How The Fund Works

Investments & Performance
Investment Review
For the Quarter Ended March 31, 2018

Overview

The first quarter of 2018 was a tale of two markets. January marked one of the strongest monthly equity market rallies, coming off a powerful year with most equity markets generating double-digit returns – in US Dollar (USD) terms – fueled by synchronized global growth, a U.S. tax cut, and accommodative central bank policies. This euphoria began to wane in February, however, with hints of inflation coming in above expectations via a higher-than-expected figure for U.S. hourly wages. Yet, this was not the underlying cause for the February sell-off in stocks. The initial sell-off was more technically-driven in the U.S., induced by the unwinding of levered and crowded positions, driven by owners of risk premia and short volatility products and, to a lesser extent, commodity trading advisors.

This sell-off continued in March due to: (1) additional concerns around higher interest rates, which increase the discount rate at which stocks are valued, increase the cost of borrowing for companies and consumers, and lessen the appeal of stocks relative to bonds; (2) the potential for a trade war between the U.S. and China; as well as (3) the more recent data privacy issues that could result in additional regulation of major technology corporations. Due to rising rates, inflation, and the reduction of short volatility pressure, going forward we expect markets to be more volatile, unlike 2017, yet more like the experiences of February and March and, indeed, most time periods.

Against this backdrop and despite the recent equity market volatility, the Fund enjoyed a positive quarter, growing 0.9% (after all management fees paid and the Fund’s investment-related costs, as are all return figures herein shown). As a long-term investor, we pay more attention to longer periods. Over the last five and seven years, for instance, the Fund generated annualized returns of 7.3% and 7.1%, respectively.

These results are encouraging, as they exceed the threshold required to match the growth of our liabilities. We recognize, however, that these 5- and 7-year periods did not include a period of significant market downturn. The 10-year returns of 5.6% reflect and capture the market downturn during the global financial crisis (GFC) of 2008.

While we primarily focus on absolute returns, relative returns (versus a benchmark of similar investments) can provide helpful data points as well. During the quarter, our Fund outperformed our customized Composite Benchmark by +57 bps. Over longer periods of five and seven years, we outperformed this benchmark by +35 bps and +43 bps, respectively.

Despite the recent turbulence in markets, the outlook for global growth and relatively low inflation remains intact. However, equity valuations still remain on the high side. When one factors in higher discount rates on future earnings and cash flows, it still appears to be difficult for many retirement plans (such as ours) to find attractive generic opportunities to earn long-term returns approximating the rate at which their liabilities grow. In light of this, we at the Fund are continuing to structure a distinctive portfolio that we believe gives us the best chance of achieving our investment objectives.

Some Perspective: Our Goals and Core Strategy

The Fund's mission is to empower YMCA employees to achieve economic security, resulting in loyalty to the YMCA Movement. To help achieve this mission, the Fund seeks to build a portfolio that generates attractive long-term returns (over many years, cycles, and even decades) while maintaining defensive characteristics to safeguard the pension promises.

The core elements of our investment philosophy for achieving our mission include the following:

  • Building a diversified portfolio in which the several asset classes behave in a different and not highly correlated fashion under different economic conditions.

  • Seeking to complement our predominantly equity-market-influenced sources of return with other return drivers, thereby diversifying the Fund’s sources of return and positioning the Fund to fall less than stocks when equity markets decline.

  • Recently, we have added to our Diversifying Strategies two managers that use trading strategies that take advantage of volatility in markets, which should provide returns uncorrelated to more traditional equity and fixed income markets. We are also adding a discretionary global macro manager that has a relative value focus and specializes in rates and foreign exchange, which should also generate less correlated returns.

  • Allocating capital to exceptional investment managers that we believe can produce superior returns through full market cycles.

  • Capitalizing on the Fund’s long-term horizon to accept some illiquidity by investing in private investments in several asset classes in exchange for higher expected returns.

Macroeconomic and Market Environment

While calendar year 2018 continued where calendar year 2017 left off with a strong equity market rally, equity markets hit an inflection point in February with a sell-off that continued through the end of the quarter. Despite the sell-off, fundamentals remain positive but wage inflation appears to be picking up and the potential for actions that inhibit global trade seems to be weighing on investors. Although equities sold off in the first quarter, they still remain near all-time highs and central banks globally have begun or may begin to taper their highly accommodative policies in 2018.

