The New Era of Alternative Asset Allocation: 33-33-33 With a surge of alternative investment opportunities now available, one new strategic approach has emerged.
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During the 2010-11 NBA season, 22.2 percent of all shot attempts were three-pointers. Last year, this increased to 39.2 percent.. As the talents and abilities of players evolve, so too does the nature of the game. Today, the game as we know it is faster and less reliant on the big man in the middle.
The same can be said about investing. For decades, the 60/40 portfolio allocation was widely used by investors. Today, however, with record stock volatility and federal interest rates on the horizon, this long-standing strategy is being challenged.
With a surge of alternative investment opportunities now available for investors, one new strategic approach to allocating your portfolio has emerged: the 33/33/33 allocation.
Traditional portfolio allocation (60/40)
The late John Bogle, the founder of Vanguard Investment Group, popularized the classic portfolio allocation and inspired many to adopt a simplistic approach to investing. His classic allocation is composed of 60 percent equities to provide capital appreciation and 40 percent fixed-income securities for stability. Through this traditional portfolio allocation, investors strive to generate returns and minimize volatility through holdings of stocks and bonds.
The 60/40 portfolio additionally has a history of yielding solid and double-digit returns; from 2011 to 2021, 60/40 portfolios generated an average annual return of 11.1 percent. In 2021, traditional 60/40 portfolios, using Vanguard total market funds, returned 14.6 percent, including a 1.73 percent dividend yield.
In addition to its long-term consistency, many supporters also cite that the 60/40 portfolio's diversification benefits can help to protect investors from risk. In fact, this strategy has historically reduced portfolio volatility and mitigated market risk for the past three decades. Between 1991 and 2021, the 60/40 portfolio had a Sharpe ratio of 0.7.
Past performance, not a future indicator
In January 2022, however, the Bloomberg 60/40 Index lost 4.2 percent, the largest one-month drop for the index since the beginning of the pandemic. This could be evidence that a traditional portfolio allocation may no longer serve investors' best interests.
The purpose of diversifying across stocks and bonds is to minimize overall portfolio risk. In the past, the price movements of stocks did not tend to impact those of bonds and vice versa. However, the correlation between these two asset classes has begun to turn positive. Meaning, both assets might be likely to take a hit when markets take a turn, which can pose a significant risk to your portfolio.
Today, stocks are experiencing heightened volatility. Since November 2021, 40 percent of the 3,300 companies listed on the NASDAQ have lost more than 50 percent of their market value. Meanwhile, Meta's single-day $251 billion drop in market cap on February 3rd was the largest single-day market value drop of any U.S. public company ever. Despite a market selloff to start the year, numerous valuation metrics show the stock market as overvalued; at the start of February 2022, the S&P 500 was trading at 20.4 times its annual earnings. Some analysts warn of a stock market superbubble similar to those seen during the 1929 Great Depression and 2000 dot-com bubble.
The geopolitical conflict between Russia and Ukraine has also intensified market volatility. The NASDAQ has dropped more than 18 percent since its November all-time high, while the S&P 500 sits at its nine-month low. The Dow Jones has officially entered stock market correction territory, just eight weeks after the index hit its all-time high.
Meanwhile, due mainly to officials' attempts to curb rising inflation, the Fed plans to raise interest rates this year. These rate increases will likely place pricing pressure on the bond market as fixed-income securities have historically dropped when the Fed raises interest rates.
But inflation impacts more than the bond market. During periods of inflation greater than 2.5 percent, equities and bonds have historically become even more correlated. With inflation at a 40-year high, analysts warn of further implications for both asset classes.
All this is to say that the 60/40 portfolio might not make sense in today's shifting economic landscape.
Seeking a new approach to investing
Where can investors turn if the 60/40 might not perform how it used to? Investors have already begun fleeing from high-yield bonds. There seems to be little incentive to switch to lower-risk bonds with much lower yields. Some believe greater weight should be given to equities; others suggest forgoing asset diversification and investing 100 percent in broad stock market indexes.
In light of looming interest rate hikes, some believe cash and cash equivalents should replace bonds as the safe haven — though that strategy comes with a unique set of risks. Others believe traditional portfolios' failure to diversify into emerging markets leaves money on the table.
There is also growing sentiment that alternative investments might deserve more consideration.
Alternative assets rise to prominence
First, alternatives have historically generated equal, if not better, returns than both stocks or bonds. Precious metals were the top-performing asset class in 2020, while cryptocurrency and commodities led the way in 2021. From 1992 to 2020, farmland returns outperformed the S&P 500, bonds and even real estate.
Second, alternatives can act as a strong portfolio diversifier. The correlation between venture capital and large-cap stocks in the past had been -0.06, indicating no investment performance relationship between the two. Farmland historically had a negative correlation to both stocks and bonds, while digitized real estate security tokens had a low correlation with the stock market of 0.15. Commodities — considered among the top hedging opportunities against inflation — previously held only a 30 percent correlation to equities.
Third, alternative investments have historically been less volatile than traditional asset classes. In fact, adding real assets to a traditional portfolio can reduce a portfolio's overall standard deviation. As demonstrated in the chart above, allocating just 15 percent of portfolio assets to farmland reduced the portfolio's volatility by ~2 percent, dropping the average standard deviation from 10.53 percent with a 60/40 portfolio to 8.92 percent. Adding real estate alongside farmland also reduced volatility. Ten percent allocations to both farmland and real estate also historically increased returns, reduced volatility and resulted in a higher Sharpe Ratio.
The case for 33/33/33
As the alternative industry becomes increasingly accessible and transparent, evidence is emerging for a new portfolio allocation strategy: 33/33/33. A portfolio that is split between stocks, bonds and alternatives has historically performed well, often outperforming other allocations. Compared to a 60/40 allocation during this period, a 40/30/30 (40 percent equities) portfolio generated a higher annualized return with lower volatility and a lower maximum drawdown.
Incorporating alternative investments has also historically outperformed more defensive positions. A different study compared the performance of a 60 percent bond, 40 percent equity portfolio to a portfolio evenly-weighted across stocks, bonds and alternatives. From 1989 to June 2021, the portfolio with alternative assets generated lower volatility and higher returns than the defensive portfolio.
The new era of allocation
Every portfolio is uniquely created to meet each investor's own goals. Many have previously relied on a traditional portfolio allocation, though evidence exists to support incorporating alternative investments into one's portfolio. Forecasts are pegging global assets under management in alternatives to exceed $17 trillion by 2025. There are plenty of opportunities to embrace the new era of asset allocation and begin incorporating new investments in your portfolio.