ETF Trends
ETF Trends

InstitutionalInvestor.com did a quick post on the evolution of the 60/40 portfolio with the catalyst being that the bond portion may not be able to do what it has always done (‘always done’ is of course subjective) with interest rates being so low. If interest rates ever rise or otherwise normalize then it will be a different experience for most investors and despite advisers’ best efforts there will still be clients who struggle emotionally with it.

The idea that the 60/40 portfolio needs to evolve is something we’ve discussed here many times because it is both interesting and potentially important.

The article cited a couple of investment managers with large AUM levels on their thoughts which included alternative strategies like long short, multi-strategy, activist investing and distressed debt. One adviser said he replaced half of the 40 with multi-strategy.

Another quoted adviser concedes that this strategy may not offer much in the way of return and the article acknowledges the risk of allocating to alternatives, namely that they may not do what investors hope they will when interest rates rise.

There are countless funds that target the above strategies and there are other strategies not mentioned including merger arbitrage, various option strategies as well as funds specifically designed to combat rising rates through negative duration.

Long/short is not my favorite strategy but it is definitely a valid strategy, however I would not expect too many funds in the niche to serve as bond market proxies which is what Institutional Investor was writing about.

While past performance is no guarantee of future returns it can set expectations for how a fund might perform. A fund, regardless of strategy, is unlikely to be a bond market proxy (or what people hope a bond fund will do) if it captured a large portion of the equity market rally. That fact wouldn’t invalidate the strategy/fund but many funds that look like equities on the way up will look like equities on the way down.

The negative duration funds are interesting and while I have no reason to expect them to fail they’ve not really been exposed to a prolonged period where rates actually rose.

As a related follow up, a reader left a comment on the Seeking Alpha version of my recent post about Zvi Bodie. Bodie believes in having as little in risk assets as possible having previously suggest 10% in risk assets and 90% in TIPS. The reader took issue with TIPS because they have done poorly in recent years. The reader cited that one of the TIPS ETFs lagged for 1, 5 and ten years so he had no interest in them. TIPS have probably done poorly because there hasn’t been any inflation to speak of. One of the problems that the FOMC is dealing with is not enough inflation.

And so it is with alternative strategies as bond substitutes for periods of rising rates; rates haven’t actually gone up yet in a meaningful and lasting way.

This reinforces the idea that exposure should be small, less than the 20% proposed in the above linked article. I do think several strategies can work provided the bond market doesn’t fail to function as it did in 2008. I don’t think we are in for a repeat of 2008, the next crisis will be different than 2008 just as 2008 was different than 2000-2002.