The third quarter was a positive one for almost every equity asset class around the globe. The US large market as measured by the S&P 500 was up 3.9% for the quarter and except for real estate-related equities, it was the least of the performers. US small cap stock holdings were up about 7.5% for the quarter, and then there were the international and emerging market holdings, all up between 6% and almost 11% during Q3, with the International Small Cap holding being the best of the bunch at 10.5%. The single best asset class in most client portfolios so far this year has been the Emerging Markets Value holding, itself up 21% year-to-date. High quality, short term bonds, while stable, were anemic at best, with returns flat for the quarter for a high quality global bond portfolio, and US Treasury securities of all durations from 1 to 30 years were just slightly negative. Such is the low interest, low inflation, low aggregate demand world we continue to live in.
Given this quarter’s equity market performance – and last quarter’s as well – it’s possible that we may be seeing a cooling off of the US large cap market, which has been among the strongest (and most expensive) asset classes on the planet for the last three years running. The US market’s strong relative performance has been the topic of much discussion with many clients over the last year or two (e.g., “Maybe we should have more US / less international in our portfolio, don’t you think?”)
Although it was almost three-and-a-half years through the end of the first quarter that US stocks had outperformed internationals, that doesn’t tell us much. If we look back to 1970, which is the inception date for the MSCI Europe Australia Far East (EAFE) International Stock index, the US has outperformed internationals in exactly 50% of the intervening years, and internationals have outperformed the US the other 50% of the time. But what does a three- or four-year streak, like the US market’s recent run, tell us? Not much. There have been two other periods where US stocks outperformed the international markets for four years running, 1989-1992 and 1995-1998, but international stocks have twice outperformed US stocks for six years running, 1983-1988 and 2002-2007. So, there is nothing terribly new or unusual in the US outperformance over the preceding few years.
In the end, here’s what’s worth keeping in mind about the balance between US and international stocks: First of all, diversification smooths the ride along the way; if you only own a single asset class (or for that matter, a single country) in your portfolio, you will almost certainly have a more volatile investment experience and consequently a lower expected withdrawal rate over time. Secondly, one-half of the economic activity in the world takes place outside of US borders and that’s a lot of opportunity to walk by. Finally, there’s very little predictive information in the last three year’s returns about the next three year’s returns, and basing today’s and tomorrow’s portfolio on that information would likely be a costly mistake. We’ve started to see evidence of that in the last two quarters, especially the most recent one, with stronger performance in the international holdings, and particularly in the emerging markets.
Wells Fargo, Morgan Stanley, and DOL Fiduciary Standard Rule
Leaving the topic of investments and diversification for the moment, I have a few short comments on three topics that you may have seen in the news over the last few weeks and months: the US Department of Labor’s implementation of a fiduciary standard on workplace-related retirement accounts, and in a not-completely-unrelated pair of stories, we had the Wells Fargo banking scandal and the Morgan Stanley sales contest complaint filed by regulators in Massachusetts and Rhode Island.
Earlier this year, the Department of Labor (DOL) mandated a fiduciary standard of care requirement on all work-related and retirement plans, including IRAs that originate from work-related retirement plans. In short, this means that investment firms and advisors that provide advice and/or products to retirement plans and many IRAs will now be held to a fiduciary standard (i.e., the requirement to put the client’s best interest first). The only thing that I can say is: FINALLY! As a Securities & Exchange Commission Registered Investment Advisor, my firm and I have been – and continue to be – subject to this standard. However, for almost as long as I have been in this business, much of the industry (think large brokerage firms, insurance companies, and investment product vendors) have fought tooth-and-nail to prevent the imposition of a fiduciary standard on themselves and on large swaths of the industry. This has led to all kinds of abuses of trust and to the aggressive selling of insurance and investment products that, in many cases, have done more harm than good to the unsuspecting clients to whom they have been sold.
Lest you need any specific reminder of the need for a fiduciary standard, witness the two recent sales scandals at Wells Fargo (WF) and Morgan Stanley (MS). The Wells Fargo fraudulent account opening scandal that has been splashed all over the headlines in recent weeks was actually on the banking side, but remember that many of the largest firms now operate in both the banking and investment space (e.g., Wells Fargo, Bank of America/Merrill Lynch, Morgan Stanley), and organizational cultures are driven from the C-suite and are usually pervasive throughout a firm. This week’s Morgan Stanley scandal is yet another example of a sales culture gone wrong: incenting staff to push margin/securities lending accounts in order to win lucrative bonuses via a perverted incentive structure that benefits the firm at the expense of the client. These examples are yet further evidence that the industry at large needs a uniform fiduciary standard, like the one this firm and other registered investment firms are presently subject to.
So, while this issue is not a new one, and while Congress couldn’t quite get to a fiduciary standard for ALL client accounts (again, due to aggressive lobbying by much of the industry), the Department of Labor did its own end-run around Congress, as it has broad authority over workplace retirement plans. And so, after years and years of legislative wrangling, a large portion of consumers will have increased protection in the form of a DOL-mandated fiduciary standard on workplace (and workplace-related IRA) retirement accounts. There are still many firms and industry organizations that are bringing legal challenges against the DOL rule, but with any luck, the DOL will prevail and a greater number of consumers will have the increased protection afforded by a reasonable facsimile of a fiduciary standard. And that, I believe, is a good thing for all consumers, and, ultimately, for the industry at large.
That’s it for this quarter. I hope you’re enjoying what has been a warm but spectacular Fall, the best season we have here in Colorado. As always, please don’t hesitate to reach out if you have any questions or if there is anything we can do for you.