Many advisors today are increasing allocations to alternative investments with the goal of enhancing returns or mitigating risk. We would agree that this is a prudent approach that can improve portfolio diversification and deliver a smoother ride when markets turn volatile, as they inevitably do. But many advisors hold firm in the belief that a traditional “60/40” approach can provide each of the three main ingredients in a healthy portfolio: strong performance, capital protection and diversification.
Forget for a moment that private equity (PE) has historically outperformed publicly traded stocks by roughly 300 basis points per year, or that as much as 1000 additional basis points can be accessed by investing in top-performing PE funds1 (top-performing funds have become more accessible today because of advances in technology and the growing number of PE firms prioritizing the private wealth channel). Forget too that hedge funds, despite a challenging period post-crisis, have still managed to outperform global equities with less than half the downside volatility over the past three decades. If you are one of those 60/40 traditionalists, congratulations on a banner year.
At the time of this writing,2 the S&P 500 Index has appreciated by roughly 25% in 2019, while the Bloomberg Barclays Aggregate Bond Index is up over 8.5%. Together, a blended 60% stock and 40% bond investment has delivered a return of over 18% thus far this year.
In addition to strong performance and minimal volatility, investors have also benefited from a return of the negative correlation between stocks and bonds. The only two negative months for the S&P 500 (May and August), coincided with some of the best returns for fixed income in 2019. Should the rally in traditional assets persist through year-end, a 60/40 portfolio could easily generate a return of 20% for the first time since 1998.
Will next year bring more of the same? Well, monetary policy remains accommodative, equities appear attractive on an earnings-adjusted basis versus bonds, and the macro environment is benign. Case in point: At 3.5%, the unemployment rate is at its lowest level since 1969.
Advisors with an appreciation for historical context may be interested to know that two of the years mentioned earlier – 1969 and 1998 – were also notable for S&P 500 “Sharpe Peaks.” In both of these years, while a peak in S&P 500 risk-adjusted returns was followed by a continued equity rally lasting approximately 18-24 months, equities subsequently experienced declines of 40% or more, with investors realizing cumulative losses over the next 5-10+ years. As the chart below shows, the most recent Sharpe peak occurred in September 2018, roughly 14 months ago. Since then, despite a tumultuous fourth quarter, the S&P 500 has continued on its upward trend and is again trading at record levels.
After another strong year for traditional assets, it’s reasonable for the 60/40 believers to question whether alternative strategies are needed at all. If you have faith that the current trend will continue, your answer may be no. We would certainly argue that this is an opportune time to shift some assets into alternative investment strategies, particularly those designed to capitalize on the myriad inefficiencies in private markets, to exploit complex opportunities that are less directional in nature, or to profit from shorting those securities that have been lifted by the rising tide. While the recent success of traditional assets may indeed persist, history suggests otherwise.
(1) Source: Cambridge Associates, as of December 31, 2018.
(2) November 10, 2019.
IMPORTANT INFORMATION
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security offered by Institutional Capital Network, Inc. or its affiliates (together “iCapital Network”). Past performance is not indicative of future results. Alternative investments are complex, speculative investment vehicles and are not suitable for all investors. An investment in an alternative investment entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital Network assumes no liability for the information provided.
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