Portfolio Diversification: Answers to Your Questions

Amid an uncertain market environment, how can investors build—and maintain—diversified portfolios? What asset classes are the most valuable for providing diversification, and which ones don’t provide the advantages that investors expect?

These were the kinds of questions addressed in a recent webinar with Morningstar‘s portfolio strategist Amy Arnott, director of personal finance and retirement planning Christine Benz, and associate director, multi-asset and alternative strategies Karen Zaya.

Here are some of the questions that webinar listeners asked.

What are your thoughts about diversifying into ex-US assets at this time?

Benz: The “at this time” is a pivotal aspect of this question. If you are deciding to add to ex-US, you probably haven’t timed it perfectly if you’re just looking at it now. But I think there is still gas in the tank.

My bias would be for investors to maintain globally diversified portfolios, especially for young investors with long time horizons, where the currency risk is less of a factor. I would be supportive of almost mirroring the global market caps ratio of non-US relative to US, which is about 65/35 today.

Perhaps as people move into the spend-down phase, they would want to back off that non-US allocation a little bit as they get closer to needing their money.

What is your view of dividend stocks in the current tariff environment?

Arnott: If you are looking at the potential impact of tariffs and thinking that it might lead to lower economic growth or even a recession, then in that type of environment, we typically see higher-quality dividend stocks performing relatively well. You could definitely make a case for having some exposure to dividend-paying stocks.

If you are looking at the highest-yielding stocks, you might be courting other types of risks. Those stocks tend to be more cyclical and might be more vulnerable in an economic decline.

Do 80/20, 70/30, 60/40, target-date portfolios still make sense? Or, given how much the world is changing, should we look for new strategies?

Arnott: A lot of asset-management firms have been pushing the narrative that you need to go beyond 60/40 and add heavy exposure to alternative asset classes, or private equity, or credit.

Personally, I tend more toward keeping things simple. I‘m a bit skeptical about whether people need to add a lot of nontraditional asset classes, especially given the fact that those types of asset classes often come with significantly higher costs.

How is any of your analysis affected if an investor is using the portfolio for retirement income versus in the accumulation phase?

Arnott: When you’re starting to draw down assets from your portfolio in retirement, your time horizon becomes more important.

I would say diversification is still something that you want to pursue for your portfolio, but you want to be thinking about sequence-of-returns risk and your cash flow needs over the next couple of years, the next several years, and then longer term. When you’re entering retirement, those types of time horizon and bucketing decisions can be as important as diversification.

How have publicly traded REITs or REIT funds performed as a diversifier?

Benz: We’ve found that real estate’s value as a diversifier has slowly ebbed away.

Twenty years ago, the thought was that you needed a REIT fund in your portfolio. But now, there doesn’t seem to be a strong correlation case for adding REITs, as we’ve seen the correlation jump up relative to US equities fairly significantly.

There still might be valuation reasons or income reasons that someone might gravitate to real estate securities. But from a portfolio construction standpoint, I don’t see a strong case for REITs.

In an income portfolio, would a one- to two-year income requirement be sufficient to account for sequence-of-returns risk?

Arnott: We generally recommend a total-return approach to sourcing cash flows during retirement. It makes sense for retirees to keep at least one to two years’ worth of planned spending needs in cash, but it’s also important to have several additional years’ worth of spending in lower-risk assets such as bonds.

Sequence of returns risk can be an issue for up to five years after the retirement date.

Some experts say to just buy an S&P index or international-stock index fund and wait it out. Is that a good strategy for long-term investing?

Arnott: Yes, focusing on diversified, passively managed portfolios with low costs is a sound approach for long-term investing.

We’re generally in favor of including both US and non-US exposure in the equity portion of a portfolio. Depending on your time horizon and risk tolerance, you may want to include some exposure to investment-grade bonds as well.

Where is the diversification sweet spot for corporate-bond funds?

Benz: We didn’t examine different maturities of corporates in the paper, but short-term Treasuries and cash have looked better than intermediate- and longer-term bonds recently, largely because of 2022.

What are systematic trends?

Zaya: Systematic trend is the name of the Morningstar Category for managed-futures funds. These funds use price trend data to trade futures contracts.

Are there exchange-traded funds that focus on tariff-neutral stocks?

Arnott: Yes, several ETFs focus on stocks that should be less exposed to the potentially negative adverse effects from tariffs, such as the iShares U.S. Manufacturing ETF MADE.

This article was compiled by Emelia Fredlick.