2015 Year-In-Review: Investor Fatigue But Little Respite For 2016

Includes: DIA, IWM, QQQ, SPY
by: Benjamin Lavine, CFA


Looking back at this past year as we transition into 2016, one could say that investors are experiencing ‘fatigue’ with both lackluster economic growth and lackluster equity market performance.

2015 can be summarized as ‘simple works,’ at least for U.S. investors. A plain 60/40 mix of U.S. stocks and bonds outperformed more complex, global-based strategies.

2015 can also be characterized by rollercoaster movements that oscillated between expectations for growth normalization to concerns about global growth slowdown and contagion spreading across riskier assets.

2015 turned out to be a better year for certain strategic or alternative beta (factor investing) as trend-following factors such as price momentum and more defensive factors such as quality.

If investors have grown weary of central bank policy statements driving market behavior, they won’t get much respite in 2016.

Performance Summary

Data source: Bloomberg

(Note: please refer to this link for supplemental 4Q2015 and YTD 2015 performance charts)

4th Quarter 2015 Highlights

  1. Global developed market stocks recovered from the 3Q sell-off although 4Q gains were reduced due to December month-end selling pressure.
  2. Defying typical year-end seasonal patterns (the so-called Santa Claus rally), global stocks underperformed due to the European Central Bank (ECB) disappointing expectations for aggressive quantitative easing, concerns that the U.S. economy cannot sustain a new U.S. Fed tightening regime, and more evidence of China slowdown affecting global commodities.
  3. U.S. fixed income was mixed as the intermediate part of the curve (5-10 year) outperformed the short- and long-end while U.S. high yield suffered an from investor outflows related in part to several high profile fund closures (Third Avenue) and a drop in oil prices to the low $30s as OPEC, led by Saudi Arabia, sought to further squeeze the higher cost producers by increasing production.

2015 Year-End Review Highlights

  1. This was a difficult year for most asset classes. U.S. stocks, led by the S&P 500, ended slightly positive for the year while ex-U.S. stocks and bonds, in U.S. dollar terms, posted negative returns due to a strengthening U.S. dollar and global growth concerns.
  2. Plain vanilla U.S. fixed income was the best performing asset class this year, led by municipal debt and intermediate (5-10 year) Treasuries. Riskier sectors, notably high yield debt, underperformed this year as many energy borrowers came under financial stress due to the precipitous drop in energy prices.
  3. Global commodities and precious metals came under the most pressure this year led by a slowdown in commodity consumption (notably China) resulting in a glut of oversupply. U.S. REITs turned in a better year of performance as the asset class benefited from robust industry demand and a benign rate environment.

Investor Fatigue

The 70s are back…sort of. As a young child, I vaguely recollect all the box office buzz and excitement over the new Star Wars movie that was released in 1977. I remember my parents and I saw the movie in theaters at least five times, and I also recall getting dragged out of school to see the Empire Strikes Back when it was released in 1980. This past December saw a new generation of fans experiencing a similar level of buzz with 'The Force Awakens,' although all the pre-release marketing and merchandizing has diminished the anticipated buildup that the first generation of Star Wars fans enjoyed. So, in some ways the release of 'The Force Awakens' evoked memories of the original Star Wars release, but the experience is different given the enormous advancements made in media marketing and technology.

Transitioning into 2016 from 2015 in some ways feels like the world transitioning from the 1970s to the 1980s. The world in the late 70s was experiencing a decade-long hangover brought on by the Vietnam War, OPEC oil embargo, Watergate (a moment when confidence in government was truly shaken), and economic 'malaise' of high inflation and high unemployment. By 1980, the world had grown tired of the establishments and institutions that contributed to the 70s malaise environment and opted for a different direction. The U.S. central bank, under Paul Volker, also opted for a different direction from his predecessor, Arthur Burns, by breaking the back of inflation with economy-crippling double digit interest rates.

Heading into 2016, it feels like the world is experiencing a hangover of a different sort - of a debt-fueled, capital spending boom that begat excess - first in Silicon Valley during the mid-to-late 90s dot-com boom, which then spread into residential and commercial real estate and, then into a global resource production boom driven by China, and finishing where it all started…Silicon Valley [Yahoo! (YHOO) apparently threw one heck of a Christmas Party this year]. As with the end of the 1970s, the country also seems weary of the political establishment based on the current presidential front-runners. Of course, there are as many clear differences between today's environment versus the 1970s as there are similarities. The world is grappling with an energy glut rather than an energy deficit. The world is suffering through a deflationary overhang brought on by the accumulation of too much debt rather than an inflationary overhang brought upon by the accumulation of too much spending, even though both environments benefited from accommodative central bank monetary policies. Today, the world seems stuck in a low growth, deflationary environment where employment has recovered but not wage growth or capital spending. Looking back at this past year as we transition into 2016, one could say that investors are experiencing 'fatigue' rather than 'malaise'. It's like we're back in the 70s, but different.

