Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Assembling and maintaining an investment portfolio can be overwhelming. Investors can simplify their investment lives and minimize room for error by building their portfolios around just a few core holdings, or less. Here with me to discuss some new research on which types of funds are best suited to the core of an investor portfolio is Amy Arnott. Amy is a portfolio strategist with Morningstar. Nice to see you, Amy.
Amy Arnott: Thanks. Great to be here.
A Role in Portfolio Framework
Dziubinski: You and your team have developed what you’ve called a Role in Portfolio framework. Let’s talk about what led you to work on developing this in the first place.
Arnott: Obviously, here at Morningstar we spend a lot of time doing research on individual funds and trying to help investors choose great funds with low expense ratios. And that’s a big part of your job as an investor. But, unfortunately, that’s only part of the task. And we have a lot of evidence that even if people are able to select great funds, they often struggle to use them effectively in a portfolio. We’ve talked about our Mind the Gap research, which measures the difference between a fund’s reported total returns and dollar-weighted returns, which reflect the timing of cash inflows into and out of the fund. And we found there’s about a 1.7-percentage-point gap on average over the past 10 years between those two numbers. It’s definitely a challenge to put together effective portfolios.
If you’re an institutional investor, you’re probably using something called a portfolio optimizer, which is software that helps you build portfolios that either maximize risk per unit of returns or vice versa. But if you’re an individual investor, you probably don’t have access to that type of software, or even if you did, it might be challenging to use. We tried to come up with a framework that was much more practical and accessible to the individual investor. And we really started by going back to the basic question of “Why do people invest?” And typically they’re investing for a specific goal. That’s the foundation of the framework.
Portfolio Construction
Dziubinski: The framework is providing this guidance for a portfolio construction based on these two elements of time horizon and position size. Why are these the two pillars that the framework rests upon?
Arnott: As I mentioned, time horizon is important because if you’re saving for a specific goal, maybe it’s a wedding, a down payment on a house, a child’s college education, or retirement savings, usually each of those goals has its own time horizon or a specific time when you expect to start drawing down assets to meet that goal. And we tried to minimize the risk that when you meet that time horizon, the portfolio is going to be down, which would leave you potentially underfunded for the goal. And then the other dimension is the size or the percentage of assets within a portfolio. And this really goes back to the whole idea of portfolio diversification and wanting to be balanced across a range of major asset classes and making sure you’re not overweight in any one particular area.
Portfolio Management and Time Horizon
Dziubinski: Let’s talk a little bit about time horizon. How did you determine what an appropriate recommended time horizon would be for a particular investment?
Arnott: We started out by dividing time horizons into four major groups. We looked at one to two years, two to six years, six to 10 years, and 10 years and more. These are broad groupings that we thought a lot of individual investors and financial advisors might tend to think about their investment goals in. One of the key pieces of data we looked at was the maximum time to recovery. We looked at different Morningstar fund categories and asset classes, and any time there was a loss over a certain period, we looked at the worst-case scenario for how long it might take you to break even. And that was a key input into the recommended time horizon. We also looked at things like the frequency of losses, maximum drawdown, the level of equity exposure for multi-asset funds, and duration on the fixed-income side.
Dziubinski: Got it. And then how did you arrive at your recommended position sizes?
Arnott: When you’re trying to put together a portfolio, typically you want it to be diversified across the major asset classes: stocks, bonds, and cash. We consider funds that have built-in diversification like target-date funds or allocation funds to be most suitable as stand-alone holdings. Those types of funds, because they have that built-in diversification already, could be potentially your only holding or make up a very large percentage of your portfolio, maybe 80% to 100%. And then in terms of more specialized funds, the next level down is what we define as core holdings, which would be as much as 40% to 80% of your portfolio. And then below that would be building-block funds, which could be maybe in the range of 15% to up to 40%, and then for more specialized or volatile holdings you probably would want to keep those to less than 15% of assets.
