Alts may provide the lift 60-40 portfolios need

Despite the long and storied history of the traditional 60-40 balanced portfolio, it’s quickly losing its importance as a reference point for the wealth management industry as modern markets and new realities pave the way for the latest evolution in diversification.

Equity markets are at record levels while bonds are paying next to nothing, and in some cases even providing negative yields. Cash and cash equivalents are finding it impossible to keep pace with the persistence of inflation.

Thus, the gates are swinging open once again to the mysterious and often perplexing world of alternative assets, where fees can be higher, strategies can be more complex and not all investors qualify for entry.

“I would bet a meaningful number of people allocated to a 60-40 portfolio should be in a higher risk profile to meet their long-term needs,” said Jim McDonald, chief investment strategist at Northern Trust.

In the yin and yang of investing, risk is typically coupled with returns, which is the point that big thinkers like McDonald are leaning into these days.

“The last five years have been extraordinarily positive for the equity markets, and you will be hard-pressed to find a return forecast for the next five years that comes close to what we’ve experienced over the last five,” he said. “The asset allocation has got to be driven by clients’ needs and risk tolerances.”

LOFTY LEVELS

The case for lofty levels in equity markets, which have been on an unprecedented and seemingly oblivious run since the financial crisis almost a dozen years ago, is more apparent with each passing day. It’s the fixed-income side of the portfolio where most experts are having a hard time justifying anything that resembles a traditional portfolio.

“If you were just looking at a return-based portfolio, you wouldn’t own fixed income right now,” McDonald said. “With the bond bull market over the last 20-plus years, it’s gotten harder to make a case for the return of fixed income, so that case for fixed has got to be based on liquidity or diversification.”

READ THE SIDEBAR: Tech platforms ease investing in alts

While the concept of alternative investments is way too general to be referred to as a single investment strategy or even asset class, the message is getting louder that the old blend of stocks and bonds alone is no longer expected to be enough.

“We use alternatives as a bond replacement,” said Ashton Lawrence, partner at Goldfinch Wealth Management.

“We look for those alternative investments that have a low volatility, similar to a bond, but they won’t be as interest-rate sensitive,” Lawrence said. “This allows us to still have an anchor to the portfolio with the potential for more upside than a traditional bond.”

Jeffrey Nauta, principal at Henrickson Nauta Wealth Advisors, uses alternatives as a diversifier for both stocks and bonds.

“These asset classes might be illiquid, complex, or have some other hair on them,” he said, citing everything from private real estate and farmland to reinsurance and cannabis lending.

“There are a growing number of interval funds that allow for easier implementation,” Nauta said. “We’ve also structured commingled partnerships to meet minimums and access unique asset classes for clients.”

Stuart Katz, chief investment officer at Robertson Stephens Wealth Management, describes the three primary purposes of alternatives as “the opportunity to dampen volatility, enhance returns and provide diversified forms of alpha.”

“Alternative investments should be assembled by understanding how they work together with a traditional portfolio,” Katz said. “The current environment of low yields, elevated valuations, excess liquidity in the marketplace and uncertainty regarding Covid creates a need for alts to complement a core traditional portfolio.”

BLEAK PICTURE

A recent report by J.P. Morgan Asset Management painted a particularly bleak picture of traditional stock-and-bond portfolios in the wake of the global pandemic, especially when it comes to fixed income.

“The impact on government bond yields of ultra-low interest rates is clear: over 85% of developed market government bonds are yielding below 1% and around 35% deliver negative yields,” the report states.

To be fair, the old-school portfolio of 60% stocks and 40% bonds is not a complete waste of time and effort, and its flaws are clearly being oversimplified for the sake of a good punching bag.

Since 2008, for example, the 60-40 portfolio has delivered just two years of negative returns.

The old workhorse 60-40, which is likely closer to 70-30 these days for average investors, also holds up well when looked at from a historical perspective.

According to a basic illustration by Vanguard Group, looking at the risk-return profiles of various stock-bond allocations between 1926 and 2019, you generally get what you pay for by adjusting the stock-bond exposure.

At one extreme, an all-bond portfolio produced a 6% average annual return and suffered 19 negative years over the 94-year period. The best year for the all-bond strategy was a gain of 45.5% in 1982, and the worst year was a loss of 8.1% in 1969.

ALL-STOCK PORTFOLIO

At the other end of the spectrum, the all-stock portfolio had an average annual return of 10.2%, with 25 negative years over that period. The best year for all-stocks was a 54.2% gain in 1933, and the worst was a loss of 43.1% in 1931.

Even if past performance was indicative of future returns, dumping bonds and loading up on stocks wouldn’t be a prudent strategy for investors in or near retirement, who need income and don’t have the benefit of time on their side. And most investors would not be able to stomach the volatility of an all-stock portfolio.

