The 60/40 Portfolio Conundrum
For 40 plus years, the traditional 60/40 portfolio has been successful as treasury yields often produced positive returns and limited risk. However, the 2008 financial crisis led to a change in the market, making the 40% of the traditional 60/40 portfolio less effective in providing returns while also providing risk-mitigating convexity during equity markets sell-offs. Starting with this low interest rates environment following the financial crisis, Commonwealth Bank & Trust’s (“Commonwealth”) CIO, Robert Hawkins, started experiencing the challenges that came with the necessity to make a change to the 60/40 portfolio.
Hawkins reached out to a fellow Washington and Lee University alumnus, John Fidler, who was working at a large family office dealing with quantitative macro strategies. Hawkins asked for advice on developing a strategy that would be diversifying, additive, and protective towards their typical client’s portfolio. Hawkins previous research efforts indicated too high of fees, high volatility, or was another asset class, like emerging markets or high yield which could raise portfolio risk instead of providing a mitigating factor. Instead, Hawkins was searching for a product strategy that produced reasonable risk and volatility, practical fees, and protective of the portfolio, especially during high stress periods.
Fidler responded with how they handled this challenge at his large family office, but he was not confident it would work in the retail investment world. Fidler told Hawkins that Commonwealth had to create their own strategy. Then, Fidler agreed to come work with Hawkins at Commonwealth to build and implement that strategy.
Upon his decision to join Commonwealth, Fidler asked Hawkins for a “wish list” of what he wanted this alternative investment to look like. Hawkins provided Fidler with a lengthy list, “I wanted a portfolio of funds that had reasonable volatility (~10%), a bond-like return in up markets, was cost effective, but had no correlation to stocks and bonds, so it could provide protection in market downturns. It also had to be liquid, easy to get in and out of as we balanced accounts, and seamless from an operational perspective.”
Commonwealth’s goal is to establish a strategy that produces reasonable return fees, while protecting the portfolio from volatility and high stress periods. Fidler states, “I think the ultimate goal of our Liquid Alpha strategy is adding incremental return to traditional portfolios, while at a minimum not increasing portfolio risk and ideally decreasing portfolio risk.” Hawkins adds, “We feel the diversification it provides for clients is even more critical now with stocks pretty much fully-valued and bonds yielding next to nothing.”
Trading programs selection
Commonwealth utilizes a platform that provides them efficient access to smaller, niche managers with a lesser-known profile. Fidler said, “Our focus has always been allocating to smaller, off-the-run, niche managers, when they’re early in their lifecycle. They’re going to have views that those strategies are going to outperform late lifecycle managers that are more focused on asset gathering.”
As Commonwealth built and continues to develop their portfolio of portfolios, they have self-imposed strict guidelines on adding and terminating managers. They do not chase performance without it being backed by the data they are truly looking for in a manager’s performance. Fidler says, “A big part of that is finding managers who think differently, are using different data sets, or otherwise doing something unique that allows them to operate in a less heavily-fished pond.”
Commonwealth looks for managers that have returned consistent success in a “unique, capacity-constrained, or otherwise advantaged space” with a higher Sharpe ratio, than even the top managers in a very competitive space with a lower Sharpe ratio. Fidler says, “We are constantly looking for managers doing something unique that makes them uncorrelated and additive to our existing portfolio.”
Commonwealth sets quantitative expectations around returns and focuses on a manager’s Sharpe ratio, but they also investigate the environmental dependencies. They will ask managers about the periods they expect to do better or worse and how that fits into their portfolio. The goal is to create a balance to reduce risk throughout the portfolio by having managers that can succeed in different markets and produce returns during turbulent times. They do not solely focus on the performance, but Fidler says, “when they’re outside of that cone of performance expectations, that’s when we get concerned.” When this concern arises, Commonwealth will look into terminating that manager and looking into a more stable and viable option.
Managers that use fundamental data, instead of only price-based data, have been the focus for Commonwealth as it can produce less heavily mined alphas. But it is more difficult to accumulate useful data. Fidler explains, “On the systematic side, we like managers who are building models using fundamental data. On the discretionary side, we like managers whose process incorporates both fundamental and price data.”
Trend following strategies are historically successful and have shown recent success for Commonwealth, specifically in commodities, so applying them to their portfolio has proven to be beneficial. However, Fidler suspects traditional trend following may not be as profitable in the future, especially in financial instruments such as government long bond futures because it benefitted from the positive carry byproduct of being long the fixed income market during a 30-year plus rally. Still, Fidler says, “Trend is a
core beta we want to have within our portfolios because we do believe that in stress periods [overall] trend following is going to do well.”
At the overall portfolio level, from a percentage perspective, Commonwealth seeks to allocate as a core piece between 20 and 40 percent to trend following strategies that use market prices as an input, and the other 60 to 80 percent is allocated to strategies using fundamental data in addition to market prices. Fidler believes pattern recognition, which typically works only for a year or two before eroding, tends to be more short-lived and subject to alpha decay, so the portfolio prefers to trust the fundamental macro strategies, which use many more alternative data sets that are less likely to be looked into.
The power of real diversification
When looking back at their performance in 2020, Fidler thinks that Commonwealth may have been almost too designed for the volatile markets. They had a great first quarter, leveled out as the markets rallied, but still finished the fourth quarter on a positive note. Says Fidler, “when equity markets were on their lows in late March 2020, Liquid Alpha was up high single digits year-to-date. Liquid Alpha’s positive performance in 1Q20 contributed to reducing peak-to-trough drawdown of a diversified client portfolio by about a third, as it was designed to do.”
Fidler wonders how much ability to produce returns is left in the fixed income markets and wants Commonwealth to be more aware and proactive about finding managers invested in the commodity and currency markets. Fidler says, “That’s what we’ve done and are doing, is adding risk to more commodities focused managers because we think that’s where there are more opportunities.”
Hawkins has been pleased with Fidler’s ability to deliver results laid out in Hawkins’ original wish list. Hawkins said, “Liquid Alpha has performed well during all the stress the periods experienced since 2015. Risk has been reduced and Sharpe ratios have increased across our portfolios with Liquid Alpha. It continues to beat the ’40 Act portfolios that have survived the last decade.”
This material is not intended to be investment advice, nor is it a solicitation of any offer to invest. Any such solicitation will be made by an offering memorandum. The information is for illustrative purposes only as it highlights recent market events. 3317-GAF-02172021