This decade will demand a different portfolio

Portfolio manager Russ Koesterich offers five strategies to prepare for potentially lower portfolio returns in coming years.

Even after accounting for two severe corrections, a swift but brutal bear-market and the worst unemployment in generations, a hypothetical 60/40 portfolio still has offered annualized 10% returns since mid-2016. However, most would bet against similar returns during the next 5-10 years.

With global bond yields somewhere between negative and paltry, lower expectations are understandable since the 40% of the portfolio traditionally dedicated to government bonds is likely to be a huge drag. Equities look better, but outside of a few asset classes double-digit returns are unlikely (see Chart 1). Given this dynamic, the BlackRock Investment Institute’s long-term forecast of annual returns for a 60/40 portfolio is around 5%.

Chart 1
Asset class return and volatility expectations

Asset class return and volatility expectations

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.
Source: BlackRock Investment Institute, August 2020. Data as of 30 June 2020.
Notes: Return assumptions are total nominal returns. US dollar return expectations for all asset classes are shown in unhedged terms, with the exception of global ex-US Treasuries and hedge funds.

While investors should modify their return expectations, they are not powerless. A portfolio emphasizing high-quality income, risk premiums and assets that thrive in a negative real-rate environment can do better. Here are five strategies for addressing a decade of (potentially) lackluster returns.

Address home country bias. Lost in this year’s market chaos: Although the rebound in U.S. stocks has been remarkable, other major markets – Germany, Switzerland, China, Korea - have done even better. A combination of an uncertain election, weaker dollar and more modest valuations suggest making sure your portfolio is geographically diversified and not just cleaving to the U.S.

Barbell your hedges. Given near-zero yields, I’ve recently been advocating for a more modest allocation to long duration bonds. The flip side is to hold more cash, but with one caveat: Do not completely abandon Treasuries. An allocation to long-duration U.S. Treasuries can still offer downside protection.

Include assets that may benefit from negative real rates. One of the more bizarre aspects of the current regime is that even long-term interest rates are below expected inflation. Given the evolution in central bank thinking, this is almost certain to continue. While this makes traditional sources of income less attractive, certain asset classes, notably gold and growth stocks, tend to benefit from low or negative yields.

Harvest style risk premiums. Equities may offer less robust returns, but investors don’t need to limit themselves to the traditional equity indexes. Style exposures such as momentum, quality, value and low volatility can add incremental returns. Our portfolio construction work suggests allocating a portion of your equity exposure to these styles can improve risk-adjusted returns.

Hoard high quality credit. Other than earnings growth, income is proving the scarcest of investment commodities. Look to boost portfolio income through a higher allocation to select high-quality credit. Our asset allocation work suggests that for a typical 60/40 portfolio this could include 10-15% in investment grade bonds and another 4% in both high yield and emerging market debt.

Different decade, different portfolio

The past decade witnessed gaudy returns for several asset classes, including mid-teen annual returns for the S&P 500.  At the same time, a decade long fall in long-term Treasury yields – from 3% to 0.60% - produced an impossible to replicate windfall for government bonds. Going forward, investors need to evolve their portfolio for a very different starting point and very different world.

Russ Koesterich
Portfolio Manager
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and is a regular contributor to The Blog.