The 60/40 portfolio is dead. Long live liquid alternatives? Some investment managers suggest replacing or at least heavily supplementing the classic 60/40 stocks-and-bonds allocation with liquid alternative investments. They hold that future returns won't resemble past ones and that 60/40 won't deliver the results investors need — for two reasons.
First, today's low bond yields can't drive returns or provide diversification the way higher yields do. Investors shouldn't expect the same performance starting with bond yields in the low- to mid-200 basis-point range versus starting with those 400 to 500 basis points.
Relatively high equity valuations are the second problem. Bob Rice, managing partner at Tangent Capital Partners, cites the Shiller P/E, gross domestic product-to-market cap and other valuation metrics as evidence of the expensive market.
“That doesn't necessarily mean the stock market will crash, but it does mean that unless you throw history out the window, the stock market is going to give you extremely modest expected returns from here,” Mr. Rice said.
Still, there is disagreement about 60/40's pending demise.
Fran Kinniry, senior investment strategist with the Vanguard Investment Strategy Group, pointed out that some market observers always believe the future will be very different from the past.
Nonetheless, Mr. Kinniry said, simple portfolios with long-only, publicly traded equities and bonds have been competitive historically and are likely to remain so.
The argument for 60/40 is that it can provide diversification, downside protection, upside participation and income. Achieving those results now requires adopting more flexible strategies, particularly liquid alternatives, said Steve Blumenthal, chief executive of Capital Management Group Inc.
A portfolio that Mr. Blumenthal calls the new 60/40 would include 30% equities (usually hedged with options); 30% fixed income, using flexible-strategy exchange-traded funds; and 40% of what he describes as liquid, tactical funds.
Mr. Blumenthal uses a price momentum strategy with the alternatives and shifts funds to assets showing the strongest price momentum. That discipline is a better way for advisers “to tackle the environment,” he said.
If future real returns are lower, which Mr. Kinniry believes they will be, “the forward-looking portfolio of 60/40 is not all that much different than the past,” he said. “It's just that we are in a lower-inflation world.”
PORTFOLIO CONSTRUCTION
Mr. Rice advises a 20% to 40% overall allocation to liquid alts; much below that range and the results won't matter for the portfolio. Within alternatives, he applies two strategy classifications: timeless and tactical. Timeless strategies make sense in every environment, while tactical strategies function best in particular scenarios.
As one timeless strategy for equities (which also happens to be ideally suited for the current market), Mr. Rice recommends high-quality long/short funds.
“You can get long/short strategies in a "40 Act mutual fund for very modest fees, with very high-caliber managers,” he said. Multimanager, multistrategy funds can serve as a core holding because the manager can rotate among strategies, including tactical ones that most advisers can't access directly, he added.
Activist investment is attractive and can potentially outperform the market, Mr. Rice said. Accessing such strategies outside a private placement is difficult for many registered investment advisers but easier for funds.
“A lot of the better multimanager, multistrategy mutual funds have substantial exposure to underlying activist investors,” he said. “They take their money and allocate it on a separately managed account basis to, say, an active manager.” Because the funds have a flexible investment mandate, the manager can rotate to the next strategy when activism has run its course.
Currency-based global macro strategies are appealing because they historically have performed well during periods of volatility, Mr. Rice said. As quantitative easing wanes and volatility returns, he added, such funds will “return to the fore.”
POTENTIAL PITFALLS
In addition to choosing the appropriate strategy, advisers must consider fund fees and manager performance.
Fees are declining because of industry overcapacity, but it's still necessary to monitor the markup imposed at each level in the asset management chain, according to Verne Sedlacek, president of the Commonfund Institute.
Advisers or the investment managers they hire also must identify the best managers in a category. Access to top managers is vital “because the spread between the best and the worst performers is much wider than it is in pubic equity or fixed income,” Mr. Sedlacek said.
There's good news on the manager performance-tracking front, according to Mr. Rice.
In October, Wilshire Associates Inc. began publishing five targeted liquid-alts subindexes to accompany the broader index it started in August. The new indexes are a “big step forward in helping provide tools that let you evaluate the substrategies and pick the managers better,” he said.
But are liquid alts right for everyone?
Jerry Miccolis, chief investment officer of Giralda Advisors, believes they belong “uncategorically in every portfolio.” He has used alternatives for over 20 years, and his clients' portfolios usually have a 20% to 30% allocation to them.
Giralda uses liquid and “traditional” alts — assets other than equity or fixed income, such as commodities and master limited partnerships, Mr. Miccolis said. Some liquid-alts categories are getting “crowded out” by better-performing alternatives, he said.
For example, Mr. Miccolis said, some risk-parity strategies struggled because they hold too much fixed income in light of a “multidecade
bear market for fixed income.”
Other funds may have become victims of scale.
“Strategies that work for a limited audience in illiquid form, once they become liquid and everybody piles into them, you get diseconomies of scale,” he said. “There's some of that going on, I suspect. And some others are just not well-executed strategies. So, it's a mix.”
Ed McCarthy is a certified financial planner and freelance writer.
