What’s the worst thing that could happen to 60/40 portfolios?

The answer to the above question is: a strong economic recovery.

The 60/40 portfolio is a common and historically effective way of generating consistent long-term returns.

With 60% in equities, the portfolio should normally benefit from economic and market growth, whilst the 40% in (usually) government bonds provides a cushioning effect in a downturn. Regularly rebalanced, this strategy can provide decent performance whilst dampening volatility.

A recent article for Citywire by Vanguard’s Renzi Ricci argued why this should continue to be effective in the future. I am not saying he is right or wrong, but I am worried that a particular set of circumstances could hit this portfolio hard, particularly if built using index funds.

A strong economic recovery – especially one that is stronger than expected by investors – would usually be good for investment portfolios. It would normally see earning expectations increased and this would be reflected in share prices.

However, I think your typical passive 60/40 portfolio could, at best, underperform in such circumstances and, at worst, lose quite a bit of money.

It’s all about duration, or sensitivity to changes in interest rates.

We are used to talking about duration in a fixed interest context. A UK 10-year gilt (for example) has a very low yield by historic standards of around 0.3%. The duration is extremely high relative to history, at about 9.5 years.

In other words, the potential return is low and the potential risk is high.

The high duration that means is that if the yield changes by 1% pa, the capital value will inversely move by around 9.5%.

Long duration can work in your favour. Should we see a further economic downturn and the Bank of England carries out more quantitative easing (QE) and cuts interest rates into negative territory, this duration is your friend. If the yield drops to (say) -0.2%, you’d make about 4.25% capital gain.

However, if the economy recovers and the Bank stops QE earlier than expected or (god forbid) starts talking about rates going up, then the opposite could happen. If the gilt yield went up to just 0.8% pa, you would lose about 4.25% capital. Should it go up to 1.3%, you lose approximately 9.5%.

In a way, so what? The whole point is that, whilst this might happen, the equities should be gaining in value and more than offset this loss.

However, if invested in a typical index strategy, you might be more vulnerable than you think.

The MSCI World Index, commonly used in such portfolios, is almost 67% invested in the US. The US market is dominated by the big tech stocks, with the top five tech companies making up nearly a quarter of the US market.

The World Index is slightly better diversified than the US market but still has a high proportion of around 22% in information technology.

Tech stocks have of course done extremely well as a result of the pandemic. Many of us are working from home using Apple, Microsoft and Google software, whilst we watch Netflix in the evening!

There is no doubt the pandemic has accelerated existing trends, but an early end to the crisis could also hit these companies hard. We call this “the Zoom paradox”.

Ask yourselves two questions. One year from today, do you expect (or hope) to be using Zoom less than you are now?

Is that number still probably more than you were using Zoom two years ago?

My answer to the first question is a resounding “yes”! The answer to the second question is probably a “yes” as well. Their growth has been accelerated and they’ll be long term beneficiaries, but I hope we’ve already passed peak Zoom!

When the first vaccine announcements came out, Zoom fell sharply, dropping 17% in a day. Other tech stocks fell too, albeit less spectacularly.

The types of stock which make up many index portfolios are those which would benefit the least from an economic recovery and, in some cases, could see their revenues actually fall.

But there’s another (perhaps more important) factor in play, which is the same issue we discussed with respect to bonds: duration.

These tech stocks, and other high growth companies which have outperformed over the past few years, have also been big beneficiaries of low interest rates.

Just like with a defined benefit pension scheme, bond yields are used as a discount rate when valuing future earnings. These tech stocks are valued on eye-wateringly high multiples of current earnings but are expected to grow quickly.

When analysts try and work out what those expected cash flows are worth today, they discount them back using bond yields. A rising bond yield and therefore a higher discount rate, makes future cash flows worth less in today’s terms.

A quicker than expected economic recovery, perhaps driven by a speedy vaccine roll-out, could see some shares take a double hit of reduced earnings AND a higher discount rate. The combination could be quite dramatic.

The last thing you want from a diversified portfolio is to see your equities and bonds go down at the same time. I worry that a 60/40 portfolio made up of a MSCI World tracker (or similar) and a typical government bond index fund could be hard hit in that scenario.

I am not against index funds at all. At Equilibrium we use a mixture of active and passive approaches but if a self-investor asked me where to put their money, I would always recommend low-cost index funds.

However, if you are going to be 100% passive right now, I’d suggest two possible tweaks to your 60/40 strategy to reduce your duration risk.

In the bond portfolio, consider investing part of your assets in a shorter dated fund with lower duration. In equities, consider investment a proportion in a “smart-beta” fund with a value tilt, to offset your large exposure to growth stocks. All the big index providers like Vanguard and iShares (as well as specialists like Dimensional) have short dated and value options at very low cost.

Your standard 60/40 approach has worked extremely well in an environment where rates have consistently gone down. If this trend reverses then it could be very vulnerable.

This article first appeared on www.citywire.co.uk

Risk warning: the content contained in this blog is for information purposes only and in no way constitutes a solicitation of investment advice. Investments will fall as well as rise and investors may not get back the amount originally invested.