The traditional 60/40 portfolio served investors well in 2020. Government bonds provided reliable ballast early in the year when equity markets tanked in response to the Covid-19 pandemic, and the equity portion surged thereafter in response to government stimulus and an anticipated economic rebound.
Many investors worry that performance can’t be repeated. Interest rates are expected to remain near zero for several years, which means replicating the benefit from government bonds would require negative rates from the U.S. Federal Reserve and Bank of Canada.
“All of the backward numbers look great for fixed income,” Phil Mesman, head of fixed income with Picton Mahoney Asset Management in Toronto, told Advisor’s Edge last fall. “The typical advisor portfolio looks amazing but, at current yields and current duration, it makes sense to be a little more creative.”
The 60/40 portfolio’s purpose hasn’t fallen out of fashion. Diversification and reduced volatility are as important as ever, with high equity valuations and the global economy digging its out way out of the Covid recession. But many experts are questioning the strategies to arrive at those ends.
“What used to represent a prudent way to reduce volatility has become a drag on portfolio returns,” stated a white paper from Purpose Investments published in late 2020. “Simply put, the risk and reward metrics of asset classes have shifted away from what they were when the 60/40 model was popularized.”
The traditional portfolio has reached “an inflection point,” the paper said, as investors won’t accept negative real returns for such a large portion of their portfolios.
Yet other options come with their own risks.
The simplest fix for lower returns from the fixed income portion of a portfolio is to move some of it into equities. This is easier to pull off with younger investors, who have longer investment horizons and who may be more comfortable in growth portfolios.
Clients closer to retirement will want to take on less risk, said Caroline Goode, investment advisor and portfolio manager at National Bank Financial in Surrey, B.C. “We’re not taking a portion of their portfolio and adding to high-tech growth.”
Depending on the client, she may move 5% to 10% of the fixed income share to blue-chip dividend stocks and to ETFs that hold those companies, she said.
However, an advisor can only allocate so much to equities before running into compliance issues.
“I think you add to equities and you’re likely changing the client’s risk within the portfolio. You have the potential to put them outside the risk level they’re comfortable with,” said Darcie Crowe, senior vice-president and portfolio manager at Canaccord Genuity in Vancouver.
“We’re still expecting to see volatility into 2021. There is a lot of potential risk out there.”
Low interest rates have also contributed to higher equity valuations, as more investors see no choice but to invest in stocks.
“Everything is expensive — not just bonds,” said Rodrigo Gordillo, president and portfolio manager at ReSolve Asset Management in Toronto.
He said advisors who want to replace bonds with equities could consider using minimum volatility ETFs.
“You’re reducing the overall volatility by as much as 33% by doing that while still remaining exposed to global growth,” he said.
Low-yielding government bonds have led some investors to seek returns in riskier forms of credit, be that lower-rated corporate debt or emerging market sovereigns.
Capital Group’s 2021 outlook report said a shift toward riskier bond categories left many investors exposed when the pandemic hit, but that investors returned to high yield credit when pandemic fears waned.
By the end of 2020, the report said, corporate bonds looked “only modestly less expensive than they did prior to the recession” despite stunted earnings growth and an uncertain economic outlook.
The Federal Reserve’s willingness to purchase corporate bonds made the market more expensive and masked credit risk, Mesman said, and the uncertain recovery has left more companies exposed to downgrades.
Gordillo warned against taking on more credit risk. “Reaching for yield is just turning your portfolio into 100% equities,” he said. “You are going to get burned.”
He prefers sticking to sovereign bonds that make money during market sell-offs.
“While the yields on those bonds feel like they’re not adding any value to a portfolio, there is tremendous value from a behavioural perspective in keeping those bonds there in a large proportion to equities,” he said, in terms of the rebalancing premium and reducing volatility.
Goode limits higher-yielding debt to one-tenth of a portfolio’s fixed income allocation. After getting out of preferred shares in 2019, she recently added a small component to increase the yield in the fixed income side of some portfolios.
“Preferred shares are so beaten up right now that they’re quite attractive,” she said.
Private debt can be a tax-efficient fixed income option, offering a steady income stream that can be paid in deferred capital gains.
“There’s virtually no correlation to equity markets, so it is a diversified asset class that can reduce the volatility in your overall portfolio,” said Crowe.
Depending on the client, Crowe said she would allocate 5% to 10% of a portfolio to private debt funds. The funds’ volatility is usually low and they produce steady returns (traditionally in the 6% to 8% range), but there’s risk on the liquidity side, she said.
“It’s not a short-term, three-month investment,” she said. There are one-year minimum holds for most funds, and investors typically must give 180 days’ notice for redemptions.
“If you have a cash crunch and you need funds, this is not going to be somewhere you can pull from.”
Advisors should also check fund managers’ track records and understand the loans, she said.
This may be especially important with so much economic uncertainty: the pandemic has left many companies relying on government aid and some may not survive more lockdowns.
Gordillo warned that private credit funds carry equity-like risk.
“You’re lending to a small company that can’t get lending from anywhere else,” he said. “That is pure default risk.”
Private credit funds may also be hard to use within the fixed income portion of portfolios.
“Private debt is typically considered to be higher risk than traditional fixed income securities, despite the standard deviation of the products usually being extremely low,” Crowe said.
