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Following the publication of our previous article titled “The 60/40 Portfolio Reign Challenged: A Wake-Up Call for Investors” on January 30, 2023, we aim to expand upon the insights presented therein.
The challenges posed by traditional equity and bond portfolios have become increasingly apparent. Despite their historical appeal, these portfolios are not immune to prolonged periods of negative real returns, often lasting a decade or more. In addition, the threat of a significant fall in returns is looming, which could significantly hamper long-term compound growth. One of the glaring problems with traditional diversified portfolios is their vulnerability to stock market crashes. Despite efforts to spread risk across different assets, they often collapse when equities are hit, exposing investors to substantial losses. Even the inclusion of passive tail hedges, renowned for their effectiveness in offering a buffer during equity crashes, can have drawbacks. Although they offer convexity, they can bleed excessively over a full risk-taking cycle.
Enter the solution: a comprehensive approach that combines diversified active tail hedge and curated CTA (Commodity Trading Advisor) building blocks. By incorporating these elements into asset allocations, the aim is to minimize bleed during bull market conditions while maximizing the potential for capturing convex returns during market downturns. At the heart of this approach is the combination of short volatility assets such as stocks, bonds, and real estate with diversified tail hedge and curated CTA building blocks. This synergistic blend not only aims to protect wealth during turbulent times but also seeks to capitalize on historically “cheap” assets when markets hit lows. By embracing these underestimated and often overlooked elements in asset allocation, investors can potentially optimize their long-term wealth growth without exposing their capital to undue risks.
Alquant has tested and simulated three flavours of such asset allocation (Alquant Modern Safe Portfolio Conservative, Balanced, and Aggressive) since early 2020 to showcase their benefits compared to traditional asset allocation and thus accelerate its acceptance as a new asset allocation approach.
Historically, the relationship between equities and bonds has been characterized by a positive correlation. However, the last few decades have seen a notable change, with equities and bonds showing a negative correlation. But the recent tumultuous events of 2022 and 2023 are a stark reminder that traditional investment paradigms may no longer offer the protection they once did. Bonds, long regarded as a safe haven when equities fell, failed to cushion the losses of the stock market.
Figure 1: Equities & Bonds historical correlation and recent performance
The composition of the investment portfolios of most pension funds only exacerbates the problem. Despite market developments, a large proportion of these portfolios remain heavily concentrated in traditional asset classes. Almost 60% is allocated to equity-type investments, 30% to bond-type investments and only 7% to alternative investments. Alarmingly, even among alternative investments, over 60% is still concentrated in equity- and bond-type assets such as private equity and private debt.
The consequence of this unbalanced distribution is comparable to that of a football team without a goalkeeper: poorly protected and vulnerable to unexpected blows. The dominant approach to portfolio construction, which focuses on the performance of individual assets rather than their interaction within a wider portfolio, has exposed investors to excessive risk.
The solution lies in adopting a holistic approach to portfolio diversification that transcends traditional asset classes and embraces the symbiotic relationship between different assets. By focusing on how assets interact with each other, rather than their individual performance, investors can strengthen their portfolios against market volatility and improve risk-adjusted returns.
Figure 2: Combination of assets and resulting stability of the portfolio
By focusing on individual asset performance, investors have the strong tendency to take correlated risks, especially towards the end of economic cycles, driven by the pursuit of returns. This approach, however, is short-sighted as it focuses on immediate performance and overlooks the broader perspective. Many believe their portfolios to be diversified since they have spread their investment among various style of equities (value, size, quality, region, etc.) and bonds types (credit, convertible, high-yield, etc.), yet in terms of volatility, nearly all their assets are vulnerable to significant losses when volatility inevitably spikes.
Figure 3: Impact of volatility of asset managers’ portfolios
Let us now assess what would be a satisfying strategy to tackle this problem.
Many investors inadvertently find themselves taking correlated risks, particularly at the end of the economic cycle. This propensity to seek short-term returns and ignore the bigger picture often results in fragile portfolios that are vulnerable to market volatility.
Figure 4: Assets classification based on their correlation to equities
This is where the missing component of the portfolio comes in: active tail-hedging and long volatility strategies. Unlike traditional approaches that focus solely on the search for yield, tail-hedging strategies prioritize risk mitigation in a cost-effective manner. While it is true that these strategies can deliver mediocre performance in stable market conditions, their true value is revealed during stock market crashes. During these turbulent periods, when equities suffer significant falls, tail-hedging strategies provide a much-needed cushion, offering increased protection and diversification for investment portfolios.
