A global black swan event — COVID-19 — followed by record inflation and the sharpest upward interest rate trajectory in three decades has bedeviled markets over the last three years. Moreover, the financial markets have undergone structural shifts that call into question the effectiveness of traditional portfolio construction techniques. No one can predict the future, but the next phase of the market cycle will not look like that of the last decade, when investors enjoyed the longest bull run in US history. So, investors should consider adjusting how they build their portfolios.
Here we examine alternative portfolio construction methods that supplement the traditional 60/40 stock/bond portfolio with allocations to alternatives, or alts. These include private equity/venture capital; hedge funds; and real assets, including private real estate, commodities/natural resources, and intellectual property. We explore the theoretical basis for going beyond the 60/40 portfolio and consider the present and future market conditions that could make alternative portfolio allocations useful to institutional and individual investors alike.
The State of the 60/40 Portfolio
The year 2022 was historically bad for the average 60/40 portfolio, which fell by 16%. So why stick with it? Because, for most of the last century, bonds’ low or negative correlation to stocks protected portfolios from stock market volatility. Unfortunately, this relationship tends to fall apart amid high inflation.
During “quasi-stagflationary” periods, stocks and bonds often exhibit higher correlations. Their correlations have tended to be negative or minimal — below 20%, for example — since 1998, when the five-year inflation CAGR generally fell below 3%, according to Blackstone. The current higher, 3%-plus inflation regime has pushed the stock-bond correlation to more than 60%, a level reminiscent of the 1970 to 1998 era. This has contributed to the traditional 60/40 portfolio’s third-worst annual return since 1950.
Public equities have recovered somewhat in 2023. Through the end of the third quarter, the 60/40 portfolio delivered a 7% rate of return. Still, the public markets have been volatile: The S&P 500 ended September down more than 7% from its July highs, with more volatility expected. While the stock market has performed well lately, seven major tech stocks account for much of the gains and price-earning ratios are high. Simply put, a rising rate environment impedes growth, potentially devalues bonds (and stocks), and injects uncertainty into the market. With renewed geopolitical tensions and ongoing public health threats, sentiment-based swings in stock values may be inevitable, and while future US Federal Reserve moves are unknowable, inflation may remain a fixture and constitute a headwind to dividend stocks and bond yields for some time to come. So volatility will probably be the rule rather than the exception in the months and years ahead.
Year-over-year (YoY) CPI inflation has fallen in recent months amid one of the most aggressive rate hike cycles ever. But the path to the Fed’s 2% annual inflation target remains fraught. While the Fed did recently signal possible rate cuts in 2024, nothing is guaranteed and a “higher for longer” policy is still possible if inflation persists. The stock-bond correlation has continued to hover around 60% since the start of the year. The 60/40 portfolio showed considerable diversification benefits in recent years and generated enviable returns through the pandemic. But the current moment requires a paradigm shift. Investors must consider different portfolio compositions if they want to drive risk-adjusted returns, decrease cross-asset correlations, increase appreciation potential, and diversify into alternative income sources.
Infusing Alternatives (Alts) into a Portfolio
The rationale for changing or optimizing portfolio allocations rests on Harry Markowitz’s modern portfolio theory (MPT). Bundling assets with low correlations can help maximize returns given the specific risk/return characteristics of the assets themselves. In MPT, pairing a risk-free asset with a “market portfolio” to create optimal portfolios should maximize anticipated returns for various levels of anticipated risk (downside variance). These allocation decisions, in turn, improve the “efficient frontier,” or the opportunity set that realizes the highest expected returns at the lowest volatility or standard deviation.
There are many ways to optimize a portfolio. The “Endowment Model” pioneered by the late David Swensen at Yale University is a prime example in the alternatives spaces. The perpetual nature of endowments and their smaller liquidity needs make their increased exposure to alts, which tend to be less liquid than publicly traded stocks, intuitive. Some endowments have alts allocations of more than 50%. Swensen believed in a strong equity focus but felt the bond portion of a portfolio should provide yield while also offsetting the volatility contributed by the portfolio’s stock component.
Under Swensen, the Yale Endowment did not invest in corporate bonds because of their inherent principal-agent conflict — company management has to drive value for both stock- and bondholders — and because they display a minimal premium relative to government bonds after factoring in defaults. Swensen also avoided non-US bonds because, despite potentially similar/offsetting returns, the associated currency risk and uncertain performance in volatile times did not align with his long-term investment goals. As he explains in Pioneering Portfolio Management, equity generates superior long-term returns, a well-diversified portfolio requires investing in non-publicly traded/private/illiquid securities, active managers can extract alpha in less-efficient markets, and patient investors with longer horizons have a relative advantage. During his 25 years managing the Yale Endowment, Swensen achieved a 12.5% annualized return and outperformed the S&P 500 by 280 basis points (bps).
