• Optimizing the balanced portfolio in an uncertain world

The failure of the 60/40 balanced portfolio

The traditional balanced investment portfolio, typically composed of 60 per cent equities and 40 per cent bonds, is deemed to be the goldilocks of asset allocations—neither too hot, nor too cold but just right for the average investor.

This asset allocation aims to balance risk and return, hence the name. Equities represent the risk portion, but they are also the driver of capital growth. Quality bonds represent the income generation and capital preservation portion of the portfolio.

Equity and bond prices are (usually) inversely or negatively correlated to each other. This means when one asset class is trending up, the other is trending down. In theory, holding both assets in a traditional balanced fund should smooth out portfolio volatility and still generate moderate positive returns over the long term.

Unfortunately, sometimes this historical relationship between equities and bonds breaks down as it did dramatically in 2022 when the correlations of all major asset classes converged. Instead of bond prices rising to offset falling equities prices, both asset classes fell in unison. A Bloomberg index tracking a 60/40 mix was down 17 per cent in 2022 from the effects of rising inflation and interest rates that stomped both equities and bonds.

As seen in the chart below, 2022 was the worst-ever year for US bonds going back over two centuries!

Investment strategies and growing market uncertainty

Investors may be wondering if the market volatility of 2022 was an anomaly or perhaps a taste of more uncertainty to come. Will the traditional correlation between stocks and bonds hold or will it continue to be challenged by macro and market uncertainty? As the chart below shows, the trend is for stocks and bonds to move more in lockstep, reacting to economic forces in a similar fashion.

Source: Bloomberg

The role of alternative assets in a balanced portfolio

Investors may be entering a period where greater uncertainty is the new normal. The looming probability of recessions in developed economies, pressure on corporate earnings, depressed economic growth, rising geopolitical conflict, and all of it against the backdrop of climate change mean investors may need a different kind of balanced fund, one that is well diversified and less correlated with equities and bonds, to provide better risk-adjusted returns.

There is a growing probability of recessions in developed economies, accompanied by a compression of corporate earnings and diminished economic growth. All of this is against the backdrop of rising geopolitical conflicts and the effects of climate change on businesses and communities. It will become increasingly important for investors of all kinds, not only high-net-worth and institutional investors, to be more strategic in their asset allocations to achieve the solid risk-adjusted returns they may have enjoyed in the past.

Including an allocation to alternative assets is one way to do this. But what are “alternative assets”? The broad definition is, they are financial assets which do not fit into the conventional investment categories of equities, bonds, and cash. A wide range of assets fall into the “alternative” bucket, including private equity, hedge funds, venture capital, commodities, and derivatives, among others.

Alternative assets usually have a low correlation to conventional investments like stocks and bonds. Including them in a portfolio can make it more resilient to inflation, potentially smooth volatility, and provide better risk-adjusted returns over the long term compared to a conventional balanced portfolio. Alternative strategies can be particularly beneficial in an inflationary environment.

The Pender Strategic Growth and Income Fund

The Pender Strategic Growth and Income Fund is a balanced fund that includes an allocation to alternative assets (up to 10%), in addition to a diversified selection of Canadian and foreign equities, corporate bonds, and government bonds. The aim of the Fund is to provide a lower correlation to traditional equity and bond portfolios and to provide portfolio diversification.