The (re)Balanced Portfolio

“Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that's not true of a portfolio of correlated risks.”

— Harry Markowitz, Father of Modern Portfolio Theory

Here’s just in—hiking a mountain is not the same as a beachside stroll. The tools, resources, and even clothing you bring to each outing would be starkly different. This may sound obvious (or borderline meaningless for investment management), but it does have a point: different environments require different preparations.
The same logic can, and should, be applied to how you structure your portfolio.

The Balanced Portfolio Logic

Markowitz asserted in 1952 that the optimal portfolio allocation typically consists of 60% equities and 40% fixed income, aiming to achieve a balanced risk and return profile. Historically, these two asset classes have been negatively corelated. In simpler terms, when stocks begin to weaken, bonds perk up, and vice versa. Investors could reliably seek higher returns via equities, and fixed income was a useful shock absorber to improve stability.
The concept of MPT transformed the field of portfolio management, won him a Nobel Prize in Economics, and served investors well during favourable market conditions. The primary drivers of equity returns are earnings growth, valuation multiples, and dividend payments, while interest rates, credit spreads, and coupon payments steer bonds. This is, of course, a simplification of performance drivers.

In booming economies where people are willing to spend and interest rates are low, stocks tend to perform well. If inflation creeps up, central banks might step in and raise interest rates, stifling consumer spending. This would, in theory, dampen company growth and share price appreciation, but bond prices could rise and smooth out your portfolio’s overall performance. This is the value that diversification brings to the table.

But like any compliance-friendly disclaimer will tell you, past performance is not indicative of future results, and rearview-mirror investing isn’t exactly a sound decision. The inverted relationship between stocks and bonds has decoupled in the past—in 2022, the average 60/40 portfolio recorded its worst performance (-17%) since 1937, according to Leuthold Group analysis.

The Challenges for 60/40 Portfolios 

We may be entering a time where heightened uncertainty and volatility are the norm, not the exception, against a backdrop of deglobalization, geopolitical risk, and slower real economic growth. As a result, the classic balanced portfolio may need to follow suit if it wants a better chance at keeping pace.

The chart below shows that stocks and bonds have moved in tandem more over the past three years than at any time since 1997. While this could lead to strong returns if they perform well, it could just as easily lead to losses across your entire portfolio. A positive correlation between both asset classes essentially negates the benefits of diversification and the underlying principle of the balanced portfolio as an “all-weather” approach.

To account for this paradigm shift, investors seeking superior risk-adjusted returns, enhanced diversification, reduced cross-asset allocations, and volatility protection would be wise to consider new portfolio compositions.

Welcome to the (re)balanced portfolio.

The (re)Balanced Portfolio

The 60/40 portfolio still has merit, but it can always evolve to meet changing conditions. The broad sense of pairing an equity component for growth with a fixed income strategy has value, but instead of relying solely on public market securities, we can supplement each sleeve with alternative investments that carry those same qualities with added benefits.

Enhancing the 60% Equity Component

With the S&P 500 up roughly 11% year-to-date (YTD) at the time of writing, public stocks have certainly been no slouch lately. That being said, companies may face significant macroeconomic pressures, which can have negative, compounding effects down the road.

While anything is possible, ranging from geopolitical flareups to supply chain issues, the most immediate threat is continued inflation. Higher input costs alongside lower consumer demand aren’t exactly ideal for profitability (a key driver of stock appreciation). The secondary impact is the slippage between nominal and real returns—if inflation is eroding the value of the dollar, then your returns must be adjusted to account for it. According to KKR’s research, U.S. equities had an average nominal return of 4.2% across all inflationary periods since 1928, but that number falls to -1.7% in real terms.

So, how can one improve the equity component of their portfolio to shelter against inflation?

Real Estate

There are two primary performance drivers of real estate: property appreciation and recurring revenue in the form of short- or long-term rental agreements. Interestingly, inflation tends to push property values higher as the price of building materials becomes prohibitive for developers, effectively throttling new supply. Given that people need places to live (roughly 33.1% and 35.2% of Canadians and Americans rent, respectively), recurring cash flows should also appreciate, particularly for leases that reset frequently, such as multi-family residential units.

