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First Quarter 2023 Market Snapshot

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First Quarter 2023: Resilient Economy, Weak Banks, Swift Intervention

Softening inflation, a budding banking crisis, and a strong overall economic picture caused investors to re-evaluate their expectations for future interest rates in the first quarter. As a result, many of 2022’s trends – of lower asset prices in general, investor preferences for value stocks over growth stocks, and the dominance of energy-related assets – reversed themselves.

Unexpected issues in the banking sector couldn’t derail markets from pushing higher in the first quarter. Inflation, the bane of central bankers everywhere over the past year, appeared to be easing – or at the very least, plateauing. Consumer spending and hiring, at least for now, have proven to be largely immune to the strongest monetary tightening cycle since the 1980s. And lastly, a widely anticipated recession did not materialize. All of this was enough to help push global stocks up roughly 7%, led by the largest U.S. technology companies.

For now, investors have remained resilient, even in the face of March’s unexpected banking issues. What started with the shutdown of a smaller, crypto-related bank quickly devolved into a larger financial stability issue as Silicon Valley Bank and Signature Bank collapsed. The contagion spread across the Atlantic as Swiss banking giant Credit Suisse flirted with failure before being merged, at the behest of regulators, with rival UBS. Back stateside, the Federal Reserve and the biggest U.S. banks quickly scrambled to shore up First Republic Bank in order to stop the growing panic from taking down more lenders. The quick response to the crisis has placated markets – for now – but the biggest question for investors remains how well the economy will hold up under the strain of higher interest rates and tighter financial conditions.

Those higher interest rates themselves are suddenly not a foregone conclusion, as banking system stability has added yet another needle for the Fed to thread in its quest for economic stability. Interest rates across the Treasury yield curve declined in the quarter, with the 10-year Treasury moving down from 3.8% to 3.5%, sending prices higher. Both the Federal Reserve and the market expect one more rate hike this year, but the timing of that final rate hike is where the agreement between the two parties ends. Investors are now betting that the Federal Funds rate will be at 4.4% by year-end, implying that Chairman Powell will be forced to reverse course and cut rates in the next nine months.

2023 Capital Market Assumptions

Download our 2023 Capital Market Assumptions Report.

Sellwood’s 2023 Capital Market Assumptions represent our best current thinking about future returns. They are the essential building blocks of the asset allocation work we perform for clients.

Each year, though make incremental enhancements to our methods for gauging the future value of assets, we maintain our focus on the primary, reliable drivers of risk and return. Our assumptions are anchored in the empirical facts presented by long-term capital markets rather than speculative observations on recent market conditions. We avoid unnecessary complexity, preferring instead to rely upon transparent strategies that work reliably. Our analysis is comprehensive, but not complicated — because we are convinced that the most robust solutions have no hidden constraints and few moving parts.

We update the assumptions annually, and this year’s update to the assumptions saw increases in both expected return and risk, across every major asset class we evaluate. The reasons for higher expected return are simple: higher yields imply higher expected returns from bonds, and lower equity valuations imply higher returns from stocks. Diversifiers, sharing characteristics of both stocks and bonds, rose in tandem.

The higher expected risk for most asset classes is less intuitive. To model “risk,” we are calculating the expected standard deviation of returns, which is a statistical explanation of the shape of a normal distribution of return outcomes. Input assumptions for traditional asset allocation modeling use normal distributions, but the world is not normal — so our task in creating risk assumptions is to shoehorn a non-normal world into a normal distribution, which creates tradeoffs to consider.

Our risk assumptions rely both on the historically observed distribution of returns, but also the historically experienced worst case scenario (2008, for most risky asset classes, and 2022, for fixed income), which in some cases is outside the “normal” distribution drawn by all the other observations. In those cases, we widen the distribution of outcomes enough, by increasing the expected “risk,” so that the actual historical worst case is inside the distribution. As the lower valuations and higher yields of 2022 pushed our assumed returns higher, shifting whole return distributions upward, the distributions needed to get wider to accommodate that historical worst case.

The world isn’t any riskier today than it always is, but the outcome distributions may just be wider. This is one reason among many that we believe it is essential to develop intelligent forward-looking assumptions rather than simply relying on historical returns to develop optimal portfolios, or intuitions about future returns.

Our assumptions imply a much more interesting environment for capital allocation than existed a year ago. Consistent with our 2023 Investment Themes, our 2023 Capital Market Assumptions imply a market environment in which:

  • finally, reasonable returns may be earned from high-quality bonds;
  • stocks offer more historically “normal” return prospects;
  • non-US equities offer more compelling return opportunities than their US counterparts; and
  • correlations, especially between stocks and bonds, cannot be counted on for diversification as much as they have for the last 20 years.

Finally, we note the inflation assumption. Its decline is not a typo — our forward-looking assumption for inflation actually declined over the last year. This is simply because our 10-year expectation for inflation reflects the market’s own expectation, as implied by the difference between 10-year nominal Treasury bonds and 10-year Treasury Inflation Protected Securities (TIPS). Market-based inflation expectations peaked in early 2022 and have declined since then.

2023 Investment Themes: Changing Narratives

The dozen years following the 2008-09 Global Financial Crisis can be separated into two distinct market narratives, both of which are currently being unwritten.

The first narrative period spanned the decade following the 2008 financial crisis and was characterized by low interest rates, low growth, lackluster aggregate demand, a global economy flirting with deflation, and a “Fed put” that placed an implied floor beneath the stock market. Many market observers, including Sellwood, observed a prospective “low return environment” characterized by low yields for both stocks and bonds.

The second narrative period began as COVID upended the economy in early 2020. It witnessed a rapid economic transition from the production of services to goods, supply chain constraints, and unprecedented fiscal and monetary stimulus. The sense that COVID “pulled forward” several years of previously gradual market transition from physical to digital sent a small group of stocks and speculative investments skyward. Whether it was a transition from offices to working from home, or shopping in malls to shopping online, or from gyms to Peloton, restaurants to Doordash, or even traditional currencies to cryptocurrencies, the post-COVID moment was characterized by a sense of dramatic transition from “old economy” to “new.” In markets, persistent historically low rates, large amounts of liquidity, and good old-fashioned fear-of-missing-out (FOMO) forced investors further out on the risk/return curve, from the safety of bonds to the risk of stocks, in a “There is No Alternative (TINA)” market.

As detailed in our 2022 Economic & Market Review paper, 2022 changed all that. 2022 was the year when the world emerged from COVID, shoppers returned to malls, and diners to restaurants. It was also a year that the Federal Reserve was forced, by inflation, to abandon the easy money policies that have characterized the better part of this century, so far. In 2022, long-duration assets (both bonds and stocks that expect their profits well into the future) collapsed along with the prevailing narratives of the last dozen years. As the Federal Reserve has reset the risk-free rate, the risk premiums offered by various corners of the capital markets are still finding their locations, as new market narratives take hold.

This reshuffling of the economic and market landscape offers opportunity for thoughtful long-term investors. While we are humble about making predictions – “Predictions are difficult, especially about the future”[1] – we recognize that a reshuffled deck offers new opportunities. This paper identifies several opportunities for portfolio improvement whose risks, we judge, are compensated for long-term investors:

  • Value
  • Small Cap
  • Non-US Equity
  • Bonds
  • Low-correlation alternatives


Stocks are far from cheap, but the era of needing to buy overpriced equities because “There is No Alternative” is over. Stocks represent much better bargains than a year ago, almost as if competition from bonds (see below) has forced them to become more attractive.

