7 Things I Don’t Own in My Portfolio

As someone who writes about building portfolios for a living, I do research on many types of investments, ranging from tried-and-true core holdings to more-esoteric corners of the investment world. A key part of my job is to comb through the available evidence and help readers understand the pros and cons of various investment types for their own portfolios.

But what do I actually do with my own money? Here, I’ll discuss seven popular investment types on which I’ve decided to take a pass. I’ll also discuss the rationale behind why I’ve decided not to incorporate each one.

Actively Managed Funds

I still own shares in a couple of actively managed funds. But they’re mostly holdovers from a few rollover IRAs and make up a smallish slice of my overall assets. The majority of my fund holdings are passively managed index funds.

This wasn’t always the case. I spent the first part of my career analyzing mutual funds, and it’s always fascinating to hear active managers explain the rationale behind their investment decisions. And there are a few active managers who have consistently added value for fund shareholders over time.

But with more experience in both life and investing, I’ve become more skeptical about the value of active management in general. Keeping the bulk of my assets passively managed also simplifies portfolio management. I can focus the majority of my time on making sure my overall asset mix is appropriate for my financial situation and goals instead of keeping track of whether an active manager is still adding value.

At the risk of splitting hairs, I do own shares in Berkshire Hathaway BRK.B and VanEck Morningstar Wide Moat ETF MOAT, which could both be considered quasi-actively managed portfolios. In addition to its business operations in insurance, energy generation and distribution, and rail transport, Berkshire maintains a large investment portfolio. The VanEck Morningstar Wide Moat ETF tracks an index, but the index itself relies on human judgment. The Morningstar Wide Moat Focus Index features companies that Morningstar’s equity analysts believe have two key attributes: a sustainable competitive advantage and a low price compared with their estimated fair value.

Real Estate Investment Trusts

I have small stakes in real estate as part of my holdings in a diversified equity index fund and a target-date fund, but I don’t have any dedicated exposure to REITs or other real estate stocks. I often see articles hyping up the importance of real estate in a diversified portfolio. Real estate is often touted for its generally low correlation with other equity assets, as well as its ability to generate above-average returns over time.

I’ve written about why I’m skeptical about real estate in a previous article. There are two key reasons behind my jaundiced view: diversification and idiosyncratic risk. On the diversification side, I think the value of real estate as a portfolio diversifier has often been overstated. Over the past three years, for example, the real estate sector has had a correlation coefficient of about 0.86 when measured against the broader U.S. equity market. In addition, real estate has been subject to periodic downdrafts that are difficult to predict: Witness the 21% cumulative loss in the FTSE Nareit All Equity REIT Index from 1998 through 1999, or the 47% cumulative loss in the same index from 2007 through 2008.

As these drawdowns suggest, there are a lot of idiosyncratic risks specific to real estate investing. I don’t have any specialized industry knowledge that would give me a unique capability to mitigate these risks. Since I’m not fully convinced about the merits of real estate in the first place, I’ve put it in the “too hard” pile.

Sector Funds

There’s no question that innovations in healthcare, technology, and communications have the potential to enhance human progress for years to come. But there’s often a disconnect between the growth potential of a given sector and its investment merit. By the time people start getting intrigued by the growth prospects for a given sector or industry, much of the potential is already priced into valuations. The technology sector, for example, which ranks as the most popular area for sector funds, is currently trading at 8% premium to estimated fair value.

Over the trailing 10-year period through June 30, 2023, the average sector fund (including funds that have been merged or liquidated out of existence) has gained just 7%, compared with about 12.4% for diversified market benchmarks such as the Morningstar US Market Index. What’s more, sector funds have been incredibly difficult for investors to effectively use in a portfolio. In the most recent edition of Morningstar’s annual Mind the Gap study, we found that dollar-weighted returns for sector funds over the 10-year period through 2021 trailed time-weighted returns by more than 4 percentage points per year. With a track record like that, I’m staying far, far away.

