Can static 60/40 portfolios still deliver?

Sticking to a static allocation between equities and bonds of 60/40 has resulted in very different outcomes in different decades. For the next decade we see a number of challenges for static 60/40 portfolios:

• We expect significantly lower returns in these two narrow asset classes over the longer term
• Correlations between asset classes and relationships to the phase of the economic cycle are likely to become less stable as a result of the significant fiscal stimulus that has been provided to combat the economic effects of Covid-19
• Uncertainty abounds, requiring investment hedges to protect the portfolio against detrimental scenarios, something that cannot be achieved with just two asset classes.

Looking back at the past is a necessary exercise, but investors should not stop thinking about tomorrow.

How 60/40 portfolios have fared

Static 60/40 portfolios have delivered strong performance in recent years as both equities and bonds have benefitted from favourable policy tailwinds. Portfolios with a high allocation to US assets have performed particularly well.

It has been an unusual period in history as correlations between key asset classes have been negative. Fixed income has had the benefit of falling interest rates to generate strong returns at the same time as equities have benefited from the longest bull run in history.

In this environment, dynamic and diversified approaches to asset allocation have been challenged. However, we think the future looks very different...

The 2010s were atypical

The purpose of investing for the future is typically to generate returns. On that basis, one asset reigns supreme: equities are the undisputed king of long-term return generation. But, of course, there’s a catch. With high returns come high risk. Many investors cannot, or will not, stomach the short- and medium-term volatility that comes with investing in equities.

This is where multi-asset class portfolios come in. The aim of (growth-oriented) multi-asset investing is to reduce the risk associated with the ultimate growth asset (equities), but without sacrificing too much in the way of returns.

The classic solution was to allocate some capital to government bonds, resting on the notion that government bonds tend to move inversely to equities. The rationale is understandable: a government bond is a relatively safe, government-backed asset, while an equity is a relatively less safe corporate-backed asset. The assumption is that any short-term losses in equities would at least partially be offset by short-term gains in government bonds, smoothing the path of overall returns.

That assumption has proven fair since the great financial crisis of 2007-2009. Over the period since then, equities staged their longest bull market in history while bonds caught a tailwind of unprecedented global monetary stimulus.

US asset owners have typically had the equity portfolio of their portfolio invested in US large cap equities and the bond portion of their portfolio invested in US aggregate bonds. This portfolio is represented by the blue dot in Figure 1.

But over the period since the crisis, diversifying into global exposure was costly in terms of returns. Clearly, US exceptionalism took on a new meaning as the S&P500 rose to all-time highs while the rest of the world lagged; not all equity bull markets were created equal.

Over the period following the great financial crisis, the world went through an atypical economic cycle, in which the US grew strongly, while the rest of the world struggled to gain momentum. Figure 2 shows industrial production paths in the US and the rest of the world in the most recent expansion compared to previous expansions, highlighting the difference in economic growth acceleration.

We are in a dynamic world

The monetary policy tailwind for bonds and the exceptionalism of the US stock market were unique features of 2010s that helped static 60/40 portfolios deliver strong returns. Every decade – or every economic cycle – is different, however, and sticking to static allocations has resulted in very different outcomes over the decades. As can be seen in Figure 3, in the 1990s a 60/40 portfolio provided 12% p.a. return for taking around 10% risk. In the 2000s a 60/40 portfolio taking a similar level of risk delivered just 1.5% p.a.

This can cause an issue for institutions which typically have a specific outcome (risk and/or return) that they need to target, such as US pension plans needing to target, say, 7.5% p.a. return.

New decade, new challenges

So far, we’ve established that a static asset allocation works sometimes, but not always. What matters, though, is the future, and over the next ten years we see two major challenges for a static approach.

First, equity and bond returns in the future are likely to be lower than the past 10 years. We covered this in our research on Inescapable Investment Truths for the Decade Ahead, and we show an updated version of one of our charts from that paper in Figure 4. We’re not the only commentators that have this view; a number of observers have recently highlighted that forward-looking returns are generally expected to be lower than historical returns.

The numbers in Figure 4 would mean that the simple 60/40 portfolio that we have looked at in this paper is likely to deliver less than 5% p.a. over the next 10 years.

Static portfolios rely on well-behaved correlations between asset classes. This makes instability in correlations a key risk for static multi-asset investors, but an opportunity for dynamic multi-asset investors.

As Figure 5 shows, persistent negative correlation between equity and bonds is a recent phenomenon – for most of history, correlations have fluctuated around zero or within positive territory.

We’ve already seen massive monetary stimulus push equities and bonds in the same direction post the global financial crisis of 2007-09. Now, the introduction of a new wave of fiscal stimulus as a result of the impact of Covid-19, is likely to bring further correlation uncertainty.

Much will depend on how bond investors respond; will they punish governments for their higher debt burdens as the ‘bond vigilantes’ did in the 1990s? Or will they give in to the view of the ‘modern monetary theorists’ that debt doesn’t matter?

The textbook answer is that higher debt burdens lead to higher yields and a steepening of government bond curves as investors demand a greater risk premium – either because of higher expected inflation or because of fears of future insolvency. But the evidence from a decade of quantitative easing is that investors do not seem to care about how – or whether – debt burdens will ever be paid back.

In any case, the attractiveness of bonds as a hedging asset is uncertain; looking at Figure 6, the carry available on bonds has diminished significantly over the last ten years. Although the last 30 years have posed many challenges for investors, we perhaps under-appreciated how much we benefited from bonds as a positive carry hedge.  Sometimes you don’t know what you’ve got ’til its gone.

Casting your net more widely

We’ve always argued that asset owners should ‘cast their net’ more widely. Splitting the last 15 years into stages of the economic cycle, we can see that the flexibility to use different asset classes in different cyclical environments can be valuable. (Cycle stages based on our economists’ model of the US output gap -a measure of the economy's actual output vs. its capacity for output).

Figure 7 shows that the best and worst performing asset classes are different in each stage, and the difference between the best and worst returns can be stark. Being able to adjust the asset allocation and use different asset classes to better achieve an outcome an institution needs is critical.

For us, diversification and dynamic asset allocation are intrinsically linked. Asset classes compete with each other for a place in the portfolio, not just on their individual properties, but on their role in a portfolio context - that is, on their ability to improve the return/risk trade-off in the portfolio.

The continuous competition between asset classes for a place in the portfolio is precisely what dynamic asset allocation means. Casting our net more widely, then, means discouraging static asset allocation and encouraging a continuous assessment of a broader range of asset classes for inclusion in the portfolio based on asset class valuations and the economic cycle.

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