Portfolio Construction Beyond 60/40 Improving Durability and Diversification in Portfolios
Following a period of strong returns, the foundations of traditionally balanced portfolios may not be resilient enough in an evolving and uncertain macroeconomic landscape. Diversification is increasingly key to return potential and downside protection.
Traditionally Balanced Portfolios: Weakened Foundations
A high level of co-movement between stocks and bonds, and equity concentration risks, are two factors limiting the 60/40 portfolio’s durability during a time of idiosyncratic and asymmetric macro trends. In fact, the rolling 12-month correlation of US stocks and bonds has been positive for over 600 consecutive days — the longest streak since 1992-1995, the last time the Federal Reserve sought a soft landing.
Consecutive days of positive rolling 12-month correlations
Stocks account for 35% of US S&P 500 market cap
Weighting of US equities in MSCI ACWI
Moreover, stock contribution to balanced portfolio risk is also rising back to ‘normal’ levels. If turmoil was to strike while stock volatility is rebounding, the impact on traditionally balanced portfolio drawdown risks could be significant. Among equities, concentration risk has risen as benchmarks have become more top-heavy from a security, sector, and country perspective. The 10 largest companies in the US S&P 500 now account for a record 35% of the market capitalization. Meanwhile, the US weighting in the MSCI ACWI is at an all-time high of 66%.1
The key takeaway? Stock, sector, and geographical diversification attributes are as weak as ever for core equity exposures within the traditionally balanced portfolio.
Alternative Steps to Improving Durability and Diversification
Balancing beta risks should be the first step, with other strategies added for strength. Investors should evaluate public and private market exposures based on how they improve diversification, modify risks, or offer opportunistic — and potentially less correlated — alpha generation.
Real assets such as gold, Treasury Inflation Protected Securities (TIPS), commodities, infrastructure, natural resources, real estate, and digital assets can help provide a potential inflation volatility hedge, generate additional yield, or act as a diversifier relative to broad equities and fixed income, either individually or as part of a multi-asset real return strategy.
On the opportunistic front, a tactical asset allocation (TAA) strategy that tilts toward favored asset classes to generate risk-managed benchmark-beating returns can diversify existing “betas” in a portfolio. In addition, hedge fund replication and derivative income strategies attempt to engineer asymmetric payoff structures that differ from traditional risk assets. Amid declining bond yields, derivative income has an added income overlay benefit.
Allocations to private assets also warrant consideration. Private equity, private credit, real estate, and infrastructure infuse non-traditional elements to the traditional mix of assets. These asset classes may offer higher returns, lower volatility, and enhanced portfolio diversification potential. The investment opportunities in private markets are vast, interesting, and growing.
Because information on private market investments is not as widely available as in public markets there is potential to capitalize on more widespread market inefficiencies. Yet, as the solutions and products are not publicly traded, illiquidity must also be an important consideration in portfolio construction, and a long-term perspective and careful selection of managers is key.
The Playbook for More Durable Diversification
While portfolios take many shapes, we believe that investors should consider:
- Using modifiers (such as derivative-based strategies, private credit, or infrastructure) for income.
- Seeking tactical or opportunistic unconstrainted strategies that can adapt rapidly to market conditions to target non-traditional premia/alpha opportunities.
- Diversifying via strategies with lesser correlations to traditional markets — i.e., more balance across differing environments and asset classes, such as gold, multi-asset real return, and commodities.