There's been a lot of commentary recently about the time-honored 60/40 portfolio being ripe for a rethink. We couldn't agree more. But we believe that the conversations, and particularly the solutions being suggested, are headed in entirely the wrong direction. On top of that, nobody seems to be asking if these proposals are serving clients well.
While we agree that low rates are likely here for a while and that they put new strains and new risks on the fixed income side of allocation models, the question we are asking is: What should be done to evolve the portfolio for this new zero interest rate policy world?
We take umbrage with the two primary solutions we've observed being advanced in the industry to address concerns with the 40 percent fixed income side of the classic 60/40 portfolio:
- Change the allocation to a 75/25 portfolio (75% equities and 25% fixed income).
- To keep equities at 60 percent but change the fixed income allocation to a barbell between cash and long dated bonds.
Both proposals miss solving the problem and introduce undue risk. We argue the 60/40 proxy and risk allocation models in general may need to be flipped on their head altogether.
How did we get here and what investors are likely to be impacted by this discussion?
A traditional investment profile questionnaire once matched a 60/40 portfolio to an investor with moderate risk tolerance and a medium time horizon to retirement (or event of need). That was the classic use case anyway. However, that's no longer the case.
Today, the 60/40 portfolio is being used broadly as an accepted solution for those much closer to or even in retirement. Look no further than the industry's leading target date funds and you'll observe that the only thing being retired for certain is the old 30/70 stock to bond portfolio.
Today's target date glide paths no longer glide to anything that once resembled a purer conservative approach. Today, some of the industry's leading target date series feature 2025 funds that are predominantly ranging from 50/50 to 60/40 stock to bond portfolios.
The classic implementation of the 60/40 was previously used to accommodate those with approximately a 20-year time horizon. Now, the 60/40 proxy is the new 30/70 stock to bond "conservative" go-to. This is especially evident in America's default 401(k) solutions.
Don't get us wrong, we understand why managers have been forced further out on the risk curve. Fixed income is tougher to manage and produces more underwhelming results than it did 50 years ago. Again, to that end, we agree on the problem — but not on the solutions proposed.
Given most retirement assets are held by those nearing and entering retirement, the 60/40 portfolio has never impacted more assets or more investors. These same investors have never been more vulnerable to the emotional toils someone who has worked their entire life to amass adequate savings will understandably feel during times of market volatility.
By the way, the boomer retirees have good reason to feel shell-shocked. Remember the dot-com crash, the 2008 financial crisis or Covid 2020? Yes, the market came back — eventually. And yes, we believe the market will, over the long term, keep marching up and to the right. The problem is, when we previously used the 60/40 portfolio as a recommendation, those investors had 20 years left. They could stomach the volatility and needed to, in order to achieve their goals.
However, introduce the expected market volatility of a 60/40 portfolio too near or into retirement, and you've introduced major sequence of return risk. On the opposite side of the coin, if you accept zero as a net return on bonds, you're exposing your client to the real possibility that they'll outlive their money (longevity risk).
So, the consensus question being raised about the 60/40 portfolio has to do with the 40% classic fixed income side of the equation. It goes like this … given the risks present in fixed income due to a zero-interest rate world, how should portfolios be constructed to provide adequate protection against outliving one's money while limiting duration and credit risks that may be uniquely present in today's bonds as a result of our new zero interest rate policy world?
Next, we'll examine the two proposals we've observed as being the most popular ideas for revamping the 60/40 and we'll explain why those miss the mark.
The 75/25 proposal introduces sequence of return risk
One convention suggests that we deal with low rates by introducing more equities, especially dividend payers to produce an overall mix of 75/25 stock to bond. Sure, some bonds are facing headwinds. However, we think a 25 percent increase in direct stock exposure in this proposal introduces unnecessary market volatility — volatility that may lead to unnecessary sequence of return risk, depending on the investor's age and event of need. It also fails to understand the psyche of the investment customer. It's never fun walking that client each time the market drops.
If we learned anything in the last year it is that the world can change quickly. Even if your client has time on their side in terms of planning for retirement, they may need those funds sooner than expected if an emergency arises. While retirement funds shouldn't be the first place to go for an emergency, things happen out of our control. A lost job, a global pandemic, any unforeseen can derail the best 'Plan A.'
No matter a client's age, we should assume that they would prefer the same amount of return for less risk if possible and so must be ever curious about seeking relatively safer solutions that can still maximize return without unnecessarily inserting sequence of return or bad timing risk into their portfolios. The 75/25 proposal fails on those merits.
The barbell of bonds proposal assumes average carries no greater risk
The barbell argument suggests that managers should be weary of stretching for yield during a time when it is as hard to find as disinfecting wipes were in mid-2020. The cautionary statement is on point in our opinion. You can find yield in two ways: stretch for duration or reach down to lower quality. Both are problematic.
