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A Full Out Assault on 60/40

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Are investors finally waking up to the fact that chasing recent returns isn’t the best strategy?  That may be the case with multiple publications recently calling into question the validity of a 60/40 stock/bond portfolio despite its good run over the past few years, and amazing rally off the 2009 lows.

First, BMO talked about the dangers of a 60/40 portfolio.

As we move further away from the Great Recession, the traditional 60/40 portfolio faces headwinds that have not occurred for much, if any, of its existence, [mianly] a significant assumption within the 60/40 paradigm — historically strong bond returns with low volatility — is no longer realistic with low bond yields in the current environment.

Now, a new McKinsey report is out, and it is calling on investors to lower their expectations for traditional portfolios, with a rather grim outlook:

Our analysis suggests that over the next 20 years, total returns including dividends and capital appreciation could be considerably lower than they were in the past three decades. This would have important repercussions for investors and other stakeholders, many of whom have grown used to these high returns.

Most investors today have lived their entire working lives during this golden era, and a long period of lower returns would require painful adjustments. Individuals would need to save more for retirement, retire later, or reduce consumption during retirement, which could be a further drag on the economy. To make up for a 200 basis point difference in average returns, for instance, a 30-year-old would have to work seven years longer or almost double his or her saving rate.

We’ll be the first person to say that making a 20 year prediction is an egregious thing to do, and as far as these outlier bets go – it’s a safe prediction because there’s no real consequence of being wrong. But before we dispel the thought, let’s take a look at why they believe we should expect lower returns from stocks and bonds.

Lowing Expectations

Their logic is based on the tried and true predictive science of… it’s been this way for so long, and gone down so much; it’s bound to go back the other direction. Now, things do cycle and bounce back and revert to different forms – but that isn’t foolproof,  as the old line about markets remaining irrational longer than you can remain solvent tell us. But their analysis isn’t so much that the conditions that have existed will reverse themselves, as it is those conditions are highly unlikely to persist.  Bonds can’t go from 1% to -10%,  the same way they’ve gone from 10% to 1%, for example. (or can they? Welcome negative interest rates).

Now, McKinsey goes a little deeper than just saying things aren’t likely to be as beneficial – they put their best factor analysis hat on showing how equities find their returns in a not so easy to understand chart.

Stocks Return Drivers

Asset Managers Shift towards Alternatives

Suffice it to say there’s a lot of tailwinds needed to push equity prices higher – which isn’t necessarily the case with alternative investments, which react differently when interest rates go up and when corporate profits struggle; McKinsey doesn’t miss a beat on this – broaching the topic of how asset managers may be affected by this potential drop in returns:

McKinsey’s asset management practice research shows that investment flows are increasingly moving away from active investment in equities, and toward passive equities, active or passive fixed income, or to alternatives and multi-asset products. For example, there was a net global outflow of €2.36 trillion ($2.66 trillion) from active equities between 2009 and 2014, compared with a net inflow of €1.43 trillion ($1.61 trillion) and €1.06 trillion ($1.19 trillion) into multi-asset and alternatives respectively.65 It is important to note that some alternative investments are a zero-sum game, in which one investor’s gains are another’s losses.

One option would be for them to include more alternative assets such as infrastructure and hedge funds in the portfolios they manage. Such alternative assets already account for about 15 percent of assets under management globally today. Flows into such alternative investments have outpaced flows into more traditional assets by three to six times. Institutional investors remain positive about growth prospects of alternatives, and asset managers serving them may consider boosting their exposure to these investments.66 Asset managers will also need to look at their organizational capabilities and processes to ensure that they have the skills to implement these alternate investment approaches.

Pensions Funds are at Risk

And what about the largest investors of all – the massive Pension Funds out there. What does McKinsey see there?  Well, it’s not like we didn’t know there was a problem, but their stats on the pension crisis are alarming, quoting that 90% of the state and local employee funds are underfunded, with a funding gap of $1.2 Trillion.

This is all the more worrying because most pension funds are still assuming relatively high future returns of about 7.5 to 7.7 percent in nominal terms. An analysis of more than 130 state retirement funds showed that the median expected future returns (based on the discount rate used) was 7.65 percent in 2014. While this marked a decline from 8 percent in 2012, it could still be above the returns in our growth-recovery scenario. To deliver this 7.65 percent nominal return would require a real equity return of 6.5 percent, if real fixed income returns are 2 percent and inflation is also 2.4 percent. If fixed income returns were lower, at 1 percent in real terms, this would imply real equity returns of about 7 percent.

If returns match our slow-growth scenario, the $1.2 trillion funding gap for state and local funds could grow by about $1 trillion to $2 trillion, assuming a portfolio of 30 percent bonds and 70 percent equities. In our growth-recovery scenario, the gap could grow by as much as about $0.5 trillion.

There are some out there that think this is just some pretty charts not to be given too much consideration. With interest rates, inflation, GDP, and corporate profits ripe for change; can we really expect the same tail winds we’ve had. If not, will their be new tailwinds?  That’s left to be seen, but we will say that no matter what the expected returns are, this is why investors are allocating to alternative investments. They let investors do something about the uncertainty.

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