Time to Check Your Conservative Holdings

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The equity rally may have thrown many investors' asset allocations out of whack and left them holding fewer conservative assets than they should. I'm here with Christine Benz, our director of personal finance, for closer look at what investors should keep in mind when thinking about rebalancing.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's talk little bit about why this would be a good time to even be thinking about this. Usually when things look pretty good is not the time that you're reflective on your portfolio.

Benz: Right. We've been talking about the importance of investors checking their baseline asset allocations because as you said, Jeremy, we've had this great rally in the equity market. So, even if you've been a hands-off investor, you've just not been minding your portfolio, what you've seen is that your portfolio has probably taken on a higher risk profile than perhaps you intended it to.

If you had a 50% equity, 50% bond portfolio at the start of this now eight-plus year rally, you would be at roughly 75% equity, 25% bond today. If you are 60-40 you'd be more like 80-20. So, the hands-off portfolio has gotten more aggressive, and meanwhile investors have gotten older.

If you are someone who is over 50, certainly over 55 or retired, if you've done nothing your portfolio has taken on a more aggressive look.

I think it's important to take a look at your holdings, take a look at that baseline asset class exposure as well as underneath the hood to see rather constituent holdings have perhaps shrunken in value or taken on outsize values relative to what you intended them to.

Glaser: Let's talk about that under-the-hood question. Usually it is easy to figure out your stock-bond mix. Why should you dig a little bit deeper?

Benz: Because we've seen some seismic shifts there as well. Even though they haven't been quite as great as what we've seen in the stock versus bond ratio, we have seen pretty big divergences where it's been this risk-on market where, whether you're looking at the equity piece of your portfolio or the bond piece, we've seen the risky pieces go up at the expense of the more conservative pieces.

Glaser: Let's take a closer look at that equity allocation. What parts of the market will probably need topping off and what parts will it be time to pare back on?

Benz: I'd look at a couple of key areas. One, would be the value versus growth ratio within your portfolio, and you can get a clear view of this using our X-Ray functionality. If you've been very hands-off with your portfolio you've probably seen the growth piece taking up a larger share of your overall portfolio. When I look at the Morningstar Indexes, for example, the Morningstar Large Growth Index has gained about 12% on an annualized basis over the past three years. The value index has gained a little less than 9%.

So the hands-off investor has probably seen that growth piece enlarge. Meanwhile, I think if investors are thinking about, well, how do I want to set my portfolio up in case we do see some sort of equity market shock, value stocks aren't given to outperform during a correction. But looking for companies, looking for funds that put a premium on companies with a margin of safety built into them is kind of a tried and true way of limiting downside losses.

Another thing to think about is the high quality versus low quality piece of your equity portfolio. The Morningstar Wide Moat Focus Index has returned about 11% on an annualized basis over the past three years. That's a good return for sure, but it is less than the lower quality piece. And meanwhile, when we look at our Morningstar fair value graph today what we see is that the stocks, the companies that we categorize as having wide moats are actually trading at a little bit of a discount to our total coverage universe, whereas the no-moat and narrow-moat companies are trading a little more expensively.

Glaser: What about international equity versus domestic?

Benz: This has been a really interesting area. One big phenomenon that has been affecting fund performance has been the fact that we've seen the dollar slide recently, relative to major foreign currencies. And so that has certainly had an impact on performance. What we've seen is that some of the hedged products, whether you are looking at some of the dollar-hedged ETFs or an active fund that hedges its foreign currency exposure--like, say a Tweedy, Browne Global Value--we've seen their performance look not so good recently relative to those funds that are fully encompassing the gains that we've seen in foreign currencies. So, that's one thing to pay attention to. If you do have one of those hedged products maybe that's one that is deserving certainly more of your patience, but also potentially more of your dollars because we could see that trend revert at some point.

The other thing I would point is that for retirees, those hedged products can be a nice way to maintain foreign stock exposure but diminish or reduce the foreign currency fluctuations and the volatility that can accompany those.

That's one trend to monitor as you're looking at your portfolio. Another is emerging markets versus developed-market stocks where we have seen the emerging stocks enjoy a long-awaited comeback certainly so far in 2017, whereas developed-market stocks have performed well just not as well.

If you have some sort of fund, for example, that focuses on the developed markets' equities I would give it a little more time and potentially top it up as a percentage of my international equity portfolio.

Glaser: In your fixed-income sleeve what you should be looking at there?

Benz: Well, my bias is always for the core of your fixed-income portfolio. If you are looking for true balance in your portfolio, you want that piece of your portfolio to be very high quality. So, one thing that we've seen is that it's been this risk-on market, so whether you are looking at emerging-markets equities or long-term bonds or junk bonds, all of those categories have outperformed at the expense of high quality. But when we look at the asset class that is negatively correlated with the equity market, that might even go up when your stock piece is going down, high-quality bonds are it. So make sure that you have adequate exposure to that category. Here I would just look for some of the best rated funds within our short- and intermediate-term bond categories and those are generally pretty high quality products.

Glaser: Christine, thanks for joining me today.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.