As the J.P. Morgan report states: “Low government bond yields leave investors with significant challenges when creating a balanced portfolio … Shifting to a much higher equity allocation to boost returns, such as an 80-20 portfolio, would require the acceptance of considerably higher volatility, which may be particularly uncomfortable for investors with shorter-term savings objectives.”

A better strategy, according to the report, would be to “maintain a flexible fixed income exposure” supplemented with alternative investments such as real estate, infrastructure and certain macro strategies.

Creativity is key, said Steve Skancke, chief economic adviser at Keel Point. Even though he admits there has been “waning interest from investors to diversify into alternatives” during the decade-long bull market run, he said the appeal is growing.

Skancke said a typical 60-40 portfolio today should be adjusted to hold 20% traditional fixed income, 15% diversified alternatives and 5% cash on the fixed-income side. The equity side, he said, should be made up of 25% to 30% U.S. equities, 15% to 20% international equities, and 15% alternatives.

Christopher Zook, chairman and CIO of CAZ Investments, said demand for alternatives is “as robust as ever.”

“Investors and advisers are clamoring for alts because the market is wildly overvalued by any metric and fixed income doesn’t give you anything,” he added. “The 60-40 model is dead because you can’t get the risk mitigation or yield you are looking for, so the adviser can choose to be proactive or reactive.”

Zook, who sits on the Texas Pension Review Board, which the monitors the state’s 100 public pension funds, said all but two of those funds are “increasing allocations to alternatives and plan to do so for the next five years.”

“And those two funds that aren’t adding to alts are considering it,” he added.

Of course, supporting the idea of alternative investments and getting a seat at the table are often two very different things.

‘BIGGEST THEME’

Zook said his $2.4 billion multifamily office gets alternative exposure through 40 different direct ownership stakes in private equity firms as “our biggest theme.”

“We want to own the businesses that will benefit from money flows coming to them,” he said.

But not every financial adviser has the wherewithal or clout to gain access to the best alternative investment managers or strategies.

“It’s fairly difficult to find anything right now because everything is expensive,” Zook said. “We look at 1,500 investments a year. There are good ones and ones that are not investible.”

McDonald of Northern Trust also acknowledged the challenges and the need for extreme caution when considering alternative investment opportunities.

“When you’re dealing with alternatives, you have to ask yourself why you are gaining entry,” McDonald said. “You might just be getting access to a fund that nobody else wanted, because the best ones are hard to get into.” That’s coming from an executive at a firm managing $1.1 trillion, including $10 billion in private equity and hedge fund investments.

“We spend years building relationships with the best private equity and hedge funds just to get access to one of their funds,” McDonald added.

So what does that mean for the humble financial adviser with a few hundred million under management?

Well, the alternatives market in various forms continues to try and tap into the broader financial advisory space, and technology is providing a big assist. But even as technology is helping to solve some issues, access to most pure alternative investments is still limited to wealthy investors.

While the Securities and Exchange Commission last year expanded access to alternatives to individuals with certain credentials defined as knowledgeable, most access is still restricted to accredited investors with at least $1 million worth of investible assets, and qualified purchasers with at least $5 million worth of investible assets.

LIQUID ALTS BACK ON MAP

That leaves the majority of investors to get along with the universe of liquid alternatives, which are registered funds that employ alternative investment strategies.

While liquid alternative investments have been around in various forms for decades, the big splash for the category came in the wake of the financial crisis: Alts gained steam around 2015 but never really impressed investors who wanted stronger performance and lower fees.

But according to Morningstar, the uncertainty created by the global pandemic somehow put liquid alts back on the map.

Through the first six months of 2021, liquid alt funds tracked by Morningstar had a record $14.1 billion worth of net flows. That compares to net inflows of $552 million for all of 2020, $1.8 billion worth of net outflows in 2019, and $5.1 billion worth of net outflows in 2018.

“Generally speaking, since about 2013 liquid alts have been a disappointment in terms of returns,” said Erol Alitovski, senior manager research analyst at Morningstar.

“But since 2020, we’ve seen a bit of a revival,” Alitovski said. “We’ve seen pretty decent recent performance, some good inflow traction, and for the first time in long time we’ve seen more funds launched than shuttered, globally.”

While the liquid alt category is evolving and improving, it’s also the only show in town for advisers who recognize the value of alternatives but can’t access to big hedge funds and other private investments.

This should pave the way for liquid alts, Alitovski said. “The market environment is changing,” he said. “Liquid alts could do well.”

At Envestnet PMC, the strategy with alternatives is to hedge all bets. With liquid alts already on the platform and making up 2% of all flows over the past 12 months, Envestnet is turning up its alternatives game by partnering with iCapital to offer access to private investments like hedge funds.

“It speaks to the increased demand for hedge funds and private markets,” said Dana D’Auria, co-chief investment officer at Envestnet. “Clients have asked for access to alternatives,” D’Auria added. “Over time, with the increase in interest, we knew we needed a solution in this area.”