Trevor Williams
The 60/40 portfolio has been an investment staple for decades. David Picton, president and CEO of Picton Mahoney Asset Management, explains why investors should consider going beyond the traditional asset mix in today’s trading environment.
Transcript
Greg Bonnell – As central banks aggressively raise interest rates to tame inflation, some investors have begun to question whether the 60/40 portfolio is still a viable strategy. Our guest today says investors may need to consider going beyond traditional asset mixes in today’s environment. Joining me today is David Picton, president and CEO of Picton Mahoney Asset Management. David, thanks for joining us for your first time on the show.
David Picton – It’s an honor to be here.
Greg Bonnell – Since this is your first time here, please introduce yourself to our audience. Tell us a little bit about yourself. What is your company and your philosophy?
David Picton – The firm is approaching its 20th anniversary. It currently has approximately $11 billion in capital under management and is primarily focused on alternative investments. The firm strives to provide differentiated return streams to its end investors.
Greg Bonnell – So let’s look at alternative investments. As I said at the beginning, obviously people have been looking at the 60/40 portfolio for a long time, whether to make it a 70/30 or whatever, but looking at that as kind of a framework. Coming out of the pandemic and rising interest rates has definitely put that to the test. What do we need to be thinking about?
David Picton – We look at these different asset classes simply as return streams. Stocks go up about 7% to 8% over time. Bonds go up about 5% to 6%. And the returns on each of them sometimes behave differently. So, combining these two assets, especially over the last 40 years, has given us a great experience of investing in the market.
Interest rates were falling, and every time the stock market had problems, the bond market was rising. And this whole strategy had pretty good returns overall until we got into a new inflationary regime. And as we saw in 2022, it was the first time in years that both of these asset classes not only underperformed, but they underperformed substantially at the same time. And that’s the first time a lot of investors opened their statements and were shocked because neither asset offset the other.
Well, what we’re trying to do is bring to the alternatives space the idea that assets offset each other, so if stocks and bonds are somewhat correlated, if you have another asset class that’s completely unrelated to what’s going on in the stock market or the bond market, if you add that in and you have a positive return stream over the long term, we think that gives you a diversification benefit and a much better risk-adjusted return for the end investor.
Greg Bonnell – So does that mean that so-called “market neutral” is going to be an important category?
David Picton – Market neutral or alpha generating strategies are a very important part of this strategy. For example, when you buy the stock market, you are essentially buying beta. When the stock market goes up, the mutual funds will generally go up by about the same amount, plus or minus a little. When the bond market goes up, the bond market mutual funds will also go up plus or minus depending on what the bond market does.
So what we’re looking to do is build something that doesn’t focus on either of those two betas, but focuses on company-specific factors that will generate returns regardless of what’s going on in the equity market or the bond market. And Market Neutral fits right into that category.
Greg Bonnell – Let’s take a closer look. What does that mean? How do you build such a portfolio?
David Picton – You want to isolate the performance of a company. To do that, you have to find a company that you like. We look at positive change, strong value, fundamentally positive change and quality. Then you try to offset the market exposure of that company by adding short stocks to your list.
So we like positive change, value, high quality companies. We really hate negative change, low value, low quality companies. So if we collect the negative change companies and short them, meaning we sell them instead of holding them, we hedge all of the market risk of what we like. And then we’re basically just left with equity-specific alpha in our portfolio.
Greg Bonnell – Now, is that kind of a strategy that starts to work in tandem with the traditional 60/40 mix of stocks and bonds? Is that old strategy going to be eliminated entirely, or are you combining a few things?
David Picton – Yes, we would never leave them out, because in the very long run, you want to have stocks in your portfolio, you want to have betas in your portfolio, you want to have interest rate sensitive yields in your portfolio, and in the very long run, every study shows that they are important components of a portfolio.
But having only two options in your portfolio is like playing golf with only a driver and a 2-iron. But what about wedges and putters? How do you bring all of those things into the mix? So you need to add new tools. The key to all of this is that you need to have a positive return stream. And it needs to behave differently than a portfolio of stocks and bonds. That way you start to get a smoother ride and better risk-adjusted returns along the way.
Greg Bonnell – Okay, so let’s also talk about risk management, as part of your overall strategy, especially in an inflationary regime, it seems like you need to think about those risks because both asset classes have been hit so hard in 2022.
David Picton – For an alternative investment manager, risk management is a big focus. We spend as much time on risk management as we do on the stock selection part of the portfolio. And we do that in different ways. Our portfolio is intended to be market correlated, semi-market correlated, or not market correlated at all in the case of market neutral. So we have to always have a risk management process in place and make sure that if we say not market correlated, it is not market correlated. And we have done that very well over the long term.
Secondly, to increase exposure to certain markets – for example, when things are a little volatile like today and valuations and options are low, maybe add more option protection – and finally, when the market is neutral, generally don’t make large sector bets.
Sure, you might like copper or gold, but you’re not going to build a copper and gold portfolio and then hedge it all with a tech and bank portfolio. You want to make sure that the amount of risk that you’re taking within the sector is somewhat limited as well.
Greg Bonnell – What do you think about the current market environment? It’s an interesting time. Bond yields rose until the fall and then fell. We started this year thinking it would be the year of Fed rate cuts. And we’re finally starting to emerge from the disruptions caused by the pandemic, but we’re not there yet.
David Picton – Now, I’m happy to say that Jamie Dimon of JP Morgan has stolen one of our catchphrases, which is that we are cautiously pessimistic. In other words, we’ve seen a good run in risk assets, especially in the equity market. Technology, of course, is driving this. But we’ve seen a lot of good moves across all sectors over the last six to eight months.
At the same time, interest rates are rising and at the same time expectations of rate cuts are rising. So the market is pricing in a lot of good news. It’s pricing in a lot of growth. It’s pricing in rate cuts that are coming. It’s pricing in inflation that is easing. And it’s paying for it at a much higher multiple than we’ve seen historically. So we know some of the things that could go right, but there are also some things that could go wrong, and that’s why we’re cautiously pessimistic on this issue today.
