Fixing the 40

By: Cos Braswell

The historical baseline for what an investor considers a diversified portfolio is often referred to as the 60/40: 60 percent of an investor’s assets invested in equities and 40 percent in fixed income. The 60 is generally global exposure, proxied by the MSCI ACWI Index, and the 40 by the Bloomberg Aggregate Bond Index. While this portfolio has generated satisfactory risk/return metrics in the past, there are several challenges that investors face moving forward.

Let’s consider those challenges and what alternative solutions investors can look into to mitigate the deterioration of the risk/return profile that the 60/40 faces. We have all felt the effects of inflation in recent months, and it seems the term ‘transitory’ was retired as quickly as it was created. Persistent inflation could lead to lower real returns (returns after the effects of inflation), which would hit the more conservative bond market much harder than equities.

While bonds may be more sensitive to growing inflation, the low correlation between fixed income and equities is in danger of being challenged as well. In the equity portion of the 60/40, stretched valuations have led investors to question whether stock prices have room to grow. Even so, equities are a good place to park investments if one believes inflation will continue to rise, as companies will adjust prices to keep up with expenses.

Another consideration for fixed income investors is the potential for rate increases. Rates increasing, coupled with higher-than-usual inflation, could not only diminish the value of the underlying bonds in a portfolio, but could also reduce the purchasing power investors have once they redeem their bonds.

Knowing all of this, we want to highlight some alternative investment asset classes that investors might consider. In this rapidly changing environment, risk-averse investors are looking to maintain the amount of risk they are exposed to, even if it means sacrificing returns. Others are looking to maintain their expected return, but with the understanding that risk will increase. Both investors have options to meet their needs.

For investors looking to keep a similar risk level, a simple solution might be to adjust the weighting of the 60/40 by decreasing equity allocation. Investors attempting to maintain target return would, by contrast, increase their equity allocation. But it is our belief that considerations for change are better focused on the fixed income portion of the portfolio. This opens a multitude of possibilities for increased diversification through uncorrelated asset classes, and it can be done without slashing income expectations. We’ll highlight a few general asset classes that fit this type.

An investor looking to maintain a similar level of risk and keep income steady might look to real assets, such as farmland or timberland. Farmland is a fantastic income-driver and tends to be rooted (pun intended) in long-term contracts, as less than 1% of domestic farmland is traded annually. High quality managers find farmland with both row (annual) and permanent crops to reduce cyclicality and provide an attractive risk/return profile when used in conjunction with equities. Timberland is uncorrelated to traditional markets and is historically positively correlated to inflation. The harvesting cycle also offers optionality to be efficient in taking advantage of underlying economics in real estate and other material intensive industries. Apart from real assets, core real estate is another great place to find smoother returns and consistent income. Key characteristics to achieve these metrics are high quality buildings with occupancy generally greater than 95%.

An investor looking to preserve capital while maintaining a similar return expectation might allocate to private debt. Allocators have many options within the private debt market, but in the context of a fixed income replacement with high return expectations, corporate direct lending fits this bill the best. Direct lending is when lenders other than banks finance companies without a private equity sponsor or investment bank intermediary. The opportunity set is vast, and while these companies won’t be rated at investment grade, yields continue to be attractive even with favorable senior secured debt terms.

Higher inflation expectations, increasing interest rates, and low fixed income yields have pushed investors to think outside the box of traditional investments. Thankfully, asset managers are in tune with client needs and the ever-evolving investment landscape. Hopefully the aforementioned alternative asset classes have prompted curiosity to uncover investment options that work best for your needs. Investors must first establish and prioritize their goals, whether capital preservation, income, total return growth, etc., and then investigate alternatives to the traditional 40% fixed income allocation.