60/40 isn’t dead – it just needs a rethink

In the ever-evolving landscape of investing, the traditional 60/40 portfolio has long been hailed as a beacon of diversification. But as markets continue to shift and new opportunities arise, it’s becoming increasingly evident that a one-size-fits-all approach may not suffice. We believe it's time for investors to rethink their diversification strategies.

Let’s explore why the conventional wisdom surrounding the 60/40 portfolio may no longer hold water in today’s market environment.

Bonds go back to the future

We’ll begin with government bonds, a common allocation in many multi-asset portfolios, including the 60/40 portfolio.

As at the end of April 2024, the yield on the US 10-year government bond was 4.68%.¹ For the past eight months, yields have averaged over 4%. For context, the last time this happened was back in 2007. There’s little need to repeat what happened in the years following the global financial crisis, but what is important to note here is the difference in market environment that we are seeing today.

A key part of that difference is clearly inflation. Bonds, and in particular nominal government bonds, have seen yields rise as inflation has risen from the lows of 0.1% in May 2020 (US CPI), to the peak of 9.1% in June 2022. A buy-and-hold government bond investor would have seen a negative return over that period, to the tune of around 15%.² Why does this matter? The point here isn’t necessarily about why bonds performed poorly, but rather around diversification.

The correlation conundrum

Bonds have traditionally exhibited a negative correlation to risky assets like equities. In other words, when equities fall in value, bonds typically rise in value, and vice versa. For a multi-asset portfolio, this negative correlation can be beneficial during equity down markets.

The chart below illustrates that relationship going back to January 2000, using US equities and US treasuries as the two assets of interest. As shown on the chart, the correlation between equities and bonds does tend to move around, so it is not necessarily a stable relationship (one of the reasons we believe in being active in keeping portfolios diversified), but on average, over this long-term period, the correlation was -0.28.  

Although this emphasises the potential diversification benefits of bonds over the long term, it is important to note that over the shorter term there can be periods of disruption to the diversification benefits, when we see positive correlation between equities and bonds. In these periods, the two main assets of a 60/40 portfolio would be correlated in the same direction – not necessarily in line with the diversification ambition of the strategy.

We feel it is important to recognise the potential challenges these positive correlation periods introduce, as ignoring this risk may unintentionally carry higher risk in portfolios.

Diversification to the rescue

How does the team think about this challenge? Diversification. Not just diversification into other asset classes like alternatives, especially low-correlating strategies, but also within fixed income.

Adding to other assets within fixed income, such as emerging market debt, UK government bonds, UK credit and also into multi-faceted, flexible fixed income sectors like strategic bonds and absolute return, we believe, can bring the benefit of improving overall diversification to the portfolio.

In particular, with the latter two strategy, there are potentially two main added benefits, firstly through accessing assets classes within fixed income that may be difficult to access by some, through limitations of availability on platforms (for example, asset-backed securities, or contingent convertible bonds) and secondly the ability of these strategies to offer a different duration profile than other fixed income sectors.

By being less reliant on one particular asset to provide diversification against risky assets like equities, we believe we’re more likely to have a smoother set of outcomes. This could, in our view, allow investors to access the power of compounding returns over the long term. 2022 is one instance where a diverse exposure to a range of bonds offered better portfolio diversification than allocating simply to US treasuries alone. The Bloomberg Global Aggregate index hedged to US dollars returned -11.2% compared to -12.5% for US treasuries for similar levels of duration in that year.

While this is just one select period, it helps to emphasise the point that much like how we wouldn’t advocate allocating to a single sector or region within equities, we would also advocate for a diverse range of exposure within fixed income. For instance, we are proponents of investing across a myriad of fixed income sub-asset classes and regions from EM debt and high yield to EU government bonds and credit in order to limit exposure to the idiosyncratic return drivers for each sub-asset class.  

Delving deeper into bonds

Bonds continue to play an important role in portfolios, in our view offering balance to other risky assets. But being overly reliant on just one particular asset has its shortcomings. Diversification remains an important foundation for multi-asset portfolios, especially in times of higher volatility. 

We believe it’s no longer enough to simply spread investor capital across equities and fixed income and hope for the best. By delving deeper into specific regions and sectors, investors can unlock potential opportunities that may be overlooked in broad-based portfolios.

For instance, by implementing a view on the relative attractiveness of UK government bonds versus European government bonds, investors can potentially capitalise on perceived mispricing and inefficiencies within the fixed income market. The growth of investment choices on UK platforms today means investors have a bigger toolkit to choose from.

It should be noted that diversification is no guarantee against a loss in a declining market.

1. Source: Bloomberg.

2. Source: Bloomberg, data from 31 May 2020 to 30 June 2022.