Looking at Alternatives When Traditional Diversification Struggles
While the traditional 60% stocks and 40% bonds portfolio (60/40) has historically been used as the primary example of a core diversified portfolio delivering attractive risk-adjusted returns, it has struggled year-to-date. The illustration below from BlackRock plots various annual stock and bond returns showing only four times when both stocks and bonds were down simultaneously, including this year.
Why did the 60/40 mix provide attractive risk-adjusted returns previously?
As highlighted in a recent article by Morgan Stanley, the secrets to success for the 60/40 portfolio over the last four decades included slowing inflation, falling real yields, and an accommodative Federal Reserve (“the Fed”). The Fed’s successful ability to stamp out rampant inflation experienced in the 1970s resulted in falling Treasury yields and lower correlations between stocks and bonds. This lower, and often negative, correlation experienced between stocks and bonds was one of the main pillars within the 60/40 portfolio that allowed for attractive diversification and risk-adjusted returns. Additionally, as real or inflation-adjusted (nominal yields minus inflation) yields fell over this period, both stocks and bonds tended to benefit as companies could borrow at lower costs and financial assets experienced higher valuations. Lastly, investors grew increasingly confident in the Fed’s ability to intervene and limit damage during times of uncertainty by providing liquidity in the financial system and containing market volatility.
Why has the 60/40 struggled this year?
The ongoing uncertainty for the reasons listed above have all played a role in this year’s performance for the 60/40 portfolio. The high inflation we are experiencing has led to a positive correlation between stocks and bonds, reducing the diversification benefits previously obtained in the 60/40 portfolio. Additionally, with higher inflation, investors expect rising real yields. This would pressure bond prices (bond yields and bond prices move inversely to each other) and make stocks less attractive, paving the way for lower expected returns from the 60/40 portfolio. Lastly, the Fed’s focus on combating current inflation levels has led investors to believe that the Fed may be less willing and able to intervene in moments of market turbulence. As a result, the diversification benefits of the 60/40 portfolio have become increasingly challenged, while incorporating alternative investments has become a solution for many portfolios.
What are alternative investments and how can they help?
We classify alternative investments as those that do not fall into the equity, bonds, or cash classifications. These are investments that aim to deliver, as the name suggests, alternative sources of diversification and return from those of equity, bonds, and cash. There are a broad range of alternative investments available, each with their own value proposition, and although we will not touch on all of them, we highlight some of the characteristics expected within this asset class. As noted by BlackRock, there are three “Ds” to look for in alternative investments: Diversifying, Durable, and Defensive.
Diversifying – Does this investment or strategy diversify your current portfolio? That is, does this investment offer low correlations to other asset classes in your portfolio? Some strategies or investments may offer strong double-digit returns but with very high correlations to equities or other risky assets – all of which you are trying to diversify risk away from. Many astute investment managers look to find a middle ground between return potential and low correlations when evaluating alternative investments.
Durable – Does the investment or strategy have a history of durable sources of return? One item to look for is whether the investment or strategy produces consistent returns with relatively low volatility as this will help balance out the possible losses experienced in other low risk assets like core bonds.
Defensive – Is the investment or strategy defensive when you need it? Potential ways to gauge an investment’s defensiveness is by stress testing. How has the investment or strategy historically performed in significant down equity markets? An alternative that is defensive when other assets in your portfolio are under pressure may allow you to better weather different market environments.
There is no single investment nor single strategy that fits every investor, but we believe that having a diversified, all-weather portfolio that meets your individual needs and goals is the best way to navigate any market environment.
Cesar Ortega, Associate Portfolio Manager