We are firm believers that now is the time for individual investors to rethink the traditional 60/40 approach to asset allocation. We also admit that this view is far from consensus, as highlighted by a recent WSJ article titled Yale Invests This Way. Should You?1, which warned high-net worth investors of the purported dangers of adding alternatives to a conventional portfolio of stocks and bonds. According to the director of research at the CFA institute, “if you’re high-net-worth, with assets of $1MM or more, you’re probably considering alternatives. You should have a lot more than that.”
We don’t agree. While we accept that adding alternative investments such as private equity may not be prudent for all HNW investors, namely those with significant liquidity needs, shorter time horizons, and low tolerances for risk, there are several reasons why many HNW investors should strongly consider adding alternatives to their portfolios.
The idea behind the traditional 60/40 portfolio, the cornerstone of asset allocation over the past 30 years, is to have uncorrelated, less volatile investment returns in order to grow and preserve capital in any environment. 2022’s challenging market ride, however, brought the efficacy of this portfolio into question as bonds failed to serve their intended function as portfolio shock absorbers. With surging inflation and rising interest rates, Bloomberg’s US aggregate bond index lost 13% over the full-year, while 60/40 portfolios fell 17%, according to Blackrock.2
Diversification is critical to mitigating volatility. Whether or not bonds return to their perceived status as the ideal counterweight to stocks, we believe investors should look beyond public markets and turn to alternative asset classes to enhance the risk-return profile of their portfolios. While no asset class is immune to volatility, sophisticated institutional investors have long recognized the benefits of adding low-correlated alternatives to their portfolios and have poured trillions into non-tradeable assets. Individual investors, with help from their financial advisors, should aspire to follow their lead.
Not all HNW investors are alike. A 70-year old retiree with a $1 million net worth has a very different profile than that of a high-earning young professional with a similar net worth looking to build wealth over the long-term. For the latter, a 10–15% allocation to alternatives can meaningfully increase their portfolio’s quality from a risk-return standpoint, while the lion’s share of the portfolio can still provide immediate liquidity if unforeseen circumstances arise. For investors with liquidity needs, retirement accounts, which are not designed to be tapped until retirement age is reached, can serve as ideal vehicles for allocations to less liquid investments.
As a group, the new generation of funds registered under the Investment Company Act of 1940 (the “'40 Act”) has evolved and is placing more emphasis on aligning the liquidity of funds with the liquidity of the underlying investments, with the understanding that investments in private companies are inherently long-term in nature, and should be considered as such in a broader portfolio. Generally, it is suboptimal for risk-tolerant HNW investors to be 100% allocated to liquid public securities when they have the opportunity to carve out a small portion of their portfolio to earn an illiquidity premium from private equity and alternative asset classes.
Over the past two decades, a powerful trend of companies deciding to stay private longer has emerged. Between 2000 and 2020, the number of publicly traded stocks fell from about 5,500 to 4,000,3 as many have opted to postpone the headaches of regulatory filings, relinquishing control, and having to discuss quarterly performance with short-sighted investors at the expense of executing a long-term strategy. With more companies experiencing a larger portion their growth cycle under private ownership, it makes little sense for investors to exclusively own stocks within a shrinking set of the equity universe.
A wide range of registered alternatives products has been made available to individual investors in recent years, broadening exposure to commodities, digital currencies, private real estate, fine art, infrastructure projects, private credit, and so on. An increasing number of firms are targeting the multi-trillion Accredited Investor market and are offering ’40 Act products with reduced investment minimums, allowing individuals to add conservative allocations to alternatives in their portfolios. Traditionally, access to such funds has been limited to institutions and Qualified Purchasers. This is no longer the case.
While it’s impossible to say whether the structural relationship between stocks and bonds has permanently changed, widespread adherence to the 60/40 portfolio theory will likely continue to benefit from path dependency and inertia. For decades, the 60/40 benchmark has been the measuring stick by which CIO’s evaluate their performance, manager selection, and security selection. Moreover, during uncertain times there’s a natural tendency for nervous asset allocators to revert to what has either worked or seemed safe in the past. The macroeconomic environment may remain opaque for some time, and individual investors should reconsider conventional approaches to asset allocation and begin using more of the tools at their disposal to enhance diversification in their portfolios.