David Kelly sees nothing wrong with more investors moving into private markets, provided their eyes are open to the attendant risks and benefits.
The chief global strategist at
Despite the past performance of the 60-40, real risk mitigation is likely to require some allocation to alternatives in the future.
"I think it's fine for individual investors to have exposure to alternatives," Kelly said. "They are less liquid than publicly traded markets. They're not inherently more risky. They're just less liquid, but they're also more opaque. And I think that's the issue which really has to be addressed. The more we can try to add clarity on these investment opportunities, the more comfortable I feel about them being in investors' portfolios."
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Kelly's business is partly to bring some of that clarity and eliminate much of the jargon surrounding the much debated topic of private markets. In June,
One slide in the document (page 7) compares how well a 60-40 portfolio fared against the performance of various alternative allocations from the start of 1990 to the end of 2023. The standard 60-40 produced annualized returns of 7.5%. Meanwhile a portfolio made up 40% of stocks and 30% of bonds, with the remaining 30% given over to alternatives, produced an annualized return of 9% with less volatility.
Another slide in the report that Kelly likes to point to (page 9) illustrates the difference a good asset manager can make in choosing alternatives. With investments in global private equity, the spread between the best and worst annualized returns achieved by various investment managers over a 10-year period ran from 2.1% to 23.3%.
With U.S. public equities, the difference was much smaller. The worst managers secured returns of 7.3% and the best of 8.9%.
"So you can think about 'Why alternatives?' and 'What alternatives?'" Kelly said. "But I really think you should be thinking about 'Who alternatives?' Because you need to make sure you invest with the right managers who can develop these opportunities, deliver alpha and know what they're doing in this space."
Kelly joined
This interview has been lightly edited for clarity and brevity.
Financial Planning: For years, advisors and clients were told that the 60-40 portfolio was the ultimate hedging strategy. If stocks were pulled down in an economic crash, falling interest rates would drive bond values up. Why's that no longer true?
David Kelly: Retroactively, it has had tremendous performance. The problem is, I can't tell you anything really about returns for the next year based on valuations. But in the long run, there's a strong relationship between valuations and returns. And even where we are right now, it implies returns of less than 6% going forward, even if we have the kind of relationship between valuations and returns that we've seen on average since the mid 1980s. And I would argue, we are going to see something worse going forward. So the problem is that as the 60-40 has appreciated, because the stock side has appreciated, the respective returns have gone down.
FP: In other words, there is so much money in the stock market now, and the valuations have been driven so high, that there just aren't many bargains to be found any more?
DK: That's particularly true for passive management. If you actively manage this, and you avoid the top 10 stocks, you can get good valuations. But the overall index is just expensive.
FP: What else is wrong with the 60-40?
DK: The second issue is that the ability of the 60-40 to insulate a portfolio from shocks is really being called into question. We obviously had 2022, which is the first year since 1974 when we had a down year for stocks that was actually amplified by a down year for bonds. And now we have what I'd call a ziggy point. The whole point, in the portfolio, was that bonds were supposed to zag when stocks zigged.
But what happened, in 2022, is that they both zigged down. And in 2023, they both zigged up.
And this assumption that bonds and stocks offset each other actually isn't very well grounded in history. It was true from about 2000 up to 2020. We had this negative correlation, mostly [meaning stocks and bonds moved in opposite directions].
But in the 1960s and 1970s, when inflation was rising, there was positive correlation. Then when inflation came down in the 1980s and 1990s, there was still positive correlation. And now, since the pandemic, we have positive correlation again. So the assumption that you're gonna be hedging against a stock market downturn by having bonds in the portfolio is being called into question.
Of course, the future is murky. But as you look forward, it's just not clear that bonds will protect stock portfolios as much as they have in the past. And given the types of risks that portfolios face, you don't want to hedge just against recession or hedge against inflation. So to have a broad diversification portfolio, which hedges against a lot of unknown risks, is why I think it's important to have alternatives in portfolios.
FP: So if the 60-40 portfolio doesn't cut it anymore, and if people need to be considering adding some alternatives, is there a specific allocation that you recommend?
