Q2 2021: Onward and Upward
Another three months are in the books. Growth stocks clawed back some lost relative returns this quarter, but volatility returned momentarily as the U.S. Federal Reserve indicated it may raise rates earlier than originally expected. The new target? Late 2023. This was due to high year-over-year inflation results as the economy rebounded from the COVID-19 panic extremes of 2020. (Read about our views on inflation in this quarter’s Adding Value.)
With higher inflation and an up-tick in bond interest rates, core bonds are slightly negative on the year, through June 30. Remember, they performed exceptionally well during the crash last year, and continue to be a critical component of a diversified portfolio. Bonds are in portfolios for expected stability, not high expected return. High risk, high return is for stocks, for which the market continues to reward by being risk-on.
Core and satellite portfolio construction
There are many ways to construct a well-diversified portfolio. A common method is known as “core and satellite”. Think Jupiter and its moons. Jupiter is the core, the moons are the extra.
With a core and satellite approach, you end up with three main portfolios.
Core portfolio: Long-term lifestyle
Your core portfolio is what is used to support your lifestyle over the long-term. Like Jupiter, it’s the biggest, and typically makes up 70% to 90% of a total portfolio. For some investors, it makes up their entire portfolio.
A core portfolio tends to be broadly diversified across many asset types. Therefore, low-cost index funds can deliver the desired exposure, as could many other passively held investments. It should be buy and hold. For example, a core portfolio could include one fund for each of the asset types referenced above.
Around the core are satellites. Two primary satellite clusters are preservation and growth.
Preservation satellite: Your immediate spending needs
Preservation is the most straightforward, since it’s a combination of cash and extremely low-risk treasury bills. The preservation satellite is your buffer against uncertainty. It’s for your immediate spending needs. We tend to suggest one to five years of lifestyle costs in the preservation satellite.
Growth satellite: Diversification and higher potential returns
Growth is where it gets interesting. Growth satellites are meant to add diversification and an opportunity to earn greater risk adjusted returns.
Ideally, they are meant to be investments that are very different than your core portfolio. Since growth satellites tend to be specialized, they usually have higher underlying costs. What we don’t want are expensive funds in our growth bucket that have high overlap with our core portfolio. That defeats the purpose.
Growth satellites can take many forms, from highly concentrated stock funds to specialized investments like lithium. Many of the growth satellites popular today are based on investment themes like ESG (environmental, social, and governance). These are also known as thematic investments.
Thematic investments suffer from the "shiny object" effect
Today, we see increasing interest in themes like disruptive innovation, cryptocurrency, ESG, private debt, and commodities. All of these could be options for growth satellites, and may of them became popular over the last year due to spectacular outperformance. Fund sponsors tout their brilliance and investment dollars keep flowing in.
It’s worth noting that specialized investments tend to underperform over the long-term. Many are just shiny objects which are easy to market. It’s like the story of the fisherman who asked the merchant whether fish actually bite the flamboyant new lure he was selling. The merchant replies, “I don’t know, I don’t sell to fish.” Consequently, investors send in dollars during times of great past performance and pull out when the tides turn. When using thematic funds as your satellites, you run the risk of greater volatility. Therefore, they require greater initial research, and more frequent oversight and trading.
When satellites are incorporated into portfolios, we have favored concentrated stock funds, microcap funds, emerging market funds, convertible bonds, junk bonds, and real estate. These are strategies that have been around for decades, with track records we can audit. Nevertheless, as we think about building portfolios to meet specific client goals, we stress moderation in satellites. You want to own enough for them to matter, but not so much that they can harm your money on the downside. Rebalancing to around 5% per theme/fund position makes sense to us.
The second half of 2021
Make no mistake, global stock markets have been on a tear since 2009. Despite a few hiccups along the way, like the Covid-19 fueled plummet in 2020, we have been in a raging bull market. The U.S. stock market has posted 16%+ annualized returns since 2009, well above the long-term average of 10% per year.
Really strong past returns are making investors expect really strong future returns. According to a recent survey of individual investors by Natixis, there is a large and growing expectations gap between investors, who are expecting continuing higher returns, and financial professionals, whose expectations are more restrained. In the U.S., investors are expecting 17.5% real returns, while folks like us anticipate 6.7% returns, over the long-term. The gap keeps widening too.
As we head into the second half of 2021, keep history in perspective. Price is what you pay, value is what you get.
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of the firm's fiduciary service approach and directs client engagement, service integration and investment management practices.
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