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Is 60/40 a Phoenix?
Unpacking the Headlines
You may have seen the recent news headlines putting the traditional “balanced” (60% stocks /40% bonds) portfolio allocation mix in question, due to its less-than-ideal YTD performance over the past 100 years.
With 60/40 allocation Canadian investors seeing portfolio decline of 11.08% in Canada for 2022 (with variations depending on what products or indices are observed), critics are calling the concept outdated, backward-looking, and outright dead.
Meanwhile, the advocates defend this allocation as a patient strategy designed to generate stable average returns over a long period of time. ?
In this edition of the newsletter, PDP is diving into both the past and the future of the 60/40 concept to attempt to understand how portfolio construction as we know it is changing and the potential impact of alternative assets and specifically private credit investments.
A Lesson in History
To understand whether the 60/40 strategy is still relevant, it is useful to understand the circumstances under which it was born.
In 1952, an American economist named?Harry Markowitz?introduced the Modern Portfolio theory (“MPT”) in his paper "Portfolio Selection", published in the Journal of Finance.?Eventually awarded a Nobel Prize for this work, Mr. Markowitz formalized an existing concept of diversification, by pioneering a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. Iterations of his mathematical framework have been used to construct portfolios of investments to present day.
Notably, seventy years ago the two large markets widely available to American public were the U.S. stock market and the U.S. bond market. It is very possible that the exclusive stock/bond mix was an unintentional product of the MPT modeled under asset options accessible in 1950s.
While structurally a higher allocation to stocks versus bonds makes sense due to a better performance of stocks statistically, the “optimal” 60/40 percentage split likely originated from the 1950s’ historical results available at that point in time.?This does not mean that the split is not optimal, but as small print in legal investment paperwork notes often remind us, “past performance is not a reliable indicator of future results”.
It is important to mention that the 60/40 split between equities and bonds often referred to today is by no means a “one size fits all” concept. With the 60/40 mix being a classic starting point for many portfolios, it is typically adjusted based on an investor’s risk tolerance, time horizon, and desired returns. Also, with each allocation, the composition has evolved over time as efficient access to new markets have opened for investors around the globe. For example, today’s balanced portfolio from a Canadian investor standpoint includes a well-diversified mix of global and domestic stocks and bonds.
The stock-bond combination known as the benchmark today was likely meant to demonstrate one possible model scenario of a “diversified” portfolio[1]. With changes in asset options and correlations over the decades, an optimal portfolio that MPT would call for today could be different. More importantly, even within the 60/40 allocation it is important to note that more diversification options are available.
Looking Into the Future
One of the conditions to make a portfolio diversified is negative correlation of assets allocated in the mix. For example, the 60/40 bonds allocation mix relies on the fact that typically, when growth assets (such as stocks) sell off during economic slowdowns, safer assets (such as bonds) appreciate – as investors seek stability and interest rates decline.
Looking ahead, let’s explore how the 60/40 model is expected to perform in a classic recessionary environment. While equities tend to underperform in recessions due to lower economic growth, the less-credit sensitive of areas of fixed income can outperform if interest rates are cut to prop the economy (since lower interest rates cause bond yields to drop and bond prices to increase).
Conversely, the current environment has been marked by rising interest rates, which is why bonds are falling as hard, and in some cases even harder, than stocks. With bonds and equities falling in tandem and the 60/40 approach generating losses in 2022, the above scenario did not materialize – and the 60/40 model did not perform. How so?
One theory is that disruptions and complications in geopolitics and the economy can interfere with results modeled in optimally designed portfolios, creating unintended risk correlations. As an example, in the past several decades, three events can be highlighted where bonds did not go up when stocks went down. In 1931, we saw a currency crisis that forced Britain to abandon the gold standard; in 1941, the U.S. entered World War II; and in 1969-70, a combination of multiple factors sparked a decade of higher inflation[2].
In a previous edition of our newsletter, we discussed the parallels and differences between inflationary circumstances in the 1970s and the presents days. We also highlighted that 2022 exhibited unique circumstances that call for unique measures and are expected to produce equally unique outcomes. On the fixed income side, assets such as corporate high yield, municipal high yield, bank loans, and emerging market debt may increase income and have historically shown less sensitivity to changes in interest rates.
In October 2022, Singapore’s sovereign wealth fund GIC partnered with Morgan Stanley Capital International (“MSCI”) to attempt to address the evolving complexities of modern portfolio construction. In their paper, the researchers suggest that certain “macro risks — including supply-driven inflation, a less-credible central bank, rising real rates and slowing productivity growth — were modest risks in recent decades but could significantly change the trajectory of the markets in the years ahead”[3].?GIC and MSCI suggest a new framework?for asset allocation that aims to incorporate macroeconomic considerations into the portfolio construction.
The above is just one example of the evolution of the traditional asset allocation mix. Another curious case is that of Yale university endowment fund, which has approximately 5% of its portfolio allocated to stocks, 6% to bonds, and the remaining 89% to alternative sectors and asset classes.?
In a recent investor report, Yale notes that “In 1990, over 70%?of the Endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for less than 10%?of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment.”
This strategy is not just happening in the institutional investment community, the shift of so called “smart money” to private assets is taking place across all investor types. See below asset classes that have offered higher distributions the traditional “60/40” portfolio.
Source: Morningstar, Goldman Sachs Asset Management. Distribution rates represent the asset-weighted median 12-month yield of representative Morningstar peer groups through 9/30/2022.
Wendy Lin at Goldman Sachs Asset Management released a report in January 2023 saying “In a lower return environment, we think the stability of total returns can be enhanced by increasing the component that comes from income, which tends to be more reliable than price appreciation. While rates increased in 2022, a 60/40 portfolio still only generates a modest 2.0% yield—a far cry from the 5%+ offered in the ‘70s, ‘80s, and early ‘90s. … On the fixed income side, assets such as corporate high yield, municipal high yield, bank loans, and emerging market debt may increase income and have historically shown less sensitivity to changes in interest rates. Given the potential for challenged returns for these traditional assets, we believe investors should think outside the box in their search for returns.”
While Yale’s portfolio mix may not be suitable for most, we think it worthwhile to pay attention to this trend in the market. It is evident that the delicate craft of portfolio construction is constantly evolving to adapt to the ever-changing economic landscape. While traditional portfolio guidelines may hold true for many investors, optimal diversification needs to be top of mind.
[3] chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.gic.com.sg/wp-content/uploads/2022/10/GIC-ThinkSpace-Building-Balanced-Portfolios-for-the-Long-Run.pdf