Navigating Market Volatility: A Portfolio Manager’s Guide to Building a Resilient Portfolio
Investing in today’s turbulent market can be a daunting task, but navigating this volatility successfully requires a well-diversified portfolio. Nicolo Bragazza, associate portfolio manager at Morningstar Investment Management, offers insightful advice on crafting a resilient portfolio, emphasizing a barbell strategy that balances risk and reward across diverse asset classes.
Key Takeaways:
- Diversification is key: Bragazza stresses the importance of diversifying across asset classes with different growth drivers. He recommends a traditional 60% stocks, 40% bonds split as a starting point, adjusting this allocation based on individual risk tolerance and time horizon.
- Strategic asset allocation: Younger investors aiming for wealth growth could consider a more aggressive 80% to 90% stock allocation and 10% to 20% in fixed income, while retirees seeking wealth preservation might opt for a 50/50 split.
- Harnessing the "barbell" strategy: This approach involves investing in both high and low-risk assets, allowing investors to capitalize on diverse market scenarios. Bragazza suggests targeting both cyclical and defensive areas, like U.S. small-cap stocks and Chinese stocks, balancing these with more conservative investments.
- Sector-specific bets: Bragazza believes consumer staples, healthcare, and utilities sectors are attractive for their defensive nature and valuations. He specifically highlights the utilities sector’s growth potential, particularly through BlackRock’s iShares S&P 500 Utilities Sector UCITS ETF.
- Fixed income spectrum: Beyond traditional government bonds, Bragazza advocates for incorporating high-yield and emerging market bonds into the fixed income portfolio to enhance returns during strong economic periods. He underscores the importance of considering the distinct characteristics of various bond types for effective risk management.
Building the Foundation: Diversification and Asset Allocation
Bragazza emphasizes the importance of a well-diversified portfolio to navigate market fluctuations. "A good portfolio is a well-diversified one—and by well-diversified I mean a portfolio that has exposure to asset classes that have different drivers of growth," he explains.
He highlights the contrasting performance of stocks and bonds:
- Stocks tend to perform well during periods of economic growth, driven by corporate earnings and robust business activity.
- Bonds, particularly high-quality government bonds, offer stability during uncertain times, providing security and safety.
This divergence in performance highlights the need for diversification, as Bragazza emphasizes: "If we look at the underlying drivers of different assets, it’s very important to diversify across them. So a well-balanced portfolio should always have something that protects you in case things don’t go as planned."
While individual investor portfolios should be tailored to their unique financial goals and life stage, Bragazza advocates for the traditional 60% stocks, 40% bonds split as a solid starting point. This split provides a balanced approach, combining the growth potential of stocks with the stability of bonds.
He suggests younger investors with a longer time horizon and a higher risk tolerance consider a more aggressive 80% to 90% stock allocation and 10% to 20% in fixed income. This strategy allows for greater potential for long-term wealth accumulation.
Conversely, retirees or older investors focusing on wealth preservation might opt for a more conservative 50/50 split, prioritizing bond security and reducing exposure to short-term stock market volatility. This approach aims to generate steady income while safeguarding against market downturns.
Beyond Diversification: The "Barbell" Strategy
Bragazza extends his investment philosophy beyond simple asset allocation by employing a "barbell" strategy. This approach involves investing in both high-risk, high-reward assets and low-risk, low-return assets, creating a balanced portfolio with potential for returns across different market conditions.
The term "barbell" aptly captures the strategy, with high-risk assets representing the "weights" at the ends, providing leverage and potential for large gains, while low-risk investments serve as the "bar" connecting them, offering stability and downside protection.
Bragazza seeks "opportunities in both cyclical and defensive areas of the market," reflecting this barbell strategy.
Identifying Cyclical and Defensive Plays:
Cyclical investments, such as U.S. small-cap stocks, tend to be more volatile and closely tied to economic cycles. When the economy is strong, these stocks often outperform. However, they may suffer during downturns.
Bragazza is bullish on U.S. small-cap stocks, noting that they are currently trading at "quite cheap" valuations compared to their historical levels and to larger-cap companies. He favors investing in this sector through BlackRock’s iShares S&P SmallCap 600 UCITS ETF, which tracks the S&P 600 Small-Cap Index. This ETF has demonstrated strong performance year-to-date, reflecting the current favorable market conditions for small-cap stocks.
Defensive investments, such as consumer staples, healthcare, and utilities, tend to be less volatile and provide a degree of stability during economic fluctuations. These sectors are often seen as essential services and goods, with relatively predictable demand even during difficult times.
Bragazza is overweight on these defensive sectors, noting their "defensive nature and also because they are more attractive—from a valuation perspective—than other parts of the market." He highlights the utilities sector as particularly promising, highlighting BlackRock’s iShares S&P 500 Utilities Sector UCITS ETF, which invests in leading U.S. utilities companies. This ETF has significantly outperformed its benchmark, the S&P 500 Capped 35/20 Utilities Index, demonstrating strong growth in the sector this year.
Adding Chinese Stocks to the Mix:
Bragazza is also keen on Chinese stocks, recognizing the potential of China’s broad economic recovery. Despite not highlighting any individual Chinese stocks, he sees the overall narrative of China’s economic resurgence as an attractive investment opportunity.
Navigating the Fixed Income Landscape: A Multifaceted Approach
Bragazza views fixed income as more than just traditional government bonds. He advocates for a multi-faceted approach, incorporating different types of bonds to hedge against economic risks and capitalize on promising opportunities.
Tailoring Bond Exposure to Economic Cycles:
He emphasizes the cyclicality of the bond market, noting that different types of bonds fare better in different economic environments.
- High-yield bonds and emerging market bonds, typically offer higher returns during strong economic periods, but carry greater risk during downturns.
- High-quality government bonds, provide stability and safety during economic uncertainty, offering reliable returns even when other assets struggle.
He suggests that a balanced fixed income portfolio should "always include the different shades of bonds to provision for cyclicality."
By strategically incorporating a mix of bonds with diverse risk profiles, investors can optimize potential returns while mitigating downside risks across different economic phases.
Conclusion: A Tailored Approach to Investment Success
Bragazza’s approach to portfolio construction emphasizes individualized strategies based on individual risk tolerance, financial goals, and investment time horizon. While his insights are valuable for all investors, they are particularly relevant for those seeking to navigate the complexities of a volatile market.
By prioritizing diversification, employing the barbell strategy, and carefully considering the characteristics of individual asset classes, investors can create a robust portfolio capable of outperforming in a range of market conditions.
This approach, coupled with a thorough understanding of their personal investment preferences and goals, provides a solid foundation for navigating market volatility and achieving long-term financial success.