Times are changing. So must portfolios.

Cboe Guest Author: Nick Griebenow, CFA, Portfolio Manager for Shelton Capital Management's Option Overlay Strategies

Has the 60/40 portfolio gone the way of selfie sticks and the man bun? The classic 60% allocation to stocks and 40% allocation to bonds enjoyed a good, long run during the past decade of low volatility and easy money.

But the times they are a changing. Inflation and volatility are up, and so are interest rates, bank failures, and macroeconomic uncertainty. Simply put, the 60/40 balanced portfolio that worked in the past can't keep up with today's rapidly evolving market environment. Investors can't coast with complacency as they had during the 2009-2020 bull market, which was the longest in stock market history. They need to change with the times and make adjustments to take advantage of new market realities.

Timing Matters

Making strategic portfolio adjustments is especially critical for investors in or near retirement who are looking to live off the cash flow from their portfolios. According to some estimates, about 10,000 baby boomers are reaching retirement age every day in the United States. As they struggle to find investments that can provide the yield they need, these investors would be wise to heed the "sequence of returns" risk in their portfolios. "Sequence of returns" risk refers to the potential negative impact on investment portfolios resulting from the order and timing of investment returns. Market losses early in retirement can dramatically diminish a portfolio and deplete savings at a time when it is needed most.

Unsurprisingly, many investors are hesitant to 'give up' the potential returns of stocks as demographic shifts and longer life expectancies are reshaping investment objectives. With longer lifespans, the need for income and wealth preservation has increased. So too, has the desire for higher returns so that an investor doesn't outlive their portfolio. As a result, the 60/40 portfolio may need to adapt to a more dynamic investment approach to meet investor needs.

A Third Slice of the Pie

Is there a way to hold onto the growth possibilities of stocks and still generate income? We believe there is. By adding a third slice to the pie—specifically, a covered call strategy that addresses both risk management and cash flow generation—investors may be able to transition from an aggressive, growth-oriented equity portfolio to a more stable income-producing portfolio.

Covered call funds can have lower risk than an all-equity portfolio while paying out cash flow like a fixed income investment. In fact, the yield could actually be substantially higher than the potential yield from a bond, even with recent rate hikes. More than that, this 'slice' would have more capital appreciation potential than an investor would see in a fixed income investment.

Depending on individual tolerance, an excellent way to build a covered call allocation is to borrow 10 percent from stocks and 30 percent from bonds of a traditional 60/40 allocation to create a 50/40/10 portfolio: 50% equity, 40% covered calls, and 10% fixed income. To help tell the story, we will be looking at the Sharpe Ratio or your returns relative to your risk (risk-adjusted returns). We chose a 3-year time horizon as a good starting point, it obviously includes the COVID-19 era, a strong market rebound, and plenty of volatility.

Portfolio Allocations (3-Year ending 4/30/23)

^{Source: Morningstar Direct, SPX: S&P 500 Index, Agg: Bloomberg US Aggregate Bond Index, BXM: Cboe BuyWrite Index}

As you see by the chart above for 3-year period, the Sharpe Ratio for the 50/40/10 portfolio is 0.71 compared to the traditional 60/40 portfolio of 0.47. In other words, the returns increased by nearly 415 basis points annually, but only a 128 bps increase in relative standard deviation. The Sortino Ratio focuses more on the downside risk of the investment and the numbers above further support the case of adding a third slice of pie to your portfolio with covered calls. The reduction in downside risk is especially critical for those entering retirement because of the aforementioned sequence of returns risk.

Volatility is Back

Moving forward, investors should expect to see volatility remain elevated, held up by global instability from events like the war in Ukraine, recession fears, rate increases, and even the risk of default if Congress fails to act. These factors will make for a choppy market for the foreseeable future. 

A covered call is more than just a tool for managing volatility – it also offers a way to capitalize on it. Option prices typically move in tandem with volatility. Premiums received tend to be higher in more volatile periods, so when stocks are having a tough go the premiums generated from writing calls can be a bright spot in an otherwise bleak year for returns. 

Owning high-quality names with strong balance sheets while selling covered calls to dampen volatility and generate cash flow can be one of the best strategies to execute in this environment. 

While the 60/40 investment portfolio has been a tried-and-true strategy in the past, it is facing considerable challenges and criticism in today's financial landscape. The interest rate environment, changing market dynamics, availability of alternative investments, and shifting investment objectives have all contributed to the view that the 60/40 portfolio is no longer the optimal choice for investors seeking stable returns and risk mitigation. As the investment landscape continues to evolve, it becomes increasingly important for investors to consider alternative strategies that align with their specific goals and the changing market conditions.

Nick Griebenow, CFA, is a portfolio manager for Shelton Capital Management’s Option Overwrite Strategies. Prior to joining Shelton Capital, Nick was a senior derivatives trader for a large national brokerage firm.

For more information on the Cboe BuyWrite Index (BXM), please visit this webpage.

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