A traditional standby for long-term investors — the balanced portfolio of 60% stocks, 40% bonds — has come under fire in some quarters amid year-to-date losses and bleak prospects for fixed-income markets.
Within the ETF industry, some of the most outspoken critics are providers of alternative investments. Among them is Julian Klymochko, CEO and chief investment officer of Accelerate Financial Technologies Inc.
The 60-40 portfolio, Klymochko said, has benefited massively from a 40-year bull market in bonds, as declining interest rates pushed bond prices upward. Now that this trend has reversed, he added, “40% allocated to fixed income in a rising-rate environment is very dangerous.”
Furthermore, the Calgary-based hedge-fund manager said bonds are failing to provide adequate diversification, noting that both stock and bond markets are down in the first four months of this year. “People thought that bonds diversified their stocks, but that has a limit,” he said. “In fact, stocks and bonds are now positively correlated.”
The solution, as Klymochko and many other fund sponsors are touting, are investments that have different factors driving their returns than those of core asset classes. There are alternative strategies such as long-short equities and arbitrage, assets such as precious metals, commodities and cryptocurrencies, and private equity and private debt.
Klymochko said both sides of the 60-40 portfolio could be trimmed in favour of alts, possibly to 50-30-20 or 40-30-30. “As long as the alternative portion is around 20%,” he said, “that’s there to provide more diversification with the goal of improving client outcomes, increasing returns while reducing risk.”
Depending on client preferences, the diversification principle can also apply to the alternatives portion of the portfolio. For example, Accelerate OneChoice Alternative Portfolio ETF provides exposure to 10 alternative investments: long-short, arbitrage, bitcoin, gold, real estate, infrastructure, mortgages, leveraged loans, enhanced equity and risk parity.
For income-oriented investors, a current frustration is that fixed-income yields are well below inflation, which rose 6.7% over the 12 months ended in March.
Prospects for fixed income should improve over a 10-year time horizon, according to FP Canada’s newly updated projection assumption guidelines for financial planners, effective April 30. The guidelines call for financial plans to assume fixed-income returns of 2.8%, and an inflation rate of 2.1% that is well below the current level. These guidelines are before fees and expenses, so projected returns to investors are even lower.
Because of the continuing outlook for low fixed-income returns, investors and their advisors should be rethinking the 60-40 mix, said Paul MacDonald, chief investment officer and portfolio manager with Oakville, Ont.-based Harvest Portfolios Group Inc. In the year to date, “there’s not one bond ETF that’s in positive territory at a time when you really want that portion of your portfolio to be working.”
And even though bond yields are moving higher, they’re not keeping up with inflation, resulting in negative real yields. “Each person is going to be different,” said MacDonald. “But I would suggest anybody relying on their portfolio for income really needs to be thinking about how they’re going to keep their purchasing power positive, and be able to basically generate income from their investments.”
Harvest’s suggestion is to diversify into equities ETFs that employ covered calls, which happens to be the main product line of its $2.2-billion ETF family. By writing covered calls on some or their equity holdings, these funds generate above-average cash flow while limiting potential gains in rising stock markets.
A new industry-diversified diversified covered-call ETF is Harvest Diversified Monthly Income ETF, launched in February. It holds equal weightings of five Harvest covered-call ETFs that provide exposure to technology, health care, U.S. banks, utilities and “global brand leaders.”
Other ETF providers with extensive covered-call offerings include BMO Investments Inc., CI Global Asset Management and Hamilton Capital Partners Inc. These types of strategies, MacDonald said, “make a lot of sense for those who don’t mind giving up some of the upside in order to get that bird-in-the-hand cash flow.”
Because of elevated equities valuations and the current environment for bonds, the roughly 9% average annual returns of a 60-40 portfolio over the past decade are probably unsustainable over the next 10 years, said Tim Huver, head of distribution with Vanguard Investments Canada Inc.
The $2.2-billion Vanguard Balanced ETF Portfolio, with its 60-40 mix of index ETFs in seven core asset classes, had double-digit returns for three consecutive calendar years ended in 2021, but as of April 30 had lost 9.3% in 2022.
Investors need to “reset” their expectations to what Vanguard believes will be more moderate returns in the future, Huver said. “However, those key benefits of the 60-40, the diversification, the shock absorption of the bonds within that portfolio to equities, we believe will be preserved over the long term.”
Huver emphasized the very broad diversification of the Vanguard ETF, which has exposure to more than 25,000 securities, and the historically strong risk-adjusted returns over time of a 60-40 core strategy. “If you look at some of the additional asset classes that could potentially be added, you’re increasing potential complexity, increasing volatility, and potentially increasing cost.”
While acknowledging the adverse effect on bonds of rising interest rates, Huver noted that over time the Vanguard Balanced strategy will hold bonds that pay higher interest rates, “which over the long term should benefit investors.”
Nor does a core holding in a 60-40 product preclude investors from adding complementary asset classes, Huver said. “For investors who may have a higher level of sophistication or have greater comfort with adding additional tactical weights to that portfolio, they can also do that outside of this particular product as well.”