It’s an understatement to say that much has happened recently in the capital markets and in areas that impact the capital markets. There are a few topics in particular that continue to come up so let me quickly address them in case you are one of those who have wondered similar things but have not gotten around to asking yet.
1. Will the effect of FinReg on Frontier Advisors be positive, negative, or neutral?
To the extent the financial regulation legislation solves some of the larger problems with financial sector culpability, excessive risk-taking, and a lack of proper regulatory oversight, the effect will be positive for anyone touched by the capital markets, which means everyone. Unfortunately, there is far too much yet to be determined given FinReg’s vagueness for me to be confident that it will, in fact, solve those larger problems. If pressed, my sense is that we are in for additional difficulties as we try to deal with specific issues under this legislation, but we’ll have to wait and see. As for some of the attempted provisions such as the Volcker Rule (restricting banks from speculative investing in their proprietary accounts), increasing transparency within hedge funds and the trading of certain derivatives, and requiring that all financial advisors operate under a fiduciary standard, Frontier Advisors welcomes each of those ideas because they support what we as a firm are all about – reducing systemic risk in the global financial commons, increasing transparency whenever and wherever possible, and ensuring that the incentives of asset managers are aligned 100% with their clients. Systemic risk is beyond our purview, but with respect to transparency and client alignment, Frontier receives top marks on both counts and it’s time for the rest of the industry to move in that direction.
2. It has been reported that the Flash Crash of May 6 hit exchange traded funds (ETFs) particularly hard. Given that Frontier is an advocate and heavy user of ETFs in client portfolios, did its clients suffer excessively and what has Frontier done to avoid another Flash Crash?
It is absolutely true that ETFs accounted for around 70% of the canceled trades that occurred during the 20 minutes of insanity on May 6th (IWD, the Russell 1000 Value ETF, went from around $60 to $.08 in minutes before coming back; no, we do not and did not own IWD in any client accounts!). But ETFs reacted exactly as I would have expected during such an environment and I remain absolutely confident in them as the best way to get exposure to many of the most fundamental markets for client portfolios. However, the Flash Crash does highlight the fact that ETFs are not to be taken lightly or thought of as foolproof any more than any other investment should be. No client of Frontier was negatively affected by the Flash Crash because our strategy is an investment strategy and not a trading strategy, and as long as one is of that mindset and knows to stay out of the markets during such periods, there is nothing to fear. That is not to say that improved circuit breakers and other changes shouldn’t be investigated to help markets avoid such events in the future, it just means that there is much to say about keeping one’s head during those periods and to avoid getting too fearful or greedy.
3. In light of global economic conditions, is Frontier bullish or bearish and why? How is that outlook reflected in your portfolios?
This answer is hard to keep brief, but I will try. Let me first answer the question the way I normally do – my own near-term market expectations should be taken with a grain of salt since I have as much or as little a chance of being correct as any other investor, professional or amateur, human or monkey, about what will happen in either the economy or the markets over the next few months or even a few years. Having said that, however, I do expect the developed markets to be largely range-bound for quite some time as we work through the macroeconomic problems that continue to go mostly unaddressed such as excessive leverage, high deficits, and high unemployment. I don’t foresee the equity markets testing the previous lows of early 2009 (but I could be wrong about that, too!), nor do I see them pushing strongly forward again for a while – I think a reasonable range to expect is 950-1250 on the S&P 500 although I hate to put a number on it. I don’t expect much out of other asset classes for a while, either, giving market-timers little in the way of exciting opportunities although that won’t stop them or the financial press from talking up the asset class of the week. Commodities, by the way, will continue to get far too much attention as mainstream investments and it is best to steer clear of them except through the equity markets (companies and countries that are commodity-oriented).
So how is that reflected in our clients’ portfolios? First, it is not translating into any particular shift in asset allocation because our portfolio positioning already reflects a market environment where developed economies will do less well going forward than they have in the recent past, where large cap US stocks will exhibit more risk and volatility than most account for, and where the developing economies appear to be at least as interesting as they have in the past because of their more stable fiscal positions relative to the developed markets and their own history. Second, given our expectations of range-bound markets, we are examining tightening our rebalancing rules to take advantage, to some small degree, of range-bound volatility. It might make sense to be even more vigilant about rebalancing when allocation targets get out of alignment as long as the cost of rebalancing is not excessive. When markets are trending strongly in one direction or another, rebalancing will induce drag on an upward trending portfolio and increase losses on a downward trending portfolio; but when range-bound rebalancing can help reposition portfolios to reduce losses before a downward adjustment and increase gains during an upward adjustment (and if the timing is off and the costs are insignificant, no harm is done). There is plenty to argue about this idea, however, and we are sorting through those various arguments while continuing to monitor our portfolios’ allocations relative to their targets.