Traditional Portfolios Are Out, Wildcard Portfolios Are In

Traditional Portfolios Are Out, Wildcard Portfolios Are In
Reda Farran, CFA

almost 3 years ago5 mins

What’s going on here?

Many retail investors have historically taken the simple approach of dividing their portfolios between just two asset classes: stocks and bonds. And that strategy’s worked pretty well in the past: higher-risk stock investments have generally generated attractive returns while being backed up by the reliable ballast of super-safe government bonds.

But with elevated stock valuations sparking talk of a bubble and government bonds potentially reaching the end of a 40-year run, the simple stock ‘n’ bond portfolio looks set for long-term trouble. I therefore thought now would be a good time to investigate how a few easy tweaks could help boost your returns in the years to come.

What does this mean?

Perhaps the most popular stock-and-bond allocation strategy is the 60/40 portfolio: 60% invested in stock indexes and 40% in government bonds. Just last week, however, two of the world’s biggest sovereign wealth funds (SWFs) warned that the apparent end of a four-decade era in which global government bonds only went up means the days of the 60/40 investor may be numbered.

In fact, the head of Singapore’s SWF expects such portfolios to generate a meager “real” return (i.e. after inflation) of just 1%-2% a year over the next decade – compared to 6%-8% over the past 30 to 40 years.

“Total return” includes both bonds’ interest income and price movements (Source: Bloomberg)
“Total return” includes both bonds’ interest income and price movements (Source: Bloomberg)

The 60/40 portfolio’s poor outlook for returns isn’t the only problem. Historically, investors could count on it for at least some diversification, since stock and bond prices usually moved in opposite directions. But rising inflation expectations have caused investors to sell off government bonds recently, as their fixed future payouts look likely to be worth less.

The resulting rise in bond yields (which move inversely to prices) has spooked investors in previously high-flying growth stocks, meanwhile: these companies’ profits are often far out in the future, making their stock values today more sensitive to rising bond yields. So even as bond prices fell, the tech-heavy Nasdaq Composite stock index dropped too – briefly entering “correction” territory last week.

Why should I care?

Whether or not you’re a 60/40 investor, your portfolio’s stock allocation is likely to be concentrated in those very growth stocks vulnerable to rising inflation expectations. That category includes the tech giants that dominate major US stock indexes and the exchange-traded funds (ETFs) that track them.

Now I’m not saying rising inflation means you should be rushing out to sell all your government bonds and growth stocks. But given that their returns look likely to be weaker in the coming decade, here are five potentially profit-boosting tweaks you might want to consider making to your portfolio.

Loans

The first option is to switch some of your portfolio’s bond allocation into loans instead. The main benefit of investing in loans is that the interest rates they charge borrowers (and pay lenders) are typically tied to the underlying interest rate across the economy. If bond yields (and by extension the cost of borrowing) are heading higher, then loan investments should fare relatively well. Here’s a list of related ETFs to get you started – unsurprisingly, they’ve all seen their prices increase this year, in sharp contrast to government bonds.

Gold

Investors’ worries about rising inflation mean it might be worth allocating a portion of your portfolio to gold. It’s complicated, but the shiny yellow metal’s limited supply means it tends to act as an inflation hedge – and as an added bonus, gold’s perceived “safe-haven” status may also help offset losses from your stock investments during any further periods of economic and/or geopolitical volatility.

Currencies

One of the most popular investment strategies within the foreign exchange world is the “carry trade”: buying currencies of higher-interest-rate countries with funds borrowed in low-interest currencies. As well as earning the difference (or “spread”) in interest rates, this trade also exploits the trend that currencies with relatively high interest rates tend to rise more in value than currencies with lower ones. Here’s an example of an ETF that gives you exposure to it.

One major benefit of the carry trade is that it provides your portfolio with an uncorrelated source of return – therefore increasing its diversification and lowering its risk. Since the linked ETF’s inception in October 2006, it’s had an average correlation of 0.58 with US stock prices and -0.30 with US government bonds.

Correlations between the currency carry ETF and US stocks and bonds (Source: PortfolioVisualizer)
Correlations between the currency carry ETF and US stocks and bonds (Source: PortfolioVisualizer)

Cryptocurrencies

Cryptocurrencies can also give you an uncorrelated source of return. Their values are determined in part by how quickly they’re mined by server farms and how enthusiastic their fan bases are – arguably, these drivers are untethered from the economic forces that drive stock and bond markets. Cryptocurrencies are also seen by many as a hedge against the unintended consequences of countries’ current economic stimulus policies – which could include high inflation, currency devaluation, and negative interest rates.

Infrastructure

You may also want to think about swapping some of your portfolio’s stock allocation for shares of companies that develop and run infrastructure projects. Such projects’ cash flows tend to adjust for inflation – and can therefore serve as a hedge against rising prices. The iShares Global Infrastructure ETF is one low-cost way to gain exposure to a globally diversified portfolio of infrastructure stocks. Just remember that it’ll obviously have a high correlation with the overall stock market, so you’d be better off exchanging part of your current stock allocation for the ETF rather than simply adding it.

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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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