In This Trading Environment, “60-40” Is A Losing Proposition

The Tradex Group Weekly Blog

February 18, 2013

By Richard Travia, Director of Research

In This Trading Environment, “60-40” Is A Losing Proposition

Change is constant on Wall Street – even a 24-year-old with a simple 401k plan knows that.

And that’s a good thing. Investment strategies that hang around for a while tend to resemble a loaf of bread left on the kitchen counter for a week or so. First it grows stale, and after a while you start to question whether the bread is healthy to eat or not.

In short, it’s a trust issue.

The same goes for Registered Investment Advisors and Broker/Dealers wedded to a traditional 60-40 equities and fixed income portfolio strategy model.

Whether it’s stubbornness or fear of trying a new approach, financial services professionals stick to traditional investments, and avoid alternative ones – to the detriment of their clients’ portfolio performance.

That’s a big mistake. In this chaotic investment environment, I wouldn’t want to be long only in any traditional equity or fixed income position – you really need to be diversified among both traditional and alternative investments.

That not only enhances returns historically, but it can also provide more stable cash flow, and leverages robust return opportunities in non-traditional investment sectors like shorting, interest rates, mortgage securities or commodities to name a few.

How good are those returns?

According to a NACUBO-Commonfund Study of Endowment Results from 2003 to 2012, the Standard & Poor’s 500 index returned a measly 2.7%, while 472 university endowments of all sizes consistently outperformed the index. The key factor in that over-performance? The study reports endowments with the greatest exposure to alternative assets easily outpaced the S&P Index, with average annual yields of 6.9%.

For RIA’s and Broker/Dealers, there are additional reasons for blending more alternatives into traditional portfolios. Let’s review some advantages and differences between traditional and alternative investments: 

Alternative Investments	Traditional Investments
Absolute performance objective	Relative performance objective
May use leverage	Limited or no leverage
Performance dependent primarily on alternative investment manager skill	Performance generally dependent primarily on market returns
Historically low to moderate correlation with market indices	Historically high correlation with market indices
Typically have reduced liquidity ranging from monthly to 12-month-plus lock-ups	Typically offer daily liquidity
Generally higher fees, which may include performance fees	No performance fees but may include fixed management fees for professional management.

Source: Morgan Stanley

So where should RIA’s and Broker/Dealers focus when discussing alternatives with their clients?

Target these three key areas:

Diversification – Brokers don’t talk about it much, but the traditional definition of diversification really doesn’t hold water. It’s really not about allocating client funds to dozens, or even hundreds of stocks and bonds (i.e., in the traditional 60-40 model). Instead, focus on strategy diversification, mixing in different alternative options.  Long/Short Equity, Long/Short Credit, Volatility Arbitrage, CTA’s and Mortgage Trading are some strategies that offer a diverse way to access relatively liquid asset class opportunities.

Risk evaluation – Financial services professionals should focus on targeting risk factors of both traditional and alternative investments. That said, the risk story you engage your client with is a good story to tell. Alternatives come from an asset class of investments that offer significantly different risk/return scenarios. In addition, alternatives have little correlation with each other – and to the S&P 500 or any common bond index. That gives you ample wiggle room to reduce risk in your clients’ portfolios.

Returns – As stated above, a portfolio blended among stocks and bonds and alternative investments beats a “traditional-only” portfolio model. Tout that advantage, and talk up the reduced risk and increased diversification, and your investors will be more receptive to abstaining from that stale loaf of bread on their portfolio tables.