Infrastructure

Similarly, infrastructural assets can appreciate in value while providing recurring income. Inflation protection mechanisms typically come in the form of built-in, contractual inflation indexation, given their long development times. Infrastructure, as a critical component of any functioning society, tends to show greater resilience throughout all parts of a market cycle compared to equities. An aging population needs healthcare, thriving city centres require waste management, and growing energy demands call for utility companies—strategic investments in infrastructure are linked to what nations need, not want.

Enhancing the 40% Fixed Income Component

As stated, stocks have performed well lately. Real estate and infrastructure only make up 16% of the equity sleeve in the (re)balanced portfolio, while private credit accounts for half of the fixed income component.

There are two reasons for this. First, the typical 60/40 portfolio uses fixed income as a hedging technique, but as we’ve shown, the growing correlation between stocks and bonds has reduced its effectiveness as a cushion against downside risk. To improve the "efficient frontier" (the opportunity set that realizes the highest expected returns with the lowest volatility), we'll need to fix it.

The second point is less technical—bond investors have recently suffered, with long-term U.S. bonds seeing their worst return in over two centuries in 2022. A Bank of America strategist, Michael Hartnett, even went so far as to describe it as the “greatest bond bear market of all time.”

Private Credit

Amid economic uncertainty and a string of failed regional banks across the U.S., traditional lenders have been de-risking and tightening up lending standards. Private credit managers, however, are filling the void by making direct arrangements with borrowers in need, bypassing public markets altogether.

One of their most desirable attributes for investors is their tendency to issue floating-rate debt to buffer against rising interest rates and falling bond prices. These two conditions, along with widening credit spreads, are indicative of a risk-averse market environment where diversification is even more critical. Investors can reduce overall risk within their portfolio by distributing risk across several individual securities, asset classes, sectors, and public and private investments. One security's credit quality may deteriorate (or default altogether), but it is much less likely that several will.

While there are risks, which we will outline, private lending strategies have demonstrated their capability to generate stronger risk-adjusted returns than traditional fixed income investments. Further, their private nature allows them to distribute capital quarterly, avoiding the daily fluctuations of public market bonds and allowing investors to avoid the mental strain of consistent volatility.

Nothing's Perfect

Honesty is a virtue—while alternative investments offer attractive benefits, there’s no such thing as a perfect investment. If there were, our profession wouldn’t be all that competitive. Private securities are ultimately a supplementary tool to achieve what the traditional 60/40 did for so many years by adapting to a changing, more complex environment.

Lower Liquidity

One of the primary concerns that prospective investors may have with alternative investments is their relative illiquidity. Capital is often "tied up" for a minimum commitment period without the trading volume of public securities.

If an investor needs access to their capital, it may be difficult to do so. Thankfully, our funds pair high-quality alternatives with carefully selected public investments to provide weekly liquidity as needed.

Transparency

Without the same regulations or reporting requirements, alternatives can be more difficult to assess without advanced industry knowledge and the proper screening measurements in place.

With over a century of collective experience on our investment committee and diligent monitoring, we only partner with best-in-class managers who are completely open to us.

Minimum Commitments

Historically, institutional investors typically reserved private investments with steep minimum commitments, putting the asset class out of reach for many.

With our scale, we’re able to offer our clients access to exclusive opportunities that are beyond the traditional retail market.

Complexity

Most importantly, however, might be the nuances and complexities of investing in such an asset class. A sophisticated understanding of portfolio management and a higher level of due diligence are required to make the most of this growing opportunity.

That research can be time-consuming, if not overwhelming, for any one person. However, our team's experience and shared workload enable us to give them peace of mind, ensuring the utmost care in managing their finances.

With so many options to choose from with vast differences in quality, risk, and possible returns, our clients can rest assured that our discretionary managers are actively seizing opportunities to strengthen their portfolios with nothing but their best interests in mind.