Robert van den Oever: Welcome to Morningstar. An obituary was written for the 60/40 portfolio last year, but the strategy is off to a decent start in 2023. Joining me to discuss the performance of this classic balanced portfolio is Morningstar's Manager Research Analyst, Thomas De Fauw.
Welcome Thomas. Can you remind us what the 60/40 portfolio is and why this was created?
Thomas De Fauw: Yeah. Sure, Robert. The 60/40 portfolio has been the benchmark for balanced asset allocation, particularly for American investors. In fact, in Europe, the 50/50, the balanced or sometimes called neutral portfolio would probably be more commonplace. The idea behind this is very simple. Equities drive long-term returns, but bonds will provide protection, a sort of cushion against volatility in the stock market. But what we saw in 2022 is that bonds didn't provide that protection. In fact, bond market corrected alongside the stock market as central banks aggressively raised interest rates.
Van den Oever: So, the problem has been that the correlation between stocks and bonds is turning positive. If that continues, that would spell more trouble for the 60-40 portfolio going forward, right?
De Fauw: Well, the reality is that the correlation between stocks and bonds varies over time. It goes from positive to negative and back. But of course, investors will only complain when it's positive, and both are falling for a certain period. Now, looking forward, it is possible rates could go up further – what would be bad for stocks and bonds. But even in this bad scenario, which few managers that we talk to see as their base case, it's unlikely that rates would go up at the same pace like last year. Yields are also a lot higher now, meaning bonds are less interest rate sensitive. So, if bonds sell off, I think a lot of investors will be tempted to hide out in bonds or at least more than they did in the past.
Van den Oever: Now, there are those that argue investors should add alternatives to diversify their portfolio as bonds no longer provide the diversification. So, maybe the 60/40 is just no longer the best option out there? Or is it?
De Fauw: Well, I'd like to think of the 60/40 as a good starting point and for many investors, probably a decent end point as well. It still provides that balance, and that's important. But as I said, I mean, it's always good to challenge conventional wisdom. Alternatives can certainly provide diversification, but they are not without risks either. Just think about liquidity risks in private equity credit or infrastructure, for example. Of course, besides those alternative assets there are within the traditional asset classes room for tactical allocation. For example, investors can dial up and down duration in the fixed income sleeve or over- or underweight emerging market stocks in the equity part of the portfolio. In fact, last year, we've seen that those managers that allocated to value stocks and underweight duration outperformed their peers.
Van den Oever: And Thomas, do you have interesting ideas in this space?
De Fauw: Yes, absolutely. So, much depends on whether you prefer an active approach or a more index-based multi-asset solution. A good passive option, if you can call it that, is Vanguard LifeStrategy. These ETFs take a straightforward and low-cost approach to investing in a global diversified pool of bonds and equities, making it a sound long-term option for many investors. These ETFs balance frequently and target static equity allocations of 20%, 40%, 60% or 80% depending on your risk profile. All are rewarded with Morningstar Analyst Ratings of Gold.
In the active realm, we like Capital Group's Global Allocation Fund, which we award with the Gold rating for the cheapest share closes. It remains one of our highest convictions in the moderate allocation category. In a typical Capital Group style, the fund is managed by six managers who each manage their own equal slice of the fund. Each manager has a unique investment approach which leads to style and risk diversification, but generally all follow a long-term-oriented and high conviction approach. Unlike with Vanguard, the equity allocation is not static and depends on each individual manager's allocation, with 60% being the neutral equity weight here.
Van den Oever: Okay, Thomas, thank you very much for your insights in the relevance of the 60/40 portfolio and for the two examples you gave. For Morningstar, I'm Robert Van den Oever. Thank you for watching.
