Traditional models of portfolio construction are looking increasingly outdated in today’s market environment, according to JP Morgan Asset Management’s John Bilton and Karen Ward, who say investors should be prepared to take on more risk for the returns they require.
The publication of the asset manager’s latest Long-Term Capital Market Assumptions (LTCMA) report suggested asset prices are unlikely to show the same kind of growth that they’ve seen over the past decade.
“Last year, we were in a world where bond yields began to rise – certainly in the US – and equity earnings were beginning to look as if they were capping out,” said Bilton (pictured), head of global multi-asset strategy at JP Morgan Asset Management. 
“Roll forward 12 months and we’ve got this new situation where the environment looks a lot more like a mid-cycle environment. Will we see an extension of the cycle?
“We’re 10 years into a US economic cycle, yet what’s interesting is that we’ve been barely able to get off of zero interest rates around the globe.
“Most crucial is that we’ve still got a significant relative gap between equities and bonds.”
One positive, he said, is that there is little inflation in the system, which has helped keep rates lower for longer. However, that “plays havoc” with the returns available from fixed income and is more supportive of equities.
This means that the traditional way of constructing portfolios needs a serious rethink.
Source: JP Morgan Asset Management
For example, the traditional 60/40 equity/bond split for a balanced portfolio is now starting to look out-of-date as it is likely to offer lower returns over the long term than most other assets.
“60/40 has been the way in which – for certainly most of the modern financial era and certainly most of my 25-year career – a conservative portfolio may look,” said Bilton. “It’s been very typical as the way in which risk is allocated.
“The trade-off you’re being asked to make with 60/40 is that you’ve gone from trading off a reduction in return for a bit of safety to the elimination of return in exchange for safety.
“Whether you sit in a 60 per cent equity portfolio or a 10 per cent equity portfolio, the same calculus will apply at some level.”
However, while Bilton said bonds should continue to play a role in portfolios – particularly given their negative correlation to equities – they are offering little in terms of yield.
“One of the things that we have to accept is that with yields low because of low inflation and where we sit in the cycle, it’s very difficult to make a long-term buy-and-hold case for a bond today,” he said.
“They still work extremely well because of negative correlation when it comes to hedging equity risk, but the reality is we need to think a lot more beyond bonds when it comes to thinking about portfolio design.”
He added: “The reality is that, while 40 per cent of that block might be giving you some portfolio safety, it’s giving you no income. That creates a significant challenge.
“The rethinking of the investing tools and building blocks of that portfolio is going to be one of the challenges that investors face over the next few years.”
Source: JP Morgan Asset Management
Nevertheless, while the outlook for traditional asset classes might be looking more challenging – bonds from an income perspective and equities from a growth perspective – there are some others that might be able to serve investors’ needs better. 
Karen Ward (pictured), chief market strategist EMEA at JPMAM, said that investors now need to look at alternatives, although there will always be a trade-off of risk for return, unlike the “free lunch” post-crisis era.
“We have to think beyond that 60-40 [mindset], we have to add in other alternative asset classes in order to make sure we’re delivering the best risk/return that we can,” she said.
“We just have to work a bit harder these days. We have to think, across the piece, how we generate yield, how we generate income and how – at the same time – we make sure we’ve got a resilient portfolio whilst we’re chasing that yield.”
Ward added: “If we’re looking for a higher return, we’re going to be accepting a higher risk, no matter where we’re looking.
“So, it’s about understanding what that risk is. Is it capital risk? Is it income risk? Is it liquidity risk?”
As such, areas such as private equity and emerging markets may start to offer more appealing returns in the current environment, while yield may come from other alternative areas such as infrastructure or real estate.
“Having seen 10 years of the US really doing everything right economically and in market return terms, we will expect over the next 10 to 15 years to see rather more returns coming in from global markets, whether it be emerging markets, Europe, etcetera,” added Bilton. “So, having that diversification I think is key in a low return world.”