Portfolio makeover: 3 lessons from portfolio reviews


Mark Barile
Advisory specialist manager

Casey Dregits
Senior advisory specialist


Added To Briefcase

Key Takeaways

  • Capital Group’s portfolio evaluation services analyze hundreds of portfolios per year.
  • We saw three common patterns – potential overexposure to US equity, “hidden” risk embedded in bond portfolios and recency bias in manager selection.
  • Addressing these issues could improve portfolio outcomes.

When you’ve seen as many portfolios as we have, you start noticing things – like the value of a good pair of glasses. We’ve studied hundreds of portfolios over the past year as part of our various portfolio evaluation services, ranging from an online Portfolio Analyzer tool to a more formal portfolio review process we call the Portfolio Perspectives Review.

This is a service we offer to financial professionals to help them identify potential enhancements to their portfolios. It’s a rigorous analysis built on principles of objective-based investing, global diversification and the roles of fixed income.

Three patterns kept appearing in our analyses, regardless of the type of advisor that created the portfolio or the type of client for whom it was created. And we believe there are straightforward ways to address those issues and potentially improve portfolio outcomes in the process.

Here’s what we found:

Issue 1: Overexposure to U.S. stocks

We frequently found portfolios were heavily tilted toward U.S. equities at the expense of international equities. The majority of portfolios we reviewed had less than 20% allocated to non-U.S. equities, which is low compared to many of American Funds’ model portfolios. It’s only natural to see this trend given the strong run of U.S. equities versus other regions from mid-2014 to mid-2017.

Sticking with international diversification has been difficult for investors as the U.S. delivered better results for years. Yet, markets reminded investors of the importance of global diversification in 2017. Last year, European and Japanese stocks delivered results that beat U.S. markets, rising 26% and 24%, respectively, on a U.S. dollar basis, topping the 22% gain by the Standard & Poor’s 500 Index. Emerging markets rose 37%. Investors who maintained broad international diversification would have been rewarded for their patience.

Action: Rebalance toward international equities

International diversification is as valid as ever and maintaining exposure to international stocks could give portfolios broader exposure to equities with lower valuation multiples than those in the U.S. There is also the benefit of reducing country-specific risk. American Funds’ model portfolios, built by our Portfolio Oversight Committee, show non-U.S. equity weightings in the mid-20s percentage for several of our moderate portfolios.

Asset Allocation Framework

Source: Capital Group as of 12/31/17. After accounting for U.S equities, Non-U.S. equities and Fixed Income, the remaining assets are allocated to cash.
* Annualized standard deviation is calculated at net asset value based on monthly returns and is a measure of how returns over time have varied from the mean. A lower number signifies lower volatility. The standard deviation calculations use 10 years of returns (or lifetime for models without a 10-year history) through 12/31/17. Based on F-2 share class.

These models are objective-based, built through strategic allocations to investment objectives, rather than top-down asset allocation models. Capital Group models aim to meet client objectives using a blend of funds with flexible mandates.

Case study: One portfolio we examined in November, submitted by a wealth management advisor with an insurance company in the Midwest, was typical of what we’ve seen. This portfolio had 32.6% exposure to U.S. equity and just 17.4% to non-U.S. equity. Our suggestion was to rebalance the portfolio by decreasing the U.S. equity portion down to 31% and raising the non-U.S. equity slice up to 22.2%. The analysis confirmed much of the rest of portfolio was diversified. The rebalance also resulted in a smaller allocation to fixed income.

Source: Morningstar Direct. Portfolio date of 10/31/17. Totals may not reconcile due to rounding.

Issue 2: Excessive risk in the bond portfolio

Many advisors did not realize how much potential risk was lurking in their bond portfolios. One of fixed income’s key roles is to provide diversification from equities. Yet, many of the portfolios we studied held bonds that were closely correlated to equities, namely high-yield bonds. Although bonds with low credit quality have rewarded investors with higher yields for years, these portfolios might be subject to greater-than-expected volatility when the equity market is disrupted.

Action: Upgrade to a “true core” bond portfolio

Upgrade your bond portfolio with allocations that aim to lower correlations to equities and reduce the amount of low-quality credit in the portfolio. We saw portfolios with five-year correlations between fixed income and equity of upwards of 70%. We believe those correlations should be much closer to zero — as fixed income should offer a cushion during periods of equity volatility. Part of the solution could be adding or substituting with a “true core” bond strategy, or one that aims for both solid income and diversification from equities.

Case study: An advisor from a large independent advisory firm with more than $40 billion in assets under management submitted a portfolio in November with more than a third of its weighting in fixed income, as it was designed to offer stability for conservative clients. But just 62% of the fixed income portfolio was in investment grade securities (BBB rated and higher). That presented an opportunity to increase the quality of the bond portfolio to 96% in investment grade bonds.

Source: Morningstar Direct. Portfolio date of 10/31/17. Totals may not reconcile due to rounding.

Issue 3: Overreliance on recent results when selecting managers

We found some recency bias in manager selection in many portfolios. For instance, portfolios often overemphasized funds with managers with solid three-year records, but underweighted those who have performed better over a decade or longer.
Many also didn’t place enough emphasis on two key screens – low fees and “skin in the game.” We’ve found “skin in the game” to be meaningful – in other words, funds with the highest manager ownership at the firm level. To get at this, we look at the percentage of the fund firm’s managers with personally invested assets of more than $1 million in the funds they help manage.

Additionally, low fees are critical across asset classes. Although portfolios often hold or advisors tended to choose low-expense options for large U.S. equity funds and core bonds, the filter didn’t apply in other areas. For small caps and flexible fixed income funds, many allocations tilted toward funds with expense ratios of 140 basis points or higher. Owning such high-cost funds drowned out the savings from the lower-cost options elsewhere in the portfolio and resulted in a higher total cost than needed.

Action: Select funds with low fees and high manager ownership

Consider screening for funds with lowest-quartile expenses and highest-quartile manager ownership. Although a past track record of results is a meaningful check, investors must consider if the results are repeatable. Capital Group research finds that equity funds featuring both low expenses and high ownership by fund managers have on average tended to outpace indexes more frequently.

Two Steps Raised the Success Rate
Success Rates in Large-Cap Equity Funds (Net of Fees)

Source: Capital Group, based on Morningstar data. Based on monthly returns from January 1997 to December 2016. U.S. funds are those in the Morningstar Open-End Large Value, Large Blend and Large Growth categories. U.S. index is S&P 500. International funds are those in the Morningstar Open-End Foreign Large Value, Foreign Large Blend and Foreign Large Growth categories. International index is MSCI ACWI ex USA. The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Unless otherwise indicated, all distributions were reinvested. For funds with missing expense ratios, we filled in gaps between two available data points using linear interpolation, a statistical method used to estimate the values between two known data points in a time series. Funds without manager ownership values were excluded from the quartile rankings. 

Case study: An advisor from a large New England firm showed us a portfolio with a large growth fund, U.S. high-yield bond fund and U.S. technology fund with net expense ratios of 0.89%, 0.92% and 1.23%, respectively. That placed the funds roughly in the midpoint of expense ratios for their categories. Meanwhile, just 59% of the managers at the U.S. technology fund firm had $1 million or more personally invested in the fund. The level of manager ownership was even lower at the large growth and U.S. high-yield funds in this example. These funds could be replaced with lower expense options from firms with higher portfolio manager ownership. Making these adjustments would have brought the portfolio’s expense ratio down to 0.66% from 0.78%.

The S&P 500 Composite Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2017 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.


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