“The 60% stock/40% bond portfolio is largely a relic of the past, with alternatives likely to become a bigger portion of investors’ portfolios over the next decade, asset management chiefs said during a panel discussion at the Milken Global Institute Conference on Wednesday.” (“The 60/40 Portfolio Is Dead. Here’s What Will Replace It,” https://www.barrons.com/articles/the-60-40-portfolio-is-dead-heres-what-will-replace-it-51602757800)
We disagree with that position.
Cumberland has been managing balanced accounts for decades. (“Balanced” means that a portfolio holds some bonds and some stocks.) We do it several ways. One of them is a 60/40 rebalancing technique where the 60% is an equity target that captures about 900 American-listed stocks with two very efficient ETFs. The distribution in that 60% is reviewed monthly and changed by rebalancing against certain trading thresholds. The idea behind it is to be buying in the relatively more attractively priced elements when the rebalancing occurs. And the rebalancing tries to capture some of the upside bias that occurs from the “indexing” phenomenon. The two ETFs capture about 85% of the publicly traded capital weight of the entire American stock markets.
The 40% portion is the bond allocation. At Cumberland the bond side can be taxable or tax-free. That depends on the client’s particular characteristics. And the 40% doesn’t mean US Treasury bonds or notes. We rarely own them. On the bond side the management is active duration, and the equity side is more passive. Thus, the classic 60/40 portfolio that is being consigned to the past by others is, in our hands, actually a passive but continually rebalanced 60% in ETFs and an actively traded and duration-driven 40% in bonds. We call that strategy active/passive.
It is certainly not dead!
For anyone interested in this strategy’s longer-term performance with GIPS verification, we can send that information to you, and we can include a full pitchbook that describes the mechanics and the management approach. Just email me, and I will have someone at Cumberland get the information to you.
Now let’s add a more technical comment to the issue of 60/40.
Writers who condemn a 60/40 approach should look at more than just the yield on a specific maturity of a bond. Or at an index of bonds. The anti-60/40 folks are ignoring the issue of which bonds to own and when to switch. They err by viewing bonds passively.
For stocks, they look only at the passively selected index benchmark (usually the S&P 500). They ignore when to change weightings and how to capture market changes. The classic work on the 60/40 portfolio, done decades ago, started with that very passive construction. I remember reading some of the first papers on that subject when I was an undergraduate at Wharton.
Much has changed since then. Let me offer just a few examples.
If the benchmark stock index for the 60% becomes concentrated into just a few heavily weighted names like FAANMG, does it still serve as the reference for the classic 60/40 blend? We think the answer to that question is “no,” which is why we broaden the 60% portion to include mid-caps. And then we need rules to rebalance between the mid- and the large-caps. Plus we wanted to capture the upside bias of a mid-cap stock going into the large-cap index. Think about it. How many large cap members of the S&P 500 were previously mid-cap? Take a look for yourself. Now reverse that question and examine the movement of a single stock in the downsizing direction. How many left the S&P 500 and entered the S&P 400? Can you name any? The directional movement is not symmetrical, which means it permits an investor to capture the upward bias. That has become part of the Cumberland 60/40 process.
On the bond side, we have to add the gradations of credit and not just the passive-use Treasury bonds or notes. The Treasury yield curve is constantly changing, and the shorter end of it is directly influenced by Federal Reserve policy. The middle and longer end are now influenced by global forces in bond markets in other currencies and countries. It isn’t just the Fed that sets the US Treasury term structure yields. The Fed could do it if they wanted to, just as they did in World War 2; but to do that would require them to abandon the other policy targets like economic growth, banking system stability, or currency volatility. The Fed can do any one of these things, but it cannot do them all at once. That is why the focus is on the short-term policy rate. So the 40% in bonds cannot be a static part of the blend. That is why we make it active.
