Retail investors en masse have for decades been told to abide by a simple investment trope: put 60 per cent of their portfolios into equities and 40 per cent into fixed income. And, en masse, they listened.
So-called balanced funds that use this portfolio strategy account for more than half the assets under management in Canada’s $1.6-trillion mutual fund industry and represent one of the largest growing exchange-traded-fund segments.
Investors’ love for the 60/40 strategy is for a good reason, too, since it has yielded an average return of 7.7 per cent since 1926, according to Vanguard data, which will make it even tougher for investors, advisers and market makers to let it go.
That’s because a low interest environment combined with the looming threat of inflation may be signalling the end of the 60/40 portfolio’s viability, particularly on the fixed-income portion.
The yield on a 10-year Canadian government bond has plunged to 0.5 per cent after being above 2.5 per cent as recently as October 2018. And with some expecting the Bank of Canada to follow in the U.S. Federal Reserve’s footsteps to move toward an inflation average, real returns on that side of the portfolio could even turn negative.
“It’s dead money,” Steve Hawkins, chief executive of Horizons ETFs Management (Canada) Inc., said of a 40-per-cent allocation to fixed income. “It’s sitting in cash. You’re not even earning the dividend yield of the TSX 60.”
Hawkins began challenging the 60/40 portfolio in 2018 when Horizons introduced its all-in-one portfolios ETFs. The company produced a “balanced” portfolio ETF, but went with a 70/30 split for the Horizons Balanced TRI ETF Portfolio instead of 60/40.
Horizons did the same with its growth ETF portfolio product, allocating 100 per cent to equities instead of using the traditional 80/20 split attached to these funds.
It's dead money. It's sitting in cash. You're not even earning the dividend yield of the TSX 60
Inevitably, the additional 10 per cent that Horizons allocated to equities in its balanced ETF portfolio allowed them to outperform funds using the 60/40 strategy.
On a one-year basis ending Aug. 1, Horizons said its balanced ETF returned 10.93 per cent to investors. By comparison, BMO’s balanced ETF was the second most successful in that same time frame, returning a bit more than eight per cent.
An additional 10-per-cent tilt toward equities may seem minor, but it immediately unlocks more of a portfolio’s potential in today’s environment.
The S&P 500 has rallied more than 50 per cent since bottoming out in March, and the continued use of a 60/40 portfolio in that time frame would have left significant returns on the table for investors.
There were warnings this could happen, most notably from Bank of America Merrill Lynch Global Research strategists Jared Woodard and Derek Harris, who in late 2019 said it was “time to start planning for what comes after the end of 60/40” in a research note.
They argued that investors should look to add a higher allocation of stocks to their portfolios because bond-market volatility had resulted in fixed income generating the worst returns of any asset class, barring commodities.
An additional 10-per-cent tilt toward equities may seem minor, but it immediately unlocks more of a portfolio's potential in today's environment
But could investors seek to push the goalposts even wider? Frank Ortencio, an investment adviser and portfolio manager at Raymond James’ Ortencio & Associates Wealth Management Group, has already had that conversation with his clients.
If clients want to keep shooting for returns of seven per cent, Ortencio thinks they will have to implement at least a 75/25 portfolio. At present, he said, insisting on a 60/40 split may result in returns sliding to 4.5 per cent.
Having too high an allocation to bonds in a portfolio is risky right now, Ortencio said, because interest rates are near zero. Should they rise after investors lock in bonds at a lower rate, “it’s almost like a negative return,” he said.
TD Wealth vice-president and investment adviser Michael Currie was never attached to implementing a 60/40 asset split, saying that he builds portfolios based on the return targets his clients want.
Within them, fixed income still plays an important role. Even if a client pushed him to implement an aggressive portfolio, he wouldn’t go below a 20-per-cent allocation to fixed income.
Currie said it’s still possible to put together a fixed-income portfolio that yields 3.5 per cent if it’s composed of corporate bonds, although “if rates stay where they are, that’s going to have to drop.”
Fixed income can also act like an insurance policy, he said.
“When the market fell in March, if you were 50-per-cent bonds, you didn’t drop 30 per cent (like the stock market),” Currie said. “You’re sacrificing the upside to protect yourself on the downside.”
The conversation about portfolio mix is always going to revert back to risk thresholds and return targets, he said. Some of his clients only want returns of two to three per cent per year and he’s able to comfortably do that with a 20/80 split. For others who are still seeking an average of seven per cent, he said there are two solutions.
“It’s either increase your exposure to equity or lower your return targets,” Currie said.
Financial Post
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