60/40 portfolios: end of the road?

Multi-asset investors face an inevitable question after an historic, and painful, year for equities and fixed income: has the 60/40 portfolio run out of road?

 

Need to know The severe – and unexpected – recent underperformance of the 60/40 portfolio and its variants has exposed clear shortcomings in traditional multi-asset approaches For many balanced portfolios, capital allocation masks concentration risks – resulting in a false sense of diversification as strategies become over-reliant on equity risk Diversifying by risk premia, instead of capital allocation, can help investors adapt to unpredictable market shifts and smooth the investment journey, in our view

 

Breaking down

In 2022, multi-asset strategies suffered as equities and bonds sank together. It was particularly striking that conservative portfolios favouring bonds slumped as much as those with more balanced or equity-heavy exposures: allocations to stocks may have varied from 20%-80%, but performance was essentially the same at about -17% to -20% for the year (see figure 1).

This underperformance for the 60/40 and its variants was broadly unexpected, too. In the disinflationary environment of the preceding 30 years, fixed income was a refuge during equity-market declines, with sovereign bonds being the default allocation for lowering portfolio risk and volatility. This was at the heart of Nobel laureate Harry Markowitz’s Modern Portfolio Theory, which led to the widely accepted belief that diversification is the only free lunch in investment, in practice. In general, the approach worked – even during the Global Financial Crisis (GFC), when risk profiles behaved as expected (even if performance was extremely negative). Strategies with higher allocations to bonds weathered the storm better than those with greater equity exposure (see figure 1).

But 2022 broke this relationship. Not only did conservative, balanced and growth risk profiles generate similar returns, they followed similar paths, too. Equity weakness was not offset by bond strength: the 60/40 and its cousins failed.

 

FIG 1. Comparative performance of equity-bond allocations: 2007-09 vs 2022

Source: LOIM, Bloomberg. Past performance is not a guarantee of future results.

 

Uncomfortable truths

This revealed two clear shortcomings about common multi-asset approaches, in our view:

1. It showed how risk profiling (or control) based on long-term correlations between asset classes can put investors in uncomfortable situations when these relationships break down. Covariance structures – the patterns describing how bond and equity returns behave jointly – can be volatile enough to challenge the most well-conceived diversification strategy. Change is constant and risk is restless: at some point, what worked for more than a decade was due to break down, even in a matter of quarters, if not months.
2. Many balanced portfolios are too dependent on equity risk – even if their allocations to bonds make them appear to be diversified. Since the early 1970s, balanced portfolios have followed major equity-market downturns, albeit not to their full extent. In our view, this shows how the exposures of many multi-asset strategies to different risk premia could have been better diversified, irrespective of how the portfolio was split across asset-class lines (see figure 2).

For these strategies, capital allocation has masked concentration risk, leading to a false sense of diversification.

 

FIG 2. Follow my lead: balanced strategies track equity-market downturns

Sources: LOIM, Bloomberg, For illustrative purposes only. Data as at 30 November 2022. Indices used: Government bonds: Bloomberg Barclays US Govt Total Return Value USD; Equities: MSCI USA. Balanced Portfolio: 60% equities, 40% bonds, rebalanced monthly. Past performance is not a guarantee of future results. Holdings/allocation may change. 1 It is a method used to measure the financial risk of an investment. It is the extent or the amount of losses carried by a financial instrument since it starts to decline from a high point until it bounces back to surpass such point.

 

Should investors abandon the 60/40?

Given their recent failure, should traditional constructs like the 60/40 portfolio be ditched? To understand last year’s performance, we believe investors should consider what has driven the returns of this multi-asset mainstay over a longer timeframe.

In figure 3, we compare the performance of a 50/50 equity/bond portfolio¹ with what we judge to be an appropriate long-term objective, cash plus 4.4%. In the long run, the 50/50 meets this target, but there are two extraordinary periods:

• The late 1970s, a time of high and rising real rates, when it underperformed by 30%²
• The years following the GFC until late 2021, in which rates were on the floor for more than a decade, and it outperformed by 20%

 

FIG 3. Long-term returns from a 50/50 portfolio

Source: LOIM, Bloomberg. Past performance is not a guarantee of future results.

