The 60/40 Portfolio Needs a Gold Make-OverThe traditional 60/40 split is a portfolio diversification method that aims to capture the best risk-adjusted returns from an asymmetrical allocation to stocks and bonds.
But is it still fit for purpose in an environment of zero rates? Has the bond bull market—which has been in place since the early 1980s—finally come to an end? Is it time for the global 60/40 portfolio to unwind as performance continues to be lacklustre? And what assets will investors pursue to achieve returns in zero rates?
The 60/40 Split, and Its Performance Precedent
The 60/40 rule has been in vogue for decades, and it’s easy to see why. The traditional negative correlation between the pair has enabled investors to reap the reward from risk-on assets, such as equities, while hedging any stock market volatility with the relative safety of risk-off, fixed-income investments, such as bonds. In this way, risk-averse investors can capitalize on volatile markets while maintaining a safety net.
This strategy has proven extremely effective over the years, having only once fallen 20% or more within a year. At the same time, it’s gained 20% or more in a year on ten different occasions over the last half-century—netting investors 10.7% per annum on average. Even during the worst of the pandemic, the strategy was affirmed—thanks, primarily, to a stock market rally.
But whether any of these historical risk-adjusted returns provide any insight to future returns for investors is now up for debate. Has the playing field changed forever, and are they about to experience their own Kodak moment? Many analysts are starting to look at the future of the 60/40 portfolio and the associated risks.
The historical performance of the 60/40 portfolio over the period in the graph above, had an average 10y yield of 6.2%. In the wake of the central bank’s incredible response to the economic conditions created by global shutdowns from COVID-19, we have seen global bond yields fall once again, with 10y yields dropping to 0.68%. The plunge in rates came shortly after the Fed had started a slow and procrastinated period of hiking rates to get monetary policy back to a normal rate environment following the global financial crisis of 2008.
Given current economic conditions and the inversely buoyant equity market valuations (at least vs. historical P/Es), as well as record levels of government debt coupled with unprecedented central bank stimulus, it is becoming more difficult to envisage how the 60/40 portfolio remains a central strategy of the investment community.
The risk for the average investor, given current and future conditions, is that the historical returns for the 60/40 portfolio will be extremely difficult to achieve. However, further risk lies in the unwind of this global strategy. In the event of this unwind, where would the 20%, 30%, or 40% of bond allocations get moved to? What assets offer protection and provide adequate risk-adjusted returns?
The Federal Reserve has also signalled a significant shift in its approach to managing inflation. The US central bank’s strategy is to target an average of 2% inflation, rather than a 2% hurdle before raising rates. This sizable shift to the flexibility the Federal Reserve is now afforded in managing inflation, enabling overshoots and the potential for a return of inflation —and if not, secular inflation. With the still unknown impact of the stimulus response to COVID-19, record debt levels, and unprecedented economic conditions, achieving the best risk-adjusted returns requires a wider allocation to alternative assets.
Market positioning (and/or repositioning) are large drivers of returns. Passive investing, a trend that has been in place for the last 20 years, leads to a consistent drip feed of liquidity into the long side of a broad equity index approach. A shift in the approach of the 60/40 community would not only have an impact on the remaining holders of 60/40 portfolios—as bonds are liquidated—but also alternative asset holders where liquidity shifts to. At the forefront of this shift in their investment approach, these new market participants stand to benefit alongside asset managers providing access to these asset classes.
Allocating Gold (55:40:5)
The risk of secular inflation at a time of a general risk unwind—with respect to the 60/40 portfolio—positions the precious metals markets as one of the obvious choices in the alternative asset space. And gold, as the largest asset in this group, is well-positioned to benefit from this rebalance and dramatic shift in economic conditions.
Acting as a hedge against inflation, monetary devaluation, and macro risk, gold provides the ideal alternative asset as part of an investor’s portfolio. Given the risk presented by inflation and a lower for longer approach to rates, it is very probable that real yields trade negative. And while gold doesn’t pay out dividends or interest, it has proven through time to be an effective hedge to inflation and the general devaluation of fiat currencies.
The introduction of new market participants to the precious metals sector also positions the market to benefit from the same kind of inflows (i.e., passive investment drip) that have been witnessed in equity markets for several years. This is at a time when we are seeing several large pension funds and traditional equity asset managers looking more at depth at the gold market.
Moreover, studies have proven that adding gold to a portfolio can outclass the traditional 60/40 split by some margin. Over the past 20 years, adding a 5% gold allocation has had a 79% chance of delivering equal or superior Sharpe ratios—a measure of risk-adjusted return—compared to a standard 60/40 portfolio.
Gold Plated Pensions
Bond yields sinking along with stock market enthusiasm will put added pressure on retirement plans, which almost exclusively employ the 60/40 rule. This is especially true as people typically live longer and thus require more capital in their old age.
As mentioned, pension funds are already starting to switch to this approach. Last week, Ohio’s $16 billion Police & Fire Pension Fund approved a 5% allocation to gold. This relatively small gold allocation provides some measure of portfolio diversification and could pay off in an outsized way if the gold market enters a secular bull market.
With the real risk of secular inflation, pension funds owe their investors a fiduciary duty to reduce reliance on stocks/bonds and allocate into an asset with a proven record of mitigating inflationary environments and protecting investors from negative real returns. We have already seen some of the faster, smarter money shift to the space. The real move comes in the unwind of the 60/40 portfolio and the transition from this traditional approach to alternatives, inclusive of gold.