We have all seen the typical, diversified client portfolio. It’s full of a little bit of Large Cap Growth, some Large Cap Value. Throw in some Mid Caps and Small Caps. And of course, don’t forget Foreign stocks and bonds. Mix ‘em up, and you’ve got yourself a well-diversified portfolio to withstand any environment. Or at least that’s what most advisors like to tell their prospects and clients. They hold a belief that it is impossible to know which will outperform at any given time, so it’s better to just own both.

But in reality, this type of portfolio construction is a long-term suck on potential returns, or as we like to call it: opportunity cost. The advisor knows it, too. In all fairness, maybe it’s the best he/she can do for their clients, given their knowledge base and time constraints. After all, building (and maininting) a true investment strategy is a lot of work. And to be honest, it takes a lot less effort on the advisor’s part to divy up the assets amongst a broad bucket of asset classes and call it a day.

First off, let’s use the example above of Large Cap Growth and Large Cap Value, two very popular pillars of most portfolios. It’s no secret that Large Cap stocks are the 800lb gorilla of the industry. But why would an advisor own both Large Cap Growth and Large Cap Value at the same time? Doesn’t that essentially create a Large Cap Core position? Yes, it does.

So, how can we fix this conflicting headwind in our portfolio? Well, that’s easy…we can use ratio analysis to show us which area is in a position of relative strength. This is where we should be more heavily weighted towards. In fact, at any given time, you really only need one or the other.

Below are two charts. The first is the performance of Large Cap Growth (represented by SPYG), Large Cap Value (SPYV) and Large Cap Core (SPY) dating back to January 2017. The second chart is the relative performance of SPYG versus SPYV (a ratio). By studying  this relationship, we can see which area is stronger on a relative basis.

Clearly, as we can see from both pieces of data, Growth stocks have been outperforming Value stocks over the last few years. And this relationship has experienced even more performance dispersion since late 2019. But by owning both of them, you essentially get the same return as the broad market, identified in this post as the S&P 500 (SPY). But if we are using relative strength and a very simplistic trend-following strategy (mimicked above using a 150-day moving average), we can stay on the benefiting side of the relationship. These relationships change all the time and it’s important to identify when they do. For example, in a period like 2003-2007, this relationship looked the exact opposite, and we would have wanted nothing to do with Growth stocks. It was all about the Banks, and Energy, and REITs. In today’s climate, however, these are by far the worst performing individual sectors, which has resulted in Value stocks drastically lagging the broad market.

Since January 2017, Growth stocks have outperformed Value stocks by nearly 72%! They’ve outperformed the S&P Core by nearly 40%. Having an allocation to something such as Large Cap Value, simply for the sake of diversification, is a total drag on your clients’ portfolios. And coincidently, if you’re a fee-based advisor, it’s also a drag on your overall top line. The good news is, we can use these types of studies throughout our portfolio construction process. Small Caps, Foreign stocks, etc. These relationships tell us where the most ideal areas are for our clients. You might even say, the areas that are in the best interest of our clients. Being overweight Large Cap Growth versus Value is not increasing risk. In fact, we could argue it’s lessening the overall risk by removing the weakest areas of the market from your portfolio. Who wants to own underperforming stocks?

We want to continue to put our clients in the strongest areas of the market, to increase our ability to grow their portfolio. At the end of the day, simply putting them in a diversified portfolio to ensure they have exposure to each “style box” is not in the best interest of anyone. And it’s surely not a strategy that would embody a true fiduciary experience. Whereas, by identifying relative strength, we can put our clients and their portfolios in a position to benefit that is quantifiably in their best interest.   

-Ian McMillan, CMT

If you have any questions or want to connect, please feel free to reach out to us at info@adaptiv.com.