Decomposing 60/40

With interest rates on the rise from who-can-be-sure-of-what (we have our thoughts…), bond prices are generally on the downtrend. But bond income (from the now generally higher yields) is on the rise. We therefore have once again entered the “60/40 Portfolio is Dead!” phase of the interest rate cycle. These generally lazy takes often fail to provide sufficiently broad context either as to why investors might want to incorporate bonds in their portfolios or to the various ways one can choose to do so. So, we’d like to remind folks that neither all bonds nor all bond investing methodologies are created equal. As is always the case in investing, your results will depend greatly on how you choose to invest in the asset class.

• Secular shifts in interest rates create variability across fixed income investment outcomes
• Over most any meaningful time frame, bond prices have proved rather reliably less volatile than stocks
• While it’s true that directional changes in bond prices periodically align with those of stocks, such positive correlation is not a reliable characteristic (a statement of the opposite is generally more accurate)
• Just as one can invest in stocks in a manner well different than all stocks (i.e., the “market”), one can invest in bonds in a manner well different than the “bond market”

Bonds as Ballast

“60/40 is Dead!” memes come in various forms, often focusing on stock/bond correlations and flare up conversationally when that number turns meaningfully positive or when bond prices are falling by their lonesome, such as they may have been more recently as longer-term bond yields were reaching multi-decade highs. The notion implicit to many of these takes is that investors should look to other asset classes to fill portfolio role(s) for which bonds otherwise may have been utilized. Time and again, the notes fail to present such periods as occasionally expected behavior, while also generally failing to revisit the core reason many invest in bonds: their relative price stability, even when the direction of price changes is near-term negative and/or directionally aligned with stock price moves. In Figure 1 we present the historical range of three “markets”: the U.S. stock market (SP500, represented by the S&P 500 Index), the U.S. Investment Grade bond market (AGG, represented by the Bloomberg U.S. Aggregate Bond Index, which tracks the U.S. investment grade taxable bond market), and our preferred bond benchmark (ST-IG), the Bloomberg 1-5 Yr Government/Credit Index, which comprises a short-duration subset of the Aggregate. Readily apparent from the data is the fact that stocks are more volatile (showing wider ranges with markedly higher highs and lower lows) than the broader bond market over each of the rolling periods reviewed, while the historical ranges of returns for the short-duration index are narrower still. This despite the fact that bond returns are not altogether reliably positive on a month-to-month basis (bonds carry investment risk too!!!) and that, fair to the core arguments of the T6040PID crowd, stocks and bonds rather often, actually, move down at the same time. See Figure 2 for more.

The data in Figure 1 support our preference for an approach that generally emphasizes shorter duration bonds in the portfolio. Bonds carry two primary risks: interest rate and credit. The former reflects a bond’s sensitivity to changes in interest rates, with bonds that have a longer time until maturity tending to carry more interest rate risk. Credit risk is the potential for the issuer to default. While we have sought across the portfolios we manage to modulate exposure to interest rate risk over time, both higher and lower, we generally have maintained less-than-market sensitivity to changes in interest rates (measured by “duration”; duration tends to increase with time to maturity, though the math will depend on additional bond characteristics).

Investors generally seek additional compensation for that interest rate risk, such that interest rates tend to be increasingly higher for bonds of increasingly longer duration . In normal times, therefore, it may seem attractive to add duration to a portfolio in order to pick up additional income. But as is the case with all investing, a higher expected return carries higher expected risk. These facts inform our twin preferences of 1) preferring equity exposure when seeking higher returns while 2) seeking to use bond holdings as a damper against stock market volatility. Since we mostly seek to use bonds as a stock-risk offset, we tend toward the more cautious side of the spectrum when seeking incremental income through an extension in portfolio duration.

