Navigating Uncertain Seas

By Doug Sandler, Chris Konstantinos & Rod Smyth, RiverFront Investment Group

Sometimes, despite the most favorable predictions, an unexpected storm can quickly appear with little warning. Global capital markets experienced just such a storm in 2018 when the calm seas of a synchronized global recovery were replaced by the choppy waters of trade wars and rate hikes. Unexpected storms are a common occurrence in the capital markets and how one responds to them can tell you a lot about a portfolio management team and their process. This edition of the Weekly View covers the actions we have taken in RiverFront’s Advantage portfolios over the past twelve months.

In our Outlook 2018 ‘Tug of War’ we recognized these crosswinds but expected global growth to win-out, and thus positioned our portfolios accordingly. However, the investment environment can change quickly, and plans need to be altered for the unexpected. The first signs of an approaching storm came in March of 2018 when President Trump put the world on ‘high alert’ about his desire to overhaul the US’ current trade policies. More storm clouds appeared after the Italian election, after each Fed rate hike and with every piece of data reflecting slower economic growth. Despite our long-term positive outlook, the approaching storm could not be ignored and acted as the catalyst to amend our plans and adjust our portfolios.

Throughout 2018 our portfolio management team has been navigating through the storm while keeping watch for the calmer waters we expect ahead. Keeping with the nautical metaphor, the adjustments we have made over the past twelve-months fall into three broad categories: Trimming the Sails, Adding Ballast and Securing the Cargo.

Trimming the Sails: The two biggest risks to mariners trying to navigate through a storm are the risk of capsizing and the risk of being blown significantly off course. The simplest way to reduce the risk of either is to trim the sails and the degree of trimming will depend on the expected length and intensity of the storm. Our portfolio managers have been ‘trimming the sails’ by reducing the level of our equity exposure in the Advantage portfolios throughout 2018. Today, our equity/bond allocations are roughly in alignment with our benchmarks, which equates to about 8-10 percentage points less equity exposure than one year ago (see Table 1 on next page). We have deliberately chosen not to underweight stocks given current reasonable valuations and our favorable outlook on global economic and earnings growth.

Adding Ballast: When waters are choppy, a boat needs enough ballast to offset the force of the waves, which allow it to stay ‘on course’. From a portfolio management context, ‘ballast’ are the things in a portfolio that can act as a counterbalance to choppiness in the equity markets. Currently, we believe cash and investment grade bonds are the most effective ballast for our portfolios. Over the last year, our balanced Advantage portfolios have increased their ballast (cash, TIPs and investment grade bonds) by 10-14 percentage points. Our fixed income team also believes that it is a relatively opportune time to add ballast to the portfolios given that US interest rates are near their 12-month highs and longer-term Treasuries are now offering yields not seen since 2011.

Securing the Cargo: The most secure part of a ship is near its center. We believe the ‘center’ of a portfolio is often best represented by the portfolio’s benchmark. Some portfolio managers “secure their cargo” by reducing the number of non-benchmark positions in a portfolio because they can be more volatile and impact the portfolio’s overall “seaworthiness”. A portfolio’s most volatile positions can be those that are less diversified and thus carry the greatest idiosyncratic (specific) risk, like individual stocks or specific country ETFs. For this reason, we have eliminated some of these types of positions in the portfolios we manage. Importantly, while our portfolios no longer own individual stocks, the portfolio management team continues to consider individual stocks for future inclusion in the portfolios.

We believe the next most volatile category of securities in a portfolio are often those that provide diversified exposure to a historically volatile asset class or sector. Some examples of volatile asset classes include international equities (developed and emerging), MLPs, small-caps, and high-yield bonds while more volatile sectors include technology, industrials, materials and energy. Throughout the year our portfolio managers have been ‘securing the cargo’ by removing 14-21 percentage points of international exposure and 2-5 percentage points of high yield from the portfolios. These positions were replaced with US equity and several broadly diversified international Exchange Traded Funds (ETFs).

