For much of the past 30 years, traditional investment approaches produced results that allowed most investors to meet their investment goals. But times have changed, and stock and bond returns are likely to be lower than what investors have enjoyed historically. Fortunately, options exist for investors willing to break with tradition, rethink certain aspects of conventional wisdom and implement new alternative approaches that complement strategies that have worked well in the past. Thinking alternatively may increase the probability of success in what we believe is a new era for investors and financial markets.

The initial economic and capital market conditions of the early 1980s were unique and set the stage for a multi-decade bull market for stocks and bonds. The challenging stagflation of the 1970s led to a wealth of attractive options – money-market instruments, which offered yields near 20%; 10-year Treasuries, where yields peaked near 16%; and equities, where S&P 500 dividend yields approached 6%. Meanwhile, price-earnings (P/E) ratios hit long-term lows. In short, traditional asset classes were at historically cheap levels, which resulted in sustained attractive returns over the next two decades as inflation and interest rates fell to today’s historically low levels.

During the 1980s and 1990s the rolling annualized five-year return from a conventional U.S. portfolio of 60% stocks/40% bonds ranged from more than 5% to almost 25% per year (even when we assume no additional return from active management). During this unique period, the key for investors was simply to be in the game. How the game was played was relatively inconsequential; strong market returns created ample opportunities to achieve positive results. Of course, as we now know, this two-decade period was followed by two substantial equity market declines: the bursting of the tech bubble at the beginning of the 21st century and the 2008- 2009 financial crisis. For traditional portfolios dominated by stock market risk, this translated into average five-year returns that were substantially lower (see Figure 1).

Today’s initial economic and capital market conditions are quite different from those at the beginning of the ‘80s. Money market yields are near zero, and 10-year Treasury yields are only marginally higher. In equities, S&P 500 dividend yields are low by historical standards, near 2%, and are paired with historically high cyclically adjusted P/Es (23.3x as of 31 March 2013) and all-time peak earnings. (The cyclically adjusted P/E ratio, also called the Shiller P/E ratio, uses average inflation-adjusted earnings from the previous 10 years. The average Shiller P/E since 1900 has been 16.4.)

Combine these high initial valuations with an economy that policymakers in leading developed nations are aggressively attempting to reflate, and it’s clear that the valuation and economic tailwinds that benefited traditional financial assets in the ‘80s and ‘90s are turning into potentially daunting headwinds. These headwinds are all the more troubling when we consider that the costs of higher education, retirement and, indeed, living are rising. Therefore, sticking with the conventional may not be a realistic option. If traditional approaches to investing are not going to get investors where they need to go, it’s time for alternative approaches.

Thinking (and investing) alternatively in the New Normal

At PIMCO, we have always placed a high priority on challenging conventional wisdom – in our secular and cyclical economic analysis, our investment philosophy and process, and our approach to developing solutions that address client needs. Looking forward, we believe most investors will likewise need to consider alternative approaches to achieve their investment objectives. By investing alternatively, we mean not just selecting nontraditional asset classes and strategies, but also nontraditional approaches to portfolio construction itself, including:

• Alternative asset allocation approaches
• Alternative index-construction processes
• Alternative sources of alpha
• Alternative return and risk objectives
• Alternative risk mitigation tools

Alternative asset allocation approaches: risk-centric diversification and tactical allocation

The traditional approach to portfolio construction focuses on the percentage of capital allocated to each investment strategy and, collectively, to each asset class or category. The classic example is the 60/40 stock/bond portfolio. However, while such a portfolio may appear balanced, from a risk standpoint the allocation is clearly dominated by equities (see Figure 2).

To truly reap the power of diversification, we believe investors should allocate based on the risk contributions of the assets in their portfolio, not their percent of capital. We find that a focus on risk factors, which are the elemental components of risk within an asset class or strategy, is a more effective approach, enabling better risk targeting and diversification.

In addition, we believe it is important to evaluate the prospective risk/reward trade-off offered by different exposures, and to emphasize those that offer more attractive prospective risk-adjusted returns while still maintaining a diversified portfolio. Approaches that rigidly apply equal weights to portfolio risk exposures, as an example, ignore the fluidity of economic conditions and variability of risk-adjusted returns across assets over time. This is particularly relevant now, when sovereign debt and growth differentials, combined with highly active policy interventions to direct the flow of capital, continue to change market incentives (and penalties).