Consider one item as a specific example on the bond side. Take a bond and subtract the inflation expectation component, and you have a market-based estimate of the “real” return in that bond. Let’s say the 10-year Treasury note today is yielding 0.80% (October 26) and the inflation expectation for 10 years is 1.50%. The real return for that 10-year Treasury note is -0.7%. Why would anyone buy that instrument if they didn’t have to? Holding it to maturity is a guaranteed way to incur a real loss of wealth. And I haven’t mentioned taxation, which depends on the tax status of the owner.
But what if you substituted a basket of higher-grade corporate bonds that represent a mix of the same stocks you were using in the 60% portion. That approach might change everything, and how that works depends on whether or not you are trading actively or passively buying and holding the bonds until maturity. Here’s an example. We will use the spread in yields between the investment-grade corporate bond and the 10-year Treasury note. Please understand that at Cumberland we use all maturities and all levels of credit on the bond side, so this is ONLY a single example for the purposes of this discussion.
On December 31, 2019, the yield on the 10-year Treasury note was 1.923%. Then COVID-19 hit. The Fed acted. On March 31, 2020, that yield had fallen to 0.684%. It is 0.8% as this commentary is being drafted in October. The initial drop in yield in response to the COVID shock resulted in a substantial price change in three months. Since then, the 10-year note has traded with minimal volatility, and the difference in yield is only a few basis points in the post-COVID-shock period. Folks, that is an active asset trade. Consider that during the same time period the stock market initially lost about 40% of its market value. And since the market bottomed on March 23, 2020, it has recovered most of the losses.
Let’s examine the spread between the investment-grade corporate bond index and the 10-year Treasury yield during that same time period. We are using Bloomberg data for the “S&P US IG Corp Average Yield vs GT10” spread. On December 31, 2019, that spread was 88 basis points. On March 31, 2020, it had widened to 285 basis points. Today, as this commentary is written, it is back to 114 basis points. So when the COVID shock hit, the spread widened for two reasons: IG bonds fell in price, and yield went up because of the perceived COVID shock risk. Simultaneously, Treasury notes rose in price and fell in yields because of the flight to safety. But the spread widened because the IG fell more than the Treasury rose. That is where active management comes in, to seize the opportunity in the wider spread. The reverse is true today: Spreads have narrowed again. They are not back to where they were on December 31, but they are getting closer. So today, we shorten the duration and reposition for some future shock or other spread-widening event.
So what happens in the 60/40 model? The duration on the 40% side (bonds) changes. Active management buys the wider spreads and sells the tighter spreads. Active management changes the portfolio duration. And active management also adjusts the weights in the 60% stock side at the same time. My colleague John Mousseau recommends the following discussion to assist in learning about active-duration total-return bond management. A Bond Buyer subscription is required to access the piece, but John or one of his colleagues would be happy to discuss the issues involved with anyone who is not a subscriber to the publication.
“Managing Duration Extension and Negative Convexity Near Par,”
https://www.bondbuyer.com/opinion/managing-duration-extension-and-negative-convexity-near-par
Passive, sleepy, buy, hold, and “fuhgeddaboudit” management was indeed the first iteration of the 60/40 approach, but times have changed. Cumberland’s 60/40 is anything but a passive strategy now and offers investors the opportunity to pursue a balanced, actively managed approach to achieve optimal returns.
Here are a couple of additional links about 60/40 and the ongoing debate over it. There are diverse views. Let me know if you want to see the details about how we do it.
“In New 60/40 Portfolio, Riskier Hedges Are Displacing U.S. Debt,”
https://www.advisorperspectives.com/articles/2020/10/21/in-new-60-40-portfolio-riskier-hedges-are-displacing-u-s-debt
“The 40 in 60/40 Portfolios Is Getting Wilder and Wilder,”
https://www.bloomberg.com/news/articles/2020-10-24/the-40-in-60-40-portfolios-is-getting-wilder-and-wilder
David R. Kotok
Chairman of the Board & Chief Investment Officer
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