Swedroe: Look Beyond 60/40 Portfolio

April 06, 2018

The traditional 60% stock/40% bond portfolio, using publicly available, low-cost mutual funds, performed extremely well over the last 36 years—a period that included two of the worst bear markets in U.S. history.

From 1982 through 2017, a period that begins both with a bull market and peak in interest rates, a portfolio allocated 60% to the S&P 500 and 40% to five-year Treasuries returned 10.4% a year with volatility of 10.2%. Note that 10.4% return was almost 2 percentage points a year higher than the portfolio’s 8.5% return (with volatility of 12%) over the full 90-year period from 1928 through 2017.

Unfortunately, simple mathematics makes clear that today’s investors (including pension plans and endowments) are faced with a harsher reality. Those returns, from what might be called a “Golden Era,” are not likely to be repeated.

The reason is that returns benefited from a pair of favorable tail winds, neither of which is likely to recur. Meanwhile, the risk of mean reversion continues to exist. The result is that today’s investors are presented with great challenges in terms of achieving their financial goals using traditional investments.

Issues With Traditional Portfolios

The first big problem is that favorable past performance benefited from a long, steep secular decline in interest rates. We began the 36-year period ending 2017 with the five-year Treasury yielding 14.0%. We finished the period with it yielding just 2.2%.

Not only is today’s low-yield environment creating a drag on portfolio returns, it also creates an asymmetric risk—there is likely limited room for rates to go much lower to boost returns, but a whole lot of room for them to go up.

Compounding the problem is that low interest rates themselves increase the risk of fixed-income allocations because lower rates mean greater duration (a measure of bonds’ sensitivity to changes in interest rates, measured in years).

For example, as Stone Ridge founder Ross Stevens explains in his foreword to the newly released expanded and revised 2018 edition of “Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility,” the duration of the Barclays Capital U.S. Aggregate Bond Index went from a low of 3.7 years at the beginning of 2009 to 6.0 years in January 2018.

As Stevens noted, that’s the financial equivalent of levering your bond portfolio by 62% during this time period, something you are likely not aware of. Increased duration means that any future rate increases will have a greater negative impact on returns—the proverbial double whammy.

Making this problem look even worse is that all risky assets are priced off the rate on safe Treasuries, requiring a premium. The Federal Reserve is forecasted to raise the federal funds rate three times in 2018. As Treasury yields rise, it creates increased competition for equities and could put pressure on equity valuations, and thus returns.

 

Low interest rates mean traditional investors must rely on the equity portion of their portfolios to carry more of the burden if they want to achieve the same type of returns. If the 40% of an investor’s portfolio allocated to bonds returns just 2.2%, to achieve an overall portfolio return of 10%, the equity portion would have to return more than 15%.

Another way to think about the issue is that, even if an investor shifted to an all-equity allocation, equities would have to return 10%. While they have done so historically, the investor has a problem in that stocks have benefited from a long-term secular decline in the equity risk premium, which can be seen through the lens of the Shiller cyclically adjusted price-to-earnings (or CAPE 10) ratio.

Outsized CAPE Ratio

We ended 1981 with the CAPE 10 at 7.8 (an earnings yield of 12.8%). But, as I wrote this, the CAPE 10 stood at 33.4 (an earnings yield of just 3%). Clearly, stock returns have benefited greatly from an expansion in valuations. With the ratio at 33.4, the current 10-year forward-looking forecast for real U.S. equity returns is just 3%—the inverse of the CAPE 10 is as good a predictor of future real returns to stocks as we have.

If we add in the current expected inflation rate (the difference between the yield on the 10-year Treasury and the 10-year TIPS), we get a forecasted nominal return to the S&P 500 of about 5%, nowhere close to the 10% that investors historically have received. Moreover, that doesn’t assume any reversion to the mean in valuations, which is certainly a possibility and would negatively impact returns.

Even if we were to assume a more optimistic 7% return to stocks, given the size of current yields on safe bonds, our traditional 60/40 portfolio would only be expected to return about 5%, less than half of the level it earned over the last 36 years.

Hence the challenge facing investors, especially those underfunded pension plans with forecasted return assumptions of 7 to 8% on their portfolios. Such assumptions seem not just highly optimistic, but unrealistic. The outlook seems daunting.

It’s important to note that valuations are at historically high levels and bond yields are at historically low levels. But that is not a clarion cry to try and time the market. Market valuations have never been a good timing indicator. Instead, they are the best predictors of forward-looking expected returns that we have. That said, what can investors do to improve their prospects while still taking acceptable levels of risk?

Let me first state that there are no magic bullets that can bring expected returns up to the levels achieved over the prior 36 years. And “traditional” alternatives such as private equity and hedge funds are not the answer. Private equity has not provided returns above those available on similarly risky, publicly available small value companies. Hedge funds have performed miserably; the HFRX Global Hedge Fund Index actually lost 0.4% a year for the 10 years ending in 2017. However, there are some significant actions investors can take to improve their financial picture while reducing risk through diversifying sources of risk and return.