Softening the Blow

Our preference for seeking to add portfolio stability with fixed income is not merely a personal predilection. While the range-out-outcome view of Figure 1 helps to demonstrate the relative stability of bond returns, Figure 3 conveys a characteristic of bonds perhaps even more meaningful to client investment experience. Decades of work have shown us that clients have tended to appreciate the generally more stable performance of bonds during larger equity market meltdowns, even though bonds may have limited their absolute returns during more favorable equity market climes. That is, bonds can help limit the depth, duration and/or emotional tax of market declines. In this context, history is relatively less ambiguous. In Figure 3 we show twelve of the largest U.S. equity market drawdowns (decline from prior peak back to breakeven) along with the corresponding performance of our fixed income benchmark over the same timeframe. Due to a limitation of the bond data, we are using monthly data up to September 30, 1997. From then onward we show daily data. The monthly periodicity certainly flatters the stock drawdowns over that earlier period, in that we are missing intra-month market troughs, and may well flatter the bond performance for the same reason, but we cannot know this as the data are not available. That qualification noted, this relative stability during times of market duress is among the more defensible reasons, in our view, to maintain exposure to fixed income in portfolios that, for whatever reason, require some manner of potential damper against equity market risk (e.g., intention for the funds, owner tolerance for investment risk).

There are numerous ways to demonstrate this potential dampening effect, and we present another in Figure 4, which shows the relative drawdowns of the various benchmarks that we use to compare performance of the accounts that we manage. Because we tend to target equity exposure in 10% increments, we maintain benchmarks at eleven risk levels: 0% equity/100% fixed income, 10/90, 20/80 and so on through 100% equity. The implication of the chart is that portfolio drawdowns tend to be lighter in more or less direct proportion to the amount of fixed income owned relative to equity in the portfolio. Even so, the lighter expected drawdown that tends to come along with higher ratios of fixed income to equity in a portfolio may come at the cost of lower long-term returns. In Figure 5 we chart those same data we used to create Figure 4, only this time without resetting the value to zero at each new peak. Starkly outlined by the final values is the potential benefit that may come from assuming additional investment risk, in the case of this chart by taking on additional equity exposure.

There is No 60/40

There really isn’t any “one” 60/40, which means that “the” 60/40 can’t be dead. Indeed, potential implementations of a 60/40 approach (or 20/80 split; 70/30 split, etc.) likely are as varied as there are managers who build them. We believe the construction of the 40% fixed income slice of the 60/40 portfolio can be every bit as impactful to long-term returns and client comfort on the way to realizing them as can be the composition of the 60% equity portion. As we have sought to show on these pages, for example, investor experiences likely differed widely during the Fed’s 2022-23 hiking cycle depending on how their managers had positioned the fixed income side of the ledger vis-à-vis interest rate risk. Importantly, we look for our approach within fixed income to neatly align with our overarching belief that striking an appropriate balance of expected returns against tolerance for investment risk is central to success in the pursuit of long-term financial goals.

Important Information

Signature Resources Capital Management, LLC (SRCM) is a registered investment adviser. Registration does not imply a certain level of skill or training. This material is provided for informational purposes only and should not be construed as investment advice or as an offer to buy or sell any security or implement any investment strategy. A decision to engage SRCM should be made only after carefully reviewing the applicable investment management agreement and SRCM’s Form ADV Part 2A and Part 2B, conducting any due diligence you consider appropriate, and consulting your legal, tax, and accounting advisors. All investing involves risk, including the possible loss of principal. Additional information regarding SRCM’s services, fees, risks, and conflicts of interest is available in the applicable investment management agreement and Form ADV. Information presented here is unaudited, subject to change, and intended only as a general guide to current views.

The S&P 500 Index measures the performance of the large-cap segment of the U.S. equity market.

The Bloomberg U.S. Aggregate Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MSB; agency fixed-rate pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS; agency and non-agency).

The Bloomberg 1-5 Yr Government/Credit Index is a broad-based benchmark that measures the non-securitized component of the U.S. Aggregate Index. It includes investment grade, US dollar-denominated, fixed-rate Treasuries, government-related and corporate securities with 1 to 5 years to maturity.

Past performance is not a guarantee of future results. The views expressed reflect SRCM’s opinions as of the date of writing, are subject to change, and may not reflect current thinking. This material is based on proprietary research and analysis, together with information believed to be reliable; however, SRCM does not represent that such information is accurate or complete and accepts no liability for any loss arising from its use. Certain content may be theoretical in nature and subject to inherent limitations. Any references to market exposures or specific investments are provided for illustrative purposes only and may or may not be reflected in client portfolios. No reader should assume that any investment or strategy discussed was or will be profitable. This material may also contain projections, targets, or other forward-looking statements based on current expectations and assumptions. These statements are not guarantees of future outcomes, and actual results may differ materially. You should consult your financial advisor to determine whether any investment or strategy is appropriate for your individual circumstances.

