Many investors enjoyed substantial gains on their investments in 2016, as the market indices hit new highs and economic growth increased slightly. But others have also been left scratching their heads wondering why their portfolios didn’t do as well as the S&P’s 500 Index. The index rose by nearly 12% for the year with dividends reinvested, despite the fact that it had dropped by 10.5% through February 11, 2016.
Many portfolios lagged this number, and there are several factors that account for the underperformance. Some major sectors of the market did not perform as well as the index, and clients who were diversified across a broad spectrum of assets could then have been subject to subpar performance in other areas. This is not to say that diversification is the wrong approach for most investors. But understanding the underlying causes of a portfolio's underperformance can help to allay investor concerns. (For more, see: S&P 500 Index: A Performance Analysis of Long-Term Returns.)
Four Lagging Investment Options
Here are four key factors that dragged down investment returns in 2016.
- Expenses: The average large-cap blend fund posted a return of about 10.25% in 2016 not quite as high as the S&P 500, and this difference in performance is primarily attributable to expenses such as 12b-1 fees and sales charges. But the average large-cap growth fund only rose by a mere 3.14% – far behind the index, despite the fact that the index is composed chiefly of large-cap stocks.
- Overseas Turmoil: International investors fared better last year than they did in 2015, but the improvement was nominal. Events such as Brexit and further economic upheaval in Greece and the European Union served to roil the international markets for much of the year, and the average international large-cap blend fund posted a gain of a measly 0.67% – just slightly higher than the average money market fund. Both European and Chinese holdings fell by more than 2% for the year. And those who invested in overseas bonds didn’t fare much better, due largely to the negative interest rate environment (except in emerging markets, which gained nearly 10% for the year).
- Low Interest Rates: The woes continued for bond investors, as the yield on the 10-year Treasury Note started at 2.27% for the year and then bottomed out to an all-time low of 1.34% in July. By the end of the year, the yield had rebounded to 2.45% as the Federal Reserve raised rates a quarter of a point in December, but most investors counted themselves as fortunate if they received any kind of interest payment at all. The average intermediate-term bond fund rose only 0.87% – again, not much better than a money market fund.
- Alternative Investments: Morningstar reported that the highest return that was posted by anything in its alternative sector in 2016 was multi-currency funds, which grew by 3.01%. Managed futures funds declined by just over 3%, despite the fact that broad commodities, which are not classified as alternative investments, rose by nearly 12% last year, fueled by gains in gold, oil and the dollar.
Advisors who have clients who are wondering why their portfolios lagged the index need to have a conversation about the long-term benefits of diversification and why it is necessary. Advisors who can explain to their clients that poorly performing holdings now may become tomorrow’s winners will have a much easier time managing client expectations. (For more, see: How to Make Sure Clients Diversify.)
Advisors can point out that energy funds enjoyed a banner year in 2016 compared to the year before, and funds that invested in gold mining companies rose by over a whopping 50%. Those who invested in small-cap value funds or high-yield bonds saw excellent returns on capital in these sectors, which boosted portfolios for the year. Latin American funds rose by nearly 30% and diversified emerging markets funds rose by over 8% compared to other international peers. Historical analysis shows that those who invested in both the 10 worst-performing sub sectors and the 10 best-performing sub sectors each year have enjoyed annual gains of 13.6% since 1991.
The Bottom Line
The moral of the story is that broad-based diversification still works, and investors can still earn decent returns even if they do lag the S&P 500 from time to time. (For more, see: How to Help Clients See Value of Diversification.)