Death of the 60/40 portfolio

The ubiquitous 60% stocks, 40% bonds portfolio only works sometimes, but it’s the basis of thousands of client investment strategies.

We’ve found it’s only worked in one of four main economic regimes: the disinflationary growth period from 1981 through 2000. This portfolio proved relatively ineffective during the inflationary boom period from 2003 to mid-2008.

Different types of assets react in different, but logical (structured) ways to each of the economic regimes. Accordingly, we refer to a suitable mix as structural diversification.

For instance, when inflation is expected to decline, interest rates tend to follow, which causes bond prices to rise. When monetary policy causes inflation to rise, gold, real estate and commodity prices tend to hold their value relative to a weakening currency. In nominal terms, it may seem like asset prices are rising. Meanwhile, bond prices decline as rates rise, although coupon payments often materially outweigh this drop in prices.

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Developed market equity prices tend to rise when inflation expectations fall, which means lower discount rates. But, they rise even more when the economy’s growing, generating growth in corporate earnings and book values. Low inflation also means lower industrial and labour input costs, which fattens profit margins.

On the other hand, during periods of surging global growth accompanied by rising inflation expectations, emerging market stocks tend to dominate. That’s largely because many emerging economies supply the commodities consumed during a global boom, while commodity prices rise on the back of strong demand and rising inflation expectations.

Lastly, during periods like the Great Depression, both GDP and prices are falling. Cash preserves its value relative to other goods and assets, while low and declining interest rates boost long-duration Treasury bond prices. Historically, gold has served a role in this regime as authorities print money to try to conquer deflation.

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FIGURE 1: Volatility of well-performing assets under four economic regimes

Figure 1 shows which assets typically perform well in different regimes, and what their relative volatilities are.

So, how do we translate this framework into actual portfolio allocations to best take advantage of structural diversification?

Step 1. Count the number of assets that react favourably to each regime, and assign them to each quadrant.

Step 2. Decide how to weight allocations across the four quadrants, based on the probability of each regime.

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Step 3. Equal weight each asset within the quadrants. For example, there are four assets in the bottom right (disinflationary growth) quadrant, so each would receive 25% of the capital allocated to that quadrant. And, each of the three assets in the lower left quadrant (deflationary bust) would receive 33.3% of the capital allocated to that quadrant.

Unfortunately, it’s difficult to know which regime we’re under, and much harder still to predict when the regime will change, and to what. So, let’s assume each of the four regimes is equally likely, and allocate 25% to each.

Tables 1 and 2 illustrate how to translate structural diversification into a well-balanced portfolio of core global asset classes. When gold and commodities are together in a quadrant, we treat them as a single asset class for weighting purposes.

Table 1: Portfolio derivation—Economic regime allocation
	Inflationary Boom	Dis-Inflationary Boom	Deflationary Bust	Stagflation
Regime Probability >	25%	25%	25%	25%
Accelerating growth
Inflation-protected bonds	20%	–	–	–
Developed corporate bond spreads	–	25%	–	–
Emerging bond spreads	20%	–	–	–
Intermediate Treasuries	–	25%	–	–
Gold	10%	–	–	–
Commodities	10%	–	–	–
Developed real estate	–	25%	–	–
Developed equities	–	25%	–	–
International real estate	20%	–	–	–
Emerging equities	20%	–	–	–
Slowing growth
Cash	–	–	33%	25%
Inflation-protected bonds	–	–	–	25%
Emerging bond spreads	–	–	–	25%
Long-duration Treasuries	–	–	33%	–
Gold	–	–	33%	12.5%
Commodities	–	–	–	12.5%
Rising inflation
Cash	–	–	–	25%
Inflation-protected bonds	20%	–	–	25%
Emerging bond spreads	20%	–	–	25%
Gold	10%	–	–	12.5%
Commodities	10%	–	–	12.5%
International real estate	20%	–	–	–
Emerging equities	20%	–	–	–
Slowing inflation
Cash	–	–	33%	–
Gold	–	–	33%	–
Developed corporate bond spreads	–	25%	–	–
Intermediate Treasuries	–	25%	–	–
Long-duration Treasuries	–	–	33%	–
Developed real estate	–	25%	–	–
Developed equities	–	25%	–	–

