The traditional 60% Equity/40% Bond portfolio has performed excellently for the last four decades (according to some research from Schroders, producing better returns than just equities or just bonds). They have provided good returns and a smoother ride than pure equities. There is a lot of chatter at the moment about the future for these portfolios. With bond yields now so low and fears of future inflation there is some doubt as to whether the 40 part of the 60/40 is going to struggle to do what is has in the past.
Historically, to quote our good friend Andy Hart, equities have been the whisky and bonds the water. The role of bonds in the past has been to stablise the equity part of the portfolio by providing small gains when equities suffer losses. In more recent years investors have become used to bonds producing higher returns than they strictly should, which will increase the shock as returns fall or turn negative.
The issue currently is that as central banks have printed money, rather than price inflation which might normally be expected we have had asset price inflation. This is a great time to be invested, as it feels as through everything is growing fast and all at once. The problem might come, though, when price inflation does finally arrive. Recently shareholders have been capturing most of the return from companies, certainly more than other stakeholers such as employees. These returns have been boosted by the returns being capitalised on cheap debt. Inflation could put both of these factors at risk.
At the same time as causing issues for equities the same conditions would hurt bond values, just when they were needed to act as the ‘water’. Whilst we might not be heading for the extreme levels of inflation that we saw in the 70s, that decade was brutal to the 60/40 portfolio and was the last time that the concept was truly tested.
The argument that many active managers are making currently, is that if bonds are not going to act as the diversifier then alternatives need to be found (and by extension that you won’t find them in a passive portfolio). There might be some mileage in this but prices have been rising for years across the asset classes and alternatives might not provide any more protection than bonds.
So is there anything that the traditional 60/40 investor can do to protect themselves?
Well firstly, we need to re-base our view of what bonds are there to do. Rather than be the return generator of the last few years, we need to view them again as the boring stabliser. If we adjust expectations from ‘extra growth’ to ‘not likely to lose as much’ then we can view them through the lens of a cash alternative.
Secondly, you can look at the average duration of your bonds to see how close to cash your exposure is. Longer duration bonds may be more susceptible to loss of value in an inflationary environment and so a shorter duration portfolio offers less of a return but potentially a more stable counter-point to equity risk. An overly UK-centric portfolio may have longer bond duration as the UK tends to issue longer dated bonds for example. These days there are many ways to access market returns passively and some of these will include a tilt away from longer duration bonds.
Thirdly in a lower return, more volatile or loss making investment environment, costs suddenly matter again. With global equity returns in the last 12 months of 20%+, few investors care about paying 2%-3% per annum to a combination of adviser, fund manager and custodian. However, when rates are low single digits or even negative that suddenly looks as though the financial services profession is keeping rather too much of the return or taking too much of the falling capital value.
Fourthly and most controversially, it might be good to revisit why anyone would want to dilute their whisky in the first place. All the evidence is that equities are the asset class that produce the best long-term return, so why isn’t the rational, well-advised client investing solely in shares. As advisers we spend time assessing the attitude to risk of a client, as we discussed here, and this process is supposed to identify from this, a client’s likely propensity to sell out of investments in the event of loss. It is a psychological test of a client’s ability to cope with the variability of equity returns. The issue is, if the unemotional answer to the question of how to invest for the best return over the longer term is 100% equities, why are we allowing an emotional answer to reduce our returns. The average client asset allocation is 60% equities because of the way that these risk tests have been designed and that is a long way from optimal if you aren’t convinced that investor will all dis-invest when returns turn negative.
The risk that gets ignored the most in all of this, is the risk of inflation eroding our buying power. As investors we are hugely influenced by recency bias and we have become used to very good asset growth, low inflation, low interest rates, cheap mortgage payments, low taxation on growth, low wage inflation, low food prices and easy access to cheap goods. There are signs that many of these are changing and therefore the investor with the long-term investment horizon, highest equity component, lowest costs, lowest tax exposure and the strongest stomach is likely to be the one that will survive.