A great man died recently, but this did not make headlines. In fact, it barely even made the news. Maybe it’s because many have already mourned the departure of his greatest legacy: the 60/40 portfolio.
Harry Markowitz may not be a household name, but among asset allocators he is the undisputed king. Considered the father of modern portfolio theory (MPT), his foundational work (mostly done in the late 1950s–1960s) on multi-asset portfolio construction influenced and underpins almost all models in use today.
At the heart of MPT is the belief that by combining asset classes that move differently from each other, we can create a portfolio with a total risk that is less than the sum of its parts. The simplicity of MPT is both its greatest strength and, arguably, its greatest weakness. The 60/40 portfolio reflects the belief that stocks and bonds are not highly correlated over the long term.
This is not an unreasonable thesis. Nor is it wrong, per se. It is simply highly dependent on the time horizon over which it is measured and on getting the risk, return and correlation assumptions right.
The principle has not changed, but both investors and markets themselves have, necessitating a new approach to portfolio construction.
Out with the old: from asset classes to risk factors
Portfolios of the past, constructed using the guiding principles of Markowitz’s 60/40, relied heavily on returns of public equity to accumulate wealth.
Over-reliance on equity risk is a byproduct of a fundamental misunderstanding of the difference between capital allocation and contribution to risk. Though public equities are 60% of a typical 60/40 portfolio, they contribute a far greater proportion of the portfolio’s risk. Since risk tends to come along with return, these portfolios have been overwhelmingly dependent on public equities for their wealth generation.
In order to build a more effective portfolio that takes into account the wide array of asset classes available to investors today, we need to look through the lens of return drivers (also called “risk factors”) before allocating among asset classes.
A risk factor represents a fundamental and independent
driver of portfolio return:
In with the new: risk-based diversification
A 50% allocation to private markets is not an arbitrary choice.
It is the optimal outcome of a new approach.
Every risk factor, similar to an asset class, has a corresponding assumed return, risk and correlation. These assumptions are much more stable than asset class–specific assumptions. Balancing risk factors can help ensure diversified risk and avoid unintentional concentrations, most often in equity.
Factor Portfolio
We define an optimal portfolio comprised of risk factors.
Asset Portfolio
That factor portfolio can then be expressed as asset classes.
New Moderate Model Portfolio
The asset class expression of the factor portfolio is our hypothetical in-house model portfolio, which we refer to as the “New Moderate Model” Portfolio.
Fifty percent of this New Moderate Model is in private markets across the spectrum of private equity, private credit and private real assets.
Harnessing the power of private markets
| New Moderate Model Portfolio | Traditional 60/40 | |
|---|---|---|
| Total return | 8-9% | 6% |
| Yield | 4% | 2.5% |
| Max drawdown | -22% | -33% |
| Volatility | 6% | 9% |
| Sharpe ratio | 1.13 | 0.58 |
The result2
- 50% higher return
- Part of this return can be taken in the form of yield, which is nearly 2x
- Max drawdown is our preferred measure of risk, since it fairly reflects the smoothing bias of private markets
- Importantly, the underlying risk coming from core equity is cut in half
- The combination of higher return and lower volatility doubles portfolio efficiency
More efficiency in the portfolio should mean more controlled outcomes for you and your clients.
The power of a 50% allocation to private markets is in the historically higher returns and fewer and milder drawdowns specifically, nearly double the cumulative returns over the past 20 years and meaningfully fewer drawdowns than the traditional 60/40.
Cumulative Return3
Historical Drawdown (peak-to-trough loss)
A flexible approach that can be adjusted based on client goals
Now, this model is attractive in its simplicity and effectiveness. But it is built absent of knowing anything about an individual client. That is why this is more than just a model—it’s also a process.
And that process—using risk-based diversification and a focus on alpha—can be coupled with your portfolio construction process to create customized portfolios for different goals and outcomes.
- Traditional portfolio construction combines asset classes to maximize risk-adjusted return.
- This methodology is highly sensitive to the risk, return and correlation assumptions of each asset class.
- Instead of combining asset classes we combine risk factors, because their expected risk, return and correlations are much more stable.
- We use Sharpe ratio as a measure of success, but not the basis on which we define optimality.
That goals-based portfolio might look something like a Growth & Income portfolio for retirement that emphasizes yield and smoother returns. For this objective, we lean into higher allocations to private credit and public fixed income, while de-emphasizing equities, both public and private.4
Or the desired outcome may lead to a Growth portfolio for longer investment timeframes, perhaps for a younger investor or a foundation or endowment with a multiple-decade time horizon. Here we emphasize higher returns by leaning more heavily on private equity, while maintaining the diversification benefits of real assets.
Example Models
Not dead, just different: An evolved approach
For all of Harry Markowitz’s brilliance, even he could not fully conceive of the breadth and depth with which capital markets would expand. His models of the past made no attempt to solve for private markets investments—and why would they? At the time, they simply didn’t exist in the form or size we see today.
If you were completely unburdened by and unanchored to portfolios you built in the past, and there were new tools to help you build more intentional and potentially better outcomes for your clients, would you go about it the same way you did 30 years ago? Likely not. The nature of capital markets is changing. In all other aspects of our lives we demand more customization and flexibility. We believe investors would be prudent and wise to demand the same of their portfolios.
