InvestmentsNov 23 2021

Fresh questions raised over future of 60/40 portfolios

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Fresh questions raised over future of 60/40 portfolios
AP Photo/Ng Han Guan

Over the past 18 months, equity and government bond markets have again begun to behave in ways that are confounding professional investors.

Historically there has been an inverse relationship between the two asset classes, but the elevated prices seen in recent years have led some to question the future of that dynamic. 

Market activity in September seemingly proved these critics’ point, as both equity and government bond prices fell more or less in tandem.

This has again called into question the traditional 60/40 portfolio of equities and bonds, and whether it is still suited as a building block of the investment process.

A typical 60/40 portfolio containing US equities and government bonds fell 3.5 per cent in September, according to calculations from the Financial Times.

This was the biggest loss faced by these portfolios since a 5 per cent drop in March 2020, according to the FT.

But industry experts are still split on whether this marks the beginning of the end for 60/40 portfolios.

Duncan MacInnes, co-manager of the Ruffer Investment Company, said investors should be asking themselves what to do with the 40 per cent of their portfolios that is invested in bonds and equivalent instruments.

“The reason they should be asking that question is because the bonds or bond proxies guarantee low returns; you know that with certainty from where yields currently are,” he said.

“And then we are also increasingly convinced that they have diminishing protective or diversifying characteristics. 

“So low returns that you might not diversify, so what’s the point?”

At the moment it is an unusually dangerous time to be in a passive 60/40 portfolio.Dan Brocklebank

He added the monetary and fiscal response to the pandemic had “catapulted” investors into a new economic phase.

“That regime is going to be far less friendly to asset owners than the last regime.

“Also, and this is the important bit, cross-asset correlations are going to be different in the new regime to the old regime. 

“Therefore, you need a different portfolio from the one that's done so well over the last couple of decades. And you need to think differently about the way that you put those assets together.”

He said this was the biggest portfolio construction challenge faced by the wealth management industry. 

Dan Brocklebank, head of the UK business at Orbis Investments, noted static allocation to assets did not provide static return potential and static risk. Given the current state of affairs, that might create problems for passive funds. 

“This is because asset valuations are changing all the time. There may well come a time when stock markets and bond markets are attractively valued, and passive might be great. 

But at the moment, he added, stock markets and bond markets are very expensive, and credit spreads are near record lows with valuation spreads within stock markets very wide.

“So at the moment it is an unusually dangerous time to be in a passive 60/40 portfolio.”

He said the answer was to move from nominal assets to real assets.

“You move from conventional assets, asset and portfolio construction to unconventional assets and portfolio construction. Those are just a few words. But these are really, really big, profound changes.”

However he warned most of the industry was not set up for this change.

“They're hamstrung with benchmarks. They just can't deviate from benchmarks. Or because they're not set up to own your unconventional assets, for a variety of reasons."

Brocklebank added there was a behavioural change that must happen which might also prove difficult in practice.

“[The 60/40 portfolio] is baked in very much in the heads of most financial advisers. 

With markets vulnerable to both a rates shock and a growth shock, simply allocating 40 per cent to bonds - or more correctly to rates - no longer offers the same level of protection to equities and is therefore less useful as a portfolio tool.David Storm

“We know people don't like change, we know people anchor all the behavioural biases, so it is difficult for them to change. 

“But what we’re really saying is ‘okay, it's difficult to change, but why don't you just diversify some of your portfolio for starters.’”

However, in the face of repeated warnings about 60/40 portfolios, the performance of some of the traditional mainstays remains reasonable.

Many intermediaries still use Vanguard’s LifeStrategy portfolios as a one-stop solution for certain clients. Year to date, the Vanguard LifeStrategy 60 per cent Equity fund is broadly in line with the IA Mixed Investment 40-85 per cent Shares average.

David Storm, chief investment officer at RBC Wealth Management, said there has also been an expansion in the number of portfolio tools over the past few years to help meet investors’ different objectives.

“There’s a clear evolution towards portfolio risk allocation as opposed to asset allocation, which is a more comprehensive and flexible approach to managing the risk in portfolios,” he said. 

“With markets vulnerable to both a rates shock and a growth shock, simply allocating 40 per cent to bonds - or more correctly to rates - no longer offers the same level of protection to equities and is therefore less useful as a portfolio tool.”

To counter this, he said, there are many other instruments available, with the most obvious being the use of put options for downside protection. 

“However, just like fixed income rates exposure, it’s not something you want to hold at all times, rather puts are just one tool that can be used at different stages in the market cycle to help manage total portfolio risk.”

However, not everyone is sold on this new line of thinking.

Roger Webb, investment director at Abrdn, said when rates are at current levels everything looks expensive, although credit still offers a real return or real yield.

He added that because some find it quite difficult to justify government bond investment, he is now seeing a higher demand from [adviser] clients for more flexible products that can move the risk dial up and down, to ensure they’re not exposing clients to any downside risks.

“Several years ago the majority [of the 40 per cent bond allocation] would have found its way into eight-year duration, investment grade corporate bonds, and those are great through most parts of the cycle because the spread component of investment grade tends to work in an opposite direction to the government yield component,” he said.

“So you tend to get the offsetting returns... until it all goes wrong and government bond yields rise.”

He mentioned strategic bond funds as becoming increasingly popular, as well as bond funds that aren’t tied to an index benchmark.

“Over the last five or six years we’ve seen a growth [in popularity] of short duration funds, private credit, and in funds that offer floating rate type solutions.”

Richard Ellis, financial planner at Ellis Davies, said everything in a portfolio must always be questioned.

“Our view is that everything you have in a portfolio, you have to question what is that there for,” he said. 

“Arguably the role of bonds in a portfolio has always been to dampen volatility, and to protect you when markets go about their business. 

“Our view is that actually, that hasn’t changed.”

He added markets will invariably turn once again in future.

“When they do, everyone will say ‘thank goodness we had bonds or cash in the portfolio’ and everyone who has run away from bonds and held something else will say ‘blimey, we should have just held some things that were not correlated to equities."

sally.hickey@ft.com