Morningstar - Q2 2024 - 16

Dispatches
the 15-year period through 2023. Without biotech
stocks, the index would have gained roughly 25%
more than it did.
On the other side of the Morningstar Style Box,
value managers faced a similar dilemma
with regional banks. The banking business model
is inherently leveraged, and regional banks
have more geographically concentrated deposit
bases and less diversified businesses compared
with larger banks. Value managers tended
to embrace regional banks as their weight in the
Morningstar US Small Value Index increased
to roughly 20% by late 2022. They should have
avoided them. From 2009 to 2023, the Morningstar
US Financial Services Index would have nearly
doubled its cumulative gain without regional banks.
Despite these issues, active managers had a
better chance of outperforming in small caps than
they did higher up the market-cap spectrum.
Active funds in the small-blend Morningstar
Category beat the Russell 2000 Index in roughly
69% of the rolling three-year periods from
2009 through year-end 2023. In contrast, active
large-growth category funds outperformed
the Russell 1000 Growth Index just 33% of the
time during the same period.
Quality plays a big role in small-cap stock
performance, yet active fund portfolios' aggregate
quality exposure hasn't been drastically different
from their benchmarks'. So, investors should
press self-professed high-quality managers for their
definition of quality and how they differentiate
themselves from their peers and indexes.
TRENDS
Diversification Insight: US Treasuries Provide
Long-Term Resilience
Recency bias might cause an investor to balk
at the usefulness of US Treasuries in a portfolio,
as correlations with US stocks have spiked
since 2021. But over the long term, Treasuries and
other high-quality government-backed fare,
such as agency mortgages, remain some of the
most compelling diversifiers for a portfolio. When
interest rates are stable or falling, these
offerings provide a modest but reliable return that
balances the volatile swings inherent in stocks.
Riskier allocations, such as high-yield and
emerging-markets debt, on the other hand, are
poor diversifiers relative to equity. Swiftly rising
interest rates may place US Treasuries at a
structural disadvantage, but the recalibration
period is typically relatively short, and following
that reset is when these allocations provide
low and, at times, negative correlations to
equities. A portfolio constructed for long-term
resilience will be well served by a high-quality
government bond allocation, in particular
one with US Treasuries and agency mortgages.
Taxable Bonds: Rolling Three-Year Correlations vs. Morningstar US Market Index
1.0
0.5
-0.5
-1.0
Source: Morningstar Direct. Data as of Dec. 31, 2023.
12/2002
16
12/2009
12/2016
12/2023
Morningstar US
Core Bond
0.69
Morningstar US 10+
Yr Treasury Bond
0.61
Morningstar US
Cash T-bill
-0.01
Similarly, index construction means that low-quality
areas like biotechnology and regional banks
can be hard for managers to ignore, so expertise
in these areas is paramount, as they can have a
big influence-for better or worse-on performance.
Managers who make big bets for or against such
low-quality areas should be able to differentiate
themselves with analytical or resource edges.
Finally, although it can be hard for managers to
maintain continual exposure to the highest-quality
stocks, sector weights can offer insight into
how well they've been able to identify these higherquality
stocks before the market rewards them.
Eric Schultz, Drew Carter, and Chris Tate, CFA, are manager
research analysts at Morningstar Research Services LLC.
The Temptation of
Trendy Investments
New investing trends can be exciting, but they're
not always a good fit for investors' portfolios
or their long-term goals. But because behavioral
biases often influence the desire to own them,
they can be hard to resist. To help advisors
better coach their clients who are considering
jumping on the bandwagon of a trend, we sought
to understand how investors think about them.
Our research suggests that investors lack
familiarity with trendy products, are overconfident,
and tend toward short-term thinking. Advisors
have a key role in helping investors overcome
these challenges.
What Is Trendy?
We consulted industry experts and observed
media mentions to identify nine asset classes that
we think have become recent investment
3-Year Correlation
https://www.morningstar.com/people/eric-schultz https://www.morningstar.com/people/drew-carter https://www.morningstar.com.au/insights/author/3065/chris-tate
Morningstar - Q2 2024

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