Should investors be building a new strategy for the next decade?

Some professional investors think the 60/40 portfolio model is outdated. We explore how investors can strengthen their portfolio using alternative assets, including naming the types of funds and investment trusts for investors to size up.  

The rationale for the traditional 60/40 balanced approach to portfolio modelling is that stocks and bonds have historically moved in opposite directions during times of market stress.

Indeed, prior to 2022, 60% in shares and 40% in bonds, successfully delivered positive returns in 35 of the previous 41 years, based on Bloomberg calculations.

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Last year, as we know, was very different, as stocks and bonds both lost money in 2022. The Bloomberg US Aggregate Bond Index fell by nearly 17%, while the S&P 500 suffered its seventh-worst year since the 1930s.

Reasons for balanced approach remain intact

But despite last year’s poor performance, the long-term arguments for the balanced portfolio remain intact. Janus Henderson Investors point out that 2022 was highly unusual, and that although correlations often rise over very short-term periods, if you take a multi-year view, stock-bond correlation has been close to zero. Additionally, 60/40 portfolios have historically recovered sooner than equity-only portfolios.

BlackRock has noticed, however, that both stocks and bonds tumbled in the late-1960s, a climate much like today’s with loose monetary policy, generous fiscal stimulus, and energy supply disruptions sparking higher inflation. So, BlackRock argues, bonds may be a reliable diversifier when economic growth is slowing – but not necessarily when inflation is rising. 

Whether a balanced portfolio will work well today, then, depends on whether inflation has peaked. While most of the increase in rates has already taken place and bonds are now offering some of the most attractive yields since the financial crisis, they remain low by historical standards.

 “Looking forward, inflation is showing signs of rolling over but there remain questions given extremely tight labour markets in many geographies,” says Peter Webster, multi-asset portfolio manager at Janus Henderson.

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He adds: “Central banks are expected to start cutting interest rates later this year, or early next, but it is unlikely that interest rates will revisit their lows of recent times. As such, equity market multiples are unlikely to hit their peaks of recent years and fixed income returns are likely to come more from yield.” 

Adding alternatives to the mix

Certainly, supercharged returns in the years ahead are less likely. Many fund managers have therefore increased their exposure to alternative investments, both to ramp up returns, as well as for greater diversification. JPMorgan estimates that the proportion of alternative assets in the total investment universe has increased from 5.5% in 2003 to 15.3% today, a meaningful part of the investment landscape. Investors building a portfolio could start with this number in mind and have an allocation of between 10% and 20% to alternatives, says Webster.

Dzmitry Lipski, head of funds research at interactive investor, suggests limiting exposure to alternatives to 10%, but says even this small an allocation could improve the risk-return characteristics of a portfolio. “Alternatives on their own may have higher volatility than more conventional asset classes so should be used mainly for satellite allocation, ie no more than 10%, in a well-diversified global portfolio,” he says.

Lipski adds that alternative assets “typically have low correlations with global equities”, so therefore their inclusion in an investment portfolio “tends to result in lower overall volatility”.

A wide range of assets and strategies can be deployed for different benefits. For example, physical assets such as infrastructure or renewables can generate attractive cashflows and importantly these cash flows are often inflation-linked, protecting income streams in real terms. 

Music royalties, for example, harness the increasing prominence of streaming revenues and the recurring revenue potential with a low correlation to economic activity. Hipgnosis Songs (LSE:SONG), which owns around 65,000 songs, is currently trading at a 50% discount to its NAV, with a 6.5% dividend yield.

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Real estate should also be considered, despite the rise in mortgage costs. According to Invesco, there have been 10 years between 1978 and 2021 when the Federal Reserve had a clear policy of raising rates, and US private and public real estate outperformed equities and bonds in seven and six of those years respectively.

Robin Willis, fund manager of Premier Miton Defensive Growth, points out that as with any asset allocation decision, return targets, risk tolerance and time horizons will need to be taken into account.

“For example, if investors were looking for downside protection in times of high market volatility they may consider a global macro hedge fund, which could exploit those market conditions.”

Some of these strategies are available to retail investors in the absolute return fund sector.  

If income is the priority, Willis says adding an allocation to infrastructure with inflation-linked revenues might be considered. 

He adds: “Although the objective of the alternative asset positions is to increase diversification and reduce risk, that is not to say the individual positions themselves are without risk.

“The difference is that the risk is more idiosyncratic than that of equity and bond positions, which tend to be more sensitive, especially in the short term, to market movements.”

Investment trust structure best fit for alternatives

Willis recommends using investment trusts for exposure to alternatives, owing to the permanent capital nature of these vehicles and the ability to buy and sell shares despite the often less liquid characteristics of the underlying assets. “We currently have allocations to sectors such as renewable energy generation, battery storage projects, digital infrastructure and music royalties,” he says.

Many of these investment companies are trading at discounts to their valuations, creating an attractive opportunity to gain exposure to alternative asset classes often with secular growth dynamics and high inflation linkage.

Investors looking for new sources of return might also consider funds that deploy shorting strategies. Long/short strategies target the entire opportunity set by going long companies they predict will outperform and going short companies that could flounder.

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By structuring the portfolio so that long and short positions are more or less matched, or ‘market neutral’, the return stream should capture the differences between winners and losers across the market, known as ‘security dispersion’. Long/short strategies should work in the current climate because they thrive in high dispersion environments irrespective of market direction. Many of these funds are aimed at institutions but for retail investors, BH Macro (LSE:BHMG) is one option.

Private equity oversold?

Private equity is another alternative asset to size up. Webster points out that “given its ability to generate returns in excess of listed markets, investors should consider private equity trusts.

He says: “We believe that the vast sums raised by private equity in recent years means it is now a key asset class. These sums also allow businesses to stay private for longer, allowing companies to stay private during their higher growth phases and only coming to listed markets when more mature.”

Private equity trusts have been sold-off heavily recently by concerns about rising interest rates and valuations on the unlisted holdings – most of their current net asset values (NAVs) are based on September valuations when equity valuations were at their worst. Nervous investors are factoring in that it is harder to take a guess at what they’re worth. This has hit trusts such as Chrysalis (LSE:CHRY), HgCapital (LSE:HGT) and HarbourVest (LSE:HVPE), but Numis and other analysts believe the trusts have been oversold.

Alternative assets should be small part of a portfolio

The potential illiquidity of alternative assets is still a hurdle, however, and is viewed by some fund managers as an unnecessary risk. “If there is enough opportunity in liquid vanilla assets, the merits of often esoteric illiquid areas is less clear to my mind,” says Kelly Prior, investment manager on the multi-manager team at Columbia Threadneedle Investments.

She says: “The type of asset that investors should be leaning into are simply active ones that are able to look under the bonnet of company balance sheets and win out in a world of higher inflation and interest rates.

“Diversifying into areas such as music royalties, niche property, and asset-backed lending can complement returns, but if core markets have enough dispersion of opportunity set at the granular level the complexity and illiquidity premiums needed to make these worthy investments means they are always at the periphery of portfolio construction to my mind.”