Asset Allocation Strategies

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>>> It’s Time to Rethink This Tried-and-True Investment Strategy


Barron's

By Randall W. Forsyth

July 31, 2020


https://www.barrons.com/articles/its-time-to-rethink-this-tried-and-true-investment-strategy-51596212713?mod=article_inline


The classics never go out of style, it’s often said, but the days of one classic investment strategy might be waning. That is the 60/40 portfolio, consisting of those respective percentages of stocks and bonds, which could be a victim of its own success.

The idea behind it is simple: Stocks do better during good times, while bonds act as shock absorbers during bad interludes. This negative correlation—a fancy way of saying that when one zigs, the other zags—reduces risk with relatively little sacrifice in returns.

In a sense, the concept has worked too well. While stocks and bonds have been negatively correlated over short periods, over the longer span they’ve been positively correlated, with both benefiting from the steady decline in longer-term interest rates, Marko Kolanovic, J.P. Morgan’s global head of quantitative and derivatives strategy, explained in a client call this past week.

Indeed, many equities trade in tandem with bonds, he continued, including the monster megacap technology stocks that dominate the market. These have benefited from lower rates, thereby boosting the value of their long-duration, but reliable, cash flows. Actual bond proxies, such as utilities, real estate investment trusts, and consumer-staples stocks, have similarly benefited, while their low volatilities make them popular with multi-asset portfolio managers. And ESG—environmental, social, and corporate governance—stocks tend to overlap with those factors, he added, aiding them indirectly.

But with yields on bonds approaching 0%—the benchmark 10-year Treasury note fell to 0.54% Thursday—they offer little scope for income or price appreciation, Kolanovic continued. That raises the possibility that 60/40 won’t work as it has in the past and needs to be tweaked. Assuming bond yields don’t go to zero, or below as in much of Europe and Japan, there is the chance they will move higher. That, in turn, would hurt bond proxies, as well as the megacap growth stocks heavily represented in the S&P 500 and other major indexes.

The question, then, the strategist continues, is how to hedge portfolios. Buying protection, such as through put options, is relatively expensive now. (A put gives the purchaser the right to sell a security at a stated price for a period; its value increases as the underlying security’s price decreases.)

The key is to find stocks that are highly negatively correlated with most equity portfolios. And the strategist found some, including value shares, financials, industrials, small-caps, and materials stocks. These, he says, are positively correlated with the 10-year yield (which moves inversely to the bond’s price). And not coincidentally, they have been laggards in the market’s advance, which has been led by the megacaps and low-volatility bond proxies.

This situation is relatively recent, having emerged over the past five to seven years, Kolanovic observes, and possibly enhanced by the rise of passive investments, such as S&P 500 index funds, as well as by momentum-chasing and ESG.

The problem is that traditional fixed-income investments are neither fixed nor provide much income—a key observation of the J.P. Morgan strategist’s presentation. A relatively small uptick in yields would result in price declines that would more than wipe out the meager annual income offered by bonds today.

As this column contended late last year, the chance of a rise in yields make bonds a less effective hedge for equity portfolios. What couldn’t be foreseen then, with the economy cruising along at full employment, was the catastrophe wrought by the coronavirus, which has sent bond yields crashing to record lows.

The lessened effectiveness of 60/40-type portfolios can’t be offset by just adding stocks correlated with bonds, such as the megacaps, Kolanovic argues. Rotating into currently out-of-favor assets, such as value stocks, he says, would provide the sort of ballast that bonds traditionally had. This approach could attract more big multi-asset managers, such as pension funds, which could lead to a rerating of these groups, he maintains.

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To be sure, the 10-year Treasury note’s yield could drop another 50 basis points (one-half percentage point), to near-zero. The 30-year Treasury, recently at a record-low 1.18%, could see a similar decline in yield, which would produce a double-digit total return from a price gain. Such a yield collapse would likely be associated with an economy in even more dire straits than revealed in the record 32.9% annualized plunge in second-quarter gross domestic product reported this past week.

Investors looking ahead to a recovery should consider J.P. Morgan’s advice to hedge portfolios away from the megacap tech champions and other stocks heavily correlated with bonds, to those that should benefit from a rising-rate environment, such as unloved value and financial shares.

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