What Comes After 60/40? The Great Portfolio Reset

Kristian Kerr (00:00):

Welcome to the LPL Market Signals podcast. I'm your host, Kristian Kerr, and this week I'm pleased to welcome Paul Ticu to the show. Paul is the head of asset allocation and client solutions at Calamos Investments. And in this role, Paul oversees the firm's portfolio implementation strategy and leads the design of its model portfolios. Before joining Calamos, Paul served as a senior portfolio strategist at BlackRock and was also previously head of asset allocation for the Saudi Aramco pension. With a deep experience spending institutional investing, portfolio construction, and asset allocation, Paul brings a very unique perspective to today's conversation. Paul, how are you? Welcome to Market Signals.

Paul Ticu (00:36):

Hi, Kristian. I'm fine. Thank you for having me.

Kristian Kerr (00:40):

Thanks for being here. I'm really looking forward to the conversation. You know, there's so many different areas we could go into today. But to kick things off, you know, you've sat in some unique diverse seats across the industry, you know, from a quasi-sovereign wealth environment at Aramco and now leading asset allocation at Calamos. How does the investment philosophy differ when you're managing massive capital versus building scalable wealth solutions for advisors and platforms?

Paul Ticu (01:08):

It doesn't really differ. I think some of the processes might differ, but what you might have noticed is that actually institutional and wealth are coming together. I think the best practices from the institutional world are being imported on the wealth side. And ultimately, it is the same game. Investors want to be paid for the risk that they're taking. They have objectives. They want to reach them. They want to reach them with as little pain as possible. So I think the world is converging.

Kristian Kerr (01:35):

Yeah, completely agree. Well, I guess as a follow-up then, you know, I think you and I are roughly the same age, so you've managed through, you know, the Global Financial Crisis, the European sovereign debt crisis, COVID, inflation shocks, multiple geopolitical events. What would you say is the most important lesson those experiences have taught you as an allocator?

Paul Ticu (01:59):

Being open-minded and flexible and I think very few things can replace experience and common sense. I think the rhetoric out there is that there's always a question whether this time it's different. And as a practitioner, you know that it's always different. There's not really a normal to return to. The normal that we are usually defining has been a period that has been just long enough that it looks normal to us, but the world is always changing. The only constant here is investor behavior, if you will, greed and fear. But other than that, the world is always changing and you have to adapt to it.

Kristian Kerr (02:37):

Yeah. I mean, you argue there's no such thing as normal. So why do investors keep anchoring to the idea that markets revert eventually to this mythical normal level?

Paul Ticu (02:46):

Because the long-term can be quite deceiving. If we look at the long-term, and I think this goes straight to the stocks versus bond question, the long-term average is genuinely low. But then if you look at the specific intervals, what you will find is that actually there were... It's quite regime dependent. Sometimes for years in a row, fixed income works and sometimes it doesn't. So, but if you look at overall though, the average washes all of these things out so it can be deceiving. And as investors, we don't have forever in markets. I mean, the long-term, it is, we should be long-term investors. We should be strategic, but we are not in markets forever. So achieving the goal is important and knowing that things might change on you is important too. And I think that what this means is not flip-flopping with your portfolio around and trading around that.

Paul Ticu (03:42):

What that means is building that intentionally into a robust portfolio construction.

Kristian Kerr (03:47):

Yeah, and I can't agree more. I also think, you know, the, so much of asset allocation ideas or theories kind of a lot of it's dependent on there always being time, you know, when you're talking about kind of this normal aspect that you're kind of citing. You know, if there is a 30, 40% drawdown or there is a multi-year period where, you know, you don't realize the averages, that's a very different conversation, right? That I think kind of some of the typical asset allocation models kind of probably overlook that, you know, if you're retiring and it's October 2007, right, you know, that's a very different conversation and things to think about from a market standpoint versus if you're 25 years old and have 40 years to go, right?

Paul Ticu (04:34):

Yes. And basically that means that there's an element of luck in here and it should be. And what we can do as rational investors is engage some scenario planning because rather than saying that stay in there and on average in the long term you'll be fine. What I'm arguing as a practitioner is look at the medium term, make sure that you're okay on that path. And if that works out in consecutive fashion, you'll be fine in the long term.

Kristian Kerr (05:02):

Yeah.

Paul Ticu (05:03):

There's literally no decision in life where timing or where you wouldn't manage these risks. So why would you ignore it here just in the hope that statistically speaking, you'll be fine when you get out of the market?

Kristian Kerr (05:16):

Yeah. Okay. Let's pivot a little bit here. You know, as an allocator, you're constantly bombarded with data points, headlines, and market noise. So when you cut through it all, what's the most important thing you think investors are getting wrong about today's environment?

