4 Buckets For Allocating In Current Markets

September 18, 2020

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.

I developed an idea several years ago regarding portfolio management decisions. Whenever we are making a portfolio change, I ask my team the following question: “Are we running from something, to something, or both?”

As portfolio managers, we have the mandate to invest 100% of assets in the portfolio. Therefore, we live in a zero-sum world. If we decide an asset class is undesirable and a candidate for reduction, we must invest that percentage into something else.

After 18 years of managing professional assets for thousands of investors and some of the country’s largest financial institutions, I can tell you it is rare when things line up such that we can simultaneously run “from something” and “to something” with the same strong conviction.

This reality is fundamental to the job and very true today. Currently, we hear a lot of investors wanting to run “from something” without something they would like to run “to.”  

Investors are concerned primarily with stock valuations, low interest rates and the upcoming election. But where should they run “to”?

A Solution

We believe a well-diversified portfolio, using four buckets, is a prudent game plan for many investors. Further, the four buckets help frame the conversation and outline the decision clearly.

A unique development in this report, readers will notice large cap growth U.S. stocks have their own bucket. If I had foreseen 10 years ago that large cap growth U.S. stocks would deserve their own bucket in 2020, I’d likely be writing this article from my helicopter instead of my office.

As I discuss the current landscape, I aim to outline why large cap growth U.S. stocks deserve their own bucket, and a new bucket (bucket 4) should be added.

The 4 buckets:

BUCKET 1 - Large Cap Growth U.S. Stocks

BUCKET 2 - Other Stocks (including large value, SMID, international and nontraditional)

BUCKET 3 - Bonds & Cash

BUCKET 4 - Hedged equity

 

BUCKET 1 - Large Cap Growth U.S. Stocks

Lewis Hamilton recently logged his 90th Formula 1 racing victory, which places him one win shy of Michael Schumacher’s record 91 victories.  Like Jack Nicklaus’ 18 professional major victories and John Wooden’s 10 championships at UCLA, including seven in a row, these type of reigns of dominance are legendary.

There’s an argument to be made that large cap growth U.S. stocks should be included in the group of luminaries with Hamilton, Schumacher, Nicklaus and Wooden. Large cap growth U.S. stocks have simply elevated to a different atmosphere over the last 10 years. Along with the nearly 30% YTD outperformance over large cap value U.S. stocks through Sept. 11, 2020, growth stocks have dominated for a decade.

 

Source: Bloomberg, 8/1/2010 – 8/1/2020

 

As we know, a few major players have helped to drive this outperformance. Due to sheer dominance, the FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) now make up about 25% of the S&P 500.  

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

All these victories have pushed valuations to historically rich levels.

Our team measures valuations monthly by eight different metrics for seven major asset classes. We then take the monthly values for the last 20 years and rank them in percentiles. Currently, large cap growth U.S. stocks are near the 100th percentile in valuations for every one of those metrics, with the lowest being the 90th percentile.

BUCKET 2 - Other Stocks (including large value, SMID, international and nontraditional)

It’s often said you either have it or you don’t. As such, we have grouped all other traded stocks (other than large growth) into bucket 2. While they’re definitive asset classes, there’s a clear gap between this group and large growth stocks.

There are obviously nuances to each of these asset classes, such as the makeup of value stocks and the impact of COVID on REITs. A similarity we see, though, is valuations are historically more attractive for the asset classes in bucket 2.

For example, in our 20-year study, small cap and mid cap U.S. stocks sit in the bottom quartile for price to book ratio. That’s just one example, but the theme permeates our analysis.

Given valuations, and other relevant factors, these assets in bucket 2 should react differently to current concerns than large cap growth stocks.

BUCKET 3 - Bonds & Cash

Interest rates and inflation are near historic lows. Every day we get asked, how can I earn something on my cash?

It’s a question without a good answer. Many will give an answer, though the answer will likely be a version of robbing Peter to pay Paul.

We’ve developed a strategy to balance risk in fixed income, allowing us to maintain exposure for the benefits this bucket provides.

Despite the low rates, we feel bonds and cash continue to have a valuable position in a well-diversified portfolio. No other bucket can provide the principal protection of bonds in panic markets and diversification benefits.

BUCKET 4 - Hedged Equity

Using options on U.S.-traded ETFs, investors now have the opportunity for efficient and transparent downside protection in major equity markets. With the overall growth of ETFs, the ETF options marketplace has significantly matured over the last 20 years. As of Q2 2020, the notional open interest of options on the four reference ETFs used in our TOPS Global Equity 15% Target Floor Index (SPY, IWM, EFA, and EEM) reached approximately $900 billion.

Another tool in the marketplace that can be used to hedge equity exposure is liquid index futures.

These tools represent a fourth bucket, which can be used to provide market participation with downside protection. This asset class is still developing, but some solutions we provide in this area include:

  • TOPS Global Equity 15% Target Floor Index
  • TOPS US Equity 15% Target Floor Index
  • TOPS Managed Risk Balanced ETF Portfolio
  • TOPS Managed Risk Moderate Growth ETF Portfolio
  • TOPS Managed Risk Growth ETF Portfolio.

Find your next ETF

Reset All