For many years, advisors have relied upon a conventional 60/40 stock/bond mix for client portfolios. Stocks would provide the desired growth while (hopefully) protecting against inflation, and bonds would generate income and a hedge against stock declines or recessions. 2022’s historic decline in the 60/40 mix brought to reality what was already a growing concern: the conventional 60/40 isn’t working for many clients, it likely won’t work well in the future, and more effective allocations are now more widely available to individual investors. More efficient portfolios with an alternatives allocation generate higher total returns and do so with lower volatility and drawdown while also exhibiting lower correlations to the other asset classes within the portfolio.
The Correlation Challenge
The 10-year Treasury’s recent positive correlation to stocks limits the effectiveness of portfolios principally comprised of equities and fixed income. Rolling correlation between the 10-year UST and equities (S&P 500) has increased in the last several years. Although 2022’s dismal performance is behind us, the higher and positive correlation between equities and fixed income that commenced in 2021 has persisted through August 2023.
The Risk-Adjusted Return Challenge
Finding attractive long-term returns may also be a challenge for today’s investors, as portfolios have grown more complex and riskier (as measured by standard deviation). Research from Callan Associates indicates that 30 years ago, 7% nominal returns could be generated with cash and fixed-income securities, whereas in 2022 a hodgepodge of six different asset classes would be needed, including equity across all market caps, international equity exposure, private equity and real estate—with more than 5 times the volatility.
Therefore, more than ever investors must seek allocations to asset classes that can generate meaningful returns, that are effective diversifiers to equities, and that have low volatility. Although challenging, certain alternative investments meet these criteria.
Private Real Estate: An Efficient Portfolio Diversifier
Private real estate exhibits attractive characteristics that can help diversify in today’s markets. The asset class has generated 8.75% annualized return in the last 45+ years since the NCREIF Property Index’s inception. Importantly, it has generated these returns with 4.24% annualized volatility, a figure that is more comparable 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 critical component in today’s modestly higher inflationary environment.
Additionally, two of the most important characteristics of real estate are the low correlation to, and lower drawdown compared to, publicly traded equities. The NPI has experienced a 0.04 correlation to public equities since the NPI inception. Correlation over time has been fairly consistent; the trailing figures are -0.2, -0.2, and 0.09 for the trailing 5 year, 10 year, and 20 year, respectively. Drawdown, a particularly painful component for individual investors, was also considerably lower in private real estate with a maximum drawdown of -26% vs. -55% for the S&P 500.
Adding Alternatives May Benefit Investors Regardless of Their Investment Profile
Alternatives serve a unique purpose in investors’ portfolios; through their absolute return-generating ability, they can increase a total portfolio’s returns. They can also offer significant diversification benefits, through the lower correlation and lower volatility characteristics that alternatives have relative to public equities.
Analysis from JP Morgan Asset Management shows alternatives’ benefits for a variety of risk appetites, and that an allocation to alternatives has increased both the total annualized returns while also reducing the volatility over 30 years with a variety of allocation amounts.
Alternatives Play a Crucial Role in Investors’ Portfolios
Because correlation and volatility have recently increased in the equity and fixed income markets, adding asset class alternatives such as private real estate and alternative credit to a traditional 60/40 portfolio may be beneficial. In the trailing 20 years, reallocating 20% of a 60/40 portfolio into private real estate would have increased return and reduced volatility, thus investors may be better able to generate higher portfolio risk-adjusted returns by allocating a portion of their portfolios to such alternatives.
A 20% Alternatives Allocation Was Best Taken from Bonds in the Last 20 Years; in the Future, it Might be Best Reallocated from Equities
A 60/20/20 stock/bond/private real estate portfolio would have generated higher returns with lower volatility in the last 20 years reflective of a bond market that underperformed in an ultra-low-rate environment. Stocks benefitted from this environment, but moving forward, a higher interest rate world is likely to challenge stocks in favor of credit investments. Thus, while a 20% allocation to alternatives may have been best reallocated from fixed income in the past, given the facts on the ground, a 50/30/20 or 40/30/30 stock/bond/alternative are more efficient portfolio allocation models in the future.
Miguel Sosa is Head of Market Research & Strategy at Bluerock