“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other person's mistakes of judgement.”
- Benjamin Graham
Time to tweak the 60/40 mix?
by Chris Amodeo
One of the main tenants of investing is diversification. You’ve heard the old adage - “don’t put all your eggs in one basket.”
By diversifying, you spread your risk across different asset classes, which helps to smooth a portfolios variability of returns. This has traditionally been achieved through a 60/40 mix of stocks and bonds. Over the past forty years this mix has performed quite well as stocks and bonds have both benefited from a number of factors: good economic growth, low inflation, falling interest rates and low correlation between the two asset classes. This was especially evident during recessions, when bonds demonstrated negative correlation to stocks.
In addition, since interest rates peaked in 1981 bonds have had a healthy tailwind of lower interest rates propelling prices higher. Stocks provided growth, bonds provided stability, income and downside protection.
Bonds have done an excellent job as a diversifier within a balanced portfolio over that time, primarily as a result of one key characteristic—duration, a bonds sensitivity to interest rates, which moves bond prices higher when interest rates head lower. This has been especially effective as central banks have cut rates over the past four decades, but with interest rates near zero, that tailwind is no longer available.
There are some people who believe interest rates in North America may go negative—as is the case in Europe, but let’s assume the long-term outlook is more likely higher. In addition to a longer-term view that interest rates should move higher, central banks are printing more and more money as a result of COVID-19 — arguably increasing inflationary pressures.
So, where do we go from here…
Because bond yields are just off their record lows and equities at record highs as I write this, we are led to look at the validity of the traditional 60/40 portfolio and ask if changes to the mix are needed to meet investors income and return objectives going forward. Bank of America, JP Morgan and Morgan Stanley have all warned that “a typical 60/40 mix is broken in a zero-interest rate environment and will be required to be tweaked to generate sufficient yield.”
So, how do investors protect portfolios for the days ahead?
We believe investors should consider fine-tuning portfolios and consider the addition of uncorrelated and/or alternative asset classes to help portfolios balance risk and return moving forward.
Alternative and uncorrelated investments are a broad asset class and in some cases are not an apple to apples replacement for core holdings within a portfolio. Alternatives are intended to compliment traditional holdings as each strategy will play a different role with their own idiosyncratic features. Generally speaking, the characteristics of alternative investments are, low correlation, downside protection, income generation, and enhanced returns. Consequently, the addition of alternatives may provide increased income and enhanced returns and broader diversification than a traditional 60/40 mix for the years ahead.
Some examples of investment alternatives
There is a long list of options in the broad asset class of alternative investments. Some examples are private equity, private credit, infrastructure, and real estate. You can even consider other investments such as gold, commodities, hard assets, inflation-protection or different equity style factors like increasing holding outside North America in foreign countries and currencies or, in a less followed asset class like international small caps or long/short credit. These alternatives are useful building block and are great way to bridge the gap between equities and fixed income in a low and rising interest rate environment.
How alternatives benefit portfolios
Alternatives are a complement to stocks and bonds, rather than a wholesale substitute—but what is the best mix?
Blackrock published a paper that looked at the benefits of adding alternatives to a 60/40 portfolio, keeping an eye on volatility. They studied a classic portfolio of 60% global stocks and 40% fixed income which displayed annual volatility of 8.7% over the past 5 years.
They forecast the same portfolio will show a slightly higher rate of volatility going forward at 9.0% as a result of increasing risks, and overall lower returns for stock and bonds. They looked at a number of combinations bearing in mind volatility and the best. outcome was 50% equity, 30% fixed income and 20% alternatives. Adding a 20% sleeve of alternatives — by moving 10% out of equities and fixed income — lowered the overall portfolio’s expected volatility to 8.5%, even lower than the past 5 years.
The bottom line…
The 60/40 portfolio has served most investors very well over the past four decades, during a declining interest rate environment. Both stocks and bonds have benefited and appreciated in value, but with interest rates near zero, there is not a lot of wiggle room ahead. Interest rates would need to go negative to help bonds appreciate in price, something the Fed has stated they do not want to occur.
Therefore, we feel investors should consider different asset classes and other fixed income alternatives, to improve the risk return profile of portfolios.
Please reach out if you are interested in discussing your portfolio to make sure its properly positioned. Call me at 416-369-8526 or email email@example.com. We believe a slight tweak to the traditional mix will help to increase diversification, potentially increase income and better position your portfolio for what lies ahead. Make sure you don’t miss any of my posts. Follow the blog and you’ll receive email notifications every time a new post is published.
Chris Amodeo is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Chris Amodeo do not necessarily reflect those of CIBC World Markets Inc. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.
Commissions, trailing commissions, management fees, and expenses may all be associated with hedge fund investments. Hedge funds may be sold by Prospectus to the general public, but more often are sold by Offering Memorandum to those investors who meet certain eligibility or minimum purchase requirements. An Offering Memorandum is not required in some jurisdictions. The Prospectus or Offering
Memorandum contains important information about hedge funds - you should obtain a copy and read it before making an investment decision. Hedge funds are not guaranteed. Their value changes frequently, and past performance may not be repeated. Hedge funds are for sophisticated investors only.