Breaking up an investment portfolio into its constituent pieces can reveal hidden drivers of risk and overlooked opportunities.
 
Our analysis of professionally managed investment portfolios shows that many investors are missing important potential sources of return as a result of putting too many of their “risk” eggs in one basket — U.S. equities.
 
Many investors’ hopes today are pinned on the prospects of this single asset class whose elevated valuations today stand near the 90th historical percentile.

Heather Kennedy Miner
 
 
The heavy reliance on U.S. equities we see in many clients’ portfolios today is risky and overlooks potentially attractive opportunities in areas such as emerging market equities (EME), emerging market debt (EMD) and small-cap equities in Japan, Europe, and other non-U.S.. developed countries. Many investors today have little or no exposure to these three areas.
 
We have observed this tendency to crowd into a single, recently high-performing asset class in thousands of U.S. investment professionals’ portfolios — financial advisors at broker-dealers, registered investment advisers, private banks, and other financial intermediaries — through our proprietary portfolio analysis tool, GSAM PRISM™. In some respects, this tendency to crowd is understandable. The historically unusual run of strong U.S. large-cap equity outperformance in recent years has tested even the most resolute risk managers.
 
Theodore P. Enders
 
 
The average client portfolio with a moderate-to-aggressive risk levels contains a 50% allocation to U.S. equities. That may sounds relatively low, but we would stress that risk allocation is not the same as asset allocation. A large allocation to a few asset classes can lead to extreme concentrations of portfolio risk.
 
Just about all of the risk (99%) of a traditional “70/30” equity and fixed income portfolio historically has been driven by fluctuations in equity markets. Spreading a lopsided U.S. equity allocation across traditional Morningstar “style box” designations does not move the risk needle appreciably (the Morningstar style box separates “growth” versus “value” and small-cap stocks versus mid and large).
 
Overindulging in one asset class naturally leaves less room to tap into other asset classes. The portfolios we examine typically have had small average allocations to the three diversifiers mentioned earlier — the average is 2.9% to emerging market equities, 1.5% to emerging market debt and 1.2% to international small-cap stocks. Each allocation is a fraction of what we would consider to be proper diversification.
 
In the past, adding asset classes such as these has often helped to drive improved returns over time. We tested this view by stacking up the historical returns of client portfolios which included these asset classes — three of the largest underweights in the portfolios we examined and the subject of frequent client inquiry — versus those portfolios which did not include them.The result: Including a basket of these diversifiers historically has improved returns with a negligible impact on total portfolio risk. (All returns are presented before the imposition of fees; if fees had been reflected, total portfolio returns would have been lower.)
 
On average, portfolios with any emerging market equity exposure have returned 42 basis points more annually than portfolios without it (a basis point is 1/100th of a percentage point). The presence of international small-caps increased historical returns by an average of 24 basis points compared to portfolios without this asset class.
 
Portfolios owning emerging market debt, too, possessed both higher average historical returns (by 26 basis points) and lower average volatility (by over 100 basis points).
 
Portfolios with all three diversifying asset classes experienced higher annualized returns (6.8% compared to 6.1%), at the expense of marginally higher volatility — 10.8% annualized volatility for portfolios with all three asset classes, compared to 10.7% for those which excluded all three.
 
These historical returns include the last few years of strong outperformance by U.S. equities, so we think the historical data by some measures may understate the potential benefits of diversifying across more asset classes. As of the end of the third quarter of 2016, investors have seen some reversion to higher relative performance across a range of diversifiers, such as high yield bonds and emerging market equity.
 
We see behavioral reasons to diversify as well. Investors have a well-documented tendency to chase the performance of recent winners, even though history suggests they should not. No trend lasts forever. U.S. equities’ strong relative performance eventually will end. Staying diversified in our view means being better prepared.
 
 
Heather Kennedy Miner is Global Head of Strategic Advisory Solutions at Goldman Sachs Asset Management (GSAM). Theodore P. Enders is Head of Portfolio Strategy for the same team. For the latest GSAM insights on markets, portfolios and innovative business practices.