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Chief Investment Officer
Markets around the world tumbled in the first two months of the year. Investor sentiment indicators reported extreme fear levels as some markets fell into bear market territory in February. Then, just as it looked like the decline would get worse, the market reversed course, rebounding nicely off the mid-February lows. And by quarter-end, most stock markets were slightly positive.
The S&P 500 was up 1.35%, and the MSCI All-Country World index (ACWI) was up 0.24%. As is often the case in steep market declines, the areas of the market that had been leading prior to the decline were hardest hit when the market sold off. Since we aim to invest in funds that have strong recent returns, many of our positions fell sharply in the first two months of the year. We replaced these funds with more defensive funds that had held up better in the decline, but the damage was done, and all of the equity Upgrader Funds ended the quarter with losses.
Our Upgrading approach is a continual and gradual process that seeks to capitalize on major market trends, which typically last years, and avoid some of the noise of short-term market action. It doesn’t lead us to make dramatic portfolio changes in a single month, and in our experience, this is usually a good thing. Sometimes the worst thing you can do is turn 180 degrees based on recent market action. But when market’s change direction suddenly as they did in the first quarter, it could have helped to move more quickly into more defensive funds.
Bonds were a bright spot for the quarter. The Barclays Aggregate Bond index was up 3.03% for the quarter. The Flexible Funds both had gains, but INCMX and TOTLX lagged the benchmark because they were more defensively positioned during the quarter. We’ve maintained a shorter duration for INCMX than the Barclays Aggregate index (duration measures a fund's susceptibility to interest-rate risk).
Navigating 2016's Changing Markets
The first quarter didn’t only bring a change in market direction, it also brought a change in market trends. The large-cap growth stock trend weakened, and more defensive areas of the stock market, like utilities and dividend-paying stocks, surged. And while most areas of the bond market had gains in the first quarter, some funds did better than others. This led us to make some important changes to the Fund portfolios.
Increased Exposure to Defensive Funds
At the start of the year, the Funds were focused on large-cap growth funds, but some of these funds fell sharply in the first quarter and were sold.
We bought into more defensive funds that had stronger recent returns, such as funds that invest in high dividend-paying stocks, low-volatility stocks and momentum stocks.
We also moved into more defensive sector funds during the quarter. We sold banking and home construction funds and we bought utilities, consumer staples, and, in some cases, gold. (Most of the Funds have limited exposure to sector funds; RELAX has no exposure.)
We continue to hold some large-cap growth funds as well as technology and consumer discretionary funds.
More Change to Come?
A diverse mix of funds had strong recent returns in the first quarter, and and most of the equity Upgrader Funds now have exposure to both growth and value funds. Emerging markets, which have been out of favor for years now, did well in the first quarter, but we think it’s still too early to buy in yet.
We can’t know what future markets will bring, but we do know that even the most compelling market trends eventually give way to something new, and our Upgrading strategy is designed to adapt to changing markets.
Focused on HIgher-quality Bonds
We increased exposure to higher-quality bonds in the first quarter, adding an additional position in mortgage-backed securities and taking a small position in Treasuries.
We sold out of lower-quality strategic funds entirely
The Funds were more globally diversified by quarter-end. INCMX’s exposure to world bonds grew from 8% to 20%. TOTLX had no foreign bond positions at the start of the year and it had 10% in world bonds by March 31, 2016.
The Funds’ bond exposure continued to be focused on intermediate-term bonds (42% for INCMX and 29% for TOTLX). The Funds have no exposure to long-term bonds, which tend to be more interest-rate sensitive.
Will Interest Rates Rise?
Interest rates fell in the first quarter, but many expect the Fed to increase rates later in the year. We believe we are well positioned to buffer any headwinds brought on by rising rates. We own diversified portfolios, and we aren’t limited to bond funds. We can also invest in total-return funds, like balanced and alternative funds, which typically aren’t fully invested in bonds. Both Funds continued to
Duration is a reflection of interest-rate risk, and both Funds have a shorter duration than the Barclays Aggregate Bond index.
The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. The Barclays Aggregate Bond Index is an unmanaged index generally representative of intermediate-term government bonds, investment grade corporate debt securities and mortgage-backed securities. The MSCI All Country World Index (ACWI) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. You cannot invest directly in an index.
Duration is an approximate measure of a bond's price sensitivity to changes in interest rates.
Diversification does not assure a profit or protect against loss in a declining market.
Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data quoted current to the most recent quarter- and month-end may be obtained by clicking here.