With uncertain equity mar- kets, the potential for sub- dued-to-negativeeconomicgrowth looming, and a bleak outlook forfixed income, advisors are challenged torethink foundational portfolio elementsof investor portfolios — which meansseeking out strategies that bolster thecore going forward.
In investing, the “core” has traditionally consisted of developed market equitiesand investment grade debt. Increasinglyover the last decade, investors — bothretail and institutional — have introduceda growing number of diversifying elements to that core, including commodities, floating rate and high yield debt,emerging market assets, and hedge fundstrategies, to name a few. Those assetgroups have, in portfolio constructionlingo, been termed “satellite” allocations.
But not all satellites are distinctlydifferent from core assets. Of all of thesatellite strategies, the one that mostclosely resembles the foundational components of a typical portfolio is long/short equity. After all, it is a strategy, notan asset class, which invests in equities,and more often than not, does so withnet exposure well below 100%; that endsup looking quite similar to a combination of equities and cash or bonds.
A correlation analysis of the return
streams for equities, as represented
by the S&P 500 Index, and long/short
equity strategies, as represented by the
Credit Suisse Long/Short Equity Index,
reveals that from January 1994 through
March 2020, equities and long/short
equity strategies exhibited a correlation
of about 0.59. While this is hardly the
signature of a truly diversifying asset, it
is able to accomplish what diversifying
assets are meant to do: improve the risk-
adjusted performance of a portfolio.
Consider the following risk andreturn characteristics using data fromMorningstar from January 1, 1994through March 31, 2020:
• S&P 500 Index: 9.11%
• Barclays U.S. Aggregate Bond Index:5.47%
• 60% S&P 500 Index / 40% BarclaysAggregate Bond Index: 7.94%
•Credit Suisse Long/Short EquityIndex: 7.23%
• S&P 500 Index: 14.69%
• Barclays U.S. Aggregate Bond Index:3.49%
• 60% S&P 500 Index / 40% Barclays• Aggregate Bond Index: 8.92%
•Credit Suisse Long/Short EquityIndex: 6.73%
• S&P 500 Index: 0.49%
• Barclays U.S. Aggregate Bond Index:0.79%
• 60% S&P 500 Index / 40% BarclaysAggregate Bond Index: 0.60%
•Credit Suisse Long/Short EquityIndex: 0.61%
• S&P 500 Index: -50.95%
• Barclays U.S. Aggregate Bond Index:- 3.83%
• 60% S&P 500 Index / 40% BarclaysAggregate Bond Index: - 32.54%
•Credit Suisse Long/Short EquityIndex: - 19.68%
Long/short equity strategies havecome close to matching the performanceof equities with a lower level of volatility than the 60/40 stock/bond portfolio,and with smaller drawdowns. (Note thatthis was over a time period when theyield on the 10-Year Treasury went from5.75% to 0.68%, which was unquestionably beneficial to the performance ofinvestment grade debt.)
To be fair, point-in-time statistics canhide a lot, both good and bad. There havebeen many periods over the last 22 yearswhen investors would have been betteroff in a 60/40 portfolio, most notably in2011 when the Credit Suisse Long/ShortEquity Index fell by - 6.97% and a 60/40portfolio returned almost 5%.
But here’s the question: Could eventhe most astute investment professional determine in advance when suchtime periods will be more conduciveto a 60/40 core than for a long/shortequity strategy?
We are not stating that long/shortequity should completely replace thetraditional stock/bond core, but ratherit could replace a portion of that coreand potentially improve overall performance over the long term throughan increased number of alpha sources, while dampening volatility, amongother things.
Josh Vail, CAIA, is president of 361 Capital.
By Josh Vail
Is It Time to Revisit the 60/40?
There are ways to strengthen the core of a stock/bond portfolio
without being extreme.