Volatility: How separately managed accounts were effected

Aug 14, 2011 @ 12:01 am

By Nathan Behan, senior investment analyst, Prima Capital

The domestic-equity markets were extremely volatile during the second quarter, particularly in June.

April continued the pattern of the first quarter as the Russell 1000 Index was up 3% and the Russell 2000 Index was up 2.6%. Both indexes were down slightly in May before plunging sharply in the first two weeks of June.

By June 16, the Russell 1000 was down nearly 6% and the Russell 2000 nearly 8% for the month alone. However, in the last two weeks of the quarter, the markets rebounded strongly, leaving the Russell 1000 down just 1.8% for the month and up 12 basis points for the quarter.

Small-cap stocks didn't quite make it back into the black for the quarter, as the Russell 2000 ended the month down 2.3% and down 1.6% for the quarter. Hardest hit in the quarter was the Russell 2000 Value Index, down 2.5% in June and down 2.7% over the quarter.

There was some consensus among our managers in the second quarter as it relates to valuations among the larger-cap stocks, generally noting “reasonable” to “slightly cheap” valuations from a historical standpoint, as well as relative to other investment options available.

Still, there is some significant concern over the stability of the recovery as most companies face more difficult year-over-year comparisons and the decreasing impact from cost containment. Several managers noted that the higher-quality, more fundamentally sound companies held up better in the final month of the quarter, and this may represent a shift from the higher-beta, lower-quality names that had seen the greatest price appreciation over the first four months of the year.

We heard significantly less consensus from the midcap and small-cap managers over the course of the second quarter. Several managers, admittedly prior to the June meltdown/recovery, noted that the small-caps in particular were fully valued and that growth in the asset class was likely to slow as the recovery matured.

However, we also heard convincing arguments pointing out that smaller companies hadn't seen the same type of top-line growth as the large-cap companies. Second, the sheer number of companies in the asset class continued to offer plenty of opportunities.


The international indexes were generally positive in the second quarter, though this had more to do with the general weakness of the dollar over the quarter than with consistently positive returns.

The MSCI EAFE Index was up 1.6% in dollar terms, while the Pacific Index was up just one basis point. In general, the dollar's weakness added about 2% to returns.

Outside of Greece, with its debt crisis, the Nordic countries were the worst performers in developed Europe, as Denmark, Finland and the Netherlands had sharply negative returns.

Core Europe continues to surprise on the upside, despite the potential for a negative impact from the struggling peripheral countries. France, Germany and Switzerland all posted strong gains during the quarter, as well as an upside surprise from Ireland.

Within the Asian developed market, New Zealand and Singapore had positive returns while Australia and Hong Kong were both off a bit in dollar terms.

The MSCI Emerging Markets Index was down 1.2% in the second quarter, and again, the weaker dollar improved results over the returns in local currencies. Regional returns were broadly negative, with Eastern Europe the only region with a significantly positive return.

All four of the BRIC countries turned in significantly negative results. Latin America was mixed, with surprisingly strong returns from Chile and Colombia, while Peru sustained double-digit losses.

As we heard for most of the first quarter, managers in the international space have been moving away from the emerging markets and favoring those companies domiciled in the developed markets but with substantial revenue streams from emerging markets. Most of the managers continue to be generally negative about the prospects for Europe, though most admit that Germany has the potential to be a surprise.


The domestic fixed-income markets were modestly positive and fairly homogenous during the second quarter.

All the major sectors of the Barclays Capital Aggregate Bond Index returned between 2.2% and 2.4%. Maturity was the primary -differentiator during the quarter, as longer maturities within the index uniformly outperformed shorter maturities.

The longer maturities did see yields go back up dramatically in the final month.

Treasuries had multiple supporters during the quarter including the Federal Reserve, which wrapped up the final purchases under the QE2 program, and international investors' moving away from the euro and the yen.

The revival of inflation fears pushed the Barclays TIPS Index up 3.7% for the quarter and a total of 5.8% for the year, the best of the taxable indexes. Spreads in the commercial-mortgage-backed securities and investment-grade corporate sectors widened slightly, further reducing their return for the month but still producing solid returns for the quarter.

Like the investment-grade corporate sector, spreads widened in the high-yield market during June as well. The Barclays High Yield Index was down 97 basis points in June but up just over 1% for the quarter.

As with the investment-grade sectors, the longer maturities outperformed, despite taking a bigger hit in the final month. The biggest impact came in the very bottom of the high-yield market, as those issues rated below triple C fell more than 4% in June and were down 1.6% for the quarter.

The noninvestment-grade floating-rate loan market continued to see massive inflows through May, with $20.6 billion in net new assets. Like their more traditional bond brethren, significant losses in June reduced the quarter's return on the Barclays High Yield Loan Index to just eight basis points.


By contrast to the taxable market, the municipal market enjoyed one of the best quarters in the past decade. The Barclays Municipal Index was up 3.9%, with longer-duration bonds uniformly outperforming shorter-term issues.

Reversing the pattern of the first quarter, lower-rated issues sharply outperformed the AAA-rated issues.

Noninvestment-grade munis, as measured by the Barclays Muni High Yield Index, outperformed all the investment-grade segments with the exception of the triple B-rated issues. Performance was driven by a significant drop in rates as yields fell 44 basis points for 10-year triple-A-rated issues, with similar drops in yields across the maturity spectrum, except for the very shortest maturities.

The managers we spoke to think that retail interest in the asset class should return in the second half of this year because the predictions of massive defaults made at the end of 2010 clearly haven't come to pass.

The managers also pointed out the relative steepness of the muni yield curve, as the yield differential between five-year and 10-year maturities finished the quarter at 147 basis points. Most managers are avoiding the four- to six-year maturities and tend to favor a barbelled approach using two- to four-year allocations balanced with seven- to 12-year securities.


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