Surviving and thriving in a two asset world

Investing isn't necessarily simple. Even in the ETFs world. So what are some tips to use in order to survive in a multi-faceted investing environment? Phil Huber, CIO, Huber Financial Advisors explains.

We live in a two-asset world. You want the prospect of high returns with commensurate risk? Buy stocks. You want safety and income with the accompanying lower expected returns? Buy bonds. Find yourself stuck somewhere in the middle? Buy some combination of the two.

Somewhere along the way, the specific combination of sixty percent stocks and forty percent bonds became the de facto standard in asset allocation. How come?

60/40

The “60/40” portfolio has tremendously benefited investors over the last several decades. Unfortunately, there is a high probability that this approach to investing that has worked so well in the most recent epoch will ultimately fall short in meeting the return targets and objectives of investors in the decades ahead.

There are two main culprits to blame here: high valuations of the “60” and paltry interest rates on the “40.” The end result of these two forces colliding is substantially lower expected real returns for traditional 60/40 portfolios.

Don’t get me wrong. I think almost all investors should own some stocks. I also think most investors should own some bonds.

Most investors would agree that diversification is a good thing, yet they often limit themselves to stocks and bonds.

These core portfolio pillars of are not going anywhere anytime soon. Nor should they. They both serve valuable roles in a portfolio. But we can do better. The goal is not to replace stocks and bonds, but to augment them. The investable universe has expanded significantly and investors have a new set of tools available in their toolkit.

There are three choices

With the 60/40 portfolio stuck between a rock and a hard place, allocators can choose one of three paths to confront today’s challenges on behalf of their clientele:

1. Do Nothing

This is the path of least resistance. And it is likely the road that most will take. Inertia is a force to be reckoned with, especially in the world of asset management. Maintaining the status quo will feel comfortable, but the price of admission for that comfort will come in the form of falling short of investors’ objectives.

Return targets are unreasonably high, yet capital market expectations are stubbornly low. Something’s got to give.

2. Take More Equity Risk

This choice might solve the return side of the equation, but only over a long period of time. And over that horizon, investors’ will likely have to incur cringe worthy levels of volatility and drawdowns that will keep them from sleeping well at night. In theory, this might work. In practice, the odds are slim.

3. Be Different

Investing differently than others is easier said than done. There is peer risk, career risk, and a whole host of other considerations to factor in. Choosing this path takes courage, but it is where the opportunity lies ahead.

Embrace the new opportunity

Most investors would agree that diversification is a good thing, yet they often limit themselves to stocks and bonds. Traditional asset allocation – i.e. “60/40” – has served investors quite well over the last few decades.

However, secular headwinds may challenge the reliability of traditional portfolios to deliver the required returns that most investors need to meet their objectives.

A potential solution to this dilemma is to embrace additional sources of return that lie outside the conventional orthodoxy. A wide range of exposures once considered “un-investable” are now increasingly democratized thanks to the confluence of technological advancements and financial innovation.

From niche asset classes to strategies designed to intelligently exploit structural market inefficiencies and behavioral biases, investors today can enhance their portfolios by including valuable, diversifying return streams sourced from non-traditional risk premia.

The alternative revolution

So why has this investment evolution not morphed into a full-fledged revolution?

Part of it has to do with the term itself: alternative investments

Why, you ask? It’s because “alternatives” doesn’t mean anything. Alternative is not an asset class – it’s a catchall. Calling something alternative doesn’t tell you anything about the underlying investment other than what it is not.

So what exactly makes something alternative? Depending on whom you ask, you might get some of the following responses:

• Difficult to access
• Hard to understand
• Unfamiliar
• Novel, or at least perceived to be
• Implemented with different tools
• Not easy to sell

Ask ten people; you’re likely to receive ten different answers.

I don’t expect it to happen any time soon, but I think a positive step forward would be removing the word alternative from our lexicon altogether. When evaluating any investment, traditional or not, you should be answering these three questions:

• What types of assets are being bought and sold?
• How are investment returns generated?
• What is the role of the strategy within a portfolio?

The effective implementation of non-traditional investments in the context of a diversified portfolio is simultaneously the biggest opportunity and the biggest challenge financial advisors and professional asset allocators face in today’s market environment.

Phil Huber will be discussing liquid alternatives, what it means for portfolios and the future at Inside ETFs later this month.