'60/40' Portfolio: Down But Not Out

February 03, 2014

The traditional portfolio approach is getting new scrutiny as markets change.

The inevitable end of a 30-year bull market in bonds now seems to be in sight. With yields so low and bond prices poised to go nowhere but down, a chorus of calls has piped up that perhaps the historical 60/40 paradigm of portfolio diversification is ripe for repeal.

The call to arms sounds like this: Bail out of bonds before you get killed, but be sure to load up on things like dividend-paying stocks and other income-replacement strategies. Doing so, of course, means upsetting that long-standing 60 percent stocks, 40 percent bond balance. If that sounds too facile, it’s because it probably is.

Much of that call to action is emanating from those who would benefit from the demise of the world of the 60/40 portfolio. That would mainly be tactical asset managers and, perhaps more so, those who serve up so-called risk-parity strategies that seek to bridge the gap between equity and fixed-income risks using all kinds of fancy and relatively costly tools, including leverage.

The deeper consideration that should give all investors pause is that “60/40,” while having the appearance to some of being a calcified construct, is actually a tangible way—with a tangled track record—of implementing basic diversification in asset allocation in a disciplined manner.

“Sixty/40 is anchored in a really important existential point—the benefit of diversification,” Nicholas Colas, chief market strategist at ConvergEx Group, said in a recent interview. “So, to say that 60/40 is dead is basically to say that diversification is dead—at least as far as it goes between stocks and bonds.”

The idea of throwing out 60/40 has come up before, notably after the Internet bust. But at that time, the temptation was the opposite of what it is now; namely, to pile into bonds at the expense of stocks, which had been creamed after the Nasdaq topped out on March 10, 2000.

The late Peter Bernstein, who penned the classic must-read history of risk, “Against The Gods,” mounted a simple, thoughtful and timeless defense of 60/40 in a 2002 Bloomberg Markets magazine article titled “The 60/40 Solution.” As the title suggests, Bernstein argued that even if investors were having trouble making peace with 60/40, peace they had better make.


“Placing large bets on an unknown future is worse than gambling, because at least in gambling you know the odds,” Bernstein wrote in the conclusion of the article. “This is why I propose restoring 60/40 to its rightful place as the center of gravity of asset allocation for long-term investors.”

Low Yields, Real Returns
Still, in an immediate sense, it’s hard to argue with the challenges bond investors face these days.

Bond yields are indeed terribly low, and that can be discouraging. As an example, last year, benchmark 10-year Treasury yields were as low as 1.50 percent—in other words, not high enough to even eke out a real return after adjusting for inflation.

Being pushed into the red by inflation while holding 10-year U.S. investment-grade debt is the concern, fueling sentiment that the 60/40 paradigm’s best days were over, according to Rick Ferri, founder of Portfolio Solutions, a Michigan-based registered investment advisor.

But ever since the Federal Reserve began signaling last spring that five years of quantitative easing would soon begin to end, Treasury yields have risen to twice their levels before the Fed began jawboning. Late last year, the Fed actually began the “tapering” process, pushing benchmark yields to just above 3 percent at the end of the year.

“Now that interest rates have crept back up again, the argument for less fixed income isn’t as strong as it perhaps used to be,” said Ferri, a dyed-in-the-wool indexer who adheres to a strict approach to asset allocation and, not least, rebalancing to keep that asset allocation in check.

“Should you mess around with a 60/40 portfolio now? I don’t think today I could stand up and make that argument,” he said.


What that means—and this is crucial—is that real yields on 10-year Treasurys are just 50 basis points below their historical real return of 2 percentage points, or 200 basis points, above inflation. So, currently, with 10-year yields now at around 3 percent, the inflation rate is around 1.50 percent—50 basis points below the long-term average.

Back in the difficult days of the late 1970s when 10-year Treasurys were yielding a whopping 15 percent, inflation was at around 13 percent—200 basis points below benchmark yields—not so different than now.

“Let’s understand that real rates of return are getting back to normal. Yields are low, yes; but inflation is low, and you’re still getting a real return that quite frankly is pretty attractive compared to historical standards,” said Bob Smith, chief investment officer at Sage Advisory Services in Austin, Texas.

