Alternative Allocation Provides Asset Managers More Diversification

After the 60/40 portfolio failed to generate its usual stability in 2022, asset management firms suggest higher alternative asset allocations to achieve greater diversification.

When recently asked about the investment advice he would give his younger self, Greg Davis, CIO of Vanguard, said it “would be to [better] understand diversification and the importance of it.” After all, diversification intrinsically limits a portfolio’s risk and helps an investor generate more stable returns.

Investors have a few options to create a diversified portfolio. In both equity and debt markets, investors can create diversification by investing in sectors that have minimal overlap, seek deals with geographic diversity and pursue different verticals of both private and public equity and debt, including venture opportunities.

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“The reality is: When I first started investing, the idea was to buy the best stock that you thought had a lot of potential that would generate outsized returns,” Davis continued in an answer posted on Vanguard’s website. “But the reality is: Putting all your chips on one stock is a very dangerous way to invest, and it’s not really investing—it’s speculating.”.

In 2022, the 60/40 portfolio and the diversification expected from the relationship between fixed income and equities failed to provide safety, as stocks and bonds became correlated and both asset classes had negative returns. Asset managers are now offering cash flows and yields from other, more esoteric investment offerings.

“Alternative strategies, such as those focused on hedge funds, private capital and real assets, have long been appealing as a potential source of higher yields, lower volatility and returns uncorrelated with stocks and bonds,” wrote Daniel Maccarrone, co-head of global investment manager analysis at Morgan Stanley, in wealth management research released by the firm.

Maccarrone’s research showed that adding alternative exposure to a portfolio may reduce volatility and potentially increase returns. Alternatives investing primarily in hedge funds, private debt and real assets are less likely to be volatile because those asset classes can be less subject to the fluctuation of interest rates.

Data from January 1, 1990, through December 31, 2021, show that a portfolio that was 40% stocks, 40% bonds and 20% alternatives experienced 88 basis points less difference in annual portfolio volatility than a 50% stock, 50% bond portfolio split, while outperforming the 50-50 portfolio by 45 basis points annually in returns.

Alternative strategies, such as fund of funds, non-traded REITs and interval funds, that were routinely reserved for institutional investors are becoming more accessible to high-net-worth retail investors, according to Morgan Stanley. Though these strategies were most likely not available to Davis when he was a younger investor still figuring out the gravity of diversification, they might find a role in providing diversification for investors as the rules of investing become more democratized in the future. Diversification, as Davis said, “is critically, critically important.”

Looking forward to 2023, it remains to be seen if the Fed will pivot and stop raising or start cutting interest rates, which could thwart the recent correlation of stocks and bonds.

In the meantime, alternatives manager KKR is promoting an allocation of 40% stocks, 30% bonds and 30% alternatives that “offers more robustness around diversification, and inflation protection for the macroeconomic environment ahead.”

Similar conclusions from KKR, Morgan Stanley and other market participants recommending greater diversification exists outside the traditional 60/40 portfolio and advocating an allocation to alternatives suggests exactly what Davis advocated to his younger self: Investors can always better understand diversification, recognize the importance of it, and explore strategies to increase it within their portfolios.

So When Will Stocks and Bonds Un-Link?

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Tags: 40/30/30, 40/40/20, 60-40, Alternative Investments, Alts, Daniel Maccarrone, diversification, Greg Davis, KKR, Morgan Stanley, Vanguard

Steven Herbert says his employment was terminated after he discovered that a property company, allegedly, stole money from a retirement system unit.

The ex-CIO of the $22 billion Kentucky Public Pensions Authority is suing his former employer, accusing the agency of allowing a real estate firm to filch money from a KPPA subsidiary, then retaliating against him for pointing it out. Steven Herbert contends in his suit that he was fired when he tried to bring the purported theft to light.

Herbert joined the retirement system in January 2021. He claims in his legal action that, had he known about the alleged theft, he would not have accepted the position.

The Kentucky pension system is known for longstanding low funding ratios within its various pension programs. All of these programs are considered to be in “critical status” due to funded levels lower than 65%. At the end of the fiscal year 2021, KERS Hazardous was the best funded among the state’s pensions, with a ratio of 60.4%. KERS Nonhazardous posted a miniscule ratio of 16.8%. CERS Nonhazardous’ funded ratio was 51.8%, while CERS Hazardous had a funded ratio of 46.7%.

When Herbert left the pension system in May 2022, he was replaced by his former deputy, Steve Willer, marking KPPA’s seventh investment head in 15 years. Herbert was fired in a May 31 termination letter from executive director David Eager, KPPA’s executive director, and the complaint states the termination was “without cause.”

The alleged fraud concerns Kentucky Retirement System’s Perimeter Park West, a real estate entity created by the pension agency to buy its Frankfort offices. Herbert initially questioned why Perimeter did not pay dividends to the retirement system and pointed out that its books did not balance. Then he concluded that money from the property unit had been “misappropriated, diverted or stolen,” according to his complaint.

Next, according to the complaint, Herbert determined that Crumbaugh Properties, a private commercial real estate company, had embezzled the money—and that the firm had the ability to write checks from Perimeter’s account. He also alleges he found a shortfall of $10 million in Perimeter’s account that appeared to be linked to the alleged Crumbaugh theft, the complaint contends. The lawsuit says that an audit from 2019 backs up his charge that Crumbaugh had checking access to Perimeter’s account.

Herbert is seeking a trial by jury and that he be awarded compensatory and punitive damages, plus legal costs. His court complaint falls under the Kentucky Whistleblower Act, which he argues should have shielded him from dismissal after he disclosed the material discrepancies to the board and Eager. Herbert claims he was wrongfully terminated because of the disclosure.

A KPPA spokesperson responded to the lawsuit by saying it “contains demonstrably false allegations.” In addition, the representative said, the agency “regrets that it will be forced to spend resources to defend against Mr. Herbert’s lawsuit, but we are confident in our defense of the claims he has asserted.”

Crumbaugh Properties did not return a request for comment on the allegations in Herbet’s complaint.