If you had been an American institutional investor over the past 30 years, what has been the traditional asset split, 60% equities and 40% bonds, might have performed to expectations. There’s two reasons for that. One is that stocks offered outstanding returns in first 20 years, before faltering after the tech crash. The second is that bonds, over the past 30 years, have not only stabilized portfolios, but matched equity returns.
But that means there’s something curious going on, since bonds, over long business cycles, are supposed to return less than equities – according to settled academic wisdom.
Bradley Jones, Macro Investment Strategist at Deutsche Bank thinks otherwise. In a recent presentation Rethinking Portfolio Construction and Risk Management: A Third Generation in Asset Allocation, he suggests “allocating capital across asset classes and investment styles represents superficial diversification if payoffs are exposed to the same set of risk factors. Diversification based on underlying risk factors or return sources, not historical correlations over a select sample period plugged into a MV optimizer, should be the building blocks of portfolio construction.“
This, arguably, is another assault against the hugely weakened fortress of modern portfolio theory What it gets at is something beyond just the equity risk premium that is presumed to prevail in “normal” markets.
Argues Jones: “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures.”
Among those risk exposures are a class of beta premia, such as bond duration and commodity risks; style risk premia, such as value, momentum and volatility; and systemic or macro risk premia, such as liquidity and sovereign risk.
Where the 60/40 portfolio fails, Jones thinks, in assuming that long-term average returns are indifferent to particular economic regimes. “Long waves of feast or famine are the rule for returns
… returns are regime dependent, not randomly distributed ,” he writes. Thus, the 60/40 portfolio has been underwater, post-inflation, for the U.S. since 2000. For Japan, the real drawdown extends back to March 1987.
Looking forward, the prospects of a 60/40 portfolio don’t look much happier, in real return space. “We estimate real 10-year stock returns at 2.1% and real 10 year bond returns at -0.3%” which would leas or a real annualized return of 1.1%.” Not a prospect that pension plan sponsors are going to find encouraging.
Nor will naive hedge fund investing sort through the problem, since, given an investment regime, hedge funds are no more diversifiers than bonds. Instead, to capitalize on an investment regime, Jones suggests looking at momentum factors – which, by definition, only work for a short period – and tilting towards value stocks.
Not news for plan sponsors working their way through the debris of past decade’s markets. But certainly a reason to put risk and risk premia over projected returns.