A Portfolio Construction Primer: What are Asset Classes?

Nov 2022

Portfolio construction, or selecting assets for a long-term investment portfolio, is one of, if not the most critical facets of investment management. As financial advisors, we must determine each client’s proper investment mix between stocks and bonds.

Of course, a client’s goals, objectives, and risk profile greatly determine the appropriate investment mix. Unfortunately, portfolio construction doesn’t just involve selecting a specific percentage of stocks and bonds. We have to take it a step further.  For example, the well-known “60/40” portfolio is often defined as 60% U.S. stocks and 40% bonds, represented by the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond indices. It uses two widely known asset classes—larger company U.S. stocks and the bond market. But is this enough?

The investment team at Bloom Advisors doesn’t think so. Instead, we believe long-term investors benefit from exposure to sub-asset classes to enhance diversification further. A portfolio mainly consisting of U.S. stocks and bonds ignores opportunities in other parts of the global market that we think are beneficial over the long term. The necessary building blocks start with stocks and bonds but then expand to other areas that we call sub-asset classes.

What are Sub-Asset Classes?

For equities, sub-asset classes are broken down based on investment styles, company size, and region.

Investment styles: growth, value, and blend.

The main difference between growth and value stocks is that value stocks are companies investors think are undervalued by the market, and growth stocks are companies that investors think will deliver better-than-average returns. For example, growth stocks are companies investors think will provide faster than expected growth, regardless of valuation. The technology sector is an excellent example of growth stocks. Conversely, value investors look for beaten-down stocks with promising prospects. The financial and manufacturing sectors are good examples of value stocks. Finally, the blend style is a combination of both growth and value.

Throughout history, we’ve seen cycles where growth outperforms value and vice versa or when blend performs well. Therefore, we include all three types in portfolios rather than attempting to predict which style outperforms.

Company Size: large, mid, and small companies.

In addition to investment style, company size adds diversification benefits because small companies tend to grow faster than large companies, although greater returns often come with higher volatility. As a result, we have a higher allocation to larger companies in nearly all of our strategies while having the most significant percentage to smaller companies in our more aggressive portfolios (85% stocks or higher).

Region: domestic and overseas.

We are big believers in global diversification. Foreign equities offer the potential for higher returns when coupled with domestic stocks, with marginally lower overall volatility. Emerging markets have similar characteristics to small domestic companies but have more significant market swings and higher expected returns.

As we know, domestic and foreign stocks have performance cycles dating back many decades. We are amidst a long domestic equity outperformance cycle dating back to 2010. While we expect the trend to end one day, our aim isn’t to time which region outperforms, which is why we complement foreign with domestic stocks in portfolios.

For bonds, sub-asset classes are broken down based on quality and maturity.

Quality: investment grade and non-investment grade.

Quality plays an essential role in minimizing stock market risks. For example, high-quality bonds such as treasuries and mortgages hold up well during stock market declines, while non-investment grade bonds, like floating rate and high-yield corporate bonds, tend to perform worse. However, in an odd twist this year, higher-quality bonds have suffered more significant declines, primarily due to rising short and long-term interest rates (see below). This is because high-quality bonds are more interest-rate sensitive than lower-quality bonds. For those in higher tax brackets, we also include tax-free bonds for some of the bond mix.  We categorize tax-free bonds in the high-quality camp.

Therefore, we prefer a mixture of higher quality and lower quality bonds in portfolios, which we believe may result in higher returns to bond allocations.

Maturity: short, medium, and long-term.

The maturity of bonds plays the most critical role in performance, especially during periods of interest rate volatility, like we’ve seen this year.  The longer a bond’s maturity, the more sensitive it is to interest rate swings. As a result, we’ve always positioned our bond allocations in the shorter to intermediate-term maturity range (2 to 5 years), which we think is the sweet spot. In addition, we’ve allocated to various bond areas like floating rate, strategic income, and unconstrained, allowing managers the flexibility to adjust to current market conditions.

Other asset classes might include real estate investment trusts (REITs), natural resources and commodities, and unique areas not defined as stocks or bonds. While they may be helpful in a portfolio consisting of stocks and bonds, they come with greater volatility and unknowns.

Key Takeaways

Building a portfolio comprised only of U.S. stocks and high-quality bonds may not provide enough long-term growth. It is missing essential parts of the global equity and bond market. However, combining the above asset classes helps us diversify a portfolio to capture the broadly described above characteristics.

While we avoid putting all our eggs in one or two baskets, we unequivocally want a strategically positioned basket that withstands the test of time.

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