For decades many institutional investors have employed a 60% equities, 40% bonds investment allocation as the bedrock of their portfolio. Yet several challenges are converging, leading some to question if the 60/40 strategy is still viable.
The increased correlation between bonds and equities is one factor while monetary tightening is another. The rise in inflation is also proving to be influential.
Indeed, the increase in the cost of goods and services poses an exceptional challenge to the traditional stock-bond portfolio that we have not seen since the 1970s.
The case for 60/40 has traditionally been that the inverse correlation between bonds and equities offers portfolio diversification. The 60% allocation to equities offers growth, while the 40% held in bonds protects against downturns. The assumption being that when stock markets fall, bonds tend to perform better.
Indeed, investors employing such a strategy received higher returns in every three-year period between mid-2009 and December 2021, relative to those with more complex strategies, according to Arnott, an investment manager.
But this year things have gone south, and dramatically. The performance of the average 60/40 portfolio was down 16.9% in the first half of the year, according to Arnott. Such negative numbers question the validity of the strategy as a successful form of investment in the face of the economic environment resulting from the Covid pandemic.
If that continues, such a performance would rank among the worst historical scenarios, only behind the depression-era downturns in 1931 and 1937, which saw losses top 20%, according to Ben Carlson, the director of institutional asset management at New York-based Ritholtz Wealth Management.
Reflecting on this, Neil Mason, assistant director and LGPS senior officer at the Surrey Pension Fund, says: “In the LGPS, 60/40 has echoes of the old man on the cart in the movie Monty Python and the Holy Grail, shouting: ‘I’m not dead’. “Many LGPS funds still essentially have this mix, but the traditional 60/40 has been ‘pimped’ with a variety of more versatile fixed income/inflation protecting assets. Infrastructure, multi-asset credit and private debt making up the fixed income 40% and private equity adding to the 60% equity mix,” he adds. This suggests a subtle but important move away from the formulaic 60/40 profile.
The bigger picture
What drives the increasingly positive correlation between equities and bonds? Inflation, monetary tightening and the war in Ukraine are factors behind this trend.
But Dan Mikulskis, a partner at Lane Clark & Peacock, a consultancy, says we should pause for a moment on the recent fall in 60/40 portfolios, which should be looked at in an historical context. “If you zoom out a little the picture is different,” he says.
“Over the last five years the global 60/40 portfolio has risen by 4% to 5% per year, depending on composition and currency, and would have doubled your money during the past 10 years. This year’s falls need to be seen in the longer-term context,” he adds.
Craig Mitchell, an economist at workplace pension scheme Nest, presents a different narrative, one in which the 60/40 approach has proved successful thanks to market conditions. “Over the past decade, we have experienced excellent investment conditions. Buoyant markets in equities and bonds made it relatively straightforward to achieve good returns in more traditional portfolio constructions,” he adds. “The biggest risk was missing out on such good times.”
The sceptics
The death of 60/40 is a reoccurring theme in investment. More than 10 years ago, the fund manager guru of the time, Pimco founder Bill Gross, claimed he had laid the strategy to rest. “The underlying logic of the 60/40 sceptics has not much changed over the past decade,” says John Rekenthaler, vice president of research at Morningstar. “Once again, they distrust 60/40 portfolios because bond yields have become too low and equity price/earnings ratios too high.”
On the repeated death of 60/40, James Brooke Turner, investment director at the Nuffield Foundation, a charity seeking to improve social well-being, says it is down to the natural investment search for alpha. “The industry is always looking for new products to place in between pure equity and cash which offer high returns with lower volatility.”
Mikulskis says alternatives to 60/40 are often presented as superior and more complex options. “One simple reason is that complexity sells in investment.
“We have a big chunk of the industry that is set up to sell more complex solutions,” he adds. “And how do you do that? You find a simple straw man to tear down. 60/40 is a convenient punching bag while putting forward more complex and more expensive solutions.”
Not dead yet
In a similar critique, the death of 60/40 is premature, Mason says. “I can only speak from the perspective of a long term open-ended scheme like the LGPS, but from this view, it may be premature to mourn the death of 60/40 – the brave new world might claim to be funky and directional, while under the bonnet there are a number of familiar looking component parts.”
Brooke Turner agrees. “I don’t see that 60/40 is dead,” he says. “But there will be a period of readjustment which will be linked to the rate of withdrawal of monetary support for asset prices as much as rising rates.”
Mikulskis is even more convinced that 60/40 is not dead given how it has held up this year – despite its overall poor showing. “If anything, this year’s moves have strengthened the case for the approach over the long term,” he says.
“In recent years many commentators have pointed out that going into this year the future prospective returns on the 60/40 portfolio have dwindled far below what has been seen historically,” he adds. “The underlying yields on government bonds just didn’t support it.”
The bond problem
Going forward, it looks to be the bond segment that will be the most stretched within the 60/40 framework. “It is government bonds, particularly in a higher inflation environment,” Mikulskis says. “There are a few simple things you can do to improve bond portfolios including using short-dated corporate bonds as a core holding and allocating to investment grade asset-backed securities.”