As with the broader economic environment, there are both similarities and differences in the investment environment between today versus the 70s. Back in the early 70s, the Nifty-50 propelled the markets higher only to experience major crashes in 1973 and 1974. As we stumble into 2016 with broad equity and fixed income market returns flat for the year, a small group of 'nifty' assets such as municipal debt, short-term debt, and a handful of S&P 500 stocks contributed positive performance to an investment landscape littered with poor performing assets. Picture an iceberg formation where positive performing U.S. assets form the narrow top with poor performing ex-U.S., alternative, and risky fixed income assets forming the wide bottom (Figure 1). The only assets that mattered this year were non-cyclical, larger cap, lower-risk US$-based assets; this has been an ongoing theme since 2011 at the height of the European sovereign debt crisis and when cracks first appeared around the China growth story. U.S. equity multiples were driven higher while U.S. bond yields were driven lower; diversification worked, but only in U.S. markets. Investment programs that allocated to non-$ assets and uncorrelated alternatives suffered for their diversification. With few assets outperforming CPI core inflation (running at 1.9% year-over-year) and few tried-and-true strategies outperforming plain vanilla indices, it seems as if investors have grown weary with these markets and investing in general. Or as UBS' Art Cashin succinctly put it in a recent CNBC interview,

"2015 was like commuting by rollercoaster. There were heart-stopping drops, there were nearly vertical ascents, and when it was all over you got off just about where you started and it cost you money. And not only was that true of the stock market, it was true of the yield on the 10 Year. The 10 Year is virtually where it began the year."

Figure 1: Summarizing 2015 - Not Much Sitting Room

Iceberg Performance

Image source (for public use): Data source: Bloomberg - 2015 calendar year total return performance as of 12/31/2015.

Investors Tiring of 'Fragile' Markets

Imagine you are working on a project that requires a fair amount of concentration, but just as you settle in to get started, you get distracted by a phone call, a ringing doorbell, a screaming child, or a needy Scottie. Back when my wife was working on her doctorate, she insisted that we send our Scottish Terrier to doggie day care so she could work uninterrupted on her comprehensive exams. I flinched at the cost of having to pay for a week's worth of doggie day care, but I understood why we needed to do this. We love our Scottie, but he requires a fair amount of care and attention, and he will let you know, quite effectively, if he is not getting it.

'Smart' investment strategies struggled with fragile markets this year because they couldn't get settled in as they were constantly interrupted with frequent outsized disruptions. BofA/Merrill Lynch commented on this in a recent report observing high levels of cross-market 'fragility' in 2016. They observed that hedge funds were experiencing one of their worst years of performance since 2008 despite relatively low levels of market volatility. BofA/Merrill explains that this underperformance is due to extreme levels of market fragility where there have been frequent, outsized volatile movements across multiple asset classes such as equities, currencies, bond yields, commodities, and credit instruments. What is remarkable is how these outsized movements are largely localized and have not resulted in global contagion. BofA/Merrill believes that this is more a result of overcrowding of popular investment strategies combined with lack of trading liquidity.

In other words, 2015 can be summarized as 'simple works', at least for U.S. investors. A plain 60/40 mix of U.S. stocks and bonds seems out of vogue with an investment community seeking global diversification, high absolute return, and high current income in a low yield environment. But in 2015, there was no need to diversify globally since U.S. assets and the dollar handily outperformed ex-U.S. assets. There was no need to invest in high yielding, low correlated assets that got crushed this year due to the sell-off in the energy/ commodity complex. And there was no need to invest in complex strategies designed to exploit market inefficiencies and provide high risk-adjusted absolute returns, which have underperformed a simple long-only strategy since 2008. A 'simple' portfolio of U.S. equities and bonds would have sufficed this year; however, despite the challenging year for alternative investments and hedge funds, investors are expected to allocate even more to hedge funds in the year to come, even though 674 funds liquidated during the first nine months of the year according to Hedge Fund Research Inc. Investors may be tiring of the post-2008 market environment, but they persevere in pursuing high expected return strategies while trying to minimize downside risk but ultimately, they are failing to achieve both.

