Considerations for Modern Investors

Considerations for Modern Investors

Navigating the intricacies of modern financial markets demands a tailored approach, especially for clients that have significant wealth which are often associated with unique circumstances and goals. Over the last several decades, the investment landscape has been transformed by a myriad of structural changes, including technological advancements, the emergence of new asset classes, and shifts in global economic power. In addition to these profound changes, investors must also contend with renewed challenges such as inflation, high interest rates, and geopolitical instability. These old issues, experiencing a resurgence in the current economic climate, alongside new factors such as artificial intelligence (AI) and evolving regulatory frameworks, create a complex array of considerations for all investors, whether they are managing personal wealth or institutional funds. In our view, these developments necessitate a modernized and more nuanced approach to portfolio and risk management in response to changing market dynamics.

Brief History of the 60/40 Portfolio

The 60/40 portfolio, comprising 60% stocks and 40% bonds, is a classic investment strategy that has its roots in Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s. MPT is based on the principle of diversification, aiming to maximize returns for a given level of risk by carefully selecting a mix of assets where returns are not perfectly correlated. The 60/40 allocation has been embraced widely for its simplicity and effectiveness in balancing the growth potential of stocks with the relative safety of bonds. This traditional mix seeks to capture the higher returns stocks typically offer while mitigating volatility and downside risk through bonds, making it a popular choice for long-term investors aiming for a moderate risk profile. Over the decades, the 60/40 portfolio has been considered a benchmark for achieving a diversified, balanced approach to investing, reflecting MPT's enduring influence on asset allocation strategies.

In recent years, the effectiveness of the 60/40 portfolio has come under scrutiny, particularly due to rising correlations between stock and bond returns. In theory, the added diversification from lower correlation of returns should help protect investors from a significant portfolio drawdown by limiting downside exposure via bond exposure when equity markets are down. In practice, particularly recently, this has not necessarily been the case. In 2022, global stocks lost an estimated $30 trillion in value. While the decline in the equity markets was painful, the losses in the bond market may have hurt even more following arguably the worst year ever for fixed income returns. Investors often purchase fixed income for their stability and diversification characteristics, none of which were evident in 2022.

Things were Different Then

While recent underwhelming performance has been the main concern surrounding the time tested 60/40 portfolio, we wonder if structural market changes also signal a deeper emphasis to adjust portfolio construction for modern times. To say it bluntly, a lot has changed since the 1950s.

Below we list a few examples of just how different the world was then compared to now:

1. Technology and Information Access: In the 1950s and 1960s, investing was predominantly the domain of professionals and wealthy individuals, with limited access to real-time market data and analysis for the average investor. Trading was done physically on exchange floors, and information dissemination was slow. Today, technology enables instant access to global markets, real-time data, and analytical tools for all investors, democratizing investing.

2. Trading Costs and Accessibility: Trading costs were high in the mid-20th century due to the manual nature of trades and the lack of competition. The introduction of online brokerages and the rise of algorithmic trading have significantly reduced transaction costs and minimum investment requirements, making investing more accessible to the general public.

3. Product Diversity and Complexity: The range of available investment products has expanded dramatically. While stocks, bonds, and mutual funds were the main options in the 1950s and 1960s, investors now have access to a plethora of derivatives, exchange-traded funds (ETFs), index funds, and alternative investments, catering to a broader range of risk profiles and investment strategies.

4. Globalization of Markets: The 1950s and 1960s saw markets that were relatively national in focus. Today, financial markets are highly interconnected, with global events impacting markets around the world instantaneously. This globalization has provided investors with opportunities to diversify internationally but also introduces additional complexities and risks, such as currency fluctuations and geopolitical events.

5. Investor Behavior and Strategies: Behavioral finance has gained recognition, highlighting how psychological factors influence investor decisions and market outcomes. Modern investors are more informed about these biases and can employ more sophisticated strategies, including quantitative and algorithmic trading, to manage risk and enhance returns.

6. Sustainability and Ethical Investing: While investment decisions in the mid-20th century were primarily driven by financial considerations, there's a growing emphasis today on sustainability, social responsibility, and governance (ESG) factors. Investors increasingly seek to align their portfolios with their ethical values, driving demand for ESG-focused investment products.

There is an Alternative

To be clear, we remain confident in traditional portfolio strategies. In most cases, it would be foolish to completely re-write the script and start from scratch. However, we are indicating that certain adjustments and a more nuanced approach to portfolio management is likely more appropriate than following a playbook that was written in the mid-20th century.

One prime example is the increasing availability of, and access to, private alternative investments. Like the evolution of trading and investing from the 1950’s to today, the world of non-traditional investment strategies has expanded significantly, providing greater access and options to choose from. While most private alternative investments are still reserved for sophisticated investors with large pools of investable capital, interest and appropriateness has broadened out to those beyond the largest institutional investors to wealthy families and individuals.

