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Second Quarter 2022 Market Snapshot

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Second Quarter 2022: Nowhere to Run – Nowhere to Hide

Major U.S. and global equity indices have shed almost a fifth of their value in the first half of 2022, the third-worst start to the year in the last century for U.S. stocks. Bonds, which have typically acted as a ballast in past selloffs, are off to their worst start to the year on record, with investment-grade debt down 11% over the first six months, as measured by the Bloomberg Aggregate.

Those looking for a culprit for the significant selloff in both stocks and bonds do not need to look much further than inflation. Inflation, which is running at its highest level in 40 years, has been much less “transitory” than forecasted. Pent-up demand from the pandemic fueled by record monetary & fiscal stimulus collided with supply-chain issues, and a surge in domestic energy prices that has now been sustained by Russia’s invasion of Ukraine. Resolution of the supply side of the mismatch depends on the return of normal supply chains, with semi-conductor and oil production of particular importance.

Absent the ability to fix the supply side of the equation, inflation’s persistence has forced a hawkish shift from the Federal Reserve to constrain demand. The FOMC is now projecting raising the federal funds rate above 3.4% in 2022, a far cry from the singular 0.25% hike the FOMC had foreseen as necessary to curtail inflation in their September 2021 projection materials. The swift shift in policy tightening has directly impacted the real estate market as mortgage rates have nearly doubled from 3% to almost 6% over the last year. Federal Reserve Chairman Jerome Powell noted that homebuyers “need a bit of reset” until supply can catch up to demand.

The big question in the second half of the year is if the central bank can engineer a “soft landing” for the U.S. economy where inflation comes down without provoking a recession. Powell himself has said there are no guarantees, but he remains upbeat given the relative health of businesses and the strength of the labor market.

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 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 an actual 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 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 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 is sometimes the case in the Non-Discretionary model.

“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.

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 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 strategic. If the strategic policy decision is to have 40% of the portfolio in US equity, then the benchmark should represent that decision. If the strategic 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 strategic policy, then it should not be captured in the 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 is lazy and invites bad benchmarking. 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 and independent index return information.
  • 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 strategic 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.

Conclusions

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, and it should not be possible to calculate a benchmark without reference to the Investment Policy. Exceptions to this rule should be rare and thoughtful.

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 control and full 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.

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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.

First Quarter 2022 Market Snapshot

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First Quarter 2022: Rising Prices, Rising Rates, Rising Tensions

The stock market’s mild single-digit dip in the first quarter concealed wide swings in bond and commodity markets as investors dealt with the highest inflation readings in 40 years, Russia’s invasion of Ukraine, and a tightening Federal Reserve that increased their number of projected rate hikes for 2022.

After reaching all-time highs in late 2021, equity markets were already reaching correction territory in early 2022 before the Ukrainian invasion pushed equity markets lower and commodity prices sharply higher. Supply chains, already stretched from the impact of the pandemic, took another blow as crude oil prices rose briefly above $120 a barrel. Other commodities were also impacted. With almost a third of the world’s wheat supply coming directly from Russia and Ukraine, prices per bushel doubled in early March before retreating slightly to end the quarter.

The large jump in commodity prices presents another headache for the Federal Reserve, which hiked interest rates for the first time since 2018 and has managed expectations for future hikes upward as inflation has remained persistently elevated. Expectations for higher rates sooner pushed bond yields higher and prices lower, leading to the worst quarter for investment-grade bonds in more than 40 years. The Bloomberg Aggregate, which measures investment-grade US debt, was down 6% in the first quarter while the Bloomberg Long-Term Treasury index was down almost 11%. Correspondingly, mortgage rates surged to the highest level since 2018.

What had been a double-digit loss for world equity markets midway through the quarter turned into a single-digit one as investors piled back into stocks, as well as more speculative bets, late in March to help cut losses. Energy shares were the main source of strength for the quarter, while investors with a value style tilt to their equity investments were also partially protected.

2022 Capital Market Assumptions

 Download our 2022 Capital Market Assumptions White Paper.

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.