The Demographics Of Income
Another problem with repealing 60/40 comes down to demographics. Populations in the U.S. and in many other parts of the world are getting older. Baby boomers whose wildest, most speculative days as investors—which included some of the more acute market crises in all of history—are behind them.

That’s a perfect demographic to pitch enhanced-income strategies to in this era of low rates.

But there are just too many catches and too many bells and whistles for such approaches to be credible and viable over the arc of time, says Smith. He singled out proponents of risk-parity strategies in particular.

“Those are the people who are saying 60/40 is dead, that you have to have 50 different asset classes and you need to short 80 percent of that position against 30-year Treasurys; and you have to leverage yourself 3, 4, 5, 6 times—and then you’ll eke out, with no problem, 6 percent. But I’m saying: ‘Whoa! Wait a minute,’” Smith said.

“That’s fine, but that’s not for the average investor out there. People are coupon clippers; they want to know that their principal gets to par; they want to be able to play the game again,” he added. “People who are looking to buy fixed income like the fixed part and they like the income part.”


That demographic piece is, in the end, one big reason the end of 60/40 looks rather unlikely.

In fact, it’s not a stretch to imagine that the demand pull from retiring baby boomers is likely to keep downward pressure on bond yields in the coming years.

60/40’: Version 2.0
In the end, 60/40 isn’t dead at all, but it might be more appropriate to call it what it really is, whether that’s “70/30” or “50/50,” depending on the investor.

There’s nothing original or revolutionary about these sorts of distinctions, which can occur as a matter of course for particular investors as their risk appetites change and as they move along the arc of an investment lifetime.

“We do not advocate any set allocation between stocks and bonds, but we do have some beliefs around setting a reasonable allocation, sticking with it and occasionally rebalancing,” said Fran Kinniry, a principal at the Vanguard Investment Strategy Group in Valley Forge, Pa. He added that “60/40” isn’t so much a set-in-stone approach as it is emblematic of an attitude about diversification.

Tyler Mordy, chief investment officer of Toronto-based Hahn Investment Stewards, says 60/40 isn’t dead, but it’s ripe for some fine-tuning, particularly with tools like exchange-traded funds. ETFs enable a top-down approach to asset allocation that makes accessing any number of asset classes a whole lot easier.

“I am not repudiating 60/40 altogether,” Mordy said. “It’s a reasonable starting point in constructing a balanced portfolio. But I think we can do better. It’s no surprise then that ETF strategists—many of whom have cultivated a rare ‘multi-asset-class’ skill set—are the beneficiaries. They’re adding value where it counts most.”

That said, there are very good reasons, from time to time, to look much more closely at the finer points of what actually makes up a typical 60/40 allocation, in part because of the low-rate regimen that still prevails.

More simply, amending specific elements of a 60/40 approach—such as incorporating high-yield corporate credits into the mix—is not only sensible, it’s wise, advisors and strategists say.

Back in the day when Peter Bernstein wrote “The 60/40 Solution,” assembling a 60/40 portfolio was perhaps as simple as allocating 60 percent of a portfolio to the S&P 500 Index and the remaining 40 percent to the Barclays Aggregate Bond Index.

But now, investment markets are much more global than they were even a decade ago.

Also, the Barclays Agg now has a decidedly U.S. government debt tilt, since the Fed—at the time of the market meltdown of 2008 and 2009—started buying up Treasurys and mortgage-backed securities issued by government-backed agencies like Fannie Mae and Freddie Mac.

The way Rick Ferri sees it, on the equities side, that 60 percent allocation should now be split about two-thirds U.S. and one-third international, with an allocation to the emerging markets.

In the world of bonds, the appropriate approach in Ferri’s estimation would be a 60 percent allocation to the Vanguard Total Bond Market ETF (BND | A), and 20 percent each to two mutual funds he favors: the Vanguard High Yield Fund and the Vanguard TIPS Fund.

Such shifts allow investors to continue to both embrace the discipline of the 60/40 philosophy and live that philosophy in a more thoughtful and contemporary way. In doing so, investors can have their cake and eat it too, says Ferri.

“Sixty-40 is sort of like Adam Smith’s ‘Invisible Hand,’” Ferri said. “We don’t know exactly why it works, it just always seems to work. In the end, when you look back over a 15-year period of time, it works.”



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