When it comes to rules of thumb for investing, few are as familiar—or as outdated—as the 60/40 portfolio. This model instructs investors to allocate 60% of their money to stocks and 40% to bonds. While 60/40 has endured for decades as the “default position” for many investors, it fails to capitalize on the depth and breadth of opportunities across a modern financial landscape.
Clients may be attached to the simplicity and longevity of 60/40. Still, it’s up to advisors to educate them on how a more sophisticated, updated approach may be more effective for achieving their investment goals.
Here are five components to consider when constructing a portfolio that transcends the constraints of the 60/40 model:
Non-U.S. Equities as Part of Overall Equity Exposure
Non-U.S. equities provide access to markets whose economic growth is relatively uncorrelated with America. These markets are also subject to different economic drivers, and they provide diversification by way of local sectors’ and currencies’ unique characteristics: fiscal policy, monetary policy, industrial policy, natural endowments, demographics and level of economic development.
Moreover, in contrast to the technology-heavy U.S. market, financials, industrials, health care and consumer staples comprise about 55% of the MSCI EAFE Index (developed markets). As spending on global infrastructure and health intensifies, these sectors could play an essential role in leading markets out of the current downturn, potentially setting the stage for non-U.S. stocks to outperform domestic equities over the next several years.
Finally, as of late October 2022, the forward price-to-earnings ratios for the MSCI EAFE and EM (emerging markets) indices were 11.8x and 10.1x, respectively, which translates into a 30% discount for foreign developed stocks relative to the U.S. and a 40% discount for emerging market stocks relative to U.S. equities.
Private Real Estate as a Complement to Traditional Low-Volatility Assets (Bonds)
Real estate is a low-volatility asset that provides diversification to traditional bonds. Private real estate tends to produce income that is competitive with bonds and total returns that can capture the equity-like characteristics of the underlying property. Over the 10-year period between September 2012 and September 2022, the NCREIF ODCE Index (private real estate) has returned 10.9% annualized, vs. 0.92% annualized for the ICE BofA Broad Market Bond Index.
Within commercial real estate, the industrial and multifamily categories have shown great resilience during the current downturn. As the economy gains traction, many types of retail should do well, especially grocery-anchored malls. Lastly, while demand for central business district office space is slowing, offices in secondary cities may get traction sooner.
Real Asset Exposure in the Form of Alternative Energy Infrastructure —Another Source of Income with Little Correlation to Traditional Fixed Income
Alternative energy infrastructure is an area where opportunities are growing, but some of the most attractive investment vehicles are overlooked by the 60/40 rule: for instance, funds that invest in wind and solar energy production. These investments can generate solid tax-deferred yields, as well as provide some upside if assets are sold.
For example, Greenbacker Renewable Energy Company acquires and manages income-generating renewable energy and other energy-related businesses with the goal of generating attractive risk-adjusted returns for its investors, consisting of both current income and long-term capital appreciation.
* A Tactical Asset Allocation to Complement Strategic Positioning*
A tactical asset allocation invests in a focused group of asset classes to capture short-term swings in broader market sentiment within an overall portfolio focused on a longer time horizon. While the core of the portfolio tends to be based on a consistent asset allocation determined by the client’s return expectations, risk tolerance and liquidity needs, the tactical piece can be reallocated on a monthly basis to reflect shorter-term market dynamics. Depending on current market conditions, this can produce a defensive portfolio dominated by cash and short-term bonds, an allocation entirely in an array of equities or a variety of other configurations.
Long-Short Solutions Where Appropriate
Long-short solutions can derive value from securities perceived as likely to underperform and provide focused solutions in particular areas of the equity market. These hedge funds allow investment managers to both own and short stocks and can be executed with a range of assets. Long-short solutions are particularly effective when a manager has deep expertise in a particular vertical, such as life sciences or technology equities, that enables them to distinguish between winners and losers to add value on behalf of clients.
The 60/40 rule emerged during a bygone era when markets were much less complex than they are now, and today’s financial landscape demands an approach that is both broader and more nuanced. Non-U.S. equities, private real estate, real asset exposure, tactical allocation and long-short solutions are examples of strategies advisors can deploy to build sophisticated, modern investment portfolios to better achieve clients’ goals.
The point of investing in alts is to adjust the risk weighting in a portfolio, so advisers need to identify the risk they're seeking to address, said panelists at the Morningstar Investment Conference.
8 months, 3 weeks ago