Rethinking Classic 60/40 Portfolios

[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?"

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.

Not Quite Dead Yet: Wait For QE

But Christopher Aldous, managing director at Charles Stanley Pan Asset, insists that the 60/40 model is "not dead yet."

Although the traditional and static asset allocation worked "beautifully" after the credit crisis as bond returns were much better than anticipated, if bond prices normalise—i.e. prices drop and yields rise—over the next few years, low risk investors holding more bonds will be first hit.

"But no one needs to panic over the next 12 to 18 months," he said. "I would start worrying about it six months before the quantitative easing programs end in Japan and Europe."

But it's not just bonds that will be hit. Aldous added: "Of course it impacts on the yield stocks too—they've done particularly badly this year."

Behavioural Finance

While some investors keep their eyes on central banks, others turn their attention to behavioural finance to assess asset allocation and risk. Take Shaun Port, CIO of ETF-focused discretionary wealth manager Nutmeg, who insisted that asset allocation should never be static, as clients' objectives and appetite for risk will change over time.

"So your three year holiday of a lifetime fund may be high risk, whereas your deposit for a house in five years—or in London, 20 years—will be a low risk activity," he explained.

Port criticised the fact that many advisers might rely on the traditional approach of a risk questionnaire to assess their clients' tolerance for risk, which can often result in the client having a "balanced" risk profile of 60/40.

And it might not be the case that your elderly client wants low risk investments in the first place. As Aldous points out: "It's not the end of the world if you lose some of it as you're not planning to spend it."

There comes the paradox: An AIM-equity based portfolio is extremely efficient for inheritance tax, but is much higher risk than elderly clients would normally be expected to invest in, according to Aldous.

What Is On Offer?

Whatever your approach to this debate, it appears little is likely to change soon due to the limited span of money management products in the market.

Allan Lane, managing partner of Twenty20 Investments, said the industry is simply a "factory" for risk rated model portfolios.

"A lot of the model portfolios on wrap platforms are built with cookie cutter solutions which rebalance every six months and have risk rating categories of 1 to 10, and—as we know from current market conditions—that is a little too hands off," he said.

Distribution Technology, FinaMetrica and Morningstar were the three most popular risk profiling companies, according to research from Platforum on 17 June this year, and were used by 62% of respondents in April 2015, whereas just 5% construct their own portfolios in-house. That figure remains unchanged since October 2014.

However, Lane's concerns about the factory line are starting to gain traction amongst the wider community. Platforum research also found that advisers are increasingly thinking of risk profiling tools as just one part of the process rather than providing the complete answer. It may well be that modern day financial planners are taking a closer look at the bigger picture before shoe-horning their clients into balanced, 60/40 portfolios.