We believe that the result of these adjustments, as summarized in the table below, has created a more “seaworthy vessel” for current market conditions.

Source: RiverFront Investment Group. Past performance is no guarantee of future results. The asset class weightings shown in the table above are for the RiverFront Advantage Separately Management Accounts (Portfolio) and are subject to change. They are not calculated or derived from any Unified Managed Account (UMA) or Model Delivery Platform (MDP). While our SMAs and models for UMAs and MDPs will have similar investment weightings, there may be differences between the models; as such, there will be differences in the current portfolio weights/statistics in actual client accounts. These asset class weightings are also not representative of the RiverFront RiverShares portfolios. International stocks includes Developed and Emerging Equities. Total Fixed Income incorporates Investment Grade Bonds, High Yield Bonds, Treasury Inflation Protected Securities (TIPS) and Bank Loans.

In 2018, international stocks have been most affected by the issues discussed above and are now in clear downtrends, in our view. Therefore, a reduction in international stocks has been the emphasis of our risk management and tactical decision making throughout the year. We still believe that international stocks offer more attractive long-term relative value than the US, and thus are looking for the right re-entry point.

Important Disclosure Information

Diversification does not ensure a profit or protect against a loss.

Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past.

Information or data shown or used in this material is for illustrative purposes only and was received from sources believed to be reliable, but accuracy is not guaranteed.

In a rising interest rate environment, the value of fixed-income securities generally declines.

Investing in foreign companies poses additional risks since political and economic events unique to a country or region may affect those markets and their issuers. In addition to such general international risks, the portfolio may also be exposed to currency fluctuation risks and emerging markets risks as described further below.

Changes in the value of foreign currencies compared to the U.S. dollar may affect (positively or negatively) the value of the portfolio’s investments. Such currency movements may occur separately from, and/or in response to, events that do not otherwise affect the value of the security in the issuer’s home country. Also, the value of the portfolio may be influenced by currency exchange control regulations. The currencies of emerging market countries may experience significant declines against the U.S. dollar, and devaluation may occur subsequent to investments in these currencies by the portfolio.

Foreign investments, especially investments in emerging markets, can be riskier and more volatile than investments in the U.S. and are considered speculative and subject to heightened risks in addition to the general risks of investing in non-U.S. securities. Also, inflation and rapid fluctuations in inflation rates have had, and may continue to have, negative effects on the economies and securities markets of certain emerging market countries.

Stocks represent partial ownership of a corporation. If the corporation does well, its value increases, and investors share in the appreciation. However, if it goes bankrupt, or performs poorly, investors can lose their entire initial investment (i.e., the stock price can go to zero). Bonds represent a loan made by an investor to a corporation or government. As such, the investor gets a guaranteed interest rate for a specific period of time and expects to get their original investment back at the end of that time period, along with the interest earned. Investment risk is repayment of the principal (amount invested). In the event of a bankruptcy or other corporate disruption, bonds are senior to stocks. Investors should be aware of these differences prior to investing.

Treasury Inflation Protected Securities (TIPS) are Treasury securities that are indexed to inflation in an effort to protect investors from the negative effects of inflation. The principal value of TIPS is periodically adjusted according to the rate of inflation as measured by the Consumer Price Index (CPI), while the interest rate remains fixed. TIPS will decline in value when real interest rates rise. Portfolios that invest in TIPS are not guaranteed and will fluctuate in value.

High-yield securities (including junk bonds) are subject to greater risk of loss of principal and interest, including default risk, than higher-rated securities.

RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.

RiverFront is owned primarily by its employees through RiverFront Investment Holding Group, LLC, the holding company for RiverFront. Baird Financial Corporation (BFC) is a minority owner of RiverFront Investment Holding Group, LLC and therefore an indirect owner of RiverFront. BFC is the parent company of Robert W. Baird & Co. Incorporated (“Baird”), a registered broker/dealer and investment adviser.

Individual investors cannot directly purchase an index.

VISIT ETFTRENDS.COM »