Performance, Your Portfolio, and Diversification A Q&A with Jeff Ptak. Morningstar Investment Services. Talking Points. As of October 8, 2014

Transcription

1 As of October 8, 2014 For Financial Advisor and Current Client Use Only Performance, Your Portfolio, and Diversification A Q&A with Jeff Ptak Jeff Ptak, CFA President and Chief Investment Officer Morningstar Investment Services s Morningstar Investment Services Talking Points Should I bother diversifying my investment portfolio or stick to U.S. stocks and call it a day? At times like these, when U.S. stocks are leaving other types of investments in their dust, you understandably might be asking yourself questions like those. Nevertheless, there s a strong case to be made for diversifying beyond U.S. stocks: namely, to achieve an appropriate risk/reward balance. In this commentary, we explain why a more-diversified portfolio hasn t kept pace with the S&P 500 Index, explore the possible root causes of that divergence, and re-examine the case for long-term investing and diversification.

2 Why isn t my portfolio keeping up with the U.S. stock market? Because it s spread across numerous asset classes and those other asset classes haven t kept pace with U.S. stocks. As shown in the chart below, the U.S. stock market (as represented by the S&P 500 Index) has beaten nearly all comers, including small-cap stocks (Russell 2000 Index), foreign-developed markets stocks (MSCI EAFE Index), foreign emerging-markets stocks (MSCI EM Index), and U.S. bonds (Barcap U.S. Aggregate Bond Index). In addition, U.S. stocks also would have topped a hypothetical 65%/35% diversified portfolio. This is true of both recent periods as well as slightly longer stretches like the trailing three-years ended September 30, Comparison: Recent Asset Class Returns Data as of September 30, Source: Morningstar Direct. Note: the hypothetical 65%/35% Diversified Portfolio is comprised of the S&P 500 and the BarCap Aggregate Index, respectively. Why are U.S. stocks doing so much better? Hard to say, though it probably stems from the U.S. economy s improving prospects as well as friendly monetary policy. In a developed world saddled by debt and emerging markets beset by decelerating growth, investors have increasingly come to view the U.S. economy as a refuge, likely explaining a large share of the money that has flowed here. And, as noted, Fed policy has remained decidedly pro-risk, perhaps encouraging investors to continue bidding-up more risky fare like U.S. common stocks. It s worth noting, though, that U.S. stocks do not appear compellingly cheap anymore, which limits the possibility that bargainhunters have propelled such stocks. What s more, some of the other asset classes left behind, such as foreign stocks, look inexpensive by comparison. Why bother investing outside of U.S. stocks? For the potential to boost returns while limiting risk or limit risk without dampening returns. That is, we spread out into other asset classes because the weight of evidence suggests

3 that we get paid to do so in the form of higher risk-adjusted returns. Put another way, research has shown that when we diversify our assets across multiple asset classes, we stand a better chance of earning a higher return per a given amount of risk (which we can quantify based on the degree to which a portfolio s value varies over time; this is known as standard deviation of returns or volatility ). But why diversify if it reduces returns? Because it makes a difference over longer periods, especially when we account for risk. While it s true that U.S. stocks have ruled the roost recently, there s no guarantee that they will do so over longer stretches, at least if history is a guide. These switchbacks, which have been a hallmark of markets through time, are one of the key reasons we diversify across multiple asset classes in the first place. It acknowledges that leadership can be fleeting and helps to take the edge off of abrupt reversals in fortune, when they occur, by ensuring that we re not overcommitted to any one area. For an illustration of how asset class performance changes over time, see the appendix page at the end of the commentary. Has this happened before, where U.S. stocks beat other asset classes so handily? Yes, it has happened from time to time. The chart below plots the difference between the S&P 500 s annualized returns and those of small-cap stocks (Russell 2000 Index), foreign developed-markets stocks (MSCI EAFE Index), foreign emerging-markets stocks (MSCI EM Index), and U.S. bonds (Barcap U.S. Aggregate Bond Index) for all rolling three-year periods from Oct Sept To explain the chart, the lower any of the lines juts, the more that asset class underperformed the S&P at that time; the higher a line rises, the more that asset class outperformed the S&P. As you can see, there s precedent for what we ve seen recently, as the S&P pretty resoundingly beat the other asset classes mentioned in the late- 1990s. Asset Classes vs the S&P 500 Index: Data as of September 30, Source: Morningstar Direct.

