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Trends in portfolio construction

Stay up to date on the latest portfolio trends with our Portfolio Construction team’s insights, fueled by nearly 12,000 portfolio reviews annually.

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This past quarter was characterized by generally good things. Having seen inflation taper down, the Fed decided to cut rates by 50 bps and signaled that more cuts were incoming—in order to also maintain a stable labor market. A fall in yields supported a rally in most asset classes. Easier financial conditions, with rate cuts by global central banks, shows that the global business cycle remains in expansion and a stable earnings outlook. U.S. labor markets softened, and a strong business cycle continued in the United States, demonstrating evidence of both mid and late cycle dynamics. Lower income segments of the consumer still face some strain, but the overall consumer is supported by wage gains and a strong balance sheet. The consumer continues to spend, supported by lower core inflation, falling food and energy costs, and recent cuts. While we continue to be risk on, with most of the good news priced in, it could be difficult to find another upside. Base case of prolonged cycle implies preference for economically sensitive assets, but the inflation battle is not over yet and late cycle positioning of the United States means we should exercise some restraint on active risk. As the markets reprice risk from the lower probability of near-term recession to a soft landing, it is important to maintain a well-diversified portfolio and not chase the hot asset class especially as upside surprises may be more difficult amid low market volatility and higher valuations.

 

A common composition of an advisor-created portfolio



For illustrative purposes only.

Source: FI portfolio solutions (2,989 Portfolio Reviews and Portfolio Quick Checks conducted between 7/1/24 and 9/30/24) and Morningstar.

Driven by advantages like better tax efficiency, cost, and intraday liquidity, we are seeing an increase in ETF usage. Advisors use ETFs and mutual funds fairly evenly within U.S. equities. Sixty-three percent of incoming portfolios utilized ETFs for their U.S. equity exposure, and 78% of portfolios had mutual funds. The average ETF allocation to U.S. equities was 31%, which is a significant slice of the equity sleeve. Only 35% of incoming portfolios tend to utilize ETFs in the international sleeve. However, there is higher usage of ETFs within fixed income, with 42% of incoming portfolios having some allocation to ETFs. In 2022, 13% of advisors had some allocation to active ETFs, but in 2024, that proportion has increased to 29%. The average allocation to active ETFs among users is around 17%. This is largely seen in the fixed income asset class, with 14% of incoming portfolios utilizing active ETFs. Strategic beta products were preferred in domestic and international equities—it is interesting to note that only 5% of portfolios use active ETFs in the international space.

We observed the average portfolio has:

13
holdings
6
different asset managers
50
bps of underlying blended fees

Domestic Equity
Domestic Equity

Growth Allocations in Equity Sleeve

 

In Q3, the average equity sleeve of a portfolio was 68%. Seventy-nine percent of the equity sleeve is allocated to U.S. equities versus 21% in international. Fifty-eight percent of the U.S. equity sleeve is in active products, and 42% in passive. U.S. allocation continues to remain high as we move into 2024, compared to 73% in 2021. Within U.S. equity, the average portfolio has 62% allocation to large caps, 23% to mid caps, and 15% to small caps. This is a 4% reduction in large caps compared to the previous quarter and a 3% increase in small caps. Advisors continued to increase their allocations to sensitive sectors (communication services and technology) in this quarter. Portfolios have broadened as markets have broadened.

Insights:

  • During Q3, the year-to-date laggards such as value, small caps, and non-U.S. equities outperformed the large technology and communications growth stocks that remained ahead on a year-to-date basis.
  • Growth allocations dropped to 33% of the equity sleeve, dropping from a two-year high of 42% last quarter. Thirty-seven percent of the equity sleeve is in core and 29% in value, the latter of which is a 6% increase from Q2.
  • The market seems to be broadening away from the mega-cap stocks. Stock prices of the largest U.S. companies by market capitalization—concentrated in the technology and communications sectors—rose during Q3 but were overshadowed by the gains of smaller stocks.
  • With rate cuts announced by the Fed and more expected over the coming months, advisors have been reallocating to interest rate sensitive assets, and taking profits from large growth allocations. So far, equity allocations have hovered at this peak with significant bias toward Growth/Technology creating a concentration risk. It is to be noted that of the portfolios that have large cap exposure, 22% of them utilize only passive products, which could lead to this unintentional concentration.
Alternatives
Alternatives

In a higher inflation environment, the correlations of stock and investment-grade bond turned positive, where the performance of stocks and bonds moved in the same direction. This lack of diversification between stocks and bonds led to advisors looking at alternatives as an option.

