Looking into the past for clues about the future

By Markets Covestor

We made adjustments within Island Light ETF Portfolio Series at the end of the second quarter as part of our regular rebalancing strategy. This quarter’s rebalancing introduces a new innovation to the Island Light investment tool kit, a new quantitative method that provides a relative attractiveness ranking for all asset classes.

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The new method, grounded in behavioral finance and employed in practice for the last two years, seeks to identify trends and patterns in the past behavior of asset classes in order to project their future behavior. This method is a natural extension of our existing asset allocation process, and introduces additional rigor to our forward looking capital market estimates.

Our investment strategy team makes a series of active decisions based upon our current outlook on the US and global economy, global equity and fixed income markets. These views are also influenced by a quantitative ranking of the relative attractiveness of asset classes and categories.

Every quarter, we shift assets from our strategic allocations, tilting asset classes and segments from their long term weights, in order to potentially benefit from changing conditions in global capital markets.

Q2 2014 Performance

Equities Q2 2014 YTD
All Country MSCI ACWI 5.0% 6.2%
US Large Cap S&P 500 5.2% 7.1%
US Small Cap Russell 2000 2.0% 3.2%
Non-US Developed (EAFE) 4.1% 4.8%
Non-US Emerging  (MSCI) 6.6% 6.1%
Gold Bullion 1.8% 9.4%
Barclays Bond Indices
US Aggregate 2.0%  3.9%
US Treasury 7-10 yr 2.5%  5.2%
US Treasury TIPS 3.8%  5.8%
US Gov’t Credit 1.9%  3.9%

Our portfolios were positive on an absolute basis for the quarter as nearly all global asset categories generated positive returns. Continuing economic growth, expansive monetary policy and declining interest rates created this positive investing environment.

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US equity markets modestly out-performed non-US developed markets. The US 10-Year Treasury Rate ended the quarter at 2.5%, down 50 basis points from the beginning of 2014 and well below its 10 year average of 3.4%.

During the quarter, our over-weights to US equities and alternatives (MLPs) contributed to overall positive performance while our defensive exposure to shorter duration, US fixed income, underweight to emerging markets, and overweight to US small-cap stocks were detractors from index-relative performance.

We have positioned the Island Light portfolios at quarter-end to try to take advantage of the current positive US equity market trend, modest economic growth expectations, anticipated modest increase in US interest rates, and relatively low global inflation.

Our current views on US stocks are that, while certainly more expensive than they were a few years ago, we expect the low volatility, strong growth investing environment to continue over the next few periods.

We have made modest allocation changes to reflect these views, increasing large cap exposure from small cap, which we expect to modestly underperform due to fundamental valuation factors.  We have also increased our exposure to Canadian equities and emerging market equities and reduced our allocation to European equities.

With regard to fixed income, our capital market forecasts for fixed income include the expectation that interest rates will increase sometime in the next 18 months. While this means that we favor shorter duration instruments, we also appreciate the portfolio diversification benefits offered by intermediate and long duration fixed income.

We now have a modest under-weight to longer duration instruments, and over-weights in dollar-hedged international bonds and floating-rate bank loans. With regard to our non-traditional, or alternative asset categories, we retain our modest allocations to commodities, and have increased exposure to infrastructure master limited partnerships (MLPs) while eliminating our position in the hedge fund composite proxy. MLPs currently offer good income yield in my opinion, while commodities may offer traditional diversification benefits.

Capital market forecasts and estimates are critical components in the development of our portfolio allocations. When creating capital market forecasts, we employ sophisticated statistical techniques to combine observations of history with current information and forward looking views.

In my opinion, this advanced forecasting process is rigorous, transparent and practical, allowing us to include technical, quantitative factors and investment intuition to manage our investment portfolios in a consistent dynamic framework.

We also use advanced portfolio optimization technology to turn our capital market assumptions into investable portfolios. In my opinion, this asset allocation methodology is designed to potentially improve risk-adjusted returns through enhanced diversification of asset classes, selected to satisfy a range of investment objectives.

DISCLAIMER: The investments discussed are held in client accounts as of June 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.