Q1 Slideshow Posted 2012
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Legacy², LLC
Registered Investment Advisor Firm
Q1 2012 Review
Slide Presentation _ 15 Apr 2012
□ Review of First Quarter (what happened);
□ Investment Outlook (what is happening now);
□ Our Portfolio Positioning (what we’re doing about It).
Agenda
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o Stocks and other risk assets were up sharply:
This further reduces our five-year return expectations;
o Rising Treasury yields resulted in flat first quarter returns for core bonds:
Our flexible fixed-income strategies did well, given their latitude to invest; differently than the core bond benchmark
o The euro-zone averted a crisis but did not resolve the longer-term structural problems that threaten the EU system;
o Our portfolios continue to be underweight stocks/equity-risk and core bonds/interest-rate risk.
Key Takeaways
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Review of First Quarter 2012
Drivers of October-March Stock Market Rally
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o Successful intervention that took a European financial crisis off the table, at least for the time being;
o Positive U.S. economic data points, particularly with respect to employment;
o Encouraging results of the Fed’s recent banking stress tests;
o As a result, stocks had one of the strongest gains over that six-month period in many decades.
LEGACY², LLC Registered Investment Advisor
Investment Outlook
o High debt levels create economic headwinds;
o High debt levels increase risk;
o There is no solution that does not involve economic pain.
Developed World is Still Struggling to Climb Out of Debt
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Refinancing Operations Slowed Europe’s Financial Crisis (For Now)
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o Liquidity injection reduced risk of a run on the banking system;
o Government bond yields have fallen, reducing these countries’ borrowing costs:
Allows countries to borrow cheaply to finance deficits and reduce overall debt;
o Provides countries additional time and space to enact difficult economic and political reforms;
o However, the markets are recognizing that underlying problems remain:
Yield on Spanish debt has been moving sharply higher on renewed concerns about government’s ability to meet deficit reduction targets;
New Greek debt is trading at prices that reflect a high probability of another default/restructuring.
LEGACY², LLC Registered Investment Advisor
o January 1, 2013: “massive fiscal cliff of large spending cuts and tax increases”:
Expiration of Bush-era tax cuts, the temporary payroll tax cut, extended unemployment benefits ;
$1.2 trillion of automatic spending cuts will begin to kick in as a result of last year’s Congressional Super Committee’s failure to reach consensus;
o Impact would be roughly 3.5% hit to GDP next year;
o Seems unlikely it will play out that way, but risk of policy errors and political dysfunction—particularly in an election year—remain high!
Problems at Home: The Looming U.S. “Fiscal Cliff”
9 LEGACY², LLC Registered Investment Advisor
Our Portfolio Positioning
o Core bonds are set to generate very low returns over the next five years:
Underweighted to core bonds in favor of flexible fixed-income and alternative strategies;
o Stocks also offer subpar returns over our long-term investment horizon:
o Underweighted to stocks/equity-risk;
o Continue to see attractive tactical opportunities in emerging-markets local-currency bonds, absolute-return-oriented fixed-income and alternative strategies;
o Expect periods of heightened volatility along the lines of what we saw last year:
o These environments can create opportunities to increase our weightings to riskier asset classes at lower prices.
Portfolio Positioning Reflects our Longer-Term Concerns
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Future Returns of Stocks and Bonds Will be Lower than We’re Used To Seeing
12 1 Projections as of 10/1/11.
2 As measured by the Barclays Aggregate Bond Index .
1
2 1 Projections under our base case, subpar economic scenario as of 3/31/12
2 As measured by the Barclays Aggregate Bond Index .
LEGACY², LLC Registered Investment Advisor
o We expect low returns from U.S. and developed international market stocks over the next five years;
o Emerging-markets stocks look attractive on a long-term basis, but, given higher short-term downside, we aren’t increasing our weightings;
o Periods of short-term volatility should create opportunities for skilled managers to take advantage of shorter-term mispricing at the individual stock level.
We Remain Underweighted to Stocks
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o We expect low returns in all our five-year scenarios, with minimal downside protection;
o We favor flexible and absolute-return-oriented fixed-income managers:
Managers have wide latitude to adjust portfolio characteristics. such as duration, credit quality, sector, currency and foreign bond exposure;
o We expect inflationary pressures to increase toward the end of our five-year horizon:
Our non-core bonds funds should do much better than the core bond index if inflation heats up.
We Remain Underweighted to Core Bonds
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o Core bonds (investment-grade bond funds) traditionally:
Reduce portfolio risk because they are far less volatile than stocks;
Provide protection against a major economic shock/recession;
Generate current income;
o There are two major risks inherent in bonds:
Credit risk;
Interest-rate risk;
• The longer until a bond is repaid (maturity), the more its value falls due to a rise in interest rates.
Traditional Role of Core Bonds in a Portfolio
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Current Bond Market Environment Argues for Investing Outside of Core Bonds
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o Treasury yields are near all-time lows and we expect to see rates rise within the next five years:
When rates do rise, bond values will fall;
o Flexible and absolute-return-oriented fixed-income managers have more latitude to pursue return and lessen impact of rising rates;
o It is important to maintain some exposure to core bonds as protection in a very negative scenario.
