To determine whether a portfolio shift would be beneficial, analysts in Vanguard Investment Strategy Group looked at the performance of various sub-asset classes relative to the broad equity and fixed income markets during periods of federal fund rate increases over the last 30 years. They compared U.S. value, growth, small-cap, and large-cap stocks, U.S. REITs, and international stocks with the broad U.S. equity market, and U.S. corporate investment-grade, high-yield, and Treasury bonds with the U.S. aggregate bond market.

The analysis showed that there is no predictable pattern of specific sub-asset classes performing better than the broad markets and concluded that sticking to current portfolio allocations, minimizing costs, and maintaining discipline make sense in this environment.


Historical uncertainty repeats itself

Successfully implementing a tactical strategy is challenging and risky. When considering a change to their portfolio allocation, investors must understand the risks and question whether they are able to take them on. The analysis below examines two sub-asset classes to show how seemingly logical tactical investment opportunities can lead to unexpected results.

Investors may view the Federal Reserve’s increase in the target rate as an indication of a strengthening domestic economy and high expectations for growth. A portfolio tilt toward small-cap stocks, which tend to be more domestically oriented (issued by companies that earn most of their revenues in the domestic economy), may thus seem like a suitable option. However, as we see in Figure 1, small-caps behaved erratically throughout all five tightening cycles studied, sometimes making huge jumps within a short time. At the end of each tightening cycle, the return of small-caps relative to the broad equity market was inconsistent.

U.S. small-cap stock performance

For their fixed income portfolios, investors who regard the increasing target rate as a signal that the economy is heating up may turn to U.S. investment-grade corporate bonds. They may be willing to take on the additional credit risk inherent in these bonds in their search for higher returns. Based on the research shown in Figure 2, the behavior of investment-grade corporate bonds is anything but predictable. Even more interesting, over the five tightening cycles, they seemed to closely track the aggregate bond market, displaying a lack of outperformance contrary to what investors might expect. This could mean that the markets had already anticipated the cycles’ yield and spread changes.

U.S. corporate investment-grade investment performance

Stay the course

Tactical shifts such as those described here don’t work because asset class performance does not depend solely on the direction of the federal funds rate. The rate alone does not cause any consistent behavior. Asset class returns are unpredictable, and other factors such as the larger macroeconomic environment should be considered when analyzing them. Therefore, a portfolio change based only on the expected path of the federal funds rate is not likely to lead to better long-term results. Assuming there is no change in circumstances and long-term goals, it would be prudent for investors to maintain a well-diversified portfolio.


Notes:
All investments are subject to risk, including the possible loss of the money you invest.

Past performance is no guarantee of future returns.

The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. There may be other material differences between products that must be considered prior to investing.

Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.