Mill Creek’s Chapin: Take More Risk With QE3
September 12, 2012
Tom Chapin, chief investment officer at Conshohocken, Pa.-based Mill Creek Capital Advisors, says it sure looks like the market believes the Federal Reserve will launch QE3. The market should know by Thursday after the Fed’s policy meeting concludes.
More broadly, Chapin, whose firm manages more than $2.5 billion with a particular focus on high-net-worth families as well as endowments and foundations, says patience is crucial for investors as the economy continues to work through the indebtedness that led to the financial crisis. He says his firm favors ETFs for broad equity market exposure, and is looking with particular interest at asset classes such as commodities to deal with a difficult investment environment.
Ludwig: The market seems to be warming up to the idea of QE3. For example, GLD was the most popular ETF last month. Do you think it’s going to happen?
Chapin: My sense is the market thinks it’s going to happen, and the Fed has certainly left the window open; if they think we need it, they’ll do it. It’s helping support the markets in general. But we've seen this story before. And we keep hoping for some panacea. But it seems to me a stretch that that’s really going to make all the difference.
Ludwig: We’re in the sixth year of this balance-sheet recession. What’s your general sense about what it’s going to take to restore some sense of normality—a growth trajectory that looks more like most post-war recoveries?
Chapin: It’s going to take time. That’s what we all said at the outset: that this time it’s different. It was a much worse recession. If we think about it being a three-legged stool—the U.S. consumer, the U.S. government and the U.S. corporations—the U.S. government has gotten itself overleveraged. The U.S. consumer did as well.
It is going to take some time for consumers to deleverage themselves, and for the government to get out of the problem of increasing spending at a time of decreasing revenues. Those sorts of problems are larger than any we’d seen. It will take time to work them out. Corporations, on the other hand, quickly de-leveraged themselves and are operating at very high profit margins. So that leg of the stool is on firm ground anyway.
Ludwig: Would you say the economy is halfway through this period? Less? More?
Chapin: For consumers, we’re probably at least halfway through it. Consumer balance sheets are certainly improving. We’re finally getting improvements in home prices and stuff is starting to sell in some markets. But on the government side, we don’t seem to see any progress yet, for all the obvious reasons that we’re still climbing out of a deep recession.
So we’re still spending to keep things from getting worse, and there hasn’t been any congressional progress towards closing the gap. We’re less than 50 percent of the way there in fixing that problem.
Ludwig: That said, corporate balance sheets are looking quite good, no?
Chapin: Yes. We had record-level S&P 500 earnings—the second quarter was all-time high. Dividends are rising; total payouts are high. Corporate balance sheets are strong. If you’re a major corporation, and you can't make more money by borrowing long term at these kinds of rates, then maybe you shouldn’t be in business. So yes, corporations are in great shape. Unfortunately, unless they start seeing some top-line revenue growth, they won't be able to increase earnings.
Ludwig: So, when you think about these three legs in various states of repair or disrepair, are you of the mind that some of the more traditional asset allocation concepts might be fresh for reinterpretation? Or are you much more, “Let’s not get carried away. It’s still about basic asset allocation, depending on your age, regarding equity and debt balances”?
Chapin: Well, we like to allocate client assets and recommend asset allocation based on forward-looking market assumptions. And, you know, you can derive all those in terms of what you think corporate profits and dividends and valuations will be on the equities side, and look at that and say, “OK, it takes only reasonable expectations to get decent real returns in equities. And maybe they're not 12 percent or 10 percent, but maybe they're 7 to 8 percent, which, in a low inflationary environment, is a good return on your money.”
But equities can be volatile. So you want to hold some amount of less-volatile assets like fixed-income securities in your portfolio. I think normative expectations for clients and for asset allocation models are 5 to 7 percent returns on fixed income, and we don’t see these securities producing returns anywhere near that in the years just ahead. We’re talking about this possible outcome a lot with clients.
Ludwig: We’re looking at financial repression right now, pretty much, right?
Chapin: Good old financial repression, yes. Record-low levels of nominal yields and negative real yields, and the Fed has said it will hold them down for a few more years. But at some point they’ll have to go up because investors will demand a real rate of return on their money. And rates going up from here mean flat or some negative returns on your fixed-income investments. And how does that get you closer to your retirement savings goal?
Ludwig: So do you think outside the box, like maybe a bigger commodities-related-type allocation—either through equities or futures-type instruments—is needed?
