PM Corner: In conversation with Philip Camporeale
Global Allocation’s Philip Camporeale discusses a fresh approach to the traditional 60/40 portfolio.
Investors can remain within their 'balanced' 60/40 risk profile even as they introduce dynamic shifts in asset allocation.
What is the 60/40 problem?
It’s pretty simple, actually, and it appears in the small print of every investment pitch – “Past performance is no guarantee of future results.” A static 60% S&P 500 Index and a 40% Bloomberg US Aggregate Index asset allocation has returned roughly 13% a year from March 2009 (a stock market bottom) until today.1 This impressive performance has been fueled by the unprecedented expansion of central bank balance sheets, a new generation of mega cap technology stars, and a very low interest rate environment that has benefitted both the 60 and the 40.
Unfortunately, those returns are in the past. The future, in our view, looks much different. J.P. Morgan Asset Management’s 2022 Long Term Capital Market Assumptions, which present risk and return forecasts over a 10- to 15-year investment horizon, projects just a 4.3% annual return for a 60/40 portfolio. 2 The 4.3% return is also before inflation and fees. That will be a sobering prospect for investors hoping that future returns resemble past results. But we believe there are effective levers that investors can pull to confront the 60/40 return challenge.
Does a flexible asset allocation mean more risk?
In a word, No. Investors can stay within their “balanced” 60/40 risk profile even as they introduce dynamic shifts in asset allocation. They might add new asset classes other than the S&P 500 Index and the Bloomberg US Aggregate Index to the strategic starting point as well as make tactical shifts, adding, reducing or exiting allocations. Flexible asset allocation can capture market dislocations, improving both total and risk-adjusted return, mitigating downside risk and reducing total portfolio volatility. Successful managers demonstrated the value of that flexibility as they pivoted during the sharp drawdown and rapid rebound of 2020, as well as the post-vaccine reopening of global economies.
What role can active management play?
Active asset allocation plays a major role in confronting the 60/40 challenge, but active stock and bond selection can also help provide enhanced return opportunities. We believe in the combination of active and passive investing to deliver robust after fee returns. To be clear, manager due diligence is key to successful active investing. We look for long tenured managers with a proven track record of generating alpha over multiple business cycles and environments. For example, in the past 18 months we saw dramatic swings between growth stocks that benefitted from the “work from home” trend and more cyclical value stocks that advanced amid the global reopening trade. Today, with the dispersion in valuations within the S&P 500 Index as wide as any point since the dot com era of the 1990’s, stock pickers should find ample opportunities to differentiate their portfolios from cap weighted indices.
Is there a role for leverage in multi-asset portfolios?
We believe prudent use of leverage can be used to manage risk or generate return. In many asset classes, it is more economical to use futures to tactically trade risk instead of bearing the transaction costs of buying and selling individual stocks or bonds. Exchange traded futures or options on indices such as the S&P 500 or the Eurostoxx 50 are efficient ways to add or remove beta (risk) from a portfolio. Interest rate risk can be managed with the use of Treasury futures that can quickly add or remove duration.
What’s the outlook for private markets?
Despite muted return projections in public markets, we expect more robust returns in private asset classes (including private equity, private debt, hedge funds and real assets). For example, our 2022 Long Term Capital Market Assumptions predict that cap-weighted private equity’s annualized return will be 4 percentage points greater than public equity markets over the next 10 to 15 years. Once again, manager selection will be critical. Our “Alternative Investment Essential Buyers Guide,” released this year, provides tools for matching desired outcomes with categories and investment vehicles, emphasizes the inherent risks in private markets, and presents approaches to both measure risk as well as construct portfolios.
Here’s the 60/40 challenge in a nutshell: Public market portfolios will likely deliver returns far below both historical levels and investor targets. The traditional 60/40 portfolio — in which equities provide returns and risk, and bonds provide protection— requires a fresh approach. In this challenging environment we encourage investors to be open to flexible asset allocation, establish a process to determine potential manager alpha, use leverage prudently, and, finally consider allocating to private markets where possible and appropriate. The 60/40 problem is real, but so too are the solutions.