“The 60/40 Portfolio is Dead,” read Barron’s headline. It could have just as well been Kiplinger, US News, MarketWatch, or just about any other financial publication in the last few years. In case you don’t keep up with such things, the 60/40 portfolio is the mix of stocks and bonds that make up the classic balanced retirement portfolio.
Balanced mutual funds like Vanguard Balanced Index Admiral Shares (VBIAX) frequently reflect that mix. For the better part of the last 50 years, stocks and bonds were the assets that were available to just about anyone who wanted to invest their money. Historically, other investments like real estate, precious metals, cryptocurrencies, and other alternative investments required more work, capital, or sophistication to access.
Hardly a day goes by that I don’t receive a call or email from someone who does business development for some private fund that invests in some of these alternative (or alt) assets. I’ve been pitched by funds that invest in oil wells, ships that are filled with oil waiting for higher prices, rail cars, life insurance, startups, many kinds of real estate, and on and on.
Virtually every pitch begins with how their investment isn’t correlated with the stock or bond markets. Essentially, they are selling diversification.
Diversification works best when you have various investments that behave differently and independently from one another. Traditionally, it was believed that when stocks went up, bonds went down. But over the last 40 years or so, bonds and stocks have increasingly moved in the same direction.
As can be seen in Exhibit 1, ETFs that represent the the S&P 500, like the SPDR® S&P 500 ETF (SPY) and Barclays US Aggregate Bond Index, like the iShares Core US Aggregate Bond ETF (AGG), have had generally increasing correlation to each other. The chart shows the correlation coefficient between the two securities over time. A correlation of 1 = 100% correlation, meaning the two assets move exactly in step 100% of the time. Lower coefficients suggest better diversification. A negative coefficient suggests that two securities move in opposite directions. Currently, you can see that SPY and AGG have a coefficient of .65, suggesting the two currently move together about 65% of the time.
Exhibit 1. Stocks and Bonds Have Experienced Increased Correlation
The correlation coefficient between the SPY and AGG ETFs is currently around 65%. Source: Kwanti Analytics. Past performance does not predict future results.
2022 was an extreme example. The S&P 500 Index was down over 18%, and the Barclays US Aggregate Bond Index was down over 13%. A 60/40 portfolio invested 60% SPY and 40% in AGG would have been down nearly 16% that year.
What many of the alt fund salespeople try to avoid discussing is that the funds are expensive, have large investment minimums, and are less regulated than typical mutual funds and exchange-traded funds (ETFs). In fact, investing in alts frequently means qualifying as an accredited investor, which means you certify that you have enough wealth and/or sophistication to understand and bear all the risk.
Are Alts a Good idea?
Over the past several years, democratization has come to the alt investment universe, making it more accessible to average investors. Bitcoin, gold, and real estate are all offered via mutual funds and exchange-traded funds (ETFs). For example, Vanguard (and many others) have launched alternative strategy funds like the Vanguard Alternative Strategies Fund (VASFX, currently closed to investors) and the Vanguard Market Neutral Fund (VMNIX).
The nice things about mutual funds and ETFs are that investors can typically invest modest amounts, have transparency into fees, holdings, and risks, and maintain liquidity by being able to trade out of the fund on any market day.
The not nice things typically would be a lack of long-term track records to really understand the behavior of the assets and higher expenses, which can be quite a bit more than the average stock or bond fund.
But with all the new products and their accessibility, are these good alternatives for investors? I have been pondering that question for many years.
In the early 2000s, the financial press began reporting research that suggested adding commodities to a traditional stock or bond portfolio offered diversification benefits. I followed that topic with great interest, ultimately adding modest amounts of a commodity fund to some investment models.
To make a long story short, I eventually came to the conclusion that commodity returns don’t justify the trading costs and volatility risk. In fact, as I continued to follow research and observe the fund behavior, I came to believe that they have negative expected returns after accounting for the costs of futures contracts, which is how individuals typically invest in commodities. It may be fine to pay these premiums if you are a cotton farmer hedging the cost of planting your crop, but to invest in commodities as an investor, it appears to be a losing proposition.
Real Estate Investment Trusts (REITs) are another alt investment that research has shown offers diversification. I include REITs in my typical model portfolios, but like bonds, their correlations to the stock market have increased to around 80%. Exhibit 2 illustrates that relationship between the Vanguard Real Estate Index Fund ETF (VNQ) and SPY and AGG.
Exhibit 2. Real Estate Investment Trusts Have Also Experienced Increased Correlation to Stocks and Bonds
The correlation coefficient between the VNQ, SPY and AGG ETFs. Source: Kwanti Analytics. Past performance does not predict future results.