 

This yields two conclusions. First, as in the late 1970s, rising real rates were detrimental to the balanced portfolio’s 2022 return. Second, the 50/50 benefitted from enormous central-bank stimulus following the GFC and Covid-19 pandemic. In our view, such accommodation is unlikely to return any time soon.

For an investor questioning whether to dismiss the 60/40, we believe these insights call for prudence. Last year was not the first time that the strategy has underperformed severely, and its prospects in the coming years appear linked to the path of real rates. Compared to late 2021, the outlook is more favourable, in our view.  

The real question, we believe, is how a multi-asset portfolio can be better engineered for a smoother journey – to complement, rather than replace, the 60/40.  

 

Know your diversifiers

Another lesson from 2022 – alongside the shortfalls of depending on long-term correlations and the dominance of equity risk in balanced portfolios – is that diversifying by capital allocations is not totally effective. Investors need to work harder: the free lunch must be earned, after all.

How can genuine diversification be achieved? Rather than rely on long-term correlations or risk metrics, investors should consider that there is no guarantee that any one asset class will consistently offer shelter across cycles. For instance, before bonds were became the chief diversifier during the disinflationary trend of recent decades, commodities held that role in the 1970s (see figure 4).

 

FIG. 4 New regime, new diversifer

Source: Bloomberg, LOIM. For illustrative purposes only. Holdings and allocations may vary over time. Past performance is not a guarantee of future returns.

 

A different perspective: risk-based investing

How can an investor prepare for such changes, and detect them once they are in motion? As we’ve seen, long-term asset-class correlations can’t provide these insights. In our view, understanding and diversifying among risk premia provides a superior way of helping a multi-asset portfolio to provide consistent exposures to different sources of return. This risk-based approach to multi asset informs portfolio investments across asset classes – and any adaptive of dynamic positioning required – in contrast with the rigid allocation policies guiding 60/40 portfolios (see figure 5).

 

FIG 5. Underneath the hood: differences between risk-based and capital-allocation strategies

Source: LOIM, Bloomberg. Past performance is not a guarantee of future results. For illustrative purposes only.

 

The ultimate aim of a risk-based approach is to provide positive, stable performance across market cycles through exposed to truly diverse sources of return. The emphasis on stability and diversification means that it is unlikely to provide the strongest returns in any one environment but should perform well in many and help mitigate drawdowns, smoothing the investment journey.

 

All roads, any weather

Risk-based investing has driven our All Roads philosophy since we launched our first multi-asset strategy in January 2012. Seeking diverse sources of return for conservative, balanced and growth risk appetites, we invest beyond developed- and emerging-market stocks and bonds to markets including commodities, volatility, alternative risk premia and even cash – the key diversifier when correlations go to one.

From this diversified, liquid universe, we define a strategic asset allocation balanced across three macro scenarios – expanding growth, declining growth and inflationary shocks – and complement this with dynamic strategies that respond to market and macro signals. Seeing drawdown, not volatility, as a key measure of risk, we adjust total portfolio exposure and use tail-risk hedges to manage the impacts of adverse markets. The All Roads process is disciplined, transparent and has a track record of progressive improvement through our continuous R&D programme.

The experience of 2022 reinforced one of our core principles: to seek genuine diversification – not the illusion of it – through flexible risk allocation instead of capital allocation. Rather than question whether the 60/40 portfolio has run out of road, we believe investors in such strategies should rethink diversification. A risk-based solution like All Roads helps to do just that.

Sources

[1] We are aware that in some regions, investors know 60/40 portfolios to be comprised of 60% fixed income; for others, they hold 60% equities. Here, we are using a 50/50 equity-bond allocation to suit most investors with a traditional multi-asset allocation.

[2] To derive this natural rate of excess return, we simply calculated the excess return above cash necessary for a balanced 50/50 allocation to spend as much time above and below the target over the whole period. We note that this excess return would be consistent with an excess of approximately 7% for equities and 1.7% for bonds over this period, which seems sensible to us.

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