Beyond Stocks and Bonds: Reimagining Portfolio Mix
Continuing with our previous article: Alternative Investment Strategies for an Uncertain Global Landscape, we explore how investors can build resilient portfolios with alternative assets. In 2024, you must look beyond stocks and bonds to build a resilient portfolio. The traditional 60/40 allocation to stocks and bonds no longer provides the diversification needed in today’s markets. By reimagining your portfolio mix into an alternative portfolio, you can reduce risk while still pursuing growth. The path forward requires looking beyond traditional asset classes to vehicles like private equity, venture capital, real estate, infrastructure, and hedge funds.
Why the Traditional Portfolio Is Losing Favor
Inflation Risks Weakening Bonds as Diversifiers
The traditional portfolio of 60% stocks and 40% bonds has long been a staple for investors seeking growth with diversification. However, the world is transitioning from an era of persistent disinflation, ultra-low interest rates, and fiscal restraint to a new reality marked by two-way inflation risk, more conventional monetary policy, and increased fiscal activism. This shift has profound implications for portfolio construction and diversification.
Bonds have become less reliable diversifiers compared to previous decades, as they do not always appreciate when stocks decline – especially in high inflation environments.
Correlations Rising Between Stocks and Bonds
Periods of high inflation lead to higher correlations between stock and bond returns, reducing the diversification benefits of the traditional portfolio. Stock-bond correlation has risen to over 60% currently, limiting bonds’ ability to cushion against equity volatility. This dynamic was evident in 2022 when the traditional mix suffered its worst annual return, falling by 16%.
The Rise of Alternative Investments
Expanding Returns & Diversification
To rebuild resilience, investors are exploring alternative asset classes that can provide differentiated sources of returns with lower correlations to stocks and bonds. Alternative investments have become an increasingly attractive proposition for investors seeking to bolster returns and diversify away from traditional asset classes. According to J.P. Morgan research, allocations to alternatives like private equity, private credit, real assets, and hedge funds can significantly enhance a portfolio’s risk-adjusted returns over the long term.
Even allocating a modest 10% to cash instead of bonds could improve portfolio efficiency based on recent return patterns. A 60/30/10 portfolio allocating to stocks, bonds and cash has outperformed the traditional 60/40 over the past decade. While bonds struggle, cash provides a behavioral “release valve” without significantly compromising long-term returns.
The rationale is straightforward – alternatives provide exposure to a broader opportunity set beyond public markets. This expanded investment universe allows for greater diversification, while also tapping into areas like private markets that have historically delivered illiquidity and complexity premiums.
Navigating Macro Shifts
Importantly, alternatives are also well-positioned to navigate the shifting economic landscape marked by elevated inflation risk and tighter monetary policy. As J.P. Morgan notes, many alternative strategies employ less leverage and target companies with pricing power – key advantages in an inflationary environment.
Moreover, the flexibility of hedge funds and other liquid alternatives allows for dynamic portfolio positioning as conditions evolve. Direct lending and distressed debt strategies are primed to capitalize on dislocations caused by higher interest rates.
How Much Should Be Allocated to Alternatives?
Expanding the Opportunity Set
Traditional stock and bond portfolios are no longer expected to provide sufficient returns to meet long-term investment goals. According to experts, allocating 5-15% of your portfolio to alternative investments can enhance returns while managing risk through diversification. Alternative investment instruments like real estate, private equity, hedge funds and commodities have low correlations with public markets.
Determining the Right Mix
The optimal allocation depends on factors like risk tolerance, time horizons and existing exposure to alternatives. As per CFA Institute, institutional investors have steadily increased alternatives from 7.2% in 2008 to 11.8% by 2017, with some allocating over 50%.
A phased approach spread over 3-5 years is recommended to build the target mix gradually. For a 30% target, allocating 7-8% per year can achieve this while benefiting from vintage year diversification. Liquidity needs should be balanced, as alternatives involve lock-up periods.
Managing Liquidity Constraints
While alternatives are relatively illiquid, the market has evolved with semi-liquid options. Morgan Stanley notes that interval funds, perpetual BDCs and non-traded REITs provide exposure to institutional strategies with improved liquidity profiles compared to direct alternatives.
Careful portfolio construction is needed, using cash flow modeling from CFA to manage capital calls and distributions. Overall, a 15-30% allocation range to alternatives is becoming an industry standard to optimize risk-adjusted returns.
Benefits of Adding Alternatives to a Portfolio
Key Benefits of Alternatives
• Alternatives provide diversification beyond stocks and bonds. With low correlation to public markets, alternatives can mitigate portfolio risk during market downturns.
• Alternative investments offer potential for higher returns. PE and VC provide access to fast-growing companies. Real estate and commodities benefit from supply constraints and rising replacement costs. Hedge funds utilize sophisticated strategies unavailable to traditional managers.
• Adding a 20-40% alternatives sleeve can materially improve a portfolio’s risk-return profile. Private real assets provide stable income with lower volatility.
Allocating to alternatives democratizes access to asset classes once restricted to large institutions. However, advisors should carefully evaluate liquidity needs, manager selection, and fee structures when incorporating alternatives into portfolios.
Potential Risks of Alternative Investments
• Alternative investments like private equity, hedge funds and real estate are inherently less liquid compared to traditional public markets. These assets generally lack an easily ascertainable fair market value, making it challenging to exit positions quickly without significant price discounts.
• Several alternative strategies employ leverage to amplify returns, which can magnify losses if markets turn unfavorable.
• Alternative investments have historically exhibited wide performance dispersion, with top-quartile managers dramatically outperforming their peers. Rigorous due diligence is crucial to identify skilled managers aligned with an investor’s strategy rather than chasing past returns.
• Many alternatives are structured as partnerships or pass-through entities, potentially creating unrelated business taxable income (UBTI) for tax-exempt investors like endowments or foundations.
Investors must weigh potential risks against expected returns when allocating to alternative investments.
Rather than cling to the traditional 60/40 portfolio split, modern investing wisdom urges us to reimagine our asset allocation strategy. By diversifying into alternative assets and private markets, we can reduce volatility and enhance returns. This seismic shift reflects our changing economic landscape and the maturation of once-exotic asset classes. Though change brings uncertainty, a willingness to evolve will serve us well. The investing climate now calls for creative thinking, judicious reallocation, and an openness to new paradigms. By rebalancing our portfolios, we rebalance risk. The future belongs to those who look beyond stocks and bonds.
