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The Rise of Alternatives and the New 60/40 Portfolio

May 03, 2023 | David Adler

The 60/40 portfolio—60% equity, 40% bonds—historically was the standard model for asset allocation. The intuition underlying this portfolio strategy is one of diversification: when equities fall, the bond portion of the portfolio provides stability, offsetting the equity decline. The 60/40 model has long been unquestioned as a dependable way to achieve stable returns. Market shifts in 2022 changed that thinking.

In 2022, both equities and bonds declined significantly: -19.44% for equity (S&P 500 Index) and -13.01% for bonds (BBG Barclays US Aggregate Bond Index). In simplest terms, the 60/40 portfolio stopped working, and investors experienced large drawdowns. Investors were left to wonder why traditional portfolio diversification failed and how they could better protect their portfolios in the future.

To help address these questions, XA Investments organized an expert panel discussion on February 15, 2023 at the New York Stock Exchange to re-examine the 60/40 portfolio and identify better strategies for asset allocation going forward. The panelists shared their broad range of perspectives:

  • • Brian Chiappinelli, Managing Director, Cambridge Associates
  • • Michael O’Malley, Real Estate Professor, University of Notre Dame
  • • Nathan Shetty, Head of Multi-Asset, Nuveen
  • • Moderator: Kimberly Flynn, Managing Director, Alternative Investments, XA Investments

The overwhelming consensus of the panel was that a 60/40 portfolio could still be successful, but the definition of “equity and bonds” needed to be expanded to include alternative investments to help achieve improved diversification and higher potential returns and downside protection.

Panel moderator Kim Flynn of XAI said, “With the negative performance of both stocks and bonds in 2022, many investors are considering using alternatives to replace traditional investment exposures. For example, investors might replace trading from fixed income allocations to high yield bonds with an alternative income option that might offer higher yields, diversification potential, and less duration risk.”

A related theme of the event was to highlight recent advances in product design which allow investors to implement the “new 60/40.” Alternatives are now more accessible than ever to a broad range of investors, leading to a potential revival of a 60/40 allocation, albeit one redefined to include more alternative asset classes.

While the traditional 60/40 has bounced back somewhat in Q1 2023, the experience of 2022 and the need for increased diversification within the portfolio remain at the forefront of investors’ and managers’ minds. The BlackRock Investment Institute recently issued a report on April 17, 2023 warning, “We don’t see the return of a joint stock-bond bull market. We think strategic allocations of five years and beyond built on these old assumptions do not reflect the new regime we’re in.”

New Asset Classes

Flynn also pointed out that individual investors tend to be highly reliant upon the traditional 60/40 portfolio, despite its limitations. Nuveen’s Nathan Shetty, who pronounced 2022 a “bloodbath for 60/40,” drilled more deeply into some of the traditional allocation’s inadequacies.

“60/40 is an arbitrary stock/bond split; it doesn’t consider the intra-asset class composition, objectives, constraints, or risk tolerances and most importantly it doesn’t reflect changing risk, return and correlation,” he said.

Shetty argued for the need for an expanded asset class mix for investors, particularly in fixed income: “Going forward, I don’t see bonds being the unicorn asset they were over the last 40 years. Correlations are likely to be positive with equities. We need to seek ballast elsewhere – cash, real assets, commodities, and long vol/trend following strategies seem like compelling alternatives.”

Shetty also pointed to the attractiveness of private credit, both for ballast and as a source of income. “Private credit is particularly relevant to the recent economic backdrop. These are typically floating rate structures and so could participate in rising rates,” Shetty said.

Though Shetty himself avoids the 60/40 framework, instead taking a more granular approach focused on factors and geography, many other conference participants found immense value in the simplicity of the 60/40 allocation, but one now redefined to include alternative investments.

“Today’s tools are more sophisticated than when 60/40 was devised,” said Brian Chiappinelli of Cambridge Associates. “The 60/40 split hasn’t changed but the exposure to alts will increase relative to history.”