The Core of an Investor Portfolio
Dziubinski: Amy, let’s talk a little bit more about these types of investments that can make up the core of an investor’s portfolio. How does your research define core? And then again, if you could reiterate to us what percentage of an investor’s portfolio typically should be in these core types of investments?
Arnott: We think of core holdings as being fund categories or asset classes that focus on very large mainstream asset classes. And because you’re getting a fair amount of diversification within the asset class, it could make up a fairly large percentage of your portfolio, maybe as much as 40% to 80% of the portfolio. And that’s obviously also a pretty wide range. That also gives people an ability to customize. Maybe if they are interested in adding some more-specialized holdings, they might want to be on the lower end of the range. If they want to keep the portfolio very simple, they might only hold, let’s say, maybe three different funds and use the relative weightings as a way to adjust the portfolio’s overall risk level.
Dziubinski: Let’s talk a little bit about these core holdings by time horizon. First, let’s start with two years or less. What types of funds should investors be considering for the core, if that’s the time horizon they’re looking at?
Arnott: I’d start by saying if you’re looking at the very short time horizon, say 12 months or less, I would stick with cash in that case, things like a high-yield savings account, CDs, money market funds, that type of thing. If you have a goal that’s coming up between one and two years, you might still want to invest in something like a money market fund, especially now that yields are much more attractive than they’ve been in a while. Or you might venture out into something just slightly more risky, like an ultrashort bond fund, which they typically are investing in bonds with maturities between one and two years and may have some small losses over shorter periods like a month or a quarter.
Dziubinski: Let’s step a little bit further out on the time horizon for maybe that two- to six-year time horizon. What should we be thinking about for our core holdings there?
Arnott: Usually in that two- to six-year range, I would look for a high-quality bond fund, something with a short- or intermediate-term maturity, maybe an intermediate core bond fund or intermediate-term government or short-term government, something like that.
Dziubinski: Got it. And then let’s really talk longer term those investors who maybe have a decade or more before they need to tap into these assets, what should their core look like?
Arnott: Typically, if you’re investing for a goal that’s at least 10 years away, you really want to be focusing on growth. And you probably would want to be focusing either on an allocation fund that has a fairly high level of equity exposure or maybe a pure stock fund, something like a large-blend fund.
Large-Cap Blend Funds
Dziubinski: Some might be surprised, and I was a little surprised when reviewing your research, that large-cap funds that focused on either strictly the growth style or the value style weren’t really considered core investments in your research. It was just the large-cap blend funds that were considered core. Why did they fall out of the core definition?
Arnott: If you’re looking for broad equity exposure, we would consider large blend the most representative way to get exposure to the equity market in general. And if you are looking for a style-specific fund, like a large-value fund or large-growth fund, it’s a smaller portion of the market. And you’re also going to probably see more fluctuations in performance depending on which style is in favor at any given time. If you had invested a lot of your assets in large growth, for example, you would’ve actually done pretty well during most of the period from 2009 through 2021 when growth stocks were outperforming. But there are other time periods when growth stocks are out of favor, so having a large weighting in large growth would’ve increased the portfolio’s risk profile, and sometimes it can take a long time for the portfolio to recover. Times like the tech stock correction that started in the year 2000 when the large-growth category actually took more than 13 years to break even after that.
Dziubinski: Lastly, Amy, you’re very clear in your research that you say within any fund category, including those categories that you would recommend for the core of a portfolio, there are a variety of different strategies, and some funds even within a core category may not actually be the best core funds for a portfolio. What are the types of things that investors should be looking at when it comes to actually within these categories trying to figure out, “OK, which one of these funds would make a good core holding?”
Arnott: We provide a lot of information on Morningstar.com. If you go to the Performance tab or the Risk tab or the Portfolio tab for an individual fund and look at statistics like the Morningstar Risk or a standard deviation, portfolio statistics relative to the category. If you see something that seems to be an outlier within the category, you might want to spend some time doing more research to make sure that it’s something that you’re comfortable with.
Dziubinski: Amy, thank you so much for your time today. This research is great, and I look forward to talking to you more in the future about it.
Arnott: Thanks, Susan. Great to be here.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
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