The 60/40 portfolio was born in 1952 in Chicago, IL to Harry Markowitz. It received widespread adoption in the investment community and Nobel Prize accolades. The practice of balancing the correlation between stocks and bonds has died; on March 23rd, 2020. It is survived by a whirlwind of speculation, hedging, and general uncertainty. In lieu of flowers, please send condolences to the risk adverse.
If you are familiar with the 60% stock/40% bond portfolio, you know it is largely a relic of the past. For most investors, alternatives and derivatives are likely to become a bigger portion of investors’ portfolios over the next decade. But for decades, investors would reliably count on exposure to 60% stock market equities and 40% bonds to create predictability and smooth out the stock market’s volatility. All with the hope they could still meet retirement goals. This is no longer the case.
Cause of Death
The cause death is not entirely clear, though there are several compounding maladies:
Age: While in its youth the 60/40 performed admirably in its ability to predictably drive income through the ebb and flow of the market. Constantly providing investors with assets in a favorable asset class to be selling, and in turn working additional capital into an out of favor class. The whole process worked swimmingly shifting money back and forth and ever higher. But as this process aged it no longer kept up with changes to the economy. A relentless expansion of the national balance sheet and synchronized expansion money in the supply has eroded the health and reliability of the “40” side of the portfolio and has caused investors to seek higher and higher levels of risks from bonds to accommodate the falling returns.
With little to no reprieve from the declining health of bonds, and a limited upside in returns, the predictability of the 60/40 has been questionable as of late. Nothing is more emblematic of this then the current bond markets – in the high yield space debt is priced with almost no accounting for default risks – meaning more money is chasing falling yields and leaving discerning investors to question the urgency. Simultaneously, the negative and near zero rates on treasuries are punishing the most conservative investors. This means the entire bond structure is distorted by the seemingly endless printing of money.
Purpose: The 60/40 portfolio was supposed to insulate investors when markets turned sour. Providing a reduction in overall volatility and replacing it with a predictable and stable trajectory. As investors are demanding more and more internal rate of return to meet their investment objective they are either assuming more and more risk without compensation. Or they’re seeking alternatives that require private equity, hedging, real estate, and complexity to fabricate a stable return and lowered risk.
Regarding the risk return balance, investors have been seeking more and more risk for their returns by either pushing dollars into the higher risk bond (as noted above) or out of bonds entirely. Many are finding that to secure their retirement expectations they are going to simply abandon the 60/40 for a higher admixture or equities. And with little or no negative impact for taking on that risk they are seemingly fine running their portfolio hot.
In comes alternatives, which has been described as one of the next big trends to cultivate the desired returns for investors. Even Vanguard, a company rooted in the success of the everyday investor, began exploring alternatives, launching a private-equity fund in 2019. This will pose new challenges for mainstream investors who are categorically poor at pricing this unconventional asset class. This could mean that returns will be impacted by fund flows. With the addition of retail investors to the Vanguard platform a systemic pushing up of prices will lower returns for both retail and institutional investors. It will also cause another market where too much money is chasing too few assets.
COVID-19: Correlation between asset classes has long been the lynchpin in making the 60/40 (and other Modern Portfolio Theory) concepts work. But as the correlation between bond prices and stock prices are moving in closer and closer lockstep, the advantages of correction are diminishing. No point in time was that more apparent then the sell off in March of every asset class. The volatility seen in stock, bonds and even precious metals during that time showed there is no longer a predictable flight to safety mentality that would give investors an out.
Correlation Psychology: Part of this correlation between historically oppositional asset classes comes down to the psychology of the investors. Investors are now, possibly more than they were historically, hypnotized by the returns of the capital markets. So when confronted with a low risk low return asset class like the bond market as a whole they will simply take their money into equities, causing them to invest their bond money with the same reactionary mindset that they invest their equity money. This is causing the both stock and bond markets to become sensitive to emotion and the news cycle like never before.
Distortion of risk and “bailouts”: As we have seen and continue to see governments around the world are ready and willing to bail out capital markets. Nowhere is this more apparent than in the United States. There the practice of supporting financial markets with added liquidity is having a two fold effect that erodes correlation. It is rewarding the riskiest investments like equities; and by printing money it’s adding more supply to bonds while driving yields lower. Essentially, this practice is borrowing risk compensation from bonds to create a floor for equities.
Exchange Traded Funds: While there is fantastic value in the vehicle it is limited to equities. See while a fund that contributes more assets to a company with a growing market cap created a virtuous cycle in equities, in bond it creates a bubble. By weighting and ETFs net exposure based on market cap it means the companies that borrow more, get more money…imagine that in your personal finances. If you are familiar with borrowing money, you will find that the more money you have borrowed, the less likely a bank will lend you an additional line. But in the ETF’s the more they borrow, the more their bonds are bought, causing the yield to go down, while the risk is increasing. This is inverse to our expectations for bonds.
Efforts to resuscitate:
It is unclear whether efforts to bring the 60/40 back to life will be effective, but it is certain it will not happen while the risk premiums on bonds are at these low levels. Until there is a proper reward paid to investors who are patient, cash flow centric, and discerning, there will be no change to the 60/40’s condition. Changes are being made to provide investors with an alternative, including owning real estate, using options, or exposing clients to insurance and other derivative products to secure a stable predictable return.