Bonds could suffer the most looking ahead, agrees Mitchell. “The likelihood of a higher inflation environment poses potential opportunities but also difficulties, particularly for bond markets. While the fall in bond prices has been painful for investors holding them, the superior yields they now offer can provide a reasonable income stream again, potentially benefiting portfolios constructed of public equity and bonds.”
Inevitably the shift from a negative correlation between equity and bonds, which is already apparent, plays a part here, Mitchell adds. “The risk though is of a shifting performance correlation – bond and equities have been negatively correlated for 20 years, offering a strong diversification factor for investors. Higher inflation might mean a positive correlation returning.”
Market concentration
Mitchell notes that with more volatile times ahead, 60/40 faces a different set of challenges, which it is not built for. “We have already seen greater volatility and uncertainty in markets following the pandemic, and there’s an increasingly concentrated public equity market – the number of listed companies has fallen considerably in recent years,” Mitchell says.
The latter point about a decline in company listings is a good one. Although outside the formulae of 60/40, it presents a problem for the approach as the 60% may not now, or in the future, be as wide-ranging and deep in terms of stocks as it has in the past, due to a lack of on-going listings.
Working on this theme further, Mitchell adds: “Indexes themselves are becoming more concentrated into fewer companies, as we have seen with the US tech giants. Both undermine diversification strategies and should encourage investors to seek out new areas to deploy money.”
What next?
One of the key attractions of 60/40 is a strong element of pragmatism, measured as a moderate level of risk in investment terms, and one of the reasons it may never die. This can be framed in the wise words of economist John Maynard Keynes: “It is better to be roughly right than precisely wrong.” For investors the 60/40 method does get it right most of the time.
But for some, an investment approach cannot be built on something so vague. Even those who use it as their central investment approach may be looking to alternatives, something with better returns, at least in the current environment. If investors are pondering a move away from 60/40, how much of a shift should they make – and in what direction? “Avoid the temptation to become more aggressive when investment opportunities seem scarce,” Rekenthaler says.
“Instead,” he adds, “maintain the same 60% equity position but consider reducing the portfolio’s bond-market risk by swapping into shorter notes or even raising cash. If long Treasury yields continue to rise, as they have done since summer 2020, those monies can gradually be reinvested into longer-dated securities.”
Looking at much-cited alternatives, Brooke Turner also highlights the importance of quantitative easing (QE) in the 60/40 story. “People argue for the use of alternatives in the mix, but all assets are priced o the risk-free rate and the business cycle. It has been the absence of the business cycle – thanks to QE – that has given the 60/40 portfolio such abnormally high returns as bond yields fell,” he says.
“If the business cycle is returning and QE evaporating, it will allow the 60/40 portfolio to resume its traditional place of providing modest capital growth and income, rather than a maximising strategy, but it will be a painful process to get there for bondholders.”
Even for a strong advocate of 60/40 like Mikulskis, there is a reason to modify it, even just slightly. “The traditional 60/40, which allocates between global stock markets and global government bonds, can already be substantially improved upon by looking at real assets, corporate bonds, asset backed securities and private debt.”
Future strategies
So does 60/40 have a future? Mitchell is cautiously critical. “A 60/40 approach, or similar construction, may continue to serve some investors and the risk profile they wish to take,” he says. “Public equity and bonds will continue to play important roles in investment strategies, but schemes should avoid being over concentrated in these familiar asset classes.”
However, he notes: “Nest members tell us they want strong, steady returns rather than taking on excessive risk. We don’t want to leave them exposed to poor or negative performance over the coming years.”
And building on this by offering something of another vision to 60/40, Mitchell says: “We believe the key is continuing to create a more sophisticated investment strategy, not a simpler one. Opening up new asset classes like illiquids, as we have done recently with private equity, can help drive performance when public markets are struggling, giving us options when market conditions change.”
In comparison, Mikulskis presents a different interpretation of 60/40. “The trend in the UK has been to measure investment performance against objectives or liabilities. There’s nothing wrong with this, but a simple reference portfolio that encompasses the simplest way to deploy investment risk in a globally balanced way gives you a good reference for a counter-factual, and usually injects a dose of humility into any performance review as few strategies have strongly outperformed it over long periods.”
This highlights a good case for 60/40. Mikulskis also sums up the simpler virtues of the strategy. “It remains a useful benchmark, though for the simplest way to deploy risk in a balanced portfolio and a reminder that simple approaches can be effective.”
And he adds, its essence is a realistic but successful approach. “In terms of an investment portfolio it can be easily improved upon, but it is actually a helpful benchmark to have in mind to hold fund managers and investment teams accountable and judge performance against.”
So even if 60/40 is having a tough time, it serves a solid purpose for institutional investors. And though it may not take centre stage right now, like Arnie, it will be back.
Comments