Why is my portfolio trailing the S&P 500? What do I need all this 'diversification' stuff for?
At first glance, this may appear to be a straightforward question. But as domestic equities have shot up in price over the course of the post-recession recovery, leaving a few other portfolio holdings in the dust, some of our clients have understandably asked us about this in recent weeks. Here is our investment team's take on an answer:
While they're the most high-profile and newsworthy, at some point, U.S. stocks won't be the only game in town–we know this intuitively (and from historical experience). We expect this could be increasingly the case over time if valuations evolve to more expensive levels. In 2014, we've already seen a resurgence in areas such as real estate, commodities, and emerging market equities…just as several of these assets were left for dead at the end of last year–leaving some wondering if the classic '60/40' portfolio was sufficient after all.
A classic portfolio comprised of 60% S&P 500 stocks/40% Barclays Cap U.S. Aggregate bonds covers the basics of diversification, providing the portfolio with a general balance between capital growth and dividend income in a ratio that slightly favors growth over income. It also happens to feature two asset classes with very low correlation to each other, so during environments when stocks struggle, bonds may shine–and vice versa. This portfolio has been popular as a benchmark for balanced funds over the years due to its long track record, availability of historical data going back many decades, simplicity, and a general 'home bias' many investors favor.
But there are several additional facets worth reviewing for our clients. First and foremost, today's investment world is now much larger than just the U.S. In 1970, when foreign stock indexes became formally available for tracking, U.S. stocks represented two-thirds of the world's equity basket by market cap. This proportion has steadily fallen decade by decade; today, the U.S. represents just under 50% of the MSCI All-Country World Index. Not only are foreign companies a growing piece of the investible world pie, but the globalization of world trade and branding over the past few decades has rendered geographic domiciles increasing irrelevant. (Do you know if your favorite soap is made by P&G or Unilever? More importantly, do you even care?) The expanded opportunity set offered by foreign markets provides a much greater source of investment choices, especially when macro issues can serve to depress or inflate a particular country's market for reasons unrelated to underlying firm fundamentals. This can create valuation discrepancies and potential opportunities.
The same situation is occurring with bonds. The U.S. has traditionally enjoyed 'safe haven' status due to a strong regulatory climate, rule of law and financial stability (not to mention military might and economic diversity), which has kept its credit ratings high, plus default risk–and therefore, interest rates–low. However, foreign markets have begun gaining here as well, as interest rate cycles of other developed nations that differ from ours at home offer diversification opportunities. Additionally, emerging markets are improving from a fiscal and fundamental perspective, lowering potential default and currency volatility risks for which many have traditionally been known. We are not saying these risks have disappeared, but the growth of world bond markets now offers a larger set of both profit-making and risk-reducing prospects.
Lastly, alternatives (typically represented in our portfolios by real estate and commodities) may sometimes be regarded as the forgotten stepchildren of an overall allocation. These components of our clients' portfolios are important diversifiers, and have performed differently over time from both the stock and bond assets in the group. Due to their smaller weightings in relation to larger positions, alternatives have a more subtle impact on a portfolio, but our opinion remains that they are important nonetheless. If we experience higher inflation or other geopolitical strife, these real assets serve an important purpose.
In conclusion, our clients' portfolios will look nothing like the indexes we hear discussed on the nightly news (i.e. the S&P 500 or Dow, which comprised entirely of U.S. large-cap stocks). Our process and philosophy for creating portfolios is much more nuanced than simply choosing to invest in one asset class; our perspective is that there are many more moving parts to consider. Clients may be surprised (if not impressed) that their portfolio may more closely resemble the well-diversified endowment of their college alma mater–or charitable organization they donate to each year–than a basic allocation of indexes representing only the largest U.S. stocks. Our clients trust us to handle their long-term investments with care, prudence and risk awareness. In a period where the last crisis ended a half-decade ago, with central banks are acting in increasingly divergent ways as economies are repairing themselves, having access to the diversification we believe in may be more important than ever.
Read our Weekly Review for June 30, 2014