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Investing Insights: Portfolio Makeovers, Market Volatility

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Jeremy Glaser: This week on Morningstar we are featuring five real-life portfolio makeovers by Christine Benz, our director of personal finance. She is joining me today to talk about how to do your own portfolio makeover.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: The first thing that you need to do to actually have your own portfolio makeover is to gather all the information, right?

Benz: That's right. This is something I put all of our portfolio makeover candidates through, I ask them to provide me with a lot of data. Account statements, the most recent account statements you can find; Social Security statements, so you can project your benefits; if you are someone who is covered by a pension, you want to gather those pension documents and get your arms around what sort of pension benefits you might be able to rely on in retirement. Definitely, data gathering would be the first step.

Glaser: Once you have that basic piece down, you should start evaluating your progress toward your goal?

Benz: Right. That's the key thing I think about when I'm looking at these portfolios is just, is this plan on track. For accumulators you want to gauge the adequacy of what you've managed to save so far, and here I really like the Fidelity benchmarks where they have different savings targets by age band. I think those can be a good starting point for people. I also think for accumulators this is a great place to turn to some an online retirement calculator to gauge the viability of your progress so far. One I have often recommended is T. Rowe Price's retirement income calculator, but a lot of financial providers have their own calculators and tools. Run through a few of them just to get a sense of whether your current balance plus your ongoing savings rate puts you on track to reach your retirement goal.

If you are someone who is already retired, you want to think about your withdrawal rate and think about perhaps the 4% guideline as a starting point for gauging your portfolio's withdrawal rate. I've written a lot about this topic over the past few years. People want to think about their own portfolio's asset allocation as well as where they are in their retirement trajectory. People who are young retirees, say, under 65, would want to be much more conservative than 4%, whereas older retirees maybe able to be a little bit more aggressive in their withdrawals. But that's definitely the key thing to think about for people who are already retired and drawing from their portfolios.

Glaser: The next step is to look at your overall asset allocation.

Benz: That's right. Here I like Morningstar's X-Ray tool. If you've gathered up all of your account statements, you can enter all of your holdings in Morningstar's Portfolio Manager or use our Instant X-Ray tool to enter those holdings. That way you can get a read on your total portfolio's asset allocation. Then you want to just gauge whether that's reasonable. If you are someone who is accumulating assets for retirement or already retired, you might use Morningstar's Lifetime Allocation Indexes, which are put together by our colleagues in Morningstar Investment Management. Or you might use a good target-date fund or two just to see, well, is my asset allocation, is it in the same ballpark as what these professionals are recommending. If it's not, and you might have a very good reason for it not to be--why not, and make sure that you are thinking that through.

Glaser: That gives you a sense of that broader asset allocation of stocks versus bonds, say. But there could still be allocations on sectors or style-box weightings that you'd want to take a closer look at as well?

Benz: That's right. This is something I certainly look at when conducting the portfolio makeovers. Here again, I think our X-Ray functionality can be super helpful. You are looking at sector positioning relative to the S&P 500. You are also looking at your portfolio's style-box exposure. Are you listing heavily toward one side of the style-box or the other? Are you listing heavily toward small stocks versus large? Not to say that you can't have some of those bets in your portfolio, if you have a good reason for positioning your portfolio that way. But just saying that you want to be aware of them and make sure that you are not making any big, scary inadvertent bets.

Glaser: This is also a time to check out to make sure you don't have too much overweight in any given security?

Benz: That's right. Here again, X-Ray has the stock intersection tool that shows you how much you have in various securities in your portfolio. You want to take a look at that, and make sure that you haven't inadvertently made a big bet on some stock by buying it outright when maybe a mutual fund in your portfolio also holds it. Watch out for very large individual stock bets. Certainly, if you have employer stock as a part of your plan, that can be a big risk factor for a lot of people because their financial wherewithal is also riding on the company. Watch out for that as well.

Glaser: If you are looking to streamline your accounts a little bit, streamline your portfolio, what would be some ways to do that here?

Benz: This is definitely something that should be part of any portfolio makeover process. Start at the account level. See if there aren't like-account types that you can collapse together. Maybe you have old rollover IRAs, multiple versions of them that you can put together into one large IRA, for example. That will reduce your oversight on an ongoing basis. Start with accounts, then move on to holdings. You may have holdings that are redundant with one another. Or maybe you have one large-cap growth fund that largely duplicates exposure that you are getting through your total market index fund. Look for opportunities to streamline, ideally at the same time, to lower costs and improve your overall holdings quality at the same time.

