For more than three decades, the classic portfolio of 60 per cent equities and 40 per cent bonds has delivered an attractive balance of risk and return for investors, and so been a cornerstone of the portfolio construction undertaken by advisers in that time.
Over the past thirty years, a passive investor in global stocks and global government bonds earned 7.2 per cent per annum - close to the return of global equities in the same time period, but with much less risk.
Even in this year of gut-wrenching market moves, the long-standing strategy has delivered a positive return.
But after a three decade-long party, the time may be up for the strategy as we enter a new year and decade.
To understand why the 60/40 is so challenged now, we need to revisit why it worked so well in the first place.
There is nothing magic about the approach itself. Rather, the strategy achieved prominence at a time when the market conditions for it to prosper were ideal.
When markets are volatile, the trends of even one decade can feel permanent, rather than peculiar and transient.
Yet the last three decades have been peculiar in market terms, creating the precise conditions needed for the 60/40 portfolio to thrive
Within equities, sustained momentum has boosted passive strategies. Bonds have been a reliable counterbalance to equities, reducing risk. Falling bond yields have supported the returns of bonds and equities.
None of these three trends are carved in stone tablets, and in our view, none of the three appear sustainable in anything like their recent form.
The past decade in particular has been characterized by sustained momentum within markets, with the same stocks winning (or losing) year after year after year.
That is enormously beneficial for passive approaches like the 60/40, because passive investing is a stealth momentum strategy. It does not actively seek out momentum, but it does benefit from it and participate in it. Here is how that works.
Consider Microsoft. In 2018, Microsoft shares handily outpaced the wider market. That affects index funds in two ways.
First, it boosts the return of the passive index. Second, when Microsoft outperforms, its market value gets bigger compared to other companies, so Microsoft’s weight in the index grows.
What happens when the momentum continues? Well, if Microsoft outperforms again, as it did in 2019, its boost to index returns will be bigger, because its starting weight in the index was bigger. Its weight in the index will also continue to grow.
As long as the momentum continues, the winners keep winning, they keep boosting index returns, they keep getting bigger, and they keep making ever-larger contributions to the returns of passive funds.
But this pattern has a dark side—sustained momentum can also lead to heavy concentrations in the stocks that have recently performed well. The recent poster child is the FAAMG group of Facebook, Apple, Amazon, Microsoft, and Google. Today these stocks represent over 25 per cent of the S&P 500, making the S&P more concentrated today than it was even at the peak of the tech bubble in 2000.