5 Surprising Investments That Shouldn’t Be Long-Term Core Holdings

Key Takeaways

• The role in portfolio framework is designed to give investors practical guidance when they’re trying to put funds together in a portfolio.
• We look at core holdings as something that would be appropriate for a large percentage of your assets, which we define as somewhere as much as 40% to 80% of your assets.
• U.S. large value and U.S. large growth don’t actually fall under the definition of how we’re defining the core fund camp.
• It all goes back to the idea of using the neutral market portfolio as a starting point for your equity investments. And typically, you want to keep your allocations in line with how the overall market is allocated.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. New Morningstar research shed some light on the types of funds that should be the core holdings for most investors’ long-term portfolios. But what types of funds don’t belong among an investor’s core holdings? Let’s find out. I’m joined today by Amy Arnott, who is a portfolio strategist with Morningstar Research Services.

Hi, Amy. Nice to see you today.

Amy Arnott: Thanks, Susan. Nice to be here again.

The Role in Portfolio Framework

Dziubinski: Now, we’ve talked before about your role in portfolio research, and viewers who are interested in learning more about that can watch the video through a link that will be included in the transcript. But give us a quick rundown of what the research is about and how investors can use it.

Arnott: Sure. This role in portfolio framework is really designed to give investors practical guidance when they’re trying to put funds together in a portfolio. So, it’s not just about finding good funds with low expense ratios, but then taking the next step of how do you put them together in a portfolio in a way that makes sense for your specific financial goals. When we came up with this, there are two key dimensions. One is the time horizon, and the second one, as you mentioned, is the role in portfolio or what size should a position play within the portfolio.

Which Categories Qualify as Core Holdings in Your Portfolio?

Dziubinski: Amy, in your research, you define four roles in portfolio that an investment can offer based on the diversification that it provides. And those four roles are stand-alone, core, building block, and limited. Now stand-alone funds are those one-and-done investments that are going to provide you diversification in one place, maybe a target-date fund or asset-allocation funds. Now core funds are the funds that should take up the bulk of a portfolio for an investor who doesn’t want to necessarily pursue that stand-alone approach to their portfolio, that one-and-done approach. So, the Morningstar Categories that qualified in your research as core holdings would be from the U.S. large-blend, the foreign large-blend, and the global large-blend categories. Why these three categories?

Arnott: As you mentioned, we look at core holdings as something that would be appropriate for a large percentage of your assets, which we define as somewhere as much as 40% to 80% of your assets. And we look at core holdings as something that’s going to give you broad representation for a major asset class. In the case of the three categories that you mentioned, we’re looking for broad exposure to stocks in general. And the three categories that you mentioned we think are appropriate as core holdings on the stock side because they are really giving you a broad representation of the overall stock market. If you look at something like Vanguard Total Stock Market, VTI, for example, you’re getting exposure not just to that middle section of actual large-blend stocks but also some exposure to large-growth and large-value. So, if you’re looking for something that’s going to represent the equity market in general, a fund like that or a similar fund from the foreign large-blend or global large-blend category is a good place to start.

Why Aren’t U.S. Large Value and U.S. Large Growth Considered Core?

Dziubinski: Got it. So, you mentioned U.S. large value and U.S. large growth, and it may surprise some readers—it surprised me a little bit—that these types of funds, these fund categories don’t actually fall under the definition of how you’re defining the core fund camp. Instead, they’re sort of the next tier down. They’re part of that building-block type of holding in a portfolio. Walk us through why they aren’t core.

Arnott: If you look at large value or large growth, these are smaller slices of the equity market, so it’s not giving you quite the same level of broad market exposure. Another issue is that just as we found that it’s very difficult for active managers to outperform by deviating from a market index, it’s also very difficult to outperform by overweighting a specific investment style. If you do that, there might be periods when you have good returns. For example, on the large-growth side, that style outperformed by a pretty wide margin over most of the period from 2009 through 2021. But there have been other times when that would have really hurt your results. For example, during the technology correction that started in the year 2000, large-growth stocks fell behind by a pretty wide margin. And it would have taken you a long time, actually more than 13 years, to make up that loss. So, there’s definitely more risk associated with overweighting either value or growth.

U.S. Small-Cap Blend, Small-Cap Value, and Small-Cap Growth

Dziubinski: Got it. So, now, another surprise for some investors might be that U.S. small-cap blend, small-cap value, and small-cap growth, those categories aren’t considered core in your framework. And in fact, they’re not even considered building blocks. They were assigned the limited role, which is even further down the ladder. Why is that?

Arnott: It all goes back to the idea of using the neutral market portfolio as a starting point for your equity investments. And typically, you want to keep your allocations in line with how the overall market is allocated. And so, if you look at the U.S. equity market, actually less than 10% of the outstanding market cap is in those small styles: small value, small blend, and small growth. So, that’s why we assign those limited roles.

How to Assemble the Core of Your Portfolio

Dziubinski: Got it. From a practical perspective, Amy, if investors, say, combine a U.S. large-cap growth fund with a U.S. large-cap value fund, have they really just assembled the equivalent of a U.S. large-cap blend fund? And then, in that case, if that’s what an investor is doing, could that really, those two funds combined, serve as the core of a portfolio?

Arnott: You certainly could do it that way. Starting out with equal weightings between large value and large growth, you would just have to make sure that you’re keeping an eye on those allocations over time so that they’re not getting out of balance. And you probably want to be rebalancing them once a year at least, or anytime the allocations get significantly out of balance.

Dziubinski: Amy, thank you so much for your time today. This role in portfolio research is really wonderful, and we look forward to talking with you more about it.

Arnott: Thanks. Great to be here.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “The Best Investments for the Core of Your Portfolio” for more from Amy Arnott.