Rethinking the 60-40 portfolio

Frank Talbot, Head of Investment Research

For decades, portfolios which combine 60% equities and 40% bonds have been the default for investors seeking growth tempered by stability. Yet the past 15 years have tested that. The post-credit-crisis era has been extraordinarily kind to equities, particularly US tech giants, which have propelled the global equity index up six-and-a-half-fold since 2008. Bonds, by contrast, have delivered a modest 2.5% annualised return, while commodities and cash have barely kept pace with inflation. 

The imbalance has created a sense of “FOMO”, the fear of missing out, among investors. In hindsight, the 60-40 mix often looks underexposed to equities at precisely the moment when stocks have surged. Yet this margin of outperformance cannot be sustained indefinitely. The US now accounts for roughly 75% of the global equity index, up from 40% in 2010, concentrating geographic risk in a few companies and countries. 

The problems in the fixed income portion of these portfolios stem from the fact that sovereign debt - typically seen as the safest of investments, and makes up the bulk of the global bond index - has gone through its worst run since the Second World War.  Experiencing a sell-off that has no equal, even during the inflation shock of the late 70s. US treasuries are still nearly 10% off the level they were at in 2020, while the gilt market is 30% down on levels it was at five years ago. That’s a lot of lost time, and made more acute by the fact that global equities have continued to rally. 

In response, investors have explored alternatives. High-yield debt has offered a compelling risk-return trade-off, outperforming traditional bonds while carrying equity-like volatility. Liquid alternatives also did well during the sell-off, which lasted until the middle of 2022. These strategies aim to provide returns in any and all market conditions with lower correlation to equity markets. Though they are expensive and complex, their performance can be highly timing-dependent. 

Another frontier is factor-based investing, or alternative risk premia. These quantitative investment strategies (QIS) are systematic, rules-based products that isolate and invest in persistent sources of returns. Be they looking at value, size and momentum, volatility and so on. Factors offer diversification, and in QIS, they provide a transparency often absent from traditional hedge fund lite strategies. Applied judiciously, they may enhance a portfolio’s efficient frontier, potentially boosting risk-adjusted returns by around one percentage point across typical risk profiles. 

Yet integrating such strategies into managed portfolio solutions (MPS) remains challenging. Pure expressions of these factors are difficult to access, and incorporating them adds both complexity and cost. Meanwhile, conventional bonds, battered as they have been, retain the potential for a rerating if interest rates stabilise or inflation moderates. Not only that, they would do well in a recessionary environment as investors would seek shelter in defensive fixed income sectors. Abandoning them prematurely could be as imprudent as overloading on equities in 2008. 

The lesson for investors is nuanced. The 60-40 model is under pressure, but alternatives are no panacea. Credit risk, liquid alternatives, and factor-based strategies can enhance returns and provide diversification, but only if understood and implemented with care. For the foreseeable future, a thoughtful mix of equities, bonds, and selective alternatives remains the best route through a world where traditional assumptions about risk and return have been profoundly disrupted. 

Past performance is not a guide to future performance. Capital at risk.