LEGACY², LLC Registered Investment Advisor
Positioning of Our Fixed-Income Strategies
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Osterweis Strategic Income
Double Line Total Return
Pimco Unconstrained Bond
VBMFX
Pimco Total Return
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
0 1 2 3 4 5 6 7 8
D
I
S
T
R
I
B
U
T
I
O
N
Y
I
E
L
D
INTEREST-RATE SENSITIVITY (DURATION—IN YEARS)
Our fixed-income portfolios have less interest-rate sensitivity and higher yields than traditional core bond portfolios
Source: Morningstar
The longer the duration, the greater a fund's interest-rate sensitivity
The core bond index is generally lower yielding
and has more interest-rate sensitivity
LEGACY², LLC Registered Investment Advisor
o Arbitrage positions could potentially earn mid-single-digit returns over the next five years with relatively low risk over the shorter term;
o We view these positions as “dry powder” that can generate better returns than core bonds in the meantime (not subject to the risk of rising rates).
Alternatives Provide Further Portfolio Diversification
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o We remain confident in our portfolio positioning;
o We are focused on the long term, while remaining flexible and nimble through this highly unstable and uncertain environment;
o We will take on more risk when our research convinces us it is prudent and, in so doing, we believe we can get better returns than just what the market yields.
Looking Ahead
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Asset Class Returns Asset Class
(current tactical overweighting or
underweighting )
Index 1Q 2012 12
Months
5 Years
(Ann.)
U.S. Larger-Cap Blend ( since Nov-08) Vanguard 500 12.54% 8.37% 1.94%
U.S. Larger-Cap Growth iShares Russell 1000 Growth 14.61% 10.83% 4.93%
U.S. Larger-Cap Value iShares Russell 1000 Value 11.05% 4.60% -0.91%
U.S. Smaller-Cap Blend ( since Sep-06) iShares Russell 2000 12.42% -0.18% 2.18%
U.S. Smaller-Cap Growth iShares Russell 2000 Growth 13.28% 0.75% 4.17%
U.S. Smaller-Cap Value iShares Russell 2000 Value 11.55% -1.20% -0.05%
Developed Int'l Stocks ( since May-09) Vanguard MSCI EAFE ETF 11.50% -5.43% -3.05%
Emerging-Markets Stocks ( since Jan-12) Vanguard Emerging Market ETF 13.96% -9.02% 4.55%
REITs Vanguard REIT 10.71% 12.74% 0.31%
Investment-Grade Bonds (since Dec-09) Vanguard Total Bond 0.23% 7.56% 6.12%
Absolute-Return-Oriented Bonds (since Dec-09) Citigroup 3 Month T-Bill Index 0.04% 0.07% 1.12%
High-Yield Bonds Merrill Lynch High-Yield 5.04% 5.70% 7.74%
Inflation-Protected Bonds iShares Barclays TIPS Bond 0.78% 11.98% 7.46%
Floating-Rate Loans (since Mar-11) S&P/LSTA Leveraged Loan 3.74% 2.80% 4.52%
Commodity Futures Dow Jones-UBS Commodities 0.89% -16.27% -2.78%
Global Investment-Grade Bonds Citigroup World Gov’t Bond -0.51% 5.12% 6.78%
Emerging-Markets Local-Currency Bonds (since Aug-09) JPMorgan GBI-EM Global Div. 8.29% 3.44% 10.05%
We Expect to See More Volatility Ahead
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The Chicago Board Options Exchange Volatility Index, or VIX, is a commonly used indicator of market volatility. Often referred to as the “fear index” it is a measure of investors’ expectations of S&P 500 volatility over the near term.
LEGACY², LLC Registered Investment Advisor
Our Fixed-Income Positions Are Likely to Outperform Core Bonds in Most Long Term Environments
Best Returns
Worst Returns
Short-Term “Flight to Quality” Period
(e.g. 3rd Quarter 2011)
Litman Gregory’s Five-Year Scenario Analysis
Severe Recession Stagflation Subpar Recovery Average Recovery
Barclays Capital Aggregate Bond
Index
Floating-Rate Loan Funds
Floating-Rate Loan Funds
Emerging-Markets Local-Currency
Bond Funds
Emerging-Markets Local-Currency
Bond Funds
Investment-Grade Bond Funds
Multi-Sector Bond Funds
Emerging-Markets Local-Currency
Bond Funds
Multi-Sector Bond Funds
Multi-Sector Bond Funds
Absolute-Return-Oriented Bond Funds
Investment-Grade Bond Funds
Multi-Sector Bond Funds
Floating-Rate Loan Funds
Floating-Rate Loan Funds
Floating-Rate Loan Funds
Barclays Capital Aggregate Bond
Index
Absolute-Return-Oriented Bond Funds
Absolute-Return-Oriented Bond Funds
Absolute-Return-Oriented Bond Funds
Multi-Sector Bond Funds
Absolute-Return-Oriented Bond Funds
Investment-Grade Bond Funds
Investment-Grade Bond Funds
Investment-Grade Bond Funds
Emerging-Markets Local-Currency
Bond Funds
Emerging-Markets Local-Currency
Bond Funds
Barclays Capital Aggregate Bond
Index
Barclays Capital Aggregate Bond
Index
Barclays Capital Aggregate Bond
Index
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Reminder: Our Portfolio Management Approach
Stat
ic
T
acti
cal
Active Passive/Indexing
ASSET ALLOCATION APPROACH
INVESTMENT MANAGEMENT APPROACH
Maximize risk-adjusted returns through tactical asset
allocation and “best-in-class” active manager selection.
