Markets Are High. Consider Derisking Your Portfolio.

To derisk portfolios, advisors are investing in infrastructure projects. Here a carbon capture and storage facility. (Leon Neal / AFP / Getty Images)

Key Points

About This Summary

• With the S&P 500 and Nasdaq 100 at record highs after a Fed rate cut, advisors suggest reducing large-cap equity exposure.
• Financial advisors are favoring small- and mid-caps, international markets, and short-dated Treasuries amid economic uncertainty.
• Some advisors are adding inflation hedges like Treasury inflation-protected securities, real assets, and gold to portfolios.

The S&P 500 and Nasdaq 100 are making record highs as the Federal Reserve cuts interest rates. Now is the time to consider taking some chips off the table.

A good start is to revisit your portfolio allocations as you are likely overweight large-cap equities after the summer rally. Review your cash needs now as well.

“The time to be concerned about your allocation is when things are going well, apparently, because that’s the time you have to make changes before something bad happens,” says Michael Wagner, chief operating officer at Omnia Family Wealth.

Looser monetary policy may boost a slowing U.S. economy; however, financial advisors say macroeconomics are still jittery and the broader large-cap indexes are highly concentrated and richly valued, leaving them vulnerable to a selloff.

Staying invested for the long-term remains important, but advisors are curbing large-cap equity exposure in favor of small- and mid-cap equities and international markets and holding healthy allocations in shorter-dated Treasuries. With the latest consumer price index report showing headline inflation creeping up to 2.9%, some advisors are also adding inflation hedges.

Moving Beyond Large-Caps

Erin Gibbs, chief equity strategist at SlateStone Wealth, says September’s large-cap rally was powered by only a few stocks, which makes her cautious about its vitality. She is preparing for a change in market leadership, and suggests the Fed rate cut could allow small- and mid-cap stocks to outperform relative to large-caps.

SlateStone Wealth’s research shows that six months after the Fed cuts rates up to 200 basis points, or two percentage points, small- and mid-caps have outperformed large-caps six out of seven times since 1980, with an average eight-percentage-point gain.

“We’re already 100 basis points into those cuts, we’re now looking at maybe another 50, maybe even another 75 for this year,” Gibbs says.

Small- and mid-cap stocks have a better risk/reward metric, as the average returns for S&P 600 small cap index and the S&P 400 mid-cap index have 50% less volatility, she adds.

John Davi, founder of Astoria Advisors, has added mid-cap and international equities. As of September, Astoria’s 60/40 stock/bond portfolio has 17% in developed international and 6% in emerging markets. The U.S. equity sleeve includes high-quality large-cap equities and mid-caps.

Maggie Kulyk, founder of Chicory Wealth, increased client’s international equity holdings to 30% of the firm’s portfolio’s total equity position several months ago because of U.S. large-cap valuations. The portfolio’s equity asset allocation leans to blue-chip names and has a higher dividend exposure than the MSCI World Index, its benchmark. While Kulyk owns technology stocks, the portfolio favors defensive sectors including consumer staples, utilities and materials.

Between the U.S. debt issues, macroeconomic and political instability, the markets’ euphoria is unsettling, advisors say. “This feels to me like a much more fragile market than what it might appear at a glance,” Kulyk says.

Boosting Fixed Income

Omnia’s Wagner has reduced the firm’s equity positions to a historic low of 30% to 50%, and says the firm has a heavier tilt to fixed income, which includes short-term U.S. Treasuries, private credit and all-weather-type hedge funds that serve as a bond proxy.

Up to 10% of a client’s portfolio could include iShares 0-3 Month Treasury Bond ETF for daily liquidity needs. In private credit, one holding is the Cliffwater Corporate Lending Fund interval funds, which he considers to be well-diversified. He cautions interval funds are better suited for investors who can handle having a semiliquid holding in their portfolio as these funds limit withdrawals to a quarterly basis.

For retail investors looking for a liquid alternative hedge fund, Wagner says he uses Calamos Market Neutral Income.

Dick Pfister, CEO of AlphaCore Wealth Advisory, says while investors should think about short-term risk, they should keep market fluctuations in context of money they need to access daily, versus money that’s invested for the intermediate and long term.

He breaks down portfolio allocations to liquid and illiquid investments, and holdings that are correlated and noncorrelated. He says most people only need about one third of their portfolio to be daily liquid, and in the current market environment, holdings in that allocation should be limited to fixed income and money-market funds.

Hedging for Inflation

The financial advisors are also concerned that inflation could return. To mitigate that impact, Kulyk is using Treasury inflation-protected securities as a core holding.

Certain real assets are another of the advisors’ preferred inflation hedge. Davi has 5% of his 60/40 allocation toward real assets carved out of the fixed-income side. Both Kulyk and Pfister are buying private infrastructure investments, with Kulyk looking at decarbonization infrastructure and Pfister buying data centers.

Pfister, Davi and Wagner also like gold, even though it also has recently set records. Wagner has owned gold for a few years and keeps the allocation between 3% to 5% of a portfolio. Gold acts as a geopolitical hedge and offers price return. However, he says people who invest in gold need to keep a close eye on its overall weight.

“The trick is you have to trim it. You can start at a 3% to 5% weight and end up at 10% very quickly,” Wagner says.

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