By Matthew J. Bartolini, head of SPDR Americas research, State Street Global Advisors.
Matthew Bartolini, head of SPDR Americas research at SSGA.
A strong, flexible portfolio depends heavily on how assets are allocated in its 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. And today’s low return expectations make building an ultra-low cost, diversified core more important than ever so that costs don’t erode your investment returns.
While an effective core may look different for each investor, there are four universal principles for core construction:
- Broaden your reach
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, represented by a heavier allocation to domestic stocks. Given how globalized the economy has become, international equities are essential to broaden reach.
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. As shown in the table below, when compared 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.
Source: SSGA.
- 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.
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 an equity drawdown simply won’t work. On the contrary, a more risk-seeking investor might be willing to ride out those drawdowns to seek higher total returns over the long term.
Thus, as shown below, as you move up the risk tolerance scale, you take on exposure to equities, both domestic and international.
Source: SSGA.
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. This results in a portfolio that’s more equity-like and less bond-like.
- 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 diversify your core—seeking to 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 average US-listed mutual fund is 0.79% a year. While that doesn’t seem like much, assuming an industry standard return target of 7.6% was met each year over a decade, investors consistently using mutual funds to gain core exposures would end up paying cumulative fees of 7.9% of starting principal. That’s equivalent to more than one year of portfolio returns.
Source: SSGA.
- Impose discipline
Once a strategic allocation is set, 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 below, 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 ensure your portfolio doesn’t deviate significantly from your initial allocation and expose you to additional risk.
Source: SSGA.
Do more with your core—for less
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 can provide the support you need to pivot confidently in any direction. Our new family of 15 SPDR Portfolio ETFs covers US equity, international equity and fixed income asset classes, 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 an average expense ratio of just 6 basis points.