All that said, don't forget the 'Lost Decade' earlier this century when investors saw the S&P 500 down 0.15% for the 10 years ending March 2010.

Yet, one area that continues to suffer are open-ended mutual funds as net redemptions have reached their fastest rate in two years (some of the outflows are due to tax loss harvesting). According to the Investment Company Institute, "mutual funds have experienced net redemptions every month since July…" The closure of the Third Avenue Focused Credit fund in early December drove some of the acceleration out of high yield-focused mutual funds, but the Third Avenue closure only seem to accelerate a year-long exodus from mutual funds. Incidentally, fixed income ETFs have held up relatively well during the December credit market sell-off as net asset values (NAVs) largely adjusted to price movements amidst high trading volume and liquidity without causing too much disruption in the underlying bond holdings. For those interested in reading about how ETFs fared better than open-ended mutual funds, I highly recommend reading Matt Hougan's article, "ETFs Solve Mutual Bond Fund Problem," published on ETF.com. ETFs will continue to gain market share from mutual funds due to the former's cost advantages, liquidity, fee and security transparency, tax efficiency, and targeted market exposure. And following the investor exodus from high yield in December, credit-based ETFs passed a key stress period that exposed the structural liquidity issues of open-ended mutual funds. Going forward, actively-managed mutual funds will need to demonstrate to what extent their core strategy cannot be mechanically-replicated by a rules-based approach while balancing the desire for diversification and liquidity so as not to be exposed to the issues that faced Third Avenue.

Fundamental Factor Investing: What Worked in 2015 Is What Worked in 2014

Actually, something did work in 2015 and that was 'alternative beta' or fundamental factor investing. 2015 saw the launch of several new alternative beta ETFs in response to rising interest in fundamental factor investing (not to mention currency-hedged ETFs in response to the strong U.S. dollar). Investors have shown increased appetite for fundamental factor investing that follows rules-driven strategies tied to price momentum (trend-following), quality (profitability, balance sheet strength, operational stability), low volatility (lower price swings), size (smaller companies), and value (price/book, price/earnings). And why not? This year has proven to be a banner year for fundamental factor strategies, especially momentum, quality, and low volatility as these factors handily outperformed the S&P 500 (Figure 2). Price momentum factor indices will weight stocks based on how well they performed over the trailing short- and intermediate-term periods; hence, what worked in 2015 is what worked in 2014. Value and high dividend stocks didn't perform as well, which is why many ETF sponsors have rolled out multi-factor ETFs on the premise that fundamental factors work best when combined together due to the benefits of diversification (and that one cannot predict which factors will perform the best in a particular year). We anticipate that more investors will gravitate towards fundamental indexing given the strong relative performance over traditional market- or cap-weighted indices. 3D strongly believes in alternative beta or factor investing in building our ETF portfolios.

Figure 2 - What Worked in 2015 is What Worked in 2014

MSCI Factor

Treading Water Just to Stay Afloat - A Brief Recap of 2015

A lot happened this year underneath the flat performance of U.S. equities and fixed income. Despite energy market weakness spilling over from the 2nd half of 2014, global markets started the year strong led by Pan-Asia and Europe. U.S. stocks ended the first quarter on a mixed note over concerns about the impact of a strong U.S. dollar following the announcement by the European Central Bank of an expansion of quantitative easing in order to head off a deflationary spiral. The strong dollar also drove oil prices lower by 10% to the low $40/barrel range. Despite improving signs in U.S. housing and employment, the U.S. Federal Reserve also surprised investors with their dovish policy outlook following the mid-March meeting which drove down Treasury yields. U.S. healthcare, notably biotech, was the standout sector as investors started to pour money into an area that had consistently outperformed the broader market. The West Coast port strikes also led to some concerns about inventory management issues with retailers, but the strikes were eventually resolved, and investors looked past the short-term disruption.

The Fed's dovish statement spilled over into the first half of the second quarter which saw a major reversal of what worked in the first quarter. The euro recovered against the U.S. dollar and oil price rebounded to $60/barrel as investors were relieved that many leveraged U.S. producers were able to issue equity and roll over their credit financing. China's stock market initially surged in April with the Shanghai appreciating 40% through the end of the quarter but started to buckle in the middle of June. In trying to stimulate the economy following weakness in real estate, the government had encouraged local investors to raise margin debt (2.2 billion yuan representing 12% of the market and 3.5% of GDP according to Goldman Sachs) to invest in the local markets. Fueled by speculative fervor, the Chinese stock rally quickly crashed despite government intervention efforts to support the market. Europe's first quarter strength then reversed over renewed concerns with Greece as a July 5th referendum calling for the rejection of austerity appeared as if it would pass. However, Prime Minister Alex Tispras actually capitulated to even more draconian demands by Greece's creditors in exchange for a new rescue program despite the passage of the referendum.

