For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.
With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?
Cast a Wider Net for Income
We must add new sources, new asset classes, more complexity and potentially more risk — but this also gives us the opportunity to build more diversified portfolios. Consider different areas of the fixed income landscape, dividend-paying equities and alternatives such as real estate, real assets and private credit.
In casting a wider net, however, advisors should understand the risks they are taking on and how these risks work together. As part of our investment process, we broadly sort possible asset classes into three buckets: interest rate risk, credit risk and equity risk. Each offers different yield and volatility profiles, and we suggest investors diversify across different income opportunities and risks.
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Putting It All Together
To construct an overall portfolio, advisors should first take a hard look at the investor’s risk tolerance and goals. Are they better off with a portfolio containing mainly interest rate risk and lower volatility, or do they want to add credit and equity risk to increase the yield potential, as well as volatility?
The Mid-Quality Sweet Spot Emerges
Two distinct sides of the market have emerged from the coronavirus crisis. The highest quality segment — like U.S. Treasuries and agency mortgage-backed securities — has already benefited extensively from the Federal Reserve’s rate cuts and direct purchase programs, but offers little yield.