KKR: Forget the Conventional Wisdom About Diversification

Stocks and bonds will continue to move together, undermining the value of a 60/40 portfolio.

Illustration by <i>II</i>

Illustration by II

After historic declines in fixed income, some managers and investors argue that the traditional 60/40 portfolio is making a comeback as bonds start to offer diversification benefits once again. But alternatives manager KKR says a portfolio made up of 60 percent in stocks and 40 percent in bonds won’t cut it long term, even if there is a short-term bump for the model.

Historically, bonds have provided investors’ portfolios with stability during times when stocks have dropped. That’s because stock and bond prices have moved in opposite directions. But in the last year, stocks fell and bonds suffered historic losses, in part because interest rates have been near zero for years. During previous downturns, bond prices fell, but investors’ losses were cushioned by the income they collected.

“While the 60/40 portfolio could snap back in the short-term, our fundamental, long-term view that the correlation between equities and bonds has turned positive has not changed,” according to a KKR paper published on Wednesday. Although KKR has a vested interest in recommending a portfolio that includes larger allocations to alternatives, its recommendations dovetail with other research questioning the relationship between stocks and bonds.

KKR recommends that investors add a 30 percent allocation to alternative investments that is equally distributed between real estate, infrastructure, and private credit. The goal is to deliver higher risk-adjusted returns than a plain vanilla portfolio — regardless of macroeconomic conditions.

The authors chose these three alternative asset classes because they have proved to offer protection against inflation. “Our first step was to walk before we run and tell investors that…the first thing that you should consider is more inflation-resilient asset classes, [including] real estate, infrastructure, and floating rate credit,” said Racim Allouani, head of portfolio construction, risk management, and quantitative analysis at KKR and co-author of the paper. “For equity, it’s a bit more nuanced about which companies will benefit from inflation and which will not.”

The alternatives manager first published the details on the value of a “40/30/30 portfolio” — 40 percent in stocks, 30 percent in bonds, and 30 percent in alternatives — in a May report. The recommendations came out as markets were shuddering from a confluence of rising interest rates, high inflation, and mounting geopolitical risks.

“[There’s] a higher resting heart rate for inflation this cycle,” Henry McVey, chief investment officer of KKR’s global macro and asset allocation team and co-author of the report, told II in an interview. “The markets are being driven more by a world where both growth and inflation are being influenced by supply shocks, geopolitics, higher labor costs, the energy transition. These considerations did not largely exist between 2010 and 2020.” In May, McVey and his colleagues argued that these factors would finally lead to a “regime change” and a positive correlation between stocks and bonds in the long term.

In the most recent paper, KKR follows up on its argument earlier this year with a performance review comparing its hypothetical 40/30/30 portfolio with a traditional 60/40 portfolio. The former outperformed the latter by 2.6 percentage points between June 2020 and June 2022, according to KKR. The Sharpe ratio, a popular measure of risk-adjusted return, also rose from 0.41 to 0.85 during the same period with the addition of alternatives.

“Looking ahead, although we fully acknowledge that the entry point to the 60/40 is much better today than six months ago with equities’ multiples adjusting downwards and rates closer to the Fed terminal rate, we continue to believe that an allocation solely comprised of stocks and bonds is suboptimal in this new macro regime,” according to the paper.

KKR argues that private credit, in particular, is a strong diversifier. In the next three years, newly issued junior debt and asset-based securities, which are loans secured by a company’s assets, are expected to deliver an annualized return of 14.5 percent and 13.5 percent, respectively, according to the authors. Senior direct lending will also gain 11.5 percent on an annual basis, while the 10-year Treasury yield is expected to stay at 4 percent.

“I would say the market today is giving you a better opportunity in the private credit portion of the alternatives bucket than we identified in May,” McVey said. “Most banks have started to pull back from traditional lending. That backdrop is creating an opportunity in terms of supply of credit in the marketplace. So, you are able to use private credit to achieve better terms and a higher yield and still be higher up in the capital structure.”