• 60/40 Portfolio Asset Allocation: Expensive Equities & Risky Bonds
  • An Imperfect Solution in a Land of Low to Negative Yields
  • Conclusion: The Benefits of Balance

Asset Allocation: Expensive Equities & Risky Bonds

Having noted that Warren Buffett’s favorite aggregate valuation metric was above levels seen at the peak of the dot.com bubble, we penned Why Market Neutral Now in January 2020. That paper documents the benefits of owning investment products agnostic of market direction that strive to preserve and compound wealth slowly, particularly during periods of elevated market valuations. Despite insisting that we lacked any ability to time markets, when merely weeks later equities experienced their sharpest and most violent decline since the great depression, Kailash would be lying if we did not admit to feeling intelligent. That feeling proved ephemeral as the crash lasted only 23 trading days, and US markets have since recovered nearly all losses.

The statement, “US markets have recovered nearly all of their losses,” underpins the purpose of this paper. Once again, Kailash attests to the obvious – we have no capacity to time markets but they are once again expensive relative to history. While a poor timing tool, the brief but violent sell-off that followed February 19th wiped out all market returns since 2017, as documented in our paper Crashes: When Losers Become Leaders. Kailash’s piece Value Investing & Manias documented that growth and value spreads have blown out to levels not seen since 2000. We believe this near-record dispersion in equity valuations offers allocators a solution to the increasingly difficult problem of sourcing non-correlated returns from nearly-zero yielding bonds in a world where 60/40 portfolios offer minimal diversification benefits.

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Figure 1 shows the compound return on a dollar getting long the cheapest decile of firms based on price to sales while being short the most expensive decile. With 0 net exposure, an investor following this naïve approach would build wealth over time. Kailash believes the period into the peak of the internet mania, GFC, and the period following the start of 2017 are informative, as indicated by the bubbles within Fig. 1. In the prior periods, value stocks have been ruthlessly punished by their growth peers resulting in meaningful losses for someone invested in such a naïve strategy. Subsequent to such periods, however, the benefits of sticking out the pain resulted in immense returns as value stocks went on to trounce their growth peers.

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FAQ

What is the Average Return on a 60/40 Portfolio?

60/40 Portfolios’ historical returns came in at around 8.25% over the last 30 years.  They have offered investors a simple and elegant way to capture both the longer-term upside in equities while benefitting from capital preservation through the component allocated to bonds. Traditionally, when equity markets fell, bonds would often rise with yields tightening. This concept has become nearly ubiquitous with few even contemplating the idea that the 60 40 equity bond allocation exposes investors to the most expensive stocks and most expensive bonds simultaneously today.

Is a 60/40 Portfolio Still Good Investing?

KCR is obviously aware of the precedent for negative yielding bonds that has now become oddly common. Yet we do not feel comfortable wagering on bonds rising to a level where they provide a guaranteed loss as a means of healthy diversification. The new 60/40 portfolio, in our view, requires sourcing non-diversified returns that put primacy on capital preservation and compounding. Adding alternatives to 60/40 portfolios is, in our view, a healthy and simple way to do this but it requires the right type of alternative. There is growing evidence that many venture capital, private equity and even some popular hedge funds are creating returns that look to be little more than supercharged beta.

What is 60/40?

The Basics from External Sources

For further insight on 60/40 portfolios we encourage people to visit Vanguard, Fidelity, Blackrock.  These firms offer various perspectives on 60/40 portfolios’ pros and cons and we encourage people wedded to this philosophy to do their homework.  If we should see an outbreak of price increases akin to the Great Inflation of the 1970s, 60/40 portfolios may get hit with a dual shock as both equities and bonds fall in tandem.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.