For generations, the cornerstone of asset allocation has been the 60/40 portfolio – comprised of 60 percent equities and 40 percent fixed income. This balanced mix provided investors with a straightforward, time-tested approach: equities served as the growth engine, while bonds offered stability, income, and diversification, especially during periods of equity market stress. The negative correlation between stocks and bonds was the defining feature that made the 60/40 mix both durable and intuitive.
Yet the post-Covid-19 market environment has challenged many of the assumptions that underpinned this traditional model. Forces related to fiscal expansion, supply-chain dynamics, and broader structural shifts have now fundamentally reshaped the relationships that once governed this allocation.
These developments point toward an evident conclusion: the 60/40 framework may no longer be sufficient on its own, and investors need a more expansive portfolio construction toolkit to meet their needs and objectives – one that increasingly relies on the use of alternative investments.
A key objective of investing in bonds is to hedge equity risk. But persistent and high inflation erodes not only the value of bonds but violates the low-to-negative historical correlation that bonds provide relative to equities.
Recent years of stimulus, strong consumer demand, and widespread supply-chain challenges created an inflationary environment that we haven’t witnessed in some 40 years. While inflation has eased from these peak levels, it remains stubbornly elevated, calling into question the dependability of using bonds as a passive diversifier within an investor’s portfolio.
An example of how impactful the collapse of the stock/bond balance can be was on display in 2022. The 60/40 relationship had one of its worst performances on record, having generated a loss nearly equivalent to being invested solely in the S&P 500 Index.
Stocks also have their own challenges with inflation, but what’s at the forefront of investors’ concerns is different, yet equally significant. Equity market performance is increasingly dominated by a group of mega-cap technology companies that now comprise nearly 40% of the S&P 500 composition. Investing in equities today seems to resemble a concentrated bet on a handful of companies.
But there’s more to the concentration story for investors. The investable public-equity universe itself has shrunk dramatically. In fact, over the past few decades the availability of public companies has been cut in half. And to compound the availability issue, private companies are delaying entry to public markets.
Back in the late ’90s and early 2000s, companies were staying private on average 4-5 years before pursuing an IPO. Nowadays, that figure extends to well over 10 years, meaning traditional investors are left on the sidelines during the substantial value creation period that comes about in the early stages of these businesses. It also limits investors’ ability to diversify their portfolio with different industries and sectors that may be underrepresented, if available at all, in public markets.
Rethinking the 60/40 portfolio does not require abandoning its core principles. The framework still offers a disciplined foundation for investors seeking growth, income, balanced risk, and diversification. But as modern portfolio theory reminds us, achieving these objectives requires combining assets with low correlations to help maximize returns and mitigate risk. And as we have outlined, in an environment defined by inflation uncertainty, rate volatility, declining public-company breadth, and extraordinary equity concentration, investors must increasingly consider opportunities beyond the limitations of traditional assets.
Enter alternative investments.
Source: J.P. Morgan Asset Management, Guide to Alternatives.
Allocating to alternative investments provides investors with differentiated sources of income, growth and diversification at a time when traditional assets face headwinds. To appreciate their role, it’s helpful to frame what alternative investments are and highlight the compelling nuances for portfolio inclusion.
For simplicity, alternatives can be split into two main types: private assets and public asset opportunities.
A simple defining characteristic of private assets – such as private equity, credit, real estate, and infrastructure – is that these asset classes focus on opportunities that do not trade on a public exchange such as the NYSE. But this lack of trading is exactly what makes these investments fascinating, as private investments generally provide relatively greater diversification benefits and return potential when added to a traditional portfolio.
These investments do not freely trade on an exchange; that lack of trading means we do not feel the impact of immediate price discovery. Since investors’ sentiment is not the driving force behind performance, assets are priced at fundamental value, typically on a quarterly basis – investors therefore can naturally benefit from lower levels of volatility within their portfolios.
Importantly, lower risk doesn’t mean sacrificing return potential. First, managers in the private markets have a significant leg up on their opportunity set. Approximately 87% of U.S. companies that generate $100M+ in revenue are privately held*. Second, managers often focus on investing in fragmented markets, which tend to be less efficiently priced in general. Managers with sourcing advantages and experience in complex scenarios have competitive advantage to generate additional return “premiums” not afforded in traditional asset classes.
Also, due to the fact that these positions are not freely available to exit on an exchange, investors demand a higher level of return for bearing such risk, which is known as an “illiquidity premium.” These added sources of return can be quite meaningful – ranges will vary by study, but an additional 2‒5% a year above comparable traditional asset classes is a realistic expectation for investors.
The second type of alternative asset types is relatively straightforward: strategies that mainly invest in public market opportunities, e.g., stocks, bonds, and cash, such as hedge funds. While these strategies focus on investing in public markets, they do so in a much more complex manner, often relying heavily on short selling or leverage to drive returns, providing increased diversification and return potential relative to the long-only approach of traditional strategies.
With an enhanced opportunity set and unique risk and performance drivers, the inclusion of alternative investments provides investors with the potential to increase returns in their portfolio while maintaining, if not lowering, overall risk.
Rob Kane is the director of alternative investments at Commonwealth Financial Network, member FINRA/SIPC, a Registered Investment Adviser–independent broker/dealer.
*Source: S&P Capital IQ, Apollo Chief Economist. Note: For companies with last 12-month revenue greater then $100 million by count.
This material has been provided for general informational purposes only and does not constitute tax, legal, or specific investment advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a qualified professional regarding your situation. Commonwealth Financial Network does not provide tax or legal advice.
Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Diversification and asset allocation do not assure a profit or protect against loss in declining markets, and cannot guarantee that any objective or goal will be achieved. Past performance is no guarantee of future results.
Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. There is no assurance that the investment objective will be attained.
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