How Investors Can Enhance Expected Returns

One way to improve forward-looking return expectations is to globally diversify, as international equity valuations are quite a bit lower than U.S. valuations, if not exactly cheap. According to data from AQR, the current CAPE 10 earnings yield for non-U.S. developed markets is 5.1%, about 2 percentage points higher than for the S&P 500. The current CAPE 10 earnings yield for emerging markets is 6.3%, about 3 percentage points higher than for the S&P 500. Thus, increasing allocations to global equities would raise expected returns.

Another way to raise forward-looking returns expectations is to add exposure to factors that have contributed explanatory power to the cross section of returns while providing persistent and pervasive premiums. As my co-author, Andrew Berkin, and I demonstrate in “Your Complete Guide to Factor-Based Investing,” in addition to market beta, the equity factors that meet this criteria are size, value, momentum and quality/profitability.

 

Adding exposure to these factors not only provides higher expected returns, but diversifies the traditional 60/40 portfolio’s risk away from its heavy concentration (about 85%) in market beta. Adding significant exposure (for example, a loading of about 0.3 or more) to these factors could raise expected returns 2-3%.

These are two conventional tools investors have. However, thanks to continued advances in capital markets, retail investors now have access to other alternatives that can improve forward-looking return expectations while diversifying sources of risk.

It was the availability of these new tools that led my colleague, Kevin Grogan, and I to update “Reducing the Risk of Black Swans.” In its original, the book showed how we at Buckingham Strategic Wealth had been using the science of investing to build more efficient portfolios (portfolios with similar returns but less volatility and tail risk) through an approach often described as low-beta/high-tilt. In the 2018 edition, we expand on the concept by including new alternative investments that have become available since the book’s first publication.

Financial Innovation Provides An Answer

The big financial innovation involved interval funds, which have now been approved by the SEC. Interval funds provide for limited (say, a minimum of 5% per quarter), as opposed to daily, liquidity. That allows funds to invest in assets that have longer time horizons, capturing a liquidity premium in addition to allowing investors to access new, unique/independent sources of risk. These new sources of risk and return can help investors diversify risks away from the concentrated risks of the traditional 60/40 portfolio.

Among the “new” sources of risk and return now available to investors are reinsurance (which requires one-year contracts in the form of quota shares), alternative lending (fully amortizing consumer, small business and student term loans) and the risk variance premium (selling volatility insurance across multiple asset classes).

None of these investments is actually new, though. In fact, they have been sitting on the balance sheets of financial institutions, as well as in endowment and hedge fund portfolios, in some cases for decades. It’s just that the interval fund structure has made them accessible for the first time to investors, without the 2/20 fee structure typically associated with hedge funds.

At Buckingham, we generally recommend that investors consider incorporating a broadly diversified portfolio of these three interval fund strategies, and that they also consider including an allocation to AQR’s Style Premia Alternative Fund (QSPRX) (a market-neutral, long/short strategy that allocates to four investment styles/factors—value, momentum, defensive/quality and carry—across four asset classes: stocks, bonds, commodities and currencies) for tax-advantaged accounts and to AQR’s Alternative Risk Premia Fund (QRPRX) for taxable accounts.* (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Stone Ridge and AQR funds in constructing client portfolios.)

Each of the strategies (the three interval strategies and two AQR funds) not only has little to no correlation with equity risks, but they virtually eliminate term risk as well (diversifying the term risk of the bond portion of the portfolio). I believe the forward-looking return expectations of an equal-weighted portfolio of the four strategies (using QSPRX) will be about the same as a globally diversified equity portfolio with significant exposures (about 0.3) to the size and value factors, or about 7.5%, with a volatility that will be about the same (about 5%) as five-year Treasuries, albeit without the flight-to-safety feature provided by Treasuries.**

By moving to increase allocations to these alternatives, I believe investors can significantly improve portfolio efficiency, and in particular reduce left-tail risk (critical to those in the withdrawal phase, when sequence risk can matter a great deal) thanks to the benefits of the anticipated premiums from these assets, as well as the diversification benefits provided by their low correlation with traditional stock and bond returns.

 

Summary

The bottom line is that investors should be aware that traditional 60/40 portfolios cannot be expected to provide anywhere near the level of returns experienced over the last 36 years. That likely requires action, or retirement plans will not be achieved. On one hand, investors can plan on saving a lot more, working a lot longer, or some combination of both. I believe they can also improve their odds with some of the options I’ve discussed.

The traditional 60/40 model no longer can be expected to deliver the same type of results. I think a new model could be for investors to move toward more of a risk-parity portfolio, with assets more equally divided among stocks, bonds and these new alternatives. One caveat is that most of these new alternatives are not highly tax efficient, which may limit their use for investors constrained by limited capacity in tax advantaged accounts.

*Discussion of QSPRX, QRPRX and three interval strategies is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed that the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.

**It is important to understand that forward-looking return expectations/expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 in9dependent registered investment advisors throughout the country.

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