The 60/40 Dilemma
The high bond yields of the early 1980s enabled the high bond portfolio returns over the past forty years, and bond investors were not alone in benefiting from a tailwind of falling yields: investors in stocks also benefited. An investment in the S&P 500 received an earnings yield of 13% in 1981, and a downward trend in earnings yield since then coincided with a forty-year expansion in valuations.
In contrast to the early 1980s, the S&P 500 recently offered an earnings yield of less than 3%. With such ultra-low yields in stocks and bonds, the risk/reward environment today is the opposite of the early 1980s, and this poses a particularly acute dilemma for investors in the U.S. On the one hand, the benign conditions of the last forty years produced beautiful buy-and-hold returns in a standard 60/40 portfolio of stocks and bonds, but on the other hand those conditions have resulted in a severely overgrown market environment.
The effective yield of a 60/40 portfolio today is near 2%, the lowest effective yield in data going back to the 19th century, and it represents the nominal total return investors in U.S. stocks and bonds can expect in the years ahead if yields remain low. If yields do not remain low and begin to rise, total returns from passively holding a 60/40 portfolio of stocks and bonds could possibly be lower than 2%, or even negative.
The prospect of low or negative returns from passively holding stocks and bonds represents a dilemma similar to overgrown forests: the vast growth in recent decades resulted in a beautiful landscape, but there are now significant risks which were not present before. Fortunately, there is a way to address these risks: it involves a move away from the passive 60/40 portfolio of U.S. stocks and bonds to a more active, global search for investment value. This active search for investment value is the process which underlies our Absolute Return approach.
On Resiliency, and the Goals of Our Absolute Return Approach
The tailwind powering bond returns has been strong for forty years. However, in light of the decline in yields to near zero in 2020, investors should ask themselves whether bonds will be able to fulfill their traditional role of counterbalancing risk assets going forward. For bonds, it has been a long time since the last fire. When investors receive ultra-low yields from bond allocations, total returns are guaranteed to be low, and can turn negative if yields rise — exacerbating portfolio volatility, instead of dampening it. This unfavorable range of outcomes represents a fragility similar to a severely overgrown forest: a beautiful landscape embedded with hidden risks of loss.
Absolute return investing is an approach which seeks to earn a positive return over time, regardless of whether markets are going up, down or sideways — and to do so with less volatility than stocks. By ignoring conventional benchmarks and instead striving for positive absolute returns, absolute return strategies can offer a number of potential benefits to a broadly diversified equity portfolio:
- Reduce Overall Portfolio Volatility
- Limit Losses During Market Declines
- Provide Valuable Strategy Diversification
- Broaden Sources of Returns Beyond Stocks and Bonds
- Improve Overall Portfolio’s Risk-Adjusted Return
The benefits of an absolute return approach within a diversified portfolio are particularly important in today’s ultra-low yield environment. Maintaining overall portfolio resilience when risk asset yields are low is critically important, yet investors may need to incorporate more active strategies to enjoy the portfolio resilience that bonds provided in decades past.
Our Absolute Return approach serves as an effective counterbalance to risk assets using an active, absolute-value based asset allocation approach which is not dedicated to any single asset class or region. As a result, since inception our approach has had a near zero annual correlation with the S&P 500, which has helped to provide durable, long-term portfolio resilience.
If you would like to move forward with a more resilient investment portfolio that is less dependent on bonds than the traditional 60/40 portfolio, request a summary of our Absolute Return strategy at Getting Started. We would be glad to talk with you.
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