Smart Money Ditches 'Safety Nets' for Smarter Bets

Introduction

Since the 1980s, wealthy individuals and family offices have shifted from the classic 60% stocks and 40% bonds split to now having over 45% of their portfolios in alternative investments. This change isn’t surprising given the series of major financial shocks we've experienced in the past 40 years, such as Black Monday, the Dot-Com Bubble, 9/11, the 2008 Financial Crisis, the Flash Crash, and COVID-19. These significant events, occurring roughly every six years, have transformed the investment landscape. Institutions' balance sheets, high leverage, and extreme volatility leading to sudden margin calls have linked markets more closely, compounded by the growth of the massive derivatives market. The key question is: what have we learned from these events, and are we positioned appropriately for future crises? To understand this, we examine the performance of traditional “safe” investments during crises, using 2008 as an example, and explore how portfolio construction has evolved. We also look at how the smartest investors have adjusted their strategies and what lessons we can take from their current asset allocations as we plan for the next 20 years.

The Challenges of Traditional and ‘Safe’ Assets

T-Bonds and Cash

At their core, Treasury bonds are a loan to the US government for a set period, during which the government pays the bondholder a regular fixed amount. After the specified period, the bondholder receives back their principal investment. Treasury bonds are widely considered a proxy for the ‘risk-free rate of return’ for most benchmarking ratios in the investment sector. As of January 8, 2025, these bonds offer an annual return of 4.69%. The term ‘risk-free’ comes from the idea that governments can print more money to meet their debt obligations. However, this term is somewhat misleading, as inflation has become a significant challenge for the Federal Reserve (FED) due to extensive quantitative easing. Since 2020, 28.52% of the entire US money supply has been printed, a 40.52% increase since COVID-19.

With inflation stubbornly exceeding 2.7% annually, the US holds the largest debt globally, with major holders including Japan ($1.1T), China, the United Kingdom, Belgium, and Luxembourg. For perspective, we outline below the US’s debt burden relative to the rest of the world… , and finally a sense of scale to bring these number to life…

… the holders of said US debt can be seen below…

… finally, for a sense of scale amongst the absurdity, the increase in size from each new digit added to our debt figure…

With rising interest rates, the appeal of T-Bonds diminishes, especially given that inflation at current levels can erode approximately 30% of their value over ten years. Most major economies holding significant US debt could see their returns decrease if inflation persists. This situation could lead to widespread financial contagion if defaults occur. Additionally, every six years, on average, we witness a black swan event, prompting increased money printing. This pattern, visualised in the graph below, highlights the growing velocity of money printing in response to these crises.

Equities & ETFs

Equities and ETFs present an interesting case. The US economy comprises about 42% of the global equities market and 24% of the global economy, with the NYSE and Nasdaq exchanges cumulatively having a market cap of $40T. With the rise of the Mag 7 stocks driving the majority of returns in the S&P 500, the most successful ETF in history, the market is highly concentrated in just a few stocks. This situation places US equities in a sensitive position today.

Investors face a dilemma: join the rally and risk being caught when liquidity dries up, or remain cautious and miss out on significant gains while inflation erodes returns. The concentration and sensitivity of US equities make it crucial for investors to balance their exposure carefully.

2008 Financial Crisis

The time series below shows the performance of six assets (Crude Oil, S&P 500, Gold, US 10-Year Treasury Bonds, the Dollar index, and Lehman Brother Stock for a sense of timing). during the 2008 Financial Crisis, serving as a proxy for black swan events. As seen, when these events occur, asset correlations increase substantially in a downward trend. This means that during crises, most assets drop simultaneously—a portfolio manager’s worst nightmare. In such situations, options are limited: liquidate positions and suffer losses from poor liquidity, or stay the course and endure market turbulence.

The only viable strategy is to position portfolios in advance of these circumstances. Traditional asset allocations are no longer sufficient. The question then becomes: where do we go from here? Let’s explore the evolution of portfolio construction and how smart money has adapted to these turbulent times.

The Evolution of Portfolio Construction

1980s-1990s

The 1980s and 1990s were marked by rapid economic acceleration in the US. Wall Street boomed, job opportunities were plentiful, and Leonardo Dicaprio became the craze of teenage girls globally, for his role in Titanic.

During this period, the S&P 500 increased by 1,279%, making the 60% equities and 40% bonds split the most popular portfolio construction among high-net-worth individuals (HNWIs) and family offices. This mix provided equity upside while stabilising return volatility through predictable bond cash flows in a declining interest rate environment. Despite some medium-term correlation, bonds and equities did not suffer the short-term correlation seen in 2008, although this was minimal. With rising stock bond correlations resulting in Morgan Stanley’s 17% drawdown when extrapolating the 60% / 40% split to 2025. Hindsight reveals that subsequent reallocations were necessary, given the current levels of inflation correlating to an increase in equity bond correlation.

2000s-2010s

The 2000s and 2010s saw continued declines in interest rates, the creation of cryptocurrency and Leonardo Dicaprio was the craze of teenage boys globally, for his role in The Wolf of Wallstreet.

With more frequent crashes during this period, portfolio allocations shifted closer to 50% equities, 30% bonds, and 20% alternatives, using the latter to anchor return volatility. The low cost of borrowing led to a surge in private equity performance and subsequent interest, particularly in leveraged buyouts, as smart money sought to diversify with high returns at the cost of liquidity.

2020s

Today, family offices on average allocate over 45% of their portfolios to alternatives, reflecting the established correlation between increased market turmoil and higher allocations to alternatives. Private equity accounts for 37% of these alternative allocations, followed by real estate at 31%, with the remainder in hedge funds, private credit, and venture capital. This shift indicates a strategic response to the changing investment landscape.

The Future: Higher Emphasis on Tail Risk and Liquidity

Liquidity is Key

The lessons from the past are clear: the rise in black swan events and reduced liquidity during crises necessitate a move towards liquid alternatives. In times of large portfolio drawdowns and heightened leverage, liquid, uncorrelated, and return-generating assets act as insurance against illiquidity.

Shift Away from Inflation-Exposed Assets

Due to the acceleration of quantitative easing, inflation has become the primary challenge for dollar-denominated assets, especially income-generating ones. With the FED considering raising its inflation target from 2% to 3%, it’s evident that inflation expectations are shifting. This has led to increased allocations to non-correlated alternatives and reduced bond allocations.

Democratisation of Alternatives

The rise of alternatives spans from private equity to unconventional options like alligator farming. Retail-oriented private equity and venture capital funds are now accessible, allowing individual investors to participate in differentiated, uncorrelated products. As alternatives grow deeper and broader, the need for customisation in portfolios increases, aligning investments with individual preferences and expertise.

With the end of the private equity golden era, difficult exits, and the J-curve’s illiquidity, a shift towards more balanced alternative allocations is expected. Liquid alternatives, offering diversification and easy access to liquidity, are increasingly attractive to modern investors.

Key Takeaways

The frequency of black swan events, large balance sheets, and derivative positions have driven smart money away from traditional 60%/40% splits towards more than 45% in alternatives. The demand for liquid, uncorrelated returns has become critical during deleveraging events and market correlations. Looking ahead, as inflation expectations rise and bond allocations decline, investors seek smarter bets, moving away from income-generating assets in high-inflation currencies. With the FED combating inflation in the short to medium term and rising interest rates, private equity allocations are becoming outdated. Liquid alternatives now fulfil the needs of modern investors, offering uncorrelated, diversified returns with easy liquidity access. In this complex landscape, insightful advisors and managers are essential to navigate the evolving world of alternatives.

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