In the investing world, there is often little consensus on the best investments and the superior way to structure a portfolio. However, for many years, most financial advisors and industry experts have recommended dedicating assets in retirement accounts to 60% equities and 40% bonds.
The 60/40 mix is considered to have moderate risk. The 60% allocation to equities contributes to the goal of capital growth, and the 40% earmarked for bonds has the potential to offer both income and risk moderation. However, many experts are now recommending taking a portion of the equity allocation and investing in alternative investments such as private equity, venture capital, or real estate to generate income and hedge against inflation.
Over time, the 60/40 allocation has been popular because it can provide both growth and stability. When stocks are declining, fixed-income assets such as bonds may rise in value. Stocks may fall during a recession as earnings fall, but bond prices can climb because central banks often lower interest rates to boost the economy. Lower interest rates mean that bond prices will appreciate because interest rates and bond prices move in opposite directions.
The strategy has provided positive growth when examining the 30-year, 10-year, five-year, and one-year performance results for the period ending December 31, 2023, according to the Lazy Portfolio ETF. For the 30-year period, the portfolio returned 8.11% (5.46% adjusted for inflation); a 9.61% return for the 10-year period; and 17.79% for the one-year time frame.
The concept of the 60/40 portfolio is attributed to Nobel Prize winners Harry Markowitz and William Sharpe, who developed the Modern Portfolio Theory (MPT). They argued that the best portfolio for investors exposed them to the total market universe. Randy Cohen, PhD., Cofounder of PEO Partners, wrote that since the total market has about $1.50 worth of stocks for every $1.00 of bonds, a portfolio dedicated to these asset classes should have 60% stocks and 40% bonds.
Cohen writes that the portfolio has also provided relatively low risk. Since 1975, the strategy turned in just one year of double-digit decline, 2008, with a loss of 12.2%, representing half of the losses of an equity-only portfolio. Overall, the 2000s were a difficult period for the 60/40 strategy, with a small 2.3% annual return and a net loss on an inflation-adjusted basis.
Post Pandemic Phenomenon
In the past two years, many experts have begun reevaluating the 60/40 portfolio because the 10-year-Treasury on average, has generally moved in tandem with stocks and had negative returns on days that stocks fell. The dynamic differs from that in the 2000-2007 and 2008-2020 periods when investors benefited from allocating 40% of their portfolios to bonds. In 2022, both stocks and bonds were in the red for the year, while in 2023, the two classes’ returns were positive. As a result, bonds have not provided diversification.
A Goldman Sachs report, “Is the 60/40 dead?” stated that a review of several thousand professionally managed investment portfolios through its GS PRISM™ portfolio analysis found that traditional equity assets comprised a large percentage of many of these portfolios. For example, 80% of the risk in moderate-risk portfolios was associated with the equity component, according to the Goldman Sachs analysis. As a result, Nick Cunningham, Goldman Sachs Asset Management’s vice president of Advisory Solutions, writes that these portfolios have an underrepresentation to other attractive return-generating asset classes.
Cunningham argues that long-term opportunities exist in assets such as emerging market equities, international small caps, liquid alternatives, and private assets. He noticed that many investors have little to no exposure to these asset classes. His bottom line is that the wide range of asset classes “offers the potential for return-enhancement, alpha generation, and diversification by spreading out risk concentrations among portfolios.”
Investors are now seeking to diversify their traditional portfolios by adding other types of assets. Some assets, such as high-yield bonds or global equities, may have high correlations to equities, so they would not provide diversification. When choosing alternative assets, it’s best to seek investments that represent a middle ground between return potential and low correlation to existing assets.
A more effective diversification strategy may be allotting 30% of the portfolio to private markets (equity, debt, and real estate), 30% to bonds, and 40% to equities, according to a post on LinkedIn by Daniel Scansaroli, Ph.D., Managing Director at UBS. He says that allocation is the new 60/40. He recommends that the 30% allocation to private markets should be divvied up as follows: 15% private equity, 10% private debt, and 5% private real estate.
Scansaroli wrote that portfolios of investors who followed the 40/30/30 strategy since 2008 enjoyed a 1.4-percentage-point higher return than those with a standard 60/40 portfolio, even with adding manager fees. He based his conclusion on pooled data about manager performance collected by Cambridge Associates.
U.S. universities’ endowments also pursue a similar diversification strategy. A study by the National Association of College and Business Officers (NACUBO) about the fiscal year 2022 found that portfolio allocations of university endowments were, on average, 28% in equities (U.S., non-U.S., and global), 30% in a mix of private equity and venture capital, 17% in marketable alternatives, 11% in fixed income, 12% in real assets, and slightly below 3% in other assets. Private equity, venture capital, private real estate, and other private real assets had robust returns in the fiscal year 2022, according to NACUBO. Private energy and infrastructure also posted substantial gains.
Similarly, wealthy individuals are increasing their allocations to other assets because family offices embrace the strategy. For example, the UBS Global Family Office Report was a survey of the 230 of the world’s largest single family offices, individual families’ net worth averaged $2.2 billion. The survey found that the families allocated 34% to private investments, 7% to hedge funds, and 3% to real assets. Among global family offices, the U.S.-based organizations had the largest alternative investments allocations with 47% dedicated to private investments and 10% to hedge funds.
Private equity firm KKR also proposed changing the traditional 60/40 portfolio mix to a 40/30/30 portfolio, calling it a new regime, in a 2022 study. KKR argues that the traditional allocation became problematic after 2022. The firm argues that in an inflationary climate it’s advantageous to reallocate part of the 60% portion of the typical 60/40 portfolio to increase yield and inflation protection by adding alternative investments.
Inflation has declined significantly in the past year, but the latest reading was still 3.4%. KKR’s 40/30/30 portfolio takes a 20% portion of public equities allocation and replaces it with a 10% slice of private real estate and a 10% portion of private infrastructure to create a new tranche. In addition, 10% of the traditional bond allocation should be devoted to private credit and placed within the private real estate and private infrastructure tranche for a total of 30%. As a result, this creates a portfolio of 40% equity, 30% alternatives, and 30% bonds.
In their report, KKR stresses that they believe that a portion of the equity component should be devoted to assets that can rise in value during inflationary periods. They consider real estate an attractive alternative because its performance benefits from increased property values and higher recurring cash flows in an inflationary environment. Property values generally rise as inflation increases, and existing properties benefit because new construction may be delayed due to the higher costs. Looking at recurring revenue, inflation can also boost leases. Properties with leases that reset regularly, such as multi-family properties, benefit from higher inflation.
Conclusion
After years as the primary method to diversify investment portfolios, the 60/40 model is being reconsidered by many in the investment world as the best approach to generating robust performance with limited risk. Ultimately, what has worked for many years may not be the best solution for everyone, especially when an investor desires a boost to the portion of returns that is derived from income.
Many experts argue that it is possible to diversify beyond 60% equity and 40% bonds while increasing returns and not adding considerable risk. Private equity firm KKR stresses that adding real estate is a way to hopefully benefit in an environment of rising inflation. Searching for the correct alternative for a safe, secure, and compelling investment, such as the 60/40 portfolio, is challenging. Adding alternative investments to a portfolio requires careful consideration of expected returns and all risks.
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