Evolution of 60/40 allocation continues amid high inflation

Portfolio managers and other experts are divided about the efficacy and usefulness of the traditional 60/40 asset allocation in institutional portfolios, but they noted that investing in non-traditional vehicles, particularly alternative assets, carry risks, including liquidity issues and lack of transparency.

The conversations come as the traditional 60/40 asset allocation portfolio plunged 16.9% in 2022 — its worst annual performance since 2008's 21.8% decline — as stocks and bonds moved in tandem downward amid rising interest rates and high inflation.

Jason Schwarz, Santa Monica, Calif.-based president and deputy CEO at Wilshire Advisors LLC, said by email that 2022 was a "statistical anomaly," and that it highlighted the challenge of achieving diversification when correlations rise across traditional asset classes.

Mr. Schwarz suggested that "50/30/20" might serve as a new asset allocation model for some portfolios, with the 20% referring to "high-quality alternatives," which refer to investments in "more mature markets that are less speculative and typically exhibit more stable volatility, consistent diversification benefits."

Mr. Schwarz added that he thinks the structural shift away from the traditional 60/40 will "persist over the long term."

Wilshire has $1.3 trillion of assets under advisement, including $83 billion of assets under management.

Stephen McCourt and Rafi Zaman, San Diego-based executives at consultant Meketa Investment Group, said in a joint email that if the outlook is for elevated inflation levels and higher volatility, then an allocation of 20% or more to alternatives may be appropriate. "Many of the largest and most successful pension funds today are already well beyond the 20% level," they added.

Mr. McCourt is managing principal and co-CEO at Meketa, while Mr. Zaman is CIO of Meketa Fiduciary Management, a subsidiary of Meketa that provides OCIO services.

Meketa had about $1.6 trillion in client assets under advisement as of Sept. 30.

"While 60/40 may not be obsolete, we've been educating institutional investors for years on the importance of understanding the sensitivity of their investment portfolios to economic regimes such as growth and inflation," Mr, Schwarz said. As such, Wilshire has recommended bulking up additional asset classes such as real assets and alternative investment strategies, as a permanent addition to stocks and bonds.

While this evolution in asset allocation advice has been gradual, Mr. Schwarz pointed out that "no asset allocation structure is permanent, as capital market assumptions are subject to change over time, and there will continue to be environments where increasing allocations to traditional assets will be warranted."

Messrs. McCourt and Zaman noted that some institutional investors began moving away from a 60/40 portfolio many years ago, while others are just now starting to recognize that a 60/40 allocation may not provide adequate diversification.

"As a result, they're seeking a broader set of assets that are reasonably uncorrelated," they said. "In addition, investors are focusing more and more on their own specific liabilities, not just volatility, as measures of risk. This change has been somewhat gradual but consistent over time. We expect these trends to continue."

Lara Reinhard, Denver-based U.S. head of portfolio construction and strategy at Janus Henderson Investors, said institutional investors have considered alternatives to the 60/40 for decades and that a 60/40 portfolio is not a "one-size-fits-all solution" as the investment landscape is constantly changing.

As of December 31, 2022, Janus Henderson had about $287 billion in assets under management.

Indeed, alternative assets have emerged as the most dominant third element in many investment portfolios in recent years. In fact, some institutional investors, including pension funds and endowments, now have very high allocations to alternative assets.

For example, the $35.8 billion endowment at Princeton University had 76.7% of its assets invested in alternatives (private equity, real assets, hedge funds), as of June 30, 2022, while the $40.1 billion Stanford University endowment kept 66% in alts and the $18 billion University of Michigan endowment pool had an 81.6% exposure there.

In addition, among defined benefit plans, Eastman Kodak Co. had the largest allocation to alternatives at 75%, according to data collected by Pensions & Investments.

Mr. Schwarz does not view the heavy allocations to alternatives as a dangerous trend. However, he added it "may represent elevated risk to some plans, depending on the objectives and liquidity needs of the plan relative to the types of alternative investments to which they have allocated."

He also noted that given the recent underperformance of public assets, many plans may now be overallocated to private markets investments, which can lead to liquidity issues relative to their current liabilities and/or spending needs.

"This predicament could result in cyclical headwinds for fundraising in private markets, although the structural shift towards this asset class is likely to continue," he added.

Messrs. McCourt and Zaman contend that institutional investors need to allocate assets based on striking the right balance between their return expectations and risks they can safely bear. "These risks include volatility, liquidity, drawdown risk, etc.," they said. "Second, risk management shouldn't be a mechanical process driven by some model output — rather, it is a deliberate and iterative process where various forward-looking scenarios are considered, and their impact measured. Allocations to alternatives should be determined within this framework, based on their impact in mitigating overall risks while providing adequate returns."

Alternatives are a broad category, and the key risk in this space is liquidity, noted Marc Dummer, St. George, Utah-based managing director and client portfolio manager for Principal Asset Management. "If institutions understand the liquidity profile of their liabilities, or if they have alternative sources of liquidity, the benefits of alternatives outweigh the risks," he said. "And if investors do not want the illiquidity of private assets or hedge funds, commodities provide inflation-hedging properties as well as liquidity. Infrastructure equities and natural resource equities similarly provide inflation-hedging properties in liquid markets."

Principal Asset Management, a unit of Principal Financial Group, has $517.8 billion in assets under management.

But Ms. Reinhard thinks that 60/40 is poised to make a comeback in 2023, citing that last year marked a rare occurrence in market behavior.

"With inflation slowing and the Fed rate hiking cycle nearing an end, we've already seen signs that the 60/40 is not obsolete and can once again behave as expected," she said. "I don't see any permanent change to or away from the 60/40, it's a matter of investors utilizing different frameworks to arrive at what's most suitable for their objectives and constraints."

Indeed, year-to-date through May 3, 2023, the 60/40 portfolio has returned about 6%.

Moreover, she added, after the "unprecedented sell-off in fixed income last year and the repricing of equities off record highs," there are now more fresh opportunities in the traditional 60/40 than there have been in a long time.

She further noted that given the reset in core bond rates along with the broader economic backdrop with risks of slowing growth, the "40" of the 60/40 is an "extremely important bedrock for portfolios, balancing equity volatility and allowing investors to stay in the market until the inevitable recovery."

Mr. Dummer observed that stocks and bonds tend to have higher correlations during periods of high inflation — as was witnessed last year.

"As inflation abates, correlations fell and the diversification benefits of fixed income reasserted themselves," he said. "Further, yields are now higher, suggesting that the income from fixed income will be a key contributor to total return. That high income was missing during the quantitative easing years."