The tragedy in Ukraine has been the major headline in the markets recently and the effects on the markets notwithstanding, the human loss and suffering, thus far, have been both senseless and heartbreaking. Our prayers are with the citizens and all civilians in and around Ukraine, and we hope a resolution will arise sooner than later.
From a market perspective, the repercussions of the sanctions on Russia have sent ripples throughout both financial and commodity markets, largely effecting the price of oil. As a major input in products from plastics to chemicals to travel and transportation, oil price increases have compounded already worrisome inflation concerns here in the US. Coupled with the anticipation of Fed rate hikes, whispers of a future recession are now growing.
At the same time, it should be noted that there is a popular phrase: “Economists have predicted 15 of the last 5 recessions.” We have emphasized how difficult it is to time the market, to try and predict how the economy will act over the next 12 months, where the Fed will move interest rates, and how consumers will react to all these variables---especially with global events being so dynamic. And, although anything could change, when we review the current economic data—corporate earnings and unemployment—the picture does not appear “dire”….at the moment.
Of course, when there is weakness in the stock markets, overall sentiment seems to get overly negative. Stocks are now largely in correction territory, with many stocks down well over 30%, 40% and even 50% from highs. Most of the damage from these decline in prices has been in the expensive sectors and speculative areas, however, even solid, blue-chip companies are not immune from the negativity.
It is in times like this where diversification is so important. While it is true that most sectors are still down since the beginning of the year, holding a mix of asset classes has once again proved to be an effective way to weather the challenging times. Given that correlations have increased between stocks/bonds, some investors may want to consider adding alternatives like commodities, long/short equity, and hedged equity to their portfolios. At a minimum, allocations should focus on maintaining an income stream—largely thru dividends—in periods like this. As long as investors are properly allocated and diversified, they should not succumb to the latest bursts of panic from Wall Street. The key being “properly allocated” because if investors were too heavily invested in those wildly expensive parts of the markets, they are experiencing significant drawdowns.
In summary, the market has quite a lot on its plate to digest: a war, high and rising inflation, and tomorrow is the most important Federal Reserve meeting ever! Isn’t every Fed meeting the most important ever???? That’s what market pundits keep on telling us, right? The Fed will most likely raise rates for the first time in a long time.
Lessons Learned from ARKK
We do not think there is one day that goes by on Wall Street without some sort of comment, insult, or opinion about the ARKK fund. By way of background, ARKK is an actively managed ETF run by Cathie Wood. She launched her firm (ARK Investment Management) in 2014 to focus solely on investing in what she calls “disruptive innovation.” It doesn’t take long to understand that her firm’s strategy is to invest in very high growth potential investments and is not appropriate for the conservative investor. And Ms. Wood has been crystal clear in this approach and that no investor should consider this fund without at least a 5-year time horizon. It’s a very aggressive fund, period. Shame on anyone who didn’t realize this before buying.
After starting off slowly, the fund returned 87% in 2017. Of course, that type of return started to attract some interest as investors just never seem to stop chasing past returns. Then came two spectacular years in 2019 and 2020 with returns respectively of 35% and 157%! Just as the sun comes up every day, money poured in after these two years-unfortunately too late, as the fund has suffered since then with losses of 23% in 2021 and 41% this year. All in all, the fund has had tremendous long-term success with a 20% average annual return since inception in 2014! BUT, according to Jeff Ptak at Morningstar, the average dollar invested in this fund is DOWN 16.2%! Why the big gap in returns? Again, most of the assets poured in just before the returns rolled over- a classic case of performance chasing.
Ms. Wood has been under a lot of scrutiny from Wall Street regarding her strategy and has been constantly criticized. We have no skin in the game regarding ARKK, but we would say this is unfair. We think there is just a lot of jealousy about the success her firm has had and the assets they have acquired. Ms. Wood has been very clear about her strategy and the risk involved. The only potential fault we see was that this type of strategy probably has a limited amount of dollars it can support. In simpler terms, the fund got too big, too quick and maybe the firm should have stopped accepting new flows.
