Looking beyond 60/40 again, use momentum and value

With value at extreme and rates at low levels, it is again worth discussing alternatives to 60/40 stock bond portfolios. While I will not currently advocate the set and leave 60/40 mix, it has served as a very good core benchmark. If you are going to suggest an alternative, you better show that you can beat the passive 60/40 allocation. 

The two current 60/40 problems:

1. The rising correlation between stocks and bonds

2. The high equity and bond valuations 

3. The low rate growing inflation expectations

Looking for some simple alternatives, a three step process makes sense.

1. Make sure that the equity and bond allocations are diversified. Add other equity markets to the mix (international and EM). That diversification was a drag during the last few years of superior US performance, but it may serve investors well on a relative basis going forward given the higher valuations in the US.

2. Use momentum to change the exposure against the base. This can be done easily through a number of look-back alternatives and can be employed to cut and raise asset allocations.

3. Use value metrics to change weights to asset class exposures. High valuations do not mean an immediate decline, but the threat of revision to the mean is real. 

The benefit from using a combination of diversification, value, and momentum was well-researched a view years ago in "A Case Study for Using Value and Momentum at the Asset Class Level" by Victor Haghani and Richard Dewey in the Journal of Portfolio Management. The authors show that simple value and momentum signals applied to well-accepted benchmarks create improved Sharpe ratios. The benefit of using both value and momentum is through their negative correlation. The combination of both will add more value that using each signal separately. There are higher costs from turnover, but the benefits are still significant.

Using strategy enhancements is the most effective way of beating the potential negative effects of a static 60/40 portfolio in a world where asset classes may be overvalued.