In a 2000 movie, the Perfect Storm, George Clooney portrays the captain of a fishing boat caught in a storm at sea. Cooney has often navigated stormy seas as indicated by his greying hair and confident manner. However, this time, a “perfect storm,” the convergence of three weather fronts, produces waves so large that they sink the boat despite Clooney’s best efforts.
We are not yet in a perfect storm, but there are indications that the world may be heading down that road. The signs include the global pandemic that caused massive unemployment, reduced economic growth, and spurred inflation; a flood of new money; and near-zero interest rates, which raised the specter of inflation for the first time in years. Central banks’ easy money policies and low-interest rates penalized investors and fed bubbles in stocks and other assets as investors chased after higher yields. Finally, a global return to economic mercantilism has stifled world trade and investment and is partly responsible for increasing political uncertainty in the world’s largest economies, the U.S. and China.
We had not yet recovered from these waves when the coup de grace hit: Russia invaded Ukraine in a move that overwhelmed an already unstable economic environment and tipped it towards higher inflation. Central banks responded by reversing 40-years of declining interest rates, threatening to slow economic growth and pop asset bubbles in stocks, bonds, and real estate.
Old Dependable: The 60/40 Portfolio
Investors had had the wind at their back for decades if they avoided panic selloffs when markets declined in 1998, 2001, 2008, and 2020. Globalization increased world production and kept inflation in check. An unprecedented four-decade decline in interest rates began in 1981 after Paul Volcker raised interest rates to fight inflation, causing significant, sustained gains in both the stock and bond markets. Bonds typically yielded low returns but provided a ballast during volatile times.
Investors and the money managers, supported by theories provided by economists, converged on an investment paradigm that called for diversified portfolios comprised of assets non-correlated assets with portfolios that responded to this environment with an investment portfolio that consisted of a mix of stocks and bonds. Popularly known as a 60/40 portfolio, it consisted of sixty percent stocks and forty percent bonds. The asset mix varied depending on the investor’s age and risk tolerance, with a more significant allocation to stocks for younger and more risk-tolerant investors and a more significant allocation to bonds as investors aged and became more conservative.
Investments large and small, from 401k to the largest pension funds, adopted a variation of the 60/40 portfolio. The 60/40 gave a compounded annual return of about 9% since 1987 and 10% over the past decade. Its spread was aided by the ease of implementing these portfolios with index funds and the minimal maintenance requirement. Aiding its widespread use is the ease of implementing the 60/40 with low-cost mutual funds and the minimal maintenance requirement of an annual rebalancing to bring the asset mix to its original composition.
However, money managers and economists warned that a 60/40 portfolio was optimal only if held for extended periods of time. In “shorter” periods (which sometimes lasted for years) declining returns and increasing volatility would result in a suboptimal portfolio. The longer one held the 60/40 portfolio, the closer it converged to the optimal risk/return level.
Can Alternative Investments Save the 60/40 Portfolio?
Most existing investment portfolios are stuck somewhere along the 60/40 continuum. However, there is a fierce debate among investors and money managers about the suitability of the venerable 60/40 in the present investment environment. The issue is whether the success of the 60/40 portfolio was due to a combination of factors that no longer exist, especially bull markets in stocks and bonds, sustained economic growth, low inflation, and a surge in the money supply.
Most future scenarios now project a period of higher inflation, lower economic growth, and modest returns from stocks and bonds, all of which will lower the returns of traditional portfolios. One proposed remedy is to increase portfolio allocation to “alternative investments,” with analysts recommending up to 20% allocation to alternatives and a similar decrease in the allocation to fixed income. Advocates of this strategy claim that including alternatives in portfolios will lead to higher returns and lower volatility than a 60/40 portfolio.
There are potentially fatal problems with this approach, beginning with the absence of a common definition of “alternative investments,” a loosely defined group that can include any combination of infrastructure, private equity, hedge funds, and venture capital, managed futures, art, and antiques, commodities and derivatives contracts. The list sometimes includes cryptocurrencies and related instruments. One company offers a portfolio of “alternative investments comprised of collectibles and culture items, Crypto and NFTs, fine artwork, music rights, specialty real estate, wine and whiskey, and high-end sneakers.”
However, the absence of a standard definition allows analysts to manipulate performance data to yield any desired result, which makes comparisons between different portfolios suspect. Furthermore, several of these alternatives are illiquid and too small to absorb the massive flow of money that could come from institutional investors. There is a limit to the amount of money that the vintage sneakers market can absorb. Finally, access to the best-performing alternative firms is limited or impossible for new investors.
This is not to say that alternative investments do not have a positive role in investment portfolios. However, investors often use the term as if its meaning is self-evident when it is anything but that.
Of course, another alternative is to consider the possibility that we are entering a period of lower returns and that there is a limit to what we can do without taking on greater risk. We have had a good run with the 60/40 portfolio but, like other aspects of life, things tend to revert to the mean.