Insights:

  • In this quarter, 18% of incoming portfolios had allocation to Liquid Alternatives, which is a 2% increase compared to Q2. The average weight of alternatives in a portfolio remains at 8%, compared to 5% last year. The most popular categories are hedged equity and market-neutral products.
  • The traditional 60/40 failed to perform during the downturn of 2022, which has led more and more advisors to consider alts to diversify sources of alpha.
International Equity
International Equity

Twenty-one percent of the equity sleeve is allocated to non-U.S. equities, which remains consistent to what we saw in 2023. This represents a decrease from 27% in 2021. Advisors have 83% of their international sleeve in developed markets (DM) and 17% in emerging markets (EM). Within international equity, the split between active and passive is 75/25. International exposure, both EM and DM, is at its lowest and has been for a while now. Global disinflation trends continue, but the progress remains uneven across different geographies. We saw in Q2 that 30% of advisors had no allocation to international and that decreased in Q3 to 25% of advisors. This is showing an increase in recognition of the return and diversification potential offered by expanding the opportunity set in equities.

Insights:

  • Emerging market equities registered solid quarter performance and added to their 2024 gains.
  • Global disinflation trends continued, as core inflation fell across most major developed and emerging economies. The Fed and the Bank of England cut their policy rates during Q3 for the first time this cycle. The Bank of Canada and the European Central Bank dropped their rates further, supporting the trend of global monetary easing. As of the end of Q3, futures markets reflected expectations for a sustained drop in policy rates over the next year.
  • Emerging markets trailing valuations continued to accelerate above their long-term average, while DM was the only region to finish below. Earnings growth trended upward for EM after a prolonged slump, while it remained flat for DM.
  • China continued to struggle to emerge from its growth slump, but the government announced a larger than expected stimulus package that could reach 1.8% of the GDP in late September. This has led to a rally in the China index.
  • While it remains uncertain whether new policy measures will spark an economic reacceleration amid China’s structural imbalances and gloomy consumer sentiment, this could provide an opportunity for advisors to participate by selecting good companies with strong fundamental support.
Fixed Income
Fixed Income

Fixed income allocations dipped to 26%, a decrease of 3% compared to last quarter. This is the lowest fixed income allocations have been in the last two years. Advisors have been reallocating from fixed income to equities to take on risk and participate in the market. Investment-grade allocation remains at 80% of the fixed income sleeve, like last quarter. Eighty-three percent of the fixed income sleeve is allocated to active products and 17% in passive.

Insights:

  • Investment-grade fixed income assets moved into positive territory for the calendar year on the back of strong gains supported by the decline in interest rates. Credit categories remain ahead on a YTD basis.
  • Fixed income categories benefited from the decline in bond yields. Despite the fall in Treasury rates, most fixed income categories ended the quarter with yields near their long-term historical averages. Credit spreads tightened, ending the quarter toward the lower end of most bond categories’ historical range. Overall, fixed income yields suggest valuations that are roughly in line with long-term averages and better than the past decade.
  • It is difficult to time rate moves, so it is important to align fixed income duration to portfolio objectives. Both a soft landing and recession can be good scenarios to own bonds in, as the diversification can provide protection in the event of slower than expected growth.
  • Money market assets have actually increased since the first Fed cut. This may indicate a barbell to equities and cash, which offers less diversification than a more broadly diversified portfolio. Advisors should consider moving from money market to bonds to lock in higher rates for a longer term as curve steepening happens very fast.

All data points are based on Fidelity portfolio construction reviews and Portfolio Quick Checks (PQC), as of 9/30/24.

In conclusion

Monetary policy is focused on both mandates of inflation and labor, which will drive the market in the coming months. It makes the Fed more comfortable, which makes investors more comfortable. Please reach out to our portfolio construction guidance team and services to help you build portfolios for this new market environment.

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Diversification does not ensure a profit or guarantee against a loss.

Past performance is no guarantee of future results.

ETFs are subject to market fluctuation, the risks of their underlying investments, management fees, and other expenses.

Stock markets, especially non-U.S. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. The securities of smaller, less well-known companies can be more volatile than those of larger companies.

Although bonds generally present less short-term risk and volatility than stocks, bonds do contain interest rate risk (as interest rates rise, bond prices usually fall, and vice versa) and the risk of default, or the risk that an issuer will be unable to make income or principal payments.

Additionally, bonds and short-term investments entail greater inflation risk—or the risk that the return of an investment will not keep up with increases in the prices of goods and services—than stocks. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.

Alternative investments are investment products other than the traditional investments of stocks, bonds, mutual funds, or ETFs. Examples of alternative investments are limited partnerships, limited liability companies, hedge funds, private equity, private debt, commodities, real estate, and promissory notes. Some of the risks associated with alternative investments are: Alternative investments maybe relatively illiquid. It may be difficult to determine the current market value of the asset. There may be limited historical risk and return data. A high degree of investment analysis maybe required before buying. Costs of purchase and sale may be relatively high.

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