A strong flexible portfolio begins with the core. It provides a stable foundation to pursue specific investment goals. An effective core may differ from one investor to the next, but four construction principles apply to all.
A strong, flexible portfolio depends on how you allocate assets in the core. That’s because the core is the largest part of a portfolio and research has long shown that asset allocation decisions explain over 90% of the variance in portfolio returns.1 Simply put, it all starts with asset allocation. And today’s low return expectations make building a low-cost, diversified core more important than ever, as costs accumulate over time, eroding a portfolio’s total return.
While an effective core may look different for each investor, we believe that there are four principles to core construction:
We believe today’s core should reflect an expansive investment universe, including US equities, international equities and fixed income. Investors have a well-documented tendency to exhibit a home bias (a heavier allocation to domestic stocks).2 Given how globalized the economy has become, where countries outside the US represent 75% of nominal global GDP,3 international equities are essential to broaden reach, mitigating any home bias tendency.
Yet, while a portfolio concentrated in equities has historically generated strong returns over the long term, these returns merely compensate for the higher risks assumed. And not all investors can tolerate the significant drawdown risk inherent within equities. Diversifying your core by allocating to bonds may help mitigate portfolio drawdowns and improve returns per unit of risk.4 As shown in Figures 1 and 2, relative to a pure equity portfolio, a hypothetical portfolio comprised of 60% equity and 40% fixed income reduced drawdowns and more quickly recovered its maximum losses after stock market crashes.
Figure 1: Broaden Reach for Potential Diversification Benefits
Figure 2: Broaden Reach for Potential Drawdown Mitigation
The sample 60% global equity and 40% US bond portfolio is only a starting point for diversification. The diversification benefits could be enhanced if investors include more asset categories that are less or negatively correlated to each other. As shown in Figure 3, by including more granular asset classes, such as small and mid caps, dividend stocks, high yield and investment grade bonds of different duration, inflation-protected securities, etc., the portfolio has the potential to improve returns across all risk spectrums without taking additional risks.
Your client’s risk tolerance, return expectations and time horizon inform a blueprint for constructing a core with the necessary foundational support. And, obviously, a core that’s appropriate for one client may not be appropriate for another.
In general, longer investment horizons tend to result in greater risk tolerance and higher return expectations. For example, young investors just starting their careers likely have longer investment horizons and greater risk tolerance than retirees who rely on the income from their portfolio to fund their retirement. A young couple preparing to buy their first home may have different risk and return expectations than a middle-aged couple saving for their kids’ college.
Again, the combination of core asset classes can create a portfolio core tailored to clients’ risk and return requirements. As shown below, five hypothetical core examples calibrate the risk level by adjusting the broad allocations to US equities, international equities and fixed income. A more conservative investor should have a higher allocation to bonds. If your client needs to access principal relatively soon, making withdrawals during one of those equity drawdowns shown in Figure 2 simply won’t work. On the contrary, a more risk-seeking investor might be more willing to ride out those drawdowns to seek higher total returns over the long term.
Thus, as shown in Figure 4, as you move up the risk tolerance scale, you take on exposure to equities, both domestic and international.
Figure 4: Match Core Allocations to Client Risk Profiles
It’s all about underlying exposures. If a client is more focused on capital growth over the longer term, a portfolio can be tailored to move up the risk spectrum and allocate more to equities, becoming more equity-like, as measured by the beta to the S&P 500® Index, and less bond-like, as measured by the beta to the Bloomberg U.S. Aggregate Bond Index.
Equity market fluctuations typically have a larger impact on more risk-seeking portfolios, while shifts in the bond market typically impact more risk-averse allocations. The difference is most stark when examining the worst 1-year return periods, as more bond-sensitive portfolios experienced less significant drawdowns.
However, the risk and return relationship is generally asymmetrical. The Conservative allocation with 20% equities does have some sensitivity to the stock market, while the Aggressive allocation with only 10% bonds has nearly no sensitivity to the bond market. This underscores how even slight asset allocation differences can impact risk and return, as shown in Figure 5.
Figure 5: Portfolio Sensitivities to Stocks and Bonds (Last 20 Years)
Figure 6 also illustrates the impact of moving up and down the risk spectrum and how modest adjustments to an allocation can dictate risk sensitivities.
Figure 6: 20-Year Risk and Return Profile
It’s this simple: high costs erode portfolio returns. And, as the largest part of your portfolio, the core should never be the most expensive component. So, as you add asset classes to the core to help improve stability, generate income or pursue performance, it’s important to ensure your portfolio’s cost profile remains under control.
How can high costs impact portfolio returns over the long term? Consider that the expense ratio of the median US-listed mutual fund is 0.81% a year.5 While that doesn’t seem like much, assuming an industry standard return target of 6.99%6 was met each year over a decade, investors consistently using mutual funds to gain core exposures would end up paying cumulative fees of 8.4% of starting principal. That’s more than 1% higher than one year of portfolio returns.
