Over the past 40 years, since 1980, interest rates have declined, meaning bond prices have generally increased. Now that this 40-year trend of declining interest rates has ended — and rather abruptly — investors are struggling to find ways to create an efficient portfolio with more stable returns. Why? Well, it appears that bonds may no longer provide the portfolio ballast that they have for the past decade and the traditional 60/40 portfolio¹ might no longer work as expected.

So, where do we go to find a solution? Back to the 1950s and 60s, when this very issue was really first analyzed in depth. Before that, and ever since serious investing began (for reference, the first stock market was formed in Amsterdam in 1611; the NYSE started in 1792) investors understood there was a relationship between risk and return. But, investors lacked ways to both reliably measure and manage risk and incorporate this uncertainty into the valuation of an investment portfolio.

Enter Harry Markowitz in 1952, who had the insight to measure and manage portfolio risks by holding imperfectly correlated assets together in a portfolio. He illustrated that lower correlations between assets had the net effect of canceling some — but not all — of the associated risks within a portfolio. These lower correlations, where assets would not move together in lockstep, helped reduce the variance of returns over time.

Building upon this in the mid-1960s were William Sharpe and John Lintner who created a coherent framework to understand how those associated risks within a portfolio, as explained by Markowitz, should affect its expected return, or its valuation. Et voila!, the Capital Assets Pricing Model (CAPM) was born. As such, the two troublesome questions about how to manage risk, and how to value it, were theoretically answered by these two seminal insights, which formed the cornerstone of modern financial theory. But as Albert Einstein famously said, "In theory, theory and practice are the same. In practice, they are not."

By the 1970s the CAPM model was being criticized as too theoretical in assuming a risk sensitivity to a portfolio, aka its beta, (and for a number of other factors that are beyond the scope of this paper). But this concept of beta is important because it connects market risk to the required return an investor expects to be compensated for, for taking that risk. The debate surrounding beta is unresolved and leaves investors to evaluate alternative measures of beta and to think differently about the investing future when the past may be an imperfect guide.

Today we are engaged in the same age-old debate about the most efficient balance of risks in a portfolio of stocks and bonds, and what might be the volatility of returns in the future. Is a passive 60/40 portfolio the optimal solution as many investors thought was the case for many, many years? Or is there something better? While this may be a gross oversimplification of a risk-balanced strategy for a portfolio, investors cannot ignore the fact that the 60/40 portfolio worked pretty well for 40 years. In other words, holding bonds passively lowered the beta, or risk, of the portfolio. But today, do bonds even reduce risk or lower beta in a portfolio? Alternatively, do they actually increase the risk and beta? And either way, what is the driver of this risk?

FINDING A NEW RISK BALANCE WHEN THE 60/40 IS NO LONGER OPTIMAL

The direction of interest rates in the near- and longer-term future provides critical information. If interest rates do not trend lower, but shuttle sideways in a limited range, or even drift higher, then we believe the traditional passive 60/40 portfolio is suboptimal. In our minds the solution is an actively balanced portfolio that seeks to reduce the volatility of returns. And why do we care so much about volatility? Well, the advantage of stabilizing return volatility is that it allows an investor to compound returns more predictably into the future. Note that Warren Buffett has always professed that much of his wealth can be attributed to the power of compounding. We believe the key to compounding returns is by investing in a balanced strategy that has demonstrated the ability to control risk, specifically a Global Balanced and Risk Control Strategy.

THE OBJECTIVE OF THE 60/40 PORTFOLIO

The objective of the 60/40 portfolio was to reduce the volatility of returns over a long-term investment horizon by balancing the risks between the equities and bonds an investor held in a portfolio. The overriding goal was to try to minimize downside risk, or drawdowns, and participate in the upside — and the importance of avoiding drawdowns cannot be overemphasized. Drawdowns are those moments in volatile markets that every investor has been through when their portfolio is losing money “on paper” to the point where the fear becomes palpable and they can’t take it anymore. The ability to withstand drawdowns in some ways represents an investor’s risk tolerance. During severe drawdowns (think the GFC of 2008-09) some investors sell near a market bottom, which is generally the worst time to sell. This is a real risk, and the issue with significant drawdowns “on paper” or otherwise is the simple math involved; if an investor loses 50% of their portfolio in an extreme drawdown their portfolio now has to earn 100% just to get back to even.

We believe that when balancing the risks in a portfolio, with fewer and less extreme drawdowns, an investor has a better chance of compounding returns in a stable and predictable manner, as shown in a stylized example of 8% vs. 5.3% in Display 1. After all, that is the goal of financial planning and meeting long-term liabilities.

DID THE 60/40 RISK BALANCE WORK …?

