At an investment conference held in early November last year, the moderator asked the crowd of several hundred advisors if they were confident allocating client assets using the tried and true “60/40” mix (60% S&P 500 Stock Index/40% Bloomberg Barclays US Aggregate Bond Index). An overwhelming majority of hands went up. The moderator also asked who believed additional tools were needed for diversification. A tiny number of attendees raised a hand.

Such lopsided voting is what one might expect, no? After all, as everyone knows, there has been a long bull market in bonds, and other diversifiers (such as alternatives), well, their performance has been disappointing for a while now, to put it kindly. Why bother with anything else when bonds are so much more reliable? Besides, the due diligence required to understand other diversification strategies (such as alternatives) is just too difficult (let alone explain to clients).

The timing of the aforementioned conference was ironic. Within days of the crowd’s confident expression of trust in Good Ol’ 60/40, the bond market cratered, as the yield on the 10-year Treasury note jumped from 1.83% at the end of October to 2.38% by the end of November. The result was a -4.7% loss for holders of the 10-Year Treasury in November (an -8.3% loss from the July peak). Virtually all of the year-to-date returns for the 10-Year were wiped out by the end of November, providing a harsh lesson in what happens to fixed income when duration exposure gets extended and interest rates go up.


10-Year Treasury Bond Returns
BofA/ML 10-Year Treasury Index
From 12/31/15 to 12/31/16 (daily data)
Source: Bloomberg • Past performance is no guarantee of future results



One month does not make a trend. And the S&P 500 Index rose 3.7% that month, spurred by investors’ expectations that policy under the President-elect would be business-friendly by shifting towards greater fiscal stimulus, tax reform, and deregulation. Furthermore, a good portfolio diversifier should be expected to be uncorrelated with other assets. Next time the tables are turned and stocks are down, bonds should be up, being the good anchor to windward that they have been. Right? “60/40” is a durable asset allocation solution. Right?

Certainly in recent years the answer is yes, but longer term history teaches us that the answer is no, not always. As shown in the graph below, “60/40” has been subject to distinct cycles, linked as it is to investment cycles. The most salient point illustrated below is that “60/40” is coming off one of its best periods ever (driven by global central bank easing, now fading). Historically, such peaks of value added are followed by distinct troughs of disappointment. Looking in the rear view mirror provides a large degree of comfort but at the risk of complacency. Looking through the windshield should prompt caution.


“60/40” RISK/RETURN DYNAMICS DETERIORATING
Rolling 3-Year Sharpe Ratio: 60% S&P 500 / 40% BB US Aggregate Bond
From 1/76 through 12/16 (monthly data)
Source: Lake Partners, Morningstar Direct, and Principal Management • Past performance is no guarantee of future results



Underlying this picture is a much bigger issue to consider: the long bull market for bonds is over. The rationale for such a bold statement is as follows:

• The tide is turning. First, the protracted recovery from the Global Financial Crisis of 2008 is largely complete (although it has been slow and unevenly distributed).

• Second, the Federal Reserve is normalizing interest rates.

• Third, the US is shifting towards reflationary policies at a time of sustainable, albeit moderate, economic growth not only domestically but globally.

Consequently, the long trend of low interest rates and declining bond yields is expected to reverse course, and conventional fixed income investing will be increasingly vulnerable, at least in the US. Furthermore, equity markets will be driven by fundamentals rather than excess liquidity. Such a shift in the investment environment will favor security selection, active management, and long/short strategies.

As a result, the “tried and true” asset allocation approach of “60/40” is taking on water. Investors therefore are going to need a “bigger boat.” In other words, they will need to consider other sources of diversification, particularly alternative and long/short investment strategies, which have the potential for lower volatility and reduced correlations.


“You’re Gonna Need a Bigger Boat”

Looking forward, the investment landscape is likely to be characterized by:

• a significant degree of dispersion among major equity and fixed income markets around the world (magnified by currency moves);

• a significant degree of dispersion within equity and credit markets; and

• heightened volatility across markets, which is being magnified by the political and policy uncertainties associated with the new Trump administration in the US, the onset of “Brexit” in the UK, and the election cycle in Europe. Volatility is likely to take the form of greater variance in daily and weekly market returns, as investors react to reflationary policies in the US, the diminishing effectiveness of monetary policy across the world, and geopolitical surprises.

From a policy perspective, the investment environment is undergoing a significant transition:

• In the US, the Federal Reserve has embarked on an effort to normalize interest rates. While monetary policy may remain cautious, excess liquidity will be less of a factor in driving markets, and fundamentals will be increasingly important.

• The election of Donald Trump raises a number of uncertainties. On the one hand, equity markets have been excited by the prospect of fiscal stimulus, tax reform, and deregulation. On the other hand, there are risks associated with reflation, rising interest rates, growing debt levels, and potential trade wars.

• Consequently, dispersion and sector rotation will increase, as investors try to sort out the “winners” and “losers” from policy changes.

The crosscurrents stemming from this set of divergences and dissonances are expected to engender further turbulence across markets. To quote a recent Cyclical Outlook from PIMCO entitled “Into the Unknown”: “At a time of fair to expensive valuations and less liquid financial markets, we have seen that it does not take much to prompt bouts of market volatility.” We may well find ourselves looking back at that statement a year from now and marveling at what an understatement it turned out to be.

Thus, the time for advisers to revisit their approach to portfolio construction is now, not later. Consider that over longer horizons, alternative strategies have made “Good Ol’ 60/40” even better. Since the turn of the millennium, alternatives have enhanced the diversification of balanced portfolios, as illustrated below. (A broadly diversified benchmark, the HFRI Fund-Weighted Index, represents alternatives alongside 60/40 in the chart.) A sleeve of “alts” has improved the risk/return profile of a traditional balanced portfolio by reducing volatility and adding incremental returns.


IMPACT OF ADDING ALTERNATIVES TO A 60/40 “BALANCED” PORTFOLIO
Hypothetical Risk/Return Dynamics:
S&P 500 (stocks), Bloomberg Barclays US Aggregate (bonds), and HFRI Fund Weighted Index (alternatives)
From 1/00 to 12/16 (monthly data)
Source: Bloomberg, Lake Partners • Past performance is no guarantee of future results • For illustration only. Not actual portfolios.



Revisiting alternatives may feel contrarian after recent years, but contrarian investors have always had to move differently than the crowd to succeed. (Remember who raised their hands at the conference on what was needed for effective diversification?) Proactive advisors should enhance their portfolio diversification now, rather than later, to help smooth the ride for their clients. Clients will be very appreciative.

Rick Lake is co-chairman of Lake Partners. For over 18 years, the author has been co-portfolio manager of Lake Partners’ LASSO Long and Short Strategic Opportunities portfolio of liquid alternatives.