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Is Your Stock Mix Out of Whack?

It's important to review your portfolio's equity exposures and interest-rate sensitivity.

The following is an excerpt from Christine Benz's recent webcast, Tune Up Your Portfolio in Uncertain Times. Watch the full webcast.

Christine Benz: The next step in the process is to assess your equity exposures. So, we've talked about some of the tailwinds that U.S. large-growth stocks have had. If you look at your portfolio's style box exposure, and you've been hands off with your portfolio, if you haven't been periodically stripping back U.S. growth stocks, it's a good bet that your portfolio is skewing toward U.S. versus foreign, it's skewing toward growth versus value. And so, you may need to do a little bit of repositioning to help restore balance. It may be that you have as an ongoing bias a bias toward U.S. large-cap growth stocks, that that's your choice. But it's just important to be conscious of whatever biases you have in your portfolio. If you're seeking balance, if you're anticipating reversion to the mean, anticipating that growth stocks may cede ground to value and that U.S. stocks may cede ground to non-U.S. over the next decade, doing a little bit of repositioning there probably makes sense.

On this slide, I've got an indication of the extent to which U.S. growth stocks have outperformed value. They've nearly doubled value over the past five years. U.S. stocks relative to non-U.S. stocks have also trumped non-U.S. stocks. Those are areas to think about doing some repositioning, especially if you're kind of looking forward as opposed to using the rearview mirror to drive the car.

Thinking in terms of your portfolio's fixed-income exposures, the Fed's planned interest-rate hike has certainly put pressure on bond prices that started in late 2021, and that is certainly persisted into the early innings of 2022. We've seen some losses on bond funds just recently. So, for the year to date, we've seen the biggest losses in terms of long-term bonds. They tend to be the most interest-rate-sensitive. We've also seen some weakness in emerging-markets bonds recently where they have fallen back just as much as long-term bonds. So, I think the thing to remember is that even though the Fed has not taken action to lift interest rates yet in 2022, that investors in the bond market are often pre-emptive. So, bond prices tend to factor in the market action. So, we've seen bond prices take a little bit of a hit. I think it's important to review your portfolio's interest-rate sensitivity. Most investors don't own long-term bonds as a portion of their portfolios. But it is important to understand the price effects that your portfolio might encounter during a period of rising interest rates.

I often like to point investors to what I call a duration stress test. And to do this, you don't need to be a bond market geek. But you need to find a couple of data points about the funds in your portfolio. So, you'd find the duration of a bond fund in your portfolio, and you can find that on the Portfolio tab of Morningstar.com. Find duration and then also find a statistic called SEC yield, which you'll be able to find for ETFs, exchange-traded funds, on Morningstar.com. For mutual funds, you'd want to look on your fund company's website for SEC yield. And the SEC yield is just a current snapshot of the fund's yield. And so, you're taking those two numbers and you're subtracting that yield from the duration, and the duration is a measure of interest-rate sensitivity. And the amount that you're left over with is the amount that you might expect to see that bond fund lose in a one-year period in which interest rates jumped up by 1 percentage point. So, that's a big jump up in terms of interest rates. But run your portfolio holdings through that sort of stress test. So, if you have a long-term bond in your portfolio, a long-term bond fund in your portfolio, you'll see a duration of roughly 18 years today, certainly a high double-digit duration today, and you'll probably see a yield in the neighborhood of 2% today. So, running through that little bit of math, you'll see that that's a fairly significant loss in that one-year period in which we would see a sizable interest-rate jump of 1 percentage point.

Most investors don't own long-term bonds specifically for this reason for their potential volatility. Most investors own shorter-term and intermediate-term bonds, which tend to be much less interest-rate-sensitive. So, looking at intermediate-term bond funds today, we see durations oftentimes in the neighborhood of six or seven years. Yields are pretty low. So, yields don't provide too much of a cushion. But, nonetheless, that leaves you with, I think, a little bit of comfort in terms of thinking about, "Well, how vulnerable are my fixed-income holdings in a potentially catastrophic interest-rate increase." It's probably something that you could live with. But run your holdings through this stress test. This will tend to be most useful if you have high-quality bond funds in your portfolio. It will be less instructive if you have lower-quality bonds.

While you're looking at your portfolio's fixed-income exposures, it's also worthwhile to evaluate the role of lower-quality bonds. I mentioned that lower-quality bonds had been pretty resilient during this recent market sell-off. The issue to keep in mind is just how these bonds tend to perform in varying market environments. So, one thing we know when we look at the data is that lower-quality bonds are much more correlated to stocks than they are to high-quality bonds. And so, I think that can help you figure out how to use them in your portfolio. I like them as a portion of the equity exposure in a portfolio rather than thinking about them as higher-yielding alternatives to high-quality bonds. High-quality bonds will tend to deliver ballast for your portfolio. They're what you want to hold if you want a portion of your portfolio that will potentially gain a little bit when stocks go down. Low-quality bonds will not do that for you. They will typically move in sympathy with the equity market. Even though they might not lose as much as stocks in a market sell-off, they will tend to behave in sympathy with equities, which is one reason why I like investors thinking about them as part of their long-term portion of their portfolio. If you're a bucket investor, for example, you'd think about holding them in Bucket 3 in that long-term piece.

Dig deeper:
You Probably Need to Rebalance

Are Your Bond Holdings Vulnerable in a Rising-Rate Environment?