The global head of portfolio strategy at Willis Towers Watson, Jeffrey Chee, says the traditional balanced fund’s reference portfolio of 60/40 will need to be rethought in a post-Covid-19 environment.

The 60/40 split has had its best decade in the most recent 10-year period, driven by falling bond yields and rising equities, but “that model is going to be a lot more challenged going forward,” Chee says.

“I don’t think 60/40 is dead. It is still useful as a reference point,” he says. “But investors are going to exploit different levers in order to add value relative to that.”

“From here, it [60/40] is probably not going to get you to your objectives, so investors need to think more generally about how they’re going to add value and why, and the justification for that.”

Augmenting the risk mindset

With markets, including equities and pockets of fixed income, overvalued, Chee says investors need to think about different dimensions, including risk-return.

Covid-19 has highlighted there are a wide variety of triggers of big, sharp drawdowns in equity markets that are difficult to anticipate in advance.

“That highlights the need to augment that traditional risk-return mindset with considerations of the diversity of a portfolio, so fundamentally how exposed are you to different things that drive returns?”

Chee says other important lenses include liquidity, cost and complexity. “To what extent are you able to absorb or deal with uncertainty around assumptions you’re setting?”

Those characteristics can be quantified, Chee describes, which allows investors to rank various characteristics against each other and look at trade offs between liquidity and complexity, costs and diversity, etc. “That is a much better and more holistic way of building a portfolio.”

For example, Chee explains if you want to underweight equities you can test different configurations of strategies brought into a portfolio.

Alternatively, they might increase risk but increase the cost. “You can work out how happy you feel about that. By weighting those different dimensions of portfolio quality in accordance with a particular investor’s beliefs, you can better explain how you got there and make sure the sources of value add and the levers that you pull are in line with your beliefs, your endowments, your competitive advantage, etc.”

Regime changes

When it comes to risk, Chee says that a lot of the traditional models that use historical rolling windows to measure risk will give you potentially quite misleading answers, and investors now need to take a long view of risk.

He maintains that the recent regime of extreme policy support since the GFC that dampened volatility is “just one regime”.

“There have been other regimes where we have had quite elevated volatility,” and investors need to look at different regimes that could occur and what the volatility characteristics of asset classes in those regimes, he says.

“You need to recognise there is a probability we move out of the current regime of suppressed volatility into one of those other regimes and therefore you can directly incorporate that into your asset allocation model.”

Diversification rethink

Chee agrees it is time to rethink a lot of the traditional ways of thinking about diversification in a portfolio in terms of assumed correlations being less than one therefore having other asset classes reduces risk. “In a crisis environment, you see the classic ‘failure of diversification’.”

He says it’s important to augment any framework that relies on quantitative assessment of diversification with a set of downside assumptions.

For example, using equity beta as a rough and ready measure of portfolio diversification, it may increase from 0.5 to 0.6 to 0.7 to 0.8 in a downturn. “Are you happy with that? If not, what do you need to do differently in order to mitigate or manage the fact that you equity correlation will tend to increase in a downturn?”, adding that it could include foreign exchange, duration and long volatility options.

A properly articulated process

Chee says what has just happened in markets has highlighted the need to rethink portfolios and how to build a resilient portfolio that’s diversified across a wide range of strategies.

“It’s not even thinking about it in terms of 60/40 or 20-20-20-20-20, but in terms of, what are all the investment strategies that sit within my opportunity set based on my endowment, governance and capability? And assembling them in a way that deals with equity beta increase and maximises portfolio quality.”

He suggests that it could lead to 20-20-20-20-20 for a particular investor. “But for some investors, having gone through that process and done the relevant trade-offs, you could still end up at 60/40. But I think the point is you have got a properly articulated process that considers all the dimensions of portfolio quality, weights those appropriately and gets to a portfolio, rather than 60/40 being a starting point.”

To listen to the full interview with Jeff Chee on the Market Narratives podcast click below or find the series on Apple Podcasts, Google Podcasts or Spotify:

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