Despite fees for some funds that take 20% on performance above a target return, Crowe said the net return still tends to exceed what investors can get with traditional fixed income.
While investors who owned residential real estate in Canada likely did well in 2020, funds invested in retail real estate and office space had a much harder time. Multi-family apartment funds performed fairly well, Crowe said, even though caps on rent increases hampered some upside.
Real estate funds provide an inflation hedge, she said, which is important given the massive amount of recent stimulus from governments. Funds’ monthly distributions are often tax efficient, and she said the correlation to public equities is minimal.
That said, some real estate funds offered little ballast in March when equities tanked, and didn’t recover as quickly. MSCI’s Canadian index for real estate investment trusts finished the year down double digits.
Precious metals and commodities
Precious metals such as gold and silver are seen as safe havens: their value rises when there’s fear in equity markets. They’re also a hedge against inflation and currency weakness. While holdings can’t replicate fixed income returns, the Purpose Investments white paper said that precious metals can help achieve some of a 60/40 portfolio’s goals because they’re traditionally uncorrelated to broader equity markets.
However, CIBC’s 2021 outlook report warned that correlations across asset classes are increasing: “In the current environment, gold is not necessarily a haven play as traditionally defined, and therefore is no longer an effective risk hedge from a diversification standpoint.”
The report still expected gold to perform well in the coming years, peaking at US$2,300/oz in 2021. But for investors looking to avoid downswings, the CIBC report said long U.S. dollar and long CBOE volatility index (VIX) strategies are better risk hedges.
Gordillo said maintaining gold, commodities and Treasury Inflation Protected Securities (TIPS) protects against inflationary shocks, and Crowe said she likes to allocate about 5% of a portfolio to gold.
Other alternative strategies
Crowe also uses hedged credit strategies that can go long and short on bonds, essentially hedging the interest rate risk.
“It’s designed to protect against capital losses from rising interest rates,” she said.
When credit markets froze in March 2020, the strategies “got hit pretty significantly,” she said, but the funds she uses re-entered positive territory last year.
With the introduction of liquid alternatives in 2019, retail investors now have easier access to products offering different income streams. There are now more than 100 liquid alts in Canada.
The challenge, Gordillo said, is that the Canadian market is heavy on equity products that can’t necessarily replace bond holdings. He pointed to covered call products, where an investor sells call options on a stock.
“You would think covered call writing has all the characteristics of clipping a coupon, lowering volatility,” he said. “But when Covid happened you’re down 30%.”
The nascent liquid alternative market was shaped by a decade-long equity bull run, Gordillo said. Products designed to offset losses or provide returns uncorrelated to equities were a hard sell when the S&P 500 was up almost 29% in 2019, when the first products were released.
After the pandemic, advisors will be looking for products that can go long and short, and that are nimble enough to profit from down markets, Gordillo said, while eking out a better yield than bonds in good times.
“Covid will definitely launch a whole new class of liquid alternatives that is likely to fill that gap,” he said.
A January ETF report from National Bank Financial showed some products performed according to plan, avoiding the market collapse when the pandemic hit. “We found that the market neutral products were grinding higher through various market conditions,” the report said, “and the anti-beta strategy delivered positive returns during the worst of the selloff early in the year (before mean-reverting toward the end of 2020).”
While liquid alt strategies vary widely, overall 2020 performance was solid: the Scotiabank Alternative Mutual Fund index finished the year up 4.91%, compared to the S&P/TSX Composite index’s 2.17% return.
Picton Mahoney’s Mesman said he’s focused on long and short opportunities in developed-market BBB- to B-grade bonds.
The Federal Reserve’s corporate bond purchases created opportunities on the short side to both protect the portfolio and provide alpha in cases “where the real economy’s impact on financial assets has yet to be felt,” he said.
A report from Richardson Wealth released early this year said long-short credit strategies are suited to the current environment, reducing the risk from rising rates. The higher yield comes with a trade-off, though, which is risk from using leverage.
Dividing it up
Crowe has clients who want no traditional fixed income. In those cases, she allocates the 40% to alternative assets classes: private debt, real estate, arbitrage or long-short strategies, and hedged credit. In most portfolios she maintains some traditional fixed income and puts 10% to 20% in alternatives.
Goode said balanced portfolios at National Bank can only go as low as 30% on the fixed income side for compliance reasons, so she may move 5% of the overall portfolio into equities and 5% into different alternatives, depending on the client.
“We don’t want to get too aggressive,” she said. “Most of our clients are retirees.”
For clients making RRIF payments, Goode likes to keep enough cash on hand to last 12 to 18 months in case of a dramatic market event like at the start of the pandemic. This means 5% to 10% of a portfolio in cash. For younger clients, she encourages them to stay fully invested.
Moving away from the 60/40 portfolio requires frank conversations with clients to make sure they understand the risks. It’s easy to underestimate the role of bonds when they’re returning next to nothing, but uncorrelated assets are essential in a downturn.
“Diversification remains key, as does minimizing volatility to avoid behavioural pitfalls,” the Purpose Investment white paper said.
“When a portfolio exhibits less volatility, investors are less likely to make snap decisions to sudden market moves.”