Art by Harry Campbell
Special Coverage
The traditional 60/40 portfolio is made up of public market assets, stocks and bonds, with a weight of 60% and 40%, respectively. This portfolio has traditionally been the basis of many pension funds and retirement plans. Recently, however, asset owners have adopted a “new” 60/40.
“Traditionally, 60/40 means 60% stocks/40% bonds,” says Bruce Phelps, head of institutional advisory and solutions at PGIM. “Now, it’s 60% public assets (stocks and bonds) and 40% private assets” such as private equity, real estate, private credit, venture capital and infrastructure.
In 2022, the traditional 60/40 portfolio had its worst performance year since 2008, according to Goldman Sachs Asset Management, but unlike in 2008, fixed-income returns were also negative. With the future of the traditional portfolio in question, alternative investments could be poised to take the spotlight from bonds for years to come.
Asset Allocation for State and Local Pensions, 2001-2022
100%
Misc. Alternatives
Hedge Fund
Commodities
80%
Other
Cash
Real Estate
60%
Private Equity
Fixed Income
Equities
40%
20%
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
100%
Misc. Alternatives
Hedge Fund
Commodities
80%
Other
Cash
Real Estate
60%
Private Equity
Fixed Income
Equities
40%
20%
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
100%
80%
60%
40%
20%
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
Equities
Real Estate
Commodities
Fixed Income
Cash
Hedge Fund
Private Equity
Other
Misc. Alternatives
100%
80%
60%
40%
20%
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
Equities
Real Estate
Commodities
Fixed Income
Cash
Hedge Fund
Private Equity
Other
Misc. Alternatives
Source: Public Plans Database
Transparency Issues with Alternatives
Breaking from the long-time investment defaults of stocks, bonds and cash, alternatives can offer an illiquidity premium, especially for long-term investors, but they are also an opaque asset class, which comes with more performance reporting issues and long-term investment lockup periods than traditional public equities or bonds. With public pension funds increasing their exposure to alternatives, these transparency issues have sometimes become an issue.
After the 2008 financial crisis, the issue of transparency in alternatives became much more apparent to firms, according to a Northern Trust report, “The Path to Transparency in Alternative Investing.”
“When the crisis hit, institutional investors were caught unprepared. They couldn’t assess, quantify and report on their exposure in a timely fashion,” said Samer Ojjeh, a principal in Ernst & Young Wealth & Asset Management, in the Northern Trust report.
Not only are alternatives opaque, but long lockup periods and higher management fees can conflict with a fund’s desire to drive higher returns.
“I believe that there is little debate that private asset investing is less transparent and more costly,” says Thomas Toth, a managing director at Wilshire Associates. “I find that public pensions systems need to balance transparency requirements with the target to drive higher expected returns, net of all management, performance and administrative fees. Private asset investing places a premium on upfront due diligence and investment structuring to ensure the system receives enough transparency to effectively manage the risk exposures in the total portfolio.”
Investment Trends
Alternative investments have continued to pick up increased allocation from pension funds. According to UBS Wealth Management, funds increased their allocations to alternatives to 34% in 2022 from 9% in 2001, and 80% of public pension plans had at least 20% of their assets in alternatives.
“The trend toward higher allocations in private markets may continue going forward,” Toth says. “At a high level, companies are staying private longer, so opportunities to capitalize on higher growth businesses at earlier stages of their life cycle are likely to be found in private equity. On the private debt side, the continued disintermediation of traditional banking will provide meaningful lending opportunities. An economic slowdown would be fertile ground for investors, and investors may deploy capital to distressed debt or special situations as well.”
Bonds have not been an attractive asset class in recent years, not only because lower rates (until recently) meant bond returns were weak, but because they lost their status as a reliable hedge on riskier assets, according to Jim Caron, CIO, Portfolio Solutions Group at Morgan Stanely Investment Management who says the trend toward alternative-heavy portfolios will continue.
“With the end of the 40-year bull market in bonds, which lasted from 1981 to 2021, bonds have lost their status as a consistent and reliable hedge to riskier assets like equities, and people are looking for alternatives to take the place of fixed income as a hedge,” Caron said in a statement. “Note that the purpose of a multi-asset allocation is to create diversification and hedges to reduce the volatility of one’s returns. If bond returns fluctuate along with equity returns and are likely to be more highly correlated, then the diversification benefits of just holding bonds is reduced. People are looking toward private markets to fill the void.”
‘Extension, Expansion and Enhancement’
“Although we are believers in the continued growth of private assets, knowing public markets are challenged by regulatory burdens, we also believe there are limits to that growth,” said Wouter Sturkenboom, a chief investment strategist at Northern Trust Asset Management, in a statement.. “Liquidity, in particular, remains a constraint. As a result, we don’t foresee that private markets will grab an ever-growing share of portfolios, but instead expect a stabilization to occur.”
Even if their market share levels off, alternatives should continue to be a significant portion of institutional portfolios.
“We believe institutional investors will continue to weigh the transparency and costs of private market assets in their strategic asset allocations and ongoing monitoring,” said Brian Dana, managing principal and director of OCIO services, and Rafi Zaman, managing principal and CIO of Meketa Fiduciary Management in a statement. “We expect private markets assets to continue to warrant significant use across client portfolios.”
While public pension funds are embracing alternatives, some institutional investors have been in them for a long time. University endowments for example, especially at elite institutions, have long foregone the 60/40 portfolio, with many allocating a majority of their endowment portfolio to alternatives. For example, in fiscal 2023, more than two-thirds of Harvard University’s endowment was allocated to alternative investments, with just 11% to stocks, 6% in bonds and 5% in “cash and other.”
This trend started with the late Yale CIO and investment legend David Swensen, who pioneered the “Yale model,” in which outsized returns could be achieved through alternative investments with a risk-adjusted asset allocation.
“While the 60/40 stock-bond portfolio remains at the core, it requires extension, expansion and enhancement,” wrote George Gatch, CEO of J.P Morgan Asset Management, in the firm’s 2024 Long-Term Capital Markets Assumptions report.
While pension funds, endowments and other institutional investors flock to alts, those asset classes have performed poorly in the 12-month period that ended June 30. Many university endowments posted negative returns or returns less than 10%, with many singling out alternatives, specifically private equity and venture capital, as reasons for the poor returns.
So even the “new 60/40” is far from a sure thing in today’s volatile market, but alternatives appear here to stay.
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Tags: Alternative Investments, Asset Allocation, Bonds, Brian Dana, Bruce Phelps, Jim Caron, Rafi Zaman, Samer Ojjeh, Special Coverage: Private Markets, Stocks, Thomas Toth, Wouter Sturkenboom