Other Alternatives
About a decade ago, I read an article about catastrophe (cat) bonds offering a good diversification alternative to traditional stock and bond portfolios. Cat bonds are a form of reinsurance where an insurer sells a 3–5-year bond, usually at an attractive interest rate. The catch is that the bond is linked to a specific area, like the Gulf coast of Texas. If a natural disaster causes major damage in that area during the term of the bond, the investor could lose their entire investment. Like stocks and bonds, investors can get paid for taking that risk. Unlike stocks and bonds, hurricanes, fires, floods, and other catastrophes have little or no relationship to what is happening in the overall economy. So, adding these to a portfolio of stocks and bonds can provide real diversification.
That article led me down the rabbit hole of trying to understand cat bonds better, but it also led me to other alternative strategies that seemed to offer similar diversification benefits. I have looked at many different ideas over time, and a few years ago, I started adding alts to my model portfolios as hypothetical positions. This has allowed me to observe how some of these investments behave in a variety of market conditions. The experience has been eye-opening.
The big takeaway has been that alts can provide real diversification when used correctly.
Stone Ridge Asset Management was one company that offered a cat bond fund that I stumbled upon when researching those. In 2020, they launched their Diversified Alternatives Fund (SRDAX). As the name implies, the fund offers exposure to several alternative investments, including cat bonds, single-family real estate, peer-to-peer lending, long/short strategies, and options trading. I added the fund to my hypothetical models in different proportions to observe how (or if) the fund added any diversification benefits.
To replicate that in a simple way, let’s just say I had an original model that invested 60% in SPY and 40% in AGG. For illustration’s sake, we’ll just rebalance the portfolio quarterly. I will start this hypothetical illustration on the day that Stone Ridge launched SRDAX on 5/1/2020 and ran it until 2/29/2024.
The 60/40 mix, as seen in Exhibit 3, had an annualized return of 9.33% over that period. Not bad at all. But if I replace half of the AGG position with SRDAX (called 60/20/20), the annualized return increases to 12.14%. Perhaps more impressively, the standard deviation (i.e. risk) of the 60/20/20 model decreased from 12.3% to 11.4%. Or, in other words, it was about 7% less volatile.
Exhibit 3. The 60/40 Portfolio vs a 60/20/20 With Alts
Returns of a 60/40 portfolio invested 60% in SPY and 40% AGG, rebalanced quarterly vs 60/20/20 in 60% SPY 20% AGG 20% SRDAX from 5/1/2020 - 2/29/2024. Source: Kwanti Analytics. Past performance does not predict future results.
It almost looks too good to be true, and with just almost 4 years of return information, it could just be a lucky streak for some alts. Or it could be a diversifying investment that offers investors a real alternative. The evidence that the fund offers a diversification alternative to stocks, bonds, and REITs is seen in Exhibit 4.
Exhibit 4. SRDAX Has Had Low Correlation with STocks, Bonds, and REITs
Correlation between Stone Ridge Diversified Alternatives (SRDAX) and Stocks (SPY), Bonds (AGG), and REITs (VNQ) have been low or even negative since 5/1/2021. Source: Kwanti Analytics. Past performance does not predict future results.
When SRDAX is compared to SPY, AGG, or VNQ, its current correlations are very low or even negative. And that is essentially what Stone Ridge Asset Management founder and CEO, Ross Stevens suggested alts would do in a paper he produced with Joshua Zwick and Randolph B. Cohen in 2017. The paper was titled “Illuminating the Path Forward: Breaking Free from the 60/40 Portfolio".
When I first read the paper, I was dubious but it seems that their approach has accomplished what they suggested it would. It has been compelling enough that ATX Portfolio Advisors now includes this fund in our investment models for clients.
But there are lessons I have learned along the way. As previously mentioned, expenses can appear quite high on alternative funds, but those figures can include the cost of leverage. For example, Vanguard’s Market Neutral Fund (VMNIX) posts a 1.77% expense ratio, even though the management fee is only 0.11%. The funds are also not very tax-efficient, distributing a significant portion of their return as income that is taxed. Finally, the funds can deliver disappointing, non-correlated results from time to time. For example, cat bonds have experienced losses during great stock market years over the past decade.
Ultimately, I believe that alts are a potential fit for some portions of some clients’ investment portfolios. If you need to review yours, get in touch.
Any mutual fund, exchange-traded fund, or investment model cited in the article is used for illustration purposes and should not be considered investment advice. Talk to your advisor and read the prospectus carefully before investing.