From All-Weather to All-Terrain Investing for the Stormy Decade Ahead
The endowment portfolio characterized by 60 percent in stocks and 40 percent in bonds has thrived over the past four decades, but sustained high inflation has the potential to lower returns and increase volatility in the years ahead. This has prompted an interest in All-Weather portfolios, which combine stocks and bonds with assets like commodities that may respond more favourably to inflation. This article explores how the addition of specific liquid alternative strategies produces an “All-Terrain” portfolio with the potential for improved long-term performance across a wider range of market environments.
Extended honeymoon for endowment portfolios
Over meaningful investment horizons measured in years and decades, markets are influenced by structural shifts in expectations about future trends in inflation and growth. The four decades from 1982 through 2021 were dominated by sustained disinflation and relatively stable growth.
Developed market inflation fell from high teens in 1981 to low single digits in the 2010s, driving above-average returns to bonds, with greater tailwinds for longer duration. Strong growth coupled with a supply-side political orientation generated increasingly higher returns to capital to the detriment of labour, allowing corporations to benefit simultaneously from an expansion in both revenues and margins. While profits surged, they were consistently discounted at ever-lower interest rates, driving a large expansion in multiples and producing windfall gains for equity investors.
Investors in stocks and bonds benefitted from Goldilocks conditions in both asset classes. Better still, because inflation was well contained, economic shocks were exclusively mediated by growth dynamics. For fundamental reasons, equities and bonds respond in opposite directions during economic slowdowns under benign inflation, so bonds offered a superb ballast for stocks during recessions over the past forty years.
The upshot is that the much celebrated “endowment portfolio” characterized by a 60 percent allocation to cap-weighted stocks and a 40 percent allocation to bond composites experienced a four-decade honeymoon. One could be forgiven for believing that this omnipresent portfolio, seemingly indestructible over many decades, can weather any sort of economic storm.