Recall that on this chart we plotted, in blue, the efficient frontier of a two-asset stock/bond portfolio, using the S&P 500 Total Return Index and the BarCap Aggregate Bond Total Return Index to represent the two assets.  Twenty years of daily return data (December 30, 1994 through December 31, 2014) was used, and rebalancing was ignored for simplicity.  On the same chart we plotted, in red, the efficient frontier obtained by substituting for the S&P 500 an RMI investment. This particular RMI investment has a “deductible” of -10%, a “copay” of 50%, and a “cost” of 410 basis points per year — that is, the downside protection kicks in when the S&P 500 Index suffers a drawdown of -10% or worse, the protection mitigates 50% of any subsequent decline net of the cost of the protection, and the performance drag relative to the S&P 500 during periods when the protection is not needed is 410 basis points per annum.

Comparing the two 60/40 portfolios, it is evident that the RMI-infused portfolio has a higher return and lower risk than, and therefore clearly dominates, the traditional 60/40 portfolio over this period.  This is due to the superior risk management afforded by RMI as encapsulated in the bullet points of the prior section. In fact, the graph shows that an RMI-based portfolio of roughly 73/27 delivers a much higher return, at the same level of risk, than the traditional 60/40 portfolio in this particular example.

Note that the RMI strategy displayed here is not a very robust one — its assumed cost is right at the breakeven level — and there are RMI investments outlined in our prior pieces that we judge to be materially more cost-efficient.  Also, this efficient frontier is based on prior return history of the BarCap Aggregate Bond Index — a history that, as we discussed, likely overstates, significantly, the expected future performance of fixed income investments. Finally, the two-asset portfolio in this analysis is admittedly a very simple one — adding the next-most popular asset class, alternatives, to the mix would likely make the case stronger still, given the problems with alternatives noted above. For all these reasons, we expect that a cost-effective RMI strategy would elevate the frontier higher still, allowing investors to move to an 80/20 (or even more aggressive) portfolio and enjoy a substantially better potential return, with the same or less risk, than a traditional 60/40 portfolio[2].

This finding is significant. It represents, we believe, a paradigm-shifting way to consider portfolio construction in today’s environment and the years ahead.

To recap:  Replacing a sizeable portion of traditional equities within the portfolio with cost-effective RMI counterparts can reduce the portfolio’s need to rely on non-equity asset classes to manage downside risk. The investor can therefore lower the allocation to non-equity assets and correspondingly raise the allocation to (risk-managed) equities. Based on our findings, an 80/20 portfolio could actually be safer in down markets and better performing in up markets than a traditional 60/40 portfolio is likely to be, particularly given the challenges ahead for non-equity asset classes.

This is why we believe that 80/20 could be the new 60/40.

This article was written by Jerry Miccolis, Gladys Chow and Rohith Eggidi of Giralda Advisors, a participant in the ETF Strategist Channel.

[1] This is particularly true of traditional fixed income investments, for which we believe it is a virtual mathematical impossibility, in the current and prospective interest rate environment, to achieve performance anywhere near that of the 30-year bond bull run.  And attempts to improve return through sacrificing credit quality would serve to increase the risk and decrease the diversification benefit of this asset class, thereby compromising its mandate. Liquid alternatives are also challenged due to an abundance of funds chasing too few good ideas, resulting in a long-term trend of declining returns and increasing correlation with equities.
[2] We use “80/20” and “60/40” in this instance and subsequently as a shorthand reference to asset allocations among two or more asset classes. For example, “60/40” could represent a 60/20/20 allocation to equities/fixed-income/alternatives, respectively. This is consistent with general industry usage.

Disclosure Information

This material is for informational purposes only. Nothing in this material is intended to constitute legal, tax, or investment advice.  Investing involves risk including potential loss of principal. 

Giralda Advisors, located in New York City, is an asset management firm that focuses on providing risk-managed exposure to the equity markets with a goal of limiting asset depreciation during both protracted and catastrophic market downturns while allowing substantial asset appreciation in up-trending markets.  The Giralda Advisors team welcomes your inquiries.  Call (212) 235-6801 or visit us at http://www.giraldaadvisors.com/.