Reimagining a 60/40 portfolio with alternatives

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In the wake of the COVID-19 pandemic, a new regime of lower returns, higher volatility, and resurgent inflation appears afoot. Such a challenging environment is prone to disrupt the once dependable success of the classic 60% stock/40% bond portfolio and the broader efficacy of fixed income as a source of meaningful diversification. We think investors may need to start getting more creative if they want to meet their future financial goals and may want to consider augmenting their stock/bond asset allocation strategies with alternative investments.

The framework outlined below walks through how Michael Gates, lead portfolio manager of the Target Allocation model portfolios, has thought about reimagining the traditional 60/40 portfolio with the added advantages of alternative investments to potentially strengthen risk-adjusted returns, help enhance portfolio resilience, and strive to improve investment outcomes.

This process, supported by dozens of seasoned professionals, advanced risk management technologies, and decades of portfolio construction research, can be summarized into three steps: sourcing, screening, and sizing.

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1. Sourcing (“What should I consider selling?”) 

In the current market environment, historically low but rising rates and elevated inflation can create a hostile environment for fixed income. Given these factors, at this time we prefer to source our allocation to alternatives exclusively from bonds. This allows us to recalibrate overall portfolio duration and seek enhanced return opportunities.

2. Screening (“How to choose what to buy?”)

Unlike the more neatly delineated stock and bond complexes, the universe of alternative investments is incredibly heterogenous, spanning an array of asset classes, management styles, and vehicle structures. This diversity means alternatives can be used to accomplish a wide variety of portfolio objectives. It also means that vehicle screening and selection requires more precision than is necessary for an ordinary stock or bond fund.

In our Target Allocation model portfolios that include alternatives, we start with an opportunity set of more than 500 so-called “liquid alternative funds”. From there, we apply a series of quantitative and qualitative screens that produce a curated universe of managers with consistent, demonstrable skill, justifiable fees, and robust operational infrastructures. Since we are funding our alternatives allocation from bonds, we aim to find alternative strategies that have historically exhibited defensive characteristics similar to bond funds.

3. Sizing (“How much should I consider allocating?”) 

Funds that successfully pass the screening and due diligence stages are then re-evaluated from a whole portfolio perspective, taking into consideration how the shortlisted alternative funds evaluated by our team co-move with stocks and bonds. For the selected alternative strategies to effectively serve their intended role in the portfolio, proper sleeve sizing is imperative. To achieve this, we run a two-step optimization process that selects the vehicles and weights and then scales the size of the sleeve to produce the optimal risk-adjusted return for the total portfolio. In other words, we purposefully calibrate the alternatives allocation in the context of the stocks and bonds in the portfolio.

The world is changing, and yet investors’ desire to achieve financial outcomes remains. With the precedent drivers of performance fundamentally different, we believe the success of yesterday’s 60/40 portfolio is unlikely to be sustained. But in our opinion that doesn’t mean a balanced portfolio can’t still flourish – investors simply may need to get more creative. We seek to do just that by reengineering the traditional 60/40 portfolio with the addition of alternatives.