Should you have a 60/40 portfolio allocation?

Mixing equities and bonds in a portfolio to reduce risk has been a key feature of financial planning since US economist Harry Markowitz coined Modern Portfolio Theory in the 1950s. One of its central tenets is that different assets often move in different directions, and when combined can diversify risk. Historically, on average, when equities have fallen, the price of bonds has gone up, so holding the two has smoothed out volatility. 60 per cent equities and 40 per cent bonds quickly became accepted as the benchmark for a moderate risk portfolio. It also fits nicely with the investment industry adage that “your bond exposure should equal your age".

Those who have invested via a 60/40 strategy have been handsomely rewarded, especially following the multi-decade bull run in bond markets. To give a flavour of how the asset classes have performed over the long term, the table below uses MSCI World index to represent equities and Bloomberg Barclays Global Aggregate, an investment grade bonds index, to represent this asset. But due to the current state of global monetary and fiscal policies it seems unlikely that investors will enjoy such high average returns in the short to medium term. A 3 to 5 per cent return for a 60/40 portfolio is a more realistic expectation. 

Table 1

The worry now is that the old rules of diversification don’t work. “Over the last 10 years you have been compensated on the equity and the bond side, but low bond yields challenge the basic tenet of diversification going forward,” says Andrew Keegan, head of wealth for client portfolio solutions in Europe, the Middle East and Africa at BlackRock. 

A high allocation to bonds could leave you exposed to potentially large losses with little scope for gains. This concern has grown as government bond yields have collapsed amid large programmes of quantitative easing and very low interest rates. If the global economic recovery picks up quickly as vaccines are rolled out, there is a risk that inflation could kick in and lead to a rise in interest rates, which would be particularly bad news for long-dated bond holders. 

Equities also look vulnerable to the same forces. Much of the growth in global equity markets has been driven by large technology companies, and it is reasonable to expect that if the global recovery picks up quickly or interest rates start to normalise, these could be negatively impacted as putting capital to work elsewhere becomes more attractive. 

Faith in the traditional role of bonds as diversifiers was also shaken in March when bond prices slid along with equities during the sell-off. But investors should note that this is not uncommon. “Bond and share prices do sometimes fall at the same time,” explains Giulio Renzi Ricci, senior investment strategist at Vanguard. “When we looked at the historical market data covering the two decades up to March’s global pandemic sell-off, we observed that it had happened about 29 per cent of the time.” 

A recent study by asset manager Man Group also suggests that a 60/40 portfolio may not offer as much diversification as you think. The asset manager studied the performance of global equity and investment grade bond markets over the last 80 years, and found that a 60/40 portfolio was 93 per cent correlated to equities, and only weakly correlated to bonds. 

What is the alternative?

Wealth managers have been gradually turning to alternative asset classes to spread risk across portfolios to try to protect their real value. Infrastructure has been particularly popular recently as governments looking to reboot economies are investing in infrastructure across the world, most notably in the renewable energy space.  

An attraction of infrastructure is that returns are broadly reliable, often linked to 20- or 30-year government contracts, and usually account for inflation. The downside is that most infrastructure investment trusts are trading at large premiums to their net asset values because they are so popular. 

Real estate and gold are other potential diversifiers. Real estate is lowly correlated with equities but highly correlated with the economic environment. The collapse of Arcadia and Debenhams serve as a reminder of the risk of vacancies, although some real estate investment trusts look more stable, for example, those that invest in social housing which benefits from government contracts.   

Gold is often the panic asset of choice and has done very well during the coronavirus crisis this year. It can be used in a portfolio as an insurance policy in times of stress, but is extremely volatile and does not have the volatility dampening effect of high-quality bonds. 

Absolute return funds, which often hold a mix of asset classes, can provide a defensive element to your portfolio. However, these need to be studied carefully as many have failed to deliver their target returns. 

Jason Hollands, managing director at Tilney, says that the 60/40 mix of equities and bonds for a balanced portfolio is “no longer fit for purpose” and has been “eclipsed by the need for a more diversified multi-asset approach”.

Tilney’s balanced portfolios currently consist of:

• 51% equities
• 10% corporate credit
• 17% other fixed income
• 25%  alternatives 
• 7% cash/liquidity

The table below shows the correlation between a handful of global asset classes at the end of August. Bonds and equities are mildly positively correlated, while infrastructure shows very gentle negative correlation with both equities and bonds. The difficulty is, past performance is not a guide to the future.

Table 2

Why 60/40 can work

60/40 is a euphemism for a balance of risk and reward, and a combination of bonds and equities should provide both. Gilts and Treasuries (US government bonds) are generally risk diversifiers, and it’s possible that yields could fall below zero if the UK or US follows Japan and the eurozone in implementing negative interest rates. 

“Don’t buy bonds – particularly government bonds – for what they might return going forward, as this may well be negative returns,” says Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management. "[Rather, buy them] because of what they might do if risk markets slump."

Vanguard LifeStrategy 60% Equity (GB00B3TYHH97) is the most popular of Vanguard’s LifeStrategy funds, which invests in a mixture of global equity market tracker and investment grade bond index funds. The fund had assets worth about £9.9bn at the end of November. Mr Renzi Ricci says that their analysis of the distribution of projected worst quarterly returns for global equities relative to other asset classes suggests that investment grade bonds will maintain their diversification benefits – even when yields are low to negative over a 10-year horizon. 

Investors should also be mindful of their geographic exposure. Mr Keegan says that UK investors with a significant bias to UK assets are likely to have done badly in recent years.

The table below shows a global 60/40 portfolio and one with a 25 per cent weighting to a UK equity index. Future returns may be different, but it helps to think about your global exposure.  

Table 3