Litman Gregory LEGACY², LLC
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Our “Fat Pitch” Tactical Allocation Strategy
Over the long term we expect valuations and fundamentals to converge.
Years
Asset C
lass V
alu
ations
Shifting allocation back down to
neutral
Current Valuations
Fair Value Based on Fundamentals
Potential “fat pitch” shift to allocation above neutral
When Long-Term Fundamentals and Current Valuations Diverge… We May Find a “Fat Pitch” Investment Opportunity
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SCENARIO DEFINITION
Severe Recession
• We experience a severe recession, e.g., due to another financial crisis or
debt crisis
• Weak recovery in the later years
• Assumes inflation is around 1% and the 10-year Treasury yield is around
2% at end of year 5
Stagflation
• Subpar economic growth
• Strong inflation spike at the end of our forecasting period
• Assumes inflation is around 6% and the 10-year Treasury yield is around
7% at end of year 5
Subpar Recovery
• Recovery that began late in 2009/early 2010 continues, a recession is
probable within the five-year horizon
• Assumes inflation is around 3% and the 10-year Treasury yield is around
5% at end of year 5
Average Recovery
• Recession is avoided and the economy recovers due to a combination of
effective government policy and positive self-reinforcing economic and
business cycle dynamics
• Re-flation works, but Fed avoids monetary inflation
• Assumes inflation is around 3% and the 10-year Treasury yield is around
6% at end of year 5
Our Four Broad Economic Scenarios*
*As of 3/31/12. 25
LEGACY², LLC Registered Investment Advisor
Scenario Analysis: Asset Class Return Estimates
More Pessimistic More Optimistic
Economic Scenario Severe Recession Stagflation Subpar Recovery Average Recovery
As of 3/31/12 S&P 500 at 1409, Barclays Aggregate yield at 2.0%, MSCI EM Index at 1041, BofA Merrill Lynch High-Yield Cash Pay Index at 7.0%.
Equity Asset Classes Estimated Average Annual Returns over Next Five Years
U.S. Equities -4.9% -3.5% 2.9% 11.2%
Developed International Similar to U.S. Equities
Emerging Markets 0.8% n/a 9.6% 18.9%
REITs -0.4% -2.0% 1.5% 1.9%
Fixed Income Asset Classes
Investment-Grade Bonds 1.9% -0.4% 0.6% 0.2%
High-Yield Bonds 1.7% 4.2% 3.5% 2.1%
Floating-Rate Loans 3.7% 3.5% 4.0% 4.1%
TIPS 2.4% 0.0% 0.0% -1.0%
Emerging-Markets
Local-Currency Bonds
Low single-digit
returns
Low/Mid single-digit
returns
Mid/High single-digit
returns
Mid/High single-digit
returns
Alternative Asset Classes
Arbitrage Strategies Mid single-digit returns in most scenarios
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Of Our Four Broad Economic Scenarios, We Believe “Subpar Recovery” is the Most Likely
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Economic Scenario: Subpar Recovery
Equity Asset Classes
U.S. Equities 2.9%
Developed International Similar to U.S. Equities
Emerging Markets 9.6%
REITs 1.5%
Fixed-Income Asset Classes
Investment-Grade Bonds 0.6%
High-Yield Bonds 3.5%
Floating-Rate Loans 4.0%
TIPS 0.0%
Emerging-Markets Local-Currency Bonds Mid/High single-digit returns
Alternative Asset Classes
Alternative Strategies Mid-to-upper single-digit returns in
most scenarios
Chart is as of 3/31/12 S&P 500 at 1409, Barclays Aggregate yield at 2.0%, MSCI EM Index at 1041, BofA ML High Yield Cash Pay Index at 7.0%.
LEGACY², LLC Registered Investment Advisor
% Underweight
of Current from Neutral
Current
Weight
Neutral
Weight
% Overweight
of Current from Neutral
30 25 20 15 10 5 5 10 15 20 25 30
Fixed Income
Core fixed income 37% 60%
Floating-Rate Loans 6% 0
Absolute-return-oriented/Flexible 24% 0
Emerging-markets local-currency
bonds
5% 0
Alternatives
Arbitrage 5%
Equities
Larger cap 16% 20%
Smaller cap 1.5% 4%
Developed international 2.0% 8%
Emerging-markets 3.5% 8%
Tactical Positioning of Conservative Balanced Portfolio
28 LEGACY², LLC Registered Investment Advisor
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