Will The Winning U.S. 60/40 Strategy Keep On Winning?

by: James Picerno

The Wall Street Journal tells us that tactical asset allocation funds are having a tough time beating simple passive strategies. "On average, tactical funds gained an average 6.9% over the 12 months ended Aug. 31 and 7.7% annually over the three years ended Aug. 31. A balanced portfolio with 60% invested in the S&P 500 and 40% invested in the Barclays U.S. Aggregate Bond Index would have gained 10.2% and 12.1% over the same periods, respectively, according to Morningstar."

The results aren't surprising. History suggests rather convincingly that it's tough to beat the market through time in terms of choosing superior asset mixes. In my periodic updates of comparing the Global Market Index (an unmanaged, market-value weighted mix of all the major asset classes) to 1000-plus multi-asset-class mutual funds and ETF, the index generally delivers average-to-above-average results (see this update, for instance). Nonetheless, some readers may interpret the Journal story as an endorsement of the traditional 60/40 US stocks/bonds as the optimal solution for designing and managing asset allocation. It certainly looks that way, given the strong performance of the US 60/40 mix, which has outperformed GMI and other strategies with broader holdings of global asset classes in recent years. But it's important to recognize that the US 60/40 strategy is a relatively risky allocation mix-one that's paid off handsomely of late, but one that comes with higher risk vs. GMI or its equivalent.

The issue, of course, is that the US 60/40 strategy is cherry picking from the menu of global asset classes. The fact that this US-centric portfolio has delivered handsome gains will be mistakenly interpreted by some that more of the same is fate. Maybe, but maybe not. If we could muster a high degree of confidence about which asset classes would win or lose, we wouldn't need to diversify globally. But in a world where uncertainty and surprise are forever harassing the best laid strategies of mice and men, the reality is somewhat different.

No, slavishly replicating an index such as GMI isn't necessarily the answer, although you could do a lot worse. Instead, the issue here is thinking carefully about why, or if, you'll deviate from Mr. Market's asset allocation. There are a number of reasons why you should, including the worthy goal of building a portfolio that matches your particular set of risk and return requirements. But ignoring non-US assets on the assumption that recent history will repeat looks more than a little shaky as a foundation for success.

If you start from the premise of looking at GMI as a collection of the basic risk factors available to everyone, the first issue is deciding how to pick and choose from the list. The next question: how to weight the assets? The third question: how and when to rebalance the mix? The latter question, by the way, will determine most of your success (or failure) through time. Keep in mind, too, that quite a lot of your capacity for succeeding with rebalancing will be closely linked with how you answered questions one and two.

For instance, if you decided to hold a US 60/40 mix, your expected payoff from rebalancing in the years ahead will be a function of just two asset classes. Will a binary asset allocation strategy suffice? It has in the recent past. If you assume that more of the same is coming, well, you're making a bet-and one that comes with more than a trivial amount of risk relative to GMI. If you're still willing to make this bet, you should be prepared to explain why. In short, what compels you to think that ignoring more than half of the planet's assets is a superior foundation for asset allocation? Why, for instance, is a US 60/40 strategy more likely to succeed vs. its global equivalent? If the answer is simply that the strategy worked well in the past, you're asking for trouble.