Strategist: Do This Instead of 60/40 Investing

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Well, we've got problems with the 60, we've got problems with the 40, and we've got problems with the relationship between the 60 and the 40. Even in the best possible period, the generational bull market in bonds over the past 30 years, this particular portfolio didn't work all that well.

Hello and welcome.

Have my intros been getting like too shouty? I mean, I feel like I come in as, hello, Jack.

You know, well, I mean, I usually lower the volume on the intro because it is a little, you sort of like, uh, it's like a balloon that's very full right at the beginning.

And then, so you say no, you say no, but then you tell me that you have to physically change the machinery because I'm blowing out the audio equipment.

All right, look, we're gonna do a mellow one.

You ready? We're gonna make it nice. It's gonna be smooth jazz on this one.

Wow.

Hello, welcome to the Barron Streetwise Podcast. I'm Jack Howe.

The voice you just heard, it's Jared Woodard, and he's the head of the Research Investment Committee for Bank of America Securities, B of A Securities.

And as you just heard, he's taking on one of the basic foundations of long-term investing, the 60/40 portfolio. Ahead, we'll hear what he doesn't like about it and how he thinks ordinary investors can do better.

How do you feel about that? Relaxing or?

That was quite an experience.

Listening in is our audio producer, Meta.

Hi, Meta.

Hey, Jack.

We're going to hear from Jared in a moment about 60/40 investing, but should I tell people, are there people who might not know what we mean by 60/40?

I think it can't harm to talk a little bit about it.

We're talking about asset allocation. 60% refers to the stocks, 40% refers to the bonds. Those are not set percentages. You adjust them according to— people say according to how old you are, but I think it's according to how soon you might need the money. If you have many years to save for retirement, you can have a higher percentage in stocks. If there's a possibility that you might need that money sooner, then maybe you should have a lower percentage. And there was a lot of talk last year about the 60/40 portfolio. Is it dead? Is 60/40 investing dead? We heard last year, which always struck me as strange because what people meant when they said that was that stocks stunk last year and also bonds stunk. Everything got wrecked. So both sides of the portfolio were down and they said, Does this mean it no longer works? And my thought was, I think that means that everything's a better deal, right? That doesn't mean it doesn't work anymore. That means probably it's, you know, it's a better time to buy into it than it would have been a year before. But I guess their broader point was the whole point of being split between stocks and bonds is that one side is supposed to protect you from the other side if things go kablooey. Specifically, the bonds, which have lower returns, are supposed to help you when stocks do poorly. And last year they didn't really do that. So it was discouraging for people. This year it seems to be doing better, but Jared Woodard from B of A Securities has some longer-term issues with 60/40 investing, which he'll explain in a moment. I'll just tell you about the pricing that you're getting now. If you're buying in now and let's say you're buying an S&P 500 index fund and you're buying regular US Treasuries, the S&P 500 traded recently at 20 times this year's projected earnings. That is pricey. It's not crazy, but I would say a normal PE ratio, historically speaking, is closer to 15 times, 16 times. Um, so 20 times is pretty high. On the bond side of the portfolio, I'm looking at a 10-year Treasury yield of about 3.75%. Now, if you remember, interest rates near zero for an extended period in recent years, that might seem higher. But if you're aware of the longer-term history of Treasury yields, you know that that is below average. Let's say, you know, comparing with the past half century, still relatively low, 3.75%. So, you know, stocks are a little pricey. Bonds are a better deal than they were, but not as good of a deal as they have historically been. That's where we are if you're buying in today. And that's enough from me.

Let's hear the conversation.

I am intrigued by this report that you've put out because it has things that are different. A lot of investment advice is, you know, do the same things that have always worked. And this one says, well, you better pay attention because some things might have changed here. And this is about the 60/40 strategy, your classic mix of stocks and bonds. And I gather that both had a terrible year last year, and there was some talk about whether 60/40 still works.

What should we make of that?

You talk about the end of 60/40 evidence. What do you mean? What's the evidence? And what do you mean when you say it might no longer work?

