NEW YORK (TheStreet) -- There is a concept in the investment community that is discussed primarily behind closed doors: underperformance. Whether a manager is underperforming his benchmark (like the S&P 500) or his peers (think hedgies like Einhorn, Ackman, Loeb, Paulson, etc.), believe me he is paying attention.
If that underperformance becomes dramatic -- regardless of what he's saying in shareholder letters or interviews -- you had better believe he is getting nervous.
Money managers the world over have different conversations with their clients (or shareholders/investors) than they do with their colleagues. This shouldn't come as a complete surprise. But are discipline and decision-making ever affected during periods of underperformance?
Case in point is 2013. We all know the stock market (S&P 500) was up about 30% last year, with a fairly good-sized hiccup during June's unexpected and severe rate spike. Can you name a single manager or fund that beat the S&P 500 last year? I can't. None of our client portfolios beat the S&P last year -- and we make no apologies for that fact.
But a real mistake might have been to try and "catch up" by taking on more risk at the beginning of 2014. The news flow was all positive coming into the new year and it would have been understandable (sort of) to open the year by applying pressure to the gas pedal instead of the brake. But the result would have been adding exposure to all the asset classes that got whacked hardest in January's mini-correction: Small-caps (iShares Russell 2000 Index (IWM) - Get iShares Russell 2000 ETF Report lost 7.3%), emerging markets (Vanguard FTSE Emerging Markets ETF (VWO) - Get Vanguard FTSE Emerging Markets ETF Report lost 7.9%) or even just the S&P 500 (which lost 5.6%).
"Three tomatoes are walkin' down the street.
Papa Tomato, Mama Tomato and Baby Tomato.
Baby Tomato starts lagging behind, and Papa Tomato gets really angry.
Goes back and squishes him and says: Ketchup."
- Pulp Fiction
Instead, and against the conventional wisdom that insisted interest rates would move higher, we maintained the allocations with which we closed out 2013. The result has been some fairly nice outperformance.
We held a good deal of exposure to some of the industry's most-maligned asset classes six months ago: REITs (Vanguard REIT Index ETF (VNQ) - Get Vanguard Real Estate ETF Report) up 16% year to date; MLPs (JPMorgan Alerian MLP Index ETN (AMJ) - Get J.P. Morgan Alerian MLP Index ETN Report), up 12% year to date, and long-dated bonds (iShares 20+ Year Treasury Bond Index ETF (TLT) - Get iShares 20+ Year Treasury Bond ETF Report), up 13% year to date.
While this may sound a bit self-congratulatory, it's really not meant to be. This is merely a qualitative case study about how our behavior and decision-making is affected by our own relative performance.
Ok, that's great, so what are you doing now?
You are starting to hear even the most bullish of investment professionals struggling to find good values here. Very few subsets of the U.S. equity market look inexpensive right now. We like to look at potential upside versus downside when making buy/sell decisions -- how much upside is there for U.S. stocks from here in the near term? My answer, "Not enough to be buying them."
Of course this is a bit of a sweeping generalization because some sectors and individual names still look appealing. But generally speaking, we're happy with what the stock market has given us over the past few years.
We've been discussing a more defensive posture for the past three months, and we have practiced what we've preached in client portfolios. The result has been a little counterintuitive -- further outperformance. Yes, the stock market has continued to grind higher. But so have our portfolios made up primarily of master limited partnerships, Treasuries, international and emerging market stocks, and real estate.
Defense wins championships.
Until we see a correction of some magnitude (at least 5%-10%) we are not particularly interested in adding U.S. equity exposure. In the meantime, I like the idea of maintaining a defensive, income-oriented stance: Continuing to lock in profits from last year as they convert to long-term capital gains -- whenever possible -- and keeping a nice cash cushion a-la Scrooge McDuck.
At the time of publication the author owned AMJ, IWM, TLT, VNQ, and VWO in client accounts.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.