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3 Reasons to Rethink Portfolio Construction Now

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The financial services industry “needs to rethink portfolio construction,” says Sébastian Page, head of global multi-asset at T. Rowe Price.

Speaking at the firm’s virtual global market outlook briefing, Page explained why such a change is necessary now, recounting major market developments over the past year, many due to the impact of the COVID-19 pandemic. Here are some of the highlights of his presentation. 

1. The Failure of Diversification

Recalling the close correlation between U.S. stocks and different asset classes during the late February to late March market selloff, including foreign stocks (both developed and emerging market), U.S. investment-grade and high-yield corporate bonds and real estate, Page said, “We can expect diversification will continue to fall when we need it the most. … Diversification tends to work best on the upside and very bad when you actually need it on the downside. It is a flawed concept.”

Page is not suggesting that investors don’t diversify their assets but that they add to the mix of assets since Treasurys “will no longer be as effective a diversifier for stocks” with interest rates near zero.

He recommends long-duration bonds, which still have some hedging properties because yields remain higher at the long end of the yield curve and they could possibly appreciate in price. In addition, he likes absolute return assets such as liquid alternatives that allow investors to take long and short positions; active management that dynamically manages risks; gold, which can trade like a risk asset in the short run but can be a hedge in longer run; and low-interest currencies like the Japanese yen.

Even with these alternatives, however, Page, author of a new book, Beyond Diversification, said investors “have to recognize the new reality we’re in,” and take more risk to reach a certain expected rate of return or lower their return expectations if they don’t.

2. 60/40? More like 80/20

One example of taking more risk to get an expected level of return is to increase the allocation to stocks. T. Rowe Price multi-asset team estimates that “to get a 6% expected rate of return going forward you’re going essentially to need to hold more stocks than ever before … depending on assumption and asset classes perhaps as much as 80% stocks,” Page said.

This is well beyond the traditional 60/40 portfolio that investors have traditionally used for retirement savings and a growing number of financial firms view as insufficient now.

(Related:  JPMorgan: The 60/40 Portfolio Is Done; Here’s Where to Seek Returns Now)

Page also noted there is essentially no compounding effect after inflation from investing in U.S. Treasurys given their near-zero yields. An investor contributing 10% of their salary to Treasurys to save for one year of retirement, for example, would need to save for 10 years. For those already in retirement, many currently underfunded, “not only will the search for yield continue but the search for returns will intensify.” 

Although he didn’t mention this, the compounding effect still exists for corporate bonds, but only if holding periods are extended.

3. Beware a reduction in fiscal and monetary stimulus

As a result of this two-pronged stimulus, which has been estimated as high as $25 trillion globally, or about half the total market cap of global stocks, much more money (liquidity) will be chasing fewer assets in the next 12 months, Page said. When the stimulus decelerates, stock markets will become more fragile and will require economic and earnings acceleration, adjusted for inflation, to make up for the retrenchment.  

In the meantime, “the equity risk premium is alive and well,” said Page — referring to the earnings per share of the S&P 500, which is the opposite of price-to-earnings ratio — compared to the 10-year Treasury yield. The S&P 500 earnings yield is currently 2.75%, more than three times the 0.88% 10-year Treasury yield.

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