Cumberland has utilized separately managed accounts (SMAs) to execute its fixed-income strategy since the company’s inception in 1973, long before SMAs were popularized in the early 2000s.
The reasons for managing money in this fashion are the same today as they were then:
• Transparency (you know what you own)
• Flexibility to make strategic changes
• Ability to manage transaction costs and best execution
• Active management
SMAs offer individually catered management of clients’ objectives, including tax management, income production, state-specific needs, cash flow-specific needs, and ability to institute investment restrictions.
What exactly is an SMA? Per Investopedia: “A[n] SMA is a portfolio of assets managed by a professional investment firm. In the United States, the vast majority of such firms are called registered investment advisors and operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the US Securities and Exchange Commission (SEC). One or more portfolio managers are responsible for day-to-day investment decisions, supported by a team of analysts, operations and administrative staff. SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single account (hence the name). In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts.”
Many of the elements of this update are the same as last year’s, because the benefits of SMAs remain; however, the markets, technology, and regulation are always changing, which can affect supply, cost of execution, and relationships to other markets. New areas discussed this year are the effects of the pandemic and political responses to it on securities, as well as the prospects for inflation
The Cumberland Approach
At Cumberland we have a top-down approach to investment management. We look at global macroeconomic conditions and policies to assess interest rates and growth prospects and position our portfolios accordingly. Each market and/or sector is evaluated as to how it fits in the global outlook as well as how its idiosyncratic elements may affect supply and credit quality.
The majority of our fixed-income portfolios are managed on a total-return basis using a barbell strategy to more quickly take advantage of changes in interest-rate and technical changes. In a total-return account, the return is measured against a benchmark, which is usually an index that is widely recognized. Outperformance may mean that individual portfolio returns are less negative than the benchmark’s, or that positive returns are greater than the benchmark’s.
Fixed-income total-return investing takes into consideration price appreciation or depreciation and the effects of coupon income generated and reinvested. Coupon payments over time are a large contributor to the return of an account, but the timing of buying and selling and where along the curve to buy or sell can greatly impact returns. Other buy-sell considerations include duration, or the sensitivity of a bond to changes in interest rates, embedded options such as call features, supply and demand, coupon structure, and credit-quality trends. All of these can affect the performance of a portfolio relative to an index or benchmark. Finally, to quote Cumberland’s John Mousseau, “Active management means active thinking, not always active trading.”
Oil Prices and the Pandemic
There was a double whammy to markets in early March. First came a drop in oil prices, followed by the precautionary shutdown of the economy due to the COVID-19 pandemic. Treasury markets rallied as investors sought safety, while other asset classes tanked. On March 24th municipal bonds were yielding 2.52% to 3.37% at ratios of 6.8 to 2.4 times that of comparable Treasury bonds (bonds with the same maturity). At Cumberland we had already become more defensive because rates had gotten so low, and we had already upgraded the credit quality of our portfolios because credit spreads were so narrow. See https://www.cumber.com/the-muni-selloff-that-was/.
The selloff presented opportunities. As funds were selling due to investor redemptions, we were buying long-dated municipal bonds at extremely cheap rates. Our barbell structure allowed us to do this, and many of our shorter-dated bonds were pre-refunded, meaning they were backed by Treasury securities structured to match the cashflow of the bonds to the call date – thus they were very liquid, providing funds for the purchase of the longer-dated, higher-yielding paper.
Subsequently the Federal fiscal and market response (see “The Fed and Markets,” by Bob Eisenbeis, https://www.cumber.com/cumberland-advisors-market-commentary-the-fed-and-markets/, and “Where Are Munis Getting Their Money?” by Patricia Healy, https://www.cumber.com/cumberland-advisors-market-commentary-where-are-munis-getting-their-money/) allayed investor fears and market conditions reversed. Bond prices rose, and the stock market has rallied. The stimulus applied by the Fed to ease economic fallout from the pandemic has increased the prospect for higher tax rates in the future, so municipal bonds have been in high demand. Munis have also been boosted by their higher average credit quality compared with corporate bonds.
Cumberland has been able to take advantage of oversold situations during past times of stress such as the Meredith Whitney incident (2010), the “taper tantrum” (2013), President Trump’s election (2016), and the excess supply at the end of 2017. Subsequent to the dislocation in early March, there was a “Meredith Whitney moment” when Mitch McConnell suggested some municipalities should go bankrupt – handing us an additional buying opportunity. See John Mousseau’s commentary “McConnell as Meredith Whitney”: https://www.cumber.com/cumberland-advisors-market-commentary-mcconnell-as-meredith-whitney/.
See also John Mousseau’s discussion for Oxford University, “Bond Markets Through the Virus”: https://youtu.be/YSBGibTMK4o.
The ongoing pandemic and the government’s reluctance to give direct aid to municipalities could cause some credit events or at least generate negative headlines that could spook conservative municipal bond investors; and strong outflows from funds, lowering prices, could present another buying opportunity; thus we are currently moving to more intermediate securities.
Inflation?