In 2022, the US stock market declined by 19.2%.[2] While US corporate earnings declined by an estimated 4.2%, this fact alone was not enough to explain the market’s decline, most of which was a reduction in the price investors were willing to pay for a dollar of those corporate earnings. This multiple reduction can be explained by rising rates (making future earnings dollars worth less today), expectations for lower future earnings (recession fears), or simple mood and risk preference changes. We note, however, that the P/E contraction witnessed in 2021 and 2022 merely reversed a mirror-image expansion that occurred in 2020. As the “post-COVID economy” narrative has unwound, so have the valuation premiums investors have been willing to pay for future earnings.

Source: Standard & Poors, Sellwood


While 2022 offered few places to hide, value stocks offered some shelter: across all capitalizations, US value stocks declined 8%, compared to a 29% decline for their longer-duration growth counterparts.[3] Despite this recent outperformance, we believe that value remains a compensated risk going forward, for several reasons.

First, should inflation remain elevated, value companies should benefit. Value companies tend to be more indebted than growth companies, meaning both that inflation erodes the real value of their debt and also that their higher operating leverage will convert more future revenues to profits, compared to growth companies. Additionally, being less speculative than growth companies, value companies tend to expect more of their future profits sooner, making them less susceptible to rising rates.

Second, the market itself has become more “growth” oriented over the last decade. It used to be the case that buying the entire market, for example in an index fund, would deliver a “core” (neither value nor growth-leaning) portfolio. This is no longer the case. Even after 2022, growth (especially a handful of technology) companies are simply so large that capitalization-weighted indexes tend to deliver growth, not balanced core, exposure. Depending on the degree, leaning a portfolio toward “value” may only return it to style neutrality. In 2023, an investor can have market exposure, or style balance, but not both.

Source: Morningstar, Sellwood

Third, relative valuations are still attractive, even despite value’s strong outperformance in 2022.

Source: FTSE Russell, Sellwood

Finally, investor preferences for value and growth companies tends to observe cycles. Historically speaking, it would be rather early for a value cycle to come to its end this early.

Source: FTSE Russell, Sellwood

Small Cap

Small cap stocks have the potential to offer returns above and beyond those of large cap stocks. This remains true even when considering the valuation premium investors have recently been willing to pay for the largest public companies in the US stock market. While historically, large- and small-cap companies have traded at similar price-to-earnings multiples, investor preferences for the largest (especially technology) companies have recently pushed their valuations to historic highs. To quantify this: the only time in the last 45 years that large-cap stocks have traded at a higher multiple of small-cap stock valuations was in the 1999-2000 market bubble.

Source: FTSE Russell, Sellwood

Furthermore, small cap stocks have shown resiliency in previous periods of high inflation, such as the 1970s. This, combined with their heavier weightings in cyclical industries, which tend to have pricing power in inflationary environments, suggests that small cap stocks have potential to outperform large-cap stocks as the next market narratives are written.

Non-US Stocks

It’s a big world out there, and about 40% of global investable public company value is listed outside the US stock exchanges. Still, the last decade has been a very challenging one for US-based investors to hold non-US investments, because of the US dollar’s unprecedented strength. Following many years of appreciation, the dollar reached 20-year high versus other global currencies in 2022. Going back to 1973, the inception of reliable data, the US dollar was only higher than its current level twice: during the 1999-2000 market bubble, and in the mid-1980s when interest rates peaked.

Source: Intercontinental Exchange, Inc., Sellwood

From the depths of the Global Financial Crisis until the dollar’s 2022 peak, the dollar appreciated by 50%.[4] This dramatic appreciation in the currency directly subtracted 50% from the returns of investments outside the United States. Going forward, we do not expect the same headwind, and that non-US investments should be able to stand on their own (local) merit.

The currency effect has coincided with a reduction in valuations for non-US stocks. While economic uncertainty reigns around the globe, we believe that (a) lower valuations offer a higher margin of safety for accepting the risk that comes such uncertainty, and (b) the economic picture is murky in the United States as well, only without such low valuations to compensate for it. Over the last 20 years, non-US stocks have traded at an average valuation discount of 14% compared to US stocks; that discount is currently 28% — double the average.

Source: MSCI, Sellwood


US investment-grade bonds suffered their worst year on record in 2022. After such a year, they also represent a much better bargain than they did a year ago. In another example of narratives being unwritten, it is no longer true that bonds – currently yielding 4% — must be crowded out of portfolios that seek reasonable return. This has not been true since the 2008 Global Financial Crisis.

Source: Federal Reserve Bank of St. Louis, Sellwood

The expected return for a bond, or an index of bonds, over its maturity horizon is very close to the yield at which it was purchased. An expected return of 4% or greater for bonds implies a greater role for high-quality bonds in portfolios with fixed return needs. This actually makes an asset allocator’s job harder, as bonds, after 13 years, finally offer competition for riskier assets in portfolios that require meaningful return.

Source: Federal Reserve Bank of St. Louis, Morningstar, Sellwood

This challenge is exacerbated by the yield curve, which is currently flat (in fact, slightly inverted). A flat or inverted yield curve implies that the historic relationship between bond duration and return (the longer the bond duration or maturity, the higher the return) cannot necessarily be expected going forward. The current shape of the yield curve, all else equal, weakens the case for duration.


The uncertainty of stock/bond correlations introduced in 2022 also complicates the case for duration. While over the last 20 years correlations between stocks and bonds have been negative – implying strong diversification benefit to holding both – the correlation sign flipped to positive in 2022. Whether “the norm” for stock bond correlations looks like the two decades from 2000-2021 (negative correlations), or like the several decades that preceded the turn of the millennium (positive correlations) is very much an open question. Because of its implications for diversification itself, we believe it is the most interesting question in markets today.

Source: Morningstar, Sellwood

At the same time, we have always believed that bonds should be evaluated not as standalone assets but rather in what they contribute to whole portfolios. Correlations do not need to be negative, just imperfect, to benefit portfolios.

Despite lower expected return, long-term, very high-quality bonds (like long Treasurys) have historically represented unique destinations in flight-to-quality markets (which are those when investors with stock-heavy portfolios need their bonds to perform most). Additionally, in the unlikely but devastating scenario of malign and prolonged deflation, there would be no substitute for them. As such, even despite a flat yield curve, we still believe that long Treasury bonds play an important role in diversified – especially equity-heavy – portfolios.

Spread Sectors

The market’s change of narrative, and the reshuffling of risk premia across assets, is not broadly evident in riskier areas of the bond market. At the end of 2022, we saw greater yields across bond market sectors than we have since the Global Financial Crisis. However, fixed income spreads, or the additional compensation for taking incremental risks in fixed income, are close to or below long-term historical averages. This implies more limited opportunity for active bond managers compared to prior periods of recessionary fear, when spreads widened more significantly.

Source: Federal Reserve Bank of St. Louis, Standard & Poors, Sellwood

Source: Morningstar, Sellwood


The “low return environment” narrative that prevailed post-GFC was the mother of hundreds of new alternatives funds. Most of them failed, and most of the survivors remain unattractive and overpriced.

