60/40 Portfolio Is on Borrowed Time

Advisors with decades of experienced under their belts are undoubtedly familiar with the 60% equities/40% fixed income (60/40) portfolio split. Some advisors were likely reared on this methodology.

Indeed, 60/40 served advisors and clients well for generations, but times are changing and those changes aren't encouraging for what is now an aging if not archaic way of constructing portfolios. Some might even argue that 60/40 is broken.

Penning obituaries for 60/40 might be premature, but the stark reality is this way of thinking faces significant challenges, not the least of which is a trying fixed income environment that puts advisors in the position of having to deal with anemic returns and yields on aggregate bond strategies or stretching for income by taking on added credit risk.

The 60/40 outlook wasn't always this dire. As plenty of advisors know, there was a significant stretch of time when bond investing was almost “easy.” When President Reagan took office, the Federal Reserve's benchmark lending late was a staggering 21.5%. Today, it's close to zero, meaning for about four decades, the 40 in 60/40 was a boon for clients.

Today, things are different and 60/40 might not be up for the challenges.

Times Are Changing, 60/40 Flaws Exposed

Sticking with the 40% side of the equation, low interest rates continue presenting challenges to advisors and that's not going to abate next year.

“The low-rate environment has been a well-known challenge for bonds investors for some time, resulting in a global scarcity in higher yielding bonds,” according to BlackRock research. “Looking at the Bloomberg Barclays Multiverse Index as a proxy for the entire $71 trillion investable global bond market today, we see a “4-and-4 environment” with less than 4% of bonds yielding more than 4%. Ten years ago, the share of bonds yielding more than 4% was 17.7% and just five years ago it was 7.5%.”

Not surprisingly, inflation is also a drag on 60/40 portfolios and that scenario isn't going to get easier. If forecasts are accurate, the Consumer Price Index (CPI) won't decline until the second half of 2022.

“Persistently higher inflation is eroding the already challenged return potential of bonds with inflation-adjusted, or real yields, starkly negative across major sectors. Viewing inflation across a 5-year timeframe demonstrates just how high of a hurdle inflation poses for future bond returns,” adds BlackRock.

Here's why 60/40 is vulnerable when inflation is high: Essentially everything in an aggregate bond fund ends up with negative real yields.

“Investment grade quality bonds that typically make up the bulk of core bond allocations such as Treasuries, mortgages, and investment grade corporates all result in strongly negative annual rates of real yield,” notes BlackRock.

Stocks Could Help, But...

The point of this piece isn't to pile on bonds. The 60 in 60/40 is far from perfect, particularly with valuations stretched and returns being sourced from an alarmingly small number of mega-cap stocks.

“Today, U.S. stocks are less diversified and stand at historically expensive levels compared to the past 20 years. In the S&P 500 Index, the exponential growth rates of the 'FAANGM' stocks (i.e., Facebook, Amazon, Apple, Netflix, Google, Microsoft) has been a major force driving equity returns higher,” observes BlackRock.

Those six stocks accounted for nearly a third of S&P 500 returns over the past three years. That's good while it lasts, but the preferred scenario is more diverse participation in bull markets.

Remember this: The “average” advisor has about three-quarters of client assets in domestic equities, meaning a heavy dependence on FANGNM whether they realize it or not.

Related: Plan for Profitability to Matter in 2022