Diversification Still Key Despite Tear for Large-Caps

This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.

U.S. large-cap stocks have been on a multiyear performance tear, and investors in everything from international equities to alternatives wonder whether they would be better off with a single asset class. Such a strategy would be unwise, according to panelists Bob Boyda of John Hancock Asset Management, Anne Lester of JP Morgan Asset Management, and Brad Vogt of Capital Group.

The group was united in their support of portfolio diversification, which the panelists maintain can help enhance returns, reduce volatility, and preserve capital. Although the stock market's march upward over the past nine years might seem to have kept a steady pace, Vogt said there have indeed been stumbles; the best-performing target-date funds during the runup have been those providing outstanding downside protection while participating healthily in the market's upside.

The underlying theme of the discussion--whether traditional portfolio diversification continues to be relevant in today's markets--was partly inspired by a growing choir of market participants chanting about the false promises of diversification. They often cite the market meltdown of 2008, which saw surprising spikes in asset correlations and unisonous collapses of asset prices.

Lester suggests that the skeptics' time horizons are much too short; the tangible benefits of diversification will be had over extended periods. Investors should collect assets offering distinctive sources of growth, cash flows, and risk. While asset-class diversification remains relevant, new financial data and advances in technology allow managers to view and apply the concept in novel ways--the capability to model an asset's macro and microeconomic factor exposures, for example, can flag a portfolio's unintended bets and provide a deeper understanding of risks borne.

Other recent additions to the asset manager's toolbox can be useful for diversification but are not panaceas, says the panel. Source-country revenue data for stocks, which shows a company's exposure to key regions as defined by the location of its sales, is helpful to understanding a portfolio's end-market diversification, and with many businesses' operations now spanning the globe, many argue that the link between domicile and revenue has become less prominent. Indeed, companies within the S&P 500 index--a popular bellwether for U.S. stocks--receive in total about 38% of their revenue outside the United States, including 14% from Europe and roughly 8% from China. The global expansion of the U.S. index's revenue sources has caused some investors to wonder whether foreign-company investment is necessary for obtaining exposure to foreign markets.

But the panelists stressed that a company's country of domicile is still important and that investors are unlikely to achieve optimal geographic diversification through domestic-stock ownership alone. Opportunities in the metals and mining industries, Vogt points out, are difficult to exploit without taking stakes in foreign-domiciled businesses. Boyda highlighted the dominance of Chinese firms as a reason to consider ownership of foreign stocks.

There was little disagreement among the session's panelists, and their message was clear: Diversification is critical to realizing investors' long-term goals.