Source: Morningstar, Sellwood

The case for alternative assets, as a category, is weaker now that stocks and bonds (traditional assets) are priced to deliver higher expected returns. Over the last 13 years, when investment-grade bonds yielded an average of 2.4%, any portfolio with a fixed return objective above 5% (for example) could afford only a bare minimum allocation to bonds. In a very literal sense, every dollar allocated to bonds made achieving that return objective less likely. Today, when investment-grade bonds are yielding 4%, we expect that fewer allocators will be searching for “bond replacements” as in the post-GFC period.

At the same time, if stock/bond correlations cannot be counted on to be negative, the case for truly diversifying assets (with low or even negative return correlations to traditional stocks and bonds) is stronger. While they remain a tiny subset of the overall universe of alternatives, our research is focusing on those funds that improve portfolios via low correlations to stocks and bonds. Even in a world where stocks and bonds offer acceptable returns, a lower-returning asset with imperfect correlation to those assets can still improve a portfolio.

An important caveat: investors should be careful not to be fooled into believing that stale prices diversify portfolios. We believe that many investors are due for a rude awakening in 2023 when they realize that the funds that “preserved value” in 2022 simply were not marked with market prices. We are always mindful that investments with non-market-based valuations may appear to diversify portfolios without actually doing so.

In Summary

As much as 2022 witnessed the dismantling of asset valuations, the crumbling of longstanding market narratives that had supported those valuations was equally impressive. 2022 offered a reset, taking both stock and bond valuations back to more historically normal levels, and exposing most alternative assets as less “alternative” than many investors thought.

Considering the opportunities presented by this market reset, we suggest the following themes as potentially rewarding to long-term investors:

  • Value, as a style, has suffered from narratives that prevailed over the last decade about technology overtaking the rest of the economy. We believe that this narrative was overwrought, and that value is potentially in the early innings of outperformance.
  • Small Cap stocks have higher potential returns and lower valuations compared to large cap stocks. They have shown resiliency during past high inflation periods and are heavily weighted in cyclical industries, suggesting an ability to more rapidly adjust prices in an uncertain inflation environment.
  • Post-GFC, a narrative took hold that the United States was “the cleanest dirty shirt” in the world, economically. This manifested in higher valuation premiums being applied to US corporate earnings, lower valuations outside the US, and a strengthening US dollar. We believe that this narrative will be difficult to sustain, and that currency markets are self-correcting in the long run. All of this favors continued allocation, and even higher allocation, to non-US stocks.
  • Bonds finally offer enough yield to justify inclusion in return-seeking portfolios. The “There is No Alternative” narrative has crumbled as rising rates now offer more historically normal compensation to bondholders. At the same time, the diversification case for traditional high-quality bonds may have weakened as the 20-year pattern of negative stock/bond correlations broke down in 2022.
  • Interestingly, spread sectors in the bond market have not repriced as they have in past similar stock markets. The fear evident in stock prices has not translated to riskier corners of the bond market.
  • We believe that most of the narratives sustaining alternative investments were always false, but 2022’s market reset has weakened their case for inclusion in portfolios. Rare exceptions include those alternatives that benefit portfolios through (true, market-based) correlations.

[1] Niels Bohr

[2] Russell 3000 Index.

[3] Russell 3000 Value and Russell 3000 Growth.

[4] July 15, 2008 – September 27, 2022.

[5] Source: JP Morgan Guide to the Markets. As of 12/31/2022. Indexes: S&P 500 and MSCI ACWI ex US.

2022 Economic & Market Review

2022 was a brutal year for markets, offering few places to hide to novice and professional investors alike. As we transition to 2023, the following questions are top of mind:

  1. How does 2022 market performance compare to history?
  2. What is the near-term outlook for a recession?
  3. How should recent economic data be interpreted?

2022 Investment Year in Review

Drawdowns in asset prices were widespread and severe in 2022. U.S. stocks fell 19%. Non-U.S. stocks fell 15%. Investment-grade “core” bonds, which typically protect against sudden declines in stock prices, declined 13%. Chart One below plots stock and bond returns by calendar year, dating back to 1926. There have only been three years in history (1931, 1969 and 2022) when stocks and bonds both declined in the same calendar year. 2022 was the sixth worst year for stocks since 1926 and the worst year for bonds in modern history, by a wide margin.

Chart One: U.S. Stock & U.S. Government Bond Returns: 1926-2022

Source: Morningstar, Sellwood Consulting.

Over the last two decades, stocks and bonds have reliably diversified one another. In 2008, for example, when stocks fell 42%, investment-grade bonds appreciated 5%. This relationship, however, has recently changed. Specifically, the correlation coefficient of stocks and bonds, which had been negative for 20 years, shot up rapidly in 2021-2022, turning positive. This represents a return to the correlation relationship between stocks and bonds that had prevailed in the 40 years before the year 2000.

Chart Two: Stock & Bond Correlations

Source: Morningstar, Sellwood Consulting.

This raises the question, “Is Diversification Dead?” According to Antti Ilmanen of quantitative asset manager AQR, “We have a nice story on why the sign flipped from positive to negative 20 years ago. Stocks and bonds tend to be driven by growth and inflation. When there is more growth uncertainty, stocks and bonds tend to move in opposite directions, so we’ve had negative stock/bond correlation for the last 20 years. Before that, there was, relatively speaking, more inflation uncertainty, and we tended to have positive stock/bond correlations. So, we are waiting to see if those relative uncertainties flip again.”

What should an investor expect going forward? Will bond and stock diversification resemble the last 20 years or the 40 years prior? In the past 20 years, bonds have diversified stocks due to economic growth uncertainty. In the current interest rate environment, however, it is likely that both growth uncertainty and inflation uncertainty will surface, potentially leading to less diversification benefit between stocks and bonds. Nonetheless, we still recommend that investors own bonds, as bonds should diversify in periods of extreme economic uncertainty, particularly during rapid stock market selloffs. It is impossible to know in advance whether there will be more growth or inflation uncertainty, strengthening the argument for a strategic allocation to bonds.

The Economy in 2023: Bending, Breaking, or Pivoting?

The 12-year period following the Global Financial Crisis (2009-2021), was characterized by steady Gross Domestic Product (“GDP”) growth, increasing corporate profits, and disinflation (when goods and services prices rise, but at progressively slower rates). Conditions were favorable for asset prices, leading investors to shift from traditional investments, such as government bonds, to higher-returning sectors of the market. With risk came reward, leading to the longest bull market in history. Investment speculation was encouraged. The real risk, in many investors’ eyes, was missing out.

This behavior was driven by the Federal Reserve’s aggressive monetary policies, which included lowering interest rates to zero, and purchasing trillions of dollars in bonds along with other central banks. These policies resulted in low borrowing costs across the economy, contributing to excess liquidity and market dislocations we are seeing today. This period (2009-2021) was marked by:

  • Rising stock prices
  • Low price volatility in financial assets
  • Low borrowing costs for risky borrowers
  • Low correlations
  • Rising home prices
  • A steep yield curve
  • Opportunities in less liquid markets

2022 has seen a reversal of these trends. Stocks fell, volatility rose, credit spreads climbed, correlations rose, the yield curve inverted, home prices fell, and areas of low liquidity (in public markets for now) declined more than similar areas with high liquidity.[1] But how bad are things economically? Data on U.S. production, inflation, and employment frame the economic environment.

