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The long, slow death of the 60:40 portfolio

John Prior of Patronus Partners explains why bonds will play less and less of a role in future portfolio construction.

The long, slow death of the 60:40 portfolio

LONDON - As the offspring of modern portfolio theory, the 60:40 portfolio has gained ubiquity in the modern era as the stylised expression of what a ‘typical’ portfolio looks like.

In recent times, many commentators have started to question whether the 60:40 portfolio is fit for purpose. And they are right to do so: the basic mathematics of the situation are inconvenient and unforgiving. But before delving into this issue, I offer some context.

Firstly, we must pay homage to the bond market. For 40 years, it has provided incredible returns with almost flawless consistency and – the holy grail of portfolio construction – a negative correlation to risky assets.

The USD Barclays Aggregate index has returned 7.75% per year, comfortably outpacing inflation and providing an excellent real return. Thanks to the propensity of central banks to lower interest rates in times of stress, it saved its best for when equities were falling. Adjusted for volatility, as an asset class it has trounced the equity market.

We are used to the concept that buying insurance costs money. Similarly, as investors we understand that hedging using options creates a drag on returns. The magic of bonds was that they were the ultimate hedge, but also paid you to own them.

Waive the magic bond

Does this wonder-asset that has given so much have any more to give? Maybe, but likely not a lot.

The 10-year UK gilt has a yield of 0.18%. If you buy that gilt and hold to maturity, you make 0.18% per a year, before inflation. If inflation averages 3%, you will lose 20% in real terms in that time.

The only way to make a higher return than this is to hope that yields fall even further and sell it to another investor, but this does nothing to increase returns in aggregate.

If equities fall precipitously, will yields on sovereigns plumb new lows? Probably, but it may not be enough.

The bond conundrum

In the recent equity market correction, the S&P 500 fell 10% between 2 September and 21 September. In that period the TLT, the exchange-traded fund that tracks long-dated US government bonds is down 0.9%. That is not what investors have been conditioned to expect.

The negative correlation that investors have come to rely on is not preordained, however. Throughout history, this correlation has been positive as much time as it has been negative.

The scenario in which bonds do deliver for investors, at least in real terms, is in a deflationary collapse, which cannot be ruled out in a world of extreme indebtedness and a global pandemic. This would be akin to what happened in the Great Depression.

Unlike then, we live in a purely fiat money regime, which means developed market governments can create unlimited quantities of currency to avoid such an outcome, and a strong political imperative to ensure they do so.

For our money, it is a matter of political necessity for bonds, and particularly government bonds, to remain nominally whole but to be material losers in real terms over the years and decades ahead.

The equity equation

Although equities are unequivocally not cheap, they are not necessarily doomed to the same outcome as bonds. The FTSE 100 currently languishes 17% below where it was 20 years ago.

To be sure, it is comprised of many extremely challenged businesses and sectors, but to borrow a famous old phrase, it is hardly exhibiting irrational exuberance. As the residual slice of the capital structure, equities do at least offer some protection from inflationary policies.

Overall, investors must accept the reality that real yields and returns on large swathes of the investment universe are going to be negative for the foreseeable future. The days of earning 5% over inflation to lend Unilever money to make toothpaste and sell it back to you are long gone.

More importantly, investors need to realise that there is no such thing as a passive approach to asset allocation, even as implementation goes down that route.

Small shifts, big impacts

A 100% allocation to cash is an active decision and potentially a wealth-destroying one. They need to understand that other asset classes, such as precious metals and commodities and other strategies, such as global macro, can contribute to a better long-term outcome.

The bond market has been the cornerstone of the investment portfolio and it has done a splendid job.

However, its ability to fulfil this role is now impaired by both market pricing and policy outlook to deal with the many economic issues of the day. My suspicion is that recency bias, regulatory considerations, institutional conventions, manager career risk and good old-fashioned inertia will make shifting allocations happen slowly, at least initially.

But bond markets are very large – and even a small shift in allocations could have a huge impact on much smaller alternative markets, rewarding those who were prepared to lead rather than follow.

John Prior is the chief investment officer and a director at Patronus Partners.

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