Why would you abandon confidence in a strategy that has generated a positive return 87% of the time over the past sixteen years? This appears to be the case with a growing discussion that balanced portfolios are yesterday's news. I would argue that a traditional balanced portfolio of 60%-70% equity and 40%-30% fixed income still makes a lot of sense for private investors. Why such a lack of confidence after one year of dismal returns?
2022 proved to be the year in which both equities and fixed income failed to provide a positive return (based on Bloomberg's US 60/40 portfolio....this index has had only two negative years in the last sixteen). For 2022 this index had a distressing return of -17%. The historical relationship of bonds increasing in value as stock prices decrease did not materialize and both asset classes fail to perform.
But here is where I part company with the naysayers. The damage inflicted on fixed income in 2022 provides the opportunity for 2023 and beyond. Now with an allocation of 30% to 40% of one's portfolio in bonds (that used to yield 2%-3%), you can invest in the same fixed income with yields in the mid to high single digits. Indeed one could make the case that the fixed income allocation could generate returns comparable to future equity returns, over the next five years.
A further argument against a traditional balanced asset allocation is that the risk-adjusted return (the potential profit, after taking risk into consideration) can be improved with the addition of non-publicly traded investments. Certainly, private debt and private equity have a place in one's portfolio, but it does add complexity.
The apparent historical outperformance in private equity/private debt returns, with seemingly less volatility, raises several concerns. A recently published report by a major North American bank on their fiscal 2022 pension fund returns indicated a -25% return in bonds, -10% in public equity and a +22% return in alternatives. The bond and public equity returns are easily calculated while the alternative asset return is likely computed by marking to a model.
The bank pension portfolio 2022 performance is greatly assisted by the alternative asset valuation, but I am cautious of taking the valuation as being a reflection of actual fair market value. Common sense tells you that with stocks and bonds down in value, private equity would have taken a haircut ( as opposed to the reported +22% performance). There is definitely a lack of transparency as to valuation. Not until the private investments are liquidated at arm's length, will concrete valuations be known. There is certainly a place for alternative investments, but I take reported performance with a large grain of salt.
I think perhaps the most compelling argument for a traditional balanced portfolio is the ease of rebalancing. Large institutional portfolios found themselves underweighted in public debt and equity, after the drop in 2022 valuations. The obvious solution would be to sell a portion of the private debt/equity and rebalance. The question was who to sell the holdings to? Other institutions were similarly overweight. In order to get liquidity in the private holdings liquidation might have to occur at less than the recent valuation. Does the tail start to wag the dog? Does reality set in that the private security valuations are meant to be posted on the year-end report, but not exposed to a public bid?
One recalls the tulip bulbs were meant to be traded and not to be planted.
regards, Tim
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.
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