U.S. Economic Production Outlook

U.S. real Gross Domestic Product (GDP) is at its highest level in history, but the growth rate of GDP has been inconsistent and has slowed over the last several quarters. The COVID-19 pandemic caused a low point in annualized GDP growth (-8.4%), but GDP growth quickly rebounded, to 12.5%. Now, GDP growth rates are positive but have slowed down as consumers, companies, and governments adjust their spending habits to the current economic climate. This includes rising prices, increased unpredictability, and uncertainty about the value of assets.

Chart Three: Real GDP Level, Growth

Source: St. Louis Federal Reserve, Sellwood Consulting.

The Federal Reserve is trying to slow down the economy gradually, but a recession seems likely. A survey by the Conference Board found that most CEOs, regardless of company size, expect a recession within the next 12 to 18 months. This survey reported the lowest levels of CEO confidence since the Great Recession. When asked about expectations for the next 12 to 18 months, 98% of CEOs said they were preparing for a recession in the United States, and 99% of CEOs reported preparing for a recession in Europe.

In response to economic uncertainty, relative U.S. economic strength, and higher cash rates, market participants have pushed the value of the U.S. dollar to multi-decade highs. The dollar is considered a safe haven compared to other currencies, and its strength is not surprising given higher economic growth and higher interest rates in the U.S., compared to the rest of the world. Many analysts predict that the dollar’s strength will decrease in 2023 due to lower expected growth in the U.S., improved growth prospects in other countries, and the Federal Reserve easing its monetary policies, which would reduce dollar support. A declining dollar would act as a tailwind for investments held by U.S. investors denominated in foreign currencies (e.g., international stocks).

Chart Four: Dollar Strength YTD

Source: St. Louis Federal Reserve, Sellwood Consulting.

U.S. Inflation Outlook

“Low and stable inflation in many countries is an important accomplishment that will continue to bring significant benefits.”

-Ben Bernanke, Chairman of the Federal Reserve, 2006-2014, 2022 Nobel Prize in Economics

“Inflation is like toothpaste. Once it’s out, you can hardly get it back in again.”

-Karl Otto Pohl, President of the German Bundesbank, 1980-1991

As noted, the period from 2009-2020 was characterized by disinflation. In 2021 and 2022, inflation by every measure has accelerated. Inflation has trended well above the Federal Reserve’s intended target of 2%, independent of which inflation measure is used. We present Consumer Price Inflation Index (“CPI”), Producer Price Inflation Index (“PPI”), and wage inflation over data over the last ten years in Chart Five below.

Chart Five: Inflation Measures 2001-2021

Source: St. Louis Federal Reserve, Sellwood Consulting.

Inflation – measured by the Consumer Price Index (CPI), Producer Price Index (PPI), or wages, began accelerating in early 2021. We note that each of these inflation measures is showing signs of moderating, suggesting that higher rates are reducing demand.

But why is inflation so high? Inflation at its core is caused by too much money chasing too few goods. Analyzing aggregate demand and supply can provide answers.

In the U.S., aggregate demand is a story of consumer confidence, as consumer spending accounts for approximately 60% of U.S. production. Monetary and fiscal policymakers flooded consumers and businesses with stimulus as COVID-19 lockdowns began.

Over $5 trillion in total stimulus was distributed with individuals and families ($1.8 trillion), and businesses ($1.7 trillion), as the largest beneficiaries. The largest prior fiscal stimulus, enacted by President Obama in 2009, was a paltry $831 billion by comparison. As can be seen in the table below, stimulus payments were approved even after the economy was recovering. The net effect of this was to raise consumer and business spending (demand) substantially.

Table Six: $5 Trillion in COVID Stimulus


On the supply side of the equation, the availability of both goods and services in the economy was impacted by COVID-19 around the globe. Further, as we transitioned to 2022, Russia invaded Ukraine, providing additional inflationary pressures, particularly related to energy and grain prices. As seen in Chart Seven below, inflation was widespread, with categories influenced by commodity prices hit particularly hard over the last year.

Chart Seven: Consumer Price Index Categories in 2022

Source: St. Louis Federal Reserve, Sellwood Consulting. Data reflects 11/30/2021-11/30/2022.

How has the Federal Reserve responded to high inflation? In 2021, the Federal Reserve believed that inflation was “transitory” and would ultimately trend downwards toward long-term policy targets. The Federal Reserve has two “mandates” that it tries to achieve through its monetary policy: maintain a stable level of inflation near 2% and promote maximum employment.

From 2009 to 2020, the Federal Reserve’s dual mandates of promoting low unemployment and maintaining stable prices were aligned due to disinflationary forces. In other words, flooding the market with money, through easing measures, supported both mandates in a disinflationary environment. However, in 2021 the situation changed, with high levels of employment coinciding with high levels of inflation. As a result, the Federal Reserve’s two mandates are no longer aligned, and future policy may require uncomfortable tradeoffs between the Fed’s dual mandates.

In 2021, after a decade of being below it, inflation was rising faster than the Federal Reserve’s 2% target. To try to address this, the Fed implemented a policy known as “tapering,” which reduced its purchases of bonds. At the same time, the Fed sought to avoid causing a recession by carefully balancing the reduction of stimulus with the health of the economy.

Ultimately, the Fed’s efforts to “thread the needle” between controlling inflation and avoiding a recession were not successful, as inflation has remained above target and the economy has suffered. However, monetary policy operates at a significant lag, and as we transitioned to 2022, and interest rates were climbing, it was clear that the Federal Reserve needed to bring down rates. By March of 2022, Jerome Powell took a page out of the Paul Volcker playbook and began raising the federal funds rate rapidly. This is seen in Chart Eight below:

Chart Eight: Powell’s FED Takes a Page Out of the Volcker Playbook

Source: St. Louis Federal Reserve, Sellwood Consulting.

How many additional rate hikes should we expect? History provides a guide (see above), as does economic theory. According to Greg Mankiw, Professor of Economics at Harvard, “The question is, how much monetary tightening is in order? This question is hard, and anyone who claims to know the answer for sure is not being honest either with you or with themselves…The Taylor rule[2] suggests one way to calibrate the problem. This rule of thumb says that the real interest rate needs to rise by 0.5 percentage points for each percentage point increase in inflation. The yield on the 5-year TIPS, which incorporates recent and near-term expected changes in monetary policy, has risen by 330 basis points over the past year[3]. According to the Taylor rule, that would be appropriate if inflation had risen by 6.6 percentage points.”

As noted previously, many inflationary measures have exceeded 6.6%, with only recent inflation data trending downward. These data points argue that the Fed has not tightened enough. Wage inflation, which tends to be stickier, follows a similar trend. Wage inflation peaked in August 2022 at 6.7%, and has now retreated to 6.4%. Continued strength in employment and wage growth contributes to inflationary pressures.