Private alternatives come in many different forms with very specific considerations. Even for those clients that technically qualify to invest in private alternatives, they may still not be appropriate due to key considerations such as high fees, taxability, complexity, liquidity needs and time horizon. The gap between top performing private alternative strategies and bottom performing strategies is also much wider than traditional investments, which makes getting the right advice and education on these investments critical. With that said, a thoughtful approach to the asset class, when appropriate, may help clients achieve their objectives while providing additional diversification to their investment portfolios.

As the private markets grow, a larger portion of the investable universe will lie outside of traditional stocks and bonds. We view this as a structural and persistent change that necessitates attention. The natural progression would be to consider a greater allocation to the private alternative asset class for certain clients. In addition, awareness of the impact associated with the growth of private market capital as it relates to traditional investments and the general economy is also important. For example, by providing companies with an alternative to traditional public financing, private capital has enabled businesses to stay private longer, often resulting in delayed initial public offerings (IPOs) or avoiding them altogether. This shift has implications for the public markets, as it limits the opportunities for retail investors to participate in the growth of these companies. Furthermore, the abundance of private capital has driven up valuations in both private and public markets, altering investment strategies and risk assessments. Additionally, the availability of non-bank financing provides additional options for higher risk projects and small businesses that did not exist in years past.

Our Approach: Investing in private alternatives requires specialized expertise and a deep understanding of the client’s financial situation and objectives. We take time to educate clients about the risks and opportunities associated with incorporating private alternatives in an investment portfolio. Ideally a programmatic approach with an emphasis on risk management is utilized. Allocating new private investments across several calendar years with a predetermined diversification strategy supports diversification and mitigating timing risk.

Active vs. Passive: Why not both?

Another persistent and relevant investment trend is the shift from active to passive management. The emergence of Exchange-Traded Funds (ETFs) and passive investing marked a significant evolution in the financial markets, offering investors efficient, low-cost ways to diversify their portfolios. ETFs, which began to gain popularity in the 1990s, are investment funds traded on stock exchanges, much like individual stocks. They hold assets such as stocks, commodities, or bonds and typically track the performance of a specific index, like the S&P 500. This tracking of broad-market indexes embodies the essence of passive investing, a strategy that aims to mimic market returns rather than outperform them through active management. Passive investing has surged in popularity due to its lower fees, transparency, and simplicity, appealing to both individual and institutional investors.

The rise of passive investing has been prolific. Just 10 years ago passive accounted for under 30% of assets under management (AUM) domestically and less globally. Today passive investing accounts for over 50% and is likely influencing current market phenomena, such as the narrow leadership experienced in the S&P 500 (i.e., Magnificent 7 dominance). Given that the S&P 500 and other popular market indices are market capitalization weighted, additional flows into passive securities that track these indices continue to create outsized demand for the largest companies. The implications for the markets of allocating assets in this manner are far reaching but perhaps most relevant are the potential consequences related to recent outperformance at the top of the market. If bullish U.S. equity sentiment were to fade and/or a recession were to set off systematic repricing, extreme volatility in those same companies that have led the market higher would likely ensue.

One of the key contributing reasons passive investing has gained such prominence is that beating the market, especially the S&P 500, has gotten much harder for even the most astute fundamental investors. The flow of funds via passive securities may be a contributor but other structural factors are at play. For example, business and economic cycles have elongated substantially. Following World War II, it was common for cycles to last 5 to 7 years. Other than the COVID induced recession blip, the U.S. has not experienced a true recession since the Great Financial Crisis over 15 years ago. Throughout history, active management has shined the most during challenging markets or in other words, protecting against severe losses. Given the significant growth of passive management and growing concentration at the top of the market, it’s quite possible that active management is primed to broadly outperform if the so-called “Soft Landing” is not realized.

Our Approach: While every client, and their various entities (e.g., IRAs, trusts, etc.), have different investment goals and constraints, our general philosophy is to include a combination of both active and passively managed securities in our client’s portfolios. We view certain asset classes to be more favorable for active management compared to passive management and will adjust the composition accordingly. We also leverage separately managed account (SMA) direct indexing strategies to gain passive exposure, which allows us to customize as necessary as well as systematically harvest capital losses to offset actively managed realized capital gains.

Conclusion

In a dynamic economy benefiting from continuous innovation, it is difficult to imagine that the science of investing could remain stagnant. As the investable universe changes, investors would be wise to consider both the risks and opportunities of structural and technological changes as it relates to their investment strategies. Incorporating different philosophies and asset classes into a portfolio requires specialized expertise, particularly as it pertains to multi-generational wealth management. In some situations, creativity and out of the box thinking may be appropriate since investments are never managed in a vacuum and no client situation is ever the same. If the “science” of investing is leveraging data to make informed strategic decisions, the art is selecting the appropriate mix of assets for a given client in a way that endures despite a rapidly evolving market. The importance of combining both science and art is what makes investing beautiful, challenging, and exciting.