The search continues for a formula to succeed that simple but effective mix of 60% stocks and 40% bonds that has served investors so well for decades now. The epic decline in interest rates, from an historic high over 15% for benchmark Treasuries nearly four decades ago to an equally historic low of less than 1% currently, has generated robust returns from bonds and, in turn, lifted stocks’ valuations. Every time shares faltered, bonds would rally, providing a reliable shock absorber for an equity portfolio.
It’s hard to argue against the success of the 60/40 portfolio, even during a period of strong stock returns and relatively low bond yields. The
Vanguard Balanced Index Admiral
fund (ticker: VBIAX) uses the CRSP Total Stock Market Index (which goes beyond the 500 stocks the solons at S&P anoint) and the Bloomberg Barclays Aggregate Bond Index in roughly those proportions, at a cost of 0.07%. The fund has returned 14.69% in the latest 12 months, and an average annual 10.2% over the past five years and 9.9% over the past 10. Of course, going all in on stocks via the
Vanguard Total Stock Market Index Admiral
fund (VTSAX) would have produced higher average returns—18.32%, 13.67%, and 13.72% over those periods—but with higher risk.
But given low bond yields and historically rich equity valuations, future returns from a 60/40 portfolio might be only half what they’ve been in the past decade, as this column wrote almost a year ago. Bonds also might not provide much of a buffer to stock declines if their yields have little room to fall, which limits the potential for their prices to rise.
One solution, offered here in July, would be to hedge the overall stock market with out-of-favor sectors, such as value stocks, financials, industrials, materials, and small-caps, which tend to zig when the major indexes heavily weighted to ultralarge-capital growth and technology issues zag.
Another suggestion might be to substitute gold or TIPS (Treasury Inflation-Protected Securities) for traditional bonds.Those assets would benefit from negative real interest rates (that is, below the rate of inflation). Negative rates obviate the yield disadvantage of gold. TIPS yields also can, and have, fallen below 0%, something unlikely (but not impossible) for regular Treasuries.
Yet another substitute for the traditional 60/40 portfolio would be to incorporate more equity-like bonds and bond-like stocks into the mix, as suggested here last month, by adding high-yield bonds, convertible securities, real estate investment trusts, and utility stocks.
Still, “hedging historically expensive equities with historically expensive bonds may result in futility,” writes Peter van Dooijeweert, managing director for multi-asset solutions for Man Solutions. (In bond parlance, expensive means low-yielding.)
Investors might be complacent about the risk that interest rates will rise in the next year, Dubravko Lakos, chief U.S. equity strategist for JPMorgan, told clients in a virtual conference this past week. Higher bond yields could pressure equity price/earnings multiples, including those of the megacaps, which he considers bond proxies, according to a written summary of his remarks. (The tech giants’ bond characteristics reflect their long durations, a measure of their price swings to interest-rate changes.)
Stocks’ sensitivity to a rate rise would depend on its speed and their level. But it would take a steep rise to 1.5% in the Treasury 10-year bond, from 0.83% early Friday, to sway Lakos from his bullish call, made on Tuesday, for 4000 on the
by early 2021 and 4500 by year-end, up from 3582.
No longer can investors count on lower interest rates and bond rallies to protect them from crises, Dooijeweert says. That assumes that U.S. bond yields won’t follow their European and Japanese counterparts below zero, given Federal Reserve officials’ statements they don’t see the usefulness of negative rates. With short-term rates already near zero, the central bank might use fiscal policy more. That would produce a larger supply of Treasury securities for the market to absorb, which would tend to lift yields.
Low-yielding bonds don’t provide the income that institutional investors, such as pension funds, need to help meet their return bogeys, often 7% or higher, Dooijeweert observes. But if bond yields rise from their current low levels, the price declines would overshadow the increase in income, unlike the 1970s when fairly rich coupons of 8% and higher offset price drops.
So, what should investors do? Going to 100% equities would be too concentrated. Substituting high-yield bonds and dividend stocks for investment-grade bonds would provide income, but would be relatively risky while providing less diversification, he says. Instead, he suggests a hedging strategy.
For Man Solution’s institutional clients, Dooijeweert proposes using stock futures to reduce the risk of big losses. However, he adds, equity put options are too expensive, given the high level of volatility. To mitigate the downside, the strategy could set criteria, such as a shift in market trends. That could be signaled by a break in some moving average, a sign of a trend reversal, or a pick-up in volatility, he says.
This makes it painfully evident that generating high returns with limited losses will be vastly more complicated than simply investing in an ultralow-cost balanced fund. Will that mean lowering investors’ expectations to something more realistic, like 4% to 5% returns? Or will that drive day traders to chase the next big score with their app-driven accounts? The surge in options trading and crypto currencies suggests that speculative fervor abounds—for now.
Write to Randall W. Forsyth at email@example.com