The 60/40 Portfolio Construction Overhaul

The 60/40 Portfolio Construction Overhaul
By Greg Peters, co-CIO, PGIM Fixed Income

It’s been widely reported that historically low bond yields have sounded the death knell for the 60% equity/40% fixed income portfolio. While we acknowledge that the 60/40 construct is overdue for an overhaul, it is not due to low bond yields.

The so-called ‘60/40 portfolio’ became popular due to its simplicity, as well as the theory that the combination of stocks and bonds provided an optimal balance of asset volatility.

Yet, managing asset volatility is not the ultimate objective for most investors. Investors are often focused on accumulating enough savings for future needs like retirement.

Portfolios constructed to manage asset volatility versus those constructed to meet investors’ objectives deliver different results. We suggest investors’ portfolios should be constructed to manage the risk of achieving a desired outcome.

The shortcomings of the traditional 60/40 portfolio have certainly been exposed in 2022.

The US Federal Reserve has signalled faster and more frequent interest rate rises to rein in inflation which triggered a bond sell-off and set global share markets on edge, while in Australia, official cash rates rose in May by 0.25 basis points to 0.35% – the first interest rate rise in a decade.

Russia’s war in the Ukraine and associated global sanctions has introduced additional uncertainty, also driving up volatility in the equity and fixed income markets.

The result is that any investor wanting to accumulate enough savings for their future, may need to explore other approaches such as focusing on risk premia and investment outcomes, and we believe that adding adequate duration to portfolios can provide a rare investing opportunity to hedge risk while improving returns.

The Importance Of Duration

Understanding both risk appetite and investment motivation is vital to asset management because it determines which assets are most attractive to the investor and dictates how the portfolio is constructed.

Fixed income duration has a pivotal function. Traditionally, duration was meant to offset the stock allocation during periods of equity market stress. In an environment of historically low bond yields, the asset volatility definition conditioned investors to believe that adding duration to their portfolios increases risk. In fact, the underappreciated role of duration in portfolio construction is to reduce the high levels of interest rate risk faced by investors who are saving to meet future spending needs. Investors seeking to align their investment approach with their long-term investment objectives could benefit from viewing the addition of duration as a reduction in future spending risk, rather than a “hedge” against recessions.

Why Risk Premia Strategies Matter In Portfolio Construction

What do we mean by risk premia? This generally describes the amount by which an asset’s return is expected to outperform the known return on a risk-free asset. The essential concept is the reward an investor receives for taking on risk. As investors shift their focus from bond yields to risk premia, the public fixed income markets present a compelling opportunity set with which to generate excess returns.

Within fixed income investing, risk premia can be broken down further into term and credit premia – or the strategy of capturing a premium created by one’s exposure to term (duration) or credit (default) risk in a portfolio. Both term and credit premia play a significant function in bond portfolio construction. Our preference for focusing on bonds’ risk premia as a measure of potential return is based on the existence of a diverse, heterogeneous set of premia that creates relative-value opportunities and alpha generation.

Our risk premia discussion starts with the term premium, which is the excess return over cash based on a bond’s duration. In a recent paper, we demonstrated the persistent, positive return associated with term-risk premia, or duration risk, even after controlling for the decades-long bull market in rates. Furthermore, credit risk premia consists of risk factors for which fixed income investors receive compensation, such as credit rating downgrades. Importantly, the public fixed income markets and the behaviours of certain investors are highly segmented, which contributes to the wide dispersion across the credit risk premia.

Out with the old, in with the new – is it time to be more lateral?

The classic 60/40 approach to investing, whilst simple, is no longer meeting investment objectives and may soon reach its expiration date in today’s market. While our overhaul of retirement-focused portfolios cuts across traditional investment concepts, it remains simple—portfolio construction should start with elevated allocations to equity and duration risk, the latter of which hedges the interest-rate risk of long-term investment goal. As investors age, they should reduce exposure to both asset classes.

Gregory Peters is a Managing Director and Co-Chief Investment Officer of PGIM Fixed Income. Mr. Peters is also a senior portfolio manager for Core, Long Government/Credit, Core Plus, Absolute Return, and other multi-sector fixed income strategies. Prior to joining the Firm in 2014, Mr. Peters was Morgan Stanley’s Global Director of Fixed Income & Economic Research and Chief Global Cross Asset Strategist, responsible for the Firm’s macro research and asset allocation strategy. Earlier, he worked at Salomon Smith Barney and the Department of U.S. Treasury. He received a BA in Finance from The College of New Jersey and an MBA from Fordham University. Mr. Peters is a member of the Fixed Income Analyst Society and the Bond Market Association.