The relationship between stocks and bonds that led so many people to seek a portfolio owning both, owning both, let's say, a big chunk of US equities and a big chunk of Treasury bonds as a kind of insurance policy for your equities. That worked for some very good reasons for a little while. And the view from our work is that it didn't work in the longer-run sweep of history. And we don't think it's going to work again in the future. The very high-level view and the big-picture evidence why we think a 60/40 portfolio, 60% US equities, 40% US government bonds is actually a pretty unattractive place to put money is that, well, we've got problems with the 60, we've got problems with the 40, and we've got problems with the relationship between the 60 and the 40. I think to summarize it, even in the best possible period, the generational bull market in bonds over the past 30 years, this particular portfolio didn't work all that well. The opportunity cost across a full market cycle of owning this portfolio was about 150 basis points a year, 1.5 percentage points a year of drag from owning those treasury bonds as an insurance policy. They didn't pay out a lot of the time. And the only periods where they did function well were this 20-year period from about 2000 until about 2019 or 2020 when incredibly low inflation, record low interest rates, globalization, the best possible demographics from an efficiency perspective all now behind us gave you this deflationary world. And we think that both the longer-run story in history shows you it didn't work otherwise. And we don't think the future is going to look like the last 20 years. And so independently, the problems between the two parts of the market, the stocks and the bonds, the relationship between them, the correlation between treasuries and equities is likely to be positive in the future, not negative. That means if stocks go down, treasuries can go down too. And 2022 was the best possible evidence for that view when you had stocks down 18% for the year and something like TLT, the very popular treasury bond ETF, down 30%.

[Speaker] And just to be clear, when we say 60/40, we mean that investor who uses a classic mix of 60% stocks, 40% bonds.

But if I say to you, hey, that's okay, I'm a 50/50 guy or I'm 70/30, I'm not out of the woods.

The same problem still exists if my percentages are a little different, correct?

That's exactly right. I understand that the appropriate mix changes as folks approach retirement and their needs change. But if you've got whatever your mix is, however aggressive or relatively conservative you think that you are, if you're relying on government bonds, if you're relying on investment-grade corporate bonds, Any other fixed income asset that is very sensitive to interest rates and inflation risk, if you're relying on that to provide your hedge or your insurance policy against a bear market in stocks, it's true, there's been periods in the last 20 years when that's worked very well. We don't think that owning those kinds of positions over a full market cycle is a cost-effective way to allocate capital in fixed income.

What's the problem with bonds? You mentioned the drag on returns. I think you said a point and a half a year is the cost to me to have that part of the portfolio in bonds. But what about the person who says, okay, I know there's a cost. I know that bonds don't give me the best returns, but I want them there for the safety. Am I getting the safety?

You got the safety from around, you know, the end of the dot-com bubble, 2001 until just prior to COVID, even through 2020, there was a nice rally in treasuries. The problem is that most of the time in US market history, past 100 years, let's say, stocks and bonds tend to rise and fall together in terms of returns, not move in the opposite direction. That means that a year like 2022, where stocks fell and bond returns were also deeply negative, that's actually more common in US history than the opposite. When you look at the composition of most bond benchmarks, they're actually pretty concentrated, not very well diversified. The US aggregate bond benchmark, for example, has more than 70% of its assets in treasuries and investment-grade corporate bonds, two sectors of fixed income that have basically no credit risk to speak of. You're not really tied to the real economy, to the fortunes of companies that are trying to make real goods and services. You're tied to expectations about interest rates and inflation. And in a world where inflation was falling for 30 years and interest rates were falling for 30 years and it was just one big risk of constant deflation, that trade actually worked really well. The problem is that we think that structurally speaking, over the next several business cycles out into the future, we're likely to go from what we call a 2% world to a 5% world. Where all the big macro variables, inflation, interest rates, wages, real GDP, many of which have averaged about 2% over the past couple decades, average more like 5% in the broader sweep of history. And we think that the big changes in the global economy around demographics, around trade, around financial regulation, these are going to push us closer to those 5% longer-term averages in an environment where suddenly taking big bets on inflation and interest rates becomes a lot riskier than it has been. Over the past 20 years.

