- Equities: Allocation to U.S. equities has increased amid trade tensions and a rise in the U.S. dollar.
- Fixed income: Core fixed income remains prominent; advisors are also utilizing managers with low duration and a more flexible style.
- Multi-Asset: The conservative stance we observed in the beginning of 3Q has waned and a more moderate risk profile has regained dominance.
- Alternatives: Allocation within portfolios remains low and primarily focused on reducing equity beta.
- Advisors are gravitating toward highly ranked intermediate-term bond strategies. We caution that doing so may be doubling down on risk within other strategies. We encourage using a holistic approach to ensure that your bond holdings are adhering to their role within the portfolio.
A closer look at what’s happening in fixed income
Financial advisors have become concerned about potential equity market volatility affecting portfolios. Yet responding in the typical way, by leaning on high quality fixed income, isn’t the straightforward decision it once was because of rising interest rates. Intermediate-term bonds, advisors know, introduce more interest rate sensitivity. As the J.P. Morgan Portfolio Insights team analyzed over 2,500 portfolios this year, we found advisors maintaining their allocation to fixed income but shifting styles to build more of an all-weather portfolio (see box: Asset Class Trends: 3Q 2018).
Although traditional, or “core,” (higher quality, lower volatility) fixed income holdings remained a considerable portion of portfolios, advisors are also turning in significant numbers to flexible strategies and shorter duration investments. In this publication, we take a more in-depth look at these different styles and how they may be interacting with the traditional core allocation. Our goal is to ensure that advisors maintain the appropriate balance of rate sensitivity and portfolio ballast.
Certain kinds of fixed income investments tend to be less interest-rate sensitive. We refer to these portfolio components as “core complements” (which seek returns with little correlation to rates and can reduce portfolio volatility) or “extended sectors” (which increase income and the potential for returns). The team has observed the most momentum this year in core complements (Morningstar’s Ultrashort and Nontraditional categories) with a 100% uptick in usage year over year.
Investing more with high-performing core managers—the unintended consequences
We’ve also observed advisors gravitating toward highly ranked strategies in the Intermediate-Term Bond category—we are seeing these funds with 60% more frequency, relative to last year. We deem these high performers’ style “core plus”: generally high-quality core exposure but designed to enhance yield by venturing outside the U.S., adding high yield or by taking out-of-benchmark bets. The top three most-utilized active Intermediate- Term Bond funds we have observed within our service have, on average:
- 10.5% allocated to high yield
- 20% allocated to BBB-rated debt
- high correlation (0.64) to the S&P 500 during the global financial crisis of 2008
Let’s take a deep dive into these intermediate-term managers with more flexibility, which tend to outperform those with higher-quality styles in rising rate environments. There is value in them. But they often come with a trade-off: Their potentially higher correlation to equity markets introduces a layer of risk that advisors may not be expecting from a core position. This risk may be exacerbated by the use of the core complements and extended sectors within a portfolio—precisely the type of investments for which our Portfolio Insights team has seen heightened demand during the past year. Traditional core, core complement and extended sectors all play important roles in helping investors build an all-weather fixed income portfolio, but paramount in doing so is ensuring the appropriate mix—or, to put it another way, knowing what you own.
Building stronger portfolios requires a holistic approach, beyond only finding the best performers. Facing the likelihood of rising rates and the need to dampen potential equity volatility, advisors need to look beyond returns to consider correlations, as well as the role each investment is playing within its asset class and the portfolio as a whole.
EXHIBIT 1 shows two investments from Morningstar’s Intermediate-Term Bond category: Fund A is the high performer with a strong total return, yet it is not a true diversifier to equity market risk, with its significant positive correlation to the S&P 500. Fund A also has a lower R2 to the Bloomberg Barclays US Aggregate Bond Index (BBG Agg), so relative to Fund B, it is not behaving as a core holding. Fund B, however, excelled in diversification vs. equities. It is negatively correlated to the S&P 500 and its performance was consistently positive during equity market drawdowns.
Amid a constant drumbeat of market concerns, it’s important to look beyond performance to know what you own and whether it’s adhering to its role in the portfolio overall. Following this practice, in portfolio construction and investment selection, can help increase the likelihood that clients stay invested and achieve their financial goals.
EXHIBIT 1: COMPARISON, INTERMEDIATE-TERM BOND FUNDS DURING U.S. EQUITY MARKET DRAWDOWNS
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