Finally, the market provides its own assessment about the future path of inflation. For this, we look to TIPS breakeven spreads.[4] Using this measure, Fed policy is close to anchoring longer-term inflation expectations at a 2% target. This should help reduce inflation and interest rate uncertainty in 2023. Further, the negative wealth effect from asset price declines in 2022 (stocks, bonds, real estate, and cryptocurrencies, to name a few) should further dampen consumer demand.

Chart Nine: Breakeven Inflation Rates

Source: St. Louis Federal Reserve, Sellwood Consulting.

U.S. Employment

“Unemployment is a side effect of the cure for inflation.”

-Milton Friedman, American Economist, 1976 Nobel Prize in Economics

Chart Ten: U.S. at Full Employment, Average Earnings Strong

Source: St. Louis Federal Reserve, Sellwood

U.S. employment was red hot in 2022 and it continues to look strong. The unemployment rate is low at 3.7%, while average hours and wages continue to increase. The number of current openings at 10.3 million is well above trend, as are voluntary quits at 4 million. These data points paint the picture of a healthy labor market as workers are more willing to quit when jobs are abundant.[5]

Making Sense of Recent Economic Data

Economic forecasts are difficult, and forecasting a recession is no different. On the one hand, most market participants are expecting a recession. On the other hand, the Federal Reserve believes that it can orchestrate a soft landing and avert a recession. The uncertainty surrounding the question has widespread influence across capital markets. Howard Marks of Oaktree Capital captured market sentiment and fundamentals effectively in a recent memo:

Source: Oaktree Capital.

The abrupt rise in interest rates in 2022 took many investors off guard. Rapidly rising rates had a significant impact on markets and contributed to price declines across most asset classes. To avoid another surprise, market sentiment and fundamentals should be carefully evaluated by investors as they navigate the upcoming landscape.

Current economic data are mixed, with some indicators pointing toward positive conditions and others indicating potential challenges. The continued role of inflation, which could impact the effectiveness of bonds as a diversifying investment, remains a primary concern. In the coming months, we will likely see both economic growth uncertainty and inflation uncertainty. This would make it more difficult for bonds to diversify stocks compared to an environment where economic growth uncertainty dominates.

As we begin the year 2023, it is important for investors to consider the impact of changing economic conditions. At the same time, it’s important to keep in mind that much of the available economic data is focused on the short term and may not have a significant impact on long-term investment strategy. Despite all the economic and market uncertainty, one thing we know with certainty is that the future return of any investment depends on the price paid for it. Lower prices today compared to a year ago offer opportunity. In the second part of this report, we will discuss the implications of current market conditions on portfolio design, and evaluate several opportunities that the market is offering as the calendar turns to 2023.



[1] Private investment strategies are less liquid than public investment strategies but have largely not been repriced in the current economic environment. We expect that write-downs in private markets portfolios will lag drawdowns in public market indices.

[2] The Taylor Rule is a monetary policy guideline that is used by central banks to help determine the appropriate level of interest rates. It is named after economist John Taylor, who developed the rule in the early 1990s.

[3] Since this quote was published (10/19/2022) the yield on 5-year TIPS has declined to 232 basis points, implying that rate hikes are lowering forward real interest rate expectations.

[4] The difference in yields between Treasuries and TIPS of the same maturity. This spread is a measure of expected inflation (i.e., inflation that is priced into the market) over the life of the bond.

[5] Source:

Fourth Quarter 2022 Market Snapshot

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Fourth Quarter 2022: What’s Next?

A tepid fourth-quarter rally in both stocks and bonds helped cut losses to close out a frustrating year for investors. For the full year, both global stock and investment-grade bond market indices suffered double-digit losses, as stock/bond diversification failed to meaningfully protect portfolios. A traditionally diversified portfolio of 60% stocks and 40% bonds suffered the fourth worst drawdown in the last century, measured in both real and nominal terms.

After battering markets during much of the calendar year, inflation showed signs that it may in fact have peaked in the fourth quarter. Cooler inflation readings, consumer spending resilience, as well as better-than-expected corporate earnings helped rally shares in the first two months of the quarter before a more worrisome narrative took hold in December to depress the market. Investors, who have now seen the post-COVID enthusiasm fully fade from the markets, have returned their focus to the Federal Reserve, the expected path of future interest rates, and the economic and market implications thereof. The uncertainty surrounding these complex questions has kept markets depressed.

The higher expected returns created by this uncertainty offer opportunity. Just one year ago, with interest rates near their all-time lows and valuation ratios near their highs, investors were left with a menu of unattractive opportunities. Investment options now are much more normalized. Interest rates sit near their 25-year averages, and stocks are priced by various metrics near their 25-year medians. With both stocks and bonds again offering reasonable future returns, we believe that the “T.I.N.A.” (there is no alternative) market that helped create SPAC, meme stock, and cryptocurrency mania has ended. While nobody knows what comes next, we are comforted that valuations offer more compensation for the uncertainty today.

Happy Holidays

In the spirit of the Holiday Season, Sellwood has made a financial contribution to the Community Transitional School, a non-profit organization that provides homeless and transient children with a stable educational environment that promotes their academic and personal growth.

Our company also recently volunteered at the Children’s Book Bank, preparing children’s books to be delivered to kids in the community.

We wish you a wonderful holiday season and look forward to seeing you in the new year.

Celebrating a Decade of Small Batch Portfolios

Ten years ago, Sellwood’s four founders opened the firm’s doors in a little office in Portland. At the time, we had no clients, no track record, and no assets to advise. But what we lacked in resources, we made up for in a strong vision for a different type of institutional advisory firm.

Sellwood was based on just a few, simple, straightforward founding values. We wanted to work:

  • In a stable firm,
  • With people we like and respect,
  • Serving clients we can impact
  • Expertly and thoughtfully,
  • Without any conflicts of interest,
  • Profitably.

We believed that institutional investment advice did not need to come out of an “institution.” We believed that clients would benefit from stable, long-term relationships with highly experienced professionals who knew them best, rather than the industry’s prevailing model of a rotating cast of advisory characters and a huge support staff behind the scenes. We rejected the concept of model portfolios, believing instead that the best way we can celebrate what makes every client unique is by creating their own unique portfolio for them, tailored to their own needs, risks, and objectives. We believed that scale was the enemy, not the goal. High-quality customized advice does not scale.

It is rewarding that our firm has grown in every single year of the last ten. It is satisfying to know that the $8 billion of client assets we advise places us among the largest investment advisors in the country, measured that way. Developing our professional team, with minimal turnover, has been incredibly gratifying. It means a lot to us that we did it all while remaining 100% independent and employee owned.

But looking back over the last decade, what we are proudest of is that those founding values remain true today. This founding philosophy worked for ten years, and it is our sincere belief it will work for the next ten.

Some things get better with age. Sellwood’s four founders remain actively employed here, and Sellwood enjoys stability – both in employees and in our roster of clients – that is the envy of our industry. For long-term investments to succeed, long-term relationships need to be there first.

Today, our four founders are fortunate to be part of a 15-person professional team that includes seven employee shareholders. All of these people have adopted Sellwood’s founding values as their own. We are also incredibly grateful to our clients, who have placed their longstanding trust in Sellwood’s different advisory approach.

As we mark this milestone for Sellwood, we raise our glasses to those clients, our employees, and everyone in the community who has helped us in one way or another. Thank you, sincerely.

