60/40: Not dead, just different

Key takeaways

• The classic 60/40 portfolio has mounted a respectable comeback, with most versions are still up 9% to 10% on the year.
• However today’s environment warrants a more flexible and dynamic approach to implementing hedges.

Russ Koesterich, Managing Director with Global Allocation discusses why today’s environment of higher interest rates may call for a tactical hedging approach.

After being written off in 2022, the classic 60/40 portfolio (portfolio with an allocation of 60% to stocks and 40% to bonds) has mounted a respectable comeback. While the August stock and bond market sell-off has led the strategy to pare back some of its YTD gains, most versions are still up 9-10% on the year.

While ‘rumors of its death’ may have been exaggerated, investors may still want to consider certain changes. For decades, the 60/40 stock/bond blend benefited from a secular decline in interest rates, which allowed bonds to serve as a hedge against stock volatility. With that trend, at least temporarily, at an end, investors should consider more tactical adjustments, a broader set of hedges and pay more attention to equity style exposure.

End of an era

2022 not only marked a terrible year for 60/40 portfolios, but also a milestone for the broader economy. While interest rates bottomed in 2020, last year witnessed the steepest rise in interest rates, particularly real rates (nominal less inflation), in decades (see Chart 1). Two-year real yields spiked from -3% in March of 2022 to 3%, while 10-year real yields rose from -1% to around to 2% today.

10 year government bond yields

This rupture in bond markets is both good and bad news for investors. After years of virtually no yield, bonds can once again be a meaningful source of returns. Unfortunately, as last year demonstrated, they can also be a source of risk.

As rates, the broader economy, have become less stable, portfolios should arguable become more dynamic. Today, we are holding a slightly above benchmark weight in equities but remain moderately underweight bonds.

One of the reasons we're still cautious on bonds, particularly long-dated U.S. Treasuries, is because in our view, they're no longer a reliable hedge. After decades of relative stability, the correlation between stocks and bonds keeps flipping back and forth. Most recently, correlations have reverted to positive, meaning the price of bonds and stocks are trading together. In this type of regime, it helps to look to other asset classes as a hedge. For example, recently stocks and the U.S. dollar have been moving in opposite directions. Having a larger dollar position, either through overweighting U.S. assets or hedging foreign currency exposure, has helped dampen portfolio volatility.

Finally, pay attention to equity style risk. Last year was an abysmal year for growth stocks. This was a direct result of the rise in interest rates. If cash flows are deferred to the distant future, higher rates have a greater impact on the present value of those cash flows. This illustrates an important point: Stocks have duration or sensitivity to interest rate movements as well. Adjusting equity style tilts by considering the varying impact of rates is particularly important during periods of heightened bond volatility.

Don’t abandon, adjust

For most long-term investors, a broad mix of stocks and bonds still makes sense. That said, it is likely that recent changes in bond markets represent a fundamental shift in the investment landscape. Investors needn’t abandon the 60/40 portfolio, but they should consider being more flexible and dynamic in how they implement hedges.

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