Traditional ways of putting a portfolio together have been questioned for some time. The rise of private market investments, and the continued use of hedge funds, make running money a complex business. With changes to interest rates under way, we talk to Morgan Stanley and State Street.
Asset allocators will need to be more active than perhaps they
were in the past, partly because new sources of return now come
into the picture, particularly via alternative investments.
While the so-called “60/40” equity/bond portfolio split that held
sway for decades has had its setbacks, in broad terms it retains
a lot of traction. The sharp rise in interest rates after the
pandemic, and subsequent cuts in the past few months, provide a
broadly supportive backdrop to this strategy.
But with alternatives – a term covering an increasingly
mainstream world of private equity, debt, venture capital, hedge
funds, real estate and commodities – vying for investors’
attention, the split looks more like 60/30/10 today, with
alternatives making the 10 per cent part.
The 60/40 asset allocation model is not dead, but it is also not
going to be optimal in many cases, Jim Caron, CIO, cross-assets
solutions group, at Morgan Stanley Investment Management, told
this news service recently.
In future, asset allocators/clients need to be more active and
less passive. Also, other asset classes should be considered in
the mix: alternatives (private equity, etc); however, they have
different levels of liquidity, he said.
“People typically think about the period from 1980 to 2021 and
the bond returns in that period. In US bonds, they were about 8
per cent [per annum] on average. The reason why they were so
steady was because interest rates were declining. We had a
40-year bull market in bonds.
“The impact that declining rates had on returns accounted for
about 80 per cent of those returns,” he said. As for equities, in
the US they returned about 7 per cent during 1980-2021, Caron
continued. With 60/40 portfolios, these sort of gains equated to
a 7.5 per cent return, and that compounded well over
time.
This news service has been talking to major wealth managers about
how views on asset allocation, and
asset location, are changing, and not just because of
monetary policy, geopolitics,
the rise of autocracies and loss of political liberties and
property rights, or the latest fashions in investment. An
ageing population, possible shifts in tax policy, and the
emergence from more than a decade of central bank QE have forced
a re-think about getting the broad contours of investment
right.
There has been positive correlation between bond and equity
sector returns since the onset of higher inflation since the
pandemic. Even as central banks start to ease, the positive
correlation persists,” Tim Graf, head of EMEA strategy, State
Street, told this news service. He mostly concentrates on
developed market interest rate and foreign exchange trends, and
works with the firm’s multi-assets team.
We need to talk about rates
With central banks such as the US Federal Reserve and European
Central Bank cutting rates, it begs the question of whether the
days of huge QE programmes will ever return, and what that means
for asset allocators. Graf thinks a return isn’t
likely.
“There appears [to be] a clear desire among policymakers to get
away from the policy of quantitative easing,” he said. “It has
been unclear whether these [QE] policies have had other than a
placebo effect.”
There is some risk, Graf said, that central banks might pursue
excessively tight monetary policy. “Real rates are relatively
healthy and attractive,” he said. Switching to the UK, Graf
reckons that yields on UK government bonds look
“attractive.” “Inflation in the UK is part of a cycle that
is starting to turn,” he said.
Correlations
The 60/40 equity/bond split drew much of its appeal from the idea
that bonds behave differently from stocks, with debt providing
ballast in a portfolio. A word that comes up frequently is
“correlation.” The problem is that diversification is not
what it appears.
There is still a lot of correlation between bond and equity
returns, says Morgan Stanley’s Caron.
There have only been two big periods between 1910 and today when
correlations were low: immediately after WW2 and in 1980 when
Paul Volcker, as Fed chairman, began to push up interest rates to
kill inflation, he said. Three forces in the 1981 to 2021 period
have kept bond returns steady: the defeat of inflation;
globalisation of trade and capital flows, and the 2008 financial
crash.
While private markets had a strong run from the end of the 2008
financial crisis, swept up by a tide of cheap central bank money,
recent rate hikes have taken off a bit of shine, but the market
is regaining its lustre.
The correction to illiquid markets that started in 2023 is now
beginning to wind down, Caron said.
“For most people, if you ask them `would you like to add
alternatives?’ they say yes but then ask how to do it?” he
said.
With deeper conversations about moving, say, to a 60/30/10 split
in a portfolio, it needs to be understood that putting money into
alternatives depends on specific opportunities coming up, the
types of assets involved, and so on.
“And this is where financial advisors can get a lot of help from
people like us. We look at building portfolios and put these
things together,” Caron added.