With pride but even more gratitude:

To the next decade. Cheers.

Charlie, Kevin, Ashlee, Ryan, Nick, Ruthie, & Ryan

Sellwood’s Employee Shareholders

Good and Bad Benchmarks

On the Governance Functions of Proper Benchmarking

A portfolio’s benchmark is a tool that helps a client (asset owner) perform the essential governance function of monitoring the management of its portfolio. While a good benchmark will make this governance function easier, a bad benchmark will make it more difficult.

This paper explains what a “good benchmark” is. Like portfolios, benchmarks are highly personal, and one size rarely fits all. When every portfolio implementation and governance structure is different, a “good benchmark” for one client may be a “bad” one for another. Understanding what makes a “good benchmark” is essential for asset owners – especially those who delegate the implementation of their investment policy.

There are many different ways of constructing benchmarks, and they all purport to answer slightly different questions. We suggest that when a client has delegated implementation of its investment policy to another party like an advisor, the most important question a benchmark can answer is how well the client’s investment policy is being implemented. In that scenario, only one benchmark design accomplishes the task.

Defining Roles

Every client and portfolio has two essential elements or roles: an owner of the investment policy, and an implementer of the investment policy. The party that has responsibility for these two roles can be different, depending on the investment oversight and governance structure chosen by the asset owner:

  1. The Non-Discretionary Model. An asset owner (client) can retain responsibility for both investment policy and implementation of the policy. This is the case when the client manages its own portfolio – implements its own policy – or hires an advisor to help it do so in a non-discretionary capacity. As an advisor, we call this the “Non-Discretionary Model,” but its logic applies equally to clients who do not employ an advisor at all. Responsibility for both investment policy and implementation of the policy reside with the client.
  1. The Discretionary Model. The client can retain responsibility for policy, and delegate responsibility for the implementation of policy. This is the case when the client hires a discretionary investment advisor or Outsourced Chief Investment Officer (OCIO) to manage the portfolio. In this model, it is the client’s responsibility to articulate investment policy, and the advisor’s responsibility to implement that policy with a portfolio.
  1. The Hybrid Model. The client can retain responsibility for policy, and partially delegate responsibility for implementation of policy. This is the case for a client who delegates, for example, responsibility for trading and rebalancing but not manager selection to its advisor.
  1. The Pooled Model. The client can outsource both policy and implementation of the policy. This is the case when the client joins a “pooled” investment structure alongside other similar investors, like a community foundation. This is the only scenario where the client outsources its investment policy to a third party; the only element of policy that the client retains is the selection of the pooled investment.

Every institutional portfolio we have seen follows one of these governance and oversight structures. The choice of an optimal benchmark depends on what question the benchmark purports to answer – and the answer may be different based on each of these models.

What Different Types of Benchmarks Exist?

A portfolio’s benchmark consists of two essential elements: the indexes represented, and the weights applied to those indexes. We have seen several styles of benchmarks that vary based on these two variables.

So-called “Actual Allocation” benchmarks typically combine the benchmarks of each of the underlying investment managers in the portfolio, at weightings that float based on each manager’s actual moving proportion of the portfolio. This type of benchmark can be calculated entirely without reference to investment policy or the Investment Policy Statement (IPS) – the only inputs to its calculation are from the actual portfolio itself.

This type of benchmark does a great job of helping a client evaluate the implementer’s manager selection decisions, at the exclusion of all other variables that would determine the portfolio’s return. Especially for clients who have adopted the Non-Discretionary Model, this can be a question worth answering. But because it does not reference the Investment Policy, an Actual Allocation benchmark does a poor job answering the main question of how well the client’s Policy was implemented, in total. Constructing a total portfolio’s benchmark using the underlying benchmarks of the funds or managers in the portfolio implies that the total portfolio’s benchmark will change when the underlying funds do. This only makes sense to the extent that manager selection is thought of as “policy,” not “implementation of policy” – as it sometimes can be, in the Non-Discretionary model, where these decisions are not delegated.

“Target Allocation” benchmarks combine benchmarks representing the asset classes represented in the client’s Investment Policy Statement, weighted by fixed weightings expressed in that document’s strategic target asset allocation. This method measures the translation of Investment Policy to the implementation of the actual portfolio in its totality. It captures asset allocation differences relative to the strategic target, rebalancing decisions, manager selection, implementation frictions, and everything else. Unlike an Actual Allocation benchmark, it is not possible to calculate this type of benchmark without the Investment Policy (Statement).

What Question is the Benchmark Answering?

As a client outsources more responsibilities to a third party, we suggest both that benchmarking becomes more important, and that the range of acceptable benchmark methodologies narrows considerably. Let us consider the Non-Discretionary and Discretionary models above, as bookends of the discretion spectrum, in terms of what benchmarks are appropriate:

  1. The Non-Discretionary Model. In this governance structure, nothing is delegated, and the client is benchmarking itself. The client may be interested in its manager selection ability, to the exclusion of its asset allocation decisions. It may be interested in evaluating implementation except for the “frictions” (e.g., time out of market) that can arise from implementing illiquid investments. Or it may be interested in how well it has implemented its own investment policy, in totality. A variety of appropriate benchmarking approaches exist here, depending on what questions clients seek to answer with them. Both benchmarks that reference the Investment Policy and those that do not may be appropriate in this context.
  2. The Discretionary Model. In this structure, the client has hired a third party to implement its investment policy. In a Discretionary Model process, there is a “handoff” of responsibilities from the client (owner of investment policy) to the implementer of the portfolio (the advisor) – the benchmark’s job is to continuously examine the efficacy of that handoff. We suggest that how well the investment policy has been implemented, in its totality, is the most essential and relevant question that a benchmark can answer for the client. Only benchmarks that reference the Investment Policy are appropriate in this context.

Because clients have a greater need to oversee (benchmark) third-party implementers of their investment policies than themselves, the rest of this paper will explore optimal benchmarking for the Discretionary Model. – e.g., when clients have retained responsibility for investment policy, but delegated the implementation of that policy to a third-party advisor or OCIO.

What a Benchmark Measures, and Doesn’t Measure, in the Discretionary (OCIO) Model

When clients entrust Sellwood with the responsibility of managing their portfolios, it is generally under the “Discretionary Model” outlined above, where the client retains responsibility for investment policy but delegates implementation of that policy to Sellwood. We implement portfolios for clients using the following framework:

  1. We first assess the client’s unique objectives and constraints. We want to understand what the client is trying to accomplish with their investment portfolio, and what specific relevant risks they face in doing so. We document these objectives and constraints in the client’s uniquely personalized Investment Policy Statement.
  2. We work with the client to design a customized strategic policy portfolio that best addresses the client’s unique needs, objectives, risk tolerance, and constraints. We help the client document this strategic policy (target) portfolio in the Investment Policy Statement. While we help the client with this document, proper governance dictates that the client always must be in full control of it. The advisor should never have permission to modify the client’s Investment Policy Statement. It documents essential direction from the client to the advisor.
  3. Then we implement a portfolio for the client, consistent with their Investment Policy Statement.

