Four trends influencing equity asset allocation

While the post-war economic boom shaped the last half of last century, the current environment for investors has been influenced by the events of a more recent vintage. 

The most consequential shift — the rise of the mega-cap tech stocks — has transformed modern day equity markets, but other events have also been influential. The dot-com crash, the global financial crisis, prolonged low interest rates, the global pandemic and the post-Ukraine war inflation flare-up have all had a tremendous impact on the way long-term investors think about their allocation strategy.

So, how should investors approach this shifting and challenging backdrop? Below we highlight four trends that have upended long-held assumptions about the way markets function and what lessons we can learn when positioning portfolios for the future.

Growth outside of mega tech has been scarce

A narrow group of technology-driven growth companies now dominate US indexes. Outside of this group, growth opportunities have been increasingly scarce. As a result, investors have been willing to pay a premium for a concentrated set of tech names which, in turn, has driven the prices of those names even higher. 

The impact of this trend is the predominant feature of markets over the past decade. While highly profitable for investors, it’s created a problem for asset allocators looking to build diversified portfolios. 

For one thing, the valuations of these firms are dominated by intangibles such as branding, high barriers to entry and pricing power. This can make valuation difficult to get a handle on – at least in the traditional sense. 

Another concern is just how concentrated the market has become. Mega cap tech stocks have taken an increasing significant share of the indexes in which they are members, and by extension, investors’ portfolios. This means asset allocators have had to think differently about portfolio diversification.

Value is not what it once was

Early academic work into the factors that drive stock prices have long identified value stocks as a potential source of sustained outperformance. But, in a world where returns have been dominated by just a few mega cap growth stocks, traditional value factors such as low price-to-book or price-to-earnings ratios may have lost some of their predictive edge. 

As a result, we’ve had to think about value in a different way, no longer as a single allocation, but now encompassing two types of value companies: cyclical and defensive. 

Cyclical value stocks tend to be more positively correlated with economic growth. A particular industry, for example, may be out of favor due to the economic cycle, but otherwise healthy. Heading into a cyclical upturn, these stocks have the potential to be highly profitable. 

Defensive value stocks, on the other hand, tend to have a low or negative correlation to the economic cycle. They would be expected to provide some type of performance cushion in a slowing growth environment. These companies might have a slow but stable growth rate, a consistent dividend payout or a product line with strong brand loyalty. 

The number of stocks within the Russell 1000^® Value Index indicates how heterogeneous that index has become. Our view is that a single, unmanaged allocation to large cap value stocks may now no longer capture the diverse economic sensitivities of such a large grouping — nor may it provide the diversification or, hopefully, the excess return, sought in a multi-asset portfolio.

The small cap premium has suffered

The recent performance of small cap stocks offers another challenge to the long-established orthodoxies of strategic asset allocation. Since Ibbotson and Sinquefield identified the small cap stock premium in the 1970s, a weighting towards this segment of the investment universe has played a key role in portfolios. 

The small cap premium rests on the concept that smaller companies occupy niche markets, are innovative and have a higher growth rate potential (accompanied by higher risk) than large conglomerate-type companies with aging product lines, such as those that dominated the indexes in the 1970s and 1980s. 

But over the past decade, the performance edge of small caps appears to have largely evaporated as the large cap stocks in general and large cap growth stocks in particular have overshadowed other asset classes. 

That said, over the past five years, small cap stocks, as measured by the Russell 2000® Index, have performed respectably and essentially in line with long-term stock market average returns. We hold that the small-cap premium should reassert itself and we will continue to maintain our strategic overweight in the asset class.

Non-US stocks have been out of favor

Until very recently, the performance of another diversifier — non-US stocks — has been another challenge. 

Finding the right balance between US and non-US stocks, and similarly, between developed and developing stocks, has always been difficult. Even so, allocators have long supported a significant position in non-US equities, both developed and developing, citing both lower correlations to US holdings and higher economic growth potential. 

This is fine in theory, but the returns of the last decade have done nothing to build confidence in this approach. A few years ago, a well-known industry observer even went so far as to publish an article titled: Are International Stocks Worth the Bother? 

What we can say is that the diversification angle does hold true: with the 10 largest holdings only representing approximately 12% of the index, for instance, the MSCI EAFE Index — which tracks developed markets outside of the US and Canada — is far less concentrated than the S&P 500. Additionally, the information technology sector is only about 8% of the EAFE index compared to 33% of the S&P 500®. And that 33% does not include Amazon, Meta, Alphabet or Tesla.

Currency exposure can be an additional diversifier and can work both ways. Our view is that a weakening dollar can work to the benefit of non-dollar asset holders and could be a significant contributor to returns.

Allocation in practice 

So how do we, as allocators, respond to the trends outlined above? 

Over the last few years, we’ve seen clients, and those that advise them, move their allocations ever further from what might historically be considered normal — either a passive global benchmark or some other ‘neutral’ position. 

We’ve seen increased allocations to US large cap stocks or reduced non-US exposure either by design or by not rebalancing significantly. And in the last few years, there’s not been a performance penalty, except for brief periods, for doing so. 

After seeing some of these historical relationships stay out of balance for longer than anticipated, we began to review our strategic allocations to see if there was a better way of creating a neutral portfolio (a baseline long-term allocation that suits a client’s risk preference and time horizon) and adjusting asset exposures to take advantage of near-term or tactical opportunities without significantly altering a portfolio’s risk exposure. We reviewed the last decade of performance to see if we could identify where allocation decisions could have had the most impact.

The key decisions we found that we could have added value were:

• Large vs. small
• Large growth vs. large value  
• Domestic vs. international large  
• International large vs. Emerging markets

Our experience and the data that supported it have led us to reconsider our framework for constructing a neutral, strategic allocation portfolio and what “tilts” we would consider within that framework to potentially add value.

This is an edited extract from a longer paper we have written on the new paradigm in strategic asset allocations. 

Access the full paper to learn how we have reconsidered our framework for constructing a neutral, strategic allocation portfolio and what “tilts” we would consider within that framework to potentially add value: New paradigms in equity allocations