How to Finally Ditch the 60-40 Portfolio, According to GIC and MSCI
The 60-40 portfolio has long been declared dead, but wealth owners are still working to find a worthy replacement.
Together with MSCI, Singapore’s sovereign wealth fund GIC has proposed a possible solution. GIC investors have partnered with an MSCI researcher to create a new asset allocation framework that aims to incorporate macroeconomic considerations into portfolio construction.
They believe their risk measurement framework could replace the once ubiquitous investment model, which featured a 60 percent allocation to equities and a 40 percent allocation to bonds.
“We are witnessing the rise of private assets to the core of many asset allocations from a peripheral ‘alternative’ and we have entered a new phase of heightened macroeconomic uncertainty,” read a paper released by the two organizations in October. “Both could require a fundamental evolution of the asset allocation process.”
The result is a macro framework that relates an investment’s cash flows and discount rates to a range of scenarios, including demand, supply, productivity, policy, and real interest rate shocks.
According to the paper, demand shocks have been the dominant driver of the macroeconomic environment over the past two decades. In this environment, growth, inflation and real interest rates have all been pushed down by falling economic demand. This allowed stocks and bonds to act as a hedge against each other, the newspaper said.
However, the environment has changed. Bonds and stocks have fallen together over the past few months.
“Bonds have typically fallen along with stocks in response to supply shocks when the threat of inflation has eclipsed the central bank’s aim of battling the recession,” the paper said. “Furthermore, private assets’ low volatility and correlations are largely artifacts of their smooth valuations, rather than reflecting a lack of systematic risk.”
According to the GIC and MSCI, supply-side inflation, a less credible central bank, rising real interest rates and slowing productivity growth could “significantly” change the course of markets in the coming years.
So what should an investor do?
First, moving beyond using backward-looking statistics as a measure of risk could help investors better understand what they are experiencing in the markets. Instead, the paper proposes considering the outcomes of the five macroeconomic environments and then modeling asset class sensitivities to discount rates and cash flows. As part of the modeling process, GIC and MSCI propose using a “macro-stable efficient frontier” model that balances long-term macro risk against expected return to determine an appropriate portfolio.
In addition to using different risk metrics, the two companies suggest that private and public asset classes should be treated equally within these models.
“Their slick valuations could result in many private assets exhibiting lower volatility and lower correlations with other assets,” the authors write. “Nevertheless, many personal wealth have very uncertain future values and may be exposed to the same systematic risk factors that accumulate in the rest of the portfolio.”
With proper measures of risk, the GIC and MSCI show that asset allocations aligned to the efficient frontier using macro factors typically replace Treasuries with TIPs and bond-like infrastructure assets. They also make a large allocation to equity, including personal wealth, equity-like infrastructure, and real estate.