MARKET COMMENTARY

Is The Traditional 60% Equity and 40% Fixed Income Portfolio Allocation Dead?

12.03.2020 - Douglas Cohen

“Everything dies, baby that’s a fact

But maybe everything that dies someday comes back”

-Bruce Springsteen, Atlantic City (1980)

 

For as long as we can recall the 60% equity/40% fixed income allocation has been the starting point for most investment portfolios, with clear tweaks depending on investment objectives, risk tolerance, age, yield/income requirements, comfort level with alternatives, etc. However, in an era when the Barclays Aggregate Index has a nominal yield of about 1% and the earnings yield (meaning the inverse of the price-to-earnings ratio) on the S&P 500 Index is less than 5%, all else equal, one may anticipate a roughly combined 3% forward expected return on a nominal, pre-tax basis.[1] Such a return would fall well short of the approximately 10% annual return that a traditional domestic-oriented 60/40 allocation has delivered over the past 10 years.[2] Suffice it to say that investors of all stripes, from middle-income families to the largest endowments and pension plans, have been trying to balance the current reality with their traditional annual return targets (without taking on undue risk).

Low Real Bond Returns Are Likely for Some Time

The extremely low level of interest rates is the key element threatening to throw the traditional 60/40 allocation off kilter. Simply put, the downside risk for yields appears to be about zero given the Fed’s strong commitment to avoiding negative nominal interest rates while the upside yield risk looks virtually unlimited. Inflation seems to be the key wildcard as there’s an argument for a “Japanification effect” of prolonged low growth and disinflation, as well as a case for sharply higher inflation if the Federal Reserve essentially chooses to monetize the country’s rapidly rising debt.[3] The middle of the bell curve—the base case—is that things stay largely as they currently are for several years which implies meager, flat-to-negative real returns from bonds.

Higher Yields Can Be Found …

Given that backdrop, investors may be able to eke out somewhat higher returns by shifting a portion of the traditional bond allocation into vehicles such as convertible bonds, preferred stock, low market-correlation hedge funds and high yield bonds. (Traditional dividend-oriented stocks such as electric utilities and real estate investment trusts (REITs)[4] can also fill some of the conventional bond allocation. For our part, we have generally tried to reduce broad REIT exposure that includes highly stressed areas such as commercial real estate and retail malls in favor of areas such as cell phone towers, industrial warehouses and data centers. We have also been taking a closer look at emerging market debt, although the yield pick-up would clearly come with additional risks that may keep us on the sidelines. To the extent that longer duration US Treasuries likely offer lower-than-normal ballast, we’ve generally favored higher-than-average cash/ultra-short-term duration holdings. Hedging strategies such as those that incorporate equity put options may also be considered.

… But Some Risks May Loom Ahead

While the fixed income portion of the 60/40 portfolio may offer a modest level of income, it has often played an important role in a diversified portfolio by providing ballast during equity selloffs. However, that historical relationship is not guaranteed. Indeed, one potential risk is that US Treasuries and similar forms of fixed income could fail to serve as a traditional safety net by rallying when the equity market falls. This happened in both the March and September equity selloffs this year. At some level this likely links to the potential unintended consequences of what many consider financial repression due to the Fed’s seemingly ironclad commitment to keep rates super low. Just to muddy the waters further, a prolonged period of historically anomalous equity-bond correlations could cause systemic dislocations given roughly $400 billion (often leveraged) amassed in so-called risk parity funds.[5]  

Adapting the Traditional Portfolio to Today’s Market

This may all sound rather ominous for the traditional 60/40 portfolio. But harkening back to the earlier Springsteen quote, we wouldn’t completely dismiss the longer-term power of broad 60/40 oriented diversification. Rather, we would mostly look to tweak that diversification as mentioned above. The TINA (“there is no alternative”) mentality for equities has been in place at least since former Fed Chair Ben Bernanke’s 2010 Washington Post op-ed[6] in which he specifically highlighted the Fed’s desire to keep rates low, in part to spur the equity market and produce a wealth effect. In general, the major US equity indices have subsequently been expensive relative to history on almost every measure, except for dividend discount type models that specifically incorporate the low interest rate element. However, many value-oriented equities, foreign-domiciled equities and small-cap equities have not appeared particularly expensive relative to history on many measures. As such, we would not suggest abandoning the broad 60/40 structure at this time but, more than ever, would look to adapt it to the risk-return priorities of each unique portfolio. While it may not be the joyful holiday season message one might hope to hear, our best sense is this seems to be a time for investors to adjust their return expectations more than their overall allocations.

 

 

 

[1] Source: Bloomberg, as of 11/27/2020. The example is for illustration purposes and calculated as (60% Equity allocation times S&P 500 Index earnings yield) plus (40% Fixed Income allocation times Barclays Aggregate Index yield) equals forward expected return on a nominal, pre-tax basis. Performance data represents past performance, which does not guarantee future results.

[2] Source: Bloomberg, as of 9/30/2020.

[3] An example of monetizing debt is if government bonds held by the Fed come due, the Fed would return any funds paid to it back to the US Treasury. Thus, the Treasury may "borrow" money without needing to repay it.

[4] REITs, or real estate investment trusts, are companies that own or finance income-producing real estate across a range of property sectors.

[5] Source: Bloomberg, “Bridgewater’s Risk-Parity Shift Jolts a $400 Billion Quant Trade”, Justina Lee; 9/2/2020. Risk parity funds use an approach to investment management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital.

[6] As of 11/4/2010.


This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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