Q: Over the past quarter, the U.S. dollar has strengthened more than 8% versus both the euro and the yen. Why is this occurring, and what does it mean for my portfolio?
For the first time in many years, global central banks are on divergent paths. With the U.S. economy recovering, the Federal Reserve is stopping its bond purchasing program in October. On the other hand, slower economic growth in Europe and Japan is prompting their central banks to continue quantitative easing measures to stimulate their economies. With U.S. interest rates expected to rise in 2015, global investors will likely shift assets out of low-yielding European and Japanese securities and into higher-yielding U.S. fixed income. The strengthening U.S. dollar is a reflection of this anticipated increase in demand for U.S.-based investments.
A strong dollar is good for U.S. consumers, since it causes the price of dollar-linked consumer staples, such as gasoline and food, to go down. With more disposable income, U.S. consumers can spend more on other goods and services, which could lead to additional job growth. While a stronger currency should be beneficial for the country in the longer term, there will also be some short-term pitfalls. For example, large cap U.S. companies generate nearly 40% of their sales overseas. Costs won’t change for companies that manufacture in the U.S. and sell overseas, but the revenues they receive for goods sold overseas will be worth less, putting pressure on margins.
While much of this is already built into stock prices, there will still be opportunities to shift portfolios to take advantage of changing market dynamics.
Q: In mid-September, California Public Employees’ Retirement System (CalPERS), the country’s largest state pension fund, said it would redeem its hedge fund investments. Does this mean hedge funds are no longer an attractive investment?
CalPERS currently manages nearly $300 billion in investments, yet hedge funds only represented $4 billion, or about 1.3%, of its portfolio. While the plan’s chief investment officer cited investment strategy complexity and costs as the main reasons for the decision, the more likely reasons were performance, which had been mediocre to date, and the difficulty of scaling the position to a size that would affect the portfolio meaningfully.
Given the additional fees that hedge funds charge, investors must invest with top-quartile managers to get stellar results. If CalPERS took just 5% of its portfolio ($15 billion) and allocated it to 20 managers, it would be investing $750 million with each hedge fund. Most top-tier hedge funds do not want this large an amount from one investor, since it represents too large a percent of its assets under management and poses potential business risk if the investor decides to redeem later. Hedge funds that would accept an investment of this size are likely “B-list” managers who are more interested in gathering assets than achieving stellar results for investors. Therefore, CalPERS most likely isn’t investing in hedge funds because of its size, not because they are a poor investment strategy.
Q: The number of geopolitical concerns seems to be increasing this year, including Russia and Ukraine fighting, ISIS’ emergence, and protests in Hong Kong. Are these risks affecting your investment outlook?
From the War of 1812 when both Great Britain and France restricted trade with the U.S. to fighting in Syria today, geopolitical risks have always affected markets. Rather than being nervous that their effects will cause an economic recession, we prefer to analyze each event to determine if the associated market volatility has dislocated a stock’s price from its underlying fundamentals. Quite frequently, these events cause price declines in certain companies or sectors that are not justified based on fundamentals. If so, we use the volatility to our advantage by opportunistically purchasing a security that has temporarily been affected by the market dislocation.
Q: Should I redeem my Pimco Total Return Fund 401(k) investment now that Bill Gross has left the firm?
Without a doubt, Bill Gross’s departure from Pimco in September was a market-moving event. The firm’s flagship Total Return Fund has $222 billion in assets, making it the largest bond mutual fund in the world. In addition, Pimco has invested significantly more assets in a similar manner through separate accounts for large institutional investors.
While we are confident that the fund’s new management team is highly capable and will likely do well in the medium term, Pimco may lose up to 33% of its assets in the strategy. Nearly every investment advisor and institutional consultant is discussing this issue with their clients. Since institutional clients, which are responsible for the bulk of the assets, typically have investment committees that meet quarterly, most decisions have yet to occur. Given the likelihood of large redemptions, there is likely no reason to wait and see if these redemptions affect performance. It is easy to move retirement funds, which are not subject to capital gains taxes, to another bond fund or exchange-traded fund and possibly reinvest them in Pimco once outflows have subsided.
