The challenge with the 60/40 portfolio approach

The challenge with the 60/40 portfolio approach
Prices for food commodities reached their highest levels ever last month because of Russia's war in Ukraine (credit: AP Photo/Efrem Lukatsky)

To quote John Burgon’s "Petra", the 60/40 portfolio is a strategy "half as old as time". 

The approach can be traced back as far as 1929, when the Vanguard Wellington Fund was launched, offering a portfolio invested in around one-third bonds and two-thirds stocks.

Designed for a medium-risk investor, the 60 per cent equity allocation intended to provide capital growth, while 40 per cent fixed income allocation looked to provide diversification and an income to investors.

The portfolio was based on the basic macroeconomic factor that bond prices rise when stock prices drop and vice versa.

This relationship allowed the 60/40 portfolio to improve the risk-adjusted returns of a portfolio and for many years it did just that.

However, 2022 has presented a challenge to this model as aggressive commentary from the US Federal Reserve in January triggered a bond sell-off and the Russian offensive in Ukraine drove volatility in the equity markets.  

Since 1980, yields have steadily fallen as major central banks’ interest rates have dropped, eroding away the income that once made bonds so attractive.

The current yield on the US 10-year government bond is 2.32 per cent, only slightly higher than the dividend yield of the S&P 500’s 1.79 per cent.

On this side of the Atlantic, the dividend yield of the FTSE 100 stands at 3.52 per cent next to a 10-year gilt at 1.61 per cent. 

A rising tide has lifted all boats. A long-running decline in real (inflation-adjusted) interest rates has helped keep equity valuations aloft, as financial markets have increasingly de-coupled from the fundamentals of the economy.

Most recently, quantitative easing and the coronavirus support measures have pushed these factors into overdrive. 

Many commentators point to Shiller’s cyclically adjusted price-to-earnings (Cape) ratio to illustrate the exuberance in equity markets at present given that the Cape ratio for global markets is approaching the highs of the dotcom bubble.

While the Cape ratio is only one measure of global equity valuations, almost all valuation metrics paint the same picture: global-listed equities are at multi-decade highs.

It is important, however, to also note the divergence between equity markets, neatly encapsulated in the chart above showing the Cape ratio the US S&P 500, dominated by tech, and the FTSE 100, with its much larger weighting to the staider consumer staples, financials, healthcare, industrials and energy names.

The composition and valuation levels in the FTSE has meant that in the sea of red in developed equity markets where the Dow Jones is down nearly 4 per cent and the Nasdaq down 7 per cent from the start of 2022, the FTSE 100 has risen just over 2 per cent. 

The past 50 years have been characterised by falling interest rates, persistently low levels of inflation and volatility. Most developed market investors alive today have never encountered significant inflation.