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We have entered a new paradigm of anemic return expectations for traditional asset-allocation models. The prospects of a lost decade ahead are uncomfortably high for portfolios that are 60% invested in stocks and 40% in bonds – particularly when adjusted for inflation, which is at levels not seen since the early 1980s.
Investors have witnessed expensive stock markets and incredibly low interest rates. Seldom have we experienced both concurrently.
If the outlook for the 60/40 allocation is so lackluster, why do so many advisers and investors still cling to this security blanket of portfolios?
In my opinion, it’s because it hasn’t disappointed them…yet.
The appeal of a 60/40 portfolio is obvious. It has delivered diversification and solid risk-adjusted returns for decades. Its underlying components – stocks and bonds – are quite intuitive and easy to understand for most investors. Most importantly, it is incredibly easy and inexpensive to build. You can own a globally diversified 60/40 portfolio with a few clicks of a button via an ETF like the iShares Core Growth Allocation ETF
AOR,
But as user-friendly and rewarding as this portfolio has been, investors looking to rebalance their portfolios or put new cash to work are presented with unattractive trade-offs.
It has been a somewhat rough start to 2022 for the two components of 60/40 – U.S. stocks and bonds. The U.S. stock market, as measured by the SPDR S&P 500 ETF Trust
SPY,
is down 7% year-to-date through Friday. The more growth and the tech-stock-tilted Nasdaq-100 index
NDX,
measured by the Invesco QQQ ETF
QQQ,
is down nearly 12% through Friday.
While these corrections are somewhat modest, what’s worrisome to diversified investors is that bonds are down at the same time. The iShares Core U.S. Aggregate Bond ETF
AGG,
is down 2% through Friday amid rising interest rates. This is a reminder that bonds aren’t always uncorrelated to stocks.
Fortunately, there is a growing opportunity for the average investor to harness a wider array of return streams. Adding alternative investments to the investment mix can allow investors to maintain their preferred position on the risk curve, but with less uncertainty around the tails and with a higher degree of confidence in long-term outcomes.
It may sound oxymoric, but alternative investments are becoming more mainstream. Vanguard is now in the business of private equity. Cryptocurrencies
BTCUSD,
barely a teenager, are beginning to gain traction within institutional and advisor-directed portfolios.
If history is a guide, we should expect many of today’s alternatives to become tomorrow’s diversifiers.
So if 60/40 is no longer the default answer, what is?
Investors seeking balance and using 60/40 as their baseline should generally own less of the “40,” perhaps a bit less of the “60,” and a decent amount more of “other.” But that is where the generalizations end.
There is no one-size-fits-all allocation to alternatives that makes sense for all investors. The sweet spot lies somewhere between “enough to make a difference” and “too much that investors can’t stick with it.” What’s become increasingly clear is that the only wrong answer is zero.
I built three hypothetical, index-based portfolios with varying degrees of alternatives and different investor objectives in mind. The risk and return statistics for these portfolios goes back to October 2004, which is the furthest back the index data allows. They are updated through the end of September 2021, since several of the underlying indexes use illiquid asset classes that have delayed reporting. The returns illustrated below do not represent live accounts and are designed only to provide an estimate of reasonable portfolio risk. Indices are unmanaged, do not reflect fees and expenses and are not available as direct investments.
This period covers both good times and good, including the decade-plus bull market in stocks we’ve just experienced as well as the carnage from the 2008-09 financial crisis that saw the S&P 500
SPX,
experience a peak-to-trough decline of 55%.
Stocks are represented by the MSCI All Country World Index. Bond-market performance is measured by the Bloomberg US Aggregate Bond Index.
The alternatives allocation is equally split among four broad categories: alternative risk premia, catastrophe reinsurance, real assets, and private debt, some of which are tracked by private markets indexes. However, all the strategies are implementable through SEC-registered “wrappers” like mutual funds, ETFs, and interval funds that do not require an investor to be accredited to own them.
- 50% stocks/25% alternatives/25% bonds: This is intended to have a similar risk profile as a 60/40 portfolio, but with an objective of higher returns due to the low expected returns offered by traditional fixed income.
- 60% stocks/20% alternatives/20% bonds: This portfolio is geared toward an investor willing to tolerate a little higher volatility in the pursuit of higher expected returns.
- 40% stocks/30% alternatives/30% bonds: This portfolio is intended for a more conservative investor who is looking to de-risk significantly from 60/40 but is hesitant to move too much capital into fixed income.
Each index portfolio achieved the desired objectives, as seen in the table below.
| Oct. 1, 2004-Sept. 30, 2021 | 60/40 | 50/25/25 | 60/20/20 | 40/30/30 |
| Annualized return | 7.23% | 7.65% | 7.82% | 7.26% |
| Volatility | 9.38% | 8.35% | 10.00% | 7.29% |
| Maximum drawdown | -36.48% | -32.28% | -39.11% | -27.88% |
Source: The Allocator’s Edge
The 50/25/25 portfolio outperformed the 60/40 portfolio with less volatility and a lower maximum drawdown. The 60/20/20 allocation achieved the highest returns relative to the 60/40 mix, commensurate with its slightly higher risk profile. Lastly, the 40/30/30 portfolio earned returns in line with the 60/40 portfolio but with much less volatility and maximum drawdown.
Harriman House
It’s important to remember that this is what would have happened over the last 17 years. As we look forward, which we should always do, the bond piece will not have the large tailwind of declining rates to support it and the math of low starting yields is unavoidable. History has shown that your starting yield in bonds will explain over 90% of the returns over the next decade.
The conventional portfolio building blocks of stocks and bonds are still necessary, but no longer sufficient. A future where investors can simultaneously grow and protect their wealth via meaningful diversification and return potential is still possible, but it requires substantive change. Small tweaks and incremental changes will not suffice.
The time has come for allocators to be bold, embrace alternatives and sharpen the allocator’s edge.
Phil Huber, the Chicago-based chief investment officer for Savant Wealth Management, is the author of “The Allocator’s Edge: A modern guide to alternative investments and the future of diversification”. Follow him on Twitter @bpsandpieces.