Despite the resolution of the Greek rescue package and the Chinese government's efforts to stabilize the local markets, the 3rd quarter is where the real fireworks started culminating in a late August sell-off that resulted in major 'technical' damage for equity markets. This sell-off even lead some technicians to call for the start of a bear market. The 7% drop in the S&P 500 masked significant deterioration in market health metrics such as implied volatility (VIX), market breadth, and fixed income credit spreads. Many trend-following strategies used in tactical asset allocation had turned quite defensive following the late August sell-off and have maintained this position throughout the remaining year. The quarter began weak as it became more evident that the Chinese economy was slowing down with the PMI index falling to a three-year low. Then, the Peoples' Bank of China (PBoC) unexpectedly devalued the Yuan on August 11 leading to a worldwide sell-off of equities and commodities. China's Shanghai Composite's sell-off accelerated into record territory as it dropped more than 50% over four months. The resulting volatility and increased uncertainty helped drive the Fed's (in)decision to not raise rates at its 9/16-9/17 meeting, surprising the markets and inciting further selling. The Fed had, more or less, signaled that it would take into account global market conditions in justifying its decision to hold rates, effectively becoming the world's Central Bank although it retracted this policy signal at the October meeting. The oil price weakness spilled over into the credit markets and master-limited partnerships which had financed much of the North American oil production boom resulting in major losses for credit investors.

October's sharp reversal off the 3rd quarter lows should not have been a surprise as many risk indicators such as VIX, put/call ratios, weak market breadth, and credit spreads reached extreme levels indicating broad-based panic. Global equities, led by the U.S., rallied ~8% while bonds were flat. U.S. high yield also recovered ~3% but commodities, which were down ~20% in 3Q, were barely positive. Once again central bank actions served as the catalyst for the rally. The European Central Bank met expectations for further monetary easing when President Mario Draghi essentially promised more quantitative easing (QE) once the ECB reassessed macro conditions at the December meeting. China's central bank (PBoC) then followed suit by lowering the benchmark lending rate to a record-low 4.35% and lowering reserve requirements for all banks by 0.50%. Even though the Fed kept the Federal Benchmark Reserve Rate unchanged at the October meeting, they did signal a possible rate hike at the December meeting by removing explicit references to global market volatility as well as pointing to "solid" growth in consumer spending and business investment and improvements in housing. As it became more evident that ex-U.S. central bank policy was diverging from U.S. Fed policy, the U.S. dollar continued its year-long ascent which weighed on emerging markets and commodity prices.

Following the October rally, markets settled down in November but then experienced a renewed bout of volatility in December. At the December meeting, the Fed raised their short-term rate for the first time since 2006 and having lowered rates to zero back in late 2008. The markets initially rallied following the mid-December rate hike decision but then sold off as investors became concerned about the implications of Fed tightening in the face of 1) a weakening industrial sentiment, 2) deceleration in employment trends, 3) deflationary pressures from commodity price weakness and slower overseas growth, and 4) negative S&P year-over-year earnings and revenue. As the dust settled on 2015, U.S. equities and fixed income remained largely unchanged from where they began the year leaving a wake of fatigue and uncertainty.

2016 Market Outlook: Cloudy with a Mix of Uncertainty

Market perspectives, like weather perspectives, are largely a function of one's local position. This year, the El Nino effect has resulted in balmy weather for much of the country east of the Rockies but cold, rainy weather for the western part of the U.S. For those of us in the Northeast who suffered through last February's record snowfall, we'll take 60 degrees on Christmas; we may perceive a warmer, milder Winter season even if other parts of the country do not. In the November month-end commentary, we highlighted the bullish and bearish perspectives which largely remain despite the Fed raising rates as expected. How one perceives 2016 taking shape largely depends on how much weight is assigned to the bullish vs. bearish points based on data through year-end. One thing that is certain for 2016 is the spillover of uncertainty from 2015. I am reminded that the 2014-2015 winter had been relatively mild with low snowfall activity through January, but then we got walloped in February. Likewise, investors seem on edge that the markets will get walloped from some unforeseen, exogenous event with the macro landscape already on shaky ground. A market this fragile heading into 2016 cannot absorb many more shocks.