Glaser: How about taxes?

Benz: This is another great opportunity to look at improving your portfolio's tax efficiency. If you are making contributions, are you making them to your tax-sheltered vehicles? If you have taxable accounts, are those accounts as tax-efficient as possible? For a lot of people, this is as simple as holding equity exchange-traded funds as well as municipal bonds and bond funds for their taxable accounts. Finally, for people who are already in drawdown mode, it makes sense to think about tax-efficient withdrawal sequencing. That's a topic that I've written a lot about on Morningstar.com, where you are basically hanging on to those accounts with the best tax benefits, like Roth accounts, to last in your withdrawal queue and potentially tapping less tax-efficient accounts before them.

Glaser: What other risk factors should you be considering when doing a makeover?

Benz: You really want to look inward and think about your own personal risks. Some recent examples from makeovers have included people who haven't insured against long-term care. That's certainly a big risk factor for people later in life that they might incur these large unfunded costs. You want to think about, if I haven't insured against long-term care costs, do I have enough assets in my portfolio to cover those costs later in life. Another recent example was an individual who had a pension that she would be bringing into retirement, but the pension covered her life only, and there would be no benefit for her husband if she predeceased him. You want to think about problem spots like that that could arrive. In this case, the recommendation was that they purchase life insurance should she predecease her husband. Think about all of your individual-specific risk factors. I think that that should definitely be part of any sort of portfolio makeover process.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

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

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With volatility in the stock market dominating the headlines again, many investors might be wondering if they can or if they should reduce risk in their portfolio. I'm here with Christine Benz, she is our director of personal finance. We are going to take a closer look at four light ways to reduce risk.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: Maybe we should start with what generally isn't advisable, and that's just a wholesale de-risking of an entire portfolio, particularly for investors that are far away from retirement.

Benz: Yeah, that is not a strategy I would advise. It does perhaps provide some short-term peace of mind if you are seeing the market drop a lot over a period of days or weeks. It can provide some short-term comfort to just get out of everything altogether, move everything to the safe investment on offer in your investment program. 

The key reason why you don't want to do that is that inevitably you will be stuck wondering when do I get back in. Because the market often is streaky and will often log its best days on a series of short bursts as opposed to a slow, steady progression. That sort of relief can quickly be replaced with worry about, well, am I doing the right thing here and when is the best time to edge back into stocks.

Glaser: Your first tip for a light way to de-risk is to potentially cut back on stocks through rebalancing, that this is a great time to look at your asset allocation.

Benz: Absolutely. And you know, I sometimes wince when I hear people on TV or in other places saying nobody do anything, the market is down. Well, guess what, a lot of people haven't been doing anything with their portfolios for 10 years. That means that they could in fact be heavier on equities relative to their life stage than they actually should be if they have just been letting their winners ride. 

So, even if you haven't done anything and your portfolio balance has been sinking lower and your equity holdings have been sinking lower, it's still maybe the right call to de-risk that portfolio a little bit, to take some money off the table in stocks and move it into bonds or perhaps cash. That will tend to be less advisable, the younger you are, the more you should use the market dips as an opportunity to add more to stocks not less. But for people who are getting close to retirement, people who are 50 and above, absolutely, they should use our X-Ray functionality, see where they are now, compare it to a target, and see if some de-risking is in order.

Glaser: Within asset classes, too, your second tip is to maybe think about being in more defensive sectors or in more defensive bond funds.

Benz: Absolutely. Because again, if investors have been just kind of letting their winners ride, they will tend to have a concentration in the growth side of the style box, even though that's been the epicenter of the recent market weakness. In fact, some of the portfolios that I've been working on in our portfolio makeover series have been very heavy on growth stocks. So, check that out. 

Think about especially again if you are someone who is getting close to drawdown, getting close to retirement, think about giving your portfolio equity weighting a little bit more of a defensive cast. You might emphasize quality more. If you are an individual stock picker, you might focus on what we call wide-moat companies. You might emphasize dividends a little more. You might also invest in some sort of a product that focuses on the subset of stocks that we classify as low volatility or that index providers classify as low volatility. Those are ways to stay in equities, but give your portfolio a little bit more of a conservative bias.