Fourth Quarter 2021 Market Snapshot

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Fourth Quarter 2021: There Is No Alternative

Global markets shrugged off supply-chain issues, various Covid-19 variants, and higher inflation in the fourth quarter to finish positive for the year, as the bull market that started in the spring of 2020 rolled on. Large-capitalization U.S. stocks continued their dominance as the S&P 500 ticked off 70 all-time highs, the second most highs ever recorded in a single calendar year. Exceptionally strong earnings and record-high profit margins were some of the catalysts for the stock market performance. Another driver can be summed up by the acronym “TINA” – There Is No Alternative. Investors, unexcited by low and rising fixed income yields, have shunned bonds and poured money into equity funds at record levels.

Supply-chain issues wreaked havoc on the world economy as consumers, flush with cash from record stimulus, shifted spending into consumer goods and away from in-person services. The subsequent inflation, initially contained in supply-constrained industries, has now extended to the broader economy. The resulting consumer price increases, the largest in three decades, forced Federal Reserve Chair Powell to ditch the at-best confusing “transitory” tag during his December testimony to Congress. Chair Powell also announced that the Federal Reserve is increasing the pace of bond tapering, paving the way for interest rate hikes as early as spring 2022. With inflation well above target and the unemployment rate at 4.2% in November, the path to rate raises would seem clear – but Chair Powell cited the Omicron variant and millions of U.S. adults that haven’t returned to the labor force as potential challenges for the economy in 2022.

Outside of the US, developed markets were more muted than U.S. indices but they did see double-digit returns for the year. Emerging markets, weighed down heavily by Covid-19 related closures, global supply chain disruptions, and real estate weakness in China, finished down for the year.

Third Quarter 2021 Market Snapshot

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Third Quarter 2021: Dollar Tree Breaks the Buck

After a strong start to the first half of the year, investors turned cautious during the summer as supply constraints, inflation, and the Delta variant impacted global markets. Global equities ended the quarter in roughly the same place they began, but the surface-level stillness hid the churn underneath as large-cap US stocks were once again in favor over small-cap and international shares.

The Delta variant of Covid-19 appeared to soften US economic growth this summer as consumers spent less on meals out, hotels, and airline tickets. What was predicted to be a September boom as offices and schools reopened turned into a muddled mess that looks unlikely to be resolved anytime soon. Demand, which has been buoyed by the enormous fiscal injections over the past 18 months, has remained elevated. Consumers, who have amassed higher savings than any time in recent history, have shifted their spending from services and into consumer goods. The newly purchased goods, however, still need to be manufactured and shipped; a process that has been increasingly difficult as product delays, worker shortages, and sky-high shipping costs hamper all parts of the supply chain. With all the logistical difficulties, even discount retailer Dollar Tree was forced to raise prices above their namesake $1 price point.

How quickly the world can sort out its supply-chain bottlenecks will likely go a long way toward determining whether the higher rates of inflation will be permanent. Federal Reserve Chair Jerome Powell, for his part, has remained steadfast that the higher rate of inflation is “transitory” and in his view, likely to return to normal at some point in 2022. One group that has already returned to normal is Congress, as they once again have begun inter- and intra-party squabbling on yet another contentious vote to lift the debt ceiling. So far, the markets have met the potential technical US default with a collective shrug. Interest rates bounced around before ticking up at the end of the quarter but even still, they hover near historic lows. Bond returns, like equity returns, were roughly flat for the quarter.

Second Quarter 2021 Market Snapshot

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Second Quarter 2021: Inflation, So Hot Right Now

The word of the quarter was “transitory” as investors tried to decipher the root cause behind the highest inflation readings in decades. Despite some dire predictions about the return of stagflation and a 5.0% annualized inflation increase in May, the verdict of the market suggested that inflation may just be transitory. Interest rates and inflation expectations decreased and bonds, which had sold off in the first quarter, rallied back with longer-duration assets gaining the most.

The interest rate decrease in part stemmed from mixed messaging from the Federal Reserve. The Fed, which is now using a new flexible average inflation targeting framework, is trying to strike the right balance of monetary support for the recovering economy while avoiding a repeat of the 2013 taper tantrum, which undermined market stability. Market participants, interpreting updated Federal Open Market Committee projections, expressed some skepticism of the Federal Reserve’s tolerance for future higher inflation.