US

Despite the U.S.-centric equity market sell-off in the quarter, U.S. market fundamentals remain strong: (a) earnings growth has continued upward; (b) fourth quarter 2017 earnings releases have broadly exceeded expectations; and (c) consensus full-year 2018 earnings growth estimates have been revised up, largely due to the impact of the recently passed U.S. tax cuts. GDP growth remains strong with the GDP estimate for the fourth quarter of 2017 being revised up to 2.9% from the previous 2.5% estimate while unemployment remains at a 17-year low of 4.1%.
The picture isn’t entirely rosy, however, and we may be exiting this “goldilocks” era of rising growth and low inflation. Due to rising inflation, the Fed increased the pace of its rate increases and hiked rates again in March, the sixth increase since 2015. This pace is expected to accelerate. Projections by members of the Fed indicate three hikes in 2018, but there appears to be a good chance the Fed will hike rates once per quarter. One concern that comes out of the recent rate increases is the potential for the yield curve to become inverted. As of the end of the first quarter, the yield curve from 5- to 30-years has flattened to about 40 bps, the narrowest spread since 2007. The 2- to 10-year gap has also flattened and is only 45 bps, the lowest in more than a decade. Also, for the first time since the GFC, the 2-year Treasury yield is now higher than the S&P 500 dividend yield which, on the margin, reduces the appeal of equities.

Europe

Similar to U.S. equities, European equities sold off during the first quarter but market fundamentals remain solid. Earnings results were largely positive as was growth in the fourth quarter despite unfavorable currency headwinds. Negative performance in UK stocks was the main driver for Europe’s underperformance versus those of other developed markets. This was due to Sterling strength on the expectation that the Bank of England may lift rates faster than the market had anticipated. The European Central Bank left rates unchanged this quarter at their March 8th meeting but stated it would be less willing to increase the size and/or duration of its asset purchase program even if the economic outlook were to become less favorable. Political risks in Europe partially subsided during the quarter as the European Union and the United Kingdom agreed to extend the Brexit transition period by 21 months from March 2019 to the end of 2020. Additionally, Germany was able to form a coalition government which is headed by Angela Merkel after a five-month standstill. 

Emerging Markets

Continuing the trend from 2017, the aggregation of twenty-three countries’ markets, known collectively as emerging market (EM) equities, sustained their strong performance in the first quarter of 2018, outperforming their developed market counterparts for the fifth consecutive quarter. In the first quarter, the MSCI EM Index returned 1.4% (in USD), while the S&P 500 and Stoxx Europe 600 in USD contracted -0.8% and -1.9%, respectively. EM equity performance has been supported by strong growth, rising oil prices and a continued weakening of the USD. 

Global Economy

On a global level, sentiment remains positive regarding the macroeconomic environment which should support risk assets going into the second quarter. According to the IMF, “growth this broad-based and strong has not been seen since the world’s initial sharp 2010 bounce back from the financial crisis of 2008-2009.” Global growth for 2018 is expected to rise to 3.9%, up from 2017’s 3.8%, which had been the highest since 2011. Earnings data globally remain positive as well, with the MSCI World Index growing year-over-year earnings by 20% in Q1. However, growth, especially in the more advanced economies, is not expected to last in the longer term. After several years of historic levels of expansionary monetary policy and recent expansionary fiscal policy, inflation has been accelerating. This suggests that interest rates should rise; and indeed they have begun to do so. Global inflation is also expected to accelerate to 3.5%, up from 2017’s 3.0%.  

Outlook

As has been the case for a few years now, Management views few asset classes and investment strategies as attractively priced for buyers. This makes for challenging times as we seek to protect and grow the $7 billion of pension assets with which we are entrusted.

Many institutions that we respect share this view, including Cambridge Associates, our investment consultant, which evaluates most asset classes as being either overvalued or fairly valued. The result: few compelling options for investors and hence the potential for – and even likelihood of – lackluster returns going forward, as discussed previously.

During the Fund's ninety-six years, broad and index-like exposure to stocks and bonds has been sufficient to fulfill the Fund's mission. We do not believe that this will remain so over the next decade. As a result, Management is working diligently to add exposure to other sources of returns while also enhancing the Fund's ability to perform relatively well if market conditions deteriorate. We remain focused on maintaining and refining a well-diversified portfolio that is built for the long term and that tilts, when appropriate, to sectors of more attractive, risk-adjusted returns.


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