Executive summary
The 60/40 stocks-bonds portfolio, a traditional investment strategy that has been popular for the past 40 years due to low inflation and strong economic growth, is facing challenges as it is not immune to all market conditions. The recency bias of institutional investors, who have spent their entire careers in a strongly bullish cycle, has led to over-allocation to assets that have performed well in the past 40 years. A prolonged period of stock and bond decline or stagnation could lead to insolvency for many pension funds, which are invested in these assets. Most investors are attached to the 60/40 portfolio as it has become the benchmark of reference, but to better deal with secular decline, they need to recalibrate their return expectations and diversify into more defensive, non-correlated assets.
The year 2022 will be remembered as the year that challenged the reign of the 60/40 stocks-bonds portfolio by showing that it is not immune to all market conditions. The 60/40 portfolio essentially benefits from strong economic growth and low inflation.
These factors have been so prevalent over the past 40 years that the 60/40 portfolio has only seen 6 negative performance years (including 2022). The last four decades have been one of the greatest periods of asset price growth ever recorded, history has rarely been so kind to investors. Moreover, during this unique period, bonds played a protective role within the 60/40 portfolio due to the massive drops in interest rates orchestrated by central banks during economic shocks. As a result, the gains from the bond portion of the portfolio largely offset the losses from the stock portion during crisis periods. Thus, the correlation between stock and bond returns has been negative over the past decades, unlike it has ever been over the past 100 years.
Biased by recent history, investors began to view the 60/40 portfolio as a nearly universal portfolio. This is a common bias in behavioral economics, known as the “recency bias”, which involves believing mistakenly that recent events will continue to prevail in the future. This recency bias is also well-established among institutional investors and pension funds. In fact, most asset managers have spent their entire careers in this strongly bullish cycle for bonds and stocks. All strategies that overweight equities and/or bonds have performed spectacularly.
As a result, the average asset allocation of Swiss pension funds is over-allocated to assets that have performed well in the last 40 years (stocks, credit, real estate, bonds) at the expense of more defensive alternatives that benefit from periods of disruption and panic (gold, long volatility, commodity trends (CTA) and global macro).
Although most institutions do not have a 60/40 portfolio as simplistic, almost all asset allocations tend to be variations of the classic 60/40. Thus, the vast majority of Swiss pension funds’ asset allocations can be reduced to a 60/40 portfolio with a strong domestic bias. Of course, these institutions like to emphasize that they have diversified their investments through a variety of assets such as private equity, real estate, private debt, mortgages, convertibles, and many others. They think that prudence recommends diversifying in every possible way, but the reality is that all these assets are ultimately either stocks or bonds in an alternative or illiquid form or a mixture of the two. However, in environments where growth is reduced, where inflation is higher and central banks are more lenient in reducing interest rates in case of a crisis, these allocations will produce disappointing results as they are not truly diversified.
Such scenarios are quite realistic, especially when studying financial history. In fact, over the long term, we observe “mega” secular cycles that alternate between long periods of sustained growth, like those observed in recent decades, initiated by a combination of demographic, technological, and globalization factors, and long periods of decline, contraction, or stagnation.
Given current conditions, the beginning of such a period of contraction or stagnation seems a more than likely possibility and the situation could be critical for investors stuck with allocations such as a 60/40 portfolio. That’s why investors must recalibrate their return expectations and consider diversifying into more defensive and non-correlated asset classes. By analogy, many portfolios are like a football team without a goalkeeper. Or, more precisely, as if the coach had removed the goalkeeper because, lately, the field players (especially bonds) have been so effective at avoiding conceding goals. However, you will never see a football team without a goalkeeper, even if the field players were extremely good at defense, because coaches know that to win a championship, you need a good goalkeeper.
To be clear, this does not mean the end of the 60/40 portfolio as this strategy will continue to be performant as long as there are secular growth periods. Everything depends on what we expect for the future and the real question is whether the asset allocation of our pension funds is in line with our expectations for the future. Are we ready to hope that the strong negative correlation of recent decades between bonds and stocks will persist despite what long-term analysis shows us? Do we want our retirement savings to benefit almost exclusively from GDP growth and low inflation? Is that really what we expect from the future? Most experts, in any case, do not expect this.
It is not to say that these institutions should be blamed. Their intentions are good and they have succeeded in taking advantage of the past decades. However, it is important to recognize that their current allocations are ill-equipped to deal with a secular decline. In the event of a prolonged period of stock and bond decline or stagnation, many pension funds could become insolvent and have to be rescued by the state. Given the current positioning of these institutions, one may wonder if they will become aware of the need to adjust their portfolios and challenge the status quo.
Most investors prefer to fail conventionally than succeed unconventionally. That is why they are so attached to their benchmarks. And given the performance of the 60/40 portfolio over the last four decades, it has naturally become the benchmark of reference. Deviating from it is extremely difficult because the manager will have to justify each short-term performance deviation, which explains why many try to avoid deviating from it.
However, article 72 of the LPP law states that the priority of pension funds must be to appropriately distribute risks and ensure the security of investments. In our view, given what is written in the law and the current situation, pension funds should focus on creating more “permanent” portfolios that are also equipped to deal with a secular decline, in other words, they should add a goalie to their portfolio. The solution to deal with a secular decline is simple when one studies financial history: find assets that can perform when stocks and bonds do not, and incorporate them significantly into your portfolio, regardless of short-term performance.
Counter-intuitively, defensive assets can be valuable for the portfolio as a whole, even if they don’t consistently produce returns. These assets, which generate asymmetrical returns during economic downturns, reduce portfolio volatility and offer investors the chance to reallocate capital to growth assets during times of undervaluation. Harry Browne introduced the idea of the “permanent portfolio” in the 1980s, with the aim of achieving optimal results in all economic conditions through true diversification. It consisted of equal parts stocks, bonds, gold, and cash.
Today, a modern version of the “permanent portfolio” can be created using a variety of investment tools. In place of cash, an investor might consider a mix of global macro strategies, long volatility, and tail hedging to better hedge against stock losses during secular declines. Instead of solely relying on gold, commodity trend strategies, which can invest in over 80 commodities, can provide better exposure to offset the deflationary impact of bonds and better benefit from an inflationary environment.
This modernized version of the “permanent portfolio” includes a significant allocation to hedge fund strategies. However, institutional investors have largely reduced their investments in hedge funds due to concerns such as complexity, lack of transparency, focus on individual strategy performance rather than overall portfolio strength, high cost, illiquidity, and questionable legal and regulatory structures.
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