The textbook approach to diversification is a balanced portfolio of stocks and bonds: the 60-40 model. In practice, traditional asset allocation ranges from cautious (predominantly bonds) to growth (predominantly stocks). Its merits are typically displayed as a smooth efficient frontier, promising better risk-adjusted returns than any single market instrument.

Although not ‘all weather’, the standard asset allocation approach has served investors well. However, it is time for a rethink: 60-40 no longer looks fit for purpose.

Secular success

The traditional approach assumed stocks and bonds would be weakly correlated. For most of the past four decades this has not been the case, which has suited the 60-40 approach. The absence of diversification was handsomely compensated by healthy gains.

In sub-periods, unsurprisingly, the secular trend wavered. Notable examples include the bond bear market of 1994/95, the tech crash of 2001-2003 and the collapse of global equities in the global financial crisis.

Those episodes remind us stock-bond correlations vary with the state of the world. Benign disinflation accompanied by long expansions underpinned the joint secular bull markets in stocks and bonds after 1981. Stocks and bonds also rallied after the financial crisis, as depressed valuations and surging profitability boosted equity returns, while super-charged monetary policies fuelled gains in bonds.

During cyclical turning points correlations typically turn negative. Equities rally and bond returns sag in early stages of recovery from recession or when an economy exits deflation. Negative correlation occurs when recession looms, with government bonds rallying and equities dropping.

But 60-40 has an answer for negative correlation, called ’tactical asset allocation’, which aims to spot cyclical turning points. Properly conducted, a ‘flexible’ 60-40 can navigate cycles.

Challenging the convention

That does not mean 60-40 always works. Ominously, current circumstances are not promising for 60-40.

The foremost macroeconomic challenge would be an unexpected acceleration of inflation. Surging inflation causes bonds to sell off and boosts equity risk premiums. Accordingly, equities de-rate.

Inflation today remains quiescent for a host of well-known reasons. But low inflation has also allowed central banks to remain loose for longer, pushing bonds into extreme overvaluation. Easy money also helped push most equity valuations above long-term norms.

In short, the 60-40 portfolio is challenged for two reasons. First, it will fail if inflation accelerates. Second, it holds overvalued assets, whose returns are therefore likely to be mediocre. Today, 60-40 is an amalgam of low-return and high-risk instruments, the opposite of what it was designed to deliver.

Hitting the target

Is there a better alternative? I believe so.

A key flaw of 60-40 is it relies excessively on just two sources of return: directional moves in equity and bond markets. Today, that is not enough.

In contrast, next generation multi-asset solutions, epitomised by ‘target return’, offer portfolios comprised of various independent sources of return. Target return is typically a set of 20 to 30 market positions, spanning carry, thematic, macro and mean-reversion ideas. When properly combined, these offer a higher probability of portfolio diversification than 60-40.

Moreover, each position in a target return portfolio can be evaluated for its correlation to various factor returns. Those factor exposures can then be aggregated across the portfolio, allowing the investment manager to make informed decisions about where and how much factor risk to assume for the portfolio as a whole.

Target return positions can be ‘short’, ‘long’ or ‘market neutral’, adding sources of return, and hence opportunities for diversification, relative to 60-40. Individual positions are sized according to their volatility and correlation to other positions.

Larry Hatheway is chief economist and head of investment solutions at GAM