It sounds like people who think they're diversified aren't as diversified as they might believe. And it sounds related to, you know, when people talk about correlation, they say, well, buy this because it has low correlation to the stuff you already own. And I always wonder, well, okay, that's maybe in the past 10 years, but what about when the world's going kablooey?

What happens to the correlation then?

Does that go kablooey too with my stocks? And it sounds like what you're saying is that bonds can't be counted on to be a haven if you have periods of poor performance for stocks from here on because they might struggle too as rates climb. Have I got that right?

That's exactly right. Even if you do have periods of occasional success, I think that actually maybe later this year or the next year, if we do see a recession in the United States, if we do see Federal Reserve interest rate hikes start to cool the economy, there may be a window of let's say 2 or 3 months in which treasury bonds gain while the stock market suffers. I think that very well may happen. And actually, we built a strategy around that premise we could maybe talk about in a minute. But for most investors, they're not nimbly trading in and out of different positions, nor is that appropriate for some people. And if you're holding a lot of your capital in these assets across a full market cycle, you're paying a big cost in opportunity cost, returns you don't get. And even like last year, actual losses if you ride out a stagflationary period. And I gotta tell you, Jack, it's not just about bonds. The same problems of correlation and diversification, you know, plague the stock market too. It's the 30-year anniversary of the invention of the ETF this year. So I, I looked at SPY, the first ETF tracks the S&P 500. 30 years ago, if you bought into that fund where you track the S&P 500, you had a pretty well-diversified basket of stocks. The average correlation between members of the index at that point and further back in history was something like 10 to 12% much of the time. So these companies are rising and falling on the basis of their own success or failure in the economy, exactly what you want as an investor. Today, the average correlation among members of the S&P 500 to one another is often more like 50%. You know, in a crisis it can be 80% or higher. And the index is more concentrated than ever. I think most people have kind of caught onto this point now. Something like 30% of the index is composed of just the 9 largest companies. So it's an incredibly different index. And these US benchmarks are incredibly different than they were decades ago, much less diversification than you might think that you have.

Let's take a break there. We'll be back in a moment.

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Welcome back.

Let's get back into the conversation with Jared about his concerns about the 60/40 portfolio and what investors should do about it. Okay, so let's do a portfolio overhaul, like one of those home renovation shows. We've got the investor who's got 60% in the S&P 500 index fund, and they've got 40% in the plain vanilla bond index fund. What should this investor do to better position themselves?

You can keep most of your core portfolio. You don't have to overhaul everything. But you can use some of these products to add back a bit of diversification, to add some things that actually will give you higher yield, different sources of returns. In the case of the equity market, some big themes that we talk about a lot are basically adding back the pieces that have gone missing from the big indexes. So for example, smaller and mid-cap stocks, which people don't own enough. Mid-caps, for example, contribute something like a third of corporate profits in the US. A third of returns over time, but most people only have, I don't know, 5% or something or less allocated there. Small cap value, in fact, we have data going back to the 1920s, has been a massive outperformer over the long term. If you put $100 in a small cap value index about 100 years ago, you'd have something like $38 million today. Compounding is amazing. We all know that. But if you put the same $100 in large cap growth, You'd have less than $1 million. Small-cap value has been that big of an outperformer. It's lagged in recent years. I mean, 10 years, maybe even 20 years. Not coincidentally, I think the same period in which record low interest rates, record low inflation, maximum globalization, and so on, these big macro forces have changed the world in a big way.

These were the go-go growth years where everything favored the growthy companies, the momentum companies, and it didn't necessarily favor the value companies.

