To The Moon

For the next decade: Beating the market by replacing 60/40 allocation with diversification, private markets, and active management

This time it’s different, isn’t it?

“We are in a regime shift”, “this cycle is different”, and “the world is changing” seem to be the general sentiment when reading the financial press these days. Commentators urge investors to keep an “open mind”, hinting something big is about to happen. What remains unclear.

Source: Bloomberg

What’s clear, there are multiple challenges in today’s world:

1. Average30y mortgage rate rise from 2.6% to 4.5%
2. Crude oil prices have more than doubled, commodity prices are rising
3. Inflation goes from “transitory” to 8% in the US and rising worldwide
4. Fed go from lower rates for longer to 8 rate hikes
5. Largest war in Europe since WW2
6. Stocks are expensive with lofty valuations

Investors’ 60/40 dilemma

Paradoxically, we are in a world of declining global growth and increasing inflation. Interest rates are close to zero while debt is skyrocketing. For investors, this is a challenging environment. Where should I put my money to a) protect against a loss of purchasing power (inflation) and b) generate the returns I need to reach my goals? From a risk/reward point of view, a traditional buy-and-hold approach to stocks and bonds (90/10 to 50/50 portfolios) is less advantageous, maybe even dangerous. Some strategists even expect the 60/40 portfolio to return a meager 3-4% in the next 10 years, similar to the “lost decade” from 2000 to 2009. Despite this outlook, this allocation is where most investors have their money. In times like these, active management should shine. Active management should also broaden the investment universe beyond the traditional stocks/bonds split and include as many assets classes as possible.

“We are here to declare the rise of a new era, one where fiduciaries will need to work smarter and more creatively to deliver investor outcomes.“ -CAIA Association

Bonds and Stocks with long-term headwinds

Since their peak in 1981, developed market interest rates have precipitously declined due to unprecedented accommodative monetary policy by Western central banks. Ten-year yields in the U.S. averaged ~12% in the 1980s and ~6% in the 1990s. As John L. Bowman, CFA, Executive Vice President for the CAIA Association, wrote: “This long period of cheap capital and easy money has catalyzed innovation, created countless jobs, and provided a relentless tailwind for capital market returns. A plain vanilla U.S.-based 60/40 portfolio has compounded at more than 10% since 1980, and the return has been even more attractive in the last decade.”With falling interest rates since the 1980s, Bonds have been in one of the largest bull markets ever. If this trend reverts, there is a serious risk to traditional buy-and-hold portfolios with exposure to bonds.

Source: FRED

Finding the Portfolio for the Future™

So what is a good framework for private investors to navigate this minefield? The CAIA Association recently published a paper about theirPortfolio for the Future™. It suggests five distinct marks:

1. Broadly Diversified
2. Less Liquid
3. Rooted in a Fiduciary Mindset
4. Actively Engaged
5. Dependent on Operational Alpha

Three ways to beat the market

Some of these principles are more relevant for professional investors. However, there are three very important takeaways for private investors:

Aggressive Diversification: Find opportunities with low or negative correlations across asset classes, geography, sector, and purpose. Today, only 12% of the $153 trillion global assets market is allocated to alternative assets. This is a great opportunity to find returns and lower risk. Many Alternatives can be replicated with ETFs, such as Real Estate and Commodities. ETFs also allow investing globally so the country risk can be reduced. Crypto, another potential portfolio diversified, can easily be purchased through exchanges, such as Coinbase or Kraken. Plus there are even Bitcoin ETFs available. Access is no longer an issue and it has never been easier for investors to add alternatives to their portfolios. At Returnboost, our underlying universe includes Global and U.S. Stocks, Bonds, global and U.S. Real Estate, and Commodities. Our aim has always been to diversify as aggressively as possible

Source: CAIA Association, Bloomberg, Preqin, FRED, MSCI, HFR, Bank for International Settlements Derivatives Statistics

Private Markets: Add investment in private markets as another differentiated source of return. Avoiding private capital in a portfolio denies access to an increasingly large portion of the global economy. Two drivers make private markets so attractive: 1) More and more return gets captured before companies go public (companies stay private for longer, see chart below) plus fewer firms go public and 2) private markets are detached from the short-term machinations of public markets. Both effects can work in an investor’s favor. The blurring of private and public capital is a trend that will continue for years to come. So investors need to build exposure early. There are many platforms, which allow private investors to access these markets. Some examples in various asset classes are:

• Early-stage ventures (Angellist, Stonks)
• Real estate investments (LINUS, Roofstock)
• VC and P/E funds (Liqid, Moonfare)
• Debt (Percent)

Source: Preqin

Active Management: Active investment management can be superior to passive investing. Here’s why. It is almost impossible to beat an index during a bull market unless you take on more market risk. When market conditions change, active management shines because managers can adjust to the new conditions. Looking at hedge fund performance during the COVID-19 drawdown, clearly shows how active management outperformed during this phase. Of course, it’s not easy for private investors to replicate hedge fund strategies. Some simple ways to replicate these strategies include style (growth vs value stocks), traditional hedging of long positions, and factor investing. Here is a list of ETFs replicating hedge fund strategies. ETFs can provide exposure to long/short, managed futures, merger arbitrage, and other strategies. Our research at Returnboost has shown that momentum is the most stable factor investors can find. Applying momentum to a highly diversified universe of asset classes should allow investors to actively capture return wherever and wherever it happens.

Note: Hedge fund performance is measured using the Credit Suisse Liquid Hedge Fund Indexes. Performance is from February 12 — March 11, 2020; Source: CAIA

Thinking outside of buy-and-hold

The traditional 60/40 portfolio is at risk to underperform during the next years. Macro forces in stocks (high valuation plus rising rates) and bonds (rising rates) increase the risk. However, there are ways for investors to protect themselves. By combining diversification, private markets, and active management, private investors have the chance to construct portfolios, which can a) protect their capital from negative returns and rising inflation and b) generate returns they need to achieve their investment goals.

It’s not the most intellectual or the strongest that survives but the one that is able to adapt and adjust to the changing environment. In the coming decade, investment success won’t be as easy as buying and holding stocks and bonds. Investors have to prepare to be more creative and more active.

Follow the trend and manage your risk 📈

Best, Sebastian

www.returnboost.com