The process flows from the client’s real-world circumstances, to Investment Policy, to portfolio. From a broader governance perspective, the process flows from “things the client is responsible for” to “things the advisor is responsible for”:

The client is responsible for investment policy; the advisor is responsible for implementing investment policy. A properly constructed benchmark critically examines the link between client responsibility and advisor responsibility – it evaluates, and measures the ongoing efficacy of, the handoff of responsibility from client to advisor, or the translation of “investment policy” to “implementation of investment policy.”

In simpler terms, when a client has delegated implementation of its investment policy, the purpose of a portfolio’s benchmark is to measure how well the client’s Investment Policy has been implemented.

Knowing the benchmark’s purpose, we can then construct the benchmark to suit that purpose.

A “Good Benchmark” for a Discretionary Advisor

While there are many ways to construct a total portfolio’s benchmark, only one method truly measures how well investment policy has been implemented – a total portfolio benchmark that implements the strategic target portfolio articulated in the Investment Policy Statement, in the most straightforward and lowest-cost way possible. This benchmark will be calculated using fixed, strategic target portfolio weights, and reasonable, investable index proxies for each asset category in the strategic target. There should be an intimate, unbroken link between the client’s investment policy and the advisor’s benchmark. The benchmark should flow directly from the policy. It should not be possible to calculate this benchmark without reference to the policy.

A sample benchmark that fits this framework would be as follows:

Strategic Policy Target in Client’s Investment Policy Statement

Benchmark Calculation

40% US Equity 40% Russell 3000 Index
20% International Equity 20% MSCI ACWI ex US Index
30% Investment-Grade Fixed Income 30% Bloomberg US Aggregate Bond Index
10% Public Real Estate 10% NAREIT Equity Index

Note that the benchmark’s calculation percentages match the Investment Policy Statement’s strategic target weights, and the benchmarks are good representatives of each broad asset class being strategically allocated to. The intimate link between the client’s IPS and the portfolio’s benchmark is preserved with this calculation methodology. The benchmark represents the policy and therefore the client’s objectives.

We have sometimes seen more granular strategic benchmarks, both in the Strategic Policy Target documented in the IPS and the benchmark that flows from it (for example, 30% large-cap US equity and 10% small-cap US equity, rather than 40% US equity). We suggest that the proper framing for this decision is whether the allocation is truly a “policy” allocation. If the policy decision is to have 40% of the portfolio in US equity, then the benchmark should represent that decision. If the policy decision is to have a 30%/10% mix of large- and small-cap US equities, then both the IPS policy target and the benchmark should reflect that objective. On the other hand, if the large/small-cap portfolio mix is an implementation decision rather than a policy, then it should not be captured in the benchmark. It should be expressed instead as performance differences between the portfolio and the policy benchmark.

If the goal is to assess a discretionary advisor’s implementation of a client’s investment policy, a portfolio’s benchmark should match the simplest-possible implementation of the Investment Policy’s strategic target. It is possible to make a benchmark more complicated than this, but not possible to make it better.

Benchmarking Cannot Be Delegated

It is important that the construction of the benchmark not be delegated to the advisor. While a good advisor will always assist the client in drafting the client’s Investment Policy Statement, it is essential that the client retain control of the document. A well-constructed Investment Policy Statement will give the advisor clear direction on what tools it can use to design the portfolio, and in what proportions. It will also express a clear benchmark, which is an important yardstick for measuring the advisor’s performance in implementing the Policy.

We have seen many Investment Policy Statements that do not state what the portfolio’s benchmark is, but instead offer a loose description of what types of benchmarks may be acceptable. This invites bad benchmarking, not to mention sloppy governance. Asking the advisor (implementer of investment policy) to design their own benchmark is like asking a student to write and grade their own spelling test. This is why we insist that the Investment Policy Statement, which is always controlled by the client, clearly articulate the portfolio’s benchmark. This is not to say that a good advisor shouldn’t assist a client with drafting their IPS; only to say that control over – responsibility for – the document should always rest with the client.

Benchmarks should err on the side of simplicity in their construction. They need to be well understood by both the client and the implementer of their portfolio. A good benchmark is so clearly articulated in the Investment Policy that a reader could calculate the benchmark return by hand (with available index data).

What Does Success Look Like?

With a good benchmark in place, the portfolio’s results have a reference point for comparison. Then a framework for evaluating the portfolio, and the implementer of the portfolio, can be introduced.

To be clear: a target-weighted, strategic policy benchmark constructed as outlined above will represent a very good portfolio — a portfolio that will satisfy the client’s objectives all by itself. It should be a very difficult benchmark to beat, but beating it should not necessarily be the objective.

If the purpose of the portfolio is to meet the client’s objectives, then a portfolio that matches the return of the (properly constructed) benchmark, net of investment fees, is a success. Evaluating a customized portfolio is a different exercise from evaluating an active manager. Unlike the case of an active investment manager, where we are seeking a higher return than a benchmark in exchange for a higher-than-benchmark fee, a good advisor or OCIO should be designing a portfolio that prioritizes reliable delivery of the client’s specific objectives. While delivering a higher return than the objectives (expressed in the benchmark) can be rewarding, doing so isn’t typically the point, and pursuit of higher return introduces perverse incentives for a portfolio that strays from its intended purpose and introduces unwelcome risks to the portfolio. When we sit down with clients and help them frame their goals for the portfolio, excess return is rarely one of those goals. Delivery of their unique objectives always is.

It is also important to align evaluation horizon with the investment horizon. We typically design long-term portfolios for long-term investors. Judging a portfolio’s return versus a benchmark on anything less than a multi-year horizon, ideally on a rolling basis, is likely to be counterproductive.

Best Practices

Every client, portfolio, IPS, and governance structure are a little different – but the principles of benchmark design apply equally to all. We see the following as best practices:

  • The client (asset owner), not the implementer of policy, must control the benchmark. Having the total portfolio’s benchmark calculation methodology very clearly articulated in the IPS accomplishes this. The calculation methodology should be so clear that any third party should be able to calculate the benchmark return using nothing more than the IPS, independent index return information, and a hand calculator.
  • When a client has chosen to hire a third party to implement their Investment Policy (e.g., an advisor with investment discretion), then it is essential to construct the total portfolio benchmark using the indexes and fixed policy weights articulated in the client’s Investment Policy Statement. The purpose of the portfolio benchmark should be to help the client evaluate implementation of their Investment Policy, not just the performance of a portfolio in the abstract. Insisting on this methodology best preserves the essential link between Investment Policy and implementation of that Policy.
  • If other benchmark methods are used, the client should have a clear understanding of specifically what those benchmarks are capturing, and what they are leaving out – and ideally select benchmarks that most appropriately answer their essential questions. For example, an “Actual Allocation” index, based on actual manager benchmarks at their actual, real-time weightings, will measure only the aggregated performance of those managers, and never the effects of asset allocation differences relative to a target, gaps left in structure due to manager selection, the overall design of manager structures within each asset class, the benefits or costs of rebalancing, implementation frictions, etc.
  • When in doubt, a “Target Allocation” benchmark, using fixed weights and indexes from the IPS, is a good choice for any governance model. It is the utility player of portfolio benchmarks.


What is the purpose of a benchmark? Different governance structures imply different questions that a benchmark may answer. What party is being evaluated? For what tasks and responsibilities? Are there principal/agent problems that a benchmark can address – or a lack thereof that a benchmark should not?

