Tony Davidow has questioned whether the traditional 60-40 split is the best way to construct a portfolio for a while, and he just might have found the environment to prove him right.
“Modern portfolio theory has served us well for decades and decades, but I think we have to be honest and acknowledge there are some limitations,” said the CEO and founder of T. Davidow Consulting, a New York-based advisor to financial advisors, and author of “Goals-Based Investing: A Visionary Framework for Wealth Management.”
The two primary limitations, he continued, are the underlying premise that investors rationally will always select the optimal portfolio and the fact that investors use data selected from the past to try to predict the future.
“In this environment in particular, if we use stale data with bad inputs we’re going to have bad outcomes for our clients,” he said at Investments & Wealth Institute’s ACE Academy 2022 in Nashville, Tenn., earlier this month. “We were very fortunate. We had an easy run from 2009 to 2020. Let’s celebrate that. The next 10 years are not going to be anywhere near as easy, so we’re going to need a different playbook.”
But rather than be dismayed, he said he thinks it’s a great time for financial advisors because individuals who have gone it alone are going to learn that the “cookie-cutter robo-offering isn’t going to get them where they need to be.”
The environment that will drive new clients to advisors includes the usual suspects—the S&P 500’s historic 10.2% return whittled down to a predicted 4% to 5%, still-low fixed income yields, corrosive inflation and geo-political shocks that most likely are not over. And where financial advisors can add value, Davidow said, is in the less-common realm of alternative investments, which slowly have become more accessible but still are relatively complex compared with buying stock.
Part of the appeal of private equity, private credit and real assets (real estate in particular), he said, is that they’re unique asset classes. Private equity, for example, historically has delivered a 300- to 500-basis-point illiquidity premium. Private credit’s performance has been similar and also has an income kicker. And real estate provides a hedge to inflation, picks up some incremental yield and provides a return.
“Those tools are the tools we need in this environment today. It doesn’t mean we discard everything else we’ve learned, like the value of diversification in portfolios,” he said. “But we need to expand the toolbox. We need different tools, and we need more multipurpose tools.”
The question of why someone should add one of the categories that makes up alternative investments to their portfolio can only be answered in relation to the client’s overall goals, he advised. In short, private equity offers the potential for higher returns, private credit can provide alternative sources of income, and real assets offer portfolio diversification and inflation protection.
And now, given that the public has new access to more kinds of alternatives investing, these can be those multipurpose tools that previously were unavailable to everyone except the most wealthy of clients, he said, adding that when he looks at investors who have had access, like institutions and family offices, what he sees are investors who are heavily invested in alternatives, sometimes to a point where this asset class represents 75% of a portfolio.