Traditional expectations of the 60/40 portfolio may be due for a rethink. Based on today’s yieldlevels, bonds simply can’t contribute to aportfolio the way they have historically.For advisors, this could mean shiftingassets away from fixed income and intoalternatives if they want to preserve therisk/return profile that the 60/40 portfolio has historically delivered.
Here we consider the current challenges of a 60/40 portfolio, and the simplemath behind how advisors can achieve amore optimal solution for clients.
DIMINISHING RETURNS OF
While fixed income’s primary role is as adiversifier, bonds must still provide somelevel of return if they are going to comprise a sizeable allocation within a portfolio. Yet, the Federal Reserve’s recent policyshift adopting a looser inflation target forinterest rates implies it will likely waiteven longer to raise rates from currentlevels — meaning low return expectationsfor fixed income are likely to endure.
The only option to improve the returnprofile within a fixed income portfoliowould be to take on increased creditrisk, but this in turn makes the fixedincome allocation more correlated toequities. Further, a lagging economy dueto the pandemic also raises default riskamong high-yield bonds.
TWEAKING THE 60/40 ALLOCATION
If advisors want to achieve the same
level of return that a 60/40 portfolio
has historically provided without taking
on more equity risk, they must add new
asset classes to the mix. Let’s consider,
for example, how adding alternatives
can help achieve this objective.
To set the stage, consider that if stocksearn a 5% return, their contribution to a60/40 portfolio is 3% (0.05 x 0.60). Forbonds, we used the current five-yearyield of 0.25% leading us to a 0.10%return contribution (0.0025 x 0.40). Intotal, this equates to a total portfolioreturn of just 3.10% with a beta of 0.60.
Now let’s assume the investor takes5% away from equity and 15% from fixedincome and directs that toward a portfolio made up of four alternative strategies.
(Note: Alternatives are represented bythe HFRI Equity Market Neutral Index,HFRI Merger Arbitrage Index, HFRIMacro: Systematic Diversified Index, andHFRI Equity Hedge Index. While this portfolio actually has a return of 8%, we choseto discount this to 5% given lower overallreturn expectations for all investments.)
Here, if stocks garner the same 5%return, their contribution to a 55/20/25portfolio would be 2.75% (0.05 x 0.55).
Additionally, with a 5% return for alter-
natives and 0.25% return for bonds, their
respective contribution is 1% (0.05 x
0.20) and 0.06% (0.0025 x 0.25). Thus,
with a total portfolio return of 3.80% and
an equity beta of 0.59, the investor raises
their return level without increasing risk.
The extra 70 basis points may not
sound like much, but in the context of
the current investment landscape, any
improvement is meaningful. As we’ve
mentioned, investors likely will face a
low-return environment going forward.
Lofty stock valuations don’t reflect
the current economic reality of the pan-
demic-induced slowdown. As such, it is
reasonable to believe that equities could
be volatile, or fail to achieve much high-
er returns after the run-up since March.
As discussed, the return prospects for
fixed income are even more dim.
Against this backdrop, any incremental return improvement an advisor orallocator can make to a client’s portfoliois a bigger value add than it would bein a roaring bull market. Alternativescan provide that improvement, withoutadding more risk.
Josh Vail, CAIA, is president of 361 Capital.
By Josh Vail
60/40 Blend Requires Imagination in
By adding alternatives, slight changes to the mix can bump returns
without added risk.