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The 4th Quarter and Annual Review of 2016

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There were a lot of great themes we could take out of 2016. Ideas like diversification and patience when targeting risk premiums all presented themselves this year.

First, it is important to remind investors that 2016 had a very tough start. In the month of January, the S&P 500 returned -4.96%. At the time, many investors thought we might be headed for a market correction. Thankfully, our long term approach kept most investors tied to the mast of their long term investment plan and was able to experience one of the best years in the last decade.

This year was a great example of the benefits of global diversification. On a risk-adjusted basis, a globally diversified portfolio of index funds with tilts towards small-cap and value stocks yielded a return that was 1.05% higher (IFA Index Portfolio 80) than just investing in the S&P 500, the well-known benchmark that investors look to for market performance. These superior risk-adjusted results came mainly from small cap stocks and emerging markets stocks, which have tested the patience of investors over the last 5 years. In fact, Emerging Markets as a whole have been the worst performing asset class among global equities over the last 5 years.

Now this is just one year of performance and just one data point among many, but the main take-home for investors is that we don’t know with a high degree of certainty which part of the world is going to be the best performer. There are times when we are not rewarded for the risk we take; which is the definition of risk by its very nature. But when it does show up, we want to make sure our portfolio captures it.

This leads us to our second point, which is the importance of patience and discipline when it comes to the investing process. Being exposed to volatile asset classes like Emerging Markets equities or small cap stocks means that a lot can change in a short period of time. Specifically, the great return experienced by most IFA investors came in the last 6 months of the year. From January 1st to June 30th, small cap stocks and S&P 500 were pretty much even in terms of performance. From July 1st to December 31st, the IFA U.S. Small Cap Index outpaced the S&P 500 by 11.46% (19.28% vs. 7.82%, respectively). Similar with global diversification, we don’t know with a high degree of certainty when and by how much these premiums will manifest themselves in client portfolios. That is why it is important to exercise both patience and discipline when it comes to pursuing these premiums that have historically rewarded investors.

Domestic Equities

For the different size and styles of domestic equities, the quarterly returns ranged from 13.47% for small cap value stocks to -0.42% for large cap blend stocks. For 2016 as a whole, value beat growth across the board and small cap beat large cap across both growth and value. Small cap value stocks were the top performing asset class. 

For the blend of domestic equity indexes used in the IFA Index Portfolios, the quarterly return was 10.12% for Q4 and 21.52% for 2016 as a whole. This outperformed the US market as a whole (as measured by the Russell 3000 Index), which delivered 4.21% in Q4 and 12.74% for the year.

International (Developed) Equities

On the international front, equities from our developed counterparts outside of the US had a negative 4th quarter, but positive results for 2016 in its entirety. In Q4, results ranged from -2.05% for international small cap stocks to 5.09% for international large cap values stocks. For the entire year, results ranged from 5.80% for international small cap stocks to 8.41% for international large cap value stocks.

Returns by country in Q4 ranged from -11.09% (New Zealand) to 8.93% (Italy). Top performing countries included Italy (8.93%), Norway (3.32%), France (2.64%), Canada (2.51%), and Austria (2.34%). The worst performing countries included New Zealand (-11.09%), Belgium (-10.10%), Hong Kong (-8.40%), Denmark (-8.16%), and Israel (-7.86%).

For the blend of international indexes used in the IFA Index Portfolios, the quarterly return was 1.58% and 7.41% for 2016 as a whole. This outperformed the international developed market as a whole, as measured by the MSCI World ex US Index, for both Q4 and 2016, which delivered -0.36% and 3.29%, respectively.

Emerging Markets

The Emerging Markets were a top performing asset class in 2016, although they had a difficult fourth quarter. For Q4, the returns ranged from -5.92% for emerging markets small cap stocks to -0.97% for emerging markets value stocks. For 2016, returns ranged from 10.92% for emerging markets small cap stocks to 19.84% for emerging markets value stocks.

Returns by country in Q4 ranged from -22.53% (Egypt) to 18.88% (Russia). Top performing countries included Russia (18.88%), Greece (13.87%), Hungary (8.92%), Poland (3.16%), and Peru (2.53%). Worst performing countries included Egypt (-22.53%), Turkey (-13.58%), Philippines (-12.38%), Malaysia (-8.76%), and Mexico (-8.10%).

For the blend of emerging markets indexes used in the IFA Index Portfolios, the quarterly return was -4.17% and 13.95% for all of 2016. Our blend outperformed the Emerging Markets as a whole, as measured by the MSCI Emerging Markets Index, which delivered 11.91% in 2016.

Real Estate

Global real estate securities delivered negative results in Q4, but positive for the entire year. In Q4, domestic REITs outperformed its international counterpart, delivering -2.53% and -8.36%, respectively.

Fixed Income

Interest rates across the US income markets increased in Q4. Overall, the yield curve slightly flattened given the large increase in short term rates versus a more modest increase on the longer part of the curve. 5-year US Treasuries tacked on 79 basis points (0.79%) while 30-Year US Treasuries experienced a 74 basis point increase (0.74%). For Q4, the four fixed income funds used by IFA experienced mixed results that ranged from -1.68% for 5 year global bonds to 0.03% for one year fixed income. For 2016 as a whole, we saw positive results across all 4 funds. Returns ranged from 0.84% for one year fixed income to 1.79% for five-year global bonds.

For the blend of fixed income used in the IFA Index Portfolios, the quarterly return was -0.71% and the 2016 return was 1.14%.

IFA Index Portfolios

Putting it all together, the returns of the IFA Index Portfolios are shown below net of one quarter’s worth of IFA’s maximum annual 0.90% advisory fee for the quarterly numbers and the full 0.90% for the 2016 numbers.

We would like to remind our clients that although 2016 was an outstanding year, we shouldn’t expect things to turn so well all the time. Our best estimate of returns going forward is still the historical average and based on fair prices being set in the market, there is a likely chance that things could end up on both the positive and negative side of that expected return in any given year. 2016 as a whole was a great example of the investment principles we profess to our audience. Focusing on the things we can control like risk exposure and expenses are more likely to lead to a better investment experience versus focusing on the things that we cannot control like the future direction of markets and attempting to outsmart the collective wisdom embedded in market prices.


Each Quarter, IFA monitors the funds they recommend for clients and as part of that process, we’ve developed a rating system. Below is a link to our Performance Monitoring Report for client portfolios: IFA 4th Quarter 2016 IFA Client Performance Monitoring Report

 

We recently created the IFA Investing Kit that includes a copy of Index Funds: A 12-Step Recovery for Active Investors book, the documentary, as well as the IFA Random Walker, which simulates market outcomes based on fair prices right before your very eyes. Contact your IFA Wealth Advisor to reserve your own.