Part I—Why Consider Alternative Investments?

 

For the better part of the last century, investors with retirement in their sights have invested trillions of dollars into the traditional 60/40 stock and bond portfolio mix. The rationale has been that the 60% invested in stocks drive the returns while the 40% invested in bonds provide the ballast during volatile markets, with both assets comprising the core building blocks of a long-term portfolio.  Despite ongoing predictions of the decline of the 60/40 portfolio over the past decade, the strategy has performed quite well.

 

Is it Over for the 60/40 Portfolio?

However, if the performance of a 60/40 portfolio mix to start 2022 is any indication, this may be the beginning of the end of the widely implemented asset allocation mix for some time. In general, 60/40 portfolios posted losses throughout the first two quarters of 2022 as inflation spiked and the Federal Reserve signaled a significant shift in its rate policy. Both stocks and bonds reacted negatively, indicating a higher correlation between the two asset classes than we’ve historically seen. This has seemingly left investors with nowhere to hide during this volatile market.

 

Bonds Might Not Cut It Anymore

There have been several instances of simultaneous losses by large-cap stocks and government bonds, raising the risk flag that many investing experts have been talking about. The prospect of higher interest rates makes it difficult for bonds to fill their role as a defensive hedge since bond prices decline as rates increase. And, with bonds yielding less than the inflation rate, more speculative investors will likely abandon high-quality bonds for higher-yielding bonds which further increases risk.

High-quality bonds, once the backbone of most portfolios due to their reliable yields and historical downside protection, no longer are offering commensurate protection. Today, the inflation-adjusted yields on high-quality bonds is negative, producing a drag on portfolio returns. Investors in Treasuries and high-grade corporate bonds are in a sense, guaranteed to lose purchasing power. 

It's important to remember that 60/40 is only a rule, and rules are made to be amended. It was developed long ago under very different economic and market conditions. It performed very well during in recent decades due to a historic bull market in bonds that appears to have ended. So, while bonds outperformed in their ability as a volatility hedge wonderfully, it may be time to look more closely at alternative investments as a way to provide uncorrelated returns to a diversified portfolio

 

Revamping the 60/40 Portfolio with Alternatives 

For investors seeking steady total returns, it may require a rule adjustment; but one that is consistent with their investment objectives, time horizon, and risk profile. In terms of risk and volatility, it doesn’t necessarily have to be a significant adjustment to go from a 60/40 stock and bond allocation to a 60/20/20 stock, bond, and alternative investments, for example. 

 

According to J.P. Morgan Asset Management, allocating 30% of a portfolio to alternative investments may increase annual returns substantially while potentially reducing risk and increasing portfolio stability.

 

That is accomplished primarily through enhanced portfolio diversification provided by the alternatives' non-correlated or negatively correlated returns. Some alternative investments act primarily as diversifiers to spread risk and limit downside returns. Others, such as private equity, have a moderate correlation to public equities, but they provide the opportunity for return enhancement.

In turning to an alternative investment strategy, it’s essential to understand that it works best if it is tailored to the investor’s personal circumstances. It’s also critical to understand that investment in some of these assets should be made with consideration for an investor’s tax bracket, cash flow needs, risk tolerance, and time horizon requirements.

Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. There is no assurance that the investment objective will be attained.