So, what is it about alternatives portfolios? Alts are generally less correlated to public stock and bond investments. Private equity and hedge funds, for example, may correlate with public equities, but MPT holds that adding less correlated assets may improve a portfolio’s overall risk/return profile.
Alts tend to be more illiquid, perhaps because they trade less frequently than their public counterparts or because they lack liquid prices. Valuations for alts are often based on periodic private valuations. For privately owned real estate, valuations depend on appraisals, so changes in value may have a lag and, in turn, smooth returns/volatility. The alts-trading markets may not be as efficient as the public markets where arbitrage opportunities are traded away before general investors can capitalize. There are several techniques to unsmooth returns, but how this impacts correlation and volatility, including the methodology to capture the stock/bond correlation as well as alts’ correlation/ diversification benefits, are subject to debate.
Alts often have non-normal distributions unlike short-term returns on stocks and bonds. Returns for most investments further converge to normal distributions as they approach their exit/liquidation as the risk of major shocks decreases. The inverse works as well: The longer the hold periods associated with alts, the greater the potential for distortion and skew in distributions or enhanced (tail) risk from outsized losses/gains.
Active management of illiquid alts in inefficient, opaque markets, with idiosyncratic return drivers and risk factors, contribute to performance and risk-adjusted returns. Management selection is therefore critical, and the CAIA Association estimates a return dispersion of up to 15%, depending on the alternative in question, between the performance of the top and bottom quartile of managers.
Despite ongoing academic debate on these methodologies and characteristics, long-run data indicates diversification through alts has benefits. Of course, as with any investment analysis, past performance does not predict future results. Additionally, any allocation decisions will depend on risk tolerance, liquidity needs, and long-term strategy. Furthermore, the numbers presented here are merely pro forma illustrations of potential scenarios based on historical data.
Three common portfolio compositions — the default 60/40, the more defensive 40/60, and the more aggressive 80/20 allocations — all underperformed or realized inferior risk-adjusted returns relative to portfolios that decreased their stock or bond allocations in favor of infusing alts, according to research by JPMorgan Asset Management.
Whatever the potential shortfalls of the Sharpe ratio as a measure of excess return per unit of risk or how portfolio allocations have performed in recent times in terms of Sharpe ratios, a 30% alts infusion into any of these portfolios led to better performance, according to JPMorgan analysis. The 60/40 portfolio reallocated to 40/30/30 stocks/bonds/alts improved its Sharpe ratio to 0.75 from 0.55 from 1989 to the first quarter of 2023. Similar adjustments to the 40/60 and the 80/20 portfolios also improved Sharpe ratios from 0.84 and 0.67 compared to 0.64 and 0.48, respectively.
Portfolio Diversification Example
Infusing Alternatives (Alts) into Investment Portfolios
Sources: EquityMultiple Investment Partners, Green Street Advisors, and JPMorgan Asset Management. Based on precedent analysis by JPMorgan Asset Management in Q4 2023 “Guide to the Markets,” and sourced from Bloomberg, Burgiss, FactSet, HRFI, NCREIF, and Standard & Poor’s as well as JPMorgan Asset Management. Alts include hedge funds, real estate, and private equity, all equally weighted. Portfolios are assumed to be rebalanced at the start of the year. Sharpe ratios are based on EquityMultiple Investment Partners analysis and assume an average one-year US Treasury rate over the 1989 to Q1 2023 time frame. The Sharpe ratio-based comparison does not account for the smoothing of returns or the non-normal distribution associated with all alts portfolios.
Recent research from the CAIA Association supports these findings and highlights the portfolios’ smaller maximum drawdowns. A 100% alts portfolio, with equal allocations across private equity, private debt, hedge funds, and real assets, incurred maximum drawdowns at least 20% smaller than those of 60/40 portfolio in the trailing 10- and 15-year periods as of the fourth quarter of 2020. The same portfolio had a 10-year and 15-year Sharpe ratio of 1.38 and 0.87, respectively, compared to 0.66 and 0.43 for the 60/40 portfolio.
