- Equities: Continued lack of clarity surrounding trade tensions and Brexit have amplified advisors’ historical overweight to U.S.-based equity.
- Fixed income: With the Federal Reserve’s dovish pivot, and 4Q 2018 a fresh reminder of market volatility’s impact, advisors have been shifting toward core fixed income.
- Multi-asset: Moderate asset allocation strategies remain dominant at a time when advisors see market upside yet are mindful of volatility.
- Alternatives: While options-based equity is still most popular, managed futures and market neutral strategies have gained traction as advisors seek diversifiers to traditional market risk.
- We consider metrics for assessing value-oriented investments, to help rebalance growth-heavy portfolios back toward neutral, since we believe good style diversification is crucial at a time of potentially higher market volatility.
Ensuring true equity diversification in light of potentially higher volatility
The importance of diversification is a given. Over the past few years, though, a majority of advisors have failed to keep their equity portfolios truly diversified. Instead, they’ve allowed them to tilt meaningfully toward growth stocks. What to do about this overweight has been coming up more frequently in our conversations with advisors. Their top question: When is the best time to think about rebalancing, whether to neutral or perhaps toward value stocks, in preparation for increased volatility? Let’s break down our answer.
First some background. The tilt toward growth is understandable because of how well it’s worked. The growth style (buying stock in a company poised for fast growth) outperformed value (the philosophy of buying shares in companies with attractive relative valuations) by 5% annually for the last three years. Now, however, as the global economy shows signs of slowing and as market volatility picks up, diversification is imperative. And value stocks’ valuation is more attractive, at two standard deviations below the historical average.1 When value was this relatively cheap in the past, rebounds over the subsequent 12 months in the style provided an average absolute return of 15%.
So what might an optimal balance between growth and value look like? First off, we want a value investment that can be bought for a lower price relative to history. But that’s not enough. Its historical metrics should also suggest it has the potential to hold up during periods of increased market volatility. In the bear market of 2008, value investments saw a significant dispersion between top decile performers (which had a 29% drawdown) and the bottom decile. Indeed, those in the bottom decile, with a 42% drawdown, did far worse than the S&P 500 overall (EXHIBIT 1).
EXHIBIT 1: RETURN DISPERSION BETWEEN 10TH AND 90TH PERCENTILE OF U.S. LARGE VALUE FUNDS VS. THE S&P 500
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