Every couple of years, we come across articles calling for the “death” of the 60/40 balanced fund – the traditional portfolio of stocks and bonds that has long been viewed as fundamental to a successful investment strategy. These assertions often seem to surface after periods of strong performance such as the one we experienced in 2020, when returns were magnified by ultra-easy monetary measures aimed at limiting the pandemic’s economic damage.
Doubts about balanced funds rest on claims that the current environment of low interest rates and lower expected returns will make it difficult for a 60/40 asset allocation to continue to meet investors’ return requirements. While it is true that expected returns for many asset classes may be more muted going forward, we believe that holding a well-diversified portfolio will continue to be an investor’s most important investment strategy.
That said, a constantly changing investment landscape requires investors to always be evaluating how they diversify their portfolios and whether they are positioned to achieve their long-term objectives. That includes understanding the powerful changes in markets, most importantly the low interest-rate environment and the likelihood that it will be around for a long time.
60/40 Balanced portfolio: 10-year rolling returns from 1900 to 2020
Note: Data from January 31, 1889 to January 31, 2021., based on Shiller, Market Volatility, 1989 – Annual Data on U.S. stock market – http://www.econ.yale.edu/~shiller/data/chapt26.html. Source: RBC GAM, Bloomberg
Past: A history of strong performance
Today’s investors have seen long periods of exceptionally strong returns from both stocks and bonds. This backdrop has led to consistently robust performance for most traditional 60/40 portfolios. Three key developments have contributed to this success. The first is a 40-year bull market in bonds during which the yield on the 10-year U.S. Treasury bond has fallen from peak levels of 16% in 1981 to slightly over 1% today. Second is a bull market in stocks fueled by extraordinary monetary-policy support since the 2008-2009 financial crisis. Last has been the dependable ballast provided by bonds during periods of equity market volatility, helping to provide a more consistent investment path. While it has been a great run for both bonds and stocks over the last decade, expectations that returns will be more muted over the next decade, particularly from bonds, has many investors rethinking their traditional asset mix.
Present: Challenges to the traditional asset mix
Today’s low-interest-rate environment and lower expected returns present several challenges for the traditional 60/40 portfolio and those who invest in them. Bond yields have reached historical lows, with sovereign bond yields in particular near zero in many countries. In response to the economic and financial impact stemming from the pandemic, central banks have committed to keeping short-term interest rates low to stimulate economies and financial markets, even as the recovery gains traction. This central-bank commitment has important implications for investors who hold bonds – lower expected returns and reduced income. Historically, bonds have provided not just income, but also liquidity and insurance against equity market volatility. However, the realities of today’s low-interest-rate world mean that investors, particularly more conservative investors whose portfolios are tilted heavily toward fixed income, are going to need to evaluate whether their portfolios are positioned to achieve their long-term investment objectives.
The decade-plus bull market in stocks has left equity-market valuations stretched by some measures, especially for large-cap U.S. stocks, and investors will need to moderate their total-return expectations for equities as well. While we continue to believe that stocks will outperform bonds in the decade ahead, our expected returns for both asset classes, and therefore for a balanced strategy, are lower than what investors have become accustomed to.
Historical performance versus long-term expected returns
Note: As of February 3, 2021. Equities: S&P 500 TR; Bonds: ICE BofA U.S. Gov. 1–10-year; Balanced: 60% S&P 500 TR, 40% ICE BofA U.S. Gov. 1–10-year. Long-term expected returns represent RBC GAM’s 10-year returns forecast as of January 13, 2021. Source: RBC GAM, Bloomberg
Positioning your portfolio for the future
At RBC Global Asset Management, we believe there are a number of ways that investors can position their portfolios to support returns, improve income generation, manage volatility and provide stability:
- Improve diversification by allocating to global markets
By taking a more global approach, investors can access a larger number of investment options which allows for better diversification and should ultimately lead to a smoother investment experience by reducing the impact of localized downturns on a portfolio. Last summer, we increased the allocation to global equities across several of our portfolios, sourcing the funds from Canadian equities. Given the varying impacts of COVID-19 on different economies and the potential for heightened volatility going forward, we believe that diversifying across multiple regions will continue to be an important tool for investors.
- Revisit your allocation to stocks
Lower return expectations mean there is a higher likelihood that returns for balanced portfolios will fall below levels of recent decades, increasing the risk that investors fall short in reaching their financial goals. For many investors, boosting stock market exposure is a good first step toward bolstering portfolio returns, though this outcome depends on your tolerance for risk as higher return expectations are typically accompanied by additional risk. Our analysis shows that investors will be reasonably well rewarded over the longer term for accepting a journey that is a bit bumpier in the short term. Earlier this year we increased our strategic equity weight across many of our portfolios, sourcing the funds from fixed income.
- Finding income in equities
In addition to having higher expected returns relative to bonds, stocks can also provide an added income benefit. A U.S. 10-year bond is yielding about 1.1%, versus 1.6% for the current dividend yield on the S&P 500 Index, a premium not seen for some time. While the economic environment remains unclear, we anticipate that the yield advantage of stocks over bonds will persist. Our research suggests that U.S. equities will provide a total return of 4.4% in the long-run,¹ compared with a 1.1% return for 10-year U.S. Treasury bonds.
- Adding alternatives to fixed income
Given the current low level of yields, it may be more challenging for bonds to act as a ballast against equity-market volatility. Investors would be well served to consider incorporating new asset classes and strategies that mimic the prior benefits of sovereign bonds or have relatively low correlations to traditional equities. Last November, we added to our allocation in direct real estate and introduced a position in liquid alternatives with the addition of an absolute-return credit fund in some of our balanced portfolios. These two asset classes have historically offered higher yields than sovereign bonds, and have the added benefit of low correlations to equities. Both are examples of how we are adjusting our asset mix and diversifying risk in reaction to a shifting investment backdrop.
- Continue to hold bonds, but diversify
While sovereign bonds certainly have their place in a portfolio, investors should consider diversifying their fixed-income exposure to include holdings that are less sensitive to the risks facing sovereign bonds. Such shifts can help mitigate interest-rate risk, preserve capital and lower portfolio volatility.
Over the past 20 years, we have broadened our fixed-income allocations by including investment-grade, high-yield and emerging-market debt, sourced from sovereign-bond allocations. Moving beyond government-issued bonds, however, increases an investor’s exposure to default and must be monitored diligently to ensure the portfolio does not become too risky for a given investor’s profile.
Constant evolution is key
At RBC GAM, we spend a lot of time thinking and talking about our asset mix. In our view, it is the most important decision an investor makes and is a key driver of long-term investment returns. However, no single blend of assets will remain optimal over the long-term and small incremental changes need to be made to keep portfolios current. Our 30-plus years of experience in building and managing portfolios has taught us that evolving our asset mix as market conditions change has been, and will continue to be, key for investors.
5-year trailing returns of bond market sectors
For the period January 31, 2016 to January 31, 2021. Risk order based on historical volatility (for illustrative purposes).
U.S. Government Bonds: ICE BofA All Maturity U.S. Government Index (CAD Hedged)
Global Sovereign Bonds: FTSE World 1+ Yr Gvt TR (CAD Hedged)
CDN Government Bonds: FTSE Canada Government Bond TR
CDN Corporate Bonds: FTSE Canada Corporate Bond TR
U.S. Corporate Bonds: Bloomberg Barclays U.S. Corp IG TR (CAD Hedged)
U.S. High Yield Bonds: ICE BofA U.S. High Yield BB-B TR (CAD Hedged)
Emerging Market Bonds: JP Morgan EMBI Global Diversified (CAD Hedged)
Source: RBC GAM