The 2010s have been somewhat unusual in that a simple passive investment in the S&P 500 index delivered higher risk-adjusted returns than almost any other asset class. Traditionally, the risk of stock drawdowns from all-time high levels has been mitigated by rebalancing some of the stock gains into bonds, with one rule of thumb being to maintain a portfolio of 60% stocks and 40% bonds. Rather than simply hoping that US stocks and bonds will continue their impressive past returns, this article aims to take a critical look at expected returns over the next 10 years and construct a higher returning "new 60/40" for the 2020s.
First, we take a top-down view of our investment universe, and break down the components for calculating an estimated return for each part over the next 10 years.
For stocks, our expected nominal annual rate of total return over the next 10 years will roughly add up as the sum of three components:
1. The earnings yield on our current price of the shares, equal to the inverse of the P/E ratio. For example, a P/E ratio of 20 means an earnings yield of 5%/year. We get these P/E ratios from the ETF providers' websites.
2. The growth rate of the stocks' underlying earnings. If the average stock increases earnings per share by an average of 3% annually, that should increase our annual rate of return by 3 percentage points, all else equal.
3. The change in the multiple of earnings the market will pay for stocks. For example, an expansion in the P/E ratio from 20 to 22 over 10 years will add 10%, or 1 percentage point per year, to our total return, while a contraction of the P/E from 20 to 15 will reduce our return by 2.5 percentage points per year, all else equal. This component of our return is naturally the most difficult to predict, but it is fair to assume long-term reversion to a level around 15.
Major fund providers typically divide the global stock universe into three major geographic categories: the United States, developed markets ex-US, and emerging markets. Investors can allocate to each of these categories through a choice of the following low-cost ETFs from the top (4) major providers, ranked from largest to smallest:
1. US Stocks
For US stocks at a P/E ~20, we see the expected return adding up as follows:
Earnings yield: +5.0%
Earnings growth: +3.0%
Multiple shift: -2.5%
Expected Return: +5.5%
2. Developed ex-US Stocks - mostly Western Europe and Japan
For these foreign stocks at a P/E ~16, we see the expected return adding up as follows:
Earnings yield: +6.0%
Earnings growth: +1.0%
Multiple shift: -0.0%
Expected Return: +7.0%
3. Emerging Market Stocks
For these emerging market stocks at a P/E ~12.5, we see the expected return adding up as follows:
Earnings yield: +8.0%
Earnings growth: +5.0%
Multiple shift: +1.0%
Expected Return: +14.0%
Similarly, the next decade's expected returns for bonds can be estimated using three comparable factors:
1. The quoted yield to maturity on the bond. If the bonds are held to maturity, there are no defaults, and all coupons are reinvested at this same yield, this will be the total rate of return and the following two factors can be ignored.
2. Price return from changes in yield. If yields fall, bond prices will rise, and vice versa. For example, if we buy a bond today that has a duration of 20 years at a yield of 2%, and in 10 years that bond has a duration of 10 years and a yield of 3%, the change in yield would reduce our 10-year total return on this bond by 10%, or 1 percentage point per year.
3. Adjustment for defaults or "roll down". Defaults should reduce the total return of a bond portfolio, while "roll down" (buying a longer dated bond, then selling it when it becomes shorter dated at a lower yield to move further out to a higher yielding point on the curve) depends on the shape of the curve and how duration is managed.
The ETFs for allocating to these categories of bonds are as follows:
1. US Bonds
US bonds currently trade at historically low yields, and the main reason to include significant bond allocations in a portfolio is as "recession insurance", against a scenario where US rates go to zero or below and stay there until 2030. Also note that the first of these "aggregate" bond ETFs has a duration of around 5.5 years, so our expected return on bonds would be higher rather than lower if yields rose well above 2% between 2025-2030. Based on today's numbers we can forecast the following "baseline" expected return (assuming no deep recession or inflation) through 2030:
Quoted yield: +2.0%
Change in Yield: +0.0%
Expected Return: +2.0%
2. Non-US Bonds, hedged to USD
These non-US bond ETFs hedge their foreign bonds (mostly negative-yielding government bonds of Japan and Western Europe) back to US dollars, so the primary source of yield is from short-term US interest rates net of hedging costs, and most of the return comes from roll-down:
Quoted yield: +1.0%
Change in Yield: -0.5%
Expected Return: +1.0%
3. Emerging market bonds and bond alternatives
Unlike the other categories, these three ETFs are very different from each other as far as providing "bond" exposure to emerging markets. EMB and EMHY hold USD denominated bonds issued by emerging market sovereigns and corporates in international markets, EMLC holds bonds issued locally in local currency in these markets so is subject to currency risk, and REET actually holds real estate investment trusts (REITs), not bonds, and represents how wealthy investors from emerging markets view global real estate as a bond proxy.
Without breaking down the drivers into too much detail, I would assign rough expected return forecasts for 2020-2030 for each of these as follows:
Based on the above expected returns, we now define a global asset allocation model portfolio based on the familiar "60/40" rule of thumb, but with an important twist: in addition to being 60% stocks and 40% bonds, the portfolio will also allocate 60% to emerging markets, and 40% to (developed markets including the US), based on the significantly higher expected returns for emerging markets over the next decade. This cross allocation can be simply broken down as 60% emerging markets x 60% stocks = 36% in emerging market stocks and so on. This allocation adds up to an 8 fund portfolio with a target expected return of 8%/year as follows:
|Region||Asset Class||ETF||Allocation||Expected Return|
|Portfolio Expected Return:||8.0%|
As planned, this portfolio is both 60% stocks / 40% "bonds" and 60% emerging markets (EM) / 40% developed markets including US (DM+US).
For this "basic version" of the model portfolio, I simply used the largest ETF in each category (which often is also the one with the lowest expense ratio), but when implementing, I would consider replacing each with an "enhanced" or "smart beta" version of each category's ETF that might have a higher expected return or lower expected risk, based on the above model. I also chose to allocate 0% to EMHY to keep the portfolio to 8 funds with an 8% target return based on these assumptions, but this can of course be adjusted as well.
With US equities hitting all-time highs and US bond yields still near all-time lows, 8%/year may seem like an unrealistically high return target for a simple 60/40 asset allocation. This "New 60/40" model portfolio uses only 8 funds, and relies heavily on the assumptions of higher expected returns from emerging markets (given valuations and growth), but we can trace the path to an 8% return with this portfolio across each of these assumptions. Whether or not you are rebalancing gains from excellent US stock returns in the 2010s, this emerging-heavy allocation seems like the most mainstream model portfolio for targeting similarly high returns in the 2020s.
This article was written by
Tariq Dennison TEP runs GFM Asset Management, a registered investment adviser for cross-border families and retirement plans between the US and Asia. His marketplace service "Long Run Income" focuses on dividend growth and dividend alternative ideas for generating investment income over multi-decade time horizons. Tariq is the author of the book "Invest Outside the Box: Understanding Different Asset Classes and Strategies", spends most of his time in Hong Kong and around Asia, and teaches two classes at the Masters in Finance program at ESSEC Business School in Singapore.
Disclosure: I am/we are long VTI, SPTM, ITOT, VEA, IEFA, SPDW, VWO, IEMG, SPEM, AGG, BND, BNDX, IAGG, EMB, REET, EMHY. 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.