There are two main lessons to be learned from this in our opinion:
- Understand the capacity of a strategy and the difference between an ETF and a mutual fund. Unique strategies like ARKK probably can’t support massive inflows and an uncapped asset base. That’s one benefit of the mutual fund structure-they can close their doors to new flows. This is very important for investors to know. For example, we own a long-short fund that just closed to new investors with only $500 million in assets. That tells me they care about their shareholders more than just taking in as much money as they can.
- This is just a textbook case of the dangers of chasing performance. Human nature is a failed investor. Be very wary of buying any investment just after spectacular returns.
Diversification Matters But Is Getting Harder
When it comes to portfolio construction, diversification has been referred to as the “only free lunch in investing.” For decades, diversification was fairly straightforward, but recently, as author Amy Arnott points out, it has become more difficult.
As Arnott states, the shifting landscape for both interest rates and inflation complicates the role of bonds in a diversified portfolio. During the current market correction or bear market (…could call it either), bonds are not providing the buffer they historically have. Correlations have flipped to positive and that reduces the diversification value of bonds from a portfolio perspective. Looking below the surface, the range of returns for different types of bonds is quite wide; emerging market bonds are down 15% year to date and the Vanguard Total bond market is down just under 5%.
As such, creating a truly diversified portfolio within the traditional 60% stock/40% bond portfolio has become more difficult, and it may be necessary to add additional asset classes to achieve greater diversification. But buyer beware! This “search” for other asset classes or alternative assets to replace bonds is almost like a sales contest on Wall Street. Investors need to be careful about how they approach this portfolio diversification challenge. One mandate we live by here at NCM is exemplified in a quote from Peter Lynch, a very successful investor who ran the Fidelity Magellan fund which achieve an annualized return of about 29% under Peter’s leadership – the quote says, “Know WHAT you own, and know WHY you own it.”
In summary, what has been proved over and over is that diversification is important, but how it is achieved may differ for the foreseeable future.
Not All Decisions Are Based on The Numbers
When it comes to making financial decisions about the future, it becomes very easy to dump figures into an investment program or a spreadsheet for a quick calculation. However, as highlighted in a recent Morningstar article written by Christine Benz, when it comes to making important financial decisions, many times numbers don’t tell the whole story, and there are other factors that should be considered.
One of the biggest areas of questions is about retirement. Am I ready? Do I anticipate having enough income to survive and enjoy many years of not working? Good questions, for sure. However, while figuring out your monthly/annual withdrawal percentages from your portfolio and comparing it against your expected expenses is, of course, imperative, pre-retirees should ask themselves other questions. How will I fill my days? What type of activities will I choose to do? Do I want to find part-time work or volunteer? Where would I like to live? Even though the numbers may work, not every individual who is eligible for retirement may be prepared for it.
Similarly, home purchases are another big financial decision that should include other factors than just price and affordability. For one, home ownership carries a ton of responsibility, e.g, more expenses and more maintenance. It may not only be the fact that interest rates are attractive or that the market (at the time) is presenting compelling values. Owning a home may take away from one’s social life and it may be more of a drag on finances than expected. Maintenance on the property, taxes, upkeep of more interior space, higher utility bills and the chance of greater unforeseen expenses. Of course, homeowners need to also consider location and the fact that they will have less flexibility as to where they move in the future.
The same logic applies to the question about paying off a mortgage or paying it down over time. From a financial standpoint, the calculations may point to one or the other based upon an individual’s financial situation. However, assuming one has the means to pay off a mortgage, it may be a question of one’s mindset and personal feelings of holding debt vs. owning a house outright. This is a highly individualistic decision and not one that can be based on finances.
In short, there are many areas of life where we believe it comes down to dollars and cents. And while, it is critical to always consider the numbers, many times it is important to reach a decision which satisfies your peace of mind and your quality of life. We all are different in what motivates us and what keeps us up at night. Being able to define that BEFORE you make an important decision is just as important as working through the numbers.
