Looking Beyond the 60/40


John Micklitsch, CFA CAIA, President & Chief Investment Officer

The 60% stock 40% bond portfolio has been an industry standard for the better part of the last four decades, for valid reasons. For starters, interest rates spent much of that period in decline which created a total return tailwind for bonds (yield + price appreciation from falling rates). In addition, 30-40 years ago, benign federal budget deficits and then the rapid adoption of emerging technologies like the Internet and cloud services combined with global outsourcing kept inflation low. Lastly, during much of this time period, investment alternatives beyond stocks and bonds, such as hedge funds, managed futures, private real estate, private equity and private credit, were available to only the largest investors and institutional asset owners. All these conditions contributed to the popularity of the 60/40 portfolio.

But what has changed and how can investors think about portfolio construction for the next 30-40 years as a result? We believe investors of many sizes can now consider the potential benefit of a portfolio built on a three-legged stool approach, consisting of stocks, bonds and alternatives, alongside the traditional two-legged approach, and here is why.

Although interest rates have risen recently, they are still far below the 12-15% level of the late 1970s and early 80s that ushered in the longest sustained bull market in bond market history. So, while future expected fixed income returns have risen recently due to the higher rate environment, we are far from the rate backdrop that in part drove returns from the 60/40 portfolio to widespread adoption. Moreover, systemic deficits are likely to keep interest rates higher for longer as we attempt to fund $2 trillion deficits for as far as the eye can see, which would deny bonds the tailwind of appreciation from sustained falling rates. Additionally, deglobalization is considered to be inflationary rather than deflationary, which reduces another tailwind. Lastly, the computing power and databases that boosted the economy’s overall productivity over the last three decades have made it far easier for alternative investment managers to efficiently administer funds at lower minimums for new investors. All of which has ushered in an era that will be known, in our view, as the democratization of alternatives for everyday investors. This brings us to the question of whether alternatives in a portfolio are worth it.

We believe the answer is yes. This chart from J.P. Morgan illustrates the potential impact of adding alternatives to a two-asset class portfolio. In every circumstance, the expected outcome moves up (higher return) and to the left (lower risk). Oftentimes, portfolio improvements are measured in inches, these look more like yards.

Source: Bloomberg, Burgiss, FactSet, HRFI, NCREIF, Standard & Poor’s, J.P. Morgan Asset Management.

Even recent experience in 2022 shows us the benefit of the third leg of the stool approach. In 2022, both stocks and bonds were down double-digits, yet it was alternatives that in many instances served as a lifeline during the year. In fact, correlations between stocks and bonds have risen in recent years, reducing their diversification benefit to each other, and could remain elevated as the Federal Reserve remains an enormous element of the stock and bond market backdrop.

To be clear, there are environments where alternatives will act as a drag on a portfolio’s performance. Strong equity bull markets, for example, would be an environment where certain alternatives, particularly those that hedge, could lag. In addition, there are often additional liquidity, administrative and tax considerations with alternative investments.

All things considered, the carefully researched use of alternatives, in our opinion, may have a positive overall effect on a portfolio, broaden opportunity sets and add diversification when evaluated across full market cycles. All of these factors combined with increased accessibility and a seemingly perpetual state of global uncertainty, make us believe alternatives will be an increasingly important part of the investor tool kit for many decades to come.

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