[Speaker:IAN_CASSEL] That's exactly right. And if you think that the last 20 years is the permanent template for the future, by all means, buy the 10 largest stocks in the S&P and never look back. Everyone else might want to add a little diversification into small-cap value. Two other things on the equity market I'd like to mention. One measure of quality that we like a lot in our department is free cash flow yield. It's hard to game as an accounting metric. It's difficult to fudge the numbers. It's also been an incredible outperformer. A free cash flow yield basket of quality has outperformed the S&P 500 by something like 7 percentage points a year over the past few decades. And I would add from a more visceral point of view, a little bit more substantive thesis, natural resources. There was periods in much of the 20th century when the big real economy sectors, things like energy and materials and industrials would occupy 30%, 40%, almost 50% of the market cap of the index. Today we know that that baton has been passed to the growth sectors like tech and communications. But natural resources in particular, I'm talking about oil and gas, but also metals and mining, even nuclear power are absolutely fundamental for everything that countries want to do in the future. It's an opportunity that I think applies across the policy spectrum, whether you care a lot about energy security from a more nationalistic point of view, whether you care a lot about decarbonization from the opposite policy extreme, it doesn't matter. Every big policy goal on the agenda today requires incredible amounts of raw materials and resources and electricity. And after decades of underinvestment in those areas across the world, we think it's going to be a necessity to invest in those areas again. And the scarcity of those resources is going to be a big catalyst for those companies to do well over the long term. And unfortunately, most portfolios are dramatically underexposed to those natural resource and real economy sectors.

Okay. So I keep my S&P 500 fund, but I make sure that I add a generous dollop of small-cap, mid-cap, especially maybe some small-cap value. And I want to get some exposure to companies with good free cash yield and natural resource companies. And that's the equity side of my portfolio. What about the bond side? What can I do there?

Well, right now there's some tactical things you can do, things that look attractive to us to round out that exposure. If you already have lots of treasuries and you've got maybe a lot of investment-grade, so-called high-quality corporate bonds, there's a few things that we think are attractive at the moment. Number one, cash is paying you a lot more right now than it has in a very long time. If you can get 5% or so on a fund that owns T-bills or very shorter-term treasury securities with the possibility the Fed may have to raise interest rates a little bit more, these high-level yields are actually pretty attractive and a great defensive place to be as long as it lasts. Going a bit further out though, we see some good relative value in 3 other things I'll mention. Number 1, Prefereds, are they a stock? Are they a bond? Investors debate, but they're senior in the capital structure. They pay a dividend that can't be cut until the dividend of any common stock has been cut first. And what that means is today, a preferred stock ETF gives you a yield approaching 7%, better than just about any sector in the bond market you can find, and a pretty secure dividend. One statistic that my colleague Michael Youngworth, who covers preferreds really closely, told me is that in the financial crisis in 2008, only 3% of companies paying secure preferred stock dividends actually had to cut their preferred dividend at all. Only 3%. Last year in the regional bank crisis that rolled into this year and then those stresses in the market, I think only 1% of preferreds faced any kind of cut. So you've got something that looks really secure. It's a very high yield. Some of these companies are kind of bombed out from a price chart perspective after the bear market last year. So we think preferreds are a great place to look for some income. And then I would add municipals, which for folks who want something a little bit less risky in terms of credit risk, on a relative value basis, you can get paid a higher yield in what they call high-yield municipals where there's just a little bit more risk on the portfolio. You can get more yield than you would in high-yield corporate bonds, but with much lower risk of default. So on a tax-adjusted basis, if it's in a taxable account, municipals, which had one of their worst years ever last year, are again poised, we think, for a rebound and the yield on them looks attractive relative to what you could get elsewhere. Last point on what to do in fixed income tactically, I think convertible bonds are an interesting place to look. Many investors right now missed out on the rally in growth stocks this year, if they were heavily into cash or just kind of on the sidelines, if the rally that we've seen in growth stocks year to date, which has been incredibly narrow, broadens out and you see a general uplift in the market, convertible bonds actually will participate pretty nicely, we expect, in the equity-like upside because a convertible bond has this warrant component that makes it kind of act like a stock on the upside and act like a bond on the downside. So the profile is really attractive. Right now, convertibles are trading like bonds. They're kind of at their floor. If the market turns lower, we would expect these to lose less than growth stocks would. If the market broadens out and the rally kind of turns higher, then we expect these to actually participate further. And you get a much better yield than you would on the incredibly tiny dividends you get from, say, NASDAQ stocks.

