3 specialized vehicles to keep conservative 60/40 investors happier

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If you google 60/40, you will find a plethora of information telling you that what happened to the traditional portfolio formula last year was an anomaly, and that you shouldn’t lose faith in having 60 per cent of your investments in stocks and 40 per cent in bonds despite last year being one of the worst for such an allocation since the Great Depression.

What you likely won’t find is that such a strategy has underperformed for multiple years, even resulting in some lost decades, plenty of times in the past. There are six periods going back to 1900 when a 60/40 portfolio generated flat to negative returns over a period of nine to as many as 19 years, according to Bank of America Corp. research.

The most recent period was the nine years following the dot-com bubble, when the 60/40 posted a negative return of 2.8 per cent. The other periods were the First World War, the Great Depression, post-Second World War inflation, the Great Society period in the mid-1960s and during the inflationary 1970s.

You will notice these periods occurred during or after major events, so perhaps it’s fair to ask if the March 2020 COVID-19 shutdown of the global economy was another such occurrence? So far, this year’s recovery is proving otherwise, given it’s been one of the best starts to a year for the 60/40 portfolio since the 1990s.

But there’s still a ways to go to recoup last year’s losses, because the 60/40 is down approximately 13 per cent since January 2022 (using 60 per cent in the S&P 500, and 40 per cent in 10-year U.S. Treasuries as a proxy).

One may argue that we are cherry picking dates, but this provides little comfort to conservative investors who are down double digits over the past 18 months. Fortunately, the investment environment is changing to allow for more specialized investment vehicles that can offer some compelling diversification benefits, thereby improving upon your return-to-risk profile without having such a high bond weighting.

Here are three such areas to consider investigating if you’re concerned about the go-forward performance of the traditional 60/40.

Alternatives

Alternative investments include private debt, venture capital and private equity, long/short bond and equity funds (otherwise known as market neutral), and even commodities and commodity trading advisers. These can be complex investments and require thorough research and due diligence before investing, so having a good portfolio manager with experience in these segments can be especially helpful.

We typically don’t have too large of a weighting in this category, somewhere between less than five per cent and 10 per cent, but we do recognize it is a rapidly growing segment of the market.

Option overlay and low volatility

We traded options for more than a decade and found them to be an excellent tool for creating favourable asymmetric returns. Trading options requires a lot of experience and knowledge, but there are exchange-traded funds (ETFs) that offer option overlay strategies that, for example, can add some very attractive tax-efficient income to portfolios.

We also like low-volatility ETFs that own stocks with less sensitivity to the overall equity market and can boost risk-adjusted returns over the long term.

Structured notes

Structured notes are a stock/bond hybrid because they are a debt obligation issued by a bank containing an embedded derivative component that results in a coupon payment linked to the performance of a particular index, exchange-traded fund or even basket of stocks.

There are many different note strategies, but they commonly offer varying amounts of downside protection compared to simply owning the market outright. The upside participation is often limited to just the coupon payment received, but that can be very attractive in this volatile environment, with yields ranging from five per cent to 20 per cent.

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Overall, we’ve taken our bond weightings down to our lowest allowable level and replaced them with notes while maintaining a reasonable equity allocation.

Our risk-managed balanced strategy has moved beyond the traditional 60/40 and this has resulted in a material difference to our clients. It means we don’t have to take on additional risk in this year’s uncertain market to try to play catch up for last year’s losses.

Instead, we let our alternative strategies do what they’re supposed to do by adding consistency to our return profiles. We have no idea if the 60/40 is entering another lost decade or not, but we are not taking the risk just in case.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.

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