Paul Ticu (05:33):

Today's environment is actually quite complex. I think it is somewhat unprecedented. The underlying economy is fantastic. We are coming from three really great years in markets. It does feel a little bit, you can argue, maybe stretched on the tech side. Maybe it's true, maybe it's not. The economy is fine too. But what we do know is that markets sometimes get ahead of themselves, but you can't actually take risk off the table. So what do you do? And I think it's really hard to actually stay focused on the discipline of solid portfolio construction because we can't just chase or try and time things here. What we can do is make sure that if things don't go the way we want to, we're not actually losing as much. And what we're hoping is usually when you're doing these things in a portfolio construction, you're having some sort of statistical hope that a correlation might pop up and be there for you, might not be there.

Paul Ticu (06:31):

But what I think is critically important in here is the economy's doing great. We don't know exactly if things are overdone on the tax side. It might be, it might not be. Maybe future growth justifies it. But it does make sense to be cautious. We had three great years. Most portfolios are in great shape. Protect the downside.

Kristian Kerr (06:52):

Yeah. So a litle bit more of a scenario-based framework than trying to predict where the market's going to go, right?

Paul Ticu (07:01):

That exactly right. I would just say that the military's using scenario planning. The military is not using invariance optimization. There's a good reason for that. As humans, we are built to deal with scenarios. That's how we imagine the future. We imagine things that are actually viable. We imagine bad things and we try to hedge them away and not experience them at all. And then we try to construct for that remaining set of scenarios. And I think that's a much better way rather than predicting how many Fed cuts we'll have here. Or where the S&P ends up at the end of the year. What you need to know as an investor is where should I be allocated and where should I stay away from? And if I decide to be allocated in an asset class, how much should I have in there?

Kristian Kerr (07:48):

Yeah, which brings me to my next question. You know, how concerned are you about the concentration in the market? You know, the dominance of the Mag Seven, you know, semis are now what, 20% of the index? You know, how much does that play into your thinking here?

Paul Ticu (08:04):

It's actually central and I think you're touching on the most frequent topic of mine with clients with telling them literally that diversification is the hardest thing to get. And it is. If you look around the, if you look at the typical portfolio construct here, what you have is many clients actually don't look at small caps anymore after years of underperformance. The S&P has become extremely concentrated. Most U.S.-based portfolios do have a meaningful home bias and therefore a U.S. overweight. And then you have a situation where starting with 2022, stocks and bonds, again, are starting to move in the same direction and bonds might not be there for you. So this type of the question then is how do I diversify? I can step away from equities, which are the main return drivers in my portfolio, but can I use the other asset classes to build a moat around equities and protect that performance?

Kristian Kerr (09:05):

Yeah, which leads me to okay. I think it's one of your more, how should I say, provocative views, is that the 60/40 portfolio is largely an industry construct. So one, you know, what do you mean by that? And two, if 60/40 is no longer the answer, what is in your opinion?

Paul Ticu (09:25):

So the 60/40, if you go back to modern portfolio theory and Markovitz, he never argued for the 60/40 portfolio. In fact, he used personally for his own account, a 50/50 portfolio and he never used his own theory for it. The 60/40 portfolio was invented by the industry I think in the '90s at some point. And then through repetition, it became the standard for any type of moderate allocation. It works in a world where fixed income is there to protect you, but what's happening is correlation is highly unstable. There's data out there easy to prove that actually the stock bond correlation is regime dependent. And what you're doing is you're spending a lot of your fixed income risk budget on duration, but it might not be there to help you when you need it.

Paul Ticu (10:17):

So my point is hope is not a strategy in this case. So why don't you use instruments that have a disciplined low beta to both stocks and bonds? And there are those instruments and strategies out there and they can genuinely help improve the up-down caps ratio of the portfolio. By up down, I mean how much you're participating on the benchmark upside and how much you're participating on the benchmark downside. And the message here is simple. Money that isn't lost is money made. If I can have something that's genuinely diversifying, it will always help the up-down caps ratio, which means that I am making alpha at the portfolio level in the long term.

Kristian Kerr (10:59):

Yeah. I mean, I think it's some great points. I mean, completely agree with you, you know, the Markowitz paper came out in what, the '50s, and then it was really after the '87 crash where it started to get kind of used. And then we kind of had a lot of regulation changes. Target date funds became more popular, 401(k)s, all that. So it's really kind of been, as you say, kind of this indices content that's been driven. And when you look back historically, it's not uncommon to go through very long periods where stocks and bonds are very correlated to each other. Like these can last decades. And I think kind of the questions that people are starting to pose, and we've been doing it here at LPL, you do it at Calamos. I think they're ones that we have to have.

Kristian Kerr (11:41):

I guess I'll ask you a question just for our advisors, you know. I mean, listen, I think there are a lot of these regimes and they can last a long time, but what would you say really changed, you know, post - 2021 that caused bonds to kind of lose their effectiveness as a natural hedge in portfolios?

