The 60/40 approach to portfolio construction – a mainstay of investing for many years – has come under the spotlight, but is most likely here to stay for the foreseeable future.
While the simultaneous sell-off in equities and bonds this year has alarmed investors, analysis by Schroders has shown that correlations matter less than many investors think when constructing an efficient portfolio.
“This is because most of the risk reduction in a 60/40 equity-bond portfolio comes from the lower volatility of bonds rather than their negative correlation with equities,” said Sean Markowicz, strategist, strategic research group at Schroders.
Looking ahead, the firm believes volatility and/or correlations would need to rise materially to erode the risk-reward ratio of the 60/40 compared with holding equities only.
Investing 60% into equities for capital appreciation and 40% into bonds for income and potential risk mitigation has performed well over the past two decades. With stock prices rising in a near-straight line and record-low interest rates, bond prices increased.
Concerns or doubts have arisen more recently amid a more challenging macroeconomic environment. For example, says Schroders, the S&P 500 Index fell 4.6% in the first quarter of 2022, as bond yields spiked and Russia invaded Ukraine.
At the same time, soaring inflation and tighter monetary policy knocked the ICE BofA US Treasury Index down by 5.6%. This removed investors’ go-to shelter to cushion market losses.
“Although equity and bond returns are seldom positively correlated, some fear this trend could continue. However, this does not mean investors should completely shun bonds from their strategic asset allocation,” explained Ben Popatlal, multi-asset strategist at Schroders.
Bonds can still provide valuable portfolio risk reduction and diversification, he added, even if equity-bond correlations remain positive.
Historically, Schroders says a portfolio of bonds has been roughly half as volatile as stocks.
Given this sizable difference, most of the risk reduction in a 60/40 has come from the lower volatility of bonds rather than their negative correlation with equities.
For example, since 2000, a 60/40 split has lowered portfolio volatility (versus holding equities only) from 15% to 8.6%, he added. “But just over a tenth of that reduction came from the negative correlation between equities and bonds while the rest was attributable to lower asset volatility,” said Markowicz.
Ultimately, he believes, as long as bonds remain less volatile than equities going forward, a 60/40 portfolio can still look attractive from a risk perspective.
Taking risk/reward into account
When investors weigh up a 60/40 portfolio, they also need to consider the risk/reward dynamics.
If investors only cared about reducing their portfolio volatility, they might take the decision to boost cash allocations. Yet returns are clearly a key factor, too, especially in terms of whether they are an appropriate compensation for risks being taken.
According to Popatlal, correlations and/or volatility need to increase by a lot to make investors indifferent between a 60/40 versus just owning equities.
For example, based on return forecasts from Schroders’ economics team’s (4.1% per annum for US equities and 2.9% per annum for US bonds) and assuming the last 20 years of volatility persists, the firm has found equities offer an expected return/volatility ratio of 0.27 compared with 0.38 for bonds.
However, the risk-reward for the 60/40 still beats equities under nearly all assumptions about correlations and bond volatility.
“This means correlations and/or volatility would need to rise materially in order to blunt the appeal of the 60/40,” added Popatlal.