By Sam Liddle, Sales Director, Church House Investment Management
For a long time, the 60/40 approach to portfolio management was perfectly effective. Offering a combination of equity-like returns and stable income, it allowed investors to participate in any market upside, while at the same time offering protection during periods of volatility. Simple. However, the approach has faced snowballing criticism over recent years in the face of unprecedented market performance.
Well, over time, as the value of each asset in a portfolio shifts in line with its performance, its size within the total portfolio in percentage terms will naturally also change. To keep the 60/40 split between equities and bonds in check, then, it becomes necessary to sell overperforming assets and add to underperforming ones periodically.
In and of itself, this is not a problem. In fact, rebalancing in such a way is good practice –working to reduce concentration risk and prevent emotion-driven decisions like panic buying and euphoric selling. And in an ideal world, the underperforming assets into which the investor re-invests would see an uptick in performance, enhancing total portfolio returns and smoothing out volatility.
The issue, however, is that this hasn’t been the case at all in recent years. We have seen unprecedented global central bank support since the global financial crisis in the form of interest rates and other initiatives designed to aid economic recovery.
On the one hand, this has consistently suppressed bond yields, leaving them stuck at just a fraction of the level at which they have typically sat historically. On the other, it has enabled equity prices to soar to new records, with valuations stretching to levels consistently highlighted as unsustainable by commentators.
As you’d imagine, maintaining the 60/40 split against this backdrop has consistently required investors to sell off overperforming equities and invest in underperforming bonds. And in the eyes of many, this has been akin to throwing good money after bad, effectively wiping away returns time and time again for no good reason.
So, while the 60/40 approach may not have generated the best returns in recent years, is it fair to classify it as ‘dead’? No, we don’t think so. And the reason why is that things are now changing seismically in the market.
The tremendous injection of liquidity by central banks throughout, and in the wake of, the pandemic has pushed inflation to unsustainable, multi-decade highs worldwide. As a result, those same central banks are now being forced to increase rates in earnest to steer clear of hyperinflation.
Likewise, we are now seeing institutions like the Bank of England and the Federal Reserve move away from their roles as the de facto buyers of corporate debt. In some cases, they have even begun to unwind their recent purchases back into the market.
There’s an argument to be made, of course, that the ongoing conflict in Ukraine is slowing this tightening of monetary policy. But this will only be temporary – higher rates and tougher stances are an inevitability over the long term.
And for many investors, the move away from the seemingly endless ‘growth’ phase that has favoured equities and hurt bonds for so long and into the ‘slowdown’, ‘recession’ and ‘recovery’ phases is going to come as quite a shock.
Indeed, there’s a good chance that we will see heavily stretched equity valuations come into question as rising rates continue to elevate bond yields. And if this takes place, then something closer to the 60/40 approach – with its emphasis on income alongside growth, may suddenly become much more effective.
Yes, there have been significant losses for some bond investors so far this year but by proactively protecting holdings, either through curve positioning (the duration), credit quality or more explicit interest rate hedges via floating rate bonds, is crucial to getting the fixed income element of portfolios right.
Government benchmark yields have risen sharply and holders of too much duration have certainly paid the price. But bear in mind though the opportunities that this readjustment has created through a combination of the increase in the ten-year gilt yield (discounting a move to 1.5% in UK interest rates) and the widening of the credit spread above that.
Only a few months ago, the short end of the gilt curve was almost negative, now we have two-year gilts offering a mighty 1.3%. Not that attractive in itself, but when you add a credit spread on top, you can access a fair yield on a total return basis. There are now a number of quality bonds, issued last year when yields were low, that are trading well below par.
The 60/40 approach to portfolio construction was unquestionably of limited effectiveness throughout the enormous post-millennium equity bull market. However, to describe it as ‘dead’, as many commentators have, is so definitive. After all, it promotes a responsible approach to asset allocation that accounts for both growth and volatility. And in a world where many indicators suggest we are moving towards a more depressed stage of the market cycle, this is becoming increasingly invaluable.
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First published on Trustnet. The above article has been prepared for investment professionals. Any other readers should note this content does not constitute advice or a solicitation to buy, sell, or hold any investment. We strongly recommend speaking to an investment adviser before taking any action based on the information contained in this article. Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.