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In his book, Originals, Adam Grant devotes a chapter to analyzing the concept of “groupthink” and contrasting cultures that embrace commitment vs. cultures that encourage differing opinions. Organizations that use a commitment blueprint seek to employ people that identify with the company culture and value system. Organizations that have a “think different” culture allow all employees to openly communicate their ideas, opinions and criticisms of each other, regardless of position and hierarchy. There are pros and cons to each of these cultures, but the overriding theme of the book is that original thinking in all areas of life is what moves the world.

I believe that there are two areas in the investment industry that have been negatively affected by groupthink. First, the popular and prevailing idea that low-cost index (passive) investing is the only path to riches. Second, the predominance of research analysts and portfolio managers that have earned their Certified Financial Analyst (CFA) designation has created a generation of investment professionals that have been similarly trained and thus espouse comparable investment management approaches. We conduct research and due diligence on hundreds of investment strategies and, after a while, a lot of them begin to look and sound nearly identical. One outcome of this type of groupthink is that many actively-managed strategies start to look like their benchmark indexes. These active managers consider it a form of career risk to fall too far behind an index, so they become “closet indexers.” The problem, of course, is that investors do not want to pay higher active management fees for index-like returns.

The groupthink regarding index investing is also dangerous because most investors do not understand the composition of any given investment index. For example, many investors do not understand the ramifications of a market-capitalization weighted index like the S&P 500 Index, a very popular investment for more and more people. The market capitalization of a company is simply the price of a company’s stock multiplied by the total number of outstanding shares. The danger of index investing lies in the fact that, as a company’s stock price rises, so does its weighting in the index. Eventually, a company or industry weighting in the index can become so high that new investors are effectively “buying high” valuations, rather than the common investment goal of “buying low and selling high.” The highly touted S&P 500 Index has been a top performing investment for the past eight years, which is encouraging even more investors to buy funds that track this index. Let’s look at a few charts to illustrate the potential danger of this single investment:

This chart illustrates the returns of the S&P 500 Index relative to the U.S. Large Cap Blend Universe of active managers. You can see that it has been nearly impossible for active managers to beat the S&P 500 Index in recent years. However, notice that this has not always been the case. Over the past 20 years, there is a notable pattern of outperformance of active management during bear markets. True active managers are not tied to an index and therefore tend to be more prudent investors, and they can become defensive during tough times in the market.

This chart illustrates that the S&P 500 Index has, by far, been a top performer when compared to actively-managed global stock funds in recent years. The U.S. government was the first to adopt easy-money policies that helped spur the market, and other countries were late to this game. As you can see, however, U.S. stock market dominance is not always the case, and investors should not be lulled into thinking that the recent phenomenon will continue indefinitely.

This chart illustrates that the S&P 500 Index has also been a top performer relative to actively-managed small cap funds in recent years. However, you can easily see that this has not always been the case and, in fact, small cap funds were extremely dominant for a long stretch in the first decade of the 2000s.

The most important takeaways from these charts are:

Indexing does not always beat active management, and active management is most effective during market downturns.Diversification is extremely important for long-term investors, as no single index or asset class performs best in every market cycle.Nobody can predict exactly when market cycles and asset class performance will turn.

It is not easy to break away from groupthink, and even harder to be an original thinker. What seems obvious with short-term hindsight is clearly not so apparent with a longer-term vision. I would encourage everyone to not get too caught up in following the herd and to enjoy some creativity and originality in your life…it can be a lot of fun!

2017 Q2 Review

What a strong quarter for investment performance…other than commodities, it was hard to find a broad asset class that lost money. Enjoy it while it lasts! The U.S. stock market finished the quarter in positive territory. Generally, large cap stocks earned more than small cap stocks and the growth style outperformed the value style…a continuation of the first quarter’s trend. The best performing sectors in the S&P 500 Index in Q2 included Technology (+17.2%), Health Care (+16.1%), and Consumer Discretionary (+11.0%). The worst performing sectors during the quarter were Energy (-12.6%), and Telecom (-10.7%). These were the exact same sectors that were the best and worst performers in the first quarter, which is highly unusual.

Non-U.S. stocks, in both developed and emerging markets, continued their resurgence. During the quarter, the best performing countries included China (+10.7%), France (+9.9%), and Germany (+6.9%). Countries whose stock markets delivered lower returns for U.S. investors included commodity-dependent countries like Russia (-9.8%) and Brazil (-6.6%). The U.S. Dollar generally fell (again) relative to most other currencies, increasing returns for U.S. investors in international stocks.

