For years, advisors have relied on a traditional 60/40 stock/bond mix to build client portfolios. Stocks will provide desirable growth while (hopefully) protecting against inflation, while bonds will generate income against stock declines or recessions. The historic decline in 60/40 mixes in 2022 brings to light growing concerns that the traditional 60/40 is not working for many customers and may not work well in the future, and that more efficient distribution is more important now and broadly available to individuals Open to investors. A more efficient portfolio with alternative allocations generates higher total returns with lower volatility and drawdowns, while also having lower correlations with other asset classes in the portfolio.
Relevance Challenge
The ten-year Treasury bond’s recent positive correlation with stocks limits the effectiveness of a portfolio composed primarily of stocks and fixed income. The rolling correlation between the 10-year UST and stocks (S&P 500) has increased over the past few years. Although the dismal performance of 2022 has passed, the higher positive correlation between equities and fixed income that began in 2021 has continued into August 2023.
Risk-adjusted reward challenge
Finding attractive long-term returns can also be a challenge for today’s investors as portfolios become more complex and riskier (as measured by standard deviation). Research from Callan Associates Showing that 30 years ago cash and fixed income securities could generate a nominal return of 7%, by 2022 a hodgepodge of six different asset classes will be required, including equities of all market caps, international equity exposure, private equity and real estate real estate — —More than 5x volatility.
As a result, more than ever, investors need to seek allocations to asset classes that generate meaningful returns, provide effective diversification into equities, and are less volatile. Although challenging, some alternative investments meet these criteria.
Private Real Estate: An Effective Portfolio Diversification Tool
Private real estate exhibits attractive characteristics that help diversify in today’s market. Since the inception of the NCREIF Real Estate Index, the asset class has generated annualized returns of 8.75% over the past 45-plus years. Importantly, it generated these returns with an annualized volatility of 4.24%, a figure closer to investment-grade bonds than to listed real estate and stocks. However, unlike fixed income, private real estate has the potential for capital appreciation, a key component in today’s environment of moderately higher inflation.
Additionally, two of the most important characteristics of real estate are a low correlation to publicly traded stocks and a low drawdown. Since the NPI’s inception, the NPI’s correlation with public stocks has been 0.04. The correlations are fairly consistent over time; the trailing numbers for the past 5, 10, and 20 years are -0.2, -0.2, and 0.09 respectively. Drawdowns are a particularly painful component for individual investors, and drawdowns in private real estate are also quite low, with a maximum drawdown of -26% compared to -55% for the S&P 500.
Regardless of an investor’s investment profile, adding alternative investments may benefit them
Alternative investments serve a unique purpose in an investor’s portfolio; through their absolute return generating capabilities, they can increase a portfolio’s total return. Alternatives can also provide significant diversification benefits through their lower correlation and lower volatility characteristics relative to public equities.
Analysis by J.P. Morgan Asset Management shows that alternative investments are beneficial to all risk appetites, and that allocation to alternative investments has both increased annualized total returns and reduced volatility over 30 years through various allocation amounts.
Alternative investments play a vital role in investors’ portfolios
As correlations and volatility in equity and fixed income markets have increased recently, it may be beneficial to add asset class alternatives such as private real estate and alternative credit to a traditional 60/40 portfolio. Over the past 20 years, reallocating 20% of a 60/40 portfolio to private real estate has increased returns and reduced volatility, so investors may be better able to generate returns by allocating a portion of their portfolio to private real estate. Higher portfolio risk-adjusted returns. Alternatives.
Over the past 20 years, a 20% allocation to alternatives in bonds was optimal; in the future, a reallocation from stocks would be optimal
Over the past 20 years, a 60/20/20 stock/bond/private real estate portfolio has produced higher returns and lower volatility, reflecting the bond market’s underperformance in an ultra-low interest rate environment. Equity markets have benefited from this environment, but going forward, rising interest rates may challenge equities and instead support credit investments. So, while in the past it might have been better to reallocate 20% from fixed income to alternatives, given the real world circumstances, 50/30/20 or 40/30/30 stocks/bonds/alternatives is a more effective portfolio allocation model going forward.
Miguel Sosa is director of market research and strategy at Bluerock
