60/40 Portfolio: A Performance Review (With Examples)

Is the 60/40 portfolio still relevant? How to construct a 60/40 portfolio with ETFs? Marco Santanché, a former Credit Suisse quant strategist and author of a monthly research series Quant Evolution, shares his thoughts below. 

The 60/40 portfolio, where 60% is invested in equities and 40% in fixed income, has long been a default asset allocation suggestion for many investors. Here’s how a 60/40 portfolio is supposed to work: 

• In a good year, the equities component of the portfolio should provide strong growth.
• In a down year, the fixed income component of the portfolio will protect you against losses, because bonds usually outperform stocks during downturns.

However, the proposition above has come under fire in recent times, not least because stocks and bonds moved in the same direction in 2022, which undermined the supposed value of risk diversification. 

Is the 60/40 portfolio dead? In this article, we will construct a few hypothetical examples, and evaluate the risks and opportunities for adding a 60/40 portfolio to the mix. 

Understanding the 60-40 portfolio

The 60-40 portfolio is a classic asset allocation model that consists of 60% stocks and 40% bonds. The equities component represents ownership in companies and offers growth potential, while the fixed income component provides stability through regular interest payments and capital preservation. This allocation is designed to capture market growth while mitigating the impact of market volatility.

Portfolio construction, with examples

There are several ways to build a 60/40 portfolio, although the proportion between equities and fixed income is given. In particular, the nuances of geography, sector and currency allocation can make the difference.

We can start from the BIGPX, a 60/40 portfolio built by Blackrock. If we look at the current composition as of 22 August 2023, it is focused on US equities and US fixed Income securities, with more than 80% of the portfolio allocated to the country. While this makes a solid equity portfolio, in terms of fixed income it is likely suboptimal. The portfolio could also benefit from diversification especially during a country-specific crisis, which could trigger a sell-off in securities relating to the country.  

How can we build our own 60/40 portfolio? There are some examples on the web, but we can try to build one from scratch.

For fixed income, we can have multiple splits. Let us start from the US market: a good proxy is the Vanguard Total Bond Market ETF (BND). On the other hand, iShares Global Govt Bond UCITS ETF (IGLO) will offer a better international diversification. 

For Equities, we will stick to the international approach and consider iShares MSCI ACWI UCITS ETF(SSAC).

In general, one should take into consideration geographical and currency exposure (limiting to the US could expose a higher portion of your portfolio to idiosyncratic, country-specific risk, as mentioned), but also the total costs.

Finally, once we have selected the two ETFs to use (IGLO and SSAC), the most important question is: how often should we rebalance to the equilibrium 60/40? There are several possibilities, including a fixed date (for example, first day of each month) or event-driven (for example, when weights deviate from 5%, 10% from their equilibrium), or both. 

Conceptually, I prefer the event driven approach, since it gives you a reason to rebalance the original strategy, while regular rebalancing could expose you to unnecessary transaction costs when there are only small deviations from targeted equilibrium. Hence, we will test with a 10% threshold.

60/40 portfolio: 2018-2020 performance review 

The international portfolio underperformed the US-based one in recent times, but outperformed during 2018-2020.

There are always regimes to consider, and nobody knows how the long term outlook will change. Nevertheless, the performance is comparable. Here a breakdown of the statistics:

Adding international equities to the picture and rebalancing only when the weights deviate by 10% reduces risk, without giving up too much risk per unit of volatility (Sharpe Ratio). Drawdown, or the peak-to-trough decline during the period, is also sensibly reduced.

Now we will consider an equities-only portfolio, by selecting our SSAC ETF: how does the 60/40 perform, in comparison?

In terms of performance, the proportion is comparable, with a slightly better Sharpe Ratio in Equities only. The problem is the similar drawdown, which suggests that what everyone considers the major benefit of a 60/40 portfolio (negative correlation between bonds and equities in bear markets) is not working when we need it most.

This does not completely mean that the 60/40 portfolio is dead, though. Covid is a special case that must be considered under its own circumstances.

And this is the general problem with drawdowns: nobody can truly know what would happen at the next drawdown, as they are event-specific, unexpected, violent changes in the current structure in the markets. Maximum drawdowns really refer to the realized “worst” path we see in recent history, but what about the future, possible “bad” paths that could be realized?

The 60/40 portfolio should be able to mitigate the volatility of stocks. That is where we can truly measure its performance: long term correlations play an actual role in long term, “normal” paths, not in the brutal events that affect the markets every 10 years.

Conclusion

Based on recent performances, the 60/40 portfolio is not as good as equities, per unit of risk. This is also the case from a drawdown perspective, at least when we look at the Covid period (others may vary depending on the case). The benefits of including international equities and fixed income securities are attractive from a risk perspective, although not as rewarding in terms of return and risk-adjusted performance. 

For more insights on ETF and portfolio strategy, visit Quant Evolution, a monthly research series published by Hedder.