Challenging Bias

Challenging Bias

The past decade has not been particularly kind to diversifiers; a handful of large U.S. growth stocks generally outperformed international stocks, smaller companies and Value-oriented investments. As the gap widened, diversification may have looked less like prudent risk management and more like an unnecessary constraint. But recent strength across formerly lagging market segments offers a useful reminder that diversification’s greatest challenge remains squaring the intuition (more should be better) with the fact of narrow nearer-term outperformance:

• Diversification is not designed to maximize returns in every period but, rather, to reduce dependence on any single market outcome
• A properly diversified portfolio near always will contain holdings that appear disappointing in hindsight; the strongest arguments against diversification often emerge after a lengthy period of narrow market leadership
• Market leadership has historically changed over time, though the timing of those changes is unpredictable
• Not to identify tomorrow’s winner, among the goals of diversification is to improve the probability of achieving long-term financial objectives across a wide range of possible futures

Diversification’s Drawbacks

The past decade has been kind to equity investors. It has been kinder to investors with more concentrated portfolios—most notably those focused on the U.S. large-cap stocks represented by the S&P 500 Index—than to investors holding more diversified combinations of domestic and international stocks. In hindsight, there nearly always will have been a “better” portfolio to own. For U.S. investors in particular, who already enjoy efficient access to a large and widely diversified home market, international stocks can be especially difficult to defend when they lag for an extended period. We continue to emphasize that broader approach, even though the empirical case for diversification may appear less compelling after a decade of unusually narrow market leadership.
Since 2009, with relatively few exceptions, U.S. large-cap growth stocks have outpaced developed international markets on an annual return basis. Smaller companies also generally failed to keep pace. Value-oriented investments remained largely out of favor as investors paid increasingly high prices for realized growth and the promise of a continuation of recent trends. Against that backdrop, many investors found themselves asking a reasonable question: why own anything other than what has been working?

Hindsight Is No Guarantee

Investment decisions often are evaluated with the benefit of hindsight. Looking backward, it can seem obvious that a concentrated investment in the strongest-performing market segment would have been preferable to a more diversified allocation. But in 2015, few investors could have precisely identified the companies that would dominate market returns over the following decade. At the time, sentiment toward Nvidia (NVDA), in particular, was far less enthusiastic than later results would appear to justify. Coverage was concentrated on gaming and personal computer exposure, while artificial intelligence was mostly discounted and cryptocurrency mining was not yet a key component of the investment narrative. Although Nvidia eventually delivered the strongest performance among the group, a review of contemporaneous expectations suggests it may have been among the least appreciated of the companies that later became known as the Magnificent 7 [Alphabet (GOOG/GOOGL), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), Nvidia and Tesla (TSLA)].

The difficulty, of course, is that investors do not make decisions with the benefit of hindsight. They make them before the future unfolds, and the future often develops in ways that differ meaningfully from prevailing expectations. Recent performance across the Magnificent 7 offers a useful reminder. Several members of the group have roughly kept pace with, or even trailed, the broader market this year. Apple has been a notable exception. Once scolded for its lack of aggressive AI investment, the stock now seems to have found relative strength largely because the company took a slower, more thoughtful and defensible approach to investment in AI.

Even Nvidia has trailed the market as investors seemingly have begun to realize that there must be profit to come from all this investment in capacity for AI compute capacity, while they also may be glomming onto the idea that many (most?) of us might be better off investing in our own personal AI infrastructure (side note: we are editing this doc on a MacBook Pro, which we purchased seeking to test and eventually ensure we can safely take advantage of the remarkable capabilities that genAI tech can bring without compromising privacy and blowing up our tech budget).