Asset Class Performance Example
Sources: EquityMultiple Investment Partners, CAIA Association, and Green Street Advisors. Based on/replicates CAIA Association analysis from “Portfolio for the Future.” Data sourced from Bloomberg, Burgiss, and the CAIA Association. Alternative asset portfolio is equally weighted with private equity, private debt, hedge funds, and real estate (real estate, natural resources, and infrastructure). Data is quarterly with annualized returns computed using the arithmetic mean. Data for private equity, private debt, real estate, natural resources, and infrastructure are computed using pooled time-weighted return statistics for funds with vintage years 2000 through 2016. Sharpe ratios based on EquityMultiple Investment Partners analysis assume an average one-year US Treasury rate over the analysis horizons of 2005 and 2010 to Q4 2020. The Sharpe ratio comparison does not account for smoothing of returns or a non-normal distribution associated with a 100% alts portfolio.
How can an allocation to alternatives benefit a portfolio? KKR research contrasts four different portfolio compositions in both high and low inflationary environments.
Inflationary Regime Example
Sources: EquityMultiple Investment Partners and KKR. Based on/replicates precedent analysis from “KKR Insights: Regime Change – Changing Role of Private Real Assets in Traditional Portfolio,” and sourced via Burgiss, Aswath Damodaran, Bloomberg, NCREIF, and KKR Portfolio Construction analysis. Portfolio returns and volatility are modeled using annual total returns from 1928 to 2021 for the S&P 500, from 1978 to 2021 for Real Estate, from 2004 to 2021 for Infrastructure, from 1928 to 2021 for Bonds, from 1981 to 2021 for Private Equity, and from 1987 to 2021 for Private Credit. The analysis assumes continuous portfolio rebalancing. US Equities and bonds are modeled on the S&P 500 Index and the annual returns of a 50/50 mix of US Treasury bonds and Baa Corporate Bonds, respectively, as calculated by Damodaran. Real Estate is modeled on the NCREIF Property Levered Index; Private Infrastructure on the Burgiss Infrastructure Index; Private Equity on the Burgiss North America Buyout Index; and Private Credit on the Burgiss Private Credit All Index. Cash yields are based on annual data from 2000 to 2021 for all asset classes except Private Real Estate, which has data from 2005 to 2021. Public Equity’s proxy is S&P 500 12M gross dividend yield; Private Equity’s is S&P Small Cap 12M gross dividend yield; Private Infrastructure’s is S&P Infrastructure 12M gross dividend yield from 2006 onwards and 2000 to 2006 backfilled using S&P Utilities; Public Credit’s is based on Bloomberg Aggregated Credit yield to worst; Private Credit uses Cliffwater Direct Lending Index Income Return; and Private Real Estate’s is based on NCREIF NPI cap rate.
These portfolios generated higher Sharpe ratios across a performance window of more than 20 years, albeit with a less liquid strategy. Indeed, every alts-infused portfolio generated higher Sharpe ratios than their 60/40 counterpart during periods of both high and low inflation.
The underlying data further shows that real estate nominal returns measured 11.0% during periods of high inflation and 9.9% during low inflation, according to NCREIF Property Levered Index data beginning in 1978. That compares to the nominal returns of US equities: -4.2% amid high inflation and 13.9%,during low inflation based on S&P 500 data going back to 1928.
These results are intuitive since real estate can capture inflation through underlying leases and lease escalation clauses. Over the past 40 years, real estate has provided a near-perfect inflation offset since non-sector specific global property real rental growth has averaged 0%.
The sample portfolios share a common thread: They allocate to alts at the expense of the exclusive stock/bond composition and maintain a similar appreciation/upside vs. yield/defensive balance.
“I really like to think about more opportunities within the 60 and within the 40. I think just widening the aperture of investable opportunities is what the investor should be thinking about.” — William J. Kelly, CEO, CAIA Association
The quote above describes the rationale behind reallocating to alts. Reallocating to private equity or venture capital from stocks can diversify without sacrificing aggressive upside potential. Reallocating from bond to private credit or real assets, such as real estate/infrastructure, can diversify that component and maintain the conservative/defensive element. Within real estate, triple net (NNN, credit) investments or, in the current environment, collateralized first mortgages can act as “debt-like” instruments that help balance and solidify a portfolio. Additionally, opportunistic real estate strategies — development, for example — can stand in for a (private) equity allocation.
