BALANCED portfolios are the mainstay of pension funds and individuals saving for a long-term objective such as retirement. This is likely to remain the case, even with the loss sustained by 60/40 portfolios (60 per cent equities, 40 per cent fixed income) last year – thanks to stocks and bonds falling in tandem by double digits. After that debacle, renewed and persistent calls have been made for a re-examination of balanced strategies.
To be sure, balanced strategies are still expected to deliver respectable returns over the long term. JP Morgan Asset Management’s long-term capital market assumptions for 2024 project 7 per cent annual returns for a 60/40 strategy over the next 10 to 15 years. This is in fact substantially higher than its forecast in 2022 of 4.3 per cent.
But the big question is this: In an environment of higher-for-longer inflation and interest rates, can stocks and bonds still deliver portfolio diversification?
Diversification is a core principle in portfolio construction. Choosing assets that do not move in tandem helps to mitigate the decline in value of a pot of savings should downturns occur. Historically, correlation between stocks and bonds has been mostly low to negative. But the macro environment now throws up several wrinkles. Are we in the middle of a “regime shift” in terms of correlations?
A 2022 paper by Schroders examining the underlying factors driving shifts in correlations found that macroeconomic and policy factors are significant drivers. It noted that the environment may be shifting in favour of a positive stock-bond correlation. Higher risk-free rates, for example, raise the risk premium that investors demand from equities, causing stock prices to drop. They also erode bond values. Persistently high inflation also causes stock-bond correlations to rise.
Amid this puzzle, more strategists are calling for the addition of private-market and alternative assets into portfolios, on the strength of their potential to deliver higher returns and low-to-negative correlations with public markets. The rub is that retail investors are locked out of alternative assets for many reasons, including lower transparency, higher costs and leverage and illiquidity. But this may well change.
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In 2021, a paper by the US Securities and Exchange Commission concluded that retail investors should be allowed access to private investments, subject to “design principles” that balance the benefits of access with investor protection. It notes that the United States stock market has become less diversified through the years. The number of listed companies has dropped by 45 per cent, from a peak of just over 8,000 in 1996 to about 4,400 in 2018. Today, private companies stay private longer, and more capital is flowing into private markets than public ones. This makes for a far higher concentration of wealth, exacerbating wealth disparities.
Greater access for retail investors is already on the cards, even as regulation and measures for investor protection are yet to catch up. In Europe, new rules are set to come into force in 2024 for the European Long-Term Investment Fund (ELTIF) structure, which would remove caps on retail investments and allow greater liquidity. ELTIFs were launched in 2015 to channel non-bank funding into companies via private equity, private credit, infrastructure and real estate investments. Technology also promises to widen access.
To be sure, there will be trade-offs. Greater liquidity may well reduce the risk premium of private assets, for instance. The bigger picture, however, is that more options for diversification will help enhance portfolio resilience – surely a plus for savers.
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