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Tough macroeconomic conditions will continue to put pressure on traditional equity-bond portfolios this year, some investors have warned, after last year’s gruelling market ride in which both asset classes plunged in tandem.
Portfolios which comprise 60 per cent stocks and 40 per cent bonds lost 17 per cent in 2022, according to BlackRock, their worst performance since at least 1999. That undermined a formula at the cornerstone of asset allocation for more than 30 years.
The inverse correlation between bonds and equities — the assumption that when the price of one rises the other falls — has helped balance portfolios since the 1980s. Investors have used the 60/40 split as a guide through decades of low volatility known as the Great Moderation. Returns for 60/40 portfolios averaged around 7 per cent between 1999 and 2022, according to BlackRock.
But that relationship broke down last year as surging inflation and rising interest rates hit bonds and equities alike. Some 58 per cent of institutional investors surveyed by Amundi and consultancy Create Research believe last year’s pattern will not disappear anytime soon.
“We’re not anticipating performance in 2023 will be as bad as 2022 . . . but the broader point is you can do better than 60/40 with a similar risk profile,” said Vivek Paul, head of portfolio research at the BlackRock Research Institute.
“In the last few decades, you had low volatility, negative correlation and central banks stepping in whenever there was a stumble, so everything did well — 60/40 portfolios did well, but actually so did 70/30 and 50/50. Going forward, the gap in performance will be much bigger between different portfolios with similar risk profiles to a traditional 60/40.”
Technology and other stocks that rely on future cash flows for value continue to be out of favour, while relying on buy-and-hold strategies will no longer deliver as they did before, according to Amin Rajan, chief executive at Create Research.
“The changes in market regime amount to two things: focus on the short term and focus on opportunism,” Rajan said. “In this environment, a formulaic approach doesn’t work.”
BlackRock believes investors will have to hold far more diverse portfolios to deliver similar returns to their long-term averages. The proportion of inflation-linked bonds held by investors will be much greater, as will allocation to private assets despite investor concerns about illiquidity. Among traditional assets, Paul advocates going underweight on nominal government bonds.
Ursula Marchioni, BlackRock’s head of portfolio consulting for Emea, sees greater diversification into other assets “as indicative of the more volatile and uncertain macro and market regime, and the need for investors to attain more control over portfolio outcomes”.
Greater allocation in private markets — which can include private equity, venture and real assets such as property — is viewed by many experts as a way to add ballast to the volatility of publicly traded assets.
“The asset class isn’t immune to macro volatility and we are underweight private markets in our strategic views as we think valuations could fall, suggesting better opportunities in the coming years than now,” said Paul at BlackRock, adding that he would have advised most institutional clients looking for a balanced risk profile to hold 20 per cent in private assets a few years ago, but only 15-17 per cent now.
“However, we think private markets should be a larger allocation than what we see most investors hold today.”
But many investors worry about the difficulty of getting out of such vehicles in moments of stress. “With illiquidity, it’s very hard to get out of [alternative investments], and if you go to the secondary market . . . you get paid such a discount,” said Rajan.
If approached with a degree of flexibility about regional and sectoral diversification, a 60/40 portfolio could deliver mid to high single-digit average annual returns over the next few years if investors are patient, according to David Aujla, multi-asset fund manager at Invesco.
He favours reducing exposure to US equities in favour of other regions, as well as looking at investments in small companies around the world. Aujla also tips corporate credit over sovereign debt given current yields on offer, but is slowly adding duration to government bond positions, after starting the year on the short end of the spectrum.
“The fixed income element . . . can now also provide a much greater income contribution to portfolios, which is welcome as for many years now the typical 60/40 portfolio has been incredibly reliant on its equity component for income generation,” Aujla said.
However, he cautioned that “markets are likely to remain volatile and it is therefore important to be flexible. Thankfully the traditional approach is not the only option for investors in this space”.
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