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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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We continue to stick to our base case where the US economy exhibits muted near term recession risk as the global economy expands. Major economies demonstrated persistent expansion amid improved global financial conditions and firmer manufacturing activity, even as the global environment became more varied. The move toward global monetary easing inched forward, although persistent core inflation in the U.S. continued to keep the Federal Reserve on hold. However, data from recent months shows the labor market slowing back into balance and continued disinflation. This has given the Fed confidence, and as a result, the markets are pricing in two rate cuts later this year. As we enter a new environment where rate cuts are imminent, portfolio construction and long-term asset allocation are of utmost importance. Advisor portfolios have drifted in recent times given the surge in US equity allocations, bond market challenges and persistently high cash which will eventually come off the sidelines. The last mile of disinflation toward the Fed’s target may be difficult without greater economic slowing. 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 as upside surprises may be more difficult amid low market volatility and higher valuations.

A common composition of an advisor-created portfolio

Source: FI portfolio solutions (2,546 Portfolio Reviews and Portfolio Quick Checks conducted between 4/1/24 and 6/30/24) and Morningstar.

To monitor key trends in advisors’ strategic allocations and rebalances, we have reviewed over 3,000 professionally managed investment portfolios in Q2 of 2024 through our proprietary portfolio construction capabilities. Our analysis uncovers key themes playing out within each asset class that we believe will continue to be top of mind in 2024.  

Driven by advantages like better tax efficiency, cost, and intraday liquidity, we are seeing an increase in ETF usage. Looking at portfolio reviews, 68% of incoming portfolios utilize both mutual funds and ETFs while 74% of target portfolios have both vehicles. Index funds continue to be the most popular product amongst advisors, especially when it comes to domestic equities. 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 amongst users is around 17%. This is largely seen in the Fixed Income asset class, with strategic beta products preferred in domestic and international equities.

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 Q2, 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. US allocation continues to remain high as we move into 2024, compared to 73% in 2021. Within U.S. equity, the average portfolio has 66% allocation to large-caps, 22% to mid-caps and 12% to small caps – which is largely unchanged from previous quarters. Advisors continued to increase their allocations to sensitive sectors (communication services and technology) along with growth allocations.

Insights:

  • U.S. large cap growth stocks once again topped the asset performance leaderboard during Q2, adding to strong year-to-date gains in what was otherwise a relatively quiet quarter for the markets.
  • Growth allocations reached 42% of the equity sleeve, a high over the last 2 years. Thirty five percent of the equity sleeve is in core and 23% in value.
  • A continued rally in the stock prices of the largest US companies by market capitalization, i.e. the Mag 7*, once again drove the US equity market’s gain. The share prices of these companies has more than doubled since the beginning of 2023. The bulk of the large stock gains were propelled by an expansion in valuation multiples. We do note that the market does seem to be broadening away from the mega cap stocks, which is positive in general.
  • A primary reason for the domestic bias could be the double-digit earnings growth rebound expected in 2024 and beyond. Equity allocations have hovered at this peak with significant bias towards growth and technology creating a concentration risk. In fact, a rise in passive products creates concentration within the Mag 7, whose valuations are at historic highs. It is to be noted that of the portfolios that have large cap exposure, 24% 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 advisors to look at alternatives as an option.

Insights:

  • Sixteen percent of incoming portfolios had an allocation to liquid alternatives. The average weight of alternatives in a portfolio is 8%, compared to 5% last year.
  • The traditional 60/40 failed to perform during the downtown 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 does represent a decrease from 27% in 2021. Advisors have 82% of their international sleeve in developed markets and 18% in emerging markets. International exposure, both EM and DM, are at its low and have been for a while now. In fact, 30% of portfolios do not have any exposure to international equities. Global disinflation trends continues but the progress remains uneven across different geographies.

Insights:

  • Global disinflation trends continued, but progress remained uneven. Core inflation rates moderated in several emerging market (EM) countries, while developed market (DM) countries, including the UK continued to face persistent core inflation.
  • China’s policymakers remained in easing mode, but cyclical trends are mixed. It remains uncertain whether policy easing will translate into a full-blown economic reacceleration.
  • Global earnings growth, which has been decelerating since 2021, showed signs of stabilizing. Emerging markets trailing valuations are slightly above their long-term average, while DM finished below. Earnings growth trended upwards for EM after a prolonged slump while it remained flat for DM.
Fixed Income
Fixed Income

Fixed income allocations remained at 29%, which continues to be the lowest in 2 years. Advisors have been reallocating from fixed income to equities to take on risk and participate in the market. While investment grade allocations were at a 2 year high last quarter, it has dropped to 80% in Q2. Fixed income allocations have declined but what is a “double dip” is that the quality is also declining. They are moving to lower quality products potentially to lower their portfolio duration in light of impending rate cuts.

Insights:

  • U.S. credit-sensitive sectors, such as leveraged loans and high-yield corporate bonds, registered modest gains, with most fixed-income sectors finishing roughly flat.
  • 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 are good scenarios to own bonds in, as the diversification provides protection in the event of slower than expected growth.
  • 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 6/30/24.

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 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.

*The Magnificent 7 (Mag 7) includes the following stocks: Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG and GOOGL), Amazon (AMZN), NVIDIA, (NVDA), Tesla (TSLA), Meta Platforms (META).

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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