by Brendan Schuck, CFP®, CLTC®
“The reports of my death have been greatly exaggerated.” This is a popular misquote of Mark Twain. The humorous quote is based on a letter Twain sent to a New York Times reporter who had asked Twain to respond to rumors that he was dying or already dead. In recent years, there has been several articles and white papers written about the death of the 60/40 portfolio.
The discussion is largely due to over a decade of a zero interest rate policy from the Federal Reserve following the Great Financial Crisis in 2008 (the “GFC”). This resulted in lower income generation from the 40% bond portion of the portfolio, and it was argued that bonds could not provide the same stability in the allocation that they historically provided. In 2022 as the Federal Reserve raised the Federal Funds Rate at the fastest pace in history, both stocks and bonds saw double-digit losses resulting in the third worst year for the 60/40 portfolio in history, and the worst year for bonds in history. This was the first time that both stocks and bonds saw double-digit percentage declines. Bonds, as measured by the Bloomberg US Aggregate Bond index, were down 13% in 2022, and the 60/40 portfolio was down over 16%.[1]
Proponents of the 60/40 portfolio would be likely to refer to the humorous Twain misquote when debating the future of the 60/40 portfolio and claim one bad year does not discredit the strategy. In contrast, critics of the 60/40 portfolio are likely to advise that investors diversify their portfolio beyond stocks and bonds and include alternative investments such as private equity/credit, commodities, hedge funds, real estate, and more.
To save everyone the suspense, the 60/40 portfolio is far from dead, and it could be argued that after the repricing in the bond market in 2022, the 60/40 portfolio looks more attractive at its current valuation than it has in decades. However, a strong case can be made that alternatives, when added to a multi-asset portfolio, can enhance return, manage downside risk and improve diversification. This article will look at the origins and the history of the 60/40 portfolio, an overview of the current alternative investment landscape and then explore a framework for implementing alternative investments into a multi-asset portfolio.
History of the 60/40 Portfolio
Why so much discussion around the 60/40 portfolio? Why is it so popular? Harry Markowitz’s work on Modern Portfolio Theory in the 1950s earned him the Nobel Prize in Economic Sciences in 1990. His work laid the groundwork for understanding risk, as measured by standard deviation, in investment portfolios. He shared the Nobel Prize with Merton H. Miller and William Sharpe, who won the Nobel Prize for his work on the “capital asset pricing model” and the creation of the Sharpe ratio in 1966. The Sharpe ratio measures the performance of an investment compared to a risk-free asset (US T-BILL), after adjusting for its risk (the “Standard Deviation”). It represents the additional amount of return that an investor receives per unit of increase in risk. The higher the Sharpe ratio, the more efficient the investment.
For example, two investments both return 10% per year over ten years, but if Investment 1 has twice the level of risk as measured by the Standard Deviation, a rational investor would choose Investment 2. Investment 2 would have a higher Sharpe ratio reflecting a better risk-adjusted return.
In a traditional two asset portfolio consisting of stocks and bonds, the optimal blend over extended periods centers toward 60% stocks and 40% bonds. The idea is that both assets have positive returns over the long term but are relatively non-correlated to one another. In an ideal scenario, both assets would rise over time, while on a day-to-day basis, their gains and losses would offset one another to smooth portfolio performance. The reason the 60/40 portfolio is so often discussed is because it has exhibited better risk-adjusted returns over time. In the 1980’s, Jack Bogle, the founder of Vanguard, promoted the strategy as a core component of his passive indexing approach. Bogle believed that the 60/40 approach was a prudent and straightforward way for individual investors to build wealth over the long term.
In the early 2000’s, the 60/40 portfolio faced skepticism as critics questioned whether traditional asset allocation models were still relevant in a rapidly changing global economy. However, the strategy regained popularity during the GFC when the stability of bonds became evident. Investors who maintained a 60/40 portfolio weathered the storm much better than those who were more heavily weighted in stocks. Stocks, measured by the S&P 500, were down 37% in 2008 compared to a positive 5.24% for bonds. The 60/40 portfolio was down about 20% in 2008, faring better than the 37% decline in stocks. The years following the GFC resulted in a prolonged period of low interest rates and changing market dynamics. Some experts argue that a 60/40 portfolio may no longer be as effective, and they suggest alternative approaches, such as increasing exposure to alternative investments or adopting a more dynamic asset allocation strategy.
The Rise of Alternative Investments
Alternative Investments may be classified as any investments outside the traditional assets of publicly traded stocks, bonds and cash. Alternative investing strategies have seen increased investment because of the above-average correlation between the stock and bond markets. Private markets have seen extraordinary growth in the 21st century because of increased regulation on banks and publicly traded companies. A McKinsey report estimates private markets assets under management (“AUM”) to be around $12 trillion and has grown at a rate north of 20% annually since 2017.[2]
The increased popularity in alternative investing can be attributed to the growth in private markets as well as investors seeking increased diversification beyond traditional assets. Historically, institutional investors have allocated a larger percentage of their portfolios to alternative investments compared to advisors and retail investors. A Fidelity study of allocations to alternative investments showed that Institutions on average allocated 23% of their portfolios to alternatives compared to only 6% [3] by financial advisors. In the past, there have been barriers to entry for advisors and clients such as manager access, higher costs associated with alternatives, liquidity considerations and high investment minimums. A combination of the reduction of legacy transactional frictions and the development of new vehicles and technologies could help encourage additional investment in alternatives.
Overview of Alternative Investment Landscape
Categories of alternatives generally include liquid alternatives, private equity, private credit and real assets each with several subcategories. There are several other assets that would be considered alternatives to traditional asset classes that will not be discussed here.
