Decades ago, high-net-worth individual investors often pursued 60/40 (equity/fixed income) portfolios to meet their current income and long-term investment objectives, rebalancing periodically as needed.
But today, despite a year of coronavirus lockdowns and due to low interest rates, an extended bull market and increased correlation between stocks and bonds, such 60/40 portfolios no longer offer many investors the return potential and cash flow that they seek. Where traditional fixed-income easily yielded 8%-plus 30 years ago, yields are increasingly close to 0% — and even negative in parts of the world.
As a result, many individual investors have been requesting help in sourcing yield and diversification away from fully-priced equity markets.
Moreover, equity markets are periodically driven by the same macroeconomic forces, such as real interest rates and inflation, as traditional fixed- income prices. As a result, the correlation between stocks and bonds can be unreliable, particularly as rates approach their lower bound, as demonstrated by the underperformance of German and Japanese bonds in recent equity selloffs . The result is that bonds may not be a sufficiently reliable dampener to the volatility of an equity portfolio in the decade ahead.
An option for enhancing a simple equity/fixed- income portfolios is the growing universe of alternative investments that have become accessible to high-net-worth investors. We believe a number of these investments can improve upon the yield and diversification roles that traditional fixed income once played.
Real assets and their risks
Diversified core real assets investments, for instance, have offered steady payouts of more than 5% annually in recent years. Moreover, this yield can be tax efficient as compared to traditional fixed income because depreciation offsets defer and partially shelter the annual income. In some cases, there is also room for long-term asset appreciation, which may be further upside that would be taxed at long-term rates. Despite these benefits, advisors should alert clients to the risk of using real assets as a source of yield and assess the underlying liquidity risk of the investment strategy. Several large private REITs and other real asset interval funds offer liquidity through a share repurchase program on a monthly or even a daily basis, but these vehicles typically can gate repurchases in excess of a certain threshold (for example, 5% of net asset value per quarter). It is important for investors to understand the potential liquidity risks of these investments. Moreover, some real asset classes, including residential real estate, have tended to face headwinds in a rising rate environment as leverage gets more expensive.
New entrants are gaining traction while established players continue to grow.
Hedging bets
One way to mitigate these risks is to pair real assets with other alternative investments that offer a steady return stream with limited correlation to public equities.
While hedge funds have earned a mixed reputation over the past decade in particular, a number of market neutral or absolute- return- oriented strategies have generated steady high- single-digit annual returns with low- single-digit volatility. Some of these strategies have very limited correlation to public equities or even a negative correlation to equities and can enhance the overall risk-adjusted return profile of a portfolio.
With many thousands of hedge funds in the investable universe and wide dispersion of risk-adjusted returns, it is important to spend time evaluating the fund manager and strategy.
These alternative investment strategies are examples of solutions to the diminishing benefit of including traditional fixed income as a core portfolio allocation.
The alternative investment universe has grown considerably in recent years, expanding the opportunities accessible to high-net-worth investors. This growth has not only occurred in the number of types of strategies on offer but also the fund structures. The number of alternative investment strategies available to accredited investors (rather than the higher asset threshold Qualified Purchasers) has continued to grow. Many of these strategies offer greater liquidity than was previously available even for private asset classes. Where a 60/40 portfolio easily offered a double-digit return in 1990, today a portfolio would likely need to leverage alternative investments to achieve the same return and cashflow profile. Moreover, for investors who believe that a rising rate environment may finally be on the way, a traditional fixed income allocation could quickly become a drag on overall portfolio performance.
As a final note, because of the proliferation of alternative investments opportunities, thorough fund due diligence is increasingly important. The universe is broad, and the risk profiles of these strategies are multifaceted as compared to traditional fixed income.
