After a formidable start for the capital markets in 2023, followed by the “SVB correction”, a consensus on the sense and nonsense of the 60/40 formula still remains to be found. Investment Officer takes stock again.
The “neutral” 60/40 portfolio had to be reversed, or converted to a 30/30/40 or even 20/40/20/20 portfolio. In any case, the traditional mix should go back to the drawing board, investors said in 2022.
Seventy years after US economist Harry Markowitz, Nobel laureate and founder of «Modern portfolio theory», introduced the concept of diversification in 1952 - from which the 60/40 idea originated - investors were done with it. Negative returns ran into double digits, and negative correlation gave way to positive correlation. More and more investors turned their backs on the 60/40 portfolio.
In January, the picture tilted. The average 60/40 portfolio rose 6.2 per cent in January, according to data from Bank of America, one of the best months in more than a century. Last week, however, the fall of Silicon Valley Bank (SVB) caused declines in equity markets, and rises in bond markets - a big hit to the «60/40’ers».
Inflation and correlation
With US interest rate policy rendered highly uncertain by the fall of SVB, expected bond and equity returns are also being fervently debated again. Consequently, the success of the mix is based entirely on that correlation, says Lukas Daalder, CIO at BlackRock Netherlands.
‹If inflation is running, then 60/40 portfolio is probably fine, if inflation is disappointing, then the return of 60/40 might be too early,› says Daalder.
The relationship between inflation and correlation of equities and bonds is also what Julian Dauchez, head of portfolio consulting at Natixis, calls ‹an interesting roadmap for this year›. The rate at which inflation will fall can be seen as ‹an indicator of the dampening effect - or not - of bonds on an equity portfolio›, says Dauchez.
Inflation forecasts depend on the interest rate market, but it has been muddied since the banking turmoil. Investor nervousness due to the fall of SVB bank translated into a drop in the interest rate market from over 5 per cent to less than 4 per cent on US two-year rates within days. The policy interest rate for January 2024 is now plotted by the market at 4.5 per cent, a full per cent lower than a week back.
According to Edin Mujagic, chief economist at OHV Asset Management, inflation will remain «on the high side» for now. OHV reckons equity markets are underperforming due to the combination of excessive, persistent inflation combined with uncertainty, lower economic growth and rising interest rates.
‹60/40 enforces discipline’
Olaf van den Heuvel, CIO at Aegon AM, is more positive about the effects of inflation. A 1970s scenario, in which inflation, as then, persists more persistently than is currently priced in, is the only potential risk to the ‹extremely interesting› 60/40 mix that has become, as far as he is concerned.
As far as Van den Heuvel is concerned, there is no such thing now. ‹The most important element of a 60/40 portfolio is that it enforces discipline. In the short term, you can’t predict the market anyway. The structural factors that have a dampening effect on inflation in the long term - such as ageing and digitalisation - are still present.›
‹The mix is too cyclical’
Maximilien Macmillan, director of investments at abrdn, expects the negative correlation between bonds and equities to re-emerge when a recession beckons. Investors therefore need a ‹better balance between duration and corporate risk than the 60/40 portfolio offers›, says Macmillan.
‹60/40 is heavily biased towards procyclical corporate assets, while we think developed markets will go into recession this year,› Macmillan says. The fixed income part of the mix - traditionally government bonds and more recently supplemented by corporate bonds - needs to be more ‹countercyclical and defensive›. He advocates more exposure to safe government bonds.
60/40 portfolio in coma
In contrast, Altaf Kassam, chief strategist at State Street Global Advisors, expects the positive correlation between equities and bonds to continue for longer. As far as he is concerned, the traditional 60/40 portfolio is not dead, but it is «in a coma for a while».
Like last year, he expects to see an increasing tendency towards more complex portfolios, without the simple mix of equities and fixed income, with more diversifying assets in the equity portion such as real assets and foreign exchange.
Clearly, the demand for alternatives is not yet comatose, according to Dauchez of Natixis.
No static mix
Dauchez recognises the renewed interest in alternative investments among his clients. ‹Besides,› he adds, ‹for investors who have access to less liquid strategies, some alternatives - such as investing in infrastructure - offer the added benefit of also providing protection against inflation itself›.
‹A static 60/40 portfolio can deliver a «reasonable return», says Craig Moran, fund manager in M&G Investments› Multi Asset team, «but a more flexible, dynamic portfolio is likely to deliver superior returns in the future», he says.
Also for Henning Potstada, co-head of multi asset at DWS, the key issue with a 60/40 portfolio is the static nature of the approach. Of fixed quotas for asset classes, the portfolio manager is not keen; «we recommend a more flexible and «risk controlled» approach.
The original Dutch version of this article is available on InvestmentOfficer.nl.