A strong alternative to the traditional 60/40 portfolio

Warren Aarons believes it is time to rethink the 60/40 portfolio allocation and sees MIC funds as a strong alternative to the traditional strategy.

Aarons, the Vice-President of Investor Relations at CMI Mortgage Investments (CMI), acknowledged that for the past few decades, the traditional 60/40 split of equities to fixed income has been a foundational approach in investment selection, and provided a sensible balance between risks and returns.

“The 60/40 split has been deemed, typically, a rule of thumb retirement allocation for its expected low volatility and steady income,” he explained. “It offers more exposure to higher yielding stocks, while having a potential buffer with fixed income investments against stock market volatility, and the ups and downs that can occur with equity investments.”

However, in the historically low interest-rate environment seen today, bond yields are low, and the 60/40 portfolio is generating lower returns than it has in the past decade. While fixed income’s primary role is as a diversifier, bonds should still provide some return if they are going to comprise a sizable allocation in a portfolio, explained Aarons.

“This can impact the 60/40 allocation by not providing the income enjoyed in years past. If this is the case, investors will have to take steps to redesign their portfolio to meet their retirement income goals,” he said.

As the world works through the pandemic, and investors have an expectation that nominal yields will remain low going forward, investors might look to their equity allocations to generate higher returns.

“Alternately, investors could also increase equity exposure beyond 60%, but that means taking on more risk. Low interest rates have also contributed to higher equity valuations as investors see no choice but to invest in stocks, thereby increasing the risk to buying stocks at their current peak market prices,” he said.

Aarons believes investors need to seek additional sources of income from other asset classes to supplement the reduced bond income, while not increasing risk by taking on more exposure to the stock market.

Alternative investments like MIC funds, which invest in a diversified pool of mortgages, can address the need for change, said Aarons.

“Investing into the private mortgage space can provide a compelling opportunity for investors looking to add return potential to their portfolio without assuming additional stock market risk. In Canada, one of the ways to gain passive exposure to the private mortgage market is through a registered Mortgage Investment Corporation or MIC,” Aarons said.

While MICs account for a small fraction of the overall mortgage market in Canada, Aarons said they play a critical role in meeting the short-term funding needs of a diverse range of borrowers. As stricter borrowing requirements and rising home values have contributed to the growth of private mortgages, more borrowers have turned to alternative lending solutions not offered by the major banks.

“MICs have demonstrated a low correlation to the broad equity market, and because the MIC is composed of a pool of mortgages with fixed rates and set times to maturity, the valuation of a MIC is calculated at various times throughout the year and should show little price fluctuation between time periods.”

“A small MIC exposure can enhance the yield of a portfolio while reducing the risk similar to that of  traditional asset classes like stocks and bonds,” he said.

By allocating a portion of their portfolios to MICs, Aarons said investors can reap the benefits of a traditional 60/40 strategy, namely diversification and reduced volatility, but with potentially higher returns than traditional fixed income securities like government bonds.

He explained this is because MICs routinely outperform bonds and other fixed-income securities both in terms of nominal yield and real yield.

“A wealth of data shows integrating private funds into a portfolio reduces overall correlation to the market, and that gives the portfolio a smoother ride, which is what investors want,” he said. “MICs fit that description because, unlike traditional assets, they are not affected by public markets.”

CMI’s flagship MIC, the CMI Balanced Mortgage Fund , which has nearly $45 million in assets under management, generates an average annual yield between 8% and 9%, and currently sits at 8.42% as of the end of March.

Aarons compared that to the five-year Canada bond yield, which sits at 0.93%, and the current three-year non-redeemable GIC yield of 0.5%.

“CMI also offers the Prime Mortgage Fund  – a more conservative fund that minimizes volatility by investing primarily in first mortgages and aims to deliver targeted annual returns of 6 to 6.5%,” he said.

He added CMI also offers investors access to its High-Yield Opportunity Fund , which aims to deliver a targeted annual return of 10 to 11% by investing primarily in second mortgages and has a current yield of 10.41%.

To find out more about CMI and the opportunities available there, visit cmimic.ca