An investing rule of thumb so common it’s almost become the default for retirees is the 60-40 stock-to-bond portfolio. It is amazing how many seemingly complex planning exercises result in the 60-40 allocation, and that advice only gained steam in recent years as the 60-40 portfolio enjoyed one of its best decades ever with strong stock returns coupled with the tail end of a long bond bull cycle.
It is only natural this recent history caused many to get overconfident in the ability of the 60-40 mix to continue delivering strong returns into the future, so the past five months have been a bit of a shock to some. Investors are used to stocks gyrating up and down as stock market corrections are common and we just came out of a bear market two years ago. Investors are not used to bonds falling in value, as they did each month through April for a cumulative loss of 10.1%1.
If you are a 60-40 investor, you may be questioning your asset mix and beginning to look elsewhere for solutions. But what are the alternatives to stocks and bonds? Is it possible to achieve higher expected returns without taking on more risk?
Most people only invest in two asset classes their entire life: stocks and bonds. Traditionally, portfolios are constructed by balancing willingness and ability to take risk with long-term financial goals using stocks as the risk lever and bonds as the safety lever.
But there are other options.
Commodities, real estate, private equity, and cryptocurrencies are examples of some of the more well-known alternative investments out there, but not all alternatives are created equal. Some of these provide little diversification help while others are inaccessible to most investors. Crypto is very new and very risky. It can be daunting to figure out if an alternative investment is worth the additional complexity and cost.
So, it is helpful to remember the portfolio construction process explained above also applies to other asset classes beyond stocks and bonds. The return series of alternative assets can be observed as with risk and correlation. The same process that leads to the 60-40 mix for a lot of people as they near retirement can be expanded to include these other asset classes.
An alternative investment should only be added to a traditional portfolio mix if it is expected to increase risk-adjusted returns of the entire portfolio. Risk-adjusted returns is a tricky concept because a risky asset as a stand-alone can decrease the portfolio risk level if it exhibits low correlation to other assets. If your stocks and bonds are both selling off at the same time, it would be nice to have a third asset class that is not.
Take the returns for three asset classes over the past three years: stocks, bonds, and an alternative investment called managed futures. Stocks had the highest risk, measured by standard deviation, and the highest return. Bonds had the lowest return and the lowest risk. Managed futures were in between both asset classes. Despite carrying more risk than bonds, swapping 20% of bonds for 20% of managed futures reduced the overall risk of the portfolio because managed futures exhibited very low correlation to both stocks and bonds.
It is important to keep in mind that alternative investments are not for everyone. Some are illiquid. Most carry higher fees. Some are overly complex. Some carry too much risk. Many carry manager risk on top of it all. Any investor should understand what they own. But we do think some alternatives are interesting enough to consider. Next, we are going to discuss two types of alternative investments with the potential to add value and then show how merging them with a traditional 60-40 portfolio impacts risk and returns.
Managed futures, sometimes referred to us Commodity Trading Advisors (CTAs), are investment strategies that have the flexibility to go long or short stocks, bonds, currencies, and commodities using futures contracts to gain exposure to any of these markets. These funds are frequently algorithmic in nature and aim to take advantage of momentum and/or macro factors to place their bets.
The key advantage to managed futures is their lack of correlation with the two traditional asset classes. Expectations should be for less return than stocks and more risk than bonds, but the low-to-no correlation is very attractive during selloffs like we experienced in 2020 and are experiencing today.
In the COVID bear market of 2020, concerns about credit risk in the bond market briefly caused bonds to sell off at the same time as stocks. We saw this phenomenon take place in 2008, too. In both years, managed futures held up their uncorrelated reputation while bonds let investors down. This not only lowered risk for portfolios invested in managed futures but also provided the opportunity to rebalance into stocks while they were down.
So far in 2022, stocks and bonds are selling off in tandem, but managed futures are having a banner year.
Many alternative investments are difficult to access because of illiquidity or accredited investor rules, but managed futures are liquid and easily available to buy and sell. That said, there is always a tradeoff in investing and managed futures are no exception. They typically carry higher fees than most other investments. The no correlation feature can feel more like a bug in the middle of a bull market. Additionally, not every market environment is good for managed futures as choppy markets will typically result in losses due to the trend following nature of the asset class.
But the past few years highlighted the long-term benefit an allocation to managed futures can bring to a portfolio.
Private equity is the asset class most people think of when they think of private investments, but most private equity investments require investors to be accredited and access to the top private equity funds is limited to elite institutional investors. Private credit is less well known as it may not be as exciting as investing in early-stage start-ups, but it can act as a complement to public fixed income and may be a better solution than junk bonds for investors looking for yield.
Private credit is a multi-trillion-dollar market investing directly in originated loans to businesses that cannot or do not want access to public markets for their capital needs. Due to the private nature of the loans, private credit offers potentially higher yields than public fixed income. Today, bond yields are higher than they were just a few months ago, but they are still low relative to history and private credit offers the chance at more attractive yields.
Of course, there are tradeoffs in this asset class, too. Private credit is more expensive than public fixed income and is likely riskier than investment grade bonds. But for investors looking to achieve a bit more yield out of their fixed income bucket, private credit is worth a look.
A 60-40 portfolio is typically viewed as a moderate portfolio from a risk perspective as it aims to strike a balance between risk and return. But a Moderate portfolio can also be created by adding managed futures and private credit to the mix with the goal of keeping the same risk level as a standard 60-40 portfolio.
The past three years is a good time frame to evaluate the 60-40 portfolio as it includes a bull market, a bear market, and a market correction. You get the full stock market experience in just a few short years. Here are the results of how the standard 60-40 compared against a portfolio of similar risk with alternatives added.
The portfolio with alternatives improved returns from 6.8% to 8.9% annually over the past three years with much of the return edge coming from the diversification alternatives provided during 2022’s selloff. The other side of the return coin is risk, so it is fair to ask what this change did to the risk level of the portfolio. A common risk metric is standard deviation and the monthly standard deviation of the portfolio with alts was lower than the 60-40, implying that it achieved higher returns with less risk over this time frame.
The returns showed above are hypothetical and past performance is not indicative of future performance, but it does highlight how alternative investments were able to add value during this time frame when investing was not as easy as it was the decade before. Investors frustrated with recent returns in their traditional portfolios may be able to improve results by adding alternative investments.
Ready to optimize your investments to achieve your goals? Click here to get started.
Disclosures:
1Performance number calculated from the iShares Core US Aggregate Bond ETF (AGG) from 1/1/2022 though 4/30/2022