In Defense of Your Laggard Holdings

Have both your stock and bond holdings been rocking the house, generating strong gains returns during the past three- and five-year periods? Do all of your holdings sport shiny top-decile performance rankings during those same time frames, too?

Some investors, even seasoned ones, might view those as positive indicators, an affirmation that they've built topnotch portfolios that will perform well in the future. But Morningstar research on the predictive ability of past returns (or lack thereof) suggest that they shouldn't take too much comfort from those numbers.

In fact, diversity of performance--both on an absolute- and relative-return basis—should be just as big a goal for investors as is asset-class and investment-style diversification. By assembling a portfolio of holdings with varying performance patterns--some that look good right now, some not so good--investors can check that their portfolios are truly diversified. And that may, in fact, be the best way to use past performance numbers to their advantage.

The Rearview Mirror Trap
One of the first lessons most investors learn is the value of asset-class diversification. Although stocks have historically generated better returns than any other asset class, diversifying into bonds and cash greatly reduces the volatility of an equity-only portfolio. As the Callan Periodic Table of Investment Returns illustrates, high-quality bonds can go years without making a strong case for themselves--until, that is, they jump to the top of the charts. From 2003 through 2006, for example, the Barclays Aggregate Bond Index dramatically underperformed the major stock indexes. But when those same equity indexes plummeted in value in 2008, bonds' single-digit returns didn't look so bad any more.

Yet some investors periodically "unlearn" the lesson about the merits of asset-class diversification, flocking to whatever asset class has performed best recently. Many investors retreated to the safety of bonds and jettisoned equities during and following the bear market. But five years into the current equity market rally, bond funds are out and stock funds are in again--so much so that some retirees have been telling me they don't need or want anything but stocks in their portfolios. That performance-chasing pattern tends to explain why so many investors grab such a small piece of their funds' returns, as evidenced by my colleague Russ Kinnel's annual "Mind the Gap" study.

Unloved Asset Class, Loved Category
Performance-chasing isn't just limited to unsophisticated investors who are using the rearview mirror to drive the car. Even those investors who appreciate the virtues of remaining well-diversified across asset classes may be inclined to cheat a little bit, sticking with unloved asset classes but sending their dollars to the better-performing categories within them.

For example, as equities have rallied for most of the past five years, the assets going into bonds have been gravitating to credit-sensitive bond types like bank-loan and high-yield. Not only do those fund types have stronger recent returns and higher yields than their high-quality counterparts, but they also have a fairly high correlation to stocks, as discussed in this article. Meanwhile, investors have been retreating from high-quality bonds, which historically have a much lower correlation with equities and are therefore better diversifiers.

Not Just a Newbie Problem
In a similar vein, even investors who aren't chasing hot-performing asset classes or categories may be inadvertently undermining their portfolios' diversification by focusing on the strongest-performing funds within a given peer group. Investors want to believe that the fund with winning performance numbers will continue to have an edge over its peers. But in reality, past performance isn't very predictive, especially for equity funds. Funds are often successful because they've been in sync with market trends that, as all market trends do, have a shelf life.

The most stark example of this faux diversification problem came during the runup to the dot-com bubble, when investors gravitated to the top-performing funds in categories as diverse as large-growth, mid-blend, world stock, and moderate allocation. The category names were different, but the central ingredient in the best-performing funds' success was the same: exposure to technology and especially Internet-related names. Had investors held just one or two tech-fueled assets while holding their noses and sticking with small-cap value-leaning funds for the rest of their portfolios, the bear market in tech stocks may not have wrought such havoc.

There's no similar pocket of egregious overvaluation in the market today. But the fact that small- and mid-cap stocks have outperformed large caps during the past five years does set up the possibility that there's some intracategory performance-chasing going on. Say, for example, an investor is committed to holding large-cap funds, even though such offerings have underperformed small- and mid-cap funds during the past five years. He might tend to focus on those large-cap funds that look particularly impressive within their peer groups, assuming that the fund has some sort of so-called secret sauce that gives it a performance edge relative to its peers. That may be, but there's a good chance those large-cap funds have gained their performance edge by emphasizing small- and mid-cap stocks. And when large- and mega-cap stocks trump small, as often happens in the later part of an economic cycle, that smaller-cap bias could become a handicap. 

Takeaways
That's not to say you need to go full-on contrarian, fleeing from everything that has performed well in absolute and relative terms in the recent past and packing your portfolio with laggards. Market trends can persist for years, and your winners could continue on their hot streak while your laggards struggle. Nor do I mean to suggest that laggard performance isn't worth further investigation; it may be an indication that an investment is struggling from more than an out-of-favor style.

It is a reminder, however, that the clearest and most intuitive gauge of a truly diversified portfolio isn't necessarily your style-box or asset-class exposure, but whether you're holding some winning holdings--in absolute and relative terms--as well as some holdings that have performed poorly. Rather than letting the losers cause you angst, view them as a sign that you're doing something right.

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