The Portfolio Trade Deadline Approaches: 60/40 Needs an Upgrade

Let's start with true diversifiers, and there aren't many. How many major Morningstar categories (using hedge fund indexes as proxies for some of the newer liquid alt categories) exhibited correlations below 0.5 to equities over the last 15 years ending in December 2014?

Of the 46 categories that we considered, there are 17, but that includes 12 bond categories with anemic outlooks. While Bear Market is the clear winner, the strategy (manager skill aside) has a negative expected return over most time frames, so we'll cut Bear from the team. That takes us to four true diversifiers that might be able to help out on the return side of things.

This is our playoff team of diversifiers: Managed Futures, Global Macro, Market Neutral and Multicurrency.

Next, let's pick our Downside Protection team using the same 46 categories, but with a slightly different question: How many had drawdowns of less than half of that suffered by the S&P 500 during the financial crisis, using monthly returns? About half, but again, excluding Bear Market and the 12 fixed income categories we cut before, we're down to nine. Of those, there are two more bond categories, one of which has a good chance at faring better than core fixed income: Non-traditional Bond.

What's left after that? Our star diversifiers show up again (they are utility players), plus three new prospects: Long-Short Equity, Long-Short Credit and Merger Arbitrage. Merger Arb has been an effective strategy in years past, but it is a victim of its own success; we don't think its future will look as bright as its past.

So there you have it: six categories that investors need for true diversification or downside protection, with the possibility of return generation in excess of what can be expected from investment-grade debt. The next question is how to fund and weight these additions. Using the average institutional allocation as a guide, it's reasonable to conclude that at least 20% of a portfolio should be allocated to some combination of these strategies. Replacing 20% to 30% of the equity allocation (i.e., 12% to 18% of a 60/40 portfolio) with Long-Short Equity, Managed Futures or equity-oriented Global Macro strategies would be a good start. As for the fixed income allocation, it's not a stretch to argue that half or more (i.e., 20% plus of the total portfolio) should be moved to Market Neutral, Long-Short Credit, Non-traditional Bond, Currency or tightly risk-controlled Global Macro strategies.