In the third video in our asset allocation series, Kevin Barr, Head of SEI’s Investment Management Unit, and Jim Smigiel, SEI’s Chief Investment Officer, talk about building the equity sleeve of a diversified portfolio. 

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Transcript

Kevin Barr: Hi, I'm Kevin Barr, Head of SEI's Investment Management Unit. Welcome to the third video in our Asset Allocation series. Today, we'll be talking about building the equity sleeve of a diversified portfolio. I'm again joined by Jim Smigiel, our Chief Investment Officer. Jim, thanks for joining me today. To start off, can you describe for us the general philosophy around constructing the equity portion of a portfolio?

Jim Smigiel: I sure can. I think it will come as no surprise that we try to make sure the equity segments of our portfolios are well diversified in their own right, just as we do at the broader asset allocation level. This means that we try to spread our holdings across a wide range of countries, sectors, market capitalizations, and individual stocks. The principle is the same here as it is when we diversify across asset classes. We only want to take risks where we expect to be rewarded for it, with higher expected returns. The more we diversify our exposures, the greater chance we have of maximizing returns for a given amount of risk. And in doing so, we hope to give investors greater confidence that their investment strategy is designed to help achieve their specific goals.

Kevin Barr: Great. Let's talk about the first dimension that you mentioned, countries. Investors tend to favor companies that are based in their home country. For US investors, that often results in a portfolio that is heavily rated around US stocks. Can you explain for our clients what kind of diversification you need at the country level?

Jim Smigiel: Sure. Most investors are understandably more comfortable investing in companies listed in their own country than those listed abroad. In behavioral finance, we actually refer to that as home country bias. That bias comes with a cost of exposure to unwanted risk in the form of reduced diversification. Investors who put too many stocks from the same country in their portfolios, regardless of which country that may be, are unwittingly exposing themselves to overly concentrated country-specific risks. While there are exceptions, companies listed in a particular country will generally share many of the same macroeconomic exposures, political risks, tax circumstances, and so forth. So diversifying globally can help mitigate these risks. As any consequential event that occurs in a particular country, say, somewhere in South America, it is unlikely to have the same impact on every security in the portfolio from other countries. As goals-based investors, our job is to balance investors' natural behavioral tendencies, with the meaningful benefits of a global diversified portfolio. We work hard to educate investors on the potential pitfalls associated with having too much concentration in home country stocks. This chart compares the five-year returns of equity market indices around the world over the past 50 years. The data clearly shows that different markets perform well at different times, and that there's no guarantee that one home country will lead over any given period. Global diversification helps make portfolios more efficient, and therefore, more likely to help investors meet their financial goals.

Kevin Barr: So does that mean we don't believe in that actively tilting toward or away from certain countries based on our outlook?

Jim Smigiel: No, it does not. In portfolios where it's appropriate, SEI's portfolio managers and the third party investment managers that we work with, they can, and they do, express favorable and unfavorable views of particular countries, or risk exposures in the equity markets. But it is important that we start with a globally diversified strategic base. Once we build an efficient portfolio that we believe will deliver high risk-adjusted returns, we can then tilt around that baseline with respect to our current outlook. We express views where we think we see exceptional opportunities and we diversify across areas where we have varying expectations, in an effort to maximize returns at any given level of risk. It is also worth noting that changes from our strategic models are modest. We don't abandon strategic positions, we're not making massive changes, or vacating entire sectors or countries just because we think one area may or may not do well in the near future. We build a diversified base precisely because we don't know what's going to happen with certainty over any time horizon, short or long term.

Kevin Barr: Thanks Jim. Does that same logic apply to emerging markets?

Jim Smigiel: It certainly does. Emerging market stocks sometimes do get overlooked because they aren't included in some of the more popular global indices like the MSEI World, but they are crucial and they are a growing part of the global economy. They also offer meaningful diversification benefits relative to developed markets. We wouldn't want to ignore the significant portion of the global equity markets given all of the benefits it conveys.

Kevin Barr: What about market capitalization? How do we think about allocating across the size spectrum?

Jim Smigiel: Small-cap and even mid-cap companies can sometimes find themselves in a similar situation as emerging markets. Some very well-known indices, take the S&P 500 as an example, it only captures the largest stocks in the market. So investors who allocate to that as their stock universe are really missing out on the diversification available in the small and mid-cap markets.

Kevin Barr: Thanks Jim. Does the current state of the equity market make us think any differently about that now?

Jim Smigiel: We're always supporters of diversification. And in our opinion, the more you can spread out your risks, the better, but you are bringing up a good point. We think that there's an argument to be made that diversification within equity holdings may be especially important right now. The reason is, by some measures, the US large-cap equity market is as concentrated, meaning as poorly diversified, as it has been in recent memory. The S&P 500 holds roughly 500 stocks, but its weights are dominated by just a few sectors and names. As of the close of last year, December 31st, 2020, the five largest names made up over 20% of the index. Apple alone was nearly 7%. The information technology sector as a whole constituted almost 28% of the index. If we include the related communication sectors, which includes companies such as Google, and consumer discretionary, which includes other giants like Amazon and Tesla, we're at over 51% of the index. More than half of the S&P 500 is concentrated in large, generally technology-related names, which means that more than half of the index is likely exposed to many of the same risk factors. So if anything negative happened to this narrow market segment, the S&P 500 would likely fall, bringing down with it portfolios that are highly concentrated in those few stocks. So diversifying across capitalization sizes, in addition to diversifying internationally, could help reduce this particular risk.

Kevin Barr: That's a pretty powerful way of showing the importance of diversifying the equity portion of your portfolio. The next time we get together, we'll continue our discussion about equities with a closer look at how and why we include low-volatility equity exposure in our portfolios. Thanks Jim.

Jim Smigiel: Thanks Kevin.

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Index Definitions:

  • MSCI Europe ex UK Index: The MSCI Europe ex UK Index is a free float-adjusted market-capitalization-weighted index that captures large- and mid-cap representation across 14 developed-market countries in Europe (Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland).The Index covers approximately 85% of the free float-adjusted market capitalization across European developed markets excluding the U.K.
  • MSCI Japan Index: The MSCI Japan Index is designed to measure the performance of the large- and mid-cap stocks in Japan.
  • MSCI Pacific ex-Japan: The MSCI Pacific ex-Japan is an unmanaged index considered representative of stocks of Asia Pacific countries, excluding Japan. The index is computed using the net return, which withholds applicable taxes for non-resident investors.
  • MSCI United Kingdom Index: The MSCI United Kingdom Index is designed to measure the performance of the large-and mid-cap segments of the U.K. market. The Index covers approximately 85% of the free float-adjusted market capitalization in the U.K.
  • MSCI World Index: The MSCI World Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets. 
  • S&P 500 Index: an unmanaged, market-weighted index that consists of 500 of the largest publicly-traded U.S. companies and is considered representative of the broad U.S. stock market.
     

Legal Note

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Diversification does not ensure a profit or guarantee against a loss.
There are risks involved with investing, including loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from difference in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI).