We believe discretionary investment managers and their clients can be better prepared to weather the expected lower-return environment by adding investment exposures outside the traditional investment toolkit - such as private equity, private credit and other diversifying alternative strategies. 
However, before including these strategies in a portfolio, it is important to ensure client suitability, perform appropriate due diligence and clearly identify the risks these investments may introduce.
Challenges on the horizon for the traditional 60/40 portfolio
Over the past 10 years to 30 June 2021, a traditional 60/40 balanced portfolio (comprising 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Bond Index) has returned just over 10% per annum which has likely met or exceeded clients’ return expectations.
However, based on current capital market assumptions, with inflation proving stubborn and economic growth appearing fragile, forward expectations suggest returns may be lower over the next 10 years. If interest rates continue to rise then without economic growth the outlook for both bonds and equities looks challenging.
Potential solutions for traditional 60/40 portfolios
Discretionary investment managers should educate clients and clearly identify the risks the investments discussed below may introduce to a portfolio. Similarly, discretionary investment managers should ensure they understand the complexity of performing due diligence on these strategies from both an investment and operational perspective.
Discretionary investment managers may need to seek opportunities outside the traditional 60/40 balanced framework to help meet return requirements. This process includes understanding the potential risks and opportunities and determining where to allocate investments:
• Check client portfolio liquidity criteria to identify whether alternative strategies are feasible
• Explore alternative strategies that have historically only been accessible by institutional investors, and understand their potential to provide higher risk-adjusted portfolio returns over a market cycle as well as any new risks they introduce
• Ensure that each investment is subject to an appropriate level of investment and operational due diligence
• Revisit the role of fixed income allocations
Taking on more risk, including illiquidity and complexity, may be necessary to help achieve acceptable return rates. Although clients are wary of illiquidity, especially during market declines, many will be long-term investors and so could have the ability to take on more illiquidity to possibly enhance longer-term performance.
As such, an allocation to private equity and other private markets asset classes may be something these clients wish to consider. Although private market funds generally have a longer investment horizon than public market equivalent funds, such investments, in our view, are expected to provide higher returns by allowing skilled managers to build or reorganize companies and capitalize on opportunities not accessible through public equity markets.
A discretionary investment manager’s ability to access high-quality private equity managers should be taken into consideration when allocating to private equity. Having the ability to collaborate with a third party with potential access to high-quality managers can be instrumental in building out an appropriate private equity allocation diversified by managers and vintages.
A diversifying allocation to hedge funds might also be an alternative to public equities, for clients that are averse to private equity investments with longer lockup periods. Historically, hedge funds have had lower sensitivity to traditional asset classes, which might dampen overall portfolio volatility through diversification and downside protection.
Although we believe defensive fixed income (sovereign and high grade corporates) still has a role in providing liquidity and some degree of defence in portfolios, the allocation size may need adjustment. Discretionary investment managers that don’t have the ability to access less-liquid alternative investments, such as private credit, may want to consider growth fixed income.
Consider allocating a portion of the fixed income investment to multi-asset credit (opportunistic fixed income allocations between high-yield segments, including bank loans, high-yield bonds, securitized debt and emerging market debt). Doing so can help increase return expectations for traditional balanced portfolios because of their higher overall carry and lower duration relative to their investment-grade peers. It should be noted that this doesn’t come without increased credit risk and a reduction in overall diversification benefits within the fixed income portfolio due to the higher correlation with equities.
What about high inflation?
Diversifying portfolios with inflation-sensitive real assets, such as real estate, infrastructure and commodities, can help mitigate the downside effects of a global inflationary scenario. The values and cash flows of these assets are often contractually linked to cyclical inflation, which helps to offset the potential negative impact to equities and fixed income. Additionally, an allocation to gold to combat inflation and provide diversification benefits relative to traditional asset classes could be considered.
In conclusion
We believe now is the time to review the strategic asset allocation policy of traditional 60/40 balanced portfolios given the current market environment and lower return expectations.
Although we are mindful that clients’ tolerance for complexity and need for liquidity varies, discretionary investment managers may consider diversifying their portfolios away from public equities and fixed income to include alternative asset classes, such as private equity, hedge funds, multi-asset credit, private credit and inflation-sensitive assets.
Return, volatility, liquidity and diversification benefits should be considered carefully when assessing new asset classes and the role they will play in the overall portfolio.
Steven Keshishoghli is a senior researcher at Mercer covering wealth management within UK & Europe. The views expressed above should not be taken as investment advice.