The last two years have provided a wild and turbulent ride for the markets, investors, advisors, and investment managers alike. Many portfolios with a riskier profile suffered horrible losses in the 2008 global meltdown. Portfolios that were positioned less aggressively and avoided some the downside of 2008, or that moved to cash at year-end, were left in the dust of the incredible rally of 2009.
For advisors that make heavy use of third-party investment managers in building their clients’ portfolios, the large dislocations of the last two years can cause many problems, not the least of which is understanding how effectively managers navigated the markets and how to explain performance to clients.
When evaluating managers for use in a client’s portfolio it’s important to understand how those managers invest the capital they are given. Seeking the best absolute performance going forward is an admirable goal, but time and again it has been proven to be virtually impossible to do with the historical information we have available. This does not mean that the information we have is worthless, but we have to be able to look past the simple metrics of whether a manager beat or underperformed their benchmark. It’s important to help our clients understand that most of a manager’s returns will come from what they invest in (asset class, style, security type, etc).
The last two years exhibited major shifts and swings in the markets. Most long-only managers were caught in one side of the swing or the other: 2008 was the year of fear and the markets only rewarded the safest of safe investments, namely Treasuries. Any manager who did not invest a significant portion of their portfolio in either Treasuries or cash fell significantly. The higher the perceived risk, the further they fell. Most equity indices were down 30% or more in 2008. Many investors were shocked to see their relatively safe bond portfolios down 5% to 10%.
The exact opposite of 2008 occurred in 2009 as investors’ appetites for risk were restored. The riskier a security seemed, the more the price increased, and 2009 may be represented as the “Dash to Trash.” This may be best illustrated by examining one of the riskier asset classes, the high yield bond market. As a group, high yield bonds were up almost 60% for the year, according to Barclays U.S. Corporate High Yield Index. However, the most risky and lowest credit quality subset of the universe, those bonds that were rated Ca to D, were, according to the Barclays U.S. Corporate High Yield Index, up almost 140% on the year! It was a similar story across virtually every area of the market. The astounding index returns we saw in 2009 were largely driven by the riskiest securities.