This Time We Really Really Mean It, Really!

rogernusbaum

Seth Bernstein from Alliance Bernstein had a write up at Marketwatch that put an interesting spin on the death of the 60/40 portfolio. A 60/40 is kind of the default mix of stocks to bonds in a diversified portfolio. Part of the reason, probably the biggest reason, to explore whether 60/40 can still get it done is that interest rates have been below "normal" for more than ten years. Investment grade credit and treasuries have miserably low yields for people relying on the income stream. Also complicating this picture is the possibility that the next few years, ten years, however many years, might deliver relatively low equity returns. That's not a prediction on my part but the 2000's had lousy returns for domestic equities, the teens had great returns and the 20's are off to a bad start. There has been a cyclicality to domestic equity returns and while I wouldn't say the cyclicality fits neatly into a decade, there is something to it and there will be stretches where equity returns aren't so hot.

Will bond yields ever "normalize?" Obviously I don't know but 60 basis points for a ten year treasury note breaks a lot of models. There are still high yielding instruments like junk bonds (high yield is the more PC term), bank loans, some emerging market debt as well as yield oriented niches like MLPs and REITs but there is far more risk there for 3% or 4% or 5% compared to the same yields from treasuries umpteen years ago.

Bernstein proposes ditching stocks and bonds as named assets in favor of beta, idiosyncratic alpha and defensive instruments. Beta is usually refers to broad indexed equity exposure like a fund tracking the S&P 500, Russell 1000 or a total market fund. Idiosyncratic alpha is where investor skill picking stocks or narrow based ETFs could add basis points of performance or not depending on the skill. Defensive instruments would traditionally be thought of as bonds but in Bernstein's thought it could be gold, cash and alternatives as well. Long time readers, even not so long time readers of this blog will know I have been a huge believer in small allocations to gold and alternatives since before the financial crisis.

The defensive instruments label resonates with me. This year, the iShares 7-10 Year Treasury Bond ETF (IEF) is up 10% and has a 30 day SEC yield of 0.44%. Up 10% with essentially no yield arguably makes IEF an equity proxy. Yes it has had a negative correlation and has helped anyone who bought it but to Bernstein's point, it probably isn't a real fixed income proxy. Using Bernstein's parlance it has been defensive instrument. Unfortunately, buying it here is essentially a bet on negative yields for the middle of the yield curve. At this point, clearly anything can happen but I am not inclined to bet on something that has never happened before.

Eric Balchunas from Bloomberg has long included alternatives in his ETF coverage noting the struggles that many alternative strategy ETFs have had. He noted over the weekend that JP Morgan will be closing its suite of alt funds due to low assets and apparently poor returns. With the S&P 500 below its 200 DMA and my preference to be less volatile than the index during this event, my allocation alternatives, or put differently, my allocation to defensive instruments is higher than it was during the vast majority of the bull market.

I have had good luck picking alternatives. Plenty of them don't do what investors would probably hope they'd do. I have no secret formula for picking but I think the process for picking requires first just some general reading on the strategy, like managed futures as one example or long short as another and then digging in to a specific fund to understand why it may have been successful either in real life or its back test if it's a new fund. As an example, a few years ago there was an ETF launched that equal weighted all ten of the S&P 500 sectors (this really was quite a few years ago now) at 10% each. The back test was strong because because utilities had dramatically outperformed the broad market for a good stretch. Utilities were something like 3% of the S&P 500 but 10% of this ETF. It took just a couple of minutes to isolate that and something that simple makes me suspicious about how repeatable it is. In this instance it's not really about process. I would want an alt to be about process when that is relevant. Client holding BTAL is an example of that as opposed to client holding GLD which is just gold, there is no investment process, it's just a tracker.

Idiosyncratic alpha is an interesting sleeve to consider and it probably the make or break in determining how much time you spend on your portfolio. Most people don't want to make a full time job out of managing their investments but following Bernstein's model, if 50% of your portfolio is allocated to idiosyncratic alpha in the form of individual stocks or very narrow ETFs, you'll need to spend time on it. Idiosyncratic alpha is also where asymmetric risk (huge potential upside with similar potential for going to zero) like with a lottery ticket biotech or a cryptocurrency can live.

In terms then of trying to assign percentages to beta, idiosyncratic alpha and defensive instruments, the amount you need to allocate to risk (the first two categories) depends a lot of saving rate, the ability for expenses to be less than income and some other factors but those are two big ones. The further you get ahead of your accumulation target (like you get 90% of the way there by age 50) the less exposure you need to risk assets. If you have visibility for sustainable income streams beyond Social Security and your portfolio, like a pension or real estate, then you can get by with less in risk assets.

Where most people can think in terms of 60/40, I could see a kind of default being 50% or 55% in beta, 5%-10% in idiosyncratic alpha and 40% in defensive instruments. If that is a default, then an actual mix could be driven from there to fit a specific situation. One thing to consider with a large allocation to alternatives within the defensive sleeve is the potential lost (opportunity cost) income. Remember, there still is more yield available in riskier income sectors (like high yield and bank loan mentioned above). If your idea of defensive is 20% in alternatives (hopefully effective alternatives) and 20% in treasuries then you're probably not going to get any yield to speak of.

One approach I am gravitating to personally is to think about how long it would take to double our assets based on a very ordinary, but not that low either, rate of return. At 5% annualized, it would take 14 1/2 years to double and 5% would be quite a bit higher than what inflation has been running, no guesses about the future though. I would be 68 and hopefully still have an income managing money. I would hope to keep contributing to savings too. Maintaining a 10% savings rate for the last 15 years of your expected career duration can add up to a large portion of what you ultimately end up with. This concept is bolstered by the idea that your later years are hopefully your highest earning years. The risk then is that you lose your job in your early 50's and remain underemployed for the rest of your career. To be clear, I want to keep managing money forever but at some age, people will stop hiring me.

Changes in life circumstances create the need to revisit allocation processes and decisions and make changes as appropriate. In other contexts, when I talk about the importance of staying curious, this is one example. Of all the 60/40 is dead articles I've read, Bernstein's idea is very interesting and there is something to the idea that it will be more difficult for folks who are not ahead of the game to adapt what they do with their retirements funds if fixed income doesn't provide actual, um, income.