Time for a new modern portfolio model?

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

The Modern Portfolio Theory, formulated in 1952 by Harry Markowitz, still holds, even in today’s stormy markets. However, that theory has become identified with the ubiquitous 60/40 portfolio of stocks and bonds. And that 60/40 model is now in jeopardy as the old correlations of risk and reward increasingly diverge

Investors need to think out of that box, and ideas are coming from the world of pension funds, hedge funds and liquid alternative funds. “In this unprecedented challenging and uncertain market environment with escalating global macro-economic concerns, investors need to prepare for the volatility of equity markets and declining fixed income returns,” states Belle Kaura, Chair of AIMA Canada and VP legal and CCO at Third Eye Capital. “Investors can no longer rely on the traditional 60/40 public markets model.”

Michael White, portfolio manager at Picton Mahoney, refers to a study by Callan LLC that eloquently shows how the “classic” 60/40 portfolio has drastically changed. In 1998, an investor that wanted to generate a 7.1% return could still have a portfolio built with 57% bonds, 24% equity and other asset classes and 15% cash. In 2018, to earn the same return, Callan's capital market projections had reduced the share of bonds to 2% while stocks and equity-like assets had ballooned to 83%! Also, you needed to add a real estate portion of 15% for good measure.

The punchline: that 2018 portfolio’s standard deviation had shot up from 5.8% to 19%, and its return/risk ratio from 1.22 to 0.37. Very few investors can live with such volatility and risk.

Out of bonds
The key component here hinges on bonds. “For the last 30 years, bonds gave you on average 7% to 8% return and played defence as well as an offense in a portfolio, says Som Seif, CEO of Purpose Investments. “That’s an amazing performance. But now, government bonds only play defence and may even start scoring in your own goal. Does that make sense? If I can’t allocate 40% of my portfolio to bonds, what must I look for?”

The answer to that question could come from the world of hedge funds and pension funds that have been putting into place many new options and strategies. Now these options are entering the world of retail investment through liquid alternative funds.

At a fundamental level, the “new portfolio model” introduces more asset classes in the mix. Some have already entered the mainstream, such as real estate and infrastructure, but others are being called in.

The new model also brings in more exotic instruments, like options, futures, and other derivatives such as credit default swaps. Most notably, it puts into play operational strategies like short selling (up to 50% of assets), leveraging (up to three times assets) and arbitrage. For example, the NBI Liquid Alternatives ETF calls on futures that managers purchase in the five asset classes of government bonds, currencies, energy, grains and metals. These futures can be long or short, and integrate leverage. “We aim to have a weak correlation to stocks, not to make money from the fall of stocks,” says Pierre Laroche, vice-president, research and strategy, at National Bank Investments. Other funds follow a different path and seek to increase returns through shorting, not simply minimize correlation, as it is the case with the Forge First Long Short Alternative Fund.

Another strategic layer that Picton Mahoney adds in the mix consists of calling on factor risk premiums (value, momentum, yield/carry, etc.). Diversification can be achieved because these strategies rely less on the direction of underlying markets.

At the fundamental level of asset classes, Picton Mahoney systematically seeks to minimize correlation. To achieve this, the firm has analyzed 173 different assets and filtered them down to what White calls 9 “pure” asset classes, which assembled properly, can redistribute risk away from equities and bonds.

The crossroads
White’s explanations highlight a few key expressions that characterize the new portfolio model: “neutralizing market directionality”, and “minimizing correlation”. For example, market directionality can be neutralized by investing in long/short equity pairs. “If you are long Coke and short Pepsi, the return from this equity “exposure” will not depend on the direction of the stock market, White points out. You make money based on the spread in return of Coke over Pepsi.”

In the new portfolio model, equities remain the dominant asset class, top return driver and “offensive” player. But on the “defence” side, liquid alternative funds can step in to protect the portfolio in market downturns, as they have brilliantly done in the recent storm, yet still give the portfolio a strong “offense” potential.

However, the new portfolio model is not meant to hit the ball out of the park. Most funds are structured to smooth out the peaks and troughs of market volatility. They usually dampen the upside of a portfolio, but that’s because they also minimize downside.

Obviously, the new model is not immune to risk, and investors must be particularly attentive to the risk attached to derivatives, futures and options, risk with which they are not familiar. Many instruments, for example, carry not only the market risk of a specific asset class, but also the counterparty risk of the bank that is paying out the asset’s return through a swap or a futures contract. Of course, counterparty risk is also present when an investor buys a simple bond, points out Seif, but investors should be aware that the new portfolio model widens that risk so, like everything else, it should also be... diversified.

A recent survey by AIMA revealed that advisors aim for a 10% share of their clients’ portfolios in liquid alternatives. But considering that pension funds often push the portion of alternatives up to 50%, investors can quite comfortably move the bar up. “It could be more than 10%, says Kaura, especially in the current market environment.”