For decades, the starting point of any conversation about asset allocation used to be the 60:40 portfolio – a basket of securities comprising 60% equities and 40% bonds. This made sense when the characteristics of both equities and bonds were reliable. Equities have historically delivered an annualised return just north of 6%, although short-term returns were more uncertain and vulnerable to positive and negative surprises. Adding high-quality bonds to the mix provided the ultimate shock absorber, since their return streams were well known in advance, the principal would almost certainly be repaid and price volatility was accordingly lower. With the higher long-term returns from equities almost assured, but the need to dampen volatility ever-present, it was logical to hold both with a higher weighting assigned to equities.
This combination has worked incredibly well, with a 60:40 portfolio passively invested in the S&P 500 and the Barclays Global Aggregate USD hedged index compounding at 6.5% from 1 August 1996 to 1 August 2016. This is versus just 3.8% for active asset allocators, as represented by the Lipper Global Mixed Asset Flexible index over the same period. But combine the fact that there is no guarantee that these passive returns will continue with the horizon bias that deludes many investors into believing past returns will project into the future, and the potential for upset is very real.
Passive 60:40 has trounced active multi-asset managers
Performance from 31 Jul 1996 to 1 Aug 2016
A combination of unique historical circumstances conspired to boost returns in both equities and bonds over the past few decades, meaning that the 60:40 model was never really tested. In equities, globalisation and technology-driven productivity gains from the mid-1990s boosted profits for many companies, particularly in the US. In bonds, the determined crushing of inflation by then-Federal Reserve chairman Paul Volcker opened the era termed ‘The Great Moderation’, in which yields steadily fell from the early 1980s. Finally, cheaper access to markets via ETFs has helped widen participation in both equities and bonds.
But today the upside for both asset classes seems limited. US Treasury bonds are trading at extremely low yields. In early July 2016 the 10-year yield touched 1.32% – the lowest level since the first US bond issue in 1790. It also suggests a very poor inflation and growth outlook, something not borne out in most other economic indicators. Government bond yields comprise a growth element, an inflation element and in the case of US Treasuries a negligible liquidity and default premium. 10-year inflation expectations in the US now stand at 1.44% while consensus growth for 2016 is 1.9%. Even though these are hardly stellar figures, they do suggest that current bond yields are too pessimistic and that some price correction is necessary.
As for equities, the laundry list of headwinds – both short term and secular – is daunting. US profits have been in decline for a several quarters now and their long-term outlook in the face of rising wage costs and increasing competition from emerging markets and digital platforms makes a 6% return target look rather optimistic. Furthermore, valuations are not outright cheap and the political context is adding to investor uncertainty.
Bonds yields and stocks reach extreme levels
From 31 Dec 1962 to 3 Aug 2016
With both bonds and equities expensive and facing fundamental deterioration, the ongoing reliability of the 60:40 model cannot be assumed. Observations, however consistent over a prolonged period, are not the same as a rule. The solution lies not so much in forcing investors to become market timers, but in making better choices for the long run.
Alternative approaches that can generate a return stream independent of these two major asset classes do exist, and many are competitively priced. They include innovative market-neutral equities harnessing the power of ‘big data’; smart beta themes in equities; total return bond funds; mortgage-backed securities and target return investing via direct securities. When managed by the right investment professionals, these can help clients achieve superior risk-adjusted returns versus traditionally populated multi-asset models.