You can do the same on the bond side, where you might have in your portfolio some lower quality bond holdings, maybe some more income-focused bond holdings. If you are concerned about volatility related to the equity market, make sure that your bond holdings are really ballast for you, that they are going to deliver for you on days when the equity market sells off. That's generally high-quality bonds. Long duration bonds often perform best on big equity market down days. But I think for investors who are looking for a low-risk bond portfolio, they would probably want to focus on short and intermediate-duration bonds.

Glaser: You say this is a time to potentially reduce idiosyncratic risk. What do you mean by that?

Benz: I think that's a great thing to do at times like these. Scout around your portfolio just to see if you are taking any big "dumb" risks in your portfolio--things like major style concentrations, major sector concentrations, major concentrations in individual holdings. Company stock is one that I would call out as something to avoid a big concentrated bet in, because so much of your individual wherewithal is riding on your company's fortunes. That's a place to look if you are attempting to reduce security-specific risk in your portfolio.

Glaser: Finally, you think this could be a good time to review your portfolio maintenance regimen. Why is that?

Benz: Well, I would say, for people who have specific holdings that are causing them a lot of angst, there are maybe some tweaks that you could make without completely upending your plan to reduce your exposure to those very volatile positions. For people who are making additional ongoing contributions, say, through a 401(k) plan, maybe you just reduce your future contributions to those holdings, not your contributions overall, but to those problematic holdings. That would be one way to maybe buy yourself a little peace of mind.

Another idea is, if you are kind of in maintenance mode with your portfolio, where you are neither adding to it or withdrawing from it necessarily, reinvesting the dividends and capital gains distributions--a lot of us have those boxes checked with our fund providers--maybe uncheck them for the holdings that are again causing you the most angst and causing the most volatility in your portfolio. You are not bailing out of them altogether, but you are just saying, well, for now at least, I'm not going to commit additional capital.

And finally, for retirees, I do think that they have an opportunity if they have holdings that they found especially problematic to tie their scaling back on those positions in with whatever withdrawal system they are using. If they are pulling from their portfolio anyway, why not pull from those holdings that are causing them a lot of angst. Those are some easy ways to reduce exposure to positions without getting out of those positions altogether.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

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

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Damien Conover: The U.S. election is recently completed, and the outcome has left us with a split Congress which has implications for the healthcare sector that I think investors need to be aware of.

When we take a step back, we think the split Congress will likely mean less radical change to U.S. healthcare policies. What that means is, we'll likely see smaller implementation of past laws that have already been voted on but not yet enacted. We want to walk through some of those, and then, also, what is likely to happen from the rhetoric standpoint.

We think the most important upcoming change is an increase into the Donut Hole Discount. What that means is, when patients get to a certain point in spending, their drug prices are going to change by the amount of the discount offered by the drug companies. The discount historically had been at about 50%, that's going up to 70%. That's going to hurt the drug firms, but let's keep the magnitude in mind here. This is probably about 1% earnings hit to the large-cap pharmaceutical and large-cap biotechnology firms. This is something we think is manageable through some price increases elsewhere within the drug distribution space as well as through some cost cutting.

The second thing that's very likely to happen is increased pricing negotiation for Part B drugs. These are drugs that are administered in the hospital. This is something we think a split Congress can get behind and likely pass, so that will likely cause some more pricing headwinds for the drug and biotechnology firms, probably in the neighborhood of about a 2% hit. 

In this backdrop of increasing pricing pressure, we still think the drug space is an interesting place to invest in, because we think those costs on the drug firms are manageable. We think that the firms will be able to, again, cut costs or increase prices elsewhere to get around those increasing pricing concerns.

One thing that we think is also important is the increased rhetoric that is very likely to come out of Congress and the president's office, and that is, lowering U.S. drug prices that are something compatible to what we see in other developed markets. We think this is unlikely to actually come through. We think it's going to be more rhetoric. The reason why is, there's a high degree of complexity around bringing U.S. drug prices down to developed market prices outside the U.S., because of access issues outside the U.S. versus the U.S. That leads us to believe that it's very likely going to continue to be spoken about but not enacted.