Alternative Investments

Alternative investments are designed to offer something fundamentally different from mainstream asset classes. Morningstar defines these strategies based on their ability to modify, diversify, or eliminate traditional market risks. The universe of alternative funds ranges from strategies that attempt to limit or offset their equity exposure to those that focus on absolute returns, meaning they focus on capital preservation and aim to generate positive returns no matter what the market environment.

As John Rekenthaler has pointed out, though, alts’ track record is mixed at best. Some alternative-fund categories—particularly systematic trend and equity market-neutral—were successful during 2022′s bear market. But over longer periods, they’ve generally been disappointing. Over the past 15 years, the typical alternatives fund has gained less than 2% in annualized returns.

Nontraditional equity funds, which employ strategies such as derivatives, shorting, and options overlays while maintaining exposure to traditional market risks, have fared a bit better, with annualized returns of 4.4% over the same period. But that’s well behind the 8% return of a traditional 60/40 mix of large-cap stocks and investment-grade bonds over the trailing 15-year period.

Could alternative investments fare better going forward? It’s possible. But I’m not convinced.

I Bonds

In contrast to the areas discussed above, I don’t have a philosophical objection to I Bonds, which are Treasury bonds that pay a fixed rate of interest plus another layer of interest that adjusts to keep up with the current inflation rate, with the inflation adjustment made every six months. I Bonds are one of the best ways to hedge against inflation, especially if you can purchase them at a time when they’re offering an attractive real yield.

They also boast tax benefits. I Bonds’ accrued interest is exempt from federal taxes until they mature or are sold off, and all interest is free from state and local taxes.

Why haven’t I bought them? The reasons are pretty mundane: purchase limits and other practical drawbacks. For the most part, individual investors can only purchase $10,000 worth of I Bonds per year, making it tough to amass a big enough position to make a significant difference in an already-established portfolio. And I Bonds can only be bought and sold through the Treasury Direct website, which is reportedly somewhat clunky and out of date. At this point in my life, I’m reluctant to add yet another login and password to my list, which will add complexity both during my lifetime and for surviving family members after my death.

High-Yield Bonds

High-yield bonds offer a yield premium in exchange for their additional credit risk, with the yield premium over Treasuries historically averaging more than 500 basis points.

They’ve also generated above-average returns over time. Over the past 30 years, for example, the average high-yield bond fund has produced annualized returns of about 5.4% per year, on average, compared with 3.9% for the average intermediate-term core bond fund.

But high-yield bonds also have some drawbacks. Because of their added levels of credit risk, they tend to be more equitylike than bondlike. Over the past three years, for example, the Morningstar US High-Yield Bond Index has had a correlation coefficient of about 0.85 versus a broad stock market benchmark. That makes high-yield bonds less useful as portfolio diversifiers than other fixed-income securities, such as investment-grade corporates, government bonds, and cash.

High-yield bonds have also been subject to sharp drawdowns at times. During the global financial crisis, for example, high-yield bonds lost about a third of their value from June 2007 through August 2009.

Overall, high-yield bonds don’t look that compelling to me on a risk-adjusted basis. My main goal for fixed-income holdings is to offset the risk of my equity assets, so I’ve given junk bonds a pass.

Gold

I’ve written about some of the virtues of gold in a previous article. It has a relatively solid record as a safe haven during periods of market crisis and also sports a low correlation with most major asset classes. Over the past three years, gold had a correlation of just 0.12 when measured against stocks and just 0.43 when measured against investment-grade bonds.

But I haven’t been impressed enough to add it to my portfolio. Fundamentally, gold isn’t a growth asset: Its value typically remains stable in inflation-adjusted terms over long-term market cycles. My primary investment goal is long-term growth, and I have enough cash and shorter-term bond holdings to add ballast during market drawdowns. If I were truly worried about some type of financial Armageddon, I’d probably consider adding gold as an insurance policy, but I’m still pretty sanguine about the prospects for investing in mainstream asset classes.

Conclusion

Would I ever consider adding a position in one of the areas discussed above? Maybe. If new evidence emerged about their merit or if I looked at the pros and cons again and came to a different conclusion, I wouldn’t necessarily rule them out. At this stage, though, I’m comfortable keeping them off-limits for my portfolio.

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