As intimated, the 60/40 portfolio worked well for investors from 1982 to 2021 (notice that 2022 has not been included, something that will be addressed shortly). Broadly speaking, holding bonds lowered the beta of the portfolio, but what really made the 60/40 allocation work was that the bonds generated positive returns in 36 out of 40 years.² The down years for bonds were:

• 1994, which was the worst all-time year until 2022 (-2.9%)
• 2013, during the “taper tantrum” (-2.0%)
• 2018, where bonds were essentially flat (0.0%) but generated negative return after fees.
• 2021 (-1.5%)

On average, bonds returned roughly 7.6% a year from 1982 to 2021, and during those down years for bonds in 1994, 2013, 2018 and 2021, equities returned around 7.3%³ on average, meaning that holding stocks and bonds in a 60/40 portfolio worked out reasonably well. All told, bonds compensated investors quite nicely for equity risk and lowered the volatility of returns for the overall portfolio. But to be crystal clear, the driving force of the success of the 60/40 portfolio was the consistency of bond returns.

… YES, BUT WILL IT CONTINUE TO WORK?

Will bonds continue their historical string of positive returns? If 2022 is any indication of the future, maybe not, as bonds were down -13.0%. This made 2022 a particularly bad year because equities were down too, something that hadn’t happened since 1994. Equities and bonds generally had a low correlation, meaning they did not move synchronously, and that was the essential selling point of that traditional 60/40 portfolio. But the burden of future success for bonds is in the interest rate cycle, because history shows that roughly 85% of bond returns were attributable to movements in interest rates.⁴ To reiterate, since rates trended lower from 1982 to 2021, bond returns were typically positive.

It might provide more insight to ask whether one thinks interest rates will trend lower for the next 40 years. We don’t think so, and this is where the static 60/40 risk balance allocation becomes challenged. If interest rates trend sideways in a range into the future then bonds will not be the steady hedge to equities they once were, invalidating a 60/40 balance. If rates drift higher, then bonds become even more circumspect as a hedge that provides stable returns when matched against equities. As a result the beta, the risk factor of the 60/40 portfolio, is likely to increase.

All told, there is nothing magical about a 60/40 portfolio. In fact, the term didn’t exist before 1980; it was coined that year when rates started trending lower and investors developed the concept of risk parity. Risk parity is a now common portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio, viewing the risk and return of the entire portfolio as a single construct. This was groundbreaking stuff.

Historically, all else being equal, interest rates have moved in a cyclical sideways range. This means there will be years when bonds and equities have positive correlations and years when they have negative correlations. But if interest rates do not steadily trend lower, the correlation risks between both assets will rise and the riskiness — the portfolio beta — will rise.

WHAT’S THE SOLUTION?

To start, we believe the solution is active management, not passively investing in a portfolio and watching in frustration as it does not do what it was expected to do — and unable to do anything about it. More specifically, the solution is to adopt actively managed strategies that pair the risks of assets held in a portfolio against each other in order to help reduce the volatility. We think of this as an alternative beta strategy, compared to a strategy that relies on historical bond returns during a time when interest rates are trending lower.

In other words, an investor needs to be more concerned about how a manager is balancing the risks in one’s portfolio through asset allocation decisions with the objective of reducing the volatility of returns. Which brings us right back to where we started: reducing return volatility, limiting the risk of significant drawdowns and helping to stabilize returns so they are more predictable and can compound over time. This can be achieved by balancing the risks in the portfolio but also providing a framework and the discipline to control risk. In our flagship multi-asset strategy, the Global Balanced Risk Control Strategy, we actively manage allocations across equity, fixed income, commodity-linked notes and cash in the same portfolio. As you can see from Display 2, we make significant changes to our asset mix based on what we see as upcoming risk events in an attempt to get ahead of potential market volatility.

IN SUMMARY

We believe that the start of a secularly changing investment environment is already underway, an environment in which static 60/40 allocation strategies will be suboptimal. We do not believe that bonds can provide portfolio ballast in the near and longer-term future. Furthermore, they can no longer be expected to have a low correlation to equities and to help reduce the risk beta, particularly in an unmanaged, passive portfolio with the inability to maneuver deftly. To manage ongoing market volatility and minimize potential participation in those severe drawdowns that can erode the ability to compound effectively, we believe investors will need an active volatility manager, like the Portfolio Solutions Group.

RISK CONSIDERATIONS

There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.

¹ 60% Equity / 40% Fixed Income Portfolio.
² U.S. Aggregate Bonds are defined as the Bloomberg US Aggregate Total Return Value Unhedged USD Index Source: Bloomberg, data from 1982 to 2021. Returns data provided is annual. The index performance is provided for illustrative purposes only and not meant to depict the performance of a specific investment. Past performance is not guarantee of future results.
³ U.S. Equities defined as S&P 500 (USD) Index. Source: Bloomberg, data from 1982 to 2021. Returns data provided is annual.
⁴ Bloomberg Index Data.