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The traditional go-to investment framework for many investors the last few decades has been a diversified portfolio of 60% stocks and 40% bonds – an asset allocation strategy that especially benefited from a regime of low inflation, declining interest rates, and negative correlations between stocks and bonds. However, a potential regime shift to higher rates and higher volatility amidst stricter monetary policy and falling but still elevated inflation creates a distinctly more challenging environment for 60/40 strategies to replicate the same historical success. For Michael Gates, lead portfolio manager of the Target Allocation model portfolios, this means constructing more modern portfolio solutions that incorporate alternatives.
To do this, the team leverages a rigorous, multi-step quantitative and qualitative investment process, supported by dozens of seasoned investment professionals, calculated screening methodologies, and decades of portfolio construction research. The process for how to add alts to a reimagined 60/40 portfolio can be summarized into three core steps: sourcing, screening, and sizing.
Sourcing (“What should I consider selling?”)
Higher, volatile interest rates combined with above-trend inflation can create a hostile environment for bonds – which makes them our targeted funding source. Swapping bonds for bond-like alts gives us an extra lever to recalibrate overall portfolio duration, curb volatility, and seek more diversified drivers of return. As we decrease our allocation to bonds and increase our allocation to alts, we evolve the complexion of the remaining bonds we hold, reallocating to higher-quality, longer-duration issues. The outcome is a reconstructed bond sleeve that is smaller to accommodate our newly added alts sleeve, but 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” ETFs and mutual 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 bonds.
For illustrative purposes.
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 to complement the specific strengths and weaknesses of 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 approach. 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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