Are 60-40 portfolios two-legged stools?
Traditional portfolio allocations to just long-only equities and bonds may be less optimal than adding alternatives, writes Amadeo Alentorn, lead investment manager, Jupiter systematic equities.
The motivation behind the 60-40 portfolio is to seek diversification: the hope is that when equities fall, bonds, as a separate asset class, may be uncorrelated and compensate. Seeking diversification is always sound, but allocation to only two asset classes (long-only equities and long-only bonds) does not deliver enough diversification, we suggest. Expecting a 60-40 allocation to protect investors from downturns is like trying to sit on a stool with only two legs: unsurprisingly, it falls over fairly often.
The simultaneously poor performance of equities and bonds in 2022 – a year in which they were positively correlated – has raised doubts about 60-40 in many investors’ minds. Yet what some may not fully appreciate is how often in history portfolios based on this traditional allocation have had negative returns.
Looking back almost a century, from 1928 to 2022, a portfolio allocated 60% to the S&P 500 index, and 40% to the return of the 10-year US Treasury bond, had a negative overall return in 21 separate calendar years. That’s between a quarter and a fifth of the total number of calendar years. If a stool fell over every four or five times you sat on it, you might be inclined to conclude it was poorly designed.
2022 was the third worst year for the 60-40 portfolio in that lengthy period. The worst three years were 1931, 1937 and 2022. The worst two years were encompassed by the Great Depression (which began with the Wall Street Crash of 1929 and lasted until 1939). In 1931 the S&P 500 tumbled and the 10-year Treasury fell slightly, while in 1937 the 10-year Treasury was modestly positive, but was utterly unable to make up for that year’s large fall in equities. 1974 (when there was an oil crisis) was a similar story: although the 10-year Treasury was up, it nowhere near compensated for the large loss in equities. 2008, the year of the Great Financial Crisis, was rather different: there was a flight to government bonds and the 10-year US Treasury gained 20.1%, offsetting the losses of the S&P 500 (-36.6%), although there was still a substantial loss for a 60-40 portfolio, its fifth worst performance on our list.
It is perhaps surprising that 2022 was the third worst year on our list, because the economic situation in 2022 was nowhere near as desperate as that of the Great Depression of 1930s, or the mortgage loan and banking crisis of 2008. There were two main reasons why the 60-40 portfolio did so badly in 2022. Firstly, equity prices became very frothy during the second half of 2020 and the whole of 2021. Secondly, in spring 2022, the US Federal Reserve suddenly reversed course in order to fight soaring inflation by hiking interest rates, and this shocked the bond market, as it came after a long period of very low rates. Bonds failed in providing any diversification. The equity market fall in 2022 was accompanied by the worst calendar year return (-17.8%) in the 10 year US Treasury in the whole of the period from 1928-2022. (Most of worst falls in the US 10-year have been in recent decades: 2009, 2013. 1999, 1994; prior to the 1970s it was less volatile.)
Between 1928 and 2022, there were six calendar years in which the 60-40 portfolio suffered double digit losses, and another 15 years in which it posted single-digit losses. Were these drawdowns only temporary? No. About half (10) of the 21 down calendar years for the 60-40 portfolio were not isolated years. All clusters of down years lasted only two calendar years, however, except the four-year cluster of 1929-1932, the aftermath of the Wall Street Crash.
Below is the same annual data as in the 1928-2022 table above but sorted from worst (on the left) to best calendar year return. Although the 60-40 portfolio has a positive (black) return in most years, and is on average positive (+8.9%, the grey line), it nevertheless exhibited the potential for severe drawdowns (the down years shown in red to the left).
GEAR has therefore offered a good additional source of diversification to equities and bonds. Adding GEAR to an equity-bond portfolio is rather like giving that portfolio a third dimension.
Of course, adding GEAR to a 60-40 portfolio might only mitigate a very severe equities market fall, rather than completely reversing it. But, based on the 13 year track record of the fund, it has helped, as the chart below illustrates.
The green line shows the effect of including just a 10% allocation to GEAR, with the remaining 90% split between equities and bonds in various proportions. The leftmost green dot is 80% bonds, 10% equities, 10% GEAR. The rightmost green dot is 10% bonds,