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    October 15, 2021 | GSAM Connect

    Is the 60/40 Dead?

    The “60/40 portfolio” has long been revered as a trusty guidepost for a moderate risk investor—a 60% allocation to equities intended to provide capital appreciation and 40% to fixed income to offer yield and risk mitigation. In the period following the Global Financial Crisis, a simple mix of 60% US large cap stocks and 40% investment grade bonds would have satisfied most investors as equities marched to new highs and interest rates descended to new lows. However, the tables have turned in 2022 with a 60/40 portfolio experiencing one of its worst years on record as both sides of the portfolio have come under pressure1. We believe investors should consider the following:

    Recalibrate Expectations

    Investors must first come to terms with the reality that the stellar returns they have become accustomed to are likely to be challenged. For context, the classic 60/40 portfolio has generated an impressive 11.0% annual return over the last decade (2011-2021). Even after adjusting for inflation, its 8.7% annual real return stands above long-term levels of around 6%2. Amongst many investors, this environment had given rise to a feeling that “what has worked will continue to work”—a behavioral misstep known as recency bias. However, it’s easy to forget that these strong returns haven’t always been so easy to come by. Recall not all that long ago the infamous “lost decade” to begin the 2000s, in which a 60/40 portfolio generated a meager 2.3% annual return and investors lost value on an inflation-adjusted basis. While we can’t know what the future will hold, we think investors should at the very least recalibrate expectations, especially considering the potential that higher inflation could take a bite out of real returns.

    EXHIBIT 1: 60/40 ANNUALIZED TOTAL RETURN

    Source: Goldman Sachs Asset Management and Bloomberg. As of 12/31/22. All returns reflect a blend of 60% S&P 500/40% Bloomberg US Aggregate Bond Index. “Nominal Returns” do not reflect the impact of inflation while “Real Returns” are adjusted for inflation. 1In 2022 (through 10/31/22), a 60/40 portfolio returned -16.9% on a nominal basis, which is the second worst year (2008) since the inception of the Bloomberg US Aggregate Bond Index in 1976. 2“Long-term” returns reference the last 45 years dating to the inception of the Bloomberg US Aggregate Bond Index. Exhibit 1: “Lost Decade” refers to 1/1/2000-12/31/2009. “Last Decade” refers to 1/1/2012-12/31/2021. Past performance does not guarantee future results, which may vary.

    INCREASE COMPONENT OF PERFORMANCE FROM INCOME

    Recalling the classic stages of grief, once investors have overcome denial and accept the likelihood of lower future returns, it’s time to establish a new strategy. One step investors can take to potentially improve outcomes is incorporate higher income-producing strategies into portfolios. In a lower return environment, we think the stability of total returns can be enhanced by increasing the component that comes from income, which tends to be more reliable than price appreciation. While rates have increased in recent months, a 60/40 portfolio still only generates a modest 2.0% yield—a far cry from the 5%+ offered in the ‘70s, ‘80s, and early ‘90s. In the equity market, investors may boost income outside of the most familiar US large caps by considering public real estate and infrastructure equities. On the fixed income side, assets such as corporate high yield, municipal high yield, bank loans, and emerging market debt may increase income and have historically shown less sensitivity to changes in interest rates. Diversified income strategies may also help investors efficiently bundle a variety of these asset classes together.

    EXHIBIT 2: ASSET CLASSES THAT HAVE OFFERED HIGHER DISTRIBUTIONS THAN THE “60/40”

    Source: Morningstar, Goldman Sachs Asset Management. Distribution rates generally represent the asset-weighted median 12-month yield of representative Morningstar peer groups through 9/30/2020. Please see end disclosures for asset class definitions and important disclosures. Past performance does not guarantee future results, which may vary.

    DIVERSIFY INTO RETURN-ENHANCING ASSET CLASSES

    Given that most asset classes have experienced above average returns over the last decade, investors owning a simple 60/40 portfolio have been rewarded for holding assets most familiar to them—up until 2022. Given the potential for challenged returns for these traditional assets, we believe investors should think outside the box in their search for returns. Through the review of several thousand professionally managed portfolios via our GS PRISMTM portfolio analysis, we find that the most traditional equities represent an outsized proportion of many portfolios. The average “moderate” risk portfolio has nearly 80% of its risk coming from core equities3. In our view, this results in an under-representation of other attractive return-generating assets. In addition to the income-producing assets previously introduced, we see long-term opportunities in emerging market equities, international small caps, liquid alternatives, and private assets such as private equity, credit, and real estate. Our analysis reveals that investors have limited exposure to these assets. In our view, this range of diversifying assets can offer the potential for return-enhancement, alpha generation, and diversification by spreading out risk concentrations within portfolios.

    CONCLUSION

    For all intents and purposes, we think investors have many reasons to be concerned that the 60/40 might be dead. And although most investors typically don’t hold such a simplistic portfolio, we see shades of the classic 60/40 present in many portfolios due to an overconcentration in the most familiar asset classes. We believe investors should recalibrate their return expectations, increase the component of performance coming from income, and consider diversifying into less familiar return-enhancing asset classes.

     

    1“Long-term” returns reference the last 45 years dating to the inception of the Bloomberg US Aggregate Bond Index in 1976. All returns reflect a blend of 60% S&P 500/40% Bloomberg US Aggregate Bond Index. “Nominal Returns” do not reflect the impact of inflation while “Real Returns” are adjusted for inflation. Past performance does not guarantee future results, which may vary.

    2Source: Robert Shiller and Goldman Sachs Asset Management as of 6/30/21. Equity valuation referenced is the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio.

    3Source: Goldman Sachs Asset Management as of 6/30/21. GS PRISMTM is a tool that analyzes the asset allocations of advisor portfolios. The average “moderate” risk portfolio refers to 1,600+ portfolios analyzed with a 30-40% allocation to core fixed income. “Core equities” refer to US large-, mid-, and small caps and international developed large caps. Diversification does not protect an investor from market risk and does not ensure a profit.

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