market and move up the cap structure of companies — granted, they’re spec-grade bonds, but we view them as equity surrogates or equity proxies, lower volatility, and still directionally the same as equities. So, if we’re wrong about equities getting compressed in a recessionary environment, we still have some fixed income exposure via the higher-rate debt of the equity companies as opposed to just pure equity.
What we’ve been doing is de-risking the strategies over the course of the past six months, and we typically move in a stepwise progression. This is just further de-risking from what we already started in the fourth quarter of last year. I’d almost say, given where we are with regard to the equity exposure, which is really at historical lows for most of the strategies, that’s pretty much our last leg down as far as de-risking goes. From here, according to our future expectations, we’re looking to find opportunities to introduce risk back to the strategies.
Sean Long: Echoing Greg, the Asset Allocation Committee has been focused on reining in risks for the time being. That’s how I would boil it down. We don’t try to be market timers; we spend a great deal of our time studying market cycles, and we make our transitions as market cycles evolve. If we believe we are getting closer to a recessionary period, we begin reducing our exposure to equities and balancing with other asset classes.
Greg Ellston: And one other thing, Evan, that bears mentioning is we also found a while ago that commodities made a lot more sense than bonds as a diversifying element. We did have a position in gold, but we also introduced a broad-based commodity, the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC). It’s heavy in oils — 55% oils and its derivatives — with 22.5% in softs and 22.5% in industrial metals. I don’t know how far back you want to go, so I’m going to go on a little monologue here if I can. When we first put the position in place, many energy companies were having a lot of problems accessing the capital markets. We liked oil as a bridge to green energy at some point, and we went searching for something that would have good oil exposure. This ETF had exposure not only to crude, but also to heating oil, gasoline, and natural gas. We went directly to the resource itself as opposed to the companies because the capital markets were frozen for firms that were engaged with the energy complex. So, we didn’t go into the equities, per se, but instead went directly to the commodities. It has worked well, and we still think it makes sense as a diversifying risk asset to equities proper. And the commodity asset class exposure is as large as 25% in our Aggressive Growth strategy.
Evan Harp: What do you guys think of the market right now?
Greg Ellston: I think it’s reacting as it should to problems that are manifesting. I think, personally, and this is not the view of all seven members on the Asset Allocation Committee, I am just 1/7 of them, but the street estimates are optimistic for earnings. I think we’re going to see earnings expectations come down over the next couple of quarters. So, not only are you going to see compression on P/E ratios because of inflation, but I think you’re also going to see compression because the E is going to decline as well. I think labor is going to continue to have a profound influence on earnings and, consequently, that’s why I’m personally expecting the recession to be more difficult.
But, again, our overall thought as far as the consensus view goes is that the recession is going to be more garden variety with maybe an “L”-shaped recovery, but not a deep, terrible one.
Sean Long: Just on the aspect of that mild recession — something we spend a lot of time on, not just recently but over the years, is keeping a close eye on consumer and household balance sheets, and they’ve been resilient and strong. The amount of money parked in money market funds, which continues to build, will certainly allow households to weather the storm, at least for the time being. Assuming we can keep the job openings numbers high enough to absorb some potential layoffs, and we don’t see unemployment rise significantly as GDP falls, then corporate balance sheets should be in good shape too. We believe those factors will help cushion the economy. If markets are faced with a Fed policy mistake that pushes us into recession due to raising rates too high, the stronger-positioned consumer may cushion that recession a bit and make it feel milder. Again, this is due to the strength of consumer and corporate balance sheets, at this time.
Greg Ellston: Sean made a great point, and that is we haven’t seen the excesses that we’ve seen in previous prior expansions of recessions.
Evan Harp: I know you already highlighted PDBC, but are there any other ETFs that you want to highlight?
Sean Long: Currently, the core elements of the equity allocations in our strategies are mostly comprised of an array of State Street SPDR ETFs. These not only serve as the crux across all U.S. market capitalizations, but are complemented by sector SPDR ETFs, which we use in the U.S. large-cap sleeve to achieve targeted sector overweights. For example, we currently have sector overweights to Health Care, Consumer Staples, and Energy. In the fixed income sleeves, they have been longtime adopters and users of maturity-date ETFs, notably the iShares’ iBond and Treasury series. That doesn’t explicitly highlight a specific ETF, but we like to really work with “grown-up” ETF sponsors, as we like to call them. With that, if I could just highlight them, in general: the SPDR and the iShares family of funds are staples in our strategies. We see them as preferred providers; that is, we look to them when we go through the ETF security selection process.
Greg Ellston: To add to Sean’s points, we do have two ETFs that are out of the norm; one is the iShares BB-Rated Corporate Bond ETF (HYBB). As I mentioned earlier, we use HYBB for the BB-rated spec bond exposure. The only international exposure we have right now is to the WisdomTree Japan Hedged Equity Fund (DXJ), which has Japanese equities with the yen hedged back to the dollar.
Evan Harp: What’s one thing that sets your firm apart?
Greg Ellston: I guess the fact that we do have a thesis that we typically follow, and that thesis looks forward over a rolling 36-month period. Also, we work within a very constrained risk budget for each strategy — that hasn’t changed since inception.
That inception actually predates Confluence, but let’s just stay with Confluence since 2008. So, within the process, risk budgeting hasn’t changed. Then, as we said before, we don’t move in and out aggressively or rapidly. We’re usually doing trims and adds, following a thesis, and following what Sean described as the market cycle. Reducing risk when it’s appropriate and accepting it where it is also appropriate.
I guess those are the facets that distinguish us. We have very well-articulated processes put in place by people who have tenures spanning decades — and this is without exaggeration. Six of the seven members of the Asset Allocation Committee have over 30 years of experience in the business. Collectively, we have seen a lot of different market cycles. The youngest of us has 18 years of experience. She’s the newbie. So, the process is meted out by people who’ve witnessed a lot of different markets. I guess our distinguishing characteristic is that we’re old, we’re thoughtful, and we’re laborious. But what we do seems to work.
Sean Long: I want to add that it’s a process that the committee has been honing for well over two decades. That’s something where, especially in the asset allocation world, maintaining time-tested strategies are important. Those disciplines help when investing through market cycles. We believe having a committee approach helps take some of the emotion out of investing, because it’s consensus-building in the end. That helps check the attitudes and the thought processes as we go through vetting and constructing our models.
The forecasts that our committee members make, we think, also sets us apart. It’s not a single vote. It’s a process focused on consensus-building and collaboration. We think that works throughout the entire firm here at Confluence. We do not only run asset allocation strategies; we also have value equity (domestic) and international equity strategies. The entire firm’s DNA is focused on: 1) risk mitigation; and 2) collaborative teamwork. This philosophy is not only a big part of our process on the asset allocation side, but it’s really top-down at the firm. Our returns are the byproducts of that approach.
Greg Ellston: Evan, having lived on the manager research side forever, normally, you found one person who pretty much led the effort on any portfolio that you were examining. I should have said this at the outset: the thing that really distinguishes us is that there is no one person in the room that guides it. Everyone has to be in agreement. Everyone must have his or her voice added to the determination. It is truly a consensus. So, as I described what my personal thoughts were for the recession earlier, that’s not the Asset Allocation Committee’s consensus view. The consensus is more measured, balanced, and sober than just one individual.
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