Chapin: Yes, I think you have to look outside the box at nontraditional asset classes and strategies. And that’s the sort of discussion we’re having with clients as well, to say, “Recognize that the returns on fixed income aren't going to be as great. So you need to either tiptoe out—or even waltz out—to take more risk if you want to hit your overall return targets. And what is the right amount of risk for you? Does it mean that you have a lot more in traditional assets, like equities? Do you need to get some commodities exposure? Do you need to get into other alternative investments and strategies?”
Ludwig: So the answer is client-dependent? You're taking measure of their risk appetite as it relates to what’s available in the marketplace in terms of investable assets?
Chapin: That’s right. Many of our clients are ultra-high-net-worth individuals and families, and for a lot of them it’s more about capital preservation than eking out an extra 1-2 percent return per year.
Ludwig: Got it. So are there particular asset classes that you guys look at with great interest at this juncture, given these variables we’ve been talking about?
Chapin: We always look at all of them; they're all interesting at the right entry price. I think commodities can be interesting, if even more unpredictable, than equities. We’ve dabbled a little bit there within a program of alternative investment strategies we have assembled on behalf of clients.
Ludwig: Now, as you survey the ETF market, I presume that your practice involves more than a smattering of exchange-traded funds. And I wonder if you could speak to how you got to where you're at, in terms of using ETFs, and where you think the future is.
Chapin: Yes, more than a smattering, but not much more than a handful. From the firm’s inception six years ago to date, we have always said, “Look, particularly in the efficient asset classes, getting your beta at a very low cost with index funds or ETFs is a great way to deliver expected return in those spaces to clients.” So, in large-cap U.S. equities, large-cap developed markets, and to some extent in emerging markets, we have used ETFs to gain asset class exposure.
We don’t, to this day, get into the more specialized concentrated versions of things like industry-specific ETFs, or country-specific ETFs. That’s just a little too finely sliced for what we do. Some of the professional money management firms that we use on behalf of our clients occasionally use their expertise or best judgment to enter into some of those country-specific or industry-specific sectors. But we don’t make a call to specifically say that that we think, say, Indonesia is the place to be now.
Ludwig: So is it fair to say that you hew to a type of index investing philosophy, that you’re of the mind that alpha is nothing more than well-timed beta?
Chapin: That’s good! It may sound as if we sort of speak out of both sides of our mouth when I say that we get the beta cheaply using a core of ETFs and that we also think we can identify some active managers who will add alpha—excess returns—over time. But we’ve had some success in following such an approach. So, we do that at the margin.
In fixed income, we have been less active in using ETFs. We use mutual funds, depending on the client, and we also work with separate account bond managers to construct individual portfolios for our clients. In the municipal bond space, where we have a lot of money invested, we employ a money manager who picks individual bonds and structures portfolios for clients.
That’s also true in the taxable bond space, where we use actively managed mutual funds or separate accounts. The big problem with index funds in this space is that they’re going to be heavily weighted in Treasurys or, in the case of high-yield ETFs, heavily concentrated in a small number of bonds.
Ludwig: As far as the U.S. economy in general, how would you characterize your views generally? On one hand, there are people like Paul Krugman at the New York Times, who say that there wasn’t enough stimulus at the outset. And, on the other hand, you’ve got guys like Ed Yardeni, who say they wish Ben Bernanke would just take a vacation.
Chapin: In general, it’s been a less robust recovery than we all would have hoped for. But let’s all remember that it was a particularly deep and dangerous recession. So, we were saying a couple years ago that it was going to take a while to climb out of this, and I think that’s proving to be the case. We’re not worried about the idea of a double-dip recession.
But also, it’s hard to get optimistic that, all of a sudden we’ll get 3 percent economic growth given the problems with the European economy and the apparent slowdown in Asia, particularly China. We’re all kind of muddling through. The bottom line is everybody, including ourselves, is saying, “Well, Congress isn't going to do anything until January. And tax rates are going up, and spending is going down automatically unless they do something.” And obviously, that’s bad and would cause us to fall back into a recession. So they will, of course, do something constructive. They have to!
Ludwig: So you're cautiously optimistic, time being the crucial variable?
Chapin: Time and a return of sanity being the crucial variables. It’s hard to be totally optimistic that the current acrimony will go away immediately following the November elections. But the eternal optimist in me hopes that some sort of rationality and spirit of compromise prevails in the interest of the greater good.
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