If investors have grown weary of central bank policy statements driving market behavior, they won't get much respite in 2016. All eyes will be on Fed policymakers as they embark on a rate hike regime following seven years of zero interest rates. At the December meeting, the Fed communicated it expects to raise rates four times in 2016, yet the bond market is only pricing in two or three hikes, so 2016 may see the markets and the Fed come to loggerheads as to how 'gradual' rate hikes will be this coming year. Will the U.S. economy, despite the length of the current business cycle, be resilient enough to withstand the planned schedule of Fed rate hikes? Or will the markets anticipate a much slower pace of tightening as 2015 year-end weakness in industry activity and employment trends extends into 2016, keeping the Fed on hold? The bond market may be rudely surprised given that the rotation of new voting members have more of a hawkish bent; however, the bond market may also be ahead of the Fed in terms of anticipating further economic weakness, some of which may result from Fed tightening.

Then there are the issues of the potential knock-on effects of a rate hike regime on a market that has grown used to seven years of zero interest rates. As Greg Ip from the Wall Street Journal wrote,

"The scale and nature of the distortions brought on by easy monetary policy can take time to show up… The harm from financial disruptions is much less predictable than from inflation, because it involves linkages that are apparent only under stress [underline added]."

Fortunately, the knock-on effects may be limited as the one area of the market that has experienced phenomenal credit expansion, namely North American energy production, is in the process of correcting due to supply gluts and muted global demand; conditions that existed prior to the Fed rate hike. So marginally higher financing costs won't push the energy credit markets over the edge, because credit markets are already pricing in higher default rates. There are some concerns of energy market 'contagion' spreading to other credit-sensitive sectors, but the larger question concerns the markets' willingness to extend credit for future borrowing activity in the face of tightening conditions. A pull-back in corporate lending could negatively impact the current pace of mergers-and-acquisition activity as well as share buybacks. The outlook on corporate balance sheet is mixed. Business debt as a percent of GDP stands at 70% surpassing its pre-recession peak yet S&P 500 debt-to-assets ratio is at a healthier 24.5% versus the 39% pre-recession peak (source: Bloomberg).

The 33% drop in commodities has not [yet] resulted in a benefit to net import resource-countries in the form of higher consumption, but it has impacted U.S. industrial activity. Economists have been anticipating a capital expenditure recovery that has yet to materialize, and may not materialize given how extended the current business cycle has become. Some of this weakness is related to a pullback in North American energy production, as the shale producing states in the Midwest are seeing local contractions in employment and economic activity. Lower input prices have helped contribute to cycle high operating margins in S&P 500 companies, but they have not translated into broader productivity gains partly as a consequence of this lack of capital expenditures. Without productivity gains, nominal wage growth will likely remain subdued even with current low unemployment rates. According to the Wall Street Journal, "The lack of capital spending has taken an economic toll. U.S. economic growth is on pace to expand at less than 3% for a 10th consecutive year, the longest stretch in the postwar era."

So expect the Fed and energy, both 2015 headline drivers, to drive 2016 market action. As for the markets, most Street strategists see a gain of 7-11% for the S&P 500 based on a recovery in earnings growth. These strategists are not forecasting a 2016 recession (when have they ever correctly forecasted a recession?), which is their primary rationale for not calling for a pullback in U.S. equities. This is premised on the logic that nominal GDP growth translates into nominal revenue growth and stronger EPS growth due to high operating margins. However, apart from moving past year-over-year headwinds from a strong U.S. dollar and energy weakness, it remains unclear as to what will catalyze a sharp recovery in earnings and revenue from the current negative levels. And it remains unclear whether investors are willing to pay a rich 17.3 multiple on next 12-months earnings (based on Bloomberg estimates) given the uncertainty in the earnings outlook. A strong dollar has historically buttressed U.S. equity valuations, but the mid-1990s strong dollar environment is much different from what investors face today.

Outside the U.S., the market landscape does not look much better. Japanese investors are starting to lose faith in the reform efforts of Prime Minister Abe even as Japan's Central Bank continues its buying spree of government bonds and equities. Europe is suffering through a refugee crisis that is weighing on local economies, while the export engine may stall out further as worldwide trade activity slows down. The UK is also threatening to leave the euro with an upcoming referendum. Despite implementation of long-term reform efforts and a strategic plan to shift towards consumer activity, China's economy continues to slow down as reflected in manufacturing and trade data. The more resource-intensive emerging markets continue to feel the fallout from China's slowdown, and a political scandal and rampant inflation are not helping Brazilian sentiment.

