Traditional Portfolios Are Dead

Traditional Portfolios Are Dead
Reda Farran, CFA

about 3 years ago5 mins

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What’s going on here?

Many small-scale investors divide their portfolios between just two asset classes: stocks and bonds. Perhaps the most popular of all allocation strategies – and one which has worked well in 30 of the last 40 years – is the “60/40 portfolio”, with 60% invested in stock indexes and 40% in government bonds. But with the outlook for both stocks and bonds now looking bleak, it may be time to think about throwing other types of investment into the mix.

A US 60/40 portfolio has delivered a compound annual growth rate of 10% since 1980
A US 60/40 portfolio has delivered a compound annual growth rate of 10% since 1980

What does this mean?

The pandemic’s economic effects have prompted massive government spending packages, while central banks have slashed interest rates to rock-bottom levels and purchased huge amounts of government bonds. That’s conspired to flood markets with cash this year, pushing up stock market valuations and leaving more than $17 trillion worth of bonds offering negative yields.

The graph below shows US stocks’ “cyclically adjusted price-to-earnings ratio” (a.k.a. their Shiller CAPE) at its second-highest level in history. The Shiller CAPE takes an average value for companies’ profits over the last ten years, adjusts this for inflation, and then divides the current S&P 500 index price by those adjusted earnings. The ratio thus aims to smooth out fluctuations in company profits caused by the business cycle.

Shiller CAPE
Source: multpl

The Shiller CAPE has historically proved to be a reliable indicator of stock market valuations – and therefore a useful tool for predicting future returns. A ratio above 30x, for example, has historically foreshadowed a negative return for the S&P 500 index over the next 3, 5, 7, and 10 years.

Investors scrutinize bond valuations by looking at how their yields have changed over time. If yields today are much lower than recent historical averages, then that could imply they’ll rise in the future – meaning bond prices, which move inversely, are in for a fall. As the graph below shows, the yield on 10-year US Treasuries is currently close to its lowest point in history, at 0.90%. A 10-year yield below 2.5% has previously implied a negative return for bondholders over – you guessed it – the next 3, 5, 7, and 10 years.

Treasury yields
Source: multpl

Why should I care?

The extreme valuation levels for both stocks and bonds should cause investors to question the ongoing validity of traditional long-term approaches like the 60/40 portfolio. A better bet in the current climate could be to introduce a few “alternative investments” into your portfolio – such as private equity, private debt, real estate, infrastructure, and hedge funds. A recent report from investment bank JPMorgan Chase agreed – predicting alternatives would become an essential part of any post-pandemic portfolio due to perennially low interest rates and a lack of opportunities for diversification elsewhere.

Alternative investments can bring investors several benefits: enhanced returns (from private equity’s use of leverage, for example), increased diversification (due to relatively low correlations with stocks and bonds), regular income (particularly through private debt), and a potential hedge against inflation (infrastructure projects, for one, often adjust cash flows for inflation).

While alternatives don’t often crop up in the average Joe/Jane’s portfolio, they're a staple – as shown below – in those of large institutional investors like pension funds and college endowments, as well as the ultra-rich. This isn’t entirely a question of choice: small investors’ access to alternatives is limited by high minimum investment requirements and by the need to satisfy regulatory criteria related to “accredited investor” status.

Investor allocations

So how can small investors incorporate alternative assets into their portfolios? Let’s look at each category in turn.

Private equity: The good news here is that new rules are set to allow US investors access to private equity via their 401(k) pension plans. Several private equity firms are also listed on stock markets, affording an indirect way to ride the wave. And then, as discussed in yesterday’s Insight, there are special purpose acquisition vehicles (SPACs). These let retail investors participate in private equity-style “leveraged buyouts” in which the SPAC acquires a target company using a mix of debt and investor’s money. You can invest both in individual SPACs (here’s a useful online tool to filter through them) and exchange-traded funds (ETFs) such as SPAK.

Private debt: Again, there are a number of easy-access ETFs which invest in loans. Another avenue to exposure, however, is peer-to-peer lending. If you’re interested, spend time comparing different platforms (and partners) to find the one that suits you best – and remember to always start off with a small experimental sum whenever investing in something new.

Hedge funds: Buying into hedge funds directly remains tough for individual investors. One way to deploy similar investment tactics is through “liquid alternatives” – investment funds and ETFs that mimic traditional hedge fund strategies such as long-short equities, merger arbitrage, and trend following. Here’s a list of several such ETFs.

Infrastructure: Again, it’s hard for small investors to access funds backing infrastructure projects. An alternative “alternative” involves investing in shares of the companies which develop and own these projects. The iShares Global Infrastructure ETF is one low-cost way to gain exposure to a globally diversified portfolio of infrastructure stocks.

Real estate: Individual investors do have access to funds investing directly in real estate. Just be careful of the “liquidity mismatch” issue: such funds may let you move money in or out on a daily or weekly basis, but they’re invested in assets like land and buildings which take much longer to buy or sell. If lots of people try to yank their cash during times of market stress, the fund will be forced either to freeze withdrawals or quickly sell its real estate off at firesale prices. You can avoid this risk by instead investing in real estate investment trusts (REITs), which also pay out regular dividends based on income from rents.

So there you have it. Do some research of your own on these alternative investments, and at the very least consider including a few alongside stocks and bonds in your portfolio. It may make all the difference over the next decade…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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