Can Alternative Investments save the 60/40 Portfolio?
By Ezra Zask
May 2022
In a 2000 movie, the Perfect Storm, George Clooney portrays the
captain of a fishing boat caught in a storm at sea. Cooney has often
navigated stormy seas as indicated by his greying hair and confident manner. This
time, however, a “perfect storm,” the convergence of three weather fronts, produces
waves so big that they sink the boat despite Clooney’s best efforts.
We are not yet in a perfect storm, but there are indications
that the world may be heading down that road. The indications include the
global pandemic that led to massive unemployment and unprecedented supply
bottlenecks that reduced economic growth and spurred inflation; a flood of new
money and near-zero interest rates engineered by central banks to prevent total
economic shutdown, but which also raised the specter of inflation for the first
time in years. Central banks’ easy money policies and low-interest rates penalized
investors and fed bubbles in stocks and other assets as investors chased after
higher yields. Finally, a global return to economic mercantilism has both stifled
world trade and investment and is partly responsible for increasing political
uncertainty in the world’s largest economies, the U.S. and China.
We have not yet recovered from these waves when the coup de
grace hit: Russia invaded Ukraine in a move that overwhelmed an already shaky
economic environment and tipped it towards higher inflation. Central banks then
reversed a 40-year trend of declining interest rates, threatening to slow economic
growth and to pop asset bubbles in stocks, bonds, and real estate. We have yet
to see how these trends play out both economically and politically.
Old Dependable: The 60/40 Portfolio
Investors have had the wind at their back for decades if they
avoided panic selloffs when markets declined in 1998, 2001, 2008, and 2020. Globalization increased world production and
kept inflation in check. An unprecedented four decade decline in interest rates
began in 1981 after Paul Volcker raised interest rates to fight inflation,
causing large, sustained gains in both the stock and bond markets. Bonds
normally yielded low returns but provided a ballast during volatile times.
Investors and the money managers, supported by theories
provided by economists, converged on an investment paradigm that called for
diversified portfolios comprised of assets non-correlated assets with portfolios with responded to this environment
an investment portfolio that consisted of a mix of stocks and bonds. Popularly
known as a 60/40 portfolio, it consisted of sixty percent stocks and forty
percent bonds. The asset mix varied depending on the investor’s age and risk
tolerance with a larger allocation to stocks for younger and more risk-tolerant
investors, and a larger allocation to bonds as investors aged and became more
conservative.
Investments large and small, from 401k to the largest
pension funds, adopted a variation of the 60/40 portfolio. The 60/40 performed
well providing a compounded annual return of about 9% since 1987 and 10% over
the past decade. Also important to its widespread use is the ease of
implementing the 60/40, which benefited from the growth of low-cost index funds.
The 60/40 was also minimal maintenance: an annual review served to bring the
asset mix back to its original composition.
However, money managers and economists warned that a 60/40
portfolio was optimal only if held for extended periods of time. In “shorter”
periods (which sometimes lasted for years) declining returns and increasing
volatility would result in suboptimal portfolios. The longer one held the 60/40
portfolio, the closer it came to the optimal risk/return level.
Can Alternative Investments Save the 60/40 Portfolio?
Most existing investment portfolios are stuck somewhere along
the 60/40 continuum. However, there is a fierce debate among investors and
money managers about the suitability of the venerable 60/40 in the present investment
environment. The issue is whether the success of the 60/40 portfolio was due to
a combination of factors that no longer exist, especially bull markets in
stocks and bonds, sustained economic growth, low inflation, and a surge in the money supply.
Most future scenarios now project a period of higher
inflation, lower economic growth, and modest returns from stocks and bonds, all
of which will lower the returns of traditional portfolios. One proposed remedy
is to increase portfolio allocation to “alternative investments,” with analysts
recommending up to 20% allocation to alternatives and a similar decrease in the
allocation to fixed income. Advocates of this strategy claim that the inclusion
of alternatives in portfolios will lead to higher returns and lower volatility
than a 60/40 portfolio.
There are potentially fatal problems with this approach,
beginning with the absence of a common definition of “alternative investments,”
a loosely defined group that may include any combination of infrastructure,
private equity, hedge funds, venture capital, managed futures, art, and
antiques commodities and derivative contracts. The list sometimes includes cryptocurrencies
and related instruments. One company offers a portfolio of “alternative
investments comprised of collectibles and culture, Crypto and NFTs, fine
artwork, music rights, specialty real estate, wine and whiskey, and high-end
sneakers.”
However, this lack of a standard definition allows analysts to
manipulate performance data to yield any desired result, which makes comparisons
between different alternative portfolios suspect. Furthermore, several of these
alternatives are illiquid and too small to absorb the massive flow of money
that could come from institutional investors. There is a limit to the amount of
money that the vintage sneakers market can absorb. Finally, access to the best-performing alternative firms is severely limited or impossible for new
investors.
This is not to say that alternative investments do not have
a positive role in investment portfolios. However, investors often use the term
as if its meaning is self-evident when it is anything but that.
Of course, it may be wise to consider the possibility that
we are entering a period of lower returns and that there is a limit to what we
can do without taking on greater risk and/or increased illiquidity. We have had
a good run with the 60/40 portfolio but, like other aspects of life, things tend
to revert to the mean.
