How To Diversify Beyond The 60/40 Portfolio – ValueWalk Premium
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How To Diversify Beyond The 60/40 Portfolio

This article originally appeared on ETF.COM here.

The traditional 60% stock/40% bond portfolio, using publicly available, low-cost mutual funds, performed extremely well over the last 36 years – a period that included two of the worst bear markets in U.S. history.

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From 1982 through 2017, a period that begins both with a bull market and peak in interest rates, a portfolio allocated 60% to the S&P 500 and 40% to five-year Treasury bonds returned 10.4% a year with volatility of 10.2%. That 10.4% return was almost 2 percentage points a year higher than the portfolio’s 8.5% return (with volatility of 12%) over the full 90-year period from 1928 through 2017.

Unfortunately, simple mathematics makes clear that today’s investors (including pension plans and endowments) are faced with a harsher reality. Those returns, from what might be called a “Golden Era,” are not likely to be repeated.

The reason is that returns benefited from a pair of favorable tailwinds, neither of which is likely to recur. Meanwhile, the risk of mean reversion continues to exist. The result is that today’s investors are presented with great challenges in terms of achieving their financial goals using traditional investments.

The issues with traditional portfolios

The first big problem is that favorable past performance benefited from a long, steep secular decline in interest rates. We began the 36-year period ending 2017 with the five-year Treasury yielding 14.0%. We finished the period with it yielding just 2.2%.

Not only is today’s low-yield environment creating a drag on portfolio returns, it also creates an asymmetric risk – there is likely limited room for rates to go much lower to boost returns, but a whole lot of room for them to go up.

Compounding the problem is that low interest rates themselves increase the risk of fixed-income allocations because lower rates mean greater duration (a measure of bonds’ sensitivity to changes in interest rates, measured in years).

For example, as Stone Ridge founder Ross Stevens explains in his foreword to the newly released expanded and revised 2018 edition of “Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility,” the duration of the Barclays Capital U.S. Aggregate Bond Index went from a low of 3.7 years at the beginning of 2009 to 6.0 years in January 2018.

As Stevens noted, that’s the financial equivalent of levering your bond portfolio by 62% during this time period, something you are likely not aware of. Increased duration means that any future rate increases will have a greater negative impact on returns – the proverbial double whammy.

Making this problem look even worse is that all risky assets are priced off the rate on safe Treasury bonds, requiring a premium. The Federal Reserve is forecasted to raise the federal funds rate three times in 2018. As Treasury yields rise, it creates increased competition for equities and could put pressure on equity valuations, and thus returns.

Low interest rates mean traditional investors must rely on the equity portion of their portfolios to carry more of the burden if they want to achieve the same type of returns. If the 40% of an investor’s portfolio allocated to bonds returns just 2.2%, to achieve an overall portfolio return of 10%, the equity portion would have to return more than 15%.

Another way to think about the issue is that, even if an investor shifted to an all-equity allocation, equities would have to return 10%. While they have done so historically, the investor has a problem in that stocks have benefited from a long-term secular decline in the equity risk premium, which can be seen through the lens of the Shiller cyclically adjusted price-to-earnings (or CAPE 10) ratio.

Read the full article here by Larry Swedroe, Advisor Perspectives

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