In the field of investing, the question of which assets to own and how much of each asset to own is an eternal one. Since asset blends and proportions have a large impact on portfolio performance, the importance of asset allocation cannot be overstated.
The Old Fashioned Approach
For decades, many advisors and clients have adopted a long-term strategic approach that allocates X% of a portfolio to stocks and Y% to bonds. A common allocation is a 60/40 portfolio, typically referred to as a “balanced” portfolio. One of the reasons for this approach is that stocks and bonds often move in different directions. Bonds act as ballast, or a stabilizer, for the generally higher but more volatile returns from stocks. This form of asset allocation has provided good returns while incurring substantially less risk than more aggressive options. The chart below shows a 37-year history of the S&P 500 Total Return Index, the Barclays US Aggregate Bond Total Return Index, and a 60/40 mix of the two, rebalanced monthly.
As you can see, the 60/40 stock/bond mix was less volatile than the S&P 500 alone, and posted much higher returns than a 100% bond investment. Intuitively, one would expect this result.
GROWTH OF ONE HUNDRED DOLLARS
Data Source: Morningstar
In the table below, we show investment returns for this “balanced” approach since 1980. Note that the 60/40 mix had a higher Sharpe ratio, indicating a higher risk-adjusted return, than either 100% stocks or 100% bonds. The diversifying effect worked! Sharp ratio is a measure of units of return per unit of risk.
RETURN-STANDARD DEVIATION-SHARPE RATIO
Data Source: Morningstar
Forward-Looking Expectations Are Low, and May Remain Low For Long
While this familiar 60/40 asset allocation approach worked well in the past, we believe that given today’s extraordinary market climate, investors should consider adding two additional Asset Classes to their portfolios; Alternative investments and Tactical investments.
Following a historic, multi-decade rally in bonds and a recent surge in stock market valuations, many investment experts, including pension professionals, are forecasting lower stock and bond returns in upcoming years.
As shown in the following table, forecasts from notable financial institutions for a 60/40 balanced allocation are considerably lower than the historical experience shown in the above table. Keep in mind, all the investment returns shown in these two tables are for market indices, which have zero management, trading, and advisory costs. To account for “real-life” experience, returns should be lowered by more than 1% per year. Doing so results in a forecasted return in the below table of about 3.36% (4.36% – 1.00%) per year, which is about 65% below the adjusted 37-year trailing return of 9.40% shown in the above table (10.40% – 1.00%). Remember, past performance is no guarantee of what will happen in the future.
CAPITAL MARKET ASSUMPTIONS (CMA)
2017 CMA Projections – Data Source: BlackRock, BNY Mellon, JP Morgan
Volatility Requires a Buffer
The stock and bond markets will not rise steadily over the full forecast period; there are inevitably short to intermediate time periods representing opportunities to outpace the market through either offense or defense. These opportunities can be lost when using a permanent, strategic asset allocation.
The following chart shows the S&P 500’s performance over the 13-year period ending 12/31/2012. While it declined about 3% over that period, there were two market advances of approximately 100% and two declines of about 50%.
BULL & BEAR MARKETS OF THE S&P 500 (2000-2012)
Chart courtesy of StockCharts.com. Commentary and opinions are those of Hanlon Investment Management.
A permanent, stock/bond asset allocation cannot take advantage of these market swings and relies solely on the bond component to soften the impact of the large stock setbacks.
Stocks and Bonds are Growing More Correlated
Unfortunately, the shock absorber effect of having bonds in a portfolio may not be as beneficial as it used to be. In the past, bonds helped mute downside moves in the equity markets because historically, bond prices tended to move in opposite directions of stocks. However, that relationship may be changing.
As shown in the next chart, the historically negative investment return correlation of stocks and bonds has, in recent years, weakened. When the line in the graph is high and positive, it is bad for diversification and it is less effective. Conversely, when the line in the graph is low and negative, it means diversification is more effective and better. There appears to be more and more above the line moments (shaded areas).
HIGHER STOCK-BOND CORRELATIONS HAVE HISTORICALLY UNDERMINED DIVERSIFICATION
Lower Bond Yields Mean Higher Bond Risks
The risk-reducing potential of bond investing has also been undermined by the 37-year bond bull market, which has created a historically low interest rate environment.
The lower a bond’s yield, the more the bond’s price will respond to moves in interest rates. Take, for example, a 20-year US Treasury bond purchased at par value ($1,000 per bond) with a 2.5% coupon. If interest rates were to rise to 4.5% over the next year and a half, the price of the bond would drop by 14%. That’s a considerable risk, particularly for investors, such as retirees, who may need to tap their principal for spending needs. The net return to an investor in that year and a half would be a loss of more than 10%!
The following table highlights various interest rate sensitivity scenarios over 6-month, 1-year, and 1.5-year time periods. It shows the higher risk from a static, buy-and-hold allocation to bonds.
INTEREST RATE SENSITIVITY ANALYSIS
You can see from the chart below, the current interest rate for U.S. long-term treasury yields (based on the US 10-Year Maturity) is lower than 93% of the monthly observations since 1880, a span of 137 years. Since bond prices and yields move in opposite directions, and since there’s not much room between current 2.3% yields and zero, bonds do not have a lot of room for appreciation and could be in for principal losses.
A HISTORY OF THE US 10-YEAR TREASURY INTEREST RATE
What’s An Investor To Do?
How can investors mitigate the large fixed income risks built into a traditional, 60/40 asset allocation mix? Is there a better asset allocation?
TRADITIONAL STRATEGIC 60/40 ASSET ALLOCATION
We think there is. Investors should consider blending in Tactical and Alternative investments. These Asset Classes can exhibit lower correlations with stocks, therefore adding them to a traditional 60/40 portfolio provides an additional source of diversification beyond low-yielding bonds.
As a variation to the traditional 60/40, we recommend investors consider a 35/25/20/20 allocation: 35% stocks (growth), 25% bonds (income), 20% Tactical, and 20% Alternatives, or what we call our “GITA” allocation. We use this type allocation in our Hanlon “All-Weather” Models, which are designed to be an asset allocation for all environments, especially today’s.
NEW “ALL-WEATHER” 35/25/20/20 (BALANCED) ASSET ALLOCATION
By introducing Tactical and Alternative Asset Classes, the All-Weather models address the challenges that severely undermine the traditional strengths of the 60/40 strategic asset allocation, namely stretched equity values and low interest rates, and attempt to better position investors to navigate today’s investment environment.
The Alternative allocation seeks to address the phenomenon of increasingly correlated stock and bond returns by introducing a further source of diversification. The Tactical allocation provides a substitute for ultra-low-yielding bonds, generating a higher rate of income with potential for growth, while actively managing the downside risk.
When you evaluate the Tactical allocation portion of the portfolio, keep in mind that the goal is the same as that of the traditional 40% bond allocation, to protect the portfolio from volatility and drawdowns, but the Tactical allocation has an advantage of a potentially higher rate of return, particularly since now U.S. Treasuries offer such low yields. We think this may provide an improved risk/return proposition for investors.
Asset allocation is a constantly evolving art form. While 60/40 is a nice starting point, modern investors should consider a better approach. Correlation assumptions and interest rate projections have clearly changed in recent years; investors need to make sure their asset allocation keeps pace.
The S&P 500 TR index is an unmanaged index US large-cap stocks, and is widely used as an indicator of US market trends. Bloomberg Barclays US Aggregate Bond TR index tracks the broader US Investment-grade, fixed-rate, and taxable areas of the bond market. Indices cannot be invested in directly. There is no guarantee that a diversified model will outperform a non-diversified model in any given market environment.
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