Opinion: The 60%-40% portfolio will produce anemic returns over the next decade — here’s how to adapt

If the outlook for the 60/40 allocation is so bleak, why are so many advisors and investors still clinging to this safety blanket of portfolios?

In my opinion, it’s because he hasn’t let them down yet.

The appeal of a 60/40 portfolio is obvious. It has provided diversification and strong risk-adjusted returns for decades. Its underlying components – stocks and bonds – are quite intuitive and easy to understand for most investors. Most importantly, it’s incredibly easy and inexpensive to build. You can own a globally diversified 60/40 portfolio with just a few clicks through an ETF like the iShares Core Growth Allocation AOR ETF,
+1.09%.

But as user-friendly and rewarding as this wallet is, investors looking to rebalance their portfolios or grow new cash are being offered unattractive trade-offs.

The start of 2022 has been somewhat difficult for both components of the 60/40 – US stocks and bonds. The US stock market, as measured by the SPDR S&P 500 ETF Trust SPY,
+2.48%,
is down 7% year-to-date through Friday. The more growth, the more the Nasdaq-100 index tilts towards NDX tech stocks,
+3.22%,
measured by the Invesco QQQ QQQ ETF,
+3.14%,
is down nearly 12% through Friday.

While these corrections are somewhat modest, what worries diversified investors is that bonds are falling at the same time. The iShares Core US Aggregate Bond ETF AGG,
+0.07%
is down 2% through Friday amid rising interest rates. This reminds us that bonds are not always decorrelated from equities.

Fortunately, there is a growing opportunity for the average investor to tap into a wider range of yield streams. Adding alternative investments to the investment mix can allow investors to maintain their preferred position on the risk curve, but with less uncertainty around the tails and with a higher degree of confidence in long-term outcomes. term.

It may sound like an oxymoron, but alternative investments are becoming more mainstream. Vanguard is now in the private equity business. Cryptocurrencies BTCUSD,
+0.81%,
barely a teenager, are beginning to gain traction in institutional and advisor-led portfolios.

If history is any guide, we should expect many of today’s alternatives to become tomorrow’s diversifiers.

So if 60/40 isn’t the default answer anymore, what is it?

Investors looking for balance and using 60/40 as a baseline should generally own less than 40, maybe a little less than 60, and a decent amount more of ‘other’. But that’s where the generalizations stop.

There is no single allocation to alternatives that makes sense for all investors. The middle ground is somewhere between “enough to make a difference” and “too much for investors to stick to”. What has become increasingly clear is that the only wrong answer is zero.

I constructed three hypothetical index-based portfolios with varying degrees of alternatives and different investor goals in mind. The risk and reward statistics for these portfolios go back to October 2004, the earliest date that the index data allow. They are updated to the end of September 2021, as several of the underlying indices use illiquid asset classes which have delayed publication. The returns shown below do not represent actual accounts and are designed only to provide a reasonable estimate of portfolio risk. Indices are unmanaged, do not reflect fees and expenses, and are not available as direct investments.

This period covers both the good times and the good times, including the decade-plus bull market in equities we just experienced as well as the carnage of the 2008-09 financial crisis that saw the S&P 500 SPX,
+2.43%
experience a 55% decline from peak to trough.

Stocks are represented by the MSCI All Country World Index. Bond market performance is measured by the Bloomberg US Aggregate Bond Index.

The alternative allocation is also split between four broad categories: alternative risk premia, catastrophe reinsurance, real assets and private debt, some of which are tracked by private market indices. However, all strategies can be implemented through SEC-registered “wrappers” like mutual funds, ETFs, and interval funds that do not require an investor to be accredited to own them.

• 50% equities/25% alternatives/25% bonds: This portfolio is intended to have a risk profile similar to that of a 60/40 portfolio, but with an objective of higher returns due to the low expected returns offered by traditional fixed income securities.

• 60% equities/20% alternatives/20% bonds: This portfolio is for an investor willing to tolerate somewhat higher volatility in pursuit of higher expected returns.
• 40% equities/30% alternatives/30% bonds: This portfolio is for a more conservative investor who is looking to significantly reduce risk from 60/40 but who is reluctant to move too much capital into fixed income securities.

Each index portfolio achieved the desired objectives, as shown in the table below.

Source: The Allocator Edge

The 50/25/25 portfolio outperformed the 60/40 portfolio with less volatility and a lower maximum drawdown. The 60/20/20 allocation achieved the highest returns compared to the 60/40 combination, commensurate with its slightly higher risk profile. Finally, the 40/30/30 portfolio achieved returns in line with the 60/40 portfolio but with much less volatility and maximum drawdown.

It is important to remember that this is what would have happened over the past 17 years. As we look ahead, which we always should, the bond coin will not have the big tailwind of falling rates to support it and the calculation of low starting yields is inevitable. History has shown that your starting yield in bonds will explain more than 90% of returns over the next decade.

Conventional portfolio building blocks of stocks and bonds are still necessary, but no longer sufficient. A future where investors can simultaneously grow and protect their wealth through meaningful diversification and return potential is still possible, but it requires substantial change. Small tweaks and incremental changes won’t be enough.

The time has come for dispatchers to be bold, embrace alternatives, and sharpen the dispatcher’s advantage.

Phil Huber, chief investment officer of Chicago-based Savant Wealth Management, is the author of “The Allocator’s Edge: A modern guide to alternative investment and the future of diversification”. Follow him on Twitter @bpsandpieces.