If there’s one moment that changed the course of investing forever, it was in 1952, when Harry Markowitz published his seminal paper on modern portfolio theory (MPT). After studying how different asset classes interact with one another, he posited that a diversified basket of stocks and bonds could help maximize returns while minimizing risks. Until then, many institutions invested all their money in fixed income. With MPT, they began creating the 60/40 stock-bond portfolios that many investors and advisors still use today.
While the tools and frameworks used in portfolio construction have evolved, the portfolios of most high-net-worth investors have not, even though the world has changed significantly. Today, economies are far more intertwined, central bank policy is less differentiated, inflation has returned and the list goes on. Some of these shifts have caused markets to move almost in lockstep with one another — and not just among different equity assets, but between stocks and bonds too.
Traditional investing methods are no longer sufficient. Indeed, a growing number of advisors are changing the way they allocate client money. How? By adopting the total portfolio approach (TPA), pioneered in the early 2000s by institutional investors, including the Canada Pension Plan.
The hidden risk in client portfolios
TPA was created to address some of the shortcomings of strategic asset allocation models, an investment strategy based on MPT. The approach provides a more adaptable framework, allowing investors to be more opportunistic, dynamic and flexible. A 60/40 portfolio may seem diversified, with assets in real estate, government bonds, small-cap stocks and so on. In actuality, these assets can be exposed to common underlying risk factors, which may cause them to move up and down together.
Here’s a real-life example. In 2022, an advisor employing 60/40 came to me with the call of the decade — he wanted to slash his interest-rate exposure risk to zero because he bet that interest rates and inflation would rise. He sold off his core bond portfolio, replacing it with a short-term bond fund, a global multi-sector bond fund and a long-short credit hedge fund. On the equity side, however, he wanted to add U.S. technology, dividend stocks for income and real estate to combat inflation.
The problem? All those trades created additional interest-rate risk on the equity side of the portfolio. That meant that any clients holding more stocks than bonds would be overweight interest rate risk — the exact opposite view the advisor was trying to express.
TPA does away with traditional asset allocation buckets. To those who use this approach, small-caps, value stocks, international growth — it’s all seen as equity risk. Better to consider how every single investment in a portfolio contributes to the potential of achieving the portfolio’s ultimate goals. That involves creating a factor-risk model, which accounts for 90% of what drives markets. (Only 10% of a portfolio is influenced by the fund manager.)
Building resilient portfolios
One issue with the 60/40 portfolio is that while you have depth of diversification — owning a variety of stocks and bonds in multiple ways — you don’t get breadth of diversification and you don’t own multiple asset classes uncorrelated to one another.
A 40/30/30 approach — 40% equities, 30% fixed income and 30% alternatives — can help solve this challenge. Using alternatives, which include hedge fund-like strategies such as long-short and market-neutral, is critical to TPA because it adds more breadth. These assets can provide non-correlated exposures in a portfolio. That can reduce risk and enhance returns in a way that doesn’t add to equity or fixed income exposures.
The idea is to build multiple layers of fortification into the portfolio so you create greater resilience that can weather a variety of risks, while still achieving meaningful returns in any market.
Consider how alternatives interact with other assets in the portfolio. Screen for equity and fixed income assets that boost the risk-adjusted return potential. You can then layer on liquid alternatives — versus difficult-to-sell illiquid alternatives such as real estate or private equity — to fortify the portfolio even further.
To create a portfolio in this way, you need to consider the two roles alternatives can play in a portfolio — enhancers and diversifiers.
Enhancers help advisors improve outcomes by giving your client’s portfolio a better chance to make more money or by lowering their downside exposure. Within this group are return amplifiers such as private equity, and risk mitigators such as long-short funds.
Diversifiers involve strategies that can add or lessen risk in a portfolio. Stabilizers, which include absolute-return or event-driven strategies decrease risk. Alpha engines, such as an absolute-alpha strategy, increase risk by outperforming cash over time without replicating the risks in the rest of the portfolio.
It’s also important to recognize that traditional assets in a portfolio don’t perform well when inflation is high. Stocks and bonds were great to hold when it cost nothing to borrow, and you didn’t need returns that beat inflation. In inflationary environments, where bond prices decline as yields rise and investors gravitate toward cash-like instruments, the diversification between these two asset classes breaks down.
Rethinking asset allocation
Shifting toward TPA won’t happen instantly, and it requires a change in thinking.
The bottom line though is that strategic asset allocation is quickly becoming an obsolete framework as more institutions, advisors and investors adopt TPA. Now’s the time to let go of 60/40 and take a new approach.
Robert Wilson is SVP, head of innovation, portfolio strategist with Picton Mahoney Asset Management.