I just want to mention, for people wondering, how do I get all this stuff? Your team has helpfully put out this long list of ETFs so people can buy this stuff as easily as they would stocks. And these are not in any particular order. And these are not all the names you mentioned. People have many choices of different brands. But like, for example, for the free cash flow, I see Pacer US Cash Cows, and the ticker there is COWZ. For natural resources, SPDR S&P Metals and Mining, that's XME. If people wanted to buy convertibles, there's an iShares convertible bond fund, ICVT, you know, so that—

so for each of these things you've mentioned, people can get it in the form of an ETF to make things easy. If I follow all this advice and I make exactly these changes in my portfolio, what do you expect that I will get? I would be achieving higher returns potentially in the coming decade, let's say. Would the returns be good enough to equal what investors have become accustomed to? In other words, are the good times over or are the good times still here if you do the right things? And what would your expectation be about the risk profile of this new portfolio I've created?

Let me go even one step more aggressive than that, Jack. I think that in the future, a conventional, say, 60/40 portfolio, S&P 500 plus a lot of long-term treasury bonds, may actually be set up for another what we call a lost decade in which 10 years later after inflation, what's your real return on the portfolio? And there've been quite a few actually in history, 10-year periods where if you look back, you subtract inflation, you say, "Actually, I didn't make any money on this whole journey." Unfortunately, given valuations in the market today, we took some estimates from our teams across the department and the number we came up with was that it may take you, if you're a bit underwater still in your portfolio after the losses last year, it may take you until April of 2029 just to get back to breakeven on that portfolio after inflation. We hope that's not true, but it looks, the math kind of looks that way. So what I'm trying to say is it may be that diversifying away from these broad benchmarks today is actually your only path to getting the kinds of returns that maybe you're used to over the past 20 years. It kind of has that feeling of like the guy in the adventure movie who says, "Come with us if you want to live." It's sort of a bit of a moment where after last year, people are now alert to the risks of inflation, of interest rates, and that the market cycle still exists. There still will be recessions and booms and Fed hikes and Fed cuts. None of that's changing. We're not saying the world's permanently different all the time, but that structurally on a trend basis, we see the world changing and we think that allocating differently is going to become necessary. And so to answer your question, I think that the kinds of returns, if you're thinking about high single digits in equities, are going to be hard to achieve over the next decade without better diversification. The kinds of, let's say, mid-single-digit returns in fixed income, I think will also be more difficult to achieve, especially after inflation. And so whether you do this on a sort of tactical basis, what looks attractive this year, or you do something a little bit more systematic and rules-based, I think it's going to be necessary to make some changes. Look, there've been a lot of periods in history where if you waited for the benchmarks to rebalance and for everything to kind of happen automatically, you had to endure either a really prolonged period of underperformance or some really serious market turmoil. I mean, the big examples are The dot-com bubble in the 2000s everyone knows about, but also the Nifty 50 growth stocks in the early 1970s, 1972 to '74, the big blue chip, so-called high-quality, cash-generating growth stocks that everyone loved had a lost decade. Many of them didn't survive at all. And the ones that did took at least 10 years to get back to breakeven as the Fed had to hike aggressively to contain inflation and and the darlings of that market suddenly found themselves repriced not as growth stocks, but as value stocks. A real painful repricing that may be in the future for the S&P 500, you know, today. And our contention is, why wait? Why, why wait for the rebalancing to happen, whether by time or uncomfortably by price, when you can make some changes to rebalance now?

This was thought-provoking and informative, and I think you snuck in a Terminator reference, if I'm correct. Come with me if you want to live. Although it's come with me if you want to keep up with inflation, I guess. Jared, thanks so much for taking the time to speak with me.

Jack, it's been a pleasure. Thank you.

Thank you everyone for listening. Meta Lutzoff is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple, please write us a review. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.