The case for the 60/40 balanced stock-bond portfolio

The biggest room in the world is the room for improvement.

Helmut Schmidt

The 60/40 balanced stock-bond portfolio had a great run for a number of decades, but rumours of its death are back with the collapse of interest rates across the yield curve. Should we retire the 60/40 given the 10-year Government of Canada bond barely yields 0.5 per cent and the 30-year bond is hovering near one per cent? Our answer: it’s a bit early to write the obituary for the 60/40 portfolio. True, balanced portfolios have greatly benefited from the 40-year downtrend of interest rates. However, the main reason why we think the balanced portfolio remains attractive to long-term investors is how well of a diversifier bonds are to the equity portion of the balanced portfolio. That remains true even in today’s low-yield environment, although global investors are increasingly exposed to interest-rate duration risk (See Chart 1). There is no doubt the industry must continue to adapt and innovate to address the low-yield environment. Balanced portfolios have helped dull some of the market volatility during the historical COVID-19 market storm and such volatility dampening effects can support investors’ ability to maintain a long-term view during challenging markets.

MAST-6-/40-chart 1

Government bonds as a risk buffer: Some diversification and lots of duration

Even with ultra-low bond yields heading into 2020 and the COVID-19 crisis, balanced portfolios benefited from having safer fixed income investments and from falling interest rates. While negative correlations make for greater diversification benefits, low positive correlations or the absence of abysmal negative outcome from fixed income versus equities offers a first layer of downside protection to balanced portfolios. The negative correlation between stocks and bonds that has prevailed for the past 20 years (See Chart 2) has made the balanced portfolio the tennis star Roger Federer of investing: he’s getting old, but still wins.

MAST-60/40-chart 2

Source: Federal Reserve Bank of St. Louis, Bloomberg, BMO Global Asset Management. Note: Bond returns calculated based upon the hypothetical total return derived from the Moody’s Seasoned AAA Corporate Bond Yield Index. Stock returns are represented by the S&P 500 Index (As of August 26th, 2020).

With a yield of about 2.5 per cent, barely above long-term inflation of two per cent and less than half of what it was in 2001, it’s fair to say the lemon has been squeezed although there remains a bit of juice.

Looking at current yield levels for the constituents of Canada’s fixed income benchmark, the FTSE TMX Canada Universe Bond Index, we estimate that portfolios would earn roughly nine per cent over one year if a large negative macro shock brought interest rates down to zero per cent on the entire spectrum of Canadian fixed income assets.

In this context of low long-term return expectations for benchmark fixed income assets, investors are yield starved more than ever. For longer term investors who have greater leeway to sustain portfolio volatility given their lower liquidity needs, adding riskier or alternative assets is a possible solution to low yields.

The 70/30 as the new 60/40?

Increasing the equity portion of a portfolio is the first option for investors seeking to boost their expected returns without adding new assets to their portfolio. However, moving away from a 60/40 to a 70/30 mix entails a significant impact to portfolio risk, notably in light of the equity pain inflicted by the COVID-19 induced crash or the great financial crisis. Adding 10 percentage points of equities while reducing bonds by the same amount increases the long-term expected volatility from about 12 per cent to 14 per cent.

Yield starvation will cause wild yield hunting season

A more subtle option is to reshuffle exposures within the fixed-income portion of the balanced portfolio. For many investors, re-allocating away from low yielding government bonds to higher yielding provincial, municipal or corporate debt is generally easier to implement as a quick fix to increase the yield of a portfolio, but even that simple re-allocation has limits and inevitably translates into higher portfolio risk and tracking error versus benchmarks.

However, given that central banks continue to act boldly with asset purchasing programs to support markets, investors are highly confident that policymakers will keep supporting markets in case of an economic slump or adverse market event. We expect flows toward credit assets to remain strong as monetary policy sticks to its whatever-it-takes mantra.

Yield starvation will increase appetite for alternatives

The rise of alternative investments has been partly fueled by collapsing bond yields during the past decade and the proliferation of easy-to-access alternative investment opportunities. We expect investors to further reduce their allocation to traditional stocks and bonds for a greater allocation to alternatives such private equity, liquid alternatives, or commodities.

Sound manager selection and a thorough due diligence process are critical ingredients when investing in alternative opportunities. Hedge funds or private investment vehicles tend to be opaquer and less liquid.  The greatest portfolio benefits of adding alternatives depend more crucially on sound portfolio construction than tactically picking investment styles or managers. We believe a well-diversified multi-strategy portfolio of alternatives is more likely to deliver robust risk-adjusted returns rather than tactically shifting from say global macro to real-estate. Tactically allocating amongst alternatives – much like the market timing of stock vs bonds – is never easy and may be liquidity constrained.

A potential hurdle against alternatives for some institutional investors are the higher fees associated with alternative investments. This is even more a concern for investors because of the decline in alpha generation observed across core alternative investment styles such as long-short equities or macro managers in recent years. The potential diversification benefits must, therefore, be weighed against the expected returns and the fee structures attached to such investment opportunities.

Higher equity allocation, but paying to hedge against downside risks

Another option for investors is to increase their equity allocation but spend a few percentage points of the portfolio value every year to purchase stock-index put options for downside protection. While such a strategy sounds attractive on paper, the equity-volatility risk premium is such that the costs to passively purchase such hedges are generally prohibitive and eat away a large portion of the extra return obtained by the higher equity allocation.

Conclusion

Asset allocation remains the single most important decision for meeting client objectives.  Investment managers have access to more asset classes, but they may want to consider the costs and unintended risks some alternatives may pose to long-term portfolio performance.  The traditional 60/40 asset mix remains a compelling model which can be managed for minimal cost and without liquidity risk.  Adapting credit exposure and geographic equity exposures as markets change may provide some of the Alpha and risk reduction investors seek through alternatives. 

Alternatives remain an interesting solution for sophisticated investors who can perform the required due diligence.  Larger Institutions which have long-term investment horizons and adequate cash flow to cover liabilities can implement strategies which may be more difficult for smaller investors with shorter investment horizons or with more pronounced income needs.

Disclosures

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus.  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms. 

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

 

 

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