Figure 7: The Impact of Fees
Over a decade, a portfolio invested at the median US-listed mutual fund costs would have forfeited 8.1% of starting principal to fees
Once a strategic allocation is set, we believe investors should continue to manage it through systematic and disciplined portfolio rebalancing. Keep in mind that performance of different asset classes may shift the portfolio allocation over time. As shown in Figure 8, after two decades a buy-and-hold portfolio had a greater allocation to equities, exhibiting lower return per unit of risk. Therefore, it’s important to have a disciplined rebalancing program in place to ensure your portfolio doesn’t deviate significantly from your initial allocation and expose you to additional risk.
Figure 8: Rebalancing Can Impact Returns and Risks
Asset allocation of a 60/40 portfolio after 20 years
For investors seeking to expand their toolbox for diversification, we provide a comprehensive suite of low-cost ETFs covering detailed segments of the broad equity and fixed income exposures. Our family of 22 SPDR Portfolio ETFs covers domestic and international equity and fixed income categories, making it easy to construct cost-efficient customized cores. Whether you seek to generate income, manage risk or grow capital, you can build a core with funds that have a median expense ratio of just 5 basis points.7
Figure 9: SPDR Portfolio ETFs
For thoughts on how you can build portfolios that match your clients’ risk/return objectives, check out five illustrative allocation examples. From conservative to aggressive allocations, each of these portfolios seeks to enhance diversification by offering exposure to thousands of securities across more than 90 countries.8 And all have a weighted average expense ratio between 3 to 4 basis points.
Figure 10: 5 Hypothetical Risk-based Core Portfolio Examples for Around 4 Basis Points
While constructing a core with a long-term strategic view, you also want to be able to adjust your allocations with more targeted allocations to address client-specific needs and respond to shifts in market regimes.
A core built with SPDR Portfolio ETFs provides the support you need to pivot confidently in any direction. Our line-up of 22 funds can help you expand your toolkit to pursue outcome-oriented objectives, such as:
Consider allocating a portion of your core equity exposure to segments focused on stocks with higher-than-average earnings growth and higher than average dividend yields.
Consider allocating a portion of your core equity exposure to segments that represent long-term opportunities due to expanding growth rates, improving valuations and demographic shifts.
Consider tailoring your core fixed income exposure to either shorten or lengthen duration depending on your view of rate movements, without taking on additional credit risk.
Consider augmenting core aggregate bond allocations with precise credit exposures across different maturity ranges and credit quality brackets that represent a potential source of income.
Choosing low-cost SPDR Portfolio ETFs may help you keep more of your return. Because when building your clients’ portfolios, every little bit counts. Visit the Low-Cost Core Portfolio homepage or call 866-787-2257 for more information.
1Gary P. Brinson, L. Randolph Hood, Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analyst Journal Vol.42 Issue 4 1986.
2Coval and Moskowitz, “Home Bias at Home: Local Equity Preference in Domestic Portfolios.” Journal of Finance, December 1999.
3World Bank, as of 12/31/2020.
4Return Per Unit of Risk is calculated by dividing returns by the standard deviation for the same time period.
5Morningstar, as 02/28/2022. Average Prospectus Gross Expense ratio for index ETFs and open-end index mutual funds oldest share class as defined by Morningstar.
6NASRA, Public Pension Plan Investment Return Assumption, March 2022
7State Street Global Advisors, as of 02/28/2022.
8State Street Global Advisors, FactSet, Bloomberg Finance L.P., as of 12/31/2021.
An investment strategy of mixing a portfolio’s stocks, bonds and cash equivalents — and sometimes other assets — to balance risk and return according to an individual’s goals, risk tolerance and investment horizon.
A strategy of combining a broad mix of investments and asset class to potentially limit risk, although diversification does not guarantee protecting against a loss in falling markets.
A specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
An instrument that signifies an ownership position, or equity, in a corporation, and which represents a claim on its proportionate share in the corporation’s assets and profits.
A type of investing, usually involving bills, notes or bonds, for which real return rates or periodic income is received at regular intervals and at reasonably predictable levels. Fixed income can also refer to a budgeting style that is based on fixed pension payments.
The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.
The possibility that an investment’s return will differ from expected returns, especially the possibility of losing some or all of an investment. Risk is typically measured by calculating the standard deviation on historical, or average, returns of a given investment.
The views expressed in this material are the views of Matthew Bartolini and Anqi Dong and the SPDR Strategy team through the period ended March 21, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
All asset allocation scenarios are for hypothetical purposes only and are not intended to represent a specific asset allocation strategy or recommend a particular allocation. Each investor's situation is unique and asset allocation decisions should be based on an investor's risk tolerance, time horizon and financial situation.
Diversification does not ensure a profit or guarantee against loss
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This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.