The 60-40 portfolio has long been declared dead, but asset owners are still working to determine its appropriate replacement.
Together with MSCI, Singapore’s sovereign wealth fund GIC has proposed one possible solution. Investors from GIC teamed up with an MSCI researcher to create a new framework for asset allocation that aims to incorporate macroeconomic considerations in portfolio construction.
They believe their framework for risk measurement could replace the once-ubiquitous investment model that included a 60 percent allocation to stocks, and a 40 percent allocation to bonds.
“We are witnessing the rise of private assets to the core of many asset allocations from a peripheral ‘alternative,’ and we have entered a new period of heightened macro uncertainty,” according to a paper published by the two organizations in October. “Both could require a fundamental evolution of the asset-allocation process.”
The result is a macro framework that relates an investment’s cash flows and discount rates to a set of scenarios, including demand, supply, productivity, policy, and real-rate shocks.
According to the paper, demand shocks have been the prevalent driver of the macroeconomic environment over the past two decades. In this environment, growth, inflation, and real rates were driven down by decreasing economic demand. This allowed equities and bonds to act as hedges against one another, the paper said.
The environment, however, has changed. Bonds and equities have fallen in tandem in recent months.
“Bonds have typically moved down together with equity in response to supply shocks when the threat of inflation superseded the central bank’s aim of fighting recession,” the paper said. “Further, the low volatility and correlations of private assets are largely artifacts of their smooth valuations, rather than reflecting a lack of systematic risk.”
According to GIC and MSCI, supply-driven inflation, a less credible central bank, rising real rates, and slowing productivity growth could “significantly” change where the markets go in the years ahead.
So what should an investor do?
First, moving beyond using backward-looking statistics as risk measures could help investors understand more about what they’re facing in the markets. Instead, the paper suggests considering the outcomes of the five macroeconomic environments, then modeling asset class sensitivities to discount rates and cash flow. As a part of the modeling process, GIC and MSCI suggest using a “macro-resilient efficient frontier” model that weighs long-term macro risk against the expected return to determine an appropriate portfolio.
Beyond using different risk metrics, the two firms suggest that within these models, private and public asset classes should be put on equal footing.
“Their smooth valuations might make many private assets appear to have lower volatility and lower correlations with other assets,” the authors wrote. “Nonetheless, a lot of private assets have highly uncertain future values and are potentially exposed to the same systematic risk factors accumulating in the rest of the portfolio.”
With appropriate risk measurements in place, GIC and MSCI show that the asset allocations that align with the efficient frontier using macro factors typically replace Treasurys with TIPs and bond-like infrastructure assets. They also make a great allocation to equity, including private assets, equity-like infrastructure, and real estate.