60/40: Is there life in the old dog?

Given the unpredictable times in which will live, the investment model for success may well seem aloof. How is an investor to make the best of a situation where all models seem to be full of flaws, to some extent.

At the centre of the debate, as it usually is, stands the issue of the trusted 60/40 model. Many questions surround it. Is it dead? Is it still relevant? Recent history suggests that possibly both of these are true.

This most traditional of portfolios had a truly disastrous 2022 – performing worse than Chelsea football club – falling by 16%. That would put it beyond mid-table and closer to the relegation zone. One could counter this by pointing out that few asset classes emerged unharmed from last year’s market devastation.

But some investors suggest its relevance is non-existent. Jason Fletcher, chief investment officer at local government pension pool London CIV, says that, for him, the investment model is derelict. “60/40 has not been a basis for investing by open defined benefit pension funds for 30 years,” he says. “The introduction of alternatives and private markets has changed the picture.

“Asset owners have tended to move to growth-income and stabilising asset categories with an overlay for liquidity and ESG requirements. Note that correlations between bonds and equities change over time, as do the relative risk dynamics,” he adds. This is a pretty dismissive assessment of the 60/40 portfolio and an insight into why it will not be the investment answer for DB schemes.

Bouncing back

But it is not the whole picture. Neil Mason, assistant director and local government pension scheme senior officer at the Surrey Pension Fund, offers the perspective that the continuing relevance of traditional 60/40 portfolios rests on the assumption that returns from equities and bonds are negatively correlated. “This being the case, diversification of this type does reduce portfolio risks,” he says.

But current macro-economic circumstances have corrupted that idea. Higher interest rates and inflation volatility have been negative for bonds and equities alike. This meant the positive equity-bond correlations have been less successful, to say the least.

Some blame could be laid at the feet of the Fed and its peers. “Central banks have approached this current inflation environment as if flares and long hair were all the rage,” Mason adds. “As they only appear to have a hammer made circa 1970, everything looks like a nail, despite evidence that raising interest rates will be counter-productive by reducing the likelihood of investment in the structural changes needed to the supply side infrastructure that caused the inflation in the first place,” Mason says.

Jean Boivin, head of the BlackRock Investment Institute, has a similar take on the 60/40 debate, starting with how stocks have bounced back – and what this means. “Stocks and bonds have rallied this year. Some see this as reason to return to traditional portfolio approaches like 60% stocks and 40% bonds,” he says, adding: “Those used to work when both assets trended up and bonds o set equity slides.”

Expanding on this, he notes that sticking to a 60/40 mindset could be restrictive for investors. “A focus on any one asset allocation mix misses the point,” Boivin says. “A regime of higher volatility with sticky inflation needs a new approach to building tactical and strategic portfolios. We see the appeal of income getting more granular with views and are more nimble.”

Strong foundation

This presents a potential different approach to investment. And while this may shift the breakdown of a portfolio, there are reasons to suggest 60/40 is not dead at all. Albeit a slightly contrarian conclusion.

An allocation based on the traditional investing approach of using broad, public indexes of 60% equity and 40% bonds is having a strong start to 2023 after 2022 had been the worst year in decades. This is potentially a good foundational starting point for the 60/40 scenario to build on.

Boivin recommends that investors start with income. “The longer rates stay higher, the greater the appeal of income in short-term bonds,” he says. “We see interest rates staying higher as the Federal Reserve seeks to curb sticky inflation – and we don’t see the Fed coming to the rescue by cutting rates or a return to a historically low interest rate environment.”

This though reinforces the appeal of income in short-term paper. “We also see long-term yields rising on strategic and tactical horizons as investors demand more term premium, or compensation, for holding long-term bonds in an environment of higher inflation and debt,” says Paul Henderson, senior portfolio strategist at the BlackRock Investment Institute. So 60/40 lives, albeit in a varied form.

Effective investment

Beyond this potential meddling with portfolios there is a case of how 60/40 is an effective, viable investment strategy going forward. Leading to a point where 60/40 is not just viable, but one in which it is truly back from the dead. This argument is based on a two-pronged approach.

The first is historical. Over long periods, 60/40 produces the goods. Highly applicable to many investors, particularly pension funds. Here the numbers look good on all measurements.

In the decade to the start of 2022, the classic 60/40 portfolio generated an impressive 11% annual return. Even after adjusting for inflation, its 8.7% annual real return stands up well, despite the low interest rate environment.

Critics would no doubt counter that 60/40 during the infamous ‘lost decade’ that began in the 2000s generated a paltry 2.3% annual return and investors lost value on an inflation-adjusted basis.

