Traditional expectations of the 60/40 portfolio may be due for a rethink.
Based on today’s yield levels, bonds simply can’t contribute to a portfolio the way they have historically. For advisors, this could mean shifting assets away from fixed income and into alternatives if they want to preserve the risk/return profile that the 60/40 portfolio has historically delivered.
Here we consider the current challenges of a 60/40 portfolio, and the simple math behind how advisors can achieve a more optimal solution for clients.
Diminishing Returns of Fixed Income
While fixed income’s primary role is as a diversifier, bonds must still provide some level of return if they are going to comprise a sizeable allocation within a portfolio.
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Yet, the Federal Reserve’s recent policy shift adopting a looser inflation target for interest rates implies it will likely wait even longer to raise rates from current levels — meaning low return expectations for fixed income are likely to endure.
The only option to improve the return profile within a fixed income portfolio would be to take on increased credit risk, but this in turn makes the fixed income allocation more correlated to equities. Further, a lagging economy due to the pandemic also raises default risk among high-yield bonds.
Tweaking the 60/40 Allocation
If advisors want to achieve the same level of return that a 60/40 portfolio has historically provided without taking on more equity risk, they must add new asset classes to the mix. Let’s consider, for example, how adding alternatives can help achieve this objective.
To set the stage, consider that if stocks earn a 5% return, their contribution to a 60/40 portfolio is 3% (0.05 x 0.60). For bonds, we used the current five-year yield of 0.25% leading us to a 0.10% return contribution (0.0025 x 0.40). In total, this equates to a total portfolio return of just 3.10% with a beta of 0.60.