Since the early 1990s, balanced funds – holding 60% of assets in stocks, 40% in bonds – have been a go-to strategy for institutional and individual investors alike. It is based on a popular interpretation of Modern Portfolio Theory, for which Harry Markowitz won the Nobel Prize for economics in 1990.
The reasoning, says chief investment officer Michael Rosen of Angeles Investment Advisors in Santa Monica, California, “is that stocks accrete wealth over the long term, while bonds provide a moderate but positive real yield – real meaning over inflation – and hedge against equity declines.”
Confidence in this compartmentalized design plummeted amid the inflation- and interest-rate-fueled volatility of 2022.
“It’s not the fraction that you have in stocks versus bonds that stabilizes your risk. It’s the amount of risk of that mix you have,” explains MIT Sloan School professor and Nobel laureate Robert Merton. “By keeping it in proportion, the volatility of the portfolio is varying all over the place depending on what happens to the changing volatilities in the stock and bond markets.”
Measuring volatility as the potential of a publicly listed stock to lose a percentage of its value, Merton uses simple math to explain why a 60-40 portfolio distorts its exposure to risk instead of mitigating it: “If the S&P has a volatility of 20%, your portfolio has a volatility of 12%, which is 60% of 20%. What happens if the volatility of the S&P goes up to 30%? Now your 60-40 portfolio has a risk of 18%.”
No Universal Prescription
In 2020, three years before Markowitz died at age 95, he was quoted in a GARP article saying, “I do not recommend a 60-40 mix as a universal prescription.”
Markowitz recommended that investors find an “efficient frontier” between risk assets (like public stocks) and risk-free assets (like Treasuries) where the return is potentially greater than the risk of investing in them.
Robert C. Merton, MIT Sloan School of Management
Merton proposes that investors first decide how much risk they are willing to take in the stock market, measure the risk in terms of volatility, set a volatility target, and use the target to determine how much of a portfolio to invest in stocks.
“Instead of targeting the asset allocation, target the volatility of your portfolio,” Merton said in an interview. “You say to your financial adviser, ‘In my total portfolio, 10% volatility is what I’m comfortable with until I tell you to change it, or you convince me to change it.’”
Regardless, institutional and individual investors turned away from 60-40 after the Federal Reserve Board raised interest rates from 0.25% in March 2022 to 5.50% the following December. The higher cost of funds constrained stock investing, as the S&P 500 index fell nearly 27% in calendar year 2022. The Bloomberg Aggregate Bond Index was down 13% that year as old bonds issued at lower rates were seen as less attractive than new bonds issued at higher rates.
“It was the ultimate environment for 60-40 to face some negative fronts,” says Toby Thompson, portfolio manager in T. Rowe Price’s Multi-Asset Division.
Turn to Alternatives
Investors took away the message that bonds could not be relied upon as an uncorrelated asset class to diversify the risk in equities.
“The correlation between stocks and bonds has risen to something closer to 0.5,” rather than the hoped-for “close to zero,” says Kevin Machiz, who heads the multi-asset class research effort of Callan LLC in Portland, Oregon.
Kevin Machiz of Callan LLC
That’s when pension funds, foundations and endowments started actively looking for alternatives to balanced portfolios. “A big part of the conversation revolves around, “How can we beat 60-40?” Machiz says. “So even if a client is not invested in 60-40, they can still use it as a sort of yardstick to see how they stack up against the public markets.”
As institutions pull away from bonds, “I would say that the most popular [alternative assets] have been private equity, real estate and private credit,” the Callan senior vice president adds. “There are more institutional investors talking about hedge funds and interested in hedge funds than we've seen in a long time.”
“The 40 . . . Went Away”
To be sure, some investment consultants saw the writing on the wall before 2022. Angeles Investment Advisors advised its clients to sell their bonds after observing that increases in the value of Treasuries had become less and less, to the point that when the stock market declined by 34% in 2020, Treasuries were flat.
Because Angeles has discretionary control over most of its clients’ assets, the firm sold the bonds and invested the proceeds in alternatives including private lending, venture capital and real estate nearly five years ago, according to CIO Rosen.
“We simply said, ‘If real yields were negative, and if high-quality bonds were not hedging equity risk, why are we owning these things?’” Rosen says. “So the 40 of the 60-40 went away.”
Liquidity Concerns
Alternative investments won’t be a panacea. Investors can’t sell them to raise cash as immediately as corporate bonds or Treasuries the next time the stock market goes haywire. “We at Callan believe that there is a certain risk associated with these illiquid investments that investors still demand to be compensated for,” says Machiz.
To hedge against illiquidity risks, fund managers are promoting enhanced versions of balanced funds that include a limited allocation to alternatives, which are intended to compensate for the risk that stocks and bonds could again fall in tandem. “Product development loves fighting the last war,” says Jason Kephart, director of multi-asset ratings at Morningstar.
The challenge in managing these enhanced portfolios is that while stocks and bonds can be turned into cash in a day or two, a hedge fund-of-funds, by contrast, can be accessed only once every six months.
Michael A. Rosen, Angeles Investment Advisors
In accordance with SEC regulations, the T. Rowe Price Global Allocation Fund (TGAFX) can invest no more than 15% of its $849.6 million in assets in a fund-of-funds that is managed by Blackstone Hedge Fund Solutions. To be on the safe side, the fund-of-funds allocation is 7% because “from a liquidity test perspective, it’s going up while everything else is going down,” says Thompson.
Not every institutional investor is wrestling with that dilemma. Under SEC regulations, “qualified investors” with $25 million or more under management are allowed to invest in alternatives such as commodity futures and real estate. So smaller foundations are still leaving 40% of their assets in bonds, says Angeles’ Rosen.
To be sure, 60-40 funds still have a following among financial advisers who view them as a relatively steady income producer for individual investors. Over the last 10 years, the most successful funds were those that focused on U.S. stocks and bonds, according to Morningstar’s Kephart. “That is the benchmark” for choosing among 60-40s, he says.
Ranking in Morningstar’s top quartile, the $57.2 billion Vanguard Balanced Index Fund (VBIAX), delivered an annualized 8.76% return over the 10 years – though it fell 16.41% in 2022. It beat the 10-year marks of two actively managed funds investing outside the U.S.: the BlackRock Global Allocation Fund (MALOX, 5.67%) and the T. Rowe Price Balanced Fund (RPBAX, 7.83%).
Kephart notes that corporate defined contribution plans still offer balance in the form of target date funds, which gradually decrease their percentage of equities and increase the percentage of bonds as an investor approaches retirement.
Topics: Investment Management
