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

With high returns come high risk. However, 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 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, the world went through an atypical economic cycle. Equities staged their longest bull market in history while bonds caught a tailwind of unprecedented global monetary stimulus. US exceptionalism took on a new meaning as the S&P500 rose to all-time highs while the rest of the world lagged.

New decade, new challenges

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. However, every decade – or every economic cycle – is different. Over the next ten years, we see some major challenges for a static approach.

First, equity and bond returns in the future are likely to be lower than the past 10 years.

Second, 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.

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. 

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.

The figure below 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.