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It’s Time to Enhance Modern Portfolio Theory

August 29, 2013

The 60/40 stock/bond asset-allocation model favored by most investment firms and embraced by advisors for a generation may not help clients achieve their financial objectives over the next 10 years. According to California-based Research Affiliates, the projected return over the next decade on the traditional 60/40 model is 4.1%, excluding management fees — the lowest in 140 years. If that estimate proves correct, clients face a significant disconnect between their expectations and their probable results. The traditional 60/40 portfolio is in trouble.

The conversation you should have with your clients is not that modern portfolio theory (MPT) is wrong, rather that it’s time to question whether 60/40 remains the best way to optimize the risk-reward relationship. This asset mix is simply too narrow in the current low-dividend-yield, low-inflation, low-interest-rate environment.

Fortunately, over the past 15 years a host of new, liquid investment solutions have become available, and advisors have access to investment options that, until recently, were the exclusive province of institutions. These investment vehicles can help you build more diverse, resilient portfolios designed to enhance return and reduce overall portfolio risk. Most important, helping clients understand the new investment environment and the choices available to them can build your client base and boost revenue per client. Generally described as “tactical investments,” these options aim to remove the restraints of traditional benchmark investing.

Consider three more or less equally weighted buckets: equity (33%), fixed income (33%) and tactical trading (34%). This expanded portfolio construction, combining a number of diverse and non-correlating risks, is far more aligned than 60/40 with the definition of MPT, at least according to Wikipedia: “a mathematical formulation of the concept of diversification in investing, with the aim of seeking a collection of investment assets that has collectively lower risk than any individual asset.” We call the concept of converting the traditional 60/40 portfolio to 33/33/34 "enhanced modern portfolio theory," and we believe it represents what a balanced portfolio should look like in today’s market.

The enhanced modern portfolio is constructed with the intent of capturing upside potential while mitigating downside risk. The objective is to smooth the return stream over time, instead of being whipsawed by volatile markets.

It is important to have broad equity coverage that capitalizes on positive market moves, like those we have experienced lately. Most advisors are familiar with mutual funds and ETFs that can accomplish this, but it is equally important to hedge the equity exposure, given the systemic risks in the low-dividend/high-debt world in which we now live.

As for fixed income, historically low yields and the threat of future inflation require a cautious view of bonds. High-yield bond funds have been one answer, but recessions and periods of rising interest rates can be particularly painful for such funds. Adding exposure to emerging market bond funds or ETFs might be a viable solution.

We strongly believe that tactical strategies should be a central component in any modern portfolio. “Tactical” simply means that the manager is not dependent on a bull market to make money. The manager can maneuver the portfolio to maximize participation in up trends while minimizing the impact of market sell-offs. We classify the tactical space into three categories: tactical equity, tactical fixed income and tactical long or short.

Some strategies can change weightings and exposure to different asset classes, while others trade against a benchmark like the S&P 500 Index or trade a single asset, like long-term Treasury bonds. But they have the flexibility to trade in both up-trending and down-trending environments. Another popular approach looks at the relative strength of several ETFs and allocates to the two best performers.

There are a lot of new strategies out there, and it can be difficult for advisors to figure out which will work best for clients. But no matter which approach you choose, the period ahead calls for an enhanced portfolio with broader — and, we believe, smarter — construction.