The traditional 60/40 portfolio is largely a relic of the past
- The 60/40 portfolio in the current rate/inflation environment of 2022
- Rising possibility of a lost decade for the 60/40 portfolio
- The endowment model has been ahead with its allocation to alternatives. Hedge funds and private equity, combined, equate to 60% of Harvard’s portfolio, as reported in 2020.
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A couple of years ago, the Financial Times wrote the traditional 60/40 portfolio — the mix of equities and bonds that has been the mainstay investment strategy for decades — appears to be obsolete due to the probable underperformance by both of its component parts for years to come.
Flash-forward less than two years and that message has only been amplified by our current environment. Once in a generation economic events like the Great Depression, Great Inflation, and today’s period of high inflation (and potential stagflation) often prompt financial experts to reconsider their approach, and today is no different. A couple of years ago, we presciently wrote about the need for advisors to take a different approach to the stewardship of their clients’ capital. In this now updated blog post, we talk about the obsoleteness of the 60/40 portfolio construction that was designed to capture capital appreciation through equities and subsequently mitigating risk through asset diversification into fixed income.
Rising Possibility of a Lost Decade For The 60/40 Portfolio
As Goldman Sachs’ portfolio strategist Christian Mueller-Glissmann puts it, the rising risk of stagflation in the US and Europe is raising the possibility of a lost decade for the 60/40 portfolio mix of stocks and bonds. The problem here is two-fold: on the equity side of the equation, we have a geopolitical conflict that is slowing economic growth, which in turn points to slower earnings growth, coupled with lower valuations as a consequence of higher interest rates. On the bond side of the equation, bondholders are hit with a one-two punch from lower bond prices as a result of higher rates, while the pace of inflation means that real returns for bondholders will be lower, and in many cases negative. In this case, the traditional 60/40 portfolio is ill-equipped to perform and, in some cases, down more than 10% this year – on pace for the worst performance since the 2008 financial crisis.
The Endowment Model has been a Step Ahead
According to Bob Rice, Chief Investment Strategist for boutique investment bank Tangent Capital, who spoke at the fifth annual Investment News conference for alternative investments - “You cannot invest in one future anymore; you have to invest in multiple futures. The things that drove 60/40 portfolios to work are broken. The old 60/40 portfolio did the things that clients wanted, but those two asset classes alone cannot provide that anymore. It was convenient, it was easy, and it is over. We don't trust stocks and bonds completely to do the job of providing income, growth, inflation protection, and downside protection anymore.”
Rice went on to cite the endowment fund of Yale University as a prime example of how traditional stocks and bonds were no longer adequate to produce material growth with manageable risk. This fund currently has only 5% of its portfolio allocated to stocks and 6% in mainstream bonds of any kind; the other 89% is allocated in other alternative sectors and asset classes. While the allocation of a single portfolio cannot, of course, be used to make broad-based predictions, the fact that this is the lowest allocation to stocks and bonds in the fund’s history is significant.
Harvard’s New Age “Alternative 60/40 Portfolio”
“Alternative assets served Harvard University's endowment well during the fiscal year ended June 30, 2020,” Harvard Management Co. President and CEO Nirmal P. "Narv" Narvekar said in an annual report. The university's $41.9 billion endowment returned 7.3% in "another year in which asset allocation (or risk level) played a major role in returns.”
As of June 30, Harvard's endowment has an allocation of 36.4% to hedge funds, 23% to private equity, 18.9% to equities, 7.1% to real estate, 5.6% to cash, 5.1% to fixed income/TIPS, 2.6% to natural resources and 1.3% to other real assets. Hedge funds and private equity, combined, equate to 60% of the portfolio. 40% of Harvard’s portfolio is currently dominated by equities with modest real estate and fixed income exposure.
Ivy League endowments continued to gain in a year upended by the pandemic
The Ivy Leagues’ Deepening Pockets Abandoned the Outmoded 60/40 Portfolio Gradually and Long Ago
Figure 1 (Panels A and B): Endowment Asset Allocations over the Long Run
Figure 1 (Panels C and D): Endowment Asset Allocations over the Long Run
Table 2 (panel B): Endowment Performance and Risk, 1950-2017
All of these universities managed a Sharpe ratio equal to or better than the risk-adjusted return that would have been available from going long equities throughout the 67 years, with the narrow exception of Brown, which had a Sharpe ratio of 0.47, compared to equities’ 0.48. None generated an arithmetic return quite as good as could have been achieved by going 100% long equities; all did far better than government or corporate bonds, which had made up the great majority of their portfolios at the beginning of the century.
Over the past decade, the traditional 60/40 portfolio mix of stocks and bonds have served patient, passive investors well. However, with inflation running rampant, and interest rates on the rise, the future looks bleak for traditional 60/40 portfolios. Institutional private equity and hedge funds may be a viable solution for advisors who are looking to source uncorrelated, skill-based, and non-beta reliant return streams.