What’s more, the benefits go beyond simply mitigating risk. In the aftermath of a crisis, when asset prices are depressed, investors who have opted for tail-hedging strategies find themselves in a favorable position to take advantage of the opportunities that arise. Indeed, by naturally rebalancing their portfolio back to the target weights they are taking profit from their active tail-hedges bucket that have performed well to reallocate to the equity or equity-like buckets that have performed poorly during a crisis. By doing so they actual seize the opportunity to buy risky assets at an attractive valuation which ultimately leads to long-term outperformance.
Figure 5: Modern safe investment strategy allocation
Since the publication of the paper that inspired this new asset allocation approach in January 2020, Alquant has been simulating the performance of such Modern Safe Portfolios in Swiss Francs on an ongoing basis. For the sake of simplicity, we will concentrate on the conservative version of the Modern Safe Portfolio for the remainder of this article.
The Modern Safe Portfolio Conservative in CHF invests exclusively in existing external investment products, none of which are affiliated with Alquant, and which are readily available for new investment.
The performance of the simulated portfolio is net of fees, whereas the benchmark takes no fees into account. The unique rule behind this asset allocation is to rebalance the portfolio every month according to the target weightings defined in figure 4 of this article.
It should be noted that no model or timing is used in the construction or management of this portfolio.
Figure 6: Modern Safe Portfolio Conservative CHF performance and statistics from 2020–01–31 to 2024–01–31.
The Modern Safe Portfolio has already showcased its added value multiple times since the publication of the initial paper. Without bleeding in recent bull market periods, its hedging assets allowed it to greatly reduce periods of bear market, like the Covid-19 crisis in March 2020 and the first half of 2022.
However, upon presenting this approach to numerous institutions, a recurring concern surfaced regarding the long-term implications of reducing exposure to traditional asset classes such as equities, real estates, and bonds — assets renowned for their ability to yield a risk premium over the long term in contrast to gold, commodities, or tail hedges (which are basically a sort of market insurance). The apprehension among these institutions was rooted in the fear that such adjustments might compromise performance over extended periods. In response to these valid concerns, we decided to extend the performance history to find out if these concerns were justified and also check the robustness and resilience of such an approach over prolonged periods.
Figure 7: Modern Safe Portfolio Conservative CHF performance and statistics from 2000–01–03 to 2024–01–31
The Modern Safe Portfolio has consistently demonstrated its value proposition since 2000. Even amidst one of the most substantial bull markets in bonds and equities, spanning from March 2009 to March 2020, the Modern Safe Portfolio has proven its resilience by keeping pace with its traditional benchmark.
Delving into the efficacy of this approach prompts a fundamental question: why does it work? The answer lies in the essence of the Modern Safe Portfolio — a meticulously crafted strategy that embodies genuine diversification and remains indifferent to timing, steadfastly embracing the profound uncertainty inherent in forecasting the future.
In echoing the wisdom of Socrates, who famously professed, “To know, is to know that you know nothing. That is the meaning of true knowledge,” we recognize the humility required in navigating the complexities of financial markets. It is imperative to acknowledge our limited foresight regarding future economic landscapes. Consequently, constructing a portfolio designed to thrive irrespective of the future prevailing economic conditions becomes paramount — a strategic imperative that resonates with the very core of prudent investment philosophy.
In conclusion, the Modern Safe Portfolio represents a paradigm shift in asset allocation, offering investors a compelling alternative to traditional approaches. Its ability to weather market volatility while delivering competitive returns underscores its potential to redefine asset allocation of pension schemes and regulations as well as what we understand under risk and diversification. As we navigate through an ever-changing financial landscape, embracing innovation to seek stability is imperative.
Explore our three cutting-edge Modern Safe Portfolio strategies through our user-friendly interactive platform:
Each strategy offers a version of the Modern Safe Portfolio approach adapted to a specific risk profile.
To get started, simply click on the respective links provided, complete a quick and free account setup, and then request access to the desired strategy page. Once granted access, you’ll have the opportunity to track the daily performance of these strategies at your convenience.
This content is advertising material. This content as well as all information displayed on any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.
Alquant, a Swiss Fintech and quantitative asset manager, is transforming asset management with innovative solutions. Leveraging deep financial and technological expertise, we offer a range of services including investment products, quantitative research, and software solutions, empowering financial institutions to create the financial products of the future.
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