Paul Ticu (11:58):

Personal interpretation. I think what happened was you had QE1 in 2009, basically a massive liquidity injection in markets. If you remember, both stocks and bonds went up. In 2020, we had COVID hitting. I think the government came in and you had literally trillions of liquidity coming in. But then in 2022, the entire market stuttered. And what you saw was liquidity coming out and both stocks and bonds dropping again. I am not entirely sure what drives this. I think that there are people who tie the stock bond correlation to inflation, to all kinds of other factors. I think what's happening is that the world has changed so much that we... it's more honest to say we don't know, but rather than trying to guesstimate the correlation if it might be there, why not use something that from an engineering perspective gives me that diversification outright?

Paul Ticu (12:56):

And therefore, I don't have to write a thesis in philosophy. I can use an engineering approach to the portfolio and make sure that my downside is limited.

Kristian Kerr (13:04):

Yeah. So taking the idea that who cares, right? You know, why it's happening. So you have to adjust portfolios. I can buy into that, but I also think, you know, I mean, listen, we were in a secular decline in yields for four decades and that clearly changed, right? So I think that right there just starts to change the game a lot, right? When you've kind of been in a regime that's been very favorable to bonds and you go to one that's not, I think regardless of what's causing that you've got to kind of change your tune, right?

Paul Ticu (13:39):

That's exactly right. You have to adapt to it. And we were you were right. I mean, I remember actually back in 2010, 2012, we were looking at Treasuries and the rate was just going down. And every once in a while, you had a PM making a bet to go the other way and then they would go out of business. But you can't actually make that call and actually making the call on inflation or what's happening next. I think it's a fool's errand and I would rather not do it.

Kristian Kerr (14:08):

Yeah. Okay. So we can't rely on bonds as much as we used to. I think you were kind of getting there. You're going to touch upon it, but what assets or strategies do you consider to be true diversifiers today?

Paul Ticu (14:22):

So, in terms of I do like liquid alternatives, but I would say these are not the hedge funds of 20 years ago. There are strategies out there that have a disciplined low beta to both stocks and bonds by construction. And those are, I think, critically necessary. You can use convexity. So, that basically two options. You can either go with linear instruments and in case you're using a combination of linear instruments, it depends on how the strategy is actually managed. Or you can use non-linear payoffs, i.e. options, and then you're going for convexity. But generally, what you would like is to see build some sort of complexity into the portfolio in some way, shape or form.

Kristian Kerr (15:09):

Yeah. And ultimately that reduces correlation, right? Which we're trying to at the big level trying to do. Do you, I mean, I think from a contrarian perspective, what is interesting is that, you know, hedge funds have gotten very much out of favor, right? So you can almost make the case that because no one wants to look at them anymore, it probably makes sense to start looking at them. But do you think it makes sense for, you know, the average advisor to outsource that convexity in the portfolio to managers to try to do it themselves?

Paul Ticu (15:40):

So let me just talk about hedge funds for a minute. I think hedge funds went out of favor because the Fed stepped into the market and destroyed many signals. Yeah, yeah. And at this point back in time, I think hedge funds should be looked at again, not because they're giving you, I don't know, spectacular returns, but if you can get something that pays you so far plus 3%, so it's equivalent to fixed income, but it gives you a very uncorrelated or diversifying return stream, that is genuinely valuable for the portfolio. So, from that perspective, I think hedge funds makes sense. Sorry, I'm blanking on the second question that you asked. Can you please repeat that?

Kristian Kerr (16:21):

Oh, and I was going to ask you, you know, advisors can use hedge funds or, you know, can they do it themselves, is what I was getting at.

Paul Ticu (16:31):

I think there's a broader question here, not just about advisors. I think the environment has changed so much that I don't think advisors should be in the business of managing portfolios anymore. I don't think... I think investments are hard again. You can either decide to load up on the S&P and chase momentum and pay the price or you can say, "Okay, this might not be as trivial as... I don't know, I'm just chasing the S&P." But in that case, it's better to delegate that to professionals who do that because basically we are what we do the most. You should rather stay in front of clients, or you can decide to spend 12 hours a day in front of a screen and analyzing markets. And understanding generally the hedge funds and the components and what's happening out there is a full-time job. Yeah, yeah.

Paul Ticu (17:17):

Putting them together is a full-time job. And it's not trivial anymore.

Kristian Kerr (17:21):

Yeah, and it's very hard to do everything really, really well, right? To your point. I guess as a follow-on to this though, you know, investors always say they want downside protection, but you tend to see a lot of band in it when markets are really around and getting these types of regimes where it's, you know, 20 plus S&P returns for years straight. You know, how do you keep, or help clients stay committed to risk management strategies through those types of market environments?

