The 60/40 Problem: Examining the Traditional 60/40 Portfolio in an Uncertain Rate Environment
16 Pages Posted: 27 Apr 2017 Last revised: 12 Nov 2018
Date Written: April 1, 2017
The investment industry is facing a crisis. Over the past several decades, advisors have leaned on the 60/40 portfolio to deliver a less-volatile, but still relatively reliable return for balanced investors due to their lack of tolerance for the volatility and draw-downs of a pure equity allocation. While the addition of bonds to an otherwise non-diversified portfolio of equities does indeed reduce the beta of the overall portfolio, the correlation to equities remains high given that “the 60” has been 3 times as volatile as “the 40.” In our view, the 60/40 problem boils down to an underestimation of future risks for both bonds and stocks.
Historically the trade-off between equities and bonds has conformed to intuition and been in sync with financial theory – as rates fall, bond prices increase and stocks become more attractive on a relative basis. Investors during interest rate regime changes were left with a relatively simple choice – bonds near new highs or stocks near new lows… or the converse. With U.S. stocks and bonds both at or near all-time highs, the choice today is significantly more complicated. At this juncture, investors are confronted with a changing interest rate landscape following an environment where equities and bonds have both generated Sharpe ratios above their full sample average. Could rising rates cause an economic crisis? Could equities and bonds continue to rise in tandem? What is an advisor to do in these uncertain times? Our answer at Blueprint utilizes the asset class diversification discussed previously, while also incorporating time diversification or trend following.
Using simple models to show the robust properties of this approach, we tested the effects of utilizing a trend following model applied to a 60/40 portfolio during each of the U.S. interest rate regimes vs. buy-and-hold. Using 8 and 12 month moving averages (T8 and T12 respectively), we analyzed the absolute and risk-adjusted returns to determine if the addition of trend following could benefit a traditionally allocated portfolio during rising and/or falling rate environments. The two trend following strategies included a 20% buy-and-hold component and 80% trend following component. The buy-and-hold component was included to allow for the benefits of asset diversification as well as to guard against investors making emotionally-charged decisions impacted by Availability and Hindsight biases. Regarding trend following strategy rules, when the most recent month’s closing price was above the moving average, the asset was determined to be in an uptrend. When the most recent month’s closing price was below the moving average, the asset was determined to be in a downtrend. Allocations were then shifted from downward trending assets to upward trending assets or cash.
We found that applying a trend following strategy to a 60/40 buy-and-hold portfolio improved the risk-adjusted performance across every interest rate regime since 1900. Exhibit A below displays a summary of the Sharpe Ratios for each period. Looking specifically at rising rate environments, trend following allowed an investor to achieve higher risk-adjusted returns without having to make a prediction about, or be beholden to, future bond yields or stock returns. Looking at falling rate environments, including the two largest financial crises since 1900, a trend following strategy allowed investors to sidestep a significant portion of the maximum draw-down in the '29-'31 (Great Depression) and '07-'09 (Great Recession) periods by shifting exposure away from equities and toward bonds or cash. Again, these shifts required no predictions or reliance on past relationships – they resulted merely from a simple strategy driven by data.
At Blueprint we believe that investing with discipline is more important than investing in instruments. Adding a trend following strategy to a buy-and-hold portfolio has increased positive outcomes on both an absolute and risk-adjusted basis in both rising and falling interest rate environments over the past century. Advisors and investors should have a time-tested plan by which to operate in environments that mirror and, most importantly, do not mirror the past. Given the historical uniqueness of the current period for traditional asset classes, we encourage advisors to explore incorporating efficient, robust risk management processes to solve their 60/40 problem.
Keywords: Investing, Allocations, 60/40, Trend Following
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