4 How long is this likely to last? We wish we knew, but short-term market movements are unpredictable. It s worth noting that over longer periods we tend to see stark performance differences like these narrow. Put another way, the winning asset class begins to fade and former laggards take the lead, though we would caution that this reversal process doesn t happen like clockwork--the timing and magnitude can depend on a number of factors. To put the S&P s current outperformance in context, we ve plotted its rolling three-year returns against those of a hypothetical diversified index (split roughly 65%/35% between stocks and bonds) in the chart below. As you can see, the S&P has not only outperformed recently, but done so by the widest margin in years. S&P 500 Index vs Diversified Index: Rolling Three-Year Returns Data as of September 30, Source: Morningstar Direct. Note: the hypothetical 65%/35% Diversified Index is comprised of the S&P 500 and the BarCap Aggregate Index, respectively. Why do these performance divergences arise to begin with? There s no simple or right answer. All told, the biggest differentiating factor is risk the riskier a security (or asset class) the higher its potential returns should be and vice versa, as there s no free lunch in investing. That s why, over longer periods, one would expect stock returns to beat bonds, and so forth. But that relationship doesn t necessarily hold over shorter periods. Why? Investors are human and, thus, prone to emotions like fear and greed which, when acted upon, can push security prices higher or lower than they re really worth. That, coupled with other differences say, changes in local-market climate or investor sentiment can explain why asset-class returns diverge over shorter periods. What might cause the big performance gap to narrow in the future? Investors could cool toward U.S. stocks while warming to other types of assets. Simple as that sounds, there s ample precedent, though the underlying catalyst for the reversal can vary. In our view, security valuation i.e., what you re paying to own an asset and what sort

5 of return that implies for the future tends to play a pivotal role in explaining why asset classes that have prospered eventually cool (as they become too pricey for investors to tolerate) and why those that have languished garner attention (as they become too cheap for investors to ignore). On that note, it s worth quickly comparing the major asset classes U.S. large-cap stocks (S&P 500 Index), U.S. small-cap stocks (Russell 2000 Index), foreign developed-markets stocks (MSCI EAFE Index), and foreign emerging-markets stocks (MSCI EM Index) by valuation level. As shown in the chart below, investors are currently paying more (measured as a multiple of the index s price to the aggregate estimated earnings per share of the companies that comprise it) to own U.S. stocks than they are foreign stocks. That doesn t mean U.S. stocks will immediately cede leadership to foreign stocks, but it illustrates the extent to which investor enthusiasm for U.S. stocks has surpassed that for foreign names. Valuation Levels of Major Asset Classes: Multiples of Price to Earnings/Share Data as of September 30, Source: Morningstar Direct. So, if diversification hasn t paid off lately, then why not just go with the winner U.S. stocks? Because that would involve speculation, which we re no good at. In our opinion, it s not safe to assume that an asset class like U.S. stocks will continue to excel simply because it has excelled in the recent past. In fact, investors tend to get themselves in deep trouble by making these sorts of assumptions in chasing performance. We don t want to make that same mistake and so, far from loading-up on U.S. stocks in our portfolios, have maintained a pretty stable mix of different asset classes. We think that s a more practical approach to trying to generate good outcomes for investors than hazarding guesses about the market s short-term direction.

6 For Financial Advisor and Current Client Use Only The information contained herein is the proprietary property of Morningstar Investment Services and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar Investment Services. The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use. But if asset class returns can diverge so greatly over shorter periods, why not shift the portfolio around more often to take advantage? Because that s very hard to pull off in practice. Numerous studies have found that tactical strategies, which dynamically adjust their asset-class weightings based on short-term factors, have struggled to beat a simple 60%/40% stocks/bonds mix over longer periods. Why haven t these strategies succeeded in general? It s very hard to make good short-term calls and harder still to make those calls consistently, reason being that market movements over shorter periods tend to be random and, thus, defy easy prediction. The indices noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. Diversification does not ensure a profit or protect against a loss in a declining market. The hypothetical 65/35 diversified portfolio used in this commentary consists of 65% S&P 500 Index and 35% BarCap Agg. Index Definitions: S&P 500 Index An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. MSCI Emerging Markets Index - A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. MSCI EAFE Index An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. Barclays Capital Aggregate Bond Index A market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Russell 2000 Index An index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks.