Time may not heal all wounds. As the equity market continues adding to gains from its March 2009 nadir, individual investors still favor fixed income investments. According to the Investment Company Institute, October 2010 marked the seventh consecutive month of outflows for stock funds. Determined not to take losses that left them emotionally distraught, investors seem to prefer missing the rally to risking a stock market pullback. And though some have finally started committing small allocations back to stocks after September and October’s huge gains, the flow is more a trickle than a flood.

This reluctance puts advisors in a jam. Clients cannot achieve their financial goals unless they take risk. At the same time, they must have the ability to stick with positions that experience short-term volatility in order to benefit from long-term economic growth.

Welcome to the post-credit crunch New World. Although markets are rife with investment opportunities, headlines proclaiming currency wars, partisan bickering, and sovereign debt defaults will likely dominate the cerebral real estate of many clients.

In the following pages, we will explore the best places to allocate capital—and a few ways to get clients to re-embrace investing—after experiencing the twin equity market debacles of the last decade.

60/40 Burnout
Typically, advisors start the asset allocation process by determining a client’s risk tolerance. This is achieved via a third party questionnaire or similar risk assessment. Results are then fed into software that determines the best portfolio mix for each level of volatility.

Thus explains the origin of the popular blend of 60% stocks and 40% bonds. Having only historical correlation and return data to work with, allocation software will naturally default to portfolios that have done well over the long haul. But it’s hard to believe that the next decade will resemble the prior 10 years.

Today’s advisors are certainly following some unusual asset class behavior. Equities were trounced by bonds in the 2000s. Anyone investing during that period using asset return data from the prior 10 years—a period of unusually robust equity returns—would have suffered. Clearly, there is more to the asset allocation decision than buying high and selling low.

There are ways to structure a portfolio that constrain the process to a lesser degree. Instead of using 60-40 (or another ratio) as the defining allocation to stocks and bonds, it should be thought of instead as a combination of return generating and diversifying investments. This makes both intuitive and pragmatic sense. Investors realize that stocks have more return variability, and over sufficiently long periods will probably generate higher returns than bonds. But there will be occasions when fixed income-oriented investments have enough return potential to be included in the first category.

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Take foreign denominated sovereign debt, for example. If accessed through a leveraged closed-end fund, this asset class has much greater volatility than most other bond investments—and certainly has enough upside potential to be a return generator.

Similarly, investments in utility stocks plod about like other income-oriented positions, which should put them squarely in the latter bucket.

The attraction of this risk “bucketing” method cannot be understated. Clients find comfort in knowing that the asset management approach being employed reflects the rapid changes in the markets. At the same time, advisors using this approach are not hamstrung by the traditional definitions of equity and fixed income.

What really makes risk bucketing work is the advisor’s ability to select investments for each category. Examining ways that different asset classes work together is an important first step.

A Change in Leadership
Any conversation about equities as an asset class must be done in the context of their return relative to their compatriot, fixed income.

Since stocks and bonds lie on opposite sides of the capital structure, what is beneficial for one is commonly detrimental to another. This is especially true during transition periods. Research has shown that bondholders of firms can suffer losses in a takeover, particularly if the takeover is largely funded with debt, resulting in more negative correlation between a company’s stock and bond returns.

Now consider the relationship at the asset class level. During periods of economic growth, stocks and bonds are usually slightly positively correlated. The two assets classes also tend to fall together during periods of rising interest rates, due to the negative impact of higher rates on earnings growth and the drop in the real value of coupon payments.

The circumstances that make stocks and bonds decouple from one another are far more interesting. The so-called “flight to quality” environment, where investors flee risky assets for the safety of fixed income, is one example. The credit crunch of 2008 is a case in point. With stocks being mercilessly pounded during that year’s fourth quarter, long-term government debt had a field day.

The other low-correlation scenario is during periods of low inflation and minimal economic growth. Suppose an investor wanted to wager that inflation (and economic growth) would be near zero going forward. What’s the best way to do this? By purchasing bonds. With muted inflation, the coupon payments from a bond would not lose any of their purchasing power. And if this low growth scenario came to light, it would most probably occur in tandem with low interest rates, which would cause the bond to appreciate in value.

The no-growth, low-inflation mantra typically results in lower correlations between stocks and bonds, a scenario that is occurring now. Besides affecting returns, investors’ predilection toward bonds has also driven the correlation between equity and fixed income lower.

Curiously, periods of low correlation are often associated with changes in leadership among these two asset classes. For example, the low correlation in January 1999 was followed by the tech meltdown and lower rates, which buoyed bond prices. The end of 2003 saw this reverse, and widened credit spreads brought about by the Enron and WorldCom collapses gave way to higher equity prices. Correlations were also low during much of 2008, but bounced well before stocks rebounded in the second quarter of 2009.

Correlation changes are but one reason to believe that equity markets might outpace bond returns in the coming year. Thanks to cost cutting, corporate profits have now surged above where they were in 2007. And in most cases, companies are “banking” this profit in the form of cash on their balance sheets. The current love affair with yield has made corporate borrowing (in the form of bond issues) another important source of cash for firms looking to get more liquid while the getting’s good.

So what’s to become of all this cash? In many cases—especially the large cap technology sector—firms are buying start-ups instead of investing directly in research and development. A better use for that coin may be dividends payments. This could bring income-oriented investors—a group that had no previous interest in technology stocks—into the fray.

Large cap growth stocks are especially enticing, as there are a plethora of such issues with strong earnings, good balance sheets, and an enviable record of dividend growth that are trading at very reasonable levels. According to Bloomberg data, large cap tech companies are trading at around 15 times earnings, a level not seen since at least 1992. Consumer stocks such as Johnson and Johnson (JNJ) are trading near all-time low P/E multiples.

The tendency for smaller investors to choose low yielding bonds to underpriced stocks is another reason market participants should warm up to equities. Most firms that measure investor’s attraction to stocks—including the Investors Intelligence advisor sentiment survey, the American Association of Individual Investors, and Yardeni Research—have all noted that the predilection to sell is dramatic since March 2009. Research has shown that declining sentiment is usually associated with rising stock prices.

Middling Fixed Income
Even with the compelling valuation of equities, there are still reasons to own bonds. Owning both asset classes in combination is an extremely efficient way to increase portfolio diversification. And contrary to popular belief, there does not seem to be a bond “bubble.” Based on the current inflation forecasts and near-zero short-term rates, it is not unreasonable that interest rates on government debt are so low. Further, there is scant evidence that the United States is in danger of a Treasury debt crisis. A long history of political stability, the liquidity of the Treasury debt market, and the significant control of the domestic money supply all indicate that the United States (and Great Britain, among others) can handle the current and projected amounts of public debt. Further, there does not seem to be a relationship between the public debt ratio and looming inflation. For example, the peak U.S. public debt ratio of 109% in 1946 was followed by a decade of low prices.

The above scenario isn’t necessarily an endorsement of Treasury securities. At a current yield of 2.7%, would an investor want to tie up their capital for 10 years in a Treasury note? There are much more compelling opportunities in fixed income than that.

There are three main domestic fixed income categories. Government debt makes up the first tranche. Corporate debt, which has enjoyed renewed popularity as firms return to profitability, has also been on a tear. The rally began as credit spreads (the difference in yield between corporate and government debt of the same maturity) began contracting from historically high levels. A combination of factors, including low rates and a general aversion to equities, allowed these bonds to keep moving higher. According to Bloomberg, the 10 lowest-yielding U.S. corporate bond offerings in history have all occurred in the last 14 months.

Still, the pick-up in yield between government and corporate debt puts the latter category in a better light. The iShares Barclay 1–3 Year Credit Bond ETF (CSJ), for example, yields about 2.7%, while the iShares Barclay 1–3 Year Treasury Bond ETF (SHY) currently yields 1.1%. Though there are scores of solid large cap companies with higher dividend yields, most investors need some debt in their portfolios for diversification purposes.

In an attempt to increase yields, many investors have been drawn to junk bonds. The iBoxx High Yield Corporate Bond ETF (HYG) gained 28.9% last year and was up 10% in 2010 through mid-November. Yields for junk funds have remained healthy, at around 7.5% to 8%. And demand for such bonds has stayed robust, as improved earnings and better balance sheets have provided a solid fundamental underpinning for the asset class.

Even with these attributes, high-yield debt is less than a perfect investment. As the demand for bonds continues to grow, lending standards have relaxed. For example, when MGM International recently borrowed $500 million in the open market in October, the casino operator only offered investment-grade standard covenants. As lower-rated firms continue to borrow, investors need to be more selective when adding to positions.

The third leg in the fixed income stool, mortgage bonds are arguably the most compelling sector of the fixed income universe. It’s been a tough road for the sector, as the deterioration in the housing market, the lack of available credit, and historically high default rates made the mortgage market nearly untouchable. At one point, over 90% of the mortgage bond market was rated AAA. After significant downgrades, natural buyers such as insurance companies can’t even own mortgage paper.

[Read more about mortgage bonds.]

As a result, the mortgage market has shrunk dramatically, from over $3 trillion in mid-2007 to about half that size at the end of 2010. It is expected to shrink about 20% per annum going forward, due to amortization (mortgages getting paid off), defaults, and prepayments (owners selling one home to buy another).

What’s left in the rubble could be interesting. Folks who acquired their mortgage debt in 2005 to 2006, and who haven’t missed payments, should be stellar credits.

Paying $0.60 to $0.70 on the dollar on a mortgage pool that has slight losses can make some sense—and yield 7% to 9%, in a worst case scenario.

A Touch of Alternatives
A healthy chunk of alternative investments can serve a number of roles in client portfolios. One of the attributes of alternatives is the ability to add positive portfolio convexity (i.e., the ability to capture more of the market’s upside than downside). Hedge funds in particular have been shown to produce convex returns. It is believed that the significant personal stake many managers have in their own products is the reason for this type of behavior.

Hedge funds have historically been described as absolute return strategies, as their performance does not depend on long-term trends in underlying markets. The ability of such funds to monetize changes in market factors such as credit spreads, market volatility, and currency movements allows them to add another layer of diversification and enhanced return to a traditional portfolio.

There are several ways to access hedge fund returns. Advisors can utilize single manager funds, which can be risky and is only recommended for those with an in-depth knowledge of the field; or fund of funds, which combine several strategies into a single vehicle. Hedge-like mutual funds are a final option, and can offer many of the advantages of the asset class with enhanced liquidity.

Some alternative strategies are designed to perform better in environments that are typically unfriendly to stocks. Managed futures, which utilize the services of commodity trading advisors (CTAs) to go long and short in a number of liquid futures markets, are one example. Such funds make the bulk of their profit by trend following, an approach that attempts to gain by capturing the tendency of markets to trade in one direction (either up or down) for extended periods of time. This return stream does better during periods of high market volatility, which tends to exacerbate trends. Since increased volatility (such as during the fourth quarter of 2008) tends to result in losses for stocks, a futures allocation can both add to gains and reduce overall portfolio volatility. Long-only commodity investments, however, are much more correlated with equities.

The diversification benefits of managed futures are compelling enough to make this investment a core holding in the alternatives bucket of a portfolio. As with hedge funds, futures strategies can be accessed in single-manager limited partnerships, funds of funds, or mutual fund format.

Real estate investment trusts (REITs), which hold different forms of real estate, offer investors high current income (REITs are required to pass along 90% of their revenue to avoid corporate tax) and an inflation hedge (real estate typically rises in inflationary environments). These attributes give REITs a hybrid feel, as they share traits with both stocks and bonds.

Since the beginning of 2010, 37 REITs have raised dividends while seven reduced their payouts. This reflects the higher returns and better occupancy levels being experienced in many commercial markets. The average REIT yield is around 4%, which compares favorably to most equities and Treasuries. There are some benefits to owning the asset class, and it is a better alternative than high-yield bonds in the current environment. There are individual exchange-traded REITs, limited partnerships, and REIT-based exchange traded funds available.    

Ben Warwick is co-CIO of Aspen Partners LLC, an Atlanta-based alternative asset specialist, and CIO of Quantitative Equity Strategies Inc. in Denver. His portfolio recommendations and current economic outlook can be found on his (at least monthly) Searching for Alpha blog on AdvisorOne.com. You can also sign up for his twitter feed (@QESAlpha).