Source: Natixis IM Solutions, Preqin, 2024
However, some of the limitations of the 60/40 portfolio that were highlighted in 2022 can’t be ignored. The double bear market in bonds and equities was triggered by inflation, which had a knock on impact on bonds triggering a market crash in treasuries and, in turn, an equity market correction. As I said, this was unusual.
But, while bonds and equities collapsed, other asset classes proved more resilient: money markets, volatility, and commodities – oil in particular. Money markets by definition have virtually no duration risk. Likewise, with commodities, if you’d had 5-10% exposure to the S&P GSCI – which serves as a benchmark for investment in the commodity markets – you would have offset a big chunk of your losses in your 60/40 portfolio. Remember, inflation is calculated including energy and raw commodity prices.
Of course, we can learn lessons from what happened in 2022, even though this was an exceptional year. If nothing else, it was a reminder that the negative correlation between bonds and equities is not an immutable truth and that there is merit in broader diversification into everything from commodities and real estate to liquid alternative strategies and private assets.
Indeed, the events of 2022 furthered the argument for a small allocation to commodities, including gold, for inflation hedging purposes. But it would be hard to argue that commodities should account for a full 20% allocation, especially when there are an increasingly large number of alternatives available, even to retail investors.
Take liquid alternatives, for example – strategies that would aim to generate performance regardless of the directions of bond or equity markets. In a world where traditional fixed income products aren’t always guaranteed to provide the shock absorbing qualities they once did, liquid alternative strategies may provide an answer.
Naturally, private assets are going to be scrutinised by financial advisors over the coming years. The expected enhanced return profile is obviously something that is going to be tested. People want to make sure that private equity and to a lesser extent, private debt are effectively delivering on their promise of enhanced performance and new sources of returns.”
Then you have a number of ‘wrappers’ around these assets, whether it's with regulations or tax laws, as well as access through platforms, which have, and will likely continue to increase access to private assets and thus help to increase their inclusion in portfolios. In Italy, for instance, it's no secret that there is a tax advantage provided to investing in private equity. This obviously encourages investment into these areas and is not driven purely by expected performance.
The direction of travel is clearly to leverage this democratisation of private assets more broadly into portfolios and, as a result we are likely to see growth in the prevalence of 50/30/20 portfolios. But, if they are to become a long-term feature of asset allocation they need to deliver on both their promise of enhanced returns and their promise of diversification from a risk standpoint. And, of course, exogenous elements such as the regulatory framework will need to continue to move in a favourable direction.”
Q. When we talk about democratisation, are all types of private assets suitable for all types of investors?
It's a very good question, and the answer is absolutely not. First, the democratisation of private assets seems to be working mostly, for now, for individuals who are effectively managing their own pensions contributions under defined contribution pension schemes, or for the wealthiest clients in their bucket of longer-term investments.
It's fair to say that each investor type has its own preference. Sovereign wealth funds will have a preference for infrastructure. A family office will prefer private equity. For insurance companies, it's mostly about private debt.
When it comes to individual investors, which is obviously in the context of the evolving 60/40 portfolio, it is likely to be mostly private equity, and a touch of private debt. This has to do with the overall investment horizon that we're looking at, as well as the expected ‘bang for the buck’ – in other words, the expected enhancement in performance that you can have with private equity.
Q. In the 50/30/20 concept, there’s obviously still half of the portfolio allocated to equities. What do you think will be driving the performance of the equities component in the years ahead?
While factors such as market sentiment, economic and financial conditions, share buy-backs and geopolitical events may influence equity performance, company fundamentals remain a crucial determinant of long-term stock returns. Indeed, earnings and expected earnings growth have been a consistent gauge of future equity performance and are likely to remain so in the coming decade.
By reflecting firms’ financial health and ability to grow, earnings are a bellwether of management effectiveness and industry positioning and constitute a strong indicator of a firm’s ability to become profitable and return money to investors. That said, other company fundamentals are also worth considering on a complementary basis, in particular since their importance tends to rotate in investors’ minds.
The continuing importance of earnings in equity performance can be illustrated by the US’ share of the world’s stock market capitalisation, which has climbed consistently since the Global Financial Crisis and now stands at 61%. In a study quoted by The Economist, the main reason for America’s dominance is that earnings per share of the MSCI US index have risen by 162% since March 2008.
By contrast, the earnings per share of global markets excluding America have dropped by 2% in dollars terms over that time. And no factor other than earnings may statistically explain the rise in US shares relative to the world’s stock market capitalisation.
In recent years, companies with the strongest fundamentals, also known as ‘quality’ companies, have performed best, in particular in the US. This was warranted by the economic environment which required business resilience. On the flipside, when economic growth accelerates, companies with weaker fundamentals may outperform their peers because of their inherent adherence to business cycle.
Any major deviation from core valuation principles usually is called a bubble and is corrected sooner rather than later. Rather, we believe that some fundamentals will most likely be scrutinized by investors in a rotational manner against the economic backdrop. Ultimately, the identification of firm fundamentals to follow may come down to an assessment of the phase of the macro-economic cycle we’re in and the outlook for the coming decade.
Written in November 2024
