By Jack Forehand, CFA, CFP® (@practicalquant) —
The 60-40 portfolio just finished one of its best decades in history. And that comes on the back end of a period starting in 1980 that has seen it produce extremely strong returns. In hindsight, the fact that bond yields were very high at the beginning of the period and equity valuations were fairly cheap indicated the portfolio was likely to have strong returns going forward, but I don’t think anyone expected the types of returns we have gotten.
But if we apply the same logic today that we did in hindsight to 1980, things look a lot worse. Bond yields are currently very low relative to history and equity valuations are very high. The dual forces that the 60-40 had at its back in 1980 are now both significant headwinds.
Outlining the potential future problems for the 60-40 is the easy part, though. I am certainly not breaking any ground that many other people haven’t already by talking about its lower potential future returns. The more challenging part for investors is figuring out what to do about it.
The answer to that question is one that is specific to each investor’s circumstances, so if you are looking for the one option that solves the future problems of the 60-40, I won’t be able to provide it here. But I do think that it is a worthwhile exercise to look at the options available and to consider their merits.
But before I talk about some options worth considering, I think it is first important to cover one that I think is less than ideal, but that also has probably been the most popular option thus far. That option is moving up the risk curve. With this option, investors have just been dealing with the problem of lower returns by just investing in riskier and riskier assets. For example, an investor in high grade corporate bonds might move to junk bonds to get a higher yield. Or an index investor may move from the S&P 500 to a higher-octane growth portfolio. Or a growth investor might graduate to cryptocurrencies. These options have worked so far, but the thing about risk is that it always eventually materializes in volatility and drawdowns. So dealing with lower future returns by increasing risk is a solution that is filled with potential problems.
Now that we have taken that option off the table, here are some other potential investment options that could help deal with the potential lower future returns of the 60-40 portfolio.
[1] The 60-40 Portfolio
Ok, now you probably think I am crazy. How could an investor possibly deal with lower potential returns from the 60-40 portfolio in the future by investing in it? The obvious answer is they can’t. But many people (myself included) have been talking about lower expected returns for the portfolio for a long time, and they haven’t materialized yet. The reason for that gets back to the nature of expected returns. Expected returns are meant as a guide to the future long-term returns of an asset class. They tell us very little about what might happen in the next year, or even the next several. So altering a portfolio based on them requires significant patience and ability to endure tracking error. For many investors, that is too much. When you combine that with the fact that the 60-40 has been a solid portfolio for long-term investors, the best answer for many to this problem may be doing absolutely nothing, while also understanding that returns may be lower in the future and planning for that potential reality.
[2] Making Adjustments Around the Edges
Although stocks in general are certainly expensive, there are areas of the market that look more attractive on a relative basis. We recently interviewed Ben Inker of GMO for our podcast (the interview will air next week) and he highlighted the potential opportunity in US value stocks and in markets outside the US. Prudently shifting a portion of a portfolio to areas that have higher expected returns can help to boost future returns. But those higher expected returns come with potential higher volatility and the risk that those bets won’t pay off, so sizing them relative to an investor’s ability to endure risk and tracking error is key.
[3] Introduce Uncorrelated Asset Classes
Another option many investors have considered, especially given the possibility that we will see inflation in the future, which could make stocks and bonds go down together, is introducing other asset classes such as gold and commodities into their portfolios. Others have invested in more advanced strategies like CTAs and global macro strategies that seek consistent positive returns regardless of the market environment. These alternatives could potentially add significant value if stocks and bonds falter (particularly if we do see the inflation many have predicted), but they come with the risk that they will continue to underperform the standard 60-40 and detract from returns as they have in the past decade.
[4] Use More Advanced Approaches
For investors who can endure the risk of looking different than the market, there are some interesting strategies that are worthy of consideration. For example, risk parity invests in a wide variety of asset classes and weights them such that they contribute an equal amount of risk to a portfolio. This can lead to a more efficient portfolio and more consistent returns. This used to only be available to more sophisticated investors, but there is now an ETF that follows the strategy.
We have also found some interesting quantitative approaches that use momentum to maintain exposure to the asset classes that are performing best. We discussed Protective Asset Allocation and Generalized Protective Momentum, which are two examples of those types of strategies, on this episode of our Excess Returns podcast.
One of the problems with these types of approaches is that they look very different than the market and will likely underperform in bull market periods. This can make them hard to stick with. Corey Hoffstein and Rodrigo Gordillo recently appeared on our podcast to discuss their paper “Return Stacking: Strategies For Overcoming a Low Return Environment”, which offers a very interesting way to deal with that problem. I will write more about this concept in a future article, so I won’t go into detail about it now, but the general idea is that there are currently products available (like WisdomTree’s US Efficient Core Fund – NTSX) that allow investors to maintain 100% exposure to a 60-40 portfolio through the prudent use of leverage without investing 100% of their capital in the strategy. This allows other return streams to be “stacked” on top of the 60-40 portfolio. This can both boost returns and reduce tracking error for non-conventional strategies because it maintains the core exposure to the 60-40.
A Problem Without a Simple Solution
Although I am a believer that the future returns of stocks and bonds are likely to be lower than what we have seen in recent decades, what, if anything, investors should do about that is a very challenging issue. For many investors, maintaining their current strategy and accepting the likelihood of lower potential returns very well may be the best answer. But for those who are willing to look different, there are some very interesting alternatives that are available. It is just important to keep in mind that any investing strategy is only as good as the ability of the investor who is following it to stick with it. So investing in a strategy that deviates from the 60-40 requires the ability to stay the course when those deviations work against you.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