Paul Ticu (17:51):

It's very simple. I remind them that this can't go on forever. I mean, even this year we are off at a... We have, we're having a good year, but look at the previous three years. We had three rockstar years. Another good year. How many years will that go on until something happens? And markets tend to overdo it, and it's mainly because of human psychology. And I think it does make sense when it's really good to plan for the bad days.

Kristian Kerr (18:21):

So - Yeah. So the old kind of the old hurricane insurance analogy, right? When there hasn't been one for a long time, that's probably the time that you want to start loading up on it, right? That kind of the way I think about it in simplistic form.

Paul Ticu (18:36):

Yeah, that's exactly right. But I don't think you should leave return on the trading table. Yeah. I think what I like to do in this environment, imagine that you're still fully invested with your 60% in a 60/40 portfolio in equities. Stay fully invested. Use the other 40% to make sure that if bad stuff happens, you're not losing as much. You're protecting as much as you can. It doesn't mean no fixed income. It just means reduce fixed income and considering other asset classes and other strategies.

Kristian Kerr (19:04):

Yeah. Yeah. I mean, very important, right? Like, I don't think... Like what we're saying, at least what I'm saying is that fixed income, you know, still has a role, but you got to focus more on the coupon clipping aspect of it. And you're funding some of your downside protection strategies from bonds, because that's where the natural hedge aspect of them has kind of gone away a little bit. So it's making the portfolio ultimately more robust. So that's, I mean, I think that's a very key thing here that investors need to be kind of thinking about. And also, you know, think of it in this way, kind of I think as well to your point. You know, if you're having just stellar years, year after year in equities, and you've got a big chunk of your allocation there, you know, having a little bit in downside protection is probably the right thing to do.

Kristian Kerr (19:49):

So you might not, you might underperform in up years, but it's in those down years where that's going to come back and help you outperform as well. So kind of - Yeah, that's exactly... from a corporate return perspective, right?

Paul Ticu (19:59):

That's exactly right, because as a long-term investor, you should care not just about the outcome at some hypothetical 50-year horizon, you should be caring also about the quality of your ride. Yeah. And you want to smooth that out, but to go back to the fixed, to your argument on fixed income. If you think about fixed income, I think about two functions. I would split fixed income into ballast and income. Income, good to have ballast, might not be there. So use that ballast idea and get that from other places, build your income separately. And to your point, we can keep some of the fixed income and then the rest of it can be exactly bucketed into ballast and income.

Kristian Kerr (20:38):

Yeah. Okay, great. Great discussion. Let's pivot a little bit here, just because I wouldn't be doing my job if I didn't ask you, but, you know, you had a very interesting seat as an investor in the Middle East for, you know, the largest oil company in the world. , What is your high level take on the current geopolitical energy situation? And where do you think things go from here?

Paul Ticu (21:00):

I mean, the way, and again, I've been there for three years. I think crude is not in limited supply. There's plenty of crude. I think there's a question of getting crude from A to B. That's the main issue right now. And the way the picture is in the Middle East, it's complex. It's complex because you have a very interesting, religious dynamic between the different sects there. Iran's defense strategy seems to be unconventional. And I think that it's not just an energy discussion. There is a bigger topic around a supply shock, which might affect inflation, which might affect what Warsh will be doing. But overall, I hope it will be cleared up quickly. I'm not that optimistic. I think in a few months, we might be still be talking about this.

Kristian Kerr (21:51):

Okay. Not what I was hoping to hear, but, you know, I appreciate the candid thoughts. All right. So, before we let you go, Paul, let's do a quick plug. You'll be leading a breakout session at Focus on August 11th at 1:00pm. What's the session about and why should advisors make it a priority to attend?

Paul Ticu (22:12):

So we're talking about many of the points that we touched on today. It's called "An Asset Allocation in a Changing World". I'm talking about the fact that the world today is vastly different from the world, say, of 1945, 1971, or even 1995, that the entire structure of the world has changed. The Pax Americana is gone. The world's supply is rewiring. You have a multipolar world. You have a lot of innovation, a different opportunity set. The only constant here is human nature, but everything else has changed at a very rapid pace. And then the question is, can you actually stay static or should you adapt as well? I think we gave the answer away here, but I think if you decide to adapt, how should you be doing it?

Kristian Kerr (22:58):

Yeah. I think this will be a great discussion. I'm looking forward to it. I'll be joining you as well. So to our listeners, if you're attending Focus and have time on Tuesday, August 11th at 1:00pm, I encourage you to join us for this breakout session. I think it's going to be a terrific discussion. And we'd really love to see you there. All right. I think that's a good place to wrap things up. Paul, thank you so much for joining us and sharing your insights. It was a terrific conversation, and I know our listeners will have a lot to think about, and we look forward to having you back on Market Signals. And thanks to all of you for tuning in. Please be sure to join us next week for another episode of Market Signals.

Kristian Kerr (23:33):

Until then, take care and bye for now.