Coldstream Tactical Allocation Decisions: An Example

Investment decisions at Coldstream are made by our Investment Strategies Group (ISG), which is composed of client portfolio managers, as well as managers of other Coldstream investment vehicles such as our 401K and alternative investment products. ISG sets strategic parameters for its asset allocation decisions. These parameters are designed so that client accounts are balanced and diversifi ed among asset classes. Within these strategic parameters, ISG also makes tactical decisions. These tactical decisions all fall within ISG’s strategic framework, but we will overweight and underweight asset classes based on ISG’s view of the near to medium term prospects for each particular asset class.

At the beginning of 2014, ISG made the decision to reduce small and mid cap stock (SMID) exposure in client portfolios in favor of increasing exposure to large cap stocks. This decision added value to client portfolios, particularly in the third quarter when small cap stocks, as measured by the Russell 2000 index, declined 7.4% and mid cap stocks, as measured by the S&P 400 index declined 4.0% compared to a 1.1% gain for the S&P 500 index.

In 2013, small cap stocks outperformed large cap stocks, with the small cap index gaining 38.82% on a total return basis while the S&P 500 index gained 32.28%. However, ISG felt this outperformance was due more to momentum than it was to fundamental valuation. The trailing price to earnings ratio (p/e) for SMID at the end of 2013 was 23.6, while the p/e for large cap stocks was 17.4. On a forward looking basis, large cap stocks appeared relatively undervalued as compared to SMID with an estimated 2014 p/e for SMID of 18.8 as compared to 15.5 for large cap stocks. While it is not unusual for small and mid cap stocks to have higher p/e ratios than large cap stocks (as investors often think the growth prospects for SMID are greater than those for large caps), ISG believed the degree of disparity at the end of 2013 did not have a fundamental basis. In addition, several market pundits were warning that small cap stocks could underperform large cap stocks if interest rates rose, as typically, small cap companies are more dependent on debt financing than large cap companies are. While this view was not central to ISG’s determination, it provided support for its thinking. In early 2014, ISG closely reviewed the data and recommended reducing the weight to SMID and increasing the weight to large cap stocks in client portfolios.

This tactical allocation decision worked well. At the end of the third quarter, large cap stocks generated an 8.3% return YTD, while small cap stocks have declined 4.4% YTD and mid cap stocks have gained 3.2%.

We do want to emphasize that these allocation changes do not affect the strategic parameters in client portfolios. We did not eliminate portfolio allocations to SMID, as ISG does not take big market “bets.” It tries instead to make tactical decisions, within a strategic framework that increases exposure to those asset classes that it believes will outperform in the near to medium term.