The end of the 60/40 portfolio: Where now for asset allocation?
Investors understand the benefits of diversification and one of the ways to achieve a balanced portfolio is via the 60/40 approach – 60% in equities and 40% in bonds.
Equities and bonds tend to have an inverse relationship so when one goes up, the other goes down.
This has been a well-established way for investors to generate returns and protect against market volatility.
Dan Brocklebank, director, UK Orbis Investments, explains: “By splitting a portfolio between bonds and equities in some ratio, investors can typically reduce the overall volatility of the portfolio without too much impact on overall average returns.
“When measured over long periods of time, equities can be expected to generate higher returns, but those higher returns come with greater volatility than the returns from a portfolio of bonds.
“By moving in the opposite direction to equities in periods of equity market weakness, they have served an ideal role as portfolio stabilisers for 60/40 (and similar) portfolios.”
Since the 1900s, the 60/40 has more often than not delivered great real returns (the graph below includes the global standard in US figures).
But James Norton, head of financial planners at Vanguard, says bonds and share prices do sometimes fall at the same time.
“When we looked at market data covering the 20 years up to the pandemic sell off, we observed it happened about 29% of the time,” he says.
He adds there was also a fall in both during the 2020 Covid sell-off and at the start of this year. Global equities are down just under 9% and global bonds are down around 8.5% year-to-date.
But it’s the last six months or so that has brought the 60/40 portfolio into doubt. Ben Yearsley, investment director at Shore Financial Planning, says: “The traditional 60/40 portfolio has been under pressure this year for the first time in 40 years as the 40 invests in bonds, which have been falling in price sharply for six months now.
“The US 10-year treasury (government bond) yields almost 3% now whereas at the start of the year it was half that. Rising yields mean falling prices. With inflation nearing double digits the prospect of more rate rises is a certainty. So, the 60/40 portfolio is under severe pressure as bonds are falling in price at the same time equities are struggling.”
Brocklebank adds that when yields rise, prices fall, and today, a 1% increase in 10-year gilt yields would knock prices by 9%.
According to Waverton Investment Management, the losses incurred for bond holders in Q1 2022 were “historic” at -8.5% which is the second worst since 1978. It highlights the perils of duration at a time of rising interest rates.
Further, the total returns from government bonds has been historically poor in recent months reflecting the changed view on persistent inflation, Waverton adds. It said 2022 is likely to remain a challenging year for bond investors.
Why are equities and bonds out of sync?
But it’s not just inflation which is skewing the usual 60/40 relationship. Brocklebank says bond and equity markets started 2022 at elevated valuations compared to long-term averages.
“In recent years, valuations of many high growth, and often profitless, technology companies were driven to particularly elevated levels as investors chased exposure to these names in the belief that their disruptive potential would ultimately be rewarded by further share price appreciation,” he says.
He also refers to Russia’s invasion of Ukraine. “While not a direct cause of a change in valuations, these shocking developments have reduced investors’ risk appetites and accelerated many of the trends under way by causing, or threatening to cause, actual shortages in materials that Russia or Ukraine export such as energy, wheat and nickel.”
For William Dinning, CIO of Waverton Investment Management, while they’ve been “going on about the death of the 60/40 portfolio for four or five years, it is actually happening”.
He says: “It is unfurling in front of our eyes. One of the most consequential things coming out of the persistently higher inflation rate is there’s a very high chance that it changes the relationship between equities and bonds in terms of how they relate.”
Based on the graph above, Dinning explains that with long duration index linked bonds losing double digits and with the S&P 500 down 14% year-to-date, investors are “losing money in both” and it signifies the death of the bond bull market.
“If inflation is persistently high, that correlation will get positive. In other words, when things get difficult, the equity and bond market won’t be able to beat inflation.”
He adds: “When you think about it intuitively, it makes sense because if inflation is higher, what both markets are going to be worried about is… the bond market is going to be thinking that interest rates need to go up and equity markets are going to be thinking inflation has already been persistently higher so the bond market might be right. And in particular, it might be right because the central bank is going to continue tightening monetary policy and that’s bad for the equity market.”
Brocklebank says: “For the past 30 years, the 60/40 has been as solid as a castle. Today it looks like a castle made of sand.”
Where now for asset allocation?
Dinning says that as a result of this change in relationship, it is going to finally force people to think more creatively about how they put their portfolios together and what they think of as low risk and what they think is diversified.
He adds that investors shouldn’t be underweight equities. “You should be pretty neutral equities and continue to be underweight bonds and think about how you manage your alternatives allocation. And actually, this probably isn’t a bad time to hold a little more cash,” he says.
For Yearsley, he says the answer lies in alternatives including property, private equity and hedge funds.
He says: “Having a bit of everything is always a good plan. But what I particularly like is the renewable energy space alongside a few more of the specialist property investment trusts and REITs. These provide physical asset backing, good in times of higher inflation and often the revenue of the underlying investments are often inflation-linked.
“They are equities, so will be more volatile than bonds but at the same time they do provide good diversification. You can either buy a fund like Time UK Infrastructure Income or RM Alternative Income or buy the underlying trusts.”
However, Norton says nothing has fundamentally changed and investors shouldn’t alter the way they invest.
“Yields on bonds now rising is generally a good news story for those holding a mix of equity and bonds. And equities are really important, most people can’t afford not to invest in them.
“The best course of action is to do nothing. Bonds on the whole still behave differently to equities and continue to act as important shock absorbers. On average when equities performed very poorly, government bonds still helped to protect the portfolio and the more severe the equity downturn, the better bonds performed,” he says.
Vanguard data which looked at the returns from equities and bonds between 1900 and 2020 revealed that bonds returned a nominal average annual return of 5.6% while equities returned 9.17%.
However, once adjusted for inflation, bonds returned an average 1.96% while stocks returned 5.41% “showing that equities are a good hedge against inflation over the long-term”.
But he adds that investors don’t get the average ie returns will be volatile. Further, he says it looks like inflation may have already peaked in the US, and the market expects it to be nearer 3.5% by mid-2023.
“Although we think inflation will continue to rise in the UK for a few more months we expect it to be at a similar level to the US by the middle of next year, falling sharply in the first half of 2023.”
He says: “When things aren’t working we like to fix them. When it comes to investments that means making changes to your portfolio. We believe that’s the wrong thing to do. Volatility is part and parcel of investing. Investors should stay the course unless there has been a change in their goals that necessitates a change in their portfolio.”
For Brocklebank, he says investors need to consider what will work from today’s starting point.
He says: “With bond yields low, equity valuations high, and inflation risks rising, the classic passive 60/40 seems unlikely to repeat its past success. In fact, any static or passive allocation seems unlikely to perform that well.
“While overall equity valuations are high, that does not mean that all stocks are expensive. Owning out-of-favour, neglected shares has worked much better this year than paying up for the perception of perpetual profitable growth. We continue to believe that buying businesses for less than they are worth is the surer way to avoid losses.”
He adds that their Orbis Global Balanced Strategy has found opportunities aligned with three fundamental trends that it sees playing out, and which have been exacerbated by Russia’s invasion of Ukraine: a global energy crisis, a global food shortage, and a resumption of the Cold War.
“Each of these represents a reversal of the prevailing trends in recent decades, and each could shape the world for decades to come.
“Targeting those opportunities while hedging the overall market risk provides a low-risk alternative to bonds. Other low-risk assets, like gold and inflation-linked bonds, can play a supporting role while offering a stabiliser effect in the portfolio and some protection against inflation,” he says.