The core portfolio allocation for moderate investors has traditionally been a 60% equities and 40% fixed-income mix. But changing market dynamics may pose a challenge to this construct going forward for three reasons: increased volatility, low interest rates and high correlations. To more effectively respond to changing market dynamics, traditional asset allocation models may require adaptation. Financial advisors are catching on to this idea and adding alternative assets to their clients portfolios.
INCREASED VOLATILITY, RISING RATES, HIGH CORRELATIONS
Over the past decade, the occurrence of spikes in stock market volatility has risen dramatically. Prior to the 1960s, sharp market moves of 3 percent or higher were rare. Now they seem here to stay. Over the past five decades, such moves have quintupled, averaging 10 times per year since 2000. At that level of frequency, sharp moves represent a risk that must be managed. Thats because severe short-term losses can discourage investors from remaining invested in the stock market and encourage selling at the wrong time.
With interest rates at historic lows, the low inflation, declining interest rate environment that drove stock and bond returns since early 1980s may be drawing to a close. In a rising rate environment, equities have historically delivered a modest after-inflation return of 5 percent, while the real return on fixed-income has been negative. This means the free lunch that has come from bonds is likely ending.
Because it relies on low correlations between assets, traditional portfolio diversification is also in jeopardy. In times of crisis, as we saw in 2008, the correlations of assets such as stocks, bonds and commodities tend to increase. Since then correlations have remained elevated. This renders risk management based solely on traditional diversification less effective, and it may remain so for the foreseeable future.
A FOURTH ASSET CLASS
With growing uncertainty in the financial markets, financial advisors and their clients are searching for investments that are negatively correlated with equities to help reduce volatility. They are also looking for a viable substitute for bonds with a similar risk profile. The solution is a fourth asset class a supplement to cash, bonds and stock.
With more focus on risk, advisors and investors are increasingly open to alternative assets. Alternative strategies run the gamut, but a key technique is shorting which helps allow for negative correlation with other assets. The long-short equities mutual fund space picked up $6.4 billion in new assets during 2012, according to Morningstar Inc.
Hedged-equity or low volatility equity is an increasingly popular alternative strategy. A hedged-equity approach solves two problems: it reduces the effects of the volatility problem as it is less volatile than a long-only equity approach, and provides a bond-like risk/return profile.
However, it is important for investors to understand that the job of the fourth asset class in a portfolio is to help preserve wealth and allow it to grow, not necessarily to create it with high-flying returns. In rising markets, a low volatility equity strategy may generate a lower return than a traditional equity fund, particularly if the market advance is outside historical norms. However, in volatile markets, hedging may provide more consistency and buffer the effects of steep losses making it easier for investors to remain committed to long-term investment goals.
Advisors and their clients are catching on to the value of broadening the range of outcome possibilities by supplementing cash, bonds and stock with the addition of a fourth asset class. Now lets hope investors realize there is no free lunch. That will help them stay the course and appreciate the value this additional class of assets can bring to their portfolios.
Harry E. Merriken is Chief Investment Strategist at Gateway Investment Advisers