As for long-term bonds, the 10-year Treasury yields 2.27% juxtaposed against the core deflator of the personal consumption expenditure release (the Fed's preferred measure of inflation) at 1.33% (ending November) and 5-year/5-year forward breakeven inflation expectations at 1.81%. If inflation remains subdued or even weakens further, then the Fed will turn more 'gradual' in raising rates making long-term Treasury yields attractive at current levels. However, if wage growth starts to accelerate (some retailers are already reporting higher labor input costs), then the Fed may perceive monetary policy as falling behind the inflation curve and will reaffirm its current pace of rate hikes or even accelerate it. One 'black swan' scenario could entail negative market reaction (and unknown financial stresses emerging) as a result of a more aggressive Fed, but policymakers not reacting to market volatility (as they did in September) because their hands are tied from embedded inflationary pressures. This is an unlikely scenario since the world suffers from global overcapacity resulting from the debt-fueled expansion over the last two decades, but a viable risk nonetheless.

Hence, how one positions themselves heading into 2016 largely depends on what macroeconomic forces and central-bank policies prevail. Will the Fed's rate hikes ultimately engineer a 'policy' failure as the world's growing debt burden makes it increasingly susceptible to rate increases? Will a continued slowdown in China and broader Pan-Asia spill over into global economies or can the developed economies, led by the U.S. and Europe, decouple from economies historically dependent on commodity production and exports? Can Saudi Arabia squeeze out non-OPEC producers having boosted oil production by 1.5 million barrels/day? Can easy monetary policy overcome the deflationary implications of a global oversupply of commodities and manufacturing capacity?

Seeking Better Risk/Reward in the Coming Year

Relative valuation has served as a poor signal for asset allocators, as the onslaught of trend-following, price momentum ETF product launches can attest. Premium-priced assets, whether U.S. equities, emerging market consumer stocks, or long-duration Treasury yields can enjoy even richer valuations. Some of this is driven by rational pricing reflecting fundamentals, some of it is irrational overcrowding.

With that caveat in mind, we believe the risk/reward is less favorable for what has 'worked' in 2015 despite strong arguments supporting further outperformance of high priced assets. Investors rationally want 'quality' and 'low volatility' in an environment as uncertain as the one facing 2016, and positive performing, high quality, low volatility assets are being priced accordingly. As long-term investors, we invest in these attributes because they have rewarded investors over the long-run, not because they are in current vogue with investor appetites. However, there are moments where certain themes can become over-owned and other themes largely neglected as they fall out of favor. For this coming year, we are starting to see opportunities and increased risks emerge for value style of investing, whether by region (developed, emerging markets), by risk premia (momentum, quality), or by sub-asset class (fixed income credit, duration). Investors may be growing tired of the uncertainty weighing on the markets, but that should not preclude them from allocating capital to areas where they believe they are best compensated for the risks involved.

Some Final Thoughts as We Head into 2016

"Diversification" is a [expletive deleted] poor surrogate for knowledge, control and price consciousness."

  1. Marty Whitman, founder of 3rd Avenue Management (cited in Barron's earlier this year).

Mr. Whitman is partly right in this statement (the irony of this statement is not missed on those following the collapse of the 3rd Avenue Focused Credit Fund and the subsequent drama surrounding its closure including the abrupt firing of the firm's CEO). With all due respect, we disagree with the word choice 'poor surrogate'; instead we would rephrase Mr. Whitman's statement as follows:

"Investors diversify because they don't possess full knowledge, control, and price consciousness."

Diversification can be a humbling exercise for professional investors who take it as a point of pride to deliver their primary value proposition, which is to beat the market. Diversification is an admission that even the most knowledgeable investors don't possess enough information, skill, and insight to invest an entire amount into a few securities. Even an investment concept such as 'price consciousness' (or value) needs to be tempered with other well documented risk-premia such as price momentum, quality, and low volatility. We proudly proclaim global diversification as one of our primary philosophical tenets. We diversify because we don't pretend to hold enough knowledge to warrant the type of concentrated strategies adopted by other active managers who profess to own this kind of special insight. As such, we don't concentrate our clients' assets into one or two themes. Rather, we build our ETF portfolios to provide broad diversification across market regions, sectors, and fundamental factors (alternative betas) to extract long-term risk premia while being conscious of the price we are paying within the context of the current market environment. Diversification, like compounded returns, is a gift from the market to investors that should be freely received rather than rejected out of pride.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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