Within this landscape of a new Congress and what we are anticipating not being major change in the political landscape, we're highlighting a couple of ideas for investors. First off is underappreciated innovation. Roche is a name we really like; very strong position in immuno-oncology as well as several other therapeutic areas we think the market is underappreciating. Also, any company that can do well in creating more value for anything within the healthcare landscape. Medtronic is a name that we think is underappreciated in this respect. They are bringing out a lot of products that have the ability to save costs for hospitals. Also, certain companies just have certain special situations that we think are well-positioned for investors. Bayer, we think there's a huge overreaction in some litigation that its crop science business is facing. We think that's an opportunity for investors.

And then, lastly, on the M&A front. We think that will continue to happen. We think it's important for investors to be aware of potential opportunities of targets that could be acquired. Biomarin, we think, is at the top of this list. The reason why is this firm is focused on rare disease drugs, and this is an area where a lot of the large-cap pharmaceutical and biotechnology firms want to gain more traction, and we think an easy entry point is by acquiring Biomarin.

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Stephen Ellis: The market has been, rightly, I think, skeptical around the Trump and the U.S.-China trade truce agreement announced over the weekend. We think the market is skeptical for three major reasons. 

First, if you look at the readouts from the China and the U.S. delegations, there's not necessarily a lot of agreement between the two. For example, the U.S. called for China to push for a large increase in agricultural product purchases immediately whereas the China release says nothing about that. Similarly, the China release says that the U.S. will respect China's One China policy whereas the U.S. release didn't say anything about that. So net-net, it creates a lot of confusion about what is needed for this type of agreement to be successful. 

Second, Robert Lighthizer has been appointed the new lead negotiator for the U.S.-China trade negotiations. He is generally someone who's had a harder line on China in the past, and so therefore China's going to take a while to get used to dealing with a negotiator who could, again, take time. 

Third, and most importantly, the core issues that are at stake here in terms of IP stuff, technology transfer, industrial policy, Made in China 2025, and cyber wars, these are issues that have been going on for years and, of course, extremely complicated. Resolving them in 90 days would be very unrealistic.

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Allen Good: Exxon Mobil is currently trading at $77 per share, a nearly 15% discount to our $90 fair value estimate. At this level, its $0.82 quarterly dividend implies a yield of 4.3%. While lower than European peers Shell, Total, and BP, it's higher than U.S. peer Chevron at 3.9%. Historically, Exxon has yielded less than Chevron.

While the recent declines in oil prices have weighted on shares, we see the dividend as safe. Our estimate of its oil price break-even level, which is the level at which it can cover capital spending and dividends, is less than $50 per barrel. That is lower than current levels as well as our estimated midcycle prices of $60 per barrel.

Over the last 10 years, Exxon has grown the dividend about 8% per year, but growth in recent years has slowed with the decline in oil prices. While Exxon is unlikely to match peers' cash returns via share buybacks, we estimate it will continue to prioritize dividend growth. As such, we expect dividend growth to reaccelerate in the next few years with growth of midsingle-digits, closer to historical levels.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The S&P 500 has lost 7% over the past three months and many growth-leaning mutual funds have lost more than that. Joining me to discuss some of the biggest leaders and laggards amid this stretch of volatile performance is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's start with the headlines. When you look at the categories, the diversified, domestic equity fund categories, which have suffered the most in this period of market volatility?

Kinnel: Well, from the three-month perspective, small growth has been hit the hardest. It's down about 14%. Large growth is down about 10%. And as you know, over the last few years, growth has been the best performing area. I take that at least some of that must be just simply a little correction, that they have had such a nice runup, very high expectations. In that way, it makes sense that they might correct the most.

Benz: Has the opposite side of the style box performed relatively better during this period?

Kinnel: That's right. Large value has lost the least. It's down about 6%, which is a big improvement on the growth side. I think some of that is simply that value has been the underperforming area and therefore maybe better set up to lose less in this kind of environment.

Benz: Of course, technology stocks have been kind of ground zero for this recent market volatility. So, I guess, it stands to reason that value funds would have less of some of those companies.

Kinnel: That's right. The FAANGs and some other tech areas have really been hit hard. And so, naturally, value funds tend to have very little exposure to the more aggressive side of tech. They might have some tech, but not the really fast-moving ones.

