Reimagining 60/40 with alts

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In the wake of the Covid-19 pandemic, a regime of lower returns and higher volatility amidst stretched valuations and sticky inflation appears afoot. Traditional 60% stocks/40% bonds asset allocation strategies — which have generally performed well over the last 30 years thanks to low inflation, declining interest rates, and negative correlations between stocks and bonds — may need to be reimagined to help successfully achieve one’s desired financial outcomes. For Michael Gates, lead portfolio manager of the Target Allocation model portfolios, this means constructing solutions that incorporate alternatives.

To do this, we employ a deliberate investment process built around a multi-step quantitative and qualitative framework, supported by dozens of seasoned professionals, calculated screening methodologies, and decades of portfolio construction research. This process can be summarized into three core steps: sourcing, screening, and sizing.

Sourcing (“What should I consider selling?”)

Rising rates and persistent inflation can create a hostile environment for bonds – which makes them our preferred funding source for alternatives. This gives us an extra lever to recalibrate overall portfolio duration and seek more diversified drivers of return. Since this results in reducing exposure to assets that have historically provided portfolio ballast, we intentionally increase the duration of our slimmed down fixed income sleeve (while still balancing rate risks), creating a reconstructed version that can still pack a punch in a potential low growth/recessionary environment.

Screening (“How to choose what to buy?”)

Unlike the more neatly delineated stock and bond complexes, the universe of alternative investments is incredibly heterogenous, spanning an array of asset classes, management styles, and vehicle structures. This diversity means alternatives can be used to accomplish a wide variety of portfolio objectives. It also means that vehicle screening and selection can be a resource-heavy exercise, requiring more precision and operational due diligence than is necessary for an ordinary stock or bond fund.

In our Target Allocation model portfolios that include alternatives, we start with an opportunity set of more than 500 so-called “liquid alternative funds”. From there, we apply a series of quantitative and qualitative screens that produce a curated universe of managers with consistent, demonstrable skill, justifiable fees, and robust operational infrastructures. Since we are funding our alternatives allocation from bonds, we aim to find true diversifiers that exhibit defensive characteristics: strategies that can provide access to low correlated sources of return that have historically exhibited defensive characteristics similar to bond funds.

Sizing (“How much should I consider allocating?”)

Alts funds that successfully pass the screening and due diligence stages are then re-evaluated from a whole portfolio perspective, taking into consideration how these funds are expected to co-move with stocks and bonds. For the selected alts to effectively serve their intended role, proper sizing of the alts sleeve within the broader stock/bond portfolio is imperative. To achieve this, we run a two-step optimization process that first suggests the best vehicles and ideal weights and then second re-scales the size of the allocation to fit within our intended alts sleeve and produce the optimal risk-adjusted return for the whole portfolio. In other words, we purposefully calibrate the alternatives allocation relative to the stocks and bonds in the portfolio.

The world is quickly changing, and yet investors’ need to achieve their desired financial outcomes remains. With the precedent drivers of performance fundamentally different today, we believe the success of yesterday’s 60/40 portfolio is unlikely to be sustained. But that doesn’t mean a balanced portfolio can’t still flourish – we believe investors simply need to get more creative in their allocation strategies. We seek to do just that by reimagining the traditional 60/40 portfolio with enhanced properties through the addition of alternatives.

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