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.
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.
Now let’s assume the investor takes 5% away from equity and 15% from fixed income and directs that toward a portfolio made up of four alternative strategies.
(Note: Alternatives are represented by the HFRI Equity Market Neutral Index, HFRI Merger Arbitrage Index, HFRI Macro: Systematic Diversified Index, and HFRI Equity Hedge Index. While this portfolio actually has a return of 8%, we chose to discount this to 5% given lower overall return expectations for all investments.)
Here, if stocks garner the same 5% return, their contribution to a 55/20/25 portfolio would be 2.75% (0.05 x 0.55). Additionally, with a 5% return for alternatives and 0.25% return for bonds, their respective contribution is 1% (0.05 x 0.20) and 0.06% (0.0025 x 0.25). Thus, with a total portfolio return of 3.80% and an equity beta of 0.59, the investor raises their return level without increasing risk.
The extra 70 basis points may not sound like much, but in the context of the current investment landscape, any improvement is meaningful. As we’ve mentioned, investors likely will face a low-return environment going forward.
Lofty stock valuations don’t reflect the current economic reality of the pandemic-induced slowdown. As such, it is reasonable to believe that equities could be volatile, or fail to achieve much higher returns after the run-up since March. As discussed, the return prospects for fixed income are even more dim.
Against this backdrop, any incremental return improvement an advisor or allocator can make to a client’s portfolio is a bigger value add than it would be in a roaring bull market. Alternatives can provide that improvement, without adding more risk.
Josh Vail, CAIA, is president of 361 Capital.