Benz: Let's talk about foreign stocks. Sometimes when U.S. markets sell off, we see that foreign stocks fall further still. What's been the pattern this time around?

Kinnel: In this case, the foreign equity sell-off has really mirrored what we saw in the U.S. So, pretty comparable performance. The first half of the year was not nearly as good for foreign equity funds; year-to-date, they are down significantly more than the U.S. This later sell-off hasn't been worse. But for the year, it has been worse.

Benz: When we look at sector fund performance, we talked about how the technology sector has been the hardest-hit area. Any other areas of note in terms of performing particularly well or poorly during this time frame?

Kinnel: Energy has been another area that's been hit hard. On the positive side, it's really the defensive areas that generally expect to do well, but it doesn't always work that way, but this time it has in that we are seeing utilities have held up the best. Some other defensive, high-quality consumer names have held up really nicely. It's actually kind of fitting, the basic idea, which is, defensive high-quality names that are slower growth, hold up well and the higher-risk names have sold off.

Benz: We often tell investors to hold bond funds to be a stable portion of their portfolio when we have these equity market shocks. Have they been a good place to be? Have bond funds generally delivered for investors during this time frame?

Kinnel: Only sort of. They have been less bad. Most bond funds have lost about 1% over the trailing three months. In a way, diversification does work but not maybe as well as you'd hope. Bond funds seem to be under pressure. We have a growing deficit, talk of inflation, and that's put pressure on the bond market.

Benz: Have there been safer spots to be within the bond fund space? Shorter-term and higher-quality, I would assume, may have held up a little bit better?

Kinnel: Yeah. Shorter-term and higher-quality has held up a little better in general. We are seeing longer bond sell off the most. So, they have done a little bit better, yes.

Benz: You looked through the performance rankings at some funds that have performed especially poorly during this stretch of weak market performance. Oakmark Select was one that you noted had particularly poor performance recently. What's going on there?

Kinnel: The fund is down about 15% over the trailing three months, and the reason is energy. Bill Nygren has been dialing up his exposure there, and unfortunately, so far, the timing has been bad and that's really stung the fund.

Benz: Fidelity Growth Company, probably not surprising to see that it has struggled recently. It tends to be really heavy on technology stocks, right?

Kinnel: Yes, it's made its shareholders a lot of money with tech stocks. But occasionally, you have to give some of that back. The fund has got a lot in FAANGs; it's got a lot in Nvidia. So, it's taken a rough stretch the last three months; it's lost about 16%.

Benz: You also pointed out some funds that have held up pretty well over this period. I was surprised to see Templeton Global Bond on that list, because it's a volatile fund, sometimes does worse other bond funds in periods of turbulence. What's going on there?

Kinnel: Templeton Global Bond is, as you say, much higher risk than most bond funds because they have got a lot of emerging-markets and currency risk involved. But in this case, where they've been very cautious is on duration. The fund actually has a negative duration, meaning, it actually benefits from rising rates. So, that's helped a lot. It's got a lot of emerging-markets exposure as well. That's been kind of a mixed bag, but better than a lot of other areas. It's actually been a nice performer.

Benz: On the equity side, quality has held up well. So, I guess, it's not surprising that you'd see a fund like Yacktman do relatively well during this time frame.

Kinnel: That's right. Yacktman has an emphasis on quality companies like Procter & Gamble, and those names have really held up well. It also has a big cash stake and, of course, cash does well in a bear market. It's nice to see Yacktman having a rebound. It's another of those funds that's had a rough go of it for a while, but again, we understand the reasons, and this is sort of a proof of concept to see it looking good in a down market.

Benz: Any other funds that kind of stand out to you in terms of having delivered strong performance during this rough stretch?

Kinnel: Merger Fund is a fund that's up about 2.5% over the three months. It's one you kind of expect because it's doing merger arbitrage, it's strategy that is designed to not move with the markets because they are essentially long the acquisition target and short the acquirer. It's really what you'd expect. But it's nice to see it delivering. These kinds of market-neutral type funds have not had much of a chance to deliver in this very strong bull market. So, it's nice to see Merger Fund have its day in the sunshine.

Benz: Useful recap, Russ. Thank you so much for being here to share your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.