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A popular narrative circulating for the last several years has been that the traditional balanced portfolio, as represented by a 60% equity/40% fixed income (60/40) allocation, is dead. In 2019, analysts at Bank of America released a report to great fanfare stating that the traditional 60/40 balanced allocation was unwise. More recently, Kiplinger, Bloomberg, and Goldman Sachs have weighed in with concerns about a 60/40 balanced allocation. These commentaries all recognize the primary importance of the asset allocation decision. For that reason, they question why investors would continue to hold a sizable portion of their assets in fixed income when yields are at historically low levels. It all leaves investors questioning whether the 60/40 portfolio will continue to deliver for them in the future.
How did we get here?
The 60/40 portfolio is a universal construct designed to give investors saving for retirement access to economic growth and income in a diversified manner. It might not offer the right blend of stocks and bonds for every investor; instead, the 60/40 portfolio represents the default construction for most investors as they consider a balanced allocation.
Hypothetical growth of $100, 1990–2021 (partial year)
Sources: Refinitiv, Barclays, September 2021. For illustrative purposes only. The hypothetical portfolio performance is derived directly from the S&P 500® (60%) and the Bloomberg Barclays Municipal Bond Index (40%). The portfolio is rebalanced back to the 60/40 allocation target at each month’s end. The performance doesn’t reflect the experience of any investor. It isn’t intended to reflect the performance of any strategy offered by Parametric. The performance doesn’t reflect the deduction of management fees or transaction costs, which would reduce returns. It isn’t possible to invest directly in an index. Past performance isn’t indicative of future results. All investments are subject to the risk of loss.
Looking back over the past 30 years, it’s easy to see the appeal of a balanced portfolio approach. From January 1991 through August 2021, a 60/40 portfolio produced an annual return of 9.2% while exhibiting volatility of 9.0%, equating to a Sharpe ratio of 0.7. Over this same period, the broader equity market, as measured by the S&P 500®, generated an 11.2% annual return while exhibiting volatility of 14.5%, equating to a Sharpe ratio of 0.6. The clear advantage of the balanced portfolio is that it provides investors access to 76% of the upside returns of a fully invested equity portfolio while allowing them to sleep easier at night by experiencing nearly 40% less volatility. How much better is their sleep? Consider the relative drawdowns of both portfolios.
Hypothetical drawdown, 1990–2021 (partial year)
Sources: Refinitiv, Barclays, September 2021. For illustrative purposes. The hypothetical performance doesn’t reflect the experience of any investor and shouldn’t be relied on to make investment decisions. Past performance isn’t indicative of future results. It isn’t possible to invest directly in an index. All investments are subject to the risk of loss.
Simply put, the drawdowns for the balanced portfolio have been less severe. Twice in the past 30 years, a fully invested equity portfolio realized a drawdown of more than 40%. During the global financial crisis, it exceeded 50%. Most investors approaching retirement can’t tolerate this level of drawdown; thus, they gravitate toward a balanced allocation. High-quality fixed income provides ballast to an equity portfolio, reducing volatility in these extreme market environments. The drawdown for the 60/40 portfolio, while still severe, was significantly less than the equity portfolio in all cases, enabling less risk-tolerant individuals to stay fully invested rather than forcing them to sell at an inopportune time. The absolute and risk-adjusted performance of the 60/40 portfolio over the past three decades is what’s made it so popular with investors. So why are so many quick to state that it’s dead?
The arguments against the 60/40 portfolio going forward all revolve around its exposure to fixed income. There are three specific lines of attack most critics follow when pronouncing the death of the 60/40 portfolio.
- Fixed income markets have been on a 40-year bull run, and yields have now reached a lower bound. With the 10-year Treasury yield hovering around 1.5% and spreads tight, investors can no longer afford to hold a significant allocation to fixed income.
- With the economy opening up, the Fed engaging in quantitative easing, and Congress debating a record stimulus package, the risk for interest rates is to the upside. Fixed income will underperform in the future as inflation ticks up and interest rates rise.
- One primary benefit investors have traditionally received from holding fixed income is that yields decline when growth assets come under pressure. However, with yields already near their lower bound, bonds aren’t likely to rally much further from here. In the future, if growth assets come under pressure, investors should expect limited upside from their fixed income investments.
Many critics recommend that investors replace their core fixed income holdings with alternatives like infrastructure, real estate, or reinsurance to achieve higher expected returns while maintaining some diversification benefits relative to traditional growth assets like equity. All of us at Parametric believe firmly that more diversification is preferred to less, but we want to tread cautiously before relegating an asset class that has served investors so well in the past to no role or to a minor one in their portfolio.
Fixed income benefits
Even at these low yield levels, many benefits of fixed income remain intact. Let’s consider just a few:
- Ballast. Assuming we don’t migrate to a high-inflation environment, high-quality fixed income will continue to dampen the volatility of portfolios heavily oriented toward growth assets. For investors nearing retirement, minimizing the potential for steep portfolio drawdowns is critical.
- Return. High-quality fixed income can still be a meaningful source of returns for investors. For example, the Bloomberg Barclays Municipal Bond Index has an average quality of AA2/AA3 and yields more than 1%. Managers who implement an equally weighted laddered fixed income portfolio can enhance the yield through active selection and roll down, depending on the steepness of the yield curve. The ladder structure simultaneously protects against rising rates through regular and frequent reinvestment. A general rule of thumb for investors to keep in mind is, as long as their time horizon is longer than the portfolio’s duration, rising rates will be beneficial to returns.
- Taxes and Fees. Investors and advisors understand that taxes and fees represent material drag on performance. Fixed income portfolios can be structured in a tax-aware manner to minimize tax liability. Investors can achieve this outcome for a modest fee. Private investments like real estate and infrastructure are often less tax-aware and come with substantially higher fees. Taxable investors, in particular, need to consider carefully what they expect to earn after realizing all taxes and fees.
Rather than abandoning the 60/40 allocation, investors might be better off using it as the core in a core/satellite portfolio construction. In this structure, investors keep a significant portion of their assets in a balanced core (60/40 or something similar) and opportunistically make investments in satellites that provide an enhanced return, increased diversification, or both. Importantly, each satellite investment is considered independently to understand how it interacts with the core and other satellite investments.
The bottom line
Low interest rates have caused many market pundits to declare the 60/40 portfolio dead because of its exposure to fixed income. At Parametric, we still believe fixed income can continue to play a meaningful role in a diversified portfolio. Investors seeking greater diversification and higher expected returns may want to consider a core/satellite structure that maintains balance in the portfolio core but opportunistically seeks out diversifying investment opportunities structured as satellites.
Hypothetical performance has been provided for illustrative purposes only. It does not represent actual returns of any investor. Hypothetical performance results have many inherent limitations and should not be relied on for investment decisions. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. Actual client returns will vary. No security, discipline, or process is profitable all the time. All investments are subject to risks, including the risk of loss of principal.
The Bloomberg Barclays Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. “Bloomberg” is a trademark and service mark of Bloomberg Finance L.P. (“Bloomberg”). “Barclays” is a trademark and service mark of Barclays Bank Plc, used under license. Bloomberg Finance L.P. and its affiliates (collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary rights in the Bloomberg Barclays Indexes. Neither Bloomberg nor Barclays Bank Plc or its affiliates (collectively, “Barclays”) guarantee the timeliness, accuracy, or completeness of any data or information related to the Bloomberg Barclays Indexes. This strategy is not sponsored or endorsed by Bloomberg or Barclays, and each makes no representations regarding the content of this material.