The 60/40 Portfolio

The 60/40 portfolio¹ of stocks and bonds is a simple idea. Put 60% of your money in stocks, which provide growth. Invest the remaining 40% in bonds, which provide downside protection.

For many years, investors have been using this mix, or a variant of it, when building portfolios. It has performed admirably, producing an average annual return of 10.7% from 1976؎2019. It has also done a good job of protecting against losses. The 60/40 portfolio has only been down 20% or more in one year (2008). It has had positive returns in 93% of rolling 3-year periods. Both stocks (up 12.9% on average) and bonds (up 7.5% on average) have contributed to its performance.

During this golden age for the 60/40 portfolio, U.S. core bonds² yielded an average of around 6%. U.S. stocks had an earnings yield³ of around 5%.

The situation is drastically different today. The yield on the U.S. 10-Year Treasury is only 0.7% as of September 2020. The S&P’s P/E multiple of 29 results in an earnings yield of 3.4%. These facts are causing many to question the conventional wisdom of using a 60/40 allocation for achieving annual return objectives of spending plus inflation. Can this golden age for the 60/40 portfolio continue?

60/40 Portfolio Challenges Today

A 60% equity and 40% fixed income portfolio faces many structural challenges today and in the future. Below are a few reasons why:

• Stretched Valuations: Both equity and bond valuations have gradually risen over the last 30 years. Unprecedented accommodative responses from global central banks since the Great Financial Crisis (GFC) and most recently, the COVID-19 health crisis, have resulted in asset price inflation. More borrowing and accommodation effectively moves future returns to the present.
• Low Yields & Interest Rate Risk: Long-term monetary accommodation will most likely keep interest rates lower for longer, which negatively affects savers. The yield cushion that equity and bonds provide has compressed while bond duration has gradually extended over the last decade per the Barclays Global and U.S. Aggregate indices. Inflation expectations are benign in the near-term. However, a sudden shift higher could lead to a potential interest rate spike and negative price movement for bonds and equities.
• Future Growth & Debt Burden: The annual growth rate as measured by GDP has generally averaged 2% over the last several years. However, to achieve the 2% growth rate on a go-forward basis, exponentially more debt may be needed to stimulate the economy. Total public debt as a percent of GDP has dramatically increased since the GFC:

Portfolio Construction Alternatives

If we want to move away from the 60/40 mix to pursue higher potential returns, there is no “magic bullet.” Generally speaking, we have to take on more risk. Here are some of the common ways of doing this:

• Illiquidity: Investors can generally earn a return premium by taking on more illiquid strategies and investments. Private equity, private debt, and longer-lock investment vehicles (i.e. hedge funds) are a few examples of ways to implement more illiquidity into a portfolio. Generally speaking, these strategies generate return streams and risk profiles that differ from public markets but add a layer of complexity and underwriting.
• Leverage: Leverage is a double-edged sword; it can amplify both gains and losses. In recognition of a low growth environment and to meet return expectations, some investors have borrowed on either a portion or all of their investment portfolio. A prudent risk management solution is required to manage both underlying exposures and incurred fees.
• Concentration: Concentration is the opposite of diversification. While a diversified portfolio protects against losses from an individual holding, a concentrated portfolio provides upside potential from holding a few, big winners. One example of this: From January to July 2020, an equally-weighted portfolio of Facebook, Apple, Amazon, Microsoft, and Google would have returned 36%, compared to the S&P 500, which was up only 2%. Of course, the risk of performance shortfall is also greater with a concentrated portfolio that is reliant on a small number of names.
• Asset Allocation: Instead of sticking to 60/40, investors can increase their allocation to stocks, resulting in a 75/25 or 80/20 mix. Stocks generally have higher return expectations and higher risk. This is the most traditional way of increasing risk to meet higher return objectives over longer periods. However, in a world where stock returns are also expected to be muted, sticking to 60/40 may not be as effective as a 75/25 or 80/20 mix.

Conclusion

Just because a concept (like 60/40) is tried-and-true doesn’t mean that it will keep working forever. Going forward, there are reasons to believe that it may not work as well. We believe it will become increasingly important to thoughtfully manage and take risks to meet return objectives in this low-interest rate, low-earnings environment.

This article was written by Loren Asmus, CFA, CAIA, Vice President, Investment Research and Matthew Lui, CFA, CAIA, Vice President, Investment Research.

Mr. Asmus is a shareholder and part of Canterbury’s Research Group. He is responsible for the sourcing, due diligence, and monitoring of public market investment managers. He serves as chair of Canterbury’s ESG, Fixed Income, and Real Assets Manager Research Committees, and vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Mr. Asmus joined Canterbury in 2013 as an analyst serving institutional and taxable clients. Prior to Canterbury, Mr. Asmus was an institutional fixed income representative for Mutual Securities, LLC, where he provided fixed income solutions for county and city municipalities. Mr. Asmus graduated with a Bachelor of Arts from California State University, Fullerton, where he double majored in business administration, finance, and music performance, jazz studies. He is a CFA® charterholder and a Chartered Alternative Investment Analyst.

This article was written by Matthew Lui, CFA, CAIA, Vice President, Investment Research. As a member of Canterbury’s Research Group, Mr. Lui is responsible for sourcing, evaluating, and monitoring traditional, long-only equity managers. Mr. Lui serves as the chair of Canterbury's Global Equity Manager Research Committee and the vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Prior to joining Canterbury, Mr. Lui was a trader and research analyst at Knightsbridge Asset Management. He received his Bachelor of Arts in economics from University of California, Berkeley. Mr. Lui is a CFA® charterholder and a Chartered Alternative Investment Analyst.

Sources:
¹ 60% S&P 500 Total Return Index, 40% Barclays US Aggregate Bond Index, rebalanced annually
² Represented by the U.S. 10-Year Treasury
³ Calculated as 1/the average P/E Ratio of the S&P 500