A Lackluster 2014

If I could sum up the stock market for last year, I would have to say that 2014 brought us a year of quiet stock growth mixed with a few volatile tantrums. We actually saw a small tantrum in January 2014 as the S&P 500 started the year in negative territory. By the end of August, the index had recouped those losses and grown almost 10%. That led to the September tantrum which cost the S&P nearly all of its 2014 gains by mid-October. The market reversed course again and set new all-time highs in November. The final fit of volatility in 2014 occurred in the second week of December as the S&P dropped 5%, but reversed course just as quickly and closed out the year near brand new all-time highs. Perhaps 2014 wasn’t so quiet after all.

These quick bouts of volatility also could be the reason that some mutual funds (and variable annuity sub accounts) failed to keep up with the S&P 500 index. While many of our clients saw great success with our individual stock systems, many of the funds lagged behind. Funds have managerial and administrative expenses that an index wouldn’t have, which may account for some of the under-performance. Funds must also carry a cash balance to allow for investor liquidity, which also hinders performance in an up market. This still doesn’t explain all of the lackluster fund performance we saw in 2014. So what does?

First, we need to realize that although we often generalize and use the S&P 500 as a proxy for “stocks”, it is important to note that this index is composed primarily of large cap stocks. As you can see from the table [below], the performance of stocks varied a great deal between small cap and large cap. The index is also heavily biased toward the U.S. The fact that we often diversify a portfolio with international, emerging market, or small cap fund positions would definitely explain some of the under-performance last year.JP_Morgan_index

Looking at how the S&P 500 is constructed will also provide some explanations. This index is market cap weighted, which is more realistic than a price weighted index (like the Dow Jones Industrial Average), but still doesn’t necessarily reflect the way a portfolio would normally be constructed. According to the S&P website, half of the weighting of the index is contained in the 58 largest stocks of the S&P 500. That equates to half of the index tied to a mere 11.55% of the holdings. The largest holding in the index is Apple at around 3.5% and it happened to have a 40% return last year, so the mystery is beginning to unravel as to how this index managed to outperform through the volatility.

The fund managers don’t get a free pass however. Although many times the fund objectives determine how a fund portfolio can be invested, we can sometimes observe a manager stretching the limits. If the manager is nervous about future volatility, then cash might accumulate or allocations may shift to low-beta stocks. If the manager is optimistic about the short term market prospects, cash might get invested more quickly and higher-beta stocks (even small and mid-caps) might find their way into the fund. This kind of style drift can often lead to a fund manager misreading the markets, especially when we have short periods of volatility like we saw in 2014.

The good news for 2014 is that most investors made money. We just want to make sure our clients keep up with the markets on a risk adjusted basis, and some of the funds just aren’t making the grade. Regardless, we will continue to study the investments that we use and recommend changes that we believe will better meet the goals of our clients.


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