Meanwhile, even with consumers expecting higher inflation in the coming year, U.S. consumer confidence soared to a fresh pandemic high. The proportion of consumers planning to purchase homes, automobiles, and major appliances all rose in the quarter, which should provide support for the economy in the near term. Home sales have slowed as prices have risen in the year, with the S&P CoreLogic Case-Shiller residential home price index jumping the most in more than three decades. On the employment front, the share of consumers that said jobs are plentiful increased to a 21-year high, and respondents who said jobs were plentiful exceeded the share of those who said they were hard to get by the most since 2000.

The optimistic expectations provided a supportive backdrop for stocks, as virtually all sectors and regions gained in the quarter. The S&P 500 and NASDAQ hit all-time highs and growth shares were the market leaders in the quarter after lagging earlier in the year.

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.

First Quarter 2021 Market Snapshot

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First Quarter 2021: Does the Game Have to Stop?

A bland return of 1.4% for a global 60/40 portfolio hid significant churn beneath the surface in the first quarter. Investors turned their attention from work-from-home companies that had soared in 2020 and rotated to shares of companies ready for the re-opening economy. Value-oriented, small-cap, and energy-related investments were particularly strong during the first quarter of 2021. The overall result was a choppy market with elevated volatility.

The retail investing wave that had been building for years broke into the mainstream in January. Aided by easy-to-use online brokers, retail investors, who loosely organized themselves on raucous online forums, helped enact an unprecedented “social squeeze” on the heavily-shorted stock of brick-and-mortar video game retailer GameStop. The investment excitement spilled into other millennial, nostalgia-inducing companies as investors bid up the price of companies like AMC Theaters and BlackBerry to gaudy levels. The rise in share price was short-lived for most, but GameStop rallied again in March, suggesting that there could be more to come from the online retail investing crowd.

The runoff election in Georgia was an inflection point for US Treasurys as yields bounced higher on the promise of additional fiscal stimulus coming from newly elected President Biden and the new Democrat-controlled Senate. Time will tell how much of the recent jump in bond yields is here to stay, but the rise in rates did push the Bloomberg Barclays Aggregate down 3.4% in the first quarter. Bonds with significant duration were hit particularly hard, with the Bloomberg Barclays US Long-Term Treasury Index down 13.5%, after rallying 17.7% in 2020.

2021 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 Consulting’s 2021 Capital Market Assumptions contemplate a prospective lower-return environment, caused by last year’s declining yields and expanded valuations.

These 10-year, forward-looking assumptions of asset class return, risk, and correlation are the key input variables for our asset allocation work on behalf of clients.

As a result of these updates, our 2021 forecasted “capital markets line,” depicting opportunities for investment return at varying levels of risk, has shifted downward and steepened. With last year’s unexpected collapse in short-term interest rates, return prospects for safe assets like cash declined substantially, while return prospects for riskier assets like stocks declined by a lesser amount. Our assumptions heavily depend on current market conditions, and low market yields simply don’t offer much in terms of future return. The dotted line represents the capital markets line implied by last year’s assumptions; the solid tan line is this year’s:

An Incredibly Challenging Time to Allocate

The changing shape of the capital markets line paints a frustrating picture for investors with return requirements north of zero. Whereas in the recent past, a 5% return could have been reasonably expected with a balanced portfolio of stocks and bonds, today the landscape is very different. As of the end of the year, cash and high-quality (safe) bonds yielded somewhere between about zero and one percent, and these low yields have pushed valuations for stocks upward, depressing their prospects for future return.

A portfolio that requires a 5% return, today, cannot allocate much of that portfolio to cash or high-quality bonds. A 5% return requirement therefore requires the assumption of a much more volatile portfolio than it did even a few years ago — and specifically, the assumption of much more equity risk, at a time when equity valuations are elevated. Alternatively, maintaining a balanced level of risk implies accepting the likelihood of a lower level of return.

What used to be a reasonable return expectation (5%) for a balanced-risk portfolio is today an unreasonable expectation at the same level of risk. Or alternatively: what used to be an unreasonable level of risk is what is now required to expect the same return.

Diversification helps, and not every market is as challenged in prospective return as US stocks and high-quality bonds. Many assets improve portfolios not so much via expected risk and return as with imperfect correlations of return, which reduces overall portfolio risk. Creativity can go a long way — but the table is set, and it is set for lower returns than we have seen over the last decade.