Alternating Alternatives: A Close-Up on Real Estate
How should investors approach a real estate allocation? REITs and crowdfunding platforms now provide divisible and democratized access to privately owned commercial real estate assets. Rather than serving as an intermediary, some platforms — EquityMultiple, among them — provide additional oversight by underwriting and diligencing opportunities and through active asset management in collaboration with the owner/operator through the investment hold. This resembles an REIT structure in which shareholders rely on a management team for investment decisions and daily management.
REITs are widely available and well covered in the public markets. This gives them valuable liquidity and a divisibility/exposure benefit — possibly at a sector level — as well as standardized reporting, which is also one of their key pitfalls. Publicly traded REITs tend to correlate with equities. US REITs and US large-cap equities, as proxied by the NAREIT All Equity Index and the S&P 500, respectively, show a 77% correlation for the trailing 10 years ending in the third quarter of 2023, according to JPMorgan data. KKR’s research shows an even stronger 97% correlation between US public REITs and global public equities, as proxied by the MSCI U.S. REIT index and the MSCI World Index, respectively, in the 20 years through the first quarter of 2023.
While private real estate was once confined to institutional and high-net worth investors, accredited investors now have access. Regardless of the correlation and volatility associated with alts, including appraisal-based valuations, the segment provides a differentiated return profile to an investment portfolio, as the sample portfolios above demonstrate.
Changes to value over time demonstrate this as well, both from a public (sentiment) and a private pricing perspective. We proxy public market sentiment through the REIT premium/discount to net asset value (NAV) (via Green Street Advisors’ 138 REIT coverage universe). We then overlay the 12-month YoY growth rate in the Green Street Advisors Commercial Property Price Index (CPPI), a barometer that tracks private real estate valuations across several sectors, adjusted to an annual growth rate in order to measure (appraisal) lag. Since September 1998, the two charts move in relative unison (with some private valuation lag) during the GFC in 2008 and 2009, during the subsequent recovery, and through the COVID-19 pandemic and market uncertainty and macro shocks that followed.
Pockets of public-private pricing dislocation, for example, occur during the late 1990s when significant REIT trading discounts were unmatched by declines in private valuations (vs. the charted slowdown/stagnation in growth), Similarly, in 2014 and 2018, amid the taper tantrum and subsequent events, REITs traded at discounts relative to private market valuations.
Private Real Estate Pricing vs. Public Market Sentiment
Source: EquityMultiple Investment Partners and Green Street Advisors. REIT Premium (Discount) to NAV is measured on a monthly basis based on Green Street Advisors data and span the Green Street covered REIT universe of 138 REITs as of October 2023. YoY Private Market Value Growth Rate is measured each month based on Green Street Advisors Commercial Property Price Index (CPPI), equally weighted across Green Street Advisors covered sectors.
The key takeaway is that public REIT valuations do not always match those of private real estate. There are several biases and factors at work, including the inherent smoothing of private valuations. When REITs trade at significant discounts to NAV or relative to the private values, investors may acquire shares in institutional-grade real estate at a compelling discount. Nevertheless, prolonged periods of dislocation suggest that private real estate can be less volatile than the more liquid, daily-traded REITs when it comes to public sentiment.
Private real estate tends to preserve value and cash flow through market stress, in part, because of the assets’ inherent worth. Irrespective of earnings, the Fed rate, and other factors, people need places to live, and pricing will respond to supply and demand. Multifamily has tended to outperform during down cycles. Other niche real estate sectors, such as student housing, medical office buildings, last-mile industrial, and data centers, may provide safe harbors during tough economic times.
Timely Aspect of Alternatives
Real assets, real estate, and other private market alternatives can help investors move beyond the 60/40 portfolio and deliver the superior risk-adjusted return profiles illustrated above, and at a more detailed (asset-class) level. They also can help capture inflation and protect against macroeconomic shocks. Real estate in particular can provide category-wide stability on the private side, while serving as either an alternative to bonds, in the form of NNN real estate or real estate debt, or an alternative to equity through opportunistic real estate/development, for example.
The gateway to alts is open and widening as different platforms democratize access. According to the CAIA Association, alts grew from approximately 6%, or $4.8 trillion, of the global investable market in 2004, to 12%, or $13.4 trillion, by 2018. So, while the global investable market doubled in size, the share of alts nearly tripled. By 2025, alts may account for 18% to 24% of the total market.
As institutional investors increasingly pursue alts as part of their long-term allocation strategies, investors should evaluate the options available in the marketplace today. Amid uncertain times, investors should plan and pursue their own alts-infused portfolios to achieve their investment goals.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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