There are just two problems with 60/40 investing: the 60 and the 40. Stocks are precariously priced, and bonds might not offer the protection they’re supposed to.
That’s according to a recent report from Jared Woodard, head of the Research Investment Committee at
BofA
Securities. Investors in the most popular index funds, he argues, are likely to be disappointed from here.
I reached out to learn more, including whether I should just whine and wait it out, or get off my duff and do something.
“Diversifying away from these broad benchmarks today is actually your only path to getting the kinds of returns that maybe you’re used to,” says Woodard. “That kind of has that feeling of like the guy in the adventure movie who says, you know, ‘Come with us if you wanna live.’ ”
That’s a Terminator 2 reference, I’m pretty sure, and on the Arnold Schwarzenegger scale of investor action tolerance, I’m more of a Kindergarten Cop guy. But it had my attention.
The basic premise of 60/40 investing is that stocks, the 60%, are lucrative but manic, while bonds, the 40%, are boring but dependable. Put the two together, and each will make up for the faults of the other, leaving an investor with respectable long-term returns and bearable short-term swings.
The percentages are just a starting point; investors who are many years away from needing the money might want to put more in stocks.
Last year, U.S. stocks lost 18%, which is bad, but only in a that’s-how-it-goes way. Long Treasurys lost 31%, which is bad in more of a someone-call-an-exorcist way.
At year’s end, research desks debated whether 60/40 was dead, but the timing of that question seemed off. Surely if it died, it did so at the start of last year, when long bonds yielded just 2%, and then recovered a pulse by the end, when they paid 4%.
This year, stocks have surged and long bonds have done OK. But Woodard says that the evidence that 60/40 is broken is now stronger than ever.
Take bonds. Their reputation as a good hedge for stock portfolios is owed to a few recent decades of falling interest rates and inflation. For most rolling 24-month periods since 1945, stocks and bonds have moved together, BofA finds.
Since 1920, a 60/40 investor has made 8.8% a year, while an all-stock one has made 10.3%. The lower returns are worth it for the peaceful sleep, the thinking goes, but Woodard calls Treasuries “expensive, underwhelming insurance.” For many asset allocators, they have taken up 40% of capital but provided just 25% of returns, and now that interest rates and inflation can no longer be counted on to slide, things could look worse.
Bonds contributed 4.1 percentage points of yearly returns for 60/40 investors after 1980, when they became a good hedge for stocks. But during the longer period before that, when stocks and bonds traded together, bonds provided just 1.3 percentage points of return per year.
Now, stocks. Thirty years ago the S&P 500 index was a good way to diversify. Its stocks averaged just 10% to 12% correlation with each other. That’s now 50%, and at times as high as 80%. Concentration is high, with seven stocks contributing all of this year’s gains. That evokes past periods of market leadership that ended with big downturns, like the run for the Nifty Fifty blue chips of the 1960s and early 1970s, and that of the dot-com highfliers of the late 1990s.
BofA data show that there have been six lost decades for 60/40 investors since 1900, averaging losses of 0.5% a year after inflation. Woodard thinks we could be poised for another one now.
The S&P 500 could be headed for a “real painful repricing,” he says. “Why wait for the rebalancing to happen, whether by time, or uncomfortably by price, when you can make some changes to rebalance now?”
OK, that got a little gloomy. Let’s pause for a deep breath, a peaceful thought, and maybe some chin scratches—your pet, not yourself, although I don’t want to tell you how to spend your happy time.
Woodard’s advice for fixing the old, familiar 60/40 portfolio isn’t as jarring as you might expect. Basically, get a little weirder. Walk into the Star Wars cantina of oddball asset classes and shake some hands, or claws, or whatever. That is, buy into less-crowded sources of yield and growth.
You can use exchange-traded funds. BofA recommends preferred stocks for high, stable yields through, for example, the
Global X U.S. Preferred
ETF (ticker: PFFD); municipal bonds for relative value, as in
iShares National Muni Bond
(MUB); convertible bonds for growth and yield, like in
SPDR Bloomberg Convertible Securities
(
CWB
); and a smidgen in something short and safe, such as
Schwab Intermediate-Term U.S. Treasury
(SCHR).
For the stock side, BofA Securities estimates that equal-weight index funds such as the
Invesco S&P 500 Equal Weight
ETF (RSP) are now priced for double the return of traditional funds that weight companies by market value.
Other funds that track the firm’s favored strategies and sectors include the
Vanguard Small-Cap Value
ETF (VBR), Pacer U.S. Cash Cows 100 (COWZ),
Energy Select Sector SPDR
(XLE),
SPDR S&P Metals & Mining
(XME), and
Global X Uranium
(URA).
The idea, I gather, is to sprinkle ETFs like these atop existing, plain-vanilla index funds. It’s worth considering, although it’s difficult to judge how much to put in each. Also, fees on specialized funds are generally higher than on plain ones. That COWZ one, for example, has expenses of almost a half point a year, whereas
Vanguard S&P 500
(VOO) costs next to nothing. And some niche funds demand a bit of ongoing attention to changing conditions, not a set-it-and-forget-it approach.
My current allocation is 60% cheap and 40% lazy, so I’ll have to give it more thought.
Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.
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