But the wider historic line overall can be said to hold and does so for an interlinked second reason. Looked at in historic terms, when 60/40 has had a bad period of time – as it did last year – it has typically bounced back to excel for a long period.

For example, 2022 was only the sixth year when a 60/40 portfolio fell by more than 10% and, on average, cumulative returns have been strong in the subsequent one, three and five year periods. Markets, it is often said, have a tendency to repeat history. Meaning that this could be the ideal time to jump fully in with 60/40.

Also, the result of the troublesome market for 60/40 was that valuations for the 60 segment asset classes are now lower, and most are fairly valued. The notable exception, analysts have observed, are US stocks, which are more reasonably priced. The point being this offers investors opportunities along the way.

Positive outlook

Plus, both parts of the 60/40 equation look attractive going forward in other ways. The 40 part is in a good place, with real return forecasts for most sovereign bonds moving into positive territory.

And for the first time since the global financial crisis, interest rates in most currencies have settled at or above the so-called ‘cycle-neutral’ rate – the rate that prevails on average over the long term.

And the focus has been that while equities tend to gain much of the attention within the 60/40 portfolio more of the improvement in some projections stem from fixed income, with expected returns more than two times higher than they were going into 2022.

Based on this alone, far from being dead, the 60/40 portfolio could be poised for another strong decade. For US 10-year bonds, the cycle-neutral yield rises 0.2 percentage points, to 3.2% in a forecast by JP Morgan. Much higher starting yields push its return forecast up by 1.6 percentage points to 4%, as a result.

Indeed, the 10-year US real yields are at their highest level since 2009, offering positive return prospects after inflation. “Major investment-grade bond markets are priced to deliver a return after inflation between 1.5% to 2% over the next decade,” says Mike Coop, Morningstar’s chief investment officer.

Positive picture

Looking at the 60 segment, the picture is also positive. Projected equity returns is one of sharp rises, with one forecast suggesting developed market equity will jump 3.6 percentage points to 8.4% [in dollars], and the emerging market equity forecast sees an increase of 3.2 percentage points to 10.1%.

All together, these present telling arguments for 60/40. Furthermore, modelling by Vanguard suggests 60/40 investors can reasonably expect anywhere between 2% and 5.4% a year during the next decade – down, it should be noted, from the impressive historic performance of 60/40, but still attractive returns for many investors.

In the same way, considering the improvements in equity and fixed income valuations, Morningstar valuation models suggest that the 60/40 portfolio stands to deliver a return after inflation of 3.6% during the next two decades, a 1.6% improvement from a year ago.

In addition, JP Morgan’s long-term capital market assumptions forecast return for a dollar-denominated 60/40 stock-bond portfolio during the next 10 years is even more bullish, leaping from 4.3% last year to 7.2%. It’s the highest projected return since 2010 and well above the rolling 10-year annualised realised average of 6.1%.

As with any investment strategy, nothing is simple. There is a variation to make 60/40 work, investors often need to tweak the portfolio at least once a year, to retain its roughly 60/40 balancing. How this is done depends on the investor. This action is, of course, rebalancing. In practical terms, it involves selling some outperforming assets and re-investing the proceeds in the underperforming ones, so that the mix of stocks and bonds remains 60/40.

This can be seen as playing a crucial part in the success of the 60/40 process – one that is not obvious at first sight. As the benefit here, is potentially psychological for the investors involved. Fluctuating markets can be a difficult place for investors, and rebalancing can give investors real peace of mind.

The next decade

Looking at the picture for the next decade, there are other factors that play into the hands of 60/40. As the longer-term disinflationary forces of technology and globalisation may well slow – as is predicted – but they will still be dominant. And with such an environment this is highly supportive for projected returns rising substantially for both components of the 60/40.

Reflecting more on 60/40 in its component parts, with higher yields, bonds are once again a convincing source of income and a potential haven, both at the same time. And at lower valuations, equities are more attractive.

The combination means that markets today offer the best potential long-term returns in more than a decade – something investors should plug into. And the macro-economic outlook, far from stifling 60/40 could yet be another factor that boosts it. It is a somewhat paradoxical picture.

For example, while inflation looks likely to moderate the underlying drivers of higher prices – shortages of important goods and commodities, so-called ‘tightness’ in labour markets, and growing geopolitical tension – are likely to remain risks for investors for the rest of the decade. Therefore, addressing these issues will likely require substantial, sensible and balanced investment, which fits with 60/40.

At the same time, going forward, after much market volatility, it could be the best environment in near on a decade for 60/40 related asset class returns – encouraging investors to focus on long-term portfolio goals within a potentially energized 60/40 approach.