Liquid Alternatives - These strategies are generally invested in the public markets or in derivates tied to the performance of the public markets. The use of leverage and derivatives is common in this space and can amplify returns both positively and negatively. The vehicle structure for liquid alternatives is a mutual fund or an ETF. Some common strategies are equity hedge, relative value, event driven and macro strategies such as managed futures. Think hedge fund strategies. Fidelity Investments performed a study looking at the returns of several asset classes from 2005 to 2022, which demonstrated that managed futures performed well during periods of poor US equity market performance. The worst four return years for US equities during this period show managed futures averaged 6.9% while US large-cap equities were down on average 15.1%. [4] This negative correlation that was displayed during this period is an example of how adding liquid alternatives to a portfolio can help lower volatility and improve risk adjusted returns.
Private Equity/Private Credit - Private equity is the investment in the ownership of companies that are not publicly traded, and private credit involves either direct lending to private companies or purchasing the debt of these non-publicly traded companies. The study from Fidelity Investments on asset class performance from 2005-2022 showed that private equity performed the best of the 18 asset classes observed. (4) The vehicle structure for private investments has historically been through more illiquid limited partnerships. The higher return exhibited by private equity is referred to as the “illiquidity premium.” In return for less access to funds, investors demand better performance. Product innovation has made investment in private companies more accessible to financial advisors and retail investors through semi-liquid non-traded business development companies (“BDCs”) and interval funds. Limited partnerships tend to be only available to investors that meet net-worth and income requirements and require lock up periods that make access to capital difficult. BDCs and interval funds have some lockup periods that limit liquidity, but shares can generally be redeemed at different intervals. One in five financial advisors surveyed by Fidelity reported that illiquid options are not available at their firm. (4) The proliferation of semi-liquid structures such as non-traded BDCs and interval funds will improve access to private company investment over time.
Real Assets - Real assets consist of tangible assets such as private real estate, fine art and collectibles, commodities (basic goods, raw materials, natural resources, metals, and oils) and infrastructure (bridges, ports, pipelines, data centers). Private real estate offers ownership stakes in commercial properties or land or the purchase of debt on such properties. Real assets offer additional diversification outside traditional asset classes that can help reduce overall portfolio volatility.
Framework for Implementing Alternatives
The framework for allocations in a traditional asset portfolio is simple and time tested. As the need for distributions from a portfolio gets closer over time, investors are advised to rotate out of equities into bonds and cash. What should be the framework for implementing alternatives into a multi-asset portfolio? What percentage of the portfolio should have exposure to alternatives, if any? Some proponents of alternatives suggest allocations as high as 30% to 40%. Critics of alternatives suggest no allocation to alternatives and would argue a simple traditional portfolio will allow investors to achieve their goals over the long-term. If an investor or advisor chooses to implement alternatives into a portfolio, allocation ranges need to be based on the liquidity needs of the investor and the risk/return benefits of investing in alternatives.
Exhibit 1 includes returns, risk (as measured by standard deviation) and Sharpe ratio statistics from a Fidelity study of asset class performance from 2005-2022. The liquid alternatives strategies demonstrated lower returns, but they also provided less risk and higher diversification benefits as shown by the improved Sharpe ratio. Adding a 10% allocation of liquid alternatives to a traditional 60/40 portfolio was shown to reduce the risk of the portfolio but it also slightly reduced the return over the study’s time-period. If you split the 10% allocation in alternatives between liquid and illiquid, the performance remains about the same as the 60/40 portfolio, but the risk of the portfolio is reduced. The basket of illiquid investments exhibited higher returns but also higher volatility. The last allocation in Exhibit 1 shows a 40% allocation to alternatives with 10% liquid and 30% illiquid. The larger allocation to illiquid alternatives helps increase the performance of the portfolio when compared to the 60/40, and the 10% allocation to liquid alternatives lowers the overall risk of the portfolio. This heavy weighting in illiquid alternatives would only be appropriate for an investor with a long-time horizon and very low liquidity needs.
Conclusion
The 60/40 portfolio is far from dead and still serves as a simple strategy to help investors achieve their long-term goals. It should be expected that the strategy will have bad years like 2022, but it is important to keep a long-term perspective. The risk/return tradeoff associated with bonds after their repricing in 2022 is more attractive than it has been in recent history which makes the value proposition for the 60/40 stronger when looking to the future. A case can be made for adding alternatives to a traditional asset portfolio to help reduce volatility when those bad years happen. It is important for advisors to do their due diligence when selecting managers for any of their clients’ assets. Due to the complexity of alternatives and the shorter track record, an extra emphasis should be placed on manager selection of alternative investments. Advisors must communicate to their clients the pros and cons of using a traditional approach versus adding alternatives. The traditional approach is simple and cost-effective, but may experience more volatility in certain years. Adding alternatives can help reduce volatility and enhance returns, but will increase the expense of the portfolio and might make it less liquid. If an investor is educated on these items, they are empowered to make a more confident decision on whether to incorporate alternatives into their portfolio.
Brendan Schuck, CFP®, CLTC®, is a financial representative in Yardley, PA. Brendan has 20 plus years of experience in the financial services industry. Brendan specializes in helping families and small businesses with their financial plans with a focus on designing, implementing, and monitoring investment portfolios that match the investors time horizon and risk tolerance.
[3] Source: Fidelity Investments, A Study of Allocations to Alternative Investments by Institutions and Financial Advisors, April 2023
[4] Source: Fidelity Investments, Alternative Investments and their Role in Multi-Asset Portfolios, August 2023