Four Principles of Core Portfolio Construction

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:

  1. Broaden your reach
  2. Customize to your client’s needs
  3. Control costs 
  4. Impose discipline

1. Broaden Your Reach

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.

2. Customize to Your Client's Needs

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-age 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 might benefit from 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 may not 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 3, as you move up the risk tolerance scale, you take on exposure to equities, both domestic and international. 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 Barclays 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 4.

Figure 5 also illustrates the impact of moving up and down the risk spectrum and how modest adjustments to an allocation can dictate risk sensitivities.

3. Control Costs

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 0.76% a year.5 While that doesn't seem like much, assuming an industry standard return target of 7.6%6 was met each year over a decade, investors consistently using mutual funds to gain core exposures would end up paying cumulative fees of 7.60% of starting principal. That's equivalent to one year of portfolio returns.

4. Impose Discipline

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 7, after two decades a buy-and-hold portfolio had a greater allocation to equities, exhibiting higher risks and lower return per unit of risk. Therefore, it's important to have a disciplined rebalancing program in place to if you want to prevent your portfolio from deviating significantly from your initial allocation and exposing you to additional risk.


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Footnotes

1 Gary P. Brinson, L. Randolph Hood, Gilbert L. Beebower, "Determinants of Portfolio Performance", Financial Analyst Journal Vol.42 Issue 4 1986.

2 Coval and Moskowitz, "Home Bias at Home: Local Equity Preference in Domestic Portfolios." Journal of Finance, December 1999.

3 World Economic Outlook, "International Monetary Fund." April 18, 2017.

4 Return Per Unit of Risk is calculated by dividing returns by the standard deviation for the same time period.

5 Morningstar, as of 8/31/2019.

6 Saret, Jeffrey N., Zhan, Barbara and Mitra, Subhadeep. "Investment return assumptions of public pension funds." pionline.com, March 23, 2017.

7 State Street Global Advisors, as of 9/23/2019.

8 State Street Global Advisors, as of 10/18/2018.

Disclosures

State Street Global Advisors and its affiliates have not taken into consideration the circumstances of any particular investor in producing this material and are not making an investment recommendation or acting in fiduciary capacity in connection with the provision of the information contained herein.

Important Risk Information

Risk associated with equity investing includes stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.

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.

Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

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.

Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.

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.