In summary, that’s why it’s called personal finance! And in order to help our clients with these decisions, it helps to know what makes each client “tick.” For example, just last week I had this discussion around a couple either paying off their mortgage or investing a large bonus which was recently received. My recommendation was for them to pay off the mortgage. Why? Certainly not for the financial reasons as we could invest cash in our favorite dividend paying fund with the option overlay and most likely easily earn more than the interest rate of the mortgage. The reason is because I just know this client will sleep better at night knowing their house is paid off and they would have zero debt. For some investors that is more important to them. Our job is to help figure that part out WITH them.
Financial Planning Topic: Life Insurance 101
Much like active portfolio management, we recommend reviewing one’s life insurance coverage from time to time. In this summary, we review the basic types of life insurance, how to estimate how much life insurance you should have and when it makes sense to review your current coverage.
From a high level, there are two types of life insurance policies – one that can build a “cash value” and one that does not build cash value. When we say a policy has cash value, we mean that a policy has value that can be accessed separate from the death benefit. The policy owner can access the cash value via a loan, policy withdrawal or to pay policy premiums. Some examples of cash value life insurance are whole life, universal life, variable universal life and indexed universal life – these are also referred to as permanent life insurance. Separate from cash value or permanent life insurance is term life insurance. Very simply, term insurance provides a level death benefit for a set term of years. For example, one can buy a $1M death benefit for a term of 30 years. Term insurance is the most cost-effective way to cover your life insurance needs, but it doesn’t come with any cash value or other policy features that are offered in permanent policies. We will cover the specifics around cash value life insurance in a separate newsletter.
How much life insurance should you have? Well… that depends on what you are trying to achieve and what your financial needs are. There are two ways to calculate how much life insurance is right for you. You can either buy life insurance to replace an income stream (e.g., your employment income) or you can buy enough life insurance to cover your cash flow needs (e.g., annual living expenses, college costs and other large financial expenses). What is the difference between using life insurance to replace income vs. using life insurance to cover cash flow needs? The income replacement analysis will look to replace the after-tax income stream for an individual and the cash flow analysis will look to generate a pool of funds that is capable of covering the required cash flows. We typically run both an income-replacement and cash flow needs analysis for clients and have a discussion about the pros, cons and which we believe makes the most sense for their specifics situation.
Finally, your life insurance strategy, much like managing an investment portfolio, should not use a set it and forget it mindset. It is important to review your coverage from time to time in order to make sure that you have 1) the right amount of coverage, 2) the right type (term vs. permanent) of coverage, 3) that you have competitive pricing and 4) to take into consideration how your insurance plan will/should look 10-20 years down the road. I tell clients that we should consider reviewing their life insurance needs during some of these common life events – new job, pay increase, getting married, buying a home, starting a business, having children or caring for parents.
In closing, while NCM does not sell (or receive any commissions) for any life insurance policies, we are experienced in helping our families structure a customized insurance plan that addresses their specific needs. If you should have any questions regarding your current life insurance, please feel free to reach out to us here at NCM Capital Management.
We hope everyone is doing well and are here to discuss any of the topics reviewed in this newsletter.
All the best,
NCM Capital Management
DISCLOSURE: This newsletter contains general information that may not apply to everyone. The information above should not be construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security. Past performance is no guarantee for future results. There is no guarantee that the opinions expressed in this newsletter will occur.
Investment advisory services are offered through NCM Capital Management, LLC, an SEC-registered wealth advisory firm domiciled in New Jersey. This communication is not to be construed or interpreted as a solicitation or offer to sell investment advisory services to any residents of any state other than the State of New Jersey, the State of New York, the State of Texas, or where otherwise legally permitted. For additional information about NCM Capital Management, LLC, you may request a copy of our disclosure statement as set forth on Form ADV.