Alternative index-construction processes: Focus on the fundamentals

Alternative approaches to index construction may enable investors to obtain the desired attributes of a given asset class while offering potential improvement in the return/risk profile. This can be done by reconsidering the use of capitalization-weighted indexes, especially in a passive investing context. On the fixed income side, for example, a passive strategy benchmarked to a cap-weighted bond index will have the greatest exposure to issuers with the most debt outstanding – hardly the most prudent lending criteria – instead of those with the greatest capacity to repay their debt. Further, passive equity strategies tied to cap-weighted indexes will systematically overweight overvalued stocks and underweight undervalued stocks. This creates a performance drag over time, as evidenced by the persistent subsequent underperformance by stocks with the greatest index weight, a dynamic that can prove particularly painful during noteworthy market corrections (see Figure 3).

We believe alternative indexes based on more economically relevant factors may produce better outcomes for investors. These include global bond indexes weighted by GDP (a better measure of capacity to repay) and stock indexes weighted by fundamental factors, such as sales, cash flow, dividends and book value (better measures of economic footprint).

Alternative sources of alpha: Broaden and diversify the opportunity set

Investors may also benefit by challenging the notion that alpha should be derived from the same opportunity set as the desired market exposure. True alpha – higher return than a risk-equivalent reference point, such as a market index – is the Holy Grail for investors. So why constrain the alpha opportunity set when the desired market exposure can be maintained at a very low cost, while freeing up capital to seek enhanced returns from a complementary source that has better structural alpha opportunities?

Take a combination of equity index futures and a high quality bond collateral portfolio as an example. The cost of maintaining equity exposure using futures is linked to a short-term money market interest rate. Therefore, if the bond portfolio outperforms that cost and any associated manager fees, it translates directly into additional return. Also consider that the market for stocks, especially large cap stocks, is generally efficient, while the bond market is less efficient and offers structural alpha opportunities to longer-term investors.

Finally, due to the inherent diversification benefits in this type of approach, it does not necessarily translate into a corresponding increase in risk (see Figure 4). Furthermore, if the underlying bond portfolio is actively managed with the goal of adding value versus a money market rate across different types of market environments, investors may realize additional attractive risk-adjusted returns. We believe this type of approach can offer the best of what passive and active strategies seek to deliver, as a complement to more traditional approaches.

Alternative return and risk objectives: absolute return and downside risk

Investors may also find it beneficial to allocate to strategies with alternative return and risk objectives. Traditionally, investors have focused on strategies that are measured and constrained relative to an asset class index. Yet, investors are generally most concerned with absolute returns (how much could I make) and absolute risk (how much could I lose). When a market index is expected to deliver returns and downside risk consistent with an investor’s objectives, it may make sense to limit the amount of active management discretion. However, with today’s lower-return prospects across many asset classes plus the potential for higher volatility, in some cases this approach may be structurally misaligned with investors’ needs. This disconnect explains the rising popularity of outcome-oriented strategies with relatively unconstrained, flexible guidelines and in some cases explicit downside risk management objectives. With these strategies, investors give up the certainty of a particular index exposure, but in the hands of a skilled manager may gain an absolute return and risk outcome that is much more aligned with their overall goals.

Alternative risk mitigation: explicit inflation and tail risk hedging

The first step to making money is not losing money. Within traditional portfolios, core fixed income allocations have typically served as that key risk-mitigator by preserving capital and providing an expected moderate-to-negative correlation to equity risk. However, low initial Treasury yields may limit the magnitude of this potential defensive benefit against a sharp equity market decline. To supplement this traditional anchor to windward, investors may consider allocating to strategies that are explicit hedges against inflation and large market declines (left-tail events). A modest investment in tail risk hedging instruments such as out-of-the-money puts, for example, requires only a small amount of capital but can potentially provide exponential upside in the event of a large market decline. With multiple factors converging to make negative surprises a much more distinct possibility, integrating contingent downside protection directly into an investment portfolio may be an important contributor to longer-term investment success.

Think alternatively

Traditional approaches to portfolio management need to evolve – the rising tide of both stocks and bonds over the better part of the last 30 years obscured the need for investors to refine their approaches as the investment landscape shifted. With lower returns expected prospectively versus historical norms, investors need to be very efficient in the risks they take in order to meet their return goals. PIMCO incorporates these alternative approaches in the management of multi-asset portfolios for our clients. And we similarly believe it may be more important than ever for investors to "think alternatively" in managing their own investment portfolios to successfully navigate the bumpy journey ahead.