The New 60/40

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About: Invesco S&P 500 Low Volatility ETF (SPLV), Includes: AGG, EEMV, EFAV, SPY, USMV, XMLV, XSLV
by: Ploutos
Summary

A 60/40 mix between stocks and bonds has historically been a rule of thumb for investors wishing to mute some of the volatility of equities.

With lower forward expected returns on equities and fixed income, will the 60/40 portfolio return continue to deliver for investors?

This article compares the 60/40 heuristic versus low volatility equities, which also offer lowered equity volatility akin to a bond allocation.

I also examine the performance of an 80/20 strategy that features low volatility equities in lieu of a more traditional stock allocation.

Results of the different strategies are compared over the nearly three decades of data available for low volatility equities.

Historically, a portfolio mix of 60% stocks and 40% bonds has been a formula for long-term investing success. This heuristic was commonly used by pension funds to capture a portion of the upside of equity markets while the bond component cushioned returns in weak market environments.

Over a co-terminus 28 year dataset from 1991-2018, the 60/40 rule has performed admirably. The question is whether this strategy will continue to deliver with heightened equity multiples suggesting lower forward returns on stocks and low interest rates suggesting lower forward returns on fixed income. Hedge fund giant AQR Capital Management in their 2019 Capital Market Assumptions expects a real return (i.e. inflation-adjusted) return for the traditional U.S. 60/40 portfolio of just 2.9%.

To dig into a comparison of the balanced 60/40 portfolio, I used the S&P 500 (SPY) and the Bloomberg Barclays U.S. Aggregate Index (AGG) as my representations of equity and fixed income respectively. The table below lists performance figures for the equity index (SPX), the bond index (AGG), the 60/40 portfolio of stocks and bonds, low volatility stocks (LV), and an 80/20 portfolio of low volatility stocks and bonds over this long study period.

Risk-adjusted returns of 60-40 and components Even with stocks near all-time highs, the 60/40 portfolio (rebalanced annually in this example) has trailed the standalone S&P 500 by just 1.2% per year. This strong performance occurred with around 60% of the volatility of the S&P 500 and lower drawdowns in times of stress.

The column just to the right of the 60/40 breakdown; however, shows that owning low volatility stocks (NYSEARCA:SPLV) performed even better on a risk-adjusted basis. The S&P 500 Low Volatility Index outperformed the S&P 500 on an absolute basis with under three-quarters of the variability. The incremental 2.2% annualized return of low volatility stocks versus the 60/40 mix was healthy compensation for the modest uptick in risk, as reflected in the higher Sharpe Ratio - a measure of risk-adjusted returns.

The column on the far right of the table is an 80/20 combination of the Low Volatility Index and the U.S. Aggregate Bond Index. This addition of a fixed income component, while half the level of the traditional 60/40 mix, further dampened the volatility of owning Low Volatility stocks. In fact, as you can see from the table above, the realized risk of the 80/20 portfolio was actually slightly lower than the 60/40 portfolio. The 128bp annualized positive return differential for the 80/20 strategy versus the 60/40 strategy led to a higher Sharpe ratio, a measure of risk-adjusted returns. The 80/20 strategy using low volatility equities created alpha versus the 60/40 strategy over the sample period.

The graph below shows the cumulative returns of the 60/40 strategy, its component parts - the S&P 500 (NYSEARCA:SPY) and U.S. Aggregate Bond Index (NYSEARCA:AGG) - and the low volatility index and the 80/20 portfolio. Note that the 80/20 portfolio roughly equaled the returns of the S&P 500 with much lower variability. That strategy also outperformed the S&P 500 by 20% in the 2008 selloff.

The historical success of the 60/40 strategy in smoothing portfolio returns is a function of the negative correlation between bonds and stocks as seen in the correlation matrix below. I have calculated correlation coefficients of the annual return streams of these five portfolios.

Despite the negligible correlation between the S&P 500 and the Agg, the 60/40 portfolio still strongly correlates with the equity market. This is because much of the return variability is from the equity risk, a figure much higher than 60%. Even though the Low Volatility Index constituents are pulled from the S&P 500, the correlation with the broad market gauge is lower than the 60/40 portfolio. Low volatility stocks are more correlated with the 60/40 portfolio than the S&P 500. It should also be noted that bonds are naturally more correlated with low volatility stocks.

Low volatility stocks again outperformed the broad market index in 2018. The 80/20 portfolio beat the 60/40 portfolio by nearly 3%. With the yield on the bond index hovering around a nominal 3% yield, Seeking Alpha investors may be incentivized to examine low volatility stocks as alternative to a healthy weight in the bond index. Low volatility strategies are now readily accessible to investors through low-cost exchange-traded funds. I have covered these strategies in small-cap (NYSEARCA:XSLV), mid-cap (NYSEARCA:XMLV), and large-cap stocks (SPLV,USMV) in previous articles. Additionally, I have also examined the efficacy of low volatility strategies in international developed markets (EFAV) and emerging markets (EEMV). While low volatility in this article is focused on domestic large caps, there are a number of different low cost strategies available to those who want to examine a low volatility tilt.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPLV,SPY,USMV,XMLV,XSLV,EFAV,EEMV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.