When an asset owner has delegated responsibility for managing a portfolio (implementing policy), we believe that a portfolio benchmark’s primary purpose is to assess how well the advisor is implementing the Investment Policy. There should be an intimate, unbreakable relationship between the client’s Investment Policy and the portfolio’s benchmark. The benchmark should always come directly from the Investment Policy Statement, and it should not be possible to calculate a benchmark without reference to the Investment Policy Statement. Exceptions to this rule should be very rare and thoughtfully considered.

Contemplating benchmark construction can often feel technical, and asset owners may be tempted to outsource the decision to the “experts.” But it really is essential for the asset owner to retain full control and understanding of their portfolio’s benchmark, lest allowing the portfolio’s implementer to grade their own spelling test, so to speak. If the primary purpose of a benchmark is to provide a governance mechanism, then determining the benchmark must remain the client’s responsibility. (A good advisor will always still assist the client in discharging this responsibility.)

Benchmarking a total portfolio is an essential governance function for any asset owner, and the most appropriate benchmark for any portfolio reflects the governance relationship between the client, who is responsible for Investment Policy, and the implementer of that Investment Policy (most typically, an outside hired advisor). Proper benchmark design can solve principal/agent problems between these two parties, but improper benchmark design can introduce them.

*   *   *   *   *

Appendix: What About Illiquid Investments?

Some portfolios contain illiquid investments, and it can be tempting to design a total portfolio benchmark differently to account for this illiquidity. Whether the benchmark should change (away from the optimal framework articulated above) depends on who controls the timing of the cash flows into and out of these investments.

Open-ended (sometimes called “core”) private real estate funds are a good example of an investment where we would not advocate changing the benchmark to account for illiquidity, as tempting as it can be to do so. Private real estate funds typically offer quarterly liquidity, and sometimes investors must enter a queue to either enter or exit the fund. These practical constraints make it difficult to maintain consistent targeted exposure to the asset class, especially when transitioning between funds; it is not unusual to sit “out of the market” for a quarter or two, if the timing of one fund’s redemption doesn’t perfectly align with another fund’s entry.

We have seen some investors prefer to calculate an “actual allocation” benchmark for their portfolio to account for this logistical difficulty. Under this method of creating a total portfolio benchmark, the underlying indexes are weighted using their actual weights at any point in time, rather than using the strategic target weights from the Investment Policy. The effect of this calculation is to have the benchmark unallocated to private real estate while the portfolio is.

This benchmarking approach does not measure the efficacy of the portfolio’s implementation of Investment Policy. The Policy calls for consistent exposure to real estate, or at least for returns that are comparable to consistent exposure to real estate — high enough to overcome the logistical drag inherent in choosing to employ private real estate funds. Imposing that logistical drag on the benchmark as well as the portfolio inappropriately breaks the link between Policy and implementation. In our example of private real estate funds, the portfolio implementer chose to implement the client’s investment policy in a logistically challenging way. The drag arising from that logistical challenge should be expressed in return deviation from benchmark just as much as the higher return associated with selecting a superior fund would.

At the same time, there are some illiquid investments, like private equity, where the logistics are entirely out of the client’s or the portfolio manager’s hands, because the very nature of the investment involves cash flows whose timing is directed by the fund manager, not by the client or their advisor. For portfolios with private markets investments like these, we work with clients to design their Investment Policies to acknowledge this limitation and identify the placeholder location for the assets ultimately designated for private markets, elsewhere in the client’s portfolio. Knowing this information, we can design a total portfolio benchmark that still expresses the client’s Investment Policy with high fidelity. The link between Policy and benchmarking remains unbroken.

2022 Capital Market Assumptions

Note: These assumptions are now outdated. Our current capital market assumptions and our white paper documenting their construction can always be found on our Capital Market Assumptions page.

Sellwood’s 2022 Capital Market Assumptions portray a more optimistic environment for most asset classes, compared to a year ago.

Investor expectations for inflation are a core building block for both market prices and their prospects for future return. Rising inflation expectations contributed to an increase in our return expectations for most asset classes. Importantly, our assumptions are nominal in nature, so our higher forecasted returns do not necessarily imply higher purchasing power in the future.

Rising inflation expectations pulled fixed income yields higher over the course of 2021. Across the full Treasury yield curve, nominal interest rates for default-free Treasury assets rose by an average of 0.53%. Yields for bonds with modest credit risk rose by a bit more than that as spreads widened. Our forecasts for fixed income return have risen by approximately 0.30%-0.70%, consistent with the slightly higher expected returns offered by markets at the beginning of this year, compared to a year prior.

Equities are more challenging to forecast, and therefore have a wider assumed distribution of outcomes. Our forecasts for stock markets also rose, but by a smaller amount – approximately 0.15%-0.25% per year. This modest increase reflects our expectation that companies benefit, in nominal terms, from higher inflation. Our US equity assumption rose by a bit more than our non-US equity assumption did, partially reflecting that 2021’s performance for the US stock market, while extraordinary, underperformed corporate earnings performance, which was even more extraordinary.

Diversifiers mostly saw increased returns as well, reflecting their partial sensitivity to stock and bond markets. The only exception is real estate: very high recent returns have collapsed REIT yields (cap rates) to historic lows, reducing their expected return.

Sellwood Joins Institutional Investing Diversity Cooperative

For a long time, a lack of good data has prevented diverse investment managers from being hired by institutional clients. That’s about to change, due to the efforts of the Institutional Investing Diversity Cooperative, which Sellwood recently joined.

Members of the Cooperative believe that diverse investment teams make better investment decisions, and that including more women and people of color in asset management roles improves portfolios and our greater community.

As a starting point, members of the Cooperative have partnered with eVestment, the industry’s leading investment manager database, to demand greater transparency regarding the diversity within the asset management firms we research and recommend. We expect further partnerships in the future.

Better data is only the first step, but it is a good start.

Several databases of investment manager information are available to institutional consultants. We have written that the amount of investment manager data available for us to review is so vast that it is almost beyond comprehension – thousands of data elements, times tens of thousands of managers. But there is one place where data is sorely lacking – data regarding ethnic and gender diversity of the teams of people who directly manage our clients’ money. Most databases include a field for the gender or ethnicity of the firm’s owner, but not much else. While we care about who owns every investment management firm that we research on behalf of clients, we care just as much about the teams of people who actually manage clients’ assets.

The limited availability of data regarding investment manager diversity is why our industry generates so many searches for “woman-owned” or “minority-owned” investment firms. Using existing databases, a consultant can screen on those ownership fields. But there simply isn’t robust and reliable data to screen for what we and clients care about just as much – the diversity of the team directly responsible for managing the client’s money, as opposed to the recipient of the firm’s profits. Both are important, and we have data on only one.

Why has this diversity data been limited? Because historically, nobody has demanded better data. The Institutional Investing Diversity Cooperative is changing that. The Cooperative now includes 22 investment consulting firms, advising more than $32 trillion of institutional assets, a coalition of institutional asset advisors that will be difficult for investment management firms to ignore. Together, we demand the tools and transparency to better evaluate the diversity of our clients’ money managers. With more robust data, we can do a better job of including more diverse teams in client portfolios.

What doesn’t get measured doesn’t get done. Measurement isn’t everything, but it’s the necessary first step.