Investors are Missing the Most Obvious Portfolio Addition

Key Points

• Trillions of dollars are improperly indexed to the S&P 500 as a “core” equity allocation.
• The options for investors who desire “consumer-focused” equity exposure are underwhelming.
• A thoughtful, broad-based consumption-focused equity strategy can serve two masters.

What does the term Core really mean from an investment perspective?

I googled it:

Core: “The central or most important part of something”

Let’s connect the dots as U.S. investors to see if there’s any obvious allocation decisions we can make based on the definition of core. Largely, when an investor decides to invest in a “core” passive vehicle, it’s an index ETF and when they choose an active fund, performance-chasing is often the primary driver of the fund selection. Perhaps there’s some science and art that can enhance this decision. Follow my logic: U.S. investors have what’s called a home-bias. That means the bulk of our portfolios (70-75% of the total) is invested in U.S. stocks and bonds. So, whether we realize it or not, our investment decisions and our prosperity is largely tied to the U.S. economy. Taking the definition above, what is the central or most important part of the U.S. economy? Broad household spending. Consumerism accounts for about 70% of total economic output making it the single most important driver of our economy and the most logical core equity choice for allocators of capital.

Surely core indexes, the ETF’s designed to track them and most large core equity funds are constructed with the consumer-core principle, right?  Not so much. That’s the opportunity we have today for Advisors.

The Core Index Myth: they are constructed with the economy in mind

There is a massive amount of money invested in “core” equity vehicles. Virtually all of them are benchmarked to the S&P 500 so let’s critique this widely popular index and by extension all the other strategies that mirror their exposures. I analyzed the top 4 U.S. large core ETF’s (SPY, IVV, VTI, VOO) which holds just under $1 trillion in assets at $972.6 billion. Widening my lens further, there’s over $4 trillion indexed and over $11 trillion indexed or benchmarked directly to the S&P 500 as the most popular core equity proxy. I think it’s safe to assume every professional investor has some exposure to “core equity” strategies.

Problem: If the S&P 500 is a proxy investment for the U.S. economy and the economy is 70% broad consumer spending why does the S&P and all of its peers only have a total of ~19% weight to Consumer Discretionary & Consumer Staples stocks? All of these indexes & the strategies that track them seem to fail the basic definition of what a core investment should be. That means there’s trillions of dollars benchmarked to an index that does not even closely resemble the economy in which it’s designed to track.  There’s nothing wrong with investing in the S&P 500 or its proxy strategies, but we should not expect them to reflect an investment in what really drives the economy.  The question you should be asking is: could my portfolio returns be enhanced by adding a more appropriate weighting in stocks that served the consumption economy? I’ll answer that definitively below.

Let’s first turn our attention to the active mutual fund universe that’s categorized as Large Cap Blend. There are about 1,000 funds in this category and they too are benchmarked to the S&P 500. Our research indicates the vast majority of these funds are also chronically underweight the consumer stocks, I have no idea why, because in theory, these funds are not forced to follow the index rules and sector weights. Growth investors tend to be significantly overweight in technology stocks and value investors tend to be overweight cyclicals like financials, industrials and healthcare, so the consumer stocks often get overlooked. It has always amazed me that something like Retail Sales, which is >$5 trillion a year gets little attention from investors. Assessing the most relevant brands often forces a fundamental analyst to look into the intangible nature of a brand which is something most do not have training in. Bottom line: virtually every Advisor-driven portfolio holds some exposure to “core” equity strategies. Whether they are active or passive, these allocations are very often chronically underweight the single most important driver of the economy in which they are designed to track.  Using history as a guide, performance and diversification benefits could emerge if Advisors added the appropriate exposure to their core equity allocation.

How do you beat a benchmark? Look very different than the benchmark.

Knowing what I know about the core drivers of the economy and the historical long term track records of the top consumer stocks, I have made an active decision to be persistently overweight the consumer when investing in a consumer-driven economy. The simplicity of this argument is hard to dispute.

Accessing the Consumer Stocks: Passive and Active.

We know 60% of world GDP is household consumption and that’s a roughly $44 trillion opportunity each year. One would assume a theme this large and persistent would offer a plethora of potential investment options. Ironically, the choices for investors are quite limited.

There’s a critical piece of well-known information that is ignored across virtually all of the consumption-focused investments: consumer spending is a lifetime endeavor and humans spend their money on more than discretionary and staples. Investing in these two narrow sectors is better than not having the vital consumption exposure but having a “lifetime spending” focus adds much needed, full business cycle, diversification to effectively invest in this large theme. Case in point, we spend much of our time and money on technology, healthcare, and financial endeavors these days too.  The choices for investors in the ETF arena are very narrow in scope. The largest & most popular consumer ETF, SPDR Consumer Discretionary, symbol XLY is a concentrated basket of leading consumer discretionary stocks. I have nothing bad to say about this vehicle other than to say it’s too narrow to track lifetime spending, too concentrated and therefore volatile but it has added a significant amount of value over the S&P 500 in most time periods. The chart below compares the S&P 500 Index (core) with the Consumer Discretionary Index over a 30-year period and should provide proof that simply dialing up the Consumer Discretionary exposure inside an S&P 500 core index would enhance returns of the core allocation over most time periods. Historically, our global spending focus and diversified approach added value and smoothed the risk curve. The blue line is the consumer basket, the red line is the S&P 500 Index.

I’ve said before the decision to beef up exposure to the leading consumption brands is not a crowded trade which is a very good thing. Here’s some crowded trade facts:  the assets invested in the Tech Sector are 4x that of the investment in the Consumer Discretionary category.  But surely, that’s a function of the significant outperformance track record for tech stocks over the tech sector and S&P 500, right? Here’s the fun part, the Consumer Discretionary Index is the top performing sector (tech is #2) since the bottom of the market, March 9, 2009 (below) yet the consumer sector ETF’s have significantly less assets than technology, financials, and healthcare.

Bottom line:

Most portfolio’s using core equity strategies are chronically underweight the leading consumer stocks. These wonderful companies have a history of adding significant value over the traditional core indices. Adding a dedicated allocation to the global consumption theme seems to be a sound and logical approach given every major economy is powered by consumer spending. Perhaps swapping some “old core” investments or the overweight & expensive tech allocations and adding to the core consumer stocks is a wise idea. Both Tech and Consumer Discretionary have been stellar performers since March 2009 yet the consumer stocks in aggregate are much cheaper than tech and we have some wicked pent up demand in certain consumer categories to come.