The 60/40 Portfolio
The 60/40 Portfolio
As the offspring of Modern Portfolio Theory, the 60/40 portfolio has gained ubiquity in the modern era as the stylised expression of what a “typical” portfolio looks like. The 60 refers to the allocation to equities, which is designed to capture the rewards from growth and risk taking. The 40 refers to the allocation to bonds which aims to provide more defensive qualities such as a steady, dependable income stream and even capital gains in more turbulent times.
In recent times, many commentators have started to question (for example in this recent article in the Financial Times https://www.ft.com/content/fdb793a4-712e-477f-9a81-7f67aefda21a) whether the 60/40 portfolio is fit for purpose going forward. And they are right to do so; the basic mathematics of the situation are inconvenient and unforgiving. Before delving into this issue, I offer some context.
Firstly, we must pay homage to the bond market. For the last 40 years, it has given investors the most incredible returns, with almost flawless consistency and the icing on the cake has been, the holy grail of portfolio construction, a negative correlation to risky assets. The chart shows the 40-year total return for the USD Barclays Agg index. It has given investors 7.75% per year, without missing a beat, it has comfortably outpaced inflation, giving an excellent real return and thanks to the propensity of central banks to lower interest rates in times of stress, it has saved its best returns for when equities were falling. If we adjust for volatility, as an asset class it has trounced the equity market.
Barclays Agg USD Unhedged Total Return
As citizens, we are used to the concept that buying insurance costs money. Similarly, as investors we understand that hedging using options to protect from downside creates a negative carry and a drag on returns. The real magic of the bond trade was that it was the ultimate hedge but also that paid you to own it.
Does this wonder-asset that has given so much, have any more to give? Maybe, but likely, not a lot. Consider the 10-year Gilt which currently has a yield of 0.18%. If you buy that Gilt and hold it to maturity, you make 0.18% per annum return before inflation. If inflation averages 3% over the period, you lose 20% in real terms over the life of the bond. The only way to make a higher return than this is to hope that yields fall even further and sell it before maturity to another investor, but this does nothing to increase returns in aggregate.
What if equities fall precipitously, will yields on government debt plumb new lows? Probably, but will it be enough. Recent anecdotal evidence suggests not. In the recent equity market correction from 2nd September to 21st September 2020, has seen the S&P 500 fall 10%. In that same period the TLT, the ETF that tracks long dated US Government bonds is down 0.9%. That is not what investors have been conditioned to expect. However, the negative correlation that investors have come to rely on, is not preordained. If one looks further back into history, this correlation has been positive for at least as much time as it has been negative.
The scenario in which bonds continue to deliver the goods for investors, at least in real terms is in a deflationary collapse, which cannot be ruled out in a world of extreme indebtedness and a global pandemic. This would be akin to what happened in the Great Depression. However, I would caution strongly against positioning for this outcome. Unlike the Great Depression era, we live in a purely fiat money regime, which means that developed market governments can create unlimited quantities of currency to avoid such an outcome and a strong political imperative to ensure that they do so. For our money, it is a matter of political necessity for bonds in general and government bonds in particular, to remain nominally whole but to be material losers in real terms over the years and decades ahead.
Turning to the equity component of the 60/40, while equities are unequivocally not cheap, they are not necessarily doomed to the same outcome. The FTSE 100 currently languishes 17% below where it was 20 years ago. To be sure, it is comprised of many extremely challenged businesses and sectors, but to borrow a famous old phrase, it is hardly exhibiting irrational exuberance. As the residual slice of the capital structure, equities do at least offer some protection from inflationary policies.
Overall, investors need to accept the reality that real yields and returns on large swathes of the investment universe are going to be negative for the foreseeable future. The days of earning 5% over inflation to lend Unilever money to make toothpaste to sell back to you, are long gone. But more importantly, investors need to realise that there is no such thing as a passive approach to asset allocation, even as the implementation goes more and more down that route. A 100% allocation to cash is an active decision and potentially, given the current environment, a wealth destroying one. They need to understand that other asset classes, such as precious metals and commodities and other strategies such as global macro, can contribute to a better long-term outcome.
The bond market has been the cornerstone of the investment portfolio and it has done a splendid job. However, going forward its ability to fulfill this role are impaired by both market pricing and policy outlook to deal with the many economic issues of the day. My suspicion is that recency bias, regulatory considerations, institutional conventions, career risk concerns among professional investors and good old-fashioned inertia will make shifting allocations happen slowly, at least to begin with. However, another consideration is that bond markets are very large and even a small shift in allocations could have a huge impact on alternative markets which are much smaller, rewarding those who were prepared to lead rather than follow.