When the Future Fund – which is Australia’s $200 billion sovereign wealth fund – writes a position paper titled “The Death of Traditional Portfolio Construction?” it is sure to get the attention of the media and our clients alike.
Portfolio construction has become a hot topic from late 2022, which is understandable considering cash was the best performing asset class. In fact all other asset classes were negative for the year, which last occurred in 1994 and has only occurred four times in the last 50 years.
So what is a traditional 60/40 portfolio?
The so-called 60/40 portfolio began in 1952 with the belief that a portfolio of 60% growth assets primarily shares and 40% defensive assets primarily bonds was the optimal investment portfolio. The idea being that when growth assets are not doing well the defensive assets will hold up the portfolio. This usually occurs as central banks reduce interest rates to stimulate the economy which results in an increase in bond prices.
Then in reverse, when the economy is doing well and growth assets are climbing higher, central banks will increase interest rates to put the brake on the economy resulting in a decrease in bond prices.
Based on historic returns the optimal mix is to have 60% growth assets and 40% defensive. As it is difficult to time the markets it is advocated that this allocation be the mainstay of investment portfolios.
As 2022 proved to be a dramatic year with central banks fighting an unexpected inflation battle by increasing interest rates at the fastest rate in many decades we saw historic falls in bond prices. In the lead up to 2022 with close to 0% interest rates many started questioning the defensive qualities of bonds due to their low yield, although they still retain their capital preservation qualities.
Investment professionals in search for alternative sources of returns in the defensive sector turned their eye towards unlisted assets and hedge funds (it is questionable whether these are considered defensive assets). They also tried to reduce investment fees to bolster returns by increasing allocations to passive investments. Institutional investors also looked at a mixture of investing directly into private equity and infrastructure to match the long-term investment characteristics of their clients.
I would argue that in search for diversification the 60/40 portfolio is not dead. It is just that the investment mix within these growth/defensive sectors have become more nuanced. They have been better categorised and more diversified i.e. there are many ways to invest within the share market now (private equity, ETFs managed accounts, growth, passive et cetera). Just as there are many different markets and levels of risk to take within the bond asset class. Like every aspect of life everything evolves and the 60/40 portfolio is no longer just made up of shares/bonds.