Portfolio Construction

Rate risk: The risks of portfolios with a singular focus

Tom Yager

August 29, 2024

2 MIN ARTICLE

With the U.S. Federal Reserve widely expected to begin cutting interest rates before year end, investors may be tempted to build a portfolio focused on a rate cut scenario. But recent history shows there are risks in building a portfolio around a single interest rate scenario.

 

The risk you take in building a portfolio with a singular focus is that your assumptions and expectations might prove wrong. You build a portfolio to thrive in a falling rate environment, but rates don’t fall. Or your assumption about interest rates could be correct, but what if markets don’t behave the way you expect them to?

 

That’s exactly what happened in the red areas on the chart below: Interest rates moved, but stocks didn’t behave as expected. 

When rates fall, equities haven’t always reacted as expected

chart-article_chart-of-the-month-767x500

Sources: Capital Group, FactSet, Federal Reserve Bank of St. Louis. As of 3/31/24. Rolling returns calculated monthly. Growth represented by S&P 500 Growth – Gross Return Index. Value represented by the S&P 500 Value – Gross Return Index. The S&P 500 Value Gross Return Index and the S&P 500 Growth Gross Return Index are indexes that include in the returns all cash dividends reinvested on the ex-dividend date.

The expectation tested in the chart is that value stocks will outperform growth stocks when rates rise, and growth will outperform value when rates fall. This is based on the belief that rising rates will cause investors to apply a lower multiple to the future earnings of growth stocks.

 

But during the red periods in the chart, the market didn’t follow those rules. From 2000-2003, rates fell sharply, but value stocks outperformed growth stocks as investors turned risk-averse coming out of the dot-com bubble.

 

Then in the second red period, from 2015-2018, rates were rising, but growth continued to outperform through a long run of excess returns.

The takeaway: Markets often make surprising moves, so you should avoid building portfolios that depend on binary interest rate outcomes. Capital Group encourages an approach to portfolio construction that can succeed through various scenarios. We encourage investors to build portfolios with exposure to actively managed vehicles based on bottom-up, company-specific fundamental research.

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TMOY

Tom Yager is a product manager in portfolio solutions and services. He has 14 years of investment industry experience. He holds a bachelor's degree in business management from Arizona State University. He also holds the Certified Investment Management Analyst® and Chartered Financial Consultant® designations.

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The S&P 500, formally known as the Standard & Poor’s 500, is a stock index that tracks the share prices of 500 of the largest public companies in the United States. The S&P 500 Growth Index measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum. The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price. Each S&P Index (“Index“) shown is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2024 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part is prohibited without written permission of S&P Dow Jones Indices LLC.

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