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Is the 60/40 Model Dead?

Investment and Asset Management

One of the most immediate challenges facing investors after the pandemic is how they can build resilient portfolios that still offer decent returns, given the rise in equity markets and the current low level of government bond yields.

At Lenox Advisors, we believe the optimal path to achieving long-term sustained portfolio growth is through global, multi-asset class portfolios of stock, bond, and alternative investments, which have the best potential to protect assets and generate strong returns while minimizing risk. Several capital market studies have concluded that proper asset allocation is one of the most important influences on portfolio performance. Emphasizing asset classes and investment vehicles that have little or no correlation to a market cycle helps to increase success.

In the past, government bonds used to provide both income and the prospect of positive returns in recessions and bear markets. For this reason, maintaining a balanced exposure to equities and government bonds has always been the key to building strong portfolios.

Today, however, extremely low government bond yields offer little income and upside potential, forcing investors to adopt a more creative approach to diversification, including the use of core infrastructure, real estate, and hedge funds to find income and sources of portfolio resilience. Fixed income markets will bear the scars of Covid-19 for many years to come. After we distance ourselves from the pandemic, governments will be left with a mountain of debt, as we can already see from soaring debt-to-GDP ratios.

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After a decade of austerity, it seems unlikely that governments will want to squeeze spending beyond pre-pandemic levels or raise taxes to reduce debt, at least in the short term. The US Federal Reserve has repeatedly announced its intention to remain tolerant of rising inflation. In short, we expect central banks to keep interest rates very low for an extended period. Low or negative bond yields create extraordinary challenges for investors, who have generally relied on fixed income assets to serve two purposes in the portfolio: first, as a source of steady income, and second, as a source of protection during periods of volatility.

The challenge now for investors is how to rethink the 60:40 portfolio (60% equities/40% fixed income), and specifically how to recreate the income and diversification that traditional fixed income exposure used to provide. There appear to be options for income outside of government bonds, such as high-yielding corporate debt and emerging market bonds. However, in many cases, these asset classes have a historically high correlation with global equities. We believe bonds still have a critical role to play in portfolios, but strategies require a global reach and must be sufficiently flexible and attempt to prevent macro and policy risks. In terms of income, high-dividend stocks will also play an increasing role in portfolios. Of course, while solving the income challenge, dividend-paying stocks do not help to reduce portfolio volatility. In the past, some high-dividend paying sectors have also been some of the most volatile parts of the markets.

In our view, some of the most attractive solutions for providing income and diversification can be found in alternatives. Real assets, such as real estate and infrastructure, offer more attractive yields than government bonds. However, while property continues to offer attractive yields, selectivity is critical. Global core infrastructure has produced remarkably consistent and defensive income streams in different periods, including the last two recessions, thanks to often contracted and regulating cash flows. The downside with some of these alternative strategies is their relative illiquidity or their higher correlation to equities if owned in a listed form (i.e., real estate securities).

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Some of the more liquid alternative strategies that can provide downside protection include hedge funds. However, not all the different types of hedge fund strategies perform the same during bear markets. Macro funds have done the best job of consistently protecting portfolios. While return expectations for macro funds have been relatively low, good manager selection may help to boost returns in bull markets while at the same time providing downside protection during bear markets.

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In conclusion, shifting to a much higher equity allocation to boost returns in the face of a low-interest-rate environment, such as an 80:20 portfolio, would require the acceptance of considerably higher volatility, which may be particularly uncomfortable for investors with shorter-term savings objectives. In our view, investors would be wise to instead maintain a flexible fixed income exposure but supplement this proportion of the portfolio with real estate, infrastructure, and macro strategies.

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