Rethinking Classic 60/40 Portfolios

October 14, 2015

[This article was first published in the September issue of ETF Report UK, our quarterly magazine for UK-based financial advisers.]

Most advisers will be familiar with the plethora of risk rated or risk targeted model portfolios on offer from fund managers. They tend to range from low to high risk, depending on the percentage of equity in the portfolio. Conventional theory would imply that an investor with 100% equities would be very high risk, while a client nearing retirement would have a much heavier weighting in lower risk government bonds.

But the world we live in has changed. Central banks in the US, the UK, Europe and Japan maintaining artificially low interest rates for years has had a massive impact on the behaviour of asset classes.

Government bond yields have reached record lows and prices have shot to the sky as investors are clamouring for safe havens. At the same time, the spread between junk bonds and safer government debt has reduced as investors are desperately searching for income in higher risk areas of the market. In essence, investors are no longer being rewarded with the right ratio of risk versus return.

As Rob Arnott, investment guru and chairman of Research Affiliates, said at our annual Inside ETFs Europe conference this year, low yields have forced investors to look for alternative asset classes, because traditional, investment grade bonds do not provide a decent income.

A quick look at bond yields should illustrate his point more clearly. Ten-year US Treasury yields have fallen from 3.6% in early 2011 to 1.6% at the start of 2015. Over the same period, 10 year UK gilt yields dropped from 3.8% to 1.3%.

"The classic 60/40 distribution between equities and bonds in portfolios no longer holds," Arnott told investors in Amsterdam. "Falling inflation has meant that investors have to broaden their horizons beyond stocks and bonds, and focus on markets that can hedge inflation risks."

It seems a logical assertion. Does that mean the 60/40 allocation model that so many advisers swear by is dead in the water?

Searching To Diversify

Stephen Cohen, managing director and chief investment strategist of BlackRock international fixed income and iShares EMEA, takes a similar line to Arnott. He told investors at the Chartered Institute for Securities and Investment conference on 1 July that it's very hard to achieve a fully diversified portfolio these days, as bonds and equities are not acting as they have historically.

"That is going to be one of the biggest challenges for investors over the next one to two years," he said. "How do you balance a standard portfolio when things aren't behaving as you would expect?"

Goodbye To Classic

For a larger view, please click on the image above.

Cohen pointed to German government bunds, regarded as one of the fixed income safe havens. He said the intraday volatility of these bonds since the spring of 2015 has been "huge."

"The most volatile part of the market is the one that should be the safest," he said.

What makes diversification even harder is there are simply fewer high quality bonds being issued, as governments have less need to borrow as we recover from the financial crisis. The UK's Chancellor of the Exchequer George Osborne has announced the government will not create any more UK gilts after 2018 for this reason, and will only replace the bonds that expire.

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