Table 2: Allocation weighted—Target portfolios (probability weighted)
	Inflationary Boom	Dis-Inflationary Boom	Deflationary Bust	Stagflation	Total Weight
Regime Probability >	25%	25%	25%	25%
Developed equities	–	6.25%	–	–	6.25%
Emerging equities	5%	–	–	–	5.00%
Intermediate Treasuries	–	6.25%	–	–	6.25%
Long-duration Treasuries	–	–	8.33%	–	8.33%
Corporate bonds	–	6.25%	–	–	6.25%
Emerging bonds	5%	–	–	6.25%	11.25%
Inflation-protected bonds	5%	–	–	6.25%	11.25%
Cash (T-bills)	–	–	8.33%	6.25%	14.58%
Gold	2.5%	–	8.33%	3.13%	13.96%
Commodities	2.5%	–	–	3.13%	5.63%
Developed real estate	–	6.25%	–	–	6.25%
International real estate	5%	–	–	–	5.00%
					100.00%

In this framework, developed and emerging market equities together represent just 11.25% of the total portfolio. Real estate and equities often trade in tandem and demonstrate similar risk characteristics, so if we add the 11.25% from developed and international real estate, 22.5% of the portfolio is in equity-like assets. About 20% is allocated to commodities and gold, since they have inflation-hedging properties (and gold can hedge against monetary devaluation as central banks fight deflationary forces).

Meanwhile, the bulk of the portfolio is allocated across various types of fixed income and cash, with Treasuries and T-bills consuming 29% of the portfolio. T-bills hedge against inflation and slowing growth, which justifies their relatively large allocation. Inflation-protected bonds receive 11.25%, while emerging and corporate debt together represent 17.5%. So, the broad fixed-income group gets almost 60% of the portfolio, although emerging bonds and lower- quality corporate credit exhibit equity-like properties over time.

Advantages to structural diversification

The framework of structural diversification requires you to understand the various drivers of asset returns. This framework works as long as assets behave as they theoretically should, and the universe is coherent and thoughtfully diversified.

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Compare the statistics for a structurally diversified policy portfolio versus a standard 60/40 portfolio.

However, managers are often faced with noisy, incoherent universes that have dramatically unbalanced exposures. Those factors would impair the effectiveness of this simple approach. Further, risk characteristics and correlations can change quite dramatically through time, and a static allocation like this policy portfolio can’t respond, making it vulnerable to extreme shocks.

Let’s compare the performance of a structurally diversified policy (SDP) portfolio versus a 60/40 U.S. equity/Treasury portfolio from 2001 to 2013 (go to our tablet version for more details). The SDP portfolio’s Sharpe ratio is about twice that of the balanced portfolio’s. This is the result of higher returns in the numerator (8.4% vs. 6.4%) and lower volatility in the denominator (6.8% vs. 10.7%).

Further, the drawdown of the balanced portfolio, at 30%, is almost 40% larger than the SDP’s drawdown of 22% during 2008. Lastly, the SDP delivered positive performance over almost 90% of the rolling 12-month periods, while the 60/40 was positive over just 80% of periods.

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The structurally diversified portfolio is not meant to be a perfect solution. Rather, our intent is to offer a framework for investors to think about the challenge of diversification across major economic regimes.

FIGURE 2: The Venn diagram of asset allocation

Figure 2 illustrates how a strong understanding of structural diversification for asset class risk premia can lead to better asset allocation. However, even the most coherent policy portfolio can be dynamically augmented to respond to changing risk, return and diversification properties, and to create more responsive portfolios. We’ll look at that in a future article. by Adam Butler, Michael Philbrick and Rodrigo Gordillo, advisors at Butler | Philbrick | Gordillo & Associates with Dundee Goodman Private Wealth.