By Jack Forehand, CFA, CFP® (@practicalquant) —
Inflation is coming! Or at least that is what everyone seems to think these days. We have had benign inflation in the US for a very long time now, but many experts are predicting that the recent move toward more aggressive fiscal policy is in the process of changing that. They point to the most recent CPI report released last week as further evidence that we are about to see levels of inflation that we haven’t seen in a long time.
A look at the details of that report does provide some evidence for the counterargument as well because the major sources of that inflation like used car prices could end up being transitory, but either way, we certainly are dealing with the greatest chance for significant inflation we have seen in a while.
Although my economics degree from 1999 may make me think otherwise, I am certainly not an economist, so I don’t pretend to know who will ultimately be right in the inflation debate, but I do think the fact that we need to now consider inflation as an outcome could alter the way investors look at their asset allocation.
In a world where inflation is not a threat, a standard 60-40 portfolio does an excellent job of providing growth, while also limiting downside when stocks get choppy. You don’t need anything more than the last 40 years, when the 60-40 portfolio had its best stretch ever, to illustrate that. As the chart below highlights, the 60/40 has produced a 9.2% annualized return going back to 1988 – that is an impressive return for a portfolio that buys the overall market and aggregate bond index, rebalances once a year and calls it a day.
But the phrase “best stretch ever” also is an indication that we are not likely to see the same type of performance in the next 40 years from the portfolio as we did in the previous 40, especially given that stocks are expensive and bonds yields are low.
So what is an investor to do?
I wish I had the answer, but the reality is that no one does. One potential answer could be to supplement the 60-40 portfolio with assets that perform well in an inflationary environment like commodities, real estate and gold (although its value as an inflation hedge is often overstated), but each of those also introduce some new problems while trying to solve the inflation one. For example, commodities are prone to really long periods where they perform poorly, as investors who invested in them in the past decade are well aware of. And as a quant investor, my entire approach to investing is based around trying to avoid making these types of decisions myself, so my preference is to find systematic approaches that have stood up over time.
So I thought now might be a good time to take a look at some interesting asset allocation approaches that go beyond stocks and bonds. Here are a few interesting ones we have found:
The Permanent Portfolio was developed by Harry Browne. The idea was to build a simple portfolio that would perform well in all the major types of economic environments. It invests 25% each in 4 different asset classes (stocks, long-term bonds, short-term bonds/cash and gold). Each asset is included in the portfolio to help in a specific economic climate. Stocks are included for economic expansions, cash or short-term bonds for recessions, gold for inflation and bonds for deflation. With its components setup to perform well across a variety of environments, this portfolio will likely underperform during bull markets like the one we have been in, but it offsets that by offering a smoother ride than a standard portfolio of stocks and bonds across the entire spectrum of economic outcomes.
We track this portfolio as one of our ETF models we follow on Validea and it has underperformed the 60-40 by .8% per year since 2007, but that was during an ideal environment for the 60-40. If inflation becomes an issue, it could be a much more interesting alternative going forward.
2 – Protective Asset Allocation (PAA)
PAA is more complex than the Permanent Portfolio, but it is also setup to try to perform well in varying market and economic environments. It is based on a paper by Wouter Keller and Jan Willem Keuning. The portfolio uses ETFs to invest in the top 6 out of a selection universe of 12 asset classes (the S&P 500, the Russell 2000, the NASDAQ 100, European equities, Japanese equities, emerging market equities, long-term treasury bonds, high yield bonds, corporate bonds, commodities, gold, and real estate) that have the highest momentum. When a significant number of the total assets in its universe are in a downtrend, it will begin investing in a crash protection asset to limit risk, and will raise that allocation until it reaches 100% once 6 of the 12 asset classes are in a negative trend.
This approach offers two unique advantages relative to a 60-40 portfolio. First, it includes a much more diverse set of asset classes, including some that thrive an in inflationary environment. Second, it includes a system that will put it into a defensive position when a large number of the asset classes it follows are in a downtrend. Its major downside is that the fact that it moves in and out of asset classes makes it less tax efficient than a more static approach.
3 – Generalized Protective Momentum (GPM)
GPM was also developed by Keller and Keunig. It uses the same asset classes as PAA and has a very similar approach. The one big difference is that, in addition to momentum, GPM also takes the correlation of the asset classes into account. The end result is that it has a stronger tendency to include uncorrelated asset classes in its portfolio at any given time. This can lead to lower returns over time, but it also reduces risk and drawdowns.
The All Weather Portfolio was developed by Ray Dalio. Like the other portfolios, it invests in asset classes that can do well in a variety of economic environments. It holds US stocks, long-term-bonds, intermediate-term bonds, commodities and gold. The portfolio is a very basic form of the concept of risk parity. The idea of risk parity is to setup a portfolio where each asset class contributes an equal amount of risk. So less risky asset classes are overweighted relative to riskier ones.
Are the 60-40’s Best Days Behind It?
The 60-40 portfolio has been declared dead more times than I can count. But it has continued to defy the experts and perform well. Whether the current potential for inflation will finally derail it is beyond my pay grade, so I won’t make any predictions there. But given that investing is about preparing for a range of potential outcomes, the outcome of higher-than-expected inflation does at least seem like one that deserves consideration given where we are. Portfolios that expand beyond stocks and bonds could make sense as a way to help protect investors in that type of scenario. These portfolios offer some interesting ways to do that.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.