Morningstar - Q2 2022 - 12

Dispatches
The Power of
the 60/40 Portfolio
Improving upon
common practice is
easier said than done.
IVORY TOWERS
John Rekenthaler
These days, it's fashionable to bury the
conventional investment strategy of investing 60%
of a portfolio's assets in stocks and 40% in
bonds. In September, CNBC published an article by
an investment professional stating that the
60/40 portfolio had become obsolete. A month
later, Barron's wrote that the 60/40 approach
" hasn't worked, " before following up in November
with a feature titled " The 60/40 Portfolio
Is Dead. " This January, Kiplinger's concurred.
As 20th
century philosopher Yogi Berra would have
said, " This is déjà vu all over again. " Because
10 years ago, similar claims abounded. In March
2009, an investment organization published
" The Death of 60/40. " Shortly thereafter, the era's
most famous fund manager, Pimco's Bill Gross,
also laid the strategy to rest.
It's understandable why 2009's investors
distrusted 60/40 portfolios. Although some U.S.
equities had thrived, with energy stocks
and REITs posting 10% annualized returns
for the decade, the major stock market
indexes had lost money. Thanks to their bonds,
most 60/40 portfolios had finished in the
black-but only slightly. The real money was
made elsewhere.
That " elsewhere " consisted of alternatives: hedge
funds, real estate, and private equity. Although
all three investments fell along with the stock
market during the 2008 global financial crisis, the
first two had sailed smoothly through the
2000-02 technology bust. As a result, funds that
12
Morningstar Q2 2022
had branched out into alternatives had
little trouble outgaining their more traditional
competitors.
EXHIBIT 1 illustrates the point. It provides the
annualized returns for the asset allocation
used by Yale's endowment fund and for Vanguard
Balanced Index VBINX over the 10-year period
from July 1, 2001, through June 30, 2011. (Yale's
fiscal year runs through June, not December.)
With two thirds of its holdings in alternative
securities, Yale's fund epitomized the modern
investment approach, while Vanguard Balanced
Index followed the traditional path.
For evaluating allocation results, comparing the
Yale fund's actual return against that of
Vanguard Balanced Index would be misleading,
because Yale manager David Swensen
selected securities so astutely. Therefore, I
recalculated Yale's performance by showing how
the fund would have fared had it used the
same allocation but owned indexes instead of
individual securities.
Unexpected Comeback
Vanguard Balanced Index hadn't been bad,
as it outpaced inflation during those years.
However, the fund suffered much volatility along
the way, including a 32.6% drawdown during
the financial crisis. That was a big loss for
a strategy that delivered only a moderate payoff.
Surely investors could improve their prospects
by incorporating alternatives, most of which had
outgained Vanguard's fund.
What's more, fixed-income yields had shrunk,
lowering the expected returns for a 60/40
portfolio's bonds. Fixed-income securities would
continue to serve as ballast, offering at least
some protection against stock market swings, but
their returns would be anemic. Nor would
equities deliver outsize returns. Their valuations
weren't particularly compelling, especially
as economists expected corporate earnings growth
to be sluggish for the foreseeable future.
Or so the matter seemed in 2011. To widespread
surprise, the 60/40 portfolio promptly blitzed
the competition ( EXHIBIT 2 ). It didn't surpass
Yale's return over the ensuing decade, thanks to
Swensen's continued (and unrivaled) ability to
identify, in advance, top-performing investment
managers, but this time around the 60/40
strategy outgained the Yale allocation. That's an
impressive achievement given that Yale
was heavily invested in risky private equity and
leveraged-buyout funds.
The 60/40 portfolio also comfortably led so-called
risk parity strategies, another form of alternative
investing that had become popular in 2008's
wake. To make a long story short, risk parity funds
de-emphasize equities in favor of other investment
assets. The few risk parity funds that existed
during the 2000s outperformed 60/40 portfolios.
However, as evidenced by the returns of the
S&P Risk Parity Index-10% Target Volatility, 60/40
portfolios then evened the score in the decade
that followed.
What's Next?
To give contemporary 60/40 skeptics their due,
they have broken with investment tradition
by disparaging a recently successful strategy. That
is a refreshing break from the norm. That said,
the underlying logic of the 60/40 skeptics
hasn't much changed over the past decade. Once
again, they distrust 60/40 portfolios because
bond yields have become too low and equity price/
earnings ratios too high.
Perhaps so, but as the past decade has shown,
it's certainly possible that bond yields will decline
further and equity valuations will continue
to increase. Also, who is to say that the substitutes
for a 60/40 portfolio will be an improvement?
After all, alternative investments consist either of
equities in a different wrapper (as with private
equity funds, venture capital funds, or leveragedbuyout
funds), or of real assets, many of
which are also aggressively valued. For example,
the price of gold bullion has risen 50% over
the past three years, and despite vacancies caused
by the coronavirus pandemic, the price
of U.S. commercial real estate has soared.
In the second Barron's article, five investment
advisors were asked how they would alter
the 60/40 formula, given today's conditions. Each
recommended selling bonds. Two would
replace those bonds with publicly traded equities,
https://www.morningstar.com/funds/xnas/vbinx/quote https://www.morningstar.com/funds/xnas/vbinx/quote https://www.morningstar.com/authors/208/john-rekenthaler
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