After the unusual correlation of equities and bonds, how are investors diversifying exposures beyond traditional stocks and government bonds and is the 60/40 model still fit for purpose?
Over the last year or so, several pundits proclaimed the days of the 60/40 portfolio allocation were over, citing the dismal returns from 2022, when both equity and bond securities suffered large losses at the same time. For 2022, the average equity and taxable fixed income fund suffered their worst one-year returns since 2008 and on record, losing 16.82% and 8.54% respectively. And whilst seeing both asset classes decline at the same time is unusual, it’s not unheard of. Inflation and rising interest rates were the culprits here, but given time, the approach still looks sound.
The 60/40 portfolio – that is, the practice of allocating 60% of one’s assets to equities and 40% to bonds, has been a portfolio diversification standard for years – capitalises on the adage “don’t put all your eggs in one basket”. The idea is to include various types of securities and investments from different issuers, industries, asset classes and even countries, to reduce risk and smooth out returns by using low or uncorrelated assets to equities, such as bonds, REITs, precious metals, commodities and alternatives – anticipating that when one asset class zigs, the others will zag. Harry Markowitz, Nobel prize-winning economist, described diversification as the “only free lunch in finance”.
The premise of this combination is that stock and bond prices tend to move in opposite directions. So, when the equity market has a hiccup and goes south, the steady interest income generated from bonds and even capital appreciation, when interest rates are on the decline, generally works to dampen the volatility of a portfolio – being a ballast of sorts. However, the ability of bonds to do their job in a diversified portfolio is influenced by what happens to inflation and the level of bond yields.
Inflation and rising interest rates cast a pall over the markets
The question that many investors are asking is, does a diversified portfolio, which includes bonds, still make sense given the horrible returns witnessed in 2022? Over the long haul, the answer is a resounding yes, but it is dependent upon one’s outlook on inflation, level of risk aversion and time horizon.
U.S. inflation reared its ugly head in 2022, hitting its pinnacle 9.1% year-over-year rise in June, forcing the Federal Reserve Board to aggressively hike its key lending rate at a much faster pace and magnitude than we have seen in a very long time. In fact, we’d have to go back to 1981 to see inflation levels that high.
At the beginning of 2022, the Federal Reserve’s fed funds target rate range remained an accommodative zero-to-25 basis points (bps) – with officials still focusing on the impacts of the coronavirus and supply chain disruptions. However, due to inflation far exceeding the Fed’s 2% inflation target over the following 11 months, the Federal Open Market Committee was forced to aggressively raise its key lending rate to a range of 425 bps to 450 bps to help cool down the economy and stave off inflation.
These hawkish moves stifled both equity and fixed income returns. As inflation took its toll, investors prepared for a significant slowdown in firm profitability as debt costs rose and input costs accelerated, whilst the inverse relationship between bond yields and prices had a significant negative impact on existing bonds – to investors’ consternation. Cliché, but the perfect storm.
Correlation and risk mitigation
At the heart of portfolio diversification is the view that owning diverse investments will help limit one’s exposure to any single asset class or its concentrated risk profile, yielding more stable long-term returns and lowering the risk by dampening the portfolio’s volatility. So, if one security or asset class takes a big hit, there is something else in the portfolio that goes up (or at least not down as much). As we previously stated, the correlation between bonds and equities is generally negative but as we can see in Exhibit 1, over the last 35 years there were long periods where the two asset classes were positively, and sometimes highly, correlated – on a month-by-month basis.
Exhibit 1: Lipper U.S. Index – Multi Cap Core Funds vs. Lipper U.S. Index – Core Bond Funds monthly correlations
When stock declines are realised due to a weakening economy, interest rates frequently go down via central bank accommodation to help pump up the economy, triggering plus-side bond returns and creating negative correlations between stocks and bonds, which help bonds function as a ballast against equity declines.
However, when inflation is the cause of equity declines, often the two asset classes become more correlated, as the central bank hikes interest rates to help cool down the economy, pressuring bond prices and eventually leading to a decline in company earnings. This causes the two asset classes to move in the same direction – down – as was the case in 2022.
When stocks and bonds move in the same direction, it’s only painful when they are both on the decline. The bull market in bonds over the last 40 years – prior to the most recent tightening cycle – led to both stocks and bonds often rising at the same time, with positive correlations benefitting investors.
However, last year was extremely painful for those investors depending on bonds to cushion the sharp declines in stocks and generate income. With both stocks and bonds on the decline in 2022, it wasn’t too surprising to see that Lipper’s Mixed-Asset Target Allocation Moderate Funds Index (-13.73%, designed as a benchmark for the 60/40 allocation portfolio) experienced its largest decline since 2008 (-27.38%). However, whilst still jarring, it did mitigate losses better than Lipper’s Multi-Cap Core Funds Index loss (-17.99%) by more than four percentage points (426 bps) for the year.
Putting returns in a longer-term perspective, Lipper’s Mixed-Asset Target Allocation Moderate Funds Index posted three- (+2.94%), five- (+4.09%), and 10-year (+5.97%) returns on the plus side for the periods ended 31 December 2022. So, whilst the one-year return was painful, returns for the longer time periods – whilst stingy – remained positive.
Where do we go from here?
The likelihood of a repeat performance in 2023, a double whammy if you will, is low. While we are still facing the possibility of recession, the most recent inflation data appears to be coming down. And bond yields are the highest they have been since 2009. So, bond yields could provide more support to the well-diversified portfolio’s total return than they have over the last 14 years – delivering additional cushioning and income generation. In addition, as we can see in Exhibit 2, over the last 35 years there were only four years when both equities and bonds suffered negative returns in the same year.
Exhibit 2: Rolling one-year performance % 1989 – YTD (April 2023), select Lipper Indices
So far, we have only highlighted the correlation of bonds and equities, but we haven’t talked in detail about the 60/40 portfolio’s ability to provide further diversification by using other low or negatively correlated asset classes or strategies, such as diversifying via style (growth versus value), capitalisation (small-cap versus large-cap), bond duration or maturity (short-term versus long-term), quality (investment grade versus high yield), or by introducing alternative asset classes, such as commodities, real estate investment trusts (REITs) or hedge-like (alternative) strategies.
As can be seen in Exhibit 3, the inclusion of different asset types and classifications, whilst most are not negatively correlated, can help a well-diversified portfolio add incremental returns whilst reducing volatility.
Exhibit 3: Ten-year correlation between different Lipper classifications/asset types
Portfolio diversification still works
As we have suggested, portfolio diversification is a long-term strategy that helps smooth out the bumps in the road, but it was never intended to mitigate losses altogether. With bond yields on the rise, the ability of the bond portion of the portfolio to provide both a cushion for market declines and add stronger incremental returns looks better than it has in several years, presenting a stronger starting point.
Depending on an investor’s risk tolerance, portfolio diversification could equate to 80/20, 60/40, or 20/80. The inclusion, however, of bonds and other asset classes in one’s well-diversified portfolio can provide the ballast needed when the waters get choppy.
Exhibit 4: Leaders in one year could be the losers in the next. Rolling one-year returns. Lipper U.S. Macro-Classifications 2013 through YTD 2023
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