The 60/40 Portfolio Doesn't Cut It in Today's Market
The lingering impacts of the pandemic, the Russian invasion of Ukraine, a shift in Fed policy, and record-breaking inflationary levels have exposed investors to a number of obstacles, including decreased stock returns, low yields, heightened correlations, and growing bursts of volatility.
Accordingly, the three traditional pillars of a portfolio, namely stocks, bonds, and cash, have proven highly unreliable. The conventional 60/40 method is no longer sufficient to meet the investors' objectives. As a result, they are increasingly turning to non-traditional assets, namely alternative investments.
A Historical Approach
In order to effectively manage risk and construct an investment portfolio, diversification is essential. Bonds have historically provided a potential safety net during stock market declines. This is because their values tend to increase as stock prices fall, reducing the impact of volatility on equity investments. For this reason, many financial planners and stockbrokers traditionally built portfolios for their clients composed of 60% equities and 40% bonds.
Based on the work of Nobel Prize-winning economist Harry Markowitz, this 60/40 asset allocation strategy allowed investors to optimize projected returns for a given degree of risk. They would minimize their portfolio's overall risk by diversifying their holdings with low positive or even negatively correlated assets. The rationale behind the 60/40 portfolio, and what happened over the previous decades, is that equities and bonds have indeed been negatively correlated the vast majority of the time: When equities decline, bonds provide stability.
However, bonds may not offer the same level of diversification as they did in the past as markets now struggle to cope with the new constraints of inflation and rising interest rates.
Source: YCharts
As previously mentioned, the correlation between stocks and bonds has been negative during the past several decades. However, unexpected inflationary spikes tend to reverse this correlation; 2022 perfectly illustrates this. According to BlackRock, 60/40 portfolios experienced a 17% loss last year[1], the weakest performance since 1999. And this trend is expected to continue; markets are not the same as they were in the past. They are now characterized by high valuations, strong inflationary pressures, never-before-used monetary policies, and the proliferation of technology, which had a significant impact on the economy as a whole.
In short, the factors that made successful 60/40 portfolios possible no longer exist. While they may have satisfied the needs and goals of clients in previous decades, it is no longer possible to achieve the desired level of performance by investing solely in those instruments. Investors are now compelled to adopt a more sophisticated asset allocation strategy, i.e. diversifying their portfolios with non-traditional investments. This is where alternative investments come into play, with their exceptional portfolio stabilization and risk-reward characteristics.
How Can Alternative Investments Help
Alternative investments are financial assets other than bonds, equities, cash, and fixed-income instruments. Simply put, they do not fit into conventional asset classes. Private equity, private debt, real estate, or infrastructure are some of the most common alternative asset classes.
Institutional investors and high-net-worth individuals have utilized alternative investments for decades to diversify portfolios and enhance returns - these assets have expanded from $7.9 trillion in 2013 to more than $10 trillion under management in 2020. By 2023, their volume will be expected to reach $14 trillion[2].
Due to their minimal correlation with the public markets, alternative asset investments offer strong portfolio diversification characteristics. In other words, alternative assets are less vulnerable to wide market fluctuations than traditional investments; instead, they are significantly more aligned with the intrinsic value of each invested company. As a result, portfolios that include alternative assets will have a greater hedge in case of a stock market crash.
Alternative investment strategies also display higher return potential. Private equity, in particular, is widely acknowledged to have generated higher returns than its counterparts. And coupled with its low volatility levels compared to other asset classes, it is easy to see why private equity has become a cornerstone in modern portfolios. In addition, certain alternative investments may offer tax advantages not available with conventional investments.
For all those reasons, institutional investors' allocation to alternative investments has substantially grown in recent years. A recent survey conducted by Cerulli Associates revealed an average allocation of 14.5%[3] across 100 institutions. The same firm revealed that 44% of institutional investors[4] seek to increase their allocations to alternative investments. Other examples include the well-known investment strategy of the Yale endowment fund, which allocates more than 78% of its portfolio to alternative assets.
The Bottom Line
While the 60/40 allocation approach may have yielded superior returns in the past, its effectiveness is now being heavily challenged. The market turbulence over the past few decades has led many investors to opt out of the public market's correlation and seek better risk-adjusted returns in other financial assets.
Alternative investments offer an additional layer of diversity and are immune to market volatility, making them effective risk-management strategies. Assuming that the classic 60/40 public shares and fixed income portfolio would only provide half of its historical return and with far more volatility, alternatives such as private equity, private debt, hedge funds, and real estate are in high demand.
Ultimately, investors are advised to leverage alternative assets as sources of growth and income, as instruments to temper volatility, and as a method of hedging the impact of inflation to navigate the current market properly. New technology and platforms have made these essential and flexible instruments accessible to a broader range of investors, with lower minimums, reduced costs, and more adjustable features. And in light of their recent exponential growth, their significance to portfolios is not likely to decrease anytime soon.
At Petiole, our investment philosophy sets us apart from many other funds since we provide access to top-tier strategies and co-investing opportunities in the alternative investments space. Click on the link below to find out more or arrange a meeting with one of our team.
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