The fixed income markets also delivered mostly positive returns for the quarter as lower credit quality bonds led the way, consistent with an optimistic stock market. Cash (money market funds) yields remained low and steady during the quarter.

Hedging strategies generally delivered positive returns in the second quarter, with the HFRI Composite earning +2.2%.

Here are the returns for select market indices for Q2 and YTD 2017 (as stated in U.S. Dollars):

Responsible Investing Corner

One of the most fulfilling aspects of Sustainable, Responsible and Impact (SRI) investing is the impact it can make in themes such as affordable housing, job creation, neighborhood revitalization and environmental sustainability. For all you sports fans, here is a fun example of an impact bond:

Bond proceeds were used to finance infrastructure developments for the Business Leadership Building and the Apogee Football Stadium at the Denton Campus of the University of North Texas. The Apogee Football Stadium is the first collegiate football stadium in the nation to achieve the highest level of Leadership in Energy and Environmental Design (LEED) certification as well as the first stadium designed to incorporate onsite renewable wind energy. The three wind turbines installed in 2012 have eliminated 323 metric tons of CO2 annually that would have otherwise been released into the atmosphere. Additionally, more than 80 percent of the construction waste generated by the project was either recycled or reused, thereby diverting 6,568 of the 7,881 tons of waste from the landfill.1

I was recently quoted in TheWall Street Journal about the novel concept employed by our firm (https://www.wsj.com/articles/robo-advisers-latest-foray-socially-responsible-investing-1497697212), which was a new experience for me. I was also quoted in an excellent article written by Tom Saler in the Milwaukee Journal Sentinel (http://www.jsonline.com/story/money/2017/07/15/history-has-steered-folks-environmental-social-and-governance-investing/479091001/).

Falcons Rock Impact Investments, LLC (www.prophecyimpact.com) is designed for anyone, regardless of the size of their investment portfolio, who is interested in generating a competitive rate of return while helping to make the world a better place. Our Sustainable Portfolios are performing very well on a risk-adjusted return basis. We are happy to provide you with a quarterly performance report on our model portfolios, upon request.

I would appreciate you spreading the word about Falcons Rock Impact.

This and That

The new Department of Labor (DOL) Fiduciary Rule, which expands the definition of an “investment advice fiduciary,” is designed to require all financial advisors to act in the best interests of their clients. This is a much higher level of accountability than the “know your client” rule that most commission-based brokers were required to adhere to in the past, and will dictate changes in the way investment advice is delivered to retirement plans and retirement accounts. As a non-conflicted, fee-only, Registered Investment Advisor, Falcons Rock Impact has operated under a fiduciary standard since we launched the firm.A little known addition to the Financial CHOICE Act, recently passed by the U.S. House of Representatives, would replace the current Shareholder Proposal Rule (SEC Rule 14a) and essentially eviscerate most shareholders’ ability to introduce a resolution for consideration by publicly-traded companies. The long-standing current rule allows shareholders that have owned at least $2,000 of stock for at least one year to introduce a proposal. The proposed change, under Section 844 (yes, it is a huge piece of legislation) of the CHOICE Act, states that a shareholder would have to own at least 1% of all outstanding shares of stock of the company for at least three years before it could submit a proposal. This means that a Wells Fargo shareholder would need to own more than $2 billion of stock in order to have this input! This absurd proposal will hopefully be reviewed and eliminated in the Senate, as it violates a basic shareholder right that has been enjoyed for decades. Shareholder resolutions have resulted in many positive changes for publicly-traded businesses of all sizes over the years. This proposal would be a huge blow to the shareholder advocacy efforts employed by many SRI investors. If you would like to learn more about this proposal, I can provide you with additional information and would encourage you to write your Senate representatives about this issue.In yet another example of how groupthink often is not accurate, our Milwaukee Brewers are in first place in their division at the All-Star break. Considering that the rival Cubs won the World Series last year, there were literally no “expert” prognosticators who predicted the Brewers resurgence this season…they are young and hungry. Go, Brew Crew! “In fact, the only sin which we never forgive in each other is difference of opinion.” – Ralph Waldo Emerson

My thanks to the many well-wishers who read my first quarter letter. I’m recovering well, and am even back to playing tennis again!

Thank you for being a loyal client of Falcons Rock Impact.

Gregory D. Wait, President Falcons Rock Impact Investments, LLC

1 Community Capital Management, First Quarter 2017 Investment Spotlights