Underperformance Anxiety

This article was originally published on on July 9th, 2014 at 6:00am EST

There is a concept in the investment community that is discussed primarily behind closed doors: underperformance. Whether a manager is underperforming his benchmark (like the S&P 500) or his peers (think hedgies like Einhorn, Ackman, Loeb, Paulson, etc.), believe me he is paying attention.

If that underperformance becomes dramatic — regardless of what he’s saying in shareholder letters or interviews — you had better believe he is getting nervous.

“Never let ’em see you sweat.”

Money managers the world over have different conversations with their clients (or shareholders/investors) than they do with their colleagues. This shouldn’t come as a complete surprise. But are discipline and decision-making ever affected during periods of underperformance?

You bet.

Case in point is 2013. We all know the stock market (S&P 500) was up about 30% last year, with a fairly good-sized hiccup during June’s unexpected and severe rate spike. Can you name a single manager or fund that beat the S&P 500 last year? I can’t. None of our client portfolios beat the S&P last year — and we make no apologies for that fact.

The real mistake, though, might have been to try and “catch up” by taking on more risk at the beginning of 2014. The news flow was all positive coming into the new year and it would have been understandable (sort of) to open the year by applying pressure to the gas pedal instead of the brake. But the result would have been adding exposure to all the asset classes that got whacked hardest in January’s mini-correction: Small-caps (iShares Russell 2000 Index, IWM lost 7.3%), emerging markets (Vanguard FTSE Emerging Markets ETF, VWO lost 7.9%) or even just the S&P 500 (which lost 5.6%).

“Three tomatoes are walkin’ down the street.
Papa Tomato, Mama Tomato and Baby Tomato.
Baby Tomato starts lagging behind, and Papa Tomato gets really angry.
Goes back and squishes him and says: Ketchup.”
– “Mia Wallace” (Pulp Fiction)

Instead, and against the conventional wisdom that insisted interest rates would move higher, we maintained the allocations with which we closed out 2013. The result has been some fairly nice outperformance. We held a good deal of exposure to some of the industry’s most-maligned asset classes six months ago: REITs (Vanguard REIT Index ETF, VNQ) up 18% year to date; MLPs (JPMorgan Alerian MLP Index ETN, AMJ), up 12% year to date, and long-dated bonds (iShares 20+ Year Treasury Bond Index ETF, TLT), up 13% year to date (including dividends).
While this may sound a bit self-congratulatory, it’s really not meant to be. This is merely a qualitative case study about how our behavior and decision-making may be affected by our own relative performance.

Ok, that’s great, but what are you doing now?

You are starting to hear even the most bullish of investment professionals struggling to find good values here. Very few subsets of the U.S. equity market look inexpensive right now. We like to look at potential upside versus downside when making buy/sell decisions — how much upside is there for U.S. stocks from here in the near term? My answer, “Not enough to be buying them.”

Of course this is a bit of a sweeping generalization because some sectors and individual names still look appealing. But generally speaking, we’re happy with what the stock market has given us over the past few years.

We’ve been discussing a more defensive posture for the past three months, and we have practiced what we’ve preached in client portfolios. The result has been a little counterintuitive — further outperformance. Yes, the stock market has continued to grind higher. But so have our portfolios made up primarily of master limited partnerships, Treasuries, international and emerging market stocks, and real estate.

Defense wins championships.

Until we see a correction of some magnitude (at least 5%-10%) we are not particularly interested in adding U.S. equity exposure. In the meantime, we like the idea of maintaining a defensive, income-oriented stance: Continuing to lock in profits from last year as they convert to long-term capital gains — whenever possible — and keeping a nice cash cushion a-la Scrooge McDuck.

Have a great week and please let us know if there is any way we can help you…

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on can be found here.

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