Real estate may also fit into the new 60/40 portfolio. “It is the largest asset class in the world, and is a meaningful part of a diversified portfolio as it has the ability to provide depreciation-shielded current income with long-term appreciation,” said Michael O’Malley of Notre Dame in his presentation. He further noted that real estate itself is a highly variegated asset class. Today’s investors also have new choices in how to access real estate. “Sophisticated investors have the ability to build real estate portfolios through direct investments, private funds, and publicly-traded and private REITs,” O’Malley said.

Increased Access to Alts Drives New Portfolio Construction

A consistent theme of the conference was that this new, more diversified 60/40 is now available to individual investors. “Modern advancements in product design make these allocation decisions easier and allow individual investors to access a broader set of alternative investment options,” Flynn said.

This increased accessibility of alternative investments stems from three drivers, according to Chiappinelli:

  • • Regulatory regime updates: “The SEC guidelines changed, expanding the definition of an accredited investor [thereby increasing the universe of those who can invest in alts],” he said.
  • • Financial management trends: “There is increased understanding by financial managers of how to explore alternatives within a vehicle,” Chiappinelli said.
  • • Improved vehicles: Here Chiappinelli pointed to the explosion in the number of structures that hold alts, including both listed and non-listed closed-end funds, such as interval funds, and collective investment trusts (CITs).

Not only is access to alternatives more viable than it was in the past, but alternative investments are also more prominent, leading to increased demand from individual investors. “Ten years ago, nobody talked about private investments. Now, social influencers have exposed investors to venture capital [and the like],” Chiappinelli said.

Much of alternatives’ higher historical returns derive from an illiquidity premium. This brings a new dimension – and potential caveat – to constructing a portfolio using these new vehicles. Interval funds offer only partial liquidity (typically via quarterly share repurchases), which can be particularly noticeable during a crisis. Allocators need to be aware of this potential for illiquidity, Chiappinelli said, regardless of how the product is sold. Nonetheless, he said, “Cambridge Associates has been a strong advocate for alternatives. We have seen this on the institutional side and now the retail side.”

And there is another fund structure which offers liquidity in a traded form, namely publicly listed closed-end funds. Kim Flynn closed the conference at New York Stock Exchange pointing to the elegance of this vehicle in its ability to hold illiquid alternative investments while offering liquidity by trading on an exchange.

Disclaimer

The information in this publication is provided as a summary of complicated topics for informational and educational purposes and does not constitute legal, tax, investment or other professional advice on any subject matter. Further, the information is not all-inclusive and should not be relied upon as such.

Illiquid investments are designed for long-term investors who can accept the special risks associated with such investments. Interval and tender offer closed-end funds are not intended to be used as trading vehicles. Unlike open-end mutual funds, which generally permit redemptions on a daily basis, interval and tender offer closed-end fund shares may not be redeemable at the time or in the amount an investor desires. Listed closed-end funds frequently trade at a discount to the fund’s net asset value. All investments involve risks, including loss of principal. Investors considering an allocation to alternatives should evaluate the associated risks, including greater complexity and higher fees relative to traditional investments. Investors should carefully weigh the diversification benefits, expected returns and volatility of alternatives relative to traditional investments. Investments in alternatives involve risks, including loss of principal. Performance data quoted represents past performance. Past performance does not guarantee future results. Current performance may be lower or higher than performance data quoted. Diversification does not eliminate the risk of experiencing investment losses. You should not use this publication as a substitute for your own judgment, and you should consult professional advisors before making any investment decisions.

This publication may contain “forward looking” information that is not purely historical in nature, including projections, forecasts, estimates of market returns, and proposed portfolio compositions. There is no guarantee that any forecasts will come to pass. This information does not constitute a solicitation of an offer to sell and buy any specific security offering. Such an offering is made by the applicable prospectus only. A prospectus should be read carefully by an investor before investing. Investors are advised to consider investment objectives, risks, charges and expenses carefully before investing. Financial advisors should determine if the risks associated with an investment are consistent with their client’s investment objectives.

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