When three asset classes are better than two
Amid constant worries, the need for a mindful portfolio re-evaluation has never been more pressing for investors
ENTERING the second half of the year, investors found themselves at a familiar yet precarious junction. Global equity markets were hovering near all-time highs, and corporate bond spreads were close to their all-time lows.
For those who have diligently deployed their capital and remained invested, the age-old wisdom of “time in the market, not timing the market” has reaped good returns. However, this success doesn’t quell the nagging question: How long can this last?
Amid constant worries about an increasingly fragmented geopolitical landscape, wavering faith in the US dollar’s long-term dominance, and whispers of an artificial intelligence bubble, the need for a mindful portfolio re-evaluation has never been more pressing for investors – especially those anchored to the traditional 60/40 (60 per cent equities, 40 per cent bonds) model.
Golden age of 60/40 is losing shine
The traditional 60/40 portfolio has long been the bedrock of portfolio management, with its golden age powered by a remarkable 39-year bond bull market. From 1981 to 2020, the US Federal Reserve’s determined campaign against inflation, along with quantitative easing, drove the 10-year Treasury yield from a peak of nearly 16 per cent down to less than 1 per cent.
This secular decline in rates created a historic tailwind for bond investors. A simple strategy of rolling 10-year Treasuries compounded at about 5.7 per cent a year.
During this period, equities also delivered double-digit gains. The 60/40 portfolio elegantly captured both streams, compounding at roughly 9 per cent annually, handily beating inflation and most liability hurdles.
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The magic of the 60/40 lay in the negative correlation between its two components. When equities zigged, bonds zagged. The 40 per cent bond sleeve was more than just ballast; its consistent coupon payments and steady capital appreciation turned it into a reliable secondary growth driver, smoothing out volatility and providing stability during equity market downturns.
“For investors seeking to build resilient, long-term wealth in a world of lower expected returns and shifting correlations, the move from a two-legged 60/40 stool to a three-legged 50/30/20 structure is a compelling proposition. ”
However, the landscape has shifted dramatically. With US Treasury yields now hovering in the 4 to 5 per cent range and inflation proving to be stickier than anticipated, the reliable diversification benefit that was the hallmark of the 60/40 portfolio has begun to erode.
The historic bond-as-balancer effect is fading as stocks and bonds now often move in tandem, a phenomenon that challenges the very foundation of this two-legged stool.
Building a more stable structure
This brings us to a crucial question: Where do we go from here?
The ultimate goal for most investors remains the consistent growth of wealth with reduced volatility. We do not believe the 60/40 portfolio is broken or irrelevant, but it does appear to be losing its definitive edge in the current economic regime.
For high-net-worth individuals and families, whose primary objective is the steady compounding of wealth, the limitations of a two-asset framework are becoming apparent.
Introducing a third sleeve of private assets can be transformative, evolving the portfolio into a more robust 50/30/20 structure (50 per cent equities, 30 per cent bonds, 20 per cent private assets). Why have two legs to stand on when you can have three for greater stability?
Adding a dedicated allocation to private markets allows investors to meet their future return needs, especially when traditional fixed-income yields may no longer be sufficient to carry the load.
The rationale for an allocation to private assets is multifaceted:
- Increased diversification of income: Private assets, such as private credit, infrastructure and real estate, offer income streams that are often higher and less correlated to public markets. This enhances portfolio resilience without sacrificing the potential for attractive yields.
- Navigating high equity valuations: Current equity markets are characterised by high valuations and what we describe as “narrow” leadership, where gains are driven by a handful of mega-cap technology companies. This concentration creates significant risk. Private equity, in contrast, provides access to a broader universe of companies at different growth stages, offering diversification away from the crowded public markets.
- A new source of yield: For a bond investor, the starting yield is a critical determinant of future returns. Today’s yields, while higher than in recent years, are still low by historical standards and may not offer the same potential for capital appreciation. Private assets, particularly private credit, can help maintain or even boost portfolio income while allowing for a reduction in the more volatile equities component.
A simple framework of FUR
In navigating this new environment, investors should be guided by our simple framework: be flexible, prepare for uncertainty, and build resilience. A 50/30/20 portfolio is purpose-built for this.
- Flexibility: The inclusion of private assets provides a wider toolkit to adapt to changing market conditions. It allows for opportunistic investments across different economic cycles and geographies.
- Uncertainty: The future is inherently uncertain. A three-sleeved portfolio is better equipped to handle surprises, as the different asset classes respond differently to various economic shocks.
- Resilience: By diversifying income sources and reducing reliance on the fluctuating correlation between public stocks and bonds, the overall portfolio becomes more robust and better able to withstand periods of market stress.
Practical considerations
Transitioning to include private assets requires careful planning. First, investors should stagger the deployment of capital over time. This approach, known as building a “vintage year” programme, mitigates the risk of allocating a large sum at a market peak.
Second, it is often prudent to stick with big, established players. Large, reputable private asset managers typically have the resources, access to deals and expertise to navigate these complex markets.
Third, diversification within the private asset sleeve itself is crucial. A well-constructed allocation should include a mix of sub-asset classes such as private equity, private credit, private real estate, infrastructure, and potentially diversifying alternatives such as hedge funds or gold.
Of course, one must also consider the fly in the ointment. Private assets are not without their challenges. They are generally more opaque than public securities, with valuation lags that can make it difficult to assess performance in real time.
They are more complex to understand and are subject to an increased fee drag from management and performance fees. Furthermore, they require specialist governance to monitor and have a less extensive long-term track record during periods of prolonged economic stress.
Despite these hurdles, for investors seeking to build resilient, long-term wealth in a world of lower expected returns and shifting correlations, the move from a two-legged 60/40 stool to a three-legged 50/30/20 structure is a compelling proposition.
It acknowledges the challenges of the present while strategically positioning for the uncertainties of the future.
The writer is head of investment strategy, UOB Private Bank
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