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For years, advisors have relied on a traditional 60/40 mix of stocks and bonds for their clients’ portfolios. Stocks will (hopefully) provide the desired growth while protecting against inflation, while bonds will generate income and provide a hedge against falling stock prices and recessions. His historic decline in 60/40 ratio in 2022 made what was already a growing concern a reality. His traditional 60/40 ratio hasn’t worked for many clients and likely won’t work well in the future, and more effective allocations are being made more often now. It is also widely available to individual investors. A more efficient portfolio with an alternative allocation will generate higher total returns with lower volatility and drawdowns, but will also have lower correlation with other asset classes in the portfolio.
Correlation challenges
The 10-year Treasury’s recent positive correlation with stocks limits the effectiveness of a portfolio comprised primarily of stocks and bonds. The rolling correlation between his 10-year UST and stocks (S&P 500) has increased in recent years. While the dismal performance in 2022 is now a thing of the past, the higher positive correlation between stocks and bonds that began in 2021 persisted through August 2023.
The challenge of risk-adjusted returns
Finding attractive long-term returns can also be a challenge for today’s investors, as portfolios have become more complex and riskier (as measured by standard deviation). Curran Associates research shows that 30 years ago, cash and bonds could generate a nominal return of 7%, but in 2022, stocks across all market capitalizations, international equity exposure, private equity and real estate will be less volatile. is more than 5 times as large.
Therefore, now more than ever, investors should seek allocations to asset classes that can generate meaningful returns, are effective diversifiers against equities, and have low volatility. Although difficult, certain alternative investments meet these criteria.
Private real estate: an efficient way to diversify your portfolio
Private real estate exhibits attractive characteristics that help diversify today’s market. This asset class has generated an annualized return of 8.75% over the past 45 years since the inception of the NCREIF real estate index. Importantly, it generates these returns with an annualized volatility of 4.24%, which is more comparable to investment-grade bonds than publicly traded real estate or stocks. But unlike bonds, private real estate has the potential for capital appreciation, an important factor in today’s moderately inflationary environment.
Furthermore, two of the most important characteristics of real estate are its low correlation with public equity and low drawdown compared to public equity. Since NPI’s inception, the correlation between NPI and public equity has been 0.04. The correlations over time are fairly consistent. The trailing numbers are -0.2, -0.2, and 0.09 for 5, 10, and 20 years of trailing, respectively. Drawdowns, a particularly painful factor for individual investors, were also significantly lower for private real estate, with maximum drawdowns of -26% compared to -55% for the S&P 500.
Adding alternatives can benefit investors regardless of their investment profile
Alternatives serve a unique purpose in an investor’s portfolio. The ability to generate absolute returns allows you to increase the overall return of your portfolio. Alternatives can also provide significant diversification benefits through their lower correlation and lower volatility characteristics than publicly traded stocks.
JPMorgan Asset Management analysis shows the benefits of alternatives for different risk appetites, with allocations to alternatives reducing volatility over 30 years for various allocation amounts while increasing total annual returns It has been shown that
Alternatives play an important role in investors’ portfolios
With recent increases in correlation and volatility in the stock and bond markets, it may be beneficial to add alternative asset classes such as private real estate or alternative credit to a traditional 60/40 portfolio. Over the next 20 years, reallocating 20% of the 60/40 portfolio to private real estate will increase returns and reduce volatility. Therefore, investors may be able to better generate higher portfolio risk-adjusted returns by allocating a portion of their portfolio to such properties. Alternative proposal.
Over the past 20 years, a 20% alternative allocation has been best done from bonds.It may be best to reallocate from stocks in the future.
Over the past 20 years, a 60/20/20 portfolio of stocks/bonds/private real estate would have generated higher returns with lower volatility, reflecting a bond market that underperformed in an ultra-low interest rate environment. Stock prices have benefited from this environment, but higher interest rates and favorable credit investment conditions are likely to test stock prices. Therefore, given the facts on the ground, while in the past it might have been best to reallocate his 20% allocation to alternatives from bonds; In the future, 50/30/20 or 40/30/30 stocks/bonds/alternatives will be a more efficient portfolio allocation model.
Miguel Sosa is Head of Market Research and Strategy at Bluerock
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