Structural changes in global investment markets are casting doubt on the revered 60/40 asset allocation traditionally utilised by financial advisors. Rather than boosting returns and protecting investors during downturns, it could fail to deliver an adequate mix of protection and returns.
The theory behind the 60/40 portfolio is that a 60% allocation to growth assets, such as equities and property, allows investors to benefit from high market returns. In contrast, a 40% allocation to defensive assets, including cash and bonds, will offset losses from growth assets during market downturns. It also provides income to see investors through challenging markets.
The practice has generated reasonable results thus far, aided by decades of falling interest rates and manageable inflation. However, advisors that continue to construct portfolios using a 60/40 composition will likely deliver disappointing results for clients in the future.
This assumption is based on fears that equity markets have approached bubble territory, with price/earnings ratios at historical highs. It also appears that today's ultra-low interest rates, which are likely to dampen bond yields for years to come, are unlikely to fall much further. Thus, the upward pressure that low-interest rates are placing on stock prices will not continue.
Recently concerns have highlighted the risk of rising inflation due to the high levels of government stimulus in response to the coronavirus pandemic and further fuelled by the strong economic recovery. Should commercial banks lift lending rates in response, this could spell bad news in a world burdened by debt, with corporate bond yields already rising in anticipation.
Jerome Lander, portfolio manager at Dynamic Asset, says in a Livewire article:
"The risk of a sudden heart attack affecting an overweight market - high on Kool-Aid, highlights the current market risk. So investing with a little caution and greater diversification seems appropriate right now, even if, and especially because it is exceptionally unpopular at this point to be cautious."
While rising inflation is on the near-term agenda, some argue that we are more likely to see a deflationary trend over the longer term. Unfavourable demographics and technological advancements may continue to force down prices. This uncertainty of this environment requires advisors to revisit their approach to portfolio management. The aim is to protect client funds no matter how the next few years pan out.
One increasingly common course of action is to abandon the passive 60/40 allocation that places investors at the mercy of market dynamics and instead move towards dynamic asset allocation. This approach places a greater weighting on alternative assets that have a lower correlation with equity and bond markets. For example, alternatives may include commodities whose prices are being inflated by government infrastructure stimulus. They also tend to protect against inflation. Precious metals are also a popular inflation hedge and may also perform well should the market bubble burst.
"It will pay to invest actively in the winners and avoid losers in this situation, as well as to hedge your bets. Hence see a well-structured and diversified active and alternative long/short approach to markets continuing to be highly attractive," Lander says.
"At the very least, dynamic asset allocation is more prudent and effective at managing the current risks compared to a passive approach. In this environment, passive means' buy, hold and hope nothing goes wrong."
While current market forces make the 60/40 asset allocation extremely risky, they also present ample opportunities for advisors. The opportunity is to turn to active portfolio management and be prepared to venture beyond the traditional asset classes to gain genuine diversification.
While dynamic asset allocation is more complex and time-consuming, it can be achieved by advisers. The answer is to outsource the firm's investment function to a professional investment manager via the increasingly popular managed account structure offered by Dynamic Asset.
Dynamic Asset's efficient whole-of-business investment solutions utilise a total portfolio approach. Advisors can easily blend portfolio allocations to targeted specific risk-return outcomes within a specified timeframe.
To learn more, please contact us.
