There are many commonly quoted phrases in the investment industry that seem like common sense, but require a high level of expertise to implement.
The best-known phrase is likely "buy low and sell high" – easier said than done – but a very close second should be "asset allocation is the primary determinant of a portfolio's rate-of-return profile."
Traditional investment practice over the past 30 years advocated for a balanced portfolio of 60-per-cent equities and 40-per-cent fixed income, with a regular rebalancing program. This passive asset-mix approach has worked well over that time period.
But traditions evolve over time in response to changing environments. I believe that now is one of those times, and it is being driven by two major factors – current interest rates and stock-market valuation levels.
Where have we come from?
The period from 1965 to 1982 is not-so-fondly recalled as the "Great Inflation." This period ended with inflation reaching 14 per cent and 10-year treasury bonds yielding 16 per cent.
Following the Great Inflation came the "Great Moderation," a period from 1983 until 2017 in which interest rates have been in a long-term decline. At current interest rates of 2.3 per cent on the long-term U.S. Treasury bond, the "real" bond yield after considering inflation expectations of approximately 2.2 per cent, is a paltry 0.1 per cent.
What about equities?
A well-followed indicator of whether the equity market is cheap or expensive is the cyclically adjusted price-to-earnings ratio, commonly known as the CAPE or Shiller P/E ratio. It is defined as price divided by the average of 10 years of earnings, adjusted for inflation. It is principally used to assess likely future returns from equities over a long-term time frame of at least 10 years. Higher than average CAPE values – such as we are currently experiencing – imply lower than average long-term annual average returns going forward.
The Shiller P/E currently sits at 31.3 for U.S. equities, its third-highest level since data collection began in the late 1800s. The only periods of higher Shiller P/E's than today were in 1929 and early 2000, the year the tech bubble imploded.
A single statistic such as the Shiller P/E is not a perfect predictor of future stock market returns, and should not be used as a market timing mechanism in isolation of other important factors, but it does paint a clear picture of where we sit today from a valuation point of view compared with history.
Putting it all together
The traditional 60/40 stocks-bonds portfolio that has served investors so well over the past three decades is not looking as good as it once did. In the past, we could usually rely on one of the two major asset classes representing value at a given point in time when the other asset class was expensive. For example, in 2000 when the Shiller P/E was sitting at a record-high 43, long-term government bonds were yielding approximately 6.7 per cent. If investors recognized an expensive market during the tech bubble of 2000, and rebalanced some of their portfolios toward bonds, those investors would have significantly cushioned the blow of a falling equity market because of the high-interest-rate cushion and price increases enjoyed in their bond portfolios.
Unfortunately, today we are faced with both bonds and equities being priced at historically expensive valuations. I mentioned a 0.1 per cent real rate of return on bonds at current interest rates. If you extend this analysis to the traditional 60/40 portfolio, the real yield equates to only 2.1 per cent on that type of portfolio today. This compares with a long-term average 5 per cent real return for the 60/40 portfolio.
So, if asset allocation is the primary determinant of a portfolio's rate-of-return profile, and the forward-looking assumptions are painting a scenario of anemic returns compared with historical norms using the old 60/40 asset mix, what is an investor to do today to meet their objectives?
Welcome the new 60/40
The solution is to find investments that will provide investors with both sufficient growth and a reasonable amount of diversification to protect them in the event of a market downturn or a sustained period of rising interest rates or inflation.
One way our team is applying this concept today is emphasizing certain "factors" of an equity security that differentiate it from the average stock. Examples of factors we use are value and low volatility. By overweighting these types of factors in an equity allocation, the equity portion of the overall portfolio is likely to be more stable in a falling stock market. This is the diversification advantage we are looking for when building these factor-based portfolios.
Besides factor investing, there are many other ways to access investments that can substitute for either equities or traditional bonds in a portfolio.
The list below provides some examples of these asset classes along with their expected returns for 2018, as estimated by JPMorgan.
* Global infrastructure: 6.25 per cent;
* Direct lending: 7 per cent;
* Emerging markets corporate bonds: 5.25 per cent;
* Private equity: 7.25 per cent;
* Litigation finance: 8 per cent (this is an Ullman Wealth Management estimate).
With these examples of building blocks for the new 60/40, the next steps in the construction of a properly diversified portfolio is to identify other investments that can provide positive returns regardless of capital market conditions, and add enough of these investments to your portfolio to meet your risk and return objectives.
Some examples of investments that can provide positive returns regardless of capital market conditions would be:
* Hedge funds: Long/short equity, long/short credit, tactical, trend followers (also known as commodity trading advisers);
* Private credit strategies;
* Mortgages.
Changing something that has worked well in the past is never easy and can seem counterintuitive, but the combination of more expensive equity and bond markets will very likely lead to lower returns in the future. So, if your current asset mix resembles the traditional 60/40 portfolio, it may be instructive to remember one other oft-quoted phrase in the investment industry, this one attributed to economist John Maynard Keynes: "When the facts change, I change my mind. What do you do?"
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Lawrence Ullman is the chief executive of Ullman Wealth Management Inc., which provides private capital-management services to high-net-worth individuals, endowments, charities and foundations.