At the beginning of 2017, a common view among money managers and analysts was that the financial markets would not repeat their strong returns from 2016. Many cited the uncertain global economy, political turmoil in the US, implementation of Brexit, conflicts in the Middle East, North Korea’s weapons buildup, and other factors. The global equity markets defied their predictions, with major equity indices in the US, International, and emerging markets posting strong returns for the year.
The broad global advance underscores the importance of following an investment approach based on diversification and discipline rather than prediction and timing. Attempting to predict markets requires investors to not only accurately forecast future events, but also predict how markets will react to those events. The 2017 markets were a good reminder that there is little evidence suggesting either of these objectives can be accomplished on a consistent basis.
Instead of attempting to make predictions about future events, investors should appreciate that today’s price reflects the expectations of market participants and information about future expected returns. The following quote by the late Merton Miller, Nobel laureate, describes this view:
“Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.” ― Merton Miller
Equities surged ahead, with International & Emerging stocks recording the biggest advance:
Diversified portfolios produced strong results, thanks in large part to the allocations towards global equities.
Note: Actual client portfolios may differ due to slightly different asset allocations. These returns are before TMA management fees.
Note: These index returns are from: Canadian One-Month T-Bills, FTSE TMX Canada Short-Term Bond Index, FTSE TMX Canada Universe Bond Index, S&P/TSX Composite Index, S&P 500 Index, MSCI EAFE Index (net dividend), MSCI Emerging Market Index (net dividend) and S&P Global REIT Index (net dividend). Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.
2017 Equity highlights:
In 2017, Emerging & International equity market stocks produced the highest returns for Canadian investors. Having lagged Canadian and US equities in 2016, International and emerging market equities surged last year. Furthermore, US securities produced higher returns for Canadian investors even after a negative currency impact. A great example of why investors should always be cautious about trying to time currencies based on recent good or bad performance. Leadership in equity returns in 2015, 2016 & 2017 has rotated between US, Canadian, International & Emerging market returns showing once again the merits of global diversification for Canadian investors.
Rotation of equity performance:
Highest to lowest ranking from top to bottom (returns in CAD dollars)
World stock market performance:
In 2017, the global economy showed signs of stronger growth, with 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) all on pace to expand. The below chart highlights some of the year’s prominent headlines in the context of global stock market performance as measured by the MSCI All Country World Index-Investable Market Index (MSCI ACWI IMI). The headlines in the following charts are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a long-term perspective and avoid making investment decisions based solely on the news.
Canadian fixed income: Canadian fixed Income returns were positive. The FTSE TMX Universe Bond Index returned 2.52% and its short-term counterpart 0.08%. Canadian one-month T-bills returned 0.63% for the year. Canadian dollar and other currencies Most major currencies including the euro, the Australian dollar, the British pound and the Canadian dollar appreciated against the US dollar. Given the Canadian dollar/US dollar move from $0.7225 to $0.7949, many Canadians may have felt that investing in domestic securities would have produced the best 2017 results. Ironically this is not the case. In fact, Canadian investors were better off holding unhedged international equities as the diversified international currencies fared slightly better that the Canadian dollar. Canadian equities: The chart below offers a snapshot of the Canadian stock market based on the S&P/TSX Composite Index. The S&P/TSX Composite total return index produced a 2017 return of 9.10%. The headlines should notbe viewed as determinants of the market’s direction but as examples of events that may have tested investor discipline during the year.
Performance of value, small company & profitability premiums:
Given that our portfolios are tilted to include higher allocations to value, small & profitable companies, this below section highlights the performance of these factors and premiums. These factors are compiled in the multi-factor Dimensional Fund Advisors Core & Vector strategies. Dimensional implements these factors on a consistent basis in the Canadian, U.S. and International equity portfolios for their institutional and private clients around the globe. Performance of value company stocks: In 2016, value companies outperformed growth companies in all geographic regions. In 2017, we saw a reversal for most regions as growth stocks outperformed value. Historically over long periods of time, value companies tend to outperform growth companies and produce a positive return premium to investors.Note: The value premium is the return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Performance of small company stocks: In 2016, small companies also produced strong results. 2017 saw a reversal as in most regions, large stocks outperformed small. International markets was the only region in 2017 where small companies outperformed large companies.
Note: The small cap premium is the return difference between small capitalization stocks and large capitalization stocks.
Profitability premium: On a positive note, high profitability stocks outperformed low profitability stocks and therefore, the profitability premium was positive across Canadian, US, international and emerging markets.
The complementary behavior of premiums in 2017 is a good example of the benefits of integrating multiple premiums in an investment strategy, which can increase the reliability of outperformance and mitigate the impact of an individual premium underperforming, as was the case with value among US stocks in 2017.
Value vs. growth lessons of March 2000
Even over extended periods, underperformance of the value premium or any other premium is within expectation and not unusual. Over a 10-year period ending in March 2000, value stocks underperformed growth stocks by 5.38% per year, as measured by the Russell 3000 Value and Russell 3000 Growth indices. This underperformance quickly reversed course and by the end of February 2001, value stocks had outperformed growth stocks over the previous 1-, 3-, 5-, 10-, and 20-year periods. In the one year period ending Feb 2001, the Russell 3000 Value premium had outperformed the Russell 3000 Growth indices by 51.79% completely changing the performance landscape.
Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.
Conclusion on premiums:
It is well documented that stocks with higher expected return potential, such as small cap and value stocks, do not realize these returns every year. Maintaining discipline to these parts of the market is the key to effectively pursuing the long-term returns associated with the size, value, and profitability premiums. The small cap and value premiums are well-grounded in financial economics and verified using market data spanning decades, but pursuing those premiums requires a consistent, long-term investment approach.
Note: Canadian value companies are represented by the Canadian Value Index (MSCI/Barra), and the growth companies by the Canadian Growth Index (MSCI/Barra). US value companies are represented by the Russell 1000 Value Index, and the growth companies by the Russell 1000 Growth Index. International value companies are represented by the MSCI EAFE Value Index (net div.), and the growth companies by the MSCI EAFE Growth Index (net div.). Emerging markets value companies are represented by the MSCI Emerging Markets Value Index (net div.), and the growth companies by the MSCI Emerging Markets Growth Index (net div.). Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.