DK: If you could deduce the risk tolerance of investors and the relative expected return, and then do a lot of calculations looking at volatility and assuming correlations and assuming you have the right data, you might be able to come up with a theoretically optimal number.
But I would distrust that number greatly. What I would say is that most investors don't have significant alternative investments, apart from what they physically own in real estate. And so for all investors to start from zero, maybe they could push it up to 10%, or push it up 20% and take equally from the equity and fixed-income sides of the portfolio, maybe a little bit from cash.
You put this money in, if you're a long-term investor and if you're looking for liquidity, it should not be from your alternative investments. And for people to start out with zero, moving up to 10% or 15% or 20%, you have to think about the tax consequences and do it in a tax efficient manner. But for most individual investors, you could go higher, moving up to somewhere in the 10% to 20% range for alternatives.
FP: Do you think private markets need greater "democratization"?
DK: Democracy is an interesting concept. We talk about this because democracy works best with a well-informed person, and thus democratization of asset markets would work best for the well-informed investor class if investors can be given reliable information on the risk-return ratio of different alternative investments. So the more we can try to add clarity on these investment opportunities, the more comfortable I feel about them being in investors' portfolios.
Some of this is not complicated at all. If you're investing in commercial real estate or transportation or infrastructure, or even private private equity, so long as investors are informed of what they're buying, and so long as the accounting meets certain standards, I don't have any problems with individual investors accessing private markets.
Where democratization could get you into trouble is when people are encouraged to invest in either things that are purely speculative, such as cryptocurrencies, or investing in day-trading momentum strategies, things like meme stocks. And, ironically, it seems regulators think it's fine for people to take a flier on bitcoin, but they have more problems with people putting money into portfolios of alternative assets.
But I think it's really incumbent on the industry to provide a little clarity to people about what exactly it is they are buying.
FP: What do you favor among alternative assets?
DK: I think there are two or three areas. The starting one is residential real estate, because the Federal Reserve kept rates so low that real estate prices had nothing to do but to shoot up. And they did. So between not building enough, and prices being up and these super low rates, you saw home prices rise to levels that could only be afforded if you had super mortgages. Now you've shut out millions of people from the possibility of buying decent property. It's a terrible thing. But from an investment perspective, you can buy properties and then rent them out to people. So you're going to see continual demand for multifamily housing, also for single-family housing, for condos, for different residential options.
Another is infrastructure. There is a tremendous need for capital to upgrade the grid and to provide basic water and electricity services to people. With all the data centers that are being built, the demand for electricity is going to shoot up. It's a business, but it is a business which is very insulated from typical economic shocks. If you're an electric utility, and you're the one that is supplying electricity to a bigger town or group of towns or counties, your regulator doesn't want you to go out of business. If your cost of fuel goes up, they allow you to push up your rates. So infrastructure is actually quite resistant to both inflation and recessions.
FP: What about private equity and private credit?
DK: Private equity, private credit, you've got to know your manager. Otherwise, you might as well step out on the street in Manhattan and close your eyes and say, "What's the viability of a loan to that person there?" Because we don't know.
But if you're a good manager, and you can do due diligence on the lending or the deals that they are financing, I think there still might be money to be made in private credit.
I am concerned about the incestuous nature of private credit, though. And If you look at the data, it suggests that the quality of private credit loans is not deteriorating that fast. A lot of credit managers would say, "Well, this is because we can work one-on-one with the lender and with the borrower." That's good to an extent. But if you have a vested interest in keeping this whole thing afloat, because you're also the equity stakeholder in the thing, you get something trickier.
And it could be that what will happen is that there are some zombie loans out there, which will be discovered to be zombies.
FP: What does the industry need to do to help clear up some of the misconceptions about alternatives?
DK: I would emphasize that a lot of this is about investor education. Investors need to make sure they understand the broad outline of the space and understand the managers they are investing with. That's really important.
I think also it's incumbent on the industry just to stop the jargon. There's so much jargon in alternatives and different names for the same thing. And the data is pretty poor. So one of our missions with the "Guide to Alternatives" is just to try to provide some clarity.