Could inflation rear its head with all the stimulus that has been pumped into the economy and with the Fed signaling that it could withstand periods of higher rates to compensate for periods where inflation has been under the 2% target? Bob Eisenbeis discusses some scholarly papers on the topic here: https://www.cumber.com/cumberland-advisors-market-commentary-inflation/, and David Kotok discusses the experience of France and inflation after a pandemic here: https://www.cumber.com/cumberland-advisors-market-commentary-inflation-coming-maybe-maybe-not/.
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Decades-Long Rate Rally
We have been in a 39-year rally in the bond market, and yields continue to decline in the worldwide trend to zero and even negative rates; but if you don’t pay attention to points of entry and the other details, you can miss out on performance. Similarly, in an increasing interest-rate environment – which may be upon us, given the potential for inflation from accommodative easing – points of entry and exit can affect performance. The use of a barbell strategy allows us to invest in various short-term instruments that are liquid and to use them as ammunition to buy longer-dated bonds when interest rates rise or to take advantage of the higher coupons of longer-maturity bonds compared with shorter-dated bonds. Floating-rate notes and inflation-protected securities are investments that can help returns in the face of inflation and rising interest rates.
We are addressing municipal assets in this commentary; however, we also manage taxable fixed-income, equity, and balanced accounts. In managing equity accounts, we utilize exchange-traded funds (ETFs) and actively conduct sector rotation. Exchange-traded funds allow more flexibility and generally lower total trading costs than individual-stock portfolios do, and they avoid sales and purchases that mutual funds must make due to funds flows. We will consider using fixed-income ETFs in smaller balanced accounts to get the benefit of diversification.
The advantages of SMAs have led to their increased use by investors. According to Citi Research, SMA municipal fixed-income assets, both taxable and tax-exempt, have grown from $100 billion in 2008 to $683 billion at the end of Q4 2019, with holdings expected to reach $704 billion in Q4 2020. The details are not separately reported by the Federal Reserve, so Citi Research uses a quarterly survey of its customers and certain Federal Reserve flow of funds data to arrive at an estimate. Note that the rate of growth of SMA municipal assets has been greater than growth in direct retail and mutual fund municipal assets – but pay attention to the scale. For example, direct retail is still almost double SMA assets.
As discussed earlier, mutual fund performance is affected by fund flows and herd mentality and thus presents opportunities for active fixed-income management. When investors are dumping assets, the mutual fund portfolio manager may not be able to fully practice active management and must liquidate funds as required by redemptions. In these cases, the most liquid and generally higher-quality assets may be sold first in order to minimize effects on net asset value (NAV). Alternatively, when assets are pouring into mutual funds, the increased demand for assets results in higher prices and can present a selling opportunity for SMA managers.
Supply and demand can have an effect on bond performance. The currently low municipal supply is partly due to changes in the Tax Cut and Jobs Act that no longer allow municipalities to refinance certain bonds, as well as to high demand from investors in high-tax states and “cross-over” buyers that have become more familiar with the US municipal bond market. Municipal bonds in general have higher ratings than and less correlation to corporate bonds, as well as higher yields compared to other worldwide offerings. The supply of municipal bonds may increase as budgets are passed and issuers engage in deficit financing.
At Cumberland we buy bonds in large lots and allocate positions to individual portfolios, which allows for better execution and pricing for our clients compared with doing individual trades for each client.
Retail accounts do not enjoy the economies of scale that are available to an SMA manager. In addition, active SMA managers that practice total-return investing may have credit-research resources and relationships with many broker dealers that allow them to achieve competitive execution and develop strategies to optimize investment holdings to meet individual clients’ needs.
While mutual fund shares can be purchased and sold any day in any amount, an SMA account has many individual holdings that may take longer to sell. However, when an investor sells shares in a mutual fund, the price received is calculated at the end of the day, based on the net asset value of the fund. If an investor is instead invested in high-quality liquid bonds like the ones Cumberland purchases in its accounts, then barring an extraordinary event in the market, there should be ample liquidity and the bonds will be sold at a time that maximizes price. Additionally, knowledge of our clients’ needs has Cumberland looking ahead to provide liquidity when needed. SMAs can also give every client the advantage of providing the portfolio manager with sectors or categories, such as “green” or “ESG,” to be excluded or included. Customization is not possible with a mutual fund.
Separately managed accounts generally have higher minimum investment requirements than mutual funds or roboadvisors do, so they are not available to all investors. But as an investor acquires more assets and develops more highly tailored goals and objectives, an SMA may be appropriate.
Finally, the management fee charged on SMA accounts can be affected by the competitive environment. The fee is based on the type of strategy and can be scaled based on the level of assets invested. There may also be custodial fees charged to the account. Mutual funds have an expense ratio, which includes a management fee as well as miscellaneous ancillary expenses, custodial expenses, and a distribution charge. Many have various levels of sales charges. So it is important to look at all expenses when comparing funds.
At Cumberland we continue to operate as our founders did, investing clients’ funds in separately managed accounts. Our approach to investing is top-down and takes account of global interest-rate expectations and credit-quality trends. Accounts are actively managed with a total-return or income orientation, depending on clients’ needs.
Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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