So, the challenge is identifying market-beaters before they become winners, maintaining conviction long enough to benefit from being correct and getting out before sentiment and fundamentals shift. Diversification acknowledges that this task is extraordinarily difficult. Rather than attempting to identify a narrow set of future chart toppers, diversification seeks exposure to a broad range of potential outcomes. The tradeoff is obvious: a diversified portfolio will almost certainly own some investments that disappoint. It may be just as likely to own some that surprise positively. The objective is not to maximize returns in every period. The objective is to pursue attractive long-term returns while reducing the risk that a single error meaningfully derails a financial plan.

Cycles Cycle

The strongest arguments against diversification often emerge near the peak of a particularly dominant trend. By then, investors have become increasingly convinced that recent winners deserve larger allocations and that underperforming areas are no longer worth holding. History suggests such conclusions may be unwarranted. One of the recurring lessons of investment history is that leadership changes. The individual stocks, sectors, countries and investment styles that dominate one decade often look quite different from those that dominate the next. That does not mean market leadership changes on a predictable timetable. It does mean that investors should be cautious about assuming recent trends will continue indefinitely. The challenge is that timing those transitions is exceptionally difficult. Investors frequently abandon lagging investments shortly before performance improves and enthusiastically add to recent winners after much of the gain has already occurred. The result can be a cycle of buying high and selling low that gradually undermines long-term outcomes.

Balancing Breadth

A diversified approach will always be judged against the best-performing investment(s) over some trailing period. That comparison virtually guarantees disappointment for diversifiers. But while concentration can be rewarding, it can also dramatically increase the consequences of being wrong. One need not look too far into the past to see when shares in Nvidia lost two-thirds of their value on account of the reversal of the cryptocurrency mining trade.

Our preference for portfolios diversified across a range of exposures—asset classes, regions, currencies and individual security characteristics—accepts the possibility that not every holding will shine simultaneously. In exchange, it seeks to avoid excessive dependence on a single market segment, economic outcome or investment narrative. As U.S.-domiciled investors, we maintain relatively unique home-market characteristics that push against the more-can-be-better narrative. This fact generally supports our broader tilts toward U.S. stocks and bonds across all but the most aggressive portfolios we manage. Even so, our preference for broad diversification nods to the fact that equity market records represent a moment in the course of human history. The broader historical context shows that global, regional, macroeconomic and industrial supremacy ebbs and flows in manners hard to predict, in ways generally obtuse to the preferences and predictions of the contemporary hegemon.

Less dramatically, instead of attempting to identify the single best-performing asset class over the next ten years, investors should be seeking to fund retirements, support future spending needs, preserve purchasing power and maintain confidence through a wide range of market conditions. These objectives rarely require perfection. Rather, they require discipline, patience and a portfolio construction approach that acknowledges the limits of our ability to correctly predict the future.

Important Information

Statera Asset Management is a dba of Signature Resources Capital Management, LLC (SRCM). Signature Resources Capital Management, LLC (SRCM) is a registered investment adviser. Registration does not imply a certain level of skill or training. This material is provided for informational purposes only and should not be construed as investment advice or as an offer to buy or sell any security or implement any investment strategy. A decision to engage SRCM should be made only after carefully reviewing the applicable investment management agreement and SRCM’s Form ADV Part 2A and Part 2B, conducting any due diligence you consider appropriate, and consulting your legal, tax, and accounting advisors. All investing involves risk, including the possible loss of principal. Additional information regarding SRCM’s services, fees, risks, and conflicts of interest is available in the applicable investment management agreement and Form ADV. Information presented here is unaudited, subject to change, and intended only as a general guide to current views.

Past performance is not a guarantee of future results. The views expressed reflect SRCM’s opinions as of the date of writing, are subject to change, and may not reflect current thinking. This material is based on proprietary research and analysis, together with information believed to be reliable; however, SRCM does not represent that such information is accurate or complete and accepts no liability for any loss arising from its use. Certain content may be theoretical in nature and subject to inherent limitations. Any references to market exposures or specific investments are provided for illustrative purposes only and may or may not be reflected in client portfolios. No reader should assume that any investment or strategy discussed was or will be profitable. This material may also contain projections, targets, or other forward-looking statements based on current expectations and assumptions. These statements are not guarantees of future outcomes, and actual results may differ materially. You should consult your financial advisor to determine whether any investment or strategy is appropriate for your individual circumstances.